Tax Outline – Fall 2000

I. Introduction

a. 16th Amendment = Congress has the power to collect taxes from whatever source derived.

b. Deduction v. Credit v. Exclusion (30% tax bracket -- $100 income = $70 after tax)

i. Credit: 100 + 10 credit = 100x.30 = 30 – 10 = 20 = 80 after tax (100-20)

ii. Deduction: 100 + 10 deduction = 100-10 = 90x.30 = 27 = 73 after tax (100-27)

iii. Exclusion: 100 + 10 exclusion = 90x.30 = 27 = 73 after tax (100-27)

iv. Credit is better than deduction; deduction reduces amount taxed on; credit is just that, credit.

c. Tax Accounting

i. Annual accounting

1. individuals = calendar year

2. businesses = fiscal or calendar year

ii. Accrual Method – income realized when TP right to receive or make payment becomes fixed and determined w/ reasonable accuracy.

iii. Cash Method – income reported when cash received and deducted when actually paid.

II. Fringe Benefits

a. General: fringe benefits are a way of compensating employees. They include items such as free parking, company car, reduced air fare etc. Benefits provided to an employee are included in the employee’s gross income unless expressly excluded by statute.

b. Commissioner v. Minzer: IRS appeals and court holds that commissions from an insurance agent’s own insurance policy is income despite the fact that he is a broker – he is also an employee.

c. Medical Insurance Payments: employer’s contributions to a health plan is excluded from gross income to the employee (IRC §132).

d. Certain Fringe Benefits – IRC §132 allows an employee to exclude from his gross income benefits that qualify as:

i. No-additional cost service – two requirements:

1. services must be of the type offered by the employer to customers in the ordinary course of the line of business in which the employee performs substantial services.

2. the employer must not incur substantial additional cost (including foregone revenue) by providing such benefits.

ii. Qualified employee discount – employers often offer property or services to an employee at a discount (“employee discount”). Property or services are qualified if they are offered to customers in the ordinary course of the line of business in which the employee performs substantial services. However personal property held for investment and real property are not qualified property.

iii. Working condition fringe – property or services offered to an employee will not be included in an employee’s gross income to the extent that the employee would be allowed a deduction for such items under IRC §§162 or 167 (business expense and depreciation deductions) had the employee paid for them himself.

iv. De minimis fringe – when the value is so small that accounting for it would be unreasonable or impractical, the employee will not be required to include it in gross income.

1. eating facilities – operation of an eating facility may be treated as de minimis fringe if the facility is located on or near the business premises of the employer and if revenue normally equals or exceeds the direct cost of such operation. Meals that are provided for the convenience of the employer are excluded from employee’s gross income (IRC §119).

v. Qualified transportation fringe – consists of any of the following three items. However, there is a dollar limitation on the monthly value that can be excluded. Transportation fringe need not be furnished in kind, it can be reimbursed. Fringe must be in addition to compensation, not in lieu of it (except qualified parking – environmental policy reason).

1. qualified parking

2. transportation in a commuter highway vehicle if such transportation is between the employee’s residence and place of work; and

3. any transit pass (IRC §132(f)).

vi. Qualified moving expense reimbursement – an amount received by an individual from an employer as a reimbursement for expenses that would be deductible as moving expenses if directly incurred by the individual.

vii. Athletic facility – an “on-premises” athletic facility will not cause employee to recognize gross income.

e. Reimbursed Expenses – generally will be included in gross income. But, if the expense qualifies as a deduction, the employer’s reimbursement will not be income.

i. Moving expenses – excluded as fringe to the extent it would be deductible by employee (reimbursement of meals are included in gross income).

ii. Travel expenses – if required to travel, the employee’s reimbursed travel expenses (including meals and lodging) will not be included in gross income.

iii. Expenses of interviewing for a job – reimbursement of expenses incurred to interview for a job at the invitation of a prospective employer are not included in gross income to the extent they do not exceed actual expenses (employee must already be engaged in the trade or business to qualify).

iv. Meals and lodging – (§119) unless excluded by statute, FMV of meals and lodging furnished to an employee as consideration for his services will be included in his gross income.

