Instrucctor Solution Manual for Pearson's Federal Taxation 2024 Individuals, 37th Edition by Frankli

Instructor’s Resource Manual Joshua G. Coyne

Pearson’s Federal Taxation 2024 Individuals Mitchell Franklin Luke E. Richardson

TABLE OF CONTENTS

Preface

P-1

Sample Syllabi

I:S-1

Instructor Outlines (Ordered by Chapter No.)

I:IO-1

Tax Form/Return Preparation Problems

ii Copyright © 2024 Pearson Education, Inc.

I:TRP-1

PREFACE General The text materials from Pearson’s Federal Taxation 2024: Individuals (Franklin/Richardson) are principally designed for use in a first course in federal taxation for undergraduate or graduate accounting and business students.

With the inclusion of chapters on partnerships, S corporations, C corporations, and tax considerations for investors, the text also can be used in a survey federal taxation course for undergraduate or graduate students.

The text also could be used in an introductory federal taxation course in law school to the extent the instructor prefers a more direct approach than the case method.

The text includes a full complement of supplementary and ancillary materials. We recommend that all adopters refer to the Preface to the text for the supplementary and ancillary materials provided to adopters. Many of these items are available to faculty and students at no cost. Adopters are encouraged to use these materials to enhance their teaching effectiveness and their students’ learning experience.

Sample Syllabi This guide contains sample syllabi for a one-semester and a one-quarter introductory tax course. It contains suggested reading and problem assignments that can be turned into a complete assignment sheet with only minimal work.

Instructor Outlines The instructor outline for each chapter consists of: learning objectives, areas of greater and lesser significance, problem areas for students, highlights of recent tax law changes, teaching tips, lecture outline, a set of references to court cases that are designed to be interesting and informative to the student, and instructor aids. A summary description of each area is presented below.

Learning Objectives The materials for each chapter include the learning objectives for that chapter. This focus will be useful to the instructor and may be communicated to students to assist their study.

P-1 Copyright © 2024 Pearson Education, Inc.

Areas of Greater Significance The materials for each chapter point out the areas of greater significance. This feature permits the instructor to allocate a greater share of class time and homework assignments to these areas.

Areas of Lesser Significance The materials for each chapter point out the areas of lesser significance. This feature permits the instructor to reduce the amount of class time and homework assignments devoted to these areas.

Problem Areas for Students The materials for each chapter detail areas in which students are likely to experience difficulty in learning and in retaining. Instructors may allocate more class time to these topics, while letting the student learn other topics directly from the text and problems.

Highlights of Recent Tax Law Changes Recent tax law changes are highlighted, including amendments to the Internal Revenue Code, administrative pronouncements, and judicial decisions. These changes are cross-referenced to the text materials.

Teaching Tips Each lecture outline contains a series of teaching tips designed to improve an instructor’s coverage or presentation of the materials in the chapter. Some of the teaching tips concern issues that might be added to the lecture outline at a particular point. Others focus upon the method of presentation of a topical item. All of these teaching tips have been provided by the authors or instructors who are currently using the book.

Lecture Outline The lecture outlines for each chapter are organizational tools centered on the topics that could be covered in lecture discussions. Textual examples, tables, figures, and problems are referenced to the applicable topic. Faculty members can use the outlines provided to develop their own lecture outlines.

The Instructor’s Resource Manual, including lecture outlines, is available on the Instructor’s Resource Center (IRC) online at: http://www.pearsonhighered.com/pearsontax

P-2 Copyright © 2024 Pearson Education, Inc.

Registration/login is required on the IRC online. For assistance, you may contact your Pearson representative. If you do not know your Pearson representative, you may visit: www.pearsonhighered.com/replocator The lecture outlines are designed so the instructor can share them with students to assist in taking notes and subsequent study.

Court Case Briefs Each chapter contains references to and a brief annotation of a series of selected court cases. These cases are recommended as a way for faculty members to incorporate interesting illustrations into their lectures.

Instructor Aid An additional instructor figure is provided for nearly every chapter.

Solutions to Tax Form/Return Preparation Problems The authors have prepared solutions to the Tax Form/Return Preparation Problems, provided as a separate zip file download on the IRC online, under both the Instructor’s Manual and Solutions Manual, for convenience of faculty.

Final Remarks We hope these materials are helpful when teaching with the Pearson’s Federal Taxation 2024: Individuals text. We would appreciate receiving any suggestions that you have for improving these or any other supplemental materials. To report any error corrections or suggestions, or if you would like to obtain an immediate solution to your question or problem, please do not hesitate to contact the editor at: Editor Mitchell Franklin

E-mail franklma@lemoyne.edu

P-3 Copyright © 2024 Pearson Education, Inc.

Instructor’s Resource Manual Joshua G. Coyne

Pearson’s Federal Taxation 2024 Individuals Mitchell Franklin Luke E. Richardson

TABLE OF CONTENTS

Preface

P-1

Sample Syllabi

I:S-1

Instructor Outlines (Ordered by Chapter No.)

I:IO-1

Tax Form/Return Preparation Problems

ii Copyright © 2024 Pearson Education, Inc.

I:TRP-1

PREFACE General The text materials from Pearson’s Federal Taxation 2024: Individuals (Franklin/Richardson) are principally designed for use in a first course in federal taxation for undergraduate or graduate accounting and business students.

With the inclusion of chapters on partnerships, S corporations, C corporations, and tax considerations for investors, the text also can be used in a survey federal taxation course for undergraduate or graduate students.

The text also could be used in an introductory federal taxation course in law school to the extent the instructor prefers a more direct approach than the case method.

The text includes a full complement of supplementary and ancillary materials. We recommend that all adopters refer to the Preface to the text for the supplementary and ancillary materials provided to adopters. Many of these items are available to faculty and students at no cost. Adopters are encouraged to use these materials to enhance their teaching effectiveness and their students’ learning experience.

Sample Syllabi This guide contains sample syllabi for a one-semester and a one-quarter introductory tax course. It contains suggested reading and problem assignments that can be turned into a complete assignment sheet with only minimal work.

Instructor Outlines The instructor outline for each chapter consists of: learning objectives, areas of greater and lesser significance, problem areas for students, highlights of recent tax law changes, teaching tips, lecture outline, a set of references to court cases that are designed to be interesting and informative to the student, and instructor aids. A summary description of each area is presented below.

Learning Objectives The materials for each chapter include the learning objectives for that chapter. This focus will be useful to the instructor and may be communicated to students to assist their study.

P-1 Copyright © 2024 Pearson Education, Inc.

Areas of Greater Significance The materials for each chapter point out the areas of greater significance. This feature permits the instructor to allocate a greater share of class time and homework assignments to these areas.

Areas of Lesser Significance The materials for each chapter point out the areas of lesser significance. This feature permits the instructor to reduce the amount of class time and homework assignments devoted to these areas.

Problem Areas for Students The materials for each chapter detail areas in which students are likely to experience difficulty in learning and in retaining. Instructors may allocate more class time to these topics, while letting the student learn other topics directly from the text and problems.

Highlights of Recent Tax Law Changes Recent tax law changes are highlighted, including amendments to the Internal Revenue Code, administrative pronouncements, and judicial decisions. These changes are cross-referenced to the text materials.

Teaching Tips Each lecture outline contains a series of teaching tips designed to improve an instructor’s coverage or presentation of the materials in the chapter. Some of the teaching tips concern issues that might be added to the lecture outline at a particular point. Others focus upon the method of presentation of a topical item. All of these teaching tips have been provided by the authors or instructors who are currently using the book.

Lecture Outline The lecture outlines for each chapter are organizational tools centered on the topics that could be covered in lecture discussions. Textual examples, tables, figures, and problems are referenced to the applicable topic. Faculty members can use the outlines provided to develop their own lecture outlines.

The Instructor’s Resource Manual, including lecture outlines, is available on the Instructor’s Resource Center (IRC) online at: http://www.pearsonhighered.com/pearsontax

P-2 Copyright © 2024 Pearson Education, Inc.

Registration/login is required on the IRC online. For assistance, you may contact your Pearson representative. If you do not know your Pearson representative, you may visit: www.pearsonhighered.com/replocator The lecture outlines are designed so the instructor can share them with students to assist in taking notes and subsequent study.

Court Case Briefs Each chapter contains references to and a brief annotation of a series of selected court cases. These cases are recommended as a way for faculty members to incorporate interesting illustrations into their lectures.

Instructor Aid An additional instructor figure is provided for nearly every chapter.

Solutions to Tax Form/Return Preparation Problems The authors have prepared solutions to the Tax Form/Return Preparation Problems, provided as a separate zip file download on the IRC online, under both the Instructor’s Manual and Solutions Manual, for convenience of faculty.

Final Remarks We hope these materials are helpful when teaching with the Pearson’s Federal Taxation 2024: Individuals text. We would appreciate receiving any suggestions that you have for improving these or any other supplemental materials. To report any error corrections or suggestions, or if you would like to obtain an immediate solution to your question or problem, please do not hesitate to contact the editor at: Editor Mitchell Franklin

E-mail franklma@lemoyne.edu

P-3 Copyright © 2024 Pearson Education, Inc.

SUGGESTED SYLLABUS STANDARD FIRST COURSE IN TAXATION - SEMESTER BASIS Instructor: Office: Office Phone: Office Hours:

Class Time: Class Location: Class Section:

COURSE ORGANIZATION AND OBJECTIVES Prerequisites: Text: Pearson’s Federal Taxation 2024: Individuals Franklin/Richardson Student Obligations: Expertise in the tax area is best gained through problem solving. Therefore, numerous problems will be assigned. Problems will be discussed in class on a time available basis. Student discussion of assigned problems will be the basis for earning class participation points. NO LATE ASSIGNMENTS ACCEPTED. Students will be required to prepare a written solution to an income tax return problem.

Examinations will be primarily problem-oriented and may include objective and/or subjective questions. NO MAKE-UP EXAMINATIONS WILL BE GIVEN. Composition of Final Grade: Examination I Final Examination Class Participation Problems Income Tax Return Problem TOTAL POSSIBLE POINTS

150 points 150 points 35 points 35 points 30 points 400 points

Objectives: Introduction of students to basic federal tax law as it applies to individuals.

Introduction of students to basic tax planning analysis.

I:S-1 Copyright © 2024 Pearson Education, Inc.

Date Week 1

Session (50 mins.)

1 2 3

Introduction to Course History, Types, Criteria, Entities Law Sources, Enactment, Administration, Practice

None I:1(pp. I:1-24) I:1(pp. I:24-32)

Questions and Problems None I:1-4,I:1-11 I:1-48,I:1-50,I:1-51

Formula, Deductions from AGI Standard Deduction, Dependency Requirements, Child and Dependent Credits Determining Tax, Business Income, Capital Gains, Planning, Compliance

I:2(pp. I:1-12) I:2(pp. I:12-20)

I:2-1,I:2-6,I:2-29 I:2-15,I:2-39

I:2(pp. I:20-37)

I:2-18,I:2-44,I:2-47

I:3(pp. I:1-12)

I:3-11,I:3-12,I:3-14

8 9

Concepts of Income, To Whom and When is Income Taxable?

Items of Gross Income Other Items of Gross Income, Planning, Compliance

I:3(pp. I:13-23) I:3(pp. I:23-36)

I:3-24,I:3-37,I:3-44,I:3-46 I:3-25,I:3-51

Week 4

10 11 12

Non-income Items, Exclusions Exclusions (cont.)

Planning, Compliance

I:4(pp. I:1-10) I:4(pp. I:10-23) I:4(pp. I:23-25)

I:4-6,I:4-8,I:4-38,I:4-40 I:4-21,I:4-43,I:4-55 I:4-18,I:4-42

Week 5

13 14 15

Determination of Gain or Loss, Basis Capital Assets, Treatment of Capital Gains/Losses Sale or Exchange, Holding Period, Planning, Compliance

I:5(pp. I:1-13) I:5(pp. I:13-22) I:5(pp. I:22-40)

I:5-2,I:5-7,I:5-34 I:5-17,I:5-48,I:5-53,I:5-61 I:5-21,I:5-44

Week 6

16 17 18

Classifying Deductions, Criteria General Restrictions, Substantiation, Timing Disallowance Rules, Planning, Compliance

I:6(pp. I:1-9) I:6(pp. I:9-23) I:6(pp. I:23-37)

I:6-8,I:6-33 I:6-36,I:6-38 I:6-20,I:6-28,I:6-46,I:6-54

Week 7

19 20 21

Self- Employed Expenses Deferred Compensation, Planning, Compliance EXAMINATION

I:7(pp. I:1-20) I:7(pp. I:20-39)

I:7-3,I:7-6,I:7-18,I:7-41,I:7-50 I:7-33,I:7-63

Week 8

22 23 24

Medical Expenses, Taxes Interest, Charitable Contributions Casualty and Theft, Planning, Compliance

I:8(pp. I:1-12) I:8(pp. I:12-28) I:8(pp. I:28-37)

I:8-2,I:8-12,I:8-13,I:8-34 I:8-19,I:8-24,I:8-26,I:8-44 I:8-47,I:8-48

Week 2

4 5 6

Week 3

7

Topic

Chapter

I:S-2 Copyright © 2024 Pearson Education, Inc.

Week 9

25 26 27

Loss Transactions, Classifying Losses Passive Losses Casualty and Theft Losses, Bad Debt, NOLs, Excess Business Losses, Planning, Compliance

I:9(pp. I:1-7) I:9(pp. I:7-17) I:9(pp. I:17-35)

I:9-9,I:9-44 I:9-6,I:9-39 I:9-23,I:9-50,I:9-52

Week 10

28 29 30

Depreciation and Cost Recovery Amortization, Depletion Planning, Compliance

I:10(pp. I:1-17) I:10(pp. I:18-24) I:10(pp. I:24-26)

I:10-27,I:10-33 I:10-41,I:10-45,I:10-46 I:10-47

Week 11

31 32 33

Accounting Periods, Overall Accounting Methods Inventories, Special Accounting Methods Installment Sales, Imputed Interest, Change in Methods, Planning, Compliance

I:11(pp. I:1-10) I:11(pp. I:11-17) I:11(pp. I:17-30)

I:11-37,I:11-39,I:11-40 I:11-41,I:11-43,I:11-44 I:11-45,I:11-50,I:11-55

Week 12

34 35 36

Like-Kind Exchanges Involuntary Conversions Sale of Principal Residence, Planning, Compliance

I:12(pp. I:1-9) I:12(pp. I:9-14) I:12(pp. I:15-23)

I:12-25,I:12-28,I:12-30 I:12-35,I:12-36,I:12-37 I:12-41,I:12-43,I:12-44

Week 13

37 38 39

Section 1231 General Recapture Provisions Other Recapture Provisions, Planning, Compliance

I:13(pp. I:1-8) I:13(pp. I:8-17) I:13(pp. I:18-28)

I:13-33,I:13-36,I:13-38 I:13-42,I:13-53,I:13-54 I:13-62,I:13-63,I:13-66

Week 14

40 41 42

Alternative Minimum Tax Self-Employment Tax, Personal Credits Business Credits, Refundable Credits, Health Insurance, Payment of Taxes, Planning, Compliance

I:14(pp. I:1-7) I:14(pp. I:8-18) I:14(pp. I:19-33)

I:14-40,I:14-43 I:14-46,I:14-61,I:14-65 I:14-47,I:14-48,I:14-49

FINAL EXAM

I:S-3 Copyright © 2024 Pearson Education, Inc.

Alternative Suggested Syllabus - Semester Basis Date Week 1

Session (50 mins.)

1 2 3

Topic

Chapter

Introduction to Course History, Types, Criteria, Entities Law Sources, Enactment, Administration, Practice

None I:1(pp. I:1-24) I:1(pp. I:24-32)

Questions and Problems None I:1-4,I:1-11 I:1-48,I:1-50,I:1-51

Week 2

4 5 6

Formula, Deductions from AGI Dependency Requirements Determining Tax, Business Income, Capital Gains, Planning, Compliance

I:2(pp. I:1-12) I:2(pp. I:12-19) I:2(pp. I:19-36)

I:2-1,I:2-6,I:2-29 I:2-15,I:2-39 I:2-18,I:2-44,I:2-47

Week 3

7

I:3(pp. I:1-12)

I:3-11,I:3-12,I:3-14

8 9

Concepts of Income, To Whom and When is Income Taxable?

Items of Gross Income Other Items of Gross Income, Planning, Compliance

I:3(pp. I:13-23) I:3(pp. I:23-35)

I:3-24,I:3-37,I:3-44,I:3-46 I:3-25,I:3-51

Week 4

10 11 12

Non-income Items, Exclusions Exclusions (cont.)

Planning, Compliance

I:4(pp. I:1-10) I:4(pp. I:10-23) I:4(pp. I:23-25)

I:4-6,I:4-8,I:4-38,I:4-40 I:4-21,I:4-43,I:4-55 I:4-18,I:4-42

Week 5

13 14 15

Determination of Gain or Loss, Basis Capital Assets, Treatment of Capital Gains/Losses Sale or Exchange, Holding Period, Planning, Compliance

I:5(pp. I:1-13) I:5(pp. I:13-22) I:5(pp. I:22-40)

I:5-2,I:5-7,I:5-34 I:5-17,I:5-48,I:5-53,I:5-61 I:5-21,I:5-44

Week 6

16 17 18

Classifying Deductions, Criteria General Restrictions, Substantiation, Timing Disallowance Rules, Planning, Compliance

I:6(pp. I:1-9) I:6(pp. I:9-23) I:6(pp. I:23-37)

I:6-8,I:6-33 I:6-36,I:6-38 I:6-20,I:6-28,I:6-46,I:6-54

Week 7

19 20 21

Self- Employed Expenses Deferred Compensation, Planning, Compliance EXAMINATION

I:7(pp. I:1-20) I:7(pp. I:20-39)

I:7-3,I:7-6,I:7-18,I:7-41,I:7-50 I:7-33,I:7-63

Week 8

22 23 24

Medical Expenses, Taxes Interest, Charitable Contributions Casualty and Theft, Planning, Compliance

I:8(pp. I:1-12) I:8(pp. I:12-28) I:8(pp. I:28-37)

I:8-2,I:8-12,I:8-13,I:8-34 I:8-19,I:8-24,I:8-26,I:8-44 I:8-47,I:8-48

I:S-4 Copyright © 2024 Pearson Education, Inc.

Week 9

25 26 27

Loss Transactions, Classifying Losses Passive Losses Casualty and Theft Losses, Bad Debt, NOLs, Excess Business Losses, Planning, Compliance

I:9(pp. I:1-7) I:9(pp. I:7-17) I:9(pp. I:17-35)

I:9-9,I:9-44 I:9-6,I:9-39 I:9-23,I:9-50,I:9-52

Week 10

28 29 30

Depreciation and Cost Recovery Amortization, Depletion, Planning, Compliance Like-Kind Exchanges

I:10(pp. I:1-17) I:10(pp. I:18-26) I:12(pp. I:1-9)

I:10-27,I:10-33 I:10-41,I:10-45,I:10-46 I:12-25,I:12-28,I:12-30

Week 11

31 32 33

Involuntary Conversions Sale of Principal Residence, Planning, Compliance Section 1231

I:12(pp. I:9-14) I:12(pp. I:15-23) I:13(pp. I:1-8)

I:12-35,I:12-36,I:12-37 I:12-41,I:12-43,I:12-44 I:13-33,I:13-36,I:13-38

Week 12

34 35 36

General Recapture Provisions Other Recapture Provisions, Planning, Compliance Alternative Minimum Tax, Self-Employment Tax

I:13(pp. I:8-17) I:13(pp. I:18-28) I:14(pp. I:1-10)

I:13-42,I:13-53,I:13-54 I:13-62,I:13-63,I:13-66 I:14-40,I:14-43

Week 13

37 38 39

Tax Credits, Payment of Taxes, Planning, Compliance Corporations, Computations of Tax, Transfers E&P, Distributions, Planning, Compliance

I:14(pp. I:10-33) I:16(pp. I:1-21) I:16(pp. I:21-34)

I:14-46,I:14-61,I:14-65 I:16-39,I:16-41,I:16-44 I:16-51,I:16-56

Week 14

40 41 42

Types of Pass-through Entities, Partnerships S Corporations Planning, Compliance

I:17(pp. I:1-21) I:17(pp. I:21-33) I:17(pp. I:33-36)

I:17-40,I:17-44,I:17-52 I:17-56,I:17-58 I:17-42,I:17-60

FINAL EXAM

I:S-5 Copyright © 2024 Pearson Education, Inc.

SUGGESTED SYLLABUS STANDARD FIRST COURSE IN TAXATION - QUARTER BASIS Instructor: Office: Office Phone: Office Hours:

Class Time: Class Location: Class Section:

COURSE ORGANIZATION AND OBJECTIVES Prerequisites: Text: Pearson’s Federal Taxation 2024: Individuals Franklin/Richardson Student Obligations: Expertise in the tax area is best gained through problem solving. Therefore, numerous problems will be assigned. Problems will be discussed in class on a time available basis. Student discussion of assigned problems will be the basis for earning class participation points. NO LATE ASSIGNMENTS ACCEPTED. Students will be required to prepare a written solution to an income tax return problem.

Examinations will be primarily problem-oriented and may include objective and/or subjective questions. NO MAKE-UP EXAMINATIONS WILL BE GIVEN. Composition of Final Grade: Examination I Final Examination Class Participation Problems Income Tax Return Problem TOTAL POSSIBLE POINTS

150 points 150 points 35 points 35 points 30 points 400 points

Objectives: Introduction of students to basic federal tax law as it applies to individuals.

Introduction of students to basic tax planning analysis.

I:S-6 Copyright © 2024 Pearson Education, Inc.

Date Week 1

Session (50 mins.)

1 2 3 4

Introduction to Course History, Types, Criteria, Entities Law Sources, Enactment, Administration, Practice Formula, Deductions from AGI

None I:1(pp. I:1-24) I:1(pp. I:24-32) I:2(pp. I:1-12)

Questions and Problems None I:1-4,I:1-11 I:1-48,I:1-50,I:1-51 I:2-1,I:2-6,I:2-29

I:2(pp. I:12-19) I:2(pp. I:19-36)

I:2-15,I:2-39 I:2-18,I:2-44,I:2-47

I:3(pp. I:1-12)

I:3-11,I:3-12,I:3-14

8

Dependency Requirements Determining Tax, Business Income, Capital Gains, Planning, Compliance Concepts of Income, To Whom and When is Income Taxable?

Items of Gross Income

I:3(pp. I:13-23)

I:3-24,I:3-37,I:3-44,I:3-46

Week 3

9 10 11 12

Other Items of Gross Income, Planning, Compliance Non-income Items, Exclusions Exclusions (cont.)

Planning, Compliance

I:3(pp. I:23-35) I:4(pp. I:1-10) I:4(pp. I:10-23) I:4(pp. I:23-25)

I:3-25,I:3-51 I:4-6,I:4-8,I:4-38,I:4-40 I:4-21,I:4-43,I:4-55 I:4-18,I:4-42

Week 4

13 14 15 16

Determination of Gain or Loss, Basis Capital Assets, Treatment of Capital Gains/Losses Sale or Exchange, Holding Period, Planning, Compliance Classifying Deductions, Criteria

I:5(pp. I:1-13) I:5(pp. I:13-22) I:5(pp. I:22-40) I:6(pp. I:1-9)

I:5-2,I:5-7,I:5-34 I:5-17,I:5-48,I:5-53,I:5-61 I:5-21,I:5-44 I:6-8,I:6-33

Week 5

17 18 19 20

General Restrictions, Substantiation, Timing Disallowance Rules, Planning, Compliance Self- Employed Expenses Deferred Compensation, Planning, Compliance

I:6(pp. I:9-23) I:6(pp. I:23-37) I:7(pp. I:1-20) I:7(pp. I:20-39)

I:6-36,I:6-38 I:6-20,I:6-28,I:6-46,I:6-54 I:7-3,I:7-6,I:7-18,I:7-41,I:7-50 I:7-33,I:7-63

Week 6

21 22 23 24

EXAMINATION Medical Expenses, Taxes Interest, Charitable Contributions Casualty and Theft, Planning, Compliance

I:8(pp. I:1-12) I:8(pp. I:12-28) I:8(pp. I:28-37)

I:8-2,I:8-12,I:8-13,I:8-34 I:8-19,I:8-24,I:8-26,I:8-44 I:8-47,I:8-48

25 26

Loss Transactions, Classifying Losses Passive Losses

I:9(pp. I:1-7) I:9(pp. I:7-17)

I:9-9,I:9-44 I:9-6,I:9-39

Week 2

5 6 7

Week 7

Topic

Chapter

I:S-7 Copyright © 2024 Pearson Education, Inc.

27

I:9(pp. I:17-35)

I:9-23,I:9-50,I:9-52

28

Casualty and Theft Losses, Bad Debt, NOLs, Excess Business Losses, Planning, Compliance Depreciation and Cost Recovery

I:10(pp. I:1-17)

I:10-27,I:10-33

Week 8

29 30 31 32

Amortization, Depletion Planning, Compliance Accounting Periods, Overall Accounting Methods Inventories, Special Accounting Methods

I:10(pp. I:18-24) I:10(pp. I:24-26) I:11(pp. I:1-10) I:11(pp. I:11-17)

I:10-41,I:10-45,I:10-46 I:10-47 I:11-37,I:11-39,I:11-40 I:11-41,I:11-43,I:11-44

Week 9

33

I:11(pp. I:17-30)

I:11-45,I:11-50,I:11-55

34 35 36

Installment Sales, Imputed Interest, Change in Methods, Planning, Compliance Like-Kind Exchanges Involuntary Conversions Sale of Principal Residence, Planning, Compliance

I:12(pp. I:1-9) I:12(pp. I:9-14) I:12(pp. I:15-23)

I:12-25,I:12-28,I:12-30 I:12-35,I:12-36,I:12-37 I:12-41,I:12-43,I:12-44

37 38 39 40

Section 1231 Recapture Provisions, Planning, Compliance Alternative Minimum Tax, Self-Employment Tax Tax Credits, Payment of Taxes, Planning, Compliance

I:13(pp. I:1-8) I:13(pp. I:8-28) I:14(pp. I:1-10) I:14(pp. I:10-33)

I:13-33,I:13-36,I:13-38 I:13-42,I:13-53,I:13-54,I:13-63 I:14-40,I:14-43 I:14-46, I:14-61,I:14-65

Week 10

FINAL EXAM

I:S-8 Copyright © 2024 Pearson Education, Inc.

SUGGESTED SYLLABUS STANDARD FIRST COURSE IN TAXATION - SEMESTER BASIS Instructor: Office: Office Phone: Office Hours:

Class Time: Class Location: Class Section:

COURSE ORGANIZATION AND OBJECTIVES Prerequisites: Text: Pearson’s Federal Taxation 2024: Individuals Franklin/Richardson Student Obligations: Expertise in the tax area is best gained through problem solving. Therefore, numerous problems will be assigned. Problems will be discussed in class on a time available basis. Student discussion of assigned problems will be the basis for earning class participation points. NO LATE ASSIGNMENTS ACCEPTED. Students will be required to prepare a written solution to an income tax return problem.

Examinations will be primarily problem-oriented and may include objective and/or subjective questions. NO MAKE-UP EXAMINATIONS WILL BE GIVEN. Composition of Final Grade: Examination I Final Examination Class Participation Problems Income Tax Return Problem TOTAL POSSIBLE POINTS

150 points 150 points 35 points 35 points 30 points 400 points

Objectives: Introduction of students to basic federal tax law as it applies to individuals.

Introduction of students to basic tax planning analysis.

I:S-1 Copyright © 2024 Pearson Education, Inc.

Date Week 1

Session (50 mins.)

1 2 3

Introduction to Course History, Types, Criteria, Entities Law Sources, Enactment, Administration, Practice

None I:1(pp. I:1-24) I:1(pp. I:24-32)

Questions and Problems None I:1-4,I:1-11 I:1-48,I:1-50,I:1-51

Formula, Deductions from AGI Standard Deduction, Dependency Requirements, Child and Dependent Credits Determining Tax, Business Income, Capital Gains, Planning, Compliance

I:2(pp. I:1-12) I:2(pp. I:12-20)

I:2-1,I:2-6,I:2-29 I:2-15,I:2-39

I:2(pp. I:20-37)

I:2-18,I:2-44,I:2-47

I:3(pp. I:1-12)

I:3-11,I:3-12,I:3-14

8 9

Concepts of Income, To Whom and When is Income Taxable?

Items of Gross Income Other Items of Gross Income, Planning, Compliance

I:3(pp. I:13-23) I:3(pp. I:23-36)

I:3-24,I:3-37,I:3-44,I:3-46 I:3-25,I:3-51

Week 4

10 11 12

Non-income Items, Exclusions Exclusions (cont.)

Planning, Compliance

I:4(pp. I:1-10) I:4(pp. I:10-23) I:4(pp. I:23-25)

I:4-6,I:4-8,I:4-38,I:4-40 I:4-21,I:4-43,I:4-55 I:4-18,I:4-42

Week 5

13 14 15

Determination of Gain or Loss, Basis Capital Assets, Treatment of Capital Gains/Losses Sale or Exchange, Holding Period, Planning, Compliance

I:5(pp. I:1-13) I:5(pp. I:13-22) I:5(pp. I:22-40)

I:5-2,I:5-7,I:5-34 I:5-17,I:5-48,I:5-53,I:5-61 I:5-21,I:5-44

Week 6

16 17 18

Classifying Deductions, Criteria General Restrictions, Substantiation, Timing Disallowance Rules, Planning, Compliance

I:6(pp. I:1-9) I:6(pp. I:9-23) I:6(pp. I:23-37)

I:6-8,I:6-33 I:6-36,I:6-38 I:6-20,I:6-28,I:6-46,I:6-54

Week 7

19 20 21

Self- Employed Expenses Deferred Compensation, Planning, Compliance EXAMINATION

I:7(pp. I:1-20) I:7(pp. I:20-39)

I:7-3,I:7-6,I:7-18,I:7-41,I:7-50 I:7-33,I:7-63

Week 8

22 23 24

Medical Expenses, Taxes Interest, Charitable Contributions Casualty and Theft, Planning, Compliance

I:8(pp. I:1-12) I:8(pp. I:12-28) I:8(pp. I:28-37)

I:8-2,I:8-12,I:8-13,I:8-34 I:8-19,I:8-24,I:8-26,I:8-44 I:8-47,I:8-48

Week 2

4 5 6

Week 3

7

Topic

Chapter

I:S-2 Copyright © 2024 Pearson Education, Inc.

Week 9

25 26 27

Loss Transactions, Classifying Losses Passive Losses Casualty and Theft Losses, Bad Debt, NOLs, Excess Business Losses, Planning, Compliance

I:9(pp. I:1-7) I:9(pp. I:7-17) I:9(pp. I:17-35)

I:9-9,I:9-44 I:9-6,I:9-39 I:9-23,I:9-50,I:9-52

Week 10

28 29 30

Depreciation and Cost Recovery Amortization, Depletion Planning, Compliance

I:10(pp. I:1-17) I:10(pp. I:18-24) I:10(pp. I:24-26)

I:10-27,I:10-33 I:10-41,I:10-45,I:10-46 I:10-47

Week 11

31 32 33

Accounting Periods, Overall Accounting Methods Inventories, Special Accounting Methods Installment Sales, Imputed Interest, Change in Methods, Planning, Compliance

I:11(pp. I:1-10) I:11(pp. I:11-17) I:11(pp. I:17-30)

I:11-37,I:11-39,I:11-40 I:11-41,I:11-43,I:11-44 I:11-45,I:11-50,I:11-55

Week 12

34 35 36

Like-Kind Exchanges Involuntary Conversions Sale of Principal Residence, Planning, Compliance

I:12(pp. I:1-9) I:12(pp. I:9-14) I:12(pp. I:15-23)

I:12-25,I:12-28,I:12-30 I:12-35,I:12-36,I:12-37 I:12-41,I:12-43,I:12-44

Week 13

37 38 39

Section 1231 General Recapture Provisions Other Recapture Provisions, Planning, Compliance

I:13(pp. I:1-8) I:13(pp. I:8-17) I:13(pp. I:18-28)

I:13-33,I:13-36,I:13-38 I:13-42,I:13-53,I:13-54 I:13-62,I:13-63,I:13-66

Week 14

40 41 42

Alternative Minimum Tax Self-Employment Tax, Personal Credits Business Credits, Refundable Credits, Health Insurance, Payment of Taxes, Planning, Compliance

I:14(pp. I:1-7) I:14(pp. I:8-18) I:14(pp. I:19-33)

I:14-40,I:14-43 I:14-46,I:14-61,I:14-65 I:14-47,I:14-48,I:14-49

FINAL EXAM

I:S-3 Copyright © 2024 Pearson Education, Inc.

Alternative Suggested Syllabus - Semester Basis Date Week 1

Session (50 mins.)

1 2 3

Topic

Chapter

Introduction to Course History, Types, Criteria, Entities Law Sources, Enactment, Administration, Practice

None I:1(pp. I:1-24) I:1(pp. I:24-32)

Questions and Problems None I:1-4,I:1-11 I:1-48,I:1-50,I:1-51

Week 2

4 5 6

Formula, Deductions from AGI Dependency Requirements Determining Tax, Business Income, Capital Gains, Planning, Compliance

I:2(pp. I:1-12) I:2(pp. I:12-19) I:2(pp. I:19-36)

I:2-1,I:2-6,I:2-29 I:2-15,I:2-39 I:2-18,I:2-44,I:2-47

Week 3

7

I:3(pp. I:1-12)

I:3-11,I:3-12,I:3-14

8 9

Concepts of Income, To Whom and When is Income Taxable?

Items of Gross Income Other Items of Gross Income, Planning, Compliance

I:3(pp. I:13-23) I:3(pp. I:23-35)

I:3-24,I:3-37,I:3-44,I:3-46 I:3-25,I:3-51

Week 4

10 11 12

Non-income Items, Exclusions Exclusions (cont.)

Planning, Compliance

I:4(pp. I:1-10) I:4(pp. I:10-23) I:4(pp. I:23-25)

I:4-6,I:4-8,I:4-38,I:4-40 I:4-21,I:4-43,I:4-55 I:4-18,I:4-42

Week 5

13 14 15

Determination of Gain or Loss, Basis Capital Assets, Treatment of Capital Gains/Losses Sale or Exchange, Holding Period, Planning, Compliance

I:5(pp. I:1-13) I:5(pp. I:13-22) I:5(pp. I:22-40)

I:5-2,I:5-7,I:5-34 I:5-17,I:5-48,I:5-53,I:5-61 I:5-21,I:5-44

Week 6

16 17 18

Classifying Deductions, Criteria General Restrictions, Substantiation, Timing Disallowance Rules, Planning, Compliance

I:6(pp. I:1-9) I:6(pp. I:9-23) I:6(pp. I:23-37)

I:6-8,I:6-33 I:6-36,I:6-38 I:6-20,I:6-28,I:6-46,I:6-54

Week 7

19 20 21

Self- Employed Expenses Deferred Compensation, Planning, Compliance EXAMINATION

I:7(pp. I:1-20) I:7(pp. I:20-39)

I:7-3,I:7-6,I:7-18,I:7-41,I:7-50 I:7-33,I:7-63

Week 8

22 23 24

Medical Expenses, Taxes Interest, Charitable Contributions Casualty and Theft, Planning, Compliance

I:8(pp. I:1-12) I:8(pp. I:12-28) I:8(pp. I:28-37)

I:8-2,I:8-12,I:8-13,I:8-34 I:8-19,I:8-24,I:8-26,I:8-44 I:8-47,I:8-48

I:S-4 Copyright © 2024 Pearson Education, Inc.

Week 9

25 26 27

Loss Transactions, Classifying Losses Passive Losses Casualty and Theft Losses, Bad Debt, NOLs, Excess Business Losses, Planning, Compliance

I:9(pp. I:1-7) I:9(pp. I:7-17) I:9(pp. I:17-35)

I:9-9,I:9-44 I:9-6,I:9-39 I:9-23,I:9-50,I:9-52

Week 10

28 29 30

Depreciation and Cost Recovery Amortization, Depletion, Planning, Compliance Like-Kind Exchanges

I:10(pp. I:1-17) I:10(pp. I:18-26) I:12(pp. I:1-9)

I:10-27,I:10-33 I:10-41,I:10-45,I:10-46 I:12-25,I:12-28,I:12-30

Week 11

31 32 33

Involuntary Conversions Sale of Principal Residence, Planning, Compliance Section 1231

I:12(pp. I:9-14) I:12(pp. I:15-23) I:13(pp. I:1-8)

I:12-35,I:12-36,I:12-37 I:12-41,I:12-43,I:12-44 I:13-33,I:13-36,I:13-38

Week 12

34 35 36

General Recapture Provisions Other Recapture Provisions, Planning, Compliance Alternative Minimum Tax, Self-Employment Tax

I:13(pp. I:8-17) I:13(pp. I:18-28) I:14(pp. I:1-10)

I:13-42,I:13-53,I:13-54 I:13-62,I:13-63,I:13-66 I:14-40,I:14-43

Week 13

37 38 39

Tax Credits, Payment of Taxes, Planning, Compliance Corporations, Computations of Tax, Transfers E&P, Distributions, Planning, Compliance

I:14(pp. I:10-33) I:16(pp. I:1-21) I:16(pp. I:21-34)

I:14-46,I:14-61,I:14-65 I:16-39,I:16-41,I:16-44 I:16-51,I:16-56

Week 14

40 41 42

Types of Pass-through Entities, Partnerships S Corporations Planning, Compliance

I:17(pp. I:1-21) I:17(pp. I:21-33) I:17(pp. I:33-36)

I:17-40,I:17-44,I:17-52 I:17-56,I:17-58 I:17-42,I:17-60

FINAL EXAM

I:S-5 Copyright © 2024 Pearson Education, Inc.

