Income Tax I

Fall 2002/2005 Used Spring 2007

Prof Lathrop

INTRODUCTION ________________________________________________________________________ 2 CHAPTER 2 GROSS INCOME : THE SCOPE OF 61 (PP. 48-68) ______________________________ 3
A. Introduction to Income: _______________________________________________________________________3
IRC 61(a): ___________________________________________________________________________________________ Reg. 1.61-1(a): _______________________________________________________________________________________ Reg. 1.61-14(a): ______________________________________________________________________________________ Reg. 1.61-2-(a)(1): ____________________________________________________________________________________ Reg. 1.61-2(d)(1): ____________________________________________________________________________________ Cesarini v. U.S.: _______________________________________________________________________________________ Old Colony Trust Co. v. Commissioner:___________________________________________________________________ Commissioner v. Glenshaw Glass: _______________________________________________________________________ Charley v. Commissioner: ______________________________________________________________________________ PROBLEMS: (P. 65) ___________________________________________________________________________________ Helvering v. Independent Life Insurance Co.: _____________________________________________________________ Revenue Ruling 79-24: _________________________________________________________________________________ Dean v. Commissioner: _______________________________________________________________________________ PROBLEMS: (P. 68) __________________________________________________________________________________ (a) _________________________________________________________________________________________________ (b) _________________________________________________________________________________________________ (c) _________________________________________________________________________________________________ (d) _________________________________________________________________________________________________ (e) _________________________________________________________________________________________________ (f) _________________________________________________________________________________________________ (g) _________________________________________________________________________________________________ 3 3 3 3 3 4 6 7 8 9

B. Equivocal Receipt of Financial Benefit: __________________________________________________________4

C. Income Without Receipt of Cash or Property: ___________________________________________________12

12 12 12 13 14 14 14 14 14 14 14

CHAPTER 3 The Exclusion of Gifts and Inheritances (P. 69-91) ________________________________ 15

A. Rules of Inclusion and Exclusion: [102(a) & (b) 1st sentence, 1.102-1(a) & (b)] ______________________15 B. Gifts ______________________________________________________________________________________15
1. THE INCOME TAX MEANING OF GIFT: [102(a)] _____________________________________________________ 15 Commissioner v. Duberstein:___________________________________________________________________________ 15 (h) _________________________________________________________________________________________________ 24

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Income Tax I

Fall 2002/2005 Used Spring 2007 INTRODUCTION

Prof Lathrop

History:  Prior to 1939 there was no tax code. Collected loose laws.  The tax code was substantially revised in 1954 (no simplification) and again in 1986 Internal Revenue Code still current today. Rates came down substantially and exemptions were removed. Increase base and lower rates.  The purpose of the revisions was to simplify tax law. What makes up tax law?  Tax Code 1986, as amended.  The constitution. 16th Amendment congress has power to tax. Pg. 13  House Committee Reports  Regulations interpretations by the Treasurer of what the law means; to dispute it you must show that the interpretation is unreasonable (note: some of the regs in the book have been repealed; thus, need to know when the Reg. was promulgated to determine if it is still in effect.) Treasury can create regulations.  IRS rulings the Treasurys answer to specific questions raised by a Tax Payer (TP) concerning the TPs liability. These are published in a cumulative bulletin. These are useful in planning and in understanding IRS policy.  IRS acquiescence or non-acquiescence on Tax Ct. decisions (published by the IRS) a statement of whether the IRS will continue to contest a decision.  Case law.  Treaties cut across code and modify its provisions. Treaties supersede the code.  Many tax provisions are now attached to other bills such as budget bills. It is problematic and poorly written. Administration:  Internal Rev. Code Regs. Admin. Tax Chief Counsels office Rulings  Justice Department both civil and criminal in district court of appeals.  Tax Ct. and District Ct. decisions are appealed to the Ct. of Appeals Ct. of Federal Claims decisions are appealed to the Federal Circuit the U.S. Supreme Ct. determines disputes among circuits. This is popular because you do not have to pay until after a decision is made. o Acquiesce in your favor o Nonacquiesce against your favor. Unofficial Tax Materials:  US Tax Reporter compilation of code, regs, and rulings  Tax management portfolio text of opinions (His favorite research tool)  Commerce Clearing House (middle floor of library)  Federal Tax Code. (textual w/ footnotes)  Tax Law Reviews (in Library): NYU - best, UF, & Va IRS General Counsel represents the IRS in tax court. After appeal then Federal Attorney takes.

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Income Tax I

Fall 2002/2005 Used Spring 2007 CHAPTER 2 GROSS INCOME : THE SCOPE OF 61 (PP. 48-68)

Prof Lathrop

A. Introduction to Income: IRC 61(a): flush: defines gross income as all income from whatever source derived, unless otherwise specifically excluded. For tax law purposes, the concept of income encompasses:  Realization requirement, and  Receipt of an economic benefit o Compensation for services; including fees, commissions, fringe benefits, and similar items (this includes ANY economic or financial benefit conferred on an employee as compensation for services); o Gross income derived from a business; o Gains derived from dealings in property; o Interest; o Rents; o Royalties; o Dividends; o Alimony and separate maintenance payments; o Annuities; o Income from discharge of indebtedness; o Distributive share of partnership gross income; o Income in respect of a decedent; and o Income from an interest in an estate or trust. Reg. 1.61-1(a): Gross income includes income realized in any form, whether in money, property, or services. Thus, income may be realized in the form of services, meals, accommodations, stock, or other property, as well as in cash.  Note: loans are NOT income b/c obligation exists to repay the loan, there is no accession of wealth; therefore no income. Reg. 1.61-14(a): In addition to the items listed in 61(a), there are many other types of gross income:  Punitive damages such as treble damages under the antitrust laws, and exemplary damages for fraud. (see Glenshaw Glass)  Another persons payment of the taxpayers income taxes is gross income to the taxpayer, unless excluded by law. (see Old Colony)  Illegal gains (per James v. U.S., still income despite a legal obligation to make restitution unlike true loans, which are not income.)  Treasure trove, to the extent of its monetary value, is gross income for the taxable year in which it is reduced to undisputed possession. (see Cesarini). See also: Reg. 1.61-2-(a)(1): regarding compensation for services (gives some examples); and Reg. 1.61-2(d)(1): regarding compensation paid other than in cash (FMV of services taken in payment for other services are included as compensation.)

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Income Tax I Fall 2002/2005 Used Spring 2007 B. Equivocal Receipt of Financial Benefit: [61, 1.61-1, -2(a)(1), -14(a)] Cesarini v. U.S.: Piano buyers (P) v. Federal Government (D) Nature of Case: Action by taxpayer for a tax refund. Fact Summary: The Cesarinis (P) found $4,467 in cash in a used piano purchased by them.

Prof Lathrop

Concise Rule of Law: Found money is taxable as ordinary income in the year in which the taxpayer attains uncontested possession of it. Facts: The (P) purchased a used piano in 1957. In 1964 they found $4,467 in cash hidden in the piano. This was included as ordinary income in their 1964 tax return. In 1965, the Cesarinis (P) filed for a refund on the grounds that the $4,467 was not ordinary income under 61 of the Code; that the income, if so deemed, should have been filed in 1957 and therefore a claim by the U.S. (D) was barred by the three-year statute of limitations; and that if any tax were assessed it should be a capital gains tax. The IRS (D) denied the refund and the Cesarinis (P) appealed to the district court. Issue: Is found money includable as ordinary income? Holding and Decision: (Young, J.) Yes.  Found money is taxable ordinary income in the year in which the taxpayer obtains undisputed control over it. 61(a) states that all income shall be included in gross income unless specifically excepted.  No exceptions exempt found funds from gross income. Therefore, the $4,467 must be included as gross income under 61(a).  Revenue Ruling 61 (1953) states that treasure trove must be included as income in the year in which it is reduced to undisputed possession.  Here, the money was not reduced to undisputed possession until 1964, when it was found and it was determined that no other claimant existed.  The Cesarinis (P) cannot prevail on the theory that it was a gift, since found money does not fit within the definition of gift.  Finally, the finding of money does not entitle the Cesarinis (P) to capital gains treatment. Denied. Editors Analysis: In many cases, the tax on treasure trove must be delayed for many years due to court battles over the ultimate possession of the trove. It is not necessary that the treasure be reduced to cash. Its appraisal value is deemed to be taxable income, as where a Picasso is found in an attic and is retained. Gifts are not included as ordinary income since they are taxed, if at all, to the giver by application of the gift tax rules, different tax tables. Class Notes: August 21, 2002  Paid money filed for refund and commissioner rejected it.  $836 is amount of tax paid on found money.  What are they fighting here? o says that it doesnt fall under 61 as income; and o should have been taxed in 1957 (check date, theory correct) when piano bought and statute of limitation ran; and Page 4 of 154

Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop o if taxable should have been at Capital Gains. Lower tax rate. L. may be making argument because the sale or exchange was the exchange of money at bank.  SOL o 6501  General rule is 3 years from date you file or if filed early from date due April 15th.  If omit more than 25% of GI then SOL is 6 yrs. y If that faulty it is so erroneous it doesnt give service proper notice.  If you dont file a return at all the SOL never runs.  If you file a fraudulent return the SOL never runs.  What about notion that money found should not be income at all under 61 o Court says that 61(a) flush picks up by broad statement of all income from whatever source derived and if you dont find a specific exemption then you are in trouble. o If no common law exception or statutory exceptions probably income.  What about when found money becomes income? o Taxable year when in your hands with no restrictions. o TP tries to use examples of prizes and awards being excluded and that they are specifically stated as being included so Congress must not have wanted to include found money. Court does not buy this argument.  Problem with this is that service has taken consistent bases in this and Reg. Rule supports.  Court Holds: This stuff is income.  Glen Shaw Glass even talks about this that treasure trove is income. When something is reduced to undisputed possession. o What law do you look at to see if something is undisputed possession. State law. Common law: finder is owner to all the world except true owner.  1964 is the year reduced to undisputed income and the SOL is not an issue. Gross Income The total income earned by an individual or business. Gift A transfer of property to another person that is voluntary and which lacks consideration. Capital Gain and Loss Gain and loss from the Sale or Exchange of a Capital Asset as defined in 1221. The Court held that the money was Gross Income (GI):  Fit in 61 gross income means all income from whatever source derived.  Not excludable in 101 et seq.  6501 limitations o tax will be assessed due w/in 3 years after filed or w/in 3 years after 4/15 if filed early; for amended return SOL is 3 years after filed. o (c)(1): SOL never runs if fraud/intent to evade income taxes. o (e)(1)(A): if TP omits more than 25% from GI, then the SOL is 6 years.  IRS Rev-Rule 61, 1953 is on point finder of treasure trove is in receipt of taxable incomefor taxable year in which it is reduced to undisputed possession. Dougherty does not provide an answer b/c it was decided 2 years b/4 IRS Ruling.  1.61-14(a) treasure trove, to the extent of its value in US currency, constitutes GI for the taxable year in which it is reduced to undisputed possession.  RE: SOL, this is income in 1964, not 1957, b/c 1964 was year that it was reduced to undisputed possession Rev. Rul 61, 1953-1 and 1.61-14(a).  Though no statute specifically deals w/ rights of the true owner versus the finder of treasure trove, CL holds that title belongs to finder as against all the world except the true owner. Page 5 of 154

Income Tax I

Fall 2002/2005 Used Spring 2007

Prof Lathrop

 If you want to exclude from income, find a specific exemption in the code.  Recent article states that Cesarini is the only case that cites treasure trove as income, and argues that cash should be income, but other property should not be. Old Colony Trust Co. v. Commissioner: Company (D) v. Commissioner (P) Nature of Case: Appeal from a finding of tax deficiency. Fact Summary: The Commission (P) sought to tax, as additional income to the employee, the amount of his federal income taxes, which were paid on his behalf by his employer. Concise Rule of Law: The payment by an employer of the income taxes assessed against his employee constitutes additional taxable income to the employee. Facts: The American Woolen Companys board of directors resolved that the company should pay the federal income taxes assessed upon the incomes of certain of its officers including its president, Wood. Woods taxes for the years 1918 and 1919 totaled slightly more than $1,000,000, and were paid by the company. The Commissioner (P) argued that that payment amounted to additional income to Wood and was taxable as income to him. The Board of Tax Appeals upheld the Commissioners (P) position, and this appeal followed. (The status of Old Colony (D) was not explained in the case excerpt.) Issue: Does the payment by an employer of the income taxes assessed against his employee constitute additional taxable income to the employee? Holding and Decision: (Taft, C.J.) Yes.  The payment by an employer of the income taxes assessed against his employee constitutes additional taxable income to the employee.  In this case, the payment of the tax by American Woolen was in consideration of the services rendered by the employee and was a gain derived by Wood from his labor.  The form of payment is irrelevant. The discharge by a third person of an obligation to him is equivalent to receipt by the person taxed.  Further, the taxes were paid upon a valuable consideration, namely, the services rendered by Wood and as part of the consideration for such services.  Nor was the payment of taxes a gift. Even though the payment was entirely voluntary, it was nevertheless compensation. Affirmed. Editors Analysis: The same result was reached in the following cases: (1) United States v. Boston and MainR., 279 U.S. 732 (1929), where the lessee railroad paid the taxes on its lessors income; (2) Ethel S. Amey, 22 T.C. 756 (1954), where a lease provided that the lessee, in addition to paying rent directly to the lessor, should make mortgage payments on the property; and (3) Sachs v. Commissioner, 277 F.2d 879 (8th Cir. 1960), where a corporation paid fines levied on its president. In Rev. Rule, 68-507, 1968-z C.B. 485, the IRS held that payments made to a minister by his church in order to help him pay his self-employment tax were taxable income to him. Class Notes: August 21, 2002.  What tax years are involved? 1919 & 1920 year in which these items became income to individual.  Court holds income. Page 6 of 154

Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop  Theory: Real reason this is income is submerged in notion of employer/employee relationship. Goes to the character of the income. What kind of income? Economics of this is $600,000 money in TP pocket by employer paying the taxes.  Discharge by 3rd person of obligation gives rise to income. Frees up assets of TP.  Was it a gift? No. Very seldom any payment from employer to employee will be gift.  Gross Income The total income earned by an individual or business.  Gift A transfer of property to another person that is voluntary and which lacks consideration.  Debt An obligation incurred by a person who promises to render payment or compensation to another.  Note: 104(a) excludes settlements for Personal Injuries and one case excludes attorneys fees. Commissioner v. Glenshaw Glass: Commissioner (D) v. Primitive damages awardee (P) NATURE OF CASE: Appeal from determination of tax deficiency. FACT SUMMARY: Glenshaw Glass Co. (P) recovered compensatory and punitive damages as a result of a fraud and antitrust suit. It did not report the punitive damages as income and the IRS (D) assessed a deficiency. CONCISE RULE OF LAW: The general definition of gross income includes all amounts recovered as the result of a lawsuit that represent an increase in wealth to the recipient and not merely compensation for noncontractual losses. FACTS: Two cases representing identical issues of law were consolidated for review. Glenshaw Glass Co. (P) sued a supplier for fraud and antitrust violations seeking compensatory damages and exemplary damages for fraud and treble damages for the antitrust violations. A settlement was reached whereby Glenshaw (P) received $800,000 of which $325,000 represented punitive damages. William Goldman Theatres Inc. (P) sued another corporation for anti-trust violations and was awarded $375,000, representing treble damages of the sustained loss of $125,000. Glenshaw (P) did not report the $325,000 of punitive damages as income and Goldman (P) did not report the $250,000 punitive damages. The IRS (D) assessed tax deficiencies in both instances, contending that the punitive damages constituted gross income as defined by 22(a). The Tax Court and appellate court found in favor of the companies (P), and the Supreme Court granted review. ISSUE: Does the general definition of gross income include all amounts recovered as the result of a lawsuit that represent an increase in wealth to the recipient rather than compensation for non-contractual losses? HOLDING AND DECISION: (Warren, C.J.) Yes.  Section 22(a), the general definition of gross income, concludes by including in gross income gains or profits and income derived from any source whatever  This broad language has consistently been given broad application by this Court.  Both companies (P) concede that the amounts recovered that represent lost profits are taxable as income.  But the amounts recovered as punitive damages clearly represent an increase in wealth.  If contract damage awards are taxable, it would make no sense to exclude from taxation those amounts recovered which do not represent compensation for losses but are accessions to wealth. As such they are subject to tax. Reversed. Page 7 of 154

Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop EDITORS ANALYSIS: Personal injury lawsuit recoveries are not subject to tax on the theory that they are roughly analogous to a return of capital and do not represent an increase in wealth to the recipient but rather a compensation or restoration of a loss. Contractual damage recoveries are taxable since they represent reimbursement for amounts that would have been taxable had they been received as provided for by the contract. Class Notes: August 21, 2002  22 complements 61 code.  Dealing with same language of from whatever source derived.  Court says that if you have to include compensatory damages that represent lost profits why would you not have to include punitive damages that represent a windfall.  After Glen Shaw Glass says 61 language is real broad picks up everything unless exception. GROSS INCOME: The total income earned by an individual or business. DEFICIENCY JUDGMENT: A judgment against a mortgagor for the difference between the amount obtained at a foreclosure sale and the amount of the mortgage debt that is due. PUNITIVE DAMAGE PURCHASE MONEY MORTGAGE: A mortgage or other security in property taken in order to ensure the performance of a duty undertaken pursuant to the purchase of such property.  61(a)(then 22(a)) GI includes income form whatever source derived.  These are instances of undeniable accessions of wealth, clearly realized, and over which the TP has complete dominion. Charley v. Commissioner: Frequent Flyer (P) v. Commissioner (D) NATURE OF CASE: Appeal from tax court determination of a deficiency. FACT SUMMARY: The Charleys (P) challenged the tax courts determination that travel credits accumulated by Philip Charley (P) in the course of his employment with Truesdail Laboratories constituted gross income subject to taxation. FACTS: Philip Charley (P) was President of Truesdail Laboratories, in which he and his wife, Katherine (P), owned 50.255% of the stock. Charley (P), in his capacity as employee, traveled to various accident sites in order to inspect allegedly defective machinery. Truesdail permitted its employees to retain any frequent flyer miles they accumulated in traveling on behalf of the company. Truesdail would bill the clients for first-class airfare, then Charley (P) would instruct the travel agent, Archer, to reserve a coach seat for himself. Charley (P) then utilized his personal frequent flyer miles in order to upgrade to first class, and directed Archer to transfer the credit balance into his personal account. In 1988, Charley (P) accumulated $3,149.93 of credit in his account. The tax court held this constituted taxable income to Charley (P), and charged him with a deficiency of $926. ISSUE: Do travel credits accumulated and retained by an employee in the course of his employment constitute gross income subject to taxation? HOLDING AND DECISION: (OScannlain, J.) Yes. Travel credits accumulated and retained by an employee in the course of his employment constitute gross income subject to taxation.  Gross income is defined in Internal Revenue Code 61 as all income from whatever source derived. Page 8 of 154

Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop  In the present case, the travel credits constitute taxable income under two separate theories. o First, the travel credits constitute additional compensation to Charley (P) by Truesdail. Truesdail paid for the first-class ticket, and permitted Charley (P) to utilize his frequent flyer miles and retain the difference between the first class and coach airfares. o Second, assuming Charley (P) utilized his personal frequent flyer miles for the upgrade, the gain derived from the transaction constituted taxable income as a result of Charleys (P) dealing in property.  The appropriate income subject to taxation in this case is the difference between the amount gained from the transaction and the propertys adjusted basis.  The adjusted basis of the frequent flyer miles was zero, and the total gain from the transaction was $3,149.93.  Thus, under either theory the transaction resulted in taxable income to the Charleys (P) in the amount of $3,149.93. Affirmed. EDITORS ANALYSIS: Note that the Tax Code does not provide a general definition of income. Gross income is defined as including all income obtained by the taxpayer in the form of cash or property. Gross income also includes all realized receipts of assets. In order for the asset to be realized, it must be sufficiently definite and identifiable. GROSS INCOME: The total income earned by an individual or business. REALIZED ASSET: The incurring of a change in value as the result of an event with respect to an asset or activity, which is substantial enough to affect a persons tax liability by materially changing their economic circumstances. DEFICIENCY JUDGMENT: A judgment against a mortgagor for the difference between the amount obtained at a foreclosure sale and the amount of the mortgage debt that is due.  Applied Glenshaw Glass definition of GI and said that since the TP was wealthier after the transaction than he was before, then he received income. Also, could view this as additional compensation or gains derived from dealings in property (selling the frequent flyer miles.)  James case referred to: illegal gain is income despite legal obligation to make restitution.  Income Tax of 1913, limited income to that derived from any lawful business; in 1916 lawful was deleted. The obvious intent of Congress was to tax income from both legal and illegal sources.  1.61-14: illegal gains constitute GI.  1.162-18(b): no deductions for illegal payments. PROBLEMS: (P. 65) 1. Would the results to the taxpayers in the Cesarini case be different if, instead of discovering $4,467 in old currency in the piano, they discovered that the piano, a Steinway, was the first Steinway piano ever built and it is worth $500,000? NO current tax liability under 61(a)(3). There has been no conversion to money yet, so no income has been realized. When they sell the piano, they will have income to report because they now have an accession to wealth, clearly realized, and in their possession.

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Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop 2. Winner attends the opening of a new department store. All persons attending are given free raffle tickets for a digital watch worth $200. Disregarding any possible application of I.R.C. 74, must Winner include anything within gross income when she wins the watch in the raffle?

This was not a gift because the raffle ticket was given to Winner as consideration for coming into the store. Therefore, this is income under Glenshaw Glass definition because she has an increase in wealth, realized, and in her possession (it is an undeniable accession to wealth.) However, when she sells the watch, she will not be taxed again on the gain.

3. Employee has worked for Employers incorporated business for several years at a salary of $40,000 per year. Another company is attempting to hire Employee but Employer persuades Employee to agree to stay for at least two more years by giving Employee 2% of the companys stock, which is worth $20,000, and by buying Employees spouse a new car worth $15,000. How much income does Employee realize from these transactions? Employee received $35,000 in income because both the stock and the car were compensation for services rendered by the Employee. a. All of it ($75,000 for full year compensation) is income under 61(a)(1) compensation for services, including fees, commissions, fringe benefits, and similar items. b. Under Glenshaw Glass they are undeniable accessions to wealth. c. Under Old Colony Trust the car to spouse is income because of Employees relationship with Employer. 4. Insurance Adjuster refers clients to an auto repair firm that gives Adjuster a kickback of 10% of billings on all referrals. a. Does Adjuster have gross income? Yes, Compensation for services under 61(a)(1).

b. Even if the arrangement violates local law? Yes. Illegal gains are taxable per James. 1.61-14illegal gains constitute gross income (auth repair firm cannot deduct per 1.162-18(b)no deductions for illegal payments.)

5. Owner agrees to rent Tenant her lake house for the summer for $4,000. a. How much income does Owner realize if she agrees to charge only $1,000 if Tenant makes $3,000 worth of improvements to the house? Owner would include $4,000 as income. 1.61-8(c): if lessee places improvements on real estate which constituteas substitute for rent, (then it is) income to lessor.  The $3,000 agreement is part of the rental deal, so 109, which specifically excludes improvements made by lessee from income, doesnt apply; therefore, everything is income.

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Income Tax I

Fall 2002/2005 Used Spring 2007 Prof Lathrop  109 and 1019 only apply when not part of the rental deal. If the deal is $4,000, including the $1,000 and the $3,000 improvements, you need to increase the basis immediately; but if the deal is $4,000 in cash, then the basis doesnt increase.

b. Is there a difference in result to Owner in (a), above, if Tenant effects exactly the same improvements but does all the labor himself and incurs a total cost of only $500? No, Owner still has $4,000 of income because he still received $3,000 worth of improvements. c. Are there any tax consequences to Tenant in part (b), above? 1.61-2(d)(1)if services are paid in exchange for other services, the FMV of such other services taken in payment must be included in income as compensation. Lessee gets no deduction for the $500, but can claim $2,500 because he discharged his debt. 6. Flyer receives frequent flyer mileage credits in the following situations. Does Flyer have gross income? a. Flyer receives the mileage credits as a part of a purchase of ticket for a personal trip. The credits are assignable. Flyer hasnt done anything but buy the ticket; he hasnt disposed of or used the credits, so he hasnt realized any income. The credits were simply part of the ticket that he bought. Plus, the tickets are for personal use, not because of an Employee-Employer relationship value. The real issue is when he uses them, then value can be determined (like Cesarini piano) and then basis is important.

b. Flyer receives credits from Employer for business flights Flyer takes for Employer. The credits are assignable. The fact that the credits are assignable means that they have value; and therefore, the credits are income because they were payment for services rendered (or additional compensation.) This is a form of compensation, but the problem is in determining the value.

c. Flyer receives the credits under the circumstances of (b), above, but they are nonassignable? No income. The credits are worthless. Credits have a $0 basis and he cant sell them. d. Same as (c), above, except Flyer uses the nonassignable Employer provided credits to take a trip? Credits still have $0 basis and he cant sell them. But the problem with this is that they had value for Flyer because he used them. This is a sticky situation with tax law today and will probably change. Probably income, but the problem is determining the basis. (There are arguments that frequent flyer miles are a fringe benefit, but that they are de minimis; thus excluded/not taxable.) **Note** During this semester Lathrop informs us that the IRS has ruled that it will not be pursuing frequent flyer miles as income. Page 11 of 154

Income Tax I

Fall 2002/2005 Used Spring 2007

Prof Lathrop

C. Income Without Receipt of Cash or Property: [61, 1.61-2(a)(1), -2(D)(i)] Helvering v. Independent Life Insurance Co.: IRS (D) v. Insurance company (P)  The rental value of buildings used by their owners is not taxable income. There is no income tax on the value of property you already own, so it is taxed as property (would be direct tax under the 16th amendment.) Cant lay direct tax w/o apportionment.  Owner of real estate has NO GI when he uses property for his own business.  An income tax imposed on imputed income (monetary value of using property which someone owns) would be difficult for taxpayers to comply with, and difficult for the IRS to enforce. Thus, imputed income is not included in the concept of income within the U.S. income tax system.

Revenue Ruling 79-24: Housepainter and Lawyer switched services. Individual Lawyer owned apt. rented for free in exchange work of art. FMV of work of art and 6 months fair rental value of apartment should be included in income.  When services are paid for other than in cash, the GI to the recipient is the FMV of that property or service. In other words, you dont have to have a cash flow to have income, swaps count.  Where the tax is at arms length, the presumption is that it is an even exchange; the expense could be a business deduction.  Take into income value of services received. Dean v. Commissioner: Shareholder (D) v. Commissioner (P) NATURE OF CASE: Appeal from assessment of tax deficiency. FACT SUMMARY: Dean (D) and his wife were the sole shareholders of a corporation that held title to their family residence, which they occupied without paying any rent to such corporation. CONCISE RULE OF LAW: The fair rental value of premises occupied by taxpayer without payment of rent constitutes income, which must be included in such taxpayers gross income. FACTS: Dean (D) and his wife were the sole shareholders of the Nemours Corporation. They occupied a residence which had been owned by Mrs. Dean (D) prior to her marriage. The residence was transferred to the Nemours Corporation to secure a bank loan to the corporation. The Deans (D) continued to occupy the house, but paid no rental to Nemours Corp. The Commissioner (P) sought to include the fair rental value of the residence as part of Deans (D) gross income and the Tax Court so ruled. Dean (D) appealed. ISSUE: Does the fair rental value of premises occupied by a taxpayer without payment of rent constitute income which must be included in such taxpayers gross income? HOLDING AND DECISION: (Goodrich, J.) Yes. The fair rental value of premises occupied by a taxpayer without payment of rent constitutes income which must be included in such taxpayers gross income.

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Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop  It was Deans (D) legal obligation to provide a family home, and if he did it by the occupancy of a property, which was held in the name of a corporation of which he was president, the fair value of that occupancy was income to him. Affirmed. EDITORS ANALYSIS: While the value of the free use of real property is deemed to be income, the value of interest-free loans is not taxed. Though it is difficult to draw a distinction between the two situation, importance is placed on the fact that the Commissioner has thus far declined to tax the value of interest-free loans while, since Dean, fair rental value has been taxed. Still, no tax on fair rental value was levied for the 48 years between the inception of the tax and the Dean decision. FAIR MARKET VALUE: The price of particular property or goods that a buyer would offer and a seller would accept in the open market, following full disclosure.  The Deans owned Nemours (Dupont). Because of some problem, the bank insisted that the house they owned be placed in the corporations assets. Even though the Deans continued to live there, they did not pay rent.  The Deans had an economic benefit under Glenshaw Glass. As shareholders, this free rent could be a dividend.  As owners of the corporation they had an employer-employee relationship and free rent could be compensation.  This decision was based on his legal obligation to provide a home to his family; and thus, when the corporation gave him free rent, they discharged his debt per Old Colony; the value is FMV. PROBLEMS: (P. 68) 1. Vegy grows vegetables in her garden. Does Vegy have gross income when: a. Vegy harvests her crop? No, because no income has been realized (no accession of wealth) b. Vegy and her family consume $100 worth of vegetables? No, because she made no money. c. Vegy sells vegetables for $100? Yes, she has realized income. 61(a). (She might be able to deduct costs.) d. Vegy exchanges $100 worth of vegetables with Charlie for $100 worth of tuna which Charlie caught? Yes, she traded vegetables for tuna, so she received compensation paid other than in cash. See Reg. 1.61(d)(1). FMV of property taken in payment must be included in gross income. Rev. Rule value of what received on the swap. e. Vegy agrees with Grocer to sell her vegetables in Grocers market which previously did not have a vegetable section. Grocer pays $50 per month to landlord for the portion of the market used by Vegy but Grocer does not charge Vegy any rent. Vegy keeps all proceeds from her sales? Vegy has income. Of course, any proceeds that she receives, but also the $50, which would be her rent. She is staying there rent-free and is receiving that benefit. See Dean. Page 13 of 154

Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop 1.61-2(d)(1): income if services paid in property, in services exchanged, or services rendered. 2. Doctor needs to have his income tax return prepared. Lawyer would like a general physical check up. Doctor would normally charge $200 for the physical and Lawyer would normally charge $200 for the income tax return preparation. a. What tax consequences to each if they simply swap services without any money changing hands? Both have income of $200. See 1.61-2(d)(1). If services are paid for in exchange for other services, the FMV of such services taken in payment must be included in gross income as compensation. Rule 79-24 1979 (1) applies 1.61-2(d)(1): income if services paid in property, in services exchanged or services rendered. b. Does Lawyer realize any income when she fills out her own tax return? NO, fruits of own labor. (a) (b) (c) (d) (e) (f) (g)

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Fall 2002/2005 Used Spring 2007 CHAPTER 3 The Exclusion of Gifts and Inheritances (P. 69-91)

Prof Lathrop

A. Rules of Inclusion and Exclusion: [102(a) & (b) 1st sentence, 1.102-1(a) & (b)] GI includes the receipt of any financial benefit which is (GI checklist):  Not a mere return on capital, and  Not accompanied by a contemporaneously acknowledged obligation to repay, and  Not excluded by a specific statutory provision. 101 to 137 provide specific exclusions from GI (always cite exclusion to justify it) 71 to 90 provide specific items that are includible in GI (61 echoes this)  102(a) says that GI does not include the value of property acquired by gift, bequest, devise, or inheritance. 102(b) makes sure that this exclusion DOES NOT exclude the income from any property referred to in (a).  102 does NOT apply to prizes and awards, including employee achievement awards (74); certain de minimis fringe benefits (132); employee gifts (102(c)); qualified scholarships (117). Therefore, these things are included in GI. B. Gifts 1. THE INCOME TAX MEANING OF GIFT: [102(a)] 102(a):  GI does not include the value of property acquired by gift, devise, or inheritance.  An individual can make a $10,000 gift per donee per year to avoid tax by both donee and donor and to reduce the inheritance tax payable when assets pass at death (1,000,000 can be passed w/o inheritance tax); a married couple can make $22,000 ($11,000/each) gifts per donee per year.  An individual making a gift larger than $10,000 has to pay a gift tax. The recipient has no gift tax no matter how large the gift as long as it meets the definition of a gift. 102(b):  Income generated by gift is not excludible from GI. Commissioner v. Duberstein: (2 cases were consolidated to determine whether a specific transfer to a taxpayer was a gift). Taxpayers (P) v. Federal government (D) NATURE OF CASE: Actions to determine deficiencies in payment of income taxes. FACT SUMMARY: Taxpayer Duberstein (P) received a Cadillac in return for providing a business associate with some favorable business leads. Taxpayer Stanton (P) received $20,000 upon his retirement from a Church Corporation. CONCISE RULE OF LAW: In order to be a gift under 102, amounts received must have been given with a detached and disinterested generosity. FACTS: Duberstein (P), through his company, had conducted business dealings with Berman, the president of another corporation. Duberstein (P) provided Berman with some business leads which proved so beneficial that Berman offered Duberstein (P) a Cadillac. Although Duberstein (P) already had two cars and stated that he did Page 15 of 154

Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop not intend to be compensated for the information, Berman insisted that he accept the car. Bermans company later deducted the value of the car as a business expense. Stanton (P) had for ten years been the comptroller of a Church Corporation, and was receiving $22,500 salary when he resigned from his position. Upon his resignation, the corporations board of directors passed a resolution granting Stanton (P) $20,000 in appreciation of the services rendered by Stanton (P) for the company. There was conflicting evidence as to whether Stanton (P) received the money because of his services and because he was well-liked or because he was forced to retire after having intervened on behalf of a discharged employee of the Church. ISSUE: In order to be a gift under 102, must the amounts received be given with a detached and disinterested generosity? HOLDING AND DECISION: (Brennan, J.) Yes. In order to be a gift under 102, amounts received must have been given with detached and disinterested generosity.  The car received by Duberstein (P) is taxable income; the decision in Stanton is reversed because the factual findings did not show the legal standards used by the courts below.  The governments (D) proposed definition of a gift (all transfers of property made for personal and not business reasons) is rejected on the grounds that such a definition is too concise and not suitable for all the factual situations which may arise.  A gift is not shown by the mere absence of a legal or moral duty to make a payment, or from a lack of economic incentive; where the payments are made as compensation for services, it is irrelevant whether the donor receives any economic benefit from making the payments.  As a general rule, a gift will be found where it proceeds from a detached and disinterested generosity, out of affection, respect, admiration, charity, or like impulses, and it is the donors intention which is controlling as to those factors.  In determining the donors intention, one must look at the facts surrounding the transfer of property, as was stated in Bogardus v. Commissioner, 302 U.S. 34.  Since the determination of whether a payment is a gift is so closely connected to the facts of each case, an appellate court must be limited in its review of those facts.  Based on these principles, the trier of fact was justified in finding that Duberstein (P) had received the car not as a gift, but as compensation for services. As to Stanton, the conclusion reached by the Tax Court cannot be supported by the record, and the case is remanded for further factual determinations. CONCURRENCE: (Whittaker, J.) The determination of a gift is a mixed question of law and fact. DISSENT: (Douglas, J.) A gift should be found. DISSENT: (Frankfurter, J.) The Court should have adopted the governments (D) test, and held that there was a presumption against a beneficiary who receives payments related to services performed. EDITORS ANALYSIS: Following the Duberstein decision, lower federal courts have been reluctant to review factual determinations which are not clearly erroneous. In restricting the power of appellate courts to review factual determinations, the Court does not fashion a test that would allow a trier of fact any guidelines to follow, and which could be a basis of review. By rejecting the Governments (D) test that gifts should be limited to personal, non-business transactions, the Court leaves open the possibility that some gifts might be made even if part of an employer-employee relationship. However, any gifts which are made by a business can only be deducted up to $25, as provided in 274(b). Thus, should a business seek to deduct more than that, it must show that the payment was made for valid business reasons, and is thus deductible under 162. Of course, a showing that the dominant motive for payment was business would necessarily tend to negate a showing of a gift by the recipient of such payment. Class Notes: Page 16 of 154

Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop  Government wants a test that nothing can be a gift given in a business setting. Court does not adopt.  Government really got its way adopted in 102(c) but not in this court.  Happens all the time, Congress adopted what the court was unwilling to hold.  Cannot have any Quid Pro Quo, not a gift if anything in return.  Just b/c it was deducted as a business expense does not mean that it was a gift.  Long and short of it is that disinterested generosity and no quid pro quo, if so you are in trouble and not a gift.  Problem is that it is factual driven and what happens in trial is not going to be overturned on appeal.  Court here agrees with trial court.  This was not a gift it was a quid pro quo.  Now prohibited gifts to employees b/c of 102(c)  What happened in Stanton (2nd case) o Remanded back for more factual finding based upon this ruling. GIFT: A transfer of property to another person that is voluntary and which lacks consideration. GROSS INCOME: The total income earned by an individual or business.  In order to be a gift under 102(a), amounts received must have been given with detached and disinterested generosity out of affection, respect, admiration, charity, or like impulses. Also, transferors intention must have been completely objective. o The holding in this case was that the car was not a gift. o A gift is not given:  As part of some moral or legal duty;  As an incentive of anticipated benefit of an economic nature; and  In return for services rendered, whether economic benefit is derived or not. o For it to be a gift, there must be absolutely NO QUID PRO QUO. You cant expect or get anything back from the transaction. Here, despite the characterization of the transfer of the car as a gift and the absence of any obligation, even of a moral nature, exchange of the car was in recompense for past services, or an inducement for help in the future. o Note: In any gift situation, ALWAYS go back to Duberstein to find disinterested generosity. o Gift proceeds from a detached and disinterested generosity out of affection, respect, admiration, charity, or like impulses. A donors intent is critical, but his characterization is not determinative. o Duberstein says to decide whether it is a gift on a case-by-case basis; Stanton is unusual because a Dist. Ct. rarely overturns a Tax Ct., and a Appellate Ct. rarely overturns a Dist Ct.; thus, the decision at lower level is based on facts and is critical.  In this area, the law (102(a)) is simple and concise. The facts give rise to the complexity, and cases such as these are generally won or lost at the trial level. (A trial court is also to look at intent of transferor.)

1. Our system of self-assessment requires the taxpayer to make the initial determination of gift or income, and tax administration procedures give the Commissioner the power to challenge that decision. If a judicial controversy develops, why is the decision of the trial court so important, and what role may the appellate court play? Whether it is a gift or not is an issue of fact to be determined by the trial court. Appellate courts are able to review this finding. Page 17 of 154

Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop 2. EMPLOYEE GIFTS: [102(c); 274(b); see 74(c); 132(e); 274(j); 1.102-1(f)]  102(c): (a) shall not exclude from GI any amount transferred by or for an employer to, or for the benefit of, an employee. (This rule is a result of a 9th Circuit NASA case where the Ct. held that a lifetime award to an employee was a gift.)  This section specifically requires an employer-employee relationship (so wouldnt apply to Duberstein.)  Generally, there are no gifts from employer to employee.  102 is problematic whenever the exchange has business overtones. Gifts are rarely found in business relationships. 99% of gifts from an employer have a quid pro quo; they are rarely given for another reason.  Most courts say that when a husband is killed on the job and the employer pays the widow his death benefits, then this payment is additional income.  74 Prizes GI includes prizes (except prizes to charities and certain employee achievement awards.) [74(c) certain employee achievement awards are freed from tax.]  132(e) GI does not include de minimis fringe benefits. (Certain traditional retirement gifts are treated as de minimis fringe benefits.) **LOW VALUE**  274(b)(1) generally limits the deductible amount of business gifts to $25 per donee per year, but it defines the term gift, with minor exceptions, as items excludable from the recipients gross income under 102(c). As employee gifts now are includible in gross income under 102(c), they are not subject to the 274(b)(1) ceiling. PROBLEMS: (P. 82) 1. Employer gives all of her employees, except her son, a black and white television set at Christmas, worth $100. She gives Son, who also is an employee, a color television set, worth $500. Does the Son have gross income? No question about the other employees b/c 102(c) says these are not gifts. What about the son? What do you have to do in 102(c)? Figure out if you have just an employer/ee relationship. Here you have Son. To the extent the TV is to extent of other employees probably kicked out but could exclude 100 because of 102(a). The best argument may be that the son has $100 GI and $400 gift. According to statute, Son should have to include $100 as GI under 102(c) because he is an employee, and exclude $400 as gift under 102(a). But Son could argue no income because Reg. 1.102-1(f)(2) says that 102(c) shall not apply to amounts transferred between related parties if the purpose of the transfer can be substantially attributed to the familial relationship of the parties and not to circumstances of their employment. Was Son in different class than the other employees, which supports the $500 GI in recognition of employment, or did son get more because of family relationship (supports disinterested generosity)? It may be hard to argue that the mother had no interest in sons material possessions. What arguments could the employer make for treating the son differently to characterize this as a gift, thus helping him to avoid tax liability? Reg. 1.102-1(f)(2) proposed regulation 102(c) does not apply to transfers between related parties if substantially attributed to familial relationship. 2. At the Heads Eye Casino in Vegas, Lucky Louie gives the maitre d a $50 tip to assure a good table, and gives the croupier a $50 toke after a good night with the cubes. Does either the maitre d or the croupier have gross income? Page 18 of 154

Income Tax I

Fall 2002/2005 Used Spring 2007 Prof Lathrop Yes, they are in the businesstips are income (1.61-2.) Both tips and tokes are GI. Not done out of disinterested generosity but out of standard business practices. As soon as you start getting away from 100% disinterested generosity you are getting away from gift. 3. The congregation for whom Reverend serves as a minister gives her a check for $5,000 on her retirement. Does Reverend have gross income?

Is the relationship between Reverend and the congregation an employer/employee relationship? Probably not. Therefore no GI. If his transaction doesnt fit within 102(c), go to 102(a) and Duberstein. Was this money given out of disinterested generosity? Good chance that this was a gift. But marriage fees and other compensation received by clergy is income under 1.61-2. Therefore, is this compensation for past service or not, even though no moral or legal obligation to pay under Old Colony. Schall held that $20,000 from congregation was a gift. The results would be different for a large church run like a business.