1. excluded meals and lodging – value of meals and lodging furnished to an employee and his spouse and dependants are excluded if they were:

a. furnished for the convenience of the employer; and

i. convenience of the employer = if there is a substantial noncompensatory purpose as well as compensatory.

b. furnished on the business premises of the employer; and with regard to lodging there is a third element;

i. business premises = refers to the place of employment of the employee. (construed to mean living quarters that constitute an integral part of the business property or premises on which the company carries on some of its business activities.) physical proximity is not as important as the extent to which business is conducted there.

c. employee required to accept lodging as a condition of employment so that the employee will be better able to perform his services (utilities as part of lodging can be excluded).

v. Furnished in Kind – to be excluded, meals and lodging must be actually furnished, not reimbursed or purchased.

1. groceries – unresolved

2. reimbursement for meals when working late – if it is excluded, it will most likely have to be de minimis.

f. Compensation for Services

i. Cash compensation = income to recipient

1. Tips – included in gross income

ii. Services in exchange for services – where each person performs services intended as consideration for the other, the value of the service is income to each recipient.

iii. Property in kind – where payment is made in property (not cash), the FMV of the property is included in recipient’s income and basis is FMV.

g. Frequent flyer miles – Fringe? Unresolved. Congress does not want it to be income and IRS is undecided.

i. Best argument for fringe = de minimus

h. Hypo: King and bodyguard go to the opera. Does bodyguard have income of opera ticket? No, because it’s too subjective and he may hate the opera. He is required to go. This is too difficult to measure by tax standards because everyone would say it was worth nothing to go to the opera.

i. IRC §61

III. Realization

a. Eisner v. Macomber: indicated as a constitutional matter, a gain must be realized by a TP before it can be taxed by the government.

b. Realization requirements:

i. Liquidation

ii. Valuation

IV. Damages

a. Commissioner v. Glenshaw Glass Co. – issue = are punitive damages taxable? Holding = yes; S.Ct. puts forth definition – accessions to wealth, clearly realized and over which TP has complete control.

i. Punitive damages – always taxable

1. allocation between compensatory and punitive is a question of fact and TP has the burden of proof.

b. IRC §104 – Compensation for injuries or sickness

c. KEY to exclusion = that there have been a physical injury and damages are attributable to that injury.

d. 2 categories of compensatory damages:

i. Property

1. damages for harming or destroying property will constitute income to the extent that such damages exceeds the recipient’s basis in the damaged property.

ii. Personal injury

1. damages for physical injury are excluded from income by §104(a)(2).

2. non-physical injury – the only time non-physical injuries are not taxable is when TP is awarded reimbursement for medical expenses (as long as the award is not greater than bills); rationale = not concerned w/ fraud since bills are provable.

e. Damages for loss of consortium & emotional harm due to physical injury (even of spouse) are not taxable (legislative intent – House Rpt.).

f. Wages – not taxable if received due to physical injury b/c they are just a convenient gage; trying to make TP whole; not really trying to return salary.

g. Emotional harm – taxed b/c of possibility of fraud; legitimacy hard to prove (ex. Defamation).

h. Interest – usually taxable

i. Exception – installment damages exempt (even interest); §104 and Reg. 1.104-1(c) – settlement agreement.

i. Sale of blood is taxable although not widely known.

j. Allocation of Basis

i. Made according to time of purchase.

ii. Sale of stocks – if unable to determine exact basis (due to fire etc.), look at stock prices from entire time period and use lowest stock price. If we used agerage, this could encourage people to lose records.

V. Tax Benefit Rule

a. General Rule – if TP deducted an item on his return and enjoyed a tax benefit thereby and in a later year recovers all or part of that item, he will recognize gross income in the year the deducted item is recovered.

b. IRC §111

c. Hillsboro National Bank v. Commissioner – (Bliss Dairy case) issue = is actual recovery necessary for the tax benefit rule? Holding = no, the subsequent event must just be “fundamentally inconsistent” w/ the deduction. Must look at original purpose for deduction to decide if fundamentally inconsistent.

i. Fundamentally inconsistent = if the event would have prevented the deduction from being allowed if it had occurred the same year that the deductible event took place.

d. Rojas v. Commissioner – facts = plants harvested and deductions taken for plant feed. Company was liquidated and IRS said previous deductions taken for harvesting plants must be included in return the year of liquidation (relied on Hillsboro). Holding = the materials or services for which the deductions were taken were used up by the time the corp. liquidated. Doesn’t involve deductions for cost of purchasing unsold crops, but cost of nurturing and growing the crops, so no application of tax benefit rule.