SUGGESTED SYLLABUS STANDARD FIRST COURSE IN TAXATION - QUARTER BASIS Instructor: Office: Office Phone: Office Hours:

Class Time: Class Location: Class Section:

COURSE ORGANIZATION AND OBJECTIVES Prerequisites: Text: Pearson’s Federal Taxation 2024: Individuals Franklin/Richardson Student Obligations: Expertise in the tax area is best gained through problem solving. Therefore, numerous problems will be assigned. Problems will be discussed in class on a time available basis. Student discussion of assigned problems will be the basis for earning class participation points. NO LATE ASSIGNMENTS ACCEPTED. Students will be required to prepare a written solution to an income tax return problem.

Examinations will be primarily problem-oriented and may include objective and/or subjective questions. NO MAKE-UP EXAMINATIONS WILL BE GIVEN. Composition of Final Grade: Examination I Final Examination Class Participation Problems Income Tax Return Problem TOTAL POSSIBLE POINTS

150 points 150 points 35 points 35 points 30 points 400 points

Objectives: Introduction of students to basic federal tax law as it applies to individuals.

Introduction of students to basic tax planning analysis.

I:S-6 Copyright © 2024 Pearson Education, Inc.

Date Week 1

Session (50 mins.)

1 2 3 4

Introduction to Course History, Types, Criteria, Entities Law Sources, Enactment, Administration, Practice Formula, Deductions from AGI

None I:1(pp. I:1-24) I:1(pp. I:24-32) I:2(pp. I:1-12)

Questions and Problems None I:1-4,I:1-11 I:1-48,I:1-50,I:1-51 I:2-1,I:2-6,I:2-29

I:2(pp. I:12-19) I:2(pp. I:19-36)

I:2-15,I:2-39 I:2-18,I:2-44,I:2-47

I:3(pp. I:1-12)

I:3-11,I:3-12,I:3-14

8

Dependency Requirements Determining Tax, Business Income, Capital Gains, Planning, Compliance Concepts of Income, To Whom and When is Income Taxable?

Items of Gross Income

I:3(pp. I:13-23)

I:3-24,I:3-37,I:3-44,I:3-46

Week 3

9 10 11 12

Other Items of Gross Income, Planning, Compliance Non-income Items, Exclusions Exclusions (cont.)

Planning, Compliance

I:3(pp. I:23-35) I:4(pp. I:1-10) I:4(pp. I:10-23) I:4(pp. I:23-25)

I:3-25,I:3-51 I:4-6,I:4-8,I:4-38,I:4-40 I:4-21,I:4-43,I:4-55 I:4-18,I:4-42

Week 4

13 14 15 16

Determination of Gain or Loss, Basis Capital Assets, Treatment of Capital Gains/Losses Sale or Exchange, Holding Period, Planning, Compliance Classifying Deductions, Criteria

I:5(pp. I:1-13) I:5(pp. I:13-22) I:5(pp. I:22-40) I:6(pp. I:1-9)

I:5-2,I:5-7,I:5-34 I:5-17,I:5-48,I:5-53,I:5-61 I:5-21,I:5-44 I:6-8,I:6-33

Week 5

17 18 19 20

General Restrictions, Substantiation, Timing Disallowance Rules, Planning, Compliance Self- Employed Expenses Deferred Compensation, Planning, Compliance

I:6(pp. I:9-23) I:6(pp. I:23-37) I:7(pp. I:1-20) I:7(pp. I:20-39)

I:6-36,I:6-38 I:6-20,I:6-28,I:6-46,I:6-54 I:7-3,I:7-6,I:7-18,I:7-41,I:7-50 I:7-33,I:7-63

Week 6

21 22 23 24

EXAMINATION Medical Expenses, Taxes Interest, Charitable Contributions Casualty and Theft, Planning, Compliance

I:8(pp. I:1-12) I:8(pp. I:12-28) I:8(pp. I:28-37)

I:8-2,I:8-12,I:8-13,I:8-34 I:8-19,I:8-24,I:8-26,I:8-44 I:8-47,I:8-48

25 26

Loss Transactions, Classifying Losses Passive Losses

I:9(pp. I:1-7) I:9(pp. I:7-17)

I:9-9,I:9-44 I:9-6,I:9-39

Week 2

5 6 7

Week 7

Topic

Chapter

I:S-7 Copyright © 2024 Pearson Education, Inc.

27

I:9(pp. I:17-35)

I:9-23,I:9-50,I:9-52

28

Casualty and Theft Losses, Bad Debt, NOLs, Excess Business Losses, Planning, Compliance Depreciation and Cost Recovery

I:10(pp. I:1-17)

I:10-27,I:10-33

Week 8

29 30 31 32

Amortization, Depletion Planning, Compliance Accounting Periods, Overall Accounting Methods Inventories, Special Accounting Methods

I:10(pp. I:18-24) I:10(pp. I:24-26) I:11(pp. I:1-10) I:11(pp. I:11-17)

I:10-41,I:10-45,I:10-46 I:10-47 I:11-37,I:11-39,I:11-40 I:11-41,I:11-43,I:11-44

Week 9

33

I:11(pp. I:17-30)

I:11-45,I:11-50,I:11-55

34 35 36

Installment Sales, Imputed Interest, Change in Methods, Planning, Compliance Like-Kind Exchanges Involuntary Conversions Sale of Principal Residence, Planning, Compliance

I:12(pp. I:1-9) I:12(pp. I:9-14) I:12(pp. I:15-23)

I:12-25,I:12-28,I:12-30 I:12-35,I:12-36,I:12-37 I:12-41,I:12-43,I:12-44

37 38 39 40

Section 1231 Recapture Provisions, Planning, Compliance Alternative Minimum Tax, Self-Employment Tax Tax Credits, Payment of Taxes, Planning, Compliance

I:13(pp. I:1-8) I:13(pp. I:8-28) I:14(pp. I:1-10) I:14(pp. I:10-33)

I:13-33,I:13-36,I:13-38 I:13-42,I:13-53,I:13-54,I:13-63 I:14-40,I:14-43 I:14-46, I:14-61,I:14-65

Week 10

FINAL EXAM

I:S-8 Copyright © 2024 Pearson Education, Inc.

Chapter I:1 An Introduction to Taxation Learning Objectives After studying this chapter, the student should be able to: 1. Discuss the history of taxation in the United States.

2. Describe the three types of tax rate structures.

3. Describe the various types of taxes.

4. Discuss the criteria for a “good” tax structure, the objectives of the federal income tax law, and recent tax reform proposals.

5. Describe the tax entities in the federal income tax system.

6. Identify the various tax law sources and understand their implications for tax practice.

7. Describe the legislative process for the enactment of the tax law.

8. Describe the administrative procedures under the tax law.

9. Describe the components of a tax practice.

10. Understand the importance of computer applications in taxation.

Areas of Greater Significance 1. For an introductory course in taxation, two of the topics in this chapter should be emphasized. The first topic to be emphasized is the sources of tax law (both primary and secondary). The student should understand that in spite of the black and white rule approach in much of the following material, a tax practitioner may spend a considerable amount of time dealing with issues that are not clear cut.

2. Second, the administration of the tax law should be emphasized. An understanding of how the Internal Revenue Service operates is valuable to each student, even if the only future application is with regard to the student’s own individual tax return.

I:IO1-1 Copyright © 2024 Pearson Education, Inc.

Areas of Lesser Significance In the interest of time, the instructor may determine that the following areas are best covered by student reading, rather than class discussion: 1. History of Taxation in the United States 2. Other Types of Taxes 3. Criteria for a Tax Structure 4. Objectives of the Federal Income Tax Law

Problem Areas for Students The following areas may prove especially difficult for students: 1. The relative weight to be given to various governmental interpretations of the tax law (i.e., Treasury Regulations vs. Tax Court cases).

2. The mechanics and thought process in doing tax research. An instructor who will use tax research as a significant pedagogical tool may want to spend considerable time on the topic at this point. It is very difficult for a student to understand tax research without doing tax research. (See Chapter I:15.)

Highlights of Recent Tax Law Changes The following items of tax law have changed since the 2023 edition of this chapter: 1. The income levels for tax rates for ordinary income, long-term capital gains, dividend income, and the kiddie tax have increased. (See Quick Reference.)

2. The ceiling amount for paying the full amount of payroll taxes has increased to $160,200 ($147,000 in 2022).

3. The annual exclusion for gifts has increased to $17,000 ($16,000 in 2022).

4. The unified transfer tax equivalent has increased to $12,920,000 ($12,060,000 in 2022).

5. The standard deduction has increased to $13,850 ($12,950 in 2022) and $27,700 for married filing jointly ($25,900 in 2022).

6. The beginning of the 37% tax bracket for taxable income from trusts has increased to $14,450 ($13,450 in 2022).

I:IO1-2 Copyright © 2024 Pearson Education, Inc.

Teaching Tips 1. If you want to teach tax research in the introductory class, it would be best to assign a comprehensive tax research problem to solidify concepts taught in class.

2. When teaching tax law sources, it is important to clarify to the students the relative priority of the many different sources.

Lecture Outline I.

Types of Tax Rate Structures 1. The Structure of Individual Income Tax Rates (Example I:1-1, I:1-2) a. Possible tax rate structures are progressive, proportional (flat tax), or regressive. The current federal tax system is progressive (10%-37%).

2. Corporate Tax Rates a. The tax rate for regular corporations (C corporations) is flat (21%).

3. Marginal, Average, and Effective Tax Rates for Taxpayers (Example I:1-4, I:1-5) a. Marginal tax rates may vary significantly from the nominal schedule rates.

For example, even though the nominal maximum individual rate is 37%, the realized marginal rate is higher because of health care taxes. b. Because the federal income tax for individuals is progressive, average tax is always below marginal tax. c. Effective tax rates are likely the lowest of the three calculations because economic income exceeds taxable income.

4. Determination of Taxable Income and Tax Due a. Taxable income for all types of taxpayers is calculated by subtracting allowable exclusions and deductions from total income. The tax or refund due is calculated by subtracting allowable credits and/or prepayments from the gross tax liability resulting from applying applicable tax rates to taxable income.

II.

Entities in the Federal Income Tax System 1. Taxpaying entities are individuals (Example I:1-13) and C corporations (Example I:1-14). If trusts and estates do not fully distribute their taxable income, they may pay tax.

I:IO1-3 Copyright © 2024 Pearson Education, Inc.

2. Flow-through entities are sole proprietorships, partnerships (Example I:1-18), S corporations, limited liability companies and limited liability partnerships, and trusts and estates (to the extent that the trust’s or estate’s income is distributed) (Example I:1-23).

III.

Tax Law Sources (Topic Review I:1-3; Instructor Aid I:1-1) 1. Legislative tax law sources include the Internal Revenue Code and Congressional Committee Reports.

2. Executive (Administrative) tax law sources include proposed, temporary, and final Treasury regulations and IRS revenue rulings, revenue procedures, private letter rulings, technical advice memoranda, and information releases.

3. Judicial tax law sources include various levels of court decisions.

IV.

Enactment of a Tax Law (Table I:1-2) 1. The procedures for enactment of tax legislation are the same as those for any other federal legislation, with the exception that all revenue measures are constitutionally required to be introduced in the House of Representatives. These procedures include deliberations by the House Ways and Means Committee, the Senate Finance Committee, and the Joint Conference Committee. The committee reports produced during these deliberations are valuable sources of legislative intent used in governmental and taxpayer interpretation of the enacted legislation.

2. The political process affects tax legislation as it proceeds through the House of Representatives and the Senate toward the President’s signature. The economic, social, and revenue priorities of the legislators (and their constituencies) affect the final product. Also, efforts to reduce the budget deficit in recent years have had an impact on annual tax legislation.

V.

Administration of the Tax Law and Tax Practice Issues (Instructor Aid I:1-2) 1. Organization of the Internal Revenue Service a. Important personnel in the IRS (in descending authority) are the Commissioner of the Internal Revenue, deputy and assistant commissioners, regional commissioners, and district directors. b. Unresolved disputes between taxpayers and the IRS may result in litigation.

Tax litigation in Tax Court is handled by the office of the Chief Counsel.

Tax litigation in a U.S. District Court and the U.S. Claims Court is handled by attorneys in the Department of Justice.

I:IO1-4 Copyright © 2024 Pearson Education, Inc.

2. Selection of Returns for Audit (Example I:1-25; Question I:1-29) a. With the use of computer analysis and professional judgment, taxpayer returns are selected for additional correspondence, office audit, or field audit. Mathematical errors and certain matching problems (e.g., the amount of interest on a Form 1099 received by the IRS does not match the amount of interest reported by the taxpayer) can generally be resolved by correspondence. b. In an office audit, the taxpayer is asked to bring documentation to the IRS office to substantiate income, deduction, and/or credit items on the taxpayer’s return. More complex audits are handled by a field audit where the IRS agent goes to the taxpayer’s place of business or to the office of the taxpayer’s tax professional. c. Disputes between IRS agents and taxpayers may be resolved with the IRS Appeals Division. While the overall individual audit rate is less than 1%, individuals with relatively large amounts of income and deductions are significantly more likely to be audited. If a return contains a frequently disputed item (e.g., home office deduction), the likelihood of audit also increases.

3. Statute of Limitations (Problem I:1-48) a. The normal statute of limitations (i.e., how long the IRS has to examine the return) is three years from the due date of the return (or when the return is actually filed if late). The statute of limitations is extended to six years if more than 25% of gross income is omitted on the return. There is no statute of limitations if the taxpayer committed fraud or failed to file a return. b. The applicable statute of limitations may be extended by mutual agreement between the taxpayer and the government. Reticent taxpayers are encouraged to extend the statute of limitations when the alternative is an immediate unfavorable notice of deficiency. These varying lengths of statutes of limitation also cause a record-keeping problem for taxpayers.

How can a taxpayer disprove an IRS claim of fraud without keeping tax records indefinitely?

4. Interest and Penalties (Example I:1-27) a. Interest and penalties may apply to taxes due and other taxpayer noncompliance. The deductibility of interest paid will be determined under the normal interest deductions rules. Penalties for failure to file, failure to pay, negligence, fraud, etc., are not tax deductible.

I:IO1-5 Copyright © 2024 Pearson Education, Inc.

VI.

Components of a Tax Practice 1. Tax Compliance and Procedures a. The preparation of tax returns remains a major component of most tax practices. Some major firms have a separate department to deal with tax compliance.

2. Tax Research a. The tax research process involves determination of the facts, identification of the problem, determination of the best solution and communication to the client. (See Chapter I:15 for an in-depth discussion of tax research.)

3. Tax Planning and Consulting a. Much of the tax professional’s value to a client may be in the planning and consulting areas. Minimizing taxes paid and maximizing after-tax cash flows, while accommodating clients’ desires, is a much sought-after commodity in today’s complex tax environment.

4. Financial Planning a. Some tax professionals have added financial planning to their list of services offered. Items analyzed include insurance coverage, investment strategies, and retirement planning.

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Court Case Briefs Alfred Ficalora v. CIR, 55 AFTR 2d 85-473, 85-1 USTC & 9103 (2nd Cir., 1984).

In 1980, an employee of the New York telephone company challenged the constitutional authority of Congress and the Tax Court to impose a direct tax on his wages without apportionment to the States. He cited Article I, Section 9, clause 4 of the U.S. Constitution which prohibits a direct tax without apportionment. The taxpayer further relied on the case of Pollock v. Farmer’s Loan and Trust Co., 3 AFTR 2602, 15 S. Ct. 912 (USSC, 1895) which states that a tax on the income from real and personal property was invalid without apportionment.

The Supreme Court in Pollock, however, had stated explicitly that a tax on one’s employment was not a direct tax and did not require apportionment. Further, the Sixteenth Amendment to the U.S. Constitution gave Congress the authority to tax income without apportionment. The court found that the taxpayer had ignored the developments in Constitutional law over the last ninety years and upheld the deficiency and penalties assessed against him.

Walter G. Pietsch v. CIR, 26 AFTR 2d 70-5847, 70-2 USTC & 9718 (2nd Cir., 1970).

Mr. Pietsch filed his 1968 income tax return, but denied liability for the portion of the tax that was associated with funding the military operation of the United States in the Vietnam conflict. The taxpayer sought a declaration from the court that American participation in Vietnam was unconstitutional and asked the court to enjoin the federal officials from collecting the tax.

The suit was dismissed for failure to state a claim (the taxpayer had not yet paid the tax). The court stated further that Mr. Pietsch was most unlikely to prevail in a refund suit (commenced after the tax was paid) because he did not attack the validity of the tax itself, but rather the use of it.

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Instructor Aid I:1-1 Tax Law Interpretations

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Instructor Aid I:1-2 Tax Litigation from the Taxpayer Perspective

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Chapter I:1 An Introduction to Taxation Learning Objectives After studying this chapter, the student should be able to: 1. Discuss the history of taxation in the United States.

2. Describe the three types of tax rate structures.

3. Describe the various types of taxes.

4. Discuss the criteria for a “good” tax structure, the objectives of the federal income tax law, and recent tax reform proposals.

5. Describe the tax entities in the federal income tax system.

6. Identify the various tax law sources and understand their implications for tax practice.

7. Describe the legislative process for the enactment of the tax law.

8. Describe the administrative procedures under the tax law.

9. Describe the components of a tax practice.

10. Understand the importance of computer applications in taxation.

Areas of Greater Significance 1. For an introductory course in taxation, two of the topics in this chapter should be emphasized. The first topic to be emphasized is the sources of tax law (both primary and secondary). The student should understand that in spite of the black and white rule approach in much of the following material, a tax practitioner may spend a considerable amount of time dealing with issues that are not clear cut.

2. Second, the administration of the tax law should be emphasized. An understanding of how the Internal Revenue Service operates is valuable to each student, even if the only future application is with regard to the student’s own individual tax return.

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Areas of Lesser Significance In the interest of time, the instructor may determine that the following areas are best covered by student reading, rather than class discussion: 1. History of Taxation in the United States 2. Other Types of Taxes 3. Criteria for a Tax Structure 4. Objectives of the Federal Income Tax Law

Problem Areas for Students The following areas may prove especially difficult for students: 1. The relative weight to be given to various governmental interpretations of the tax law (i.e., Treasury Regulations vs. Tax Court cases).

2. The mechanics and thought process in doing tax research. An instructor who will use tax research as a significant pedagogical tool may want to spend considerable time on the topic at this point. It is very difficult for a student to understand tax research without doing tax research. (See Chapter I:15.)

Highlights of Recent Tax Law Changes The following items of tax law have changed since the 2023 edition of this chapter: 1. The income levels for tax rates for ordinary income, long-term capital gains, dividend income, and the kiddie tax have increased. (See Quick Reference.)

2. The ceiling amount for paying the full amount of payroll taxes has increased to $160,200 ($147,000 in 2022).

3. The annual exclusion for gifts has increased to $17,000 ($16,000 in 2022).

4. The unified transfer tax equivalent has increased to $12,920,000 ($12,060,000 in 2022).

5. The standard deduction has increased to $13,850 ($12,950 in 2022) and $27,700 for married filing jointly ($25,900 in 2022).

6. The beginning of the 37% tax bracket for taxable income from trusts has increased to $14,450 ($13,450 in 2022).

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Teaching Tips 1. If you want to teach tax research in the introductory class, it would be best to assign a comprehensive tax research problem to solidify concepts taught in class.

2. When teaching tax law sources, it is important to clarify to the students the relative priority of the many different sources.

Lecture Outline I.

Types of Tax Rate Structures 1. The Structure of Individual Income Tax Rates (Example I:1-1, I:1-2) a. Possible tax rate structures are progressive, proportional (flat tax), or regressive. The current federal tax system is progressive (10%-37%).

2. Corporate Tax Rates a. The tax rate for regular corporations (C corporations) is flat (21%).

3. Marginal, Average, and Effective Tax Rates for Taxpayers (Example I:1-4, I:1-5) a. Marginal tax rates may vary significantly from the nominal schedule rates.

For example, even though the nominal maximum individual rate is 37%, the realized marginal rate is higher because of health care taxes. b. Because the federal income tax for individuals is progressive, average tax is always below marginal tax. c. Effective tax rates are likely the lowest of the three calculations because economic income exceeds taxable income.

4. Determination of Taxable Income and Tax Due a. Taxable income for all types of taxpayers is calculated by subtracting allowable exclusions and deductions from total income. The tax or refund due is calculated by subtracting allowable credits and/or prepayments from the gross tax liability resulting from applying applicable tax rates to taxable income.

II.

Entities in the Federal Income Tax System 1. Taxpaying entities are individuals (Example I:1-13) and C corporations (Example I:1-14). If trusts and estates do not fully distribute their taxable income, they may pay tax.

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2. Flow-through entities are sole proprietorships, partnerships (Example I:1-18), S corporations, limited liability companies and limited liability partnerships, and trusts and estates (to the extent that the trust’s or estate’s income is distributed) (Example I:1-23).

III.

Tax Law Sources (Topic Review I:1-3; Instructor Aid I:1-1) 1. Legislative tax law sources include the Internal Revenue Code and Congressional Committee Reports.

2. Executive (Administrative) tax law sources include proposed, temporary, and final Treasury regulations and IRS revenue rulings, revenue procedures, private letter rulings, technical advice memoranda, and information releases.

3. Judicial tax law sources include various levels of court decisions.

IV.

Enactment of a Tax Law (Table I:1-2) 1. The procedures for enactment of tax legislation are the same as those for any other federal legislation, with the exception that all revenue measures are constitutionally required to be introduced in the House of Representatives. These procedures include deliberations by the House Ways and Means Committee, the Senate Finance Committee, and the Joint Conference Committee. The committee reports produced during these deliberations are valuable sources of legislative intent used in governmental and taxpayer interpretation of the enacted legislation.

2. The political process affects tax legislation as it proceeds through the House of Representatives and the Senate toward the President’s signature. The economic, social, and revenue priorities of the legislators (and their constituencies) affect the final product. Also, efforts to reduce the budget deficit in recent years have had an impact on annual tax legislation.

V.

Administration of the Tax Law and Tax Practice Issues (Instructor Aid I:1-2) 1. Organization of the Internal Revenue Service a. Important personnel in the IRS (in descending authority) are the Commissioner of the Internal Revenue, deputy and assistant commissioners, regional commissioners, and district directors. b. Unresolved disputes between taxpayers and the IRS may result in litigation.

Tax litigation in Tax Court is handled by the office of the Chief Counsel.

Tax litigation in a U.S. District Court and the U.S. Claims Court is handled by attorneys in the Department of Justice.

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2. Selection of Returns for Audit (Example I:1-25; Question I:1-29) a. With the use of computer analysis and professional judgment, taxpayer returns are selected for additional correspondence, office audit, or field audit. Mathematical errors and certain matching problems (e.g., the amount of interest on a Form 1099 received by the IRS does not match the amount of interest reported by the taxpayer) can generally be resolved by correspondence. b. In an office audit, the taxpayer is asked to bring documentation to the IRS office to substantiate income, deduction, and/or credit items on the taxpayer’s return. More complex audits are handled by a field audit where the IRS agent goes to the taxpayer’s place of business or to the office of the taxpayer’s tax professional. c. Disputes between IRS agents and taxpayers may be resolved with the IRS Appeals Division. While the overall individual audit rate is less than 1%, individuals with relatively large amounts of income and deductions are significantly more likely to be audited. If a return contains a frequently disputed item (e.g., home office deduction), the likelihood of audit also increases.

3. Statute of Limitations (Problem I:1-48) a. The normal statute of limitations (i.e., how long the IRS has to examine the return) is three years from the due date of the return (or when the return is actually filed if late). The statute of limitations is extended to six years if more than 25% of gross income is omitted on the return. There is no statute of limitations if the taxpayer committed fraud or failed to file a return. b. The applicable statute of limitations may be extended by mutual agreement between the taxpayer and the government. Reticent taxpayers are encouraged to extend the statute of limitations when the alternative is an immediate unfavorable notice of deficiency. These varying lengths of statutes of limitation also cause a record-keeping problem for taxpayers.

How can a taxpayer disprove an IRS claim of fraud without keeping tax records indefinitely?

4. Interest and Penalties (Example I:1-27) a. Interest and penalties may apply to taxes due and other taxpayer noncompliance. The deductibility of interest paid will be determined under the normal interest deductions rules. Penalties for failure to file, failure to pay, negligence, fraud, etc., are not tax deductible.

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VI.

Components of a Tax Practice 1. Tax Compliance and Procedures a. The preparation of tax returns remains a major component of most tax practices. Some major firms have a separate department to deal with tax compliance.

2. Tax Research a. The tax research process involves determination of the facts, identification of the problem, determination of the best solution and communication to the client. (See Chapter I:15 for an in-depth discussion of tax research.)

3. Tax Planning and Consulting a. Much of the tax professional’s value to a client may be in the planning and consulting areas. Minimizing taxes paid and maximizing after-tax cash flows, while accommodating clients’ desires, is a much sought-after commodity in today’s complex tax environment.

4. Financial Planning a. Some tax professionals have added financial planning to their list of services offered. Items analyzed include insurance coverage, investment strategies, and retirement planning.

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Court Case Briefs Alfred Ficalora v. CIR, 55 AFTR 2d 85-473, 85-1 USTC & 9103 (2nd Cir., 1984).

In 1980, an employee of the New York telephone company challenged the constitutional authority of Congress and the Tax Court to impose a direct tax on his wages without apportionment to the States. He cited Article I, Section 9, clause 4 of the U.S. Constitution which prohibits a direct tax without apportionment. The taxpayer further relied on the case of Pollock v. Farmer’s Loan and Trust Co., 3 AFTR 2602, 15 S. Ct. 912 (USSC, 1895) which states that a tax on the income from real and personal property was invalid without apportionment.

The Supreme Court in Pollock, however, had stated explicitly that a tax on one’s employment was not a direct tax and did not require apportionment. Further, the Sixteenth Amendment to the U.S. Constitution gave Congress the authority to tax income without apportionment. The court found that the taxpayer had ignored the developments in Constitutional law over the last ninety years and upheld the deficiency and penalties assessed against him.

Walter G. Pietsch v. CIR, 26 AFTR 2d 70-5847, 70-2 USTC & 9718 (2nd Cir., 1970).

Mr. Pietsch filed his 1968 income tax return, but denied liability for the portion of the tax that was associated with funding the military operation of the United States in the Vietnam conflict. The taxpayer sought a declaration from the court that American participation in Vietnam was unconstitutional and asked the court to enjoin the federal officials from collecting the tax.

The suit was dismissed for failure to state a claim (the taxpayer had not yet paid the tax). The court stated further that Mr. Pietsch was most unlikely to prevail in a refund suit (commenced after the tax was paid) because he did not attack the validity of the tax itself, but rather the use of it.

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Instructor Aid I:1-1 Tax Law Interpretations

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Instructor Aid I:1-2 Tax Litigation from the Taxpayer Perspective

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Chapter I:2 Determination of Tax Learning Objectives After studying this chapter, the student should be able to: 1. Use the tax formula to compute an individual’s taxable income.

2. Determine the amount of deductions from adjusted gross income.

3. Calculate the income tax for individuals.

4. Explain the basic income tax rules relating to business entities.

5. Explain the basic income tax rules of capital gains and losses.

6. Describe tax planning considerations for various tax matters.

7. Describe compliance and procedural matters for filing tax returns.

Areas of Greater Significance It is absolutely vital that students understand the individual formula for calculating the tax or refund due (including standard deduction and filing status). This formula is necessary throughout the balance of the text to work out the problems. Any deficiencies in understanding at this point would be carried over to subsequent materials.

Areas of Lesser Significance In the interest of time, the instructor may determine that the following area is best covered by student reading, rather than class discussion: 1. Business Income and Business Entities

Problem Areas for Students The following areas may prove especially difficult for students: 1. Whether a taxpayer qualifies for head of household filing status.

2. The relationship between the standard deduction and itemized deductions.

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3. Whether the qualification (or non-qualification) of a person as a dependent affects the head of household filing status (i.e., the rules for head of household and qualifying dependents overlap but are not totally consistent).

Highlights of Recent Tax Law Changes The following items of tax law have changed since the 2023 edition of this chapter: 1. The standard deduction for each filing status has increased. (See page I:2-10.)

2. The increase in standard deduction for elderly or blind when filing as single or head of household has increased to $1,850 ($1,750 in 2022) and when married filing jointly to $1,500 ($1,400 in 2022).

3. The limit for the gross income test for a qualifying relative has increased to $4,700 ($4,400 in 2022).

4. The income levels for tax rates for ordinary income, long-term capital gains, dividend income, and the kiddie tax have increased. (See Quick Reference.)

5. The deduction amounts for the kiddie tax have increased to $1,250 ($1,150 in 2022) for the statutory deduction and the greater of $1,250 ($1,150 in 2022) and earned income plus $400 ($400 in 2022).

6. The floor for filing a tax return for each filing status has increased. (See page I:235.)

Teaching Tips 1. Due to the annual changes in many of the rules covered in this chapter (e.g., standard deduction), you may wish to inform the students that examinations and/or quizzes will be held on an open-book basis or that you will provide any required statutory amounts for testing purposes. Using this approach allows the students to concentrate on the concepts rather than memorizing numbers.

2. This introductory chapter is a good place to begin emphasizing the difference between deductions for AGI and deductions from AGI. This distinction will increase in importance in subsequent chapters.

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Lecture Outline I.

Formula for Individual Income Tax (Figures I:2-1, 1:2-2) 1. Basic Formula (Table I:2-1; Example I:2-1; Question I:2-1; Problem I:2-29) a. The basic formula for calculating individual income tax is: i.

Gross income – Exclusions - Deductions for AGI = Adjusted gross income

ii.

Adjusted gross income - Deductions from AGI = Taxable income

iii.

Taxable income × Tax rate(s) = Gross tax

iv.

Gross tax - (Credits + Prepayments) = Net tax

2. Definitions (Tables I:2-2 through I:2-5) a. Brief definitions of income, exclusions, gross income, deductions for adjusted gross income, adjusted gross income, deductions from adjusted gross income, itemized deductions, standard deduction, taxable income, tax rates, gross tax, and tax credits are presented with references to detailed coverage later in the text.

II.

Deductions from Adjusted Gross Income 1. Itemized Deductions (Table I:2-6; Example I:2-2) a. The total of qualifying medical expenses, taxes, investment and residential interest, and charitable contributions are claimed only if the total of such items exceeds the standard deduction. b. Deductions for medical expenses and charitable contributions are limited by varying percentages of adjusted gross income. Deductions for taxes and residential interest are also capped (generally $10,000 for taxes and interest on $750,000 of indebtedness).

2. Standard Deduction (Examples I:2-3, I:2-4) a. The full amount of the standard deduction (which varies with filing status, age, and vision) may be claimed when it exceeds the taxpayer’s itemized deductions. i.

EXAMPLE: A single taxpayer in 2023 has $10,000 of allowable itemized deductions. Since the applicable standard deduction for this taxpayer ($13,850) is greater than his itemized deductions, the taxpayer deducts $13,850 in determining his taxable income.

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Filing Status Married couple filing jointly Surviving spouse Head of household Single (unmarried individual other than surviving spouse or head of household) Married individual filing separately

Standard Deduction 2022 2023 $25,900 $27,700 25,900 27,700 19,400 20,800 12,950 13,850 12,950

13,850

b. Additions to the standard deduction are available for taxpayers who are 65 or older and/or blind. The 2023 additions are $1,500 for married taxpayers and $1,850 for single taxpayers. i.

EXAMPLE: A single taxpayer in 2023 who is 65 and blind would have a standard deduction of $17,550 [$13,850 + $1,850 (age) + $1,850 (blindness)].

3. Dependency Requirements (Examples I:2-8, I:2-12, I:2-16, I:2-17; Topic Review I:2-1; Problem I:2-32) a. Qualification of dependents can affect a taxpayer’s filing status and access to deductions and credits. Dependents must meet the following requirements: i.

Have a Social Security number reported on return;

ii.

Be a U.S. Citizen, U.S. Resident, or reside in Canada or Mexico; and

iii.

Not have filed a joint return (unless filed for the sole purpose of obtaining a refund).

b. Additional requirements for “qualifying children” i.

Be a natural, adopted, foster child, or stepchild of the taxpayer, a sibling of the taxpayer, or descendants of any of the previous;

ii.

Be under 19, a full-time student under age 24, or a permanently and totally disabled child;

iii.

Have the same principal abode as taxpayer, and

iv.

Dependent may not provide more than one half of his or her own support.

c. Additional requirements for “qualifying relatives”

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i.

Be related to the taxpayer or reside in the taxpayer’s household for the entire year;

ii.

Have gross income less than $4,700; and

iii.

The taxpayer must normally provide more than one half of the dependent’s support. (Receipts of the potential dependent are counted as support only if the receipts are spent for support, i.e., if the dependent puts all his social security payments in a savings account, the payments do not count in the support test.)

iv.

Exceptions may exist under multiple support agreements and parental releases.

4. Child Credit (Example I:2-21; Problem I:2-52) a. Individual taxpayers may claim a $2,000 credit for each qualifying child (U.S. citizen/national/resident under 17 who qualifies as the taxpayer’s dependent descendent, stepchild, or foster child) under age 17 plus a $500 credit for each other dependent. b. The total credit for all children is reduced by $50 for each $1,000 (or fraction thereof) of AGI over $200,000 ($400,000 for married filing jointly). c. Under certain circumstances, the credit is refundable.

III.

Determining the Amount of Tax (Examples I:2-26, I:2-27; Topic Review I:2-2; Problem I:2-48; Instructor Aid I:2-1) Gross tax is determined by applying the tax table (see Tables appendix) to the taxpayer’s taxable income.

In 2023, tax brackets of 10%, 12%, 22%, 24%, 32%, 35%, and 37% are applicable to individual taxpayers. The income level covered by the six brackets varies with filing status.

1. Married Filing Jointly a. A joint return may be filed by a man and woman if they are considered married for tax purposes on the last day of the tax year. Common law marriages and same-sex marriages are recognized. Annulled marriages are viewed as having never occurred. b. Taxpayers legally divorced at the end of the year may be treated as married for tax purposes, if the divorce is considered a sham.

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i.

EXAMPLE: Taxpayers obtain a foreign divorce effective 12-302022 and remarry 1-2-2023. The only reason for the procedure was to improve tax filing status. The taxpayers will be treated as married for the tax year ending 12-31-2022.

2. Surviving Spouse (Example I:2-28) a. A widow or widower may file as a surviving spouse in the two years after the year the decedent spouse died if the surviving spouse: i.

Has not remarried;

ii.

Is a U.S. citizen or resident;

iii.

Was qualified to file a joint return in the year of death; and

iv.

Paid over half the costs of maintaining a household in which a dependent child, adopted child, or stepchild lives during the entire tax year.

b. The widow or widower may file jointly in the year of the spouse’s death with the cooperation of the executor of the estate. Both the surviving spouse and the executor must sign any joint return. If either party does not agree to file a joint return, then they must file as married filing separately. c. The widow or widower may qualify as head of household in the years after the expiration of the surviving spouse status, assuming the surviving spouse meets the qualifications outlined below.

3. Head of Household (Example I:2-29) a. An individual may file as head of household if the individual: i.

Is considered single for tax purposes (see abandoned spouse, below);

ii.

Is not a surviving spouse;

iii.

Is a U.S. citizen or resident; and

iv.

Pays over half the costs of maintaining a household in which a qualifying child or dependent relative lives for more than half of the tax year. Dependent parents may reside in a separate household, and children do not have to be tax dependents to qualify.

4. Single Taxpayer a. A taxpayer who does not qualify for any other filing status must file under the single status.

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5. Married Filing Separately a. Married individuals may choose to file separate returns rather than one joint return. Separate returns will seldom provide the best overall tax results due to the higher rates. However, every married couple’s tax should be computed using both the joint return rules and the separate return rules to insure the lowest overall tax.

6. Abandoned Spouse (Examples I:2-32, I:2-33; Question I:2-18) a. A legally married individual may file as head-of-household if the individual: i.

Lived apart from the spouse for the last 6 months of the year;

ii.

Pays over half of the cost of maintaining a household in which the taxpayer and a dependent child lived for over half the year; and

iii.

Is a U.S. citizen or resident.

b. Without the abandoned spouse rule, the only alternative for the taxpayer would be to file married-separately (due to the unavailability of the absent spouse to prepare and sign a joint return). Head-of-household tax rates are significantly better than married-filing separately rates.

