Tax IA Outline Tax IA Outline Analysis Tips: 1. 2. 3. 4. 5. 6. 7. I. Is it a receipt or disbursement?

Look at the relationship between the parties: buyer/seller, H&W, Parent/child, ee/er. Look at the transaction setting: donative or bargained for, arms length, unintended transactions, and windfalls. Look for an exchange mode. Look to general rule first, then to exceptions. What are the values? Focus in on what is relevant. Everything does not require hornbook treatment. Introduction A. Tax Policy Measuring the tax burden based on your ability to pay. A matter of yield: how much revenue you want to collect and the role of government. The government can subsidize or discourage a particular activity through the tax code. The higher the tax rate you are in, the better the subsidy for preferred activities. The taxing formula reflects policy: certain non-discretionary business expenditures are above the line deductions while other personal discretionary expenditures are below the line deductions. Implicit in the taxing formula is the government policy not to tax those below the poverty line: the personal exemption and standard deduction are figured so those at the poverty line pay a zero tax rate. The standard deduction depends upon your filing unit. The Alternative Minimum Tax (AMT) was created for policy reasons: some wealth taxpayers were taking advantage of preferences in the code to zero out their taxes. Under the AMT, they have to pay some minimum level of tax.

Tax IA Outline B. Tax Planning Ask: What is the income/deduction? Whose income/deduction is it? When is it taxable?

3 Basic planning ideas: 1) Conversion-can we convert a dollars character from taxable to deductible or tax it at a lower rate? 2) Whos income can it be shifted from A to B 3) Deferring income to other years When you analyze a code section, try to fit it in one of these 3 categories. C. Sources of Tax Law Primary Sources________________ 1) 2) Internal Revenue Code (IRC) of 1986 Regulations regs - issued by the Treasury Dept/IRS

*Courts give the regs tremendous difference. **Note the effective date of the reg, they can be retroactive. The effective dates are not in the IRC. Secondary Sources________________ 1) House reportlegislative history 2) Courts Opinions of the U.S. Supreme Court. Appellate Courts. Then Tax Court. IRS Revenue Rulings issued by the IRS to the local offices so rules are uniform. Rev rulings are binding on the IRS, but not the taxpayer. It is useful b/c it informs the taxpayer of the IRS position. Revenue Procedures Private Letter rulings like a pre-audit a private taxpayer gives the IRS a detailed description of a proposed transaction and asks for an advisory opinion on the tax consequences. Not given the weight as a revenue ruling, but still useful.

3) 4)

Tax IA Outline D. Tax Legislation When the Ways and Means /Committee of congress brings a bill back to the floor of the House, a report accompanies the bill. The report seeks to explain to the other House members just what the bill is designed to do, usually with illustrations. Later, when the Finance Committee reports its bill to the Senate, another committee report emerges. In addition, the Joint Committee on Taxation (JCT) issues a bluebook explanation of the Act that explains the ambiguities etc.. These reports are the most important part of the legislative history of a statute and the courts often resort to them as guides to the meaning of the legislation. Especially in the early life of a statute when there arent any regulations or case law. E. Tax Procedure Taxpayers have a duty to file a tax return and pay the tax, if not, they are penalized. Get a statutory notice if you under pay and continue to dispute If there is a dispute, the IRS will send a revenue report (30 day letter) where you have 30 days to appeal it with an appellate conference. If you continue to dispute, you receive a Notice of Deficiency (90 day letter). Now you have 90 days to petition tax court if you wish to continue the dispute. There are no extensions to the 90-day letter. In tax court, the taxpayer is the petitioner and the commissioner is the respondent. During the 90-day process, the IRS is precluded from doing anything against you. In tax Court, you can litigate the matter before paying the deficiency, but if you lose, you are liable for interest and penalty all the way back. To do it another way: if under the 30-day letter, you can pay the tax and file an amended return asking for a refund. If after 6 months the IRS does not give notice of a refund, you may file in the US Court of Claims or US District Court. **To go the Claims Court or US District Court route, you must pay the full tax first.** The IRS has power to collect only after giving notice to the taxpayer. The IRS cannot make an assessment without giving notice or the taxpayers DUE Process rights are violated. The notice must be timely. **Note: In tax court, the facts are largely stipulated by the parties and not in dispute. The Board of Tax Appeals (BTA) used to be an administrative court, but it was later peeled out into an independent court.

Tax IA Outline II. Gross Income A. What is GI? First begin with the Code, and then go to the Regs, then to case law. Subtitle A IRC 61 Gross Income Defined (a) Except as otherwise provided in this subtitle, gross income means all income from whatever source derived, including (but not limited to) the following items: 1) Compensation for services, including fees, commissions, fringe benefits, and similar items; 2) GI derived from business; 3) Gaines derived from dealings in property; 4) Interest 5) Rents; 6) Royalties; 7) Dividends 8) Alimony and separate maintenance payments; 9) Annuities; 10) Income from life insurance and endowment contracts; 11) Pensions; 12) Income from discharge of indebtedness; 13) Distributive share of partnership GI; 14) Income in respect of a decedent; and 15) Income from an interest in an estate or trust. 61 is very broad and not limiting. Although the laundry list doesnt say wages, it is included in GI. What does the Regs add to the meaning of GI?
There is no limit to the form of

income

1.61-1: (a) Gross income means all income from whatever source derived, unless excluded by law. Gross income includes income realized in any form, whether in money, property, or services. Income may be realized, therefore, in the form of services, meals, accommodations, stock, or other property, as well as in cash. GI is not limited to only those items enumerated in 61. 1.61-2: Compensation for services, including fees, commissions, and similar items: (a)(1) Wages, salaries, commissions paid salesmen, compensation for services on the basis of a percentage of profits, commissions on insurance premiums, tips, bonuses (including Christmas Bonuses), termination or severance pay, rewards, jury fees, marriage fees, and other contributions received by a clergyman for services, pay of

Labor/ barter

Tax IA Outline persons in the military or Naval forces, retired pay of employees, pensions, and retirement allowances are income to the recipients unless excluded by law. (d) (1) Compensation paid other than in cash: Except as otherwise provided, if services are paid for in property, the fair market value of the property taken in payment must be included in income as compensation. If services are paid for in exchange for other services, the fair market value of such other services take in payment must be included in income as compensation. If the services are rendered at a stipulated price, such price will be presumed to be the fair market value of the compensation received in the absence of evidence to the contrary. (d) (2) i if property is transferred by an employer to an employee or if property is transferred to an independent contractor, as compensation for services, for an amount less than its fair market value, then regardless of whether the transfer is in the form of a sale or exchange, the difference between the amount paid for the property and the amount of its fair market value at the time of the transfer is compensation and shall be included in the gross income of the employee or independent contractor. In computing the gain or loss from the subsequent sale of such property, its basis shall be the amount paid for the property increased by the amount of such difference included in gross income. 1.61-14 (a) Miscellaneous items of gross income. (These are one-sentence summaries of case law.) In addition to the items enumerated in 61(a), thee are many other kids of gross income. For example, punitive damages such as treble damages under the antitrust laws and exemplary damages for fraud are gross income (Glenshaw Glass). Another persons payment of the taxpayers income taxes constitutes gross income to the taxpayer unless excluded by law (Old Colony Trust). Illegal gains constitute gross income (James). Treasure trove, to the extent of its value in United States currency, constitutes gross income for the taxable year in which it is reduced to undisputed possession (Cesarini). ** The general rule is all income is gross income unless excluded. The burden of proving an exception is on the taxpayer (b/c the taxpayer has the facts). Exceptions to gross income are narrowly construed against the taxpayer. B. Equivocal Receipt of Financial Benefit Case law on GI

Tax IA Outline Taxpayer deficiency went thru tax court Commissioner v. Glenshaw Glass -1955 U.S. Supreme Court Taxpayers were awarded punitive damages as a result of antitrust litigation. TP included compensatory damages in GI, but excluded the punitives. IRS claimed a deficiency. I. Whether money received as exemplary damages or as punitive damages are GI. RoA: in favor of IRS H. A taxpayer has GI when there is 1) an undeniable accession to wealth, 2) clearly, realized, and 3) over which the taxpayer has complete dominion. (This is a positive definition, with these 3 things present, and then you have income.) The income tax is source blind, and any measurable gain is within its reach. Nothing in the Code excludes punitives from GI. Gains or Profits derived from any source gives Congress full taxing power, and is given a liberal construction by the courts. The mere fact that punitives are punishment for wrongdoing does not change the character of what they received (taxable income).

Distinguished: Eisner v. Macomber, which had described income as the gain derived from labor, from capital, or from both combined. In Glenshaw, the court said this definition was too limited and is not the touchstone to all questions of GI. Important notes from Glenshaw: * The IRS subtracted the amount of attorneys fees from the punitive award to calculate the deficiency. This net amount of the punitive award reflects the policy to deduct business expenses incurred in pursuit of income (Cost of Doing Business or CODB). * The TPs made 3 arguments: The first is a statutory argument, that punitives arent listed in the code as income, that is, punitives are windfalls not listed as GI (the court said this definition Code is broad and given liberal construction); second they argue case law, that was Eisner (which the court distinguished), and third, they argued when congress reenacted the statute, they didnt reject the holding in Highland (held punitives not taxable) and explicitly include punitives in GI (the court rejected this b/c they said congress wasnt aware of the Highland holding). IF using ch 10, see ftnt8 If this had been an award of personal punitives (awarded to a person rather than a company), the court May have decided the case differently: b/c personal injury

Tax IA Outline recoveries are treated as a return of capital and not taxable. **So the setting of the transaction is important* What do the elements of Glenshaw mean?: *Assession to wealth new wealth you didnt have before; it calls for a measurement of the TPs personal wealth from one point in time to another (usually one year). Only an increase in wealth is taxed. Borrowing doesnt increase your wealth b/c you have to repay it. A return of capital is not an increase in wealth, it is your old wealth coming back to you. Wealth has a value in the market. Cash and non-cash property can increase wealth. *Clearly realized when the benefit is sufficiently in hand to be taxable; realization is tied to timing: if your asset appreciates in value, your wealth may have increased, but you dont have income until it is sold. This sale is a closing transaction using an exchange model. This realization concept, requiring a closing transaction, helps avoid the constant valuation of assets you own. Self created property is not income until you sell it. Unrealized appreciation of assets is not income. *dominion means who is in charge of the wealth or property. It is broader than physical possession or legal ownership and includes who controls the property is substance. Ownership and possession are not defined in the regs, but is defined under the c/l of the state. Dominion also supports when (timing) it is income: ex: when reduced to undisputed possession.

Treasure trove

Cesarini v. U.S. 1969 U.S.D.C. of ND of Ohio TP found money in a piano they had purchased used. After including it in GI and paying the tax, the TP filed for a refund, which was rejected. I. Whether found money is GI to the finder. RoA: for IRS. H. Income from all sources is taxed unless the tax can point to an express exemption. Windfalls, including found money, are properly included in GI. Rationale: 61 says all income from whatever the source, the taxpayer must point to a specific exclusion to escape taxation.

Tax IA Outline Rev ruling 61 treasurer trove is taxable in the year when it is reduced to undisputed possession. Finder of lost property gets superior title when the property is found under the c/l, so the S of L begins running when found. Possession of the money was undisputed when it was found in 1964.

Notes from Cesarini: The taxpayer made 3 alternate claims: 1) The money wasnt income under 61; the court said all income from whatever source derived 2) If it wasnt income, the tax was due in 1957 when piano was purchased and the s of L had run; the court said it was reduced to undisputed possession in 1964, so that began the S of L running 3) It is a capital gain, taxed at the lower rate; the court rejected this too. Cesarini is important b/c it tells us the important interaction of federal and state law. State law here tells us what ownership and when there is possession.

Old Colony Trust v. Commissioner US 1929 a corporation, by resolution of the Board of Directors, agreed to pay the income taxes (and did pay) of the company president. IRS claimed a deficiency. BTA ruled for IRS, Circuit Court of appeals ruled for TP. I. Whether the payment of an employees income taxes by an employer constitutes additional taxable income. RoA: reversed, in favor of IRS. H. The discharge by a third person (or party) of an obligation is equivalent to receipt of income by the person taxed. Rational: Here the taxes paid by an employer upon a valuable consideration, namely, the services rendered by the employee, are part of the employees compensation and constitutes income to the employee. It is compensation, not a gift. Notes from Old Colony GI can be direct or indirect, the direction of the payment doesnt matter, and it was still compensation. Here the employee had dominion over the arrangement (dont pay me, pay the IRS or whoever, he induced the third party.

Tax IA Outline exam tip In an analysis, start with: what is the relationship between the parties? Here, employer and employee. What is going on? Why is it happening? Here there was an exchange model working, even though the payments were indirect: the employee got the equivalent to receipt of the income. Charley v. Commissioner -USCA 9th cir 1996 TPs employer was charged by the travel agent for the TP to fly first class, but the TP would arrange for a coach ticket, which he upgraded to first class with his frequent flyer miles he earned in connection with his business travel. He received $3,149 in his personal travel account from this exchange process. I. Whether travel credits converted to cash in a personal travel account established by an employer constitutes GI to the employee. RoA: Tax court was affirmed for the IRS, but the penalty reversed b/c the TP didnt know travel credits were taxable and they did not try to conceal it. H. Travel credits which a taxpayer receives as compensation or as property with a zero tax basis, is taxable as GI to the TP. The TP was wealthier after the transaction than before (accretion of wealth is the receipt of income) The funds/money in the account came from the employer, so it is compensation TP had no basis in the frequent flyer miles, which were earned by the employers travel.

Notes from Charley the court here began with the Code, then Glenshaw and the 3 elements. The court found it as additional compensation; there was a realization when the credits were converted to cash. Here there was an exchange model working between an employer and employee. Although the TP made a definitional argument (it is not income), the code is source blind and the TP was wealthier. Same analysis: who are the parties and what is their relationship? Close relationships are given more scrutiny. What is being exchanged? Helvering v. Clifford -USSC 1940 H created a short term trust for his W, who was to have exclusive benefit of the net income. However the H, as trustee, had absolute discretion over how much of the net income was to be turned over to his W.

Tax IA Outline He also retained control over the assets, ex: selling, exchanging, mortgaging Also certain items, such as extraordinary cash dividends were to be treated as principal, not income. W didnt have any rights or control of over the income until it was actually paid to her. IRS claimed deficiency; BTA ruled for IRS, the Circuit Court reversed.

I. Under what circumstances may the grantor of a trust still be treated as an owner of the corpus (principal) and liable for the taxes? RoA: Circuit court of appeals was reversed in favor of the IRS. H. A grantor is considered owner of a trust when the trust is of a short duration, the income remains in the family, and the grantor retains practical control over the corpus (principal). 22 (61) language gives a broad sweep. The analysis depends upon the individual terms and circumstances of the trust. Case by case. The courts looks further than legal paraphernalia The trust was at best a temporary reallocation of income within an intimate family group The grantor didnt feel any poorer after the trust was executed. The grantor retained control of the principal, and still had the same bundle of rights.

Notes from Clifford: the H(grantor) still retained dominion over the property, and in substance, the owner. So dominion is a broader concept than just legal ownership (here the legal owner was the trust). C. Income Without Receipt of Cash or Property

Helvering v. Independent Life Ins. Co. -US 1934 This case raised a question whether a taxpayer must include in GI the rental value of a building owned and occupied by the TP. H The rental value of the building used by the owner does not constitute income within the meaning of the Sixteenth Amendment. **The potential use of your own property is not taxable: imputed income is not taxable.**

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Tax IA Outline Imputed income potential use of your own property not taxable b/c it is difficult to measure, also the TP doesnt have the cash to even pay the tax. If you later sell or rent the property then you have income: there is a closing transaction in an exchange model that increases wealth. Same with self-created value: if you fix up an old house you may increase your wealth by virtue of your own labor, but it isnt taxable until you sell it when there has been an exchange model. Dean v. Commissioner -USCA 3rd 1951 The Corporation owned by the taxpayer and his wife was indebted to the bank. The bank required the TP to transfer the ownership of the family residence to the corporation. The TP continued to live there rent-free. IRS claimed deficiency, tax court ruled in favor of IRS. I. Whether the rental value of property held in the name of a corporation of which the TP is the sole shareholder is GI to the TP. RoA: TAX court ruling affirmed in favor of IRS. H. The FMV of rental property held by a corporation and used as a personal residence by the TP is income to the TP. The TP has an obligation to provide a home. The corporation existence and transfer of property was bona fide. The bank could have taken the property if the corp defaulted.

Notes from Dean The courts viewed this as a barter exchange between employer (the corporation) and employee (TP), it was part of a compensation agreement. Since there was an exchange model here, the income is now no longer imputed. It is a realized benefit received by the TP. Non-cash transactions are income when it is compensatory or earned, true if there is a property exchange or barter. (Dean/Charley) However, Treasure Trove that is non-cash, such as a homerun baseball, may not be realized income b/c there has been no exchange model. But cash treasure trove (in US currency) is income per 1.61-14. Notes on measuring wealth/income: Taxable income under an exchange model: *Cash *Non Cash barter *Non-cash compensation *Non Cash property

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Tax IA Outline Taxable income without an exchange model: *Windfalls and treasure trove (in US currency) Not measured in wealth and is not taxable income: (b/c no exchange model or closing transaction, the income is not realized): *Imputed income *Unrealized appreciation of assets *Self created property Gross income includes the receipt of any financial benefit which is: I. Not a mere return of capital II. Not accompanied by a contemporaneously acknowledged obligation to repay III. Not excluded by a specific statutory provision Example of a revenue ruling: situation: an individual who owned an apartment building received a work of art created by a professional artist in return for the rentfree use of an apartment for six months. Law: Code 61 and reg 1.61-2(d)(1): the fmv of the work of art and the six months fair rental value of the apartment are includible in the GI of the apartment owner and the artist under 61.

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Tax IA Outline III. The Exclusion of Gifts and Inheritances A. Rules of Inclusion and Exclusion Congress has specifically excluded certain items from gross income. Explicit statutory provision takes precedence over the general definitions. Exclusions from GI are different from deductions. 102 is an exclusionary provision of the tax code. Exclusions are particular about the source of the income (as opposed to the general rule of 61 that gross income is source blind). So 102 doesnt care what type of property is, the concern is with the value and source. Exclusions are narrowly construed against the taxpayer. The section uses the word property, as opposed to income: it is the value of the property that is excluded, but not the income derived from that property. Property has two ways to create wealth: 1) appreciation and 2) dividends or income generated from it. Income from property is not excluded as a gift 102 (b)(2). I.R.C. 102 Gifts and inheritances. A) general rule gross income does not include the value of property acquired by gift, bequest, devise, or inheritance. B) Income subsection (a) above shall not exclude from gross income: 1) the income from any property referred to in subsection (a); or 2) where the gift, bequest, devise, or inheritance is of income from property, the amount of such income. (a) Where, under the terms of the gift, bequest, devise, or inheritance, the payment, crediting, or distribution thereof is to be made at intervals, then, to the extent that it is paid or credited or to be distributed out of income from property, it shall be treated for purposes of paragraph (2) as a gift, bequest, devise, or inheritance of income from property. Any amount included in the gross income of a beneficiary under subchapter J shall be treated for purposes of paragraph (2) as a gift, bequest, devise, or inheritance of income from property.(the income from a gift, bequest, devise, or inheritance is taxable.) (b) Employee gifts. (i) in general. Subsection (a) shall not exclude from gross income any amount transferred by or for an employer to, or for the benefit of an employee. (ii) Cross references employee achievement awards 74(c); de minimis fringes 132(e). Reg. 1.102-1 Gifts and Inheritances.

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Tax IA Outline A) General rule. Property received as a gift or received under a will or under statutes of descent and distribution, is not includible in gross income, although the income from such property is includible in gross income. An amount of principal paid under a marriage settlement is a gift. However, see 71 and the regulations there under for rules relating to alimony or allowances paid upon divorce or separation. 102 does not apply to prizes and awards (see 72 and 1.74-1) nor to scholarships and fellowship grants (see 117 and the regulations there under). Income from gifts and inheritances. The income from any property received as a gift, or under a will or statute of descent and distribution shall not be excluded from gross income under paragraph (a) of this section. Gifts and inheritances of income. If the gift, bequest, devise, or inheritance is of income from property, it shall not be excluded from gross income under paragraph (a) of this section. 102 provides a special rule for the treatment of certain gifts, bequests, devises, or inheritances which by their terms are to be paid, credited, or distributed at intervals. Except as provided in 663(a)(1) and paragraph (d) of this section, to the extent any g/b/d/I is paid, credited, or to be distributed out of income from property, it shall be considered a g/b/d/I of income from property. 102 provides the same treatment for amounts of income from property which is paid, credited, or to be distributed under a gift or bequest whether the gift or bequest is in terms of a right to payments at intervals (regardless of income) or is in terms of a right to income. To the extent the amounts in either case are paid, credited, or to be distributed at intervals out of income, they are not to be excluded under 102 from the taxpayers gross income.

B)

C)

Exclusions In general - 102 does not apply to prizes and awards (including employee achievement awards)(see74); certain de minimis fringe benefits (see 132); any amount transferred by or for an employer to, or for the benefit of, an employee (see 102(c)); or to qualified scholarships (see 117). Employer/employee transfers for purposes of 102(c), extraordinary transfers to the natural objects of an employers bounty will not be considered transfers to, or for the benefit of, an employee if the employee can show that the transfer was not made in recognition of the employees employment. Accordingly, 102(c) shall not apply to amounts transferred between related parties (e.g. father and son) if the purpose of the transfer can be substantially attributed to

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Tax IA Outline the familial relationship of the parties and not to the circumstances of their employment.

Gifts gift is not defined in the code Commissioner v. Duberstein US 1960 Duberstein: TP, a business executive gave a lead to a business associate; the lead proved fruitful and the associate gave the TP a new Cadillac. The associate deducted the cost of the Cadillac.

H. not excludable from GI. (The deduction taken by the donee indicated his intent wasnt to make a gift but as compensation for the lead, quid pro quo) Stanton: TP resigned from a management position with a church and the B of D voted to pay him $20K as a gratuity and in appreciation for his services rendered, plus release from any pension claim. Remanded to find more facts I. Whether payments made with business overtones are excluded from GI as gifts. H. Whether a transfer of money or property constitutes a gift within the exclusion of 102 is an issue of fact to be determined by the trier of fact. It is a case by case basis. Rationale: Very Important here! It is critical to ascertain the transferors intentions. A gift proceeds from a detached and disinterested generosity, out of affection, respect, charity or like impulses. The inquiry must be into the donors state of mind. Critical: the transferors intentions. There needs to be an objective inquiry, you cant take the word of the donor or donee that it is a gift. The donors characterization is not determinative. Decision of the issues in these cases must be based on the application of the fact finding tribunals experiences with the mainsprings of human conduct. The Statute is not complicated, the fact finder should be able to sort through it. The c/l definition of gift and the tax definition are two different things.

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Tax IA Outline Dissent: with all the individuals using their experiences, the tax code wont be uniform. Important notes: The IRS wanted the court to fashion a bright line test and say that gifts should defined as transfers of property made for personal as distinguished from business reasons. The court didnt like this broad test and rejected it as unworkable. The court relied on Cardozo: what is a business deduction is a question of fact. Congress responded to this case by codifying the IRSs proposed test in 102(c): now it is a matter of law that in the employer/employee setting that transfers are income and there is no need for a factual inquiry. The statute indicates a broad congressional intent to deny gift classification to all transfers by employers to employees. IV. Congress also responded with 274(b) that limits business gifts to $25. But under 102(a) there is still a factual inquiry. Analysis tips from Duberstein: facts are important in determining what a gift is!! Look at the relationship of the transferor and transferee. Here, the relationship is not in a family setting, but business. Look for a quid pro quo, like the lead for a car; the transferor didnt intend a gift b/c he deducted it; no one would have paid taxes on it if it was deemed a gift. **Go through the 3 elements of Glenshaw, then look for exclusions. The TP has the burden of proving the exclusion. The standard for review this court applies is the clearly erroneous standard. If a question of law, it is a de novo review, but if it is a question of fact, it must be clearly wrong in fact finding: a very high standard. So if a lower court finds the facts against you, you have a very hard time overturning that conclusion. If an independent contractor, maybe not an employee. Look to see if you are under 102(a) or (c). 102 makes a distinction between the value of property given and the income generated from property. Ex: the stock is the gift, the dividends are income. Inheritance Lyeth v. Hoey US 1938 TP is grandson of deceased, he challenged the will and the executors agreed to a compromise settlement where he received more than was in the will as

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Tax IA Outline written. Under state law, the extra money is considered to be acquired by contract and not inheritance. I. Whether property received by an heir in fact from the estate of his ancestor, when distributed under an agreement settling a contest of the will, is acquired by inheritance [within the meaning of 102(a)]. H. When the contestant is an heir in fact and a valid compromise agreement has been made and there is a distribution to the heir from the decedents estate accordingly, the property received is acquired by inheritance within the meaning of the statutory exemption. Rationale: A) The construction of an exemption in the federal statute is not determined by local law. B) State law determines the heir status, federal law determines the character of the property for income tax purpose. (state law determines who is an heir. C) Federal tax laws should be interpreted so to give uniform application to the nationwide scheme of taxation. State laws vary too much and not contusive to uniformity. D) State laws may control only when the federal taxing act by express language or necessary implication makes its operation dependent on state law. Notes: look at the origin of the claim. Here it is based on heirship. Look at the relationship between the TP, that status is determined by local law. After that, federal law kicks in. Similar to Ceseraini where state law determined what was possession. Even if the heir has to sue, he is still heir in fact and takes an inheritance. Death is not a taxable event for income tax purposes, not a realization. For Gross Income, it is source blind. But for an exclusion from Gross Income, it is source dependent. Wolder v. Commissioner - US 1974 TP and the decedent signed a K in which the TP would provide lifetime legal services with no charge if the decedent would bequeath certain stock to him in her will. The TP performed the services, and the decedent left him stock in her will. I. Whether the bequest in the will was inhered or postponed compensation.

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Tax IA Outline

H. Obligations for services rendered under K are postponed payments and taxable as income to the recipient, whether in the form of a bequest or not. Rationale: A) TP did not come as an heir in fact, but as someone who performed services. B) The transfer is the same as in Duberstiein, look at the donors intentions, Why is she doing this? Notes: What hat was the TP wearing? Was there a quid pro quo? Yes, it was bargained for. Look at the facts, not at the label of distribution of inheritance. Look at the origin of the claim (in Lythe, it was heriship, here it is payment of services). What if an heir (ex: child) performs services also? If a child performs $20 in services under a K, when parent dies, the estate settles the claim for $12 instead of $20. But then the child still receives the $8 on the residual clause of the will b/c the child is the heir in fact. The $8 has been recharacterized as inheritance instead of for services. Is the $8 is excludable from GI. This is a factual question! Are the executor and child related or is the settlement an arms length transaction. Look at substance, if the executor collude, the child still has income of $20!! Substance governs over form. If not a bona fide settlement, then it is GI. Can services be donated or gifted to an estate? That is if the executor/heir waive any statutory fee and take the money through inheritance? Yes, if certain conditions are met: Revenue Ruling 66-167:Waiving the right to receive the fee can keep the fee from being included in the GI of the executor/heir. The intent to waive the fee must be shown upfront at the beginning before the services are rendered. If you dont waive up front, it is harder to prove you are doing it free. It doesnt look so much like a quid pro quo if done at the beginning. If the timing, purpose, and effect of the waiver make it serve any other important objective, it may then be proper to conclude that the fiduciary has thereby enjoyed a realization of income by means of controlling the disposition thereof, and at the same time, has also effected a taxable gift by means of any resulting transfer to a third party of his contingent beneficial interest in a part of the assets under his fiduciary control. The intention to serve on a gratuitous basis will ordinarily be deemed to have been adequately manifested if the executor or administrator provides the decedents principal legatees a formal waiver within six months after his initial appointment. If the estate deducts the fee from its income taxes, then a waiver cannot be intended (it does not look gratuitous).

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Tax IA Outline V. Ch 4 Awards A) Prizes Usually resemble a "donative arrangement" and lack of "quid pro quo." In 1986 Congress broadened the tax base by denying exclusion of prizes and awards from GI under the overworked "gift" theory. These tax rules can relate to such things as winning a company's sales or other contest, the Nobel Peace Prize, a contest to guess how many jelly beans in a jar. 74(a) expressly includes prizes and awards in GI but carves out two limited exceptions: 74(b) excludes the award from GI if the recipient transfers the award directly to a governmental unit or charity. Thus the only way the winner can escape an inclusion in GI is to never receive the award. However, the designation of the recipient can be made before or after the taxpayer is aware of being the recipient of the award. 74(c) creates a limited exclusion for certain employee achievement awards. An award may qualify if it relates to length of service or to safety. It must be in the form of tangible personal property, be awarded as part of a meaningful ceremony, and not be mere disguised compensation. A length of service award does not qualify unless the employee has been in the employer's service for five years or more and has not received a length of service award for the current or any of the prior four years. A safety achievement award qualifies only if made to other than a manager, administrator, clerical employee or other professional employee and only if 10 percent or less of an employer's qualified employees receive such awards during the year so that is discriminating and not just a part of the general pay scale. the amount of employee exclusion is geared to the extent to which the employer qualifies for a deduction under 274(j). IRC 74 Prizes and awards. A) General rule Except as otherwise provided in this section or in section 117 (relating to qualified scholarships), gross income includes amounts received as prizes and awards. B) Exception for certain prizes and awards transferred to charities. Gross income does not include amounts received as prizes and awards made primarily in recognition of religious, charitable, scientific, educational, artistic, literary, or civic achievement, but only if: 1) The recipient was selected without any action on his part to enter the contest or proceeding; (a) The recipient is not required to render substantial future services as a condition to receiving the prize or award; and

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Tax IA Outline (b) The prize or award is transferred by the payor to a governmental unit or organization described in paragraph (1) or (2) of 170(c) pursuant to a designation made by the recipient. 2) Exception for certain employee achievement awards. (a) Gross income shall not include the value of an employee achievement award (as defined in 274(j)) received by the taxpayer if the cost to the employer of the employee achievement award does not exceed the amount allowable as a deduction to the employer for the cost of the employee achievement award. (b) Excess deduction award. If the cost to the employer of the employee achievement award received by the taxpayer exceeds the amount allowable as a deduction to the employer, then gross income includes the greater of (i) an amount equal to the portion of the cost to the employer of the award that is not allowable as a deduction to the employer (but not in excess of the value of the award), or (ii) the amount by which the value of the award exceeds the amount allowable as a deduction to the employer. The remaining portion of the value of such award shall not be included in the gross income of the recipient. (c) Treatment of Tax-exempt employers. In the case of an employer exempt from taxation under this subtitle, any reference in this subsection to the amount allowable as a deduction to the employer shall be treated as a reference to the amount which would be allowable as a deduction to the employer if the employer were not exempt from taxation under this subtitle. Cross reference: for provisions excluding certain de minimis fringes from gross income see 132(e). Under 74(a) prizes and awards are income. This is a catchall provision where you are stuck unless you can meet the 4 elements of 74(b). The TP has the burden to prove an exception under 74(b) 4 elements to be met to be excluded from GU under 74(b): 3) merit based 4) not based on past services 5) no quid pro quo for future services 6) the award must be shifted off at the beginning to a charitable institution. **don't put your hands on it or it could be poison**

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Tax IA Outline IRC 274(j) Employee Achievement Awards. General Rule. No deduction shall be allowed under section 162 or section 212 for the cost of an employee achievement award except to the extent that such cost does not exceed the deduction limitations of paragraph (2). Deduction Limitations. The deduction for the cost of an employee achievement award made by an employer to an employee (a) Which is not a qualified plan award, when added to the cost to the employer for all other employee achievement awards made to such employee during the taxable year which are not qualified plan awards, shall not exceed $400, and (b) Which is a qualified award, when added to the cost to the employer for all other employee achievement awards made to such employee during the taxable year (including employee achievement awards which are not qualified plan awards), shall not exceed $1,600. Definitions. For purposes of this subsection Employee achievement award. The term employee achievement award means an item of tangible personal property which isTransferred by an employer to an employee for length of service achievement or safety achievement, Awarded as part of a meaningful presentation, and Awarded under condition and circumstances that do not create a significant likelihood of the payment of disguised compensation. Qualified plan award. In general. The term qualified plan award means an employee achievement award awarded as part of an established written plan or program of the taxpayer which does not discriminate in favor of highly compensated employees (within the meaning of 414(q)) as to eligibility or benefits. Limitations. An employee achievement award shall not be treated as a qualified plan for any taxable year if the average cost of all employee achievement awards which are provided by the employer during the year, and which would be qualified plan awards but for this subparagraph, exceeds $400. For purposes of the preceding sentence, average cost shall be determined by including the entire cost of qualified plan awards, without taking into account employee achievement awards of nominal value. Special rules. For purposes of this subsection

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Tax IA Outline Partnerships. In the case of an employee achievement award made by a partnership, the deduction limitations contained in paragraph (2) shall apply to the partnership as well as to each member thereof. Length of service awards. An item shall not be treated as having been provided for service achievement if the item is received during the recipients First 5 years of employment or if the recipient received a length of service achievement award (other than an award excludable under 132(e)(1)) during that year or any of the prior 4 years. Safety achievement awards. An item provided by an employer to an employee shall not be treated as having been provided for safety achievement if During the taxable year, employee achievement awards (other than awards excludable under 132(e)(1)) for safety achievement have previously been awarded by the employer to more than 10% of the employees of the employer (excluding employees described in clause (ii), or such item is awarded to a manager, administrator, clerical employee, or other professional employee. Recall that under 102(c) a gift from employer to employee is included in gross income. However, a gift from an employer to an employee such as a retirement gift after a long period of service may escape gross income inclusion by qualifying as a 132(a)(4) de minimis fringe benefit. 74(c) adds a partial exclusion for certain employee awards for service or safety. Caselaw: Allen J. McDonnell - Tax Court 1967 facts were stipulated, so thus in Tax Court. TP was an assistant sales manager who was, with his wife, required by his employer to go on a trip to Hawaii to keep tabs on and otherwise "guide" independent sales reps and distributors. The reps and distributors had received their trip from the TP's employer as a prize for top sales. The TP was randomly chosen and required to go unless he had a good excuse. TP had to participate in all the scheduled activities. TP and wife didn't get to shop or swim.

I. Whether the trip was an award and additional compensation taxable to the TP.

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Tax IA Outline H. When business reasons, coupled with equally compelling business circumstances require the TP to devote substantially off of their time on a trip for performance of their duties, the expenses of the trip are not GI to the TP. Rationale: The employer had good business reasons for sending TP. The TP was required to go: this was a condition of his employment, so it wasn't a fringe benefit. Fringes don't include what is a condition of employment. There was no compensatory flavor to it. The wife's presence was essential. [however, now 274(m)(3) would require the spouse to be an employee also in order to be deductible.] You don't need to find a statutory exemption for this b/c it is not income to begin with: it is a condition of his employment. A good assignment is still not a fringe if it is a condition of his employment.

Reg. 1.74- Prizes and Awards. Inclusion in gross income. 74(a requires the inclusion in gross income of all amounts received as prizes and awards, unless such prizes or awards qualify as an exclusion under (b), or unless such prize or award is a scholarship or fellowship grant excluded from GI by 117. Prizes and awards which are includible in GI include, but are not limited to: amounts received from radio and television giveaway shows, door prizes, and awards in contest of all types.

If the prize or award is not made in money but is made in goods or services, the fair market value of the goods or services is the amount ot be included in income.

Proposed Reg. 1.74 - 1 Prizes and Awards. Exclusion from GI. and the payor transfers the prize or award to one or more governmental units or organizations described in 170(c) as a qualified charity. Accordingly, awards such as the Nobel prize will qualify for the exclusion if the

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Tax IA Outline award is transferred by the payor to one or more qualifying organizations pursuant to a qualified designation by the recipient. To qualify for exclusion under this section, the recipient must make a qualifying designation, in writing within 45 days of the date the prize or award is granted. A qualifying designation is required to indicate only that a designation is being made. The document does not need to state on its face that the organizations are entities described in 170(c) to result in a qualified designation. It is not necessary that the document do more than identify a class of entities from which the payor may select a recipient. However, designation of a specific nonqualified donee organization or designation of a class of recipients that may include nonqualified donee organizations is not a qualified designation. Ex: A distinguished ophthalmologist, S, is awarded the Nobel prize for medicine. S may designate that the prize money be given to a particular university that is described in 170(c)(1), or to any university that is described in that section. However, S cannot designate that the award be given to a donee that is not described in 170(c)(1), such as a foreign medical school. Selection of such donee or inclusion of such donee on a list of possible donees on S's designation would disqualify the designation.