VI. Donee’s Basis in Gifts

a. IRC §102 – gifts and inheritance

b. IRC §1014 – basis of property acquired from a decedent

c. IRC §1015 – basis of property acquired by gifts and transfers in trust; (a) puts burden on IRS to figure out basis when unknown.

d. Reg. 1.1001-1(e) – transfers in part sale part gift

e. Bequests

i. Don’t include in income

ii. Basis in property = FMV

f. Pure Gifts

i. Don’t include in income

ii. Basis in property = transferor’s basis (except w/ depreciated property b/c IRS doesn’t like transfer of losses)

1. Appreciated property (when FMV is greater than donor’s basis)

a. Donee’s basis = donor’s basis

2. Depreciated property (when basis is greater than FMV)

a. Gain basis

i. Use greater of donor’s basis or FMV

b. Loss basis

i. Use lesser of donor’s basis or FMV

iii. If sold for amount between FMV and donor’s basis, then no gain or loss b/c in gray area.

g. Part Sale/Part Gift

i. Gain Basis (if sold for gain)

1. greater of price paid or donor’s basis

ii. Loss Basis (if sold for loss)

1. lesser of FMV or donor’s basis

iii. Donor NEVER recognizes loss on part sale/part gift (he does recognize gain though).

iv. If sold for amount between FMV and donor’s basis, then no gain or loss b/c gray area.

VII. Taxation of Gifts

a. Commissioner v. Duberstein – develops “detached and disinterested generosity” standard for gifts. Key = donor’s intent.

b. Olk v. U.S. – Holding = tokes are income due to (1) regularity of flow (2) viewed as compensation (3) tokes are split among all dealers.

c. Mixed motivations – where motives of the donor are mixed, the tax consequences turn on the dominant purpose of the donor.

d. IRC §86 – Social Security benefits (included in gross income)

e. IRC §102 – Gifts and inheritances

i. §102(c) – no gifts to employees

f. IRC §274(b) – no gift deductions for businesses

g. IRC §527 – campaign funds are not income to candidate as long as used in campaign (would be income if used for personal reasons).

VIII. Cancellation of Debt (aka: discharge/forgiveness of indebtedness)

a. Generally – a creditor’s discharge of debtor’s debt/obligation for less than the full amount owed, results in income to the debtor (or decreases the amount of his insolvency). When debt is cancelled w/o consideration.

b. Transactional approach – like a renegotiation of price. What was the end result? Total increase in net transaction? Was there a gain after everything was said and done?

c. U.S. v. Kirby Lumber – forgiveness of debt can constitute income to the debtor. Established “net worth” test.

d. Zarin v. Commissioner – compulsive gambler – debt forgiven. Court says money advanced was unenforceable b/c casino was told not to advance him money anymore; bad debt, if unenforceable, is not income (bad reasoning, but right result). Should have used transactional approach – debt forgiven and so TP/casino agree that debt was only worth 50K instead of 2 million.

e. Solvency – if forgiven debt makes TP solvent, then he is taxed only to extent he becomes solvent. Rationale = don’t want to discourage forgiveness of debt by creditors.

i. Insolvent = when FMV of assets is less than liabilities.

f. Intent to pay - when Statute of Limitations expires, cancellation of debt income comes into play unless debtor still intends to pay.

g. FYI - Tax Benefit Rule trumps Cancellation of Debt rule.

h. IRC §108 – Income from discharge of indebtedness

i. §108(e)(5) – when buyer and seller are involved (i.e., purchase money loan), then reduction is treated as a purchase price adjustment. So, result is a reduction in basis, not cancellation of debt.

i. IRC §1017 – Discharge of indebtedness

IX. Claim of Right

a. Claim of Right Doctrine: the recipient acquired the property w/o a consensual recognition (express or implied) of an obligation to repay and w/o restriction as to his disposition of the property at least until the error is discovered. Income is received under mistake of fact or law and included in gross income.