7. Children with Unearned Income (Example I:2-37; Problem I:2-57; Instructor Aid I:2-2) a. A dependent’s statutory deduction is $1,250, and a dependent’s standard deduction is the greater of $1,250 or the dependent’s earned income plus $400. b. For a child under 18, unearned income in excess of $2,500 is taxed in a special way. Between the ages of 18 and 23, this “kiddie tax” only applies if the child is a full-time student and the child’s earned income represents less than half of his or her total support.

IV.

Business Income and Business Entities Unlike for individuals, the tax rate schedule for C corporations is not progressive.

Instead, a flat 21% tax rate applies. Flow-through entities, such as S corporations and partnerships, may be eligible for a 20% qualified business income (QBI) deduction, depending on the nature of the business activity, to bring flow-through tax rates in line with the flat C corporation tax rate.

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V.

Treatment of Capital Gains and Losses (Question I:2-21; Instructor Aid I:2-3) 1. Definition of Capital Assets a. Capital assets are assets other than inventory; depreciable property used in a trade or business; real property used in a trade or business; patents; copyrights or literary, musical, or artistic compositions in the hands of the creator or a donee of the creator; letters or memoranda; accounts or notes receivable from the ordinary course of a trade or business; or certain U.S. Government publications. b. The tax definition of capital assets is significantly different from the financial accounting definition of capital assets (i.e., property, plant, & equipment).

2. Tax Treatment of Gains and Losses a. Net long-term capital gains (with a holding period greater than one year) are generally taxed at 0% if taxable income is not over $44,625, 15% if taxable income is between $44,625 and $492,300, and 20% if taxable income is over $492,300. Different thresholds apply to other filing statuses ($89,250 and $553,850 for married filing jointly; $59,750 and $523,050 for head of household). Net short-term capital gains are taxed at ordinary income rates. Net capital losses offset a maximum of $3,000 of other income, with an unlimited carryforward for individuals. b. A net investment income tax of 3.8% applies to certain high-income taxpayers.

VI.

Tax Planning Considerations 1. Shifting Income Between Family Members (Examples I:2-42 through I:2-44) a. Shifting taxable income to family members to lower tax brackets will reduce the overall family tax burden. b. Restrictions apply to transactions that only involve assignment, and not shifting, of income, as well as transactions that trigger the kiddie tax.

2. Splitting Income (Example I:2-45) a. Creating additional taxpayers can reduce the overall tax burden, but administrative costs, especially of additional corporations, reduce the overall savings.

3. Maximizing Itemized Deductions (Examples I:2-46, I:2-47)

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a. Itemized deductions only provide value to the extent that they exceed the standard deduction. Timing expenses and charitable contributions so that they fall in a single tax year can increase the value of the resulting deductions.

4. Filing Joint or Separate Returns (Example I:2-50) a. Both tax and non-tax issues determine whether married couples should file jointly or separately. b. Spouses who file jointly are jointly liable for income tax, including the tax on disallowed deductions or unreported income. The innocent spouse provision protects spouses who were not aware of the magnitude of the understated tax liability, and the separate liability election allows spouses or former spouses to elect to be separately liable for the tax.

VII.

Compliance and Procedural Considerations 1. Who Must File (Example I:2-51) a. Generally, the income limitation for filing is the standard deduction for a particular status. The limitation is zero for married filing separately. (See page I:2-35 for the gross income filing levels.) i.

EXAMPLE: For 2023, a single taxpayer (under 65, not blind, not a dependent on another return) must file a return when gross income exceeds $13,850.

2. Due Dates and Extensions a. Tax returns for calendar-year individual taxpayers (Form 1040) are generally due April 15 (or first business day thereafter if April 15 is not a business day) following the end of the taxable year, with an automatic sixmonth extension if Form 4868 is filed by the due date for the return. b. Schedule 1 reports sources of income that are not reported on Form 1040. c. Schedule 2 reports AMT, various other taxes, and excess advance premium tax credit repayment. (See Chapter I:14.) d. Schedule 3 reports various nonrefundable tax credits and estimated tax payments. e. Partnerships must file Form 1065 and S corporations must file Form 1120S by the fifteenth day of the third month following year end (i.e., March 15 for calendar-year-end taxpayers). C corporations must file Form 1120 and have the same due date as individual taxpayers. Any of these organizations can file Form 7004 to obtain a six-month extension.

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f. An extension to file is not an extension on paying taxes. Interest and penalties apply for underpayment even when filing an extension.

3. Systems for Reporting Income a. Payments made by certain entities are reported to the IRS for computer cross-checking that all income has been reported. b. Items reported include pensions, annuities, wages, dividends, interest, sales of securities, unemployment compensation, rents, royalties, and lump-sum distributions from retirement plans.

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Court Case Briefs Kenneth Royce Boykin v. CIR, 1984 PH T.C. Memo & 84,297, 48 TCM 267.

The taxpayer and his wife were divorced in February of 1979, but he continued to live with his former wife and their children after the divorce in 1979 and 1980. IRC Sec.143 provides that the “determination of whether an individual is married shall be made as of the close of his taxable year.”

IRC Sec.143 further provides that an individual legally separated by divorce or a separate maintenance decree is not considered married. The taxpayer was denied the filing status of married, filing jointly because he was not married at the close of the tax years at issue. Texas (state of residence) recognizes common law marriages that have the elements of mutual agreement, cohabitation, and the holding out of themselves as married to the public. Their cohabitation did not qualify because they had not mutually agreed to be remarried. However, he was permitted “head of household” filing status because he met the requirements of Sec. 2(b). He was not married at the close of the tax year and he maintained a household for over half of the tax year for his dependent children.

Haynes, 119 AFTR 2d 2017-865.

Mr. and Mrs. Haynes hired Mr. Dunbar, a CPA, to prepare and file their 2010 individual tax return.

In 2011, Dunbar filed for an extension to submit the Haynes’s 2010 income tax return, which was granted by IRS. On Oct. 17, 2011, Dunbar attempted to use the Lacerte software program to electronically file the Haynes’s 2010 tax return. The IRS rejected the filing because the return listed Mrs. Haynes’s social security number on the line designated for the employer identification number. Dunbar advised Mr. Haynes that the return had been filed, but eleven months later, the IRS notified the Haynes that it had not received their 2010 return. In December 2012, Dunbar filed the Haynes’s 2010 tax return on paper. IRS assessed a late-filing penalty, which the Haynes paid.

They subsequently filed a refund suit in district court, but the court rejected their claim. The court stated that relying on a CPA’s erroneous word that the return had been filed was not reasonable cause for failing to file a tax return in a timely fashion.

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Instructor Aid I:2-1 Relative Tax by Filing Status*

Lowest

Married Filing Jointly/Surviving Spouse Head of Household Single

Highest

Married Filing Separately**

*Assuming the same amount of taxable income. **In the few cases where the married couple both has income and only one has substantial amounts of itemized deductions, the result may vary.

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Instructor Aid I:2-2 Kiddie Tax

1. Compute the child’s taxable income in the normal fashion for dependents.

2. Compute the child’s net unearned income (investment income, including dividends, taxable interest, capital gains, rents, and royalties): Unearned income Less: Statutory deduction of $1,250 Less: Greater of a. $1,250 of standard deduction, or b. Itemized deductions directly connected with the production of the unearned income Equals: Net unearned income (not less than zero) 3. Compute the child’s tax as net unearned income times parents’ marginal tax rate plus taxable income exceeding net unearned income times child’s tax rate.

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Instructor Aid I:2-3 Capital Assets

Capital assets are defined in a negative manner under the Internal Revenue Code. Capital assets are assets that are not: •

Inventory

•

Depreciable property used in a trade or business

•

Real Property used in a trade or business

•

Patents

•

Copyrights

•

Literary, musical, or artistic compositions

•

Letters or memorandums

•

Accounts or notes receivable from the ordinary course of a trade or business

•

Certain U.S. Government publications

In the hands of the creator or a donee of the creator

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Chapter I:2 Determination of Tax Learning Objectives After studying this chapter, the student should be able to: 1. Use the tax formula to compute an individual’s taxable income.

2. Determine the amount of deductions from adjusted gross income.

3. Calculate the income tax for individuals.

4. Explain the basic income tax rules relating to business entities.

5. Explain the basic income tax rules of capital gains and losses.

6. Describe tax planning considerations for various tax matters.

7. Describe compliance and procedural matters for filing tax returns.

Areas of Greater Significance It is absolutely vital that students understand the individual formula for calculating the tax or refund due (including standard deduction and filing status). This formula is necessary throughout the balance of the text to work out the problems. Any deficiencies in understanding at this point would be carried over to subsequent materials.

Areas of Lesser Significance In the interest of time, the instructor may determine that the following area is best covered by student reading, rather than class discussion: 1. Business Income and Business Entities

Problem Areas for Students The following areas may prove especially difficult for students: 1. Whether a taxpayer qualifies for head of household filing status.

2. The relationship between the standard deduction and itemized deductions.

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3. Whether the qualification (or non-qualification) of a person as a dependent affects the head of household filing status (i.e., the rules for head of household and qualifying dependents overlap but are not totally consistent).

Highlights of Recent Tax Law Changes The following items of tax law have changed since the 2023 edition of this chapter: 1. The standard deduction for each filing status has increased. (See page I:2-10.)

2. The increase in standard deduction for elderly or blind when filing as single or head of household has increased to $1,850 ($1,750 in 2022) and when married filing jointly to $1,500 ($1,400 in 2022).

3. The limit for the gross income test for a qualifying relative has increased to $4,700 ($4,400 in 2022).

4. The income levels for tax rates for ordinary income, long-term capital gains, dividend income, and the kiddie tax have increased. (See Quick Reference.)

5. The deduction amounts for the kiddie tax have increased to $1,250 ($1,150 in 2022) for the statutory deduction and the greater of $1,250 ($1,150 in 2022) and earned income plus $400 ($400 in 2022).

6. The floor for filing a tax return for each filing status has increased. (See page I:235.)

Teaching Tips 1. Due to the annual changes in many of the rules covered in this chapter (e.g., standard deduction), you may wish to inform the students that examinations and/or quizzes will be held on an open-book basis or that you will provide any required statutory amounts for testing purposes. Using this approach allows the students to concentrate on the concepts rather than memorizing numbers.

2. This introductory chapter is a good place to begin emphasizing the difference between deductions for AGI and deductions from AGI. This distinction will increase in importance in subsequent chapters.

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Lecture Outline I.

Formula for Individual Income Tax (Figures I:2-1, 1:2-2) 1. Basic Formula (Table I:2-1; Example I:2-1; Question I:2-1; Problem I:2-29) a. The basic formula for calculating individual income tax is: i.

Gross income – Exclusions - Deductions for AGI = Adjusted gross income

ii.

Adjusted gross income - Deductions from AGI = Taxable income

iii.

Taxable income × Tax rate(s) = Gross tax

iv.

Gross tax - (Credits + Prepayments) = Net tax

2. Definitions (Tables I:2-2 through I:2-5) a. Brief definitions of income, exclusions, gross income, deductions for adjusted gross income, adjusted gross income, deductions from adjusted gross income, itemized deductions, standard deduction, taxable income, tax rates, gross tax, and tax credits are presented with references to detailed coverage later in the text.

II.

Deductions from Adjusted Gross Income 1. Itemized Deductions (Table I:2-6; Example I:2-2) a. The total of qualifying medical expenses, taxes, investment and residential interest, and charitable contributions are claimed only if the total of such items exceeds the standard deduction. b. Deductions for medical expenses and charitable contributions are limited by varying percentages of adjusted gross income. Deductions for taxes and residential interest are also capped (generally $10,000 for taxes and interest on $750,000 of indebtedness).

2. Standard Deduction (Examples I:2-3, I:2-4) a. The full amount of the standard deduction (which varies with filing status, age, and vision) may be claimed when it exceeds the taxpayer’s itemized deductions. i.

EXAMPLE: A single taxpayer in 2023 has $10,000 of allowable itemized deductions. Since the applicable standard deduction for this taxpayer ($13,850) is greater than his itemized deductions, the taxpayer deducts $13,850 in determining his taxable income.

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Filing Status Married couple filing jointly Surviving spouse Head of household Single (unmarried individual other than surviving spouse or head of household) Married individual filing separately

Standard Deduction 2022 2023 $25,900 $27,700 25,900 27,700 19,400 20,800 12,950 13,850 12,950

13,850

b. Additions to the standard deduction are available for taxpayers who are 65 or older and/or blind. The 2023 additions are $1,500 for married taxpayers and $1,850 for single taxpayers. i.

EXAMPLE: A single taxpayer in 2023 who is 65 and blind would have a standard deduction of $17,550 [$13,850 + $1,850 (age) + $1,850 (blindness)].

3. Dependency Requirements (Examples I:2-8, I:2-12, I:2-16, I:2-17; Topic Review I:2-1; Problem I:2-32) a. Qualification of dependents can affect a taxpayer’s filing status and access to deductions and credits. Dependents must meet the following requirements: i.

Have a Social Security number reported on return;

ii.

Be a U.S. Citizen, U.S. Resident, or reside in Canada or Mexico; and

iii.

Not have filed a joint return (unless filed for the sole purpose of obtaining a refund).

b. Additional requirements for “qualifying children” i.

Be a natural, adopted, foster child, or stepchild of the taxpayer, a sibling of the taxpayer, or descendants of any of the previous;

ii.

Be under 19, a full-time student under age 24, or a permanently and totally disabled child;

iii.

Have the same principal abode as taxpayer, and

iv.

Dependent may not provide more than one half of his or her own support.

c. Additional requirements for “qualifying relatives”

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i.

Be related to the taxpayer or reside in the taxpayer’s household for the entire year;

ii.

Have gross income less than $4,700; and

iii.

The taxpayer must normally provide more than one half of the dependent’s support. (Receipts of the potential dependent are counted as support only if the receipts are spent for support, i.e., if the dependent puts all his social security payments in a savings account, the payments do not count in the support test.)

iv.

Exceptions may exist under multiple support agreements and parental releases.

4. Child Credit (Example I:2-21; Problem I:2-52) a. Individual taxpayers may claim a $2,000 credit for each qualifying child (U.S. citizen/national/resident under 17 who qualifies as the taxpayer’s dependent descendent, stepchild, or foster child) under age 17 plus a $500 credit for each other dependent. b. The total credit for all children is reduced by $50 for each $1,000 (or fraction thereof) of AGI over $200,000 ($400,000 for married filing jointly). c. Under certain circumstances, the credit is refundable.

III.

Determining the Amount of Tax (Examples I:2-26, I:2-27; Topic Review I:2-2; Problem I:2-48; Instructor Aid I:2-1) Gross tax is determined by applying the tax table (see Tables appendix) to the taxpayer’s taxable income.

In 2023, tax brackets of 10%, 12%, 22%, 24%, 32%, 35%, and 37% are applicable to individual taxpayers. The income level covered by the six brackets varies with filing status.

1. Married Filing Jointly a. A joint return may be filed by a man and woman if they are considered married for tax purposes on the last day of the tax year. Common law marriages and same-sex marriages are recognized. Annulled marriages are viewed as having never occurred. b. Taxpayers legally divorced at the end of the year may be treated as married for tax purposes, if the divorce is considered a sham.

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i.

EXAMPLE: Taxpayers obtain a foreign divorce effective 12-302022 and remarry 1-2-2023. The only reason for the procedure was to improve tax filing status. The taxpayers will be treated as married for the tax year ending 12-31-2022.

2. Surviving Spouse (Example I:2-28) a. A widow or widower may file as a surviving spouse in the two years after the year the decedent spouse died if the surviving spouse: i.

Has not remarried;

ii.

Is a U.S. citizen or resident;

iii.

Was qualified to file a joint return in the year of death; and

iv.

Paid over half the costs of maintaining a household in which a dependent child, adopted child, or stepchild lives during the entire tax year.

b. The widow or widower may file jointly in the year of the spouse’s death with the cooperation of the executor of the estate. Both the surviving spouse and the executor must sign any joint return. If either party does not agree to file a joint return, then they must file as married filing separately. c. The widow or widower may qualify as head of household in the years after the expiration of the surviving spouse status, assuming the surviving spouse meets the qualifications outlined below.

3. Head of Household (Example I:2-29) a. An individual may file as head of household if the individual: i.

Is considered single for tax purposes (see abandoned spouse, below);

ii.

Is not a surviving spouse;

iii.

Is a U.S. citizen or resident; and

iv.

Pays over half the costs of maintaining a household in which a qualifying child or dependent relative lives for more than half of the tax year. Dependent parents may reside in a separate household, and children do not have to be tax dependents to qualify.

4. Single Taxpayer a. A taxpayer who does not qualify for any other filing status must file under the single status.

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5. Married Filing Separately a. Married individuals may choose to file separate returns rather than one joint return. Separate returns will seldom provide the best overall tax results due to the higher rates. However, every married couple’s tax should be computed using both the joint return rules and the separate return rules to insure the lowest overall tax.

6. Abandoned Spouse (Examples I:2-32, I:2-33; Question I:2-18) a. A legally married individual may file as head-of-household if the individual: i.

Lived apart from the spouse for the last 6 months of the year;

ii.

Pays over half of the cost of maintaining a household in which the taxpayer and a dependent child lived for over half the year; and

iii.

Is a U.S. citizen or resident.

b. Without the abandoned spouse rule, the only alternative for the taxpayer would be to file married-separately (due to the unavailability of the absent spouse to prepare and sign a joint return). Head-of-household tax rates are significantly better than married-filing separately rates.

7. Children with Unearned Income (Example I:2-37; Problem I:2-57; Instructor Aid I:2-2) a. A dependent’s statutory deduction is $1,250, and a dependent’s standard deduction is the greater of $1,250 or the dependent’s earned income plus $400. b. For a child under 18, unearned income in excess of $2,500 is taxed in a special way. Between the ages of 18 and 23, this “kiddie tax” only applies if the child is a full-time student and the child’s earned income represents less than half of his or her total support.

IV.

Business Income and Business Entities Unlike for individuals, the tax rate schedule for C corporations is not progressive.

Instead, a flat 21% tax rate applies. Flow-through entities, such as S corporations and partnerships, may be eligible for a 20% qualified business income (QBI) deduction, depending on the nature of the business activity, to bring flow-through tax rates in line with the flat C corporation tax rate.

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V.

Treatment of Capital Gains and Losses (Question I:2-21; Instructor Aid I:2-3) 1. Definition of Capital Assets a. Capital assets are assets other than inventory; depreciable property used in a trade or business; real property used in a trade or business; patents; copyrights or literary, musical, or artistic compositions in the hands of the creator or a donee of the creator; letters or memoranda; accounts or notes receivable from the ordinary course of a trade or business; or certain U.S. Government publications. b. The tax definition of capital assets is significantly different from the financial accounting definition of capital assets (i.e., property, plant, & equipment).

2. Tax Treatment of Gains and Losses a. Net long-term capital gains (with a holding period greater than one year) are generally taxed at 0% if taxable income is not over $44,625, 15% if taxable income is between $44,625 and $492,300, and 20% if taxable income is over $492,300. Different thresholds apply to other filing statuses ($89,250 and $553,850 for married filing jointly; $59,750 and $523,050 for head of household). Net short-term capital gains are taxed at ordinary income rates. Net capital losses offset a maximum of $3,000 of other income, with an unlimited carryforward for individuals. b. A net investment income tax of 3.8% applies to certain high-income taxpayers.

VI.

Tax Planning Considerations 1. Shifting Income Between Family Members (Examples I:2-42 through I:2-44) a. Shifting taxable income to family members to lower tax brackets will reduce the overall family tax burden. b. Restrictions apply to transactions that only involve assignment, and not shifting, of income, as well as transactions that trigger the kiddie tax.

2. Splitting Income (Example I:2-45) a. Creating additional taxpayers can reduce the overall tax burden, but administrative costs, especially of additional corporations, reduce the overall savings.

3. Maximizing Itemized Deductions (Examples I:2-46, I:2-47)

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a. Itemized deductions only provide value to the extent that they exceed the standard deduction. Timing expenses and charitable contributions so that they fall in a single tax year can increase the value of the resulting deductions.

4. Filing Joint or Separate Returns (Example I:2-50) a. Both tax and non-tax issues determine whether married couples should file jointly or separately. b. Spouses who file jointly are jointly liable for income tax, including the tax on disallowed deductions or unreported income. The innocent spouse provision protects spouses who were not aware of the magnitude of the understated tax liability, and the separate liability election allows spouses or former spouses to elect to be separately liable for the tax.

VII.

Compliance and Procedural Considerations 1. Who Must File (Example I:2-51) a. Generally, the income limitation for filing is the standard deduction for a particular status. The limitation is zero for married filing separately. (See page I:2-35 for the gross income filing levels.) i.

EXAMPLE: For 2023, a single taxpayer (under 65, not blind, not a dependent on another return) must file a return when gross income exceeds $13,850.

2. Due Dates and Extensions a. Tax returns for calendar-year individual taxpayers (Form 1040) are generally due April 15 (or first business day thereafter if April 15 is not a business day) following the end of the taxable year, with an automatic sixmonth extension if Form 4868 is filed by the due date for the return. b. Schedule 1 reports sources of income that are not reported on Form 1040. c. Schedule 2 reports AMT, various other taxes, and excess advance premium tax credit repayment. (See Chapter I:14.) d. Schedule 3 reports various nonrefundable tax credits and estimated tax payments. e. Partnerships must file Form 1065 and S corporations must file Form 1120S by the fifteenth day of the third month following year end (i.e., March 15 for calendar-year-end taxpayers). C corporations must file Form 1120 and have the same due date as individual taxpayers. Any of these organizations can file Form 7004 to obtain a six-month extension.

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f. An extension to file is not an extension on paying taxes. Interest and penalties apply for underpayment even when filing an extension.

3. Systems for Reporting Income a. Payments made by certain entities are reported to the IRS for computer cross-checking that all income has been reported. b. Items reported include pensions, annuities, wages, dividends, interest, sales of securities, unemployment compensation, rents, royalties, and lump-sum distributions from retirement plans.

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Court Case Briefs Kenneth Royce Boykin v. CIR, 1984 PH T.C. Memo & 84,297, 48 TCM 267.

The taxpayer and his wife were divorced in February of 1979, but he continued to live with his former wife and their children after the divorce in 1979 and 1980. IRC Sec.143 provides that the “determination of whether an individual is married shall be made as of the close of his taxable year.”

IRC Sec.143 further provides that an individual legally separated by divorce or a separate maintenance decree is not considered married. The taxpayer was denied the filing status of married, filing jointly because he was not married at the close of the tax years at issue. Texas (state of residence) recognizes common law marriages that have the elements of mutual agreement, cohabitation, and the holding out of themselves as married to the public. Their cohabitation did not qualify because they had not mutually agreed to be remarried. However, he was permitted “head of household” filing status because he met the requirements of Sec. 2(b). He was not married at the close of the tax year and he maintained a household for over half of the tax year for his dependent children.

Haynes, 119 AFTR 2d 2017-865.

Mr. and Mrs. Haynes hired Mr. Dunbar, a CPA, to prepare and file their 2010 individual tax return.

In 2011, Dunbar filed for an extension to submit the Haynes’s 2010 income tax return, which was granted by IRS. On Oct. 17, 2011, Dunbar attempted to use the Lacerte software program to electronically file the Haynes’s 2010 tax return. The IRS rejected the filing because the return listed Mrs. Haynes’s social security number on the line designated for the employer identification number. Dunbar advised Mr. Haynes that the return had been filed, but eleven months later, the IRS notified the Haynes that it had not received their 2010 return. In December 2012, Dunbar filed the Haynes’s 2010 tax return on paper. IRS assessed a late-filing penalty, which the Haynes paid.

They subsequently filed a refund suit in district court, but the court rejected their claim. The court stated that relying on a CPA’s erroneous word that the return had been filed was not reasonable cause for failing to file a tax return in a timely fashion.

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Instructor Aid I:2-1 Relative Tax by Filing Status*

Lowest

Married Filing Jointly/Surviving Spouse Head of Household Single

Highest

Married Filing Separately**

*Assuming the same amount of taxable income. **In the few cases where the married couple both has income and only one has substantial amounts of itemized deductions, the result may vary.

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Instructor Aid I:2-2 Kiddie Tax

1. Compute the child’s taxable income in the normal fashion for dependents.

2. Compute the child’s net unearned income (investment income, including dividends, taxable interest, capital gains, rents, and royalties): Unearned income Less: Statutory deduction of $1,250 Less: Greater of a. $1,250 of standard deduction, or b. Itemized deductions directly connected with the production of the unearned income Equals: Net unearned income (not less than zero) 3. Compute the child’s tax as net unearned income times parents’ marginal tax rate plus taxable income exceeding net unearned income times child’s tax rate.

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Instructor Aid I:2-3 Capital Assets

Capital assets are defined in a negative manner under the Internal Revenue Code. Capital assets are assets that are not: •

Inventory

•

Depreciable property used in a trade or business

•

Real Property used in a trade or business

•

Patents

•

Copyrights

•

Literary, musical, or artistic compositions

•

Letters or memorandums

•

Accounts or notes receivable from the ordinary course of a trade or business

•

Certain U.S. Government publications

In the hands of the creator or a donee of the creator

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Chapter I:3 Gross Income: Inclusions Learning Objectives After studying this chapter, the student should be able to: 1. Explain the difference between the economic, accounting, and tax concepts of income.

2. Explain the principles used to determine who is taxed on a particular item of income.

3. Determine when a particular item of income is taxable under both the cash and accrual methods of reporting.

4. Apply the rules of Sec. 61(a) to determine whether items such as compensation, dividends, alimony, and pensions are taxable.

5. Describe tax planning considerations for inclusions of gross income.

6. Describe compliance and procedural considerations for gross income.

Areas of Greater Significance It is important for the student to understand that the tax definitions of income items may vary significantly from lay definitions, and even accounting definitions. Statutory tax definitions of income items should be stressed.

Areas of Lesser Significance In the interest of time, the instructor may determine that the following area is best covered by student reading, rather than class discussion: 1. Economic and Accounting Concepts of Income

Problem Areas for Students The following areas may prove especially difficult for students: 1. Determination of the taxable portion of social security benefits received.

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2. Properly including/excluding subsequent payments related to previously deducted amounts (tax benefit rule).

Highlights of Recent Tax Law Changes The following items of tax law have changed since the 2023 edition of this chapter: 1. The gross receipts threshold for adopting the cash method has increased to $29 million ($27 million in 2022).

2. The floors and ceilings for phase-out of the Series EE savings bond interest exclusion have increased. (See page I:3-14.)

3. The income levels for tax rates for ordinary income, long-term capital gains, dividend income, and the kiddie tax have increased. (See Quick Reference.)

4. The deduction amounts for the kiddie tax have increased to $1,250 ($1,150 in 2022) for the statutory deduction and the greater of $1,250 ($1,150 in 2022) and earned income plus $400 ($400 in 2022).

Teaching Tips 1. The calculation for taxable social security benefits may be the students’ first exposure to a major complex tax calculation. You may want to spend considerable time in helping the students master the calculation so that they develop confidence in their abilities to deal with the complex calculations that follow (and to avoid undue discouragement).

2. The distinction between inclusions (Chapter I:3) and exclusions (Chapter I:4) is not an important distinction for theoretical or practice purposes. Specific items discussed in Chapter I:3 may also have an exclusion effect (e.g., portion of annuities excluded from gross income, exclusion of municipal bond interest). You may want to use an overall approach to gross income as detailed in Chapter I:3 and Chapter I:4.

Lecture Outline I.

Tax Concept of Income 1. Administrative Convenience a. The concept of objectivity and administrative convenience support the tax law selection of income on realization, rather than taxing unrealized appreciation.

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i.

EXAMPLE: If a piece of land owned by the taxpayer appreciates from $100,000 at the beginning of the tax year to $130,000 at the end of the tax year, there is no tax on the $30,000 appreciation until the disposal of the land.

2. Wherewithal-to-Pay a. Taxing unrealized appreciation would cause cash flow problems for taxpayers. i.

EXAMPLE: If the $30,000 appreciation described in the previous example was taxed at a 25% marginal rate, the taxpayer could be hard pressed to come up with the $7,500 tax due without liquidation of the investment.

3. Gross Income Defined (Examples I:3-3 through I:3-7) a. Code Sec. 61 includes in gross income “all income from whatever source derived.” Specific examples listed in the statute include: i. ii. iii. iv. v. vi. vii. viii. ix. x. xi. xii. xiii. xiv.

II.

Compensation for services, including fees, commissions, fringe benefits, and similar items Gross income derived from business Gains derived from dealings in property Interest Rents Royalties Dividends Annuities Income from life insurance and endowment contracts Pensions Income from discharge of indebtedness Distributive share of partnership gross income Income in respect of a decedent Income from an interest in an estate or trust

To Whom is Income Taxable?

1. Assignment of Income a. Income from personal services is taxed to the taxpayer who rendered the services, and income from property is taxed to the owner of the property. b. Family trusts are not effective to change the incidence of tax on personal service income from the taxpayer earning the income to trust beneficiaries.

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2. Allocating Income Between Married Persons (Example I:3-8) a. Income allocation between husband and wife is dependent on state law (i.e., common law state vs. community property state). b. The law may be different between community property states. i.

EXAMPLE: Income from separate property for California residents is separate income. Income from separate property for Texas residents is community income.

c. Allocation of income between married persons is important only if separate returns are to be filed. All income of the spouses is included on a joint return.

3. Income of Minor Children (Question I:3-11) a. Children are taxed on their own earned income. b. Even though minor children are taxed on their own earned income, minors under the age of 18 may be taxable on certain unearned income at higher rates. (See Chapter I:2.)

III.

When is Income Taxable? (Topic Review I:3-1) 1. Cash Method (Examples I:3-11, I:3-12; Question I:3-12) a. The cash method is used by most individuals, as well as businesses without inventories and businesses with inventories whose average gross receipts for the three prior years do not exceed $29 million, with income being reported in the year of actual or constructive receipt. b. Constructive receipt occurs when the taxpayer has access to the income, but does not actually receive it (i.e., interest credited to a savings account). c. Exceptions exist for certain U.S. Savings Bonds, crop insurance proceeds, and certain draught-related livestock sales.

2. Accrual Method (Example I:3-15; Question I:3-14) a. Accrual method taxpayers generally report income in the year the income is earned (i.e., when “all events” have occurred to fix the right to income, and the amount of income can be determined with reasonable accuracy). b. Prepaid income (i.e., prepaid rent) is generally taxable in the year of receipt.

Exceptions are available on certain prepayments for goods not on hand and prepayments for services not rendered until the following tax year.

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3. Hybrid Method a. Certain small businesses may be on the accrual method for purchases and sales (e.g., inventory), while using the cash method in computing all other income and expense items.

IV.

Items of Gross Income: Sec. 61(a) 1. Compensation a. Payments for personal services, however titled, are included in gross income. These include salaries, wages, fees, commissions, tips, bonuses, and other specialized forms of compensation.

2. Business Income a. Total receipts are gross income for service businesses. b. Gross margin (total sales less cost of goods sold) is gross income for manufacturing, merchandising, and mining businesses.

3. Gains from Dealings in Property a. Unless one of the several statutory non-recognition provisions applies, gains from dealings in property are included in gross income. b. Statutory non-recognition provisions include involuntary conversions, likekind exchanges, sale of a personal residence, and reorganizations. (See Chapter I:12.)

4. Interest (Problem I:3-44) a. Interest is generally included in gross income. b. An exclusion for interest on municipal bonds is available as long as the bonds are not (1) issued for certain private activities, (2) issued in excess of the statutory limit, (3) guaranteed by the federal government, or (4) issued for the purpose of acquiring higher interest investments (arbitrage). c. An exclusion is also available for interest from Series EE U.S. saving bonds if the proceeds are used to pay certain college expenses for the taxpayers or dependents. The exclusion is phased out over certain AGI levels.

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5. Rents and Royalties (Examples I:3-18, I:3-19) a. Gross income includes rents and royalties. Refundable security deposits are not income until forfeited. b. Losses from these activities may be subject to the passive loss rules. (See Chapter I:9.) c. Leasehold improvements in lieu of rent are included in gross income at their FMV upon completion. Leasehold improvements not in lieu of rent are not gross income. d. Amounts received by the lessor to cancel or modify a lease are included in gross income.

6. Dividends (Examples I:3-20, I:3-21; Instructor Aid I:3-1) a. Distributions from corporations to shareholders are taxable as dividends to the extent of the shareholder’s pro rata share of current or accumulated earnings and profits. b. Corporate distributions that exceed a shareholder’s pro rata share of earnings and profits are treated as return of capital to the extent of the shareholder’s adjusted basis in the subject stock. c. Corporate distributions exceeding both E&P and adjusted basis are subject to gain (usually capital) treatment. d. Qualified dividends are subject to special tax rates (0%, 15%, and 20%) under the same rules as net long-term capital gain. e. C corporations receiving dividends from other domestic C corporations may claim a dividends received deduction based on how much of the distributing corporation the recipient owns: i.

50% if recipient owns less than 20%

ii.

65% if recipient owns between 20% and 80%

iii.

100% if recipient owns 80% or more

f. C corporations owning 10% or more of a foreign subsidiary with only foreign earnings can claim a 100% dividends received deduction.

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7. Alimony and Separate Maintenance Payments (Examples I:3-26, I:3-27; Topic Review I:3-2; Problem I:3-38) a. Tax alimony, as defined in the Code, is included in gross income. Currently tax alimony must be pursuant to an approved written agreement between the parties, paid in cash for spousal benefit, must terminate at death, and the parties must be living in separate households. b. For divorce agreements entered into after December 31, 2018, alimony payments are neither taxable to the recipient nor deductible by the payer.

8. Pensions and Annuities (Examples I:3-29, I:3-30; Table I:3-1; Problem I:3-46; Instructor Aid I:3-2) a. Annuities and pensions are partially included in gross income based on a calculation involving the excess of the expected return over the taxpayer’s cost. Exclusion % = Cost / Expected return. The exclusion percentage is applied to each receipt in a particular tax year until the cost is fully recovered. b. Qualified retirement plan annuities use a simplified method to determine the taxable portion of the payments. Under the simplified method the nontaxable portion of each annuity payment is equal to the taxpayer’s aftertax investment divided by an anticipated number of payments determined by a statutory table based on the taxpayer’s age at the start date. c. Even if the taxpayer outlives the calculated life expectancy, only the actual cost of the annuity is excluded from income. d. If the taxpayer dies before the entire cost is recovered tax free, any unrecovered cost is deducted on the decedent’s final income tax return.

9. Income from Life Insurance and Endowment Contracts a. The face amount of life insurance proceeds received after death is not taxable. b. Interest income from life insurance proceeds left with the insurance company is included in gross income. c. Proceeds collected by the insured prior to death (i.e., endowment-type policy) which exceed premiums paid are treated as income.

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10. Income from Discharge of Indebtedness a. Generally, the forgiveness of debt is included in gross income. b. Exceptions to this general rule exist for bankruptcy and certain other insolvency situations. (See Chapter I:4.)

11. Income Passed through to Taxpayer a. Taxpayers may receive gross income from their interests in partnerships, S corporations, estates, trusts, and income in respect of a decedent. b. Any losses from these entities should be evaluated in light of the passive loss rules. (See Chapter I:9.)

V.

Other Items of Gross Income 1. Prizes, Awards, Gambling Winnings, and Treasure Finds (Example I:3-32) a. Generally, prizes, awards, gambling winnings, and treasure finds are included in gross income. b. Certain achievement awards properly transferred to qualifying charitable organizations will not be included in gross income. (See Chapter I:4.)

2. Illegal Income a. Illegal income must be included in gross income. b. Examples of illegal income include embezzlement proceeds, ransom, bookmaking profits, robbery proceeds, sales of illegal narcotics, and bribes.

3. Unemployment Compensation a. Both government-financed and employer-financed compensation are fully included in gross income.

unemployment

4. Social Security Benefits (Example I:3-33) a. A maximum of 85% of social security benefits may be included in gross income for certain taxpayers. (See page I:3-25.) b. Married taxpayers filing jointly whose total of adjusted gross income (without FICA) plus 50% of FICA, plus tax-exempt interest and certain excluded foreign income is less than or equal to $32,000 will pay no tax on their FICA. c. Single taxpayers whose total of the above-described items is less than or equal to $25,000 will pay no tax on his/her FICA. I:IO3-8 Copyright © 2024 Pearson Education, Inc.

5. Insurance Proceeds and Court Awards (Example I:3-34; Problem I:3-51) a. The potential inclusion of insurance proceeds and court awards in gross income is affected by the reason the amounts were received. i.

EXAMPLE: Recoveries of lost profits, whether as insurance proceeds or damages, are includible in gross income.

b. Amounts received because of personal injury or sickness are generally excluded from gross income. Punitive damages awarded on the basis of sickness or physical injury are taxable.

6. Recovery of Previously Deducted Amounts (Examples I:3-35, I:3-36) a. Recovery of previously deducted amounts in a subsequent year may cause income recognition (i.e., Tax Benefit Rule). i.

