Personal Income Tax Outline – Kahn – Fall 2000 - SCU
Major Topics:
Basic questions to ask in tax problems:
Ø Does an item constitute income?
Ø Does an item constitute a loss?
Ø Is the income or loss realized?
Ø To whom was the income or loss realized?
Ø When was the income or loss realized?
Ø Was the income or loss recognized and if so, when?
Ø How is the income or loss characterized (capital gain or loss, section 1231 gain or loss, or ordinary income or loss)?
Ø If a loss was recognized, is it deductible?
Ø What items constitute tax deductions?
Ø Are such tax deductions allowed?
Ø When are such tax deductions allowed?
Ø How is a tax deduction to be characterized (o9rdinary deduction or as capital loss)?
Ø Is a tax deduction an itemized or nonitemized deduction?
Ø Is a tax deduction a miscellaneous itemized deduction?
Ø What surtaxes are applicable?
Ø What credits may be deducted from the tax bill?
Benefits to be excluded: (Gil22)
1.. no additional cost service – regularly provided to customer and employer incurs no additional costs (EX: stewardess flies for free on standby)
2.. qualified employee discount – employee not taxed on discount on merchandise sold to him by employer as long as discount at least equals cost (products), or not more than 20% discount (for services)
3.. working condition fringe – property or services, provided to an employee which, had the employee paid for item, it would have been deductible (EX: car provided to employee used exclusively for business, car value is not taxed)
4.. transportation fringes – vanpool of at least 6 persons , transit pass and free parking not taxable as long as free parking does not exceed $155 per month, and vanpool and transit pass does not exceed $60 per month
5.. de minimis fringe – fringe that is so small to make accounting for it unreasonable or administratively impractical
6.. qualified moving expense deduction – if employee would have been entitled to a moving expense deduction if paid for himself, no tax if employer pays or reimburses the expense
7.. life insurance - Employer purchased life insurance is excluded from gross income of employee, if the proceeds are payable to a beneficiary selected by the employee.
8.. lodging – excluded if on business premises, for convenience of employer, and required as condition of employment
Damages (Gil15)
1.. personal injuries – damages on account of personal physical injuries or physical sickness are excluded from gross income. Punitive damages are NOT excluded from gross income.
a.. must originate from physical injury – all damages (except punitive), including emotional distress are excluded from GI as long as the emotional distress stemmed from a physical injury (such as a car accident). If emotional distress stems from non-physical injury (such as intentional infliction of emotional distress) none of damages are excluded even if they are physical (such as a headache).
b.. if damages compensate for medical expenses that were previously deducted, that portion of the damages must be included in income
c.. periodic damage payments are deductible as well as lump sum payments. Periodic payment only deductible after they are actually paid
2.. business injuries – partial exclusion on certain recoveries of damages for business injuries (patent infringement, breach of contract, breach of fiduciary duty, anti trust violations)
Ames v. Commissioner
Interest on a damages payment is taxable income
Before any increase in net worth becomes taxable (or deductible, if declined in value) a crystallizing event (a realization) must occur that makes it reasonable and convenient to compute gain or loss. An event which recognizes the severance of gain (or loss) from the property that produced the gain (or loss).
Eisner v. Macomber – requirement that income be realized held to be constitutional limitation on government’s power to tax. Doubtful whether it would be followed today.
1.. realization in property transactions – realize gain or loss at disposition of property (sale or transfer).
a.. mortgages – NOT a realizing transaction
b.. transfers as payments of debts – if property transferred has appreciated, it is a
realization
c.. exchanges – is a realization if the property received “differs materially either in kind or in extent” from the property given up
Basis – the maximum amount a taxpayer can receive in payment for an asset without realizing a gain. It is the TP’s investment in the property.
Basis of gifts - donee’s original basis in donated property is equal to the basis that the donor had at the time of the transfer (IRC § 1015); unless - if basis is greater than FMV at time of gift, then for purposes of determining loss the basis shall be such FMV. If determining gain, use basis at time of gift.
