Prentice Halls Federal Taxation 2014

Individuals 27th Edition Rupert

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 Chapter I:8

Losses and Bad Debts

Discussion Questions

I:8-1 The closed transaction doctrine states that a realized loss must be evidenced by a completed
transaction or identifiable event. This doctrine exists to prevent taxpayers from recognizing a loss as
a result of fluctuating prices prior to the disposition of the property. This is, of course, different
from the economic concept for realized loss. p. I:8-2.

I:8-2 The amount of the deductible loss when property is disposed depends on (1) the type of
property, (2) the manner in which the property is used, (3) the basis in the property, (4) the amount
realized upon disposition, and (5) the way the property is disposed. pp. I:8-2 and I:8-3.

I:8-3 In order to deduct a loss on worthless securities, the taxpayer must first establish when the
security actually became worthless. The deduction is only available in the year the security becomes
worthless. Once this is determined, Sec. 165(g) provides that the loss incurred is treated as a loss
from the sale of a capital asset on the last day of the taxable year. Because of the limitations
imposed on the deductibility of capital losses, this may severely restrict the current tax benefit to the
taxpayer. Under certain circumstances, if a domestic corporation holds worthless securities in an
affiliated corporation, the loss to the domestic corporation is treated as having arisen from a sale of a
noncapital asset. This makes the loss an ordinary loss. In order for this exception to apply, two
requirements must be met: (1) the domestic corporation must own at least 80% of the voting power
of all classes of the affiliated corporation's stock, and (2) more than 90% of the affiliated
corporation's gross receipts for all its taxable years must be from nonpassive income. pp. I:8-3 and
I:8-4.

I:8-4 If the worthless securities consist of securities of an affiliated corporation held by a domestic
corporation, the loss is treated as an ordinary loss rather than a capital loss. For this exception to
apply the domestic corporation must own at least 80% of the voting power of all classes of the
affiliated corporation's stock and 80% of the total value of the stock. Additionally, more than 90%
of the affiliated corporation's gross receipts for all its taxable years must be from nonpassive income.
(i.e., sources other than dividends, interest royalties, rents, annuities, and gains from the sale or
exchange of stock and securities.) pp. I:8-3 and I:8-4.

I:8-5 To have a capital loss, (1) there must be a sale or exchange and (2) the transaction must
involve a capital asset. For example, the loss from the destruction of a capital asset is an ordinary
loss and not a capital loss because there has not been a sale or exchange. Furthermore, a loss on the
sale of inventory is ordinary because inventory is not a capital asset. pp. I:8-4 and I:8-5.

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I:8-1
I:8-6 In order for stock to be considered Sec. 1244 stock, the following requirements must be met:

1. The stock must be owned by an individual or a partnership.

2. The stock must have been originally issued to the individual or to a
partnership in which the individual is a partner.
3. The stock must be stock in a domestic corporation.
4. The stock must have been issued for cash or property other than stock or securities.
5. The corporation may not have derived over 50% of its gross receipts from passive
income sources (i.e., sources other than royalties, rents, dividends, interest, annuities, and
sales or exchanges of stock and securities) during the immediately preceding five taxable
years.
6. At the time the stock is issued, the amount of money and property contributed to both
capital and paid-in surplus may not exceed $1 million. p. I:8-5.

I:8-7 Losses on the sale or worthlessness of Sec. 1244 stock are deductible as ordinary losses up to a
maximum of $50,000 per taxable year ($100,000 for married taxpayers filing a joint return). Any
excess loss for the year is a capital loss. Gains on the sale of Sec. 1244 stock are capital gains. p. I:8-5.

I:8-8 A loss on the sale of investment property between an individual and a controlled partnership
or corporation (the individual owns more than 50% of the partnership or corporation) is disallowed.
The individual and the controlled entity are deemed to be related parties, and therefore, the loss is
disallowed. If the loss were not disallowed, the individual would be able to create a tax loss and still
retain economic control of the property. The same reasoning applies to the wash sale provisions
where losses on the sale of stock or securities are disallowed if substantially identical stock or
securities are purchased within 30 days before or 30 days after the sale. A loss realized on property
transferred to a controlled corporation in exchange for stock or securities of the corporation is
deferred. Furthermore, losses realized on exchanges of like-kind property are also deferred.
p. I:8-6.

I:8-9 a. A passive activity is any trade or business in which the taxpayer does not materially
participate. A passive activity also includes any rental activity that is not a trade or business.
b. Individuals, estates, trusts, closely held C corporations, personal service corporations,
and certain publicly traded partnerships, are subject to the passive loss limitation rules. The purpose
of the passive loss rules is to prevent certain taxpayers from offsetting their portfolio and active
income with losses generated in passive activities. pp. I:8-10 through I:8-12.

I:8-10 a. A closely held C corporation is a C corporation where more than 50% of the stock is
owned by five or fewer individuals at any time during the last half of the corporation's taxable year.
b. A closely held C corporation may offset its passive losses against its active business
income but not its portfolio income. Individuals and personal service corporations may not offset
either their active or portfolio income with passive losses. pp. I:8-12 through I:8-14.

I:8-11 A taxpayer's material participation in an activity is determined separately for each activity.
Furthermore, suspended losses are deductible only upon the complete disposition of the passive
activity. Also, the rental losses allowed under the special real estate exceptions must not be mixed
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I:8-2
in with losses from other types of passive activities. For these reasons, it is critical to identify
exactly what constitutes an activity. pp. I:8-10 and I:8-11.

I:8-12 a. Under the Regulations, different business operations may constitute one or more
activities, depending upon all the pertinent facts and circumstances. The facts that are given more
weight in this determination include:

• Similarities and differences in the types of business

• The extent of common control
• The extent of common ownership
• The geographical location, and
• Any interdependencies between the operations (i.e., the extent to which they purchase or
sell goods between themselves, have the same customers, are accounted for with a single
set of books, etc.).

Generally, taxpayers have a good deal of flexibility in identifying how operations are to be
combined into activities based on these facts. However, once this determination is made, taxpayers
must be consistent from year to year.
b. In general, a business operation and a rental operation cannot be combined into the same
activity for purposes of the passive activity loss rules. However, if the business operation and the
rental operation are situated at the same location and the business operation is insubstantial in
comparison to the rental operation, or vice versa, the two may be combined into one activity. The
Regulations do not define what constitutes insubstantial. p. I:8-10.

I:8-13 a. No. The rental unit qualifies as a real property trade or business with respect to
Laura. This is the case because she meets the following requirements:
1. The rental unit is Laura's only business and she spends over 750 hours during the
year managing and caring for the rental unit.
2. Because Laura is the sole manager of the unit, she meets the material participation
requirement.
3. More than 50% of Laura's personal services for the year is spent in this real estate
business.
b. Yes. The lab is a passive activity with respect to Kami. A business activity is passive
with respect to a taxpayer if the taxpayer does not materially participate in the activity.
In order to materially participate, the taxpayer must meet one of several tests:
1. The individual participates in the activity for more than 500 hours during the year.
2. The individual's participation in the activity for the year constitutes substantially all
of the participation in the activity by all individuals, including individuals who do
not own any interest in the activity.
3. The individual participates in the activity for more than 100 hours during the year,
and that participation is more than any other individual's participation for the year.
4. Under the facts and circumstances, the individual participates in the activity on a
regular, continuous, and substantial basis during the year.