EXAMPLE: Receipt of a state income tax refund in a tax year subsequent to a year in which state income taxes were deducted on the cash method may give rise to gross income.

7. Claim of Right (Example I:3-38; Problem I:3-52) a. A taxpayer may receive funds, which have disputed ownership. Under the claim of right doctrine, the taxpayer must report the disputed amount as income, unless the use of funds is restricted. b. If the taxpayer is subsequently required to repay the disputed amount, a deduction is available in the year of repayment. An adjustment may be available if the taxpayer’s marginal tax rate in the year of inclusion exceeds the taxpayer’s marginal tax rate in the year of deduction.

VI.

Tax Planning Considerations 1. Shifting Income a. Shifting income from high-bracket taxpayers to low-bracket taxpayers can reduce the overall family tax burden. i.

EXAMPLE: Taxpayer irrevocably transfers income-producing property (i.e., bonds) to his/her daughter. Income from property is taxed to the new owner. If the daughter’s marginal tax rate is lower than the transferor’s, the overall family tax burden may be lower (subject to kiddie tax considerations).

b. Shifting income is constrained by assignment of income doctrine and gift taxes.

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2. Divorce Settlements (Example I:3-40) a. Under the prior law, tax alimony shifts taxable income from the payor to the payee. b. Under the current law, alimony payments are made from after-tax income.

3. Prepaid Income a. Lessors may want to collect the first month’s rent plus a refundable deposit, rather than first and last month’s rent to avoid prepaid income. b. There is a risk of recharacterization to income if the amount of the deposit is similar to the amount of one month’s rent.

4. Taxable, Tax-Exempt, or Tax-Deferred Bonds (Example I:3-42) a. The taxpayer should compare after-tax yields when comparing among taxable, tax-exempt, and tax-deferred bonds.

5. Reporting Savings Bond Interest a. It may be a tax advantage to report interest from U.S. savings bonds owned by minor children on an annual income tax return. If the amount of interest is less than the standard deduction, such annual reporting will result in no tax. This approach will avoid the bunching of income in the year of redemption.

6. Deferred Compensation Arrangements (Example I:3-43) a. Advance contractual agreements to defer income (such as those common for professional athletes) are respected for tax purposes and are not treated under the constructive receipt rules.

VII.

Compliance and Procedural Considerations (Example I:3-44; Topic Review I:3-3, Figures I:3-1 through I:3-5) 1. Gross income is summarized on Form 1040 (Page 1) from various supporting schedules, including Schedule B (interest and dividends), Schedule C (business income), Schedule D (capital gains), Schedule E (rents and royalties), Schedule F (farm income), Schedule 1 (additional income and adjustments to income), and Form 4797 (supplemental gains).

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Court Case Briefs Elizabeth C. Sympson v. CIR, 67 TCM 1914 (1994).

Mrs. Sympson was the executor of her husband’s estate. Mr. Sympson was hired as a financial manager by Mr. Roderick. When Mr. Roderick died, Mr. Sympson had sole authority to pay all bills from Mrs. Roderick’s checking accounts. In addition to paying Mrs. Roderick’s bills, however, Mr. Sympson also made frequent transfers from Mrs. Roderick’s account to his own personal account ($1,376,647). Mr. Sympson reported only about $400,000 in income over this period.

The government claimed that the difference of approximately $900,000 was embezzlement income.

Mr. Sympson claimed before his death that the excess amounts were loans, even though there was no documentation of any kind. Also, Mrs. Roderick denied any knowledge or intent to loan money to Mr. Sympson. The Tax Court held that there was no evidence to support the loan theory, and that the $900,000 was taxable as embezzlement income in the years the transfers were made.

Norris v. CIR, T. C. Memo 2011-161.

William Norris and his wife, Sharon, owned and managed a convenience store. In the back room of the store, the couple ran an illegal video poker operation. Mrs. Norris made an error in calculating the convenience store’s receipts, which resulted in an understatement of the income from the legal portion of their business in 1996, and the IRS alleged that they did not pay tax on the income from their illegal gambling operation. In 2008, the IRS issued a notice of deficiency for 1996, assessing deficiencies for tax owed and fraud penalties. Although the notice of deficiency was not issued until long after the Sec. 6501(a) deadline for assessing tax had passed, the IRS relied on Sec. 6501(c)(1), which allows the IRS to assess tax at any time “in the case of a false or fraudulent return with the intent to evade tax.”

The Tax Court assessed fraud intent based on 11 factors: (1) Understating income, (2) maintaining inadequate records, (3) implausible or inconsistent explanations of behavior, (4) concealment of income or assets, (5) failing to cooperate with tax authorities, (6) engaging in illegal activities, (7) an intent to mislead which may be inferred from a pattern of conduct, (8) lack of credibility of the taxpayer’s testimony, (9) filing false documents, (10) failing to file tax returns, and (11) dealing in cash. Factors (1), (6), (7), and (10) favored a finding of fraud; factors (3), (4), (5), (8), and (11) did not favor a finding of fraud; and factors (2) and (9) were neutral. Because it treated each factor equally, the Tax Court held that Mr. Norris was not liable for fraud penalties for 1996 and that Mrs. Norris had not committed fraud with respect to the 1996 taxes. Consequently, it also held that the assessment for the 1996 tax year was invalid because the statute of limitation for assessment under Sec. 6501(a) had run and the unlimited period under Sec. 6501(c)(1) did not apply.

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Instructor Aid I:3-1 Taxation of Distributions from Corporations

1) Distributions from regular (“C”) corporations are treated as dividends to the extent of the shareholder’s pro-rata share of the corporation’s current and accumulated earnings and profits.

2) Distributions in excess of the corporation’s current and accumulated earnings and profits are treated as return of capital (nontaxable) to the extent of the shareholder’s adjusted basis in the relevant stock.

3) Distributions that exceed both the corporation’s current and accumulated earnings and profits and the shareholder’s adjusted basis in the relevant stock are treated as gain. If the stock is a capital asset, the gain will be capital gain (long-term or short-term based on the holding period of the stock).

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Instructor Aid I:3-2 Pension or Annuity Inclusion Single Life Annuity

Cost = Employee’s nondeductible contributions for a pension; otherwise = Investment Expected Return = Annual payment × Life expectancy (from IRS tables) Exclusion Ratio = Cost / Expected Return Current Year’s Exclusion = Exclusion ration × Total pension or annuity payments received during the year Current Year’s Inclusion = Total pension or annuity payments received during the year Less: Current year’s exclusion For qualified retirement plan annuities, see page I:3-22 of text for simplified calculation.

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Chapter I:3 Gross Income: Inclusions Learning Objectives After studying this chapter, the student should be able to: 1. Explain the difference between the economic, accounting, and tax concepts of income.

2. Explain the principles used to determine who is taxed on a particular item of income.

3. Determine when a particular item of income is taxable under both the cash and accrual methods of reporting.

4. Apply the rules of Sec. 61(a) to determine whether items such as compensation, dividends, alimony, and pensions are taxable.

5. Describe tax planning considerations for inclusions of gross income.

6. Describe compliance and procedural considerations for gross income.

Areas of Greater Significance It is important for the student to understand that the tax definitions of income items may vary significantly from lay definitions, and even accounting definitions. Statutory tax definitions of income items should be stressed.

Areas of Lesser Significance In the interest of time, the instructor may determine that the following area is best covered by student reading, rather than class discussion: 1. Economic and Accounting Concepts of Income

Problem Areas for Students The following areas may prove especially difficult for students: 1. Determination of the taxable portion of social security benefits received.

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2. Properly including/excluding subsequent payments related to previously deducted amounts (tax benefit rule).

Highlights of Recent Tax Law Changes The following items of tax law have changed since the 2023 edition of this chapter: 1. The gross receipts threshold for adopting the cash method has increased to $29 million ($27 million in 2022).

2. The floors and ceilings for phase-out of the Series EE savings bond interest exclusion have increased. (See page I:3-14.)

3. The income levels for tax rates for ordinary income, long-term capital gains, dividend income, and the kiddie tax have increased. (See Quick Reference.)

4. The deduction amounts for the kiddie tax have increased to $1,250 ($1,150 in 2022) for the statutory deduction and the greater of $1,250 ($1,150 in 2022) and earned income plus $400 ($400 in 2022).

Teaching Tips 1. The calculation for taxable social security benefits may be the students’ first exposure to a major complex tax calculation. You may want to spend considerable time in helping the students master the calculation so that they develop confidence in their abilities to deal with the complex calculations that follow (and to avoid undue discouragement).

2. The distinction between inclusions (Chapter I:3) and exclusions (Chapter I:4) is not an important distinction for theoretical or practice purposes. Specific items discussed in Chapter I:3 may also have an exclusion effect (e.g., portion of annuities excluded from gross income, exclusion of municipal bond interest). You may want to use an overall approach to gross income as detailed in Chapter I:3 and Chapter I:4.

Lecture Outline I.

Tax Concept of Income 1. Administrative Convenience a. The concept of objectivity and administrative convenience support the tax law selection of income on realization, rather than taxing unrealized appreciation.

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i.

EXAMPLE: If a piece of land owned by the taxpayer appreciates from $100,000 at the beginning of the tax year to $130,000 at the end of the tax year, there is no tax on the $30,000 appreciation until the disposal of the land.

2. Wherewithal-to-Pay a. Taxing unrealized appreciation would cause cash flow problems for taxpayers. i.

EXAMPLE: If the $30,000 appreciation described in the previous example was taxed at a 25% marginal rate, the taxpayer could be hard pressed to come up with the $7,500 tax due without liquidation of the investment.

3. Gross Income Defined (Examples I:3-3 through I:3-7) a. Code Sec. 61 includes in gross income “all income from whatever source derived.” Specific examples listed in the statute include: i. ii. iii. iv. v. vi. vii. viii. ix. x. xi. xii. xiii. xiv.

II.

Compensation for services, including fees, commissions, fringe benefits, and similar items Gross income derived from business Gains derived from dealings in property Interest Rents Royalties Dividends Annuities Income from life insurance and endowment contracts Pensions Income from discharge of indebtedness Distributive share of partnership gross income Income in respect of a decedent Income from an interest in an estate or trust

To Whom is Income Taxable?

1. Assignment of Income a. Income from personal services is taxed to the taxpayer who rendered the services, and income from property is taxed to the owner of the property. b. Family trusts are not effective to change the incidence of tax on personal service income from the taxpayer earning the income to trust beneficiaries.

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2. Allocating Income Between Married Persons (Example I:3-8) a. Income allocation between husband and wife is dependent on state law (i.e., common law state vs. community property state). b. The law may be different between community property states. i.

EXAMPLE: Income from separate property for California residents is separate income. Income from separate property for Texas residents is community income.

c. Allocation of income between married persons is important only if separate returns are to be filed. All income of the spouses is included on a joint return.

3. Income of Minor Children (Question I:3-11) a. Children are taxed on their own earned income. b. Even though minor children are taxed on their own earned income, minors under the age of 18 may be taxable on certain unearned income at higher rates. (See Chapter I:2.)

III.

When is Income Taxable? (Topic Review I:3-1) 1. Cash Method (Examples I:3-11, I:3-12; Question I:3-12) a. The cash method is used by most individuals, as well as businesses without inventories and businesses with inventories whose average gross receipts for the three prior years do not exceed $29 million, with income being reported in the year of actual or constructive receipt. b. Constructive receipt occurs when the taxpayer has access to the income, but does not actually receive it (i.e., interest credited to a savings account). c. Exceptions exist for certain U.S. Savings Bonds, crop insurance proceeds, and certain draught-related livestock sales.

2. Accrual Method (Example I:3-15; Question I:3-14) a. Accrual method taxpayers generally report income in the year the income is earned (i.e., when “all events” have occurred to fix the right to income, and the amount of income can be determined with reasonable accuracy). b. Prepaid income (i.e., prepaid rent) is generally taxable in the year of receipt.

Exceptions are available on certain prepayments for goods not on hand and prepayments for services not rendered until the following tax year.

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3. Hybrid Method a. Certain small businesses may be on the accrual method for purchases and sales (e.g., inventory), while using the cash method in computing all other income and expense items.

IV.

Items of Gross Income: Sec. 61(a) 1. Compensation a. Payments for personal services, however titled, are included in gross income. These include salaries, wages, fees, commissions, tips, bonuses, and other specialized forms of compensation.

2. Business Income a. Total receipts are gross income for service businesses. b. Gross margin (total sales less cost of goods sold) is gross income for manufacturing, merchandising, and mining businesses.

3. Gains from Dealings in Property a. Unless one of the several statutory non-recognition provisions applies, gains from dealings in property are included in gross income. b. Statutory non-recognition provisions include involuntary conversions, likekind exchanges, sale of a personal residence, and reorganizations. (See Chapter I:12.)

4. Interest (Problem I:3-44) a. Interest is generally included in gross income. b. An exclusion for interest on municipal bonds is available as long as the bonds are not (1) issued for certain private activities, (2) issued in excess of the statutory limit, (3) guaranteed by the federal government, or (4) issued for the purpose of acquiring higher interest investments (arbitrage). c. An exclusion is also available for interest from Series EE U.S. saving bonds if the proceeds are used to pay certain college expenses for the taxpayers or dependents. The exclusion is phased out over certain AGI levels.

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5. Rents and Royalties (Examples I:3-18, I:3-19) a. Gross income includes rents and royalties. Refundable security deposits are not income until forfeited. b. Losses from these activities may be subject to the passive loss rules. (See Chapter I:9.) c. Leasehold improvements in lieu of rent are included in gross income at their FMV upon completion. Leasehold improvements not in lieu of rent are not gross income. d. Amounts received by the lessor to cancel or modify a lease are included in gross income.

6. Dividends (Examples I:3-20, I:3-21; Instructor Aid I:3-1) a. Distributions from corporations to shareholders are taxable as dividends to the extent of the shareholder’s pro rata share of current or accumulated earnings and profits. b. Corporate distributions that exceed a shareholder’s pro rata share of earnings and profits are treated as return of capital to the extent of the shareholder’s adjusted basis in the subject stock. c. Corporate distributions exceeding both E&P and adjusted basis are subject to gain (usually capital) treatment. d. Qualified dividends are subject to special tax rates (0%, 15%, and 20%) under the same rules as net long-term capital gain. e. C corporations receiving dividends from other domestic C corporations may claim a dividends received deduction based on how much of the distributing corporation the recipient owns: i.

50% if recipient owns less than 20%

ii.

65% if recipient owns between 20% and 80%

iii.

100% if recipient owns 80% or more

f. C corporations owning 10% or more of a foreign subsidiary with only foreign earnings can claim a 100% dividends received deduction.

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7. Alimony and Separate Maintenance Payments (Examples I:3-26, I:3-27; Topic Review I:3-2; Problem I:3-38) a. Tax alimony, as defined in the Code, is included in gross income. Currently tax alimony must be pursuant to an approved written agreement between the parties, paid in cash for spousal benefit, must terminate at death, and the parties must be living in separate households. b. For divorce agreements entered into after December 31, 2018, alimony payments are neither taxable to the recipient nor deductible by the payer.

8. Pensions and Annuities (Examples I:3-29, I:3-30; Table I:3-1; Problem I:3-46; Instructor Aid I:3-2) a. Annuities and pensions are partially included in gross income based on a calculation involving the excess of the expected return over the taxpayer’s cost. Exclusion % = Cost / Expected return. The exclusion percentage is applied to each receipt in a particular tax year until the cost is fully recovered. b. Qualified retirement plan annuities use a simplified method to determine the taxable portion of the payments. Under the simplified method the nontaxable portion of each annuity payment is equal to the taxpayer’s aftertax investment divided by an anticipated number of payments determined by a statutory table based on the taxpayer’s age at the start date. c. Even if the taxpayer outlives the calculated life expectancy, only the actual cost of the annuity is excluded from income. d. If the taxpayer dies before the entire cost is recovered tax free, any unrecovered cost is deducted on the decedent’s final income tax return.

9. Income from Life Insurance and Endowment Contracts a. The face amount of life insurance proceeds received after death is not taxable. b. Interest income from life insurance proceeds left with the insurance company is included in gross income. c. Proceeds collected by the insured prior to death (i.e., endowment-type policy) which exceed premiums paid are treated as income.

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10. Income from Discharge of Indebtedness a. Generally, the forgiveness of debt is included in gross income. b. Exceptions to this general rule exist for bankruptcy and certain other insolvency situations. (See Chapter I:4.)

11. Income Passed through to Taxpayer a. Taxpayers may receive gross income from their interests in partnerships, S corporations, estates, trusts, and income in respect of a decedent. b. Any losses from these entities should be evaluated in light of the passive loss rules. (See Chapter I:9.)

V.

Other Items of Gross Income 1. Prizes, Awards, Gambling Winnings, and Treasure Finds (Example I:3-32) a. Generally, prizes, awards, gambling winnings, and treasure finds are included in gross income. b. Certain achievement awards properly transferred to qualifying charitable organizations will not be included in gross income. (See Chapter I:4.)

2. Illegal Income a. Illegal income must be included in gross income. b. Examples of illegal income include embezzlement proceeds, ransom, bookmaking profits, robbery proceeds, sales of illegal narcotics, and bribes.

3. Unemployment Compensation a. Both government-financed and employer-financed compensation are fully included in gross income.

unemployment

4. Social Security Benefits (Example I:3-33) a. A maximum of 85% of social security benefits may be included in gross income for certain taxpayers. (See page I:3-25.) b. Married taxpayers filing jointly whose total of adjusted gross income (without FICA) plus 50% of FICA, plus tax-exempt interest and certain excluded foreign income is less than or equal to $32,000 will pay no tax on their FICA. c. Single taxpayers whose total of the above-described items is less than or equal to $25,000 will pay no tax on his/her FICA. I:IO3-8 Copyright © 2024 Pearson Education, Inc.

5. Insurance Proceeds and Court Awards (Example I:3-34; Problem I:3-51) a. The potential inclusion of insurance proceeds and court awards in gross income is affected by the reason the amounts were received. i.

EXAMPLE: Recoveries of lost profits, whether as insurance proceeds or damages, are includible in gross income.

b. Amounts received because of personal injury or sickness are generally excluded from gross income. Punitive damages awarded on the basis of sickness or physical injury are taxable.

6. Recovery of Previously Deducted Amounts (Examples I:3-35, I:3-36) a. Recovery of previously deducted amounts in a subsequent year may cause income recognition (i.e., Tax Benefit Rule). i.

EXAMPLE: Receipt of a state income tax refund in a tax year subsequent to a year in which state income taxes were deducted on the cash method may give rise to gross income.

7. Claim of Right (Example I:3-38; Problem I:3-52) a. A taxpayer may receive funds, which have disputed ownership. Under the claim of right doctrine, the taxpayer must report the disputed amount as income, unless the use of funds is restricted. b. If the taxpayer is subsequently required to repay the disputed amount, a deduction is available in the year of repayment. An adjustment may be available if the taxpayer’s marginal tax rate in the year of inclusion exceeds the taxpayer’s marginal tax rate in the year of deduction.

VI.

Tax Planning Considerations 1. Shifting Income a. Shifting income from high-bracket taxpayers to low-bracket taxpayers can reduce the overall family tax burden. i.

EXAMPLE: Taxpayer irrevocably transfers income-producing property (i.e., bonds) to his/her daughter. Income from property is taxed to the new owner. If the daughter’s marginal tax rate is lower than the transferor’s, the overall family tax burden may be lower (subject to kiddie tax considerations).

b. Shifting income is constrained by assignment of income doctrine and gift taxes.

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2. Divorce Settlements (Example I:3-40) a. Under the prior law, tax alimony shifts taxable income from the payor to the payee. b. Under the current law, alimony payments are made from after-tax income.

3. Prepaid Income a. Lessors may want to collect the first month’s rent plus a refundable deposit, rather than first and last month’s rent to avoid prepaid income. b. There is a risk of recharacterization to income if the amount of the deposit is similar to the amount of one month’s rent.

4. Taxable, Tax-Exempt, or Tax-Deferred Bonds (Example I:3-42) a. The taxpayer should compare after-tax yields when comparing among taxable, tax-exempt, and tax-deferred bonds.

5. Reporting Savings Bond Interest a. It may be a tax advantage to report interest from U.S. savings bonds owned by minor children on an annual income tax return. If the amount of interest is less than the standard deduction, such annual reporting will result in no tax. This approach will avoid the bunching of income in the year of redemption.

6. Deferred Compensation Arrangements (Example I:3-43) a. Advance contractual agreements to defer income (such as those common for professional athletes) are respected for tax purposes and are not treated under the constructive receipt rules.

VII.

Compliance and Procedural Considerations (Example I:3-44; Topic Review I:3-3, Figures I:3-1 through I:3-5) 1. Gross income is summarized on Form 1040 (Page 1) from various supporting schedules, including Schedule B (interest and dividends), Schedule C (business income), Schedule D (capital gains), Schedule E (rents and royalties), Schedule F (farm income), Schedule 1 (additional income and adjustments to income), and Form 4797 (supplemental gains).

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Court Case Briefs Elizabeth C. Sympson v. CIR, 67 TCM 1914 (1994).

Mrs. Sympson was the executor of her husband’s estate. Mr. Sympson was hired as a financial manager by Mr. Roderick. When Mr. Roderick died, Mr. Sympson had sole authority to pay all bills from Mrs. Roderick’s checking accounts. In addition to paying Mrs. Roderick’s bills, however, Mr. Sympson also made frequent transfers from Mrs. Roderick’s account to his own personal account ($1,376,647). Mr. Sympson reported only about $400,000 in income over this period.

The government claimed that the difference of approximately $900,000 was embezzlement income.

Mr. Sympson claimed before his death that the excess amounts were loans, even though there was no documentation of any kind. Also, Mrs. Roderick denied any knowledge or intent to loan money to Mr. Sympson. The Tax Court held that there was no evidence to support the loan theory, and that the $900,000 was taxable as embezzlement income in the years the transfers were made.

Norris v. CIR, T. C. Memo 2011-161.

William Norris and his wife, Sharon, owned and managed a convenience store. In the back room of the store, the couple ran an illegal video poker operation. Mrs. Norris made an error in calculating the convenience store’s receipts, which resulted in an understatement of the income from the legal portion of their business in 1996, and the IRS alleged that they did not pay tax on the income from their illegal gambling operation. In 2008, the IRS issued a notice of deficiency for 1996, assessing deficiencies for tax owed and fraud penalties. Although the notice of deficiency was not issued until long after the Sec. 6501(a) deadline for assessing tax had passed, the IRS relied on Sec. 6501(c)(1), which allows the IRS to assess tax at any time “in the case of a false or fraudulent return with the intent to evade tax.”

The Tax Court assessed fraud intent based on 11 factors: (1) Understating income, (2) maintaining inadequate records, (3) implausible or inconsistent explanations of behavior, (4) concealment of income or assets, (5) failing to cooperate with tax authorities, (6) engaging in illegal activities, (7) an intent to mislead which may be inferred from a pattern of conduct, (8) lack of credibility of the taxpayer’s testimony, (9) filing false documents, (10) failing to file tax returns, and (11) dealing in cash. Factors (1), (6), (7), and (10) favored a finding of fraud; factors (3), (4), (5), (8), and (11) did not favor a finding of fraud; and factors (2) and (9) were neutral. Because it treated each factor equally, the Tax Court held that Mr. Norris was not liable for fraud penalties for 1996 and that Mrs. Norris had not committed fraud with respect to the 1996 taxes. Consequently, it also held that the assessment for the 1996 tax year was invalid because the statute of limitation for assessment under Sec. 6501(a) had run and the unlimited period under Sec. 6501(c)(1) did not apply.

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Instructor Aid I:3-1 Taxation of Distributions from Corporations

1) Distributions from regular (“C”) corporations are treated as dividends to the extent of the shareholder’s pro-rata share of the corporation’s current and accumulated earnings and profits.

2) Distributions in excess of the corporation’s current and accumulated earnings and profits are treated as return of capital (nontaxable) to the extent of the shareholder’s adjusted basis in the relevant stock.

3) Distributions that exceed both the corporation’s current and accumulated earnings and profits and the shareholder’s adjusted basis in the relevant stock are treated as gain. If the stock is a capital asset, the gain will be capital gain (long-term or short-term based on the holding period of the stock).

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Instructor Aid I:3-2 Pension or Annuity Inclusion Single Life Annuity

Cost = Employee’s nondeductible contributions for a pension; otherwise = Investment Expected Return = Annual payment × Life expectancy (from IRS tables) Exclusion Ratio = Cost / Expected Return Current Year’s Exclusion = Exclusion ration × Total pension or annuity payments received during the year Current Year’s Inclusion = Total pension or annuity payments received during the year Less: Current year’s exclusion For qualified retirement plan annuities, see page I:3-22 of text for simplified calculation.

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Chapter I:4 Gross Income: Exclusions Learning Objectives After studying this chapter, the student should be able to: 1. Determine whether an item is income.

2. Determine which major statutory exclusions are available to a taxpayer.

3. Describe tax planning considerations for exclusions of gross income.

4. Describe compliance and procedural considerations for exclusions of gross income.

Areas of Greater Significance The area of employee fringe benefits (including employer-paid insurance, meals and lodging, cafeteria plans, etc.) is important because most employee taxpayers are affected.

In addition, any employer offering such employee benefits will be interested in the tax consequences to the employee.

Areas of Lesser Significance In the interest of time, the instructor may determine that the following area is best covered by student reading, rather than class discussion: 1. Introduction and Overview

Problem Areas for Students The following areas may prove especially difficult for students: 1. The difference between a gift and an award or prize.

2. To what extent, if any, income from the discharge of indebtedness is recognized (dependent on status of taxpayer - bankrupt, insolvent, solvent, or deceased) and the effect of such unrecognized income on tax attributes (net operating loss, etc.).

Highlights of Recent Tax Law Changes The following items of tax law have changed since the 2023 edition of this chapter: I:IO4-1 Copyright © 2024 Pearson Education, Inc.

1. The minimum daily exclusion for periodic payments made to a chronically ill person has increased to $420 ($390 in 2022).

2. The annual per donee gift tax exclusion has increased to $17,000 ($16,000 in 2022).

3. The per month exclusion for employer-financed transportation and parking has increased to $300 ($280 in 2022).

4. The per-child exclusion for employer-paid adoption expenses increased to $15,950 ($14,890 in 2022) with the phase-out beginning at $239,230 of modified adjusted gross income ($223,410 in 2022).

5. The maximum annual contribution to a flexible spending account has increased to $3,050 ($2,850 in 2022). The maximum rollover amount has increased to $610 ($570 in 2022).

6. The foreign earned income exclusion increased to $120,000 ($112,000 in 2022).

Teaching Tips 1. Continue using an overall view of gross income utilizing both Chapters I:3 and Chapter I:4.

2. Many of the rules in this chapter will directly affect the students during their lives.

Try to build enthusiasm for tax by applying these topics to the students (i.e., Would you rather receive property by gift or inheritance? How many of you have scholarships - What are the tax consequences? How could the employee benefits provided by potential employers affect your job selection decision?).

Lecture Outline I.

Items that are Not Income 1. Unrealized Income a. EXAMPLE: If the value of certain stock held by the taxpayer appreciates from $10,000 at the beginning of the tax year to $25,000 at the end of the tax year, that $15,000 unrealized income is not subject to tax.

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2. Self-Help Income (Problem I:4-33) a. EXAMPLE: If a taxpayer repairs his own car, instead of paying a mechanic, the amount saved is not subject to tax.

3. Rental Value of Personal-Use Property a. EXAMPLE: The rental value of a personal residence occupied by the taxpayer is not subject to tax, even though the taxpayer could have rented the house.

4. Selling Price of Property a. EXAMPLE: Only the gain (i.e., selling price less the costs of sale and tax adjusted basis) in a taxpayer disposition of property is subject to tax, rather than the entire sales proceeds.

II.

Major Statutory Exclusions 1. Reasons for Statutory Exclusions a. Social policy i.

EXAMPLE: Exclusion of payments for sickness and injury

b. Economic Incentive i.

EXAMPLE: Exclusion of certain scholarships (to encourage education)

2. Gift and Inheritances (Example I:4-3; Question I:4-6) a. Transfers of property with donative intent, whether made during life (gift) or at the death of the transferor (inheritance), are excluded from gross income. Income earned from such property is subject to the regular income tax rules. i.

EXAMPLE: Mother gives daughter bonds having a value of $100,000. The value of the gift ($100,000) is excludable from the daughter’s gross income. Any taxable interest earned by the daughter subsequent to the transfer is included in the daughter’s gross income.

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3. Life Insurance Proceeds (Examples I:4-6 through I:4-10; Problem I:4-37; Instructor Aid I:4-1) a. Life insurance proceeds paid by reason of the death of the insured are generally nontaxable. Any amounts received in excess of the face amount are taxable as interest. i.

EXAMPLE: Father dies. Son is the named beneficiary in an insurance policy on the life of Father in the amount of $1,000,000.

Son receives the $1,000,000 proceeds free of income tax. If instead of receiving the proceeds in a lump sum, assume that Son receives $120,000 a year for ten years. The excess of the $1,200,000 received over the $1,000,000 face amount ($200,000) will be taxable as interest on a straight-line basis over the 10-year period.

b. If the life insurance policy is purchased from another individual, the owner treats the proceeds as a gain from investment (i.e., the excess of the proceeds over the acquisition cost plus premiums paid is taxable gain). Certain policy acquisitions related to partnerships and closely-held corporations are excluded from this rule. c. If a life insurance policy matures or is surrendered, the excess of proceeds over the premiums paid is generally taxable to the recipient. However, an exclusion is available for accelerated death benefits paid to a terminally ill person or periodic payments paid to a chronically ill person. d. Dividends earned on life insurance policies are nontaxable to the extent they are equal to or less than the premiums paid. Interest paid on dividends left with the insurance company is taxable.

4. Awards for Meritorious Achievement (Question I:4-8) a. Awards are generally taxable. Awards for religious, charitable, scientific, educational, artistic, literary, or civic achievement are excluded from income if the taxpayer did not enter the contest or proceeding, is not required to perform substantial future services, and designates a qualified charitable organization or governmental unit to receive the payment. i.

EXAMPLE: If the taxpayer receives the Nobel Prize in recognition of her discovery of the cure for cancer, the award will be included in her gross income unless properly assigned to a qualifying nonprofit organization.

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5. Scholarships and Fellowships (Example I:4-11; Problem I:4-40) a. Scholarships (for tuition, fees, books, supplies, and equipment only) are excluded for degree candidates. i.

EXAMPLE: The taxpayer receives a “full-ride” scholarship to play football at a large university. The amount of the scholarship allocable to tuition, fees, books, supplies, and equipment will be excludable from the taxpayer’s gross income. Any additional amounts received (e.g., for room and board) will be included in gross income.

6. Distributions from Qualified Tuition Programs (Example I:4-12) a. Distributions made from qualified tuition programs are taxable only to the extent they exceed qualified education expenses, including room and board if the student is at least half-time. b. Education costs may be associated with higher education, as well as public, private, and religious elementary and secondary schools.

7. Payments for Injury and Sickness (Examples I:4-13 through I:4-15) a. Amounts received as compensation for injury and sickness are excluded, whether paid by insurance or otherwise. The exclusion only applies to personal physical injuries or physical sickness. Most damages on nonphysical injuries are taxable. Punitive damages are taxable per statute. i.

EXAMPLE: Taxpayer receives $10,000 from his health insurance company to reimburse costs of a recent hospital stay. This $10,000 amount is not subject to tax.

b. Payments under a disability income policy are nontaxable if the policy was purchased by the taxpayer, but are fully taxable if the policy is purchased by the taxpayer’s employer. c. Any reimbursed medical expenses cannot be deducted as an itemized deduction.

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8. Employer-Paid Insurance (Examples I:4-18, I:4-19; Topic Review I:4-1, Table I:41) a. Employer-paid premiums on health, accident, disability, and qualifying group term insurance are excluded from the employee’s income. i.

EXAMPLE: Taxpayer’s employer pays the entire premium for health and accident insurance on the taxpayer and her family ($1,500 per month). The entire annual cost to the employer ($18,000) is excluded from the taxpayer’s gross income.

b. The benefits from nondiscriminatory self-insured accident and health plans are also excluded from the employee’s income. c. Most employee life insurance premiums paid by the employer are taxable to the employee. An exception exists for group-term life insurance coverage not exceeding $50,000 per employee. Premiums for coverage exceeding $50,000 will be taxable to the employee. Different calculations may exist for key and non-key employees if the plan is discriminatory.

9. Section 132 Fringe Benefits (Topic Review I:4-2) a. The following benefits may be excluded from an employee’s gross income: i.

No-additional-cost benefits (e.g., standby flight benefits for airline employees).

ii.

Qualified employee discounts (e.g., 20% discount on legal services for law firm’s receptionist).

iii.

Working condition benefits (e.g., free snacks at place of employment).

iv.

De minimis benefits (e.g., free holiday turkey).

v.

Qualified transportation fringes (parking, public transportation, and/or commuter vehicle exclusion up to $300 per month).

vi.

Recreation and athletic facilities (e.g., free use of the employer swimming pool).

b. Employers may not deduct expenses associated with employee transportation, parking, recreational facilities, and de minimis benefits.

Employers may deduct one half of the net cost of operating employee eating facilities.

10. Employee Awards (Example I:4-20)

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a. Certain employee achievement awards and qualified plan awards are excluded from an employee’s gross income. i.

EXAMPLE: Taxpayer receives a watch (value $350) from his employer as recognition of 10 years of service. The value of the watch is excluded from gross income.

11. Meals and Lodging (Example I:4-21) a. Also excluded from an employee’s gross income are employer-provided meals and lodging, if they are provided on the employer’s premises for the convenience of the employer. An additional condition for excludable lodging is that the employee is required to accept the lodging as a condition of employment. i.

EXAMPLE: Taxpayer is the day restaurant manager. She is required by her employer to stay on the restaurant premises during the hours of 8:00 a.m. through 5:00 p.m. to handle all management responsibilities. The employer provides the taxpayer her noon meal for each working day. The value of these provided meals is excluded from the taxpayer’s gross income.

b. Employers may deduct one half of the cost of these meals.

12. Meals and Entertainment (Examples I:4-24, I:4-25) a. The value of employee meals and entertainment paid for by either the employer or the employee are nondeductible. However, an employee is not required to include a reimbursement in income if the expenses are job related and the employee is required to provide an accounting to the employer unless they represent compensation for services.

13. Employee Death Benefits a. Employer payments to the family or friends of deceased employees may be excluded from income depending on whether the employer’s intention was to provide payment for past services or a gift.

14. Dependent Care a. Nondiscriminatory dependent care provided by the employer is excluded up to $5,000 annually ($2,500 for married filing separately). i.

EXAMPLE: Taxpayer is a nurse. The hospital where she is employed provides free child care for the taxpayer’s four children.

The value of this child care is $6,000. Taxpayer must include $1,000 ($6,000 - allowable dependent care exclusion of $5,000) in gross income.

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15. Adoption Expenses a. An employee is allowed a $15,950 per-child exclusion for qualified adoption expenses paid by an employer. The exclusion is not limited to expenses incurred for a child with special needs. A phase-out is provided for taxpayers at high AGI levels. (An alternative adoption credit is discussed in Chapter I:14.)

16. Educational Assistance a. An exclusion of up to $5,250 is available for employer-paid qualified educational cost reimbursements (undergraduate and graduate).

17. Cafeteria Plans a. Employers may provide qualifying cafeteria plans through which employees can select from cash or nontaxable fringe benefits, without destroying the exclusion for the non-cash benefits. i.

EXAMPLE: Taxpayer’s employer provides a qualifying cafeteria plan under which the taxpayer may choose cash or health and accident insurance premiums. To the extent the taxpayer selects the nontaxable fringe benefit (H & A insurance), nothing is included in the taxpayer’s gross income. To the extent the taxpayer selects cash, that amount is included in gross income.

b. Cafeteria plans have two basic designs. Supplemental wage plans involve additional compensation in the form of fringe benefits. Wage reduction plans allow employees to reduce wages to pay for fringe benefits. c. Wage reduction medical reimbursement plans are a common form of cafeteria plan. Problems can arise for employees in accurately determining medical expenses a year in advance. Employers may encounter problems with differences in timing between benefit payments and collections from employees.

18. Advantage of Fringe Benefits (Example I:4-26; Problem I:4-43) a. Nontaxable fringe benefits are preferable to additional cash compensation when the cash would be used to buy the same benefit anyway. The tax on the cash compensation is saved by the taxpayer.

19. Foreign Earned Income Exclusion (Example I:4-28; Question I:4-22) a. U.S. citizens can exclude $120,000 of foreign-earned income in lieu of taking the foreign tax credit on this income.