4. Retiree receives a $5,000 trip on his retirement. To pay for the cost of the trip, Employer contributed $2,000, and fellow employees of Retiree contributed $3,000. Does Retiree have gross income? Yes, there is GI with the $2,000 under 102(c). No, there is not GI with the $3,000 under 102(a) and Duberstein test. This is because the fellow employees made the contribution under detached and disinterested generosity out of affection, respect, admiration, charity or like impulses.  Goodwin held that an anonymous collection by an assistant pastor was GI because it was regularly done (regular and continuous payments), the congregation knew if they didnt collect this money then the pastor would leave; the pastor comes to expect it.  Is the pastor an independent contractor to the employee? United Methodist ministers are employees, but they are free to do weddings and funerals. Law clerk is an employee because the employer provided clients, work space, paper, and withheld taxes, which are indicia of employees.  Payments to widows are GI because there is no disinterested generosity. The exception is Pierpont, where the employer knew she was destitute and spent her last dollar on her husbands illness. Class Notes: August 26, 2002  Remember court looks for Duberstien: Disinterested generosity for finding gift.  If you have employer/ee you are stuck but if you can get around then you go to 102(a) for the Duberstien test.  Case out of Iowa, Guy pastor in 87,88 & 89 congregation through one of the officers contributed 12,000, 13,000, & 15,000 on separate occasions. Court treated as compensation. When you see a pattern it looks like it is part of the compensation package and pastor thinks he is going to be getting it each year. L. Doesnt think he was an employee of the congregation so not a 102(c) problem.  Same area one minister was treated as an independent contractor he could take certain deductions but no one told him what to do. Lawyers are independent contractors to clients.  Who cares if you are an employee is the employer b/c they have to pay employment taxes in amount of social security tax of 7.5% of income. I/C pays self-employment tax. Page 19 of 154

Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop  Now if you are not an employee when transfer look for past services or something, it still takes you out of 102(a).  Rev. Rule where law clerk was an employee and not I/C. The firm supplies the office, supplies, etc. you are an employee. Must take out the withholding taxes.  Other side of 102 is inheritance, bequest, and devises. C. Bequests, Devises, and Inheritances: [102(a), (b) 1st sentence, (c); 1.102-1(a), (b)] Class Notes: August 26, 2002  Can exclude from income without limit.  1015 is a non-recognition when gift the donee takes the basis of donor.  In Bequest, inheritance, is opposite it wipes out the gain that has accrued in the hands of the decedent and you take a stepped up basis at FMV at time of death, this is a true exclusion.  Serious estate planning tool.  Look at two cases whether 102(a) applies. Lyeth v. Hoey: Heir (P) v. IRS (D) NATURE OF CASE: Appeal from a deficiency tax assessment. FACT SUMMARY: contested. Lyeth (P) received money under a compromise when his grandmothers will was

CONCISE RULE OF LAW: Money received from the compromise of a will contest is received through inheritance and is exempt from income tax. FACTS: Lyeths (P) grandmother died leaving the bulk of her estate to a church. Lyeth (P) and her other heirs contested the will, alleging undue influence. A compromise was reached whereby the estate was split between the church and the heirs. The IRS (D) assessed a tax against Lyeth (P) contending that the money had been received by contract rather than by inheritance. A construction of state law supported this viewpoint. The district court found for Lyeth (P), but was reversed by the court of appeals. ISSUE: Are funds received through the compromise of rights under a will contest income under the tax laws? HOLDING AND DECISION: (Hughes, C.J.) No. Money received from the compromise of a will contest is received through inheritance and is exempt from income tax.  Lyeth (P) was one of his grandmothers heirs.  Any money or rights he had were due to his heirship.  As an heir he had the right to take under the will or to contest it.  Lyeth (P) chose the latter course.  The money received by him was for the release of his rights as an heir.  Under these circumstances, it was as though Lyeth (P) received the money through intestate succession.  The tax laws in this area should be uniformly applied.  Congress did not intend that the state law should mandate a different result between the states.  For tax purposes, state law on the nature of a taking in a will contest is not controlling.  An estate tax is applied regardless of the will contest.  When an heir compromises his claim, the funds received are not income.  They are excluded under 102 of the Revenue Act of 1932 as funds received through inheritance. Reversed. Page 20 of 154

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Prof Lathrop

EDITORS ANALYSIS: In Burnet v. Harmel, 278 U.S. 103, the Court stated that it was Congress announced intention to give a uniform nationwide expression to the tax laws unless a contrary intention is demonstrated. The imposition of a tax or the allowance of an exemption should not be dependent on state law. Property received by bequest, devise, or intestacy does not yield taxable income on acquisition. If the property appreciates subsequently, a sale or other disposition of the property will produce taxable gain. Class Notes: August 26, 2002  Enter into settlement agreement and TP gets paid 141,000 by way of inheritance.  DC enters judgment in favor of TP  Appeals reversed.  What did the SC say that the appellate court did not do properly? o Applied Mass. Rule for Mass. Inheritance tax to a Fed. Tax question. Must look at intent of Congress to determine under Fed. Law. o Mass. Rule does tell you when and who has a right to testamentary dispostion of an heir to take or contest or has standing to take.  Court says Congress intended that by the words of not only inheritance in 102(a) but also the words of bequest and devise means a broad interpretation. o Only reason there was a compromise was because he was an heir. o Dont be so picky.  Good enough under 102(a) and is excluded.  If they would have went to a jury trial the government would have never went after them but they went through a compromise agreement.  What is another way of stating Appellate court ruling is that he took by compromise agreement which is really a contract. o Hints to what we will cover in Wolder Case.

BEQUEST: A transfer of property that is accomplished by means of a testamentary instrument. GAIN: Refers to situation where Amount Realized exceeds the Basis of an asset.  While state law can establish certain probate rights, it cannot establish definitions to federal tax issues. State law determines whether a party has standing as heir; tax law decides whether it is GI or gift.  Money received in compromise of right under a will is an inheritance (because TP obtained his standing as an heir.) Wolder v. Commissioner: Attorney (D) v. Commissioner (P) NATURE OF CASE: Appeal from a determination of tax liability. FACT SUMMARY: Wolder (D), an attorney, contracted with a client to receive upon her death her securities by bequest in exchange for his providing her with free lifetime legal services. CONCISE RULE OF LAW: Where a bequest is made by contract to satisfy an obligation, its receipt is income, taxable under 61 of the Internal Revenue Code of 1954, and not excludable under 102.

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Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop FACTS: Wolder (D), an attorney, contracted with a client, Mrs. Boyce, to provide her with free legal services for the rest of her life in exchange for her leaving to him, by bequest in her will, her securities. Upon Mrs. Boyces death, Wolder (D) received $15,845 from redeemed convertible preferred shares of Schering Laboratories stock and 750 shares of Schering common stock. Wolder (D) argued that the bequest was specifically excluded from income under 102(A), which provides that gross income does not include the value of property acquired by gift, bequest, devise or inheritance. Wolder (D) appealed an adverse judgment of the Tax Court. ISSUE: Where a bequest is made to satisfy an obligation under a contract, is its receipt income taxable under 61? HOLDING AND DECISION: (Oakes, J.) Yes. Where a bequest is made by contract to satisfy an obligation, its receipt is income, taxable under 61, and not excludable under 102.  Wolder (D) and his client contracted for services, and while limited in nature, those services were actually rendered.  In effect, the contract was for postponed payment of legal services.  A transfer in the form of a bequest was the method that the parties chose to compensate Mr. Wolder (D) for his legal services, and the transfer is therefore subject to taxation, whatever its label by federal or by local law may be. Affirmed. EDITORS ANALYSIS: In United States v. Merriam, 263 U.S. 179 (1923), upon which Wolder (D) relied unsuccessfully, a will stated that the executors were to receive gifts as stated in the will in lieu of any fees they would otherwise receive as executors. The court said that the test was whether the executors-legatees had to perform the services in order to earn their bequests and not whether the testator gave the legacies for services. Under that test, the legacies were found not to be taxable income, the Court finding the condition an expression of the testators intent that the executors not receive statutory compensation for the services they may have rendered. BEQUEST: A transfer of property that is accomplished by means of a testamentary instrument. INCOME: The earning of money, received in a way that benefits the economic situation of a taxpayer, of which a portion may be subject to income tax liability. LEGACY: A disposition of real or personal property in the form of a gift, as stipulated in a doctors will.  Whether a payment is a gift (bequest) or compensation (GI) depends on the intentions of the parties using the Duberstein intention test. o The transfer in the form of a bequest was the method the parties chose to compensate the lawyer for legal services. o Distinguish Merriam, where bequest and payment are tied together, but some intent to be gift testators cash bequests in lieu of compensation was a gift because executors had no obligation to perform specific services but only to make good faith effort to be executors. Class Notes: August 26, 2002  This is a payment of a debt and a claim against the estate.  Ultimately estate paid.  Dont have any Duberstien indications at all in this case. Clearly based upon Contract and 102 does not apply, it is not taking pursuant to a will but taking pursuant to a contract. PROBLEMS: (P. 91) Page 22 of 154

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Fall 2002/2005 Used Spring 2007

Prof Lathrop

1. Consider whether it is likely that 102 applies in the following circumstances: a. Father leaves Daughter $20,000 in his will. Yes, 102(a) applies-inheritance. $20,000 excluded from Daughters income. b. Father dies intestate and Daughter receives $20,000 worth of real estate as heir. Still under inheritance and fine. Same as (a), above. c. Father leaves several family members out of his will and Daughter and others attack the will. As a result of a settlement of the controversy Daughter receives $20,000. 102(a) applies-inheritance according to Lyeth case (money received in compromise of rights under a will is an inheritanceshe has status as his heir.) d. Father leaves Daughter $20,000 in his will stating that the amount is in appreciation of Daughters long and devoted service to him. 102(a) would apply. Probably good chance to show a Duberstien disinterested generosity. e. Father leaves Daughter $20,000 pursuant to a written agreement under which Daughter agreed to care for Father in his declining years. Here, money is income. Daughter is receiving money in exchange for services rendered. Like Wolder case, GI because of a written contractthis is what the parties chose to compensate Daughter. Better to be in a d. situation unless you are out of will and can show that you performed a service and could make a claim against the estate. Lathrop says may be better some times to be in situation you have an enforceable agreement b/c testator can change at a whim and you are out. f. Same agreement as in (e), above, except that Father died intestate and Daughter successfully enforced her $20,000 claim under the agreement against the estate. 102(a) does not apply. Here, Daughter is enforcing the contractual arrangement, and the money is GI according to the Wolder case.

g. Same as (f), above, except that Daughter settles her $20,000 claim for a $10,000 payment. Same answer as (f), above. h. Father appointed Daughter executrix of his estate and Fathers will provided Daughter was to receive $20,000 for services as executrix. 102(a) does not apply. The will specified that she is to be paid for services rendered; anything else she inherits would be gift/inheritance.

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Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop i. Father appointed Daughter executrix of his estate and made a $20,000 bequest to her in lieu of all compensation or commissions to which she would otherwise be entitled as executrix. 102(a) does not apply. This is GI because of payment for services rendered. Although Meriam says it would be a gift and not GI because there is no good faith to perform, it would probably count as compensation today by 2nd circuit and Wolder case. Lathrop says dont take chance separate out what is what. Need to separate this payment provision in the will and not associate the money with the executor function in order to preserve the gift status. 2. Boyfriend who has a mental problem with marriage agrees with Taxpayer that he will leave her everything at his death in return for her staying with him without marriage. She does, he doesnt, she sues his estate on a theory of quantum meruit and settles her claim. Is her settlement excludable under 102? No, this settlement is income because it was a contract for services rendered. 3. If the Wolder case arose today, would 102(c) apply to resolve the issue? No, a lawyer/client relationship is not an employer/employee relationship. Exception to 102(a): Employee gifts: 102(c) says that (a) shall not exclude from GI any amount transferred by or for an employer to, or for the benefit of, an employee.

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Income Tax I

Fall 2002/2005 Used Spring 2007 CHAPTER 4: Employee Benefits (PP. 92-106)

Prof Lathrop

A. Exclusions for Fringe Benefits: [132 (omit (j)(2) and (5)); see 61(a)(1); 79; 83; 112; 120; 125; 1.61-1(a), -21(a)(1) and (2), (b)(1) and (2); see 1.132-1 through 8] Class Notes: August 28, 2002  Note that 132 is not the only employee fringe benefit section, there are others scattered through the code.  Idea 132 is to codify a lot of business practice accepted by the commissioner.  61(a)(1) which modifies slightly by a couple of words with the intent to say that fringe benefits are not necessarily excluded.  132 works usually be (a) operative rule then you have to go to the definitions in other sections.  Get the exclusion in sub. (a) and then to other sections to find out what that exclusion is. 132 is the largest section dealing with fringe benefits, but it is not the only section; to use 132 you need to apply (b) thru (j); where one of those sections does not apply, then youre in 61- GI (if a fringe benefit is not specifically excluded, then it is GI).  61(a)(1) says fringe benefits are included in GI. Examples in Reg. 1.61-21(a) are an employerprovided care; flight on an employer-provided plane; employer-provided free or discounted commercial flight; employer-provided vacation; employer-provided discount on property or services; employerprovided membership in a country club or other social club; and employer-provided ticket to an entertainment or sporting event.  Unless the fringe benefits are specifically excluded under 132, they must be included in GI. Some exclusions per Reg. 1.61-21(a)(2) are qualified tuition reductions; meals or lodging furnished to an employee for the convenience of employer; benefits provided under a dependent care assistance program; and no-additional-cost services, qualified employee discounts, working condition fringes, and de minimis fringes per 132.

 132(a)(1) Excludes No-Additional Cost Services (i.e., Airline tickets to stewardesses) o 132(b)(1) and (2) defines no-additional cost services:  (1) services offered for sale to customers in the same line of business where the employee is performing services;  (2) the employer incurs no substantial additional cost by providing the services to employee; and  (3) per highly-compensated employees, services are provided on a non-discriminatory basis (found in 132(j)(1)). o Here, employee means those currently employed, retired and disabled ex-employees, the surviving spouses of employees (includes spouses of retired or disabled ex-employees), spouses and dependant children of employees. (See 132(h)(1) and (2)).

 132(a)(2) Excludes Qualified Employee Discounts (i.e., courtesy discounts, like price reductions or rebates.) o 132(c)(1) defines this fringe benefit. Includes the same line of business restriction and nondiscriminatory rule as 132(a)(1), above. This exclusion can exclude purchases of both property (but not real property and personal property held for investment) and purchases of services (including insurance policies but not loans to employees.) Page 25 of 154

Income Tax I Fall 2002/2005 Used Spring 2007 o Same definition of employee (above.) o This exception has ceilings (see text p. 97)

Prof Lathrop

 132(a)(3) Excludes Working Condition Fringe (i.e., use of company car; employees subscription to a business periodical; on the job training.) o Defined in 132(d): any property or services provided to an employee to the extent that if the employee paid for the property or services, such payment would be allowable as a business expense or depreciation deduction. o No discrimination limitation.  132(a)(4) Excludes De Minimis Fringes (i.e., typing personal letters at work; use of copy machine; occasional cocktail parties or picnics for employees; donuts; low-value holiday gifts; traditional retirement gifts presented to an employee after lengthy service.) o Defined in 132(e)(1): any property or service whose value is so small as to make required accounting for it unreasonable or administratively impracticable. o This exemption takes into account the frequency with which an employer provides similar fringes to employees.  132(a)(5) Excludes Qualified Transportation Fringe o Defined in 132(f): value of benefits provided to employee by employer in the form of transportation in a commuter highway vehicle between employees residence and job; transit passes; tokens; fare cards; vouchers; qualified parking.  132(a)(6) Excludes Qualified Moving Expense Reimbursement.  132(e)(2) Excludes Employee Eating Facilities.  132(j)(4) Excludes Athletic Facilities. This excludes value of use of any on-premises athletic facility if substantially all the facilities use is by employees, their spouses, and their dependant children.

A new statutory fringe benefit has been added to 132 for the taxable years beginning after 2001. New 132(a)(7) provides an exclusion for qualified retirement planning services, which are defined in 132(m)(1) as retirement planning advice or information provided to an employee and his spouse by an employer maintaining a qualified employer plan. PROBLEM: (P. 101) 1. Consider whether or to what extent the fringe benefits listed below may be excluded from gross income and, where possible, support your conclusions with statutory authority: a. Employee of a national hotel chain stays in one of the chains hotels in another town rent-free while on vacation. The hotel has several empty rooms. Yes, 132(a)(1) states that no-additional-cost services are excluded from GI. 132(b)(1) & (2) provides (2 elements): must be offered in the normal course of business and the employer incurs no substantial additional cost (no forgone revenue.) Employee works in the same line of business of that where he received the benefit (the hotel chain). The employer didnt incur any additional cost because several rooms were empty. What is happening here is that staying in hotel room is treated as a service and no additional cost incurred by employer. Page 26 of 154

Income Tax I

Fall 2002/2005 Used Spring 2007 Prof Lathrop Critical language in 132(b)(1) as well as (c) what is working in here is that it has to be in the same line of business that the employee is providing service. Must be a hotel employee.

b. Same as (a), above, except that the desk clerk bounces a paying guest so Employee can stay rentfree. See Reg. 1.132-2(a)(2) and (5). No, because the employer has forgone revenue (there is no excess capacity) 132(b)(2). Therefore, revert back to 61(a)(1) GI. But, might qualify under 132(c) [See Reg. 1.132-2(a)(2)] which could justify a deduction of 20% in cases where the employer incurs additional cost, the rest would be included in income. Substantial is in terms of rent for that room. Say he paid 90 for a 100 room that may not be substantial. It relates to the item or nothing would be substantial. Cost of room is bench mark to determine if it is substantial forgone revenue. If you stay there for nothing that is substantial. c. Same as (a), above, except that Employee pays the bill and receives a cash rebate from the chain. See Reg. 1.132-2(a)(3). Yes, excluded because Reg. 1.132-2(a)(3) permits an exclusion for free service, partial cost service, and rebates. 119 is in kind exchanges only this is a broader approach than in 119 another type of employer fringe. Exclude the reimbursement.

d. Same as (a), above, except that Employees spouse and dependent children traveling without Employee use the room on their vacation. Yes, excluded because 132(h)(2)(A) treats spouses and dependent children as employees for purpose of 132. Remember that this is limited. Look at 132(h) it says for purposes of paragraphs (1) and (2) of subsection (a) This only applies to no additional cost services and qualified employee discount. e. Same as (a), above, except that Employee stays in the hotel of a rival chain under a written reciprocal agreement under which employees pay 50% of the normal rent. Yes, excluded. 132(i) covers reciprocal agreements when they are in writing and neither employer incurs any substantial additional costs. Partial charges are still excluded under Reg. 1.132-2(a)(3). Very specific section. So can exclude the 50% he does not have to pay. f. Same as (a), above, except that Employee is an officer in the hotel chain and rent-free use is provided only to officers of the chain and all other employees pay 60% of the normal rent. No, 132(a)(1) only applies if there is no discrimination. 132(j)(1) and Reg. 1.132-8(a)(2) requires that services be available to all employees on substantially the same terms. Here, Employee would have to include this in income because of the discriminatory nature of the benefit it is not substantially the same terms for him and the other employees. Page 27 of 154

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Prof Lathrop

132(a)(1) section is very limited in that it applies to (a)(1) and (2) if not on substantially same terms. Literally that means he cant even take a 40% only if there is no discrimination does he exclude anything. Reg. Rul. 1.132(8)(a)(i) that says this (Check Reg. Rule.) Lathrop says that substantially means cant be much variation. Doesnt know what this really means. Probably wont find anything concrete in Regs. But 40% is pretty substantial here. If not highly compensated you are not covered by this rule even if you are an employee. This is for to keep highly compensated employees to lock out the secretary for example. This raises another question of what is a highly compensated employee. J(6) & J(7) state what a highly compensated is defined in 414Q dont ever want to go here. g. Hotel chain is owned by a conglomerate which also owns a shipping line. The facts are the same as in (a), above, except that Employee works for the shipping line. No, included because these are not in the same line of business as required under 132(b)(1). Here, Employee is not performing substantial services for the hotel, so no exclusion. See Reg. 1.132-4(a). h. Same as (g), above, except that Employee is comptroller of the conglomerate. See Reg. 1.1324(a)(1)(iv). Excluded if Employees position relates to both businesses and performs substantial services in each line. Reg. 1.132-4(a)(1)(iv)(A) an employee who performs substantial services that directly benefit more than one line of business is taxed as performing services in all the lines of business. i. Employee sells insurance and employer Insurance Company allows Employee 20% off the $1,000 cost of the policy. Yes, excluded under 132(a)(2) operative rule. 132(c)(1)(B) allows a 20% discount on service, and insurance is a service under case law. 132(c)(3) defines employee discount and 132(c)(4) defines qualified property or services and requires that it has to be in the same line of business. j. Employee is a salesman in a home electronics appliance store. During the year the store has $1,000,000 in sales and a $600,000 cost of goods sold. Employee buys a $2,000 video-cassette recorder from Employee for $1,000. Go through these steps when answering: 132(c)(1)(A), (c)(2)(B), (c)(3), (c)(4), and Reg. 1.132-3(e). There is some GI and some excluded fringe. Under 132(c)(2) he can exclude 40% of $2,000 or $800 (the maximum discount for property), but he must claim $200. Same line of business limitation applies. $1M (aggregate sales) - $600K (cost) $1M Page 28 of 154

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Fall 2002/2005 Used Spring 2007 Prof Lathrop = 40% (gross profit percentage on goods in employers line of work) limit on what he can exclude.

k. Employee attends a business convention in another town. Employer picks up Employees costs. Yes, this would be excluded as a working condition fringe benefit under 132(a)(3) and (d). Since Employee would be able to deduct this expense as a business expense 162 if he paid it, the value is excluded from his income. l. Employer has a bar and provides the Employees with happy hour cocktails at the end of each weeks work. Yes, this normally would fall under de minimis fringe benefit under 132(a)(4) and (e) [See also Reg. 1.132-6(e)(1)], BUT, this is a frequent event and can be accounted for; thus compensation. Lathrop, disagrees. This is de minimus. m. Employer gives Employee a case of scotch each Christmas. See Reg. 1.132-6(e)(1). Yes, excluded as a de minimis fringe benefit under 132(e)(1). Reg. 1.132-6(e)(1) excludes holiday gifts of low value. Lathrop says that frequency may also be a problem here; also the value of a case of scotch would not be minimal!! He thinks that if it happens every year, its probably too frequent and is not de minimis. Not a lot of case law on (1) and (m), but Lathrop thinks they are both compensation. Different from coffee and donuts, which are really nothing.

n. Employee is an officer of corporation which pays Employees parking fees at a lot one block from the corporate headquarters. Non-officers pay their own parking fees. Assume there is no post-1993 inflation. Yes, qualified parking is excluded under 132(a)(5) and 132(f)(1)(C). Under 132(f)(2)(B), fees cant exceed $175/month; the excess is GI. Qualified parking under 132(f)(5)(C) states that parking can be provided to an employee on or near the business premises. Under 132(j)(1), special rules on discrimination for officers apply to no additional cost services and qualified employee discounts but NOT parking (no anti-discrimination requirement.) o. Employer provides Employee with $900 worth of vouchers for commuting on a public mass transit system during a year prior to 2002. Assume there is no post-1993 inflation. Yes, excluded under 132(a)(5) and 132(f)(1)(B) (any transit pass) and (5)(A) (pass means voucher.) 132(f)(2)(A) allows for $65/month ($100/month after 12/31/01) deduction for aggregate of transportation and transit pass. Therefore, $780 can be excluded and $120 is GI. p. Employer puts in a gym at the business facilities for the use of the employees and their families. Yes, excluded under 132(j)(4), because its an on-premises athletic facility operated by Employer for substantial use by employees.

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Income Tax I Fall 2002/2005 Used Spring 2007 B. Exclusions for Meals and lodging: [107; 119(a); see 119(d); 1.119-1] Herbert v. Hatt: Funeral home manager (P) v. Tax commissioner (D) NATURE OF CASE: Petition for exclusion of lodging from gross income.

Prof Lathrop

FACT SUMMARY: Hatt (P), president and majority stockholder of a funeral home corporation, who lived in an apartment located in the building used for the funeral home, used the apartment twenty-four hours a day to conduct the funeral business. CONCISE RULE OF LAW: The value of lodging furnished to an employee may be excluded from gross income if the lodging is on the business premises of the employer, the employee is required to accept such lodging as a condition of his employment, and the lodging is furnished for the convenience of the employer. FACTS: Hatt (P) married the president and majority stockholder of Johann, a funeral home and embalming business. By antenuptial agreement, Hatt (P) became the president, general manager, and majority stockholder of Johann. He moved into an apartment located in the building used by Johann for its funeral home business; the building also housed the ambulance crew which picked up the decedents bodies. The telephone that rang in Johanns business office also rang in the apartment, and Hatt (P) used the apartment to answer the business telephone and to meet with clients after regular business hours. From this apartment, Hatt )P) also supervised the ambulance crew, which lived in the same building. The crew was not authorized to handle funeral home business other than the pick-up and transportation of bodies. Hatt (P) sought to deduct the cost of the apartment on Johanns corporate tax return as a business expense, or alternatively to deduct it from his personal return. The Tax Commissioner (D) disallowed the corporate deduction on the grounds that Hatt (P) was not required to live in the apartment as a condition of his employment with Johann, and that the apartment was not furnished for the convenience of Johann, it also taxed Hatt on the fair market value of the apartment as a constructive dividend. Hatt (P) filed a petition in the tax court to contest this decision. ISSUE: Is the value of lodging furnished to an employee excluded from gross income if the lodging is on the business premises of the employer, the employee is required to accept such lodging as a condition of his employment, and the lodging is furnished for the convenience of the employer? HOLDING AND DECISION: Yes.  I.R.C. 119 grants an exclusion from gross income of the value of lodging furnished to an employee if three conditions are met: (1) The lodging is on the business premises of the employer; (2) the employee is required to accept such lodging as a condition of his employment; and (3) the lodging is furnished for the convenience of the employer.  Acceptance of lodging is considered a condition of employment if the employee must use the lodging in order to enable him to properly perform the duties of his employment, such as where the employee must be available for duty at all times.  Whether lodging is furnished for the convenience of the employer is subject to the same test.  Here Hatt (P), as president and majority stockholder of Johann, himself determined the convenience of Johann and the conditions of his own employment, and required himself to be available around the clock to answer telephone calls, to meet with bereaved relatives, and to direct the ambulance crew.  The on-call nature of this work supports the finding that maintenance of the apartment was a necessary condition of Hatts (P) employment with Johann. Page 30 of 154

Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop  Thus Hatt (P) qualified for the exclusion of the value of the apartment from his gross income, and Johann is allowed to deduct its cost from its corporate returns. Petition granted. EDITORS ANALYSIS: The first prong of the 119 test was not disputed in this case; however, whether the lodging is on the business premises does arise in a significant number of cases. The term has been defined as meaning either at a place where the employee performs a significant portion of his duties or where the employer conducts a significant portion of his business. See Commissioner v. Anderson, 371 F.d. 59 (6th Cir. 1966), cert. Denied, 387 U.S. 906, (1967) (motel manager lived at home owned by motel owner and located two blocks from motel; because he was only on call, 119 held not applicable). See also Jack B. Lindeman, 60 T.C. 609 (1973) (lodging located across the street from motel deemed not significantly separate from motel itself, and thus qualified for the 119 exclusion.) DEDUCTION: Subtraction (from gross income) in arriving at taxable income (the tax base.)  The fact that the TP is the CEO and principle shareholder does not disqualify the TP for exemption under 119.  Three elements of 119: o 1). On the employers business premises; o 2). Required as condition of employment; and o 3). For the convenience of the employer.  The strict scrutiny standard applies when the CEO owns the company.  119 deals w/ non-compensatory and assumes that the employee is paid a wage. Where the employee has no choice but t reside on the premises, then 119 applies. There must be an employer-employee relationship here and in 132.  107 is the counterpart to 119. Housing benefits (both money and rental value) to a preacher are excluded from his GI if he uses the benefit for housing; therefore 107 allows money compensation for housing.  Cash allowances are forbidden under 119. It must be lodging or a meal, not cash substitute, to be excluded under this section. Must also be non-compensatory in nature to be excluded.  119(d) excludes lodging furnished by certain educational institutions to employees outright where teachers have to live on campus. Dont have to go through Hatt test. PROBLEMS: (P. 106) 1. Employer provides Employee and spouse and Child a residence on Employers business premises, having a rental value of $5,000 per year, but charging Employee only $2,000. a. What result if the nature of Employees work does not require Employee to live on the premises as a condition of employment? Under 119(a)(2), Employee must include the $3,000 difference as GI. The exclusion can only apply under 119(a)(2) if Employee is required to live on the premises as a condition of employment and the lodging is on the business premises and is for the convenience of the employer (Hatt.) b. What result if Employer and Employee simply agreed to a clause in the employment contract requiring Employee to live in the residence? 119(b)(1) states that an employment contract is not determinative of whether lodging is intended as compensation; thus GI (not excluded.) Only excludable if there is an actual need. Page 31 of 154

Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop c. What result if Employees work and contract require Employee to live on the premises and Employer furnishes Employee and his family $3,000 worth of groceries during the year? As for living on the premises, the value of the discount ($3,000) is excludable under 119(a)(2) because the lodging is required by the employer. As for the groceries, not mentioned under 119(a)(1), which requires that meals be furnished on the premises (furnished means prepared, ready to eat.) Only one case holds that groceries are excludable under 119(a)(1) but cases say exclusion is for meals ready to be eaten then and there; meals are not groceries. d. What result if Employer transferred the residence to Employee in fee simple in the year that Employee accepted the position and commenced work? Does the value of the residence constitute excluded lodging? No, the value of the residence is not excluded lodging. We are no longer within 119 because the residence must be owned by Employer and Employer must require Employee to live there as a condition of the employment; there must be an employer/employee relationship for 119 to apply. Giving the residence to Employee is like a signing bonus, which is compensation to Employee. 2. Planner incorporated her motel business and the corporation purchased a piece of residential property adjacent to the motel. The corporation by contract required Planner to use the residence and also furnished her meals. Planner worked at the motel and was on call 24 hours a day. May Planner exclude the value of the residence or the meals or both from her gross income?

These types of cases are fact specific. An owner can incorporate in order to take advantage of 119 in order to create an employer/employee relationship, which means these facts will be subject to subject to strict scrutiny. BUT Anderson holds that there is no exclusion where on-call is not a specific portion of the employees duties. AND Lindeman holds that it can be excluded where property is adjacent to business. Therefore, she should be able exclude the value of the residence and the meals under 119(a)(1) and (2) and Hatt. The nature of the business requires her to be present 24 hours a day. Keep in mind that a sole proprietorship cannot exclude under 119, but once she incorporated, then it was okay. The problem is that she is requiring herself to live on the premises, so you really need to look at the nature and customs of the business (facts.) If she cant exclude here, maybe she could under 162(a) as an ordinary income expense.

3. State highway patrolman is required to be on duty from 8 a.m. to 5 p.m. At noon he eats lunch at various privately owned restaurants which are adjacent to the state highway. At the end of each month the state reimburses him for his luncheon expenses. Are such cash reimbursements included in his gross income? See Commissioner v. Kowalski.

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Fall 2002/2005 Used Spring 2007 CHAPTER 5 Awards (PP. 107-116)

Prof Lathrop

A. Prizes: [74; see 102(c); 132(a)(4), (e); 274(j); 1.74-1(a)] 74(a) expressly includes prizes and awards as GI. 1986- Lowered rates dramatically but broader base. Knocked out a lot of deductions. Two MAJOR EXCEPTIONS to this rule:  74(b) excludes from income a prize or award that: o recognizes achievement in specified fields, like religion, charity, science, education, civic, literature, art  IF o The recipient was selected without any action on his part to enter the contest  AND o The recipient wasnt required to render substantial future services as a condition to receiving the prize or award.  In these cases, if the winner donates the award to the government or a charity, and the award is directly transferred to the donee without any use or enjoyment of the winner, then the prize or award is excluded from income. 74(b)(3).  74(c) excludes de minimis awards for retirement or achievement from GI if the employee has 5 years of service, or safety if employee is not a manager, administrative, clerical or other professional employee and only if 10% or less of the employers qualified employees recover during the year. o 74(c) excludes from income employee achievement awards if the award:  relates to length of service or to safety;  is tangible personal property;  is awarded in a meaningful ceremony; and  is not disguised compensation. o Scholarships and fellowships under 117 (see below)

Allen J. McDonnell: Salesperson (P) v. Tax Commissioner (D) NATURE OF CASE: Petition for tax refund. FACT SUMMARY: McDonell (P) and his wife (P) were instructed by McDonells employer DECO, a bulk mild cooler sales company, to accompany the winners of DECOs incentive sales contest to Hawaii for a weeklong vacation; however, during the trip, they were never to leave the group alone in order to discourage it from engaging in a complaint session about DECO. CONCISE RULE OF LAW: An all-expenses paid business trip does not constitute taxable disguised remuneration when the recipient is required to go as an essential part of his employment and is expected to devote substantially all of his time on the trip to performance of duties on behalf of the employer. FACTS: McDonell (P) was an assistant sales manager for DECO, a bulk milk cooler sales company, which sold its products through territorial salesmen and independent distributors. At the time he was hired by DECO, McDonell (P) wife was also interviewed and informed that she was expected to accompany McDonell (P) on business trips as well as engage in DECOs social activities. In 1959, DECO held an incentive sales contest for top performers in the company, excluding sales managers such as McDonell (P). DECO selected eleven Page 33 of 154

Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop winners that year and paid for free trips to Hawaii for them and their wives. DECO also decided to send, after random drawings, four of its sales managers and their wives to accompany the winners; McDonell (P) was thus chosen, and he and his wife (P) went with the group. DECO instructed McDonell (P) that he should consider the trip an assignment, not a vacation, that he should stay with the group at all times, and that he should guide informal discussion among the winners in such a way as to enhance DECOS image among them. DECO was concerned that without such supervision, such discussions would quickly turn into gripe sessions about the company. Neither McDonell (P) or his wife (P) had any spare time on the trip; nor did they engage in any separate activities. McDonell (P) did not report the approximately $1,122 cost of his trip on his 1959 return, but did report about $600 as additional income attributable to his wifes presence on the trip. The Commissioner (D) assessed a deficiency based on the entire cost of the trip, on the grounds that it constituted a taxable award or additional compensation. McDonell (P) petitioned the tax court for a determination that the Commissioner (D) was in error, and for a refund of the tax paid on the $600 reported as his wifes (P) share of DECOs trip expenses. ISSUE: Does an all-expense paid business trip constitute taxable disguised remuneration when the recipient is required to go as an essential part of his employment and is expected to devote substantially all of his time on the trip to performance of duties on behalf of the employer? HOLDING AND DECISION: (Tannenwald, J.) NO.  An all-expenses paid trip does not constitute a taxable award under I.R.C. 74 or additional compensation under I.R.C. 61 when the recipient is required to go as an essential part of his employment and is expected to devote substantially all of his time on the trip to performance of duties on behalf of the employer.  Although the presence of an employer business purpose does not necessarily preclude a finding of compensation, and the fact that a trip is taken to a resort area may be taken into account, neither of these is conclusive.  Here, the McDonells (P) were required to make a trip which was in essence no different from any other business trip requiring their services.  Merely because they were selected by random drawing does not convert a required business trip into a taxable award; the random method was merely a means of obviating any discrimination in selection.  Nor was McDonells (P) right to go on the trip determined by any standard of work performance.  Thus the trip had no fair market value to the McDonells (P); they are entitled to a tax refund on the $600 in additional income reported, and the Commissioners (D) deficiency assessment is denied. EDITORS ANALYSIS: Prizes and awards prior to 1986 were largely excluded from a taxpayers gross income, but the tax code amendments of that year severely curtailed these executions. Currently, under I.R.C. 74(b), prizes or awards given to recognize achievement in religious, charitable, scientific, educational, artistic, literary, or civic fields are excluded from gross income only if the winner designates a government unit or eligible charity for receipt and if the winner enjoys absolutely no use of the award. I.R.C. 74(c) excludes employee achievement awards from gross income if they relate to length of service or safety in the workplace. It requires that the award be tangible personal property awarded during a meaningful ceremony and not as disguised compensation; the recipient must have been employed for at least five years and must not have received a similar award within the preceding four years. REMUNERATION: Payment given in exchange for services.  Note: This case was decided before 132(d) was enacted. o The value of a trip taken for business purposes is not GI where the employee is required to go. o Here, Allens wife also had to go and she was allowed to exclude the value of the trip as well. However, the law is different now; she would have to include as income today. Page 34 of 154

Income Tax I PROBLEMS: (P. 112)

Fall 2002/2005 Used Spring 2007

Prof Lathrop

1. Each year national sportswriters get together and select the single most outstanding amateur athlete in the country and award that person a check for $5,000. Picabo, a talented skier, has been selected for this years award. The award given with the stipulation that the winner deliver a 15 minute acceptance speech at an awards banquet. Picabo, essentially delivering an acceptable refection acceptance speech, designates the National Ski Patrol Organization, a charity under 170, to receive the $5,000 award. The sportswriters send the check to the Ski Patrol Organization. Will Picabo be able to exclude the $5,000 from her gross income? No, not excludable under 74 because 74(b) applies to awards for education, science, literary, etc., but not athletics. According to 74(a) and (b) flush, there is no mention of athletics, thus there is no need to go further. 2. Gusher Oil desires to make its employees feel more appreciated. To implement this desire, Gusher creates an awards program whereby employees are given awards for achieving certain lengths of service. In each case, determine the extent to which employee, Cliff Hanger, is able to exclude the award from gross income. a. Cliff has been working for Gusher for 12 years. Announcing Cliffs retirement at the Oil Barons Ball, Gusher Oil gives him a $300 gift certificate. 74 expressly states that prizes and awards are GI, BUT 74(c)(1) refers us to 274(j)(3)(A) for the definition of employee achievement awards, which states that if a gift certificate is considered tangible personal property, then go to 274(j)(4)(B) [length of service requirement is 5 years or moreso Cliff could exclude the $300.] However, gift certificates are NOT tangible personal property unless the certificate cannot be traded in for cash. Also could argue for 132(e) de minimis exclusionbut probably not. b. Same as (b), above, except that Cliff has worked for Gusher for only four years. This is included in GI because to qualify as length of service award, then the employee cant receive an award in the first five years of service. 274(j)(4)(B). B. Scholarships and Fellowships: [117; 127(a) and (b)(1); 1.117-6(b)-(d)]  117 excludes from gross income amounts received as a qualified scholarship by a degree candidate at an educational institution. This exclusion carries the Duberstein aura no quid pro quo in scholarship award.  Qualified scholarship is money received as a scholarship or fellowship grant that is used for qualified tuition and related expenses.  117(c) limits this exclusion when the amount is payment for services by the student required as a condition for receiving the otherwise excludable amount. For example, educational grants by an employer to an employee is gross income because the amount represents compensation for past, present or future services.  127 allows an employee to exclude up to $5,250 from gross income for money paid by an employer for educational assistance if it meets certain requirements, including a nondiscrimination requirement.  127 has been amended to once again allow an exclusion for the expense of graduate level courses. See IRC 127(c)(1). Page 35 of 154

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Fall 2002/2005 Used Spring 2007

Prof Lathrop

Class Notes Sept. 4, 2002 (Tape):  Use to be able to exclude meals and lodging also but the 1986 acts knocked that out. So meals and lodging are out but books, lab fees, tuition are in.  General rule sub. A: Gross income does not include any amount in qualified scholarship. So you know that qualified scholarship must be defined some place. 117(b): Must be qualified tuition and related expense. 117(b)(2) defines qualified tuition and related expenses as (A) tuition and fees and (B) fees, books, supplies, and equipment required for courses of instruction.  117(c): Limitations. Cant get payment for services such as teaching, research, or other services.  117(c)(2) has some new things. (A) & (B) will talk a little bit later.  117(d) is some qualified tuition reductions. Staff that works for U, U can waive tuition for courses. There dont have to worry to much about Duberstein but do have to worry about Duberstein in regular scholarship because of Quid Pro Quo. Cant have anything coming back because of scholarship.  The other section relevant is 127. Educational assistance programs by employers. Limit of 5,250 and educational systems are defined by (c)(1). Been a recent change to (d) taken out that you could not use for professional school such as doctors and lawyers, that has been taken out and made broader. PROBLEMS: (P. 115) 1. Student working toward an AB degree is awarded a scholarship of $6,000 for full tuition and for room and board during the academic year. The tuition, including the cost of books, is $3,000, and the room and board costs $3,000. As a scholarship recipient, Student is required t do about 300 hours of research for the professor to whom he assigned. Non-scholarship students, if hired, receive $10 per hour for such work. a. What tax consequences to Student? Not in 117(d) is talking about reduction tuition provided by employer, this is student. Well part of the problem is that some of this is excluded for room and board and tuition and room is $3,000 break those out. 300 hours of research and most students get paid $10 an hour. Must figure out how much is for room and board and other. At least $3,000 is excludable under (b)(1) & (2). But has to work that looks like it is about $3,000, what problem does that pose. If someone comes to you with this tell them to make sure you ear mark and assign the work to room and board because you have to do it any way and under (c)(1) work done is not excludable so earmark this to room and board that is not excludable. Fairly straight forward but sometime students dont even know where it is coming from, clearest way is to earmark exactly what money is for. Under 117(a); 117(b)(1) and (2), Student can exclude $3,000 from GI for tuition and books. Room and board is included because there is no exception for personal living expenses under Reg. 1.117-6(c)(2). But the problem is that the whole $6,000 might be included in income depending on how you allocate the $3,000 representing the portion that falls within 117(c). If work is in exchange for tuition, then all $6,000 is included in GI. Donor designation controls here. b. What tax consequences to Student if all students are required to do 300 hours of research for faculty?

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Income Tax I

Fall 2002/2005 Used Spring 2007 Prof Lathrop What does the statute tell you? Problem focuses on 117(c)(1). So any services performed in addition to receiving scholarship knocks you out of 117. It use to be before 1986 that if others had to do work you could still exclude that $3,000. Doesnt help this guy. Anytime service is condition of scholarship you are dead cant exclude.

117(c) makes this GI even though all the students are required to do the research. Under Reg. 1.117-6(c)(2), that portion of qualified scholarship representing payment required as condition of grant is gross income, regardless of whether all candidates for the degree are required to perform such duties. Still included in gross income under 117(c). c. What result if Student is not required to do any research but receives the $6,000 as an athletic scholarship? What is the problem if this is Football scholarship? Still could not exclude the $3,000 but what about the tuition $3,000. What if he gets hurt and cant play. What circumstance would allow him to still exclude? If the scholarship could not be taken away even if he cant play, still ok.

Under Rev. Rul. 77-263, athletic scholarships are excluded if (1) university expects but doesnt require student to participate in the sport; (2) requires no specific activity in lieu of playing the sport; and (3) cannot terminate scholarship if student cannot participate. In other words, the grant must be completely gratuitous or non-contractual, like Duberstein. Absolutely no quid pro quo. d. What tax consequences to Student if Student receives only a tuition scholarship worth $2,500 (no books) because Students spouse is an employee at a neighboring educational institution and the tuition scholarship is part of a nondiscriminatory plan between several institutions applicable to all employees of such institutions? Can be tough area such as RA full scholarship, monthly stipend, free room, free food. Package for RA. Free meals and food would fall under 119 not a problem b/c must be there to perform job. Monthly stipend may be the only thing on W2. Makes L. nervous but that is how University does it. If getting scholarship you must perform service that is close call. (c)(2) was put in there for this reason that person gets exclusion if they work for say 3 years for Fed. Gov. in depressed area at reduced salary. Now we are under 117(d)(2)(B) cross-refers to 132(h) so that spouses of employees can take advantage of exclusion. Pretty nice. Still have the same problem of performing services and (c)(1) would knock it out. This is excludable under 117(d)(2)(B) and 117(d)(3) for qualified tuition reduction. Note that 117 refers to 132(h) for who is an employee for purposes of this section (spouse and dependants included.) 2. Lawyer, an associate in a large tax law firm, receives a $10,000 stipend from her firm to assist her while on a leave of absence to obtain her LLM degree in taxation. The stipend is part of a firm plan under which all recipients are required to return to the firm following their educational leave. Page 37 of 154

Income Tax I Fall 2002/2005 Used Spring 2007 a. What tax consequences to Lawyer?