(proposed Reg. 1.74-1 continued) Prizes and awards granted before 60 days after date of publication of final regulations. In the case of prizes and awards granted before 60 days after the date of publication of final regulations, a qualifying designation may be made at any time prior to 105 days after date of publication of final regulations.

Transferred by payor. [Summary of the provision] 1) The transfer by the payor to the qualified donee by the due date of the return (without regard to extensions) for the taxable year in which the items or amounts would otherwise be includible in the recipient's GI. 2) Possession of a prize or award by any person before a designation is made will not result in the dissallowance of an exclusion unless a disqualifying use of the items or amounts is made before the items or amounts are returned to the payor for transfer to one or more qualified donee organizations.

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Tax IA Outline 3) "Disqualifying use" means, in the case of cash or other intangibles, spending, depositing, investing or other wise using the prize or award so as to enure to the benefit of the recipient or any person other than the grantor or an entity described in 170(c). In the case of tangible items, the term "disqualifying use" means physical possession of the item for more than a brief period by any person other than the grantor or an entity described in 170(c). Thus, physical possession by the recipient may constitute a disqualifying use if the item is kept for more than a brief period of time. For example, receipt of an unexpected tangible award at a ceremony that other wise comports with the requirements of this section will not constitute a disqualifying use unless the recipient fails to return the item to the payor as soon as practicable after receipt. 4) For purposes of this section, an item will be considered "granted" when it is subject to the recipient's dominion and control to such an extent that it otherwise would be includible in the recipient's GI. 5) Charitable deduction not allowable. Neither the payor nor the recipient will be allowed a charitable deduction for the value of any prize or award that is excluded under this section. CH 4(B) Scholarships and Fellowships In 1954 Congress enacted 117 with the express purpose of providing a clear-cut method for distinguishing between taxable and nontaxable educational grants. As in the case of the exclusion for prizes and awards, the exclusion for scholarships and fellowships was substantially narrowed by the Tax Reform Act of 1986. 117(a) excludes from GI amounts received as a "qualified scholarship" by a degree candidate at an educational organization. Not all scholarships are "qualified", that is a term of art, defined internally by the code. A "continuing education" candidate is not a degree candidate either. Reg 1.117-6(c)(3)(i) defines scholarship or fellowship generally as an amount paid for the benefit of student to aid him in the pursuit of study or research. However the terms do not include amounts provided by an individual to aid a relative, friend, or other individual in pursuit of study or research if the grantor is motivated by family or philanthropic considerations. There is no quid pro quo arrangement, without strings attached. Reg. 1.117-3(e) defines the term candidate for a degree: as an individual whether an undergraduate or graduate, who is pursuing studies or conducting research to meet the requirements for an academic or professional degree conferred by colleges

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Tax IA Outline or universities. A student who receives a scholarship for study at a secondary school or other educational institution is considered to be a candidate for a degree. The principal requirements of the exclusion are found in the definition of a qualified scholarship, which is defined as any amount received as a scholarship or fellowship grant that in accordance with the grant is used for "qualified tuition" and related expenses. Those expenses encompass tuition and enrollment fees at the educational organization as well as fees, books, supplies and equipment required for courses of instruction. there is no exclusion for amounts which cover personal living expenses, such as meals and lodging, or for travel and research. Under 117(c), a portion of an otherwise excluded scholarship or fellowship is required to be included in the recipient's GI to the extent that the portion represents a payment for teaching, research or other services by the student required as a condition for receiving the otherwise excludable amount. Educational grants made by an employer to a current or former employee have generally been held taxable b/c they represent compensation for past, present or future services. If an educational institution awards a scholarship but as a condition of the scholarship requires services to be performed, the scholarship is not excludable from GI. However, the IRS has allowed an exclusion for a university athletic scholarship if the university expects but does not require the student to participate in a particular sport, requires no particular activity in lieu of participation, and cannot terminate the scholarship if the student cannot participate. Scholarships for room and board is not a qualified scholarship, it is not excludable from GI. Thus, to qualify for the exclusion, there must still be a gratuitous or non-contractual flavor to the grant. (similar to gift in Duberstin.) 117(d) allows a "qualified tuition reduction" to be excluded from GI in the case of education below the graduate level or at the graduate level if the graduate student is engaged in teaching or research activities. The reduction may be avilable to the employees of the educational organization granting the reduction or to employees of some other educational organization as well. The term "employee" is defined by reference to the broad definition of employee in 132(h) which includes the employee, the employee's spouse and dependent

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Tax IA Outline children, and the surviving spouse of a decease demployee. The plan, however, must be non-discriminary (can't favor highly compensated.). 127 permits an employee to exclude up to $5,250 from gross income for amounts paid by employer for educational assistance, provided the education assistance program meets certain requirements (non-discriminatinary). Assistance can include tuition, books supplies, and employer provided educational course, but does not included sports, hobbies. (Graduate courses used to be excluded, but as of 1/1/02, employer can provide graduate courses.) The TP doesnt have to trace the scholarship money to payment of the tuition. If you get a $10,000 scholarship and pay $10,000 in tuition, it is assumed to be spent on tuition. IRC 117 Qualified Scholarships. General rule.Gross income does not include any amount received as a qualified scholarship by an individual who is a candidate for a degree at an educational organization described in section 170(b)(A)(ii). Qualified Scholarship. For purposes of this section. In general. The term qualified scholarship means any amount received by an individual as a scholarship or fellowship grant to the extent the individual establishes that, in accordance with the conditions of the grant, such amount was used for qualified tuition and related expenses. Qualified tuition and related expenses. For purposes of paragraph (1), the term qualified tuition and related expenses means1) tuition and fees required for the enrollment or attendance of a student at an educational organization described in 170(b)(1)(A)(ii), and 2) fees, books, supplies, and equipment required for courses of instruction at such an educational organization. Limitation. Subsections (a) and (d) shall not apply to that portion of any amount received which represents payment for teaching, research, or other services by the student required as a condition for receiving the qualified scholarship or qualified tuition reduction. Qualified tuition reduction. In general. Gross income shall not include any qualified tuition reduction. (2)Qualified tuition reduction. For purposes of this subsection, the term qualified tuition reduction means the amount of any reduction in tuition provided to an employee of an organization described in 170(b)(1)(A)(ii) for the education (below

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Tax IA Outline the graduate level)[the graduate level limitation is deleted on 1-1-02] at such organization (or another organization described in 170(b)(1)(A)(ii) of: 1) such employee, or 2) any person treated as an employee (or whose use is treated as an employee use) under the rules of 132(h). 3) Reduction must not discriminate in favor of highly compensated, etc. Paragraph (1) shall not apply with respect to any qualified tuition reduction provided with respect to any highly compensated employee only if such reduction is available on substantially the same terms to each member of a group of employees which is defined under a reasonable classification set up by the employer which does not discriminate in favor of highly compensated employees (within the meaning of 414(q)). For purposes of this paragraph, the term highly compensated employee has the meaning given such term by section 414(q). 4) Repealed 5) Special rules for teaching and research assistants. In the case of the education of an individual who is a graduate student at an educational organization described in 170(b)(1)(A)(ii) and who is engaged in teaching or research activities for such organization, paragraph (2) shall be applied as if it did not contain the phrase (below the graduate level). Reg. 1.117-6 Proposed: Qualified scholarships. Exclusion of qualified scholarships. Gross income does not include any amount received as a qualified scholarship by an individual who is a candidate for a degree at an educational organization described in 170(b)(1)(A)(ii), subject to the rules set forth in paragraph (d) of this section. Generally, any amount of a scholarship or fellowship grant that is not excludable under 117 is includable in the gross income of the recipient for the taxable year in which such amount is received, notwithstanding the provisions of 102 (relating to the exclusion fro GI of gifts). However, see 127 and the regulations thereunder for rules permitting an exclusion from gross income for certain educational assistance payments. See also 162 and the regulations thereunder for the deductibility as a trade or business expense of the educational expenses of an individual who is not a candidate for a degree. If the amount of a scholarship or fellowship grant eligible to be excluded as a qualified scholarship under this paragraph cannot be determined when the grant is received because expenditures for qualified tuition and related expenses have not yet been incurred, then that portion of any amount received as a scholarship or

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Tax IA Outline fellowship grant that is not used for qualified tuition and related expenses within the academic period to which the scholarship or fellowship grant applies must be included in the gross income of the recipient for the taxable year in which such academic period ends. Definitions 1) Qualified Scholarship. For purposes of this section, a qualified scholarship is any amount received by an individual as a scholarship or fellowship grant to the extent the individual establishes that, in accordance with the conditions of the grant, such amount was used for qualified tuiton and related expenses (as defined in paragraph (c)(2)of this section). To be considered a qualified scholarship, the terms of the scholarship or fellowship grant need not expressly require that the amounts received be used for tuition and related expenses. However, to the extent that the terms of the grant specify that any portion of the grant cannot be used for tuition or related expenses or designate any portion of the grant for purposes other than tuition and related expenses, such amounts are not amounts received as qualified scholarship. [portions designated for room and board, and meal allowances are not qualified tuition.] 2) Qualified tuition and related expenses. For purposes of this section, qualified tuition and related expenses are a. Tuition and fees required for the enrollment or attendance of a student at an educational organization described in 170(b)(1)(A)(ii); and b. Fees, books, supplies, and equipment required for course instruction at such an educational organization. i. In ORDER to be treated as related expenses under this section, the fees, books, supplies, and equipment must be required of all students in the particular course of instruction. Incidental expenses are not considered related expenses. Incidental expenses include expenses incurred for room and board, travel, research, clerical help, and equipment and other expenses that are not required for either enrollment or attendance at an educational organization, or in a course of instruction at such educational organization. 3) Scholarship or fellowship grant. in general. Generally, a scholarship or fellowship grant is a cash amount paid or allowed to, for the benefit of, an individual to aid such individual in the pursuit of study or research. A scholarship or fellowship grant also may be in the form of a reduction in the amount owed by the recipient to an educational organization for tuition, room and board, or any other fee. A scholarship or fellowship grant

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Tax IA Outline may be funded by a governmental agency, college or universy, charitable organization, business, or any other source. To be considered a scholarship or fellowship grant for purposes of this section, any amount received need not be formally designated as a scholarship. For example, an allowance is treated as a scholarship if it meets the definition set forth in this paragraph. However, a scholarship or fellowship grant does not include any amount provided by an individual to aid a relative, friend, or other individual in pursuit of study or research if the grantor is motivated by family or philanthropic considerations. Inclusion of qualified scholarships and qualified tuition reductions representing payment for services. In general. The exclusion from GI under this section does not apply to that portion of any amount received as a qualified scholarship or qualified tuition reduction that represents payment for teaching, research, and other services by the student required as a condition to receiving the qualified scholarship or qualified tuition reduction, regardless of whether all candidates for the degree are required to perform such services. The provision of this paragraph (d) apply not only to cash amounts received in return for such services, but also to amounts by which the Tuition or related expenses of the person who performs services are reduced, whether or not pursuant to a tuition reduction plan described in 117(d). Payment for services. For purposes of the section, a scholarship or fellowship grant represents payment for services when the grantor requires the recipient to perform services in return for the granting of the scholarship or fellowship. A requirement that the recipient purse studies, research, or other activities primarily for the benefit of the grantor is treated as a requirement to perform services. A requirement that a recipient furnish periodic reports to the grantor for the purpose of keeping the grantor informed as to the general progress of the individual, however, does not constitute the performance of service. A scholarship or fellowship grant conditioned upon either past, present, or future teaching, research, or other services by the recipient represents payment for services under this section. Determination of amount of scholarship or fellowship grant representing payment for services. If only a portion of a scholarship or fellowship grant represents payment for services, the grantor must determine the amount of the scholarship or fellowship grant (including any reduction in tuition or related expenses) to be allocated to payment for services. Factors to be taken into account in making this allocation include, but are not limited to, compensation paid byThe grantor for similar services performed by students with qualifications comparable to those of the scholarship recipient, but who do not receive scholarship or fellowship grants;

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Tax IA Outline

The grantor for similar services performed by full-time or part-time employees of the grantor who are not students; and Educational organizations, other than the grantor of the scholarship or fellowship, for similar services performed either by students or other employees. If the recipient includes in GI the amount allocated by the grantor to payment for services and such amount represents reasonable compensation for those services, then any additional amount of a scholarship or fellowship grant received from the same grantor that meets the requirements of paragraph (b) of this section is excludable from GI.

IRC 127 Educational assistance programs. (a)Exclusion from gross income. In general.Gross income of an employee does not include amounts paid or expenses incurred by the employer for educational assistance to the employee if the assistance is furnished pursuant to a program which is described in subsection (b).$5,250 maximum exclusion. If, but for this paragraph, this section would exclude from GI more than $5,250 of educational assistance furnished to an individual during a calendar year, this section shall apply only to the fIRSt $5,250 of such assistance so furnished. Educational assistance program. In general. For purposes of this section an educational assistance program is a separate written plan of an employer for the exclusive benefit of his employees to provide such employees with educational assistance. The program must meet the requirements (2) through (6) of this subsection. [the program cant discriminate in favor of highly compensated employees;]

IRC 85 Unemployment compensation. General Rule. In the case of an individual, gross income includes unemployment compensation. Unemployment compensation defined. For purposes of this section, the term unemployment compensation means any amount received under a law of the United States or of a State which is in the nature of unemployment compensation.

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IRC 86 Social security and rr benefits. In general Except as provided in paragraph (2), GI for the taxable year of any taxpayer described in subsection (b) notwihstanding 207 of the SS Act) includes social security benefits in an amount equal to the lesser of one half of the social security benefits received during the taxable year, or one half of the excess described in subsection (b)(1). (2) ***Summary of the rest of the provision** Depending upon the amount of a taxpayers AGI and the amount of the SS benefits received, the percentage of SS benfits that must be included in GI ranges from zero to 85%. At what point is a TP well off? When a single has $25k in AGI, married is $32K in AGI. See p. 90 in statute book for computation details. Temporary Assistance for Needy Families Generally, Welfare (transfer payments) generally are not includible in GI. But if it is for work, then it is in GI. IRS Notice 99-3: Treatment of certain payments received as temporary assistance for needy families. This notice addresses the federal income and employment tax consequences of payments received by individuals with respect to certain work activities performed in state programs under part A of title IV of the Social Security Act, as amended by the Personal Responsibility and Work Opportunity Reconciliation Act of 1996 (Temporary Assistance for Needy Families or TANF). Payments by a governmental unit to an individual under a legislatively provided social benefit program for the promotion of the general welfare that are not basically for services rendered are not includible in the individuals gross income and are not wages for employment tax purposes, even if the individual is required to perform certain activities to remain eligible for the payments. However, if taking into account all the facts and circumstances, payments by a governmental unit are basically compensation for services rendered, even though some training is provided, then the payments are includible in the individuals gross income and are generally wages for employment tax purposes.

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Tax IA Outline TANF payments are not includible in gross income when three conditions are satisfied (test): 1) The only payments received by the individual with respect to the work activity are received directly from the state or local welfare agency (for this purpose, an entity with which a state or local welfare agency contracts to administer the state TANF program on behalf of the state will be treated as the state or local welfare agency); 2) The determination of the individuals eligibility to receive any payment is based on need; and he only payments received by the individual with respect to the work activity are funded entirely under a TANF program; and 3) The size of the individuals payment is determined by the applicable welfare law, and the number of hours the individual may engage in the work activity is limited by the size of the individuals payment divided by the higher of the federal or state minimum wage. Taxing Labor Fringe Benefits Remember 61(a)(1) explicitly includes fringe benefits in gross income. The Supreme Court has stated that 61(a)(1) is broad enough to include in taxable income any economic or financial benefit conferred on the employee as compensation, whatever the form or mode by which it is effected (Smith). That is a fringe benefit. Whether an employee is paid in dollars, property, or use of property, directly or indirectly, any form of compensation is gross income. Looking at it from the prospective of the employer, there are some arrangements that do not merely serve to replace cash as compensation. The employer has a good business reason for providing the benefit conferred on the employee. That is why Congress provided statutory exemptions for certain fringe benefits. The legislative history makes it clear: 1) many industries have long established practices of offering free or discounted services to employees for encouraging employees to avail themselves of the products which they sell to the public. 2) Clear boundaries needed to be established from what was a tax-free fringe and one that is includible in GI. 3) Without well defined limits, employers could shift compensation to non-cash benefits and a disproportionate tax burden would fall on those paid in cash wages.

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Tax IA Outline 4) Most fringes must be nondiscriminatory. It would be fundamentally unfair to provide tax-free treatment for economic benefits received only by highly paid executives.

The tax law on fringe benefits is now completely statutory. Now, the rule is, if an employee benefit is not specifically excluded from gross income, its value must be included within gross income (61(a)(1)). For purposes of fringe benefits, sole proprietors are not employees. What is exempted as a fringe benefit is a reflection of our culture and what we expect. There is a dual approach to fringes: there is a general catch all of fringes that are excluded (132: no additional cost, qualified employee discount, working condition, de minimis, qualified transportation and moving); and specific exclusions (119 for meals and lodging, 127 education fringes, 106 employer paid health care, 179 group term life insurance). Always look to the specific exclusion provision FIRST, that overrides a general provision. See use the general analysis tip: Is it income? Is there an exclusion? Is there a deduction? When is it income? Can it be deferred? Whose income is it? Can it be shifted? IRC 132 Certain Fringe Benefits. (a) Exclusions from GI. Gross income shall not include any fringe benefit which qualifies as a: (1) No-additional-cost service. (2) Qualified employee discount. (3) Working condition fringe. (4) De minimis fringe. (5) Qualified transporttion fringe, or (6) Qualified moving expense reimbursement. (b) No-Additional-Cost service defined. For purposes of this section, the term no-additional-cost service means any service provided by an employer to an employee for use by such employee if (1) Such service is offered for sale to customers in the ordinary course of the line of business of the employer in which the employee is performing services, and (2) The employer incurs no substantial additional cost (including forgone revenue) in providing such service to the employee

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Tax IA Outline (determined without regard to any amount paid by the employee for such service). [Notes on 132(b): elements: 1) it must be a service used by employee in the ordinary course of business. The rationale for this is the employee is advertising the employers products by the employee using it. 2) The business must not forgo any revenue (lose a customer) or incur extra cost (read big, look at facts to determine) to provide it. And 3) the plan cant be discriminatory. The fringe is excludable only only only if there is equal treatment for all employees. None of the benefit is excludable if there is any discrimination, even the rank and file wont get the exclusion! All these elements must be satisfied or it is income per Glenshaw.] Examples: airline, railroad, or subway seats, and hotel rooms furnished to employees, if they are working in those respective business, in a way that does not displace non-employee customers, and free telephone service to telephone employees within existing capacity of the employer company. The exclusion is allowed whether the services are provided free of charge, at cost or some partial charge or under a cash rebate program. [more notes: The services must be provided in the same line of business as that in which the employee is employed. If an employee is a steward for an airline owned by a company that also owns a cruise ship, free standby airline flights for the employee, his spouse, and dependents are excludable but a free cruise is not. This resitriction is framed carefully to preclude an unfair advantage for employees of conglomerates. If two companies have a written reciprocal agreement that makes services of one available to the employees of the other, employees of one company may exclude, as no-additional-cost services, services provided by the other, if the services in question are in the employees line of business.] Qualified employee discount defined. For purposes of this section: Qualified employee discount.The term qualified employee discount means any employee discount with respect to qualified property or services to the extent such discount does not exceed: 1) in the case of property, the gross profit percentage of the price at which the property is being offered by the employer to customers, or 2) in the case of services, 20% of the price at which the services are being offered by the employer to customers. Gross profit percentage. In general.The term gross profit percentage means the percent which:

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Tax IA Outline 1) the excess of the aggregate sales price of property sold by the employer to customers over the aggregate cost of such property to the employer, is of 2) the aggregate sale price of such property. Determination of gross profit percentage. Gross profit percentage shall be determined on the basis of 1) all property offered to customers in the ordinary course of the line of business of the employer in which the employee is performing services (or a reasonable classification of property selected by the employer), and 2) the employers experience during a representative period. Employee discount defined. The term employee discount means the amount by which 1) the price at which the property or services are provided by the employer to an employee for use by such employee, is less than 2) the price at which such property or services are being offered by the employer to customers. 3) Qualified property or services.The term qualified property or services means any property (other than real property and other than personal property of a kind held for investment) or services which are offered for sale to customers in the ordinary course of the line of business of the employer in which the employee is performing services. [Notes on qualified employee discounts: there is a maximum for what can be excluded! Historically, an employee has been allowed to exclude from GI the value of courtesy discounts on items purchased from his employer for use by the employee. As in the case of the no-additional-cost-services, the plan 1) nondiscriminary; 2) 2) in the same line of business; 3) 3) applies to purchase of property and services; it usually means consumables, but does not include real property or property held for investment. It also does not include loans to employees of financial institutions. The discount may take the form of price reduction or rebate. The ceiling of the exclusion is 20% off services (includes life insurance), or in the case of goods, by the gross profit percentage, up to 40%.] Is a painting investment property? That is a factual issue. If you over use a discount, or if the discount is over the cap, you are enriched and then it is compensation (Glenshaw). Also, if property converts too easily to cash, it may smell too much like compensation.

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Tax IA Outline Working Condition fringe defined. For purposes of this section, the term working condition fringe means any property or service provided to an employee of the employer to the extent that, if the employee paid for such property or services, such payment would be allowable as a deduction under 162 or 167. [note on working condition fringe: any property, not qualified, that would have been deductible (under 162 or 167) by the employee as a cost of doing business is a working condition fringe. There is no reference to line of business. This helps reduce the need for booking of wash out transactions, where you got the cash but then turned around and made a deductible purchase. Example: as an attorney you pay $1000 to be a member of the bar, that is deductible to the employee. If the employer pays it for you instead, it is excluded from your GI. Also, use of a company car for business travel; an employers subscription to a business periodical, on the job training.] There is no discrimination limitation on this deduction.

De minimis fringe defined. For purposes of this section In general. The term de minimis fringe means any property or service the value of which is (after taking into account the frequency with which similar fringes are provided by the employer to the employers employees)so small as to make account for it unreasonable or administratively impracticable. Treatment of certain eating facilities.The operation by an employer of any eating facility for employees shall be treated as a de minimis fringe if 1) such facility is located on or near the business premises of the employer, and 2) revenue derived from such facility normally equals or exceeds the direct operating costs of such facility. The preceding sentence shall apply with respect to any highly compensated employee only if access to the facility is available on substantially the same terms to each member of a group of employees which is defined under a reasonable classification set up by the employer which does not discriminate in favor of highly compensated employees. For purposes of subparagraph (B), an employee entitled under 119 to exclude the value of a meal provided at such facility shall be treated as having paid an amount for such meal equal to the direct operating costs of the facility attributable to such meal. [Note on de-minimis fringe: an administrative need drives this policy! If it is not routine and difficult to value, a bookkeeping nightmare, it is deminimis. If used too much, it may be compensation. Ex of deminimis fringes: occasional cocktail parties

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Tax IA Outline or picnics, use of the company copying machine, occasional sporting event tickets, and low value holiday gifts.] Qualified transportation fringe. In general. For purposes of this section, the term qualified transportation fringe means any of the following provided by an employer to an employee: 1) Transportation in a commuter highway vehicle if such transportation is in connection with travel between the employees residence and place of employment. a. Any transit pass. b. Qualified parking. c. Limitation on exclusion. The amount of the fringe benefits which are provided by an employer to any employee and which may be excluded from gross income under subsection (a)(5) shall not exceed i. $65 per month [$100 per month in taxable years beginning after 12/31/01] in the case of the aggregate of the benefits described in subparagraphs (A) and (B) of paragraph (1), and ii. $175 per month in the case of qualified parking. 2) Cash reimbursements. For purposes of this subsection, the term qualified transportation fringe includes a cash reimbursement by an employer to an employee for a benefit described in paragraph (1). The preceding sentence shall apply to a cash reimbursement for any transit pass only if a voucher or similar item which may be exchanged only for a transit pass is not readily available for direct distribution by the employer to the employee. a. No constructive receipt. No amount shall be included in the gross income of an employee solely because the employee may choose between any qualified transportation fringe and compensation which would otherwise be includible in gross income of such employee. Definitions. For purposes of this subsection Transit pass. The term transit pass means any pass, token, farecard, voucher, or similar item entitling a person to transportation (or transportation at a reduced price) if such transportation is 1) on mass transit facilities (whether or not publicly owned), or 2) provided by ay person in the business of transporting persons for compensation or hire if such transportation is provided in vehicle meeting the requirements of subparagraph (B)(i). Commuter highway vehicle. The term commuter highway vehicle means any highway vehicle 1) the seating capacity of which is at least 6 adults (not including the driver), and 2) at least 80% of the mileage use of which can reasonably be expected to be

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Tax IA Outline a. for purposes of transporting employees in connection with travel between their residences and their place of employment, and b. on trips during which the number of employees transported for such purposes is at least of the adult seating capacity of such vehicle (not including the driver). Qualified parking. The term qualified parking means parking provided to an employee on or near the business premises of the employer or on or near a location from which the employee commutes to work by transportation described in subparagraph (A), in a commuter highway vehicle, or by carpool. Such term shall not include any parking on or near property used by the employee for residential purposes. Transportation provided by employer. Transportation referred to in paragraph (1)(A) shall be considered to be provided by an employer if such transportation is furnished in a commuter highway vehicle operated by or for the employer. Employee. For purposes of this subsection, the term employee does not include an individual who is an employee within the meaning of 401(c)(1). Inflation adjustment. (see p. 124 of statute book if necessary. Coordination with other provisions. For purposes of this section, the terms working condition fringe and de minimis fringe shall not include any qualified transportation fringe (determined without regard to paragraph (2)). Qualified moving expense reimbursement. For purposes of this section, the term qualified moving expense reimbursement means any amount received (directly or indirectly) by an individual from an employer as a payment for or a reimbursement of) expenses which would be deductible as moving expenses under 217 if directly paid or incurred by the individual. Such term shall not include any payment for (or reimbursement of) an expense actually deducted by the individual in a prior taxable year. Certain individuals treated as employees for purposes of subsections (a)(1) [Noadditional-cost services] and (a)(2) [qualified employee discount]. For purposes of paragraphs (1) and (2) of subsection (a): Retired and disabled employees and surviving spouse of employee treated as employee. With respect to a line of business of an employer, the term employee includes 1) any individual who was formerly employed by such employer in such line of business and who separated from service with such

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Tax IA Outline employer in such line of business by reason of retirement or disability, and any widow or widower of any indiidual who died while employed by such employer in such line of business or while an employee within the meaning of subparagraph (A).

2)

Spouse and Dependent Children. In general. Any use by the spouse or a dependent child of the employee shall be treated as use by the employee. Dependent child. For purposes of subparagraph (A), the term dependent child means any child (as defined in 151(c) (3)) of the employee 1) who is a dependent of the employee, or 2) both of whose parents are deceased and who has not attained age 25. For purposes of the preceding sentence, any child to whom 152(e) applies shall be treated as the dependent of both parents. Special rule for parents in the case of air transportation. Any use of air transportation by a parent of an employee (determined without regard to paragraph (1)(B)) Shall be treated as use by the employee.

Reciprocal agreements. For purposes of paragraph (1) of subsection (a) [noadditional-cost-service], any service provided by an employer to an employee of another employer shall be treated as provided by the employer of such employee if: 1) such service is provided pursuant to a written agreement between such employers, and 2) neither of such employers incurs any substantial additional costs (including foregone revenue) in providing such service or pursuant to such agreement.

Special Rules. Exclusions under subsection (a)(1) [no-additional-cost service] and (2) [qualified employee discounts] apply to officers, etc. only if no discrimination. Paragraphs (1) and (2) of subsection (a) shall apply with respect to any fringe benefit described therein provided with respect to any highly compensated employee only if such fringe benefit is available on substantially the same terms to each member of a group of employees which is defined under a reasonable classification set up by the employer which does not discriminate in favor of highly compensated employees.

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Tax IA Outline Auto Salesmen. In general. For purposes f subsection (a)(3) [working condition fringe], qualified automobile demonstration use shall be treated as a working condidtion fringe. Qualified automobile demonstration use. For purposes of subparagraph (A), the term qualified automobile demonstration use means any use of an automobile salesman in the sales area in which the automobile dealers sales office is located if 1) such use is provided primarily to facilitate the salesmans performance of services for the employe, and 2) there are substantial restrictions on the personal use of such automobile by such salesman. On-premises gyms and other athletic facilities. In general. Gross income shall not include the value of any on-premises athletic facility provided by an employer to his employees. On premises athletic facility.- For purposes of this paragraph, the term on premises athletic facility means any gym or 1) which is located on the premises of the employer, 2) which is operated by the employer, and 3) substantially all the use of which is by employees of the employer, their spouses, and their dependent children. Customers not to include employees. For purposes of this section (other than subsection (c)(2)), the term customers shall only include customers who are not employees. Section not to apply to fringe benefits expressly provided for elsewhere. This section (other than subsections (e)[de minimis] and (g)[qualified moving expenses], shall not apply to any fringe benefits of a type of the tax treatment of which is expressly provided for in any other section of this chapter. [This is a traffic light, specific provisions override general provisions.] Note: 132 uses the word or in the laundry list of fringes; if you miss one then go to the next. If one doesnt fit, you are not precluded from the next one.

*see p. 929 1.32-2 Earned income credit for taxable years beginning after December 31, 1978. (a) Allowance of credit. For taxable years beginning after December 31, 1978, subject to the limitations of paragraph (b) of this section, an eligible individual (as defined in paragraph

41

Tax IA Outline (c)(1) of this section) is allowed as a credit against the tax imposed by subtitle A of the Code for the taxable year, an amount equal to 10 percent of the first $5,000 of earned income (as defined in paragraph (c)(2) of this section) for the taxable year. For earlier taxable years beginning before January 1, 1979, see 1.43-1. (b) Limitations--(1) Amount of credit. The amount of the credit allowed by section 43 and paragraph (a) of this section for the taxable year must not exceed the excess, if any, of $500 over 12.5 percent of that amount of the adjusted gross income (or, if greater, the earned income) of the taxpayer for the taxable year which exceeds $6,000. For the meaning of the term "earned income," see paragraph (c)(2) of this section. Adjusted gross income is determined under section 62 and the regulations thereunder. If an individual has adjusted gross income or earned income of $10,000 or more, the individual is not entitled to the credit. (2) Married individuals. No credit is allowed by section 43 and paragraph (a) of this section in the case of an eligible individual who is married (within the meaning of section 143 and the regulations thereunder) unless the individual and spouse file a single return jointly (a joint return) for the taxable year (see section 6013 and the regulations thereunder relating to joint returns of income tax by husband and wife). The requirements of the preceding sentence do not apply to an eligible individual who is not considered as married under section 143(b) and the regulations thereunder (relating to certain married individuals living apart). (3) Length of taxable year. No credit is allowed by section 43 and paragraph (a) of this section in the case of a taxable year covering a period of less than 12 months. However, the rule of the preceding sentence does not apply to a taxable year closed by reason of the death of the eligible individual. (c) Definitions--(1) Eligible individual. For purposes of this section, an eligible individual is an individual who meets the following requirements of this paragraph (c)(1). (i) For the taxable year the individual must meet any one of the following three requirements set forth, respectively, in (A), (B), and (C) of this subdivision (i). (A) The individual must be married (within the meaning of section 143 and the regulations thereunder) and be entitled to a deduction under section 151 for a child (within the meaning of section 151(e)(3) and the regulations thereunder). The child must have the same principal place of abode (as defined in 1.2-2(c)) as the individual and that principal place of abode must be in the United States for the entire taxable year. (B) The individual must qualify as a surviving spouse (as determined under section 2(a) and the regulations thereunder). Thus, the spouse of the individual must have died within the period of the 2 taxable years immediately preceding the individual's taxable year. Also, the individual must have furnished over half the cost of maintaining as the individual's home a household in the United States for the entire taxable year which is the principal place of abode of a child of the individual who qualifies as a dependent for whom the individual is entitled to a deduction under section 151. (C) The individual must qualify as a head of household (as determined under section 2(b) and the regulations thereunder but without regard to section 2(b)(1)(A)(ii) and (B) and the regulations, thereunder). Thus, the individual cannot be married as of the close of the taxable year and also cannot qualify as a surviving spouse under section 2(a). Also, the individual must have furnished over half the cost of maintaining as the individual's home a household in the United States for the entire taxable year which is the principal place of abode of a child or descendant of the individual who is unmarried or who qualifies as a dependent for whom the individual is entitled to a deduction under section 151.

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Tax IA Outline (ii) For the entire taxable year, the individual must not be entitled to exclude any amount from gross income under section 911 (relating to earned income by individuals in certain camps outside the United States) or section 931 and the regulations thereunder (relating to income from sources within the possessions of the United States). (iii) The rules of this paragraph (c)(1) are illustrated by the following examples: Example 1. A, who is married and a member of the United States Armed Forces, maintains his household outside the United States for part of the taxable year. A is not an eligible individual. However, if A maintains his household inside the United States for the entire taxable year and is only temporarily absent therefrom by reason of military service and if the household is his principal place of abode and the principal place of abode of his child who receives over half of his support from the taxpayer for the calendar year in which the taxable year of the taxpayer begins and who either has less than $1,000 of gross income for the calendar year in which the individual's taxable year begins or who has not attained the age of 19 at the close of the calendar year in which the individual's taxable year begins or is a student, then the individual is an eligible individual if he meets the requirements of subdivision (ii) of this paragraph. Example 2. B's wife died in 1975 and B has not remarried. For his entire taxable year beginning January 1, 1979, B maintains his household inside the United States. The household is, for the entire taxable year, B's principal place of abode and the principal place of abode of B's unmarried grandchild whose natural parents are deceased. Thus B qualifies as a head of household (as determined under section 2(b) without regard to subparagraphs (A)(ii) and (B) of section 2(b)(1)). In these circumstances, regardless of whether B provides sufficient support to claim the grandchild as a dependent, B is an eligible individual if he meets the requirements of subdivision (ii) of this paragraph. Example 3. C is married and maintains his household inside the United States for the entire taxable year. The household is his principal place of abode and, for the entire year, is also the principal place of abode of a 12 year old child whose natural parents are deceased and who is placed with C by a State agency to provide the child with foster care. C receives compensation from the State agency to cover all of the cost of maintaining the child in his home. The child is in C's care and is cared for as C's own child. In these circumstances, the child is C's foster child, but C is not able to claim the child as a dependent since C did not provide half the child's support for the year. C is not eligible for the earned income credit. Example 4. Assume the same facts as in example (3) except that C receives no compensation from the State agency, and C provides over half the child's support and is able to claim the child as a dependent. C is an eligible individual if he meets the requirements of subdivision (ii) of this paragraph. Example 5. D's husband died in 1974 and D has not remarried. For the entire taxable year beginning January 1, 1979, D maintains her household inside the United States. The household is D's principal place of abode and, for the entire taxable year, is also the principal place of abode of D's unmarried son. D cares for her son in all respects except that her parents provide over half of the son's support. D qualifies as a head of household (as determined under section 2(b) without regard to subparagraph (A)(ii) and (B) of section 2(b)(1)). D is an eligible individual if D meets the requirements of subdivision (ii) of this paragraph. Example 6. Assume the same facts as in example (5) except that D is married. Since D cannot qualify as a head of household, and D's son cannot be claimed as D's dependent, D is not an eligible individual.