Basis in property acquired as a gift within one year of death - basis of the property will equal the basis that the decedent had therein immediately prior to his death
Basis of property acquired from a decedent - basis of property that was included in a decedent’s gross estate is equal to the FMV of the property at the date of the decedent’s death (or FMV 6 months after death, if alternate valuation date is selected) § 2032
Basis in Stock if Purchase Price Unknown – you pick the lowest price possible of stock during time when stock was purchased. Don’t take average price because it would encourage people to lose records.
Basis in Stock if Purchase Price Unknown – you pick the lowest price possible of stock during time when stock was purchased. Don’t take average price because it would encourage people to lose records.
Allocation of Basis
1.. allocation values determined as of date the TP acquired the property
2.. sale of stock – FIFO – unless individual shares of stock are identified, the stock is deemed to have been sold on First In First Out basis. TP’s sale of some of the stock will be treated as the sale of the earliest stock acquired by him.
Tax Benefit Rule (Gil106)
GENERAL RULE: When a deduction in an earlier year is followed by a recovery in a later year of the amount deducted, the TP must include the amount previously deducted as income in the later year. A recovery is NOT income unless the earlier outlay produced a tax benefit.
Hillsboro – subsequent event which is fundamentally inconsistent with a prior deduction requires recognition of income; tax benefit rule does not depend on there being actual recovery of deducted item; tax benefit rule can be construed as a device to recapture deduction that was based on an assumption that certain events would occur if it subsequently becomes clear that neither the assumed events nor any comparable events will occur.
Bliss Dairy – inconsistent use of expensed goods; liquidating distribution of the feed was fundamentally inconsistent with the corporation’s previous deduction of the cost of that feed as an expense
Donee’s Basis in Gifts
Property received by bequest, inheritance or devise will be excluded from gross income and the recipient is not subject to tax (§ 102).
Basis of gifts - donee’s original basis in donated property is equal to the basis that the donor had at the time of the transfer (IRC § 1015); unless - if basis is greater than FMV at time of gift, then for purposes of determining loss the basis shall be such FMV. If determining gain, use basis at time of gift.
Ø for purposes of determining the donee’s loss on a subsequent disposition of the donated property, the donee’s original basis is the lesser of 1) donor’s basis at time of transfer, or 2) the FMV of the donated property on the date of transfer
If gift tax was paid on the transfer of an item, the donee’s basis in that item will be increased by the portion of such gift tax that is attributable to the appreciated element of the property (the excess of the value of the property over the donor’s basis). IRC § 1015(d)(6). (10k annual exclusion taken into account in determining the amount of the gift, but not for determining the appreciated amount).
Example of increasing donee’s basis by amount of gift tax paid on appreciated portion:
X -> Y property FMV 37k; X basis 19k; K paid 3k gift tax; 10k annual exclusion
Y’s basis – 19k plus fraction of value of gift representing appreciated element of
gift tax paid (18k appreciation / 27k taxable gift x 3k gift tax = 2k)
Y’s basis – 19k + 2k = 21K
Example of realizing a gain on sale of a gift:
X -> Y 100 shares; X’s basis 8k; FMV 10K; no gift tax paid
Y sold for 12k – 4k gain on sale
Y sold for 7K – 1k loss on sale
Example of realizing no gain or loss on sale of a gift:
X -> Y 100 shares; X basis 10k; FMV 8k; no gift tax paid
Y sold for 12k – 2k gain on sale (use X basis)
Y sold for 7k – 1k loss (use FMV as basis)
Y sold for 9k – no gain or loss (gain basis is 10k; loss basis 8k – this is between)
Bargain purchases (Kahn 206) – Where X purchases property from Y and the consideration paid by X is less than the property’s value, the difference will constitute gross income to X if disguised as compensation. If close familial relationship, the difference will constitute a gift from X to Y. If no such relationship, bargain element has no tax consequences.