Prof Lathrop

Going to get master and firm paid a stipend, case out of PA, can you get under 117. It is a 117(c)(2) problem cant render service in return for scholarship. When she returns from work she repays out of services. She probably could get through 117(d) but limited to 5,250 since they have taken out professional school limitation. This is clearly taxable because it is in return for either past or future services. 102(c) do not apply because of quid pro quo and employee/employer relationship. Any time you receive money from an employer, it looks like compensation for past, present or future services rendered. Under 127(c)(1)(B), would be GI because it doesnt apply to law or other professional degrees; only undergraduate degrees. b. What tax consequences to Lawyer if she is not required to return to the firm after completing her LLM degree? Anytime you have a payment coming from employer to employee you have problem getting into Duberstein range. You are not in (d) you are in (a) and (c) and they removed that law degree and other degrees. Brings us back to 74. 74(a) carves out an exception for prizes that are also scholarships under 117. If this is a 117 scholarship, then 74(a) allows an exclusion. But not excluded if for past service and employee/employee relationship. Can argue both ways. Note: if its a prize and also fits under 74, then it falls under 117 and is excluded IF it fits the exceptions, regardless of how you entered the contest. c. What are the tax consequences to Lawyer if she is not an employee, but instead receives the stipend as a prize in an essay contest? This is included as a prize in GI under 74. She will try to exclude under 117. 74(a) says that prizes and awards includable unless you can get out with (b) or (c) or unless it is a scholarship. Dont have to include under 74 because 117(a) trumps. Although 117 could be applied (depending on the facts) to make it excludable as a scholarship.

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Income Tax I Fall 2002/2005 Used Spring 2007 CHAPTER 6- Gain From Dealings in Property (pp. 117-154)

Prof Lathrop

Class Notes: September 9, 2002  Buy something and sell it for something more you have a profit if you sell it for less you have a loss.  Amount realized is what your selling it for.  1st figure out what is your realized gain. Which means you did something with that property.  Gain may be realized and may or may not be recognized. The general rule is that it is recognized unless something specifically excluding it from being recognized.  Exclusions start with 101s  About 1031 corporate areas that give nonrecognition.  1001 o (a) tells how to compute gain or loss.  Cross reference to 1011 which is your adjusted basis. y 1012 is cost basis rule. y 1011 is that original cost basis adjusted for certain things adjusted by 1016. Improvements increase for example.  Adjusted basis may or may not be the same as 1012 original cost basis. o 1001(c) says that gain is recognized unless you find something in the code that says not recognized. o Remember that nonrecognition is not an exclusion it is a timing device. Delays recognition.  When you acquire from a decedent you take at the FMV at the time of death.  Gift under 1015 is exactly opposite. You get carryover basis of the donor. Donee gets gain or loss when he sells it.  For purposes here looking at 1012 cost basis because not looking at adjusted basis yet.  Then looking at 1001(b) to get amount realized is. It is sum of money + the FMV of any property received.  Philadelphia case below deals with how we determine amount realized when there is no cash given in the exchange. The rule comes out that it is the FMV of property received.

A. Factors in Determination of Gain: [ 1001(a), (b) first sentence, (c); 1011(a); 1012; 1.1001-1(a)]  No tax on mere return of capital: basis = cost; value = worth.  1001(a) tells you how to compute gain OR loss from dealing in property.  1001(b) Amount Realized (AR) = o Money received for the property + FMV of property other than money (usually mortgages) o 1001(a) gain is excess of AR over the 1011 AB AND loss is the excess of the AB. o 1001(b) AR = sum of money received and the FMV of any property received other than money.  1011(a) Adjusted Basis (AB) for determining gain/loss = o The cost basis determined under 1012 (what you expended for the property how much you have in the property) + Adjustments under 1016. o 1012 basis = the cost excluding property tax (your investment can be recovered when property is sold, thus no tax liability on investment/basis.) o 1016 proper adjustments shall be made for expenditures, receipts, losses, or other items properly chargeable to capital account, but not for property taxes (i.e., improvements increase basis; depreciation decreases basis.)  Therefore: GAIN = AR AB. LOSS = AB AR. Page 39 of 154

Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop  1001(c): except as otherwise provided (nonrecognition statutes), the entire amount of the gain or loss on the sale or exchange of property shall be recognized. You will always recognize gain or loss UNLESS something specifically says that you dont. B. Determination of Basis: 1. Cost As Basis: [109; 1012; 1016(a)(1); 1019; 1.61-2(d)(2)(i); 1.1012-1(a)]  Basis is your investment in property.  Cost as Basis: o 1012 is the primary cost basis rule. o You will start at 1012 but look to 1016 to see if the basis changes (deductions, depreciation, etc.) o Basis is typically the cost of the property; however, when you exchange property, the basis = FMV.

Philadelphia Park Amusement Co. v. U.S.: Amusement park (P) v. Federal government (D) NATURE OF CASE: Action to require the allowance of a deduction. FACT SUMMARY: Philadelphia Park Amusement Co. (P) deeded its interest in a bridge to the city in exchange for a ten-year extension on a franchise. FACTS: Philadelphia Park Amusement Co. (P) obtained a fifty-year franchise to operate a railroad service to its amusement park. A bridge was constructed for over $300,000 to operate the railroad. When the franchise was about to expire, Philadelphia Park (P) offered to transfer the bridge to the city in exchange for a ten-year franchise extension. No gain or loss was reported from the transaction. Philadelphia Park (P) later abandoned the railroad service in favor of bus transportation. It then attempted to take a loss deduction from its income based on the abandonment of the franchise. The IRS (D) denied the deduction on the ground that since the bridge had no value and there had been no taxable exchange, no loss could be maintained. Philadelphia Park (P) maintained that the value of the franchise was equal to the value of the bridge and, therefore, it was entitled to take the undepreciated basis as a loss. ISSUE: Is the basis of property established as of the date of a taxable transfer? HOLDING AND DECISION: (Laramore, J.) Yes.  Where a taxable exchange of property occurs, gain or loss should be recognized in establishing the basis for the property on the date of the transfer.  A transfer of assets, except where exempted by statute, is a taxable event.  The taxpayers basis in the new property is its fair market value as of the date of transfer plus any taxable gain to him associated with the transaction.  Where the transfer was made at arms-length and the new asset cannot be valued, it is deemed to be equal to the value of the asset which was given up by the taxpayer.  While the franchise extension cannot be valued, the bridge had some value on the date of transfer.  This amount should be deemed the basis of Philadelphia Park (P) in the franchise.  The undepreciated value of the franchise as of the date of abandonment was a proper deduction. Page 40 of 154

Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop  The failure of Philadelphia Park (P) to properly record the transaction originally does not prevent it from later establishing the valuations for the purpose of deducting the loss. Reversed and remanded for proper valuation of the bridge and, if possible, the franchise. EDITORS ANALYSIS: The amount paid for an asset is its basis. If the property is later sold for more than its original price, the taxpayer has made a taxable gain. If the Taxpayer depreciates the asset over a period of time, his basis is reduced to the extent of the depreciation deductions. If the property is exchanged for something other than cash, the adjusted basis is the value of the property received, plus any gain which was taxed to the taxpayer as a result of the transaction. If a loss was taken, the adjusted basis is the value of the property received. Cont. Class Notes: September 11, 2002  What is the bridge worth and why do we need to know any of this stuff? In 1944 & 1945 they abandon the franchise and to determine what their deduction for abandoning the franchise and what the depreciation will be they need to know what the basis was beginning in 1934.  In 1934 city says that they will accept the bridge in exchange for the bridge. That is the exchange. What is the basis? What is the arguments to see what the basis in exchange of property? o FMV of property gave. o FMV of what you give up.  Court discusses that and says that the basis should be the FMV of property receive. Thats what you have left. In this case the value of the franchise will be your 1012 cost basis.  Why? This is dependent upon the property being at arms length transaction.  What does the value of what you receive represent as far as basis is concerned? Keep in mind that basis represents what you paid for the property. Very strong connection in amount realized and basis in what you receive. They should be the same in a taxable transaction.  So if you paid cash for something that is simple. That being the case the court says that what you would have paid in cash for this property is the FMV of that property and keeps the basis of property received on the same footing.  In a taxable transaction you should always have the FMV of property received in the basis.  This means that the FMV of the franchise from 1934 would be the basis for depreciation in following years.  So what is the value of the extended franchise? The court assumes that it is an arms length transaction but they dont know what the FMV of franchise is.  What does the government want? Low basis.  TP wants a higher basis.  TP saying: When the value of the franchise cannot be determined with a reasonable degree of accuracy the TP can carry over the undepreciated basis of the property exchanged.  Court says simply that they can figure out the basis in some way. Not going to give you the undepreciated basis in a taxable transaction. How? In arms length transaction should be the same. You dont know the value of franchise but you should be able to figure out what the value of the bridge was. Have testimony of what the bridge was worth. Remanded back.  Remember that SOL may not let TP go back and take depreciation and whether you take it or not the basis is reduced anyway.  Rule simply stated is that in a taxable transaction is the basis is FMV of the property received.  When looking at these cases look at the facts and determine what the economics of the transaction are. BASIS: The value assigned to a taxpayers costs incurred as the result of acquiring an asset and used to compute tax amounts towards the transactions in which that asset is involved.

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Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop DEPRECIATION: An amount given to a taxpayer as an offset to gross income, to account for the reduction in value of the taxpayers income producing property due to everyday usage. GAIN: Refers to situation where Amount Realized exceeds the Basis of an asset.  A transfer of assets is a taxable event, unless exempted by statute. The taxpayer is taxed on the difference between the adjusted basis of property given and the FMV of property received. Thus, the cost basis of the property received in a taxable exchange is the FMV of the property received, not of the property given, on the date of transfer. But if the FMV of the new asset cannot be readily determined with a reasonable degree of accuracy, then the taxpayer is entitled to carry over the undepreciated cost of the asset given up as the cost basis of the asset received. Where a taxable exchange of property occurs, gain or loss should be recognized in establishing the basis for property on the date of the transfer.  The court equated an exchange of property with a cash acquisition. You have to treat the FMV of the item received as basis because that is what you would have paid for it had you bought it for cash.

PROBLEMS: (P.121) 1. Owner purchases some land for $10,000 and later sells it for $16,000. a. Determine the amount of Owners gain on the sale. $6,000 gain. Realized and Recognized. 1012 basis is the cost of the property 1011(a) to determine the loss/gain (the adjusted basis shall be the basis determined under 1012) 1001(b) AR is the sum of the money received plus the FMV of any property received (other than money). $10,000

$10,000

$16,000

1001(a) gain is the excess of the amount realized over the adjusted basis per 1011 ($16K - $10K)

$6,000

1001(c) the entire amount of the gain/loss shall be recognized. b. What difference in result in (a), above, if Owner purchased the land by paying $1,000 for an option to purchase the land for an additional $9,000 and subsequently exercised the option? The same analysis and result as in (a), above. Owner still made an investment of $10,000 ($1,000 option is an investment and is included when determining loss/gain.)

c. What result to Owner in (b), above, if rather than ever actually acquiring the land Owner sold the option to Investor for $1,500? Page 42 of 154

Income Tax I $500 gain. 1012 cost 1011(a) AB 1001(b) AR 1001(a) Gain 1001(c) Recognized

Fall 2002/2005 Used Spring 2007

Prof Lathrop

$1,000 $1,000 $1,500 $500 $500

d. What result in (a), above, if Owner purchased the land for $10,000, spent $2,000 in clearing the land prior to its sale, and sold it for $18,000? $6,000 Gain. 1012 cost 1011(a) AB $10,000 $12,000 ($10K + 2K clearing is a capital improvement.)

1016(a)(1) the cost bass of $10K was adjusted upward for the $2K expenditure per 1016(a)(1), which says that the basis will be adjusted for expenditures, receipts, losses, or other items, properly chargeable to capital account. Had the clearing costs been spread over time and a current deduction taken for them, then could not increase the basis. Concept: if currently deductible, then not a capital improvement. 1001(b) AR 1011(a) AB 1001(a) Gain 1001(c) Recognized $18,000 $12,000 $6,000 $6,000

e. What difference in result in (d), above, if Owner had previously rented the land to Lessee for five years for $1,000 per year cash rental and permitted Lessee to expend $2,000 clearing the property? Assume that, although Owner properly reported the cash rental payments as gross income, the $2,000 expenditures were properly excluded under 109. See 1019. $8,000 gain. 1012 Cost $10,000 1019 basis is not increased or decreased by income derived by the lessor and excludable under 109; as long as 109 applies it converts exclusionary rule to one of non-recognition. 109 applies if the improvements are not a substitute for rent payments. 1011(a) AB $10,000 (AB is not $12K because the $2K expenditures is properly excluded from gross income under 109 because it is not part of the rental agreement.) 1001(b) AR $18,000 Page 43 of 154

Income Tax I 1001(a) Gain 1001(c) Recognize It

Fall 2002/2005 Used Spring 2007 $ 8,000 $ 8,000

Prof Lathrop

Note: 109 becomes a non-recognition section because of 1019s basis provision. Note that if the $2,000 were part of the rental agreement, then it would be immediately added into the basis. The $2,000 will eventually be taxed when Owner sells the property. 1012 Cost 1011(a) AB 1001(b) AR 1001(a) Gain 1001(c) Recog. It. $10,000 $12,000 ($10K + 2K in clearing) $18,000 $ 8,000 $ 8,000

Here the taxpayer has claimed $2,000 I GI and this result prevents double tax. Class Notes September 11, 2002:  $1,000.00 a year rental is ordinary income to landlord and taxed at ordinary income rates.  When the lease expires, this guy is sitting there with property that is worth $2,000 more and you would think under Glen Shaw Glass that the guy would have to take it into income because there is no interest in the property except he owns it. 109 says that as long as these improvements are not part of the rental deal but incidental to that the landlord does not include these improvements it into income, tradeoff is 1019 which says that if 109 applies then you cannot increase your basis by that amount.  In this problem your basis remains at $10,000  Picks the 2,000 up when he sells the property into income.  Favorable to TP b/c lower tax rates than ordinary income rates. f. What difference in result in (a), above, if when the land had a value of $10,000, Owner, a real estate salesperson, received it from Employer as a bonus for putting together a major real estate development, and Owners income tax was increased $3,000 by reason of the receipt of the land? $6,000 Gain. This is not a gift under Duberstein because of the employer/employee relationship. Under 61(a) $10,000 is GI. If he sells, then the basis is $10,000 because thats what the taxpayer claimed as GI, then the gain is $6,000. 1011(a) AB 1001(b) AR 1001(a) Gain 1001(c) Recogn. It. $10,000 (the FMV of the property received in an exchange per Philadelphia Park) $16,000 $ 6,000 $ 6,000

Also, look under Reg. 1.61-2(d)(2)(i), exchange as compensation for services. Owner has to report the bonus as GI like cash, which then establishes the basis as $10,000.

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Fall 2002/2005 Used Spring 2007 Prof Lathrop Cannot add income tax into basis. Even if TP would have gotten $10,000 cash bonus he would have paid the tax. The income tax has nothing to do with basis. Red Herring in this problem. The income tax here is incidental to receiving the property.

g. What difference if Owner is a salesperson in an art gallery and Owner purchases a $10,000 painting from the art gallery, but is required to pay only $9,000 for it (instead of $10,000 because Owner is allowed a 10% employee discount which is excludable from gross income under 132(a)(2)), and Owner later sells the painting for $16,000? Got 9,000 in it that he paid, but if you only give him a 9,000 basis then it takes away the benefit of 132 or at best converted from exclusion to non-recognition. Here, TP would still have a $10,000 basis on the argument that every exclusionary rule that is converted into a nonrecognition rule there is a specific basis provision in the code that causes that to happen and there is no such specific basis rule to 132 and L. thinks that Congress truly meant to make 132 a true exclusionary rule (never to be included into income again.) Only way to protect that here is to give the TP a $10,000 basis. TP should have a gain of $6,000.

Class Notes: September 11, 2002  Go back to Philadelphia Parks for a moment where they talked about not only to keep his acquisition of his property by exchange on a par basis as to a tax acquisition that why the FMV value of what you receive is the basis b/c that is what you would have paid in cash. They also said that if the properties are of different value, if you dont use the value of what you receive as basis which is also your amount realized and you use the basis of what you gave up then you get cockeyed results. Remember there is a direct relationship between basis and what you received. If you are talking a taxable transaction your basis should be the amount realized.

2. PROPERTY ACQUIRED BY GIFT: [1015(a); see 1015(d)(1)(A), (4) and (6); 1.1001-1(e); 1.1015-1(a), -4]

1015(a): if property is acquired by gift, the basis is the same as it would be in the hands of the donor or last owner (carry-over basis.) The companion rule is 102(a) says that gifts are excludable. Each excludable rule has companion basis rule (1015). Here basis follows the property. However, if the basis is greater than the FMV of property at the time of the gift, and, you are in a loss situation, then basis = FMV. This limits your loss and you dont get the loss that accrued in the donors hands. Taft v. Bowers: Shareholders daughter (P) v. Commissioner (D) NATURE OF THE CASE: Action by taxpayers against a determination of basis. FACT SUMMARY: appreciated value. Taft (P) was given shares of appreciated stock and contended her basis was the

CONCISE RULE OF LAW: The donee receives the basis of the donor in gift property.

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Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop FACTS: Taft (P) received appreciated stock from her father as a gift. Taft (P) later sold the stock for a profit. Taft (P) paid a tax on the profits associated with the increase in value while she held the stock. No tax was paid on the amount the stocks appreciated while held by her father. The IRS (D) assessed a deficiency on the ground that the donee of a gift only obtains the basis of the donor. Taft (P) argued that her basis was the fair market value of the stock on the date of transfer. Taft (P) argued that Congress did not have the authority to enact 1015(a) which supported the IRSs (D) position on basis. Taft (P) argued that income can only be attributed to the increase in value while the asset was actually owned by her. The district court agreed, but the court of appeal reversed, and the Supreme Court granted review. ISSUE: Is the donees basis in a gift the same as the donors? HOLDING AND DECISION: (McRenolds, J.) Yes.  The donee receives the basis of the donor in gift property.  The donor is exempt from income taxation if he makes a gift of property. Therefore, any increase in value during the period it was held by him is untaxed.  If Tafts (P) position is sustained, the IRS (D) could not collect a tax on this appreciation.  Congress intended to exact a tax on the sale or other disposition of appreciated property.  Section 1015(a) was a proper vehicle for deferring this tax until the property was ultimately disposed of by the donee by giving him the donors basis rather than the value of he asset at the date of transfer.  The transaction herein is no different than if Tafts (P) father had sold the stock, given the money to Taft (P), and she had purchased stock with it.  Tafts (P) father would have paid a capital gains tax on the original appreciation of the stock and Taft (P) would have paid the increase associated with her earnings.  The total tax would have been the same as if Taft (P) were forced to pay the entire increase in value at the date of her disposition of the stock.  Congress undoubtedly has the authority to defer the collection of a tax to a proper date. Only income is being taxed. Affirmed. EDITORS ANALYSIS: Congress defers the imposition of an immediate tax in a number of other situations. For example, property transferred to qualified corporations in exchange for stock is not immediately taxed. The taxpayers basis in the property is deemed his basis in the stock. Property obtained through inheritance is not deemed a taxable event. The heir or legatee receives the FMV (Stepped up basis) basis of the property at the date of death of the decedent. When a person sells his family residence, and uses the funds to purchase a new family residence the tax is also deferred. In each of these situations Congress has decided that it would be inappropriate to deem the transaction a taxable event for policy reasons. Class Notes: September 11, 2002  No constitutional problem here and Congress can do this. Again, broad language 61(a).  Father in this case was Chief Justice Nash. GIFT: A transfer of property to another person that is voluntary and which lacks consideration. BASIS: The value assigned to a taxpayers costs incurred as the result of acquiring an asset and used to compute tax amounts towards the transactions in which that asset is involved. PROFIT: An amount gained above those monies or value paid in the form of costs.  The donee receives the basis of the donor in gift of property. For income tax purposes, the donee accepts the position of the donor with respect to the thing received takes on the position of the donor. Page 46 of 154

Income Tax I Fall 2002/2005 Used Spring 2007 Farid-Es-Sultaneth v. Commssioner Wife of company owner (P) v. Commissioner (D) NATURE OF CASE: Appeal from judgment of tax deficiency.

Prof Lathrop

FACT SUMMARY: Farid-es-Sultaneh (P) received stock from her future husband under an antenuptial agreement whereby, in exchange for the stock, she released all her rights for support and any interests she would obtain in his property. CONCISE RULE OF LAW: In an antenuptial agreement, shares of stock received from one who lacked donative intent and given in exchange for a fair consideration are not a gift under I.R.C. 1015(a). FACTS: Farid-es-Sultaneh (P) and her future husband entered into an antenuptial agreement pursuant to which she was to receive shares of stock in the husbands company, for which she relinquished all right to support and any inchoate interests in his property. The husbands cost basis in the stock was about $.16 per share, which would become her basis if the stock was a gift within 1015(a). Since the husband was worth more than $400 million, her inchoate interests in his property were worth more than the value of the stock to be transferred to her. If Farid-es-Sultaneh (P) had purchased the stock for the value of her inchoate interest, she could use as a basis $10 per share for determining gains or losses. The Commissioner (D) determined that the arrangement lacked consideration and, thus, constituted a gift to Farid-es-Sultaneh (P) under I.R.C. 1015(a), that the basis of the shares was their original purchase price, and that a deficiency was due on the amount unreported (the difference between the original basis and the amount for which the stock was sold.) Farid-es-Sultaneh (P) petitioned the tax court, which upheld the Commissioners (D) ruling. Farid-es-Sultaneh (P) appealed, arguing that consideration existed for the transfer to be taken out of the gift requirements of 1015(a). ISSUE: In an antenuptial agreement, are shares of stock received from one who lacked donative intent and given in exchange for a fair consideration a gift under I.R.C. 1015(a)? HOLDING AND DECISION: (Chase, J.) No. In an antenuptial agreement, shares of stock received from one who lacked donative intent and given in exchange for a fair consideration are not a gift under I.R.C. 1015(a).  The tax court, in holding the stock was a gift, relied on Wemyss v. Commissioner and Merrill v. Fahs. where the term consideration was determined to not include the value of inchoate property under similar factual circumstances.  However, both cases arose under code provisions dealing with estate and gift tax.  Even though those statutes were amended to limit the definition of consideration, they are not controlling when dealing with the issue of gifts under the income tax provisions [1015(a)].  Thus, although the transfer here may not have been for adequate consideration under the estate and gift tax provisions, it was for adequate consideration under 1015(a).  This is supported by the legislative history of 1015(a), which shows that Congress was attempting to close a loophole whereby the donee would use as a basis the value at the time of transfer, and, thus, any increase in value while held by the donor would not be taxed.  By requiring a donee to take a basis equal to his donors basis, 1015(a) affected only net taxable income and did not attempt to generate a greater amount of tax on transfers, which could be taxed under the estate and gift tax provisions.  Since Farid-es-Sultaneh (P) received the stock in return for her relinquishing her rights in her husbands property, the transfer was supported by consideration and was not a gift within 1015(a).  Thus, Farid-es-Sultaneh (P) could use as a basis the cost of the stock to her. Reversed. Page 47 of 154

Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop DISSENT: (Clark, J.) No strong reason has been advanced for not applying the same rules for determining what is a gift under different sections of the tax code. The congressional purpose would appear to be identical. EDITORS ANALYSIS: Section 1012 provides that for determining realized gain or loss on the sale of property, one is to use as a basis the cost of purchasing the property. Under 1015, when property is received as a gift, and for the purpose of determining gain on the sale of such property, one must use as a basis in the hands of the donor. Thus, by concluding that Farid-es-Sultaneh (P) had purchased the stock, rather than having received it as a gift, the court allowed her to receive over $10 per share tax-free income. Had she instead suffered a loss on the sale of the property, then the tax consequences would probably have been the same under both sections, since 1015 provides that for the purposes of determining loss on the sale of property received as a gift, one must use the greater of either the donors basis or the fair market value at the time the gift is made. Since she used the fair market value of the stock in computing her gain, presumably the same basis would be used for determining loss, under both 1015 and 1012. Class Notes: September 11, 2002  Exchange of stock for marital rights for release.  TP wants basis of 1012 basis as the value of FMV when she got it. $10.cs  Commissioner wants it to be a gift, a straight carryover basis. Husbands basis. .16c  Huge difference.  Tax court held in fact she did take by gift. Second circuit said no. ANTENUPTIAL AGREEMENT: An agreement entered into by two individuals, in contemplation of their impending marriage, in order to determine their rights and interests in property upon dissolution or death.  This case follows the rule in Philadelphia Park that in a property exchange, the basis is the FMV of the property received in the exchange. Basis is treated as exchange of property like Philadelphia Park. This rule keeps exchange on an even keel with a cash transfer.  Wemyss held that giving up marital rights for stock is a gift, not a bonafide consideration. Congress enacted a law that said the release of dower rights was fair consideration.  Merrill held that estate and gift are similar construr pari materia. Gift is a one time transfer. Where income requires an annual accounting, then should be taxed differently (i.e., gift law should not be imported into tax law.)  The result in Farid is reversed for divorce cases per 1041. PROBLEMS: (P.128) Class Notes September 13, 2002 1. Donor gave Donee property under circumstances that required no payment of gift tax. What gain or loss to Donee on the subsequent sale of the property if: a. The property had cost Donor $20,000, had a $30,000 fair market value at the time of the gift, and Donee sold it for: i. 1. $35,000 $ 35,000 AR under 1001(b) $-20,000 AB under 1015(a) transfer 7701(a)(42)(43)(44) (a lot of people say carryover basis, both mean same thing) basis is in the hands of the donor. Donee takes the donors basis. $ 15,000 Gain (1001(a), then recog it - 1001(c))

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Income Tax I ii. 2. $15,000

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When the basis is greater than the FMV on the date of the gift, then the basis is that FMV (property lost value while donor held property) $15,000 AR under 1001(b) $-20,000 AB under 1015(a) ($5,000) Loss 1001(a) still in 1015 for basis because the basis is < FMV iii. 3. $25,000 $25,000 AR under 1001(b) -30,000 AB under 1015 $5,000 Gain (1001(a), then recog it - 1001(c)) b. The property had cost Donor $30,000, had a $20,000 fair market value at the time of the gift, and Donee sold it for: i. 1. $35,000 $35,000 AR under 1001(b) -30,000 AB under 1015(a) $5,000 Gain (1001(a), then recog. It - 1001(c)) ii. $15,000 Here there is a loss, so it falls within 1015s special exception because of the loss situation and because the basis is greater then the FMV. So donees basis now equals $20,000 and he only has a loss of $5,000. Doesnt let donee take donors high loss, which isnt particularly fair. 1015 lets the donee take advantage of appreciation on property but not depreciation (TP is limited to his economic loss and cannot get donors loss also.) This is a very particular situation; you have a loss in 1(a)(2) above, why not the same rule? When do use the FMV as basis? When donors basis is higher than the value of the gift at the time of gift. Donor has lost 10,000 in his hands. Causes donee not to be able to deduct the loss in hands of donor. Only time you dont use transfer basis in hands of donor. Limits donees economic loss. iii. 3. $24,000 Here the basis is still greater than the FMV, so you use $20,000 as the basis. BUT, this will result in a gain ($24,000 - $20,000.) You can only use 1015s special exception in a loss situation, so what do you do? Reg. 1.1015-1(a)(2) says that nothing is realized in this situation; therefore this is a wash, no gain or loss. Whats happening here is that if you are figuring gain you have to use 30,000 and no gain. If figuring loss you have to use 20,000 and no loss. So Reg. says no gain or loss. It is a wash. Notes September 13, 2002  The next problem the students have problems because they cant see the difference between (a) & (b). The difference is that (a) is a bargain sale between related parties where the bargain end Page 49 of 154

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Fall 2002/2005 Used Spring 2007 Prof Lathrop of it would be treated as a gift. In other words selling the property for much less. In (b) to show what happens if there is no part/gift sale there is a sale of 120,000 for 120,000 worth and an outright gift of the other. In the tax world there is a outright sale of 2/3 and outright gift of 1/3 in (b). In (a) there is no a bargain sale on the whole ball of wax that throws us into part/gift part sale rules that show up in these two regs. TEST MUST KNOW ABOUT THESE REGS.

2. Father had some land that he had purchased for $120,000 but which had increased in value to $180,000. He transferred it to Daughter for $120,000 in cash in a transaction properly identified as in part a gift and in part a sale. Assume no gift tax was paid on the transfer. a. What gain to Father and what basis to Daughter under Reg. 1.1001-1(e) and 1.1015-4? Fathers gain/loss situation: 1.1001-1(e) says that Father gets full basis and will have a gain to the extent that the AR is greater than the AB, and will not recognize a loss if the AR is less than AB. Here, Father has no gain because AR = AB. Daughters basis situation: 1.1015-4 (part gift/part sale) says that Daughters basis equals either the amount paid by her (here, $120,000) or Fathers adjusted basis at the time of the transfer (also $120,000), whichever is greater. Therefore, Daughters basis = $120,000. Conflict here is between 1012 and 1015. What are the conflicting of the Code we are dealing with in the part/gift part/sale? 1012 if you buy and transfer basis under 1015. What is nice about the reg. is she gets the higher of the two. Reg. tells you that the higher basis is used, would not know this from the code. (Ex. If she paid $130,000 then 1012 wins and she gets $130,000 basis. This makes sense because her father would then pick-up gain of $10,000 on the part sale.) Taking this further, if Daughter now sells the property, she must report a $60,000 gain ($180,000 120,000.) This rule is very favorable to the donor and the donee gets screwed. Note: This problem demonstrates the conflict between 1012 cost basis for property and 1015 gift basis. If the donors basis is greater than what donee paid, then 1012 supercedes 1015. If the donors basis is less than what the donee paid, then 1015 supercedes 1012. 1012 and 1015 are basis rules. b. Suppose the transaction were viewed as a sale of two thirds of the land for full consideration and an outright gift of the other one third. How would this affect Fathers gain and Daughters basis? Is it a more realistic view than that of the Regulations? Cf. 170(e)(2) and 1011(b), relating to bargain sales to charities. We are no longer in the part-sale/ part-gift area. You are outside the Regs. Above. Key to this problem that you dont do in 1.1001-1(e), is that you MUST allocate the basis between the sale and the gift elements. Therefore, split the property into 3 parts. 2 of these parts is the sale. Fathers AB = $120,000 on entirety so $80,000 on the 2 sale parts (2/3 of $120,000.) AR on sale for Father. Daughter purchased property for $120,000, so ($120,000 - $80,000 = $40,000.) Thus, Father has a gain on the sale of $40,000 (he is taxed on this amount.)

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Fall 2002/2005 Used Spring 2007 Prof Lathrop RE Daughter: must figure out her basis for both parts. So, in total, Daughters basis on whole property = $160,000 ($120,000 (Purchase of 2/3 + $40,000 (transfer basis of gift from father under 1015(a).) If daughter then sells the property, she will have a $20,000 gain ($180,000 $160,000) she pays tax on this amount.

3. PROPERTY ACQUIRED BETWEEN SPOUSES OR INCIDENT TO DIVORCE: [1041; 1.1041-1T(a) and (d)] Class Notes: September 13, 2002  1041 is a nice non-recognition rule self contained.  1st true non-recognition. Gain is not recognized.  Basis rule is in 1041(b) which is a straight carry over basis.  If a conflict where this may have been a gift you use 1041(b) for basis.  1041 provides that a gain/loss will not be recognized on a transfer of property from an individual to a spouse or former spouse if the transfer is incident to a divorce; it neutralizes property transfers between spouse to the extent that transferee takes basis that transferor had; this is important in property.  Tax law treats spouses (or former spouses) as a single economic unit; and therefore, transfers of property between them shouldnt be taxed.  1041 says that no gain or loss is recognized in these transactions. This initial transfer is tax-neutral.  There is always a transferred basis, even for computing loss. So when a transferee sells the property, she is greatly taxed. PROBLEMS: (P. 130) 1. Andre purchased some land ten years ago for $4,000 cash. The property appreciated to $7,000 at which time Andre sold it to his wife Steffi for $7,000 cash, its fair market value. a. What are the income tax consequences to Andre? None. 1001(b) AB of $7,000 - 1012 AB of $4,000 = $3,000 gain realized under 1001(a). BUT, gain is not recognized b/c 1001(c) says that it is recognized unless another specifically excludes and it is excluded under 1041(a)(1) (in transfers between spouses, no gain or loss shall be recognized.) b. What is Steffis basis in the property? 1015(e) says that in the case of any property acquired by gift in a transfer governed by 1041(a), the basis of the property in the hands of the transferee is to be determined under 1041(b)(2) and NOT 1015. 1041(b)(2) is a straight carryover rule. Therefore, Steffis basis = $4,000. c. What gain to Steffi if she immediately resells the property? 1001(b) AR of $7,000 - 1041(b)(2) AB of $4,000 = $3,000 realized gain under 1001(a), recognized under 1001(c), because we are now outside the marital unit. Downside to 1041(b) is that the transferee will have a low basis. d. What results in (a) (c), above, if the property had declined in value to $3,000 and Andre sold it to Steffi for $3,000? Page 51 of 154

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Fall 2002/2005 Used Spring 2007 Prof Lathrop Andres income tax consequences are the same as in (a). Steffis basis is still $4,000 (see (b) reasoning.) BUT, Steffis tax consequences are now affected. 1001(b) AR of $3,000 1041(b)(2) AB of $4,000 means that a loss of $1,000 will be realized and recognized under 1001(c). Transferee spouse steps right into the shoes of the spouse that transferred no difference in loss or gain.

e. What results (gains, losses, and bases) to Andre and Steffi if Steffi transfers other property with a basis of $5,000 and value of $7,000 (rather than cash) to Andre in return for his property? Andre has a $3,000 gain that is not recognized. Andre has a $5,000 basis in new property and Steffi has a $2,000 gain that is not recognized. There is no gain/loss recognized to either under 1041(a)(1). 4. PROPERTY ACQUIRED FROM A DECEDENT [1014(a), (b)(1) and (6), (e); 1.1014-1(a), -3(a)] Class note September 13, 2002:  General rule: FMV at the date of death of the decedent. Diff. from 1015 of a gift. The appreciation or loss in the hands of the decedent is never picked up by the income tax and is wiped out.  1014(e) prevents transferring property before someone dies in order to get stepped up basis. 1 yr. window. L. might be worth the risk. No harm if you try.  This is the last basis rule we will cover.  1014(a) property acquired from a decedent generally receives a basis equal to its FMV on the date it was valued for federal estate tax purposes. The effect is to give property that appreciated during the decedents ownership a stepped up basis with no income tax to anyone. o Opposite of gift where Donee takes Donors basis. o Great estate planning tool. o BUT per 1014(e) this provision does not apply where death occurs within 1 year after transferhere I think it would be treated as a gift.  Basis in these situations is determined by 1014, which says that the basis is the FMV of the property on the date on which the property was valued for federal estate tax purposes. Therefore, the appreciated amount of property entirely escapes income tax, although it will probably be picked up in the estate tax. C. The Amount Realized: [1001(b); 1.1001-1(a), -2(b)] International Freighting Corporation, Inc. v. Commissioner Shipping Company (P) v. Commissioner (D) NATURE OF CASE: Review of decision upholding determination of tax deficiency. FACT SUMMARY: International Freighting Corporation (IFC) sought review of the Tax Courts decision that IFC (P) had realized a gain by paying a bonus in stock that had cost IFC(P) less than its market value at the time the bonus was given. CONCISE RULE OF LAW: An employer who pays bonuses in stock realizes a taxable gain if the market value of the stock at the time the bonus is paid is greater than the cost of the stock to the employer. FACTS: DuPont owned all the shares of IFC(P) from 1933 to 1935 and two-thirds of the shares in 1936. During those years, IFC (P) informally adopted DuPonts bonus plan for its employees. Class B bonuses were awarded to employees who contributed the most to IFCs (P) success in a general way. The bonuses were Page 52 of 154

Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop funded by profits set aside by IFC (P). There was no requirement that the entire bonus fund be used, and the program could be discontinued at any time. In 1936, IFC (P) paid to the class B award winners certificates representing 150 shares of DuPont stock, costing IFC (P) $16,153.36, and having a market value of $24,858.75. Each recipient paid income tax on the market value of the stock he received. IFC (P) took a deduction of $24,858.75. In a notice of deficiency, the Commissioner (D) reduced the deduction to $16,153.35, and recalculated IFCs (P) tax, finding a deficiency of $2,156.76. IFC (P) petitioned the Tax Court for a redetermination of deficiency. The Tax Court upheld the deduction for $24,858.75, but also held the IFC (P) realized a taxable profit of $8,705.39, the difference between the market value and the cost of the stock. The deficiency resulting from this decision was the same, $2,156.76. From this decision, IFC (P) appealed. ISSUE: Does an employer who pays bonuses in stock realize a taxable gain if the market of the stock at the time the bonus is paid is greater than the cost of the stock to the employer? HOLDING AND DECISION: (Frank, J.) Yes. An employer who pays bonuses in stock realizes a taxable gain if the market value of the stock at the time the bonus is paid is greater than the cost of the stock to the employer.  The Tax Court was correct in allowing the deduction for the full market value of the shares since the payment depleted IFCs (P) assets in an amount equal to that market value.  Clearly, the delivery of the shares was not a gift, but was in reality compensation for services rendered.  The basis of the shares is their cost, and the gain realized is the excess of the amount realized from the disposition over the basis.  Technically, money or property has not been received by IFC(P), but moneys worth has been received.  Here, there was a disposition of shares for a valid consideration equal to at least the market value of the shares when delivered, and there was a taxable gain equal to the difference between the cost of the shares and the market value. Affirmed. EDITORS ANALYSIS: The tax laws recognize that the time of sale or disposition of property is the most appropriate time to determine the owners gain or loss on the transaction. Even after a gain is realized, it is not necessarily taxable; the gain must also be recognizable under I.R.C. 1001(c). Even if a gain is not recognizable, the taxpayer takes a substituted basis, and the gain or loss is simply deferred until the property is sold. Class Notes: September 16, 2002  Definitely a quid pro quo for the bonus program for employee services.  Whos amount realized are we worried about under 1001(b)? Int.F. What is it is the problem? Service of the employees and this bothers the court b/c it doesnt fit in 1001(b) flush. PG. 136 it has been held that moneys worth is received and that such a receipt comes within 1001(b). Therefore, value of the services is the amount received.  This is a discharge of indebtedness with an appreciated property. When this happens you may have a gain or loss.  Int. Fre. recognizes a gain of 8.  Int. Fre gets the deduction but have to recognize some gain to get it. Gain Refers to situation where Amount Realized exceeds the Basis of an asset. Gift A transfer of property to another person that is voluntary and which lacks consideration. Basis The value assigned to a taxpayers costs incurred as a result of acquiring an asset and used to compute tax amount actually paid. Page 53 of 154

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 The corporation can realize a taxable gain when it pays a stock bonus because this was compensation to an employee, not a gift; without a stock plan the company would have had taxable gain. o The taxpayer retained control until transferred. o Apply 1001(b) because when stock is transferred, no money or property is received in exchange by Transferor, thus you count it as moneys worth.  First, International Freighting properly deducted the stock as a business expense. Second, the bonuses were not gifts (they were compensation for past services rendered.) The disposition of the stocks was for valid consideration, so taxable gain occurred.  A discharge of an obligation with appreciated property is always a realized gain. Here, no property or money was received by the taxpayer (International Freighting), but it got services from the employees in exchange for the stock. So, AR can equal moneys worth of services. Here, the AR = value of the services rendered and the basis = FMV of what was given upwhat was exchanged for services per Philadelphia Park. Crane v. Commissioner: Apartment building inheritor (P) v. Commissioner (D) NATURE OF CASE: Review of judgment up-holding determination of deficiency. FACT SUMMARY: Crane (P) inherited real property subject to an unassumed mortgage. CONCISE RULE OF LAW: A taxpayer who sells property encumbered by a nonrecourse mortgage must include the unpaid balance of the mortgage in the computation of the amount the taxpayer realizes on the sale. FACTS: Crane(P) inherited an apartment building. The building had a mortgage on it which, when combined with unpaid interest exactly equaled the estate tax appraisers valuation of the building and property. Crane (P) did not assume the mortgage. She agreed to remit the net rental proceeds after taxes to the mortgagee. Some six years later, faced with the threat of foreclosure, Crane (p) sold the property and received $2,500 in cash for it (net). Crane (P) included $1,250 in her income for the year on the theory that the property was a capital asset; her original basis in the property was zero; and, therefore, one-half the profits had to be included as income form the sale of a capital asset. The Commissioner (D) levied a deficiency tax. He claimed that her basis was the fair market price at the time of acquisition, less allowable depreciation. Therefore, Crane (P) actually realized a net taxable gain of $2,500 in cash plus six years of depreciation deductions, a total of $23,767.03. Crane (P) argued that only her equity in the property could be considered as her basis. Since it was zero to begin with, no depreciation was allowed. Since she only realized $2,500 in cash, this was all that could be taxed. The tax court found in her favor, but the appeals court reversed. The Supreme Court granted certiorari. ISSUE: Must a taxpayer who sells property encumbered by a nonrecourse mortgage include the unpaid balance of the mortgage in the computation of the amount the taxpayer realizes on the sale? HOLDING AND DECISION: (Vinson, C.J.) Yes. A taxpayer who sells property encumbered by a nonrecourse mortgage must include the unpaid balance of the mortgage in the computation of the amount the taxpayer realizes on the sale.  Section 113(a)(5) states that the basis for property received by inheritance is the fair market value of the property on the date of acquisition. Now 1014  Value is nowhere defined or treated as synonymous with equity. Therefore, Cranes (P) basis in the apartment was $262,045, i.e., its fair market value at date of acquisition. Page 54 of 154

Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop  The apartment building was an asset subject to exhaustion through wear and tear used in Cranes (P) trade or business.  Section 113(b)(1)(B) requires that proper adjustments to basis shall be made in such cases. Now 1016  On sale of the asset, the seller realizes any cash received plus the amount of the indebtedness on the property.  167 authorizes depreciation. Now 1016  This is necessary to compute the selling price, which must be subtracted from the taxpayers adjusted basis to compute a loss or gain on the transaction.  Adjusted basis is defined under 113(b)(1)(B) as the basis less allowance for depreciation of the asset whether or not actual deductions were taken.  The difference between the selling price and Cranes (P) adjusted basis is $23,767.03.  Crane (P) actually took most of the deductions allowed her by law.  Crane (P) used these deductions to reduce her income.  Crane (P) cannot be allowed the benefit of such deductions with no corresponding gain as of the date of sale.  The Commissioner was correct in determining that she realized $257,500 on the sale of the property. Affirmed. DISSENT: (Jackson, J.) When Crane (P) acquired the property it was in default and could have been immediately foreclosed. Under such circumstance, she actually received nothing of value. When she later sold the property, there was no accompanying release of debt since she had never assumed the mortgage and was not personally liable. Her net profit on the transaction was $2,500. The depreciation issue is not before the court and it need not decide whether deductions were properly taken. EDITORS ANALYSIS: In determining profit or loss on the disposition of an asset, liens and other indebtedness are not considered. The formula is fair market value at date of acquisition minus depreciation (if allowed) equals adjusted basis. This is subtracted from the selling price. It is immaterial whether the lien has gotten greater or smaller during the interim. If the selling price is greater than the adjusted basis, a profit has been made which is taxable even if, because of an increase in mortgage indebtedness, the taxpayer receives no money. Class Notes: September 16, 2002  Important Cases. Dont overrule IF but tells us how to deal with debt.  Can always reduce the amount realized by the cost of sale.  What did Commissioner say was her basis? $262,000 o What Code 1014? Valuation at the date of death is how the commissioner came up with this amount. o Since depreciated basis and the basis goes down, so when she sold it she had a different basis with amount realized of $257,500. Caused a gain.  Court: o First figured out what basis was?  FMV at the date of death.  Which is the value of the raw value of property undiminished by the debt + any net cash received. y Does not include the interest accrued on the debt.  Court says big difference b/t equity and value of property. Congress has never mixed them up and means the value of the property. o Second, What is the amount realized?  1001(b) same language shows up property. And the court says that should mean the same as in the basis rule. Page 55 of 154

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o o o

o o

Fall 2002/2005 Used Spring 2007 Prof Lathrop  Raw value of the land undiminished by the debt or add the debt doesnt matter how you want to look at it.  Amount realized of 257,500. What is non-recourse (no personal liability) and recourse (personally liable) for the debt. If non-recourse the mortgagor can only come and get the building. What happens once that building is transferred? You have debt relief. You dont have to pay anything b/c they cant come after you. This is what happened here, she sold the building subject to the mortgage. What Crane stands for is that the economic reality is that the borrower under recourse or nonrecourse the same. So what Crane stands for is that non-recourse financing is treated the same as personal liability as far as the mortgagor is concerned and therefore has debt relief 255000 + cash of 2500 and gain of 23 (represents the depreciation taken on the building that reduced the basis over the years). FN#37 is famous footnote.