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 The only test Kami possibly could meet is the fourth one. However, her participation is
probably not continuous and substantial. Since Kami does not meet any of these tests, she does not
materially participate, and the activity is passive.
c. There is a possibility that under the Regulations, the three operations (the lab, the
medical supply company, and the medical services partnership) could be combined into one activity.
If this is the case, Kami will have materially participated (over 500 hours) in the activity and the
activity would not be passive with respect to her. If the three operations are treated as separate
activities, she probably does not materially participate in any of them, based upon the tests
mentioned in part b above. However, since she has participated over 100 hours in each of them, they
are considered "significant participation" activities. Taxpayers can aggregate participation in these
significant participation activities for purposes of determining material participation. This
aggregation causes her participation to exceed the 500 hour test. Thus, none of the activities is
passive with respect to Kami. pp. I:8-11 through I:8-14.

I:8-14 A taxpayer materially participates in an activity if he or she meets one of the following tests.

1. The individual participates in the activity for more than 500 hours during the year.
2. The individual's participation in the activity for the year constitutes substantially all
of the participation in the activity by all individuals, including individuals who do not own
any interest in the activity.
3. The individual participates in the activity for more than 100 hours during the year,
and that participation is not less than any other individual's participation for the year
(including participation by individuals who do not own any interest in the activity).
4. The individual participates in "significant participation activities" for an aggregate of
more than 500 hours during the year. A significant participation activity is one in which the
taxpayer participates for more than 100 hours during the year but which does not meet the
material participation test alone. An individual who spends over 100 hours each in several
separate significant participation activities may aggregate the time spent in these activities in
order to meet the 500 hour test.
5. The individual has materially participated in the activity in any five years during the
immediately preceding ten taxable years. These five years need not be consecutive.
6. The individual materially participated in the activity for any three years preceding the
year in question, and the activity is a personal service activity.
7. Taking into account all the relevant facts and circumstances, the individual
participates in the activity on a regular, continuous, and substantial basis during the year.

Active participation, on the other hand, is a less strict test. The taxpayer need not be
involved on a regular or continuous basis. However, he or she still must be involved in management
decisions or in the arranging for others to provide services. The active participation test is used in
the case of rental real estate activities. pp. I:8-11 and I:8-14.

I:8-15 a. Individual taxpayers who have actively participated in the rental of real estate may
deduct losses from that passive activity of up to $25,000 against their active and portfolio income.
However, this deduction is reduced by 50% of the taxpayer's AGI in excess of $100,000. Thus, the
requirements are (1) the taxpayer must be an individual, (2) the taxpayer must have actively

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participated in the management of the rental activity, (3) the activity generating the loss must be a
real estate rental activity, and (4) the taxpayer must not have AGI in excess of $150,000 (the loss is
phased out at a 50% rate for AGI between $100,000 and $150,000).
b. To be exempted from the passive activity loss rules, an individual's rental activity
must qualify as a real property trade or business. For individuals, more than one-half of the personal
services performed in trades or businesses by the taxpayer during the year must be performed in real
property trades or businesses in which the taxpayer materially participates. Additionally, the
taxpayer must perform more than 750 hours of service during the taxable year in real property trades
or businesses in which the taxpayer materially participates. pp. I:8-14 through I:8-16.

I:8-16 Losses suspended under the passive loss rules are not lost forever. The suspended losses are
carried over indefinitely and are treated as losses allowable to the activity in the following taxable
years. Any suspended losses that still exist when the taxpayer disposes of the property or activity
may be deducted in the year of disposal. pp. I:8-7 and I:8-8.

I:8-17 A deductible casualty loss is a loss that (1) occurs in an identifiable event and (2) is sudden,
unexpected, or unusual. For a loss to be a deductible casualty loss, the taxpayer must be able to
determine or identify the event that caused or resulted in the loss. For example, a taxpayer will have a
deductible casualty loss if she can show that a storm caused damage to her property. A sudden event is
one that is swift, not gradual or progressive. An unexpected event is one that is ordinarily
unanticipated and which the taxpayer did not intend. An unusual event is one that is not a day-to-day
occurrence and that is not typical of the activity in which the taxpayer is engaged. For example,
damage to property as a result of years of stormy weather will not qualify as a casualty loss. pp. I:8-17
through I:8-19.

I:8-18 A casualty gain is realized when the insurance proceeds the taxpayer receives exceed the
property's adjusted basis. For personal-use property, all the casualty gains and losses realized during
the year are netted together. If the losses exceed the gains, the excess is reduced by 10% of the
taxpayer's AGI and the remainder is deductible as a from AGI deduction. However, if the casualty
gains exceed the casualty losses for the year, the gain is treated as a long-term capital gain.
p. I:8-20.

I:8-19 Under Sec. 165(h)(5)(E), no casualty loss deduction may be taken on personal-use property
to the extent it is covered by insurance but a timely insurance claim is not filed. Since Rulon’s
insurance will only cover half the damage, he may argue that the uncovered portion is eligible for a
casualty loss deduction. However, $4,400 (half of the $9,000 damage minus $100 floor reduction)
will not exceed the 10% of AGI limitation (10% x $50,000 = $5,000). Thus, Rulon probably won’t
be able to deduct any of the casualty loss. p. I:8-20.

I:8-20 The casualty loss deduction on personal-use property is limited to the lesser of (1) the
taxpayer’s basis in the property or (2) the reduction in fair market value. This is the case whether
the property is totally or partially destroyed.
The casualty loss deduction on partially destroyed business or investment property is limited to
the lesser of (1) basis or (2) reduction in FMV. The amount of the casualty loss deduction for the total

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destruction of business or investment property is equal to the basis of the property. Casualty losses on
personal-use property are reduced by $100 per casualty and then are further reduced by 10% of AGI.
Casualty losses on business property are not subject to these limits and floors. Casualty losses on
business property and investment property that produce rents or royalties are for AGI deductions.
Casualty losses on other types of investment property are not subject to the 2% of AGI reduction.
Furthermore, high income taxpayers (e.g. married filing jointly with AGI in excess of $300,000 and
$250,000 for filing single) do not have to reduce these from AGI casualty loss deductions under the
overall limit on itemized deductions. pp. I:8-18 through I:8-20.

I:8-21 Theft losses are deducted in the tax year in which the theft is discovered, not when the theft
actually occurs. Thus, if the theft is discovered in a year subsequent to the year of the theft, the
deduction is taken in the later year. Also, if the insurance reimbursement is less than anticipated, the
unrecovered portion can be deducted in the subsequent year. Another situation in which the casualty
loss can be deducted other than in the year in which the loss occurred, is if the taxpayer sustains a
loss in a location that the President of the United States declares a disaster area. In this case, the
taxpayer can make an election to deduct the loss in the year just prior to the year in which the loss
occurred. pp. I:8-22 and I:8-23.