Ø if sale constitutes a gift, donor-vendor will have gain only to extent the amount realized exceeds donor’s basis
Ø donor can never realize a loss on a bargain sale
Ø donee’s basis on bargain purchase, for purpose of determining gain is greater of the purchase price paid by donee OR the donor’s basis
Ø for determining loss basis – lesser of FMV or donor’s basis
Ø when purchaser-donee pays less than donor’s basis, donee will assume basis of donor
Ø purchaser-donee’s basis for determining loss cannot exceed FMV at date of transfer
Basis in property acquired as a gift within one year of death - basis of the property will equal the basis that the decedent had therein immediately prior to his death
Basis of property acquired from a decedent - basis of
property that was included in a decedent’s gross estate is equal to the FMV of
the property at the date of the decedent’s death (or FMV 6 months after death,
if alternate valuation date is selected) § 2032
Taxation of Gifts (Kahn 200)
Property received as a gift (other than a gift from an employer to an employee) will be excluded from the donee’s taxable income.
Gift – a transfer without adequate consideration which is made out of the donor’s detached and disinterested generosity.
Olk v. US – tokes (chips given to dealer as tips in gambling hall) were a form of wages received because of their regularity and because of the dealer’s anticipation of such payments as a form of compensation.
Claim of Right
§ 1341
When income is received under a mistake of law or fact, the income is in the gross income of the recipient, even though the recipient may be required to return the income item. When mistake is paid back, person who gave the money back gets a deduction.
Deduction is typically an itemized deduction, but not subject to 2% floor.
Limitations
1.. amount of allowable deduction must exceed $3,000
2.. statutory relief does not apply to an item which was included in gross income by reason of sale or held for sale to customers in ordinary course of business
3.. 1341 does not apply to the return of an overpayment
received as a consequence of a clerical error or an error of computation
(the validity of this rule has not been established)
Nonrecognition (Gil140)
Gain or loss is only taxable/deductible if both realized and recognized. The Code has many exceptions to the general rule that all gain or loss is recognized at the time of a sale or exchange.
a.. Price for nonrecognition – the basis of the property received by the TP is the basis of the property transferred. Therefore the gain or loss is simply deferred until the acquired property is sold.
§ 1031 – no recognition of gain or loss when property held for productive use in a trade or business or for investment is exchanged solely for property of a like kind
like-kind – refers to nature or character of property, not grade or quality
Exchanges with a related person – gain or loss recognized if occurs within 2 years after the date of the last transfer incident to that exchange. Three exceptions:
1.. if disposition takes place after death of either the parties
2.. if exchange takes places as a consequence of a compulsory or involuntary
conversion if the like kind conversion occurred before the threat or imminence arose
3.. if neither the exchange or disposition had as one of its principal purposes the avoidance of Federal income tax
basis of property in like kind exchange – same as TP’s basis in the property transferred by him reduced by any MONEY received by the TP and increased or decreased by any gain or loss recognized by the TP on the exchange
TP new basis = (basis) – (money received) + (gain recognized) – (loss recognized) + (mortgage amount on new property) – (mortgage on transferred property)
HOW IS GAIN RECOGNIZED CALCULATED????
Gain is recognized on involuntary conversions to the extent amount realized exceeds replacement property
Taxable Income
Overview for calculating income tax:
i. depreciation and amortization
Section 61 - gross income - all income from whatever source derived
Net worth concept - income is any item that increases a taxpayer’s net worth
STEP ONE - DETERMINE WHETHER IN INCOME OR NOT
The following is excluded from gross income:
|
Ø Gifts and inheritances Ø life insurance paid upon insured’s death Ø interest on state and local bonds Ø most social security income Ø damage payments on account of physical personal injuries or physical sickness Ø value of meals and lodging furnished by employer to employee and his family for the convenience of the employer (business necessity test) if furnished on the employer’s business premises |
Ø contributions to capital Ø annuity payment that represents taxpayer’s investment Ø welfare benefits Ø benefits paid from medical insurance where employee pays premiums Ø large amounts of foreign earned income Ø lessee’s improvements on leased land Ø casualty losses to TP’s home resulting from fire, storm, etc. |
The following is included in gross income:
|
Ø compensation for services rendered Ø illegal increases in net worth Ø anything that causes an increase in net worth (subject to exceptions) |