ADJUSTED BASIS: The occurrence of events with respect to an asset that require a corresponding increase or decrease in the value a taxpayer assigns to the costs expended in acquiring that asset, to reflect the occurrence of those events. DEPRECIATION: An amount given to a taxpayer as an offset to gross income, to account for the reduction in value of the taxpayers income producing property due to everyday usage. PROFIT: An amount gained above those monies or value paid in the form of costs.  Deals with situation where mortgage is less than FMV o Amount of non-recourse mortgage (no personal liability involved) is included in AR. So, taxpayer who sells property encumbered by a non-recourse mortgage when mortgage is LESS THAN the FMV, you must include unpaid balance of mortgage in AR computation. o A transfer of a mortgage, whether or not youre personally liable to the creditors, is an economic benefit because its gone no longer liable in any way, still got debt relief. o Basis is not equal to net value less unassumed mortgage.  Mortgagor, though not personally liable, realizes an economic benefit (does not have to pay it anymoredebt relief) when she sells, which is equal to the amount of the mortgage and additional consideration received. o If not, she would have a negative basis in property. o This rule keeps the definition of property the same for acquisition, depreciation, and disposition. o Property does not equal equity; its the FMV, physical property undiminished by the mortgage/debt for both AR and for basis. o Subject to means non-recourse and that the taxpayer is not obligated to assume the mortgage BUT the bank can only enforce against the property not the taxpayers personal assets. o The taxpayer conceded that if she was personally liable and that if purchaser had either paid money or assumed mortgage, that amount paid or assumed would be part of the amount realized. o Use 1001(b), AR should mean same thing as 1014(a) property undiminished by debt (debt relief + cash receivedboot). Commissioner v. Tufts: Commissioner (D) v. Construction partners (P) NATURE OF CASE: Review of judgment expunging deficiency assessment. Page 56 of 154

Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop FACT SUMMARY: tufts (P) contended that the assumption of a mortgage which exceeded the fair market value of the property by the purchaser was not a taxable event. CONCISE RULE OF LAW: The assumption of a non-recourse mortgage constitutes a taxable gain to the mortgagor even if the mortgage exceeds the fair market value of the property. FACTS: Tufts (P) and others entered into a partnership with Pelt, a builder who had previously entered into an agreement with Farm and Home Savings to transfer a note and deed of trust to the bank in return for a loan to construct an apartment complex in the amount of $1,851,500. The loan was made on a non-recourse basis in that neither the partnership nor the partners assumed personal responsibility for repayment. A year after construction was completed, the partnership could not make the mortgage payments, and each partner sold his interest to Bayles. The fair market value of the property at the time of the transfer did not exceed $1,400,000. As consideration, Bayles paid each partners sale expenses and assumed the mortgage. The IRS (D) assessed a deficiency against each partner, contending the assumption of the mortgage constituted the creation of taxable gain to each of them which they failed to report. Tufts (P) and the others sued for a redetermination, contending that no gain was realized because the mortgage exceeded the fair market value of the property. The Tax Court upheld the deficiencies, but the court of appeals reversed. The Supreme Court granted certiorari. ISSUE: Does the assumption of a non-recourse mortgage constitute a taxable gain to the mortgagor even if the mortgage exceeds the fair market value of the property? HOLDING AND DECISION: (Blackmun, J.) Yes. The assumption of a non-recourse mortgage constitutes a taxable gain to the mortgagor even if the mortgage exceeds the fair market value of the property.  When a mortgage is executed, the amount is included, tax free, in the mortgagors basis of property. The amount is tax free because of the mortgagors obligation to repay.  Unless the outstanding amount of an assumed mortgage is calculated in the sellers amount realized, the money originally received in the mortgage transaction will forever escape taxation.  When the obligation to repay is canceled, the mortgagor is relieved of his responsibility to repay the amount he originally received.  Therefore he realizes value to the extent of the relief from debt. When the obligation is assumed, it is as if the mortgagor was paid the amount in cash and then paid the mortgage off.  As such it is clearly income and taxable. Reversed. CONCURRENCE: (OConnor, J.) The situation presented in this case is easily analyzed if the purchase of the property, the mortgage, and the assumption of the mortgage are treated as separate events. This clarifies the situation as merely one of debt relief and demonstrates beyond doubt that the assumption of the mortgage was a taxable event. EDITORS ANALYSIS: This case illustrates that the cost basis of property under I.R.C. 1012 is the cost of the property including any amount paid with borrowed funds. These funds must be included regardless of their source. When property is purchased subject to debt, the purchaser is deemed to have received cash in the amount of the debt and, in turn, to have used it to purchase the property. Class Notes: September 16, 2002  What did these guys claim? $55,000 loss using the FN#37 under Crane the limitation FMV is the limit of the amount realized in a case like this when the debt exceeds the FMV.  Commissioner said what? Debt relief is the amount realized and has gain of $400,000  Quite a difference.  Court: Page 57 of 154

Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop o Disinclined to overrule Crane. o Read Crane as non-recourse loan as a true loan. o What is a true loan? Presumably a loan you intend to pay back and the security equal the value you put on it.  Causes loan to be your basis in the property. o What is a loan that is not a true loan? Where security is not worth the amount of the loan. Borrow 50 million and have property of 2 million but say it is worth 50 million that is a tax shelter. Get an inflated interest deduction and get an inflated depreciation deduction. If not a true loan you have a 0 basis and no interest or depreciation deduction. Some courts will allow true loan up to FMV of property and allow interest and depreciation to that extent. o So we had a true loan and Tufts says treat that as if you paid out of your own pocket and have an immediate basis. If do pay it back nothing happens. o If you dont pay it back or dont have to then you have debt relief. o Partners off the hook for 1.8 million. o Occurs in an exchange and causes debt relief. FN#37 wrong but theory behind Crane correct. o Makes it clear that non-recourse and recourse does not effect the borrower, must account for it. COST An amount that is considered the equivalent in value for an item of goods or an activity or event. BASIS The value assigned to a taxpayers costs incurred as the result of acquiring an asset and used to compute tax amounts towards the transactions in which that asset is involved. MORTGAGE An interest in land created by a written instrument providing security for the payment of a debt or the performance of a duty. DEFICIENCY Refers to amount of tax taxpayer owes, or is claimed to owe, the IRS.  Held that the assumption of a non-recourse mortgage constitutes a taxable gain to the mortgagor even if the mortgage exceeds the FMV of the property. o Same rule as Crane: the taxpayer must account for the loan (recourse or non-recourse) that is transferred with the property.  Where the mortgage exceeds the FMV of the property disposed of, the transferee takes on the debt (which assumes that the mortgage will be paid in full and recognizes that it is an obligation to pay) and basis equals the net value plus the mortgage. y When the FMV is less than the debt, Transferee takes on the debt. When the FMV is greater than the debt, Transferee takes at FMV. y Absence of personal liability does not relieve person of obligation to pay. Borrower gets benefit when mortgage is assumed by 3rd person. y Overrules FN 37 in previous case. o A loan is not income when it is received, but it is included in establishing basis. When an encumbered property is sold, the associated extinguishments of the mortgagors obligation to repay is accounted for in the AR. If this were not the rule, allowing the original inclusion of the mortgage in the basis but not accounting for it on sale would cause the taxpayer to receive a higher basis and untaxed income. o What entitles the taxpayer to account for a non-recourse loan in the basis? Non-recourse loans are true loans. There is no reason NOT to treat these loans any differently then personal liability loans.

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Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop o A true loan is secured by property that roughly approximates the value of the loan. But, you can add it into your basis. So when you no longer have to pay the debt, you must account for the money. o DEBT-RELIEF IS ECONOMIC BENEFIT. Diedrich v. Commissioner: held that a donor who makes a gift of property on condition that the donee pay the resulting gift taxes realizes taxable income to the extent that the gift taxes paid by the donee is transferred as a gift subject to a debt and the debt is greater than the basis, then youre in part-gift, part-sale situation.  When a person is relieved of tax liability, he receives an immediate economic benefit by the others assumption of the donors legal obligation to pay the tax.  So, the transfer was treated as part gift/part sale; the donor sells the property for less than the FMV; sale price is the amount of the gift tax (to discharge donor from indebtedness to the U.S.); the balance of the value of transferred property is the gift.  Donors gain is the gift tax AB. Income realized per 1001(b) to the extent that the gift tax is greater than the basis.  Example: o Case #1 FMV = $150,000; gift tax = $62,000; basis = $51,000. Gain of $11,000. o Case #2 FMV = $300,000; gift tax = $232,000; basis = $8,000. Gain of $224,000. o When property is transferred and the debt exceeds the basis, you have a part gift, part-sale situation. Here, the gift tax is the debt, and its the debt-relief in a sense (the debt to the US is relieved.) Then, the difference between the tax and the basis is pure gift.  But what if the basis is greater than the gift tax? FMV = $300,000; gift tax = $232,000; basis = $400,000. Same principle , so loss of $168,000, which is realized but not recognized under Reg. 1.1001-1(e).  FN #37 (P.143) with these facts, the AR is limited to the FMV. FMV is less than debt. Diedrich Court interprets it as a true loan. o There is no problem when the Taxpayer borrows and pays back o If you borrow and invest, then tax amount of loan as basis, deduct depreciation (this was the beginning of the tax shelter). o A true loan is both recourse and non-recourse, they are basis because the Taxpayer is obligated to repay and the value of property is close to the amount of the loan. o When property is transferred the debt goes with the property because the lender can only recover from property; thus, the lender cares about these transactions more than other parties. o BUT abuse occurs and NO true loan exists if the value of the property is significantly less than the amount of the loan, because the Taxpayer can never pay back. The property has a $0 basis. Depreciation and interest are disallowed.  Land is never depreciated; property can be. 1016(a) reduces basis after depreciation even if the Taxpayer does not claim depreciation. The Taxpayer then needs to do an amended return for open years.) $1,855,000 $1,455,000 $1,400,000 Debt Basis (the Red herring) FMV/AR $400,000 gain (What SC held) $55,000 loss (What the TP wanted)

Diedrich (before this case the IRS and case law had a long history of taxing this type of Transfer as net gift) Diedrich 100,000 62,000 Grant 100,000 232,000 Page 59 of 154

FMV Gift tax

gift AR

Income Tax I Basis 51,000 Gain 11,000

Fall 2002/2005 Used Spring 2007 8,000 224,000

Prof Lathrop

Issue: whether the gift to the Donee is conditioned on the Donee paying tax creates taxable income to the Donor to the extent that the gift tax paid exceeds the Donors adjusted basis? YES. 2 cases: Diedrich: Diedrichs made a gift of 85,000 shares of stock to their 3 children with the condition that the children pay the gift tax. The Donors basis was $51,073 and the gift tax paid was $62,992. The Taxpayer did not claim as income any portion of the gift tax paid. The IRS audited and determined that the Taxpayer had realized income to the extent that the gift tax owed by the Taxpayer, but paid by Donee exceeded the Donors basis of $51,073. The Taxpayer appealed to the Tax Court. The Tax Court held for the Taxpayer concluding that no income had been realized. Mi Bank/Grant Grant gave son 90,000 voting trust certificates on the condition that he pay a gift tax. The Taxpayers basis was $8,742 and the gift tax was $232,620. The Taxpayer did not claim any portion of the gift tax owed, but paid by the son. The IRS audited and determined that the Transfer was part gift and part sale and that the Taxpayer realized income to the extent that the amount of the gift tax exceeded the adjusted basis. Thus, increased her income by $112,000. The Taxpayer appealed to the Tax Court and held for the Taxpayer concluding that no income had been realized. The 8th Circuit consolidated the 2 cases and reversed: Donors realized taxable income to the extent the gift tax paid by the Donee exceeded the Donors adjusted basis in the property transferred because the Donor receives benefit when the Donee discharges a Donors legal obligation to pay gift taxes. Supreme Court:  GI is income from whatever source derived; even by indirect means.  Old Colony payment of the employees income tax is income to the employee because it was consideration for services; discharge of obligation by a 3rd party is equivalent to receipt by person taxed (the employee was in a better financial position after the employer paid the employees tax.)  Crane relief from obligation of non-recourse mortgage where the value of the property exceeded the value of mortgage constituted income to the Taxpayer; the Taxpayer realized an economic benefit.  When a gift is made, the gift tax liability falls on the Donor; this is a legal obligation.  The Donors intent is a factor only in determining whether a gift was made.  When the Donee agrees to pay tax the Donor realizes an economic benefit; this is indistinguishable from a benefit arising from a 3rd partys discharge of the Taxpayers indebtedness.  The Supreme Court follows the IRS position that this is a part sale/part gift. The part sale is the amount necessary to discharge the gift tax indebtedness. The part-gift is the balance of the value of the transferred property OR Donors gain = tax liability less Donors adjusted basis. Income is realized to the extent that the gift tax exceeds the Donors adjusted basis. This is consistent with 1001(b). Dissent: Old colony and Crane do not control. They were compensation and sale. Congressional intent should control (ie., whether Congress intended to characterize gift as partial sale when the Donee agrees to pay tax); the statutes do not support this intent.

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Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop Clarification: Footnote #8 (p.148) the Tufts analysis applies even where the Taxpayer takes no deduction. It is a true loan regardless of whether it is a recourse or non-recourse loan. This is the reason for Footnote #37 in Crane. ALSO Diedrich is an example loan used to purchase property that is later given away and Donee pays gift tax. The analysis is mechanical = Donor is liable for the gift tax; the Donee pays the gift tax; the Donee pays the gift tax/ the Donee makes a gift back to the Donor; and the Donor has an economic benefit. PROBLEMS (P.153) 1. Mortgagor purchases a parcel of land from Seller for $100,000. Mortgagor borrows $80,000 from Bank and pays that amount and an additional $20,000 of cash to Seller giving Bank a non-recourse mortgage on the land. The land is the security for the mortgage which bears an adequate interest rate. a. What is Mortgagors cost basis in the land? Assuming the mortgage is to pay for the land, his basis is $100,000. 1012 and Crane & Tufts. Crane & Tufts says that if this is a true loan you can treat it as if you took it out of your own pocket and put it in basis. $80,000 is added to the basis because it was used to buy the land. b. Two years later when the land has appreciated in value to $300,000 and Mortgagor has paid only interest on the $80,000 mortgage, Mortgagor takes out a second non-recourse mortgage of $100,000 with adequate rates of interest from Bank again using the land as security. Does Mortgagor have income when she borrows the $100,000? See Woodsam Associates, Inc. v. Commissioner.

No income when you borrow money because of the obligation to repay it. c. What is Mortgagors basis in the land if the $100,000 of mortgage proceeds are used to improve the land? $200,000. 1012 basis of $100,000 is adjusted by $100,000 capital improvements under 1011 and 1016(a)(1) proper adjustment for expendituresproperly chargeable to capital account. The second mortgage is a capital expense under 1016, so its included in the basis. d. What is Mortgagors basis in the land if the $100,000 of mortgage proceeds are used to purchase stocks and bonds worth $100,000? $100,000, because the stocks and bonds dont have anything to do with the land even though the land secures the note. The stocks and bonds have a basis of their own of $100,000 under 1012. The second mortgage isnt used to improve the land, so it isnt added to the lands basis. e. What result under the facts of (d), above, if when the principal amount of the two mortgages is still $180,000 and the land is still worth $300,000, Mortgagor sells the property subject to both mortgages to Purchaser for $120,000 of cash? What is Purchasers cost basis in land? Mortgagors situation: AR = $120,000 (cash boot) + $180,000 (debt-relief) It is like FMV of any other property received in 1001(b). = $300,000 under 1001(b) and Crane and Tufts. Page 61 of 154

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Basis = $100,000 (for the land only stocks and bonds not included here) under 1012. Therefore, the Mortgagor realizes a gain of $200,000 under 1001(a), which is also recognized under 1001(c). Purchasers situation: Basis = $300,000 (his 1012 cost basis to purchase property, $120,000 + $180,000 of the mortgages he is assumingCrane). Remember this makes sense because in a taxable situation the sellers amount realized should be the buyers basis. If not something is wrong. f. What result under the facts of (d), above, if instead Mortgager gives the land subject to the mortgages and still worth $300,000 to her Son? What is Sons basis in the land? Mortgagors situation: Gift to son, therefore AR = $180,000 (the debt onlydebt relief) per Crane/Tufts; her basis = $100,000. Mom has a gain of $80,000 under Reg. 1.1001(e). Sons situation: Here we have a Diedrich situation where debt is greater than basis, which then throws us into a part-sale/part-gift situation. Under Reg. 1.1015-4, basis is the greater of the donors basis or what Son paid for the property b/c you have a conflict between 1012 and 1015 and the cost basis under 1012 trumps. Here, basis = $180,000. The sale element is the debt relief. The gift element is the balance over the basis. g. What result under the facts of (f), above, if Mortgagor gives the land to her Spouse rather than her Son? What is Spouses basis in the land? What is Spouses basis in the land after Spouse pays off the $180,000 of mortgages? Mortgagors situation: AR = $180,000 under Crane & Tufts b/c of debt relief. Basis = $100,000 under 1011(a) and 1012. Therefore, the Mortgagor realizes a gain of $80,000 under 1001(a), but it is not recognized under 1041(a)(1). Spouses situation: Basis in the land is pure carryover basis under 1041(b)(2), so $100,000. If Spouse pays off the mortgages, the basis is still $100,000 youre supposed to pay off the debt, so nothing happens. But if Spouse sells the property, then shes going to pick up the $80,000 gain that Mortgagor didnt recognize. h. What results to Mortgagor under the facts of (d), above, if the land declines in value from $300,000 to $180,000 and Mortgagor transfers the land by means of a quitclaim deed to Bank? See Parker v. Delaney. AR = $180,000 (Crane or Tufts Debt relief and Value of prop. Same) Basis = $100,000 Gain = $ 80,000 Page 62 of 154

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What results to Mortgagor under the facts of (h), above, if the land declines in value from $300,000 to $170,000 at the time of the quitclaim deed? Here, the debt is greater than the FMV; therefore were thrown into FN 37 of Crane, which says: if the value of property is less than the amount of the mortgage, then a mortgagor who is not personally liable cannot realize a benefit equal to the mortgage. Suggest that the AR should be limited to the FMV. But Tufts says that this situation doesnt matter the mortgagor is still receiving economic benefit of the debt relief. $170,000 FMV $180,000 Debt Relief This becomes AR $100,000 Basis $ 80,000 Gain If this would have been recourse debt then he would have had $70,000 gain and $10,000 in debt forgiveness which would have been taxed as ordinary income.

2. Investor purchased three acres of land, each acre worth $10,000 for $30,000. Investor sold one of the acres in year one for $14,000 and a second in year two for $16,000. The total amount realized by Investor was $30,000 which is not in excess of her total purchase price. Does Investor have any gain or loss on the sales? See Reg. 1.61-6(a). Just like a part gift part sale problem. Must allocate basis to the different sales. Must look at each year separately. Take $30,000 basis and put into 1/3. Here the transactions were completed in two different tax years; therefore Investor must report each separately. In year one, gain of $4,000; in year two, gain of $6,000. So the total gain = $10,000. Under Reg. 1.61-6(a), when part of larger property is sold, the basis of the entire property shall be equitable apportioned and gain or loss on part of the property is calculated separately for each part. ***Allocate basis in each piece as you sell it*** Make it simple by telling you what each years basis is; sometimes this is very difficult to know. 3. Gainer acquired an apartment in a condominium complex by inter vivos gift from Relative. Both used it only as a residence. It had been purchased by Relative for $20,000 cash and was given to Gainer when it was worth $30,000. Relative paid a $6,000 gift tax on the transfer. Gainer later sells the apartment to Shelterer. a. What gain or loss to Gainer on his sale to Shelterer for $32,000? Gainer: AR = $32,000 1001(b) Basis = $20,000 under 1015(a). But 1015(d)(6) says that basis is increased if the gift tax is paid by the donor. Must make adjustment to donees basis b/c of gift tax paid. Therefore, you must figure out a percentage:

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Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop 1015(d)(6)(A)(i)&(ii) layout the formula for determining % allowed as an increase in basis to donee for payment of gift tax by donor. 1015(d)(6)(B) defines net appreciation. In this problem: Net appreciation (A)(i)/amount of gift (A)(ii) Net appreciation (Defined in $1015(d)(6)(B) = $30,000 (FMV) - $20,000 (donors basis) = $10,000 Amount of gift = $30,000 (FMV of gift) $10,000/$30,000 = 1/3 1/3 X $6,000(amt. of gift tax paid by donor) = $2,000 benefit to donee to increase basis of gift transferred by donor; therefore Gainers basis is $22,000. Gainer realizes and recognizes a gain of $10,000. ($32,000-$22,000) Class Notes: September 20, 2002 L. Why do you think we have this adjustment? We used to get an increase by all the gift tax paid but not above the FMV in 1981. 1986 it is limited. What is the limit rational? What is the relationship of net appreciation of the gift is 1/3 to the gift and what does the net appreciation have to do with donee? Donee turns around and sells it and picks up the net appreciation of gain of $10,000 that occurred in the hands of the donor and thats 1/3 the value of the gift. What L. thinks is happening is that donee will get 1/3 of gift tax attributable to that gain that he may pick up under the income tax to increase his basis. Service gives a little break to the donee on paying income tax on the amount of the net appreciation that occurred in the hands of the donor. Not so bad. **Just a note. L. says that the regs. Say to calculate your denominator differently by allowing the donor to take out the annual exclusion and other items before figuring out the ratio to apply to the gift tax paid. This would raise the amount of the gift tax that would be added to the basis of the donee. May want to look at.** b. What is Shelterers basis in the apartment? $32K (1012 cost basis) c. Same questions now assuming that Relative acquired the property for $8,000 cash, but subject to a $12,000 mortgage on which neither she nor Gainer was ever personally liable or ever paid any amount of principal, and that Relative paid $3,000 tax on the gift. See 1015(d)(6). Upon purchase, Shelterer merely took the property subject to the mortgage, paying $20,000 cash for it. Relatives basis = 20K Basis = $8,000 cash + $12,000 debt (entitled to add to basis immediately per Tufts and Crane; true loan is like cash paid). Gainers AR = 20K cash + debt relief of 12 = 32K Basis = 20K but pd gift tax. Final Basis = 21K (10/30 X $3,000 (gift tax paid) = 1K added to donees basis). Shelterers basis = 32K = 20K pd + 12K debt relief b/c property is secured of debt. Same as Gainers AR in taxable transaction.

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Income Tax I

Fall 2002/2005 Used Spring 2007 Prof Lathrop This is what the Reg. 1.1015-5 Increase basis for gift. Does to figure out the denominator because the reg. Says it is the amount of gift for gift tax purposes. Here if you used the services rational you would back out the debt and the annual exclusion and it would be over a 100%. L. says this is why it doesnt make any sense. **Just a note: I would argue if this happened that the TP got to use the whole $3,000 to add to basis of the property so the basis would be 23.** To give a full answer on the test, L says to do it the problem way and tell him that it is favorable to the donee and can be done this way. L. says dont spend a lot of time. Need to know it is there, would be a lot of money for the client.

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Income Tax I Fall 2002/2005 Used Spring 2007 Chapter 7 Life Insurance Proceeds and Annuities (PP. 155-163; Problems 1-3 on p. 158)

Prof Lathrop

Class Notes: September 20, 2002:  Here we get a true exclusion and there is no limit on 101  Recipient can exclude all under 101(a).  (a) is the operative rule.  (a)(2) has some wrinkles in it when you exchange for consideration. Limit to exclusion of consideration paid.  (c) tells you which is always true that interest earned is included in income and taxed at ordinary rates.  (d) some of that is a return of capital and other part is income whether interest or something else.  Must be able to distinguish between (c) and (d) and the long and short of that is if you dont invade the principal you are in (c), not getting any of your principal back.  (g) is relatively new section where you can get proceeds from life insurance although not dead yet. Also, deals with viatical companies.

A. Life Insurance Proceeds: [101(a), (c), (d) and (g); 1.101-1(a)(1), (b)(1), -4(a)(1)(i), (b)(1), (c)] 1. Insured died in the current year owning a policy of insurance that would pay Beneficiary $100,000 but under which several alternatives were available to Beneficiary. a. What result if Beneficiary simply accepts the $100,000 in cash? Exclude all under 101(a)(1) b. What result in (a), above, if Beneficiary instead leaves all the proceeds with the company and they pay her $10,000 interest in the current year? 101(c) Interest Include all $10,000 in GI c. What result if Insureds Daughter is Beneficiary of the policy and, in accordance with an option that she elects, the company pays her $12,000 in the current year? Assume that such payments will be made annually for her life and that she has a 25-year life expectancy. 101(d)(1) Prorate over pay out period of 25 years. (100K / 25 = 4K exclusion representing principal portion of the 100K per year) Include in income amounts paid above principal portion (12K paid a yr. 4K principal portion = 8K included in GI.) Dont have to look at the regs. But helps because shows you exactly how to calculate. If she lives past her life expectancy she keeps excluding the $4,000 once prorate under life insurance you keep. 1.101-4c keep excluding; generous attitude. d. What result in (c), above, if Insureds Daughter lives beyond her 25 year life expectancy and receives $12,000 in the twenty-sixth year? Still get to exclude 4K and include 8K in GI. Generous if live beyond life expectancy.

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Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop 2. Jock agreed to play football for Pro Corporation. Pro, fearful that Jock might not survive, acquired a $1 million insurance policy on Jocks life. If Jock dies during the term of the policy and the proceeds of the policy are paid to Pro, what different consequences will Pro incur under the following alternatives? a. With Jocks consent Pro took out and paid $20,000 for a two year term policy on Jocks life. 101(a)(1) Get 1 million tax free. b. Jock owned a paid-up two year term $1 million policy on his life which he sold to Pro for $20,000, Pro being named beneficiary of the policy. 101(a)(2) Amt. excluded cant exceed amt pd for it. Only exclude 20K trap. c. Same as (b), above, except that Jock was a shareholder of Pro Corporation. 101(a)(2)(B) b/c shareholder in corp. $1 million excludable back into 101(a)(1). 3. Insured purchases a single premium $100,000 life insurance policy on her life for a cost of $40,000. Consider the income tax consequences to Insured and the purchaser of the policy in each of the following alternative situations: a. Insured sells the policy to her Child for its $60,000 fair market value and, on Insureds death, the $100,000 of proceeds are paid to Child. Purchaser - 101(a)(2) exclude 60K of consideration paid. 1012 cost basis is 60K. She realizes gain of 40K and recognizes it as GI. Insured Realizes and recognizes 20 Gain. b. Insured sells the policy to her Spouse for its $60,000 fair market value and, on Insureds death, the $100,000 of proceeds are paid to Spouse. Insured realize gain 20K gain not recognized under 1041(a)(1). Non-recognition special basis role that not 1012 cost basis. Spouse has 1041(B)(2) straight carryover basis - 40K. 100K excludable b/c 101(a)(2)(A) gets out of trap and into 101(a). Ends up in 101(a)(2)(A). c. Insured is certified by her physician as terminally ill and she sells the policy for its $80,000 fair market value to Viatical Settlement Provider who collects the $100,000 of proceeds on Insureds death. Insured does not recognize 80K FMV 101(g)(1)(A) Kicks it into 101(a)(1) payments due to insureds death and excludable. Viatical Provider Recognizes GI in the amount of 20K.

B. Annuity Payments: [72(a), (b), (c); 1.72-4(a), -9(Table V)] Problem (p.163) Page 67 of 154

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1. In the current year, T purchases a single life annuity with no refund feature for $48,000. Under the contract T is to receive $3,000 per year for life. T has a 24 year life expectancy. a. To what extent, if at all, is T taxable on the $3,000 received in the first year?

b. If the law remains the same and T is still alive, how will T be taxed on the $3,000 received in the thirteenth year of the annuity payments?

c. If T dies after nine years of payments will T or Ts estate be allowed an income tax deduction? How much?

d. To what extent are T and Ts spouse taxable on the $3,000 received in the current year if at a cost of $76,500 they purchase a joint and survivorship annuity to pay $3,000 per year as long as either lives and they have a joint life expectancy of 34 years?

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Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop Chapter 8 Discharge of Indebtedness (pp. 164-180). [61(a)(12); 102(a); 108(a), (b)(1)-(3), (d)(1)-(5), (e)(1) and (5); 1017(a), (b)(1), (2), (3)(A) and (B); see 108(c), (f), and (g); 385; 1.16-12(a); 1.1001-2(a), 2(c) Ex. (8); see 1.1017-1(a)] Cross reference discharge of indebtedness and debt relief under Tufts and Crane. Debt relief involves sale/exchange of property for consideration and you never get into 108Tufts/Crane. U.S. v. Kirby Lumber Co.: Federal government (D) v. Bond issuer (P) NATURE OF CASE: Review of judgment in favor of taxpayer in suit for refund of income taxes paid. FACT SUMMARY: Kirby Lumber (P) issued bonds at par value and then later repurchased some of them in the open market below par. The IRS (D) contended that the difference between the issuing price and the repurchase price was a taxable gain to Kirby Lumber (P). CONCISE RULE OF LAW: The retirement of debt by a corporation for less than face value represents a realized increase in net worth to the corporation and is therefore a taxable gain. FACTS: Kirby Lumber (P) issued bonds having a par value of $12,126,800 for that amount. Later in the same year it was able to repurchase a part of the bonds for a price below par. The aggregate difference in price between the par value and repurchase price was $137,521. The IRS assessed a tax on that amount, contending that it was a taxable gain to Kirby Lumber (P). Kirby (P) paid the tax and sued for a refund. The lower courts found in Kirbys (P) favor, and the Supreme Court granted review. ISSUE: Does retirement of debt for less than face value represent a taxable gain to a corporation? HOLDING AND DECISION: (Holmes, J.) Yes.  Section 61(a) defines gross income as gains or profits and income derived from any source whatever.  The retirement of debt for less than face or issuing value represents a gain or income for the taxable year.  By this transaction, Kirby (P) made available $137,521 previously offset by the bond obligations.  This represented an accession to income within the popular meaning of those words and is a taxable event. Reversed. EDITORS ANALYSIS: The proceeds of a loan are not taxable to the borrower and the repayment of the principal is not deductible since neither transaction affects the borrowers net worth. An issue arises, however, when the liability is discharged without repayment by the borrower. Where a father relinquishes a liability from the son, this can quite properly be considered a gift of that amount and not taxable to the son. Where the debt is repaid through services rather than in cash, the debt reduction would clearly be income. GAIN: Refers to situation where Amount Realized exceeds the Basis of an asset. PAR VALUE: The stated value of a security. DEBT: An obligation incurred by a person who promises to render payment or compensation to another.  For the definition of indebtedness use Kirby or 108, but not both. Page 69 of 154

Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop  108 and 132 are similar.  108(a) what is excludable.  108(b) how much is excludable.  108(d) definitions  108(e) general rules for discharge of indebtedness (NOT bankruptcy or insolvency)  108(e)(5) purchase money debt reduction for solvent debtor taxed as price reduction.  108(e)(5)(A) IF debt of purchaser of property to the seller which arose out of purchase of property IS reduced.  108(e)(5)(B) reduction does not occur in bankruptcy or when purchaser is insolvent.  108(e)(5)(c) - but for this paragraph, such reduction would be taxed as GI to the purchaser from the discharge of indebtedness.  1017(a)(1) says that if an amount is excluded under 108(a) AND under 108(b)(2)(E), (b)(5), or (c)(1), any portion of the amount is to be applied to reduce the basis, THEN such portion shall be applied in reduction of the basis of any property held by taxpayer at the beginning of the taxable year following the tax year when discharge occurs.  1017(b)(2) says that in case of a discharge under 108(a)(1)(A) or (B), must only reduce the basis under 1017(a) by the amount of solvency after discharge. Zarin v. Commissioner: Compulsive gambler (P) v. Commissioner (D) NATURE OF CASE: Appeal from tax court recognition of income from discharge of indebtedness. FACT SUMMARY: Zarin (P) incurred $3,435,000 in gambling debts at a New Jersey casino; after contesting the debt in court, he and the casino settled it for $500,000, and the Tax Commissioner (D) assessed a deficiency based on the difference. CONCISE RULE OF LAW: If a taxpayer, in good faith, disputes the amount of a debt, a subsequent settlement of the dispute will be treated as the amount of debt cognizable for tax purposes. FACTS: Zarin (P) was a compulsive gambler who frequented Resorts Hotel International and held a line of credit there. As a valued gaming patron, he had his line increased over the course of two years from $10,000 to $200,000 and above. Under this line, Zarin (P) could write a check, called a marker, and in return receive chips that could be used to gamble at the casinos tables. Although between June 1978 and December 1979, Zarin (P) incurred $2,500,000 in gambling losses which he pad in full, in January 1980 he lost about $3,435,000. To pay for these losses, he wrote personal checks and counterchecks to Resorts, but they were returned dishonored. When Resorts filed a state action to collect the $3,435,000, Zarin (P) claimed the debt was unenforceable under New Jersey state regulations protecting compulsive gamblers. Resorts and Zarin (P) settled the claim for $500,000 in 1981. Although at first the Tax Commissioner (D) assessed a deficiency based on recognition of $2,935,000 of income in 1980 from larceny by trick and deception, upon challenge by Zarin (P) in the tax court the Commissioner (D) changed the basis of his assessment to recognition of $2,935,000 of income in 1981 from cancellation of indebtedness. The tax court agreed with the Commissioner on the latter ground, and Zarin (P) appealed. ISSUE: If a taxpayer, in good faith, disputes the amount of a debt, will a subsequent settlement of the dispute be treated as the amount of debt cognizable for tax purposes? HOLDING AND DECISION: (Cowen, J.) Yes.

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Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop  The proper approach in viewing the Resorts/Zarin (P) transaction is as a disputed debt or contested liability.  Under the contested liability doctrine, if a taxpayer, in good faith, disputes the amount of a debt, a subsequent settlement of the dispute will be treated as the amount of debt cognizable for tax purposes.  Here Zarin (P) incurred a $3,425,000 debt while gambling at Resorts, but in court disputed liability on the basis of unenforceability.  The subsequent settlement of $500,000 served only to fix the amount of the debt, and no income was realized or recognized. Zarin (P) could not have recognized income from cancellation of indebtedness because his debt did not satisfy the requirements of I.R.C. 108.  108(d)(1)(A)&(B) requires that for a canceled debt to be recognized as income under I.R.C. 61(a)(12), it must be indebtedness for which the taxpayer is liable, or indebtedness subject to which the taxpayer holds property.  However, Zarins (P) was unenforceable as a matter of New Jersey law, and therefore Zarin (P) could not have been held liable for it.  Moreover, he did not have a debt subject to property which he held; the gambling chips which he purchased were not property, but a medium of exchange within the Resorts casino and a cash substitute. Right to borrow $ to gamble.  They were mere evidence of indebtedness which had no independent economic value outside the casino.  Thus, Zarin (P) did not have income from cancellation of indebtedness both because he did not meet the requirements of I.R.C. 108, and because the settlement of his debts represented a contested liability.  REVERSED. DISSENT: (Stapleton, J.) Zarins (P) debt was incurred during a purchase money transaction ; he merely paid with credit for the right to gamble at Resorts, a thing of value traded in the marketplace like any other commodity and for which other persons paid cash. Here, income was recognized when the debtor, Zarin (P), was relieved of his obligation to repay $2,935,000, and creditor Resorts released this debt or acknowledged its unenforceability. EDITORS ANALYSIS: The logical underpinning for this case lies in the fact that when a taxpayer receives money as a loan he also incurs an obligation to repay the loan; thus, although the taxpayer receives an economic benefit from the receipt of funds, that receipt has no immediate tax consequences. No income is realized because there has been a wash by the taxpayers taking on of an obligation. However, a taxable event occurs if part of the debt is released or forgiven, because then some of the taxpayers assets are freed from being subject to the obligation. DEFICIENCY: Refers to amount of tax taxpayer owes, or is claimed to owe, the IRS. INCOME: The earning of money, received in a way that benefits the economic situation of a taxpayer, of which a portion may be subject to income tax liability. DEBT: An obligation incurred by a person who promises to render payment or compensation to another. Settlement of contested liability on debt is not gross income because parties agreed that debt was not worth $3.4 Million, but the amount of the liability was not determined until the parties agreed to $500,000. 108 does not apply because the gambler was not liable for unenforceable debt (unenforceable distinguishes this from Tufts.) Parallel with Tufts at least can go after bldg. PROBLEMS (P. 180) Class Notes: September 25, 2002 Page 71 of 154

Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop 1. Poor borrowed $10,000 from Rich several years ago. What tax consequences to Poor if Poor pays off the so far undiminished debt with: a. A settlement of $7,000 of cash? Poor has $3,000 of discharge of indebtedness income (economic benefit under Kirby and 61(a)(12).) Zarin doesnt apply because the amount of debt is not in dispute. $3,000 realized GI. What has happened here is that he has freed up $3,000 of assets in his pocket that were otherwise encumbered. Under Glen Shaw Glass that is the kind of economic benefit that should be taxed and under 61(a)(12) it will. Must use Kirby to see if discharge of indetedness.

b. A painting with a basis and fair market value of $8,000? Exchange of property, per Tufts, $8,000 worth of debt relief (using this term means that you are exchanging underlying property for relief of debt) in exchange for an $8,000 painting. Poor has $2,000 of discharge of indebtedness which counts as GI. (AR = $8,000, Basis = $8,000, gain = 0.) This is a combination problem Tufts debt relief and a discharge of indebtedness. Zarin does not apply b/c no dispute and 108 does not apply b/c TP does not meet any of 108(a)(1)(A)-(D). If underlying exchange of property it is debt relief to the FMV of the property given.

c. A painting with a value of $8,000 and a basis of $5,000? Per Tufts: AR (debt relief) = $8,000 1001(b) Basis = $5,000 1012 y Therefore, a realized gain of $3,000 on the sale of the painting in exchange for debt relief. 1001(c) Recognized and included in GI under 1001(a) & 61(a)(3). Tufts & Crane y Also discharge of indebtedness income per 61(a)(12) of $2,000 (Kirby). y Total included in GI = $5,000 (the $3,000 is probably capital gain and the $2,000 is ordinary income). y Still has debt relief of $8,000 but here are basis is lower than the painting so we have a capital gain to the amount the AR or debt relief is over basis. y The 2,000 is still discharge of indebtedness and will be ordinary income under 61(a)(12).

d. Services, in the form of remodeling Richs office, which are worth $10,000? $10,000 is income per 61(a)(1) (compensation for services.) With respect to discharge of indebtedness (it is not classified as this, b/c it is compensation just paid in services), no gain Page 72 of 154

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Fall 2002/2005 Used Spring 2007 Prof Lathrop because loan is being repaid with remodeling services. Not being forgiven the $10,000 but is working off. Compensation.

e. Services that are worth $8,000? $8,000 is income to Poor under 61(a)(1), payment in exchange for services. $2,000 is discharge of indebtedness income per 61(a)(12).

f. Same as (a), above, except that Poors Employer makes the $7,000 payment to Rich, renouncing any claim to repayment by Poor. Definitely no gift under Duberstien. $7,000 is income for Rich per 61(a)(1) and Old Colony. (Employer pays Employee debt, treated as compensation). $3,000 is discharge of indebtedness income per 61(a)(12) and Kirby.

2. Mortgagor purchases a parcel of land held for investment from Seller for $100,000 with $20,000 of cash paid directly by Mortgagor and $80,000 paid from the proceeds of a recourse mortgage incurred from Bank. Mortgagor is personally liable for the loan and the land is security for the loan. When the land increases in value to $300,000, Mortgagor borrows another $100,000 from Bank again incurring personal liability and again with the land as security. Mortgagor uses the $100,000 of loan proceeds to purchase stocks and bonds. Several years later when the principal amount of the mortgages is still $180,000, the land declines in value to $170,000, Mortgagor transfers the land to the Bank, and the Bank discharges all of Mortgagors indebtedness. a. What are the tax consequences to Mortgagor? See Reg. 1.1001-2(a) and 2(c) Example (8). 1.1001-2(a); general amount realized form disposition of property including amount of discharge debt, but not if it is recourse debt, then AR will not include amounts that are income from discharge debt under 61(a)(12). Ex. 8 AR = FMV, also income from discharge of indebtedness AR = $170,000 (FMV) AB = $100,000 (Crane/Tufts)1012, 1016 1001(a) gain = $70,000 (AR of $170,000 AB of $100,000) recognized under 1001(c). Crane/Tufts in relation for exchange of property for relief of debt. Only to the $170,000 not the $10,000 b/c it is discharge of debt and taxable at ordinary income rates per 61(a)(12). If personal liable the debt relief is limited to amount property given to bank. Now if non-recourse his debt relief is exactly $180,000 and he would have $80,000 gain. Good and Bad b/c it is taxed at capital gain, however, if he qualified for 108 he can not exclude b/c he cant even get to 108 because it is not debt forgiveness. Plus he has discharge of indebtedness income. $180,000 debt (recourse) less $170,000 (AR) = $10,000 (61(a)(12) and Kirby discharge of debt. (This could get into 108) Recourse analysis: Debt $180,000 $10,000 discharge of debt Page 73 of 154

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Fall 2002/2005 Used Spring 2007 FMV $170,000 Basis $100,000 $70,000 Gain

Prof Lathrop

b. What are the tax consequences to Mortgagor if the liabilities had been non-recourse liabilities? See problem 1(i) at page 154 of the text.