I:8-22 Casualty losses are first reported on Form 4684 (Casualties and Thefts). Casualty losses on
personal-use property then flow to Schedule A where they are reported as itemized deductions.
Casualty losses on business property flow from Schedule 4684 to Form 4797 and then to line 14 on
Form 1040. p. I:8-21.

I:8-23 The reduction on personal-use casualty losses is $100 per casualty. The $100 reduction is
not imposed upon each individual item if more than one item is destroyed in a single casualty. The
$100 floor decreases the amount of the casualty loss before the loss is netted against the casualty
gains. pp. I:8-20 and I:8-21.

I:8-24 Sarah must treat the loan as a nonbusiness bad debt (assuming the loan is bona fide and is not
a gift) even though John used the money in a business. Thus, the $15,000 bad debt is treated as a
short-term capital loss. If Sarah has no capital gains for the year, she may take a capital loss
deduction of $3,000, carrying the remainder over to subsequent years. On the other hand, if Sarah
were in the business of lending money, then she could treat the loan as a business bad debt and
deduct the entire loss as an ordinary loss in the current year. p. I:8-25.

I:8-25 Dana may not take any deduction with respect to this bad debt. Although it is a bad debt that
had been incurred in her business, she has no basis in the debt because she is a cash basis taxpayer
and did not report the receivable in income. pp. I:8-25 and I:8-26.

I:8-26 A third party guarantor of a loan who is required to repay the debt is entitled to a bad debt
deduction under certain circumstances. To obtain the bad debt deduction, the guarantee must not be
considered a gift. pp. I:8-24 and I:8-25.

I:8-27 A nonbusiness bad debt is defined as any debt other than: (a) a debt created or acquired in
connection with a trade or business of the taxpayer or (b) a debt the loss from the worthlessness of

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which is incurred in the taxpayer's trade or business. Nonbusiness bad debts are deductible as
short-term capital losses. pp. I:8-26 and I:8-27.

I:8-28 a. In deducting a loss on a deposit in a qualified financial institution a taxpayer may

elect to treat the loss as a personal casualty loss in the year in which the loss can be reasonably
estimated. The taxpayer may also elect to treat the loss as incurred in a transaction entered into for
profit (but not a trade or business). The amount treated as such under this election is limited to
$20,000 per institution per year and is subject to the 2% AGI reduction. If no election is made, the
loss is a nonbusiness bad debt in the year of worthlessness or partial recovery, whichever comes last.
b. If a taxpayer would benefit more in the current year from a loss deduction, the
election to treat the loss as a personal casualty loss may be desirable. This is true in the case of
partial worthlessness since no deduction is available for partially worthless nonbusiness debts. Also,
since the election effectively converts a short-term capital loss into an ordinary loss, the taxpayer
may use the election to minimize taxable income. This may be so because of the $3,000 limit on the
deductibility of capital losses after netting against any capital gains. However, by treating the loss as
a personal casualty loss, the total loss is reduced by 10% of the taxpayer's AGI. The second election
might be made if the loss is less than the $20,000 limit and the taxpayer has other miscellaneous
itemized deductions in excess of 2% of AGI. Otherwise, under this election a taxpayer may lose
more tax benefits than if the election had not been made. pp. I:8-28 and I:8-29.

I:8-29 When a taxpayer collects a bad debt that was previously written off, the recovery must be
reported in income to the extent the taxpayer received a tax benefit from the write-off in the prior
year. p. I:8-28.

I:8-30 An NOL deduction is a deduction taxpayers take against their income of a year either
preceding or following the year in which the NOL is incurred. The NOL arises when the taxpayer's
business deductions (and personal casualty loss deductions) exceed the taxpayer’s business and other
income. Generally, the deduction is first carried back to the two immediately prior years (in
chronological order) and then forward to the 20 succeeding years (again in chronological order).
The statute allows the deduction in an attempt to equalize the federal income tax burden imposed on
taxpayers with business income that fluctuates from year to year, with the tax burden imposed on
taxpayers with business income that is relatively stable from year to year. p. I:8-29.

I:8-31 An individual taxpayer's net tax loss is adjusted by the following items in computing an
NOL: (1) any NOL deduction, (2) any capital loss deduction, (3) deductions for personal
exemptions, and (4) the excess of nonbusiness deductions over nonbusiness income. These
adjustments are made either in an attempt to measure only the economic loss that occurs when
business expenses exceed business income or to prevent a possible double benefit from the
deduction. For example, the deduction for personal exemptions does not reflect a true economic
loss. Since capital losses have their own carryover provisions, allowing them to create or increase a
net operating loss would create a double benefit for the same loss. pp. I:8-30 and I:8-31.

I:8-32 a. Generally an NOL is carried back 2 years and carried forward for 20 years. For
NOLs arising in certain farming businesses, the carryback period is 5 years. Furthermore, NOLs
incurred in a qualified small business that are attributable to a Presidentially declared disaster, or in
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a casualty or theft sustained by an individual, may be carried back 3 years. Likewise, for NOLs
incurred in a tax year that (1) either begins or ends in 2008 or 2009, or (2) begins or ends in 2009 or
2010, a special provision allowed a taxpayer to elect to carry the loss back to the 5th, 4th, or 3rd prior
years. This election applied to only one of the eligible NOL years and was subject to detailed
requirements. The purpose of this election was to enable taxpayers to receive a tax refund sooner in
order to help them weather the economic downturn that occurred in 2008 through 2010.

b. A taxpayer may elect not to carry back the NOL and to carry the loss forward
instead.

c. If the taxpayer anticipates higher income in the subsequent years, thus pushing the
taxpayer into higher marginal tax rates, it may be advantageous to forego the
carryback and carry the NOL forward in order to reduce taxable income.
Furthermore, if carrying the NOL back will prevent the use of tax credits that will
expire, the taxpayer may want to forego the carryback. pp. I:8-32 and I:8-33.

I:8-33 Yes. For purposes of the NOL computation, casualty losses on personal-use assets are
treated as business losses. Therefore, casualty losses on personal-use assets are excluded in making
the adjustment for excess nonbusiness deductions over nonbusiness income and can create or
increase an NOL. p. I:8-31.

I:8-34 An NOL deduction is a deduction for AGI. Thus, the prior year's AGI is reduced. Because
of this reduction, other from AGI deductions taken in the year of the carry back may also have to be
reduced since the amount of these deductions is dependent upon the taxpayer's AGI. For example,
the taxpayer will have to recompute the medical expense deductions (these are deductible only if
they exceed 10% of AGI), personal casualty losses (these are deductible only if they exceed 10% of
AGI), and miscellaneous itemized deductions (these are deductible only if they exceed 2% of AGI).
Although the deduction for charitable contributions is limited to a certain percentage of the
taxpayer's AGI (the general limit is 50% of AGI), the charitable contribution does not need to be
recomputed. p. I:8-33.