Ø income from cancellation of indebtedness Ø spousal and child support payments taxable to the recipient |
STEP TWO - IS ITEM DEDUCTIBLE OR CREDIT AGAINST TAX
Deduction - subtracted from gross income or adjusted gross income to arrive at taxable income
Credits - subtracted from taxes due to fix tax payable
The following items are deductible:
1.. Business and investment expenses
- travel expenses (while away from home in pursuit of trade or business)
- 50% of meals (if TP is away long enough to require sleep or rest)
- moving expenses (if new job more than 50 miles farther from the old home, TP works full time, new place of work permanent)
- 50% of entertainment expenses if directly related to TP’s business
- business gifts up to $25
- litigation expenses (if origin of dispute is related to trade or business and ordinary and necessary)
- educational expenses (if do not qualify TP for new trade or business, and do not constitute minimum education requirement to stay in job) deductible if for maintaining or improving skills required in current job
- insurance premiums
- home office (if used exclusively for business)
- uniforms (if cannot be worn for non work purposes)
Depreciation and Amortization - reasonable deductions allowed for exhaustion and wear and tear of property used in trade or business, or held for production of income
1.. computation of depreciation (tangibles)
a.. recovery periods of 3, 5, 7, 10, 15, 20 years under ACRS
b.. ACRS ignores salvage value - no distinction between new and used
c.. methods:
1.. straight line - divide cost by the useful life
2.. accelerated depreciation - greater depreciation allowed in early years
d.. small business may elect to expense purchase price (deduct immediately) up to amount allowed in § 179 (1998 - $18,500; 1999 - $19,000; 2000 - $20,000; 2001 - $24,000; 2002 - $24,000; 2003 and on - $25,000)
2.. computation of depreciation (intangibles) - 15 year amortization period under § 197 applies to the following intangibles: purchased goodwill, going-concern value, workforce, more on page 88Gil
2.. Personal Deductions
To be deductible as a business expense, the expense must be ordinary and necessary:
1.. Three factors to
consider: voluntariness of the payment, the customariness of the
payment, and whether it is reprehensible
2.. reasonable compensation costs for services rendered is deductible
Non business expenses – deductible if for production of income
1.. individual can deduct expenses paid for production of income
Personal Deductions
1.. interest – personal interest generally not deductible; business or investment interest is deductible, with limitations:
a.. interest is incurred with respect to a bona fide debt
b.. some interest is nondeductible – personal (credit cards); interest expenses attributed to the production of tax exempt income disallowed; interest on debts to purchase tax exempt bonds not deductible; interest on loans to purchase insurance not deductible generally;
2.. interest on loans for higher education can be deducted from gross income (max deduction (§ 221)
3.. taxes are deductible
4.. charitable contributions – individuals limited to 50% of AGI, corporations limited to 10% of net income
5.. medical expenses – cost of diagnosis, cure, mitigation, treatment, or prevention, and travel expenses deductible, UNLESS compensated by insurance; must exceed 7.5% of AGI to be deductible
6.. personal deduction - $2000 per person (indexed for inflation), and exemption for dependants
7.. casualty losses – deduction allowed to extent loss exceeds $100 and is to TP’s own property; and must exceed 10% of AGI.
8.. other deductions – nonbusiness bad debts, alimony payments, certain contributions to retirement plans
Tax Credits – reduce tax payable dollar for dollar
1.. credit for taxes withheld and prepaid
2.. foreign tax – credit for tax paid to foreign countries
3.. credit for TP over age 65 receive 15% of section 22 amount
4.. work incentive credit for disadvantaged employees
5.. child care
6.. earned income credit for low income TP
7.. adoption credit – claim a credit for adoption expenses
8.. education credits
STEP 3 - COMPUTE BASIS – DETERMINE GAIN OR LOSS
1.. adjusted basis = unadjusted basis + additions – reductions
2.. gain = amount realized – adjusted basis
3.. loss = adjusted basis – amount realized
1.. unadjusted absis – usually what the item cost
a.. inter vivos gifts
§ for computing gain – donee take’s donor’s basis
§ for computing loss – donee’s basis is FMV at time of the gift OR donee’s basis, whichever is less
2.. inherited property – basis is the property’s value at the date of death of decedent (or 6 months later if alternate valuation selected)
1.. determined by adding to the unadjusted basis all subsequent expenditures chargeable to the asset that were not deductible as current expenses. Then subtract receipts, losses, or other items properly chargeable to a capital account, and subtract depreciation, depletion, amortization or obsolescence allowed
When only part of an asset is sold, must allocated the basis between the part sold and part retained.