b. U.S. v. Lewis – employee reports 22K bonus; bonus was too high; employee has to return 11K. Employee is allowed 11K deduction when he repaid the bonus. Claim of Right doctrine develops.

c. James v. U.S. – issue = whether embezzled funds are to be included in gross income of embezzler in the year in which funds are misappropriated. Holding = yes, TP must report illegal gain. Expands claim of right doctrine b/c now no longer need claim against entire world. (IRS does give deduction when have to pay money back - itemized).

d. Van Cleave v. U.S. – deals w/ applicability of §1341.

e. IRC §1341 – Computation of Tax Where TP Restores Substantial Amt Held Under Claim of Right:

i. (a)(1) – included in income b/c it appeared he had unrestricted right

ii. (a)(2) – deduction allowable b/c no such right

iii. (a)(3) – amount must exceed 3K

then, the tax imposed shall be the lesser of:

iv. (a)(4) – the tax for the tax year computed w/ such deduction; OR

v. (a)(5) – an amount equal to:

1. the tax for the year computed w/o such deduction, minus

2. the decrease in tax under this chapter for the prior year which would result solely from the exclusion of such item from gross income for such prior tax year.

f. Special Rules under §1341 – refund available.

g. Statute of limitation for amending tax return does not close when fraud is involved.

X. Non-recognition

a. Generally: certain exchanges of property (specifically recognized by the code) permit nonrecognition of gain or loss.

b. Exchanges of Like Kind Property - §1031 precludes recognition of gain or loss when property held for productive use in a trade or business is exchanged solely for property of a “like kind” to be held for productive use in a trade or business or for investment purposes.

i. Realty – constitute like kind property regardless of whether they are improved or unimproved and regardless of functional use to which the realty is put. Only restriction applies to foreign realty.

ii. Sometimes referred to as a “tax free” exchange.

iii. “like kind” – refers to the nature or character of the property, not its grade or quality.

iv. Regs treat a leasehold interest in realty for a term of 30 years or more as property that is of like kind to a fee interest in realty.

c. Personal Properties – the like kind standard for personal property is more restrictive. Personal properties are divided into 3 broad categories:

i. Depreciable tangible personal property

ii. Intangible personal property

iii. Nondepreciable tangible personal property

d. Involuntary Conversions – when prop is involuntarily converted into money as a result of its destruction in whole or in part, theft, seizure, requisition, condemnation, the TP may elect to avoid recognition of the gain of the conversion if he acquires replacement property. A loss sustained b/c of an involuntary conversion is recognized. (§1033)

i. Elective – when prop is involuntarily converted into money or dissimilar property, TP may elect whether or not to recognize gain if §1033 applies.

1. if converted into similar property, §1033 is mandatory and prohibits recognition of gain.

2. election is made on the year TP realized a gain from the conversion.

ii. Requirements – if during the statutory period, for the purpose of replacing the converted property, the TP purchases other property similar or related in service to the converted property, at TP’s election, TP will recognize gain on the conversion of his prop into money only to the extent that the amount realized by him on the conversion exceeds to cost of such replacement prop.

iii. Statutory period – begins w/ date of disposition of converted prop or earliest date of threat or imminence of condemnation and ends two years after the close of TP’s first taxable year in which any part of the gain from the conversion was realized. Reg. 1.1033(a)-2(c)(3).

iv. Similar or related in service or use requirement – stricter than “like kind” exchanges.

1. improved real estate is not similar to unimproved real estate.

e. Crane v. Commissioner – Crane doctrine = non-recourse debt is generally treated the same as cash invested for figuring basis. Equity is not used to determine basis, determined by FMV b/c if used equity, basis would constantly change as you paid off the mortgage etc. Treat non-recourse debt like recourse debt.

i. Non-recourse debt = can only go after property (take prop subject to the loan).

ii. Recourse debt = personal liability (assume loan).

f. Commissioner v. Tufts – borrows 1.85 million; pays 45K. partnership claims depreciation; full amount of loan realized, not just FMV.

g. Boot = amount received above trade (in non-recognition transaction) and must be recognized.

i. Effect of boot on recognition of gain:

1. §1031 – TP receipt of boot causes him to recognize gain on the exchange only to the extent of the boot received.