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Tax IA Outline (2) Earned income. For purposes of this section, earned income means-(i) Wages, salaries, tips, other employee compensation, and (iii) Net earnings from self-employment (within the meaning of section 1402(a) and the regulations thereunder). Earned income includes compensation excluded from gross income, such as disability income excluded under section 105(d), the rental value of a parsonage excluded under section 107, and the value of meals and lodging furnished for the convenience of the employer excluded under section 119. Earned income is computed without regard to any community property laws which may otherwise be applicable. Earned income is reduced by any net loss in earnings from self-employment. Earned income does not include amounts received as a pension, an annuity, unemployment compensation, or workmen's compensation, or an amount to which section 871(a) and the regulations thereunder apply (relating to income of nonresident alien individuals not connected with United States business). (d) Examples. The application of this section is illustrated by the following examples. For purposes of these examples, assume that the eligible individual does not receive a pension, an annuity, or an amount to which section 871(a), 911, or 931 applies. Example 1. A and B (married individuals) maintain a household inside the United States which is their principal place of abode and the principal place of abode of their two children who are 12 and 14 years old. A and B are calendar year taxpayers and, for 1979, they file a joint return. A and B have a total earned income of $7,600 (computed without regard to any community property laws) and have adjusted gross income of less than $7,600. The earned income credit of $300 is determined as follows:
Basic credit (10 percent of $5,000 under paragraph (a) of this section) .................. ..... $500 Initial limitation amount ......................... ..... .... Less: Reduction under paragraph (b)(1) of this section: Earned income for taxable year ................... $7,600 .... Less ............................................. $6,000 .... --------Excess over $6,000 ................................ 1,600 .... ----------------12 1/2 percent of excess ($1,600) ................. ..... .... ---Maximum credit (if less than basic credit) ........ ..... $300 ..... $500 .

..... ..... .....

. . .

$200

. -----

.....

Example 2. Assume the same facts as in example (1) except that A and B have earned income of $4,000 and adjusted gross income of $7,000. The earned income credit of $375 is determined as follows:

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Tax IA Outline
Basic credit (10 percent of $4,000 under paragraph (a) of this section) .................. ..... $400 Initial limitation amount ......................... ..... .... Less: Reduction under paragraph (b)(1) of this section: Adjusted gross income for taxable year ........... $7,000 .... Less .............................................. 6,000 .... --------Excess over $6,000 ................................ 1,000 .... ----------------12 1/2 percent of excess ($1,000) ................. ..... .... ---Maximum credit (if less than basic credit) ........ ..... $375

..... $500 .

..... ..... .....

. . .

125

. -----

.....

(e) Coordination of credit with advance payments--(1) Recapture of excess advance payments. If any advance payment of earned income credit under section 3507 is made to an individual by an employer during any calendar year, then the total amount of these advance payments to the individual in that calendar year is treated as an additional amount of tax imposed (by chapter 1 of the Code) upon the individual on the tax return for the individual's last taxable year beginning in that calendar year. (2) Reconciliation of payments advanced and credit allowed. Any additional amount of tax under paragraph (e)(1) of this section is not treated as a tax imposed by chapter 1 of the Code for purposes of determining the amount of any credit (other than the earned income credit) allowable under subpart A, part IV, subchapter A, chapter 1 of the Code. 1.32-3 Eligibility requirements after denial of the earned income credit. (a) In general. A taxpayer who has been denied the earned income credit (EIC), in whole or in part, as a result of the deficiency procedures under subchapter B of chapter 63 (deficiency procedures) is ineligible to file a return claiming the EIC subsequent to the denial until the taxpayer demonstrates eligibility for the EIC in accordance with paragraph (c) of this section. If a taxpayer demonstrates eligibility for a taxable year in accordance with paragraph (c) of this section, the taxpayer need not comply with those requirements for any subsequent taxable year unless the Service again denies the EIC as a result of the deficiency procedures. (b) Denial of the EIC as a result of the deficiency procedures. For purposes of this section, denial of the EIC as a result of the deficiency procedures occurs when a tax on account of the EIC is assessed as a deficiency (other than as a mathematical or clerical error under section 6213(b)(1)). (c) Demonstration of eligibility. In the case of a taxpayer to whom paragraph (a) of this section applies, and except as otherwise provided by the Commissioner in the instructions for Form 8862, "Information To Claim Earned Income Credit After Disallowance," no claim for the EIC filed subsequent to the denial is allowed unless the taxpayer properly completes Form 45

Tax IA Outline 8862, demonstrating eligibility for the EIC, and otherwise is eligible for the EIC. If any item of information on Form 8862 is incorrect or inconsistent with any item on the return, the taxpayer will be treated as not demonstrating eligibility for the EIC. The taxpayer must follow the instructions for Form 8862 to determine the income tax return to which Form 8862 must be attached. If the taxpayer attaches Form 8862 to an incorrect tax return, the taxpayer will not be relieved of the requirement that the taxpayer attach Form 8862 to the correct tax return and will, therefore, not be treated as meeting the taxpayer's obligation under paragraph (a) of this section. (d) Failure to demonstrate eligibility. If a taxpayer to whom paragraph (a) of this section applies fails to satisfy the requirements of paragraph (c) of this section with respect to a particular taxable year, the IRS can deny the EIC as a mathematical or clerical error under section 6213(g)(2)(K). (e) Special rule where one spouse denied EIC. The eligibility requirements set forth in this section apply to taxpayers filing a joint return where one spouse was denied the EIC for a taxable year prior to marriage and has not established eligibility as either an unmarried or married taxpayer for a subsequent taxable year. (f) Effective date. This section applies to returns claiming the EIC for taxable years beginning after December 31, 1997, where the EIC was denied for a taxable year beginning after December 31, 1996. Reg. 1.61-21 Taxation of Fringe benefits.[summary of the provision] (a)(1) In general. *** Examples of fringe benefits include: employer provided automobile, a flight on an employer-provided aircraft, an employer provided free or discounted commercial airline flight, an employer provided vacation, an employer provided discount on property or services, an employer provided membership in a country club or other social club, and employer provided ticket to an entertainment or sporting event. [lists the specific sections that exclude certain fringes from GI] Compensation for services. A fringe benefit provided in connection with the performance of services shall be considered to have been provided as compensation for such services. Refraining from the performance of services (such as pursuant to a covenant not to compete ) is deemed to be the performance of services for purposes of this section. Person to whom fringe benefit is taxable . In general. A taxable fringe benefit is included in the income of the person performing the services in connection with which the fringe benefit is furnished. Thus a fringe benefit may be taxable to a person even though that person did not actually receive the fringe benefit. If a fringe benefit is furnished to someone other than the service provider such benefit is considered in this section as furnished to the service provider, and use by the other person is considered use by the service provider. For example, the provision of an automobile by an employer to an employees spouse in connection with the performance of services

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Tax IA Outline by the employee is taxable to the employee. The automobile is considered available to the employee and use by the employees spouse is considered use by the employee. All persons whom benefits are taxable referred to as employees.*** The person to whom a fringe benefit is taxable need not be an employee of the provider of the fringe benefit, but may be, for example, a partner, director, or an independent contractor. For convenience, the term employee includes any person performing services in connection with which a fringe benefit is furnished, unless otherwise specifically provided in this section. Provider of a fringe benefit referred to as an employer. The provider of a fringe benefit is that person for whom the services are performed, regardless of whether that person actually provides the fringe benefit to the recipient. The provider of a fringe benefit need not be the employer of the recipient of the fringe benefit, but may be, for example, a client or customer of the employer or of an independent contractor. For convenience, the term employer includes any provider of a fringe benefit in connection with payment for the performance of services, unless otherwise specifically provided in this section. Valuation of fringe benefits. In general. An employee must include in GI the amount by which the fair market value of the fringe benefit exceeds the sum of (i) the amount, if any, paid for the benefit by or on behalf of the recipient, and (ii) the amount, if any, specifically excluded from GI by some other section of the code. Therefore, if the employee pays fair market value for what is received, no amount is includible in the gross income of the employee. In general, the determination of the fair market value of a fringe benefit must be made before subtracting out the amount, if any, paid for the benefit and the amount, if any, specifically excluded from gross income by another section of subtitle (A). (2) Fair market value. Is determined by facts and circumstances. Specifically, the FMV of a fringe benefit is the amount that an individual would have to pay for the particular fringe benefit in an arms length transaction. Thus, for example, the effect of any special relationship that may exist between the employer and the employee must be disregarded. Similarly, an employees subjective perception of the value of a fringe benefit is not relevant to the determination of the fringe benefits FMV nor is the cost incurred by the employer determinative of its FMV. Notes: when a business incorporates, what was the sole proprietor can receive taxfree fringes as an employee.

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Tax IA Outline

IRC 119 Meals or lodging furnished for the convenience of the employer. (a) Meals and lodging furnished to employee, his spouse, and his dependents, pursuant to employment. There shall be excluded from gross income of an employee the value of any meals or lodging furnished to him, his spouse, or any of his dependents by or on behalf of his employer for the convenience of the employer, but only if (1) in the case of meals, the meals are furnished on the business premises of the employer, or (2) in the case of lodging, the employee is required to accept such lodging on the business premises of his employer as a condition of his employment. (b) Special rules. For purposes of subsection (a): (1) In determining whether meals or lodging are furnished for the convenience of the employer, the provisions of an employment contract or of a State statute fixing terms of employment shall not be determinative of whether the meals or lodging are intended as compensation. (2) Certain factors not taken into account with respect to meals. In determining whether meals are furnished for the convenience of the employer, the fact that a charge is made for such meals, and the fact that the employee may accept or decline such meals, shall not be taken into account. (3) (A) Certain fixed charges for meals. In general. If:

(i) an employee is required to pay on a periodic basis a fixed charge for his meals, and (ii) such meals are furnished by the employer for the convenience of the employer, there shall be excluded from the employees gross income an amount equal to such fixed charge. (B) Application of subparagraph (A). Subparagraph (A) shall apply (i) whether the employee pays the fixed charge out of his stated compensation or out of his own funds, and

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Tax IA Outline (ii) only if the employee is required to make the payment whether he accepts or declines the meals. (4) Meals furnished to employees on business premises where meals of most employees are otherwise excludable. All meals furnished on the business premises of an employer to such employers employees shall be treated as furnished for the convenience of the employer if, without regard to this paragraph, more than half of the employees to whom such meals are furnished on such premises are furnished such meals for the convenience of the employer. (d) Lodging furnished by certain educational institutions to employees. (1)In general. In the case of an employee of an educational institution, gross income shall not include the value of qualified campus lodging furnished to such employee during the taxable year. (2) Exception in cases of inadequate rent. Paragraph (1) shall not apply to the extent of the excess of (A) the lesser of: (i) 5 percent of the appraised value of the qualified campus lodging, or (ii) the average of the rentals paid by individuals (other than employees or students of the educational institution) during such calendar year for lodging provided by the educational institution which is comparable to the qualified campus lodging provided to the employee, over (B) the rent paid by the employee for the qualified campus lodging during such calendar year. The appraised value under subparagraph (A)(i) shall be determined as of the close of the calendar year in which the taxable year begins, or in the case of a rental period not greater than 1 year, at any time during the calendar year in which such period begins. (3) Qualified campus lodging. For purposes of this subsection, the term qualified campus lodging means to which subsection (a) does not apply and which is (A) located on, or in the proximity of, a campus of the educational institution, and (B) furnished to the employee, his spouse, and any of his dependents by or on behalf of such institution for use as a residence. (4) Educational institution, etc. For purposes of this subsection (A) In general. The term educational institution means(i) an institution described in 170(b)(1)(A)(ii) (or an entity organized under State law and composed of public institutions so described), or (ii) an academic health center.

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Tax IA Outline (B) Academic Health Center.. For purposes of subparagraph (A), the term academic health center means an entity (i) which is described in 170(b)(1)(A)(ii), (ii) which receives payments under [certain sections of the Social Security Act relating to graduate medical education], and (iii) which has as one of its principal purposes or functions the providing and teaching of basic and clinical medical science and research with the entitys own faculty.

Notes on 119(d): employees of an educational institution to exclude from GI the value of lodging, not otherwise excluded under 119(a), if the lodging is located on or in the proximity of the campus of the educational institution. The lodging may be used as a residence by the employee and the employees spouse and dependents. There is a ceiling on the amount of the exclusion (119(d)(2)). In 119, the employee includes the family. IRC 107 Rental value of parsonages. In the case of a minister of the gospel, gross income does not include (1) the rental value of a home furnished to him as part of his compensation; or (2) the rental allowance paid to him as part of his compensation, to the extent used by him to rent or provide a home. Notes on 107: Housing benefits provided to a minister of the gospel are excluded from the ministers GI but they must be provided to him as compensation. In order to qualify, the allowance must be specifically earmarked in the ministers employment contract, the church minutes, or some similar documents, and then it is excluded only to the extent that it is actually used to rent or provide a home. Congress may have made this exclusion available b/c ministers are more likely to use their homes in conjunction with church activities than are other employees in their business activities. Case law: Herbert G. Hatt Tax Court 1969 TP was president and general manager of a funeral home (which was a corporation). He lived in the apartment above the funeral home which was provided by the corporation. The phone for the funeral home rang into the TPs apartment, TP also met w/family members of decedents after hours.

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Tax IA Outline Area residents expected the funeral home director to be available 24/7.

I Whether the FMV of the apartment rent is gross income to Hatt, or excludable under 119. H To be excludable, it must pass a 3 part test: 1) The lodging is on the premises of the employer, 2) the employee is required to accept such lodging, as a condition of his employment, and 3) the lodging is furnished for the convenience of the employer. condition of employment means that the employee must be required to accept the lodging in order to enable him to properly perform the duties of his employment. for the convenience of the employer is a big element, and it really means the same as a condition of employment on the business premises means either at a place where the employee perform a significant portion of his duties or where the employer conducts a significant portion of his business. (ownership was not the test.) (The further away you are, the harder it is to argue that it is for the convenience of the employer. It is a geographic analysis, the facts draw the line out of the gray area.) Here, the lodging was held to be excludable from GI. Rationale:

The lodging was provided for the convenience employer. Area residents had a reasonable expectation that the funeral director would be available 24/7, so there is objective evidence for the need of the TPs presence. There is no disguised compensation flavor here.

Analysis tips: The TP/funeral director also wears another hat, he is also a shareholder! Does that relationship preclude if 119 is applicable? Not necessarily, but this is a factual question, there must be objective scrutiny! Because of the ownership relationship between the TP the corporation the lodging could be disguised compensation. The analysis is very fact intensive. Here, the community expected the director to be available 24/7, so objective evidence supported the TPs contention. Remember from Dean, there is no free lunch! 51

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In cases like this, the presence of cash is poisonous! A state trooper who was given a meal allowance in cash to eat close to the highway was not held to be excludable. Meals mean meals in the code. Reg. 1.119 talks about a bargain element **read reg. 1.119-1 on p. 926, it is too lengthy to retype, but read it!!)

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Tax IA Outline Identifying the Proper Taxpayer A. Assignment of Income Based on Labor

IRC 1 Tax imposed the taxable income of: (a) Married individuals*** surviving spouses *** (b) Heads of households *** (c) Unmarried individuals *** (d) Married individuals filing separate *** (e) Estates and trusts *** (f) (Adjustment in tax tables so that inflation will not result in tax increases *** (g) Certain unearned income of minor children taxed as if parents income *** (h) Maximum capital gains rates *** 6013 (a) Joint Returns A husband and wife may make a single return jointly of income taxes under subtitle (A), even though one of the spouses has neither gross income nor deductions, except as provided below: 1) No joint return shall be made if the H & W have different taxable years; except*** 2) In the case of death of one spouse or both spouses the joint return with respect to the decedent may be made only by his executor or administrator; except*** 63 Taxable Income Defined (a) In general except as provided in subsection (b), for purposes of this subtitle, the term taxable income means gross income minus the deductions allowed by this chapter (other than the standard deduction). Individuals who do not itemize their deductions. *** Standard Deductions are: *** Itemized Deductions are: *** 66 Treatment of Community Income (a) Treatment of community income where spouses live apart. If: (1) 2 individuals are married to each other at any time during a calendar year; (2) Such individuals (A) Live apart at all times during the calendar year, and (B) Do not file a joint return under 6013 with each other for a taxable year beginning or ending in the calendar year; (3) One or both of such individuals have earned income for the calendar year which is community income; and (4) No portion of such earned income is transferred (directly or indirectly) between such individuals before the close of the calendar year,

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Then, for purposes of this title, any community income of such individuals for the calendar year shall be treated in accordance with the rules provided by 879(a). (b) (c) (d) *** 73 Services of a Child (a) Treatment of amounts received. Amounts received in respect of the services of a child shall be included in his gross income and not in the gross income of the parent, even though such amounts are not received by the child. (b) Treatment of expenditures. All expenditures by the parent or the child attributable to amounts which are includible in the gross income of the child (and not of the parent) solely by reason of subsection (a) shall be treated as paid or incurred by the child. (c) Parent defined. For purposes of this section, the term parent includes an individual who is entitled to the services of a child by reason of having parental rights and duties in respect of the child. Introduction to Assignment of Income: Progressive income tax rates provide a strong incentive for an individual taxpayer to try to fragment income. If a taxpayer in the highest tax rate bracket can transfer some income to another individual or entity in the lowest bracket, the taxpayer will reduce the total amount of tax owed to the government. In many instances, it is a matter of indifference to a taxpayer whether the taxpayer actually receives an item of income or whether it goes instead to a related individual or an economically related entity such as a trust or corporation. Generally, you do not try to shift income to strangers; you try to keep it within your sphere. Congress has added some rules to the game which affect the degree of success one can achieve by assignments of income. For example, a child under the age of 14 years is generally taxed on almost all of her unearned income at her parents tax rate, nullifying the tax advantage in assignment of income to such minors. There are both statutory and judge-made restraints on the efficacy of assignment of income. 73 provides, amounts received in respect of the services of a child shall be included in the childs gross income, not the parents. It is hard to assign income and retain the benefit. It is easier to assign property. Labor income is treated differently than property income. Income from Services

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Tax IA Outline Lucas v. Earl Landmark case for Income Shifting Holmes 1930 By K, Earl and his wife agreed that any property or earnings acquired by either of them should be received, held, taken, and owned as joint tenants. I. Whether the H could be taxed for the whole of the salary and attorneys fees earned by him, or should be taxed for only a half in view of the K with his W. H. The person performing the services will be the one taxed, no matter how skillfully the K is designed. Rationale: The fruit (income) is attached to the tree (earner). The H was the only party to the contracts by which the salary and fees were earned, he alone could have performed the services. Implicit rationale: The earner creates the right to be paid and exercises dominion, ownership, and creation of the wealth. Commissioner v. Giannini For 2 years, TP performed the services as a Director and President of a bank without being paid. The board of directors voted to give the TP 5% of the profits each year. After the TP learns he is to be paid, he refuses it. He then tells the board: do something useful with it. I. Can a TP work for free, or is income imputed? Sub issue: whether the TP made an effective assignment of income. IRS says he realized the income b/c he controlled where it went (directed the disposition). The TP said he waived the right to the income; he had no right to it. Pg 247 rule as stated in Schaffner H. One who is entitled to receive, at a future date, interest or compensation for services and who makes a gift of it by an anticipatory assignment, realizes taxable income quite as much as if he had collected the income and paid it over to the object of his bounty. Rationale: The dominance over the fund and taxpayers direction show that he beneficially received the money by exercising his right to diver it to a use. Entitlement of the money leads to the dominion over it.

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Tax IA Outline A taxpayer realizes income when he directs the disposition thereof in a manner so that it reaches the object of his bounty; if you direct the income to go somewhere, that is poisonous. Anticipatory assignments, like Lucas, where the services were performed in the future are not affective. In this case, the assignment was effective b/c the TP waived the income before he was entitled to it. He did not exercise dominion over it. Do something useful was a term of endearment. Rev. Rule 66-167 TP was administrator of his wifes estate. Administrator performing services can refuse state law sanctioned income from the estate. If the fee is waived up front, the waiver is effective, so the money can be inherited tax-free. Test: whether the waiver involved will at least primarily constitute evidence of intent to render a gratuitous service; the timing, purpose, and effect of the waiver must support this intent. It can be shown by supplying a formal waiver w/in 6 months, or implied when the commission is not included in the accounting of the estate. If a deduction was taken by the estate for the fee, then no intent is shown for the services to be gratuitous. Rev. Rule 74-581 Agency/Principal faculty member (agent) performs services in the clinic and turns over the earned fee to the university (principal). This is not the same thing as entitlement. The faculty was a conduit to the university. If there is an agency relationship, the fee is effectively assigned and the principal has income, not the agent. Look at the factual situation

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Tax IA Outline Ch 20(C) Deferred Compensation Arrangements By entering into deferred compensation arrangements, you can perform services now, and defer the income until later and average it out. Keep in mind: 1. What are the benefits of setting up deferred compensation arrangements; 2. What happens to the money while it is in the plan; and 3. How is it taxable when it is withdrawn. General rule: if you want security now, you must recognize the income now. There is a tension between having security and recognizing the income presently. Rev. Rule 60-31 TP performs the services now, but is paid in the future. There is no cash in hand, but a promise to be paid. Is that income now? The promise is income now if it is funded and secure, then you have constructive receipt and you are a secured creditor. If it is not funded and secure, there is no income now, even if services have already been performed, you are a general creditor. You must give up security to defer the income. **if the income is deferred by the one who earns it, the deduction cannot be taken by the employer yet either** when the income is recognized by the employee the deduction is recognized by the employer.** 1.451-1(a) General rule for taxable year of inclusion. Gains, profits, and income are to be included in gross income for the taxable year in which they are actually or constructively received by the taxpayer unless includible for a different year in accordance with the taxpayers method of accounting. A mere promise to pay, not represented by notes or secured in any way, is not regarded as receipt of income within the intendment of the cash receipts and disbursements method. Taxpayers on a receipts and disbursements method (cash basis) are required to report only income actually received no matter how binding any contracts they may have to receive more. Receipt may be actual or constructive. 1451-2 Constructive receipt of income. (a) Income although not actually reduced to a taxpayers possession is constructively received by him in the taxable year during which it is credited to his account or set apart for him so that he may draw upon it at any time. However, income is not constructively received if the taxpayers control of its receipt is subject to substantial

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Tax IA Outline limitations and restrictions. Thus, if a corporation credits its employees with bonus stock, but the stock is not available to such employees until some future date, the mere crediting on the books of the corporation does not constitute receipt. Under the Doctrine of Constructive Receipt: A taxpayer may not deliberately turn his back upon income and thereby select the year for which he will report it. Nor may a taxpayer, by a private agreement, postpone receipt of income from one taxable year to another. Amounts due from a corporation but unpaid, are not to be included in the income of an individual reporting his income on a cash receipts basis unless 1. It appears that the money was available to him, that the corporation was able and ready to pay him, 2. That his right to receive was not restricted, and 3. That his failure to receive resulted from exercise of his own choice. Whether the doctrine of constructive receipt is applicable must be made upon the basis of the specific factual situation involved. Taken from Reg. 1.451-2, Examples (in the case of interest, dividends, or other earnings are on deposit or account in a bank or similar institution) where there is no substantial limitations or restrictions (that is, there is constructive receipt): A requirement that the deposit or account, and the earnings thereon, must be withdrawn in multiples of even amounts; The fact that the TP would, by withdrawing the earnings during the taxable year, receive earnings that are not substantially less in comparison with the earnings for the corresponding period to which the TP would be entitled had he left the account on deposit until a later date. For example: if an amount equal to three months interest must be forfeited upon withdrawal or redemption before maturity of a one year or less certificate of deposit, time deposit, bonus plan, or other deposit arrangement then the earnings payable on premature withdrawal or redemption would be substantially less when compared with the earnings available at maturity. A requirement that the earnings may be withdrawn only upon a withdrawal of all or part of the deposit or account.

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Tax IA Outline A requirement that a notice of intention to withdraw must be given in advance of the withdrawal Examples of constructive receipt from the same Reg.: Amounts payable with respect to interest coupons which have matured and are payable but which have not been cashed are constructively received in the taxable year during which the coupons mature, unless it can be shown that there were no funds available for payment of the interest during such year. Dividends on corporate stock are constructively received when unqualified made subject to the demand of the shareholder. However, if a dividend is declared payable on December 31 and the check is not received by the shareholder until January of the following year, such dividends are not considered to have been constructively received in December. Generally, the amount of dividends or interest credited on savings bank deposits or to shareholders of organizations such as building and loans, is income to the depositors or shareholders for the taxable year when credited. However, if any portion of such dividends or interest is not subject to withdrawal at the time credited, such portion is not constructively received and does not constitute income to the depositor or shareholder until the taxable year in which the portion first may be withdrawn. Any contribution made by an employer on behalf of an employee to a trust during a taxable year of the employer which ends within or with a taxable year of the trust for which the trust is not exempt under 501(a), shall be included in income of the employee for his taxable year during which the contribution is made if his interest in the contribution is non-forfeitable at the time the contribution was made. Rev. Ruling 57-528 held that certain contributions conveying fully vested and nonforfeitable interests made by an employer into separate independently controlled trusts for the purpose of furnishing unemployment and other benefits to its eligible employees constituted additional compensation to the employees includible in their income for the taxable year in which they were made. Statutory Deferred Compensation Arrangements Qualified Plans The exception to the no security/no income rule If the requirements of 401(a) are met, there can be assured payment with the desired tax deferral. Thus both the employee and employer benefit: the employee is not taxed on the contributions and the employer still gets a deductions when they make the contributions. Another benefit: income generated while it is within the plan is not taxed until it is withdrawn.

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Tax IA Outline There are two types: Defined benefit: contributions are made to a trust in sufficient amounts to provide a set, promised benefit payable out of the trust to the employee in retirement. Defined contribution: contributions based on a percentage of the employees salary, or of the profits of the business in a profit sharing plan, are made in cash or securities of the employer, to an amount that the employee will receive on retirement. One key requirement for all qualified plans is that the plan not discriminate in favor of highly compensated employees. Two distinct tax advantages: 1) The employee is not taxed on contributions made for the employees benefit until amounts are distributed. Thus, one pays tax later on this deferred compensation, and very likely, at lower rates because distributions may be received over ones retirements years. 2) The trust to which contributions are made is exempt from tax. Thus, gains and losses and income earned by pre-taxed (untaxed) compensation grow while held in trust without the usual tax attrition. While it is trust, it grows tax free!! Another benefit: the fund is vested and creditors cannot get to it. Keogh Plans similar to qualified plans except that as the self-employed person contributes to a Keogh plan, the person takes an income tax deduction, rather than being allowed gross income exclusion as in the case of a qualified plan. IRAs allows the taxpayer a deduction for contributions, freedom from tax attrition during growth, and taxation only as distributions are made from the account if they are delayed until the individual is at least 59 . $2000 is the max deduction per year. Roth IRA the normal IRA rules are reversed Contributions to a Roth IRA are not deductible. Income generated by the Roth IRA is not taxed and distributions known as qualified distributions are excluded from income if they are paid more than 5 years after the establishment of the IRA and after the TP reaches 59 . $2000 max contribution. Simple plans may be used by small businesses (100 employees or less). It can be an IRA for each employee or part of a 401(k) qualified cash or deferred arrangement. Not subject to discrimination rules. Deferred Payments Made in Property

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A related deferred compensation devise for corporate employees is the incentive stock option (ISO). An ISO is an option granted by an employer corporation to an employee to purchase stock in the corporation at a fixed or determinable price. If certain requirements are met concerning dates the option is granted and exercised, the option price etc., then no income is recognized by the employee when the ISO is granted or even when the option is exercised. Income is recognized by an employee who exercised the option only upon the employees subsequent sale of the stock acquired with the option. Read above as: the ISO must be a qualified plan under 421/422. Otherwise, the property is transferred under the general rule of 83 Property transferred in connection with performance of services!

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Tax IA Outline VIII. Property Transferred in Connection with Services Reg. 1.83-3(e) defines property: includes real and personal property, other than either money or an unfounded and unsecured promise to pay money or property in the future. It also includes a beneficial interest in assets (including money), which are transferred or set aside from the claims of creditors of the transferor. 83 Property transferred in connection with performance of services. (a) General rule. If, in connection with the performance of services, property is transferred to any person other than the person for whom such services are performed, the excess of (1) the fair market value of such property (determined without regard to any restriction other than a restriction which by its terms will never lapse) at the first time the rights of the person having the beneficial interest in such property are transferable or are not subject to a substantial risk of forfeiture, whichever occurs earlier, over (2) The amount (if any) paid for such property, shall be included in the gross income of the person who performed such services in the first taxable year in which the rights of the person having the beneficial interest in such property are transferable or are not subject to a substantial risk of forfeiture, whichever is applicable. The preceding sentence shall not apply if such person sells or otherwise disposes of such property in an arms length transaction before his rights in such property become transferable or not subject to a substantial risk of forfeiture. (b) Election to include in gross income in year of transfer. (1) In general. Any person who performs services in connection with which property is transferred to any person may elect to include in his gross income, for the taxable year in which such property is transferred, the excess of (A) the fair market value of such property at the time of transfer (determined without regard to any restriction other than a restriction which by its terms will never lapse), over (B) the amount (if any) paid for such property. If such election is made, subsection (a) shall not apply with respect to the transfer of such property, and if such property is subsequently forfeited, no deduction shall be allowed in respect of such forfeiture. (2) Election. An election under paragraph (1) with respect to any transfer of property shall be made in such manner as the Secretary prescribes and shall not be made later than 30 days after the date of transfer.***

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(c)Special rules. (1) Substantial Risk of forfeiture. The rights of a person in property are subject to a substantial risk of forfeiture if such persons rights to full enjoyment of such property are conditioned upon the future performance of substantial services by any individual. (2) Transferability of property. The rights of a person in property are transferable only if the rights in such property of any transferee are not subject to a substantial risk of forfeiture. (d) Certain restrictions which will never lapse. (1) Valuation. In the case of property subject to a restriction which by its terms will never lapse, and which allows the transferee to sell such property only at a price determined under a formula, the price so determined shall be deemed to be the fair market value of the property unless established to the contrary by the Secretary, and the burden of proof shall be on the Secretary with respect to such value. (2) Cancellation. If, in the case of property subject to a restriction which by its terms will never lapse, the restriction is cancelled, then unless the taxpayer establishes (A) that such cancellation was not compensatory, and (B) that the person, if any, who would be allowed a deduction if the cancellation were treated as compensatory, will treat the transaction as not compensatory, as evidenced in such manner as the Secretary shall prescribe by regulations, the excess of the fair market value of the property (computed without regard to the restrictions) at the time of cancellation over the sum of (C) the fair market value of such property (computed by taking the restriction into account) immediately before the cancellation, and (D) the amount, if any, paid for the cancellation, shall be treated as compensation for the taxable year in which such cancellation occurs. (e) Applicability of section. This section shall not apply to (1) a transaction to which 421 applies, (2) a transfer to or from a trust described in 401(a)*** the transfer of an option without a readily ascertainable fair market value, (4) the transfer of property pursuant to the exercise of an option with a readily ascertainable fair market value at the date of grant, or (5) group-term life insurance to which 79 applies. (f) Holding period. In determining the period for which the taxpayer has held property to which subsection (a) applies, there shall be included only the period

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Tax IA Outline beginning at the first time his rights in such property are transferable or are not subject to a substantial risk of forfeiture, whichever occurs earlier. (g) omit (h) Deduction by employer. In the case of a transfer of property to which this section applies or a cancellation of a restriction described in subsection (d), there shall be allowed as a deduction under 162, to the person for whom were performed the services in connection with which such property was transferred, an amount equal to the amount included under subsection (a), (b), or (d)(2) in the gross income of the person who performed such services. Such deduction shall be allowed for the taxable year of such person in which or with which ends the taxable year in which such amount is included in the gross income of the person who performed such services. What is the difference between 83 and 61 (General definition of gross income)? The transfers of property are subject to restriction. If you have a substantial restriction, no income is recognized until the restriction lapses. Then you have full enjoyment and ownership, so it is income (Glenshaw). 83 provides that a TP who performs services must include the fair market value of property received for those services, less anything paid for the property, in gross income when the TPs beneficial interest in the property is substantially vested. This can affect both the timing and characterization (converting from labor income to capital gain)of income. Under 83(a), if property is transferred to any person in connection with the performance of services, then at the time when the property is substantially vested (either not subject to a substantial risk of forfeiture or transferable) the service provider generally has gross income in an amount equal to the excess of the propertys fair market value over the amount paid for the property. (Codifies Lucas, where the person who performs the services has the income.) Property includes real and personal property, other than money or an unfunded and unsecured promise to pay money in the future. A transfer of property occurs when a taxpayer acquires a beneficial ownership interest in property. If the property is substantially non-vested property that is, the taxpayers beneficial interest in the property is subject to a substantial risk of forfeiture and not transferable, then the transfer of property is not taxable until the property becomes substantially vested, that is, when the property is either not subject to a substantial risk of forfeiture or it is transferable.

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Tax IA Outline Until such property becomes substantially vested, the transferor shall be regarded as the owner of such property; and any income from such property received by the employee or the right to the use of such property by the employee shall be included in the gross income of such employee for the taxable year in which such income is received or such use is made available. Reg. 1-83-1(a). Under this provision, the employee doesnt include the actual stock in his income until it is vested, but the dividends earned in the meantime are included in his income. Thus, the grant of an option to purchase property is not a transfer of the property. A transfer may not occur when property is transferred under conditions that require its return on the happening of an even that is certain to occur, such as the termination of employment. The transfer can be in an employment or an independent contractor relationship. A taxpayers beneficial interest in property is subject to a substantial risk of forfeiture when full enjoyment of the property is conditioned, directly or indirectly, on the future performance of substantial services. For example: if stock in a corporate employer is transferred to an employee subject to a binding commitment to resell the stock to the employer if the employee leaves the employment for any reason within two years of the transfer, the employees rights to the stock are subject to substantial risk of forfeiture during the two year period. If retention of the property is conditioned upon the earnings of the employer increasing, that restriction is a substantial risk of forfeiture. But there is no substantial risk of forfeiture if the property must be returned only if an employee is terminated for cause or as a result of committing a crime. A non-lapse restriction is a restriction which by its terms will never lapse. A nonlapse restriction is a permanent limitation on the transferability of the property which requires the transferee or a subsequent holder to sell, or offer to sell, the property at a price determined under a formula. Thus, a permanent right of first refusal held by a particular person at a formula price would be a non-lapse restriction. Example from Reg. 1.83-1(b) Subsequent sale, forfeiture, or other disposition of non-vested property. If non-vested property is disposed of in an arms length transaction: the person who performed such services shall have gross income to the extent the amount realized exceeds the amount paid for such property.

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Tax IA Outline In Reg. 1.83-1(c) Disposition of non-vested property in a non-arms length transaction: If in 1971, an employee pays $50 for a share of stock which has a FMV of $100 and is substantially non-vested at that time, and later in 1971 the employee sells the stock to his wife for $10,, the employee has $10 of income in 1971. If in 1972 when the stock becomes substantially vested, and the FMV is $120, the employee (not the wife) realizes additional compensation in 1972 in the amount of $60 ($120 FMV - $50 paid - $10 taxed as compensation in 1971 = $60 additional income). ** The income cant be assigned or shifted, it belongs to the provider of services!!

The 83(b) Election. If there is a transfer of substantially non-vested property to a TP in connection with the performance of services, the TP may elect to include in gross income, for the taxable year of the transfer, the difference between the FMV of the property at the time of the transfer and the amount paid for the property. If a 83(b) election is made, 83(a) does not trigger additional gross income when the property becomes substantially vested. This is the choice of the person performing the services (as opposed to the actual recipient of the property). The TP can pick and choose, do a little private ordering. As a result, the TP may include the income in year one even though the TP does not have beneficial ownership. That is good to do when the FMV is lower now, or your tax bracket is lower now. Gain is realized later at capital gains rate.. You cant shift the identity of the earner, but you can shift the timing of the income, and under 83(b), the character of the income can be changed also. Benefit of the 83(b) Election: You can change the character of the income from labor to capital gain (conversion), which is taxed at a lower rate. Take the property into income now at FMV less amount paid, then when it appreciates, any future gain is recognized as a capital gain. On the later disposition, the propertys basis for determining gain or loss is the amount paid for the property increased by the amount included in gross income under 83(b). The taxpayers holding period for the property also begins when the property is transferred. However, there is a risk involved to this election: if the property is forfeited later, the taxpayer is not allowed a deduction for the amount included in income when the election was made. Also, if the property declines in value instead of appreciating, the TP will have paid tax on income never realized.