Realization Requirement – realization must occur prior to the taxation of the increase in
net worth
Non Recognition of Gain or Loss - generally all gain or loss is recognized, subject to
some exceptions:
1.. nonrecognition provision – gain or loss is deferred until the acquired property is sold
2.. like kind exchange – no gain or loss recognized if property exchanged for like kind property. Stocks and bonds not included
a.. boot – if TP receives like kind and non like kind property, the non like kind property (boot) is considered, and the realized gain is recognized (and basis adjusted)
3.. involuntary conversion – gain recognized to extent realized amount exceeds replacement amount
4.. non recognition of gain on personal residence
STEP 4 – DETERMINE WHAT TYPE OF INCOME IT IS
Capital Gains – to determine whether transaction qualifies for capital gain or loss treatment consider the following factors:
1.. is it a capital asset?
2.. was there sufficient holding period?
3.. what was the basis?
4.. what is the method of computing the gain or loss?
5.. is the gain or loss realized or recognized?
1.. is it a capital asset?
a.. Generally all property held by TP is a capital asset with some exceptions:
1.. property held for sale in ordinary course of business not capital asset
2.. payments for services, sale of inventory item not capital asset
3.. depreciable property and real property used in a trade or business
4.. sale of rights to income – if TP sells future right to income while
retaining property, sale proceeds are taxable as ordinary income, not capital gains
a.. sale of life estate by a trust beneficiary taxed as capital gain
sale pf personal rights are treated as ordinary income (ie sale of right to
privacy)
5..
Definitions:
business expenses - all ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business
trade or business - expectation of profit, regular and continuous operation, active pursuit thereof
ordinary and necessary expense - type encountered by other businesses in the community, appropriate or helpful to the business (factors to consider: voluntariness of the payment, customariness of payment, and whether it is reprehensible; must be reasonable compensation)
amortization - deduction allowed for wear and tear of intangible object
adjusted gross income – gross income less certain deductions
amount realized – the sum of the money, plus the FMV of any other property, received by TP in the realizing transaction
Alimony - Kahn
106
Alimony payment is ordinary income to payee and deductible
Alimony – payments in cash, received by or on behalf of a spouse under a divorce or separation instrument; must not share same household at time payments are made. Liability to make payments must terminate with payee’s death.
Recapture Rules
1.. If the amount of alimony paid in second post separation year is more than $15,000 greater than the amount paid in the third year, a certain amount of the deduction granted to payor in the second year will be recaptured by requiring payor to include that amount in gross income of third year.
2.. if the amount paid in the first year is more than $15,000 greater than the average of the amount paid in the second and third years, the excess payment in the first year is also recaptured in the taxable year that begins in the third year.
3.. Payee is granted a deduction equal to the amount recaptured that payor included in gross income in third year
Steps:
1.. determine excess payments for second year
a.. excess of amount paid in second year over $15,000 and amount paid in third year
2.. determine excess payments for first year
b.. excess of amount paid over 15,000 in first year plus average of amount paid in second and third years; before taking average reduce second year payment by amount determined in step one above
3.. add excess payments together to determine amount payor must include in third year gross income
Cancellation of Debt (Kahn 41)
IRC § 108
Kirby Lumber - forgiveness or discharge of a debt can constitute income to the debtor
RULE: if person is insolvent when the discharge occurs, the amount discharged is excluded from the debtor’s income (IRC § 108(a)(1)(A) and (B)
DEF: Insolvent - if the total of outstanding liabilities exceed the total value of assets
If discharge causes debtor to become solvent, debtor will recognize income to extent of his solvency.
108(b)(1) - the amount excluded from gross income shall be applied to reduce the tax attributes of the TP as provided in paragraph 2.