Issue Identification Questions

I:8-35 The primary tax issues are (1) whether the stock is worthless, (2) when it became worthless,
and (3) the character of the loss. Since stock held for investment is a capital asset, the loss, if
allowed, should receive capital loss treatment. Under Sec. 165(g), a security that becomes worthless
during the taxable year is treated as having been sold on the last day of the taxable year. In this case,
Sheryl must determine exactly when the stock became worthless. Although bankruptcy is one
indication of worthlessness, the stock may, in fact, have become worthless in a prior year. Thus, if
Sheryl can demonstrate that the stock became worthless in the prior year, she can report a short-term
capital loss in that year. If it is determined that the stock became worthless in the current year,
Sheryl will report a long-term capital loss in the current year. pp. I:8-3 and I:8-4.

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I:8-36 The primary tax issue is the character of the $75,000 loss (i.e., ordinary or capital). If, for the
last five years, more than 50% of Gold, Inc.’s aggregate gross receipts were from sources other than
royalties, rents, dividends, interest, annuities, and sales or exchanges of stocks or securities, then the
Gold stock should qualify as Sec. 1244 stock because (1) Cora (an individual) received the stock in
exchange for cash or property that she contributed directly to the corporation, (2) at the time the
stock was issued, Gold, Inc.'s capital was less than $1,000,000, and (3) for the last five years, more
than 50% of its aggregate gross receipts were from sources other than royalties, rents, dividends,
interest, annuities, and sales or exchanges of stocks or securities. Thus, of the total $75,000 loss,
Cora will report $50,000 as ordinary loss and $25,000 as a long-term capital loss. The capital loss,
of course, is first netted against any capital gains. The current year deduction for any excess capital
loss is limited to $3,000. pp. I:8-5 and I:8-6.

I:8-37 The primary tax issue is whether the accident qualifies as a personal-use casualty loss. If
qualified, Evan must apply the $100 and 10% of AGI limits to the personal-use casualty loss. A
corollary issue is whether the failure to file an insurance claim will invalidate the deduction.
Although automobile accidents in general have been held to qualify for casualty loss treatment, an
exception is made if the accident is caused by the taxpayer's willful negligence or willful act. Even
if this accident qualifies as a casualty, no deduction is available if the taxpayer doesn't file an
insurance claim to the extent that the loss is covered by insurance. Thus, if Evan does not file a
claim, the casualty loss should be limited to the amount of the loss that is not covered by insurance.
p. I:8-17 through I:8-20.

I:8-38 The principal tax issue is the character of the bad debt (i.e., business or nonbusiness). Since
a nonbusiness bad debt is treated as a short-term capital loss, whereas a business bad debt is an
ordinary loss, the determination of what kind of loan Dan has made to Beta, Inc. becomes critical. In
order to show that this loss is a business bad debt, Dan must demonstrate that his motivation in
making the loan was to protect his job rather than to protect his stock ownership. In cases where the
loan was made to protect the taxpayer's job, the courts have held that the loss is a business bad debt.
On the other hand, if the loan was made to protect the taxpayer's investment, the loss is a
nonbusiness bad debt. pp. I:8-25 through I:8-27.

Problems

I:8-39 a. Amount realized $ 22,000

Minus: Basis ( 89,000)
Loss recognized $(67,000)

Because the stock qualifies as Sec. 1244 stock, the first $50,000 of the loss is ordinary loss.
The remainder is a long-term capital loss.
b. A $67,000 ordinary loss is recognized. The yearly limit on the ordinary loss
deduction for Sec. 1244 stock by a taxpayer who is married and filing a joint return is $100,000.
c. To qualify the loss as ordinary under Sec. 1244, the stock must have been originally
issued to the individual or to a partnership in which an individual is a partner. Therefore, under this
revised fact pattern the sale of the stock would result in a $67,000 long-term capital loss. Sec. 1244
does not apply.
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 d. By selling a portion of the stock in one year and the remaining stock in another year
the taxpayer could convert all $67,000 to an ordinary loss. The $50,000 maximum is per taxable
year. This would also avoid the annual $3,000 limit on the deductibility of capital losses. p. I:8-5.

I:8-40 a. Because Fox, Inc. is insolvent, all of its assets will go toward its debts, leaving
nothing for Randall. Randall will not recover any of his basis in the stock. Because the stock was
not acquired from the corporation on original issuance, the stock does not qualify as Sec. 1244 stock.
Thus, Randall suffers a $250,000 long-term capital loss.
b. The stock is qualified Sec. 1244 stock since it is original issue stock. Since Randall is
single, the loss will consist of $50,000 ordinary loss and $200,000 long-term capital loss.
c. Since at least 80% of the voting power of Fox’s stock is owned by Randall
Corporation, and more than 90% of Fox’s gross receipts are from its business operation, the
$250,000 loss is all ordinary.
d. Same as part (c).

pp. I:8-5 and I:8-6.

I:8-41
Short-Term Long-Term Ordinary
Gain or Gain or Gain or
Item Loss Item Loss Item Loss
Tidal Radio $ 20,000 IBM $ 5,000 Salary $114,000
Wavetable ( 6,000) Microsoft (20,000) Stewart (Sec. 1244) ( 15,000)
Non-business bad debt ( 14,000) BTR ( 92,000)
Net STCG $ -0- Net LTCL $ (107,000) Ordinary $ 99,000

a. Brian’s Net Long-Term Capital Loss is $107,000 ($107,000 - $0).

b. Brian’s AGI for the year is $96,000.

AGI
Ordinary $99,000
Net LTCL ( 3,000)
AGI $96,000

pp. I:8-5 and I:8-6.

I:8-42 Activity X $ 20,000

Activity Y ( 35,000)
Activity Z ( 15,000)
Net passive loss carryover ($30,000)

$35,000
Activity Y: $30,000 x = $21,000
$50,000

$15,000
Activity Z: $30,000 x = $9,000
$50,000
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I:8-10
 These losses carry over to subsequent years and may be used to offset any income from
passive activities. Additionally, any remaining loss attributable to an activity that is disposed of may
be deducted in the year of disposal. This is why it is important to allocate the portion of the total net
passive loss carryover to each individual activity. pp. I:8-7 through I:8-12.

I:8-43 a. When a passive activity is disposed of, the suspended losses of that activity may
offset other than passive income.

Loss from Z for the year ($20,000)

Suspended losses from Z ( 40,000)
Gain from the sale of Z 30,000 ($30,000)

Income from X $28,000

Loss from Y ( 10,000) 18,000

Loss deductible against active

business and portfolio income ($12,000)

b. Clay’s AGI for the current year will be $88,000 ($100,000 - $12,000).
pp. I:8-7 through I:8-9.

I:8-44 Irene’s AGI for the year is $120,000, computed as follows:

a. Salary Income $130,000
Minus: maximum rental real estate loss $25,000
Reduced by phase out:
($130,000 - $100,000) x 0.50 ( 15,000)
Deductible amount (not to exceed
actual loss of $50,000) ( 10,000)
AGI $120,000

b. $40,000 - $10,000 = $30,000 suspended loss attributed to:

$30,000
Activity Y: $30,000 x = $18,000
$50,000

$20,000
Activity Z: $30,000 x = $12,000
$50,000

Note: The total passive loss for the year is $50,000. $10,000 of this loss is offset against the passive
income of $10,000 from Activity X and $10,000 is deductible because Irene actively participates in
the rental real estate activities (Activity Y and Activity Z). Thus, there is a total of $30,000
suspended loss ($50,000 – [$10,000 + $10,000]). This suspended loss must be allocated between the
two loss activities, based on their relative proportion of the total loss incurred by each rental activity.

pp. I:8-15 and I:8-16.