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Tax IA Outline Under 83(h) the employer gets a deduction when and in the amount the employee takes the property into income. Symmetry of treatment. Remember: if the employer gives the EE stock with no restrictions, the EE has income right then! Illustration of 83(b) election: (p. 870 top.) EE an employee of X Company is transferred 100 shares of X Company stock for $90 per share when the FMV is $110/share. The X Company stock is non-vested for two years, at which time it is worth $140/share. If EE forfeits the stock, it must be resold to X Company for $90/share. Under 83(a), EE will have $5000 of ordinary gross income when the stock is substantially vested at the end of two years ($14,000 FMV - $9000 paid for the stock = $5000 ordinary income). Under 83(b) Election: EE makes the election in the year of transfer and includes $2000 in ordinary income at that time ($11,000 FMV - $9000 paid for the stock = $2000 ordinary income.) EE would not recognize any further gain until the stock is sold. If the EE sells the stock two years after the transfer when the stock is $140, the income recognized at that time would be a $3000 capital gain. ($14,000 FMV - $11,000 basis = $3000 capital gain). The effect of the election would be to convert the additional $3000 of appreciation in the property from the time of the election until it becomes substantially vested from ordinary income to long term capital gain. But if EE forfeits the stock before it becomes vested but after taking the 83(b) election, EE will recover $9000 of cash but will not be allowed a deduction for the $2000 that was included in gross income when the election was made. 83(b) is a wise election when it will produce little or no gross income b/c the transferred property has little or no current value. 83(b) election is also advisable when little gross income will be included b/c the amount paid for the property is equal or very close to its current value. The EE has to be able to pay the tax triggered by the election though. 83(b) allows the EE to ignore the restriction and take income in the year when the stock is received, even though it is still restricted. By doing this, you account for the labor transaction in year one. Then later, when the restriction is lifted and you dont have to account for the income. Then when you sell the stock, it is now capital gain, and not taxed at the higher labor rate. You avoid paying the ordinary income tax rate doing this.

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Tax IA Outline Reg. 1.83-2(a) The fact that the transferee has paid full value for the property transferred, realizing no bargain element in the transaction, does not preclude the use of the election as provided for in this section.*** In computing the gain or loss from the subsequent sale or exchange of such property, its basis shall be the amount paid for the property increased by the amount included in gross income under 83(b). Stock Options as Compensation for Labor Services (nonqualified stock options) Stock options are a good way to pay employees in start up businesses; the employer gets the services from the employees now and defer the payment when the company is doing better. The employee gets a chance to purchase stock at a price when the company was still speculative. Reg. 1.83-3 (a)(2) Defines an Option: The grant of an option to purchase certain property does not constitute a transfer of such property (unless it has a readily ascertainable FMV). 83 applies to the grant of an option that has a readily ascertainable FMV. Then the option is property in itself. If an option does not have a readily ascertainable value (as in the start-p business situation), then 83(a) and (b) do not apply to the transfer of the option, but they apply at the time of the exercise of the option to the transfer of the property subject to the option. Reg. 1.83-7 Taxation of nonqualified stock options. (a) In general. If thee is granted to an employee or independent contractor an option to which 421 does not apply (qualified plans), 83(a) shall apply to such grant if the option has a readily ascertainable FMV. The person who performed such services realizes compensation upon such grant at the time and in the amount determined under 83(a). IF the option does not have a readily ascertainable FMV (actively traded) at the time of the grant, 83(a) shall not apply at the time of the grant of the option, HOWEVER, 83(a) and (b) shall apply at the time the option is exercised or otherwise disposed of, even though the fair market value of such option may have become readily ascertainable before such time.

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Tax IA Outline Example: Date #1: year of grant of the option. NO ascertainable FMV. It is not a taxable event, b/c there is no transfer of property. A promise for something that doesnt have value yet. (There is no bargain element, the stock was worth $1.50 per share and the option to buy it was $1.50 per share.) The option is not secure or funded. Date #2: the stock price goes up to $8.00 per share and the option is exercised. If the stock is not restricted, this is a taxable event. Run the transaction through 83(a): $8 FMV - $1.50 paid = $ 6.50 gain in income. The labor transaction is now closed out. If the stock was restricted, then there is no income recognized until the restriction is lifted. Unless 83(b) is invoked. Analysis Notes for stock options: 1) At the time of the grant, does the option have a readily ascertainable FMV? If yes, then 83(a). If No, then go to 2. 2) if after the option is exercised, go to 83 (a). Is the stock restricted? If it is, no income until restriction is lifted, unless 83(b) is invoked. If stock is not restricted, income. What if a stock option is gifted to a child from the parent? Gifting is not a trigger to close out the labor transaction, it is a tax neutral event. But when the option is exercised by the child, the parent is taxed through 83!! The labor income cannot be shifted over to the child.

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Tax IA Outline Ch 6, pg 117 XI. See notes Gains From Dealing in Property

Property can be two sources of wealth: income it produces (rent etc.) and gain on its disposition. Rent is recognized under 61, gain is recognized under 1001 the flagship provision. The mere return of capital is not included in gross income. Basis is used to measure what is the return of capital or what have I got in it. Basis is an after-tax position. Basis is the key to property transactions; also deductions are keyed on basis. Basis is unique to income tax (not needed for sales tax, Social security tax..) Example: you have $200 in wages, on which you are taxed. Then you take $100 of this and buy stock. Then sell this stock for $150. The gain is $50, the $100 you were already taxed on once, that is your basis and you are not taxed on it again.

50% of the exam ans be sure to include this

Analysis tips for property transactions: Whenever you have a property transaction, always run the transaction through 1001, do not go straight to the exceptions. Also: look at how the property was acquired, was it a gift? Was it part gift and part sale? Inheritance? For services provide? A purchase? A property settlement between H & W? Was the exchange taxable or tax free or partially tax free? The tax rules are different for each. 1001(b) defines amount realized; 1012 defines basis (cost is basis); 1001(c) is where the gain is recognized, unless another code section kicks in. IRC 1001 Determination of amount of and recognition of gain or loss. (a) Computation of gain or loss. The gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the adjusted basis provided in 1011 for determining gain, and the loss shall be the excess of the adjusted basis provided in such section for determining loss over the amount realized. (b) Amount realized. The amount realized from the sale or other disposition of property shall be the sum of any money received plus the fair market value of the property (other than money) received. In determining the amount realized-

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Tax IA Outline (1) there shall not be taken into account any amount received as reimbursement for real property taxes which are treated under 164(d) as imposed on the purchaser, and (2) there shall be taken into account amounts representing real property taxes which are treated under 164(d) as imposed on the taxpayer if such taxes are to be paid by the purchaser. (c) Recognition of gain or loss. Except as otherwise provided in this subtitle, the entire amount of the gain or loss, determined under this section, on the sale or exchange of property shall be recognized. (d) Installment sales. Nothing in this section shall be construed to prevent (in the case of property sold under contract providing for payment in installments) the taxation of that portion of any installment payment representing gain or profit in the year in which such payment is received. (e) Certain term interests. (1) In general. In determining gain or loss from the sale or other disposition of a term interest in property, that portion of the adjusted basis of such interest which is determined pursuant to 1014, 1015, or 1041 (to the extent that such adjusted basis is a portion of the entire adjusted basis of the property) shall be disregarded. (2) Term interest in property defined. For purposes of paragraph (1), the term term interest in property means(A) a life interest in property, (B) an interest in property for a term of years, or (C) an income interest in a trust. (3) Exception. Paragraph (1) shall not apply to a sale or other disposition which is a part of a transaction in which the entire interest in property is transferred to any person or persons.

IRC 1012 Adjusted basis for determining gain or loss (a) General rule. The adjusted basis for determining the gain or loss from the sale or other disposition of property, whenever acquired, shall be the basis (determined under section 1012 or other applicable sections of this subchapter***, adjusted as provided in 1016. (b) Bargain sale to a charitable organization. **see book** IRC 1016 Adjustments to basis (a) General Rule. Proper adjustment in respect of the property shall in all cases be made(1) for expenditures, receipts, losses, or other items, properly chargeable to capital account, but no such adjustment shall be made-

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Tax IA Outline (A) for taxes or other carrying charges described in 266, or (B) for expenditures described in 173 (relating to circulation expenditures), for which deductions have been taken by the taxpayer in determining taxable income for the taxable year or prior taxable years; (2) in respect of any period since February 28, 1913, for exhaustion, wear and tear, obsolescence, amortization, and depletion, to the extent of the amount *see book p. 585* Reg. 1.1001-1 Computation of gain or loss. (a) General rule. Except as otherwise provided in subtitle A of the Code, the gain or loss realized from the conversion of property into cash, or from the exchange of property for other property differing materially either in kind or in extent, is treated as income or as loss sustained. The amount realized from a sale or other disposition of property is the sum of any money received plus the fair market value of any property (other than money) received. The fair market value of property is a question of fact, but only in rare and extraordinary cases will property be considered to have no fair market value. The general method of computing such gain or loss is prescribed by 1001(a) through (d) which contemplates that from the amount realized upon the sale or exchange there shall be withdrawn a sum sufficient to restore the adjusted basis prescribed by 1011 and the regulations thereunder (i.e. the cost or other basis adjusted for receipts, expenditures, losses, allowances, and other items chargeable against and applicable to such cost or other basis.) The amount which remains after the adjusted basis has been restored to the taxpayer constitutes the realized gain. If the amount realized upon the sale or exchange is insufficient to restore to the taxpayer the adjusted basis of the property, a loss is sustained to the extent of the difference between such adjusted basis and the amount realized. The basis may be different depending upon whether gain or loss is being computed. For example, see 1015(a) and the regulations thereunder. 1001(e) and paragraph (f) of this section prescribe the method of computing gain or loss upon the sale or other disposition of a term interest in property the adjusted basis (or a portion) of which is determined pursuant, or by reference, to 1014 (relating to the basis of property acquired from a decedent) or 1015 (relating to the basis of property acquired by gift or by a transfer in trust).

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(e) Transfers in part a sale and in part a gift. (1) Where a transfer of property is in part a sale and in part a gift, the transferor has a gain to the extent that the amount realized by him exceeds his adjusted basis in the property. However, no loss is sustained on such a transfer if the amount realized is less than the adjusted basis. For the determination of basis of property in the hands of the transferee, see Reg. 1.1015-4. Examples from Reg. 1.1001-1: Example (1) A transfers property to his son for $60,000. Such property in the hands of A has an adjusted basis of $30,000 (and a FMV of $90,000). As gain is $30,000, the excess of $60,000, the amount realized, over the adjusted basis, $30,000. He has made a gift of $30,000, the excess of $90,000 the FMV, over the amount realized, $60,000. Example (2) A transfers property to his son for $30,000. Such property in the hands of A has an adjusted basis of $60,000 (and a FMV of $90,000). A has no gain or loss, and has made a gift of $60,000, the excess of $90,000, the FMV, over the amount realized, $30,000. [no loss is sustained on such a transfer if the amount realized is less than the adjusted basis] Example (3) A transfers property to his son for $30,000. Such property in As hands has an adjusted basis of $30,000 (and a FMV of $60,000). A has no gain and has made a gift of $30,000, the excess of $60,000, the FMV, over the amount realized, $30,000. Example (4) A transfers property to his son for $30,000. Such property in As hands has an adjusted basis of $90,000 (and a FMV of $60,000). A has sustained no loss, and has made a gift of $30,000, the excess of $60,000 the FMV, over the amount realized, $30,000. A. 1. Determination of Basis Cost as Basis

IRC 1012 Basis of property cost. The basis of property shall be the cost of such property, except as otherwise provided in this subchapter and subchapters C (relating to corporate distributions and adjustments), K(relating to partners and partnerships), and P (relating to capital gains and losses). The cost of real property shall not include any amount in respect of real property taxes which are treated under 164(d) as imposed on the taxpayer.

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Tax IA Outline Reg. 1.1012-1. Basis of property. (a) General rule. In general, the basis of property is the cost thereof. The cost is the amount paid for such property in cash or other property. This general rule is subject to exceptions stated in subchapter O (relating to gain or loss on the disposition of property), subchapter C (relating to corporate distributions and adjustments), subchapter K (relating to partners and partnerships), and subchapter P (relating to capital gains and losses), chapter 1 of the Code. (c)sale of stock. *see book* Reg. 1.61-2 Compensation for services (d)(2)(i)*** if property is transferred by an employer to an employee or if property is transferred to an independent contractor, as compensation for services, for an amount less than its fair market value, then regardless of whether the transfer is in the form of a sale or exchange, the difference between the amount paid for the property and the amount of its fair market value at the time of the transfer is compensation and shall be included in the gross income of the employee or independent contractor. In computing the gain or loss from the subsequent sale of such property, its basis shall be the amount paid for the property increased by the amount of such difference included in gross income. [run through S1001] Reg. 1.1011-1 Adjusted basis. The adjusted basis for determining the gain or loss from the sale or other disposition of property is the cost or other basis prescribed in 1012 or other applicable provisions of subtitle A of the Code, adjusted to the extent provided in 1016, 1017, and 1018 or as otherwise specifically provided for under applicable provisions of internal revenue laws. Philadelphia Park Amusement Co. v. U.S. 1954 - legendary case what the notion of cost or basis is all about: 57 years earlier, TP built a bridge for $381,000. In consideration for a 10 year extension of a franchise agreement, the TP deeded the bridge over to the city. When the franchise still had 3 years left to run, the TP abandoned the franchise and asserted depreciation deductions based on the cost of the extension and a loss upon abandonment of the franchise.

I What is the basis of the 10-year extension of the TPs franchise? The IRS asserts that the basis is the FMV of the franchise.

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Tax IA Outline H. When you acquire property in a taxable exchange, the basis in the acquired property is its FMV. The FMV of the property received is the cost basis. The abandonment of the lease is the realization event. When property is exchanged for property in a taxable exchange, the TP is taxed on the difference between the adjusted basis of the property given in exchange and the FMV of the property received in exchange. However, if the cost basis of the extension cannot be determined with reasonable accuracy, the FMV of the bridge can be substituted b/c it is in an arms length transaction. Assume the values of the two properties are equal. For purposes of determining gain or loss, the FMV of the property received is treated as cash. All deductions (such as for depreciation) are keyed on basis. If cost were not basis, there would be disharmony! The TP could avoid paying taxes: Basis only includes thus amounts previously included in income. That is the only way to step up your basis. If you recognize the gain, then the gain can be added to the basis. The role of basis is to give you your capital back tax-free. However, that capital must be taxed initially. Basis is an after tax position! No cheap step up in basis without paying tax on the gain!! Other Notes: A lapse of an option is like an abandonment, so the amount realized is zero; so if the option had a basis of $1000 you have an economic loss: run through 1001 and recognize it as a deduction. [An option is an interest in property.] Basis is an adjustable concept: example of a creeping basis: if the option to purchase the land is $1000 and you later purchase the land for $9000, the basis of the land is $10,000. If your basis is $10,000 and you make $2000 worth of improvements (capital expenditures), the adjusted basis is $12,000. What if the expense is not a capital expenditure? The expense is currently deducted instead of being added to basis. But there is a timing benefit to this: You have a higher gain later, but you get the deduction now. You are making your

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Tax IA Outline current ordinary income lower, which is at a higher tax rate. The later gain is recognized at a lower capital gains rate. [example of conversion] Deductions and basis really measure the same thing. No basis, no deduction. Special Note for 1019 & 109: What if TP acquired the property in a tax free way? Tenant is paying rent to land lord, so rent is ordinary income. Tenant gets a deduction for rent expense. Tenant improves property during the lease and the tenant gets the deductions related to the improvements. When the tenant erected the improvement, the tenant had use and dominion over it. The landlord had no beneficial enjoyment at that time, so the landlord had no income then. (Glenshaw). When the lease expires, the property reverts to the landlord. The land is old wealth, but the improvement made by the tenant is new wealth. The LL has dominion and benefit of it. Now it is income. But there is an exception for this: 109 & 1019!! 109 Improvements by lessee on lessors property. Gross income does not include income (other than rent) derived by lessor of real property on the termination of a lease, representing the value of such property attributable to buildings erected or other improvements made by the lessee. [** Because the income is recognized as a gain when the property is sold. It is a timing issue, not a permanent exclusion of GI.**]

1019 Property on which lessee has made improvements. Neither the basis nor the adjusted basis of any portion of real property shall, in the case of the lessor of such property, be increased or diminished on account of income derived by the lessor in respect of such property and excludable from gross income under 109(relating to improvements by lessee on lessors property). If an amount representing any part of the value of real property attributable to buildings erected or other improvements made by a lessee in respect of such property was included in gross income of the lessor for any taxable year beginning before January 1, 1942, the basis of each portion of such property shall be properly adjusted for the amount so included in gross income. 109 and 1019 avoids the problem of the LL having to sell the property just to pay the tax on the improvements made by the tenant. This helps the real estate industry. Also, an arms length sale is the best evidence of the propertys value. It only kicks in when 109 is invoked.

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Tax IA Outline But the exclusion under 109 is only temporary: it is a timing benefit. Because the LL has a zero basis in the improvements, he will recognize the income as a gain on the property when there is a later taxable realization event. The LL cannot depreciate the improvements either, because he has no basis in them. Between 109 and 1019, Philadelphia Park is codified. Exceptions to 109: If the leasehold improvement is in exchange for rent or is a liquidation payment (where the tenant abandons the lease and leaves the property in lieu of future rent), it is a barter and is included in the LLs gross income upon termination of the lease. It is a cash equivalent so it is not excluded under 109, it is ordinary income. See Reg. 1.109-1. Example: A mobile home left on the LLs property by a tenant who could have taken the mobile home with them, but they left it instead of paying the rent owed, the LL has gross income when the lease is terminated (not later when he sells the property). Other examples from text problems p. 121: (g) Owner is a salesperson in an art gallery and purchases a $10,000 painting from the gallery, but is required only to pay $9,000 for it because it is a qualified 132(a)(2) employee discount. Owner later sells the painting for $16,000. Answer: This is not a fully taxable transaction because 132 was intended to be a permanent exclusion. The owners basis is the FMV of $10,000, so the recognized gain is $6000. Look to see how the property was acquired!! (f) Owner received $10,000 (FMV) in land as a bonus from his employer for doing a good job. Owner paid income tax on the land in the amount of $3,000. Answer: There is a bargain element to the exchange here in the employee/employer setting, so 83 kicks in. The employee must take the $10,000 into gross income when received. But under Philadelphia Park, the employees basis is the FMV of the property received (or what you gave up), so his basis is $10,000. There is no upward adjustment for the income taxes he paid on the land. Income taxes are not deductible, so you cant include them in basis. The $3000 was a red herring. Other notes: Your basis in services are zero. Human capital has a zero basis. When you exchange your services for something, then you have a realization event and it can be run throughout 1001:

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Tax IA Outline Amount realized: Basis in employees services: Gross income to the employee: $10,000 0 ________ $10,000 when you get it!

If you perform services and are stiffed, that is not paid, you dont get a deduction because you have no basis in it. The deduction is only limited to what you have a basis in. If you paid another person $200 to do the work, then you would have a $200 basis and could deduct up to that amount.

2. Property Acquired by Gift The donee steps into the shoes of the donor. IRC 1015 Basis of property acquired by gifts and transfers in trust. (a) Gifts after December 31, 1920. If the property was acquired by gift after 12/31/1920, the basis shall be the same as it would be in the hands of the donor or the last preceding owner by whom it was not acquired by gift, except that if such basis (adjusted for the period before the date of the gift as provided in 1016) is greater than the FMV of the property at the time of the gift, then for the purposes of determining loss, the basis shall be such FMV. If the facts necessary to determine the basis in the hands of the donor or the last preceding owner are unknown to the donee, the Secretary shall, if possible, obtain such facts from such donor or last preceding owner, or any other person cognizant thereof. If the Secretary finds it impossible to obtain such facts, the basis in the hands of such donor or last preceding owner shall be the fair market value of such property as found by the Secretary as of the date or approximate date at which, according to the best information that the Secretary is able to obtain, such property was acquired by such donor or last preceding owner. (b) & (c) gifts and transfers from trusts **see text** (d) Increases basis for gift tax paid. **see text** (6) Special rules for gifts after 12/31/1976. **see text** (e) Gifts between spouses. In the case of any property acquired by gift in a transfer described in 1041(a), the basis of such property in the hands of the transferee shall be determined under 1041(b)(2) and not this section. NOTE: The EXCEPT Clause

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The except clause of 1015: This prevents the donor from trafficking in loses. There are two elements of the except clause: 1) it must be loss property (the donors basis is higher than the FMV) and 2) the property must be sold at a loss; then the donees basis is the FMV at the time of the gift. The donor must sell the property himself to get the loss recognized. Gaines are taxed but losses are not allowed. Example from Reg. 1.1015-1 Basis of property acquired by gift after 12/31/1920: This is very tricky!! Big Hint! A acquires by gift income-producing property which has an adjusted basis of $100,000 at the date of gift. The FMV of the property at the date of gift is $90,000. A later sells the property for $95,000. In such case there is neither gain nor loss. The basis for determining loss is $90,000; therefore, there is no loss. Furthermore, there is no gain, since the basis for determining gain is $100,000. Review of these examples from determining basis then compare with the flipside examples for the sons basis: Reg. 1.1001-1 Computation of gain or loss. (a) General rule. **see above determination of basis** (e) Transfers in part a sale and in part a gift. (1) Where a transfer of property is in part a sale and in part a gift, the transferor has a gain to the extent that the amount realized by him exceeds his adjusted basis in the property. However, no loss is sustained on such a transfer if the amount realized is less than the adjusted basis. For the determination of basis of property in the hands of the transferee, see Reg. 1.1015-4. Examples from Reg. 1.1001-1: Example (1) A transfers property to his son for $60,000. Such property in the hands of A has an adjusted basis of $30,000 (and a FMV of $90,000). As gain is $30,000, the excess of $60,000, the amount realized, over the adjusted basis, $30,000. He has made a gift of $30,000, the excess of $90,000 the FMV, over the amount realized, $60,000. Example (2) A transfers property to his son for $30,000. Such property in the hands of A has an adjusted basis of $60,000 (and a FMV of $90,000). A has no gain or loss, and has made a gift of $60,000, the excess of $90,000, the FMV, over the amount realized, $30,000. [no loss is sustained on such a transfer if the amount realized is less than the adjusted basis]

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Example (3) A transfers property to his son for $30,000. Such property in As hands has an adjusted basis of $30,000 (and a FMV of $60,000). A has no gain and has made a gift of $30,000, the excess of $60,000, the FMV, over the amount realized, $30,000. Example (4) A transfers property to his son for $30,000. Such property in As hands has an adjusted basis of $90,000 (and a FMV of $60,000). A has sustained no loss, and has made a gift of $30,000, the excess of $60,000 the FMV, over the amount realized, $30,000. Now compare what the sons basis is for these part/sale and part/gift transactions: Reg. 1.1015-4 Transfers in part a gift and in part a sale. (a) General Rule. Where a transfer of property is in part a sale and in part a gift, the unadjusted basis of the property in the hands of the transferee is the sum of (1) Whichever of the following is greater: (i) The amount paid by the transferee for the property, or (ii) The transferors adjusted basis for the property at the time of the transfer, and (2) The amount of increase, if any is basis authorized by 1015(d) for gift tax paid. For determining loss, the unadjusted basis of the property in the hands of the transferee shall not be greater than the FMV of the property at the time of such transfer. For determination of gain or loss of the transferor, see 1.1001-1(e). For special rule where there has been a charitable contribution of less than a taxpayers entire interest in property, see 170(e)(2). Examples: 1) If A transfers property to his son for $30,000, and such property at the time of the transfer has an adjusted basis of $30,000 in As hands (and a FMV of $60,000), the unadjusted basis of the property in the hands of the son is $30,000. 2) If A transfers property to his son for $60,000, and such property at the time of transfer has an adjusted basis of $30,000 in As hands (and a FMV of $90,000), the unadjusted basis of such property in the hands of the son is $60,000. 3) If A transfers property to his son for $30,000, and such property at the time of transfer has an adjusted basis in As hands of $60,000 (and a FMV of $90,000), the unadjusted basis of such property in the hands of the son is $60,000. 4) If A transfers property to his son for $30,000 and such property at the time of transfer has an adjusted basis of $90,000 in As hands (and a FMV of $60,000), the

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Tax IA Outline unadjusted basis of the property in the hands of the son is $90,000. However, since the adjusted basis of the property in As hands at the time of the transfer was greater than the FMV at that time, for the purposes of determining any loss on a later sale or other disposition of the property by the son its unadjusted basis in his hands is $60,000.

Notes: 1015 ascribes the meaning of gift the same as Duberstin. The making of a gift is not a realization event to the donor or donee, it is not an income tax event. Example: Parent purchased stock for $4, when gifted to the child the FMV was $10. The child later sells for $13. What is the childs basis? The donee steps into the shoes of the donor, so the childs basis is $4. The gain recognized by the child would be $9. The child cannot step up the basis by the $6 appreciation at the time of the gift. The appreciation (gain) has been assigned to the donee. This cannot work with labor income, but it can work on property transfers in a gift setting. In transactions that are part-sale and part-gift, the gift part is ignored because it is not a realization event. The donor has a gain to the extent the amount realized exceeds his basis. However, no loss is sustained on such a transfer if the amount realized is less than the adjusted basis. That amount of the unrecognized loss is really accounted for in the gift part of the transaction. The amount realized is first allocated to the sale part, which is good for the TP but bad if it generates a loss.

Case law: Taft v. Bowers 1929 In 1916 TPs father purchased stock for $1000. In 1923, the father transferred the stock to the TP when the stock had a FMV of $2000. The TP later sold the stock for $5000. I Whether the basis of a gift is the basis of the donor, or the FMV at the time of the transfer.

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H The basis of the donee is the same as the donors. The donee steps in the shoes of the donor. Rational:

The stock represented only a single investment of capital that made by the donor. When through sale or conversion, the increase in value was separated from the investment, that gain is subject to income tax by the donee. To hold otherwise would allow the increases in value to permanently escape taxation (cheap step ups in basis

Farid-Es-Sultaneh v. Commissioner 1947 Before TP married her husband, he had given her 2500 shares of stock to hold onto in case he died before they married. When they married, the husband gave the stock to the TP in consideration for their pre-nuptial agreement where the TP released her dower and other marital rights. Later when the TP sold the stock, the IRS claimed her basis was that of her husband. I Whether the stock was acquired by gift or purchase. H Transfers in consideration for the relinquishment of marital rights are not gifts for income tax purposes. The TP held the stock as a purchaser for fair consideration. Rationale: The income tax provisions dont need to be construed as though they were in conjunction with either the estate tax or gift tax law. The TP performed the terms of the K under which the stock was transferred to her.

3.

Property Acquired from a Decedent

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Tax IA Outline Under 1014(a) property acquired from a decedent generally receives a basis equal to its FMV on the date on which it was valued for federal estate tax purposes (which is the date of death). The effect of this basis rule is to give property that appreciated during the decedents ownership a stepped up basis with no income tax cost to anyone. Of course, a stepped down basis results without deductible loss if property declined in value during the decedents ownership. Thus if property is acquired from a decedent, the donees basis is the FMV at the time of death. This is very important for estate and tax planning when, for example an elderly person has highly appreciated property. The making of a gift by inheritance is not a realization event. Dying is not a realization event either. Ex: If the decedents basis is $4 and at the time of his death the FMV is $10, the $6 gain is not recognized by anyone. The heirs basis is $10. The $6 gain is not recognized by anyone, not even the decedent. The heir acquires a stepped up basis tax free. Policy: tracking the basis of a decedent is too hard, he may have acquired the property 50 years ago. It is easier to make basis FMV at the time of death. 1014 Basis of property acquired from a decedent. (a) In general. Except as otherwise provided in this section, the basis of property in the hands of a person acquiring the property from a decedent or to whom the property passed from a decedent shall, if not sold, exchanged, or otherwise disposed of before the decedents death by such person, be(1) the FMV of the property at the date of the decedents death, or (2)(3)(4) see text (b) Property acquired from the decedent. For purposes of subsection (a), the following property shall be considered to have been acquired from or to have passed from the decedent: (1) Property acquired by bequest, devise, or inheritance, or by the decedents estate from the decedent; (2) Property transferred by the decedent during his lifetime in trust to pay the income for life to or on the order or direction of the decedent, with the right reserved to the decedent at all times before his death to revoke the trust; (3)(4)see text (6) In the case of decedents dying after December 31, 1947, property which represents the surviving spouses one half share of community property held by the decedent and the surviving spouse under the community property laws of any State, or possession of the United States or any foreign country, if at least one half of the

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Tax IA Outline whole of the community interest in such property was includible in determining the value of the decedents gross estate under chapter 11 of subtitle B or 811of the IRC. (e) Appreciated property acquired by decedent by gift within 1 year of death. (1) In general. In the case of a decedent dying after December 31, 1981, if (A) appreciated property was acquired by the decedent by gift during the 1-year [look back] period ending on the date of the decedents death, and (B) such property is acquired from the decedent by (or passes from the decedent to) the donor of such property (or the spouse of such donor), the basis of such property in the hands of such donor (or spouse) shall be the adjusted basis of such property in the hands of the decedent immediately before the death of the decedent. (2) definitions. (A) Appreciated property. The term appreciated property means any property if the FMV of such property on the day it was transferred to the decedent by gift exceeds its adjusted basis. Notes for 1014(e) above: example: Highly appreciated property: Basis is $2 and FMV is $10. Donor makes a gift to an old dying uncle with the understanding the donor will soon inherit it back. The scheme is to inherit the property and get a step up in basis to $10 without recognizing the gain. This wont work! Congress caught onto this trick: 1014(e) has created a look back provision, which is a bright line test. Now the property must have been gifted or transferred to the uncle at least one year earlier. The longer the uncle keeps the property, the more risk to the transfer back to the donor, and the less likely it was a sham transaction. 1014(e) does not kick in if there is loss property, or if the transfer is more than one year and one day earlier than the decedents death. Reg. 1.1014-1 through 3-see text, nothing significant. 4. Property Acquired between Spouses or Incident to Divorce

In the case of any transfer of property between spouses or former spouses, the transferee is treated as if the property were acquired by gift, and the basis of the property in the hands of the transferee is the same as the basis of the property in the hands of the transferor. Unlike the gift basis rule, the 1041 transferee spouse or former spouse always takes a transferred basis, even for computing loss. Policy: Congress considered it inappropriate to tax transfers of property between spouses or former spouses. The policy implemented reflects the attitude that a

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Tax IA Outline husband and wife are a single economic unit and tax law should be unobtrusive. 1041 accords almost complete tax neutrality to transfers of property between spouses and former spouses if, in the latter instance, the transfer is incident to divorce. Property transfers between H & W are non-recognition transactions. No gain or loss is recognized. Getting married is not a realization event. Getting divorced is not a realization event either. 1041 Transfers of property between spouses or incident to divorce. (a) General Rule. No gain or loss shall be recognized on a transfer of property from an individual to (or in trust for the benefit of) (1) a spouse, or (2) a former spouse but only if the transfer is incident to the divorce. (b) Transfer treated as gift; transferee has transferors basis. In the case of any transfer of property described in subsection (a)(1) for purposes of this subtitle, the property shall be treated as acquired by the transferee by gift, and (2) the basis of the transferee in the property shall be the adjusted basis of the transferor. (c) Incident to divorce. For purposes of subsection (a)(2), a transfer of property is incident to the divorce if such transfer(1) occurs within 1 year after the date on which the marriage ceases, or (2) is related to the cessation of the marriage. (e) Transfers in trust where liability exceeds basis. **see text** Reg. 1.1041T Treatment of transfer of property between spouses or incident to divorce. Selected notes: 1041 applies to any transfer of property between spouses regardless of whether the transfer is a gift or is a sale or exchange between spouses acting at arms length (including a transfer in exchange for the relinquishment of property or marital rights or an exchange otherwise governed by another nonrecognition. A divorce or legal separation need

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Tax IA Outline not be contemplated between the spouses at the time of the transfer nor must a divorce or legal separation ever occur. Transfers of services are not subject to 1041. A transfer of property acquired after the marriage ceases may be governed by 1041, as long as it is it is incident to divorce. incident to divorce can be: 1) when the transfer occurs not more than one year after the date on which the marriage ceases, or 2) the transfer is related to the cessation of the marriage (up to 6 years, but that is rebuttable). Annulments and the cessations of void marriages are considered divorce. Do the rules of 1041 apply even if the transferred property subject to liabilities, which exceed the adjusted basis of the property? Yes. For example: A owns property having a FMV of $10 and an adjusted basis of $1. In contemplation of making a transfer of this property incident to a divorce from B, A borrows $5 from a bank, using the property as security for the borrowing. A then transfers the property to B and B assumes, or takes the property subject to, the liability to pay the $5 debt. Under 1041, A recognizes no gain or loss upon the transfer of the property, and the adjusted basis of the property in the hands of B is $1. The transferor of property under 1041 recognizes no gain or loss on the transfer even if the transfer was in exchange for the release of marital rights or other consideration. This rule applies regardless of whether the transfer is of property separately owned by the transferor or is a division of community property.

But: what if the transferor and transferee are prospective spouses (not married yet) and the transferee gives up marital rights in a premarital agreement and in exchange, the transferor transfers property to the transferee? 1014 is not applicable! The property was not acquired between spouses or incident to divorce. 1015 does not apply, there is a quid pro quo and valid consideration, so it is a sale (Duberstein gift test is not met). Go back to

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Tax IA Outline Philadelphia Park, the FMV is the transferees basis, and the transferor must recognize any gain on the transfer (because he received something in return). Example: H has a basis of $4, he transfers the property to W when the FMV is $10. W receives it tax fee as a gift under 102, and the W has a basis of $4. It is deemed a gift even if the W purchased the stock from H for $10. For tax purposes, this is not a sale. W has a $4 basis, if she sells it for $13, W has a gain of $9. The H has shifted the tax burden on W. This shifting of the tax burden on W should be considered when divorce settlements are made.

B.

The Amount Realized

The gross increase in wealth received from the buyer (consideration) is the amount realized, from this, you subtract your basis (old wealth), to determine your gain (new wealth). 1001(b) defines the amount realized as = cash + FMV value of any property received + debt relief (Crane-Tufts) Borrowing money is not a realization event, but not paying it back is a realization event. Debt relief is a cash equivalent, as if you got the money and paid the debt yourself. Case law: International Freight Corp. v. Commissioner 1943 TP a corp, owned primarily by DuPont, adopted an incentive bonus plan for employees in which eligible employees received DuPont stock. The plan could be terminated at any time by the TP. [Stock was transferred to the employees for services provided.] In 1936, TP paid employee bonuses of 150 shares of stock which had cost the TP $16. At the date of delivery to the employees, the stock had a FMV of $24. The TP took a deduction for $24. The commissioner asserts the proper deduction was $16.

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Tax IA Outline I. Whether the TP realized a gain of $8 when it transferred the stock with a basis of $16 to the employees when it had a FMV of $24. H. Since the transfer was not a gift, but a disposition of shares for a valid consideration equal at least to the FMV of the shares when delivered, there was a taxable gain equal to the difference between the cost of the shares and the FMV. Rationale:

The stock was transferred in exchange for the employees services, so 83 applies. This is a quid pro quo, stock for services, and it is a taxable realization event. The corporation owed the stock for bonuses, so payment was debt relief. Debt relief is an amount realized. The corporation received services from the employee, under Philadelphia Park, the FMV of the stock is a proper value for those services. The exchange of stock for services was no different from the corporation selling the stock for cash, and then paying the employees with the cash. Philadelphia Park says that the only way to step up from the historical cost to the current cost is by recognizing the gain. No cheap step ups in basis.

1032 is a non- recognition provision, even though there is an exchange. But it only applies to the companies own stock. If the corporation here had used its own stock instead of DuPont, it would have been a non- recognition event, and the company would have still got the deduction. Crane v. Commissioner 1947 Big Case TP inherited an apartment building and lot subject to a mortgage. When the husband died, the value of the property was appraised to be equal to the mortgage. From this standpoint, the TP had zero equity in the property. When she subsequently sold the property for $3000, and the buyer assumed the mortgage, the TP claimed only the $3000 gain (less $500 selling commission. I Whether the mortgage amount assumed by the purchaser [debt relief] was an amount realized by the TP.

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Tax IA Outline H Assumption of the non-recourse mortgage by the purchaser was debt relief to the TP and must be included in the amount realized on the sale. Debt relief is always included in the amount realized. Rationale: Property is defined as the physical thing which is the subject to ownership; the court used the plain dictionary meaning of property: the words of statutes including revenue acts-should be interpreted where possible in their ordinary, everyday sense. equity is not property. The TP used the value of the building undiminished by the value of the mortgage as her basis for depreciation; she did not use just the equity as the basis for depreciation. Basis in property is not diminished by the debt attached to it. When debt is paid or assumed by the buyer it is as if the buyer game the seller the money and the seller paid the bank. Debt relief is included in the amount realized. There is no difference between non-recourse debts and recourse debts. Dissent: the TP was not personally liable for the debt and hence she wasnt relieved from any debt.