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b. If the foreign tax rate is higher than the U.S. tax rate on the same earned income, the foreign tax credit will be preferable. If the U.S. tax rate is higher than the foreign tax rate, the foreign earned income exclusion will be preferable. c. Both spouses may take the exclusion on a joint return, assuming that both spouses have sufficient foreign earned income. d. Taxpayers changing from the exclusion method to the credit method may not elect the exclusion method again for five years without IRS approval. e. The exclusion must be prorated if the taxpayer is not a resident of one or more foreign countries for the entire tax year or 330 days during twelve consecutive months. f. Deductions directly attributable to excluded foreign income are disallowed. g. An additional exclusion is available for housing costs that exceed 16% of the foreign earned income exclusion limitation.

20. Income from the Discharge of a Debt (Examples I:4-30, I:4-32, I:4-33, I:4-34; Problem I:4-52; Instructor Aid I:4-2) a. The general rule is that income is recognized on a discharge of indebtedness. b. Exceptions exist when: i.

The discharge is a gift.

ii.

The discharge is a bequest (forgiven through a will).

iii.

The discharge occurs in bankruptcy.

iv.

The discharge occurs when the taxpayer is insolvent to the extent the forgiveness does not make the taxpayer solvent.

v.

The discharge of a student loan occurs for certain approved posteducation employment.

vi.

The discharge of a student loan on account of the student’s death.

vii.

Home mortgage forgiveness.

c. When debt forgiveness is not recognized as income in a bankruptcy or insolvency situation, the taxpayer must reduce tax attributes (NOL, general business tax credits, capital loss carryovers, basis of the taxpayer’s property, foreign tax credit carryover) in an amount equivalent to the forgiven debt.

21. Exclusion for Gain from Small Business Stock (Example I:4-35; Problem I:4-55).

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a. 100% of the gain on the disposition of certain qualified small business stock may be excluded by noncorporate taxpayers. i.

The stock must have been acquired after September 27, 2010 and be held more than five years.

ii.

A qualified small business for this purpose is a C corporation with not more than $50 million of gross assets, with 80% of the value of its assets used in the active conduct of a trade or business. Corporations in the following industries are excluded from eligibility: professional services, financial services, hospitality, and mining/oil/gas production.

b. The amount of excluded gain per-issuer in a taxable year is limited to the greater of: i.

$10,000,000 less prior year exclusions, or

ii.

10 times the aggregate adjusted bases of the stock disposed of by the taxpayer, computed on a FMV basis.

c. For qualifying stock purchased from February 18, 2009 through September 27, 2010, the exclusion is 75% of the gain. d. For qualifying stock purchased from August 10, 1993 through February 17, 2009, the exclusion is 50% of the gain.

III.

Tax Planning Considerations 1. Employee Fringe Benefits (Examples I:4-37, I:4-38) a. Employers must carefully evaluate both taxable and nontaxable employee fringe benefits from the employee perspective, as the employer is generally able to deduct both as forms of compensation. b. Providing a cafeteria plan may provide the best alternative so that employees can select the benefits that they desire, rather than the employer making that decision.

2. Self-Help and Use of Personally Owned Property a. The tax law encourages the ownership of personal residences over the rental of the same property. Deductions for carrying costs (interest and taxes) are available for purchased residences while rent on personal residences is not deductible.

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IV.

Compliance and Procedural Considerations 1. Withholding and W-2 reporting for fringe benefits vary with the type of benefit.

Penalties are provided for employers who fail to withhold or report properly.

2.

Nontaxable fringe benefits are not reported by the employer on the W-2 or by the employee on his/her tax return.

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Court Case Briefs Ray S. Robinson v. CIR, 44 T.C. 20 (1965).

Ray S. Robinson, better known as “Sugar Ray” Robinson, reported income on his federal income tax return from the Robinson-Basilio world middleweight championship fight of 1957. Robinson had signed a deferred payment contract for his share of the proceeds from the event and was a cash basis taxpayer. He reported only $139,600, the amount that he actually received in 1957. The IRS contended that he should have included his entire share of the proceeds from the fight which amounted to $483,666.

The IRS argued that the doctrine of constructive receipt required the inclusion of the entire amount in his 1957 income. The court rejected this argument because Robinson was a cash basis taxpayer and had signed a deferred payment contract. The court ruled that only the amounts actually received should be included in his 1957 return and that the remaining sums could be deferred until payment.

The remaining proceeds were to be included in the years that Robinson received them.

Wendell Olk v. U.S., 38 AFTR 2d 76-5219, 76-2 USTC & 9484 (9th Cir., 1976).

A Las Vegas craps dealer excluded money received as “tokes” from his federal income tax return.

The dealer in a craps game does not provide any special services for the players, and the players are under no obligation to make such payments. Are “tokes” received by craps dealers in Las Vegas taxable income or gifts?

The Ninth Circuit, reversing the district court’s decision, held that “tokes” were not gifts and, therefore, are includable in income. Even though “tokes” may be motivated by “impulsive generosity or superstition on the part of the players,” they are not gifts as the taxpayer argued. The court considered that “tokes” were not “acts of detached or disinterested generosity,” but rather were “involved and intensely interested” acts. The court compared “tokes” to tips as being a receipt in rendering services in the course of the performance of the dealer’s services, and consequently income.

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Instructor Aid I:4-1 Taxability of Life Insurance Proceeds

*An exclusion would be available for accelerated death benefits paid to a terminally ill person or periodic payments paid to a chronically ill person.

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Instructor Aid I:4-2 Recognition of Income from the Discharge of Indebtedness

*Certain student loans receive nontaxable forgiveness treatment for approved post-education employment or following student’s death.

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Chapter I:4 Gross Income: Exclusions Learning Objectives After studying this chapter, the student should be able to: 1. Determine whether an item is income.

2. Determine which major statutory exclusions are available to a taxpayer.

3. Describe tax planning considerations for exclusions of gross income.

4. Describe compliance and procedural considerations for exclusions of gross income.

Areas of Greater Significance The area of employee fringe benefits (including employer-paid insurance, meals and lodging, cafeteria plans, etc.) is important because most employee taxpayers are affected.

In addition, any employer offering such employee benefits will be interested in the tax consequences to the employee.

Areas of Lesser Significance In the interest of time, the instructor may determine that the following area is best covered by student reading, rather than class discussion: 1. Introduction and Overview

Problem Areas for Students The following areas may prove especially difficult for students: 1. The difference between a gift and an award or prize.

2. To what extent, if any, income from the discharge of indebtedness is recognized (dependent on status of taxpayer - bankrupt, insolvent, solvent, or deceased) and the effect of such unrecognized income on tax attributes (net operating loss, etc.).

Highlights of Recent Tax Law Changes The following items of tax law have changed since the 2023 edition of this chapter: I:IO4-1 Copyright © 2024 Pearson Education, Inc.

1. The minimum daily exclusion for periodic payments made to a chronically ill person has increased to $420 ($390 in 2022).

2. The annual per donee gift tax exclusion has increased to $17,000 ($16,000 in 2022).

3. The per month exclusion for employer-financed transportation and parking has increased to $300 ($280 in 2022).

4. The per-child exclusion for employer-paid adoption expenses increased to $15,950 ($14,890 in 2022) with the phase-out beginning at $239,230 of modified adjusted gross income ($223,410 in 2022).

5. The maximum annual contribution to a flexible spending account has increased to $3,050 ($2,850 in 2022). The maximum rollover amount has increased to $610 ($570 in 2022).

6. The foreign earned income exclusion increased to $120,000 ($112,000 in 2022).

Teaching Tips 1. Continue using an overall view of gross income utilizing both Chapters I:3 and Chapter I:4.

2. Many of the rules in this chapter will directly affect the students during their lives.

Try to build enthusiasm for tax by applying these topics to the students (i.e., Would you rather receive property by gift or inheritance? How many of you have scholarships - What are the tax consequences? How could the employee benefits provided by potential employers affect your job selection decision?).

Lecture Outline I.

Items that are Not Income 1. Unrealized Income a. EXAMPLE: If the value of certain stock held by the taxpayer appreciates from $10,000 at the beginning of the tax year to $25,000 at the end of the tax year, that $15,000 unrealized income is not subject to tax.

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2. Self-Help Income (Problem I:4-33) a. EXAMPLE: If a taxpayer repairs his own car, instead of paying a mechanic, the amount saved is not subject to tax.

3. Rental Value of Personal-Use Property a. EXAMPLE: The rental value of a personal residence occupied by the taxpayer is not subject to tax, even though the taxpayer could have rented the house.

4. Selling Price of Property a. EXAMPLE: Only the gain (i.e., selling price less the costs of sale and tax adjusted basis) in a taxpayer disposition of property is subject to tax, rather than the entire sales proceeds.

II.

Major Statutory Exclusions 1. Reasons for Statutory Exclusions a. Social policy i.

EXAMPLE: Exclusion of payments for sickness and injury

b. Economic Incentive i.

EXAMPLE: Exclusion of certain scholarships (to encourage education)

2. Gift and Inheritances (Example I:4-3; Question I:4-6) a. Transfers of property with donative intent, whether made during life (gift) or at the death of the transferor (inheritance), are excluded from gross income. Income earned from such property is subject to the regular income tax rules. i.

EXAMPLE: Mother gives daughter bonds having a value of $100,000. The value of the gift ($100,000) is excludable from the daughter’s gross income. Any taxable interest earned by the daughter subsequent to the transfer is included in the daughter’s gross income.

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3. Life Insurance Proceeds (Examples I:4-6 through I:4-10; Problem I:4-37; Instructor Aid I:4-1) a. Life insurance proceeds paid by reason of the death of the insured are generally nontaxable. Any amounts received in excess of the face amount are taxable as interest. i.

EXAMPLE: Father dies. Son is the named beneficiary in an insurance policy on the life of Father in the amount of $1,000,000.

Son receives the $1,000,000 proceeds free of income tax. If instead of receiving the proceeds in a lump sum, assume that Son receives $120,000 a year for ten years. The excess of the $1,200,000 received over the $1,000,000 face amount ($200,000) will be taxable as interest on a straight-line basis over the 10-year period.

b. If the life insurance policy is purchased from another individual, the owner treats the proceeds as a gain from investment (i.e., the excess of the proceeds over the acquisition cost plus premiums paid is taxable gain). Certain policy acquisitions related to partnerships and closely-held corporations are excluded from this rule. c. If a life insurance policy matures or is surrendered, the excess of proceeds over the premiums paid is generally taxable to the recipient. However, an exclusion is available for accelerated death benefits paid to a terminally ill person or periodic payments paid to a chronically ill person. d. Dividends earned on life insurance policies are nontaxable to the extent they are equal to or less than the premiums paid. Interest paid on dividends left with the insurance company is taxable.

4. Awards for Meritorious Achievement (Question I:4-8) a. Awards are generally taxable. Awards for religious, charitable, scientific, educational, artistic, literary, or civic achievement are excluded from income if the taxpayer did not enter the contest or proceeding, is not required to perform substantial future services, and designates a qualified charitable organization or governmental unit to receive the payment. i.

EXAMPLE: If the taxpayer receives the Nobel Prize in recognition of her discovery of the cure for cancer, the award will be included in her gross income unless properly assigned to a qualifying nonprofit organization.

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5. Scholarships and Fellowships (Example I:4-11; Problem I:4-40) a. Scholarships (for tuition, fees, books, supplies, and equipment only) are excluded for degree candidates. i.

EXAMPLE: The taxpayer receives a “full-ride” scholarship to play football at a large university. The amount of the scholarship allocable to tuition, fees, books, supplies, and equipment will be excludable from the taxpayer’s gross income. Any additional amounts received (e.g., for room and board) will be included in gross income.

6. Distributions from Qualified Tuition Programs (Example I:4-12) a. Distributions made from qualified tuition programs are taxable only to the extent they exceed qualified education expenses, including room and board if the student is at least half-time. b. Education costs may be associated with higher education, as well as public, private, and religious elementary and secondary schools.

7. Payments for Injury and Sickness (Examples I:4-13 through I:4-15) a. Amounts received as compensation for injury and sickness are excluded, whether paid by insurance or otherwise. The exclusion only applies to personal physical injuries or physical sickness. Most damages on nonphysical injuries are taxable. Punitive damages are taxable per statute. i.

EXAMPLE: Taxpayer receives $10,000 from his health insurance company to reimburse costs of a recent hospital stay. This $10,000 amount is not subject to tax.

b. Payments under a disability income policy are nontaxable if the policy was purchased by the taxpayer, but are fully taxable if the policy is purchased by the taxpayer’s employer. c. Any reimbursed medical expenses cannot be deducted as an itemized deduction.

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8. Employer-Paid Insurance (Examples I:4-18, I:4-19; Topic Review I:4-1, Table I:41) a. Employer-paid premiums on health, accident, disability, and qualifying group term insurance are excluded from the employee’s income. i.

EXAMPLE: Taxpayer’s employer pays the entire premium for health and accident insurance on the taxpayer and her family ($1,500 per month). The entire annual cost to the employer ($18,000) is excluded from the taxpayer’s gross income.

b. The benefits from nondiscriminatory self-insured accident and health plans are also excluded from the employee’s income. c. Most employee life insurance premiums paid by the employer are taxable to the employee. An exception exists for group-term life insurance coverage not exceeding $50,000 per employee. Premiums for coverage exceeding $50,000 will be taxable to the employee. Different calculations may exist for key and non-key employees if the plan is discriminatory.

9. Section 132 Fringe Benefits (Topic Review I:4-2) a. The following benefits may be excluded from an employee’s gross income: i.

No-additional-cost benefits (e.g., standby flight benefits for airline employees).

ii.

Qualified employee discounts (e.g., 20% discount on legal services for law firm’s receptionist).

iii.

Working condition benefits (e.g., free snacks at place of employment).

iv.

De minimis benefits (e.g., free holiday turkey).

v.

Qualified transportation fringes (parking, public transportation, and/or commuter vehicle exclusion up to $300 per month).

vi.

Recreation and athletic facilities (e.g., free use of the employer swimming pool).

b. Employers may not deduct expenses associated with employee transportation, parking, recreational facilities, and de minimis benefits.

Employers may deduct one half of the net cost of operating employee eating facilities.

10. Employee Awards (Example I:4-20)

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a. Certain employee achievement awards and qualified plan awards are excluded from an employee’s gross income. i.

EXAMPLE: Taxpayer receives a watch (value $350) from his employer as recognition of 10 years of service. The value of the watch is excluded from gross income.

11. Meals and Lodging (Example I:4-21) a. Also excluded from an employee’s gross income are employer-provided meals and lodging, if they are provided on the employer’s premises for the convenience of the employer. An additional condition for excludable lodging is that the employee is required to accept the lodging as a condition of employment. i.

EXAMPLE: Taxpayer is the day restaurant manager. She is required by her employer to stay on the restaurant premises during the hours of 8:00 a.m. through 5:00 p.m. to handle all management responsibilities. The employer provides the taxpayer her noon meal for each working day. The value of these provided meals is excluded from the taxpayer’s gross income.

b. Employers may deduct one half of the cost of these meals.

12. Meals and Entertainment (Examples I:4-24, I:4-25) a. The value of employee meals and entertainment paid for by either the employer or the employee are nondeductible. However, an employee is not required to include a reimbursement in income if the expenses are job related and the employee is required to provide an accounting to the employer unless they represent compensation for services.

13. Employee Death Benefits a. Employer payments to the family or friends of deceased employees may be excluded from income depending on whether the employer’s intention was to provide payment for past services or a gift.

14. Dependent Care a. Nondiscriminatory dependent care provided by the employer is excluded up to $5,000 annually ($2,500 for married filing separately). i.

EXAMPLE: Taxpayer is a nurse. The hospital where she is employed provides free child care for the taxpayer’s four children.

The value of this child care is $6,000. Taxpayer must include $1,000 ($6,000 - allowable dependent care exclusion of $5,000) in gross income.

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15. Adoption Expenses a. An employee is allowed a $15,950 per-child exclusion for qualified adoption expenses paid by an employer. The exclusion is not limited to expenses incurred for a child with special needs. A phase-out is provided for taxpayers at high AGI levels. (An alternative adoption credit is discussed in Chapter I:14.)

16. Educational Assistance a. An exclusion of up to $5,250 is available for employer-paid qualified educational cost reimbursements (undergraduate and graduate).

17. Cafeteria Plans a. Employers may provide qualifying cafeteria plans through which employees can select from cash or nontaxable fringe benefits, without destroying the exclusion for the non-cash benefits. i.

EXAMPLE: Taxpayer’s employer provides a qualifying cafeteria plan under which the taxpayer may choose cash or health and accident insurance premiums. To the extent the taxpayer selects the nontaxable fringe benefit (H & A insurance), nothing is included in the taxpayer’s gross income. To the extent the taxpayer selects cash, that amount is included in gross income.

b. Cafeteria plans have two basic designs. Supplemental wage plans involve additional compensation in the form of fringe benefits. Wage reduction plans allow employees to reduce wages to pay for fringe benefits. c. Wage reduction medical reimbursement plans are a common form of cafeteria plan. Problems can arise for employees in accurately determining medical expenses a year in advance. Employers may encounter problems with differences in timing between benefit payments and collections from employees.

18. Advantage of Fringe Benefits (Example I:4-26; Problem I:4-43) a. Nontaxable fringe benefits are preferable to additional cash compensation when the cash would be used to buy the same benefit anyway. The tax on the cash compensation is saved by the taxpayer.

19. Foreign Earned Income Exclusion (Example I:4-28; Question I:4-22) a. U.S. citizens can exclude $120,000 of foreign-earned income in lieu of taking the foreign tax credit on this income.

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b. If the foreign tax rate is higher than the U.S. tax rate on the same earned income, the foreign tax credit will be preferable. If the U.S. tax rate is higher than the foreign tax rate, the foreign earned income exclusion will be preferable. c. Both spouses may take the exclusion on a joint return, assuming that both spouses have sufficient foreign earned income. d. Taxpayers changing from the exclusion method to the credit method may not elect the exclusion method again for five years without IRS approval. e. The exclusion must be prorated if the taxpayer is not a resident of one or more foreign countries for the entire tax year or 330 days during twelve consecutive months. f. Deductions directly attributable to excluded foreign income are disallowed. g. An additional exclusion is available for housing costs that exceed 16% of the foreign earned income exclusion limitation.

20. Income from the Discharge of a Debt (Examples I:4-30, I:4-32, I:4-33, I:4-34; Problem I:4-52; Instructor Aid I:4-2) a. The general rule is that income is recognized on a discharge of indebtedness. b. Exceptions exist when: i.

The discharge is a gift.

ii.

The discharge is a bequest (forgiven through a will).

iii.

The discharge occurs in bankruptcy.

iv.

The discharge occurs when the taxpayer is insolvent to the extent the forgiveness does not make the taxpayer solvent.

v.

The discharge of a student loan occurs for certain approved posteducation employment.

vi.

The discharge of a student loan on account of the student’s death.

vii.

Home mortgage forgiveness.

c. When debt forgiveness is not recognized as income in a bankruptcy or insolvency situation, the taxpayer must reduce tax attributes (NOL, general business tax credits, capital loss carryovers, basis of the taxpayer’s property, foreign tax credit carryover) in an amount equivalent to the forgiven debt.

21. Exclusion for Gain from Small Business Stock (Example I:4-35; Problem I:4-55).

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a. 100% of the gain on the disposition of certain qualified small business stock may be excluded by noncorporate taxpayers. i.

The stock must have been acquired after September 27, 2010 and be held more than five years.

ii.

A qualified small business for this purpose is a C corporation with not more than $50 million of gross assets, with 80% of the value of its assets used in the active conduct of a trade or business. Corporations in the following industries are excluded from eligibility: professional services, financial services, hospitality, and mining/oil/gas production.

b. The amount of excluded gain per-issuer in a taxable year is limited to the greater of: i.

$10,000,000 less prior year exclusions, or

ii.

10 times the aggregate adjusted bases of the stock disposed of by the taxpayer, computed on a FMV basis.

c. For qualifying stock purchased from February 18, 2009 through September 27, 2010, the exclusion is 75% of the gain. d. For qualifying stock purchased from August 10, 1993 through February 17, 2009, the exclusion is 50% of the gain.

III.

Tax Planning Considerations 1. Employee Fringe Benefits (Examples I:4-37, I:4-38) a. Employers must carefully evaluate both taxable and nontaxable employee fringe benefits from the employee perspective, as the employer is generally able to deduct both as forms of compensation. b. Providing a cafeteria plan may provide the best alternative so that employees can select the benefits that they desire, rather than the employer making that decision.

2. Self-Help and Use of Personally Owned Property a. The tax law encourages the ownership of personal residences over the rental of the same property. Deductions for carrying costs (interest and taxes) are available for purchased residences while rent on personal residences is not deductible.

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IV.

Compliance and Procedural Considerations 1. Withholding and W-2 reporting for fringe benefits vary with the type of benefit.

Penalties are provided for employers who fail to withhold or report properly.

2.

Nontaxable fringe benefits are not reported by the employer on the W-2 or by the employee on his/her tax return.

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Court Case Briefs Ray S. Robinson v. CIR, 44 T.C. 20 (1965).

Ray S. Robinson, better known as “Sugar Ray” Robinson, reported income on his federal income tax return from the Robinson-Basilio world middleweight championship fight of 1957. Robinson had signed a deferred payment contract for his share of the proceeds from the event and was a cash basis taxpayer. He reported only $139,600, the amount that he actually received in 1957. The IRS contended that he should have included his entire share of the proceeds from the fight which amounted to $483,666.

The IRS argued that the doctrine of constructive receipt required the inclusion of the entire amount in his 1957 income. The court rejected this argument because Robinson was a cash basis taxpayer and had signed a deferred payment contract. The court ruled that only the amounts actually received should be included in his 1957 return and that the remaining sums could be deferred until payment.

The remaining proceeds were to be included in the years that Robinson received them.

Wendell Olk v. U.S., 38 AFTR 2d 76-5219, 76-2 USTC & 9484 (9th Cir., 1976).

A Las Vegas craps dealer excluded money received as “tokes” from his federal income tax return.

The dealer in a craps game does not provide any special services for the players, and the players are under no obligation to make such payments. Are “tokes” received by craps dealers in Las Vegas taxable income or gifts?

The Ninth Circuit, reversing the district court’s decision, held that “tokes” were not gifts and, therefore, are includable in income. Even though “tokes” may be motivated by “impulsive generosity or superstition on the part of the players,” they are not gifts as the taxpayer argued. The court considered that “tokes” were not “acts of detached or disinterested generosity,” but rather were “involved and intensely interested” acts. The court compared “tokes” to tips as being a receipt in rendering services in the course of the performance of the dealer’s services, and consequently income.

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Instructor Aid I:4-1 Taxability of Life Insurance Proceeds

*An exclusion would be available for accelerated death benefits paid to a terminally ill person or periodic payments paid to a chronically ill person.

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Instructor Aid I:4-2 Recognition of Income from the Discharge of Indebtedness

*Certain student loans receive nontaxable forgiveness treatment for approved post-education employment or following student’s death.

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Chapter I:5 Property Transactions: Capital Gains and Losses Learning Objectives After studying this chapter, the student should be able to: 1. Determine the realized gain or loss from the sale or other disposition of property.

2. Determine the basis of property.

3. Distinguish between capital assets and other assets.

4. Understand how capital gains are taxed for noncorporate taxpayers.

5. Understand how capital gains are taxed for corporate taxpayers.

6. Recognize when a sale or exchange has occurred.

7. Determine the holding period for an asset when a sale or disposition occurs.

8. Describe tax planning opportunities for property transactions.

9. Describe compliance and procedural matters for property transactions.

Areas of Greater Significance A solid knowledge of the adjusted basis computation and the concept of realized vs. recognized gain or loss is necessary for further tax study by the student. In addition to the applications in the study of individual taxation, many of the special rules for corporations and partnerships deal with the concepts of gain or loss recognition and adjusted basis.

Areas of Lesser Significance In the interest of time, the instructor may determine that the following areas are best covered by student reading, rather than class discussion: 1. Tax Treatment of Capital Gains and Losses - Corporate Taxpayers 2. Compliance and Procedural Considerations

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Problem Areas for Students The following areas may prove especially difficult for students: 1. Differentiating between realized gain or loss and recognized gain or loss.

2. Determining the basis of gift property, especially when the property has a different basis if sold for a gain, than if sold for a loss.

3. Understanding the tax definition of a capital asset, as compared with the financial definition of a capital asset.

Highlights of Recent Tax Law Changes The following items of tax law have changed since the 2023 edition of this chapter: 1. The annual exclusion for gifts has increased to $17,000 ($16,000 in 2022).

2. The unified transfer tax equivalent has increased to $12,092,000 ($12,060,000 in 2022).

3. The deduction amounts for the kiddie tax have increased to $1,250 ($1,150 in 2022) for the statutory deduction and the greater of $1,250 ($1,150 in 2022) and earned income plus $400 ($400 in 2022).

4. The income levels for tax rates for ordinary income, long-term capital gains, dividend income, and the kiddie tax have increased. (See Quick Reference.)

Teaching Tips 1. The concepts in this chapter are key to several later chapters in this text and to the study of partnership and corporation taxation. Adjusted basis, realized gain or loss, and recognized gain or loss must be mastered by the students at this point in their tax study careers. Emphasize this urgency to the students and provide sufficient time in and/or out of class to answer student questions.

2. A significant rate preference for gain on sale or exchange of long-term capital assets motivates knowing the capital asset rules. Spend time on how these special rules should affect transaction planning.

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Lecture Outline I.

Determination of Gain or Loss 1. Realized Gain or Loss (Examples I:5-2 through I:5-5, I:5-8) a. If a realizing event occurs (normally a sale or exchange), the amount realized less the asset’s adjusted basis will equal realized gain or loss. b. Amount realized consists of money and FMV of property received plus taxpayer’s debt assumed by the buyer less costs of sale (i.e., commissions). c. Adjusted basis equals original basis (i.e., cost, gift, inheritance) plus additions (i.e., capital improvements) less reductions (i.e., depreciation, cost recovery, depletion, casualty loss, severance damages). d. EXAMPLE: The taxpayer sells a piece of land for $200,000. Costs of sale are $10,000. The land cost the taxpayer $150,000 two years ago. Realized gain equals the amount realized of $190,000 ($200,000 sale price less $10,000 costs of sale) less the adjusted basis of $150,000 (cost) or $40,000.

2. Recognized Gain or Loss (Example I:5-9) a. The amount of recognized gain or loss on disposition of an asset may be less than the realized gain or loss due to special nonrecognition or deferral of recognition statutory provisions (e.g., like-kind exchanges and involuntary conversions).

II.

Basis Considerations (Topic Review I:5-1) 1. Cost of Acquired Property (Examples I:5-10, I:5-11, I:5-14, I:5-15; Question I:52) a. The most frequently applicable original basis is a cost basis. Cost basis includes cash, FMV of other property, debt, and transactional costs incurred in the acquisition. b. Uniform capitalization rules are mandated for certain kinds of inventory and certain other property. c. Construction period interest and taxes must be capitalized for certain “long useful life” property. d. With homogeneous property (e.g., blocks of identical common stock), specific identification of sold property may not be possible. In this case, the tax law requires a FIFO approach.

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e. Owners of mutual funds may use an average cost method in addition to FIFO and specific identification.

2. Property Received as a Gift (Examples I:5-16 through I:5-18; Problem I:5-36; Instructor Aid I:5-1) a. The donee’s adjusted basis for gain is the donor’s adjusted basis plus a gift tax adjustment for the gift tax paid related to the gift property’s appreciation to the date of gift. b. The donee’s adjusted basis for loss is the lesser of the gain basis or the FMV at the date of gift. c. The gain basis is used for calculating any depreciation/cost recovery. The amount of depreciation / cost recovery allowed or allowable is subtracted from the applicable gain basis or loss basis in the event of a disposition.

3. Property Received from a Decedent (Examples I:5-20, I:5-24 through I:5-26) a. Basis of inherited property is generally fair market value at date of death or alternate valuation date. The alternate valuation date is six months after the date of death. If property owned by the decedent at the time of death is not held by the estate six months later, such property is valued at its disposition date for alternate valuation purposes. The alternate valuation can be elected by the executor only if its use lowers the value of the estate and lowers the estate tax liability. b. Both halves of community property receive a step-up in basis at the death of one of the spouses. c. Certain items (income in respect of a decedent) for which the decedent did not recognize income during her life because of accounting method or special deferral rules will not receive a step-up in basis at the date of death. i.

EXAMPLE: If a taxpayer reports a sale under the installment method at the time of death, the person inheriting the installment notes would be taxed on the unrecognized gain in the transaction on the same basis as the decedent taxpayer would have been taxed.

4. Property Converted from Personal Use to Business Use (Examples I:5-27 through I:5-29) a. Basis of personal use property converted to business use property is the lower of the personal use adjusted basis or the property’s fair market value at conversion.

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i.

EXAMPLE: If a taxpayer converts a personal residence (cost $325,000) into rental property at the time when the residence’s fair market value is $400,000, depreciation / cost recovery must be calculated on the lesser amount - $325,000.

5. Allocation of Basis (Examples I:5-31, I:5-33 through I:5-35, I:5-37; Question I:57) a. If multiple assets are acquired for a single purchase price (i.e., basket purchase), the acquisition cost must be allocated to the individual assets on the basis of their relative FMV. b. If identical shares are received as a nontaxable stock dividend (e.g., common on common) the old adjusted basis is allocated equally to all shares. c. If different shares (e.g., preferred on common) or rights are received in a nontaxable transaction, the old adjusted basis is allocated based on the relative fair market of each different type of asset. d. Allocation of basis to a nontaxable stock right received is mandatory if the right has a fair market value of at least 15% of the FMV of the underlying stock. Allocation of basis to other nontaxable stock rights is elective.

III.

Definition of a Capital Asset (Examples I:5-38, I:5-39; Question I:5-11) 1. Capital assets for tax purposes are defined as assets other than inventory, depreciable property, or real property used in a trade or business, certain accounts or notes receivable, certain taxpayer produced works, patents, certain government publications, and hedging transactions. a. EXAMPLE: A taxpayer’s personal residence is a capital asset.

2. Influence of the Courts a. Corn Products Refining Co. and Arkansas Best Corporation are two important Supreme Court cases defining capital asset treatment in trade or business situations. (See page I:5-14.)

3. Other IRC Provisions Relevant to Capital Gains and Losses (Examples I:5-40, I:5-42, I:5-45) a. Dealers normally treat securities as inventory, which generates ordinary income. Security dealers must use the mark-to-market inventory method [yearly appreciation taxed] for tax years ending December 31, 1993, or later.

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i.

EXCEPTION: On acquisition, dealers may elect to treat certain securities as held for investment, thereby generating capital gain or loss on disposition.

b. Certain noncorporate, nondealer taxpayers can subdivide land and sell a limited number of lots while retaining capital gain treatment. c. Nonbusiness bad debts are treated as short-term capital losses.

IV.

Tax Treatment for Capital Gains and Losses of Noncorporate Taxpayers (Topic Review I:5-2) 1. Capital Gains (Examples I:5-46 through I:5-51) a. Net capital gain results when net long-term capital gains exceed net shortterm capital losses. i.

EXAMPLE: If the taxpayer has a $10,000 long-term capital gain on the sale of stock and a $5,000 short-term capital loss from the sale of land, the net long-term capital gain is $5,000.

b. For capital assets held more than one year, the applicable rate on net longterm capital gain is 0%, 15%, or 20%, depending on the taxpayer’s filing status and taxable income. (See Table I:5-1.) Long-term gains from collectibles are generally taxed at 28%.

2. Adjusted Net Capital Gains (Example I:5-56) a. Long-term capital gains fall into four different buckets: i.

Collectibles gain (taxed at 28%)

ii.

Section 1202 qualified small business stock gain (taxed at 28%)

iii.

Uncaptured Section 1250 gain (taxed at 25%)

iv.

All other long-term capital gains (taxed at 0%, 15%, or 20%)

3. Capital Losses (Examples I:5-57, I:5-58, I:5-60, I:5-61) a. Net short-term capital losses are offset against net long-term capital gains in this order: (1) 28% group, (2) 25% group, and (3) 15%/20% group. b. Net capital losses (whether short-term or long-term) offset ordinary income to a $3,000 maximum, with an unlimited carryover to future years.

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i.

EXAMPLE: If the taxpayer has an $8,000 net capital loss (whether short-term or long-term), he may offset $3,000 of ordinary income in the current tax year and carry over $5,000 of net capital loss indefinitely until utilized.

4. The 3.8% Net Investment Income Tax (Examples I:5-64; I:5:65) a. The 3.8% rate is applied to the lesser of net investment income or excess over a stated threshold varying with filing status.

V.

Sale or Exchange (Example I:5-67) Generally, a capital gain or loss results from the sale or exchange of a capital asset.

1. Worthless Securities (Example I:5-68) a. Securities that become totally worthless in a tax year are treated as a capital loss on the last day of the tax year. i.

EXAMPLE: If a security becomes worthless on February 1st, a calendar-year taxpayer treats the loss as a capital loss occurring on December 31st.

2. Retirement of Debt Instruments (Examples I:5-70, I:5-73, I:5-75; Table I:5-2) a. Amounts received on retirement of debt are treated as being received in an exchange, with original issue discount and market discount impacting the final calculation of income or loss. b. Sale or exchange of market discount bonds purchased after April 30, 1993, may result in additional ordinary income rather than capital gain.

3. Options (Examples I:5-76, I:5-77, I:5-79) a. Options that are exercised are added to the cost basis. Options that are sold or lapse give rise to sale or exchange treatment.

4. Patents a. The TCJA adds patents to the list of self-created intangible assets which are not capital assets.

5. Franchises, Trademarks, and Trade Names (Example I:5-84) a. Certain franchises, trademarks, and trade names may generate capital gain or loss on sale or exchange.

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6. Lease Cancellation Payments (Example I:5-85) a. Lease cancellation payments received by the lessor are treated as ordinary income, while lease cancellation payments received by the lessee are generally treated as capital gain.

VI.

Holding Period (Example I:5-87) The holding period for long-term treatment is more than one year.

1. Property Received as a Gift (Examples I:5-88, I:5-89) a. If the donee’s adjusted basis is determined by reference to the donor’s adjusted basis, the donor’s holding period is added to the donee’s holding period. b. If the donee’s adjusted basis is the fair market value at date of gift, the holding period begins at the date of gift.

2. Property Received from a Decedent (Example I:5-90) a. Inherited property always receives a long-term holding period. i.

EXAMPLE: The decedent buys stock on May 1. The decedent dies on May 2. The taxpayer inherits the stock on May 3 and sells the stock on May 4. Even though only a few days are involved, the gain or loss on sale is treated as long-term.

3. Nontaxable Exchanges a. The holding period of the property given up in a tax-free exchange is added to the holding period of the property received in the exchange. i.

EXAMPLE: The taxpayer acquires an apartment building in 2000.

On December 30, 2022, she exchanges the apartment building for a shopping center, qualifying under the like-kind exchange rules. The holding period of the shopping center is long-term even if it is sold on January 3, 2023.

4. Receipt of Nontaxable Stock Dividends and Stock Rights (Examples I:5-91, I:592) a. The holding period of nontaxable stock dividends and stock rights generally includes the holding period of the underlying stock.

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i.

EXAMPLE: The taxpayer acquires common stock in 2010. The taxpayer receives stock rights in a nontaxable distribution in 2022.

The holding period of the rights is long-term.

5. Justification for Preferential Treatment of Net Capital Gains (Example I:5-93) a. Factors supporting preferential treatment for net capital gains are mobility of capital and the mitigation of the effects of inflation and progressive tax rates. b. While net capital gains may receive a maximum 17% (37%-20%) rate preference for high-income taxpayers, additional special treatment for net capital gains is a continuing topic of discussion.

VII.

Tax Planning Considerations 1. Selection of Property to Transfer by Gift (Examples I:5-95, I:5-98) a. The decision to make lifetime gifts may be influenced by available annual exclusions, a desire to reduce future estate tax, and/or a desire to shift the income tax burden. b. It is usually unwise to gift depreciated property (FMV less than adjusted basis) because the donee may be forced to take the lower FMV basis.

2. Selection of Property to Transfer at Time of Death (Example I:5-101) a. Generally, highly appreciated property should be retained until death and loss property should be sold before death. i.

EXAMPLE: A taxpayer holding property with an adjusted basis of $500,000 and a fair market value of $300,000 would want to sell the property before death to recognize the $200,000 loss. If this property was held until death, the person inheriting would receive a $300,000 adjusted basis, and the benefit of the $200,000 loss would be lost.

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Court Case Briefs Steven D. Strickland and Doris K. Strickland v. CIR, 67 TCM 1927 (1994).

The Stricklands reported the sale of a tractor/trailer rig used in Mr. Strickland’s business on Schedule D. A loss of $7,291 was calculated as the difference between the sales proceeds of $45,709 and the rig’s cost of $53,000. On audit, the revenue agent determined that the taxpayers had claimed a Sec. 179 expense deduction of $5,000 and depreciation deductions of approximately $12,000. The agent calculated the rig’s adjusted basis at 36,172 with a resulting gain (not loss) of $9,537. The Strickland’s defense was that Schedule D did not have a column for depreciation taken, and therefore they had just used the wrong form. The court pointed out that the correct form was 4797. The court disallowed the loss computed by the taxpayers and sustained the additional tax on the gain computed by the government.