Non-recourse debt follows property. Per Fn. 37 of Crane: AR = debt instead of FMV = $180,000. Basis = $100,000 Therefore, $80,000 gain under 1001(a). All debt-relief, not discharge of indebtedness. Non-recourse analysis: FMV is not a factor. Debt $180,000 Basis $100,000

$80,000 Gain

3. Businessman borrows $100,000 from Creditor to start an ambulance service. He then purchases ambulances for use in his business at a cost of $100,000. Assume the ambulances are his only depreciable property and, unrealistically, that after some time their adjusted basis and value are still $100,000. What consequences under 108 and 1017 in the following circumstances: a. Businessman is solvent but is having financial difficulties and Creditor compromises the debt for $60,000. $40,000 discharge of indebtedness income per 61(a)(12) and Kirby. No underlying exchanges of property so no debt relief under Tufts and Crane. The next step is to see if 108 applies? No, doesnt fall within exclusions of (A) (D) of 108(a)(1). Businessman is solvent and no other exceptions fit, so must report all of the $40,000 as ordinary income under. b. Same as (a), above, except that Creditor is also the ambulance dealer who sold the ambulances to Businessman and, as a result of depreciation deductions, the adjusted basis of the ambulances is $35,000. Still has discharge of indebtedness income of $40,000 under 61(a)(12) and Kirby. 1. Does 108 apply? YES. Per 108(e)(5)(A) (Remember cant be insolvent) an exception to Kirby, if the debt of purchaser of property to seller of property is reduced, here by $40,000, the $40,000 would be discharge of indebtedness income, but is treated as purchase price adjustment. Purchase price adjustment occurs when the seller is also creditor and agrees to reduce debt and purchaser doesnt have to include the reduction in income. Treat as if you bought the ambulances for $60,000. This is an exception to the Kirby Doctrine. 2. New basis calculation: Original basis before purchase price adjustment = $100,000. Took $65,000 worth of depreciation deductions to the basis per 1016(a)(2) AB = $35,000. Therefore, the $40,000 purchase price adjustment reduces the cost of the ambulances to $60,000 (new basis), which would reduce the basis to 0 with the $65,000 deductions. Page 74 of 154

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Fall 2002/2005 Used Spring 2007 Prof Lathrop 3. Here we are missing $5,000 ($60K-65K), because $65,000 depreciation exceeds his $60,000 basis. What do you do with that? This is the tax-benefit rule: Bliss Dairy, because the deductions were improper, you must report this $5,000 as income in the year the event occurs (when deal was struck.). Makes sense if you think about the depreciation expense was taken off of ordinary income in the year the depreciation expense was taken, makes sense that it should have to be included as ordinary income to offset the amount taken off ordinary income. (Dont go below 0 in the tax world). New basis of property is $0. 4. This rule cryptically changes the basis by changing the original purchase price to the adjustment.

c. Assume the same facts as in (a), above, except that Businessman is insolvent and his liabilities of $225,000 exceed his assets (the ambulances worth $100,000) by $125,000. Further assume Businessman has no net operating losses, general business credit carryovers, minimum tax credit, capital loss carryovers, passive activity loss or credit carryovers, or foreign tax credit carryovers. Creditor discharges $40,000 of the $100,000 loan without any payment. This shows no Tufts problem. 1. $40,000 discharge of indebtedness income per 61(a)(12) and Kirby. 2. Insolvent (108(a)(1) gives help under 108(d)(3) tells you whether a TP is insolvent), so 108(a)(1)(B) exception applies. Excess of liabilities over FMV of assets = Insolvent by $125,000 ($225,000-$100,000). 108(a)(1)(B) GI doesnt include amountTP is insolvent; therefore, discharge of $40,000 by creditor is excluded. This amount is determined immediately before the discharge(108(d)(3) immediately before the discharge) this is important because the taxpayer may become solvent during analysis. DONT switch in the middle of the analysis. Either insolvent or not and determined right before the discharge. Amount of discharge of indebtedness is excludable up to $125,000 per 108(a)(3) Limitation. Therefore, entire $40,000 is excluded from income. 3. The next step is to reduce excludable amount by tax attributes in 108(b)(1) tradeoff apply exclusion in rank order of tax attributes. 108(b)(2)(A) (D) there are no tax attributes. Here the tax attributes are good for the TP so if he reduces them it is the penalty he pays for the exclusion. The only one we need to worry about is 108(b)(2)(E)(i)(ii), which sends us to 1017(a)(1). This rule says that the exclusion of $40,000 might have to be applied in reduction of the basis of any property held by the taxpayer at the beginning of the tax year following the tax year in which discharge occurs. 1017(b)(2) says reduction shall not exceed excess of the aggregate of the bases of the property held by the TP immediately after the discharge over the aggregate of the liabilities of the TP immediately after the discharge. Aggregate bases of property immediately after the discharge = $100,000 1017(b)(2)(A). Aggregate of liability immediately AFTER discharge = $185,000 91017(b)(2)(B). ($225,000-$40,000). Here we have an excess of $0 no excess of basis ($100,000-$185,000 = 0). Therefore, basis remains the same and the entire $40,000 is excluded. Tax world usually never go below 0. This means that go back to 108(b)(2)(E) no limitation. 4. This rule favors the taxpayer, because if he is insolvent both before and after the discharge, then he doesnt have to reduce his basis. This comes indirectly from Kirby. **Note** - 108(b)(5) gives the TP an option to elect apply reduction first against depreciable property only.*** If you chose to you can not limit reduction by 1017. d. Same as (c), above, except that Businessman has a $30,000 net operating loss.

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Fall 2002/2005 Used Spring 2007 Prof Lathrop Same analysis as above except once you get to step 3, you have a tax attribute. Per 108(b)(2) flush and (A), reduce the net operating loss first. So the entire $30,000 net operating loss is wiped out and you have $10,000 to exclude. Run down list and basis will still have to be reduced under 1017 and still get same result up above. 0 basis adjustment under 1017(b)(2). May want to elect 108(B)(5) TO PRESERVE NOLS

e. Same as (c), above, except Businessmans liabilities exceed his assets by $25,000. Same analysis as in (c), above, except in Step 2, the liabilities only exceed assets by $25,000. Per 108(a)(3), exclusion is limited to amount of insolvency; therefore only $25,000 can be excluded. The $15,000 is income per 61(a)(12) for discharge of indebtedness. 1017(b)(2) recognizes if taxpayer gets out of the woods partially, then whether you recognize income depends upon how far out of debt you get. So in step 4 of (c), we do have a reduction in basis. Here, taxpayers basis of $100,000 exceeds his liability immediately after discharge ($125,000 40,000 = $85,000) by $15,000. Therefore, basis is reduced by $15,000 to $85,000. This is a benefit to the TP b/c when or if he sells the property later he will have a higher basis to offset any gain or add to any loss sustained in result of disposal of the asset. The basis without this limitation would have been $75,000 immediately after applied to the asset at the beginning of the taxable year following the taxable year in which the discharge occurs. EX. If he sold the ambulance the following year for 75,000 the TP would have capital gain of $0. If you apply the limitation of 1017 properly the TP basis is only reduced to $85,000. Considering a sale for $75,000 the TP would have a capital loss in the amount of $10,000 instead of a gain of $0.

4. Decedent owed Friend $5,000 and Nephew owed Decedent $10,000. a. At Decedents death Friend neglected to file a claim against Decedents estate in the time allowed by state law and Friends claim was barred by the statute of limitations. (Lets defer our concern for Nephew.) What result to Decedents estate? Clearly an economic benefit to the estate in the amount of $5,000, therefore, discharge of indebtedness income per 61(a)(12) and Kirby. b. What result to the estate in (a), above, (with Nephew still in cold storage) if instead Friend simply permitted the statute to run stating that she felt sorry for Decedents widow, the residuary beneficiary of his estate? Is still economic benefit to the estate, so possible discharge of indebtedness income. BUT could this be considered a gift under 102(a)? If so, then there would be no income to the estate. c. Now, what result to Nephew if Decedents will provided that his estate not collect Nephews debt to the estate? Is still economic benefit to Nephew, but could be considered an inheritance under 102(a)therefore no income. Page 76 of 154

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Class Notes: September 30, 2002  Something to be aware of with 108, in past the IRS said you could exclude assets that were excluded under bankruptcy when determining whether you were insolvent but they have changed this and it makes it harder to get into 108. Also, having to do with contingent liabilities it is not clear how to handle. L. says that national accounting board that there must be a substantial probability that the debt will be realized.  Tax court is following new rule not allowing a backout of exempt assets under the bankruptcy rule.  Problem is you now may have more assets than under the old holding excluding exempt assets determining insolvency under 108.  In 108(b)(2)(E) that takes you to 1017(b)(2) what happens is that if your basis is above the liabilities immediately after discharge then this starts cutting into your basis. But this occurs only if you are not insolvent as to the formula.

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Income Tax I Fall 2002/2005 Used Spring 2007 CHAPTER 9 DAMAGES AND RELATED RECEIPTS (pp. 182-194)

Prof Lathrop

A. Introduction In general rule you should not have income if capital. Look at the substance of the transaction. What does the recovery represent. Class Notes: September 30, 2002:  Damage to goodwill is a return of capital unless the recovery is above the basis of the goodwill.  General rule is that you look at what the damages represent. B. Damages in General: Raytheon Production Corporation v. Commissioner: Manufacturer (P) v. Commissioner (D) NATURE OF CASE: Appeal reviewing the taxability of a settlement award. FACT SUMMARY: Raytheon (P) argued that a settlement it received pursuant to a federal antitrust suit was excludable from its gross income. CONCISE RULE OF LAW: A settlement award is properly includable in the computation of gross income where the damages represent compensation for lost profits. FACTS: Raytheon (P) and R.C.A. settled out of court after Raytheon (P) sued R.C.A. for violating federal antitrust laws. The tax commissioner (D) ruled that the settlement should be included in Raytheons (P) gross income, and Raytheon (P) appealed. ISSUE: Is a settlement award properly includable in the computation of gross income? HOLDING AND DECISION: (Mahoney, J.) Yes.  A settlement award is properly includable in the computation of gross income where the damages represent compensation for lost profits.  The rationale supporting the rule is that had the business received the profits directly, such income would be properly taxable. Thus, damages received through litigation in replacement of such income is similarly taxable.  The determinative issue is what the damages are awarded in compensation of.  Damages based on injury to good will are not properly taxable as lost profits. In the present case, the record demonstrates that Raytheon (P) did not sue for lost profits.  Rather, the settlement constituted remuneration of the destruction of Raytheons (P) business and good will.  The fact that the award takes the form of a settlement or damages is irrelevant.  The taxability of the receipt is based on the character of the underlying claim.  However, such a receipt still constitutes a taxable event where the value of the business is converted into cash.  In such a case, the taxable gain is equal to the amount received in excess of the cost of the good will to Raytheon (P), and that amount is properly includable in his gross income.

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Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop EDITORS ANALYSIS: Punitive damages, to the extent they do not represent compensation for personal injuries, are properly includable in the calculation of gross income. This inclusion dispelled the idea that gross income only included gain acquired as a product of labor or capital. Where the recovery is in remuneration of an asset that has been destroyed, the proper measure of damages constitutes the difference between the value obtained and the victims basis in the destroyed item. Note the characterization of the gain is probably capital gain if you created the goodwill. Now if you purchased the goodwill then 1231 says that you have to amortize the goodwill over a certain number of years. This may cause a different characterization of the goodwill. It is still the amount in excess representing the damage to goodwill that would be gross income. Notes: September 30, 2002:  Recovering goodwill is different from recovering lost profits. Goodwill is a recovery of principal up to the point you have basis. Only gain if recovery is above what RCA had invested in the goodwill. If it is goodwill you created then probably a capital gain. If it is goodwill you acquired it would probably be a 1231 asset and if amortized may have some result on classification.  If buying business may allocate some of the purchase price to goodwill.  Acquired Goodwill can be amortized over 15 yrs now. GROSS INCOME: The total income earned by an individual or business. LOST PROFIT: The potential value of income earned or goods which are the subject of the contract; may be used in calculating damages where the contract has been breached. CAPITAL GAIN AND LOSS: Gain or loss from the Sale or Exchange of a Capital Asset as defined in 1221.

Problems (p. 185) 1. Plaintiff brought suit and unless otherwise indicated successfully recovered. Discuss the tax consequences in the following alternative situations: a. Plaintiffs suit was based on a recovery of an $8,000 loan made to Debtor. Plaintiff recovered $8,500 cash, $8,000 for the loan plus $500 of interest. brought suit to recover his/her $8,000 principal that was loaned to Debtor. Since $8,000 of the $8,500 was a return of principal there would be no income tax to TP on the first $8,000. However, the additional $500 was a recovery of interest earned by TP for loaning Debtor the $8,000. Therefore, the $500 would be considered income under 61(a)(4) Interest. Interest is always income unless exempted. Seen this in 101(c) Life Insurance.

b. What result to Debtor under the facts of (a), above, if instead Debtor transferred some land worth $8,500 with a basis of $2,000 to Plaintiff to satisfy the obligation? What is Plaintiffs basis in the land? Debtor: Debtor received $8,500 debt relief in exchange for property worth $8,500 under Crane/Tufts. However, TP (Debtor) has sold his property in essence for $8,500 1001(b)(Debt relief), therefore TPs basis under 1012 cost is $2,000 and TP Page 79 of 154

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Fall 2002/2005 Used Spring 2007 Prof Lathrop gain under 1001(a) equals $6,500 and recognized under 1001(c). TP would have long-term capital gains of $6,500 taxable at capital gains rates. Plaintiff: 1012 cost basis to is $8,500. Still would have to include $500 in ordinary income under 61(a)(4) for interest earned. Should have a basis of $8,500 b/c he is taking the $500 into income on his tax return for the year.

c. Plaintiffs suit was based on a breach of a business contract and Plaintiff recovered $8,000 for lost profits and also recovered $16,000 of punitive damages. Under Raytheon Production Corporation v. Commissioner, we must look to the essence of the transaction. The $8,000 was awarded for lost profits; therefore, this amount would have been taxable if defendant would have carried out his contractual obligation. The $8,000 will be taxable as ordinary income because the TP would have made $8,000 in income includable on his tax return if the contract had been good. The $16,000 will also be included in income based upon Glenshaw Glass; punitive or exemplary damages recovered in a recovery arising in a business context are taxable even if they are properly characterized as a windfall.

All is included into income.

d. Plaintiffs suit was based on a claim of injury to the goodwill of Plaintiffs business arising from a breach of a business contract. Plaintiff had a $4,000 basis for goodwill. The goodwill was worth $10,000 at the time of the breach of contract. 1. What result to Plaintiffs if the suit is settled for $10,000 in a situation where the goodwill was totally destroyed? Under Raytheon Production Corporation v. Commissioner, the recovery for loss of goodwill is taxable if the recovery is above the amount of basis in the goodwill. (Recovery Basis = Taxable income) Here, the recovery of $10,000 - $4,000 basis = $6,000 gain included in taxable income and taxable to TP under 61(a).

2. What result if Plaintiff recovers $4,000 because the goodwill was partially destroyed and worth only $6,000 after the breach of contract? Recovery is $4,000 less basis of $4,000 = $0 taxable income. If sold later then TP has no basis left and all would be capital gains or ordinary income.

3. What result if Plaintiff recovers only $3,000 because the goodwill was worth $7,000 after the breach of contract? Page 80 of 154

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Fall 2002/2005 Used Spring 2007 Prof Lathrop Recovery is $3,000 Basis of $4,000 = $O gain/loss no taxable income. Also, Goodwill basis remains at $1,000.

C. DAMAGES AND OTHER RECOVERIES FOR PERSONAL INJURIES: [104(a); 105(a)-(c) and (e); 106(a); 1.104-1(a), (c), (d); 1.105-1(a),-2,-3; 1.106-1] Revenue Ruling 79-313: (may want to read on page 192) Important part of chapter is in 104(a)(2); damages other than punitive on account of physical injury or physical sickness. Recently amended. Emotional distress cannot stand as physical injury alone, must be the result of a physical injury. Must be attached to a physical injury. Unlike general damages 104(a)(2) all damages that arise out of physical injury or physical sickness are excluded from gross income no matter how you measure it. Even if measured by loss of wages. Problems (p. 193) 1. Plaintiff brought suit and successfully recovered in the following situations. Discuss the tax consequences to Plaintiff. a. Plaintiff, a professional gymnast, lost the use of her leg after a psychotic fan assaulted her with a tire iron. Plaintiff was awarded damages of $100,000. 104(a) flush, (a)(2) excludes the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness. TP excludes all $100,000 for the physical injuries of the loss of her leg. Reg. 1.104-1(c).

b. $50,000 of the recovery in (a), above, is specifically allocated as compensation for scheduled performances Plaintiff failed to make as a result of the injured leg. Here, 104(a)(2) excludes the amount of any damages received on account of personal physical injuries or physical sickness, therefore the $50,000 amount associated with the loss of work performances will still be excluded from income. 104(a)(2) cuts across general rule of Ratheon and you dont look at the substance of the injury. Any damages received if resides in Tort and includes physical injuries or physical sickness unless it is punitive is excluded even if measure by lost wages damages. Major difference between general damages rule and 104(a)(2). All $100,000 excluded.

c. The jury also awards Plaintiff $200,000 in punitive damages. Page 81 of 154

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Fall 2002/2005 Used Spring 2007 Prof Lathrop 104(a)(2) specifically includes any punitive damages awarded. Whether in Glenshaw Glass or under 104(a)(2) whether physical or not punitive is just not excludable. Must be compensatory and if not excluded is a windfall. Why? Congress and SC say cant exclude b/c 104 is aimed at something you lost, if go beyond that it is a windfall.

d. The jury also awards Plaintiff damages of $200,000 to compensate for Plaintiffs suicidal tendencies resulting from the loss of the use of her leg. 104(a)(2) excludes the $200,000 because the physical loss of her leg caused the emotional distress of suicidal tendencies. Recoveries for emotional distress depend on the nature of the underlying action. (Book Page 187). (In this case action for loss of leg). Damages recovered for emotional distress incurred on account of physical injury are excludable. Clearly, the suicidal tendencies were caused by the physical loss of her leg. Not that the suicidal tendencies came first and she lost her leg.

e. Plaintiff in a separate suit recovered $100,000 of damages from a fan who mercilessly taunted Plaintiff about her unnaturally high, squeaky voice, causing Plaintiff extreme anxiety and stress. Falls outside the coverage of 104(a)(2). Emotional distress itself is not a physical injury, despite the manifestation of physical symptoms, and recoveries arising out of emotional distress are included in gross income except to the extent that damages are received for amounts paid for medical care which is attributable to the emotional distress. 104(a) flush (Page 187). All $100,000 includable in gross income under 61(a), gross income means all income from whatever source derived. Remember included unless specifically excluded. This is not specifically excluded therefore, falls under the broad language of 61(a).

f. Plaintiff recovered $200,000 in a suit of sexual harassment against her former coach. Falls outside the coverage of 104. If not a physical injury then you are not in 104(a)(2) in the first place. All $200,000 is includable in gross income. Damages for nonphysical personal injuries, such as defamation, First Amendment rights, and sex and age discrimination are no longer excludable. (Page 187) 104(a) the recovery must be for personal physical injuries or physical sickness.

g. Plaintiff dies as a result of the leg injury, and Plaintiffs parents recover $1,000,000 of punitive damages awarded in a wrongful death action under long-standing State statute? This is the exception to 104(a)(2) that punitive damages are included in gross income. 104(c)(1)(2) must be met to exclude the 1 million dollars. If the award was for a wrongful Page 82 of 154

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Fall 2002/2005 Used Spring 2007 Prof Lathrop death action and with respect to which applicable State law (as in effect on September 13, 1995 and without regard to any modification after such date) provides, or has been construed to provide by a court of competent jurisdiction pursuant to a decision issued on or before September 13, 1995, that only punitive damages may be awarded in such a action, then the 1 million may be excluded from gross income by the TP.

2. Injured and Spouse were injured in an automobile accident. Their total medical expenses incurred were $2,500. a. In the year of the accident they properly deducted $1,500 of the expenses on their joint income tax return and filed suit against Wrongdoer. In the succeeding year they settled their claim against Wrongdoer for $2,500. What income tax consequences on receipt of the $2,500 settlement? 104(a) excludes from gross income awards under certain conditions except to the extent the TP takes a deduction under 213 dealing with medical expenses. 213(a) Allowance of deduction There shall be allowed as a deduction the expenses paid during the taxable year, not compensated for by insurance or otherwise, for medical care of the taxpayer, his spouse, or a dependent (as defined in section 152), to the extent that such expenses exceed 7.5% of adjusted gross income. In lay terms 213(a) just says that the IRS allows on an individual tax return a standard or itemized deduction. If the TP decides it is best to itemize deduction instead of taking the IRS standard deduction, one of the allowable deductions from gross income of TP is medical expenses paid by the TP. The rule states that the TP may take a deduction for any medical expenses paid in excess of 7.5% of adjusted gross income. An example would be when the TP adjusted gross income is $35,000. First, figure the floor (the amount of medical expense the TP must have before a deduction may be taken), here it is $35,000 x .075% = $2,625. Lets say the TP had qualifying medical expenses of $4,125, the TP itemized deduction in this case would be $4,125 - $2,625 (floor) = $1,500. Back to problem: In this problem the question is telling us that the TP took $1,500 as a qualifying itemized deduction (the $1,500 in the example above) off of his adjusted gross income in the year prior to settling the case. 104(a) says that amount received under 104(a)(2) that represent reimbursement of medical deductions taken under 213(a) are included in income not in excess of the deduction allowed under 213(a). Here, the TP must include in gross income $1,500 of the $2,500 settlement amount because of taking the proper deduction under 213(a). The additional $1,000 is excluded under 104(a)(2). Note: Think about the IRS reasoning of making the $1,500 includable in income. If it were not included then the TP gets a double windfall; TP gets a deduction without any cash outlay because he gets the money back and doesnt have to include it in income. An expense and nonrecognition. Fairness says include in ordinary income up to the deduction you got off of ordinary income thru 213(a).

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b. In the succeeding year Spouse was ill but, fortunately, they carried medical insurance and additionally Spouse had insurance benefits under a policy provided by Employer. Spouses medical expenses totaled $4,000 and they received $3,000 of benefits under their policy and $2,000 of benefits under Employers policy. To what extent are the benefits included in their gross income? (see footnote 29 on page 191, supra.) 104(a)(3) excludes amounts received through accident or health insurance for personal injuries or sickness. Therefore, the $3,000 of benefits under the individual policy coverage is excluded from gross income. The whole amount because there is no limitation under 104(a)(3). However, 105 (a) covers the amount received attributable to employer contributions. Amounts received are included in income if attributable to coverage paid by the employer that were not included in the employees income per 106. However, 105(b) excludes amount otherwise received under 105(a) that were for the reimbursement of medical expenses paid. Therefore, it would seem that the $2,000 received under the employers policy is also excluded. Not exactly, upon close examination of the 105(b) language it says reimburses employee for medical expenses. Here, TP is getting a windfall above her medical expenses and you must prorate according to FN29 page 191. Rev. Ruling 69-154, indicates that the amount of medical expense to be considered paid by each policy is proportionate to the benefits received from each policy. Total received is $5,000 which was $3,000 from individual policy and $2,000 from employer policy. Therefore, 40% ($2,000/$5,000) is attributable to employer and 60% ($3,000/$5,000) is attributable to individual policy. Medical expenses totaled $4,000, therefore $1,600 ($4,000 x 40%) represents reimbursement of employer % and can be excluded under 105(b) but the additional $400 ($2,000 - $1,600) must be included in gross income. The $2,400 ($4,000 $1,600) attributable to the individual policy is fully excludable under 104(a)(3) because it has no such language to restrict the windfall. Even though she received $3,000 from her individual policy there is no need to prorate. All is excluded under 104(a)(3).

c. Under the facts of (b), above, may Injured and Spouse deduct the medical expenses? (See 213(a).) No, 213(a) says that you cannot take a deduction for medical expenses that are compensated for by insurance or otherwise. The expenses were compensated for and no deduction is allowed under 213. Perfectly good sense b/c you are excluding it from income.

3. Injured, who has a 20-year life expectancy, recovers $1 million in a personal injury suit arising out of a boating accident. a. What are the tax consequences to Injured if the $1 million is deposited in a money market account paying 5% interest? Page 84 of 154

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Rev. Ruling 65-29, holds that, when the taxpayer actually received the present value of an award for personal injury in a lump sum and invested it, any interest earned on the amount invested was taxable. Therefore, 104(a)(2) excludes the lump sum $1 million dollars, however, the 5% interest earned off the money market account each year is gross income to TP.

b. What are the tax consequences to Injured if the $1 million is used by injured to purchase an annuity to pay Injured $100,000 a year for Injureds life? 104(a)(2) excludes the 1 million from gross income. However, since the insured used the money himself to buy the annuity, 72(b) exclusion ratio would tax any amount received that relates to income paid on the annuity. Some will represent return of principal and sum will be income. 20 yr. Life expectancy x $100,000 per year = Total over life is $2,000,000. Therefore, $50,000 per year is a return of principal and $50,000 is interest and included in gross income under 61(a)(9).

c. What are the tax consequences to Injured if the case was settled, and in the settlement, Injured received payments from Defendant of $100,000 a year for life? All $100,000 a year are excludable. TP has no control over that and did not have the money in his hands. 1.101-1(c) of the Income Tax Regulations provides that the term damages received (whether by suit or agreement) means an amount received (other than workmens compensation) through prosecution of a legal suit or action based upon tort or tort type rights, or through a settlement agreement entered into in lieu of such prosecution. The annual payments to be received by the taxpayer are amounts received through a settlement agreement entered into in lieu of the prosecution of a legal suit based upon tort or tort rights within the meaning of 1.104-1(c) of the regulation. (Rev. Rul. 79-313). Here, the $100,000 is a settlement agreement entered into in lieu of the prosecution of a legal suit based upon tort or tort rights.

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Class Notes: October 7, 2002  Dont get into 215 until you have gone through 71.  If something is included as alimony under 71 then payor is allowed deduction under 71.  One question is if you itemize these expenses or not? Where would you look? Adjusted gross income under 62 that is where you look to see if you are going to deduct expenses come off the top from gross income under 61 to get to adjusted gross income under 62. 63 tells you expenses you must itemize. 62(a)(1) says alimony is deducted off of Gross Income 61 directly of f the top. Favorable to TP.  84 Congress made this very mechanical. What Congress was concerned in enacting (f) was the difference between support for former spouse alimony and property settlements. (f) says that if you load up in early years that looks like property settlements. Without (f) you could count a property settlement as alimony and is a great advantage to the payor at the expense of the payee because they have to include in income.  What is this stuff? 61a)(8) says alimony is income; 71(a) mirrors and says that alimony is income.  Dont have to be divorced to take advantage of 71.  71(b)(1) says cash. Liquid stuff, kind of thing the payee can use to buy things to take care of herself.  71(b)(1)(A) says must be by Divorce Decree or separation agreement. 71(b)(2) defines Divorce Decree (A) or separation agreement (B).  71(b)(1)(B) says that parties can agree how the tax consequences will be handled.  71(b)(1)(C) says that you can not live in same house.  71(b)(1)(D) says that no payment can be made after death of spouse and is critical.  71(c) can not be child support.  71(f) attempt to separate property settlements and alimony. Property settlements should be handled through 1041. A. Alimony and Separation Maintenance Payments:  The payor spouse need not use taxable income to make the payments. Alimony is deductible whatever source of the payments. (Lunding v. New York Tax Appeals Tribunal.)  BNA Tax Management Portfolio: A payment is alimony, includible in the payor spouses gross income, when: o the payment is made in cash; o the payment is received by (or on behalf of a spouse) under a divorce or written separation instrument; o if the spouses are divorced or legally separated, they reside in separate households when payment is made; o the payments to a third party on behalf of the payee spouse are evidenced by a timely executed writing; o the payor spouses liability to make the payment does not continue for any period after the payee spouses death; o the payor and payee (if married) do not file a joint return; and o the divorce or separation instrument does not designate non-alimony treatment.  Cannot get to 215 unless you go through 71.  Look at 62 expenses that come off of gross income to arrive at adjusted gross income. 62(a)(10) says you can deduct alimony off of gross income.  71(f) Congress concerned about separating out what is support and what is property settlement.  If didnt have (f) you could hide a property settlement as alimony and very beneficial to payor b/c can deduct under 215. Page 86 of 154

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1. Direct Payments: [71 (omit (c)(2) and (3)); 215(a) and (b); 7701(a)(17); 1.71-1T(a) and (b) (omit Q6, 7, 11, and 12)] 71 (Income Rule); 215 (Deduction Rule) 71(a) says that gross income includes alimony or separate maintenance payments for payee spouse. 71(b)(1) A-C set forth the requirements of alimony/separate maintenance payments as:  Payment in cash (or check or money order liquid money);  Payment received by spouse under divorce or separation instrument (defined in 71(b)(2));  Instrument doesnt designate payment as excludable for payee and not allowed as deduction under 215 for payor;  If legally separated, not members of the same household at the time of the payment;  There is no liability for payments after death of payee spouse in cash or property, the problem here is that the payments that were alimony during life will be disqualified. Some states say that if the decree is silent, it means that payments are indefinite. ALWAYS put in decree that payments do not exceed death!! CRITICAL, prior to 84 had to be in decree. Lathrop says dont have to now but would be stupid for not including. Must be clear, if you put it in decree you get away from this problem.  Payments do not include those for child support must specifically earmark what money is going toward child support. Problems Page 203: 1. Determine whether the following payments are accorded alimony or separate maintenance status and therefore are includible in the recipients gross income under 71(a) and deductible by the payor under 215(a). Unless otherwise stated, Andy and Fergie are divorced and payments are called for by the divorce decree. a. The divorce decree directs Andy to make payments of $10,000 per year to Fergie for her life or until she remarries. Andy makes a $10,000 cash payment to Fergie in the current year. 71(a) General rule Gross income includes amounts received as alimony or separate maintenance payments. 71(b)(1) The term alimony or separate maintenance payment means any payment in cash if: 1. The payment is received by, or on behalf of, a spouse under a divorce or separation instrument; (Yes, divorce decree)(71(b)(1)(A)). 2. The divorce or separation instrument does not designate the payment as a non-alimony payment; (No designation as non-alimony) (71(b)(1)(B)). 3. In the case of a decree of legal separation or of divorce, the parties are not members of the same household at the time the payment is made; (No mention of living together)(71(b)(1)(C)). 4. There is no liability to make any payment in cash or property, after the death of the payee spouse; and (To Fergie for life or until she remarries, No after life payments) (71(b)(1)(D)). 5. The payment is not for child support. (No mention of children)(71(c)(1)). Fergie would include in gross income $10,000 per year under 71(a) & 61(a)(8) and Andy would deduct the $10,000 per year under 215(a).

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b. Same as (a), above, except that Andy, finding himself short on cash during the year, transfers his $10,000 promissory note to Fergie.

71(a) only applies to cash payments. 71(b)(1). The promissory note would not qualify. Therefore, Andy cannot deduct the $10,000 and Fergie does not have to include in income. Regs. 1.71-1T(b), Q A-5.

c. Same as (b), above, except that instead of transferring his promissory note to Fergie, Andy transfers a piece of art work, having a fair market value of $10,000. Same as (b), 71(a) applies to cash payments. Regs. 1.71-1T(b), Q A-5.

d. Same as (a), above, except that in addition the decree provides that the payments are nondeductible by Andy and are excludible from Fergies gross income. 71(b)(1)(B) says that the divorce or separation instrument does not designate such payment as a payment which is not includible in gross income under this section and not allowable as a deduction under section 215. In other words, a court can direct, or the parties can elect, nonalimony treatment simply by designating such payments as such in the divorce instrument. PLR 9610019. T.C. Memo 1995-554. According to the Seventh Circuit, the term designate in 71(b)(1)(B) must be given its plain common sense dictionary meaning. The court concluded that the divorce decree, which lacked a clear, explicit and express direction that the support payments were not to be treated as income to the payee, did not negate alimony treatment. This really just tells the parties they may contract out of 71. Agreement is valid. Andy cannot deduct the $10,000 payment and Fergie does not have to include the $10,000 in gross income.

e. Would it make any difference in (d), above, if you learned that Andy anticipated that he would have little or no taxable income in the immediate future, making the 215 deduction practically worthless to him, and as a consequence of this agreed to the nondeductibility provision in order to enable Fergie to avoid the imposition of federal income taxes on the payments? No. The parties are free to negotiate the divorce decree. Page 88 of 154

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f. What result in (a), above, if the divorce decree directs Andy to pay $10,000 cash each year to Fergie for a period of 10 years? Not deducible for A and includible for F b/c As alimony payment could stretch beyond Fs death. Thus violating the requirement that a payment can not extend beyond the life of the payee spouse. 71(b)(1)(D). Contract to pay alimony is for ten years regardless of payees life. Probably b/c not specifically end on death.

g. Same as (f), above, except that under local law Andy is not required to make any post-death payments.

Maybe. A good lesson that the divorce decree should include a statement relieving payor from having to make post-death payments. Andy would qualify for the 215(a) deduction for 10 years and Fergie would have to include in gross income the alimony payments under 71(a) & 61(a)(8) for 10 years.

h. Same as (a), above, except the divorce decree directs Andy to pay $10,000 cash each year to Fergie for a period of 10 years or her life, whichever ends sooner. Additionally, the decree requires Andy to pay $15,000 cash each year to Fergie or her estate for a period of 10 years. Andy makes a $25,000 cash payment to Fergie in the year. $10,000 of the $25,000 qualifies as alimony deductions under 215 for Andy. Also, Fergie would include $10,000 in income under 71(a) & 61(a)(8). The additional $15,000 would be seen as a property settlement and not be considered deductible alimony. Because the $15,000 must be paid even after death it violates 71(b)(1)(D).

i.

Same as (a), above, except that at the time of the payment, Andy and Fergie are living in the same house. Page 89 of 154

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Non-deductible for violation of 71(b)(1)(C); cannot live in same household. Andy cannot take a deduction under 215 and Fergie does not include into gross income the amount of $10,000 under 71 & 61(a)(8).

j.

Same as (i), above, except that Andy and Fergie are not divorced or legally separated and the payments are made pursuant to a written separation agreement instead of a divorce decree. This is possibly ok because it is important to note that the separate residence requirement only applies to divorced or legally separated under a decree of divorce or separate maintenance, payments made pursuant to a written separation agreement or support order described in 71(b)(2)(B) or 71(b)(2)(C) may qualify as alimony, even if the parties reside under the same roof when payment is made. BNA 515-2nd A-8 at 4.

2.

A divorce decree requires Tina to make the following payments (which meet all the requirements of 71(b)) to Ike: Year 1 Year 2 Year 3 $80,000 40,000 10,000

a. What are the tax consequences of these payments to Tina and Ike? Front loading: 71(f)(4)(A)&(B); Calculate Year 2 Excess: (Year 2 (Year 3 + $15,000)) = 2nd postseparation year excess alimony. ($40,000 (10,000+15,000) = $15,000 year 2 excess recognized in year 3. 71(F)(3)(A)&(B)(i)(ii); Calculate Year 1 Excess: 1st year payment [(2nd year payments 2nd year excess payments) + 3rd year payments] /2 + $15,000] = 1st year excess payments.

($80,000 [($40,000-$15,000)] + $10,000] /2 + $15,000 = $47,500 Excess year 2. 71(f)(2)(A)&(B); Add Excess Year 1 & Excess Year 2 = Recapture in Year 3 of $62,500. Summary: Tina would take a deduction under 215 of $80,000 in year 1, $40,000 in year 2, and $10,000 in year 3. However, she also include in gross income the excess alimony payments in an amount equal to $62,500 in year 3. 71(f)(1)(A). Ike would include in gross income $80,000 in year 1, $40,000 in year 2, and $10,000 in year 3. Page 90 of 154

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Fall 2002/2005 Used Spring 2007 Prof Lathrop 71(a) & 61(a)(8). However, he is entitled to deduct in year 3 the excess alimony in an amount equal to $62,500. 71(f)(1)(B)

b. What result if the payments are: Year 1 Year 2 Year 3 $80,000 70,000 60,000

No front loading; If the amounts paid within year one and two and three are all within $15,000 of each other, there will be no recapture. The reason? Relatively level payments for at least three years fit the congressional notion of alimony which, in turn, falls within the congressional inclusion-deduction policy of letting the income tax obligation tag along after the support roll. (Page 202-203). Tina would deduct the amounts in each year under 215 and Ike would include amounts in each year as income under 71(a) & 61(a)(8). 71(f)(4)(A)&(B)(i)(ii): $70,000-($60,000+15,000)=-5,000 **Just an example, the calculations do not work if each year alimony payments are all within $15,000 of each other.

c. What result if the payments are: Year 1 Year 2 Year 3 $30,000 40,000 80,000

This is rear loading and 71 does not concern this. All will be considered alimony. Tina will deduct yearly amounts under 215 and Ike will include in income amounts each year under 71(a) & 61(a)(8).

d. What result if the payments are: Year 1 Year 2 Year 3 $80,000 50,000 80,000

71(f)(4)(A)&(B)(i)(ii): (50,000-(80,000+15,000))= 0 71(f)(3)(A)&(B)(i)(ii): (80,000-[(50,000-0) + 80,000] /2 +$15,000 = 0 71(f)(2) Excess Alimony Payment = $0 (Year 1 of $0 + Year 2 of $0). Tina takes a deduction in each year for amounts paid to Ike as 215 alimony deductions. Page 91 of 154

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Fall 2002/2005 Used Spring 2007 Prof Lathrop Ike must include in gross income each year the payments made by Tina under 71(a) & 61(a)(8).

e. Suppose that instead of requiring Tina to make the payments set forth in (a), above, the divorce decree requires Tina to pay Ike 50 percent of the net income (before taxes) of her oil business for three years. The payments above represent 50 percent of the net income from the oil business for the respective years. What tax consequences to Tina and Ike? 71(f)(5)(C) Fluctuating payments not within control of payor spouse are not subject to the recapture rules. Recapture rules do not apply to any payment made pursuant to a continuing liability over the period of the first three post-separation years to pay a fixed portion (which may be determined by a formula) of the payor spouses income form a business, property or from compensation for employment or self-employment. 71(f)(5)(C). The payments can vary with the payors income so long as the percentage used is fixed by the pre-existing formula. A variable payment agreement is exempt only if it is effective for at least three years. BNA A-13 Vol. 515-2nd. Therefore, the 50% amount in each year will be considered alimony. Tina will deduct the payments in (a) above each year under 215 and Ike will include amounts in gross income under 71(a) & 61(a)(8) each year. NO RECAPTURE IN YEAR 3 EVEN IF FRONT LOADING.

f. What are the tax consequences if the decree instead provides for level payments of $80,000 per year for three years, but Ike dies at the end of year 2 and the payments terminate at that time according to the express provisions of the instrument?

Tina would take a deduction in Years 1 & 2 under 215 for $80,000 and Ike would include in income for Years 1 & 2 under 71(a) & 61(a)(8) $80,000.

g. What result in (a), above, if the payments are made pursuant to a 71(b)(2)(C) decree for support? Recapture rules do not apply to support payments made pursuant to a court order described under 71(b)(2)(C) according to 71(f)(5)(B). Therefore, Tina would take a deduction under 215 of $80,000 in year 1, $40,000 in year 2, and $10,000 in year 3. Ike would include in gross income $80,000 in year 1, $40,000 in year 2, and $10,000 in year 3. 71(a) & 61(a)(8). h. Tina and Ike are legally divorced and live in the same household in year one. Tina moves to a new apartment at the beginning of year two. Under the divorce decree, Tina makes payments to Ike of: Page 92 of 154

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What results to Tina and Ike in each of the years?

3.

Indirect Payments [71(b)(1)(A); 1.71-1T(b)(Q6 and 7)]

Class Notes: Indirect payments come directly out of 71(b)(1)(A) I.T. 4001: Page 205 dealing with the payment of insurance payments by the husband pursuant to a divorce decree. If the insurance policy is owned by wife then the payment by payor is alimony and can be deducted under 215 but if the payor is still the owner and just contingent beneficiaries then it is not alimony and cannot be deducted by payor. Doesnt do any good to pay on life insurance you dont own, it is to the economic benefit of the payee. The payee can sell it, keep it, borrow against it, etc. Worried about the current economic benefit, payee gets something right now. Not concerned about the death benefit. Payee would include in gross income under 71 & 61(a)(8). PROBLEMS: (P. 207) 1. Tom and Nicole are divorced. Pursuant to their written separation agreement incorporated in the divorce decree, Tom is required to make the following alternative payments which satisfy the 71(b) requirements. Discuss the tax consequences to both Tom and Nicole. a. Rental payments of $1,000 per month to Nicoles landlord. 71(b)(1)(A) & Reg. 1.71-1T(b)(Q6) The payment of rent is on behalf of the spouse pursuant to the divorce decree and qualify as alimony payments. Nicole must include in income under 71(a) and 61(a)(8). Tom may take a deduction under 215.

b. Mortgage payments of $1,000 per month on their family home which is transferred outright to Nicole in the divorce proceedings. 71(b)(1)(A) & Reg. 1.71-1T(b)(Q6) Indirect payment may be made to a third party and qualify as alimony payments if otherwise qualify under 71(b) and the payor has no incident of ownership of the property to which payment is being made. Since Nicole received the home outright the mortgage payments made by Tom qualify as alimony. Nicole must include in gross income $1,000 per month under 71(a) & 61(a)(8). Tom may deduct the payments under 215.

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c. Mortgage payments of $1,000 per month as well as real estate taxes and upkeep expenses on the house where Nicole is living which is owned by Tom. Not deductible according to IT 4001: Under Glenshaw Glass the wife is getting an economic benefit by having free rent. Not 71.

2. Roseanne agrees to pay Tome $15,000 a year in alimony until the death of either or the remarriage of Tom. The alimony satisfies the 71(b) requirements. After 3 years, Tom is concerned about Roseannes life expectancy and they agree to reduce the alimony amount to $10,000 a year if Roseanne provides Tom $100,000 of life insurance on her life. a. What are the tax consequences to Tom and Roseanne if Roseanne purchases a single premium $100,000 policy on her life for $60,000 and she transfers it to Tom?