Commissioner v. Tufts 1983 TP, as part of a partnership, constructed an apartment building, subject to a non-recourse mortgage. The TP claimed depreciation on the property. The adjusted basis of the property was $1.4m, the mortgage was $1.8m, and the FMV of the property was less than $1.4 million. The partnership had financial difficulties and walked away from the property and another party assumed the debt. The TP claimed a loss of $.55, ($1.4 FMV - $1.455 adjusted basis).

I Whether the debt relief is included in the amount realized when the unpaid amount of the non-recourse mortgage exceeds the FMV of the property sold.

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Tax IA Outline H Debt relief is included in the amount realized. [Codified in 7707(g): ***in determining the amount of gain or loss with respect to any property, the FMV of such property shall be treated as being not less than the amount of any non-recourse indebtedness to which such property is subject.] Rationale: Crane applies. Abandonment of the property is a realization event. This is a property transaction that should be run through 1001. The TP took advantage of the depreciation deduction. The re-payment of a debt is central to the fact that borrowed money is not income [fn8]. If you dont repay it, there is an increase in wealth (Glenshaw) and the transaction must be run through 1001. If the loan is not repaid you cant have a cheap step up in basis without including the debt relief in income. Basis includes cash and debt incurred in the acquisition of the property (plus costs like attorneys fees). The basis does not go up by the value of the second mortgage b/c it is not in the acquisition of the property. But if the second mortgage is used to improve the property, then it does go into the adjusted basis.

Example: the asset costs $100 and you put down $10 of your own cash and borrow $90. Because this is a bona fide debt you intend to pay back, the IRS allows you to include it in basis. From this basis you make take depreciation deductions right away, even though the loan has not yet been repaid and you only put down $10 of your own money. If the property appreciates to $125 and is sold for $125, and the buyer gives the TP $35 in cash and takes over the $90 loan, the TP realizes $125. If the FMV drops to $75, and the buyer gives the TP no cash, but takes over the$90 debt, the amount realized by the TP is $90. The TP can take a $10 loss. **review question #1 on p. 153 of text**

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Tax IA Outline XII. Other Exclusions From Gross Income

The general rule is 1001, exclusions are the exception. 1. Gain From the Sale of the Principal Residence Congress decided that homeownership should be encouraged, so under 121 the gain is not recognized in certain circumstances. The flip side: if there is a loss on the sale of the home, it is not deductible: it is a personal loss and it is not deductible. Under 121 a TP is able to exclude up to $250K ($500K if married filing joint) of gain realized on the sale or exchange of a principal residence. The exclusion is allowed each time a taxpayer selling or exchanging a principal residence meets the eligibility requirements, but generally no more frequently than once every two years. To be eligible for the exclusion, a TP must have owned the residence and occupied it as a principal residence for at least two of the five years prior to the sale or exchange. A taxpayer who fails to meet these requirements by reason of a change of place of employment, health, or unforeseen circumstances is able to exclude the fraction of the $250k ($500K if married joint) equal to the fraction of two years that these requirements are met. If a single TP who is otherwise eligible for an exclusion marries someone who has used the exclusion within the two years prior to the marriage, the [provision] allows the newly married TP a maximum exclusion of $250k. Once both spouses satisfy the eligibility rules and two years have passed since the last exclusion was allowed to either of them, the TP may exclude $500k of gain on their joint return. The term residence is defined broadly to include not only a house, but a house trailer, a house boat, stock in a cooperative housing unit, and any other dwelling place. A residence can include surrounding vast acreage, so long as it is not used for business or profit. The statute expressly requires that the residence qualify as the TPs principal residence. Ex: if a TP resides in a NYC apartment during the week, using a country house only on weekends, the sale of the country house will not meet the test of the statute. Analysis tip: always run the sale of the home through 1001 first b/c it is the general rule. Then go through the exclusionary provision of 121. A TP may elect to have 121 not apply to a sale and if such election has been made with respect to the prior sale, 121 may be used on the subsequent sale.

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Tax IA Outline

If the two year ownership and use tests or the multiple sales within two years rule are not met b/c subsequent sale is job related, health related, or due to other unforeseen circumstances there is an exception and a portion of the normal $250K or $500k exclusion amount of applies. The portion is the ratio of the shorter of the actual ownership and use during the prior five years or the time between the prior and current sale to two years. If a TP satisfies the ownership and use requirements for one year in the five-year period and then becomes physically or mentally incapable of self-care and moves to a care facilitythe TP is treated as using the principal residence during the time actually spent in the facility. The qualified property must be used for 2 years or more during the 5-year look back period. It must have been used as the principal residence. Both spouses muse meet use requirements for the house sold! Otherwise, the $250k cap applies. This is tricky when newly married. The gain on the sale does not have to be reinvested to qualify for exclusion. I.R.C.121 Exclusion of gain from sale of principal residence. (a) Exclusion: Gross income shall not include gain from the sale or exchange of property if, during the 5 year period ending on the date of the sale or exchange, such property has been owned and used by the taxpayer as the taxpayers principal residence for periods aggregating 2 years or more. (b) Limitations: (1) In general. The amount of gain excluded from gross income under subsection (a) with respect to any sale or exchange shall not exceed $250K. (2) Special rules for joint returns. In the case of a H and W who make a joint return for the taxable year of the sale or exchange of the property (A) $500k limitation for certain joint returns. Paragraph (1) shall be applied by substituting $500k for $250k if (i) either spouse meets the ownership requirements of subsection (a) with respect to such property; (ii) both spouses meet the use requirements of subsection (a) with respect to such property; and (iii) neither spouse is ineligible for the benefits of subsection (a) with respect to such property by reason of paragraph (3). (B) Other joint returns. If such spouses do not meet the requirements of subparagraph (A), the limitation under paragraph (1) shall be the sum of the limitations under paragraph (1) to which each spouse would be entitled if such

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Tax IA Outline spouses had not been married. For purposes of the preceding sentence, each spouse shall be treated as owning the property during the period that either spouse owned the property. (3) Application to only 1 sale or exchange every 2 years. (A) In general. Subsection (a) shall not apply to any sale or exchange by the taxpayer if, during the 2 year period ending on the date of such sale or exchange, there was any other sale or exchange by the taxpayer to which subsection (a) applied. (B) Pre-May 7, 1997, sales not taken into account. Subparagraph (A) shall be applied without regard to any sale or exchange before May 7 1997. (c)Exclusion for taxpayers failing to meet certain requirements. (1) In general. In the case of a sale or exchange to which this subsection applies, the ownership and use requirements of subsection (a), and subsection (b)(3), shall not apply; but the dollar limitation under paragraph (1) or (2) of subsection (b), whichever is applicable, shall be equal to (A) the amount which bears the same ratio to such limitation (determined without regard to this paragraph) as (B)(i) the shorter of(I) the aggregate periods, during the 5-year period ending on the date of such sale or exchange, such property has been owned and used by the taxpayer as the taxpayers principal residence; or (II) the period after the date of the most recent prior sale or exchange by the taxpayer to which subsection (a) applied and before the date of such sale or exchange, bears to (ii) 2 years. (2) Sales and exchanges to which subsection applies. This subsection shall apply to any sale or exchange if (A) subsection (a) would not (but for this subsection) apply to such sale or exchange by reason of (i) a failure to meet the ownership and use requirements of subsection (a), or (ii) subsection (b)(3), and (B) such sale or exchange is by reason of a change in place of employment, health, or to the extent provided in regulations, unforeseen circumstances. (d) Special rules. (1) Joint returns.If a H and W make a joint return for the taxable year of the sale or exchange of the property, subsections (a) and (c) shall apply if either spouse meets the ownership and use requirements of subsection (a) with respect to such property. (2) Property of deceased spouse. For purposes of this section, in the case of an unmarried individual whose spouse is deceased on the date of the sale or exchange of property, the period such unmarried individual owned and used such property shall include the period such deceased spouse owned and used such property before death. (3) Property owned by spouse or former spouse. For purposes of this section (A) Property transferred to individual from spouse or former spouse.

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Tax IA Outline In the case of an individual holding property transferred to such individual in a transaction described in section 1041(a), the period such individual owns such property shall include the period the transferor owned the property. (B) Property used by former spouse pursuant to divorce decree, etc. Solely for purposes of this section, an individual shall be treated as using property as such individuals principal residence during any period of ownership while such individuals spouse or former spouse is granted use of the property under a divorce or separation instrument (as defined in section 71(b)(2)). (4) Tenant-stockholder in cooperative housing corporation. For purposes of this section, if the taxpayer holds tock as a tenant-stockholder in a cooperative housing corporation, then (A) the holding requirements of subsection (a) shall be applied to the holding of such stock, and (B) the use requirements of subsection (a) shall be applied to the house or apartment which the taxpayer was entitled to occupy as such stockholder. (5) Involuntary conversions. (A) In general. For purposes of this section, the destruction, theft, seizure, requisition, or condemnation of property shall be treated as the sale of such property. (B) Application of section 1033. In applying section 1033 (relating to involuntary conversions), the amount realized from the sale or exchange of property shall be treated as being the amount determined without regard to this section, reduced by the amount of gain not including gross income pursuant to this section. Property acquired after involuntary conversion. If the basis of the property sold or exchanged is determined (in whole or in part) under section 1033(b) (relating to basis of property acquired through involuntary conversion), then the holding and use by the taxpayer of the converted property shall be treated as holding and use by the taxpayer of the property sold or exchanged. (6) Recognition of gain attributable to depreciation. Subsection (a) shall not apply to so much of the gain from the sale of any property as does not exceed the portion of the depreciation adjustments (as defined in section1250(b)(3)) attributable to periods after May 6 1997 in respect of such property. (7) Determination of use during periods of out-of-residence care. In the case of a taxpayer who(A) becomes physically or mentally incapable or self care, and (B) owns property and uses such property as the taxpayers principal residence during the 5 year period described in subsection (a) for periods aggregating at least 1 year, then the taxpayer shall be treated as using such property as the taxpayers principal residence during any time during such 5 year period in which the taxpayer owns the property and resides in any facility (including a nursing home) licensed by a state or political subdivision to care for an individual in the taxpayers condition.

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Tax IA Outline (8)Sales of remainder interests. For purposes of this section(A) In general. At the election of the taxpayer, this section shall not fail to apply to the sale or exchange of an interest in a principal residence by reason of such interest being a remainder interest in such residence, but this section shall not apply to any other interest in such residence which is sold or exchanged separately. (B) Exception for sales to related parties. Subparagraph (A) shall not apply to any sale to, or exchange with, any person who bears a relationship to the taxpayer which is described in section 267(b) or 707(b). (e) Denial of exclusion for expatriates. This section shall not apply to any sale or exchange by an individual if the treatment provided by section 877(a)(1) applies to such individual. (f) Election to have section not apply. This section shall not apply to any sale or exchange with respect to which the taxpayer elects not to have this section apply. (g) Residences acquired in rollovers under section 1034. See Text. Reg. 1.121-1 Exclusion of gain from sale or exchange of a principal residence. (b) Principal residence. Whether or not property is used by the taxpayer as the taxpayers residence, and whether or not property is used by the taxpayers principal residence (in the case of a taxpayer using more than one property as a residence), depends upon all the facts and circumstances. If a taxpayer alternates between two properties, using each as a residence for successive periods of time, the property that the taxpayer uses a majority of the time during the year will ordinarily be considered the taxpayers principal residence. A property used by the taxpayer as the taxpayers principal residence may include a houseboat, a house trailer, or stock held by a tenant-stockholder in a cooperative housing corporation, if the dwelling that the taxpayer is entitled to occupy as a stockholder is used by the taxpayer as the taxpayers principal residence. Property used by the taxpayer as the taxpayers principal residence does not include person property, that is nota fixture under local law. Examples from the Regs: Ex: Taxpayer k owns two residences, one in New York and one in Florida. From 1999 through 2003, he lives in the New York residence for 7 months and the Florida residence for 5 months. Thus, K used the New York residence a majority of the time in each year from 1999 through 2003. Therefore, in the absence of facts and circumstances indicating otherwise, the New York residence is his principal

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Tax IA Outline residence, and only the New York residence would be eligible for the 121 exclusion if it were sold at the end of 2003. Ex: Taxpayer L owns two residences, one in Virginia and one in Maine. During 1999 and 2000, she lives in the Virginia residence. During 2001 and 2002, L lives in the Maine residence. During 2003, she lives in the Virginia residence. Her principal residence during 1999, 2000, and 2003 is the Virginia residence. Her principal residence during 2001 and 2002 is the Maine residence. Either residence would be eligible for the 121 exclusion if it were sold during 2003. Ex from class: First 2 years, taxpayer lived in home A. Then the taxpayer moved into home B but retained home A. In 5 years, the taxpayer lived in both homes for 2 years. The taxpayer must sell home A within the 5 year look back, or the 2 years banked in home A could be lost. Probate work: (d)(2) In year of death, surviving spouse can still file joint. If the home is sold, can double the cap. If the surviving spouse waits until next year, then she only gets the $250 cap, but the basis can be stepped up. If a home is inventory (held to be resold), it is not being used as a primary residence. It is inventory.

With banking of time and frequently of selling, wealth can be generated using this tax exclusion provision.

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Tax IA Outline XIII. Life Insurance Proceeds and Annuities 1. Life Insurance Proceeds

A common element of all life insurance policies is the agreement by the insurer to make payments upon the insureds death to the insureds estate or to others who are designated as beneficiaries. The plain thrust of 101(a)(1) is to exclude the proceeds of such policies from the gross income of the recipients. Usually an insurance policy will identify a fixed sum to be paid at death (the face amount). Essentially, it is this amount that is to be received tax-free. There is no limitation on the amount. 101(a)(1) contains restrictions and exclusions. The exclusion only applies to amounts paid by reason of the death of the insured. It is possible, for example, that after a policy has been in effect for some time, the cash surrender value of the policy will exceed the net premiums paid. If so and if the insured elects to take the cash surrender value, the insured will realize an amount in excess of basis, which is a taxable gain unprotected by the exclusionary rules of 101(a)(1), because it is an amount not paid by reason of the insureds death. If for example, an insurance policy contains an alternative lifetime benefits, such as, payments of fixed annual sums for life in lieu of and upon cancellation of any right to death benefits. If such a demand is made, the receipts are obviously not paid by reason of the insureds death and they are not excluded under 101(a)(1). Exception to the death requirement: Under 101(g*, accelerated death benefits received from a life insurance policy on the life of a terminally ill or chronically ill insured person are treated as paid by reason of the death of the insured and are therefore, excluded from gross income under 101(a)(1). The accelerated death benefits may be received from the insurer or received as a result of a sale of the policy to a vital settlement provider, one who is engaged in the trade or business of purchasing or taking assignments of life insurance policies on the lives of the individuals described above. Even though the proceeds of a policy are paid by reason of the death of the insured, the 101(a)(1) exclusion generally does not apply to the proceeds of a policy if the policy has been transferred for valuable consideration during the insureds life. Under 101(d), if the life insurance proceeds are taken in payments over time, the portion that represents the insurance proceeds is excluded, but the excess is taxable income. Ex: Surviving spouse can receive $100,000 upon the death of her husband. Instead she elects to be paid $250 ($3000 per year) per month for life. Her life expectancy is 50 years. $2000 per year is considered the life insurance proceeds and

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Tax IA Outline excluded from GI (100,000/50), the $1000 is income and is included in gross income. If she lived years beyond her life expectancy, the same exclusionary rule continues to apply in subsequent years. An insurance beneficiary may have the right to leave the entire $100,000 of proceeds with the insurer, drawing only interest on the amount that otherwise would be paid as a lump sum. 101(1)(C) specifies that such interest payments are fully taxable like the interest earned on a bank account, but any subsequent receipt of the $100,000 proceeds is not taxable. A corporation could also purchase insurance on a employee or owner and use proceeds to purchase the owners share tax free. IRC 101 Certain Death Benefits. (a) Proceeds of life insurance contracts payable by reason of death. (1) General rule. Except as otherwise provided in paragraph (2), subsection (d), and subsection (f), gross income does not include amounts received (whether in a single sum or otherwise) under a life insurance contract, if such amounts are paid by reason of the death of the insured. (2) Transfer for valuable consideration. In the case of a transfer for a valuable consideration, by assignment or otherwise, of a life insurance contract or any interest therein, the amount excluded from gross income by paragraph (1) shall not exceed an amount equal to the sum of the actual value of such consideration and the premiums and other amounts subsequently paid by the transferee. The preceding sentence shall not apply in the case of such a transfer(A) if such contract or interest therein has a basis for determining gain or loss in the hands of a transferee determined in whole or in part by reference to such basis of such contract or interest therein in the hands of the transferor, or (B) if such transfer is to the insured, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is a shareholder or officer. The term other amounts in the first sentence of this paragraph includes interest paid or accrued by the transferee on indebtedness with respect to such contract or any interest therein if such interest paid or accrued is not allowable as a deduction by reason of section 264(a)(4). (c) Interest. If any amount excluded from gross income by subsection (a) is held under an agreement to pay interest thereon, the interest payments shall be included in gross income. (d) Payment of life insurance proceeds at a date later than death.

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Tax IA Outline (1) General Rule. The amounts held by an insurer with respect to any beneficiary shall be prorated (in accordance with such regs as may be prescribed by the Secretary) over the period or periods with respect to which such payments are to be made. There shall be excluded from the gross income of such beneficiary in the taxable year received any amount determined by such pro-ration. Gross income includes, to the extent not excluded by the preceding sentence, amounts received under agreements to which this subsection applies. (2) Amount held by an insurer. An amount held by an insurer with respect to any beneficiary shall mean an amount to which subsection (a) applies which is(A) held by any insurer under an agreement provided for in the life insurance contract, whether as an option or otherwise, to pay such amount on a date or dates later than the death of the insured, and (B) equal to the value of such agreement to such beneficiary (i) as of the date of death of the insured (as if any option exercised under the life insurance contract were exercised at such time), and (ii) as discounted on the basis of the interest rate used by the insurer in calculating payments under the agreement and mortality tables prescribed by the Secretary. (3) Application of subsection. This subsection shall not apply to any amount to which subsection (c) is applicable. (g) Treatment of certain accelerated death benefits. (1) In general. For purposes of this section, the following amounts shall be treated as an amount paid by reason of the death of an insured: (A) Any amount received under a life insurance contract on the life of an insured who is a terminally ill individual. (B) Any amount received under a life insurance contract on the life of an insured who is a chronically ill individual. (2) Treatment of viatical settlements. (A) In general. If any portion of the death benefit under a life insurance contract on the life of an insured described in paragraph (1) is sold or assigned to a viatical settlement provider, the amount paid for the sale or assignment of such portion shall be treated as an amount paid under the life insurance contract by reason of the death of the death of such insured. (B) Viatical settlement provider. See Text. Reg. 1.101-1 Exclusion from gross income of proceeds of life insurance contracts payable by reason of death. 101(a)(1) states the general rule that the proceeds of life insurance policies, if paid by reason of the death of the insured, are excluded from the gross income of the recipient. Death benefit payments having the characteristics of life insurance proceeds payable by reason of death under contracts, such as workers comp

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Tax IA Outline insurance, endowment contracts, or accident and health insurance contracts are covered by this provision. The exclusion from gross income allowed by 101(a) applies whether payment is made to the estate of the insured or to any beneficiary (individual, corporation, or partnership) and whether it is made directly or in trust. In the case of a transfer, by assignment or otherwise, of a life insurance policy or any interest therein for a valuable consideration, the amount of the proceeds attributable to such policy or interest which is excludable from the transferees gross income is generally limited to the sum of (i) the actual value of the consideration for such transfer, and (ii) the premiums and other amounts subsequently paid by the transferee. The limitation does not apply where the policy is transferred to the insured, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is a shareholder or officer. In the case of a gratuitous transfer of a life insurance policy, the amount excludible is limited by the amount excludible by the transferor, and any premiums and other amounts subsequently paid by the transferee. If the gratuitous transfer is made by or to the insured, a partner of the insured, a partnership in which the insured is a partner, or a corporation in which the insured is a shareholder or officer, the entire amount of the proceeds attributable to the policy shall be excludable from the transferees gross income. Reg. 1.101-3 Interest Payments If any amount excluded from gross income by 101(a) or (b) is held under an agreement to pay interest thereon, the interest payments shall be included in gross income. This provision applies to payments made of interest earned on any amount so excluded from gross income which is held without substantial diminution of the principal amount during the period when such interest payments are being made or credited to the beneficiaries or estate of the insured or the employee. For example, if a monthly payment is $100, of which $99 represents interest and $1 represents diminution of the principal amount, the principal amount shall be considered held under an agreement to pay interest thereon and the interest payment shall be included in ghe gross income of the recipient. 101(c) applies whether the election to have an amount held under an agreement to pay interest thereon is made by the insured or employee or by his beneficiaries or estate, and whether or not an interest rate is explicitly stated in the agreement. 101(d), relating to the payment of life insurance proceeds at a date later than death, shall not apply to any amount to which 101(c) applies.

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Reg. 1.01-4 Payment of life insurance proceeds at a date later than death. 101(d) states the provisions governing the exclusion from gross income of amounts received under a life insurance contract and paid by reason of the death of the insured which are paid to a beneficiary on a date or dates later than the death of the insured. However, if the amounts payable as proceeds of life insurance to which 101(a)(1) applies cannot in any event exceed the amount payable at the time of the insureds death, such amounts are fully excludable from the gross income of the recipient without regard to the actual time of payment. The prorated amounts are to be excluded from the gross income of the beneficiary regardless of the taxable year in which they are actually received. 2. Annuities

An annuity is an arrangement under which one buys a right to future money payments. Annuities have a starting date, a payment that is periodic, and the rest is contractual. It is not income until it is paid, and a portion of the payment represents income and is taxed, and a portion represents return of capital, which is not taxed. 72 allows a recovery of capital over the expected life of the contract by excluding the portion of each payment that is in the ratio of the investment in the contract to the expected return under the contract. The excess receipt is taxed as the income element in each payment. I.R.C. 72 Annuities; certain proceeds of endowment and life insurance contracts. (a) General rule for annuities. Except as otherwise provided in this chapter, gross income includes any amount received as an annuity (whether for a period certain or during one or more lives) under an annuity, endowment, or life insurance contract. (b) Exclusion ratio. (1) In general. Gross income does not include that part of any amount received as an annuity under an annuity, endowment, or life insurance contract which bears the same ration to such amount as the investment in the contract (as of the annuity starting date) bears to the expected return under the contract (as of such date). (2) Exclusion limited to investment. The portion of any amount received as an annuity which is excluded from gross income under paragraph (1) shall not exceed the unrecovered investment in the contract immediately before the receipt of such amount.

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Tax IA Outline (3) Deduction where annuity payments cease before entire investment is recovered. (A) In general. If (i) after the annuity starting date, payments as an annuity under the contract cease by reason of the death of an annuitant, and (ii) as of the date of such cessation, there is unrecovered investment in the contract, the amount of such unrecovered investment (in excess of any amount specified in subsection (e)(5) which was not included in gross income) shall be allowed as a deduction to the annuitant for his last taxable year. (B) Payments to other persons. In the case of any contract which provides for payments meeting the requirements of subparagraphs (B) and (C) of subsection (c)(2), the deduction under subparagraph (A) shall be allowed to the person entitled to such payments for the taxable year in which such payments are received. (C) Net operating loss deductions provided. For purposes of 172, a deduction allowed under this paragraph shall be treated as if it were attributable to a trade or business of the taxpayer. (4) Unrecovered investment. For purposes of this subsection, the unrecovered investment in the contract as of any date is (A) The investment in the contract (determined without regard to subsection (c)(2) as of the annuity starting date, reduced by (B) the aggregate amount received under the contract on or after such annuity starting date and before the date as of which the determination is being made, to the extent such amount was excludable from gross income under this subtitle. (c) Definitions. (1) Investment in the contract. For purposes of subsection (b), the investment in the contract as of the annuity starting date is (A) the aggregate amount of premiums or other consideration paid for the contract, minus (B) the aggregate amount received under the contract before such date, to the extent that such amount was excludable from gross income under this subtitle or prior income tax laws. (2) Adjustment in investment where there is refund feature. If (A) the expected return under the contract depends in whole or in part on the life expectancy of one or more individuals; (B) the contract provides for payments to be made to a beneficiary (or to the estate of an annuitant) on or after the death of the annuitant or annuitants; and (c) such payments are in the nature of a refund of the consideration paid,

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then the value (computed without discount for interest) of such payments on the annuity starting date shall be subtracted from the amount determined under paragraph (1). Such value shall be computed in accordance with actuarial tables prescribed by the Secretary. For purposes of this paragraph and of subsection (e)(2)(A), the term refund of the consideration paid includes amounts payable after the death of an annuitant by reason of a provision in the contract for a life annuity with minimum period of payments of certain, but (if part of the consideration was contributed by an employer) does not include that part of any payment to a beneficiary (or to the estate of the annuitant) which is not attributable to the consideration paid by the employee for the contract as determined under paragraph (1)(A). (3) Expected Return. For purposes of subsection (b), the expected return under the contract shall be determined as follows: (A) Life expectancy. If the expected return under the contract, for the period on and after the annuity starting date, depends in whole or in part on the life expectancy of one or more individuals, the expected return shall be computed with reference to actuarial tables prescribed by the Secretary. (B) Installment payments. If subparagraph (A) does not apply, the expected return is the aggregate of the amounts receivable under the contract as an annuity. (4) Annuity starting date. For purposes of this section, the annuity starting date in the case of any contract is the first day of the first period for which an amount is received as an annuity under the contract; except that if such date was before January 1, 1954, then the annuity starting date is January 1, 1954. Reg. 1.72-1. Annuities, Endowments, Life Insurance K (a) [summarizing] amounts received as an annuity payment are includible in the gross income of the recipient except to the extent that they are considered to represent a reduction or return of premiums or other consideration paid. (b) Amounts received as an annuity are amounts which are payable at regular intervals over a period of more than one full year from the date on which they are deemed to begin, provided the total of the amounts so payable or the period for which they are to be paid can be determined as of that date. Reg. 1.72-4 Exclusion ratio. (a) General Rule. (1)(i)To determine the proportionate part of the total amount received each year as an annuity which is excludable from the gross income of a recipient in the taxable year

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Tax IA Outline of receipt, an exclusion ratio is to be determined for each contract. In general, this ratio is determined by dividing the investment in the contract as found under 1.72-6 by the expected return under such contract as found under 1.72-5. Where a single consideration is given for a particular contract which provides for two or more annuity elements, an exclusion ratio shall be determined for the contract as a whole by dividing the investment in such contract by the aggregate of the expected returns under all the annuity elements provided thereunder. (ii) The exclusion ratio for the particular contract is then applied to the total amount received as an annuity during the taxable year by each recipient. Any excess of the total amount received as an annuity during the taxable year over the amount determined by the application of the exclusion ration to such total amount shall be included in the gross income of the recipient for the taxable year of receipt. Examples from Regs: Taxpayer A purchased an annuity contract providing for payments of $100 per month for a consideration of $12,650. Assuming that the expected return under this contract is $16,000 the exclusion ration to be used by A is $12,650/16,000 or 79.1%. If 12 such monthly payments are received by A during his taxable year, the total amount he may exclude from his gross income in such year is $949.20 ($1,200 x .791 ) the balance of $250.80 ($1,200 949.20) is the amount to be included in gross income. If A instead received only five such payments during the year, he should exclude $395.50 ($500 x .791) of the total amounts received. Notes: The mere making of an annuity contract is not income b/c there is no constructive receipt. At the time the investment in the annuity is made, take a snapshot picture: based on the life expectancy, calculate your return and ratio. 72(b) address the problem if you die before or after you are expected. If you longer than expected, all is income b/c you recovered your basis. If the annuitant dies before recovering all of her basis, the unrecovered investment is deducted in the final tax return of the deceased, characterized as a net operating loss NOL, so it can be carried back to income of prior years if no income to offset loss in the ear of death. Examples from text: Taxpayer pays an insurance company $60,000 for their agreement to pay her $5,000 each year for the rest of her life. Taxpayer is expected to live 20 more years. The ration is: $60,000 investment/$100,000 expected return ($5,000 x 20) = 3/5; So 3/5 of the $5,000 payment or $3,000 would be excluded as a return of capital (basis) and the rest $2,000 is included in gross income.

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Some annuities contain what are known as refund features. One example of a refund occurs if any annuity is paid to an annuitant for her life, but if the annuity payments made prior to the annuitants death do not equal the premiums paid for the contract, the excess is refunded. In such a situation 72(c)(2) requires that the value of the potential refund (based on the annuitants life expectancy) be subtracted from the investment in the contract, which has of course the intended effect of increasing the income portion of each annuity payment. Ways to Create Wealth and Different Taxation Aspects: Compare investment in a life insurance annuity v. savings account: In the life insurance investment, no constructive receipt of the inside buildup of the income. Inside build up is not taxed to you until paid in the annuities. Death is not a realization event. In the savings account, you have constructive receipt of the inside build up so it is income as it grows. Labor income: is taxed up front, so income 102 wages are deferred in a pension plan, then there is tax deferral. The income in the pension plan has an inside build up that is tax free. When paid out, then it is income. The inheritor is taxed as you would have been taxed, they step into your shoes. If you invest in property, no income while it appreciates only. Income is only when realized (sold). If you die, the person who inherits the property gets to step up the basis to FMV, the gain or appreciation is not recognized.

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XIV

Income From Property

1. Assignment/Shifting of Income Whose income is it? For income tax purposes, we track ownership. The owner is the one who enjoys, controls, and exercises domain over the property. IRC 102 Gifts and inheritances. (a) General rule. Gross income does not include the value of property acquired by gift, bequest, devise, or inheritance. (b) Income. Subsection (a) shall not exclude from gross income (1) the income from any property referred to in subsection (a); or (2) where the gift, bequest, devise, or inheritance is of income from property, the amount of such income. Where, under the terms of the gift, bequest, devise, or inheritance, the payment, crediting, or distribution thereof is to be made at intervals, then to the extent that it is paid or credited or to be distributed out of income from property, it shall be treated for purposes of paragraph (2) as a gift, bequest, devise or inheritance of income from property. Any amount included in the gross income of a beneficiary under subchapter J shall be treated for purposes of paragraph (2) as a gift, bequest, devise, or inheritance of income from property. Case law: Helvering v. Horst US 1940 The owner of negotiable bonds, detached from them negotiable interest coupons shortly before their due date and delivered them as a gift to his son, who in the same year collected them at maturity. I Whether the interest income from the bonds is taxable to the father or the son. H The power to dispose of income is the equivalent of ownership of it. The exercise of that power to procure the payment of income to another is the enjoyment, and hence the realization, of the income by him who exercises it. The assignment of income is not effective here. Rationale:

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Tax IA Outline Even though the assignor never receives the money, he derives moneys worth from the disposition of the coupons which he has used as money or moneys worth in the procuring of a satisfaction which is procurable only by the expenditure of money or moneys worth. The enjoyment of the economic benefit accruing to him by virtue of his acquisition of the coupons is realized as completely as it would have been if he had collected the interest in dollars and expended them for any of the purposes named. The income is realized and taxed to the assignor b/c he, who owns or controls the source of the income, also controls the disposition of that which he could have received himself and diverts the payment from himself to others as the means of procuring the satisfaction of his wants. The owner of the tree is taxed on the fruit, no matter who gets the fruit. The father is still the holder of the tree (bond) so he cant shift the income. If you keep the tree, you are taxed on the fruit. When he clipped the coupon, he decided who got it, he exercised dominion and control of it. It was his income. If the taxpayer procures payment directly to his creditors of the items of interest or earnings due him, or if he sets up a revocable trust with income payable to the objects of his bounty, he does not escape taxation b/c he did not actually receive the money. Here the father, as owner of the bonds, had acquired the legal right to demand payment at maturity of the interest specified by the coupons and the power to command its payment to others, which constituted an economic gain to him.

Blair v. Commissioner US 1937 different conclusion than Horst above. The taxpayer owned an income interest in a trust for life. He assigned a portion of all of his future income from the trust to his children.

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Tax IA Outline The S Ct concluded that under state law, the taxpayer had made a valid assignment of his interest in the trust.

I: Whether the taxpayer was still taxable upon the income under the federal income tax act. H The taxpayer/father assigned his equitable interest in the property (trust) to the children. Since the assignment was valid, the children became owners of the specified beneficial interests in the income, and that as to these interests, they (the children) are taxed on the income. Rationale:

Here the interest in the whole trust was conveyed. The taxpayer gave the whole tree away, as well as the fruit. There is a new owner of the whole property. The tree and the fruit must be assigned; The very ripe fruit stays with the old owner b/c it is constructive receipt, but the future fruit is taxed to the new owner of the tree.

Estate of Stranahan v. Commissioner 1973 6th Cir The taxpayer had a very large interest deduction but he did not have enough income to fully absorb the deduction. The taxpayer accelerated his income by assigning to his son stock dividends payable in the future. His son paid FMV consideration for the stock dividends he was to receive. The father/taxpayer directed the transfer agent to issue all future dividend checks to his son. The son paid income tax on the dividends when he received them (after subtracting out his basis of what he paid). I Whether the father/taxpayers assignment of future dividends was an effective transfer of the son for income tax purposes. It was conceded by the taxpayer that the sole aim of the assignment was the acceleration of income so as to fully utilize the interest deduction. H The agreement is unquestionably a complete and valid assignment to decedents son of all dividends the son acquired an independent right against the corporation since the latter was notified of the private agreement. Decedent completely divested himself of any interest in the dividends and vested the interest on the day of execution of the agreement with his son.

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Rationale: A cash basis taxpayer ordinarily realizes income in the year of receipt rather than the year when earned. A taxpayer who assigns future income for consideration in a bona fide commercial transaction will ordinarily realize ordinary income in the year of receipt. A taxpayer is free to arrange his financial affaIRS to minimize his tax liability, thus the presence of tax avoidance motives will not nullify an otherwise bona fide transaction Here, the transaction was not a sham. The purchase price was adequate and the father and son had a binding contract to sell the right to future dividends. Distinguishes Horst: This was a transaction for good and sufficient consideration, and not merely gratuitous. The acceleration of income was not designed to avoid or escape recognition of the dividends, but rather to reduce taxation by fully utilizing a substantial interest deduction which was available. The fact that valuable consideration was an integral part of the transaction distinguishes this case from those where the simple expedient of drawing up legal papers and assigning income to others is used. The transaction here was economically realistic and with substance. The father had the tree, but the fruit was not yet ripe. The father assigned the future fruit in a bona fide sale with full and adequate consideration.

Famous footnotes from Stranaham: #1: Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase ones taxes. #2: As to the astuteness of taxpayers in ordering their affairs so as to minimize taxes, we have said that the very meaning of a line in the law is that you intentionally may go as close

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Tax IA Outline to it as you can if you do not pass it. This is so because nobody owes any public duty to pay more than the law demands; taxes are enforced exactions, not voluntary contributions. If you have deductions, you need to do tax planning: can it be characterized as a net operating loss that can be carried back? Susie Salvatore Tax Court 1970 Susie owned property, which she wished to sell to a buyer already in hand. Before the sale was transaction, she deeded one half interest of the property to her children. I Whether Susie can make an anticipatory assignment of a capital gain. H Susies tax liability cannot be altered by a rearrangement of legal title after she had already contracted to sell the property to Texaco. All gain from the sale was taxable to Susie. Rationale:

The transaction must be viewed as a whole, and each step, from the commencement of negotiations to the consummation of the sale is relevant. A sale by one person cannot be transformed for tax purposes into a sale by another by using the latter as a conduit through which to pass title. Susies subsequent conveyance to her children was merely an intermediate step in the transfer of legal title from her to Texaco. Whether the Susies conveyance was a bona fide gift is immaterial in determining the income tax consequences of the sale, for the form of a transaction cannot be permitted to prevail over its substance. In substance, Susie made an anticipatory assignment to her children of one half of the income from the sale of the property. The artificiality of treating the transaction as a sale in party by the children was confirmed by the testimony of Susies witnesses. The transfer from Susie to her children was done too late!! Susie already had a buyer, the kids didnt locate the buyer.

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Tax IA Outline Look at the substance of the transaction, not the form!