Copyright © 2014 Pearson Education, Inc.
I:8-11
I:8-45 Although in 2013, activity A is not a passive activity, it is treated as a former passive
activity. Thus, the suspended losses of $24,000 for activity A are first offset against the current
income of activity A, leaving a remainder of $14,000 ($24,000 - $10,000). This $14,000 excess is
still treated as a passive activity suspended loss and is only deductible against passive income.
Passive activity B has income of $20,000 in 2013. This income is first reduced by the $8,000
suspended loss from activity B, leaving a remainder of $12,000 of passive income. Thus, $12,000 of
the remaining suspended loss from activity A is used to offset this income. $2,000 of the suspended
loss from activity A is carried over to 2014. pp. I:8-7 through I:8-9.

I:8-46 Since Juan is in the 28% tax bracket, the credits equal $10,714 ($3,000 ÷ 0.28) in deduction
equivalents. This amount, plus the $6,000 in losses, equals a total of $16,714 in deductions and
deduction equivalents. Since this amount is less than the $25,000 real estate deduction amount, Juan
normally would be able to use all of the loss deductions and credits against his active business
income. However, because Juan has AGI in excess of $100,000, the real estate deduction is reduced
to $13,000 {$25,000 - [($124,000 - $100,000) x 0.50)]}, and the maximum that Juan may use is
$13,000 in deductions and deduction equivalents. The deductions are taken first. Thus, Juan
deducts the total of the $6,000 losses, leaving $7,000 in deduction equivalents available to be used in
the current year. This translates to $1,960 ($7,000 x 0.28) in credits. Therefore, the suspended
losses and credits carried over to next year are:

Losses: $6,000 - $6,000 = $0

Credits: $3,000 - $1,960 = $1,040

pp. I:8-15 and I:8-16.

I:8-47 Julie’s 2013 taxable income is $141,300, computed as follows:

The first step is to compute AGI. This step consists of a two-step process. First the limit on the
deduction of the $25,000 real estate exemption for passive losses is computed as follows:

Salary $166,000
Interest income 14,000
Net long-term capital gains 5,000
Tentative AGI (for passive loss) $185,000

Thus, the passive loss exemption for real estate is reduced to $0 [$25,000 -($185,000 - $100,000) x
0.50]. AGI is $185,000.

AGI $185,000

The next step is to compute the deductions from AGI.

Copyright © 2014 Pearson Education, Inc.

I:8-12
 AGI $185,000
Itemized Deductions
Property taxes on residence 5,000
Interest:
Qualified Residence 12,000
Investment Interest ($21,000),
Limited to Investment Income ($14,000) 14,000
26,000
Charitable Contributions 8,000
Miscellaneous Itemized:
Tax preparation fees 2,500
Unreimbursed Employee Expenses 2,000
Minus: 2% AGI ($185,000 x .02) ( 3,700)
800
Total Itemized Deduction 39,800 ( 39,800)

Personal Exemption ( 3,900)

Taxable Income $141,300

Note: For 2013 since Julie did not use net LTCG in computing net investment income, she may use
the 15% rate for LTCG when computing her tax (20% rate if Julie’s income exceeded $400,000).
pp. I:8-7 through I:8-16.

Copyright © 2014 Pearson Education, Inc.

I:8-13
I:8-48

Casualty
Item Gain/(Loss)

Equipment A. The decrease in FMV is $8,300, which is less than Tony’s adjusted basis in the
property. Because the decrease in FMV is available, the cost to repair the equipment should
not be used. The deductible loss is the amount of the loss not compensated for by insurance,
which is $4,600 ($8,300 - $3,700). ($ 4,600)

Equipment B. The decrease in FMV is $8,100, but the deductible loss is limited to Tony’s
$3,000 adjusted basis in the property. Thus, Tony realizes a gain of $4,800 ($7,800 - $3,000).
Because the machine is a depreciable Sec. 1245 asset, all of the gain is probably attributable to
the prior depreciation taken on the property, and all of the gain will be recaptured as ordinary
income. Even though Tony realized the gain because of a casualty, this gain is not included in
the casualty gain/loss netting process.

Equipment C. Because the decrease in FMV is not available, the taxpayer can use the cost of
repairing the asset, as long as the repairs bring the property back to its condition immediately
before the casualty, do not cost an excessive amount, do no more than repair the damage
caused by the casualty, and do not increase the value of the property over its value immediately
before the casualty. Assuming Tony’s repairs on Equipment C meet these requirements, the
deductible loss is $2,400:
the $13,800 cost of repairs less $11,400 of insurance proceeds. ( 2,400)

Delivery Truck. The deductible loss is $1,500 – Tony’s adjusted basis in the truck, $17,500,
less $16,000 of insurance proceeds. ( 1,500)
Net Business Casualty Loss Deduction (8,500)

Automobile. A personal casualty loss is limited to the lesser of the property’s fair market value
before the casualty or the taxpayer’s adjusted basis in the property, less any insurance
proceeds. The automobile’s fair market before the theft was $15,000, which is less than Tony’s
$28,000 basis in the property. Therefore, the loss is $3,000: the 15,000 fair market value
before the casualty less the $12,000 insurance reimbursement. This $3,000 loss is reduced by
the $100 floor, and is further limited by the 10% AGI limitation on personal casualty
deductions. *See calculation

*AGI before casualty losses $80,000

Less: Business casualty loss ( 8,500)
deduction
AGI $71,500
Personal casualty loss $ 3,000
Less $100 floor ( 100)
$ 2,900
Less: 10% AGI ( 7,150)
Deductible Personal casualty loss $ 0
pp. I:8-17 through I:8-24.

Copyright © 2014 Pearson Education, Inc.

I:8-14
I:8-49 a. The $3,000 cash is a business asset and is deductible without reduction or netting
with other items. The ring and necklace are both personal-use items. Thus, the loss on the ring must
be netted against the gain on the necklace.

Necklace ($6,000 insurance - $2,300 basis) $3,700

Minus: Ring ($3,000 - 100) (2,900)
Net gain $ 800

Since Kelly has a $800 net personal casualty gain, the $3,700 gain on the necklace is
reported as a long-term capital gain and the $2,900 loss on the ring is reported as a short-term capital
loss. Since a net gain was reported, there is no reduction for the 10% of AGI floor.
b. $0. Theft losses are deductible in the year of discovery. pp. I:8-17 through I:8-24.

I:8-50 a. The loss and reimbursement should not be reported since Jerry has a reasonable
expectation of full recovery.

b. Assuming Jerry didn’t know until after he filed:

He should report a $9,200 loss in 2014, computed as follows:
Amount of loss ($15,000 - $1,500) $13,500
Minus: $100 floor ( 100)
$13,400
Minus: 10% of AGI ( 4,200)
Deductible loss $ 9,200

c. If Jerry deducted the loss on his 2013 return, he doesn’t file an amended return for
2013. Rather, Jerry should include as income on his 2014 tax return an amount equal to the tax
benefit he received for the deduction in the previous year. pp. I:8-22 through I:8-23.