The life insurance policy is not a cash transfer to S from C. 71(b)(1). Hence S does not include value in GI and cannot deduct policy price under 215(a). Sonny will have a carry over basis of 60K 1041(b)(2) and no gain recognized under 1041(a)(2) as the transfer is related to the cessation of the marriage b/c transferred w/n 6 yrs. Reg. 1.1041-1T(b) A-7. Under 101(a)(2)(A), when Cher dies, the full 100K exclusion will be allowed b/c the trap under 101(a)(2) for valuable consideration does not apply when there is a carry over basis under 1041(b)(2).

b. What result in (a), above, if Roseanne instead pays Tom $60,000 cash and he purchases the policy for $60,000? B/c the transfer was in cash and assuming all the other 71(b) requirements are met, under 71(a) the entire 60K insurance payment would be alimony and Cher would have a deduction 215(a) and Sonny would include the 60K in GI under 61(a)(8). No 101(a)(2) trap problem b/c C not transferring the policy. If payment was in 1st yr could have front loading.

c. What result if Roseanne buys an ordinary policy on her life for $5,000, transfers it to Tom, and agrees to transfer $5,000 cash to him each year so he can pay the annual premiums on the policy?

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Fall 2002/2005 Used Spring 2007 Prof Lathrop Transfer of policy is not alimony b/c still not a cash payment under 71(b)(1). The 5K cash transfer for premiums is alimony for 71(a) paid on behalf of spouse incident to divorce. Deductible for R under 215(a). T will get transferred basis of Cs policy under 1041(b)(2) b/c related to the cessation of the marriage 1041(c)(2) and hence incident to divorce under 1041(a)(2) which allows for the full value of the policy to be excluded from GI under 101(a)(2)(A).

d. Same as (c), above, except that Roseanne pays the $5,000 annual premiums directly to the insurance company. Same as (c), 71(b)(A)

e. Same as (d), above, except that instead of transferring the policy to Tom, Roseanne retains ownership of the policy but irrevocably names Tom as its beneficiary. Still no alimony, current economic benefit goes to Tom. Remember the question is what can you do with it right now? No deduction to Roseanne she retains ownership. So its the retention of ownership and not the fact that she will not get the proceeds upon death. Its what can you do with it right now. Her insurance fell out side that arena she cant do anything with that. Key is the current economic benefit.

B. Property Settlements [1041; See Section 1015(e)] Reg. 1.1041-1T(b).

Class Notes: October 7, 2002: when looking at 1041(c)(2) must know what cessation of the marriage means in the Reg. 1.1041-1T(b) Q6 and the transfer that occurs not more than one year after the date the marriage ceases there is a preclusive presumption and transfer of property need not be related to the cessation of marriage, so if it happens 1 yr. after does not have to related to the cessation of marriage but if happens after that you have to get into these Regs. that gives you the 6 year rule that there is a presumption not related to the divorce but rebuttable and subject to the divorce decree. History of this is the Davis case before you had 1041 controlled. Davis gave his wife stock in satisfaction of marriage rights. Davis had a loss on the stock. Wife got a FMV basis. Might want to look at case. After Davis case the state courts looked into how the ownership of the property was between the spouses, whether jointly or what. The states had different rules. 1041 enacted and cuts across the Davis case ruling on this issue and says non-recognition for the transferor and carry over basis for the transferee. Davis other ruling are good law. When would you not want to be in 1041 is when you have a loss. Page 95 of 154

Income Tax I PROBLEMS: (P. 212)

Fall 2002/2005 Used Spring 2007

Prof Lathrop

1. Michael and Lisa Maries divorce decree becomes final on January 1, 2000. Discuss the tax consequences of the following transactions to both Michael and Lisa Marie: a. Pursuant to their divorce decree, Michael transfers to Lisa Marie in March, 2000 a parcel of unimproved land he purchased 10 years ago. The land has a basis of $100,000 and a fair market value of $500,000. Lisa Marie sells the land in April, 2000 for $600,000. Ms AR in the gift = 500K (FMV of the gift to his former spouse) 1001(b) AB in the land = 100K 1011(a) 1001(a) Gain for M is 400K 400K gains is realized but not recognized under 1001(c) b/c the transfer was to his former spouse two months after divorce. 1041(a)(2). B/c the transfer was made within one year of the divorce it is a preclusive presumption that it is incident to the divorce that under 1041(c)(1) says that if within one year it is incident to divorce and the gain is not recognized by Michael. Ls gain = AR = 600K 1001(b) AB = 100K 1041(b)(2) Transferred basis of former Lisas Gain = 500K which is realized 1001(a) and recognized 1001(c).

b. Same as (a), above, except that the land is transferred to satisfy a debt that Michael owes Lisa Marie. The land has a basis of $500,000 and a fair market value of $400,000 at the time of the transfer. Lisa Marie sells the land for $350,000.

LMs AR = 350 1001(b) AB = 500K (Transferred basis of spouse under 1041(b)(2). Loss of 150K is realized under 1001(a) and recognized under 1001(c). Note that although the basis of the transfer is treated as a gift, 1015(e) allows for the transfer to be governed by 1041(b)(2) instead of 1015(a) (which husbands basis which would have only produced a 50K loss). You do not use 1015 to determine loss, you use 1041 so dont have to use different basis to determine loss as you do on a gift not between spouses. Under 1041 transferee steps into the shoes of the transferor. Also, brings into play 1041(c)(1) b/c it occurs within one year. If this would have been 1015 basis she would have used the 400,000 as basis b/c of the limitations of FMV basis of donor when loss on sale.

c. What result if pursuant to the divorce decree, Michael transfers the land in (a), above, to Lisa Marie in March, 2005. If M transfers the land to LM five years after divorce then it is still presumed to be related and that if within 6 years of the divorce to be related the cessation of the marriage and thus still a Page 96 of 154

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Fall 2002/2005 Used Spring 2007 Prof Lathrop non-recognition rule under 1041(c)(2). See also [Reg. 1.1041-1T(b) at A-7]. No gain recognized to M and same gain to L as in (a).

d. Same as (c), above, except that the transfer is required by a written instrument incident to the divorce decree. Same as above in (c). L. You must have writing, if not you have no instrument to attach to this section. Put something in writing.

e. Same as (c), above, except the transfer is made in March, 2007. Rebuttable presumption that the transfer was not related to the cessation of the marriage under [Reg. 1.1041-1T(b) at A-7] and 1041(c)(2). Could rebut the presumption that the transfer of the property within the 6 year time period. Such as: legal or business barriers, disputes over the property, etc. [Reg. 1.1041-1T(b) at A-7]

C. Other Tax Aspects of Divorce [71(b)(1)(D); (c).] Reg. 1.71-1T(c).

PROBLEMS: (P. 214) Class Notes: 10/9/02:  You can still do what is called WV Summit Statute and say I am giving you $1,000 a month for your support and support of children. That is alimony and not child support b/c you must have fixed amount or fixed % to distinguish/qualify as child support. That is the general rule and if the divorce decree says this it is alimony.  If you break something out specifically it is 71(c)(1) and is child support.  What in the Lester case: Lester makes these payments to his wife and the question is can he deduct them? He says I am paying you 12,000 and once any of his three kids reach majority the payments is reducted by 4,000. Court said the problem is that it is not fixed and that is not child support. 71(c) comes along to overrule this case. Today Lester $4,000 reduction would be treated as child support and immediately the payment would be child support and backed out and the rest would be alimony. 71(c)(2). Page 97 of 154

Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop  To figure out how you handle 71(c)(2)(B) you must go to the regs. Two condition is regs that cause this section to operate. 1. Sean and Madonna enter into a written support agreement which is incorporated into their divorce decree at the time of their divorce. They have one child who is in Madonnas custody. Discuss the tax consequences in the following alternative situations: a. The Agreement requires Sean to pay Madonna $10,000 per year and it provides that $4,000 of the $10,000 is for the support of their child. 71(c)(1) states that 71(a) does not apply to payments for the support of children. So 4K would be not taxed as alimony and would not be deductible for S and includible in GI for M. If all of 71(b) is met (appears that all is met), then the remaining 6K is treated as alimony and is includible for M 71(a), 61(a)(8) and deductible for S under 215(a).

b. The agreement requires Sean to pay Madonna $10,000 per year, but when their child reaches age twenty-one, dies, or marries prior to reaching twenty-one, the amount is to be reduced to $6,000 per year.

$4,000 is not going to be treated as alimony, but as payment for the support of a child which is excludable for M and not deductible for S. 215(a), 71(c)(2)(A), the section that overrules Lester case. The remaining 6K if it satisfies 71(b) requirements will qualify as alimony includible in GI under 71(a) & 61(a)(8) and deductible under 215(a).

c. The agreement requires Sean to pay Madonna $10,000 per year but that the payments will be reduced to $8,000 per year on January 1, 2008, and to $6,000 per year on January 1, 2012. Sean and Madonna have two children: Daughter (born June 17, 1990), and Son (born March 5, 1993). Two test that prevent parents from getting around 71(c)(2)(A) under (B) are found in [1.711T(c) Q & A 18.] (1) Can take a reduction 6 months before or after 18th or 21st birthday; or (2) Two separate reductions on two separate occasions which occur not more than one year before or after a different child of the payor spouse attains the age between 18-24. Two-year window reduction will equal child support. On Jan. 1, 1998 D will be 6 months short of 18 yrs old when the deduction would take place. On Jan. 1, 2003, S will be 10 months after 18th birthday. This meets the reduction test 2 and 4K reduction in alimony will be treated as child support and will be excluded from GI and not deductible under 215. 71(c)(1)(2)(b). Remaining 6K will be treated as alimony income deductible for S under 215(a) and includible for M in 61(a)(8) as GI.

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Fall 2002/2005 Used Spring 2007 Prof Lathrop Class Notes: Marjorie McConnell Book in library about divorce. Start by giving 1 yr window on each side that majority of kids happen D. S. 1/1/2012 1/1/2008 6/17/2008 1/1/2007 1/1/2009 1/1/2011 3/5/2011 1/1/2013

Class Notes: October 9, 2002  Situation where payments are reduced on a certain date and not a certain age.  What reg.? 1.71-1T(c) Q18  Two situations that presumed to be related to aid of children and in all other situations will not be presumed (Rebuttable): o Where the payments are to be reduced not more than 6 months before or after the date child attains the age of 18 or 21 or local majority. So if the kid is going to turn lets say 18 6 months of either side that reduction occurs there is a presumption that it is child support. o Second situation is what we have. Payments that are to be reduced on two or more occasions cannot occur more than one year before or after a different child of the payor spouse attains a certain age between the ages of 18 and 24, inclusive. The certain age referred to in the preceding sentence must be the same for each such child, but need not be a whole number of years. Presumption can be rebutted either by the service or the TP. If representing the payee and want it to be child support so it is not included in income as alimony and if you are the payor you want it to be income. o Book in library Marbury McConnell. o Start with the year the deduction takes place, 1/1/08 and 1/1/12 and then make a one-year window on each side. 1/1/07 & 1/1/09 and 1/1/11 & 1/1/13. That is window. o So if these kids turn 18 within this two-year window and if you get this far there is a presumption that it is child support. Can be rebutted. But each turn 18 within the two-year window. The idea behind the reg. is these reductions are close enough that when these two kids turn 18 there is a presumption that it falls within (c)(2)(A). o Dont have to be 18 can be any age between 18 and 24 but has to be same age but dont have to be whole year. Example would be if children turn 23 within this window.

d. What result in (a), above, if Sean pays Madonna only $5,000 of the $10,000 obligation in the current year?

Under 71(c)(3) when the payor is paying less than the amount agreed, then so much of the payment as does not exceed the sum payable for support shall be considered a payment for spouse support. This means that 4K will be excluded under 71(c)(1) and 1K will be included as alimony in GI under 71(a) & 61(a)(8) and deducted under 215(a). 71(a), (b)(1)(A-D) if satisfied.

Class Notes:  Look for fixed amount. Page 99 of 154

Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop  Must have fixed amount to have child support. Remember that it is a presumption of child support and can be rebutted and the IRS does rebut sometimes.  Put into divorce decree who has the right to take dependency exemption on return. Remember must fill out waiver form to give up dependency exemption. Must have waiver from custodial spouse.  IRS can rebut the presumption of child support.  Dependency exemptions upon divorce 152(e) long of it is that the custodial spouse gets exemption unless waived. There is a form to waive and better use form to waive. Must be in writing. It is like 71(b)(1)(B) the divorce decree must be in writing. Put dependency exemptions in divorce decree so that if spouse says that she/he wont do it then go to court for enforcement. Must assume that each is paying support to be able to waive.

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Fall 2002/2005 Used Spring 2007 Chapter 11: Other Exclusions From Gross Income

Prof Lathrop

A. Gain From The Sale Of A Principal Residence [1.121-1(a)-(e), -1(f) Examples 1,6,10 and 11, -2(a), -3(a), (b) Example 1.] Class notes: October 9, 2002:  Old rules under 1034 (has been repealed). No age qualification under 121. 1034 had to be your principal residence when you sold it but under 121 the 2 year in 5 year term came into play. This was referred to role over gain and if you died owning the home then no tax.  Remember 121(f) that you can elect out of this. Ex. Would be if you were living in a trailer there may be a small gain the TP may know that they will be selling a house later for more gain so decide to use 121(f).  121 no age limit, 2 year living in requirement, and outright exclusion of gain up to $250,000 if single or $500,000 if married.  Basis rule is simple under 121 is a cost basis and you dont have to worry about it. The only wrinkle to this is probably in (c), where you dont meet ownership and use requirements because of health related problems and there is prorating.  Confusing part in (d).  L. recommends that you do keep records because of improvements added or depreciation taken you want to stay within gain exclusions when sell. Higher cost basis more likely you stay in exclusion amounts.  Under 1034 if people got divorced it had to be principal residence when sold, but under 121 just within time frame before sold. Old rule not living in house when sold cant exclude. 121(b)(3) addresses this situation.  Old 1031 was a once in a life time gain exclusion that you did not have to buy another home. 121 is nothing like that you can exclude every 2 years.  Question of what is a principal residence is the same, it means where you eat and sleep, where you live. Building a house it is not your principal residence until you move in.  Difference b/t 11034 and 121 is that in 121 does not have to be principal residence when you sell it. Have a window. PROBLEMS: (P. 226) 1. Determine the amount of gain that Taxpayers (a married couple filing a joint return) must include in gross income in the following situations: a. Taxpayers sold their principal residence for $600,000. They had purchased the residence several years ago for $200,000 and lived in it over those years. Taxpayer under 1001(b) has amount realized of $600,000 from the sale of residence and has Basis under 1012 of $200,000, which under 1001(a) taxpayer has a gain of $400,000. However, the gain may be able to be excluded 121(a) Exclusion of gain from sale of principal residence. Since taxpayer meets rules under 121(a) (operative rule, gives you your exclusion) of the property being owned and used by the taxpayer as taxpayers principal residence for periods aggregating 2 years over the last 5 years before the date of sale and taxpayer meets 121(b)(2)(A)(ii) concerning the filing of a joint return the taxpayer may exclude up to $500,000 of gain. Therefore, all $400,000 of gain is excluded from income. First, 121(a) is your operative rule and gives you your exclusion. (b) gives you a limitation after (a) gives you the exclusion. (b) says how much can be excluded. (b) gives a $500,000 limitation to the TPs. Page 101 of 154

Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop b. Taxpayers in (a), above, purchased another principal residence for $600,000 and sold it 2 years later for $1 million. Same analysis as (a), TP may exclude gain once every 2 years. 121(b)(3). Amount Realized Basis Gain $1,000,000 600,000 400,000 1001(b) 1011(a) 1001(a)

TP may exclude under 121(a) the full $500,000. 121(b)(2)(A)(ii) allowing $500,000 exclusion for spouses that meet 121(a) that file a joint return. TP does not get caught up in (b)(3). Demonstrates you can keep doing this.

c. What result in (b), above, if the second sale occurred 1 years later? All gain would be taxable according to 121(b)(3)(A) Subsection (a) shall not apply to any sale or exchange by the TP if, during the 2-year ending on the date of such sale or exchange there was any other sale or exchange by the taxpayer to which subsection (a) applied. Therefore, all would be recognized as $400,000 capital gain under 1001(a) & 1001(c). This falls under 61(a)(3). Can elect under (f) to have section not apply and if so then may be able to exclude 2nd sale. L. says we are not going to worry here about that. (f) can be useful though if they new the sale of 1st house was going to generate a lower gain than the sale of the second house, both within the window of two years. Hard to know though when and what gain on sale of houses. Remember 121 applies unless you elect out of it in (f). Most will exclude up front, one good reason is that you may drop dead the next day. Exclude 400,000 now and most dont have foresight they will sale again before 2 yr. limitation.

d. What result in (b), above, if Taxpayers had sold their first residence and were granted nonrecognition under former Section 1034 (the rollover provision) and, as a result, their basis in the second residence was $200,000? Amount realized Basis Gain $1,000,000 200,000 800,000 1001(b) 1011(a) 1001(a)

TP may exclude up to the $500,000 exclusion under 121(b)(2)(A). Must recognize $300,000 capital gains under 1001(c) & TP includes into income under 61(a)(3). This problem is here to show the problem of those who have used 1034 in past. Even if 30 yrs. ago. Basis reduction caused by 1034. 1034 was not amended until 1997 so a lot of people sitting around with reduced basis. 1034 use to force people to buy up so they did not have to recognize gain. Congress did not want this mostly b/c of elderly that did not need this.

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Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop e. What result in (a), above, if the residence was Taxpayers summer home which they used 3 months of the year? Amount realized Basis Gain $600,000 200,000 400,000 1001(b) 1011(a) 1001(a)

TP would recognize all capital gains under 1001(c) & 61(a)(3) of $400,000 and no exclusion under 121 allowed for failure to meet 121(a) requirements of not being principal residence. Another issue is if the whole 500 acres are part of the principal residence. Service says probably not. How do you handle that is to jam all the value in the house and 5 acres which can be justified to some extent. f. What result if Taxpayer who met the ownership and use requirements is a single taxpayer who sold a principal residence for $400,000 and it had an adjusted basis of $190,000 after Taxpayer validly took $10,000 of post-1997 depreciation deductions on the residence which served as an office in taxpayers home? Amount realized Basis Gain $400,000 $190,000 210,000 1001(b) 1011(a) 1001(a)

TP may exclude up to 250,000 as a single TP under 121(b)(1), However, 121(d)(6) cuts across (a) when it comes to depreciation, makes the TP recognize gain up to the amount of depreciation taken on sale of qualified 121(a) property. Therefore, $200,000 of the gain is excluded under 121(b)(1) and TP recognizes capital income under 61(a)(3). This is capital gains at a special high rate most likely 25% 1(h) income b/c TP got a depreciation deduction. 121(d)(6) is exception to general rule and brings 1250(b)(3) into play: To the extent taken depreciation must recognize gain and then next step will be rate of tax at 25%.

2. Single Taxpayer purchased a principal residence for $500,000 and after one year Single sold the residence for $600,000 because Singles employer transferred Single to a new job location. a. How much gain must Single include in gross income? 121(c)(2) applies to exception for TP not meeting certain requirements under 121(a), mainly the two-year occupancy requirement. Make sure you are under 121(c)(2) in the first place. 121(c)(2) says which special circumstances in which this exclusion will apply. The exclusion amount will be determined by a ratio set forth in 121(c)(1)(B). In this case the ratio falls under (B)(I) TP owned the residence for 1 year (12 months)/2 year (24 months) (-(B)(ii)) = 50%. Therefore, Singles exclusion of $250,000 under 121(b)(1) is limited to $125,000. In this problem all $100,000 of gain would be excludable from GI under 121(a). What triggers (c) is that sales before 2 yr. time period. First question does (c) apply under 121(c)(2) and then go up under (c)(1)?

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b. What result in (a), above, if Single sold the residence for $700,000? Same as (a), except, exclusion limited to $125,000 exclusion. Therefore, $75,000 of gain would be recognized in GI under 61(a)(3) & 1001(c)

3. Taxpayer has owned and lived in Taxpayers principal residence for 10 years, the last year with Taxpayers Spouse after they married. Spouses decide to sell the residence which has a $100,000 basis for $500,000. a. If the Spouses file a joint return do they have any gross income? 121(b)(2)(A) says that (i) only one spouse needs to meet the ownership requirement, however, (ii) both spouses need to meet the use requirement. In this case only one spouse meets both requirements. Therefore, TP is only entitled to 121(b)(1) exclusion of $250,000. The additional $150,000 of gain recognized of the $400,000 gain realized from the sale is included in GI under 61(a)(3).

b. What result if the Spouses had lived together for two years in Taxpayers residence prior to their marriage and sold the residence after one year of marriage for $500,000? Under 121(b)(2)(A)(i) at least one spouse satisfies the ownership requirement and Under 121(b)(2)(A)(ii) both satisfy the use requirement so under 121(b)(2) couple is entitled to 500K exclusion from GI 61(a)(3). 121(a). $400 gain excluded. c. What result in (a), above, after one year of marriage Taxpayer pursuant to their divorce decree deeded one-half of the residence to Spouse and Spouse lived in the residence while Taxpayer moved out and, one year later, they sold the residence for $500,000? WIFES gain = 400K = 200K 1001(a) B/c of this property was transferred pursuant to divorce decree under 1041(c)(1) wife may tack on ownership of husband who owned the property for 10 yrs. 121(d)(3)(A). The wife also satisfies the use requirement b/c she lived in the house for more than 2 years and can thus exclude 250K under 121(b)(1). HUBBYS gain = 200K 1001(a) Husband meets all 121(a) requirements and can exclude all 200K of his gain from GI 61(a)(3). Both must file separate returns.

d. What result in (a), above, if after one year of marriage Taxpayer pursuant to their divorce decree deeded one-half of the residence to Spouse and Taxpayer continued to occupy the residence while Spouse moved out, and, one year later, they sold the residence for $500,000?

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Fall 2002/2005 Used Spring 2007 Prof Lathrop Both use and ownership requirements are met for both spouses. 121(a). For TP he lived 10 yrs in residence. Wife also lived in the house for 2 years as she is treated as using the house as her principle residence during the time former spouse was allowed to live there under a divorce decree. 121(d)(3)(B). So each can exclude their portion of the gain.

4. Estate Planner sold a remainder interest in Planners principal residence for $300,000 (its FMV) to Planners Son. Planners basis in the remainder interest was $125,000. Does Planner have any gross income?

121(d)(8)(B) cannot be to a related person.

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Fall 2002/2005 Used Spring 2007 Chapter 12: Assignment of Income

Prof Lathrop

 WILL NOT BE ON EXAM  Lucas v. Earl Start of the assignment of income doctrine. Rule: He who earns it you cant assign away the income.

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Income Tax I

Fall 2002/2005 Used Spring 2007 CHAPTER 14: Business Deductions (pp. 314-444)

Prof Lathrop

Class notes: October 16, 2002  162 is the major business deduction expense section.  Pay attention to 274 because this may limit otherwise legitimate 162 deductions. Always have to look at this.  Must be same trade or business under 162 not a new trade or business.  162(e) &(f) & (g) all limit  Our tax is based upon net income the idea is that you can take off expenses in generating income. A. Introduction [1 & 63]  There is no constitutional obstacle of disregarding expenses in the computation of tax. Therefore, deductions are spoken of as a matter of legislative grace. A TP must find a statutory provision that specifically allows the deduction claimed.  Note that individual income tax rates in IRC 1 are applied to taxable income in IRC 63. Taxable income is defined as gross income minus deductions allowed by this chapter (other than the standard deduction).  Key in these cases are you maintaining or acquiring something.  162(a) flush is what we will deal with mostly.  Must be in carrying on trade or business and not a new business. New business is more like capital expenditures. B. The Anatomy of the Business Deduction Workhorse: 162 [162(a); Reg. 1.162-1(a)]

Welch v. Helvering (P. 316) Welch (P) v. Helvering (D) NATURE OF CASE: Appeal from commissioner ruling that payments were not deductible from income as ordinary and necessary expenses, but were rather in the nature of capital expenditures, an outlay for the development of reputation and good will. Affirmed by Board of Tax Appeals & Court of Appeals for the Eighth Circuit. FACT SUMMARY: Welch (P) made voluntary payment to creditors of the E.L. Welch Company after the company went into involuntary bankruptcy. The amounts paid to the individual creditors were amount that were forgiven in bankruptcy. Welch (P) made these payments because he became a grain broker for the Kellogg Company and relied on these same creditors for business to earn commissions with the Kellogg Company. CONCISE RULE OF LAW: FACTS: E.L. Welch Company was forced into involuntary bankruptcy by its creditors and petitioner was the secretary of the company. Petitioner became a grain salesman for the Kellogg Company and earned commissions off of the amounts of sales per year. Some of the sales the petitioner solicited were from creditors that had lost money because of the involuntary bankruptcy settlement of the E.L. Welch Company. Petitioner believed that if he paid some of the money back to the creditors who had lost in the involuntary bankruptcy, he would be able to increase his reputation and standing in the community and therefore, sale more grain. Between Page 107 of 154

Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop 1924 and 1928 the petitioner paid back a substantial amount of $47,207.86 which petitioner seen as expenses under 162(a). Commissioner disagreed and ruled that the expenses were not ordinary and necessary under 162(a) and applied a deficiency to TP. ISSUE: Whether payments by a taxpayer, who is in business as a commission agent, are allowable deductions in the computation of his income if made to the creditors of a bankrupt corporation in an endeavor to strengthen his own standing and credit. Class: Are these ordinary and necessary expenses. HOLDING AND DECISION: (Cardozo, J.) No. Affirmed.  Court is slow to override when a TP thinks a payment or expense is necessary. Court here accepts that the payment is necessary under 162(a).  The expense is an ordinary one because we know from experience that payments for such a purpose, whether the amount is large or small, are the common and accepted means of defense against attack.  In this situation of paying debts not obligated to do so, the court states that Men do at times pay the debts of others without legal obligation or the lighter obligation imposed by the usages of trade or by neighborly amenities, but they do not do so ordinarily, not even though the result might be to heighten their reputation for generosity and opulence. Class: Court says he is reacquiring a good reputation (This is the essence of this case), when you reacquire something that is a capital outlay. Acquiring something you did not have before, these are capital expenses. Cant deduct going to law school because you are acquiring something (knowledge).  Actually, the payment of debts of others is highly extraordinary.  Court states that the standard set by the statute is not a rule of law; it is rather a way of life. Life in all its fullness must supply the answer to the riddle. The decisive distinctions are those of degree and not of kind.  Unless we can say from facts within our knowledge that these are ordinary and necessary expenses according to the ways of conduct and the forms of speech prevailing in the business world, the tax must be affirmed.  Court abides by Commissioners finding that these expenses are more akin to capital outlays. Affirmed. EDITORS ANALYSIS: Case deals with the first part of 162(a) what is necessary and ordinary. Note that even if something is necessary according to the TP it may not be ordinary. Court notes that it will look to practicable experiences in the business community to see if something is ordinary. In this case, the TP may have thought that payment of these prior obligations of the company were necessary to his producing income through brokering grain but the court points out that it is not ordinary for individuals to pay the debts of others without a legal obligation to do so. Question for this classification is whether the court would allow the TP to now capitalize these expenses and amortize the good will? Class Notes: October 16, 2002:  Issue is whether these expenses are ordinary and necessary.  What do they say about ordinary?  Turns on what he is paying for. Court says that TP is protecting his reputation in the community and is reacquiring reputation and that is a capital asset.  162 deals with maintaining.  Trick to this is maintaining something not acquiring something. Ex. is acquiring law license is acquiring something.  Holding is that this is a capital asset.  Under 162 must be maintaining and not acquiring or reacquiring something you lost in order to get deduction.

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Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop INVOLUNTARY BANKRUPTCY: Occurs when creditors of a company who have delinquent debt get together and force a company into bankruptcy in order to get paid. I believe it takes 3 creditors to file.

PROBLEMS: (P.319) 1. Taxpayer is a businessman, local politician who is also an officer/director of a savings and loan association of which he was a founder. When, partially due to his mismanagement, the savings and loan began to go under, he voluntarily donated nearly one half a million dollars to help bail it out. Is the payment deductible under 162? See Elmer W. Conti, 31 T.C.M 348 (1972). Might be necessary but not ordinary. In Conti he got to deduct it because he was maintaining an existing business reputation not acquiring a good reputation like in the Welch case supra. He got off the hook. Key here is that the savings and loan had not gone up in smoke yet, the TP made the payment to maintain his reputation he still had with the community. 2. Employee incurred ordinary and necessary expenses on a business trip for which she was entitled to reimbursement upon filing a voucher. However, employee did not file a voucher and was not reimbursed but, instead, deducted her costs on her income tax return. Is Employee entitled to a 162 deduction? See Heidt v. Commissioner, 274 F.2d 25 (7th Cir. 1959). Expenses are not necessary under 162(a). Heidt Case. If you can get reimbursed you should do it b/c you dont even put it in income and then deduct, offset and wash, it is not a fringe benefit it comes right out under Reg. 1.162-17. A lot of cases say it is not necessary if the TP can be reimbursed. Cant convert employer expense into your own.

B. Expenses [162(a); 198(a), (b)(1), (c)(1)(A)(ii), (c)(2)(A); 263(a); Reg. 1.162-4; 1.263(a)- 2.]

INDOPCO, Inc. v. Commissioner (P. 319) INDOPCO (P) v. Commissioner (D) Class Notes: October 16, 2002  Are these currently deductible expenses. Lincoln Savings case in a merger like this they created a separate asset and held that it was a capital asset. This court said that Lincoln Savings is not always the case. If you have benefits running into the future benefits b/c of the expenditure, even though a separate asset is not created it is still capitalized. This is because it is not like you are maintaining any more but creating additional asset.  These are not incidental to the asset, rule of thumb is if goes benefit beyond a year it is a capital expenditure.  General rule if a repair can expense but a capital expenditure is an expense to extend life beyond. Very fine line.  At the very least establish a basis and then if depreciable asset then take depreciation.  Mirky Case. Establish a basis on them and if you can establish an asset with a life you can depreciate.  General rule is even if you dont acquire an additional asset but future benefit you must still capitalize. Page 109 of 154

Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop NATURE OF CASE: Appeal to the Supreme Court from finding of deficiency by the Commissioner of Internal Revenue Service and upheld by the Tax Court and United States Appeals Court for the Third Circuit. FACT SUMMARY: INDOPCO (P) was a corporation that was engaged in a merger agreement with another company. Thru the transaction of the merger INDOPCO (P) incurred expenses from Morgan Stanley the investment banking firm in the amount of $2,225,586 and from Debevoise (not sure what role this firm played in the merger) in the amount of $505,069. In addition, there were miscellaneous expenses of $150,962 for such items as accounting, printing, proxy solicitation and SEC fees. INDOPCO (P) claimed a deduction for the $2,225,586 paid to Morgan Stanley, but did not deduct the $505,069 paid to Debevoise or the other expenses. Commissioner disallowed the deduction and sent a notice of deficiency. CONCISE RULE OF LAW: ISSUE: Whether certain professional expenses incurred by a target corporation in the course of a friendly takeover are deductible by that corporation as ordinary and necessary business expenses under 162(a) of the Internal Revenue Code? HOLDING AND DECISION: (Blackmun, J.) No. Expenses must be capitalized and amortized over the useful life of the benefit. Lower Court rulings affirmed.  Case represents the conflict between TP wanting to take an immediate deduction under 162(a) and Commissioner wanting TP to have to capitalize under 263. The difference is that TP under 263 will take over the useful life a portion of the expense matched to revenues earned during that period.  While business expenses are currently deductible, a capital expenditure usually is amortized and depreciated over the life of the relevant asset, or, where no specific asset or useful life can be ascertained, is deducted upon dissolution of the enterprise.  Notice the language of the above mentioned point, if TP cannot identify an asset or ascertain the useful life of the capital expenditure the expense can only be taken upon dissolution of the enterprise. It may be possible that these types of costs may never get to be expensed.  The Code is trying to better match outlays by a company to the proper revenues that these expenditures represent. For example, if you spent $100,000 to improve your office space and those improvements were to last 10 years, it makes sense to match revenues and the expenditure at $10,000 a year. If you made $20,000 in gross revenues per year you could deduct $10,000 a year for the improvements in your building.  Deductions are strictly construed and allowed only as there is a clear provision therefore. TP must specifically find a legislative granting of the deduction.  Court in Lincoln Savings, to qualify for deduction under 162(a), an item must (1) be paid or incurred during the taxable year, (2) be for carrying on any trade or business, (3) be an expense, (4) be a necessary expense, and (5) be an ordinary expense.  Necessary imposes only the minimal requirement that the expense be appropriate and helpful for the development of the TP business.  Ordinary Welch v. Helvering supra., the expense must relate to a transaction of common or frequent occurrence in the type of business involved. o Decisive distinctions between current expenses and capital expenditures are those of degree and not of kind. (Just saying what is expense in one business could be a capital expenditure in another.)  The expenditures do not have to create a separate and distinct asset to be capitalized. It may, but it may also just be expenditures that enhance the company position over a term of time. o Although the mere presence of an incidental future benefit some future aspect may not warrant capitalization, a taxpayers realization of benefits beyond the year in which the Page 110 of 154

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Fall 2002/2005 Used Spring 2007 Prof Lathrop expenditure is incurred is undeniably important in determining whether the appropriate tax treatment is immediate deduction or capitalization.  263(a)(1) refers to permanent improvements or betterments, envisions an inquiry into the duration and extent of the benefits realized by the taxpayer.  The Tax Court and Court of Appeals findings that the transaction produced significant benefits to National Starch that extended beyond the tax year in question is amply supported. Ruling affirmed.

EDITORS ANALYSIS: In note after case, the IRS after the ruling in INDOPCO has issued several rulings to allow deductions under 162 for advertising expenses, incidental building repairs, severance pay, employerincurred training costs of an ongoing business, and costs incurred to clean up land and to treat groundwater that a taxpayer contaminated with hazardous waste from its business. This case is really about how to distinguish between a currently deductible expense under 162 and an expense that will have to be capitalized and if possible amortized or depreciated over some period of time. Remember the reasoning behind the IRS making a TP account for expenses in a certain way. The basis is that revenue for a period should be matched to expenses incurred in the same period. If the expenditure is going to give benefit beyond the current tax period, the IRS is most likely going to see it as a capital expenditure and want the amount to be expensed in portions over the expected benefit period. This makes sense, a business profit and loss statement or income statement to some will more closely reflect the actual operations of the business if expenditures that benefit long term are capitalized and taken as expense over the useful life.

Norwest Corporation and Subsidiaries v. Commissioner (P. 326) Norwest (P) v, Commissioner (D) Class Notes: Deals with property. To repair is to restore and keep in operating condition. To improve is increase value. Tons of cases on this area. Cases go all ways. Did the expenditures increase the life or change the nature of the building for other use? Is it maintaining the current state of the building? If so, current expense. NATURE OF CASE: FACT SUMMARY: CONCISE RULE OF LAW: ISSUE: HOLDING AND DECISION: EDITORS ANALYSIS:

PROBLEMS: (P. 331) 1. Contaminator Incurs asbestos removal costs on a business building. Consider the extent to which they are currently deductible in the following alternative situations and assume, unless otherwise indicated, the building is not at a 198(c) qualified contaminated site. a. Contaminator acquired the building aware that it contained asbestos. When he bought it he knew it had asbestos, when he takes it out the asset value should go up. This is an indication it should be a capital expense. Presumably he paid something less than Page 111 of 154

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Fall 2002/2005 Used Spring 2007 Prof Lathrop someone would have without the asbestos in it. Question here is that you may be increasing the value of the building which requires capitalization.

b. Same as (a), above, except the building is at a 198(c) qualified contaminated site. 198 can elect to deduct as current deduction and TP does not have to capitalize. c. Several years ago, Contaminator constructed the building containing the asbestos. Presents the hardest problem. Between (a) & (d). Lathrop doesnt know what the answer is. Should he get a deduction for something he messed up in the first place. d. Contaminator acquired the building unaware that it contained asbestos. Probably deductible, trying to maintain the existing value. e. Same as (d), above, except that the removal occurs in conjunction with a remodeling of the building. Maybe able to separate out the removal and the remodel. Wont get to deduct all. C. Carrying on Business [162(a); 195; 262; Reg. 1.195-1(a)] Morton Frank (P. 332) Tax Court of the United States, 1953. TP and wife spent about a yr. Traveling around the country in an attempt to locate a newspaper or radio station to buy and operate. They deducted their travel and other related expenses. The Commissioner determined a deficiency, and Frank appeals to tax ct. Expenses of investigating and looking for a new business and trips preparatory to entering a business are not deductible as an ordinary and necessary business expense incurred in carrying on a trade or business. The word pursuit in the statutory sense means in pursuit of a trade or business is not used in the sense of searching for or following after, but in the sense of in connection with or in the course of a trade or business. TP were not engaged in any trade or business at the time the expenses were incurred.

PROBLEMS: (P. 339) 1. Determine the deductibility under 162 and 195 of expenses incurred in the following situations. a. Tycoon, a doctor, unexpectedly inherited a sizeable amount of money from an eccentric millionaire. Tycoon decided to invest a part of her fortune in the development of industrial properties and she incurred expenses in making a preliminary investigation.

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Fall 2002/2005 Used Spring 2007 Prof Lathrop 162 will not work b/c the doctor is not in the trade or business to apply but 195(c)(1)(A)(ii), these are business start-up expenditures which are costs incurred subsequent to the TPs decision to establish a particular business and prior to the time the business begins operating. Deductible. Elect to amortize over no shorter than 5 years (b)(1). If you shut down the business before the 5 year period you can deduct the additional loss under (b)(2). Must start up the business that in (b)(1) stating (beginning with the month in which the active trade or business begins).

b. The facts are the same as in (a), above, except that Tycoon, rather than having been a doctor, was a successful developer of residential and shopping center properties. Same as (a) or under 162 can deduct. Close enough in same business that possibly could use 162. This is more of an expansion of an existing business to fall under 162. c. The facts are the same as in (b), above, except that Tycoon, desiring to diversify her investments, incurs expenses in investigating the possibility of purchasing a professional sports team. 195(c)(1)(A)(i) investigatory costs. Deductible. d. The facts are the same as in (a), above, except that Tycoon then begins developing industrial properties. Tycoon is advised by her lawyer that her prior expenses qualify as 195 start-up expenditures. Since Tycoon has commenced developing the properties, may she forego a 195 election and deduct her prior expenses under 162? No. See 195(a). e. The facts are the same as in (d), above. However, after two years Tycoons fortunes turn sour and she sells the business at a loss. What happens to the deferred investigation expenses? Per 195(b)(2) if TP disposes of business b-4 60 mos. expires, deductible to extent allowed under 165. 2. Law students Spouse completed secretarial school just prior to student entering law school. Consider whether Spouses employment agency fees are deductible n the following circumstances: a. Agency is unsuccessful in finding Spouse a job. No. This is 1st job. b. Agency is successful in finding Spouse a job. Same as (a). c. Same as (b), above, except that Agencys fee was contingent upon its securing employment for Spouse and the payments will not become due until Spouse has begun working. Hundley case. Deductible. Difference here is that she is engaged in a trade or business at the time the payment becomes due. d. Same as (a) and (b), above, except that Spouse previously worked as a secretary in Old Town and seeks employment in New Town where student attends law school. Page 113 of 154

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Fall 2002/2005 Used Spring 2007 Seeking same kind of work in a new place is easy. Covered under 162.

Prof Lathrop

e. Same as (d), above, except that Agency is successful in finding Spouse a job in New Town as a bank teller. Not clear cut. Lathrop would probably take it but advising client may be a little careful. Tough one b/c the service makes the analogy based upon what you are doing on a daily basis and a secretary doesnt do what a bank teller does. Cases on traveling away from home (162(a)(2): Rosenspan v. United States  Salesman that doesnt have a home but works out of mid-west. Employer is based out of NY. TP says that his tax home is NY but the service says your tax home is where you work.  Here TP doesnt really have a tax home in either.  Court says arguing of this allowance was to take the excess of meals and lodging you had on the road over the amount you would have had at home. Makes sense but to hard to figure out so 162(a)(2) enacted that all are.  Bottom line of this case is that if you dont have duplicating expenses then you dont have use for this section.  History of cases of what a tax home represents.  TP had no tax home.  Original rule was that deduction was limited to the excess of what you incur away from home over what you would have spent at tax home. To hard. 162 gets rid of this.  Never thought that if you dont have duplicate expenses you did not report.  TP tried to deduct expenses that were not duplicated at a tax home.  Necessary under 162 o (1) The expense must be a reasonable and necessary traveling expense, as that term is generally understood. This includes such items as transportation fares and food and lodging expenses incurred while traveling. o (2) The expense must be incurred while away from home o (3) The expense must be incurred in pursuit of business. This means that there must be a direct connection between the expenditure and the carrying on the trade or business of the taxpayer or of his employer. Moreover, such an expenditure must be necessary or appropriate to the development and pursuit of the business or trade. Andrews v. Commissioner (P. 363)  Lives in Mass. and carrying out two business one in Mass. And Florida. 6 months in one and 6 months in the other.  Service found that didnt have a tax home.  Court said that one is the tax home and duplicate expenses are deducted. Court remanded back to see which one was his tax home.  Cant have two tax homes.  One tax home for this purpose and you do duplicate expenses.  To the extent that the duplication of expense is in pursuit trade or business is deductible. *Note: If you are an attorney in WV and you move to California to be an attorney you are entering a new trade or business because you get new license.

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Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop Educational Expenses:  If you take educational classes that puts you in position to engage in new business or trade no deduction. Reg. 1.162-5. This is because you are acquiring a new asset.  Fine lines. Real fine. Class Notes: October 18, 2002: 163 Interest  Definition of interest is in Rev. Ruling 69-188: Really all it is money paid for the use of money. If not it is not interest.  J. Simpson Dean (P. 481)  Has interest free loans from corporation and commissioner goes after them on a shareholder basis.  You are a shareholder of the corporation and the corporation is making these payments for you so it is a dividend.  Court does not by it.  Court said something that has been criticized for years, you did get an economic benefit but there is an offsetting deduction in 163 therefore a wash and therefore no income.  Concurrence and dissent point out the error. Income side yes but there may not be a corresponding offset b/c of 265.  Reason of case is to start off on 7872 the idea is not as much to get after the Deans of the world but to get after the lenders.  Top of 488: loans between family members are being used to avoid assignment of income  7872 is getting at lenders trying to avoid assignment of income.