2. Liabilities as boot – when property which is subject to a mortgage or other encumbrance is transferred in a §1031 exchange, the amount of the encumbrance is treated as boot received by the transferor.

ii. Effect of boot on recognition of loss:

1. no loss can be recognized in an exchange of like kind property under §1031 even if TP also receives boot in the exchange.

iii. FYI – in nonrecognition transactions, boot basis isn’t subject to nonrecognition provisions, so boot’s basis is equal to FMV.

iv. Code does not allow you to offset cash w/ mortgage – recognize boot (cash) no matter what.

h. Basis of Property Received in §1031 exchange:

i. Basis = old basis – cash + gain recognized – loss recognized

ii. Basis w/ mortgage involved = old basis – cash + gain recognized – loss recognized – mortgage given up + mortgage assumed

i. IRC §1031 – Exchange of property held for productive use or investment

i. Purpose of §1031 – to defer recognition of gain. Don’t want to discourage trades. IRS recaptures any gain (boot etc.) at later time w/ adjustment of basis or return to original basis (i.e., A’s basis in prop = 5K w/ FMV=10K; exchange for B’s prop worth 10K; A’s basis in new prop remains 5K – original basis).

j. IRC §1033 – Involuntary Conversions

i. Rational – b/c involuntary

ii. Does not require non-business purpose

XI. Alimony

a. Determined by parties or state court

b. Requirements - Alimony must be:

i. In cash

ii. Received under a divorce or separation agreement

iii. Elect to have §71 apply

iv. Liability must terminate at death of payee spouse

v. Can’t be in same house at the time payments are made

c. Rationale for alimony payments under §71 – want §71 to apply to support payments, not property settlements.

d. Mortgage payments – not alimony under §71 when payor owns the house.

e. IRC §71 – Alimony and Separate Maintenance Payments

i. If payment from a payor spouse to a spouse or former spouse qualifies as alimony for tax purposes, the payment will constitute ordinary income to the recipient and will be deductible to the payor.

1. Payor gets deduction

2. Payee takes into income

ii. Deduction = nonitemized b/c used in calculating AGI.

f. Payment of property in kind – does not qualify as alimony

g. Cash Paid to a Third Party

i. Pursuant to divorce or settlement agreement – qualifies as alimony

ii. At W’s request or ratification – qualifies as alimony if W makes timely written request.

h. Lump Sum Payment Required by Divorce or Separation Agreement

i. There is nothing to prevent a lump sum payment required by the divorce or agreement from qualifying as alimony if requirements of §71 are satisfied.

i. Front Loading

i. Congress has restricted to extent to which alimony deductions can be concentrated in the early years of payment.

ii. Recapture rules – if the amount paid to W in the 2nd post separation year is more than 15K greater than the amount to W in the 3rd year, a certain amount of the deduction granted to H for such payments in the 2nd year will be “recaptured” by requiring H to include that amount in gross income for his taxable year that begins in the 3rd post-separation year.

1. Payee’s deduction of H’s recaptured amount – W is granted a deduction equal to the amount H recaptured by including it in his gross income. This deduction is allowable to W in the year that begins the 3rd post separation year. It is nonitemized.

j. IRC §215 – Alimony, Etc., Payments

k. IRC §682 – Income of an Estate or Trust in Case of Divorce, Etc.

XII. Business Expenses

a. IRC §162

b. IRC §165

c. IRC §212

d. IRC §262

e. IRC §263

f. Flowers

g. Correll

h. Gilmore

i. Hunter

j. Wild

k. Hantzis

XIII. Ordinary & Necessary

a. Welch v. Helverling

b. INDOPCO, Inc. v. Commissioner

c. IRC §162

d. IRC §195

e. IRC §263

f. IRC §280A

XIV. Depreciation

XV. Recapture of Depreciation

a. IRC §1245

XVI. Capital Gains

XVII. Quasi Capital Assets

XVIII. Anticipatory Assignment of Income

XIX. Anticipation of Income