Launce Gamble v. CIR, 68 T.C. 800 (1977).

Launce Gamble was engaged in the business of racing thoroughbred horses. In 1969, he purchased for $60,000 a broodmare, Champagne Woman, who was carrying a foal sired by Raise a Native.

Both the mare and the stud had excellent pedigrees and impressive racing records. The mare gave birth to a colt which was handled as if expected to be trained and raced. However, as the colt reached the age approaching the time for training, Mr. Gamble sold her for $125,000. In reporting the sale of the colt on his federal income tax return, Mr. Gamble deducted $30,000 as a cost basis for a long-term capital gain. The IRS determined that the sale resulted in ordinary income and assumed a cost basis of zero.

The court found that the taxpayer was primarily in the business of racing thoroughbred horses and that the colt had not been held primarily for sale. The evidence indicated that the owner intended to exploit the colt, but that the possibility of selling the colt did not dominate the possibility of training and racing the colt. The horse was considered “property used in the trade or business” and as such was held to be Sec. 1231 property eligible for capital gain treatment. The cost basis of the colt was determined as $20,000. This was ruled to be a reasonable allocation of the cost of its mother, Champagne Woman, based on the benefit payable from Live Foal Insurance Coverage.

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Instructor Aid I:5-1 Calculation of Donee’s Basis for Gift Property

Basis for Gain* = Donor’s Adjusted Basis + Gift Tax Adjustment Gift Tax Adjustment Gift Tax Paid × =

(FMV of Gift - Donor’s Adjusted Basis) Taxable Gift [FMV of Gift - Annual Exclusion]

Basis for Loss = Lower of Basis for Gain or FMV on the Date of Gift

*Gain basis may be used for depreciation/cost recovery calculation purposes.

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Instructor Aid I:5-2 Allocation of Basis for Nontaxable Stock Dividend

Identical Stock Issued: Per Share Adjusted Basis of All Shares* =

Adjusted Basis of Stock Before Stock Dividend Number of Shares Owned After Stock Dividend

Different Shares Issued: Basis of Old Shares* = Adjusted Basis of Stock Before Dividend ×

FMV of Old Shares FMV of Old Shares + New Shares

Basis of New Shares* = Adjusted Basis of Stock Before Dividend ×

FMV of New Shares FMV of Old Shares + New Shares

*Holding Period of all shares = Holding Period of Pre-distribution shares

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Chapter I:5 Property Transactions: Capital Gains and Losses Learning Objectives After studying this chapter, the student should be able to: 1. Determine the realized gain or loss from the sale or other disposition of property.

2. Determine the basis of property.

3. Distinguish between capital assets and other assets.

4. Understand how capital gains are taxed for noncorporate taxpayers.

5. Understand how capital gains are taxed for corporate taxpayers.

6. Recognize when a sale or exchange has occurred.

7. Determine the holding period for an asset when a sale or disposition occurs.

8. Describe tax planning opportunities for property transactions.

9. Describe compliance and procedural matters for property transactions.

Areas of Greater Significance A solid knowledge of the adjusted basis computation and the concept of realized vs. recognized gain or loss is necessary for further tax study by the student. In addition to the applications in the study of individual taxation, many of the special rules for corporations and partnerships deal with the concepts of gain or loss recognition and adjusted basis.

Areas of Lesser Significance In the interest of time, the instructor may determine that the following areas are best covered by student reading, rather than class discussion: 1. Tax Treatment of Capital Gains and Losses - Corporate Taxpayers 2. Compliance and Procedural Considerations

I:IO5-1 Copyright © 2024 Pearson Education, Inc.

Problem Areas for Students The following areas may prove especially difficult for students: 1. Differentiating between realized gain or loss and recognized gain or loss.

2. Determining the basis of gift property, especially when the property has a different basis if sold for a gain, than if sold for a loss.

3. Understanding the tax definition of a capital asset, as compared with the financial definition of a capital asset.

Highlights of Recent Tax Law Changes The following items of tax law have changed since the 2023 edition of this chapter: 1. The annual exclusion for gifts has increased to $17,000 ($16,000 in 2022).

2. The unified transfer tax equivalent has increased to $12,092,000 ($12,060,000 in 2022).

3. The deduction amounts for the kiddie tax have increased to $1,250 ($1,150 in 2022) for the statutory deduction and the greater of $1,250 ($1,150 in 2022) and earned income plus $400 ($400 in 2022).

4. The income levels for tax rates for ordinary income, long-term capital gains, dividend income, and the kiddie tax have increased. (See Quick Reference.)

Teaching Tips 1. The concepts in this chapter are key to several later chapters in this text and to the study of partnership and corporation taxation. Adjusted basis, realized gain or loss, and recognized gain or loss must be mastered by the students at this point in their tax study careers. Emphasize this urgency to the students and provide sufficient time in and/or out of class to answer student questions.

2. A significant rate preference for gain on sale or exchange of long-term capital assets motivates knowing the capital asset rules. Spend time on how these special rules should affect transaction planning.

I:IO5-2 Copyright © 2024 Pearson Education, Inc.

Lecture Outline I.

Determination of Gain or Loss 1. Realized Gain or Loss (Examples I:5-2 through I:5-5, I:5-8) a. If a realizing event occurs (normally a sale or exchange), the amount realized less the asset’s adjusted basis will equal realized gain or loss. b. Amount realized consists of money and FMV of property received plus taxpayer’s debt assumed by the buyer less costs of sale (i.e., commissions). c. Adjusted basis equals original basis (i.e., cost, gift, inheritance) plus additions (i.e., capital improvements) less reductions (i.e., depreciation, cost recovery, depletion, casualty loss, severance damages). d. EXAMPLE: The taxpayer sells a piece of land for $200,000. Costs of sale are $10,000. The land cost the taxpayer $150,000 two years ago. Realized gain equals the amount realized of $190,000 ($200,000 sale price less $10,000 costs of sale) less the adjusted basis of $150,000 (cost) or $40,000.

2. Recognized Gain or Loss (Example I:5-9) a. The amount of recognized gain or loss on disposition of an asset may be less than the realized gain or loss due to special nonrecognition or deferral of recognition statutory provisions (e.g., like-kind exchanges and involuntary conversions).

II.

Basis Considerations (Topic Review I:5-1) 1. Cost of Acquired Property (Examples I:5-10, I:5-11, I:5-14, I:5-15; Question I:52) a. The most frequently applicable original basis is a cost basis. Cost basis includes cash, FMV of other property, debt, and transactional costs incurred in the acquisition. b. Uniform capitalization rules are mandated for certain kinds of inventory and certain other property. c. Construction period interest and taxes must be capitalized for certain “long useful life” property. d. With homogeneous property (e.g., blocks of identical common stock), specific identification of sold property may not be possible. In this case, the tax law requires a FIFO approach.

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e. Owners of mutual funds may use an average cost method in addition to FIFO and specific identification.

2. Property Received as a Gift (Examples I:5-16 through I:5-18; Problem I:5-36; Instructor Aid I:5-1) a. The donee’s adjusted basis for gain is the donor’s adjusted basis plus a gift tax adjustment for the gift tax paid related to the gift property’s appreciation to the date of gift. b. The donee’s adjusted basis for loss is the lesser of the gain basis or the FMV at the date of gift. c. The gain basis is used for calculating any depreciation/cost recovery. The amount of depreciation / cost recovery allowed or allowable is subtracted from the applicable gain basis or loss basis in the event of a disposition.

3. Property Received from a Decedent (Examples I:5-20, I:5-24 through I:5-26) a. Basis of inherited property is generally fair market value at date of death or alternate valuation date. The alternate valuation date is six months after the date of death. If property owned by the decedent at the time of death is not held by the estate six months later, such property is valued at its disposition date for alternate valuation purposes. The alternate valuation can be elected by the executor only if its use lowers the value of the estate and lowers the estate tax liability. b. Both halves of community property receive a step-up in basis at the death of one of the spouses. c. Certain items (income in respect of a decedent) for which the decedent did not recognize income during her life because of accounting method or special deferral rules will not receive a step-up in basis at the date of death. i.

EXAMPLE: If a taxpayer reports a sale under the installment method at the time of death, the person inheriting the installment notes would be taxed on the unrecognized gain in the transaction on the same basis as the decedent taxpayer would have been taxed.

4. Property Converted from Personal Use to Business Use (Examples I:5-27 through I:5-29) a. Basis of personal use property converted to business use property is the lower of the personal use adjusted basis or the property’s fair market value at conversion.

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i.

EXAMPLE: If a taxpayer converts a personal residence (cost $325,000) into rental property at the time when the residence’s fair market value is $400,000, depreciation / cost recovery must be calculated on the lesser amount - $325,000.

5. Allocation of Basis (Examples I:5-31, I:5-33 through I:5-35, I:5-37; Question I:57) a. If multiple assets are acquired for a single purchase price (i.e., basket purchase), the acquisition cost must be allocated to the individual assets on the basis of their relative FMV. b. If identical shares are received as a nontaxable stock dividend (e.g., common on common) the old adjusted basis is allocated equally to all shares. c. If different shares (e.g., preferred on common) or rights are received in a nontaxable transaction, the old adjusted basis is allocated based on the relative fair market of each different type of asset. d. Allocation of basis to a nontaxable stock right received is mandatory if the right has a fair market value of at least 15% of the FMV of the underlying stock. Allocation of basis to other nontaxable stock rights is elective.

III.

Definition of a Capital Asset (Examples I:5-38, I:5-39; Question I:5-11) 1. Capital assets for tax purposes are defined as assets other than inventory, depreciable property, or real property used in a trade or business, certain accounts or notes receivable, certain taxpayer produced works, patents, certain government publications, and hedging transactions. a. EXAMPLE: A taxpayer’s personal residence is a capital asset.

2. Influence of the Courts a. Corn Products Refining Co. and Arkansas Best Corporation are two important Supreme Court cases defining capital asset treatment in trade or business situations. (See page I:5-14.)

3. Other IRC Provisions Relevant to Capital Gains and Losses (Examples I:5-40, I:5-42, I:5-45) a. Dealers normally treat securities as inventory, which generates ordinary income. Security dealers must use the mark-to-market inventory method [yearly appreciation taxed] for tax years ending December 31, 1993, or later.

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i.

EXCEPTION: On acquisition, dealers may elect to treat certain securities as held for investment, thereby generating capital gain or loss on disposition.

b. Certain noncorporate, nondealer taxpayers can subdivide land and sell a limited number of lots while retaining capital gain treatment. c. Nonbusiness bad debts are treated as short-term capital losses.

IV.

Tax Treatment for Capital Gains and Losses of Noncorporate Taxpayers (Topic Review I:5-2) 1. Capital Gains (Examples I:5-46 through I:5-51) a. Net capital gain results when net long-term capital gains exceed net shortterm capital losses. i.

EXAMPLE: If the taxpayer has a $10,000 long-term capital gain on the sale of stock and a $5,000 short-term capital loss from the sale of land, the net long-term capital gain is $5,000.

b. For capital assets held more than one year, the applicable rate on net longterm capital gain is 0%, 15%, or 20%, depending on the taxpayer’s filing status and taxable income. (See Table I:5-1.) Long-term gains from collectibles are generally taxed at 28%.

2. Adjusted Net Capital Gains (Example I:5-56) a. Long-term capital gains fall into four different buckets: i.

Collectibles gain (taxed at 28%)

ii.

Section 1202 qualified small business stock gain (taxed at 28%)

iii.

Uncaptured Section 1250 gain (taxed at 25%)

iv.

All other long-term capital gains (taxed at 0%, 15%, or 20%)

3. Capital Losses (Examples I:5-57, I:5-58, I:5-60, I:5-61) a. Net short-term capital losses are offset against net long-term capital gains in this order: (1) 28% group, (2) 25% group, and (3) 15%/20% group. b. Net capital losses (whether short-term or long-term) offset ordinary income to a $3,000 maximum, with an unlimited carryover to future years.

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i.

EXAMPLE: If the taxpayer has an $8,000 net capital loss (whether short-term or long-term), he may offset $3,000 of ordinary income in the current tax year and carry over $5,000 of net capital loss indefinitely until utilized.

4. The 3.8% Net Investment Income Tax (Examples I:5-64; I:5:65) a. The 3.8% rate is applied to the lesser of net investment income or excess over a stated threshold varying with filing status.

V.

Sale or Exchange (Example I:5-67) Generally, a capital gain or loss results from the sale or exchange of a capital asset.

1. Worthless Securities (Example I:5-68) a. Securities that become totally worthless in a tax year are treated as a capital loss on the last day of the tax year. i.

EXAMPLE: If a security becomes worthless on February 1st, a calendar-year taxpayer treats the loss as a capital loss occurring on December 31st.

2. Retirement of Debt Instruments (Examples I:5-70, I:5-73, I:5-75; Table I:5-2) a. Amounts received on retirement of debt are treated as being received in an exchange, with original issue discount and market discount impacting the final calculation of income or loss. b. Sale or exchange of market discount bonds purchased after April 30, 1993, may result in additional ordinary income rather than capital gain.

3. Options (Examples I:5-76, I:5-77, I:5-79) a. Options that are exercised are added to the cost basis. Options that are sold or lapse give rise to sale or exchange treatment.

4. Patents a. The TCJA adds patents to the list of self-created intangible assets which are not capital assets.

5. Franchises, Trademarks, and Trade Names (Example I:5-84) a. Certain franchises, trademarks, and trade names may generate capital gain or loss on sale or exchange.

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6. Lease Cancellation Payments (Example I:5-85) a. Lease cancellation payments received by the lessor are treated as ordinary income, while lease cancellation payments received by the lessee are generally treated as capital gain.

VI.

Holding Period (Example I:5-87) The holding period for long-term treatment is more than one year.

1. Property Received as a Gift (Examples I:5-88, I:5-89) a. If the donee’s adjusted basis is determined by reference to the donor’s adjusted basis, the donor’s holding period is added to the donee’s holding period. b. If the donee’s adjusted basis is the fair market value at date of gift, the holding period begins at the date of gift.

2. Property Received from a Decedent (Example I:5-90) a. Inherited property always receives a long-term holding period. i.

EXAMPLE: The decedent buys stock on May 1. The decedent dies on May 2. The taxpayer inherits the stock on May 3 and sells the stock on May 4. Even though only a few days are involved, the gain or loss on sale is treated as long-term.

3. Nontaxable Exchanges a. The holding period of the property given up in a tax-free exchange is added to the holding period of the property received in the exchange. i.

EXAMPLE: The taxpayer acquires an apartment building in 2000.

On December 30, 2022, she exchanges the apartment building for a shopping center, qualifying under the like-kind exchange rules. The holding period of the shopping center is long-term even if it is sold on January 3, 2023.

4. Receipt of Nontaxable Stock Dividends and Stock Rights (Examples I:5-91, I:592) a. The holding period of nontaxable stock dividends and stock rights generally includes the holding period of the underlying stock.

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i.

EXAMPLE: The taxpayer acquires common stock in 2010. The taxpayer receives stock rights in a nontaxable distribution in 2022.

The holding period of the rights is long-term.

5. Justification for Preferential Treatment of Net Capital Gains (Example I:5-93) a. Factors supporting preferential treatment for net capital gains are mobility of capital and the mitigation of the effects of inflation and progressive tax rates. b. While net capital gains may receive a maximum 17% (37%-20%) rate preference for high-income taxpayers, additional special treatment for net capital gains is a continuing topic of discussion.

VII.

Tax Planning Considerations 1. Selection of Property to Transfer by Gift (Examples I:5-95, I:5-98) a. The decision to make lifetime gifts may be influenced by available annual exclusions, a desire to reduce future estate tax, and/or a desire to shift the income tax burden. b. It is usually unwise to gift depreciated property (FMV less than adjusted basis) because the donee may be forced to take the lower FMV basis.

2. Selection of Property to Transfer at Time of Death (Example I:5-101) a. Generally, highly appreciated property should be retained until death and loss property should be sold before death. i.

EXAMPLE: A taxpayer holding property with an adjusted basis of $500,000 and a fair market value of $300,000 would want to sell the property before death to recognize the $200,000 loss. If this property was held until death, the person inheriting would receive a $300,000 adjusted basis, and the benefit of the $200,000 loss would be lost.

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Court Case Briefs Steven D. Strickland and Doris K. Strickland v. CIR, 67 TCM 1927 (1994).

The Stricklands reported the sale of a tractor/trailer rig used in Mr. Strickland’s business on Schedule D. A loss of $7,291 was calculated as the difference between the sales proceeds of $45,709 and the rig’s cost of $53,000. On audit, the revenue agent determined that the taxpayers had claimed a Sec. 179 expense deduction of $5,000 and depreciation deductions of approximately $12,000. The agent calculated the rig’s adjusted basis at 36,172 with a resulting gain (not loss) of $9,537. The Strickland’s defense was that Schedule D did not have a column for depreciation taken, and therefore they had just used the wrong form. The court pointed out that the correct form was 4797. The court disallowed the loss computed by the taxpayers and sustained the additional tax on the gain computed by the government.

Launce Gamble v. CIR, 68 T.C. 800 (1977).

Launce Gamble was engaged in the business of racing thoroughbred horses. In 1969, he purchased for $60,000 a broodmare, Champagne Woman, who was carrying a foal sired by Raise a Native.

Both the mare and the stud had excellent pedigrees and impressive racing records. The mare gave birth to a colt which was handled as if expected to be trained and raced. However, as the colt reached the age approaching the time for training, Mr. Gamble sold her for $125,000. In reporting the sale of the colt on his federal income tax return, Mr. Gamble deducted $30,000 as a cost basis for a long-term capital gain. The IRS determined that the sale resulted in ordinary income and assumed a cost basis of zero.

The court found that the taxpayer was primarily in the business of racing thoroughbred horses and that the colt had not been held primarily for sale. The evidence indicated that the owner intended to exploit the colt, but that the possibility of selling the colt did not dominate the possibility of training and racing the colt. The horse was considered “property used in the trade or business” and as such was held to be Sec. 1231 property eligible for capital gain treatment. The cost basis of the colt was determined as $20,000. This was ruled to be a reasonable allocation of the cost of its mother, Champagne Woman, based on the benefit payable from Live Foal Insurance Coverage.

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Instructor Aid I:5-1 Calculation of Donee’s Basis for Gift Property

Basis for Gain* = Donor’s Adjusted Basis + Gift Tax Adjustment Gift Tax Adjustment Gift Tax Paid × =

(FMV of Gift - Donor’s Adjusted Basis) Taxable Gift [FMV of Gift - Annual Exclusion]

Basis for Loss = Lower of Basis for Gain or FMV on the Date of Gift

*Gain basis may be used for depreciation/cost recovery calculation purposes.

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Instructor Aid I:5-2 Allocation of Basis for Nontaxable Stock Dividend

Identical Stock Issued: Per Share Adjusted Basis of All Shares* =

Adjusted Basis of Stock Before Stock Dividend Number of Shares Owned After Stock Dividend

Different Shares Issued: Basis of Old Shares* = Adjusted Basis of Stock Before Dividend ×

FMV of Old Shares FMV of Old Shares + New Shares

Basis of New Shares* = Adjusted Basis of Stock Before Dividend ×

FMV of New Shares FMV of Old Shares + New Shares

*Holding Period of all shares = Holding Period of Pre-distribution shares

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Chapter I:6 Deductions and Losses Learning Objectives After studying this chapter, the student should be able to: 1. Distinguish between deductions for and from AGI. 2. Discuss the criteria for deducting business and investment expenses.

3. Describe the restrictions for deducting expenses.

4. List the substantiation requirements for deducting travel and entertainment expenses.

5. Explain the timing of deductions under both the cash and accrual methods of accounting.

6. Discuss special disallowance rules for certain deductions.

7. Describe tax planning considerations for deductions and losses.

8. Describe compliance and procedural considerations for deductions and losses.

Areas of Greater Significance Students must understand whether an expense is a deduction for or from adjusted gross income. The adjusted gross income subtotal is used to calculate several different limitations. Also, the relationship between the standard deduction and itemized deductions is affected by whether deductions are taken for or from AGI.

Areas of Lesser Significance In the interest of time, the instructor may determine that the following areas are best covered by student reading, rather than class discussion: 1. Expenses and Losses Must Be Incurred Directly By the Taxpayer 2. Constructive Ownership

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Problem Areas for Students The following areas may prove especially difficult for students: 1. Whether an expense is deductible for or from AGI. 2. When a home office is deductible.

3. Which expenses related to a vacation home are deductible.

Highlights of Recent Tax Law Changes The following item of tax law has changed since the 2023 edition of this chapter: 1. The gross receipts threshold for the deductibility of business interest has increased to $29 million ($27 million in 2022).

Teaching Tips 1. At this point you may wish to stress the proper substantiation requirements. The importance of adequate record-keeping should be emphasized for both the taxpayer and the preparer.

2. This chapter has several topics of special interest. It is important to keep the students’ interest level up by spending time on “fun” topics. Topics that students typically enjoy include expenditures that are contrary to public policy, expenses related to drug activity, hobby activities, vacation homes, and home office deductions.

Lecture Outline I.

Classifying Deductions as For versus From AGI (Question I:6-2; Problem I:6-33) Whether a deduction is for AGI or from AGI (an itemized deduction) is important for utilization reasons and limitation reasons.

1. If a deduction is classified as an itemized deduction, it will have tax benefit only if the total of itemized deductions exceeds the applicable standard deduction.

Examples of itemized deductions are medical deductions, qualified residence interest, certain nonbusiness expenses, taxes, and charitable contributions.

2. If a deduction is deductible for AGI, it reduces AGI, which affects the allowable deduction for medical expenses and charitable contributions. Examples of deductions for AGI are trade or business expenses, reimbursed employee expenses, losses on business or investment property, and IRAs. I:IO6-2 Copyright © 2024 Pearson Education, Inc.

3. EXAMPLE: Reimbursed employee business expenses (under an accountable plan) are deductible for AGI. Reimbursed employee business expenses affect the AGI amount, which in turn affects the limitations on certain itemized deductions (e.g., medical expenses are deductible only to the extent they exceed 7.5% of AGI).

II.

Criteria for Deducting Business and Investment Expenses (Topic Review I:6-1) 1. Business or Investment Activity (Examples I:6-2, I:6-3) a. Expenses are deductible if incurred in a trade or business (IRC Sec. 162, e.g., depreciation on a delivery truck). The activity must have been engaged in for profit. b. Expenses are also deductible if incurred in the production of income, or for the maintenance and conservation of income producing property (IRC Sec. 212, e.g., investment advice expense).

2. Legal and Accounting Fees (Example I:6-4) a. Legal and accounting fees incurred in the regular conduct of a trade or business, for the production of rental or royalty income, or for preparation of certain tax schedules are deductible for AGI. b. Personal legal and accounting fees are not deductible.

3. Ordinary Expense (Examples I:6-5, I:6-6) a. One requirement for deductible business or investment expense is that the expense be ordinary (i.e., reasonable in amount and proximately related to the business or investment activity).

4. Necessary Expense (Example I:6-8) a. A second requirement for deductible business or investment expense is that the expense be necessary (i.e., appropriate and helpful in the income producing activity).

5. Reasonable Expense (Example I:6-9) a. Deductible expenses must be reasonable (e.g., unreasonable compensation is a common dispute in this area between the IRS and taxpayers).

6. Expenses and Losses Incurred Directly by the Taxpayer (Example I:6-10) a. The general rule is that any deduction or loss must be proven to be the taxpayer’s and not any other party’s. b. One exception to the general rule is that a taxpayer may take a deduction for medical expenses of a dependent. (See Chapter I:8.)

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III.

General Restrictions on the Deductibility of Expenses (Topic Review I:6-2) 1. Capitalization versus Expense Deduction (Example I:6-12; Problem I:6-35) a. Expenses that add value, prolong useful life, or adapt property to a new use are generally capitalized. b. The tax incentive is normally to try to characterize expenditures as repairs (generating a current deduction) rather than as a capital addition (expensed over the cost recovery life or utilized on disposition as a reduction of gain). c. Taxpayers may elect to currently deduct a limited amount of capital expenditures for new tangible property used in a trade or business under IRC Sec. 179 and 100% bonus depreciation rules. d. IRC Sec. 266 mandates the capitalization of interest, property taxes, and certain other costs of real property.

2. Expenses Related to Exempt Income (Example I:6-14) a. Expenses allocated or related to tax-exempt income are not deductible. i.

EXAMPLE: If a taxpayer took out a $100,000 loan to purchase taxexempt bonds, the $10,000 annual interest would not be deductible.

3. Expenditures that are Contrary to Public Policy (Example I:6-15; Problem I:6-39) a. Bribes, kickbacks, fines, penalties, and certain legal fees are not deductible. i.

EXAMPLE: A fine paid as a result of a traffic ticket is not deductible, even though the vehicle was being used in a trade or business.

4. Other Expenditures Specifically Disallowed (Example I:6-18; Figure I:6-1) a. Political contributions and lobbying expenses are not deductible. b. Business interest expense is a for AGI deduction up to the limit of business interest income, plus 50% of adjusted taxable income. c. Certain business investigation expenses and business pre-opening or startup costs are not currently deductible, but an election can be made to amortize these expenses over a period not less than 180 months. De minimis and phase-out rules apply.

IV.

Proper Substantiation Requirement (Example I:6-20) 1. The taxpayer has the burden of proving the existence of any deduction by appropriate documentation.

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2. More restrictive substantiation requirements are applicable to travel, business gifts, computers, and transportation vehicles.

V.

When An Expense Is Deductible (Topic Review I:6-3) 1. Cash Method (Examples I:6-21, I:6-22) a. Taxpayers under the cash method are generally allowed to deduct expenses when paid. i.

EXAMPLE: Mailing a check on or before December 31st will generate a charitable contribution deduction for a calendar-year cash method taxpayer.

b. Prepaid expenses which have a useful life substantially beyond the end of the tax year must be amortized over the applicable period. c. Points paid on a principal residence acquisition will be treated as deductible by the IRS if the closing agreement clearly designates the payment as points, the amount is computed as a percentage of the loan, the established business practice in the area includes payment of points, and the loan is secured by the residence.

2. Accrual Method (Examples I:6-25, I:6-26; Table I:6-1) a. Accrual method taxpayers are generally allowed to deduct expenses in the period in which the expenses accrue under the all-events test. i.

EXAMPLE: State income tax expense for the current taxable year could be deducted by an accrual method taxpayer in the current year, even if the payment did not occur until the subsequent year.

b. The all-events test is met when the existence of the liability is established and the amount of the liability is determined with reasonable accuracy.

Economic performance must also have occurred.

VI.

Special Disallowance Rules 1. Wash Sales (Examples I:6-30, I:6-31; Question I:6-21) a. Losses on sales of stock in which the taxpayer acquires substantially identical stock within 30 days before or 30 days after the loss sale are disallowed. i.

EXAMPLE: Taxpayer sells 100 shares of stock on March 1 resulting in a loss of $5,000. Taxpayer buys 100 shares of identical stock on March 15 for $10,000. The $5,000 loss is disallowed.

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b. The amount of any disallowed loss is added to the basis of the new shares. i.

EXAMPLE: The $5,000 loss in the previous example is disallowed, but the basis of the new shares is $15,000 ($10,000 cost + $5,000 disallowed loss).

2. Transactions Between Related Parties (Examples I:6-35, I:6-36; Instructor Aid I:61) a. Losses between related parties as defined in IRC Sec. 267 (e.g., individual and families) are disallowed. While the basis of the loss property is not adjusted for the disallowed loss, future gains on the disposition of the loss property are reduced by the amount of the disallowed loss. i.

EXAMPLE: Mother sells stock to daughter resulting in a loss of $8,000. The loss is disallowed but may be used by the daughter to offset gain in a subsequent disposition of the same stock by the daughter.

b. Unpaid expenses between related parties as defined in IRC Sec. 267 are not deductible until the payee recognizes the income from the transaction.

3. Hobby Activities (Problem I:6-52) a. Expenses on activities not entered into for profit are not deductible. i.

EXAMPLE: Expenses generated from the raising and racing of horses may be non-deductible if a profit from these activities is not shown in two out of seven tax years.

4. Vacation Home (Example I:6-42; Figure I:6-4; Question I:6-27; Problem I:6-54; Instructor Aid I:6-2.) a. Rental deductions for vacation homes may be limited or disallowed based on the relationship of personal days vs. rental days. b. If a personal residence is rented less than 15 days per tax year, all the income is excluded from gross income and only “otherwise deductible” expenses are allowed (e.g., interest and taxes). c. Deductible expenses fall into three tiers and are deducted in order of tier: i.

Tier 1: Expenses that are deductible even though not incurred in a trade or business.

ii.

Tier 2: Other expenses that would be deductible in a trade or business context, but which do not affect the property’s basis.

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iii.

Tier 3: Expenses deductible in a trade or business context which reduce the basis of the property.

5. Expenses of an Office in the Home a. Expenses of a home office are deductible only under stringent requirements. b. The requirement of exclusive and regular usage also restricts the widespread availability of a home office deduction.

VII.

Tax Planning Considerations 1. Hobby Losses a. To the extent possible, taxpayers should control timing of income and deductions in hobby loss situations to maximize the number of profit years. i.

EXAMPLE: If the taxpayer was operating a horse ranch on the cash method, discretionary cash expenses could be delayed at year-end to show a profit for a particular tax year, thereby demonstrating some profitable activity.

2. Unreasonable Compensation a. A payback agreement should be considered in potential unreasonable compensation situations.

3. Timing of Deductions a. The desirability of current deductions vs. capitalizable expenses may be affected by the taxpayer’s net operating loss position.

VIII.

Compliance and Procedural Considerations 1. Proper Classification of Deductions a. Individual trade or business expenses are reported on Schedule C and Schedule 1. These expenses are taken for AGI. b. Expenses related to rents and royalties are reported on Schedule E and Schedule 1. These expenses are also taken for AGI. c. Other for AGI expenses are reported as “Adjustments to Income” on Schedule 1. d. Other expenses are reported on Schedule A. These expenses are deducted from AGI.

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2. Property Substantiation a. Proper substantiation of expenses is necessary due to IRS scrutiny and statutory requirements. b. Travel expenses are especially susceptible to verification due to potential for abuse.

3. Business Versus Hobby a. Form 8829 attached to Schedule C is necessary to claim a home office deduction. b. Form 5213 may be required to extend the statute of limitations period to the hobby activity determination period. c. Since the normal statute of limitations for assessment is three years and the hobby loss test is three years of profit out of five years (or two out of seven years in the case of horses), the taxpayer may be willing to extend the limitation period to be able to prove profit years.

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Court Case Briefs Estate of Nelson A. Rockefeller v. CIR, 56 AFTR 2d 85-5094, 85-1 USTC & 9429 (2nd Cir., 1985).

In 1973, Nelson A. Rockefeller resigned his position as Governor of New York without intention to run for re-election and devoted himself full time to the chairs of two commissions [Commission on Critical Choices for Americans (1973-74) and National Commission on Water Quality (1973-74)].

In 1974, Mr. Rockefeller appeared before the House and Senate in connection with his confirmation hearings for the Vice President of the United States. Mr. Rockefeller incurred expenses of $550,000 in connection with these confirmation hearings. The expenses were primarily for legal and other professional services. On his 1974 federal income tax return, Mr. Rockefeller deducted the entire amount of $550,000 as necessary trade or business expenses under Sec. 162. The IRS disallowed these, the Tax Court supported their denial, and the case was appealed to the Second Circuit.

Sec. 7702(a)(26) says that the “term ‘trade or business’ includes the performance of the functions of a public office.” The Second Circuit, however, held that Mr. Rockefeller’s trade or business at the time that the expenses were incurred were not the performance of the functions of a public office comparable to the Vice Presidency. The court disallowed the deduction as outside Sec 162.

Linda M. Meyers v. CIR, T.C. Summary Opinion 2007-194.

In 2003, Ms. Meyers spent 25 to 35 hours per week managing her own trucking company and 40 hours per week gambling. She began gambling in 1992 after her husband’s death, focusing on $1 slot machines, and considered herself a professional gambler by 2000. On her 2003 tax return, she deducted expenses associated with her gambling activities as business expenses. Although the IRS believed that her gambling was a hobby, Ms. Meyers asserted that she derived no pleasure from gambling, but rather that it was “stressful, tiresome, and time-consuming.” The Tax Court concluded that her gambling constituted as business, in part, because of regularity in engaging in the activity, her expertise in running a business as evidenced by her trucking company, and her frequent wins and occasional big wins sufficient to cover her expenses. As a result, the Court allowed her a section 162 deduction of her gambling expenses.

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Instructor Aid I:6-1 Related Party Losses Losses incurred in transactions between the following related parties are disallowed*: •

Members of a family (brothers, sisters, spouse, ancestors, lineal decedents)

•

Individual and the individual’s more than 50% - owned corporation (whether directly or indirectly owned)

•

Two corporations which are members of the same controlled group

•

A grantor and fiduciary of any trust

•

Fiduciaries of different trusts, if the trusts have the same grantor

•

A fiduciary of one trust and a beneficiary of a different trust, if the trusts have the same grantor

•

A fiduciary and beneficiary of the same trust

•

A fiduciary of a trust and a corporation owned more than 50% (directly or indirectly) by the trust’s grantor

•

A person and certain controlled charitable organizations

•

Partnerships and corporations controlled (more than 50%) by the same persons

*Disallowed losses may reduce gains on any subsequent sale of the same assets. (See Sec. 267.)

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Instructor Aid I:6-2 Vacation Home

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Chapter I:6 Deductions and Losses Learning Objectives After studying this chapter, the student should be able to: 1. Distinguish between deductions for and from AGI. 2. Discuss the criteria for deducting business and investment expenses.

3. Describe the restrictions for deducting expenses.

4. List the substantiation requirements for deducting travel and entertainment expenses.

5. Explain the timing of deductions under both the cash and accrual methods of accounting.

6. Discuss special disallowance rules for certain deductions.

7. Describe tax planning considerations for deductions and losses.

8. Describe compliance and procedural considerations for deductions and losses.

Areas of Greater Significance Students must understand whether an expense is a deduction for or from adjusted gross income. The adjusted gross income subtotal is used to calculate several different limitations. Also, the relationship between the standard deduction and itemized deductions is affected by whether deductions are taken for or from AGI.

Areas of Lesser Significance In the interest of time, the instructor may determine that the following areas are best covered by student reading, rather than class discussion: 1. Expenses and Losses Must Be Incurred Directly By the Taxpayer 2. Constructive Ownership

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Problem Areas for Students The following areas may prove especially difficult for students: 1. Whether an expense is deductible for or from AGI. 2. When a home office is deductible.

3. Which expenses related to a vacation home are deductible.

Highlights of Recent Tax Law Changes The following item of tax law has changed since the 2023 edition of this chapter: 1. The gross receipts threshold for the deductibility of business interest has increased to $29 million ($27 million in 2022).

Teaching Tips 1. At this point you may wish to stress the proper substantiation requirements. The importance of adequate record-keeping should be emphasized for both the taxpayer and the preparer.

2. This chapter has several topics of special interest. It is important to keep the students’ interest level up by spending time on “fun” topics. Topics that students typically enjoy include expenditures that are contrary to public policy, expenses related to drug activity, hobby activities, vacation homes, and home office deductions.

Lecture Outline I.

Classifying Deductions as For versus From AGI (Question I:6-2; Problem I:6-33) Whether a deduction is for AGI or from AGI (an itemized deduction) is important for utilization reasons and limitation reasons.

1. If a deduction is classified as an itemized deduction, it will have tax benefit only if the total of itemized deductions exceeds the applicable standard deduction.

Examples of itemized deductions are medical deductions, qualified residence interest, certain nonbusiness expenses, taxes, and charitable contributions.

2. If a deduction is deductible for AGI, it reduces AGI, which affects the allowable deduction for medical expenses and charitable contributions. Examples of deductions for AGI are trade or business expenses, reimbursed employee expenses, losses on business or investment property, and IRAs. I:IO6-2 Copyright © 2024 Pearson Education, Inc.

3. EXAMPLE: Reimbursed employee business expenses (under an accountable plan) are deductible for AGI. Reimbursed employee business expenses affect the AGI amount, which in turn affects the limitations on certain itemized deductions (e.g., medical expenses are deductible only to the extent they exceed 7.5% of AGI).

II.

Criteria for Deducting Business and Investment Expenses (Topic Review I:6-1) 1. Business or Investment Activity (Examples I:6-2, I:6-3) a. Expenses are deductible if incurred in a trade or business (IRC Sec. 162, e.g., depreciation on a delivery truck). The activity must have been engaged in for profit. b. Expenses are also deductible if incurred in the production of income, or for the maintenance and conservation of income producing property (IRC Sec. 212, e.g., investment advice expense).

2. Legal and Accounting Fees (Example I:6-4) a. Legal and accounting fees incurred in the regular conduct of a trade or business, for the production of rental or royalty income, or for preparation of certain tax schedules are deductible for AGI. b. Personal legal and accounting fees are not deductible.