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Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop CHAPTER 16: Deductions Not Limited To Business Or Profit-Seeking Activities B. Interest [163(a), (h); 280A(d)(1); 7872. 163(d) and (f); 221; 263A; 265(a)(2) through (4); 266. 1.7872-1(a). Revenue Ruling 69-188  Issue is whether or not interest was deductible in a situation where TP who wished to purchase a building, arranged with a lender to finance the transaction. A conventional mortgage loan of 1,000x dollars was negotiated, secured by a deed of trust on the building, and repayable in monthly installments over a ten-year period at a stated annual interest rate of 7.2%. Loan processing fee of 70x dollars (Points).  The loan-processing fee was not really for processing, other fees handled all the processing fees. This amount was paid out of proceeds from lender.  163(a) provides that there shall be allowed as a deduction all interest paid or accrued within the taxable year on indebtedness.  TP in this situation used the cash receipts and disbursements method of accounting (better known as Cash Method of accounting which means that Income is earned when received and Expenses incurred when paid.) 446(a) provides that taxable income shall be computed under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books. 446(b) provides that if the method used does not clearly reflect income, the computation of taxable income shall be made under such method as the Secretary of the Treasurer sees fit.  Supreme Court defines interest as the amount one has contracted to pay for the use of borrowed money, and as the compensation paid for the use or forbearance of money.  The payment or accrual of interest for tax purposes must be incidental to an unconditional and legally enforceable obligation of the taxpayer claiming the deduction.  It is sufficient that the payment be a prerequisite to obtaining borrowed capital. I think the ruling is discussing the payment of points up front in order to get the loan. It is not necessary that the parties to a transaction label a payment made for the use of money as interest for it to be so treated.  Revenue Ruling 67-297 loan origination fee paid by the purchaser of a residence from a lending institution was considered interest by means of 163.  RULE: To qualify as interest for tax purposes, the payment, by whatever name called, must be compensation for the use or forbearance of money per se and not a payment for specific services which the lender performs in connection with the borrowers account.  Holding: 70x was paid as compensation to the lender solely for the use or forbearance of money, and because he did not initially obtain the funds to pay this fee from the lender, the 70x dollars is considered to be interest. J. Simpson Dean (P. 481) Tax Court of the United States, 1961 NATURE OF CASE: Appeal to Tax Court from Commissioner determination of deficiencies for 1955 and 1956. FACT SUMMARY: TPs are the only two holders of a closely held corporation named Nemours Corporation. J. Simpson Dean owed Nemours on non-interest bearing notes various amounts borrowed at different times over two years totaling 882,565.70. Paulina duPont Dean borrowed $4,038,569.37 over a period of two years interest free. The commissioner found a deficiency based upon the prime rate that the TPs would have had to pay to borrow the money from a third party. The commissioner seeks to charge to petitioners, because they filed a joint return, income in the amount of $65,648.79 for 1955 and $97,931.71 for 1956. Page 116 of 154

Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop CONCISE RULE OF LAW: There shall be no income recognized by borrower upon obtaining interest free loans. ISSUE: Whether petitioners realized taxable income to the extent of the alleged economic benefit derived from the interest-free use of funds which they had borrowed from a family corporation controlled by them. HOLDING AND DECISION: (Raum, Judge) No. Taxpayers do not realize income to extent of the interest that would have been charged were it not for interest-free loan.  Court makes a distinction between cases where the TP gets free rent from a corporation. The court says that the TP would have had to make an expenditure if it were not for the free rent therefore, the TP must include in income. In the case of interest free loans, however, the court states that petitioners borrowed funds in question on interest-bearing notes; their payment of interest would have been fully deductible by them under 163. Critized for this ruling for years. Dissent clearly points out this error.  Not only would TP be charged with the additional income in controversy herein, but also they would have a deduction equal to that very amount. EDITORS ANALYSIS: Dissent makes some good arguments in this case. Doesnt make much sense to allow a broad sweep of interest-free loans being excluded from the income of a TP. The notes at the end of the case indicate that The Tax Reform Act of 1984 with the enactment of Section 7872 changed the results. In Greenspun v. Commissioner, the Tax Court conceded that in certain instances very close to the Dean case there could be gross income to the borrower and no offsetting deduction under 163. Supreme Courts decision in Dickman v. Commissioner, the Court held that an interest-free loan to a family member was a transfer of property by gift. The lender was treated as having made a taxable gift of the reasonable value of the use of the money. 163:  163(a) = general rule. There shall be allowed as a deduction all interest paid or accrued w/in the taxable year on indebtedness.  163(h) Disallowance of deduction for personal interest. o (1) Individual gets no deduction for personal interest paid or accrued during the taxable year. o (2) Defines personal interest by telling what is not personal interest.  (D) says qualified residence interest is not personal interest. o (3) Defines qualified residence interest.  (A) in general includes y (i) acquisition indebtedness or y (ii) home equity indebtedness.  (B) Acquisition indebtedness is that y (i) in general, o (I) is incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer, and o (II) is secured by such residence. y Also includes indebtedness secured by residence resulting from refinancing of indebtedness meeting requirements of the preceding sentence; but only to extent of the original refinanced indebtedness.  (ii) $100,000 limitation for any period. $50,000 for married filing separate. o (4)(A) Qualified residence:  (i) in general, qualified residence means Page 117 of 154

Income Tax I y y

Fall 2002/2005 Used Spring 2007 Prof Lathrop (I) the principal residence (w/n the meaning of 1034) of the TP and (II) 1 other residence of the taxpayer which is selected by the taxpayer for purposes of this subsection for the taxable year and which is used by the taxpayer as a residence (within the meaning of section 280A(d)(1)).

Class notes: 7872  Page 488: Tells what the court is trying to get at. 1st full paragraph. o Loans between family members (and other similar loans) are being used o Really trying to get at the lenders. Class Notes 10/21/2002: Reiterate that 163 is fair game for the exam. Start Class at Problem 3.

PROBLEMS: (P. 504) 1. Lender makes a $100,000 interest-free demand loan to Borrower on January 1 at a time when the applicable federal rate is 10 percent. The proceeds of the loan are used to purchase a principal residence for Borrower. Ten percent interest compounded semiannually on $100,000 is $10,250 per annum. Consider the tax consequences to both parties at the end of the year if the loan is still unpaid and is in the nature of: a. A gift. 7872(a) deals with gift and demand loans, (b) gives the limits to below market loans (Federal rate) so if you have 0 interest the difference between the fed rate and 0 is the interest free part that causes problems. What happens here is that (b) would be a term loan and handled differently. 7872(a)(1) in case of any below market loan which this section applies (c), Gifts, Compensation related loans, and Corporation shareholder loans, the forgone interest the borrower did not have to pay will be treated as paid to the lender by the borrower and then retransferred from the borrower to the lender as interest. Timing is at end of the year. (2). 7872 applies per 7872(c)(1)(A). 7872(a)(1)(A) & (B) says to treat as a transfer from the lender to the borrower and a retransfer from the borrower to the lender as interest. 7872(a)(2) continues on to say this transfer occurs on the last day of the calendar year. The idea is that this will be treated as a gift from Father to son and then son turns around and pays 10,250 as interest to the Father. Son would get deduction for the 10,250 if itemizes and Father would have 10,250 as income. Here, opposite of the Dean case the lender is going to get hit with income. On the deemed transfer, no income to donee per 102(a), but donor may be subject to gift tax must be pretty big because it must eat up unified gift tax which currently is 1million. See reg. above. On the retransfer, lender has income and borrower has interest expense. b. Compensation.

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Fall 2002/2005 Used Spring 2007 Prof Lathrop Here, employee (TP) is taxed on deemed transfer as compensation. Corp. gets compensation deduction on deemed transfer. On retransfer, corp. recognizes interest income and employee may get interest deduction. Total wash to both.

c. A dividend. On transfer, corp. gets no deduction if the pmt. is deemed a dividend. Employee recognizes income. On retransfer, same as b. Wash for TP but not corporation. Corp. gets hit with interest income b/c it can not take a deduction for dividends.

2. Skip question per syllabus. Class Notes : October 18, 2002 :  163 has a lot of history behind it.  163(h) tells you that in case other than corp. No deduction allowed on personal interest paid in the year. Personal interest is defined as anything not defined here. Everything else is non-deductible by TP.  Now these things are revolving credit stuff and its not like you pay off the principal and interest every month. After awhile you figure out that the interest is the only thing that is paid and principal really doesnt go down much. 3. Taxpayers purchase a home in 1998 which they use as their principal residence. Unless otherwise stated, they obtain a loan secured by the residence and use the proceeds to acquire the residence. What portion of the interest paid on such loan may Taxpayers deduct in the following situations? a. The purchase price and fair market value of the home is $350,000. Taxpayers obtain a mortgage for $250,000 of the purchase price. General rule per 163(a) is that all interest is deductible. 163(h) is an exception in that personal interest is not deductible. 163(h)(2) defines personal interest by stating what is not personal interest. Have to get into (A), (B), (C), (D), or (E) in order to deduct interest. Here, the interest is paid on 163(h)(2)(D) qualified residence interest as defined in 163(h)(3). Since it is a qualified residence per 163(h)(4)(A) and not over 163(h)(3)(B)(ii) $1,000,000 limitation (on underlying debt not interest), it is deductible.

b. The facts are the same as in (a), above, except that Taxpayers by 2000 have reduced the outstanding principal balance of the 1998 mortgage to $200,000 and the fair market value of the residence has increased to $400,000. In 2000, Taxpayers take out a second mortgage for $100,000 secured by their residence to add a fourth bedroom and a den to the residence. All $300,000 is acquisition indebtedness per 163(h)(3)(B). Well w/in the $1,000,000 limitation so all deductible. c. The facts are the same as in (b), above, except that Taxpayers use the proceeds of the $100,000 mortgage to buy a Ferrari. All debt is secured by qualified residence, but not all is acquisition indebtedness per 163(h)(3)(B). Part is home equity indebtedness per 163(h)(3)(C). All deductible, though. Page 119 of 154

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Fall 2002/2005 Used Spring 2007 Prof Lathrop Value of house may become an issue in calculating the limitation under 163(h)(3)(C)(i)(I) and (II).

163(h)(3)(c)(i)(I) 163(h)(3)(c)(i)(II) Initial limitation

400 FMV 200 Debt 200

Subject to overall limitation under 163(h)(3)(C)(ii) flush of $100,000. Two limitations when you get into home equity indebtedness, the overall $100,000 and the limitation that the home equity indebtedness cannot be more than the equity in the qualified residence. Cant go over $100,000 even though second test is $200 equity. d. The facts are the same as in (a), above. By 2010, Taxpayers have paid off $200,000 of the $250,000 1998 mortgage and the residence is worth $500,000. In 2010, Taxpayers borrow $200,000 on the residence, $50,000 of which is used to pay off the remaining balance of the 1998 loan and the remainder is used to pay personal debts. 1st any acquisition indebtedness? Per 163(h)(3)(B) flush, refinancing is acquisition indebtedness to the extent it d/n exceed the amount of refinanced indebtedness. Thus, since the original debt was paid down to $50,000, that is all that can qualify as acquisition indebtedness. Note: use flush for material after the subparts of a given section, subsection, paragraph, subparagraph, etc. 2nd any home equity indebtedness? Per 163(h)(3)(C), must be secured by qualified residence. All is. Limitation on this house. Per 163(h)(3)(C)(i)(I)(II) limited to the excess of FMV of qualified residence over the amt. of acquisition indebtedness w/respect to such residence. Here, FMV is $500,000 and total debt is $50,000. The excess is $450,000. TP meets this limitation. But, overall limitation per 163(h)(3)(C)(ii), the overall limitation is $100,000. TP may only deduct interest on $100,000 of the limit deduction. New borrowing, $50,000 is acquisition indebtedness and the additional $150,000 borrowed is limited to $100,000 home equity deduction. $50,000 is personal indebtedness and falls outside of (h). e. Skip per syllabus.

f. Skip per syllabus. 4. Skip per syllabus. Page 120 of 154

Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop 5. Investor incurs investment interest of $100,000. To what extent is it deductible in the current year if: a. She sells stock during the year at a $60,000 gain, that under 163(d)(4)(B) does not qualify for 1(h) preferential treatment, has $20,000 in dividends on all her stock, and has $10,000 in deductible investment adviser fees? Are there any other tax consequences to Investor? Per 163(d)(4)(B), net investment income is $80,000. Per 163(d)(4)(C) investment expenses are $10,000. Therefore, net investment income is $70,000 per 163(d)(4). Per 163(d)(1), the TP can only deduct investment interest to the extent of net investment income. Thus, only $70,000 is deductible in the current year. However, 163(d)(2) allows a carryover to the next tax year any investment interest disallowed as a deduction b/c of 163(d)(1). b. The interest of $100,000 is on loans whose proceeds are used to purchase tax exempt bonds? Per 265(a)(2) disallows an interest deduction when the proceeds of the loan are used to carry obligations the interest on which is wholly exempt from taxes imposed by this subtitle. Rev. Rul. 74-294 also disallows the deduction. c. The facts are the same as in (a) and (b), above, except that the proceeds of the loans are used 50% to purchase tax exempt bonds and 50% to buy stock and the bonds and stock are her only investments? $50,000 deductible per 163(d)(3)(a) investment interest includes any interest on indebtedness properly allocable to property held for investment. 50% not deductible under 265(a)(2).

C. Taxes (P. 506) [164(a), (b), (c), (d)(1); 275; 1001(b)(2). Reg. 1.164-3(a)-(d)]

Cramer v. Commissioner Cramer (P) v. Commissioner (D)

NATURE OF CASE: Tax Court United States where petitioner Cramer (P) disputes deficiencies found by respondent Commissioner (D) in the amounts of 1964 - $257.62; 1965 - $561.21; and 1966 - $594.22. FACT SUMMARY: Cramer (P) was a taxpayer who was involved in three separate properties during the time these deductions were taken. The first property the court identified as the Auburn Street Property, this property was under a land sale contract to a Mr. Osborn. The agreement between Cramer (P) and Osborn was that Osborn would make monthly payments to Cramer (P) and pay the property taxes. The title to the property remained in Cramer (P) until the note paid off. Osborn defaulted without making any payments and without paying the property taxes. Cramer (P) got a default judgment and paid the property taxes. Petitioner Cramer (P) mother who was ill and had to be hospitalized owned the second property, which the court refers to as the Atkinson Street Property. Cramer paid the property tax for her mothers residence out of her own pocket. The third property, which the court refers to as Clearview Street Property, was a home in which Cramer (P) purchased after the agreement on the first property with Osborn, was signed. Cramer (P) paid property tax on this property. In all Cramer (P) took property tax deductions in the amount of 1965 for $1,144.87 and in 1966 for the amount of $915.39. Commissioner (D) determined only $436.94 and $470.88 respectively. Page 121 of 154

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CONCISE RULE OF LAW: TP to deduct personal property tax must be liable under law for the assessment and payment of the personal property tax. ISSUE: Whether the taxes which petitioner paid on certain real property during 1965 and 1966 are deductible under 164. HOLDING AND DECISION: (Featherston, Judge.) Affirmed in part.  Clearview Street Property Commissioner stipulates that there is no argument towards the deduction of this property by Cramer (P).  Auburn Street Property The court holds that these taxes are deductible to a point by Cramer (P). o Two Parts:  The time period that Osborn was under an agreement to pay the property tax and did not, petitioner Cramer (P) may deduct the payment. The taxes are assessed to the owner if known, and also to the occupant. As the record owner of the property, petitioner was assessed for the property taxes, and they became a debt to the taxing authority for the collection of which her chattels, as well as the realty, could be seized and sold.  This property however, was sold in the beginning of 1966 to a new buyer. 164(d)(1) provides: y (1) General Rule. For purposes of subsection (a), if real property is sold during any real property tax year, then o (A) so much of the real property tax as is properly allocable to that part of such year which ends on the day before the date of the sale shall be treated as a tax imposed on the seller, and o (B) so much of such tax as is properly allocable to that part of such year which begins on the date of the sale shall be treated as a tax imposed on the purchaser. y This is easy, Prorate as in Property I & II. Seller deducts up to the portion of tax allocable when they owned it and the Buyer can deduct up to the portion of tax allocable when they owned it. y Remember that 164(d)(1) applies automatically, must prorate even if you didnt.  Atkinson Street Property This is the property owned by mother. 164 allows a deduction for real property taxes; but they are, in general, deductible only by the person upon whom they are imposed. 1.164-1(a). o Cramer (P) did not own the property and the taxes were not imposed upon her. She acquired no interest in property until after the taxes were paid. The payment could have been seen as a gift to the mother. I would have argued that the taxes paid by the daughter were an expense against the estate and asked for reimbursement. It would have been a wash.

EDITORS ANALYSIS: Case is pretty simple, if you have an interest in property and the personal property tax is imposed upon you and you have a legal obligation to pay the tax, most likely the taxes are deductible by you if paid. In the case of a sale you must take into account 164(d)(1) and prorate the taxes obligation between the buyer and seller. Remember from Property I & II that when closing on a real estate sale that this is part of the final closing documents. Also, notice that on the Clearview property that the taxes were automatically taken out by the bank in the monthly mortgage payment, this does not matter because it is still the TP who is making the payment.

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Income Tax I PROBLEMS: (P. 509)

Fall 2002/2005 Used Spring 2007

Prof Lathrop

1. Which of the following taxes would be deductible as such under 164? a. A state sales tax imposed at a single rate on sellers but required to be separately stated and paid by purchasers to sellers, applicable to retail sales of any property except food, clothing, and medicine. No, 164(a) is operative section and states the type of taxes allowed for deduction. Sales tax is not a personal property or a real estate tax. Non-deductible. Best you can do is add it to basis and when sell may have a smaller gain. b. A state real property tax of $1,000 for which A became liable as owner of Blackacre on January 1st but which B agreed to pay half of when he acquired Blackacre fro A on July 1st. 164(a)(1) allows deduction of State and local, and foreign, real property taxes. 164(d)(1) requires the TP to apportion or prorate the tax when the property is sold during any real property tax year. TP may deduct under 164(d)(1) $500 of the $1,000 state personal property tax. c. A state income tax. Yes, 164(a)(3) allows deduction of state income tax. d. The federal income tax. No. 275(a)(1) no deduction for federal income tax, also not in operative 164(a) list. e. A state gasoline tax imposed on consumers. No. Not in 164(a). 2. Which of the following expenditures would be deductible, if not as taxes, as 162 or 212 expenses within the second sentence of 164(a)? a. A state tax on cigarettes (imposed on their sale at a rate five times the rate of the general sales tax) paid for cigarettes provided by the taxpayer gratuitously to customers. The five times rate is in there so that it is not treated as a general tax. If it was treated as sales cannot deducted anyway under 164, it is not a tax listed. This is a special tax on cigarettes. Not under 164 because not on list. But under 162 is probably is a necessary business expense. Idea is that the guy is running a business of sum sort and gives cigarettes away to his customers. People buy pens and pencils all the time. The idea here is that this is a tax that is not listed in 164(a) but arises in a business that falls under 162.

b. A filing fee required to be paid to the State Democratic Party by candidates entering state primary elections. See Horace E. Nichols, 60 T.C. 236 (1973).

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Fall 2002/2005 Used Spring 2007 Prof Lathrop Not deductible b/c deemed a new Trade or Business even if an incumbent. Thus, not a trade or Business within 162. Another issue is whether it is a tax or not. All political offices = New Trade or Business even incumbent judge. Can have taxes not listed in 164(a) if incurred in Trade or Business or a 212 activity. Difference between fee and tax is that the fee you get a direct benefit where the tax is for the general benefit not directly related to you. Under 164 must be a tax and not a fee.

3. Son who is still in college owns substantial securities. Father, when paying his own intangibles tax to State X, pays the intangibles tax due by Son. a. May Father deduct the tax paid? Cramer states that Father cannot deduct tax because he is not personally liable for the tax. Same situation with Cramer deducting the personal property tax on a home her mother owned. Court held non-deductible. b. Is it deductible by Son? Son may not deduct the tax because he did not pay it. What would you advise father and son do? Have Father make a gift to son to pay the tax. Must be liable for the tax if you deduct it. 4. Dr. Medic employs Charles to work for her as receptionist. She pays Charless salary but withholds X dollars to which she adds Y dollars all of which she pays to the federal government under the Federal Insurance Contributions Act (for social security). a. Can Dr. Medic deduct amount X? Amount Y? X plus Y? Amount X cannot be deducted under 275(a)(1)(A) relating to the tax on employees under Federal Insurance Contribution Act. However, the employer can deduct the amount matched by him under 275(a)(1)(A) b/c it only says employees part is non-deductible. This is ordinary and necessary business expenses to the employer. b. Is Charles entitled to a deduction for the payments? No, 275(a)(1)(A) says no deduction of 3101 Social Security Taxes withheld on employees part. Tax on Social Security Taxes on employers part is 3111 and there is no prohibition of her deducting the employer part as a necessary business expense.

5. The City of Oz constructs a yellow brick road that runs past Woodmans property. He and other property owners adjacent to the road are assessed varying amounts by Oz, based on the relative amounts of front footage of their properties. Woodman elects to pay off the assessment over five years and pays $400 in the taxable year. Deductible? No, 164(c)(1) disallows deduction of taxes assessed against local benefits of a kind tending to increase the value of the property assessed. Reg. 1.164-3 defines the term real property taxes means taxes imposed on interests in real property and levied for the general public welfare, but it does not include taxes assessed against local benefits. Reg. 1.164-4 defines taxes for local benefit as assessments, Page 124 of 154

Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop paid for local benefits such as street, sidewalk, and other like improvements, imposed because of and measured by some benefit inuring directly to the property against which the assessment is levied are not deductible. Here, government has improved the property value in relation to the TP. Property tax must be for the general benefit of all. This should be added to the cost of the property and added to the 1011 basis adjustment when sold. What is really going on here is that it is not a tax everybody has to pay. This is an assessment for improvements that just a few people have to pay. What do you do with this stuff? Capitalize by increasing your adjusted basis under 1011 of your property. If you sell later this will decrease the amount of gain realized by sale.

CHAPTER 18 DEDUCTIONS FOR INDIVIDUALS ONLY 3 (COVERING MOVING EXPENSES ONLY.)

B. Moving Expenses [62(a)(15); 82; 132(a)(6); 217; 1.217-2(b)(2), (3), (4) and (8)] Class Notes: October 23, 2002:  217 now if you remember when we talked about 162(a) and expenses you incur moving from one job to another you had to be moving in the same trade or business. 217 does not have that restriction.  One thing 217 assumes that you are making a permanent move, if not you would may fall under 162(a)(2). If you are not then you may fall in 162(a)(2) status of travel away from home.  Two kinds of limitation o Time o Distance o Shows up in c  (b) tells you want kind of expenses you can deduct moving goods and moving yourself. NO MEALS.  (d) is when you can take deduction: o Must take the deduction in the year you incur the expenses. If it turns out you do not meet time requirement you include in income the following year or amend your return. Cannot take deduction in a prior year, must amend back to year incurred. If beyond amendment time period too bad.  Look to reimbursement that if you are you dont deduct or include under 132(a)(6). (Check This)  62(a)(15) says that you deduct the moving expenses above the line. This means that you can use standard deduction if you cant itemize. Just saying that this is not an itemized deduction. This item is deducted off of Gross Income of TP to get to Adjusted Gross Income.  82. Reimbursement for expenses of moving. Must include back into income any reimbursement of moving expenses taken as a deduction in which employer pays back to you. Class Notes: 10/28/02: Continues starting w/ problems. PROBLEMS: (P. 553) 1. Lawyer has been practicing law in Town X and he and his family live in Suburb of Town X ten miles away. He decides to open an office in Town Y. Consequently he moves himself and his family to a home in Town Y. a. How far away from Suburb must Town Y be located in order for Lawyer to be allowed a moving expense deduction? Page 125 of 154

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Fall 2002/2005 Used Spring 2007 217(a) Flush referred to 217(c)(1)(A) the Town Y must be at least 60 miles.

Prof Lathrop

b. How far away from Suburb must Town Y be located in order for Lawyer to be allowed a moving expense deduction if Lawyer has just graduated from law school in Town X and he was not employed? If no previous work 217(c)(1)(B) the Town Y must be at least 50 miles. c. Assuming Lawyer is a sole practitioner what time requirements are imposed on him in order for 217 to apply? 217(f)(1) and (2) define self-employed. proprietorship. (f)(1) defines self-employed to include sole

Must meet the time requirements in 217(c)(2)(B). 78-week requirement out of 24 month period immediately following his arrival in the general location of his new principal place of work.

d. What difference in result in (c), above, if Lawyer joins a firm in Town Y as a partner? No difference in c if lawyer joins firm in Town Y as a partner b/c partner is considered to be self-employed. 217(f)(2). e. What difference in result in (c), above, if Lawyer goes to work for a firm in Town Y but as an associate rather than a partner? Now, the Lawyer is only subject to the time limitation of 39 weeks out of immediate 12 months under 217(c)(2)(A). f. Assuming the necessary time and distance requirements are met, and that a joint return is filed, what is the amount of Lawyers 217 deduction if he incurs the following expenses: $400 in moving his familys belongings; $150 in transporting his family; and $100 in lodging and $200 in meals in conjunction with transporting the family? $400 $150 $100 $200 Moving family belongings Transporting his family Lodging Meals in conjunction w/transporting family

$400 Deductible per 217(B)(1)(A) $150 Deductible per 217(B)(1)(B) $100 Deductible per 217(B)(1)(B) $200 Non-Deductible per 217(B)(1) Total deductible $650. g. Is there any difference in the result in (f), above, if Lawyers spouse also takes a job in Town Y and meets the necessary time and distance requirements? Page 126 of 154

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One spouse can ride the others coat tail. As long as moving, whole familys expenses are deductible if the meet the 217(b)(1)(A) and (B) definition. Dont even have to travel in same car. Can deduct mileage on two cars. 217(b)(2). h. If Lawyers firm reimburses Lawyer for $850 of his expenses in the year they are incurred, what tax consequences will the reimbursement have? $200 income for meal amount. The rest is includible in income per 82, and per 62 deductible above the line. So it is a wash. As long at TP dont deduct expenses, dont have to include in income. 2. Tardy closes her law practice in Chicago on May 1, 1988, to seek greener pastures in Springfield, Illinois. She began work there on July 1, 1998, and has been there in active practice ever since, meeting the 78 week test of 217(c)(2)(B) late in 1999. In her return for 1999 she claimed a deduction for her moving expenses in the amount of $4,000. On April 10, 2002, the Commissioner issued a deficiency notice disallowing the claimed deduction. Any likely need at that time for speedy action by Tardy? See 6072, 6511(a); and see Della M. Meadows, 66 T.C. 51 (1976). She has until 4/15/02 to amend her 1999 tax return assuming return filed on due date. 6511 allows 3 yr. Statute from time return was filed. Problem here is she should have taken deduction in the year incurred 1998, She took it in 1999, the wrong year, thats the year she completed the requirements. Must amend before the statute runs. She has till April 4/15/02, 5 days from now. The point of that is you must deduct in year you take. Now if she wanted, not to take advantage of the code section, 217(d)(2) where you havent satisfied the condition in (c) on the assumption that you will meet it and if you dont then just include it in the subsequent year or file an amended return and include it in income. Key is that you take it in the year incurred.

3. When Employer moved her to Indianapolis, Ms. Keen bought a house for $140,000. Several years later her Employer asked her to move to San Francisco which she did. The best offer Ms. Keen could get for her house was $135,000 so, under her employment contract, Employer bought the house from her for $140,000 (her cost). He later resold it for $135,000. What are the tax consequences to Ms. Keen and to Employer? See Seth E. Keener, 59 T.C. 302 (1972).

Essentially, this is salary to employee. Employer should be able to deduct it per 162(a)(1) and employee must include it in income per 61(a). Employer is making employee whole for potential loss here. $5,000 income to the employee. Employer has a $5,000 loss the question is whether it is capital. Lathrop says probably. But is there really a loss. Seems to Lathrop that should be a downward adjustment to the basis b/c the employee took the $5,000 as compensation from the employer. Then when the employer sold it for $135,000 the basis would have been $135,000 and no gain or loss. Loss rules for individuals are in 165. Cant deduct losses on sale of principal residence.

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Fall 2002/2005 Used Spring 2007 Chapter 21: Capital Gains and Losses (P. 680)

Prof Lathrop

A. Mechanics of Capital Gains Class Notes: October 28, 2002:  There will be no 1(h) calculation of tax on the exam.  Remember all this starts with 1001(a) figuring out whether you have a gain or loss.  Preferential treatment of capital assets that are characterized as long term capital gains. About the rate as ordinary income.  To have this stuff must have a capital asset, must be a sale or exchange, and must be held more than a year to get special tax treatment.  Reasons for preferential treatment on P. 682: 1. a disposition of a capital asset may involve only a continuation of an investment in a different form; 2. gain said to be realized may merely or largely reflect only changes in the overall price structure; and 3. the gain may have been some time in the making, raising the question whether it is fair to bunch it into a single taxable year with possible attending tax attrition through progressive rate tables.  1997 current tax structure of 1(h), cleaned up a little in 1998.  Capital Losses Can wipe out all ordinary income if you didnt have special rules limiting the deduction. Could create a tax shelter b/c of preferential treatment for gains and unlimited deduction of losses against income, therefore, congress limits against ordinary income to a substantial amount. Corps. cannot offset and Individuals can only deduct against up to $3,000 of ordinary income.  Classification is critical. For a corp. there is a great advantage to being able to say the loss is not a capital gain.  Before 1(h) must figure what we have under 1222.  1221 tells us what a capital asset is.  1223 gives a bunch of holding period rules called tacking. Seen some of that like in gift where there is a carryover basis the donee gets to carryover the donors holding period also  1222 merely tells you whether you have a capital gain or loss. Definitions of losses and gains.  Must net long and shorts against each other. So 1222(1) (4) give you raw gains or losses. Then you net longs and shorts against each other, thats 1222(5)-1222(8). Then shoot to 1222(11) tells what net capital gains is and that sends us to 1(h) for rates. If you have net capital gains you will end up in 1(h) and get preferential rates.  Lets take a look at 1(h), 1(h)(5): 28% rate on collectibles, 25% rate on unrecaptured section 1250 gain which represents depreciation on buildings; 1250 really doesnt operate anymore because 1250 picks up the spread between accelerated depreciation and straight line depreciation on real property. But since 86 must use straight line under 168. So for 1250 to apply it has to be on property put in service before 1986. 20% rate. Most of time you have 20% 1(h)(1)(C). Then if you buy property after December 31, 2000 and if you hold it for 5 years then you can opt for an 18% rate. Then drop down to 15% rate when you have net capital gain in the 15% rate bracket you can drop down to 10% again if you buy property even before December 31, 2000 and hold for 5 years and sell it after December 31, 2000 you can opt for an 8% rate. 1(h)(1)(c)  Review the part in 1(c) where the TP has income only in the 15% bracket how Capital gains would work.  To the extent under 1(c) that you have special stuff not in excess of $29,600 you are either going to pay 15% or 10% because it would not be preferential treatment of capital assets to low income earners if they had to tax at rates as high as 28%. Must fill up that box first of ordinary income rate of 15% in 1(c).

PROBLEMS: (P. 694) Page 128 of 154

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Prof Lathrop

1. T, a single taxpayer, has a salary of $50,000 in the current year. T also has the following transactions all involving the sale of capital assets: (1) a gain of $15,000 on a collectible held for 2 years; and (2) a gain of $20,000 on stock held for 15 months. a. Determine the amount of Ts net capital gain. LTCG 1222(3): LTCG 1222(3): Net LTCG: 1222(7) Net Capital Gain: 1222(11) gain) $15,000 (Collectible) held for more than one year $20,000 (Stock) $35,000 $35,000 (If you had a short loss then you net out to get net capital

Now since a net capital gain under 1222(11) gets us into 1(h) to determine tax rates to be applied to the amount of capital gains.

b. At what rate will the components of Ts net capital gain be taxed? $50,000 salary taxed at ordinary income rates 1(h)(1)(A) LTCG in collectibles1(h)(1)(E): (Remember that gross income is way out of the 15% bracket under 1(c) so it keeps us out of that mess.) 1(h)(5) 28 percent rate gain means the excess of (A) the sum of collectible gain over the sum of collectible loss = $15,000. LTCG in stock: 1(h)(4) says that the term adjusted net capital gain means net capital gain reduced by the sum of (A) unrecaptured section 1250 gain; and (B) 28-percent rate gain found in 1(h)(5), therefore, the net capital gain of $35,000 would be reduced by $15,000 collectible 28% gain and gives us a $20,000 adjusted net capital gain. 1(h)(C) states that the adjusted net capital gain on the stock will be taxed at 20%.

c. Assuming there is a flat 30% tax on ordinary income and disregarding any deductions (including the standard deduction and personal exemption), what is Ts tax liability in the current year? 1(h)(1)(A) backing out ordinary income on greater of: (i) 50,000 or lesser of (ii)(I) O or (II) 65 (85,000-20,000). So you back out the $50,000.

(Taxable Income $85,000 Net Capital Gains $35,000 = $50,000) X 30% Ordinary Income tax Rate = $15,000. 1(h)(E): $15,000 x 28% = $4,200 1(h)(C): $20,000 x 20% = $4,000 Taxpayer total tax liability = $23,200 d. What differences in result in (c), above, if the current year is more than 5 years after the year the stock in (2) was acquired which was a year after 2001?

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Fall 2002/2005 Used Spring 2007 Prof Lathrop 1(h)(2)(B) reduces the rate to 18% on the stock. Qualified 5-year gain is defined under 1(H)(9).

2. Taxpayer, who is the highest federal tax bracket in the current year, has a $5,000 gain from a collectible and a $5,000 gain from stock, both held long-term. a. What is Taxpayers net capital gain and how is it taxed if Taxpayer also has a $5,000 loss from a collectible held long-term? LTCG 1222(3): LTCG 1222(3): LTCL 1222(4): Net LTCG 1222(7): $5,000 $5,000 ($5,000) $5,000

First thing figure out what you have $10,000 LTCG and $5,000 STCL = Net LTCG $5,000 which is also net capital gain that throws us into 1(h). How do we know what rate that it is taxed at? 1(h)4 then to 1(h)(5) which tells us that it is collectibles gain less collectible loss which is 0. Collectibles get netted out against each other. Net Capital Gain 1222(11) $5,000 No 28% Gain 1(h)(5)(A) & (B): ($5,000 Gain - $5,000 Loss) = $0 1(h)(4): 20% LTCG on Stock of $5,000 gain = $1,000 capital gains tax 1(h)(C). b. What results in (a), above, if instead Taxpayers $5,000 loss is from stock held long-term? LTCG on Collectible taxed at 28% rate = $1,400. c. What results in (a), above, if instead Taxpayers $5,000 loss is from stock held for 9 months rather than from the collectible? $5,000 STCL is netted against the $5,000 LTCG of $5,000 in stock leaving $5,000 of LTCG of collectibles taxed at 28% = $1,400. Lathrop is saying this is taxed at 20%.

Example problem in Class Lathrop 10 STCG Stock 15 LTCG Collectible 20 LTCG Stock Must fill up ordinary income of the taxpayer in the 15% bracket. In other words up to 22,100 of income with the gains. 1(A) greater (i) 45-35 = 10, or Page 130 of 154

Income Tax I (ii)

Fall 2002/2005 Used Spring 2007 lessor of 1. 22,100 (15% tax bracket) or 2. 45-20=25

Prof Lathrop

(B) 0 (C) 20% x 20 = 4,000 (D) (E) 28% of 45-42,100 = 2,900 = 812 STG of 10 NG of 12,100 22,100 x 15% 20,000 x 20% 2,900 x 28%

PROBLEMS: (P 699) 1. Here are two questions on capital losses incurred in the current year. The figure for taxable income given in column A reflects a single taxpayers taxable income for each of two years without regard to his capital gains and losses. Note that in computing gross income (as adjusted) on the return no gains will be included, since capital losses exceed capital gains and the 1211(b) excess amount will be a reduction (see note 4, supra.) Taxable Income 1. $10,000 2. $10,000 LTCG $2,000 $2,000 LTCL $6,000 $10,000 STCG $2,600 $2,000 STCL $1,000 $4,000

For each year separately, without regard to computations for other years, determine the amount of the taxpayers capital loss that is allowed as a deduction from ordinary income under 1211(b)(1) or (2) and the amount and character of his capital loss carryover, if any, under 1212(b).

1. Nets: LTCL 1222(4) $6,000 LTCG 1222(3) $2,000 NLTCL 1222(8) $4,000 STCL 1222(2) STCG 1222(1) NSTCG 1222(7) $1,000 $2,600 $1,600

1211(b) Flush, In the case of a taxpayer other than a corporation, losses from sales or exchanges of capital assets shall be allowed only to the extent of the gains from such sales or exchanges, plus (if such losses exceed such gains) the lower of a. $3,000 ($1,500 in the case of a married individual filing a separate return), or b. the excess of such losses over such gains. Flush language of 1211(b) allows offset of CL of $7,000 against CG of $4,600 to establish an off set of $4,600 losses against gains. Page 131 of 154

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Fall 2002/2005 Used Spring 2007 1211(b)(1) & 2: Amount allowed against ordinary income is the lower of: i. $3,000 ii. $2,400 (amount of excess losses over gains above)

Prof Lathrop

TP may take deduction of $2,400 capital loss against ordinary income per 1211(b)(2). TP total benefit under 1211(b) is $7,000. (Flush of $4,600 & (b)(ii) of $2,400) Plug into 1222(1) Net Capital Loss definition and have $0 to carryover to 1212.

2. Nets: LTCL 1222(4) LTCG 1222(3) NLTCL 1222(8) $10,000 $ 2,000 $ 8,000 STCL 1222(4) STCG 1222((1) NSTCL 1222(6) $4,000 $2,000 $2,000

1211(b)(1) & (2): Limitation on capital losses 1211(b)(1) & (2): Amount allowed against ordinary income is the lower of: a. $3,000; or b. $10,000 (Excess of Losses over Gains) TP may take a maximum $3,000 against ordinary income for the year per 1211(b)(1). TP may qualify to carry over the additional losses per 1212(b)(1) if TP has a net capital loss for any taxable year. Net capital loss is defined in 1222(10) as the excess of the losses from sales or exchanges of capital assets over the sum allowed under 1211. In this case, the excess of $14,000, losses for the taxable year, less the $3,000 (bump) of offset of the losses against ordinary income provided by 1211(b)(1) + 1211 flush of $4,000. This entitles TP an amount of carryover loss of $7,000. Classification of carryover loss per 1212: Step 1: Figure Treatment of amounts allowed under section 1212(b)(1) or (2) first: i. shall be treated as a short-term capital gain in the taxable year an amount equal to the lesser of: 1. The amount allowed for the taxable year under paragraph (1) or (2) of section 1211(b), or 2. the adjusted taxable income for such taxable year. Calculations: a. $3,000 b. $13,000 (Adjusted taxable income) Page 132 of 154

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Fall 2002/2005 Used Spring 2007 Prof Lathrop Adjusted taxable income is defined in 1212(b)(2)(B) as taxable income increased by the sum of (i) (ii) the amount allowed for the taxable year under paragraph (1) or (2) of 1211(b), and the deduction allowed for such year under 151 or any deduction in lieu thereof.

Calculations: (i) Taxable income $10,000 + $3,000 (1211(b)(1)) = $13,000

Step 2: Figure classification under 1212(b)(1)(A) & (B): (A) The excess of the net short-term capital loss ($0) over the net long-term capital gain ($0) shall be a short-term capital loss in the succeeding taxable year. (B) The excess of the net long-term capital loss ($8,000) over the net short-term capital gain ($1,000 figured from 1212(b)(2)(A)(i) inclusion of $3,000 STCG in recalculating net results for tax year) shall be a long-term capital loss in the succeeding taxable year. Calculations: Nets Again for purpose of 1212(b) ONLY: LTCL 1222(4) LTCG 1222(3) NLTCL 1222(8) $10,000 $ 2,000 $ 8,000 STCL 1222(2) STCG 1222(1) STCG 1222(1) NSTCG 1222(5) $4,000 $2,000 $3,000(per 1212(B)(2)(A)(i)) $1,000

(A) $0 $0 = $0 short-term capital loss in the succeeding taxable year. (B) $8,000 - $1,000 = $7,000 long-term capital loss in the succeeding taxable year.

Hypo Problem in Class: Lt 2G 10L 8 NLTCL NCL 16L -7 9 NCL up goes 3 short term gain Page 133 of 154 St 2G 6L 4NSTCL

4G 16L 12 Excess

Income Tax I LT 2G 10L 8NLTCL Then 1212(b)(1)(A) & (B)

Fall 2002/2005 Used Spring 2007 ST 2G 3G 6L 1 NSTCL

Prof Lathrop

Carryover 8 long-term Carryover 1 short-term D. The Meaning of Capital Asset 1. The Statutory Definition [1221(a)(1)-(4). 1234; 1236; 1237]

Mauldin v. Commissioner (P. 700) Maulding (P) v. Commissioner (D) NATURE OF CASE: Appeal from Tax Court decision against TP Maulding (P) holding that sale of lots were property held b the taxpayer primarily for sale to customers in the ordinary course of his trade or business within the 117(a)(1) now 1221. FACT SUMMARY: Mauldin (P) was a veterinarian who moved to Clovis, New Mexico in 1916 where he bought 160 acres to engage in the cattle business for $20,000. Because of conditions in New Mexico at the time, Mauldin (P) decided it was not the right time to get into the cattle business. He tried to sell the entire tract in 1924 but was unsuccessful because of highway splitting the land. Mauldin (P) decided to divide up the land into small tracts and blocks. The land was platted into 29 tracts and 4 blocks containing 88 lots each. At the time the land was platted in 1924, there was no demand for residential property because the land was outside city limits and the town was not growing. In 1927, Mauldin (P) built himself a home near the center of the Addition. By 1939, the property was in the city limits of Clovis and the city assessed a paving lien against the Addition for $25,000. When Mauldin (P) was unable to pay the City instituted suits on its paving liens. Mauldin to save his land sold lots in the Addition and spent his full time at this endeaver. During 1939 and 1940, he sold enough lots to liquidate the paving indebtedness. Mauldin (P) says that once the paving assessments were paid off he decided to hold the additional land for investment purposes. Mauldin (P) went into the lumber business. War broke out and the City of Clovis grew in population which caused the Mauldin Addition lots to be in great demand. By the end of 1945, Mauldin had disposed of all but 20 acres of his original 160 acre tract. In their income tax returns for the years 1944 and 1945, petitioners showed the lots sold during those years as long-time capital assets, and computed tax accordingly. The Commissioner determined that the profit realized was ordinary income and assessed the additional tax. CONCISE RULE OF LAW: There is no set formula to determine whether an asset should be classified by the TP as a capital asset held for investment or an asset held in the ordinary course of business; the court should take all factors into account depending upon the unique situation of the TP. ISSUE: Whether the purchase of land initially as an investment but later subdivided into lots and sold over several years should be taxed as a capital asset or as ordinary income from a trade or business? HOLDING AND DECISION: Page 134 of 154

Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop  No fixed formula or rule of thumb for determining whether property sold by the taxpayer was held by him primarily for sale to customers in the ordinary course of his trade or business. o Each case must rest upon its own facts.  Factors to consider: o The purpose for which the property was acquired, whether for sale or investment. o Continuity and frequency of sales as opposed to isolated transactions. o Was sales I furtherance of an occupation of the taxpayer. o With note that a TP may change his purpose and occupation towards an asset.  While the purpose for which the property was acquired is of some weight, the ultimate question is the purpose for which it was held.  Affirmed that income was derived out of trade or business. o While Mauldin initially bought land for investment purpose, his purpose changed. o When he subdivided and offered it for sale, he was undoubtedly engaged in the vocation of selling lots from this tract of land at least until 1940. o As to contention after 1940 he held for investment the court notes:  At all times lots were up for sale.  Sold lots in 1941, 1942, 1943, 1944, 1945, and 1946.  Mauldin (P) sold more lots in 1945 on a sellers market without solicitation than he did in 1940 on a buyers market.  Sold depended primarily upon the prevailing economic conditions.  Returns plainly show that a substantial part of his income was derived from the sale of the lots. EDITORS ANALYSIS: Look to action of TP as a whole and use the facts of the situation to make argument of whether or not the asset should be classified as one held for investment of held in the ordinary course of business of the TP. Latham says tough case in his opinion, will find many cases in tax world like this. Most of the time it will go against the taxpayer. Question really is why are you holding the property not why you bought the property. Note: Usually the court does not focus on the to customer language.