I:8-51 Automobile - lesser of basis or reduction for FMV decline $18,000

Minus: Insurance reimbursement ( 14,000)
Loss before limitation $ 4,000
Minus: $100 floor ( 100)
Net loss $ 3,900

Theft of antiques $ 8,000

Minus: $100 floor ( 100)
Net loss $ 7,900

Antiques $ 7,900
Auto 3,900
Total loss $11,800
Minus: 10% of AGI ( 6,000)
Deductible loss $ 5,800
pp. I:8-22 and I:8-23.

Copyright © 2014 Pearson Education, Inc.

I:8-15
I:8-52 Since the losses on the business property exceed the gains, they are all ordinary losses for
AGI. Thus Pam's AGI is $65,000 ($80,000 - $15,000). Pam's net loss on the personal-use property
is $11,000. This is first reduced by $100 because the losses were all suffered in the same casualty.
The net $10,500 is then reduced by 10% of AGI for a deductible personal casualty loss of $4,000
($10,500 - [0.10 x $65,000])

Asset Loss Insurance Net

Business 1 ($15,000) $ 4,000 ($11,000)
Business 2 ( 8,000) 3,000 ( 5,000)
Business 3 ( 18,000) 19,000 1,000
Net loss on business property ($15,000)
Personal 1 ($12,000) $ 2,000 ($10,000)
Personal 2 ( 3,000) -0- ( 3,000)
Personal 3 ( 6,000) 8,000 2,000

Net loss on personal use property ($11,000)

Less: nondeductible floor ( 100)
Net loss on nonbusiness property ($10,900)

Business income $80,000

Business casualty (15,000)
AGI $65,000

Residential interest $ 6,000

Property taxes 2,000
Charitable Contributions 4,000
Casualty losses [$10,900 - (0.10 x $65,000)] 4,400 (16,400)

Personal exemption ( 3,900)

Taxable income $44,700

pp. I:8-20 through I:8-24.

I:8-53 The bad debt deduction is $0. Since Elaine is a cash-method taxpayer, she does not have any
basis in the receivable. pp. I:8-25 and I:8-26.

I:8-54 2013: $0. No bad debt deduction is allowed since no bona-fide debtor-creditor relationship
exists.

2014: $0. No bad debt deduction is allowed since a bona-fide debtor-creditor relationship
does not exist. pp. I:8-26 and I:8-27.
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I:8-16
I:8-55 2013: $0. No deduction is allowed for partial worthlessness of a nonbusiness bad debt.

2014: $4,500. Since the debt is a nonbusiness bad debt, no deduction was available in 2013
because the debt was not totally worthless. pp. I:8-26 and I:8-27.

I:8-56
a. Michelle and Mark’s taxable income is a loss of ($34,800), computed as follows:
Taxable Income
Dental Practice Items:
Revenues $65,000
Payroll and Salary Expense ( 49,000)
Supplies ( 17,000)
Rent ( 16,400)
Advertising ( 4,600)
Depreciation ( 8,100)
Net Business Loss ($30,100)
Mark’s Salary 18,000
Interest earned on savings account 1,200
Total AGI ($10,900)

Itemized Deductions:
Interest paid on personal residence 7,100
Itemized deductions for state and local taxes 3,400
10,500
or Standard Deduction 12,200 ( 12,200)
Personal Exemptions ($3,900 x 3) ( 11,700)
Taxable Income ($34,800)

b. Michelle and Mark’s NOL for the year is ($12,100) computed as follows:
NOL
Taxable Income ($34,800)
Non-business Deductions $12,200
Non-business Income ( 1,200)
Plus: Excess of Non-business Deductions over
Non-business Income 11,000
Plus: Personal Exemptions 11,700
Net Operating Loss ($12,100)

pp. I:8-29 through I:8-32.

Copyright © 2014 Pearson Education, Inc.

I:8-17
I:8-57
a. Michelle and Mark’s taxable income is a loss of ($37,600), computed as follows:
Taxable Income
Dental Practice Items:
Revenues $65,000
Payroll and Salary Expense ( 49,000)
Supplies ( 17,000)
Rent ( 16,400)
Advertising ( 4,600)
Depreciation ( 8,100)
Net Business Loss ($30,100)
Mark’s Salary 18,000
Interest earned on savings account 1,200
Total AGI ($10,900)

Itemized Deductions:
Interest paid on personal residence 7,100
Itemized deductions for state and local taxes 3,400
Casualty Loss 4,500
15,000
or Standard Deduction 12,200 ( 15,000)
Personal Exemptions ($3,900 x 3) ( 11,700)
Taxable Income ($37,600)

b. Michelle and Mark’s NOL for the year is ($16,600) computed as follows:
NOL
Taxable Income ($37,600)
Non-business Deductions
Itemized Deductions $15,000
Minus: Casualty Loss Deduction ( 4,500)
$10,500
Minus: Non-business Income ( 1,200)
Plus: Excess of Non-business Deductions over 9,300
Non-business Income
Plus: Personal Exemptions ($3,900 x 3) 11,700
Net Operating Loss ($16,600)

pp. I:8-29 through I:8-32

Copyright © 2014 Pearson Education, Inc.

I:8-18
I:8-58
a. Michelle and Mark’s taxable income is a loss of ($34,800), computed as follows:
Taxable Income
Dental Practice Items:
Revenues $65,000
Payroll and Salary Expense ( 49,000)
Supplies ( 17,000)
Rent ( 16,400)
Advertising ( 4,600)
Depreciation ( 8,100)
Net Business Loss ($30,100)
Mark’s Salary 18,000
Interest earned on savings account 1,200
Total AGI ($10,900)

Itemized Deductions:
Interest paid on personal residence 7,100
Casualty Loss 3,400
10,500
or Standard Deduction 12,200 ( 12,200)
Personal Exemptions ($3,900 x 3) ( 11,700)
Taxable Income ($34,800)

b. Michelle and Mark’s NOL for the year is ($15,500) computed as follows:
NOL
Taxable Income ($34,800)
Non-business Deductions
Itemized Deductions $12,200
Minus: Casualty Loss Deduction ( 3,400)
$8,800
Minus: Non-business Income ( 1,200)
Plus: Excess of Non-business Deductions over 7,600
Non-business Income
Plus: Personal Exemptions ($3,900 x 3) 11,700
Net Operating Loss ($15,500)

pp. I:8-29 through I:8-32.

Copyright © 2014 Pearson Education, Inc.

I:8-19
I:8-59
a. Karen’s taxable income is a loss of ($31,900), computed as follows:
Taxable Income
Interior Design Business
Revenues $52,000
Cost of Goods Sold ( 41,000)
Advertising ( 3,300)
Office Supplies ( 1,700)
Rent ( 13,800)
Contract Labor ( 28,000)
Net-Business Loss ($35,800)
Salary 13,500
Net Long-Term Capital Gain ($4,200 - $3,800) 400
Total AGI ($21,900)

Itemized Deductions: 5,200

or Standard Deduction 6,100 ( 6,100)
Personal Exemption ( 3,900)
Taxable Income ($31,900)

b. Karen’s NOL for the year is ($22,300) computed as follows:

NOL
Taxable Income ($31,900)
Non-business Deductions $ 6,100
Non-business Income ( 400)
Plus: Excess of Non-business Deductions over
Non-business Income 5,700
Plus: Personal Exemptions 3,900
Net Operating Loss ($22,300)

pp. I:8-29 through I:8-32.