Step one - determine if income is realized
Step two - if income is realized, but not recognized, consider whether the item is excluded from income or whether it is nonrecognized under some type of deferral arrangement
Definitions:
Discharge - cancellation of debt without receiving adequate consideration
Business Expenses (Ordinary and Necessary)
General rule - § 162 - deduction allowed for ordinary and necessary expenses of conducting a trade or business
Trade or business - activity entered into for the purpose of making a profit and with the expectation that the activity ultimately will produce a profit; primary purpose must be for income or profit (Kahn 370). Must be involved in activity with regularity and continuity.
Non Business Expenses - a deduction allowed for ordinary and necessary expenses paid or incurred 1) for the conservation of income; 2) for the management, conservation or maintenance of income-producing property (IRC § 212) - most of these type deductions constitute miscellaneous itemized deductions under § 67b and will be subject to the 2% floor imposed by §67a.
Ordinary and Necessary (Kahn 420)
In order to be deductible under § 162 or § 212, the expenses must be ordinary and necessary
Necessary - an expense that is appropriate and helpful to the TP’s conduct of his trade or business or of his profit seeking venture.
Ordinary - the expense must not be unique in the experience of the group or community of which the T is a member.
Origin test - look to see what the origin (cause) of the expenses to see whether a deduction applies; requires an examination of the facts
Capital or ordinary expense? Can apply the origin test to determine. From Gilmore
Ø cannot
be deducted in the year in which it is paid or accrued; must be capitalized
(amortized)
Ø
difference is timing of the recovery of TP’s cost
o expense
deducted in year paid or accrued
o capital
expenditure must be amortized over period of time
Ø no current deduction allowed for amount spent for acquisition of asset which will be used by TP over a period of 12 or more months
Ø small cost exception- if cost of item to be used for more than 12 months is too small to warrant amortizing it, may be currently deductible (K401)
Indopco - USSC held fees paid during a friendly corporate acquisition were capital expenditures and therefore not deductible; TEST - whether the expense will produce substantial benefits in the future
Ø in general the cost of replacing a major component of a property will have to be capitalized
DEF: incidental repairs which neither materially add to the value of the property nor appreciably prolong its life, but keep it in an ordinary, efficient operating condition
RULE: cost of repairs on business property or property held for profit is a currently deductible expense
Miscellaneous Situations - Determining Capital or Ordinary Expense
Software (K406) - Developing software is akin to research and TP can treat its expenses as currently deductible
Major renovations - such as renovation of an apartment building, all expenditures are capitalized, even though some parts would be deductible if incurred separately
Repair of damage caused by casualty - in the nature of replacement so must be capitalized
Environmental cleanup costs - currently deductible as business expenses
Groundwater treatment facilities - cost of construction capital expense
Purchase or sale of asset - capital expenditure
Expanding a business - four stages: 1) determining whether to enter business (generally capitalized); 2) start up expenses (generally capitalized); 3) current conduct expenses (deductible); 4) termination expenses (deductible)
Abandoned project (K411) - deductibility turns on how much the TP had done to enter business before abandoning project
Investigatory search for new business (K412) - once TP has focused on specific business, related expenses to acquire are capital and may be amortized
Expenses of seeking employment - not deductible; probably because they constitute capital expenditures of entering a business
Uniforms (K418) - cost of acquisition and maintenance deductible if required by employer, and not readily adaptable to general use so that it could be used in place of regular clothing; deductible as itemized (a miscellaneous itemized deduction subject to 2% floor of §67 and §68) unless employer reimburses TP for expense; if reimbursed by employer then deductible under § 62a (a nonitemized deduction)
Production of book, film, sound recording, plays, fine arts - §263a - qualified creative expense allows authors to take many expenses as current deductions
Office in home (K423) - §280a - severe restrictions on deductibility of home office; no deduction allowed if used for general purpose for more than 14 days per year (unless exclusively used on regular basis as principal place of business for any trade or business of TP, OR as a place of business used by patients, clients, customers in meeting with TP in the normal course of TP’s trade or business)
Employee’s home office - no deduction allowed if TP is employee, unless the exclusive use of home office is for convenience of employer; if employer provides employee with normal office at work, and employee also works at home, work at home is for convenience of employee, not employer (so no deduction allowed)
Unreasonably large expenses - unreasonable portion of expense not deductible
Bribes to government officials - no deduction allowed if payment is unlawful
Travel expenses - deductible under §162 if TP self employed (nonitemized deductions); if TP is employee, deductions are miscellaneous itemized deductions
Ø must be incurred while TP is “away from home” - DEF: home - for §162a2 purposes, a home is location of TP’s principal place of business, rather than TP’s residence (K440)
Ø travel away from home refers to travel where TP is away for a sufficient perior to reasonably require sleep or rest (K441)