Malat v. Riddell (P. 704)

NATURE OF CASE: Appeal to US Supreme Court from District Court ruling that petitioner had failed to establish that the property was not held primarily for sale to customers in the ordinary course of business; Affirmed by the Appeals Court. FACT SUMMARY: Petitioner, Malat (P), contends that he engaged in a joint venture with a dual purpose of developing the property for rental purposes or selling, whichever proved to be the more profitable. Interior lots of the tract were subdivided and sold because of financing difficulties. The profit from those sales was reported and taxed at ordinary income. Zoning restrictions were encountered in considering the additional ground for commercial use and the venture sold out their interest in the remaining property. The District Court ruled that petitioner had failed to establish that the property was not held primarily for sale to customers in the ordinary course of business. Petitioner Appeals. CONCISE RULE OF LAW: The word primarily as used in 1221(1) means of first importance or principally. Page 135 of 154

Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop ISSUE: What is the meaning of the word primarily as used in 1221(1) of the Internal Revenue Code of 1954? HOLDING AND DECISION: (Per Curiam) Remanded.  Respondent urges upon us a construction of primarily as meaning that a purpose may be primary if it is a substantial one. Court rejects.  Court says that the words of the statutes should be interpreted where possible in their ordinary, everyday senses.  Purpose of the statutory provision with which we deal is to differentiate between the profits and losses arising from the everyday operation of a business on the one had and the realization of appreciation in value accrued over a substantial period of time on the other.  Ruling: Primarily means of first importance or principally.  Need more facts at trial level. Remanded. EDITORS ANALYSIS: Case stands for the proper use of the word primarily in 1221 to apply against the factors set forth in previous case. Lathrop sees this as a silly case.

3. The Corn Products Doctrine [1221(a)(7) and (8), (b)(2)]

Corn Products Refining Co. v. Commissioner Corn (P) v. Commissioner (D) NATURE OF CASE: Appeal to US Supreme Court on lower court ruling that corn futures were to be considered income in the ordinary course of business. FACT SUMMARY: Corn (P) is a major nationally known manufacturer of products made from corn. Its average yearly grind of raw corn ranges from thirty-five to sixty million bushels a year. It originally done business within a 30 day market but because of draughts that prevented Corn (P) products from being competitive with other substitutes the company began in 1937 to establish a long position in corn futures. This was done as a part of its corn buying program and as the most economical method of obtaining an adequate supply of raw corn. Corn (P) would buy futures when the price appeared favorable and take as much as it needed and would sell if no shortages in the market. In 1940 it netted a profit of $680,587.39 in corn futures, but in 1942 it suffered a loss of $109,969.38. Corn (P) originally filed these figures as ordinary profit and loss from its manufacturing operation for the respective years. Corn (P) now contends that these should have been capital transactions under 117 now 1221 because the futures were separate and distinct from its manufacturing business. CONCISE RULE OF LAW: If asset is so integrally tied to your business they are not capital assets. (Doctrine) ISSUE: HOLDING AND DECISION: (Clark, J.) Affirmed  Disagrees with Petitioners contention that the futures were separate from manufacturing business. Page 136 of 154

Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop o Futures were vitally important to the companys business as a form of insurance against increases in the price of raw corn. o Corn futures assured the company a source of supply which was admittedly cheaper than constructing additional storage facilities for raw corn. o Closely geared to the companys enterprise.  Rejects the argument by Corn (P) that they were capitalist in the market. Why? o Testimony of its own officers that in entering that market the company was trying to protect a part of [its] manufacturing costs o That its entry was not for the purpose of speculating and buying and selling corn futures but to fill an actual need for the quantity of corn [bought in order to cover what [products] we expected to market over a period of fifteen or eighteen months.  For tax purposes petitioners purchases have been found to constitute an integral part of its manufacturing business.  Court admits that corn futures do not fall into the literal language of 117(a). They were not stock in trade, actual inventory, property held for sale to customers or depreciable property used in a trade or business. o However, court must interpret congress intent which was that profits and losses arising from the everyday operation of a business be considered as ordinary income or loss rather than capital gain or loss. o 117 applies to transactions in property which are not the normal source of business income. o It was intended to relieve the taxpayer from excessive tax burdens on gains resulting from a conversion of capital investments, and to remove the deterrent effect of those burdens on such conversions.  This court has always construed narrowly the term capital assets in 117.  hedging transaction argument by Corn (P) is dismissed and stated that hedging transactions were essentially to be regarded as insurance rather than a dealing in capital assets and that gains and losses therefrom were ordinary business gains and losses.  Judgment affirmed. Arkansas Best Corp. v. Commissioner (P. 723) A.Best (P) v. Commissioner (D) NATURE OF CASE: FACT SUMMARY: CONCISE RULE OF LAW: ISSUE: HOLDING AND DECISION: EDITORS ANALYSIS: Must have sale or exchange to support capital asset.

Page 137 of 154

Fall 2002/2005 Used Spring 2007 Prof Lathrop Kenan v. Commissioner (P. 730)  Trustee claim no gain to the trust when they gave some securities to the beneficiary.  Commissioner says first capital gains and then tried to say ordinary.  Point to case is whether or not there is a capital gain to the trust when the securities were given to the beneficiary.  P/H: Capital gains.  Lay language what is the difference b/t what T/P are arguing and what court is holding? What is a specific legacy? Specific property with risk of ownership. Did Louise run the risk of ownership? No. That is the key here. She has a right to 5 million dollars. She did not run the risk of ownership. T/P are really arguing that she (Louise) owned these securities from the day Bingum died but could not get her hands on them. Key securities could have went to 0 when she turned 40 which would have been a specific legacy what she had was a right to get 5 million without risk. Court says that you have a sale or exchange by trustees getting debt relief and Louis getting Stock. Amount realized to the trustees is the debt relief. So there is a gain over the value of the stock.  Flip side of this to Louise does not get date of death basis because not taking out of a bequest. Value of property received is the basis to Louise under 1012 under Philadelphia Park is the value received. No double tax. If got date of death value would be taxed again. Louise gets basis of 5 million which is FMV basis.  Key of this case is the difference between specific bequest and right to receive certain amount. Galvin Hudson (P. 735)  Court held ordinary income.  No doubt that note in their hands was a capital asset and that if sold note it was a capital sale. However, when the note is in the hands of the judgment debtor it is not a capital asset. Was not property anymore. Judgment debtor did not receive any property. L. That is crazy as hell but has been law for many years.  Court held: Property in hands of holder simply vanished when paid off. NO sale or exchange.  P. 739- After June 8, 1997 1271 would treat as sale or exchange. Problem (P. 741) 1. Creditor purchased an individual Debtors $5,000 interest bearing note from a third party as an investment at a cost of $4,000 in 1996. Several years later, Debtor pays off the principal of the note using General Motors stock which debtor purchased several years ago at a cost of $2,000 which is now worth $5,000. What are the tax consequences to Creditor and Debtor? Problem brings both cases above into play. The debtor is using depreciated property to pay off debt and will have a gain. Getting debt relief for exchange of stock. Persons who bought the note under Galvin would have ordinary income. Before enacted 1271. If after these guys would be treated as capital gain. E. The sale or exchange requirement For a transaction to be taxed as a capital G or L, 1222 and 1231 require a sale or exchange to occur. At times the cts. Have confused the sale or exchange requirement w/the previously discussed capital asset requirement. The distinction b/t the two is not a clear one. In other contexts, the cts. Have ignored the sale or exchange requirement, as was done in Arrowsmith, where the pmt. of a judgment was characterized as a capital loss. The cts. Have usually focused more attention on the status of the asset than on the manner of its disposition. 1. Introduction Page 138 of 154

Income Tax I

Income Tax I

Fall 2002/2005 Used Spring 2007

Prof Lathrop

F. The Holding Period 1223(1) Substituted basis provision. Says basically that in determining holding period for property recd in an exchange, include period for which he held the property exchanged if, the property has the same basis of the property t/p exchanged. Typical expample is 351 transfer. 1223(2) Carryover basis provision. Says basically that in determining holding period, t/p includes period property was held by any other person whose basis in the property the t/p takes in whole or in part for purpose of determining gain or loss from sale or exchange. 1223(11) for property acquired from a decedent, if _ (A) the basis for such property in the hands of the recipient is determined under 1014, and (B) such property is sold or otherwise disposed of by such person w/in 1 yr. After the decedents death, then such person shall be considered to have held such property for more than 1 yr. Rev. Rul. 66-7: Holding period must be made with reference to months versus days. The holding period of a capital asset begins to run on the day following the date of acquisition of the asset involved. A capital asset acquired on the last day of any calendar month, regardless of whether the month has 31 days or less, must not be disposed of until on or after the first day of the 12th succeeding month of the calendar in order to have been held for more than a year w/in the meaning of 1222(3) and (4). Lathrop: 1. Holding period for capital assets made w/reference to calendar months and fractions thereof, rather than w/reference to days. 2. Start counting on day after you acquire if bought in middle of month.

Rev. Rul. 66-97: Trade dates are used to determine date purchased and date sold. Settlement dates are of no value. Note: What about situation where trade date (Critical Date) of a sale occurs in December, but calendar year t/p (cash basis) receives $ in January of next year? Service says recognize in year of trade date in Rev. Rul. 93-84. Senate report concurs. Lathrop says the law is unclear on this point, though. Lathrop: Tacking, with few exceptions, always applies where the t/p takes a substituted or a carryover basis and other situations similar to it (1034 we will cover later). Carryover basis when basis follows the property transferred. You get your basis from transferee. Typical gift situation. Substituted basis basis you had in property you gave up becomes the basis in the property you receive. 351 transfers.

Page 139 of 154

Income Tax I PROBLEMS: (P. 755)

Fall 2002/2005 Used Spring 2007

Prof Lathrop

1. Taxpayer, a cash method, calendar year taxpayer, engaged in the following transactions in shares of stock. Consider the amount and character of Ts gain or loss in each transaction: a. T bought 100 shares of stock on January 15, year one at a cost of $50 per share. T sold them on January 16, year two at $60 per share. $1,000 LTCG. It is capital b/c it doesnt fit any of the exceptions listed in 1221. It is LT per 1222(3) b/c he held the capital asset more than 1 yr. Lathrop: Start year on 1/16. When you get to 1/15/13, you have a complete year, so next day is over a year. Dont have to hold to 16th to have a full year. If you think about this if you start counting on the 16th of the first year by the 15th of following year you do have a year.

b. T bought 100 shares of stock on February 28, 2003 at a cost of $50 per share. T sold them on February 29, 2004 for $60 per share. $1,000 STCG per Rev. Rul. 66-7. If you buy on the last day of month go by months not days. Here, he sold at end of 12th month. Trap in leap years. If you buy on last day of a month, you must hold it until the 1st day of the 13th month regardless of what day bought on. (Check this in class) Must wait till March 1 if you want LTCG. c. T bought 100 shares at $50 per share on February 10, 2002 and another 100 shares at $50 per share on March 10, 2002. T sold 100 of the share on February 15, 2003 for $60 per share. See Reg. 1.1223-1(i) and 1.1012-1(c)(1). 1.1223-1(i) When shares of stock in corp. are sold from lots bought at different dates or at different prices and the identity of the lots cannot be determined, 1012 regs. Govern cost or basis and holding period of the shares. 1.1012-1(c)(1) If can adequately identify lot sold from, O.K. Otherwise, presumed to be sold from earliest lot purchased for basis and holding period purposes. First in First out. Thus, here, unless the shares sold could be adequately identified as being of the 2d lot, the sale will be deemed to be from the 1st lot. The gain will be $1,000. Regs. Say FIFO unless t/p can identify specifically which shares sold. Regs. Offer 2 ways to identify: Confirmation slip or stock certificate.

Page 140 of 154

Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop d. T told Ts broker to purchase 100 shares of stock on December 29, 2002 at a time when its price was $50 per share. The stock was delivered to T on January 3, 2003 (Red Herring, Dont Care) when it was selling for $52 per share. T told Ts broker to sell the stock on December 30, 2003 when it sold for $60 per share, and it was delivered to Buyer on January 4, 2004 when it was selling for $63 per share. Assuming the trade date is 12/29/02 for $50 and the sale took place on 12/30/2003 at $60/share, it is a LTCG of $1,000. Rev. Rul. 66-97 specifies that it is the trade date, not the date of delivery that governs the holding period (both purchase date and sale date) of debentures acquired by purchase. The holding period includes the trade date on which the debentures are sold. Same rule applies to stock purchased. 1993 Rev. Rule says you have to report on trade date. If not traded stock you may fall into 453 and be able to pay in following year. If publicly traded cant use the installment rule under 453. Lathrop: Went off on installment sales (453). Said individuals are usually cash basis. Issue is when does the sale her enter t/ps income? 453 says if you get paid in other than yr. Of sale, 453 applies & you report in yr. of sale. 453(k)(2)(A) says installment sale rules d/n apply to publicly traded stock. e. Same as (d), above, except that the value of the stock on December 30, 2003 was $45 per share and on January 4, 2004 was $48 per share. LTCL of $500. Trade dates d/n change when gain or loss position changes. D/n have a 453 problem b/c 453 doesnt apply to losses & you take in year of loss 12/30/2003. Always use trade dates for holding period. This problem deals w/yr. of reporting. With respect to losses, trade date governs when deductible. Beneficial take losses earliest as you can.

f. Ts father bought 100 shares of stock on January 10, 2002 at $30 per share. On March 10, 2002 when they were worth $40 per share he gave them to T who sold them on January 15, 2003 for $60 per share (see 1223(2)). Per 1223(2), if you determine your basis for G or L in whole or in part from the basis of another (i.e. a 1015 gift), then you also tack their holding period. Thus, in this case, Ts holding period includes that of his dad. T is deemed to have acquired the stock on 1/10/2002. Therefore, per 1222(3), T has a LTCG of $3,000. 1223 is referred to as tacking rules. g. Ts father purchased 1000 shares of stock for $10 per share several years ago. The stock was worth $50 per share on March 1, 2002, the date of Fathers death. The stock was distributed to T by the executor on January 5, 2003 and T sold it for $60 per share on January 15, 2003. Ts basis is the FMV on date of dads death per 1014(a)(1). Ts holding period is statutorily deemed to be > 1 year per 1223(11) b/c (A) basis is determined under 1014 and (B) such property is sold or otherwise disposed w/in 1 yr. after decedents death. Note that if T sold more than 1 r. after dad died, no need for deemed LT holding period. Page 141 of 154

Income Tax I

Fall 2002/2005 Used Spring 2007 Prof Lathrop Lathrop: Says this rule is an oddball. Ties basis into FMV. Almost all other tacking rules for holding period apply when base is same in whole or in part as property given up or basis in hands of transferee.

h. Same as (g), above, except that T was executor of Ts fathers estate and as such T sold the stock on January 15, 2003 for $60 per share to pay the estates administration expense. Estate is a taxable entity in its own right and can also take advantage of the 1014 rule just as an individual can. 1223(11) still available to estate to give it LT treatment on the sale.

Depreciation: (P. 404) Class Notes: November 11, 2002  167(a) tells you what kind of property you can depreciate. Primary depreciation section.  Deduction for some amount every year.  168 you can depreciate property down to 0 because no salvage value taken into account. What this means is usually when you sell it you will have a gain.  Land does not have a limited useful life so dont depreciate. Under 168 dont have to worry about useful life because section gives you classifications of useful life assets.  Under 168 do not have salvage value.  Methods o Basically, for our purposes, is straight line or declining balance. o Straight line is same each year o Declining balance bigger deduction up front and declines in each succeeding year. Fixed rate applied to a declining basis b/c of 1016. o 1016 must decrease your basis for depreciation. o Double declining is double your straight line result. If for example you have 5 yr. 1,000 property which is 20% a year, double declining is 40%. 40% is applied against the declining basis balance each year. o 168(a) is the ACRS. o Must time cost recover is 3,5, or 7 year. o General rule is double declining balance switch to straight line when straight line will be more.  Other options to elect. o When in 168  Have conventions: y Half year conventions makes you assume property was put in to use in the middle of the year. o Depletion Coal, Oil, or Gas.  How does 168 work? o (a), (b), & (c) , (d), tell you about all you need. o (a) o (b) tells you in (a) the method is double declining balance switch. o (c) applicable recovery period. o (d) Applicable conventions.  Exam must know how conventions work and what they do to the taxable year. And what 1016 a2 does to basis of asset you are depreciating.  (d)4 tells you what the conventions are.  167 traditional 30% depreciation after 9/11/01 and before 04.  179 can elect to take up to 24,000 depreciation this year.  1245 recapture provision.  Amortization of Good Will Page 142 of 154

Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop o Not until recently you could amortize good will o Could on covenants not to compete o To extent you acquire good will (bought good will), that is amortizable. o Over 15 yrs. o Covenants not to compete over 15 yrs also no matter how long the covenants run. o If 197 asset it is a 1231 asset in your hands and makes a difference in gain or loss.  Reality. o Half month convention o Must straight line after 86 and usually 39 yrs. unless residential 27.5

Class Notes: November 13, 2002 Chapter 22: Characterization on the Sale of Depreciable Property  1231(b) defines property used for trade or business. (1) tells you that depreciable property held more than a year and real property used in the trade or business held for more than a yr. What does that sound like? 1221(a)(2).  If you fall in 1231 if is the best of both worlds for the taxpayer except under 1231(c) which is a conversion, it is a look back rule over 5 years that will would have been 1231 gains will convert to ordinary income to the extent you had 1231 losses over that 5 year period. Recapture rule. o Before you had (c) if you had more losses than gains everything was off of ordinary income. Very favorable. o Why the change. WWII ships going across Atlantic taking big losses. Ships being taken by government or big insurance policies that when ships blew up. Huge war time gains Congress said should be capital gains but losses could be treated as ordinary. Now we deal with it more in the sales and exchange area. o General rule is in 1231(a)(1) & (2) o 1231(a)(3) Critical  What are 1231 gain or losses y Two things (i) any recognized gain on the sale or exchange of property used in the trade or business, and y (ii) compulsory or involuntary conversion (This is the one forgot about most). o If have these situations then 1231 turns into sales or exchange. A conversion is not normally a sale or exchange. o 1231(a)(4)(C) Text calls Hotchpot Deals with Casualty conversions.  Way it works if you have more casualty conversion losses than casualty conversion gains throws them out of 1231 and are not considered sales or exchanges this causes all of the losses can be taken off ordinary gains and losses. This only happens if you have net casualty conversion losses. Very favorable to the taxpayer. o 1231(a)(4)(C) concepts if you had net 1231 losses over last 5 years you have gotten the benefit of losses off of ordinary income. So if you have a gain you should have to recognize as ordinary income. Look back over 5 years. It is a recharacterization of 1231 gain to ordinary income. o Good provision except for (C). Really in there to prevent hop scotch. One year load up on gains to get LTG treatment and then in the next year load up on losses and get deduction against ordinary income.  Stephen P. Wasnok Page 143 of 154

Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop o Couple owned home in Cin. and wanted to move to CA. Rented it out for period of about 4 years. Took depreciation on that period. When sold 1967 back to back took a capital loss of 3,611. Commissioner disallowed the loss and said it was ordinary. TP wanted to carryover the loss for deduction in other year. o What did the court say about it being a capital loss?  Property used in trade or business is depreciable so gets kicked out of 1221 and gets picked up under 1231.  What do TP say about this? y They had rented for 4 years and under old 1034 purposes there was some exclusion when renting principle residence. Just arguing capital asset b/c they did not carry on any activity that raised it to the level of a trade or business.  Lathrop: thinks this was a capital asset and not a trade or business. Court with little discussion says that it is a trade or business. o Remember 167(a)(1) & (2) you can depreciate property held for the production of income. You can have investment property and depreciate it. Capital asset that you invest in but do not hold for a active trade or business you can still depreciate. Ex. Is a net lease. Leasee doesnt do anything accept collect rent. o Once you determine that this is a capital asset in trade or business (Real Question) you are out of 1221 and you are now in 1231(a)(2). Result losses are ordinary and the court said in 1965 you had enough income to offset and you can not carry forward. o Characterization case.  Williams v. McGowan o Williams and Reynolds had engaged in a partnership in the hardware business. o Reynolds later dies and Williams buys out Reynoldss interest. o When he sells he has a gain on his 2/3 part and a loss on the part bought from the executrix. o Reported everything as ordinary income. o Treated the sale of the business as entity. o When you look at current 1221 the court says when you sell a business you must calculate the gains or losses on each asset sold. o Some may throw off capital gains or losses and some may be ordinary income. o Some will be capital asset and some will not be. o Now when you sell the corp. by sale of stock is not this case the stock is a capital asset you are just changing owner. Now if the corp. sells all the assets of the corp. you do have a WM situation.

PROBLEMS: 768 1. Hotchpot engaged in (or encountered) the following transactions (or events) in the current year. Determine separately for each part (a) through (i) how the matters indicated will be characterized for the current year, assuming in all parts other than (g)-(i) that 1231(c) is inapplicable. a. Hotchpot sells some land used in his business for four years for $20,000. It had cost him $10,000. He also receives $16,000 when the State condemns some other land that he had purchased for $18,000 three years ago which he has leased to a third person. Note: Remember that 1231 is a recharacterization section and you must still look at 1001 to see what you have. 1st land is clearly used in T or B. 1221(a)(2) cant be used in a trade or business but 1231(a)(3)(A)(i) picks this up. Definition of what 1231 gain is. Page 144 of 154

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Fall 2002/2005 Used Spring 2007 $20,000 AR per 1001(b) $10,000 AB per 1012 & 1011 $10,000 Gain per 1001(a) all recognized per 1001(c). 1231(a)(3)(A)(ii): condemnation of land is investment property & held > 1 yr. $16,000 AR per 1001(b) $18,000 AB per 1011 & 1012 $ 2,000 Loss per 1001(a) all recognized per 1001(c).

Prof Lathrop

When looking at these problems start in 1221 if kicked out look at 1231 if not applicable may end up in 1245. (L. Seesaw approach) Loss is picked up in 1231(a)(3)(B). Once the gains and losses are identified as 1231 the next step is to net. Since 1231 gains exceed 1231 losses, treat each as LTC. Per 1231(a)(1)(A)&(B). Thus, next step is taking $10,000 LTCG and $2,000 LTCL to be netted under 1222 w/other CGs and CLs. If no other capital gains and losses, $8,000 net LTCG per 1222(7). Then must determine tax rate under 1(h).

b. Same as (a), above, including the same bases, except that both pieces of land were inherited from Hotchpots Uncle who died three months before the dispositions. At Uncles death, the business land was worth $16,000 and the leased land was worth $18,000. 1223(11) treats property w/basis under 1014 as held > 1 yr. Problem illustrates you need to have held 1 yr. to get under 1231.

$20,000 AR per 1001(b) $16,000 AB b/c 1014 FMV at time of death. $4,000 gain per 1001(a) & 1001(c) Can get into 1231 because 1223(11) treats that it is held > 1yr. Gain treated as LTCG. Recap what you are doing in the Code: You start in 1001 to get gains and losses. Then go to classification under 1221, if kicked out, then to 1231, if no good, 1245 which is not TP favorable. c. Hotchpot sells a building used for several years in his business, which he depreciated under the straight-line method. The sale price is $15,000 and the adjusted basis $5,000. His two year old car, used exclusively in business, is totally destroyed in a fire. The car had a $6,000 adjusted basis but was worth $8,000 prior to the fire. He received $4,000 in insurance proceeds. Look for regs. On this problem. 165(a). Illustrates the difference b/t 1231(a)(3)(A)(ii) conversions and 1231(4)(C) casualty conversions. Page 145 of 154

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Fall 2002/2005 Used Spring 2007

Prof Lathrop

Treat the $4,000 as an amount realized. Initially the loss of the car is under 1231(a)(3)(A)(i) because the car is used in a T or B. Then go down to (C) because this is a casualty loss. $10,000 is 1231 gain per 1231(b)(1). The $2,000 loss is not 1231 loss b/c of 1231(a)(4)(C) flush [Act of God conversions]. Here, if losses > gains, all losses = ordinary, 1231(a) will not apply. If you have other casualty losses & gains & losses > gains, subsection (a) d/n apply & all get ordinary treatment. $2,000 ordinary loss because you dont have a sale or exchange to support capital treatment and $10,000 1231 LTCG gain per 1231(a)(3)(A)(i).

d. In addition to the building and the car in (c), above, assume that Hotchpot had a painting that he had purchased two years ago which was held in connection with his business and which was also destroyed in the fire. The painting had been purchased for $4,000 and he received $8,000 in insurance proceeds. $8,000 AR per 1001(b) $4,000 AB per 1011 & 1012 $4,000 Gain per 1001(a) recognized under 1001(c). Initially the picture is pickup under 1231(a)(3)(ii)(II), casualty go to (C) Now, casualty gains > casualty losses, so subsection (a) does apply & all are 1231 Gs and Ls. Net all of them up: $14 $2 1231 Gain 1231 Loss

Per 1231(a)(1) flush, all are LTCG and LTCL. Go to 1222 to net CGs and CLs. The result under 1222 is that you have a net LTCG of $14,000 and Net LTCL of $2,000. Once netted look to 1(h) for classification of gains. L if casualty loss that d/n fit into 1231, such as a house, 165(h) has a parallel rule to 1231. e. In addition to the building sale, car loss, and painting gain in (c) and (d), above, assume Hotchpot sells land used for several years in his business for $30,000. The land, which he had hoped contained oil, had been purchased for $50,000. Definitely property used in T or B per 1231(b)(1) flush. $20,000 1231(b) loss. Net this with previous problems 1231 situation yields a net $8,000 1231 loss. So all treated as ordinary 1231(a)(2). 1231 just characterizes items as ordinary. f. Would Hotchpot be pleased if the Commissioner successfully alleged that the land in problem (e), above, was held as an investment rather than for use in Hotchpots business? No. Not 1231. Although held for profit, the land d/n qualify for 1231 treatment under 1231(a)(3)(ii)(I) b/c not involuntarily converted. 1231 only picks up property held for Page 146 of 154

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Fall 2002/2005 Used Spring 2007 Prof Lathrop investment in connection with T or B or used in connection w/T or B if an involuntary conversion. Now the $20,000 is capital on its own two feet. $8,000 is 1231 gain (treated as LTCG). Thus, the $8,000 1231 gain and the $20,000 capital loss would be taken to 1222 and netted against other Gs and Ls and subjected to the 1211 limitation. Held in connection w/ T or B = painting hanging in office. Used in T or B = actual equipment. Sale or exchange of property under 1231 only applies to property used in T or B. 1231(a)(3)(A) defines 1231 gain. Need to know category of property to be sure whether you are in or out of 1231.

g. What result under the facts of (d), above (building gain, car loss, and painting gain), if four years before the fire Hotchpot had had a $5,000 net 1231 loss and three years before a $3,000 net 1231 loss, and he had had no other 1231 transactions in other years. Yr. Current Yr. 1 2 3 4 5 Amount $12,000 Description This is building gain, car loss, and painting gain.

(3,000) (5,000)

1231 Net non-recaptured Hotchpot Loss 1231 Net non-recaptured hotchpot Loss

Per 1231(c)(2) non-recaptured net 1231 losses = $8,000 from yrs. 3 & 4. Per 1231(c)(1), to the extent the current yr. 1231 gain d/n exceed non-recaptured net 1231 losses, it will be treated as ordinary. Thus, here, you have $8,000 ordinary and $4,000 LTCG. h. Same as (g), above, except that in addition two years before the tax year Hotchpot had a $6,000 net 1231 loss. Yr. Current Yr. 1 2 3 4 5 Amount $12,000 Description Total amt. will be recaptured as ordinary income, not get capital gains treatment. $2,000 non-recognition after working 1231(c)(2) flush. 1231 Hotchpot Loss 1231 hotchpot Loss

(6,000) (3,000) (5,000)

Start w/earliest yr. and work forward using up non-recaptured net 1231 losses. Here, start with 5,000 then 3,000 and 4,000 of yr. 2, all $12,000 current yr. 1231 gain will be recaptured as ordinary and you will have $2,000 loss not recaptured in yr. 2. Page 147 of 154

Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop i. Same as (h), above, except that one year before the tax year Hotchpot had had a $10,000 net 1231 gain. Now, $10,000 of the prior yr.s losses has been used up and only $4,000 of the prior yrs losses remain in the year 2 to offset the current yr. gain. Thus, $4,000 ordinary gain and $8,000 LTCG. FOR all 1231 problems, 2 steps: 1st is it 1231 property? Then, put all 1231s in bag & see what shakes out. 2. Car Dealer uses some cars for demonstration purposes. Are the cars depreciable? Disregarding 1245 if they are held long-term does gain on their sale qualify for 1231(a) main hotchpot treatment? See Rev.Rul. 75-538, 1975-2 C.B. 34. Rev. Rul. 75-538: This ruling treats as inventory because they are primarily held for sale to customers. Any gain is ordinary. L said if not capital asset under 1221(a) you are also out of 1231 by definition. Why? 1231(b)(1)(A) and (B) says to be 1231, must be used in T or B or held for sale to customers. 3. Merchant who has been in business for four years sells her sole proprietorship consisting of the following assets, all of which, except for the inventory, have been held for more than one year. Adjusted Basis $8,000 0 $30,000 15,000 12,000 $85,000 Fair Market Value $16,000 20,000 20,000 20,000 14,000 $90,000

Inventory Goodwill (generated by Merchant) Land (used in business) Building (used in business) Machinery & Equipment (used in business) Total

Merchant also agrees, for an additional $10,000 that she will not compete in the same geographical area during the succeeding ten years. a. Disregarding any consideration of 1245 and 1250, which are considered in the succeeding subchapters of the text, what are the tax consequences to Merchant on her sale of the Business for $140,000? $8,000 inventory gain is ordinary. $20,000 GoodWill is a capital asset for our purposes even though 197 made it a 1231 asset. Covenant not to compete is amortizable over life of covenant & thus is 1231 asset. Seller gets ordinary treatment. Land, bldg. and machinery are clearly 1231 assets. b. What difference in result if Merchants business has always been incorporated, she is the sole shareholder, and she has a $90,000 basis in the stock which she sells for $120,000, assuming that she is again paid an additional $20,000 for her covenant not to compete? $30,000 capital gain per 1221 and $20,000 ordinary income. A vs. b = not selling business in b, it stays in corporate solution. Only stock is sold. Capital asset per AK Best Case. Not a McGowan sale of a business. Page 148 of 154

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Fall 2002/2005 Used Spring 2007

Prof Lathrop

E. Recapture Under Section 1245 [64; 1245(a)(1) and (2), (c), (d); 179(d)(10); 1041(b); 1222; 1231. Reg. 1.1245-1(a)(1), (b), (c)(1), (d), -2(a)(1) through (3)(i) and (7), -6(a)] 1. Summary of sections 64 Ordinary Income Defined. For purposes of this subtitle, the term ordinary income includes any gain from the sale or exchange of property which is neither a capital asset nor property described in section 1231(b). Any gain from sale of property treated as O.I. will not be treated as gain from sale of a capital asset or 1231(b) property. 1245(a)(1) Ordinary Income. Except as otherwise provided in this section, the amount by which the lower of (A) the recomputed basis of the property, or (B)(i) in the case of a sale, exchange, or involuntary conversion, the amount realized, or (ii) in the case of any other disposition, the FMV of such property, exceeds the adjusted basis of such property shall be treated as O.I. Such gain shall be recognized notwithstanding any other provision of this subtitle. The recapture bite of 1245(a) will be the lower of two alternatives: 1. In the case of a sale or exchange or involuntary conversion: a. Recomputed basis less adjusted basis; or b. Amount realized less adjusted basis. 2. In the case of other dispositions: a. Recomputed basis less adj. basis; or b. FMV less adj. basis. (2) Recomputed Basis: (A) In general. The term recomputed basis means, w/respect to any property, its adjusted basis recomputed by adding thereto all adjustments reflected in such adjusted basis on account of deductions (wether in respect of the same or other property) allowed or allowable to the TP or to any other person for depr. Or amort. (B) If TP can establish that amt. allowed for depr. or amort. for any period is < the amt. allowable, the amt. added for such period shall be the amt. allowed. (3) 1245 property. For purposes of this section, means any property which is or has been property subject to depr. under 167 or subject to amort. in 197 and is either (A) personal property, L. this is the big part of the definition. (B) other property (b) Exceptions and limitations. 1. Gifts. Subsection (a) shall not apply to a disposition by gift. Page 149 of 154

Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop 2. Transfers at death. Except as provided in 691 (IRD), subsection (a) shall not apply to a transfer at death. (c) Adjustments to basis. Secretary shall prescribe regs. to provide for adjustments to basis of property to reflect gain recognized under subsection (a). (d) Application of section. This section shall apply notwithstanding any other provision of this subtitle. L. Fully self-contained. If you want to get out of 1245, have to get out under 1245. Cant get out of it through other parts of the code. 1245 converts what would otherwise be 1231 gain into ordinary gain from the get go. Can cause recognition where it otherwise would not be. Can create a taint. Happens when transaction d/n trigger 1245 but depr. has been taken. Ex gift. If donee sells, must recapture. Rev. Rul. 69-487: TP, an individual operation a business as a sole proprietorship, converted to personal use an auto that had been used solely for business purposes. At the time, the FMV > adjusted basis. Rule: For purposes of 1245, conversion to personal use is not a disposition of the auto. There is no gain to be recognized by the TP upon the conversion to personal use. Conversion to personal use d/n = disposition. L. But the property is tainted. If TP later sells to unrelated 3rd party, TP then has 1245 recapture. L. But the property is tainted. If TP later sells to unrelated 3rd party, TP then has 1245 recapture. Class Notes: November 18, 2002:  All it does is that if you sell 1245 assets for a gain then you will recapture as ordinary income any deductions taken from depreciation that were taken against ordinary income over the years.  PROBLEMS (P. 781) 1. Recap, a calendar year taxpayer, owns a piece of equipment that Recap uses in business. The equipment was purchased in 1996 for $100,000, is 5-year property within the meaning of 168(c), and Recap has taken the ACRS deductions on it allowed by 168. Recap did not elect 179. Assume Recap has no net 1231 losses in prior years. a) What result to Recap if Recap sells the equipment to Buyer on December 31, 2002 for $30,000.00? AB = 0 b/c $100,000 1012 basis has been fully depreciated by beginning of 2002. Under HY convention, take yr. in 1996, full yr. in 1997, 98, 99, 00, and remaining yr. in 2001. 1245 cuts across all sections and takes 1245 1st. Per 1245(a)(1), recapture lower of gain on sale [1245(a)(1)(B)(i)AR less adjusted basis] or (a)(1)(A)recomputed basis [(a)(2)(A)adjusted basis plus depr. Taken] as O.I. Here, gain = $30,000 AR less 0 AB, or $30,000. Recomputed basis = 0 AB plus $100,000 depreciation allowed or allowable, or $100,000. Thus, recapture all $30,000 gain. Page 150 of 154

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Fall 2002/2005 Used Spring 2007 b) What difference in result if Recap had elected to use 179?

Prof Lathrop

No. Per 1245(a)(2)(C), 179 deduction shall be treated as if it were a deduction allowable for amortization. Do 1231 recapture after 1245 recapture. 1245 takes what would be 1231 & turns it into ordinary. c) What result to Recap in (a), above, if Recap had failed to take any depreciation deductions on the equipment? Would Recap be content to let things be or would Recap want to seek a refund based on depreciation allowable for prior years? 1016(a)(2)(A) says reduce basis for depr. Allowed or allowable. Basis is still 0, so gain is still $30,000. 1245(a)(2)(B) does have an out provision if you can establish that the amt. allowed d/n = the amount allowable. L has never seen it. Thinks only way is if IRS disallowed some depr. in an audit. Note: This will not help you in your gain calculation under 1016, but may help in your recapture calculation under 1245. Thus, only impact is to reduce the O.I. recapture. Any open years he would want to go back and take depreciation because it is going to reduce basis anyhow. (allowed or allowable.) Wants to take the depreciation expense. L. If not sure about taking deduction, take it so Statute of Limitation does not run out. L. 1231 gain if you can get relief under 1245(a)(2)(B). L. Note if you fail to take depr., 1016 says take it on SL basis over applicable 168 recovery period. My note is that this only apples if no method has been adopted. Thus, if TP starts depr., then that method governs. d) What results in (a), above, if Recap sells the equipment to Spouse? 1041(a) says no G or L on transfer of property from an individual to (1) a spouse. 1041(b)(1) says property described in (a) shall be treated as acquired by the transferee by gift. Issue = does 1245 override 1041 and cause recognition of gain as O.I.? No. 1245(b)(1) says 1245(a) shall not apply to a disposition by a gift. Therefore, no 1245 recapture. e) What result if as a result of a scarcity of equipment Recap is able to sell the equipment to Desperate for $110,000?

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Fall 2002/2005 Used Spring 2007 Prof Lathrop Now, per above computation, the recomputed basis [$100,000] 1245(a)(1)(A) or (B) is lower than the amount realized on the sale [110,000]. Therefore, 100,000 is recaptured as O.I under 1245. The other $10,000 is 1231 gain. Treat as LTCG if 1231 gains exceed 1231 losses under 1231(a). End up after netting in 1(h) and getting favorable rates. 1231 only characterizes. f) What result to Recap in (e), above, if in addition Recap sold some land used for storage in Recaps business for $9,000? Recap had owned the land for three years and it had a $20,000 adjusted basis. $9,000 AR less $20,000 AB = $11,000 1231 loss. Couple this with the $10,000 1231 gain from c and you have 1231 losses > 1231 gains, thus all are treated as ordinary. But, remember, the $100,000 1245 chunk from c still comes out first. That is what this problem is designed to show you. Total of $110,000 gain; $10,000 ordinary per 1231 and $100,000 ordinary per 1245. g) Same as (f), above, but the sale price of the land is $15,000?

2. Do you see a significant relationship between 1245(a)(2) and the transferred basis rules of 1015 and 1041(b)(2)? Does the statute sanction assignment of fruit in these circumstances? No recognition to transferor and transferee takes carry over basis. in hands of any other What happens is the recapture sits there in the hands of the transferee and must use adjusted basis and may have recapture under 1245. Gift doesnt trigger 1245 but the sale may.

E. Recapture of Depreciation on the Sale of Depreciable Real Property [1(h)(1), (2), (4), and (7); 1250(a)(1)(A) and (B)(v); (b)(1), (3) and (5); (c); (g); and (h). 64; 1222; 1231. 1250 picks up all depreciation if held more than a year the recapture is just on the difference between SL and Accelerated, this is different than 1231. 1(h) treats unrecaptured 1250 gain as 25% rate.

1. To what extent does 1250 apply to real property placed in service after 1986? It does not effect. 168(b)(3) says applicable depreciation method for RP is SL after 1986. Therefore, there is no additional depreciation. Only old ACRS property is subject to 1250 recapture. 2. On January 1, 1994 Owner purchased a commercial building at a cost of $490,000 of which $390,000 was properly allocable to the building and $100,000 was allocable to the land. On December 31, 2003, Owner who is single and who has $100,000 of other ordinary income in the year sells the property for $700,000, of which $550,000 is allocable to the building and $150,000 is allocable to the land. Disregarding the mid-month convention (assuming a full 10 years of depreciation) and assuming no Page 152 of 154

Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop other 1231 or capital gains or losses for the year and no 1231 losses in prior years, what are the amount, character, and rates of tax on Owners gain on the sale? Land Basis 1012 = $100,000 1/1/94 Building Basis 1012 = $390,000 1/1/94. Land AR 1001(b) = $150,000 AB 1011(a) = $100,000 Gain 1001(a) = $50,000 Building AR 1001(b) = $550,000 AB 1011(a) = $290,000 (Fully depreciated after 10 yrs. reduced under 1016) Gain 1001(a) = $260,000 1250(a)(1)(A) property disposed after December 31, 1975 applies. However, 1250(b)(1) recapture only applies to additional depreciation which is the amount of Accelerated depreciation taken above the amount of SL depreciation that would have been taken on the property. In this question the asset was purchased after 86 and 168(b)(3)(A) makes SL depreciation mandatory over 39yrs. 1231(a)(1) says that if gains exceed losses such gains will be treated as long-term capital gains. Classification under 1(h). Lathrop in Class: Bldg. 390 100 290 Land 100 Cost Basis Depreciation (39 yr. recovery period have taken 10 yrs.) 100 Adjusted Basis

AR 550 290 = 1231 Gain of 260 AR 150 100 = 1231 Gain of 50 O depreciation over accelerated no recapture. 310 1231 Gain. Must figure if LTCG and it is 1231(a)(1) Throws us into 25% bracket under 1(h)(7) Basically tax 100 of gain at 25% and leaves us with 210 gain. 1(h)(4) taxed at 20%. 3. On January 1, 1986 Owner purchased a new residential building for use in business for $150,000 of which $100,000 was properly allocated to the building and $50,000 to the land. Owner properly used the 175% declining balance method over an 19-year recovery period on the building. Assume this resulted in total depreciation deductions of $93,000 and an adjusted basis of $7,000 for the building on December 31, 2002. Assume there would have been $90,000 of depreciation on the building if Owner had used the straight-line depreciation method. ON January 1, 2003 Owner sells the building for Page 153 of 154

Income Tax I Fall 2002/2005 Used Spring 2007 Prof Lathrop $275,000, of which $150,000 was all0cable to the building and $125,000 to the land. Assume Owner is single and also has $100,000 of ordinary income in 2003. Assuming no other 1231 or capital gains or losses for the year, what are the amount, character, and rates of tax on Owners gain on the sale? Bldg. 100 93 7B Land 50 (Depreciation 1016)

AR 150 7 = 143 Gain AR 125 50 = 75 Gain If accelerated 93 and SL 90 = Spread is 3 and will be picked up as ordinary income. 1(h)(7)(i) unrecaptured not otherwise treated as ordinary. Back out 3 ordinary from 143 which is 140 1231 gain. 215 LTCG 1231 how much taxed at special rate. $90 at 25% and rest at 20%.

Final what will be and wont be: Chapter 2 Gross Chapter 2 7 But dont do annuities. Sale of residence only. 121 Assignment of income NO. Business deductions. Interest and taxes but not interest free loans. 163 & 164 Moving expenses. Depreciation to extent talked about. Characterization 1231 & 1245 & 1250 (1250 will not be on exam.)

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