Rev. Ruling 69-102: The taxpayer sold an unencumbered endowment life insurance contract to a charitable organization for an amount equal to his basis, donating his remaining interest to the charity. At the same time he made a gift of an unencumbered annuity contract to his son. In the donors succeeding taxable year, both contracts matured and were surrendered by the donees to the insurance company for their then cash surrender values. The cash surrender value of each contract at the time of the transfers to the donees exceeded the amount of the donors basis. What is the income tax consequences to the taxpayer upon the maturity and surrender of the endowment and annuity contracts? Rules: Reg. 1.61-1: Gross income includes income realized in any form. Lucas v. Earl: Income is taxable to the person who realizes it, the incidence of the tax not being shifted by a gift thereof to another. Harrison v. Schaffner: One who is entitled to receive at a future date, interest or compensation for services and who makes a gift of it by an anticipatory assignment, realizes taxable income quite as much as if he had collected the income and paid it over to the object of his bounty. The power to dispose of income is the equivalent of ownership of it. The exercise of the power to procure its payment to another, whether to pay a debt or to make a gift, is within the reach of the statute taxing income derived from any source whatever. Friedman v. Commissioner: The theory of the cases dealing with anticipatory assignment of income by gift has not been concerned with when the income was accrued in a legal sense of accrual, but rather with whether the income ha been earned so that the right to the payment at a future date existed when the gift was made. It is the giving away of this right to

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Tax IA Outline income in advance of payments which has been held not to change the incidence of the tax. A cash basis taxpayer is not taxable on income until he receives it actually or constructively. The making of a gift of his right to receive income does not cause such income to be received until the donor derives the economic benefit of having the income received by his donee.

Helvering v. Horst: Where the taxpayer does not receive payment of income in money or property realization may occur when the last step is taken by which he obtains the fruition of the economic gain which has already accrued to him. It follows that the time of the gift is not determinative of the time when income is realized. A gift of income does not operate to accelerate the year of taxability. Apply the rules to the facts of this problem: The taxpayer is in receipt of taxable income for the taxable year in which the endowment and annuity contracts were surrendered for their cash surrender values by the recipients, the amounts of such income being the excess of the cash surrender value of each contract at the time of the gift over the taxpayers basis in that contract. The gain realized through the transfer of the contracts is ordinary income. The excess of the FMV of the endowment contract sold to the charitable organization over the amount received therefore is the measure of the charitable contribution for the taxable year in which the contract was transferred. Notes: Horst: The owner of the tree picks some fruit and gives it to another who converts it to cash. As the owner has kept the tree that produces the fruit, the trees produce (interest paid later) remains his for tax purposes, even though economically it has become the property of another. If the owner gives away the tree (the bond itself in the Horst setting), the donee in general is taxable on fruit subsequently produced (later interest payments), because he has become the owner of the income producing property himself. (Blair/Stranahan) Mere appreciation in the value of the property (tree) is not fruit until it is realized.

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Tax IA Outline Campbell v. Prothro 1954 5th Cir The taxpayer raised calves. On May 7th, he transferred 100 head of calves by written instrument to a charity. The donated calves were never physically removed from the rest of the taxpayers herd. On June 8, the taxpayer entered into a k to sell the entire herd to a third party. The court held that gain on the sale of the calves to the charity could not be attributed to the taxpayer. H The calves were appreciated property, and the gift of the calves does not make the donor taxable on unrealized appreciation in the value of the calves (property) given. Tatum v. Commissioner 5th Cir. 1968 Taxpayer owned land which they leased to sharecroppers who paid their rent in the form of a portion of the crops produced. Had the rent been payable in cash or in any form other than crop shares, the landlord would have had to report the rent as gross income for the year of receipt. However, Reg.1.61-4(a), a reporting regulation, permits a landlord to defer reporting crop share rent until the year in which such crops are reduced to money or the equivalent of the money (this is just a matter of administrative convenienceplus the farmer doesnt have the cash to pay the tax until it is reduced to money). Taxpayer/landlord upon receiving the crops immediately transferred them to a charitable donee, which sold them in the same year. I Whether the value of the crops should be included in the taxpayer/landlords gross income. H The value of the crops are included in the taxpayer/landlords gross income. Rationale:

Share crops are potential income assets, not property, and that a landlord may not avoid taxation by assigning his rights to the income prior to the reduction of the crop shares to money or its equivalent. (Horst). When the crops are harvested and delivered the landlord has been paid in kind for the use of his land. Crop shares representing payment by the tenant for the use of the land are rental income

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Tax IA Outline assets no les than money paid for the same purpose. Crop shares in the hands of the landlord essentially are income assets, taxable when reduced to money or the equivalent of money. Distinguishes Campbell v. Prothro: Crops in the hands of a farmer (rather than a landlord) are appreciated property items not taxable if assigned to a third party prior to the realization of any income. An operating farmer who donated crops to a third party prior to a taxable event, and prior to the point at which he must recognize income, is not required to include the value of the crops in gross income. The farmer has done nothing more than assign to another a property asset which has appreciated in value. There has been no taxable event. Neither the harvesting of the crop nor the donative transfer is a taxable event.

Under an extension of the fruit tree metaphor, it is not just fruit but ripe fruit that may leave a donor taxable on post-transfer income. In Tatum, crop shares in hand represent realized income just waiting around to be taxed. If the income generated by property accrues ratably over time, that portion accrued at the time of the gift is likewise ripe. ** Know this**Ex: If interest on a coupon bond is payable semi-annually on January 1 and July 1, and a donor transfers the bond (not just the coupon) on April 1, midway between payment dates, one-half of the current interest coupon is ripe as of the time of the transfer and one-half the amount of the coupon is taxed to the donor and the other one-half is taxed to the donee, generally upon payment. This same principle applies to rents, interest on bank accounts and other items that accrue or are generated merely by the passage of time. Dividends on stock create a more difficult problem. They do not automatically accrue with time but are dependent on a decision by the Board of Directors to issue dividends. Consequently, for business purposes a relevant date must be determined on which ownership of the stock fixes the right to the dividend, the so-called record date. There are normally four important dates with respect to the issuance of dividends: the declaration date, the record date, the payment date, and the date of actual receipt.

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Sometimes, in a closely held corporation, two dates, possibly the record and payment dates, coincide. In one such case the court held that the fruit ripened on the declaration date, taxing the dividend to a donor who made a gift of the stock the day before the record date. But the case involved a small, closely held corporation. In contrast, with a minority shareholder of a more widely held corporation, the court reached the conclusion that the fruit ripened on the record date because no enforceable right accrued to any shareholder at the time of the dividend declaration. *Review problem on p. 272, it appeared on the KY Bar Exam*

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Tax IA Outline XV Non-Recognition Provisions

Gain or loss has no income tax significance as long as it is represented by a mere increase or decrease in the value of the taxpayers property. Something more must occur, as for example, a sale or an exchange of the property, before the gain or loss is to be realized. If gain is realized, is it subject to tax? Not necessarily. Not all realized gains or losses are to be accorded immediate consideration in the determination of taxable income. Usually this is just a deferral of the recognition (a timing issue). Some code provisions permit some gains that could clearly be taxed to be excluded from gross income, and loss that could be deducted loses its potential for reducing taxable income. The question must therefore always be raised whether a realized gain or loss is recognized. The nonrecognition provisions are all predicated on the notion that realized gain, or a loss that otherwise would qualify as a deductible loss, is sensibly deferred when the taxpayer has retained the investment in property that is essentially the same type as the originally held property. These rules are not universally applicable to all types of property. The statute provides nonrecognition to selective transactions, and it must be carefully examined. Nonrecognition rules are largely rules of deferral. 368 usually when corporations merge, they exchange stock for stock, so it is not a taxable event: non-recognition. 1. Installment Sales

453 Installment method (a) General rule. Except as otherwise provided in this section, income from an installment sale shall be taken into account for purposes of this title under the installment method. (b) Installment sale defined. For purposes of this section(1) In general.. The term installment sale means a disposition of property where at least 1 payment is to be received after the close of the taxable year in which the disposition occurs. (2) Exceptions. The term installment sale does not include: (A) Dealer dispositions. Any dealer disposition. (B) Inventories of personal property. A disposition of personal property of a kind which is required to be included in the inventory of the taxpayer if on hand at the close of the taxable year.

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Tax IA Outline (c) Installment method defined. For purposes of this section, the term installment method means a method under which the income recognized for any taxable year from a disposition is that proportion of the payments received in that year which the gross profit (realized or to be realized when payment is completed) bears to the total contract price. (d) Election out.** see text** (e) thru (l) see text 2. Like Kind Exchanges

1031 provides non-recognition of gain or loss on like kind exchanges when there is a continuation of the proprietary investment. There are three policy reasons for non-recognition in this setting (from fn 10 of Leslie): There would be an administrative burden trying to value property received in a like-kind exchange; The inequity, in the case of an exchange, of forcing a taxpayer to recognize a paper gain which was still tied up in a continuing investment; (dominant reason) The prevention of taxpayer from taking colorable losses in wash sales and other fictitious exchanges. Before 1031 is applicable three conditions must be met: 1) The property must be held for productive use in a trade or business or for investment; (this excludes inventory, stocks, bonds, partnership interests) 2) The disposition must qualify as an exchange (as opposed to a sale). 3) The consideration received must be property of like kind to be held for productive use in at trade or business for investment. 1031 is a two edged swordit applies to defer both gains and losses. In addition, it is a non-elective provision: if its requirements are satisfied, it automatically applies. 358(a) is the non-recognition provision for the corporate setting, and it operates in the same way as 1031(a).

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Tax IA Outline

IRC 1031 Exchange of property held for productive use or investment. (a) Nonrecognition of gain or loss from exchanges solely in kind. (1) In general. No gain or loss shall be recognized on the exchange of 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 either for productive use in a trade or business or for investment. (2)Exception. This subsection shall not apply to any exchange of (A) stock in trade or other property held primarily for sale, (B) stocks, bonds, or notes, (C) other securities or evidence of indebtedness or interest, (D) interests in partnership, (E) certificates of trust or beneficial interests, or (F) chooses in action. For purposes of this section, an interest in a partnership which has in effect a valid election under 761(a) to be excluded from the application of all of subchapter K shall be treated as an interest in each of the assets of such partnership and not as an interest in a partnership. (3) Requirement that property be identified and that exchange be completed not more than 180 days after transfer of exchanged property. For purposes of this subsection, any property received by the taxpayer shall be treated as property which is not like-kind property if (A) such property is not identified as property to be received in the exchange on or before the day which is 45 days after the date on which the taxpayer transfers the property relinquished in the exchange, or (B) such property is received after the earlier of(i) the day which is 180 days after the date on which the taxpayer transfers the property relinquished in the exchange, or (ii) the due date (determined with regard to extension) for the transferors return of the tax imposed by this chapter for the taxable year in which the transfer of the relinquished property occurs. (b) Gain from exchanges not solely in kind. If an exchange would be within the provisions of subsection (a), of section 1035(a), of section 1036(a) or of section 1037(a), if it were not for the fact that the property received in exchange consists not only of property permitted by such provisions to be received without the recognition of gain, but also of other property or money [boot], then the gain, if any, to the recipient shall

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Tax IA Outline be recognized, but in an amount not in excess of the sum of such money and the fair market value of such other property. (c) Loss from exchanges not solely in kind. If an exchange would be within the provisions of subsection (a), of section 1035(a), of section 1036 (a), or of section 1037(a), if it were not for the fact that the property received in exchange consists not only of property permitted by such provisions to be received without the recognition of gain or loss, but also of other property or money [boot], then no loss from the exchange shall be recognized. (d) Basis. If property was acquired on an exchange described in this section, section 1035(a), section 1036(a), or section 1037(a), then the basis shall be the same as that of the property exchanged, decreased in the amount of any money received by the taxpayer and increased in the amount of gain or decreased in the amount of loss to the taxpayer that was recognized on such exchange. If the property so acquired consisted in part of the type of property permitted by this section, section 1035(a), section 1036(a), or section 1037(a), be received without the recognition of gain or loss, and in part of other property, the basis provided in this subsection shall be allocated between the properties (other than money) received, and for the purpose of the allocation there shall be assigned to such other property an amount equivalent to its fair market value at the date of the exchange. For purposes of this section, section 1035(a), and section 1036(a), where as part of the consideration to the taxpayer another party to the exchange assumed (as determined under section 357(d)) a liability of the taxpayer, such assumption shall be considered as money received by the taxpayer on the exchange. (e) Exchange of livestock of different sexes. For purposes of this section, livestock of different sexes are not property of a like kind. (f) Special Rules for exchanges between related persons. (1) In general. If(A) a taxpayer exchanges property with a related person, (B) there is nonrecognition of gain or loss to the taxpayer under this section with respect to the exchange of such property (determined without regard to this subsection), and before the date 2 years after the date of the last transfer which was part of such exchange (i) the related person disposes of such property, or (ii) the taxpayer disposes of the property received in the exchange from the related person which was of like kind to the property transferred by the taxpayer, there shall be no nonrecognition of gain or loss under this section to the taxpayer with respect to such exchange; except that any gain or loss recognized by the

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Tax IA Outline taxpayer by reason of this subsection shall be taken into account as of the date on which the disposition referred to in subparagraph (C) occurs. (2) Certain dispositions not taken into account. For purposes of paragraph (1)(C), there shall not be taken into account any disposition(A) after the earlier of the death of the taxpayer or the death of the related person, (B) in a compulsory or involuntary conversion (within the meaning of section 1033) if the exchange occurred before the threat or imminence of such conversion, or (c) with respect to which it is established to the satisfaction of the Secretary that neither the exchange nor such disposition has as one of its principal purposes the avoidance of Federal income tax. (3) Related person. For purposes of this subsection, the term related person means any person bearing a relationship to the taxpayer described in section267(b) or 707(b)(1). (4) Treatment of certain transactions. This section shall not apply to any exchange which is part of a transaction (or series of transactions) structured to avoid the purposes of this subsection. (g) Special rule where substantial diminution of risk. see text. (H) Special rules for foreign real and personal property. For purposes of this section (1) Real property. Real property located in the United States and real property located outside the United States are not property of a like kind. (2) Personal property. (A) In general. Personal property used predominantly within the United States and personal property used predominantly outside the United States are not property of alike kind. (B) (C) (D). See text Reg. 1.1031(a)-1 Property held for productive use in trade or business or for investment. (a) Summary: 1031(a) provides an exception from the general rule requiring recognition of gain or loss upon the sale or exchange of property. Under 1031(a), no gain or loss is recognized if property held for productive use in a trade or business or for investment is exchanged solely for property of a like kind to be held either for productive use in a trade or business or for investment. Under 1031(a)(1), property held for productive use in a trade or business may be exchanged for property held for investment (or vice versa). However, 1031(a)(1) does not apply to any exchange of(i) stock in trade or other property held primarily for sale; (ii) stocks, bonds, or notes; (iii) other securities or evidences of indebtedness or interest;

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Tax IA Outline (iv) Interests in a partnership; (v) certificates of trust or beneficial interests; or (vi) chooses in action. (b) Definition of Like Kind. As used in section 1031(a), the words like kind have reference to the nature or character of the property and not to its grade or quality. One kind or class of property may not, under that section be exchanged for property of a different kind or class. The fact that any real estate involved is improved or unimproved is not material, for that fact relates only to the grade or quality of the property and not to its kind or class. Unproductive real estate held by one other than a dealer for future use or future realization of the increment in value is held for investment and not primarily for sale. (c) Examples of exchanges of property of a like kind. No gain or loss is recognized if (1) a taxpayer exchanges property held for productive use in his trade or business, together with cash, for other property of like kind for the same use, such as a truck for a new truck or a passenger automobile for a new passenger automobile to be used for a like purposes; or (2) a taxpayer who is not a dealer in real estate exchanges city real estate for a ranch or farm, or exchanges a leasehold of a fee with 30 years or more to run for real estate, or exchanges improved real estate for unimproved real estate; or (3) a taxpayer exchanges investment property and cash for investment property of a like kind. Reg. 1.1031(a)-2 Additional rules for exchanges of personal property. (a) 1031(a) nonrecognition does not apply to an exchange of one kind or class of property for property of a different kind or class. Personal properties of a like class are considered to be of a like kind for purposes of 1031. In addition, an exchange of properties of a like kind may qualify under 1031 regardless of whether the properties are also of a like class. Depreciable tangible personal properties are of a like class if they are either within the same General Asset Class or within the same Product Class. (b)(1) A single property may not be classified within more than one General Asset Class or within more than one Product Class. Property classified within any General Asset Class may not be classified within a Product Class. A propertys General Asset Class or Product Class is determined as of the date of the exchange. General Asset Class See p. 1420 if necessary Examples: Product Class

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Tax IA Outline 1) Taxpayer A transfers a personal computer (asset class 00.12) to B in exchange for a printer (asset class 00.12). With respect to A, the properties exchanged are within the same General Asset Class and therefore are of a like class. 2) Taxpayer C transfers an airplane (asset class 00.21) to D in exchange for a heavy general purpose truck (asset class 00.242). The properties exchanged are not of a like class because they are within different General Asset Classes. B/c each of the properties is within a General Asset Class, the properties may not be classified within a Product Class. The airplane and heavy general purpose truck are also not of a like kind. Therefore, the exchange does not qualify for nonrecognition of gain or loss under 1031. 3) Taxpayer E transfers a grader to F in exchange for a scraper. Neither property is within any of the General Asset Classes, and both properties are within the same Product Class (SIC Code 3533). With respect to E therefore, the properties exchanged are of a like class. 4) Taxpayer G transfers a personal computer (asset class 00.12), an airplane (asset class 00.21) and a sanding machine (SIC Code 3553), to H in exchange for a printer (asset class 00.12), a heavy general purpose truck (asset class 00.242) and a lathe (SIC Code 3553). The personal computer and the printer are of a like class b/c they are within the same General Asset Class; the sanding machine and the lathe are of a like class b/c neither property is within any of the General Asset Classes and they are within the same Product Class. The airplane and the heavy general purpose truck are neither within the same General Asset Class nor within the same Product Class, and are not of a like kind. (c) Intangible personal property and non-depreciable personal property. (1) General Rule. An exchange of intangible personal property of non-depreciable personal property qualifies for nonrecognition of gain or loss under 1031 only if the exchanged properties are of a like kind. No like classes are provided for these properties. Whether intangible personal property is of a like kind to other intangible personal property generally depends on the nature or character of the rights involved (eg. A patent or copyright) and also on the nature or character of the underlying property to which the intangible personal property relates. (2) Goodwill and going concern value. The goodwill or going concern value of a business is not of a like kind to the goodwill or going concern value of another business.

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Tax IA Outline Examples: 1) Taxpayer K exchanges a copyright on a novel for a copyright on a different novel. The properties exchanged are of a like kind. 2) Taxpayer J exchanges a copyright on a novel for a copyright on a song. The properties exchanged are not of a like kind. Reg. 1.1031(b)-1 Receipt of other property or money [boot] in tax-free exchange. (a) If the taxpayer receives other property (in addition to property permitted to be received without recognition of gain) or money (1) In an exchange described in 1031(a) of property held for investment or productive use in rade or business for property of like kind to be held either for productive use or for investment, *** the gain, if any, to the taxpayer will be recognized under 1031(b) in an amount not in excess of the sum of the money and the fair market value of the other property, but the loss, if any, to the taxpayer from such an exchange will not be recognized under 1031(c)to any extent. Example 1) A who is not a dealer in real estate, in 1954 exchanges real estate held for investment, which he purchased in 1940 for $5000, for other real estate (to be held for productive use in trade or business) which has a fair market value of $6000 and $2000 in cash. The gain from the transaction is $3000, but is recognized only to the extent of the cash received of $2000. (c) Consideration received in the form of an assumption of liabilities (or a transfer subject to a liability) is to be treated as other property [boot] for the purposes of 1031(b). Where, on an exchange described in 1031(b), each party to the exchange either assumes a liability of the other party or acquires property subject to a liability, then, in determining the amount of other property or money [boot] for purposes of 1031(b), consideration given in the form of an assumption of liabilities (or a receipt of property subject to a liability) shall be offset against consideration received in the form of an assumption of liabilities (or a transfer subject to a liability). Reg. 1.1031(d)-1 Property acquired upon a tax-free exchange. [Basis calculation] (a) If, in an exchange of property solely of the type described in 1031, 1035(a), or 1036(a), no part of the gain or loss was recognized under the law applicable to the year in which the exchange was made, the basis of the property acquired is the same as the basis of the property transferred by the taxpayer with proper adjustments to the date of the exchange. If additional consideration is given by the taxpayer in the exchange, the basis of the property acquired shall be the same as the property transferred increased by the amount of additional consideration given.

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Tax IA Outline (b)If a taxpayer recognized gain from boot under 1031(b): Basis of the Property Transferred Less: the amount of the money received Plus: The amount of gain recognized on the exchange Example: A, an individual in the moving and storage business, in 1954 transfers one of his moving trucks with an adjusted basis in his hands of $2,500 to B in exchange for a truck (to be used in As business) with a fair market value of $2400 and $200 in cash. A realizes a gain of $100 upon the exchange, all of which is recognized under 1031(b). The basis of the truck acquired by A is determined as follows: Adjusted basis of As former truck.. Less: Amount of Money received Difference.. Plus: Amount of gain recognized $2500 - 200 ______ $2300 + 100 ------Basis of truck acquired by A: $2400 (c) If the taxpayer received other property (not permitted to be received without the recognition of gain) and gain from the transaction was recognized as required under 1031(b), or a similar provision, the basis of the property transferred by the taxpayer, decreased by the amount of any money received and increased by the amount of gain recognized, must be allocated to and is the basis of the properties (other than money) received on the exchange. For the purpose of the allocation of the basis of the properties received, there must be assigned to such other property an amount equivalent to its fair market value at the date of the exchange. Example: A who is not a dealer in real estate, in 1954 transfers real estate held for investment which he purchased in 1940 for $10,000 in exchange for other real estate (to be held for investment) which has a fair market value of $9000, an automobile which has a fair market value of $2000 and $1500 in cash. A realizes a gain of $2500 all of which is recognized under 1031(b). The basis of the property received in exchange is the basis of the real estate A transfers ($10,000) decreased by the amount of money received ($1500) and increased in the amount of gain that was recognized ($2500), which results in a basis for the property received of $11,000. This basis of

Basis of the Property Acquired =

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Tax IA Outline $11,000 is allocated between the automobile and the real estate received by A, the basis of the automobile being its fair market value at the date of the exchange, $2000, and the basis of the real estate received the remainder, $9000. Example: A exchanges real estate held for investment plus stock for real estate to be held for investment. The real estate transferred has an adjusted basis of $10,000 and a fair market value of $11,000. The stock transferred has an adjusted basis of $4000 and a FMV of $2000. The real estate acquired has a FMV of $13,000. A is deemed to have received a $2000 portion of the acquired real estate in exchange for the stock, since $2000 is the FMV of the stock at the time of the exchange. A $2000 loss is recognized on the exchange of the stock for real estate. No gain or loss is recognized on the exchange of the real estate since the property received is of the type permitted to be received without recognition of gain or loss. The basis of the real estate acquired by A is determined as follows: Adjusted basis of real estate transferred. $10,000 Adjusted basis of the stock transferred 4,000 -------$14,000 Less: Loss recognized on transfer of stock.. 2,000 -------Basis of real estate Acquired upon the exchange. $12,000

Reg. 1.1031(d)-2 Treatment of assumption of liabilities. For purposes of 1031(d), the amount of any liabilities of the taxpayer assumed by the other party to the exchange (or of any liabilities to which the property exchanged by the taxpayer is subject) is to be treated as money received by the taxpayer upon the exchange, whether or not the assumption resulted in a recognition of gain or loss to the taxpayer under the law applicable to the year in which the exchange was made.

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Tax IA Outline Examples: 1) B, an individual, owns an apartment house which has an adjusted basis in his hands of $500,000, but which is subject to a mortgage of $150,000. On September 1, 1954, he transfers the apartment house to C, receiving in exchange therefore $50,000 in cash and another apartment house with a FMV on that date of $600,000. The transfer to C is made subject to the $150,000 mortgage. B realizes a gain of $300,000 on the exchange, computed as follows: Value of property received $600,000 Cash.. 50,000 Liabilities subject to which old Property was transferred150,000 --------Total consideration received. $800,000 Less: Adjusted basis of property Transferred( $500,000) ---------------Gain Realized. $300,000 Under 1031(b), $200,000 of the $300,000 gain is recognized. The basis of the apartment house acquired by B upon the exchange is $500,000 computed as follows: Adjusted basis of Property Transferred

$500,000

Less: Amount of money received: Cash.. ( 50,000) Amount of liabilities Subject to which property Was transferred( $150,000) ________________ Difference:.. $300,000 Plus: Amount of gain recognized Upon the exchange. $200,000 _________________ Basis of property acquired upon The exchange $500,000

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Tax IA Outline 2)(a) D, an individual, owns an apartment house. On December 1, 1955, the apartment house owned by D has an adjusted basis in his hands of $100,000, a FMV of $220,000, but is subject to a mortgage of $80,000. E an individual, also owns an apartment house. On December 1, 1955, the apartment house owned by E has an adjusted basis of $175,000, a FMV of $250,000, but is subject to a mortgage of $150,000. On December 1, 1955, D transfers his apartment house to E, receiving in exchange therefore $40,000 in cash and the apartment house owned by E. Each apartment house is transferred subject to the mortgage on it. D realizes a gain of $120,000 on the exchange, computed as follows: Value of property received. $250,000 Cash. 40,000 Liabilities subject to which old Property was transferred 80,000 --------Total consideration.. $370,000 Less: Adjusted Basis of property Transferred ( $100,000) Liabilities to which new Property is subject (

150,000) --------------Gain Realized$120,000 For purposes of 1031(b), the amount of other property or money [boot] received by D is $40,000. Consideration received by D in the form of a transfer subject to a liability of $80,000 is offset by consideration given in the form of a receipt of property subject to a $150,000 liability. Thus, only the consideration received in the form of cash, $40,000 is treated as other property or money [boot] for purposes of 1031(b). Accordingly, under 1031(b), $40,000 of the $120,000 gain is recognized.

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Tax IA Outline The basis of the apartment house acquired by D is $170,000 computed as follows: Adjusted basis of property Transferred $100,000 Liabilities to which new Property is subject 150,000 --------Total. $250,000 Less: Amount of money received: Cash. ..($ 40,000) Amount of liabilities Subject To which Property Was transferred...($ 80,000) ---------------Difference. $130,000 Plus: Amount of gain recognized Upon the exchange. Basis of property acquired by D Upon the exchange

$ 40,000 ---------------$170,000

Now turn to E: E realizes a gain of $75,000 on the exchange, computed as follows: Value of property received.. Liabilities subject to which Old property was transferred.. Total consideration received: Less: Adjusted basis of Property transferred.( Cash.( Liabilities to which new Property is subject...( Gain Realized.. $175,000) 40,000) 80,000) --------------$ 75,000 $220,000 150,000 --------$370,000

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Tax IA Outline (which is not the same as recognized gain!!) For purposes of 1031(b), the amount of other property or money [boot] received by E is $30,000. Consideration received by E in the form of a transfer subject to a liability of $150,000 is offset by consideration given in the form of a receipt of property subject to an $80,000 liability and by the $40,000 paid in cash by E. Although consideration received in the form of cash or other property is not offset by consideration given in the form of an assumption of liabilities or a receipt of property subject to a liability, consideration given in the form of cash or other property is offset against consideration received in the form of an assumption of liabilities or a transfer of property subject to a liability. Accordingly, under 1031(b), $30,000 of the $75,000 is recognized.

[If property on both sides of the exchange is encumbered, the amounts of the liabilities are offset against one another and when the amount of liability relief exceeds the amount of liability assumption, only the net amount is treated as cash boot. The amount of a taxpayers net liability relief is reduced by any cash paid by the taxpayer. If the amount of liability assumption exceeds the amount of liability relief to a taxpayer, there is no boot related to the liability relief; however, if the taxpayer also receives cash or other boot property, gain is recognized by the taxpayer to the extent of the boot.] [1031(d) codifies Crane/Tufts: debt relief is cash equivalent so it is considered boot.]

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The basis of the apartment house acquired by E is $175,000, computed as follows: Adjusted basis of the Property Transferred $175,000 Cash.. 40,000 Liabilities to which new Property is subject. 80,000 ---------Total. $295,000 Less: Amount of money received: Amount of liabilities subject to which property was transferred. ( $150,000) ---------------Difference... $145,000 Plus: Amount of gain recognized Upon the exchange.... $ 30,000 ----------------Basis of property acquired Upon the exchange. $175,000

Examples from class: A has a building in Highland Heights he rents to law students; he exchanges it for a building in Lexington he rents to law students. He has not cashed out his investment, it is still continuing, so it is a like kind exchange subject to nonrecognition. Look at the planning potential offered by 1031: A farmer has a high value, low basis farm. A buyer wants the farm and goes out and buys a building and swaps it for the farm. This is not a taxable event, even though it was a three cornered exchange. The farmer gets out of the farm w/o recognizing the gain at that time. If the farmer dies, the new building goes to his heIRS with a basis at FMV (1014) so the gain would never be recognized.

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Example from text: p. 907, problem #2:

T has 100 acres of unimproved land which T farms. Its cost basis is $10,000 but its value is much greater. T trades it to B for a city apartment building worth $70,000, which has a basis to B of $30,000, and B transfers to T as well, $4,000 in cash and 100 shares of X Corp stock held for 3 years for which Bs basis is $40,000 but which have a FMV of $26,000. None of the property involved is mortgaged, and B always claimed straight line depreciation on the apartment. Always begin by running the transaction through 1001 to find out what the maximum gain would be unless another section would apply. Consideration received: FMV of Apartment: FMV of stock: Cash: Total. Less: Basis of farm: Max Gain realized: $ 70 $ 26 $ 4 ----$100 ($10) -----$ 90

But since the farmer is continuing his proprietary investment and making a like kind exchange, 1031 is applicable. 1031(a) provides: ***, however, in addition to receiving like property, the farmer is also receiving boot, or other property or cash. Boot equalizes the transaction. The presence of boot does not poison the transaction because 1031(b) explains how to handle boot: 1031(b) provides ***. So in this case, the farmers gain is recognized only to the extent he received boot, or $30,000 (26+4).

How much basis is allocated to the new property and how much to the stock?

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Old basis of the land is $10, but he incurred a $30 gain in acquiring the new apartment, so his basis should increase by $30, which must be allocated among the assets he acquired. The $4 in cash has a basis of $4, the stock acquired has a FMV of $26, which is its basis, So the basis of the new apartment has $10. Under 1031(d) [related to Philadelphia Park], you start with: Basis of property transferred: Less: Money received. Plus: Gain recognized Basis to be allocated: $10 ( 4) 30 ---$36

$26 is the FMV of the stock, so $26 of the basis to be allocated goes to the stock, and the rest goes to the new property: $10. Check your answer: If the farmer would sell (cash out) the apartment, ending his proprietary investment: He would get $70 for the apartment (the FMV) less his basis of $10, leaving him a gain of $60. This makes sense because if he had sold his original farm for cash, he would have unlocked $90 in gain, and he already recognized $30 of it when he received boot with the exchange. Change the facts of this problem: If the farmers basis was $80 instead of $10, his max gain under 1001 would be $20. So even though he got $30 in boot, his gain would be the lower of the 1001 gain or 1031(b) boot. So his max gain would be $20. Make a comparison and take the lower of the two. Under 1031(d), start with: Basis in property transferred: Less: cash received Plus: gain recognized Basis to allocate: $80 ( 4) $20 ---$96

The FMV of the stock is $26, so that leaves $70 to allocate as the basis of the new property.

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Tax IA Outline If you cashed out the new apartment building you would get $70 (the FMV), and the basis of it is $70, there would be zero gain. You already recognized the $20 max gain! Change facts again: Same farmer, same values, except his basis in the farm is $110. Loss property as opposed to highly appreciated property. If the farmer sold the property under 1001, he would realize a $10 loss. Does boot unlock the loss the way it unlocked part of the gain when the property was appreciated? No!! No loss is recognized under 1031(c). The only way to take the loss is if they sell the farm outright. If you exchange it for like kind, you cant take the loss. Notes: Under 1031(c), no loss is recognized when boot is received. So if you are giving up boot, 1031 (c)is not applicable. However, loss can be recognized if boot is given up. [On the other side of the swap, stock is not like kind, so gain is recognized, if there is a loss, it is recognized as well.] 1031(f) is the related party rule. This is a very big concept in tax. The service looks at the parent/child (or whomever) relationship. There is a 2 year look back where the parent and child are considered to be one unit. If the parent or child turns around and sells the property within two years, there is no continuation of the propriety investment [COPI], and the amount is attributed to the parent or child as if they had sold it. This is not a question of fact, it is a bright line test! A taxpayer can make an unlimited number of exchanges and hold property until she dies when the property receives a stepped-up basis [under 1014] and totally avoids the income tax on its prior appreciation. If property is exchanged for cash, it is a sale: exchange, realization event, and recognition of the gain UNLESS you can point to an exception. Three Cornered Exchanges: This is sanctioned by the IRS: A has property (property X) that B wants and C has property (property Y) that A wants. Assuming the properties are of alike kid are of equal value. B can purchase Cs property Y and exchange that with A for property X. If A is using the property for productive use, this is ok for A; but it may not work for B if B is not using the property for product use. If B cannot find C for a while, he can use an escrow account to facilitate the exchanges so A does not have constructive receipt of the

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Tax IA Outline cash and bring the transaction within the sale category. So if B uses a qualified intermediary, the transaction will not be poisoned for A. The use of non-simultaneous exchanges (like the 3 cornered exchange) has been sharply curtailed by 1031(a)(3), which requires the property received in the exchange to be identified within 45 days. The taxpayer must also receive the new property within 180 days after transfer of the old property. Case law: Bloomington Coca-Cola Bottling Co. v. Commissioner A sale is a transfer of property for a price in money or its equivalent. The property is transferred in consideration of a definite price expressed in terms of money. Exchange means the giving of one thing for another. The property is transferred in return for other property without the intervention of money. The presence of a small amount of cash, to adjust certain differences in value of the properties exchanged will not necessarily prevent the transaction from being considered an exchange. Commissioner v. Crichton The taxpayer exchanged her mineral rights (an interest in land) for a city lot in a transaction with her children. 1031(f) the related party rule, did not kick in here b/c neither party sold the property within the two year look back period. I Whether this was a like kind exchange. H Both properties were interests in land under Louisiana law, so it was a like kind exchange. Rational: Real property for real property is a like kind exchange. It is very broad. Notes from Crichton: The term like Kind is interpreted very broadly when applied to real estate transactions. Parcels of real property, however dissimilar, are like kind properties. Remember: personal property for personal property is more narrow: for business swaps the Regs tell us that the property must be within the same General Asset

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Tax IA Outline Class or Product Classification. To the extent the exchanged property is not like kind, it is boot. The service has held that an exchange of gold bullion for silver bullion, both held for investment, is not an exchange of like kind property b/c they are intrinsically different metals used primarily in different ways. Know for exam Leslie Co. v. Commissioner ripe for exam purposes TP was a profitable company looking for a way to unlock some deductions/losses. TPs building had a basis of $3.1 (million), but only had a FMV of $2.4 (million). TP sold its building for $2.4 to Prudential, who leased (long term)it back to the TP. The lease payments were FMV. I Whether the TP transacted a sale and effectively unlocked a loss, or whether the transaction was a like kind exchange (interest in land for interest in land) in which no loss is recognized (under 1031). H The exchange was a sale for money consideration only. Rationale: LOOK AT THE VALUES EXCHANGED: IT WAS AN ARMS LENGTH TRANSACTION. The property was sold and purchased at the FMV. The lease payments were at FMV, so the lease had no capital value. Distinguished Century Electric: where the sale and leaseback were solely reciprocal, and the value of the properties were irrelevant b/c of the administrative burden of valuation. In Century, the court just looked at COPI, not at values.

Leslie is a good example of a step transaction. The steps were broken up to show that this was an arms length transaction. Rev. Ruling 61-119: substance over form: the TP sold some old equipment used in his trade or business at a gain. In a separate transaction he purchased new equipment from the same dealer

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Tax IA Outline The Service looked to the fact that the sale and purchase were reciprocal and mutually dependent transactions and concluded that, in substance, they constituted a 1031 exchange. Involuntary Conversions

3.