Travel expenses of person accompanying TP - not deductible unless 1) person is employee of TP, 2) travel of that person for bona fide business purpose, AND 3) such expenses must otherwise be deductible by that person
Cost of meals on business trip - 50% of meals allowed as itemized deduction
Commuting expenses - non deductible; if principal place of business is residence, TP can deduct cost of going between residence and other work locations
Travel among multiple jobs - transportation costs of traveling between job sites a deductible business expense (§162a)
Moving expenses - when moving at least 50 miles from former residence to new place of work, expenses incurred are deductible as long as 1) be a full time employee for at least 39 weeks during 12 month period following move, OR 2) be a full time employee for at least 78 weeks during 24 month period following move
Education expenses - deductible as business expenses even though the education may lead to a degree IF 1) maintains or improves skills required by TP in employment or trade or business, OR, 2) satisfies a requirement imposed by the TP’s employer, law, condition or retention of an established employment or rate of compensation
Ø not deductible if 1) education is essential to satisfy minimum requirements for qualification in chosen employment or trade or business, OR, 2) if education will lead to qualifying the TP for a new trade or business regardless of whether TP intends to enter new trade or business
Bad debt - deduction allowed to creditor for bona fide debt which became worthless; if in connection with TP’s trade or business, can deduct part when partially worthless; a non business debt only deductible when it becomes totally worthless; if debt is paid later, must apply tax benefit rule
Depreciation
Theory - assets that are to be used for more than 12 months usually are not currently deductible because IRS views it as converting your money into a different type of property - you have not actually spent the money; it is an asset of like value; deduct a portion each year because after a certain number of years the item will no longer be useful
Depreciation - allocation of the cost or basis of the property among the years of its use in a trade or business or for the production of income; refers to the deduction under § 167, § 168; an amortization under any other section of the code is referred to as amortization (such as § 169, 197, 248)
Amortization - requires that the allocation of basis be spread evenly over the recovery period; depreciation deductions are not so restricted
§ 168 - establishes MACRS
§ 179 - TP who purchases § 179 section property can elect to deduct all or part of the cost of the asset as a current expense in the taxable year property is placed in service
§ 179 property - any tangible property to which 168 applies which is section 1245 property (property of a character subject to the allowance for depreciation in § 167, and is either personal property or other tangible property with adjusted basis) and which is acquired by purchase for use in the active conduct of a trade or business
§ 179 amounts - 1998 - $18,500; 1999 - $19,000; 2000 - $20,000; 2001 - $24,000; 2002 - $24,000; 2003 and on - $25,000
Ø maximum amount that can be deducted under §179 cannot exceed the taxable income that TP derived for that year from active conduct of trade or businesses
Ø §179 election irrevocable; TP must specify the items whose cost is to be expensed
Ø amount of §179 deduction is not charged to capital account, and NOT part of basis; deduct 179 amount from original basis
MACRS property - only property that is depreciable under MACRS is tangible property, real or personal, of a character that is used in a trade or business, or otherwise held for production of income; applies only to property placed in service after 1980; salvage value not taken into account; valuable works of art do not have a determinable useful life
Determining amount of depreciation under MACRS
1.. determining classification of property in question
a.. generally: 3, 5, 7, 10, 15, 20 year property; residential rental property; nonresidential real property
b.. five year property - includes automobile, light purpose truck, qualified technological equipment
2.. determine applicable depreciation method
a.. election to use straight line or 150% method - where TP would otherwise have depreciated an asset on the 200% declining balance method, TP can elect to depreciate such asset on the 150% declining balance method; irrevocable election
3.. determine applicable recovery period
a.. for most items, the recovery period is the same as the years used in classifying the property
4.. determine application convention
a.. buildings and structural components - mid month convention is used; property is treated as if it were placed in service in the middle of that month
b.. half year convention used on other property - UNLESS - more than 40% of total property bought that year was placed in service in the last quarter of the taxable year; mid quarter convention used in this situation
c.. see pages 514-516 for examples
Straight line method - deduct salvage value from original basis and divide the difference by the estimated useful life of the property
Declining balance method - apply a fixed percentage to property’s adjusted basis at the beginning of the tax year for which the depreciation is claimed; this is called declining balance because adjusted basis will be lower each year; salvage value not taken into account
Recapture of Depreciation
Types of depreciation methods:
1.. Straight line - deduct the asset’s salvage value from the original basis of the asset and divide the difference by the estimated useful life of the property; under MACRS salvage value is ignored
2.. declining balance - apply a fixed percentage to property’s adjusted basis as of the beginning of the tax year for which the depreciation is claimed; since the adjusted basis will be lower each year, this method is called declining balance. Salvage value not considered under MACRS.