Tax Strategy Problems

I:8-60

TO: Treehouse Rentals

FROM: Your CPA
DATE: March 15, 2014
SUBJECT: Suspended Passive Activity Losses

Treehouse can deduct the suspended activity losses related to the properties you sold during 2013.

In 1996, citing Sec. 1371(b), the IRS disallowed a former C corporation’s suspended passive activity
losses (PALs) related to property it sold after it had obtained S corporation status, (T.A.M.
Copyright © 2014 Pearson Education, Inc.
I:8-20
9628002). In 2000, however, the Tenth Circuit Court of Appeals ruled that the deduction of such
losses was allowed under Sec. 469(b) (St. Charles Investment Co. v. Commissioner, 86 AFTR 2d
2000-6882). Therefore, you can deduct the $63,000 and $112,000 previously suspended PALs
related to property you sold in 2013.

I:8-61

TO: Seaton & Associates, LLC

FROM: Your CPA
DATE: February 14, 2014
SUBJECT: Losses Generated in 2013

Each member of your company can deduct his or her full portion of the $530,000 loss generated in
2013.

A taxpayer may fully deduct a flow-through loss if the taxpayer materially participated in the
business during the year. If the taxpayer did not materially participate in the business, the loss is
subject to passive activity loss limitations. In general, a limited partner is not considered to material
participate in an activity (Reg. 1.469-5T(e)(1)). The limited partner does materially participate,
however, if the partner meets one of three material participation tests (Reg. 1.469-5T(e)(2)).

Maria and Jamal both meet the first test, which is that the individual participate in the activity for
more than 500 hours during the year. Therefore, they can both deduct their full portion of the loss,
$53,000 each.

Jace, however, does not meet the first test because he worked only 215 hours during the year. The
two final tests are qualitative tests. One requires that the taxpayer materially participated in the
activity for any five of the previous ten taxable years. The activity has not been in existence long
enough for Jace to meet this test.

Fortunately, Jace meets the final test. This requires that the activity be a personal service activity
and the individual materially participated in the activity for any three taxable years preceding the
taxable years. The regulations specifically state that architectural services are a personal service
activity. Further, Jace worked as the CEO of an architectural firm for six years, thereby meeting the
three-year requirement.

Finally, this conclusion is supported by an Oregon U.S. District Court decision involving an LLC
involved in health services (Gregg v. U.S., 87 AFTR 2d 2001-337). Thus, Jace can deduct his full
portion of the loss, which is $424,000.

I:8-62 If the Kents stay in the rental home for more than the greater of 14 days or 10% of the total
rental days, they must recognize income and expenses relating to the home using the vacation home
rules of Sec. 280A. Additionally, they must allocate the expenses of the rental property between the
rental activity and their personal use. If they do not stay in the home, the entire activity is treated as
a passive activity entered into for profit, and the passive activity rules of Sec. 469 apply.

Copyright © 2014 Pearson Education, Inc.

I:8-21
Assuming the Kents personally use the property starting December 10 through December 31, they
have personally used the property for a total of 22 days during the year. Their personal use of the
property exceeds the greater of (1) 14 days or (2) 21 days [10% of the 210 rental days]. Thus, the
vacation home rules of Sec. 280A apply. In this case, the tax consequences are as follows:

Vacation Home Treatment

Total Personal Rental Activity
Rental income $16,000 $16,000
Mortgage interest* ( 12,400) ( 1,176) ( 11,224)
Property taxes* ( 4,300) ( 408) ( 3,892)
HOA fees* ( 3,500) ( 332) ( 3,168)
Depreciation* ( 18,000) ( 1,707) ( 16,293)
Net loss ($22,200) ($3,623) ($18,577)**

*Based on total use days (22/232)

**The loss is limited to the gross income from the property pursuant to Sec. 280(A).

Taxable Income

Ordinary Income
Deanna’s salary $75,000
Alex’s salary 65,000
Passive income 1,000
Rental income 16,000
Rental expenses (16,000)

AGI $141,000

Less itemized deductions:

Medical expenses 8,100
Reduced by 10% AGI ( 14,100)
Taxes
State income taxes 9,700
Property taxes (home) 2,900
Property taxes (vacation home) 408
$13,008
Mortgage interest
Personal residence 7,800
Vacation home 1,176
8,976
Charitable contribution 14,200
Total itemized deductions ($36,184)
Personal exemptions ($3,900 x 2) ( 7,800)

NET TAXABLE INCOME $97,016

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I:8-22
Assuming they do not stay in the rental property, the tax consequences are as follows:

Passive Activity Treatment

Total Personal Passive Activity
Rental income $16,000 $16,000
Mortgage interest ( 12,400) ( 12,400)
Property taxes ( 4,300) ( 4,300)
HOA fees ( 3,500) ( 3,500)
Depreciation ( 18,000) ( 18,000)
Net loss ($22,200) ($22,200)

Taxable Income

Ordinary Income
Deanna’s salary $75,000
Alex’s salary 65,000
Passive income 1,000
Less: Deductible passive loss ( 1,000)
_______
AGI before rental real estate deduction $140,000
Rental real estate deduction: $25,000
Decreased by 50% of AGI over $100,000
[$25,000 – (50% x $140,000 - $100,000)] ( 5,000)

AGI $135,000

Less itemized deductions:

Medical expenses 8,100
Reduced by 10% AGI ( 13,500)
Taxes
State income taxes 9,700
Property taxes (home) 2,900
$ 12,600
Mortgage interest
Paid on personal residence 7,800
Charitable contribution 14,200
Total itemized deductions ($34,600)
Personal exemptions ($3,900 x 2) ( 7,800)

NET TAXABLE INCOME $92,600

Note: The nondeductible passive loss of $16,200 [$22,200 – ($1,000 + $5,000)] may be carried
forward and deducted against passive activity income of a subsequent year.

Copyright © 2014 Pearson Education, Inc.

I:8-23
Passive Loss Carryforward Loss ($22,200)
Less: Total allowed loss 6,000
Carryforward to future years ($16,200)

By staying in the home, their taxable income is increased by $4,416 ($97,016 - $92,600) because
they would be unable to deduct any of the loss attributable to the rental portion against the other
passive income ($1,000). Furthermore, they could not deduct the additional $5,000 because of the
rental real estate active participation rule under the passive loss rules. They can, however, deduct an
additional $408 in property taxes and $1,176 in interest allocated to the personal use of the unit.

I:8-63 Jim can treat the loss in one of three different ways. The first two require an election.