1033 permits non-recognition of gain in certain circumstances in which property is involuntarily converted. The involuntary conversion may be the result of destruction, theft, seizure, requisition or condemnation or threat or imminence thereof. When property is involuntarily converted into money, if the taxpayer so elects, gain is recognized only to the extent that the amount realized as a result of the conversion exceeds the cost of the replacement property. The replacement property must be similar or related in service or use to the converted property and the replacement must occur within the time limit of the statute (2 years). The provision does not apply to losses resulting from involuntary conversion. If loss property is involuntarily converted, the loss can be recognized. 1033 generally does not apply if the property is acquired from a related person. The related person restriction is not applicable to an individual taxpayer whose realized gain does not exceed $100,000. The basis of the replacement property is the cost of such property, reduced by the gain that is not recognized. Except to the extent that 1014 intercedes, this is simply a deferral of tax to the future. Policy reasons for 1033: The realization event is forced on the taxpayer. The COPI is not abandoned, so it is not an appropriate time to tax. IRC 1033 Involuntary Conversions (a) General rule. If property (as a result of its destruction in whole or in part, theft, seizure, or requisition or condemnation or threat or imminence thereof) is compulsorily or involuntarily converted (1) Conversion into similar property. Into property similar or related in service or use to the property so converted, no gain shall be recognized. (2) Conversion into money or into property not similar or related in service or use to the converted property, the gain (if any) shall be recognized except to the extent hereinafter provided in this paragraph:

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Tax IA Outline (A) Nonrecognition of gain. If the taxpayer during the period specified in subparagraph (B), for purpose of replacing the property so converted, purchases other property similar or related in service or use to the property so converted, or purchases stock in the acquisition of control of a corporation owning such other property, at the election of the taxpayer the gain shall be recognized only to the extent that the amount realized upon such conversion (regardless of whether such amount is received in one or more taxable years) exceeds the cost of such other property or such stock. Such election shall be made at such time and in such manner as the Secretary by regulations prescribe. For purposes of this paragraph (i) no property or stock acquired before the disposition of the converted property shall be considered to have been acquired for the purposes of replacing such converted property unless held by the taxpayer on the date of such conversion; and (ii) the taxpayer shall be considered to have purchased property or stock only if, but for the provision of subsection (b) of this section, the unadjusted basis of such property or stock would be its cost within the meaning of 1012. (B) Period within which property must be replaced. ** see text** [2 years] (C) & (D) Time for assessment of deficiency attributable to gain upon conversion. ** see text** (b) Basis of property acquired through involuntary conversion. (1) Conversion described in subsection (a) (1). If the property was acquired as the result of a compulsory or involuntary conversion described in subsection (a)(1),, the basis shall be the same as in the case of the property so converted-(A) decreased in the amount of any money received by the taxpayer which was not expended in accordance with the provisions of law (applicable to the year in which such conversion was made) determining the taxable status of the gain or loss upon such conversion, and (B) increased in the amount of gain or decreased in the amount of loss to the taxpayer recognized upon such conversion under the law applicable to the year in which such conversion was made. (2) Conversions described in subsection (a)(2). In the case of property purchased by the taxpayer in a transaction described in subsection (a)(2) which resulted in the nonrecognition of any part of the gain realized as the result of a compulsory or involuntary conversion, the basis shall be the cost of such property decreased in the amount of the gain not so recognized; and if the property purchased consists of more than 1 pierce of property, the basis determined under this sentence shall be allocated to the purchased properties in proportion to their respective costs.

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(3) Property held by a corporation the stock of which is replacement property. ** see text** (g) Condemnation of real property held for productive use in trade or business or for investment. (1) Special rule. For purposes of subsection (a), if real property (not including stock in trade or other property held primarily for sale) held for productive use in trade or business or for investment is (as the result of its seizure, requisition, or condemnation, or threat or imminence thereof) compulsorily or involuntarily converted, property of a like kind to be held either for productive use in trade or business or for investment shall be treated as property similar or related in service or us to the property so converted. (i) Related persons. ** see text** 1223 Holding period of property. ** see text ** Reg. 1.033(a)-2 (b) Conversion into similar property. If property is compulsorily or involuntarily converted only into property similar or related in service or use to the property so converted, no gain shall be recognized. Such nonrecognition is mandatory. (c)Conversion into money or into dissimilar property. (1) If property is compulsorily or involuntarily converted into money or into property not similar or related in service or use to the converted property, the gain, if any, shall be recognized, at the election of the taxpayer, only to the extent that the amount realized upon such conversion exceeds the cost of other property purchased by the TP which is similar or related in service or use to the property so converted, or the cost of stock of a corporation owning such other property which is purchased by the TP in acquisition of control of such corporation,. Reg. 1.1033(b)-1 Basis of property acquired as a result of an involuntary conversion. Example: A TP realizes $22,000 from the involuntary conversion of his barn in 1955; the adjusted basis of the barn to him was $10,000, and he spent in the same year $20,000 for a new barn which resulted in the nonrecognition of $10,000 of the $12,000 gain on the conversion. The basis of the new barn to the TP would be $10,000the cost of the new barn ($20,000) less the amount of the gain not recognized on the conversion ($10,000). The basis of the new barn would not be a substituted basis in the hands of the taxpayer within the meaning of 1016(b)(2). If the replacement of the converted barn had been made by the purchase of two smaller barns which together, were

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Tax IA Outline similar or related in service or use to the converted barn and which cost $8,000 and $12,000 respectively, then the basis of the two barns would be $4,000 and $6,000 respectively, the total basis of the purchased property ($10,000) allocated in proportion to their respective costs (8,000/20,000 of $10,000 or $4,000; and 12,000/20,000 of $10,000 or $6,000). Case law: Harry G. Masser Tax Court 1958 TP operated a trucking business, bout at one time two pieces of property situated across the street from each other, one improved by a building, and the other used as truck parking. The two pieces of property were used together as an economic unit. The parking lot was involuntarily converted by NYC. If TP retained the improved property, the closes available parking area would be a mile away. TP in good faith decided to sell the improved property and use the proceeds of both properties to buy property in the same locality suitable for similar use as a truck terminal. I Whether the sale of the improved property was an involuntary conversion. H It was an involuntary conversion. Rationale: The two pieces of property were acquired and used as an economic unit, when one piece was involuntarily converted, the continuation of the business on the remaining piece of property was impractical. Clifton Inv. Co. V. Commissioner 6th Cir. 1963 TP sold, under threat of eminent domain, an office building used for production of rental income from commercial tenants. The funds realized from the sale were used by TP to purchase 80% of the outstanding stock of the Times Square Hotel of New York. I Whether the purchase of the stock in the hotel was an investment property similar to or related in service or use to the office building the TP had been forced to sell, thus deserving nonrecognition of gain under 1033(a)(3)(A).

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Tax IA Outline H That which the taxpayer receives from his properties and that which such properties demand of the taxpayer must both be considered in determining whether or not the properties are similar or related in service or use to the taxpayer. Rationale:

The prior building was managed directly by the TP, whereas the Hotel was managed by a professional management company. In the prior building, income was generated from commercial tenants, in the Hotel it was from a large number of transients. The office building only required 2 employees, the hotel need 120. The TPs interest the investment was altered.

Rev. Ruling 76-319: TPs bowling ally burned down. The proceeds were used to buy a pool hall. The pool hall was not considered similar or related in service or use to qualify for 1033 nonrecognition. Rev. Ruling 67-254: TP owned a warehouse which he rented to third parties. The warehouse and the land were condemned by the State and a gain was realized by the TP. The condemnation proceeds were used by the TP to erect a gas station on other land already owned by the TP. The TP rented the gas station to an oil company. The TP did not qualify for the special rule under 1033(g) as the replacement property (gas station) and the property converted (land and warehouse) were not properties of a like Kind. I The issue was whether the TP can qualify for treatment under 1033(a) even though he fails to qualify under 1033(g). H The gas station is property similar or related in service or use within the meaning of 1033(a). The TP recognizes gain only to the extent that the amount realized upon such conversion exceeds the cost of the replacement property. Test applied: whether the properties are of a similar service to the taxpayer, the nature of the business risks connected with the properties, and what such properties demand of the TP in the way of management, services, and relations to his tenants.

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Tax IA Outline Apply the facts: The TP was an investor for the production of rental income in both cases. Examples from Class: 1) Elderly farmer with highly appreciated farm near the airport. The airport exercises condemnation on the farm. What are the options? 1) cash sale: but this is a taxable event, 1001 gain recognized now, no chance of 1014. 2) installment sale: where gain is reported over time; also 1014 is not available; 3) airport could do a 3 cornered exchange w/farmer; so no gain is recognized and a substituted basis, so 1014 would be available upon the death of the elderly farmer. 4) 1033; sell farm for cash and roll over the proceeds into similar property: no gain recognized. 2) TP had a plant used in business, but was destroyed by lightening. 100 FMV, 10 basis. Insurance co paid $100 in cash: run the transaction through 1001 fIRSt: amount realized was $100, $90 gain is recognized. But if proceeds are put into another plant, 1033 permits non-recognition of the gain. The momentary presence of cash is no poisonous. The TP has 3 years to do this (2 years for personality). If the TP added $30 more of his own money to build a bigger plan, the new basis is $40, new FMV is $130. The $90 unrecognized gain is still the distance between the FMV and basis. What if TP only reinvested $80 of the insurance money into a new plant? The remaining $20 is boot. It is a taxable event in regard to the boot.. The new plant has a $80 FMV and $10 basis. Recognize $20 gain, which is the extent of the boot. The remaining distance is $70 between the $80 new FMV of smaller plant and the substituted basis ($20 of the $90 realized gain is recognized.) 4. Other Nonrecognition Provisions

See text p. 919: But briefly they include: a transfer of property to a new corporation; transfers of property to a partnership in exchange for a partnership interest; exchanges of life insurance, endowment, or annuity contracts, exchange of some US obligations; certain repossessions. Analysis note: if there is a question that involves an involuntary conversion and a damages award: A quick First step through damage awards (following) to first show that damages for destruction of property are gross income only to the extent that they exceed the basis in the property. So make a note of In lieu of what were the damages awarded? (Raytheon). Then go through 1001 to determine the gain and 1033 to see if the excess over basis [gain] has to be recognized.

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Tax IA Outline XVI. Damage Recoveries A. Damages in General Taxability of a recovery of damages can be determined, in part, by identifying the nature of the injury. In lieu of what were the damages awarded? Different sources of damages [business, contract, tort] and origins of claims give you different results. Look at the substance of the transaction, not the form. If a taxpayer recovers damages for loss of profits incurred on account of an injury to the TPs business, the damages as a substitute for lost profits are easily identified as gross income. Punitive or exemplary damages recovered in a recovery arising in a business context are taxable even if they are properly characterized as a windfall. Recoveries for patent infringement, antitrust violations, breach of contract, or breach of fiduciary duty, a compensating deduction may nullify or offset the inclusion in gross income. Damages or other recoveries for the improper taking of or injury to physical property operate simply to reduce the loss deduction otherwise potentially available, but they may become taxable income where the recovered amounts exceed the propertys basis. Tax analysis requires allocation of the award in such circumstances. Raytheon Production Corporation v. Commissioner 1st Cir. 1944 I Whether damages recovered in an antitrust action are nontaxable as return of capital? H Test: In lieu of what were the damages awarded? Here, the damages were for damage to goodwill (property). Compensation [damages] for the loss of Raytheons good will in excess of its cost [basis] is gross income. Rationale:

Recoveries which represent a reimbursement for lost profits are income, the reasoning is that since the profits would be taxable income, the proceeds

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Tax IA Outline of litigation which are their substitute are taxable in the like manner. Damages for violation of the anti-trust acts are treated as income where they represent compensation for loss of profits. Where the suit is not to recover lost profits but is for injury to good will, the recovery represents a return of capital and, with certain limitations, is not taxable. Apply the facts: the tube business of the TP and the property good will of the TP had been totally destroyed at a time when it then had a present value in excess of three million dollars, and thereby the plaintiff was then injured in its business and property in a sum in excess of three million dollars. The TPs business no longer exists, so injury was to more than just lost profits. Since the suit was to recover damages for the destruction of the business and good will, the recovery represents a return of capital. Even though the suit was settled, the nature of the recovery was not changed. Although the injured party may not be deriving a profit as a result of the damage suit itself, the conversion thereby of his property into cash is a realization of any gain made over the cost or other basis of the good will prior to the illegal interference. His prior gain due to the appreciation in value is realized when it is turned into cash by the money damages. Compensation for the loss of good will in excess of its cost is gross income. If the company offers lost profits as evidence of damage to goodwill, it does not categorically mean the damages are for profits and taxable.

If recovery is for lost profits, the basis in profits is zero, so all is taxed. If the recovery is for property, and the basis is $10 and recovery is $100, $90 is taxed. Usually in K, there is no basis, so all is taxed.

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Tax IA Outline B. Damages and Other Recoveries for Personal Injuries

One who has incurred personal injury should not additionally suffer injury to ones purpose in the form of tax liability on the receipt of some financial recompense. 1. Compensation for Injuries and Sickness

104 Compensation for injuries or sickness. (a) In general. Except in the case of amounts attributable to (and not in excess of) deductions allowed under 213 (relating to medical, etc., expenses) for any prior taxable year, gross income does not include: (1) amounts received under workmens compensation acts as compensation for personal injuries or sickness; (2) the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness. (3) Amounts received through accident or health insurance (or through an arrangement having the effect of accident or health insurance) for personal injuries or sickness (other than amounts received by an employee, to the extent such amounts (A) are attributable to contributions by the employer which were not includible in the gross income of the employee, or (B) are paid by the employer); (4) amounts received as pension, annuity, or similar allowance for personal injuries or sickness resulting from active service in the armed forces of any country or in the Coast and Geodetic Survey or the Public Health Service, or as a disability annuity payable under the provisions of 808 of the Foreign Service Act of 1980; and (5) amounts received by individual as disability income attributable to injuries incurred as a direct result of a violent attack which the secretary Of State determines to be a terrorist attack and which occurred while such individual was an employee of the United States engaged in the performance of his official duties outside the United States. For purposes of paragraph (3), in the case of an individual who is, or has been, an employee within the meaning of 401(c)(1) (relating to self-employed individuals), contributions made on behalf of such individual while he was such an employee to a trust described in 401(a) which is exempt from tax

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Tax IA Outline under section 501(a), or under a plan described in 403(a) shall, to the extent allowed deductions under 404, be treated as contributions by the employer which were not includible in the gross income of the employee. For purposes of paragraph (2), emotional distress shall not be treated as a physical injury or physical sickness. The preceding sentence shall not apply to an amount of damages not in excess of the amount paid for medical care (described in subparagraph (A) or (B) of 213(d)(1)) attributable to emotional distress. (b) Termination of application of subsection (a)(4) in certain cases. ** see text ** (c) Application of prior law in certain cases. The phrase (other than punitive damages) shall not apply to punitive damages awarded in a civil action (1) which is a wrongful death action, and (2) with respect to which applicable State law (as in effect on September 1, 1995 and without regard to any modification after such date) provides, or has been construed to provide by a court of competent jurisdiction pursuant to a decision issued on or before September 13, 1995, that only punitive damages may be awarded in such an action. This subsection shall cease to apply to any civil action filed on or after the fIRSt date on which the applicable State law ceases to provide (or is no longer construed to provide) the treatment described in paragraph (2).

Reg. 1.104-1 Compensation for injuries or sickness **see text**, but (b) is summarized for Workers Comp: payments based on retirement pension, employees age or length service, or employees prior contributions are not excluded from gross income. Non-occupational workers comp payments are also not excluded. (c) damages received through suit or settlement based on tort or tort type rights, are excluded. (d) If you pay your own health insurance premiums with after tax dollars (where no deduction was taken), when the insurance company pays you, it is not income to you it is excluded. The Supreme Court has held that damages must be incurred on account of personal injuries or sickness to be excludable. The court has denied exclusion for: back pay in a sex discrimination case, age discrimination. (Because back pay is not tort like.) Punitive damages recovered in a physical personal injury suit are specifically included within gross income (104(a)(2)). There is one exception: punitive damage awards in wrongful death actions are excludable if they are the only recovery made 104(c).

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Tax IA Outline The most litigated provision: 104(a)(2) 104(a)(2) is now limited to damages incurred on account of personal physical injuries or physical sickness. Damages for nonphysical personal injuries, such as defamation, First Amendment Rights, and sex and age discrimination are no longer excludable from gross income. Emotional distress itself is not a physical injury despite the manifestation of physical symptoms, so awards are included in gross income. However, damages received for amounts paid for medical care attributable to the emotional distress are excludable. Go through the elements of 104(a)(2): ANY DAMAGES RECEIVED ON ACCOUNT OF PERSONAL PHYSICAL INJURIES OR PHYSICAL SICKNESS. ANY: There are limitations to any. Compensatory damages: make you whole, you are not made better, there is no enrichment. Compensatory damages are excludable, whether in lump sum or installments (periodic or structured settlement). There is no limitation to compensatory damages. Rev. Ruling 79-313: if interest is included with a compensatory award paid over time, the interest is also excludable. Consortium: is also excludable b/c it is compensatory. If it goes to the noninjured spouse, it is still excludable. Pain and Suffering: are excludable Lost Wages and Lost Earnings capacity: these are also excluded as compensatory damages. This seems like an economic recovery and inconsistent, it is still excluded. Punitives: are not excluded from gross income, these are windfalls. Exception to this: punitives for wrongful death if it is the only recovery awarded. 104(c). Post judgment interest: is not excluded. It is not received b/c of the injury, is received on account of the time value of money. PHYSICAL : There are only negative definitions in the code.

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Tax IA Outline Emotional injuries: are not physical injuries, so awards not excludable. If the origin of the claim is emotion, the ulcers developed later, even though physical, are not excludable damage awards. But reimbursement for medical expenses incurred due to the emotional distress are excludable. Recoveries for future costs are not excludable. Discrimination in the workplace: not a physical injury and not excludible. Whistleblower damages: (Ashland on KY Bar exam) were not excludable. Private letter ruling: an employee went through 3 states of sexual harassment: 1) just words; 2) included touching but no pain; 3) pain, bruising, bleeding, bites. She got a lump sum. It had to be allocated among the three: for just words, that part allocated was not excludable; for just touching, not excludable but it was a question of fact; but the allocation for the biting and bleeding was excludable. Allocating settlement judgments is important for tax purposes! Other notes: Should the jury be instructed about the tax effects of different damages? As a general rule, States dont permit the jury to know, but in federal court, it is ok to instruct the jury on the tax effect. Attorneys Fees in Connection to Damage Awards Compensation awards are excluded from gross income, but what about the costs incurred, such as attorneys fees, to get the award? Attorney fees in connection with compensation awards are not deductible in this situation because there is no income stream to deduct it from. No income, but on the other hand, no deduction. HOWEVER: For punitive and interest awards, attorneys fees are deductible because the award is income to the TP. There is an income stream to deduct the costs from. Estate of Clark: 6th Cir. 2001 personal injury recovery Jury awarded TP large PI damages, and by time it was paid, there was a large interest portion.

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Tax IA Outline The TP did not include the interest portion of the attorney (contingent) fee award as interest income because the TP did not receive any of the money. It was paid directly to the lawyer, who deducted his fee and sent the rest to the TP. The IRS claimed a tax deficiency b/c the estate improperly failed to include as income the interest paid to the lawyer on the contingent fee contract. [The non-interest portion of the award was clearly not taxable to the TP under 104(a)(2), so that was no issue.] The IRS argued that the tree produced $100 and it was all the TPs, no assignment of income.

The 6th Circuit held that the interest award was more akin to a division of property instead of an assignment of income. The TP assigned a part of the tree, not merely the fruit. The lawyer earned the income through his skill. Why didnt the court use 83, property for services? Guess: When the TP made the contingency fee arrangement, the claim was speculative and not property. Through the lawyers skill, it became property and he earned the income. 2. Contract Recoveries from Health Insurance Plans

Employer purchased arrangements: If the employer pays the premiums, it is a fringe benefit, but under 106 it is a taxfree benefit to the employee. So the recoveries on employer purchased health plans are pre-tax to the employee. If employee is injured and receive $50 payment on this employer paid plan, it is all gross income to employee under 105(a). However, it is gross income only to the extent it is excess of the actual medical services provided to the employee. Ex: The hospital bill is $20, and the insurance company pays you $50, you have gross income of $30. $30 is figured to be lost income while the employee was sick or disabled (which is income). Self-employed individuals are not employees for purposes of 105. 105 Amounts received under accident and health plans. (a) Amounts attributable to employer contributions. Except as otherwise provided in this section, amounts received by an employee through accident or health insurance for personal injuries

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Tax IA Outline or sickness shall be included in gross income to the extent such amounts (1) are attributable to contributions by the employer which were not includible in the gross income of the employee, or (2) are paid by the employer. [HOWEVER] (b) Amounts expended for medical care. Except in the case of amounts attributable to (and not in excess of) deductions allowed under 213 (relating to medical, etc., expenses) for any prior taxable year, gross income does not include amounts referred to in subsection (a) if such amounts are paid, directly or indirectly, to the taxpayer to reimburse the taxpayer for expenses incurred by him for the medical care (as defined in 213(d)) of the TP, his spouse, and his dependents (as defined in 152). Any child to whom 152(e)applies shall be treated as a dependent of both parents for purposes of this subsection. (C) Payments unrelated to absence from work. Gross income does not include amounts referred to in subsection (a) to the extent such amounts (1) constitute payment for the permanent loss or loss of use of a member or function of the body, or the permanent disfigurement, of the taxpayer, his spouse, or a dependent, and (2) are computed with reference to the nature of the injury without regard to the period the employee is absent from work. [for the rest of 105 see text} If medical expenses were [itemized] deducted, reimbursement is included in gross income, otherwise the TP would have a double tax benefit. Reg. 1.105-2 Amounts Expended for medical care. Summary. Amounts specifically paid to reimburse the taxpayer for expenses incurred by him for medical care are excludible. Ex: If under a wage continuation plan the TP is entitled to regular wages during a period of absence from work due to sickness or injury, amounts received under such plan are not excludable from his gross income. Reg. 1.105-3 Payments unrelated to absence from work. 105(c) provides an exclusion from gross income to the extent such payments are for the permanent loss or permanent loss of use of a member or function of the body, or the permanent disfigurement, of the TP, his spouse, or a dependent. This payment must be computed WITHOUT regard to the period the employee is absent from work. Ex: loss of an eye, loss of substantially all of the vision of an eye, hearing. The

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Tax IA Outline term disfigurement shall be given a reasonable interpretation in the light of all the particular facts and circumstances. 105(c) does not apply if the amount of the benefits is determined by reference to the period the employee is absent from work. EX: if an employee is absent from work as a result of the loss of an arm, and under the accident and health plan established by his employer, he is to receive $125 a week so long as he is absent from work for a period not in excess of 52 weeks, 105(c)is not applicable to such payments. Reg. 1.105-5 Accident and Health Plans. The plan does not need to be in writing and the employees rights under the plan do not need to be enforceable. It is immaterial who makes payment of the benefits provided by the plan: payment may be made by the employer, a welfare fund, a State sickness or disability benefits fund, an association of employers or employees, or by an insurance company. 106 Contributions by employer to accident and health plans. (a) General Rule. Except as otherwise provided in this section, gross income of an employee does not include employer-provided coverage under an accident or health plan. **see text for the rest**

Reg. 1.106-1 Contributions by employer to accident and health plans. Gross income of an employee does not include contributions which his employer makes to an accident or health plan for compensation to the employee for personal injuries or sickness incurred by him, his spouse or dependents. If an insurance policy provides other benefits in addition to accident or health benefits, only the portion of the employers contribution which is allocable to the accident or health benefits is excludable.

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XVII. Separation and Divorce 1. Direct Payments

Alimony is includible in the payees gross income 71, and deductible by the Payor 215. Divorced or separated persons may in effect allocate taxability between them of some of the Payor spouses income by the payee assuming the tax burden for the amount received as alimony and the Payor being accorded a deduction for that amount. This overrides Lucas v. Earl (where the earner of income is taxed). The manner in which interspousal payments are arranged becomes a bargaining matter in negotiations for any settlement, with a close eye on the tax consequences. There is a huge difference tax wise, between alimony and a property settlement. If it does not fit the definition of alimony it is a property settlement. Because uniformity was needed for tax law, there is a federal definition of alimony; local laws dont apply. 71 can be divided into three parts: 1) identifies taxable and deductible alimony or separate maintenance payments, 2) by negative inference, identifies payments that are not treated as alimony or separate maintenance, which are accorded the nontaxable non-deductible status of property settlements; 3) child support. 71 Alimony and separate maintenance payments. (a) General Rule. Gross income includes amounts received as alimony or separate maintenance payments. (b) Alimony or separate maintenance payments defined. For purposes of this section (1) In general. The term alimony or separate maintenance payment means any payment in cash if (A) such payment is received by (or on behalf of) a spouse under a divorce or separation instrument, (B) the divorce or separation instrument does not designate such payment as a payment which is not includible in gross income under this section and not allowable as a deduction under 215, (C) in the case of an individual legally separated from his spouse under a decree of divorce or of separate maintenance, the payee spouse and the Payor spouse are not members of the same household at the time such payment is made, and

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Tax IA Outline (D) there is no liability to make any such payment for any period after the death of the payee spouse and there is no liability to make any payment (in cash or property) as a substitute for such payments after the death of the payee spouse. (2) Divorce or separation instrument. The term divorce or separation instrument means (A) a decree of divorce or separate maintenance or a written instrument incident to such a decree, (B) a written separation agreement, or (C) a decree (not described in subparagraph (A)) requiring a spouse to make payments for the support or maintenance of the other spouse. (c) Payments to support children. (1) In general. Subsection (a) shall not apply to that part of any payment which the terms of the divorce or separation instrument fix (in terms of an amount of money or a part of the payment) a sum which is payable for the support of children of the Payor spouse. (2) Treatment of certain reductions related to contingencies involving child. For purposes of paragraph (1), if any amount specified in the instrument will be reduced (A) on the happening of a contingency specified in the instrument relating to a child (such as attaining a specified age, marrying, dying, leaving school, or a similar contingency), or (B) at a time which can clearly be associated with a contingency of a kind specified in subparagraph (A), an amount equal to the amount of such reduction will be treated as an amount fixed as payable for the support of children of the Payor spouse. (3) Special rule where payment is less than amount specified in instrument. For purposes of this subsection, if any payment is less than the amount specified in the instrument, then so much of such payment as does not exceed the sum payable for support shall be considered a payment for such support. (d) Spouse. For purposes of this section, the term spouse includes a former spouse. (e) Exception for joint returns. This section and 215 shall not apply if the spouses make a joint return with each other. (e) Recomputation where excess front-loading of alimony payments. ** see notes for explanation ** detail is not required.

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Tax IA Outline 215 Alimony, etc., payments (a) General rule. In the case of an individual, there shall be allowed as a deduction an amount equal to the alimony or separate maintenance payments paid during such individuals taxable year. (b) Alimony or separate maintenance payments defined. For purposes of this section, the term alimony or separate maintenance payment means any alimony or separate maintenance payment (as defined in 71(b)) which is includible in the gross income of the recipient under 71. (c) Requirement of identification number. ** Payor must give payees SSN on his 1040 when he takes the deduction) (d) Coordination with section 682. ** omitted ** Notes from Reg. 1.71-1T Alimony and separate maintenance payments. Alimony payments do not have to be periodic. Alimony payment may only be made in the form of cash. Payments of cash to a third party of behalf of a spouse qualifies as alimony if the payments are pursuant to the terms of a divorce or separation instrument. [ex: rent, mortgage, tax, tuition] Any payments to maintain property owned by the payor spouse and used by the payee spouse (including mortgage payments, real estate taxes and insurance premiums) are not payments on behalf of a spouse even if those payments are made pursuant to the terms of the divorce or separation instrument. Premiums paid by the Payor spouse for term or whole life insurance on the Payors life made under the terms of the divorce or separation instrument will qualify as payments on behalf of the payee spouse to the extent that the payee spouse is the owner of the policy. Payments of cash to third parties of behalf of a spouse qualify as alimony if the payments are made to the third party at the written request of the payee spouse. The Payor and payee of alimony can elect out of 71 and 215 treatment: payments can be nondeductible by the Payor and excludible from gross income from by the payee.

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Tax IA Outline Payor and payee must not be members of the same household, even if they physically separate themselves within the dwelling unit. If the Payor is required to continue to make the payments after the death of the payee, none of the payments before or after the death qualify as alimony.

Examples from Reg. 1.71-1T(b): 1) Under the terms of a divorce decree, A is obligated to make annual alimony payments to B of $30,000, terminating on the earlier of the expiration of 6 years or the death of B. B maintains custody of the minor children of A and B. The decree provides that at the death of B, if there are minor children of A and B remaining, A will be obligated to make annual payments of $10,000 to a trust, the income and corpus of which are to be used for the benefit of the children until the youngest child attains the age of majority. These facts indicate that As liability to make annual $10,000 payments in trust for the benefit of his minor children upon the death of B is a substitute for $10,000 of the $30,000 annual payments to B. Accordingly, $10,000 of each of the $30,000 annual payments to B will not qualify as alimony or separate maintenance payments. 2) Under the terms of a divorce decree, A is obligated to make annual alimony payments to B of $30,000, terminating on the earlier of the expiration of 15 years or the death of B. The divorce decree provides that if B dies before the expiration of the 15 year period, A will pay to Bs estate the difference between the total amount that A would have paid had B survived, minus the amount actually paid. For example, if B dies at the end of the 10th year in which payments are made, A will pay to Bs estate $150,000 ($450,000-$300,000). These facts indicate that As liability to make a lump sum payment to Bs estate upon the death of B is a substitute for the full amount of each of the annual $30,000 payments to B. Accordingly, none of the annual $30,000 payments to B will qualify as alimony or separate maintenance payments. The result would be the same if the lump sum payable at Bs death were discounted by an appropriate interest factor to account for the prepayment. NOTES: Requirements for Taxable and Deductible Alimony: A payment that is made in CASH (if it is not cash, it is not alimony for federal tax purposes; check or money order is considered cash) qualifies as alimony or as separate maintenance, if five requirements are met:

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Tax IA Outline 1) The payment is received (not just dropped in the mail) by, or on behalf of, a spouse under a divorce or separation instrument; The divorce or separation instrument does not designate the payment as a non-alimony payment; In the case of a decree of legal separation or of divorce, the parties are not members of the same household at the time the payment is made; There is no liability to make any payment in cash or property, after the death of the payee spouse; and The payment is not for child support.

2)

3)

4)

5)

The first requirement is that payments be received to a divorce or separation instrument. Thus 71 and 215 are applicable only to taxpayers who find themselves in one of the following four different situations: 1) divorced; 2) legally separated by decree; 3) married but payments are directed by a written separation agreement; or 4) married but payments are directed under a support decree. No joint returns! The designation of any payment as non-alimony generally yields tax relief to the recipient (no gross income under 71(a)) and an increased tax burden for the Payor (no deduction under 215(a)). This allows the parties to allocate the income tax consequences of the marital dissolution between themselves. The payor cannot have any obligation after the death of the payee, or the payments smell like property settlements. None of the payments would considered alimony. Payments made other than in cash do not meet the federal definition of alimony and, even though incident to divorce, cannot be subject to the inclusion-deduction rules. 71(f) Alimony Recapture Provision frontloading To keep the Payor and payee from abusing the inclusion-deduction rules of 71 and 215 by calling property settlements alimony, Congress put the frontloading provision in 71(f). Congress believes that level payments are more indicative of alimony, rather than property settlements. This subsection applies to situations where disproportionately large payments are made during the early years of the payments. When inordinately large amounts of alimony and support are paid in the first or second year in relation to year three, an amount is recaptured in year three. That recapture takes the form of an amount included in the Payor spouses gross income for year three (offsetting prior deductions) and a deduction in the same year

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Tax IA Outline by the recipient spouse (offsetting prior inclusions). Recapture is a device that, when applicable, simply says that as the amount recaptured was not properly treated as alimony or separate maintenance for the earlier year, correction is in order. If the payments in the second year exceed payments in the third year by more than $15,000, then there is a recapture of that excess in the third year. If the alimony payments in the first year exceed the average of the payments in the second year and the third year by more than (after reducing second-year excess payments as determined above) by more than $15,000, that excess amount is also recaptured in the third year. Recapture is a very bad trap. When drafting pay attention to this. This provision does not apply to rear loading where the alimony amounts are higher in years two and three. Attorneys Fees Payor: pays alimony, no deduction for attorneys fees b/c the origin of the claim is a personal transaction. hired an attorney and received alimony and property settlement; the payee can deduct the attorney fees: the attorney generated income to the payee in the form of alimony. A portion of the fee can be deducted from the income stream of the alimony, and a portion of the fee can be capitalized into the basis of the property received. Cite Reg. 1.262-1 (b)(7) & Reg. 1.212-1(a) (1).

Payee:

But attorney fees related to generating child support is not deductible. 2. Indirect Payments

I.T. 4001 - 1950 H and former W entered into a property settlement agreement in which the H had to pay premiums on 2 life insurance policies. One of the policies is assigned absolutely to the wife. She is designated as the irrevocable beneficiary of such policy and the children as irrevocable contingent beneficiaries. The other policy designates the children as beneficiaries and the W as contingent beneficiary. This policy is not assigned to the wife and its possession and control are retained by the husband. This property settlement was entered into as an incident of divorce. The payments on the policy assigned (owned) by the former wife are alimony and deductible by the H and includible to the W. The payments on the policy not assigned to the former W are not alimony and not subject to deduction/inclusion.

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Notes: The statutory definition of alimony expressly contemplates that payments can be made indirectly to the payee (71(b)(1)(A) on behalf of the spouse). They payments still must be in cash. What types of indirect payments qualify as alimony? The answer turns on the nature of the payments, i.e. the rights and legal interests of the payor and payee with respect to the payments. Ex: Payments made by the Payor merely to maintain property owned by the payor spouse which is simply being used by the payee spouse do not qualify as indirect payments (same with life insurance, mortgage payments, taxes). But if the payments are in satisfaction of a legal obligation exclusively that of the payee spouse and are applicable with respect to property in which the payor has no legal interest, then such payments qualify as indirect alimony payments. Example from class: 1) Payor stays in the family home and payee moves into a rental house. Payor pays payees rent. This is an indirect payment. 2) Payee lives in the family home and the Payor pays the mortgage. On whose behalf is the mortgage being paid? If the Payor owns the home when he makes the payments he is building his own equity so that is not alimony (no payment on behalf of payee). 3. Alimony Payments Made by a Third Party

If the Payor spouse discharges the alimony obligation by transferring property to a trust that produces income that is in turn, paid to the payee spouse, the income is taxable to the payee. The payee is treated as the owner of the investment. The payee is not taxed under 71, but rather is treated as any other taxpayer and taxed under 102(b)(2): income from property. The Payor gets no deduction under 215 either. Funding the trust is not a realization event. If he transfers stock to a trust, no realization event. It is really tax neutral to him. What is the benefit of an alimony trust? It provides security to the payee.

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Tax IA Outline 4. Property Settlements

See outline p. 96, property transfers incident to divorce and 1041. Remember: 1041 provides non-recognition of gains and losses with respect to any transfer of property between married persons and between formerly married persons. B. 1. Other Aspects of Divorce Child Support

71(c)(1) requires the parties in their divorce to specifically state the amounts or parts therefore allocable to the support of children. Amounts received as child support by the custodial parent has no gross income to either parent or child. The parent paying child support has no deduction, as it is a personal expenditure.

XVIII. Business Deductions Technically, there is no constitutional obstacle to a tax on gross income. So expenses incurred earning income might constitutionally be disregarded in the computation of tax. For this reason, deductions are spoken of as a matter of legislative grace. A taxpayer has no constitutional right to a deduction, so a taxpayer must find a statutory provision that specifically allows the deduction claimed. The provisions permitting deductions are narrowly interpreted against the taxpayer. 162 is the flagship provision for business deductions. TWEEN OUTLINE:

Gross Income Less: (Deductions) Above the line business deductions -------------------Adjusted Gross Income Less: (Itemized or Std Deducts)Below the Line personal ---------------------(may be capped/phased out) Taxable income 212 Cost of investment transactions: deductions

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Tax IA Outline 262 Personal Expenditures are not deductible Types of Business Spending: 1) operational expenses 2) capital expenditures (assets (tangible & intangible) & equipment) 3) maintenance/repairs (distinguished from capital expend.)

A.