3.. double declining balance - same as above, just multiply by whatever percentage specified (200% for double) time number of years. Use the charts.
Covered in Problem 16
§ 1231 - recognized gains and losses of property used in a trade or business are netted. If computation results in a net gain, all such gains and losses are treated as long-term capital gains and losses. If net figure is a loss or zero, all such gains and losses are treated as ordinary income and loss. If net loss, net figure given ordinary loss treatment. If net gain, net figure given long-term capital gain treatment. Kahn 669.
§ 1245 - gain realized from disposition of depreciable personal property will be treated as ordinary income to the extent the gain is attributable to adjustments to basis caused by deductions previously allowed for depreciation or amortization of that property. Kahn 680.
RULE: TP will recognized ordinary income in the amount by which the TP’s adjusted basis is exceeded by the lower of either 1) TP’s recomputed basis (adjusted basis plus deductions allowed or allowable) or 2) FMV of the property in case of other disposition
See examples Kahn p. 682
Steps:
1.. determine amount of deductions actually taken (allowed), and maximum allowable
2.. determine basis at time of sale (called adjusted basis):
(original basis) - (any § 179 deduction) - (greater of amount allowed or allowable)
3.. determine gain or loss on sale
(amount realized) - (basis at time of sale)
4.. determine recomputed basis:
(basis at time of sale) + (lesser of amount allowed or allowable) + (§179 deduct.)
5.. determine § 1245 amount: lesser of amount realized and recomputed basis
6.. determine ordinary income or loss under § 1245:
(§1245 amount - step5) - (adjusted basis - step2)
7.. determine §1231 gain or loss on sale:
(step3 gain) - (ordinary income - step6)
Capital Gains
Long term capital gain/loss - if the TP held the asset for more than one year; gains and losses are netted before determining if any gain or loss recognized
Short term capital gain/loss - if TP held the asset for one year or less; gains and losses are netted before determining if any gain or loss recognized
Maximum rates for net capital gain - 28%, 25%, 20%, 10%; general rule is that the maximum tax rate that will be applied to a net capital gain is 20%
a.. 28% category
o collectibles (rugs, wine, art, etc..)
o § 1202 gains (NOT ON TEST)
b.. 25% - unrecaptured § 1250 gain
c.. 20% - everything else (with one exception)
d.. 10% category - if you are in a tax bracket of less than 20% you are taxed at 10%
You are only in the above categories if you have capital gain
If losses exceed gains, § 1211 has limitations on taxable losses
§ 1221 - Capital Asset - property held by TP is a capital asset except for inventory, stock in trade, or property held primarily for sale to customers
Allocation of capital losses (Kahn 637)
1.. divide long term and short term gains and losses into separate accountings
2.. deduct short term capital losses from short term capital gains. If there is a loss, it is first applied to reduce any gains in the 28% category. Any unused loss allocated to lower categories in descending order.
3.. if there is a net loss in the 28% category, it is applied in descending order to the next highest categories that have a net gain