1. Casualty Loss. The loss would be reduced by the $100 floor, then by 10% AGI
($110,000 x .10 = $11,000). Thus, he would be allowed an itemized deduction of
$88,900 ($100,000 - $100 - $11,000).
2. Loss incurred in a transaction entered into for profit (but not a business loss). He would
be allowed a $20,000 itemized deduction (the limit on losses from financial institutions),
decreased by 2% AGI ($110,000 x .02 = $2,200). Thus, he would be allowed a net
itemized deduction of $17,800.
3. Nonbusiness bad debt. The loss would be treated as a short-term capital loss limited to
an ordinary deduction of $3,000 because he has no other capital gains or losses in the
current year. The remaining $97,000 can be carried forward to future years.

In this case, Jim should elect to treat the loss as a casualty loss. In other situations, where Jim
reports large short-term capital gains, the third option may be more beneficial because the loss is
treated as a short-term capital loss, which can offset (without reduction) the other short-term capital
gains.

Tax Form/Return Preparation Problems

I:8-64 (See Instructor’s Resource Manual)

I:8-65 (See Instructor’s Resource Manual)

Copyright © 2014 Pearson Education, Inc.

I:8-24
Case Study Problems
I:8-66 November 10, Current Year

Dr. John Brown

444 Physician's Drive, Suite 100
Anytown, USA 88888

Dear Dr. Brown:

I thank you for the opportunity of helping you with your tax work this year.
I understand that for the current year you estimate you will earn $150,000 of taxable income
from your medical practice as well as $10,000 in dividends and interest income. You also
anticipate that your share of Limited's loss this year will be $10,000 in addition to last year's
$15,000 loss. Finally, you estimate $30,000 in taxable income from the new lab that you
established this year. The lab is staffed by two full-time qualified technicians and a part-
time bookkeeper keeps the accounts. You have managed the lab to date, spending 320 hours
during the year.
As you will recall, you were unable to deduct the $15,000 loss from Limited last year
because of what are known as the passive loss limitations on passive activities. This loss is
deferred or suspended into subsequent years and is only deductible against your income from
passive activities. Among other things, a business or investment is considered passive if you
work less than 500 hours in that activity during the year.
Through the end of this year, you will have a total of $25,000 in suspended passive losses
from Limited. In general, if you limit your involvement in the lab to less than 500 hours for
the year, the lab will also be treated as a passive activity this year. That means that the
cumulative losses of $25,000 from Limited can be deducted against the $30,000 income
from the lab. On the other hand, if you work in the lab over 500 hours this year you will not
be able to deduct the cumulative losses of $25,000 from Limited. Thus, I recommend that
you limit your involvement in the lab for the rest of the year. Furthermore, each year we
should analyze your involvement in the lab because circumstances may change from year to
year.
I must mention that the IRS can, under certain circumstances treat a taxpayer's involvement
in an activity as active even if the taxpayer's involvement is less than 500 hours. I believe,
however, that the facts in your situation do not warrant this treatment since the lab should be
self-sustaining without any of your efforts.
As always, my recommendations are based upon the facts as I have stated them above. If I
have not identified the facts correctly, please contact me immediately since a change in the
facts may cause a change in the recommendation.
Again, I thank you for the opportunity of serving you.
Sincerely,

Copyright © 2014 Pearson Education, Inc.

I:8-25
I:8-67 Pursuant to Statement on Standards for Tax Services (SSTS) No. 1, a CPA should not
recommend that a tax return position be taken with respect to any item unless he or she "... has a
good-faith belief that the position has a realistic possibility of being sustained administratively or
judicially on its merits if challenged." [SSTS No. 1 .02(a)]. If a position does not meet the realistic
possibility standard, a CPA may still recommend a position as long as it is not frivolous and the
position is adequately disclosed on the return. Furthermore, paragraph .04 states that a CPA. "... has
both the right and responsibility to be an advocate for the taxpayer with respect to any position
satisfying the aforementioned standards.”
According to SSTS Interpretation No. 1-1, the realistic possibility standard is less stringent
than both the "substantial authority" and the "more likely than not" standards that are established by
the Internal Revenue Code with regard to substantial understatements of liability. Furthermore, in
addition to the authorities used in establishing "substantial authority," a CPA can rely on "... well-
reasoned treatises, articles in recognized professional tax publications, and other reference tools and
sources of tax analyses commonly used by tax advisers and preparers of returns" in meeting the
realistic possibility standard.
Although your client's position is a grey one, it appears that there is sufficient authority to
meet the realistic possibility standard, allowing you to sign the return taking the deduction.
However, you should advise Jack that if there is not "substantial authority," he may be subject to a
penalty unless he discloses the position. [SSTS No. 1 ¶.02(d)].
In any event, you should not take a position that exploits the audit selection process or serves
as a mere arguing position [SSTS No. 1 ¶.03].

Tax Research Problem

I:8-68 Keith will be allowed to deduct the $30,000 loan as a theft loss in the year of discovery. The
loan is not treated as a nonbusiness bad debt since the loan was made based upon the false
representations of Dan.
In R.S. Gerstell [46 T.C. 161 (1966)] and M. Monteleone [34 T.C. 688 (1960)], the taxpayers
were allowed to deduct as theft losses the amount of money or property taken from them under false
pretenses. In both cases, the court stated that "for tax purposes, whether a theft loss has been
sustained depends upon the law of the jurisdiction wherein the particular loss occurred"
[Monteleone, p. 692]. For example, theft is defined in the California penal code as "the taking of
money from another under false representations or false pretenses" [Monteleone, p. 692]. Assuming
a similar law in the state where Kay resides, the $30,000 would be treated as a theft loss also. Of
course, it will be subject to the $100 and 10% of AGI limitations.
The distinction must be made between a bona fide loan and a loan made based upon false
pretenses. In Monteleone, the IRS contended that the loan was a nonbusiness bad debt and therefore
should be treated as a short-term capital loss. If the loan is a bona-fide loan made without deceit and
it subsequently becomes worthless due to bankruptcy or some other reason, the loan is treated as a
bad debt. In the instant case, fraud was involved and, as a result, the loan, by definition, constitutes
theft.
See also: Code Sec. 165, the Regulations under Sec. 165 and Paul C.F. Vietzke 37 T.C. 504
(1961).

Copyright © 2014 Pearson Education, Inc.

I:8-26
“What Would You Do In This Situation?” Solution

Ch. I:8, p. I: 8-35

This is an interesting situation. If this is truly a loan that the taxpayer made to his child, it would
generally be considered a non-business bad debt unless the client is in the business of making loans.
The client has produced a document that appears to be a properly executed note with a stated
interest and payment dates. However, under these circumstances, several of the facts that you know
indicate that this is probably a gift to the child. These facts include: (1) Over the entire two-year
period that the “loan” has been outstanding, the child hasn’t made any payments of interest or
principal, and (2) the child who has filed for bankruptcy appears to either (a) have enough cash to
spend a long and expensive vacation in Europe, or (b) is receiving substantial gifts from the taxpayer
because the child’s vacation in Europe is with other family members. Under these circumstances,
you should question if the intent of the taxpayer was a gift instead of a loan. If it was a gift, then, of
course, the taxpayer can’t take a deduction.

Copyright © 2014 Pearson Education, Inc.

I:8-27
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