3. Ordinary Expense (Examples I:6-5, I:6-6) a. One requirement for deductible business or investment expense is that the expense be ordinary (i.e., reasonable in amount and proximately related to the business or investment activity).

4. Necessary Expense (Example I:6-8) a. A second requirement for deductible business or investment expense is that the expense be necessary (i.e., appropriate and helpful in the income producing activity).

5. Reasonable Expense (Example I:6-9) a. Deductible expenses must be reasonable (e.g., unreasonable compensation is a common dispute in this area between the IRS and taxpayers).

6. Expenses and Losses Incurred Directly by the Taxpayer (Example I:6-10) a. The general rule is that any deduction or loss must be proven to be the taxpayer’s and not any other party’s. b. One exception to the general rule is that a taxpayer may take a deduction for medical expenses of a dependent. (See Chapter I:8.)

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III.

General Restrictions on the Deductibility of Expenses (Topic Review I:6-2) 1. Capitalization versus Expense Deduction (Example I:6-12; Problem I:6-35) a. Expenses that add value, prolong useful life, or adapt property to a new use are generally capitalized. b. The tax incentive is normally to try to characterize expenditures as repairs (generating a current deduction) rather than as a capital addition (expensed over the cost recovery life or utilized on disposition as a reduction of gain). c. Taxpayers may elect to currently deduct a limited amount of capital expenditures for new tangible property used in a trade or business under IRC Sec. 179 and 100% bonus depreciation rules. d. IRC Sec. 266 mandates the capitalization of interest, property taxes, and certain other costs of real property.

2. Expenses Related to Exempt Income (Example I:6-14) a. Expenses allocated or related to tax-exempt income are not deductible. i.

EXAMPLE: If a taxpayer took out a $100,000 loan to purchase taxexempt bonds, the $10,000 annual interest would not be deductible.

3. Expenditures that are Contrary to Public Policy (Example I:6-15; Problem I:6-39) a. Bribes, kickbacks, fines, penalties, and certain legal fees are not deductible. i.

EXAMPLE: A fine paid as a result of a traffic ticket is not deductible, even though the vehicle was being used in a trade or business.

4. Other Expenditures Specifically Disallowed (Example I:6-18; Figure I:6-1) a. Political contributions and lobbying expenses are not deductible. b. Business interest expense is a for AGI deduction up to the limit of business interest income, plus 50% of adjusted taxable income. c. Certain business investigation expenses and business pre-opening or startup costs are not currently deductible, but an election can be made to amortize these expenses over a period not less than 180 months. De minimis and phase-out rules apply.

IV.

Proper Substantiation Requirement (Example I:6-20) 1. The taxpayer has the burden of proving the existence of any deduction by appropriate documentation.

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2. More restrictive substantiation requirements are applicable to travel, business gifts, computers, and transportation vehicles.

V.

When An Expense Is Deductible (Topic Review I:6-3) 1. Cash Method (Examples I:6-21, I:6-22) a. Taxpayers under the cash method are generally allowed to deduct expenses when paid. i.

EXAMPLE: Mailing a check on or before December 31st will generate a charitable contribution deduction for a calendar-year cash method taxpayer.

b. Prepaid expenses which have a useful life substantially beyond the end of the tax year must be amortized over the applicable period. c. Points paid on a principal residence acquisition will be treated as deductible by the IRS if the closing agreement clearly designates the payment as points, the amount is computed as a percentage of the loan, the established business practice in the area includes payment of points, and the loan is secured by the residence.

2. Accrual Method (Examples I:6-25, I:6-26; Table I:6-1) a. Accrual method taxpayers are generally allowed to deduct expenses in the period in which the expenses accrue under the all-events test. i.

EXAMPLE: State income tax expense for the current taxable year could be deducted by an accrual method taxpayer in the current year, even if the payment did not occur until the subsequent year.

b. The all-events test is met when the existence of the liability is established and the amount of the liability is determined with reasonable accuracy.

Economic performance must also have occurred.

VI.

Special Disallowance Rules 1. Wash Sales (Examples I:6-30, I:6-31; Question I:6-21) a. Losses on sales of stock in which the taxpayer acquires substantially identical stock within 30 days before or 30 days after the loss sale are disallowed. i.

EXAMPLE: Taxpayer sells 100 shares of stock on March 1 resulting in a loss of $5,000. Taxpayer buys 100 shares of identical stock on March 15 for $10,000. The $5,000 loss is disallowed.

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b. The amount of any disallowed loss is added to the basis of the new shares. i.

EXAMPLE: The $5,000 loss in the previous example is disallowed, but the basis of the new shares is $15,000 ($10,000 cost + $5,000 disallowed loss).

2. Transactions Between Related Parties (Examples I:6-35, I:6-36; Instructor Aid I:61) a. Losses between related parties as defined in IRC Sec. 267 (e.g., individual and families) are disallowed. While the basis of the loss property is not adjusted for the disallowed loss, future gains on the disposition of the loss property are reduced by the amount of the disallowed loss. i.

EXAMPLE: Mother sells stock to daughter resulting in a loss of $8,000. The loss is disallowed but may be used by the daughter to offset gain in a subsequent disposition of the same stock by the daughter.

b. Unpaid expenses between related parties as defined in IRC Sec. 267 are not deductible until the payee recognizes the income from the transaction.

3. Hobby Activities (Problem I:6-52) a. Expenses on activities not entered into for profit are not deductible. i.

EXAMPLE: Expenses generated from the raising and racing of horses may be non-deductible if a profit from these activities is not shown in two out of seven tax years.

4. Vacation Home (Example I:6-42; Figure I:6-4; Question I:6-27; Problem I:6-54; Instructor Aid I:6-2.) a. Rental deductions for vacation homes may be limited or disallowed based on the relationship of personal days vs. rental days. b. If a personal residence is rented less than 15 days per tax year, all the income is excluded from gross income and only “otherwise deductible” expenses are allowed (e.g., interest and taxes). c. Deductible expenses fall into three tiers and are deducted in order of tier: i.

Tier 1: Expenses that are deductible even though not incurred in a trade or business.

ii.

Tier 2: Other expenses that would be deductible in a trade or business context, but which do not affect the property’s basis.

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iii.

Tier 3: Expenses deductible in a trade or business context which reduce the basis of the property.

5. Expenses of an Office in the Home a. Expenses of a home office are deductible only under stringent requirements. b. The requirement of exclusive and regular usage also restricts the widespread availability of a home office deduction.

VII.

Tax Planning Considerations 1. Hobby Losses a. To the extent possible, taxpayers should control timing of income and deductions in hobby loss situations to maximize the number of profit years. i.

EXAMPLE: If the taxpayer was operating a horse ranch on the cash method, discretionary cash expenses could be delayed at year-end to show a profit for a particular tax year, thereby demonstrating some profitable activity.

2. Unreasonable Compensation a. A payback agreement should be considered in potential unreasonable compensation situations.

3. Timing of Deductions a. The desirability of current deductions vs. capitalizable expenses may be affected by the taxpayer’s net operating loss position.

VIII.

Compliance and Procedural Considerations 1. Proper Classification of Deductions a. Individual trade or business expenses are reported on Schedule C and Schedule 1. These expenses are taken for AGI. b. Expenses related to rents and royalties are reported on Schedule E and Schedule 1. These expenses are also taken for AGI. c. Other for AGI expenses are reported as “Adjustments to Income” on Schedule 1. d. Other expenses are reported on Schedule A. These expenses are deducted from AGI.

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2. Property Substantiation a. Proper substantiation of expenses is necessary due to IRS scrutiny and statutory requirements. b. Travel expenses are especially susceptible to verification due to potential for abuse.

3. Business Versus Hobby a. Form 8829 attached to Schedule C is necessary to claim a home office deduction. b. Form 5213 may be required to extend the statute of limitations period to the hobby activity determination period. c. Since the normal statute of limitations for assessment is three years and the hobby loss test is three years of profit out of five years (or two out of seven years in the case of horses), the taxpayer may be willing to extend the limitation period to be able to prove profit years.

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Court Case Briefs Estate of Nelson A. Rockefeller v. CIR, 56 AFTR 2d 85-5094, 85-1 USTC & 9429 (2nd Cir., 1985).

In 1973, Nelson A. Rockefeller resigned his position as Governor of New York without intention to run for re-election and devoted himself full time to the chairs of two commissions [Commission on Critical Choices for Americans (1973-74) and National Commission on Water Quality (1973-74)].

In 1974, Mr. Rockefeller appeared before the House and Senate in connection with his confirmation hearings for the Vice President of the United States. Mr. Rockefeller incurred expenses of $550,000 in connection with these confirmation hearings. The expenses were primarily for legal and other professional services. On his 1974 federal income tax return, Mr. Rockefeller deducted the entire amount of $550,000 as necessary trade or business expenses under Sec. 162. The IRS disallowed these, the Tax Court supported their denial, and the case was appealed to the Second Circuit.

Sec. 7702(a)(26) says that the “term ‘trade or business’ includes the performance of the functions of a public office.” The Second Circuit, however, held that Mr. Rockefeller’s trade or business at the time that the expenses were incurred were not the performance of the functions of a public office comparable to the Vice Presidency. The court disallowed the deduction as outside Sec 162.

Linda M. Meyers v. CIR, T.C. Summary Opinion 2007-194.

In 2003, Ms. Meyers spent 25 to 35 hours per week managing her own trucking company and 40 hours per week gambling. She began gambling in 1992 after her husband’s death, focusing on $1 slot machines, and considered herself a professional gambler by 2000. On her 2003 tax return, she deducted expenses associated with her gambling activities as business expenses. Although the IRS believed that her gambling was a hobby, Ms. Meyers asserted that she derived no pleasure from gambling, but rather that it was “stressful, tiresome, and time-consuming.” The Tax Court concluded that her gambling constituted as business, in part, because of regularity in engaging in the activity, her expertise in running a business as evidenced by her trucking company, and her frequent wins and occasional big wins sufficient to cover her expenses. As a result, the Court allowed her a section 162 deduction of her gambling expenses.

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Instructor Aid I:6-1 Related Party Losses Losses incurred in transactions between the following related parties are disallowed*: •

Members of a family (brothers, sisters, spouse, ancestors, lineal decedents)

•

Individual and the individual’s more than 50% - owned corporation (whether directly or indirectly owned)

•

Two corporations which are members of the same controlled group

•

A grantor and fiduciary of any trust

•

Fiduciaries of different trusts, if the trusts have the same grantor

•

A fiduciary of one trust and a beneficiary of a different trust, if the trusts have the same grantor

•

A fiduciary and beneficiary of the same trust

•

A fiduciary of a trust and a corporation owned more than 50% (directly or indirectly) by the trust’s grantor

•

A person and certain controlled charitable organizations

•

Partnerships and corporations controlled (more than 50%) by the same persons

*Disallowed losses may reduce gains on any subsequent sale of the same assets. (See Sec. 267.)

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Instructor Aid I:6-2 Vacation Home

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Chapter I:7 Business Expenses and Deferred Compensation Learning Objectives After studying this chapter, the student should be able to: 1. Understand the deductibility of business and rental estate activities.

2. Distinguish the classifications of employees and independent contractors.

3. Determine the proper deductible amount for travel expenses.

4. Understand the deductibility of transportation expenses.

5. Understand the deductibility of business meals and the 50% disallowance rule.

6. Identify deductible moving expenses.

7. Describe the requirements for deducting education expenses.

8. Determine whether the expenses of an office in home meet the requirements for deductibility and apply the gross income limitations.

9. Discuss the tax treatment and requirements for various deferred compensation arrangements.

10. Describe tax planning considerations for business expenses and deferred compensation.

11. Describe compliance and procedural considerations for business and deferred compensation expenses.

Areas of Greater Significance The areas of travel, transportation, and deferred compensation will affect the vast majority of self-employed individuals and employers. Students should understand the rules and planning opportunities in these areas.

Areas of Lesser Significance In the interest of time, the instructor may determine that the following areas are best covered by student reading, rather than class discussion: I:IO7-1 Copyright © 2024 Pearson Education, Inc.

1. Per Diem Allowances for Meals and Lodging 2. Qualification Requirements for a Qualified Plan 3. Nonqualified Plans 4. Plans for Self-employed Individuals 5. Tax Planning Considerations

Problem Areas for Students The following areas may prove especially difficult for students: 1. The rules regarding deductibility of foreign travel.

2. Whether an educational expense qualifies for a deduction.

3. Tax consequences of incentive stock options and nonqualified options.

Highlights of Recent Tax Law Changes The following items of tax law have changed since the 2023 edition of this chapter: 1. The ceiling amount for paying the full amount of payroll taxes has increased to $160,200 ($147,000 in 2022).

2. The standard mileage rate has increased to $.655 ($.585 in 2022).

3. The basis reduction for changing from standard mileage method to actual expense method has increased to $.28 ($.26 in 2022).

4. Per diem allowance rates have decreased. (See footnote 18.)

5. The maximum annual employee contribution to 401(k) plans has increased to $22,500 ($20,500 in 2022).

6. The compensation threshold for the highly compensated employees test has increased to $150,000 ($135,000 in 2022).

7. The limit for employer contributions to defined contribution plans, and contributions to H.R. 10 plans, SEP IRAs, and solo 401(k) plans has increased to $66,000 ($61,000 in 2022).

8. The maximum defined benefit plan annual benefit has increased to $265,000 ($245,000 in 2022).

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9. The income ceiling for H.R. 10 plans and SEP IRAs has increased to $330,000 ($305,000 in 2022).

10. The limit for SIMPLE plan contributions has increased to $15,500 ($14,000 in 2022).

11. Maximum age, AGI limits, and phase-outs for deductibility of IRA contributions and phase-out floor and ceiling for Roth IRA contributions have increased. (See Topic Review I:7-4.)

12. The limit on annual contributions to HSAs has increased to $3,850 ($3,650 in 2022) or $7,750 ($7,300 in 2022) for married filing jointly. The maximum out-of-pocket expenses threshold for an HDHP plan has also increased to $7,500 for individual coverage ($7,050 in 2022) and $15,000 for family coverage ($14,100 in 2022).

Teaching Tips 1. You may wish to give only a broad overview of deferred compensation in a first course in taxation, as the concepts are very complex. However, a full discussion of IRAs is appropriate due to the frequent occurrence of this topic in the real world.

Lecture Outline NOTE: Part 1 of this chapter deals with expenses classified as for AGI deductions. These deductions are reported on Schedule 1 of Form 1040 under two broad categories: (1) expenses connected with a trade or business (Schedule C), expenses connected with rental real estate or royalties (Schedule E), or expenses connected with farm income (Schedule F); and (2) additional “adjustments to income” (Schedule 1). (See Figure I:7-2.)

I.

Business and Rental Real Estate Deductions 1. Self-Employed Individual Versus Employee (Examples I:7-1, I:7-2) a. Significant tax consequences flow from the characterization of a taxpayer as an employee vs. self-employed (independent contractor). b. Self-employed business expenses are deductible for AGI. c. Employee business expenses are not deductible. d. A self-employed individual is responsible for self-employment tax which is much higher than an employee’s share of Social Security tax. e. A taxpayer is considered an employee if the employer has the right to direct and control both the end result and the way the result is accomplished.

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II.

Travel Expenses 1. Deductibility of Travel Expenses (Table I:7-1) a. The deductibility of travel expenses is dependent on the nature of the expenditure. b. Travel expenses for self-employed individuals are deducted for AGI. c. Employee travel expenses are not deductible. Reimbursements are excluded by the employee if paid under an accountable plan. d. Prior to 2018, unreimbursed employee travel expenses were deducted as a miscellaneous itemized deduction. e. In most tax years, meals associated with travel are only 50% deductible.

2. Definition of Travel Expenses (Examples I:7-4, I:7-5) a. Travel includes transportation, meals, lodging, and other reasonable and necessary expenses related to a trade or business incurred while away from the taxpayer’s tax home. b. The deductible amount of travel expenses may be reduced if actual expenses are lavish or extravagant.

3. General Qualification Requirements (Examples I:7-6, I:7-7) a. The purpose of the trip must be connected with a trade or business or rental real estate activity. b. The taxpayers must be away from his tax home temporarily, but long enough to require sleep or rest before returning home. c. A person’s tax home is the location of his principal place of business.

4. Business Versus Pleasure (Examples I:7-9, I:7-10) a. Travel expenses on combination business/personal trips will be only partially deductible. b. If a domestic trip is primarily business, travel expenses to and from the business destination are deductible even though there is some personal time during the trip. Expenses for personal days will not be deductible. c. No deduction is allowed for the travel expenses of a companion (e.g., spouse) unless the companion works in the business and the travel is business-related and otherwise deductible.

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5. Foreign Travel a. Even more stringent allocation rules apply to the deductibility of travel expenses on foreign business/personal trips. b. Deductions for foreign conventions are only allowed for “directly related” activities for which the taxpayer can prove that a meeting held outside North America is reasonable.

6. Additional Limitations on Travel Expenses (Examples I:7-11, I:7-12; Question I:77) a. Additional limitations on deduction for travel expenses exist for educational travel, certain conventions and seminars, luxury water travel, and charitable travel.

III.

Transportation Expenses 1. Definition and Classification (Examples I:7-15 through I:7-17) a. Transportation expenses are those incurred for local transportation. b. Commuting costs are generally nondeductible personal expenses. c. Commuting costs between multiple places of business are deductible.

2. Treatment of Automobile Expenses (Examples I:7-20, I:7-21; Problem I:7-46) a. Actual business automobile expenses can be deducted, or a standard mileage rate (65.5 cents per mile) can be elected. b. For newer cars the deduction for actual expenses will generally exceed the standard mileage deduction. This advantage may be offset by the hassle of required recordkeeping. c. If a taxpayer changes from the standard mileage rate method to the actual expense method, the basis of the automobile must be reduced by 28 cents per mile.

IV.

Meals and Entertainment Expenses Entertainment expenses of any type are not deductible. In most tax years, 50% of business meals are deductible, but any portion of meals that are considered entertainment are not deductible.

1. Business Meals and Beverages (Examples I:7-22, I:7-24) a. Notice 2018-76 provides current requirements for a taxpayer to deduct 50% of a business meal expense: I:IO7-5 Copyright © 2024 Pearson Education, Inc.

i.

The expense is an ordinary and necessary expense incurred in carrying on a trade or business.

ii.

The expense is not lavish or extravagant under the circumstances.

iii.

The taxpayer, or an employee of the taxpayer, is present in the furnishing of the food or beverages.

iv.

The food and beverages are provided to a current or potential business customer, client, consultant, or similar business contact.

v.

If food and beverages are provided during or at an entertainment activity, a deduction is only allowed if the food and beverages are either paid for separately or are stated separately from the cost of the entertainment.

b. These rules do not apply for meals that qualify as travel expenses.

2. Business Gifts (Example I:7-26) a. Generally, deductible business gifts are limited to $25 per donee.

V.

Moving Expenses For years 2018 through 2025, moving expenses are only deductible for members of the Armed Forces of the United States on active duty who move pursuant to a military order and incident to a permanent change of station.

VI.

Education Expenses (Table I:7-2; Question I:7-18; Problem I:7-50; Instructor Aid I:7-1) 1. Classification of Education Expenses a. Education expenses may be nondeductible, offset against employer reimbursements, or be deductible for AGI, all dependent on facts and circumstances. b. Nondeductible personal education expenses may be eligible for certain tax credits. (See Chapter I:14.)

2. General Requirements for a Deduction (Examples I:7-26 through I:7-29) a. Educational expenses are generally deductible if they maintain or improve skills used in employment trade or business or meet legal requirements for retention of rank or compensation rate. b. However, if the education is required to meet current minimum educational requirements of the taxpayer’s trade or business or qualifies the taxpayer for a new trade or business, the educational expenses are disallowed.

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VII.

Office in Home Expenses (Instructor Aid I:7-2) 1. General Requirement for a Deduction (Example I:7-31) a. The minimum requirements for a home office deduction include exclusive use on a regular basis as a principal place of business, or as a place for meeting with patients, clients, or customers. Self-employed individuals may deduct these expenses for AGI. 2. Deduction and Limitations (Example I:7-33) a. Home office deductions are limited by the gross income of the subject business activity. Unused expenses are carried forward subject to the same income limitations. b. A safe harbor provision allows taxpayers to deduct $5 per square foot of qualified use up to a maximum deduction of $1,500.

NOTE: Part 2 discusses deferred compensation arrangements including qualified pension and profit sharing plans, nonqualified deferred compensation arrangements, and selfemployed retirement plans and individual retirement accounts (IRAs).

VIII.

Deferred Compensation 1. Qualified Pension and Profit-Sharing Plans (Example I:7-33; Topic Review I:7-1) a. Qualified retirement plans, such as pension plans, profit-sharing plans, and stock bonus plans, provide immediate tax deductions for employers while deferring taxes for employees.

2. Tax Treatment to Employees and Employers (Example I:7-36) a. Generally, employer contributions to a qualified plan are immediately deductible, and such amounts (plus accumulated income) are not taxable to the employee until received. b. Defined contribution plan contributions are limited to no more than $66,000. c. Defined benefits plan annual benefits to an employee are limited to no more than $265,000.

3. Employee Stock Options (Example I:7-42; Topic Review I:7-3) a. Incentive stock option (ISO) and nonqualified stock option (NQO) plans are used by corporate employers to attract and retain key employees. b. Employees have no tax consequences on the grant or exercise date for ISOs, and the employer receives no compensation deduction as long as the I:IO7-7 Copyright © 2024 Pearson Education, Inc.

employee does not dispose of the stock within two years of the option’s grant date or with one year of the option’s exercise date.

4. Traditional IRA (Examples I:7-47, I:7-48; Topic Review I:7-4; Question I:7-33; Problem I:7-55) a. Fully deductible IRA contributions (lesser of $6,500 or earned income) are available only to two groups of taxpayers: i.

Taxpayers who are not active participants in a qualified employer retirement plan; and

ii.

Taxpayers who are active participants, but their AGI is $73,000 or less for single taxpayers or $116,000 or less for married taxpayers filing jointly.

b. Partial deductions are available to active participants with AGIs less than $83,000 for single taxpayers or $136,000 for married taxpayers filing jointly. The deduction is phased out ratably over the $10,000 AGI range for single taxpayers and over the $20,000 AGI range for married taxpayers filing jointly. i.

EXAMPLE: A single active participant with $80,000 AGI could make a $4,550 deductible contribution.

c. Nondeductible IRA contributions can be made by any taxpayer to the extent disqualified from making a deductible contribution. i.

EXAMPLE: A single active participant with $85,000 AGI could make a $6,500 nondeductible contribution to a traditional IRA.

d. A nonworking spouse may contribute up to $6,500 as a deductible (or nondeductible) contribution to an IRA under the same rules as the working spouse. e. Individuals can make contributions to a traditional IRA until the age of 73.

5. Roth IRA (Examples I:7-73, I:7-75) a. In a Roth IRA, no contribution is deductible, but all distributions (including earnings) are nontaxable. b. The maximum contribution to a Roth IRA is the same as the maximum deductible contribution to a traditional IRA. The ability to contribute is phased out over certain AGI levels: between $138,000 and $153,000 for single taxpayers and between $218,000 and $228,000 for married taxpayers filing jointly.

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c. No more than $6,500 can be contributed in total to a traditional IRA and/or a Roth IRA. d. To achieve full nontaxability on a Roth IRA, there is a five-year holding period requirement. e. Pre-existing traditional IRAs can be rolled over into a Roth IRA. The tax on accrued income must be paid on rollover, but no penalty tax is extracted.

6. Coverdell Education Savings Account (Examples I:7-54, I:7-55) a. The CESA is available to cover qualified education expenses (including elementary, secondary, and higher education). The maximum contribution is $2,000 per year per beneficiary under age 18. b. CESAs can be set up in addition to any traditional or Roth IRAs. c. No deduction is available for a CESA, but all qualified distributions are nontaxable. d. The right to contribute to a CESA is phased-out using the same AGI levels as used for the Roth IRA. e. Beneficiaries cannot claim an exclusion from a CESA for the same expenses used in any year to calculate the HOPE scholarship credit or Lifetime Learning Credit.

7. Health Savings Accounts (Example I:7-57) a. HSAs are available to certain individuals with high-deductible health plans to accumulate funds on a tax-free basis to pay qualified medical expenses.

IX.

Tax Planning Considerations 1. Providing Nontaxable Compensation to Employees a. Nontaxable fringe benefits and tax-deferred compensation plans are valuable to employees while providing current deductions to the employer.

2. Rollovers to Roth IRA a. The advisability of rolling over funds from a traditional IRA to a Roth IRA is based on the following factors: (1) AGI level, (2) anticipated marginal tax rate at retirement, (3) taxpayer’s age, and (4) availability of funds to pay tax.

X.

Compliance and Procedural Considerations 1. Substantiating Travel and Business Meal Expenses I:IO7-9 Copyright © 2024 Pearson Education, Inc.

a. Travel expenses may be disallowed if the taxpayer does not maintain adequate records.

2. Reporting Office in Home Expenses a. Home office expenses are reported on Form 8829 3. Qualification of Pension and Profit-Sharing Plans a. Reports for qualified retirement plans are required to be filed with the IRS, and in some cases with the Department of Labor.

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Court Case Briefs Robert F. Six and Ethel Merman Six v. U.S., 27 AFTR 2d 71-739; 71-2 USTC & 9694 (2nd Cir., 1971).

Entertainer Ethel Merman deducted hotel and transportation expenses incurred while appearing in Gypsy on Broadway in New York. She maintained a home in Colorado but had business contacts and activities of greater importance in New York. The IRS claimed that the term “home” as used in Sec.162 Trade or Business Expenses (i.e., “traveling expenses ... while away from home ...”) means the taxpayer’s “principal or regular place of business” and consequently denied her travel expense deductions for the expenses incurred in New York.

The Court’s decision turned on whether the engagement was considered temporary or indefinite enough that a reasonable person would “pull up stakes and make her permanent residence in New York.” The Court found that the latter was more likely and remanded the case to the lower court for further proceedings which resulted in the denial of the deduction.

Joseph L. Flaig v. CIR, 1984 PH T.C. Memo & 84150, 47 TCM 1361.

An attorney in Los Angeles, California, whose primary business involved personal injury cases, claimed a business expense deduction for an $8,000 birthday party. The IRS denied the deduction and the Tax Court upheld the Service. The question of whether the expenses were “ordinary and necessary expenses paid or incurred ... in carrying on any trade or business” was not addressed because the expenses fell within Sec. 274 which renders non-deductible any entertainment expenses.

Even though clients inquired about pending litigation or introduced potential clients to the attorney, and even though legal documents were signed by clients, Flaig admitted that these activities were not the primary purpose of the party. The Tax Court found that the purpose of the party was not business related and that a “gathering of 1,000 guests to enjoy food, drink, music and dancing” was clearly entertainment.

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Instructor Aid I:7-1 Deductible Education Expenses

DEDUCTIBLE IF INCURRED: •

To maintain or improve skills in existing job OR

•

To meet requirements of the law to return to current job UNLESS

•

Education is required to meet minimum educational standards for the job OR

•

Education qualifies the taxpayer for a new trade or business

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Instructor Aid I:7-2 Home Office Deduction

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Chapter I:7 Business Expenses and Deferred Compensation Learning Objectives After studying this chapter, the student should be able to: 1. Understand the deductibility of business and rental estate activities.

2. Distinguish the classifications of employees and independent contractors.

3. Determine the proper deductible amount for travel expenses.

4. Understand the deductibility of transportation expenses.

5. Understand the deductibility of business meals and the 50% disallowance rule.

6. Identify deductible moving expenses.

7. Describe the requirements for deducting education expenses.

8. Determine whether the expenses of an office in home meet the requirements for deductibility and apply the gross income limitations.

9. Discuss the tax treatment and requirements for various deferred compensation arrangements.

10. Describe tax planning considerations for business expenses and deferred compensation.

11. Describe compliance and procedural considerations for business and deferred compensation expenses.

Areas of Greater Significance The areas of travel, transportation, and deferred compensation will affect the vast majority of self-employed individuals and employers. Students should understand the rules and planning opportunities in these areas.

Areas of Lesser Significance In the interest of time, the instructor may determine that the following areas are best covered by student reading, rather than class discussion: I:IO7-1 Copyright © 2024 Pearson Education, Inc.

1. Per Diem Allowances for Meals and Lodging 2. Qualification Requirements for a Qualified Plan 3. Nonqualified Plans 4. Plans for Self-employed Individuals 5. Tax Planning Considerations

Problem Areas for Students The following areas may prove especially difficult for students: 1. The rules regarding deductibility of foreign travel.

2. Whether an educational expense qualifies for a deduction.

3. Tax consequences of incentive stock options and nonqualified options.

Highlights of Recent Tax Law Changes The following items of tax law have changed since the 2023 edition of this chapter: 1. The ceiling amount for paying the full amount of payroll taxes has increased to $160,200 ($147,000 in 2022).

2. The standard mileage rate has increased to $.655 ($.585 in 2022).

3. The basis reduction for changing from standard mileage method to actual expense method has increased to $.28 ($.26 in 2022).

4. Per diem allowance rates have decreased. (See footnote 18.)

5. The maximum annual employee contribution to 401(k) plans has increased to $22,500 ($20,500 in 2022).

6. The compensation threshold for the highly compensated employees test has increased to $150,000 ($135,000 in 2022).

7. The limit for employer contributions to defined contribution plans, and contributions to H.R. 10 plans, SEP IRAs, and solo 401(k) plans has increased to $66,000 ($61,000 in 2022).

8. The maximum defined benefit plan annual benefit has increased to $265,000 ($245,000 in 2022).

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9. The income ceiling for H.R. 10 plans and SEP IRAs has increased to $330,000 ($305,000 in 2022).

10. The limit for SIMPLE plan contributions has increased to $15,500 ($14,000 in 2022).

11. Maximum age, AGI limits, and phase-outs for deductibility of IRA contributions and phase-out floor and ceiling for Roth IRA contributions have increased. (See Topic Review I:7-4.)

12. The limit on annual contributions to HSAs has increased to $3,850 ($3,650 in 2022) or $7,750 ($7,300 in 2022) for married filing jointly. The maximum out-of-pocket expenses threshold for an HDHP plan has also increased to $7,500 for individual coverage ($7,050 in 2022) and $15,000 for family coverage ($14,100 in 2022).

Teaching Tips 1. You may wish to give only a broad overview of deferred compensation in a first course in taxation, as the concepts are very complex. However, a full discussion of IRAs is appropriate due to the frequent occurrence of this topic in the real world.

Lecture Outline NOTE: Part 1 of this chapter deals with expenses classified as for AGI deductions. These deductions are reported on Schedule 1 of Form 1040 under two broad categories: (1) expenses connected with a trade or business (Schedule C), expenses connected with rental real estate or royalties (Schedule E), or expenses connected with farm income (Schedule F); and (2) additional “adjustments to income” (Schedule 1). (See Figure I:7-2.)

I.

Business and Rental Real Estate Deductions 1. Self-Employed Individual Versus Employee (Examples I:7-1, I:7-2) a. Significant tax consequences flow from the characterization of a taxpayer as an employee vs. self-employed (independent contractor). b. Self-employed business expenses are deductible for AGI. c. Employee business expenses are not deductible. d. A self-employed individual is responsible for self-employment tax which is much higher than an employee’s share of Social Security tax. e. A taxpayer is considered an employee if the employer has the right to direct and control both the end result and the way the result is accomplished.

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II.

Travel Expenses 1. Deductibility of Travel Expenses (Table I:7-1) a. The deductibility of travel expenses is dependent on the nature of the expenditure. b. Travel expenses for self-employed individuals are deducted for AGI. c. Employee travel expenses are not deductible. Reimbursements are excluded by the employee if paid under an accountable plan. d. Prior to 2018, unreimbursed employee travel expenses were deducted as a miscellaneous itemized deduction. e. In most tax years, meals associated with travel are only 50% deductible.

2. Definition of Travel Expenses (Examples I:7-4, I:7-5) a. Travel includes transportation, meals, lodging, and other reasonable and necessary expenses related to a trade or business incurred while away from the taxpayer’s tax home. b. The deductible amount of travel expenses may be reduced if actual expenses are lavish or extravagant.

3. General Qualification Requirements (Examples I:7-6, I:7-7) a. The purpose of the trip must be connected with a trade or business or rental real estate activity. b. The taxpayers must be away from his tax home temporarily, but long enough to require sleep or rest before returning home. c. A person’s tax home is the location of his principal place of business.

4. Business Versus Pleasure (Examples I:7-9, I:7-10) a. Travel expenses on combination business/personal trips will be only partially deductible. b. If a domestic trip is primarily business, travel expenses to and from the business destination are deductible even though there is some personal time during the trip. Expenses for personal days will not be deductible. c. No deduction is allowed for the travel expenses of a companion (e.g., spouse) unless the companion works in the business and the travel is business-related and otherwise deductible.

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5. Foreign Travel a. Even more stringent allocation rules apply to the deductibility of travel expenses on foreign business/personal trips. b. Deductions for foreign conventions are only allowed for “directly related” activities for which the taxpayer can prove that a meeting held outside North America is reasonable.

6. Additional Limitations on Travel Expenses (Examples I:7-11, I:7-12; Question I:77) a. Additional limitations on deduction for travel expenses exist for educational travel, certain conventions and seminars, luxury water travel, and charitable travel.

III.

Transportation Expenses 1. Definition and Classification (Examples I:7-15 through I:7-17) a. Transportation expenses are those incurred for local transportation. b. Commuting costs are generally nondeductible personal expenses. c. Commuting costs between multiple places of business are deductible.

2. Treatment of Automobile Expenses (Examples I:7-20, I:7-21; Problem I:7-46) a. Actual business automobile expenses can be deducted, or a standard mileage rate (65.5 cents per mile) can be elected. b. For newer cars the deduction for actual expenses will generally exceed the standard mileage deduction. This advantage may be offset by the hassle of required recordkeeping. c. If a taxpayer changes from the standard mileage rate method to the actual expense method, the basis of the automobile must be reduced by 28 cents per mile.

IV.

Meals and Entertainment Expenses Entertainment expenses of any type are not deductible. In most tax years, 50% of business meals are deductible, but any portion of meals that are considered entertainment are not deductible.

1. Business Meals and Beverages (Examples I:7-22, I:7-24) a. Notice 2018-76 provides current requirements for a taxpayer to deduct 50% of a business meal expense: I:IO7-5 Copyright © 2024 Pearson Education, Inc.

i.

The expense is an ordinary and necessary expense incurred in carrying on a trade or business.

ii.

The expense is not lavish or extravagant under the circumstances.

iii.

The taxpayer, or an employee of the taxpayer, is present in the furnishing of the food or beverages.

iv.

The food and beverages are provided to a current or potential business customer, client, consultant, or similar business contact.

v.

If food and beverages are provided during or at an entertainment activity, a deduction is only allowed if the food and beverages are either paid for separately or are stated separately from the cost of the entertainment.

b. These rules do not apply for meals that qualify as travel expenses.

2. Business Gifts (Example I:7-26) a. Generally, deductible business gifts are limited to $25 per donee.

V.

Moving Expenses For years 2018 through 2025, moving expenses are only deductible for members of the Armed Forces of the United States on active duty who move pursuant to a military order and incident to a permanent change of station.

VI.

Education Expenses (Table I:7-2; Question I:7-18; Problem I:7-50; Instructor Aid I:7-1) 1. Classification of Education Expenses a. Education expenses may be nondeductible, offset against employer reimbursements, or be deductible for AGI, all dependent on facts and circumstances. b. Nondeductible personal education expenses may be eligible for certain tax credits. (See Chapter I:14.)

2. General Requirements for a Deduction (Examples I:7-26 through I:7-29) a. Educational expenses are generally deductible if they maintain or improve skills used in employment trade or business or meet legal requirements for retention of rank or compensation rate. b. However, if the education is required to meet current minimum educational requirements of the taxpayer’s trade or business or qualifies the taxpayer for a new trade or business, the educational expenses are disallowed.

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VII.

Office in Home Expenses (Instructor Aid I:7-2) 1. General Requirement for a Deduction (Example I:7-31) a. The minimum requirements for a home office deduction include exclusive use on a regular basis as a principal place of business, or as a place for meeting with patients, clients, or customers. Self-employed individuals may deduct these expenses for AGI. 2. Deduction and Limitations (Example I:7-33) a. Home office deductions are limited by the gross income of the subject business activity. Unused expenses are carried forward subject to the same income limitations. b. A safe harbor provision allows taxpayers to deduct $5 per square foot of qualified use up to a maximum deduction of $1,500.

NOTE: Part 2 discusses deferred compensation arrangements including qualified pension and profit sharing plans, nonqualified deferred compensation arrangements, and selfemployed retirement plans and individual retirement accounts (IRAs).

VIII.

Deferred Compensation 1. Qualified Pension and Profit-Sharing Plans (Example I:7-33; Topic Review I:7-1) a. Qualified retirement plans, such as pension plans, profit-sharing plans, and stock bonus plans, provide immediate tax deductions for employers while deferring taxes for employees.