162 The Flagship provision

162 Trade or Business Expenses. (a) In general. There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including (1) a reasonable allowance for salaries or other compensation for personal services actually rendered; (2) traveling expenses (including amounts expended for meals and lodging other than amounts which are lavish or extravagant under the circumstances) while away from home in the pursuit of a trade or business; and (3) rentals or other payments required to be made as a condition to the continued use or possession, for purposes of the trade or business, of property to which the taxpayer has not taken or is not taking title or in which he has no equity. For purposes of the preceding sentence, the place of residence of a Member of Congress (including any Delegate and Resident Commissioner) within the State, congressional district, or possession which he represents in Congress shall be considered his home, but amounts expended by such Members within each taxable for living expenses shall not be deductible for income tax in excess of $3000. For purposes of paragraph (2), the taxpayer shall not be treated as being temporarily away from home during any period of employment if such period exceeds 1 year. The preceding sentence shall not apply to any Federal employee during any period for which such employee is certified by the Attorney General (or the designee thereof) as traveling on behalf of the United States in temporary duty status to investigate or prosecute, or provide support services for the investigation or prosecution of, a federal crime. Reg. 1.162-1 Business expenses. (a) In general. Business expenses deductible from gross income include the ordinary and necessary expenditures directly connected with or pertaining to the taxpayers

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Tax IA Outline trade or business, except items which are used as the basis for a deduction or a credit under provisions of law other than 162. The cost of goods purchased for resale, with proper adjustment for opening and closing inventories is deducted from gross sales in computing gross income. Among the items included in business expenses are management expenses, commissions, labor, supplies, incidental repairs, operating expenses of automobiles used in the trade or business, traveling expenses while away from home solely in the pursuit of a trade or business, advertising and other selling expenses, together with insurance premiums against fire, storm, theft, accident, or other similar losses in the case of a business, and rental for the use of business property. No such item shall be included in business expenses, however, to the extent that it is used by the taxpayer in computing the cost of property included in its inventory or used in determining the gain or loss basis of its plant, equipment, or other property. *** The full amount of the allowable deduction for ordinary and necessary expenses in carrying on a business is deductible, even though such expenses exceed the gross income derived during the taxable year from such business. 162Elements: ordinary & necessary paid during the taxable year while carrying on a trade or business

1.

Ordinary and Necessary

Welch v. Helvering 1933 TP was secretary of Welch company that went bankrupt. In order to reestablish his business relations with customers whom he had known when he was acting for Welch Company, he decided to personally pay the debts of the Welch business so far as he was able. I Whether these payments were deductible as ordinary and necessary expenses of the TP. H Although the payments may have been necessary for the development of the TPs business, men do not ordinarily pay the debts of others. The expenditure is a capital expenditure, and not ordinary. Rationale:

Many necessary payments are charges upon capital. The expenditures were necessary in that they were appropriate and helpful. Necessary is a question of fact. But men do not normally pay the debts of others, so the payments were extraordinary.

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Tax IA Outline To allow this kind of payment to be charged as ordinary would permit too many bizarre analogies. The decisive distinctions between current expenses and capital expenditures are those of degree and not of kind. Each case turns on its facts.

What to know from Welch: NECESSARY: Tells the TP if he gets to deduct the expenditure at all. There must be a nexus between the expenditure and the business. The expenditure must be appropriate and helpful for the development of the business. It cannot be a personal expenditure or investment related. This is not a bright line test, it is a question of fact. If the expenditure is necessary, then see if the expenditure is ordinary.

ORDINARY: Once an expenditure is determined to be necessary, the question of if it is ordinary tells the TP when he gets the benefit. To qualify as ordinary, the expense must relate to a transaction of common or frequent occurrence in the type of business involved. If the expenditure is ordinary, the TP gets the deduction now. If the expenditure is not ordinary, it must be capitalized as basis or added to basis and depreciated over time under 263.. Even if the expenditure is not ordinary, the TP does not go empty handed: he gets to depreciate the asset, or deduct the basis from the amount realized. The normal thing is capitalization: you spend money and build basis. 162(a) is the exception and the TP carries the burden to prove deduction under 162(a) (deductions are a matter of legislative grace, and are narrowly construed against the TP).

Welch is often cited for the presumption of correction that attaches to a deficiency notice. FN (1) from Welch speaks to the factual inquiries in tax cases. Judges and juries come up w/different results, based on their own experiences. Cases w/similar facts could be decided differently. It is important to work through the facts. FN (1) cites other caselaw for: 161

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Ordinary Expenses expenses incurred in the defense of a criminal charge growing out of the business of the taxpayer; contributions to a civic improvement fund by a corporation employing half of the wage earning population of the city, the payments being made, not for charity, but to add to the skill and productivity of the workmen; donations to a hospital by a corporation whose employees with their dependents made up two thirds of the population of the city; payments of debts discharged in bankruptcy, but subject to be revived by force of a new promise; where additional compensation, reasonable in amount, was allowed to officers of a corporation for services previously rendered. NOT ordinary expenses: payments by the TP for the repair of fire damage, such payments being distinguished from those for wear and tear; counsel fees incurred by the TP, the president of a corporation, in prosecuting a slander suit to protect his reputation and that of his business; gratuitous payments to stockholders in settlement of disputes between them, which they had been made defendants; payments in settlement of a lawsuit against a member of a partnership, the effect being to enable him to devote his undivided efforts to the partnership business and also to protect its credit. 2. Expenses

IDOPCO v. Commissioner INDOPCO was the target of a friendly take over. In the course of the merger/acquisition, large amounts of professional fees were incurred. I Whether certain professional expenses incurred by a target corporation in the course of a friendly take over are deductible by that corporation as ordinary and necessary business expenses under 162(a). H The expenditures are not ordinary and necessary. The expenditures produce significant benefits to the TP beyond the tax year in question, and are thus capital in nature. Rational:

The normal thing is capitalization. You spend money and build basis. 162(a) is the exception and TP carries the burden to prove deduction under S162(a). A deduction is a matter of legislative grace. The primary effect of characterizing a payment as either a business expense or a capital expenditure concerns the timing of

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Tax IA Outline the taxpayers recovery: While business expenses are currently deductible, a capital expenditure usually is amortized and depreciated over the life of the relevant asset, or if where no specific asset or useful life can be ascertained, is deducted upon dissolution of the enterprise. The Code endeavors to match expenses with the revenues of the taxable period to which they are properly attributable, thereby resulting in a more accurate calculation of net income for tax purposes. The expenditures for professional services produced significant benefits to National Starch that extended beyond the tax year in question are amply supported by the record. These are capital in nature and must be matched to future revenue.

INDOPCO gets into the idea of MATCHING: if the expenditure is related to creating current income, it would be deducted now under 162(a). But if it creates future income, the expenditure should be matched with the income it creates so the expenditure should be capitalized and depreciated or amortized to match with future revenue. Ex: Pre-paid rent. When do deduct it? INDOPCO says it should be matched to the future income it is related to , so deduct the portion related to current revenue, and deduct the rest in the future. Prepaid expenses only a part is connected to current activity and generating current revenue. Match that portion of the expense to current activity, match the rest to the later revenue it generates. Wages, interest, rent: needed today to generate todays revenue, so deduct it in the current tax year.

Example: TP is a tax attorney and has a boat. He puts a 1040 flag up and uses it to meet with clients. Deductible? No. 274 expressly precludes this type of deduction. 274 is a bright line: no deductions for the listed expenditures. If Congress hasnt precluded the deduction under 274, go through necessary and ordinary analysis. Several Rev. Rulings have allowed deductions for:

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Tax IA Outline Advertising expenses, incidental building repairs, severance pay, employer-incurred training costs of an ongoing business, and costs incurred to clean up land and to treat groundwater that a taxpayer contaminated with hazardous waste from its business. Types of Business Expenditures: Operating Expenses Assets acquisition costs Repairs Capital Improvements on Assets Expansion existing business Expansion new business Norwest Corporation v. Commissioner TC 1997 TP constructed a building with asbestos-containing materials as its main fire retardant material. Taxpayers decided to remove the asbestos-containing materials from the building in coordination with an overall remodeling project and attempted to deduct their costs under 162. I Whether TPs costs of removing the asbestos-containing materials are currently deductible pursuant to 162 or must be capitalized pursuant to 263 or as part of a general plan of rehabilitation.

H The costs of removing the asbestos-containing materials must be capitalized because they were part of a general plan of rehabilitation and renovation that improved the building. Rationale: This is a Factual Inquiry But for the remodeling, the asbestos removal would not have occurred. The asbestos removal and remodeling were part of one intertwined project, entailing a full-blown general plan of rehabilitation, linked by logistical and economic concerns. A remodeling project, taken as a whole, is but the result of various steps and stages. **This is an example of a step transaction (see Leslie).**

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Tax IA Outline Test from Norwest: What is a repair and what is a capital expenditure? [keep v. put] REPAIR: If the expenditure was made merely to keep the asset in efficient operating condition. If you buy an asset, from the beginning you expect certain expenditures to keep it running or going in good condition, it is a repair and deduct it now.

CAPITAL EXPENDITURE:

If the improvements were made to put the particular capital asset in efficient operating condition. Ex: replacement, alterations, improvements or additions which prolong the life of the property, increase its value, or make it adaptable to a different use.

The distinction between capital improvements and repairs is timing! Repairs are currently deductible while capital improvements are added to basis and depreciated over time. Plainfield Union If you buy property known to be polluted, and you are forced to clean it up, you must capitalize the cost. Rationale: You probably bought the property at a discount b/c of the contamination. What if you pollute your own property? It is fully deductible b/c of the matching principle. You incurred the pollution generating current revenue, you must match the cost to it, so deduct it currently. The future revenue would not have any relationship to the current pollution. Penalties are not deductible! Assets Assets are necessary, but are they ordinary? It is not an ongoing operating expense. When you buy the asset, no cost has yet been incurred: you parted with cash but you

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Tax IA Outline still have the asset. HOWEVER, as you use the asset, you wear it out over time, so over the years, you can deduct that cost as depreciation. Depreciation is tied to the notion of matching. As the asset generates revenue over the years, match the cost of the wearing out of the asset to the revenue it generates. The basis of the asset is recovered over the years; when the cost of the assets actual wear and tear is matched to the revenue it generates, it gives a better picture of the actual profits of the business. [INDOPCO is about this matching idea.] The IRS provides schedules of Recovery Periods for classes of assets. ** see p. 1762, appendix Table 1 ** These schedules give the recovery period and the percent of depreciation per year. It is still the matching principle, but more accelerated. These schedules (ACRS Accelerated Cost Recovery System or MACRS Modified Accelerated Cost Recovery System) usually accelerate the recovery period at the beginning of the useful life of the asset. (Versus straight line depreciation.) Depreciation Ex: Purchase equipment for $100, place it in business. For tax purposes, there is a recovery range where a percent of the cost can be deducted. As you take depreciation deductions, the basis of the asset adjusts downward. Asset cost = $100, depreciate $60, the adjusted basis = $40. If you sell for $55, there is a $15 gain. Assets eligible for depreciation: assets that wear out as you use them. Assets that do not wear out (like land or goodwill) are not eligible for depreciation.

2.

Carrying On Business

You must be carrying on a business when you incur ordinary and necessary expenditures. If you arent carrying on you dont get 162 deduction. However, the TP may still be able to amortize it over time, or capitalize it as goodwill. Frank Morton TP was interested in purchasing and operating a newspaper or radio station. TP incurred travel, legal, and communication expenses going to various cities to evaluate these business opportunities. I Whether the TP is entitled to deduct traveling expenses and legal fees in connection to starting up and investigating a business.

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Tax IA Outline H TP was not carrying on a business when the expenditures were incurred, so no current deduction under 162. Rationale:

In pursuit of a trade or business does not mean searching for; it presupposes an existing business.

195 is a Congressional response to start up costs. This is an elective provision where you can amortize start up costs over 60 months. Of course, the TP must actually enter a trade or business. Start up expenditures are defined as: I) investigating the creation or acquisition of an active trade or business; ii) creating an active trade or business; (iii);activities engaged in for profit before the day on which the active trade or business begins, in anticipation of such activity becoming an active trade or business. Additionally: THE EXPENDITURES MUST BE OF THE TYPE THAT WOULD BE ALLOWABLE AS A DEDUCTION IF PAID OR INCURRED BY AN EXISTING TRADE OR BUSINESS. Fn(9) Ordinary and necessary expenditures incurred in the expansion of an existing business are currently deductible under 162. Expenditures that are not deductible by an existing trade or business under 162 are ineligible for amortization under 195. Ineligible expenditures include amounts paid for the acquisition of property held for sale or depreciable property, amounts paid as part of the acquisition cost of a trade or business and amounts paid in connection with the sale of stock, securities or partnership interests (securities registration expenses, underwriters commissions). So, to some extent, 195 cures the lack of carrying on element, but the expenditure must still have been ordinary and necessary. If you buy a building before you are carrying on, you cant amortize under 195, it is a capital expenditure that must be depreciated. 195 has no application to an individual having employee status with respect to the deduction of expenses incurred in seeking new employment. Expansion of Existing Business: there is carrying on, so expenses deductible under 162 Expansion into new business: no carrying on so expenditures must be capitalized. When exploring the general idea of expanding an existing business, the expenses are currently deductible. But once you focus in on the particular business you want to buy, then capitalize the expenditures. When just the accountants are involved in a general way, deductible. But when the attorneys get involved, it is capitalized.

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Ex: PNC bank looked to buy another bank in IOWA, there were wages and costs spent looking at the new bank, thus had to be capitalized. If education cost is incurred for entry into the business, it is not deductible (it is a personal expense under 262). No deduction for a JD. If you are already an attorney and must attend CLE (akin to a repair) you are carrying on a trade or business and it is currently deductible.

B. 1.

Specific Business Deduction Reasonable Salaries

162(a)(1) makes specific reference: Salaries must be 1) reasonable, and 2) for services actually rendered. This (a)(1) provision is a policing provision, to prevent the assignment of income: so gifts arent passed off as salary and the income shifted to another while a deduction is also taken. Lavish payments for salary are not deductible, but whether it is deductible to the payor or not, it is still income to the recipient. The reasonableness element is usually an issue in a non-arms length transaction. Harolds Club v. Commissioner 9th Cir. 1965 TP, a corporation, paid its manager, Smith, a salary in annual amounts ranging from about $350,000 to $560,000 per year. Smith was the father of the TPs stockholders. At the beginning of Smiths employment with the TP, it was decided that Smith would be paid a $10,000 salary pus 20% of the profits. Smith was the brains of the operation (a casino) and percentage employment contracts were not uncommon in the gaming business. The commissioner disallowed in part, the corporations deduction based on these payments. Competitors testified that, in their opinion, the salary contract between Smith and Harolds Club was reasonable, and that he was worth all that was paid to him.

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Tax IA Outline I Whether Smiths compensation agreement resulted from a free bargain [arms length transaction]. H The compensation agreement was not the result of a free bargain and therefore, the salary at the time of payment was not reasonable and not deductible. Rationale: Test for reasonableness for contingent compensation [from Reg. 1.1627(b)(1)&(2)]: If paid pursuant to a free bargain between the employer and individual, and if the contract for compensation was reasonable under the circumstances at the time the contract for services was made, then the deduction should be allowed even though it may prove to be greater than the amount which would ordinarily be paid. If the salary agreement was not the result of a free bargain within the meaning of 1.62-7(b)(1), then reasonableness must be judged as of the time the compensation was paid. The question of whether the compensation agreement resulted from a free bargain is one of fact. One circumstance to look at is the family relationship. The record showed that Smith dominated his sons (the shareholders). The sons surrendered their judgments to that of their fathers because he exerted control rather than b/c he was indispensable. The agreement was not a free bargain or arms length transaction, so the salary at the time of payment, was unreasonable. To the extent a salary is unreasonable, it is not deductible.

Note: Ex of non-arms length setting: Closely held corporations: dividends are income to stockholders and not deductible by the corporation. There is temptation to avoid this double taxation by paying the stockholder/manager huge salaries. 162(a)(1) polices this: is it a lavish salary? Is it reasonable? If it is not reasonable, it may be recharacterized as dividends. Reg. 1.162-7 Compensation for personal services. (a) There may be included among the ordinary and necessary expenses paid or incurred in carrying on any trade or business a reasonable allowance for salaries or other compensation for personal services actually rendered. The test of deductibility

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Tax IA Outline in the case of compensation payments is whether they are reasonable and are in fact payments purely for services. (b) The test set forth in paragraph (a) of this section and its practical application may be further stated and illustrated as follows: (1) Any amount paid in the form of compensation, but not in fact as the purchase price of services, is not deductible. An ostensible salary paid by a corporation may be a distribution of a dividend on stock. This is likely to occur in the case of a corporation having few shareholders, practically all of whom draw salaries. If in such a case the salaries are in excess of those ordinarily paid for similar services and the excessive payments correspond or bear a close relationship to the stockholdings of the officers of employees, it would seem likely that salaries are not paid wholly for services rendered, but that the excessive payments are a distribution of earnings upon the stock. An ostensible salary may be in part payment for property. This may occur, for example, where a partnership sells out to a corporation, the former partner agreeing to continue in the service of the corporation. In such a case it may be found that the salaries of the former partners are not merely for services, but in part constitute payment for the transfer of their business. (2) The form or method of fixing compensation is not decisive as to deductibility. While any form of contingent compensation invites scrutiny as a possible distribution of earnings of the enterprise, it does not follow that payments on a contingent basis are to be treated fundamentally on any basis different from that applying to compensation at a flat rate. Generally speaking, if contingent compensation is paid pursuant to a free bargain between the employer and the individual made before the services are rendered, not influenced by any consideration on the part of the employer other than that of securing on fair and advantageous terms the services of the individual, it should be allowed as a deduction even though in the actual working out of the contract it may prove to be greater than the amount which would ordinarily be paid. (3) In any event the allowance for the compensation paid may not exceed what is reasonable under all circumstances. It is, in general, just to assume that reasonable and true compensation is only such amount as would ordinarily be paid for like services by like enterprises under like circumstances. The circumstances to be taken into consideration are those existing at the date when the contract for services was made, not those existing at the date when the contract is questioned. Reg. 1.162-8 Treatment of excessive compensation. The income tax liability of the recipient in respect of an amount ostensibly paid to him as compensation, but not allowed to be deducted as such by the Payor, will depend upon the circumstances of each case. Thus, in the case of excessive payments

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Tax IA Outline by corporations, if such payments correspond or bear a close relationship to stockholdings, and are found to be a distribution of earnings or profits, the excessive payments will be treated as a dividend. If such payments constitute payment for property, they should be treated by the Payor as a capital expenditure and by the recipient as part of the purchase price. In the absence of evidence to justify other treatment, excessive payments for salaries or other compensation for personal services will be included in gross income of the recipient. Reg. 1.162-9 Bonuses to employees. Bonuses to employees will constitute allowable deductions from gross income when such payments are made in good faith and as additional compensation for the services actually rendered by the employees, provided such payments, when added to the stipulated salaries, do not exceed a reasonable compensation for the services rendered. It is immaterial whether such bonuses are paid in cash or in kind or partly in cash and partly in kind. Donations made to employees and others, which do not have in them the element of compensation or which are in excess of reasonable compensation for services, are not deductible from gross income. Other notes: Golden parachutes: When a key executive bails out of a company when it is taken over, excessively generous severance pay is a golden parachute. 280G prohibits 162 deduction to the Payor corporation for excess parachute payments and by tagging the recipient of such payments with a 20% excise tax in addition to income and social security tax. A parachute payment is any payment in the nature of compensation made to a disqualified individual. **See p.339 of text** There are a few exemptions. 162(m) also imposes a $1 million ceiling on the amount of compensation (either cash or other remuneration) that a publicly held corporation may deduct in any year as remuneration for services performed by a covered employee. Certain types of compensation are not taken into account in computing the $1 million ceiling: compensation paid on commission basis; compensation paid solely on account of attainment of performance goals The $1 million ceiling does not modify the 162(a)(1) requirement that compensation must be reasonable in order to be deductible; thus compensation of less than $1 million may not be deductible.

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Tax IA Outline 2. Travel Away from Home

162 Trade or Business Expenses. (a) In general. There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including (1) a reasonable allowance for salaries or other compensation for personal services actually rendered; (2) traveling expenses (including amounts expended for meals and lodging other than amounts which are lavish or extravagant under the circumstances) while away from home in the pursuit of a trade or business; and Reg. 1.162-2 Traveling Expenses (a) Traveling expenses include travel fares, meals and lodging, and expenses incident to travel such as expenses for sample rooms, telephone and telegraph, public stenographers, etc. Only such traveling expenses as are reasonable and necessary in the conduct of the taxpayers business and directly attributable to it may be deducted. If the trip is undertaken for other than business purposes, the travel fares and expenses incident to travel are personal expenses and the meals and lodging are living expenses. If the trip is solely on business, the reasonable and necessary traveling expenses, including travel fares, meals and lodging, and expenses incident to travel, are business expenses. (b)(1) If a taxpayer travels to a destination and while at such destination engages in both business and personal activities, traveling expenses to and from such destination are deductible only if the trip is related primarily to the taxpayers trade or business. If the trip is primarily personal in nature, the traveling expenses to and from the destination are not deductible even though the taxpayer engages in business activities while at such destination. However, expenses while at the destination which are properly allocable to the taxpayers trade or business are deductible even though the traveling expenses to and from the destination are not deductible. (2) Whether a trip is related primarily to the taxpayers trade or business or is primarily personal in nature depends on the facts and circumstances in each case. The amount of time during the period of the trip which is spent on personal activity compared to the amount of time spent on activities directly relating to the taxpayers trade or business is an important factor in determining whether the trip is primarily personal. If, for example, a taxpayer spends one week while at a destination on activities which are directly related to his trade or business and subsequently spends

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Tax IA Outline an additional five weeks for vacation or other personal activities, the trip will be considered primarily personal in nature in the absence of a clear showing to the contrary. (d) Expenses paid or incurred by a taxpayer in attending a convention or other meeting may constitute an ordinary and necessary business expense under 162 depending upon the facts and circumstances of each case. No distinction will be made between self-employed persons and employees. The fact that an employee uses vacation or leave time or that his attendance at the convention is voluntary will not necessarily prohibit the allowance of the deduction. The allowance of deductions for such expenses will depend upon whether there is a sufficient relationship between the taxpayers trade or business and his attendance at the convention or other meeting so that he is benefiting or advancing the interests of his trade or business by such attendance. If the convention is for political, social or other purposes unrelated to the taxpayers trade or business, the expenses are not deductible. (e) Commuters fares are not considered as business expenses and are not deductible. 274 Disallowance of certain entertainment, etc. expenses. (c) Certain Foreign Travel. ** see text ** (h) Attendance at conventions. (1) In general. In the case of any individual who attends a convention, seminar, or similar meeting which is held outside the North American area, no deduction shall be allowed under 162 for expenses allocable to such meeting unless the taxpayer establishes that the meeting is directly related to the active conduct of his trade or business and that, after taking into account in the manner provided by regulations prescribed by the Secretary(A) the purpose of such meeting and the activities taking place at such meeting, (B) the purposes and activities of the sponsoring organizations or groups, (C)the residences of the active members of the sponsoring organization and the places at which other meetings of the sponsoring organization or groups have been held or will be held, and(D) such other relevant factors as the taxpayer may present; it is as reasonable for the meeting to be held outside the North American area as within the North American area. (2) Conventions on cruise ships. In the case of any individual who attends a convention, seminar, or other meeting which is held on any cruise ship, no deduction shall be allowed under 162 for expenses allocable to such meeting, unless the taxpayer meets the requirements of paragraph (5) and establishes that the meeting is directly related to the active conduct of his trade or business and that(A) The cruise ship is a vessel registered in the United States; and (B) all ports of call of such cruise ship are located in the United States or in possessions of the United States. With respect to cruises beginning I any calendar year, not more than $2000 of the expenses

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Tax IA Outline attributable to an individual attending one or more meetings may be taken into account under 162 by reason of the preceding sentence. (m) Additional Limitations on travel expenses. (1) Luxury water transportation. (A) In general. No deduction shall be allowed under this chapter for expenses incurred for transportation by water to the extent such expenses exceed twice the aggregate per diem amounts for days of such transportation. For purposes of the preceding sentence, the term per diem amounts means the highest amount generally allowable with respect to a day to employees of the executive branch of the Federal Government for per diem while away from home but serving in the United States. **exceptions see text** (3) Travel expenses of spouse, dependent, or others. No deduction shall be allowed under this chapter (other than 217) for travel expenses paid or incurred with respect to a spouse, dependent, or other individual accompanying the taxpayer (or an officer or employee of the taxpayer) on business travel, unless (A) the spouse, dependent, or other individual is an employee of the taxpayer, (B) the travel of the spouse, dependent, or other individual is for a bona fide business purpose, and (C) such expenses would otherwise be deductible by the spouse, dependent, or other individual. (n)Only 50% of meal and entertainment expenses allowed as deduction. (1) In general. The amount allowable as a deduction under this chapter for(A) any expense for food or beverages, and (B) any item with respect to an activity which is of a type generally considered to constitute entertainment, amusement, or recreation, or with respect to a facility used in connection with such activity, shall not exceed 50 percent of the amount of such expense or item which would (but for this paragraph) be allowable as a deduction under this chapter. Reg. 1.262-1(b)(5) Expenses incurred in traveling away from home (which include transportation expenses, meals, and lodging) and any other transportation expenses are not deductible unless they qualify as expenses deductible under 162, and Reg. 1.162-5 (other sections omitted). The taxpayers costs of commuting to his place of business or employment are personal expenses and do not qualify as deductible expenses. The costs of the taxpayers lodging not incurred in traveling away from home are personal expenses and are not deductible unless they qualify as deductible expenses under 217. Except as permitted under 162, 212, or 217, the costs of the taxpayers meals not incurred in traveling away from home are personal expenses. Reg. 1.262-1(b)(9) Expenditures made by a taxpayer in obtaining an education or in furthering his education are not deductible unless they qualify under 162 and 1.162-5 (relating to trade or business expenses).

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Tax IA Outline Revenue Ruling 99-7: Issue: Under what circumstances are daily transportation expenses incurred by a taxpayer in going between the taxpayers residence and a work location deductible under 162(a)? Law and Analysis: 162(a) allows a deduction for all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business. 262, however, provides that no deduction is allowed for personal, living, or family expenses. Holding: In general, daily transportation (commuting) expenses incurred in going between a taxpayers residence and a work location as nondeductible commuting expenses. 1.162-2(e) and 1.161-1(b)(5). However, such expenses are deductible under the circumstances described below: 1) A taxpayer may deduct daily transportation expenses incurred in going between the taxpayers residence and temporary (1 year or less)work locations outside the metropolitan area where the taxpayer lives and normally works. However, unless paragraph (2) or (3) below applies, daily transportation expenses incurred in going between the taxpayers residence and a temporary work location within that metropolitan area are nondeductible commuting expenses. (2) If a taxpayer has one or more regular work locations away from the taxpayers residence, the taxpayer may deduct daily transportation expenses incurred in going between the taxpayers residence and a temporary work location in the same trade or business, regardless of the distance. (3) If a taxpayers residence is the taxpayers principal place of business within the meaning of 280A(c)(1)(A), the taxpayer may deduct daily transporation expenses incurred in going between the residence and another work location in the same trade or business, regardless of whether the other work location is regular or temporary and regardless of the distance. Class notes: Commuting expenses: home to work are not deductible.

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Tax IA Outline Transportation expenses: once you get to work, and you need to go to the courthouse, that is a transportation expense and is deductible, (but the food is not deductible).[some transportation expenses are deductible] Travel expenses while you are away from home, at least overnight. Transportation, lodging, and meals [only 50% of food is deductible while traveling per 274), is deductible. Ex: you go to Lexington for a two week trial, all is deductible. But if you come home each night, that is only a transportation expense and food isnt deductible. What does home mean? Rosenpan v. U.S. TP, a jewelry salesman did not have a home but traveled through his territory 300 days a year. Five or six times a year he returned to NY and spend several days at his employers office and visit his brother, where he kept some clothing and got his mail. I Whether TPs meals and lodgings expenses are properly deducted under 162(a)(2) as incurred while away from home in pursuit of a trade or business. H The TP had no home so the expenses were not deductible since he was never away from home. Rationale: Three conditions must be satisfied before a traveling expense deduction may be made: (citing CIR v. Flowers): 1) The expense must be a reasonable and necessary traveling expense, as that term is generally understood. This includes such items as transportation fares and food and lodging expenses incurred while traveling. 2) The expense must be incurred while away from home. 3) The expense must be incurred in pursuit of business. This means that there must be a direct connection between the expenditure and the carrying on of the trade or business of the taxpayer or of his employer. Living expenses paid by a single taxpayer who has no home and is continuously employed on the road may not be deducted in computing net income. TP had no home, so second condition of test was not met.

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Tax IA Outline

Andrews v. Commissioner 1st Cir. 1991 TP had a swimming pool business in New England and a horse racing business in Florida. TP spent part of the year in Florida running the horse business and part of the year in New England running the pool business. TP resided in Massachusetts with his wife, but in order to reduce travel costs, TP purchased a condo, and later a house, in Florida. TP claimed 100% business usage on his Florida house, and claimed depreciation deductions on the furniture and house in connection with his horse racing business. He characterized tax, mortgage interest, utilities, insurance, and other miscellaneous expense as lodging expenses in connection with his Florida business. Commissioner disallowed these expenses on the grounds that Andrews was not away from home (he had two tax homes). I Whether TPs expenses related to the second home in Florida are allowable expenses as traveling expenses while away from home in the pursuit of a trade or business. Narrower issue: Whether, within the meaning of home in 162(a)(2), the TP could have had two tax homes. H TP can have only one home for tax purposes. Rationale: The guiding policy must be that the taxpayer is reasonably expected to locate his home, for tax purposes, at his major post of duty so as to minimize the amount of business travel away from home that is required. The length of time spent engaged in business at each location should ordinarily be determinative of which is the TPs principal place of business or major post of duty. Defining that location as the TPs home, should result in allowance of deductions for duplicate living expenses incurred at the other minor post of duty, whether that is the primary residence or not.

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Tax IA Outline 3. Necessary Rental and Similar Payments

162 (a)(3)rental payments TP cannot have title or equity of the rental. Test: Are you the owner at the property at the end of the payments? If you own it or have equity at the end it is an acquisition cost, you are buying the asset and the payments go to basis and are not deducted when paid. However, the asset can be depreciated over time, so the deduction is just a matter of timing. Starrs Estate v. Commissioner 9th Cir. 1959 TP leased automatic fire sprinklers, which were installed in the TPs plant, for $1240 per year. At the termination of the lease, the TP could renew the lease for 5 years at $32 per year. TP deducted the annual rental payments in the current year as rent. The commissioner disallowed the rent deduction, holding that the lease payments were capital expenditures, and as such, TP was entitled to depreciation expense instead. Basically, the taxpayer was paying rent amount to use an asset with the option to continue using it for ever. This means it is more like a purchase than a lease, and this means you are building basis and you should simply depreciate it as a deduction and not deduct it as a business expense. I Whether the lease payments were in substance, acquisition costs that should be capitalized rather than currently deducted. H The lease agreement was in substance a sale, and the payments should be capitalized as acquisition costs. If you have a sale, you call it an acquisition and you depreciate the cost under a basis theory and you do not deduct it as a business expense. Rationale: Sprinkler systems have to be tailor-made for a specific piece of property, and if it needs to be removed, it has negligible salvage value. The total of the discounted payments are near the normal purchase price. The $32 payment at the end of the lease is just a nominal charge for inspection.

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Tax IA Outline White v. Fitzapatrick H conveyed property to W, who in turned leased back the property to the H. The H deducted the payments to wife as rental and royalty expenses. I Whether the property transfers to the wife were a valid basis for deduction of rent and royalties. H Since the H has remained the actual enjoyer and owner of the property, payments to the wife do not constitute valid business deductions within the statute. Rationale: * The unsubstantial assignment within the family group for no obvious business purpose, renders the assignment ineffective for federal tax purposes. The crucial question remains whether the assignor retains sufficient power and control over the assigned property or over receipt of the income to make it reasonable to treat him as the recipient of the income for tax purposes. Helvering v. Clifford. The transaction is in all practical aspects a mere paper reallocation of income among the family members.

4.

Expenses for Education

Traditional View: Reg. 1.162-5 Expenses for education. Does the expense qualify you to meet the minimum requirements to enter that job or trade? If yes, the expenses are not deductible (it is like a start up cost, and there is a personal element and benefit.) However, once you are in that job or profession, if you need more training to continue in that occupation, that is deductible (like repaIRS and maintanece). Modern View: recently new code sections deal with this issue, new policy focuses on education. 222 allows a limited deduction for education ($3000), targeted to lower income, but this section expires at the end of this year. 25A is tax credits for education. One for undergrad, and one lifetime learning credit. Under the Lifetime Learning Credit, JD tuition is eligible for the tax credit. Must choose between the education deduction or the credit, cant claim both.

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Tax IA Outline 221 Interest Deductible on Student Loans. 117 Scholarships not income. 530 Educational IRAs. 529, 135 EE govt bond interest used for tuition is not taxable. Hill v. Commissioner TP was a teacher, who was required by her employer (the school) to take continuing education classes. The deduction was allowed as ordinary and necessary, and incurred carrying on a trade or business. Coughlin v. Commissioner Attorney was required by his firm to be informed as to changes in the tax laws. Attorney took tax seminars. The deduction was permitted as ordinary and necessary in carrying on a trade or business. Basically, what this section says that if you pay the tuition in order to qualify for a certain profession, such as med or law school, it is not deductible. So basically, if you are in a trade or profession and you go back to school, you probably can deduct your tuition payments because you are not trying to qualify for a certain profession. o If you are trying to improve your potential in a certain industry when you are already in a business, you may deduct this tuition. o If you are simply trying to maintain or hone your skills, you may deduct this. o EX: Once you graduate from law school, and you have to take CLE hours of education, you are simply trying to hone your skills, and you may deduct this. o Also, once you bootstrap into this deduction, your travel expenses and related are also deductible. o So if you have to travel to the CLE (continued legal education) courses, you may deduct meals, lodging, etc. Things like Facilities Such as hunting lodges, ski lodges, etc. Even if these things are used exclusively for business purposes, these expenses are not deductible. However, things associated with this such as a ski ticket, or a meal, may be deductible up to fifty percent.

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Tax IA Outline Section 274 Section 274 is to narrow the scope of section 162 with respect to expenses for business meals, entertainment, gifts, employee awards, and travel imposing some limitations and requiring substantiation. o Basically, only 50% of business meals and entertainment is deductible. o Only if the meal or activity is directly related to or associated with the taxpayers trade or business. o So if you go on a business meal with a client that is directly related to your business, you may deduct 50% Directly Related to requires that business go on during the entertainment for which an expense deduction is claimed, and the phrase associated with requires that the entertainment have a business purpose and either immediately precede or follow a bona fide business discussion. XIX. Capital Gains

Positive treatment: preferential treatment [read: lower tax rates] for net long term capital gains. Negative treatment: limitations on capital losses, you can only deduct to the extent you have offsetting LTCG. What is a capital transaction? Sale or exchange of a capital asset. Collection of rental income is not a capital transaction. 1221 any and all property are a capital assets, then carve out exceptions: inventory is not a capital asset, neither is accounts receivable. Example of capital asset: stock You must ask how long the capital asset was held: Short term transactions: Capital asset held less than 1 year, produces short term gains or losses. Long Term Transactions: Capital assets held more than one year, produces long term gains or losses. Gifted property- years of donor become your holding period.

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Tax IA Outline Net Long Term Gains, with Long Term Losses, then Net Short Term Gains with Short Term losses. After netting within the baskets, Net between the baskets: Only net long term Capital Gains get preferential treatment. If you have a NLTCG, the marginal rates are in 1(a): 28% for collectables (stamps, coins) 25% for buildings 20% for everything else (stock) Why preference for LTCG? Maybe some of the gain is from inflation, so give a break for that. Matching the offsetting LTCL [losses] keeps the TP from abusing provision by only selling loss property. Section 165 (c) (1) is for business losses o It permits the deduction of an individual of anly loss incurred in a trade or business o Just as mere appreciation in the value of property is not income subject to tax, so a mere decline in the value of property is no a loss that can be deducted. o To be deductible, a loss must be evidenced by a closed and completed transactions, such as a sale, or fixed by an identifiable event, such as a fire. Last updated 4/10/2002

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