2. Tax Treatment to Employees and Employers (Example I:7-36) a. Generally, employer contributions to a qualified plan are immediately deductible, and such amounts (plus accumulated income) are not taxable to the employee until received. b. Defined contribution plan contributions are limited to no more than $66,000. c. Defined benefits plan annual benefits to an employee are limited to no more than $265,000.

3. Employee Stock Options (Example I:7-42; Topic Review I:7-3) a. Incentive stock option (ISO) and nonqualified stock option (NQO) plans are used by corporate employers to attract and retain key employees. b. Employees have no tax consequences on the grant or exercise date for ISOs, and the employer receives no compensation deduction as long as the I:IO7-7 Copyright © 2024 Pearson Education, Inc.

employee does not dispose of the stock within two years of the option’s grant date or with one year of the option’s exercise date.

4. Traditional IRA (Examples I:7-47, I:7-48; Topic Review I:7-4; Question I:7-33; Problem I:7-55) a. Fully deductible IRA contributions (lesser of $6,500 or earned income) are available only to two groups of taxpayers: i.

Taxpayers who are not active participants in a qualified employer retirement plan; and

ii.

Taxpayers who are active participants, but their AGI is $73,000 or less for single taxpayers or $116,000 or less for married taxpayers filing jointly.

b. Partial deductions are available to active participants with AGIs less than $83,000 for single taxpayers or $136,000 for married taxpayers filing jointly. The deduction is phased out ratably over the $10,000 AGI range for single taxpayers and over the $20,000 AGI range for married taxpayers filing jointly. i.

EXAMPLE: A single active participant with $80,000 AGI could make a $4,550 deductible contribution.

c. Nondeductible IRA contributions can be made by any taxpayer to the extent disqualified from making a deductible contribution. i.

EXAMPLE: A single active participant with $85,000 AGI could make a $6,500 nondeductible contribution to a traditional IRA.

d. A nonworking spouse may contribute up to $6,500 as a deductible (or nondeductible) contribution to an IRA under the same rules as the working spouse. e. Individuals can make contributions to a traditional IRA until the age of 73.

5. Roth IRA (Examples I:7-73, I:7-75) a. In a Roth IRA, no contribution is deductible, but all distributions (including earnings) are nontaxable. b. The maximum contribution to a Roth IRA is the same as the maximum deductible contribution to a traditional IRA. The ability to contribute is phased out over certain AGI levels: between $138,000 and $153,000 for single taxpayers and between $218,000 and $228,000 for married taxpayers filing jointly.

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c. No more than $6,500 can be contributed in total to a traditional IRA and/or a Roth IRA. d. To achieve full nontaxability on a Roth IRA, there is a five-year holding period requirement. e. Pre-existing traditional IRAs can be rolled over into a Roth IRA. The tax on accrued income must be paid on rollover, but no penalty tax is extracted.

6. Coverdell Education Savings Account (Examples I:7-54, I:7-55) a. The CESA is available to cover qualified education expenses (including elementary, secondary, and higher education). The maximum contribution is $2,000 per year per beneficiary under age 18. b. CESAs can be set up in addition to any traditional or Roth IRAs. c. No deduction is available for a CESA, but all qualified distributions are nontaxable. d. The right to contribute to a CESA is phased-out using the same AGI levels as used for the Roth IRA. e. Beneficiaries cannot claim an exclusion from a CESA for the same expenses used in any year to calculate the HOPE scholarship credit or Lifetime Learning Credit.

7. Health Savings Accounts (Example I:7-57) a. HSAs are available to certain individuals with high-deductible health plans to accumulate funds on a tax-free basis to pay qualified medical expenses.

IX.

Tax Planning Considerations 1. Providing Nontaxable Compensation to Employees a. Nontaxable fringe benefits and tax-deferred compensation plans are valuable to employees while providing current deductions to the employer.

2. Rollovers to Roth IRA a. The advisability of rolling over funds from a traditional IRA to a Roth IRA is based on the following factors: (1) AGI level, (2) anticipated marginal tax rate at retirement, (3) taxpayer’s age, and (4) availability of funds to pay tax.

X.

Compliance and Procedural Considerations 1. Substantiating Travel and Business Meal Expenses I:IO7-9 Copyright © 2024 Pearson Education, Inc.

a. Travel expenses may be disallowed if the taxpayer does not maintain adequate records.

2. Reporting Office in Home Expenses a. Home office expenses are reported on Form 8829 3. Qualification of Pension and Profit-Sharing Plans a. Reports for qualified retirement plans are required to be filed with the IRS, and in some cases with the Department of Labor.

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Court Case Briefs Robert F. Six and Ethel Merman Six v. U.S., 27 AFTR 2d 71-739; 71-2 USTC & 9694 (2nd Cir., 1971).

Entertainer Ethel Merman deducted hotel and transportation expenses incurred while appearing in Gypsy on Broadway in New York. She maintained a home in Colorado but had business contacts and activities of greater importance in New York. The IRS claimed that the term “home” as used in Sec.162 Trade or Business Expenses (i.e., “traveling expenses ... while away from home ...”) means the taxpayer’s “principal or regular place of business” and consequently denied her travel expense deductions for the expenses incurred in New York.

The Court’s decision turned on whether the engagement was considered temporary or indefinite enough that a reasonable person would “pull up stakes and make her permanent residence in New York.” The Court found that the latter was more likely and remanded the case to the lower court for further proceedings which resulted in the denial of the deduction.

Joseph L. Flaig v. CIR, 1984 PH T.C. Memo & 84150, 47 TCM 1361.

An attorney in Los Angeles, California, whose primary business involved personal injury cases, claimed a business expense deduction for an $8,000 birthday party. The IRS denied the deduction and the Tax Court upheld the Service. The question of whether the expenses were “ordinary and necessary expenses paid or incurred ... in carrying on any trade or business” was not addressed because the expenses fell within Sec. 274 which renders non-deductible any entertainment expenses.

Even though clients inquired about pending litigation or introduced potential clients to the attorney, and even though legal documents were signed by clients, Flaig admitted that these activities were not the primary purpose of the party. The Tax Court found that the purpose of the party was not business related and that a “gathering of 1,000 guests to enjoy food, drink, music and dancing” was clearly entertainment.

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Instructor Aid I:7-1 Deductible Education Expenses

DEDUCTIBLE IF INCURRED: •

To maintain or improve skills in existing job OR

•

To meet requirements of the law to return to current job UNLESS

•

Education is required to meet minimum educational standards for the job OR

•

Education qualifies the taxpayer for a new trade or business

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Instructor Aid I:7-2 Home Office Deduction

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Chapter I:8 Itemized Deductions Learning Objectives After studying this chapter, the student should be able to: 1. Identify qualified medical expenses and compute the medical expense deduction.

2. Identify taxes that are deductible as itemized deductions.

3. Identify different types of interest deductions.

4. Compute the amount of a charitable contribution deduction and identify limitations.

5. Discuss casualty and theft losses.

6. Determine the calculation of the qualified business income deduction.

7. Describe tax planning considerations for itemized deductions.

8. Describe compliance and procedural considerations for itemized deductions.

Areas of Greater Significance Knowledge of limitations for each type of itemized deduction is important. In order to itemize rather than take the standard deduction, many taxpayers will have to own their home, which will generate substantial deductions for residential mortgage interest and real property taxes. Additionally, students should understand how to calculate the qualified business income (QBI) deduction.

Areas of Lesser Significance In the interest of time, the instructor may determine that the following area is best covered by student reading, rather than class discussion: 1. Casualty and Theft Losses

Problem Areas for Students The following areas may prove especially difficult for students: 1. Calculation of allowable mortgage interest.

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2. Calculation of the amount of a charitable contribution based on type of property and characteristics of the charity.

3. Calculation of the currently deductible amount of charitable contributions after applying the applicable limitations.

Highlights of Recent Tax Law Changes The following items of tax law have changed since the 2023 edition of this chapter: 1. The mileage rate for medical transportation has increased to $.22 per mile ($.18 in 2022).

2. The ceiling amount for paying the full amount of payroll taxes has increased to $160,200 ($147,000 in 2022).

3. The gross receipts threshold for the deductibility of business interest has increased to $29 million ($27 million in 2022).

4. The beginning of the phase-out for the deductibility of student loan interest has increased to $75,000 ($70,000 in 2022) or $155,000 ($145,000 in 2022) for married filing jointly.

5. The income threshold for QBI limitations has increased to $182,100 ($170,050 in 2022) or $364,200 ($340,100 in 2022) for married filing jointly.

Teaching Tips 1. In teaching the deductibility of personal taxes, compare the tax structure in your state with the structures in adjoining states.

2. The study of charitable contributions is very difficult for students. You may want to encourage the students by telling them that the taxpayers who are concerned with the limitations on charitable contributions are the type of clients they will want (i.e., wealthy). Also, be sure to point out that this is another area where the difference between an asset generating short-term capital gain vs. long-term capital gain is very important (i.e., the amount of deduction can be significantly different).

Lecture Outline I.

Medical Expenses (Topic Review I:8-1) 1. Qualified Individuals (Example I:8-1)

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a. Medical expenses paid for the taxpayer, taxpayer’s spouse, or taxpayer’s dependent may qualify for a deduction. b. Medical expenses for dependents of the taxpayer who do not qualify for a dependency exemption solely due to the gross income or joint return tests will be allowed. c. Also, medical expenses for children of divorced parents are deductible by either parent paying such expenses, as long as one of the parents is entitled to the dependency exemption.

2. Qualified Medical Expenses (Examples I:8-2, I:8-3; Question I:8-2) a. Qualifying expenses are those paid for the diagnosis, cure, mitigation, treatment, or prevention of disease, including transportation, meals and lodging, certain capital expenditures, and medical insurance premiums. i.

EXAMPLE: Examples of qualifying medical expenditures are those for hospital, doctors, dentists, eyeglasses, and prescription drugs.

b. Cosmetic surgery is not deductible unless it promotes the proper functioning of the body or prevents or treats an illness or disease. c. Deductible transportation costs include mileage (at 22 cents per mile), tolls, parking, taxis, airfare, etc. if the travel is primarily for and essential to qualified medical care. d. Meals en route to medical treatment are usually subject to a 50% disallowance. e. Lodging is limited to $50 per person per night (patient plus attendant).

Lodging is available only if the patient is being treated at a licensed hospital or its equivalent. f. Qualified long-term care expenditures and long-term care insurance premiums are deductible medical expenses. Deductible limits for such premiums vary with age of the covered individual. (See footnote 8.) g. Capital expenditures that improve the residence (e.g., swimming pool for paraplegic) are deductible only to the extent that the cost of the improvement exceeds the increase in the FMV of the residence.

3. Amount and Timing of Deduction (Example I:8-6; Problem I:8-34) a. A medical expense deduction is only allowed to the extent qualified medical expenses exceed 7.5% of AGI.

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i.

EXAMPLE: A taxpayer with $20,000 of qualifying medical expenses and a $100,000 AGI will be allowed only a $12,500 medical expense deduction [$20,000 - (0.075 × $100,000) = $12,500].

b. Reimbursements during the tax year reduce allowable deductions.

Reimbursements received in subsequent tax years are included in gross income under the tax benefit rule.

II.

Taxes (Instructor Aid I:8-1) 1. Definition of a Tax a. The statutory definition of a tax is a mandatory assessment levied under the authority of a political entity for the purpose of raising revenue to be used for public or governmental purposes. b. The tax must be a liability of the taxpayer attempting to deduct the tax.

2. Deductible Taxes a. Deductible taxes include state, local, and foreign real property taxes, state and local personal property taxes, foreign, state and local income or sales taxes, and federal environment tax. b. Personal property taxes are deductible only to the extent the amount is based on the value of personal property.

3. Limits on Itemized Deductions for State and Local Taxes a. The deduction for state and local real property, personal property, and income or sales taxes is limited to $10,000 ($5,000 for married filing separately).

4. State and Local Income Taxes (Example I:8-8) a. Cash-basis taxpayers deduct state and/or local income tax in the year paid or withheld, regardless of the tax year involved. i.

EXAMPLE: The last estimated state income tax payment for 2022 is due and paid on January 15, 2023. A cash-basis taxpayer cannot deduct this payment until 2023, even though it applies to the 2022 tax year.

5. State and Local Sales Taxes

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a. Individuals may elect to deduct state and local sales taxes in lieu of state and local income taxes. Documented actual expenditures for sales taxes may be deducted or the amount allowed by Treasury tables.

6. Personal Property Taxes (Question I:8-12) a. In order to be deductible the tax must be an ad valorem tax on personal property imposed on an annual basis. b. Any portion of the tax which is a flat fee (e.g., registration fee the same for all vehicles) is not deductible.

7. Real Estate Taxes (Example I:8-10; Question I:8-13) a. Apportionment of taxes is necessary when real estate is sold during the year. b. Taxes assessed only against the property benefited (e.g., sewer improvement) are capitalizable costs, not deductions.

8. Self-Employment Tax a. Wages paid to an employee and self-employment income are subject to a payroll tax which consists of two components: i.

Old-age, Survivors, and Disability Insurance (OASDI, often called Social Security) at 12.4% of the first $160,200 of wages and selfemployment income

ii.

Medicare at 2.9% of wages and self-employment income

iii.

Additional Medicare tax at 3.8% of investment income and 0.9% of wages and self-employment income

b. Employers and employees each pay one half of payroll tax (6.2% for OASDI and 1.45% for Medicare), but only employees pay the additional Medicare tax. c. Self-employed individuals pay all of the payroll tax and deduct one half as a for-AGI deduction.

9. Nondeductible Taxes a. Nondeductible taxes include federal income tax, employee’s social security tax, and federal estate and gift tax. b. The employer’s share of social security tax is deductible as a business expense. A self-employed taxpayer may also deduct one half of the selfemployment taxes paid for AGI. I:IO8-5 Copyright © 2024 Pearson Education, Inc.

III.

Interest (Topic Review I:8-2) 1. Definition of Interest a. Interest is the charge for the use or forbearance of money. b. Bank service charges and certain loan acquisition costs are not considered interest for tax purposes.

2. Classification of Interest Expense (Examples I:8-13, I:8-15, I:8-17; Question I:821; Problem I:8-44) a. Different rules exist for the deductibility of active trade or business interest, passive loss interest, investment interest, personal interest, and qualified residence interest. b. Business interest is deductible for AGI and personal interest (including investment interest) is deductible from AGI. c. Businesses with gross receipts of at least $29 million must limit their deduction for interest to 30% of taxable income. The excess is carried forward. d. The investment interest deduction is limited to net investment income. Net investment income includes net long-term capital gain and qualified dividends only to the extent the taxpayer agrees to subject such income to marginal tax rates less investment expenses. e. Personal interest (e.g., credit card interest, automobile loan interest) is not deductible. f. Qualified residence interest is fully deductible. Qualified residence interest is available on a maximum of two residences for acquisition indebtedness (maximum $750,000; $1,000,000 for debt incurred before December 16, 2017; these numbers are halved for married filing separately). i.

Prepaid interest paid in the form of points is usually capitalized and amortized over the life of the loan.

ii.

Points paid to purchase a principal residence may be automatically deductible.

g. The maximum amount of deductible interest on student loans is $2,500. The loans must be incurred to pay qualified higher education expenses. This interest deduction is taken for AGI and is subject to phase-out over certain AGI levels.

3. Timing of the Interest Deduction (Examples I:8-21, I:8-22) I:IO8-6 Copyright © 2024 Pearson Education, Inc.

a. The general rule is that cash-basis taxpayers deduct interest when paid. b. Exceptions exist (deduction is partially or fully deferred) for prepaid interest, interest paid with loan proceeds, discounted notes, and interest owed to a related party by an accrual-basis taxpayer.

IV.

Charitable Contributions (Topic Review I:8-3) 1. Qualifying Organization a. Only contributions to IRS-approved public and private charities qualify for the charitable contribution deduction. b. Organizations are added to and deleted from the IRS-approved list on a regular basis. Care must be exercised to determine that a purported qualified charitable organization is in fact qualified at the time of contribution.

2. Type of Property Contributed (Examples I:8-23 through I:8-25; Questions I:8-23, I:8-24) a. The amount of the charitable contribution is affected by the type of property contributed: i.

Ordinary income property: FMV less recognized gain if sold on the contribution date.

ii.

Tangible personal property unrelated to the charitable function: Adjusted basis of the property.

iii.

EXAMPLE: A painting held more than one year with a FMV of $5,000,000 and an adjusted basis of $500,000 is given to a charity.

If the charity is the American Cancer Society, the amount of the deduction is $500,000 (tangible personal property unrelated to the charitable function.) If the painting is given to an art museum, the amount of the deduction is $5,000,000 (related to the charitable function).

iv.

Long-term capital gain property (held more than 12 months): FMV.

3. Deduction Limitations (Examples I:8-29 through I:8-31; Problem I:8-51; Instructor Aid I:8-2) a. Annual limitations based on AGI are applicable to charitable contributions, including overall limitation (50%), cash contributions (60%), capital gain property (30%), and certain private foundation contributions (20%). i.

EXAMPLE: The taxpayer contributed $100,000 cash to the Red Cross in a tax year when her AGI is $150,000. The taxpayer’s I:IO8-7 Copyright © 2024 Pearson Education, Inc.

current charitable contribution deduction is limited to $90,000 ($150,000 × 60%). b. When contributing cash and other property in the same tax year, the 30% and 50% limits are reduced dollar for dollar by the amount of the cash contribution subject to the 60% limit.

4. Application of Carryovers (Example I:8-32) a. Charitable contributions exceeding the annual percentage limitations may be carried over for five years. i.

EXAMPLE: In the above example, the taxpayer would have a $10,000 carryover ($100,000 contribution less $90,000 deduction) for five years.

b. Contributions subject to the 60% limit take highest priority when determining the deductibility of a carryover. Contributions subject to the 50% limit take the next highest priority, followed by contributions subject to the 30% and 20% limits.

5. Special Rules for Charitable Contributions Made by Corporations a. Corporate charitable contributions are limited to 10% of modified taxable income, with a five-year carryover.

V.

Qualified Business Income Deduction (Example I:8-33; Problem I:8-58) The tax law allows a deduction for qualified business income (QBI) under Sec. 199A that taxpayers can take the deduction regardless of whether the taxpayers itemize their deductions or utilize the standard deduction. QBI is generally defined as 20% of qualified business income. Restrictions apply for high-income taxpayers with businesses in service industries.

VI.

Tax Planning Considerations 1. Medical Expense Deduction (Example I:8-34) a. Elective medical treatment should be bunched in one tax year to alleviate the effect of the 7.5% of AGI limitation. b. The year chosen to maximize the medical expense deduction should be different than the year for significant charitable contributions because medical expenses are subject to an AGI floor while charitable contributions are subject to an AGI cap.

2. Interest Expense Deduction

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a. Personal residences must meet the personal use test in order for interest to qualify as residence interest. b. If residence fails the personal use test, interest from rental use is deductible against rental income.

3. Deduction for Charitable Contributions (Example I:8-36) a. The donation of appreciated long-term capital gain property utilizes the full benefit of the property’s fair market value without gain recognition for the appreciation. i.

VII.

EXAMPLE: The contribution of $100,000 of cash will generate the same deduction as the contribution of $100,000 FMV stock with an adjusted basis of $10,000 (assuming a long-term holding period).

The taxpayer may be better off tax-wise to contribute the stock and avoid taxation on the $90,000 unrealized gain.

Compliance and Procedural Considerations 1. Medical Expenses (Example I:8-38) a. Expenses qualifying for both dependent care credit and medical expense deduction can be taken either place, but not double-utilized. b. To maximize tax benefit, the taxpayer should compare the dependent care credit rate with the effective marginal tax rate for additional medical deductions.

2. Charitable Contributions (Example I:8-39) a. Taxpayers claiming noncash charitable contributions exceeding $500 must file Form 8283, and the property must be in at least “good” condition. b. If property contributed exceeds $5,000 in value, a qualified appraisal must generally be attached to the return. c. Additional documentation is required for cash charitable contributions.

3. Taxes (Example I:8-40) a. Deductions are reported on: i.

Schedule C - related to taxpayer’s trade or business,

ii.

Schedule E - related to the production of rents and/or royalties, or

iii.

Schedule A - if personal.

I:IO8-9 Copyright © 2024 Pearson Education, Inc.

Court Case Briefs Lynn Crawford v. CIR, 65 TCM 2540 (1993).

The taxpayer was a physician and noticed some personal symptoms that he thought were due to stress. The taxpayer was examined by a fellow physician and diagnosed with hypoglycemia, a condition caused by low blood sugar. A special diet was instituted to correct the condition.

The taxpayer cited previous case law that disallowed a medical deduction for substitute foods and beverages as a personal expense, but allowed prescribed additional foods and beverages as a medical deduction.

The court found that the diet was not prescribed by the examining physician, and that there were no additional expenses associated with the diet. Therefore, the medical deduction based on the special diet was disallowed.

Oswald “Ozzie” G. Nelson v. CIR, 1966 PH T.C. Memo & 66,224, 25 TCM 1142.

Ozzie Nelson was the principal actor in the television series entitled “The Adventures of Ozzie and Harriet.” His wife, Harriet, and their two children, David and Eric, were also actors on the program. Ozzie Nelson purchased all the clothing for the family. Some of the clothing was personal and kept at their homes. Some of the clothing was to be worn on the television show and was kept at the studio. Mr. Nelson deducted the amounts allocated to the cost of the television clothing on his income tax return as necessary business expenses. The IRS disallowed the deductions claiming that the clothes were suitable for their personal use.

The court found that the clothing was deductible because Ozzie and Harriet, who worked 12 to 13 hours a day and did not “go out” very often, had little time or occasion to use their television clothing for personal use. Further, the clothing was kept at the studio rather than their home.

I:IO8-10 Copyright © 2024 Pearson Education, Inc.

Instructor Aid I:8-1 Deductible and Nondeductible Taxes

Deductible Taxes

Nondeductible Taxes

State and local income taxes or State and local sales taxes*

Federal income taxes

Personal property taxes (ad valorem only)*

Employee’s social security taxes

General real estate taxes*

Estate tax

Business-related taxes

Gift tax Nonbusiness excise taxes Nonbusiness gasoline tax Additional Medicare tax

*All deductible income, sales, property, and real-estate taxes are subject to a $10,000 cap.

I:IO8-11 Copyright © 2024 Pearson Education, Inc.

Instructor Aid I:8-2 Charitable Contribution Limitations 60% of Adjusted Gross Income Cash Contributions 50% of Adjusted Gross Income Annual Overall Limitation 30% of Adjusted Gross Income Annual Limit on Contributions of Long-Term Capital Gain Property (held more than 12 months) and Certain Gifts to Nonoperating Private Foundations.

The 50% limit may be elected for long-term capital gain property if the adjusted basis of the property is utilized instead of the fair market value of the property.

20% of Adjusted Gross Income Annual Limit on Long-Term Capital Gain Property Contributed to Private Nonoperating Foundations.

If 30% of AGI less any contributions of long-term capital gain property to public charities is less than the 20% limit, that lower amount is the limit on long-term capital gain property contributions to private nonoperating foundations.

Any amounts exceeding the annual percentage limitations can be carried over for five years in the same percentage limitation categories.

I:IO8-12 Copyright © 2024 Pearson Education, Inc.

Chapter I:8 Itemized Deductions Learning Objectives After studying this chapter, the student should be able to: 1. Identify qualified medical expenses and compute the medical expense deduction.

2. Identify taxes that are deductible as itemized deductions.

3. Identify different types of interest deductions.

4. Compute the amount of a charitable contribution deduction and identify limitations.

5. Discuss casualty and theft losses.

6. Determine the calculation of the qualified business income deduction.

7. Describe tax planning considerations for itemized deductions.

8. Describe compliance and procedural considerations for itemized deductions.

Areas of Greater Significance Knowledge of limitations for each type of itemized deduction is important. In order to itemize rather than take the standard deduction, many taxpayers will have to own their home, which will generate substantial deductions for residential mortgage interest and real property taxes. Additionally, students should understand how to calculate the qualified business income (QBI) deduction.

Areas of Lesser Significance In the interest of time, the instructor may determine that the following area is best covered by student reading, rather than class discussion: 1. Casualty and Theft Losses

Problem Areas for Students The following areas may prove especially difficult for students: 1. Calculation of allowable mortgage interest.

I:IO8-1 Copyright © 2024 Pearson Education, Inc.

2. Calculation of the amount of a charitable contribution based on type of property and characteristics of the charity.

3. Calculation of the currently deductible amount of charitable contributions after applying the applicable limitations.

Highlights of Recent Tax Law Changes The following items of tax law have changed since the 2023 edition of this chapter: 1. The mileage rate for medical transportation has increased to $.22 per mile ($.18 in 2022).

2. The ceiling amount for paying the full amount of payroll taxes has increased to $160,200 ($147,000 in 2022).

3. The gross receipts threshold for the deductibility of business interest has increased to $29 million ($27 million in 2022).

4. The beginning of the phase-out for the deductibility of student loan interest has increased to $75,000 ($70,000 in 2022) or $155,000 ($145,000 in 2022) for married filing jointly.

5. The income threshold for QBI limitations has increased to $182,100 ($170,050 in 2022) or $364,200 ($340,100 in 2022) for married filing jointly.

Teaching Tips 1. In teaching the deductibility of personal taxes, compare the tax structure in your state with the structures in adjoining states.

2. The study of charitable contributions is very difficult for students. You may want to encourage the students by telling them that the taxpayers who are concerned with the limitations on charitable contributions are the type of clients they will want (i.e., wealthy). Also, be sure to point out that this is another area where the difference between an asset generating short-term capital gain vs. long-term capital gain is very important (i.e., the amount of deduction can be significantly different).

Lecture Outline I.

Medical Expenses (Topic Review I:8-1) 1. Qualified Individuals (Example I:8-1)

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a. Medical expenses paid for the taxpayer, taxpayer’s spouse, or taxpayer’s dependent may qualify for a deduction. b. Medical expenses for dependents of the taxpayer who do not qualify for a dependency exemption solely due to the gross income or joint return tests will be allowed. c. Also, medical expenses for children of divorced parents are deductible by either parent paying such expenses, as long as one of the parents is entitled to the dependency exemption.

2. Qualified Medical Expenses (Examples I:8-2, I:8-3; Question I:8-2) a. Qualifying expenses are those paid for the diagnosis, cure, mitigation, treatment, or prevention of disease, including transportation, meals and lodging, certain capital expenditures, and medical insurance premiums. i.

EXAMPLE: Examples of qualifying medical expenditures are those for hospital, doctors, dentists, eyeglasses, and prescription drugs.

b. Cosmetic surgery is not deductible unless it promotes the proper functioning of the body or prevents or treats an illness or disease. c. Deductible transportation costs include mileage (at 22 cents per mile), tolls, parking, taxis, airfare, etc. if the travel is primarily for and essential to qualified medical care. d. Meals en route to medical treatment are usually subject to a 50% disallowance. e. Lodging is limited to $50 per person per night (patient plus attendant).

Lodging is available only if the patient is being treated at a licensed hospital or its equivalent. f. Qualified long-term care expenditures and long-term care insurance premiums are deductible medical expenses. Deductible limits for such premiums vary with age of the covered individual. (See footnote 8.) g. Capital expenditures that improve the residence (e.g., swimming pool for paraplegic) are deductible only to the extent that the cost of the improvement exceeds the increase in the FMV of the residence.

3. Amount and Timing of Deduction (Example I:8-6; Problem I:8-34) a. A medical expense deduction is only allowed to the extent qualified medical expenses exceed 7.5% of AGI.

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i.

EXAMPLE: A taxpayer with $20,000 of qualifying medical expenses and a $100,000 AGI will be allowed only a $12,500 medical expense deduction [$20,000 - (0.075 × $100,000) = $12,500].

b. Reimbursements during the tax year reduce allowable deductions.

Reimbursements received in subsequent tax years are included in gross income under the tax benefit rule.

II.

Taxes (Instructor Aid I:8-1) 1. Definition of a Tax a. The statutory definition of a tax is a mandatory assessment levied under the authority of a political entity for the purpose of raising revenue to be used for public or governmental purposes. b. The tax must be a liability of the taxpayer attempting to deduct the tax.

2. Deductible Taxes a. Deductible taxes include state, local, and foreign real property taxes, state and local personal property taxes, foreign, state and local income or sales taxes, and federal environment tax. b. Personal property taxes are deductible only to the extent the amount is based on the value of personal property.

3. Limits on Itemized Deductions for State and Local Taxes a. The deduction for state and local real property, personal property, and income or sales taxes is limited to $10,000 ($5,000 for married filing separately).

4. State and Local Income Taxes (Example I:8-8) a. Cash-basis taxpayers deduct state and/or local income tax in the year paid or withheld, regardless of the tax year involved. i.

EXAMPLE: The last estimated state income tax payment for 2022 is due and paid on January 15, 2023. A cash-basis taxpayer cannot deduct this payment until 2023, even though it applies to the 2022 tax year.

5. State and Local Sales Taxes

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a. Individuals may elect to deduct state and local sales taxes in lieu of state and local income taxes. Documented actual expenditures for sales taxes may be deducted or the amount allowed by Treasury tables.

6. Personal Property Taxes (Question I:8-12) a. In order to be deductible the tax must be an ad valorem tax on personal property imposed on an annual basis. b. Any portion of the tax which is a flat fee (e.g., registration fee the same for all vehicles) is not deductible.

7. Real Estate Taxes (Example I:8-10; Question I:8-13) a. Apportionment of taxes is necessary when real estate is sold during the year. b. Taxes assessed only against the property benefited (e.g., sewer improvement) are capitalizable costs, not deductions.

8. Self-Employment Tax a. Wages paid to an employee and self-employment income are subject to a payroll tax which consists of two components: i.

Old-age, Survivors, and Disability Insurance (OASDI, often called Social Security) at 12.4% of the first $160,200 of wages and selfemployment income

ii.

Medicare at 2.9% of wages and self-employment income

iii.

Additional Medicare tax at 3.8% of investment income and 0.9% of wages and self-employment income

b. Employers and employees each pay one half of payroll tax (6.2% for OASDI and 1.45% for Medicare), but only employees pay the additional Medicare tax. c. Self-employed individuals pay all of the payroll tax and deduct one half as a for-AGI deduction.

9. Nondeductible Taxes a. Nondeductible taxes include federal income tax, employee’s social security tax, and federal estate and gift tax. b. The employer’s share of social security tax is deductible as a business expense. A self-employed taxpayer may also deduct one half of the selfemployment taxes paid for AGI. I:IO8-5 Copyright © 2024 Pearson Education, Inc.

III.

Interest (Topic Review I:8-2) 1. Definition of Interest a. Interest is the charge for the use or forbearance of money. b. Bank service charges and certain loan acquisition costs are not considered interest for tax purposes.

2. Classification of Interest Expense (Examples I:8-13, I:8-15, I:8-17; Question I:821; Problem I:8-44) a. Different rules exist for the deductibility of active trade or business interest, passive loss interest, investment interest, personal interest, and qualified residence interest. b. Business interest is deductible for AGI and personal interest (including investment interest) is deductible from AGI. c. Businesses with gross receipts of at least $29 million must limit their deduction for interest to 30% of taxable income. The excess is carried forward. d. The investment interest deduction is limited to net investment income. Net investment income includes net long-term capital gain and qualified dividends only to the extent the taxpayer agrees to subject such income to marginal tax rates less investment expenses. e. Personal interest (e.g., credit card interest, automobile loan interest) is not deductible. f. Qualified residence interest is fully deductible. Qualified residence interest is available on a maximum of two residences for acquisition indebtedness (maximum $750,000; $1,000,000 for debt incurred before December 16, 2017; these numbers are halved for married filing separately). i.

Prepaid interest paid in the form of points is usually capitalized and amortized over the life of the loan.

ii.

Points paid to purchase a principal residence may be automatically deductible.

g. The maximum amount of deductible interest on student loans is $2,500. The loans must be incurred to pay qualified higher education expenses. This interest deduction is taken for AGI and is subject to phase-out over certain AGI levels.

3. Timing of the Interest Deduction (Examples I:8-21, I:8-22) I:IO8-6 Copyright © 2024 Pearson Education, Inc.

a. The general rule is that cash-basis taxpayers deduct interest when paid. b. Exceptions exist (deduction is partially or fully deferred) for prepaid interest, interest paid with loan proceeds, discounted notes, and interest owed to a related party by an accrual-basis taxpayer.

IV.

Charitable Contributions (Topic Review I:8-3) 1. Qualifying Organization a. Only contributions to IRS-approved public and private charities qualify for the charitable contribution deduction. b. Organizations are added to and deleted from the IRS-approved list on a regular basis. Care must be exercised to determine that a purported qualified charitable organization is in fact qualified at the time of contribution.

2. Type of Property Contributed (Examples I:8-23 through I:8-25; Questions I:8-23, I:8-24) a. The amount of the charitable contribution is affected by the type of property contributed: i.

Ordinary income property: FMV less recognized gain if sold on the contribution date.

ii.

Tangible personal property unrelated to the charitable function: Adjusted basis of the property.

iii.

EXAMPLE: A painting held more than one year with a FMV of $5,000,000 and an adjusted basis of $500,000 is given to a charity.

If the charity is the American Cancer Society, the amount of the deduction is $500,000 (tangible personal property unrelated to the charitable function.) If the painting is given to an art museum, the amount of the deduction is $5,000,000 (related to the charitable function).

iv.

Long-term capital gain property (held more than 12 months): FMV.

3. Deduction Limitations (Examples I:8-29 through I:8-31; Problem I:8-51; Instructor Aid I:8-2) a. Annual limitations based on AGI are applicable to charitable contributions, including overall limitation (50%), cash contributions (60%), capital gain property (30%), and certain private foundation contributions (20%). i.

EXAMPLE: The taxpayer contributed $100,000 cash to the Red Cross in a tax year when her AGI is $150,000. The taxpayer’s I:IO8-7 Copyright © 2024 Pearson Education, Inc.

current charitable contribution deduction is limited to $90,000 ($150,000 × 60%). b. When contributing cash and other property in the same tax year, the 30% and 50% limits are reduced dollar for dollar by the amount of the cash contribution subject to the 60% limit.

4. Application of Carryovers (Example I:8-32) a. Charitable contributions exceeding the annual percentage limitations may be carried over for five years. i.

EXAMPLE: In the above example, the taxpayer would have a $10,000 carryover ($100,000 contribution less $90,000 deduction) for five years.

b. Contributions subject to the 60% limit take highest priority when determining the deductibility of a carryover. Contributions subject to the 50% limit take the next highest priority, followed by contributions subject to the 30% and 20% limits.

5. Special Rules for Charitable Contributions Made by Corporations a. Corporate charitable contributions are limited to 10% of modified taxable income, with a five-year carryover.

V.

Qualified Business Income Deduction (Example I:8-33; Problem I:8-58) The tax law allows a deduction for qualified business income (QBI) under Sec. 199A that taxpayers can take the deduction regardless of whether the taxpayers itemize their deductions or utilize the standard deduction. QBI is generally defined as 20% of qualified business income. Restrictions apply for high-income taxpayers with businesses in service industries.

VI.

Tax Planning Considerations 1. Medical Expense Deduction (Example I:8-34) a. Elective medical treatment should be bunched in one tax year to alleviate the effect of the 7.5% of AGI limitation. b. The year chosen to maximize the medical expense deduction should be different than the year for significant charitable contributions because medical expenses are subject to an AGI floor while charitable contributions are subject to an AGI cap.

2. Interest Expense Deduction

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a. Personal residences must meet the personal use test in order for interest to qualify as residence interest. b. If residence fails the personal use test, interest from rental use is deductible against rental income.

3. Deduction for Charitable Contributions (Example I:8-36) a. The donation of appreciated long-term capital gain property utilizes the full benefit of the property’s fair market value without gain recognition for the appreciation. i.

VII.

EXAMPLE: The contribution of $100,000 of cash will generate the same deduction as the contribution of $100,000 FMV stock with an adjusted basis of $10,000 (assuming a long-term holding period).

The taxpayer may be better off tax-wise to contribute the stock and avoid taxation on the $90,000 unrealized gain.

Compliance and Procedural Considerations 1. Medical Expenses (Example I:8-38) a. Expenses qualifying for both dependent care credit and medical expense deduction can be taken either place, but not double-utilized. b. To maximize tax benefit, the taxpayer should compare the dependent care credit rate with the effective marginal tax rate for additional medical deductions.

2. Charitable Contributions (Example I:8-39) a. Taxpayers claiming noncash charitable contributions exceeding $500 must file Form 8283, and the property must be in at least “good” condition. b. If property contributed exceeds $5,000 in value, a qualified appraisal must generally be attached to the return. c. Additional documentation is required for cash charitable contributions.

3. Taxes (Example I:8-40) a. Deductions are reported on: i.

Schedule C - related to taxpayer’s trade or business,

ii.

Schedule E - related to the production of rents and/or royalties, or

iii.

Schedule A - if personal.

I:IO8-9 Copyright © 2024 Pearson Education, Inc.

Court Case Briefs Lynn Crawford v. CIR, 65 TCM 2540 (1993).

The taxpayer was a physician and noticed some personal symptoms that he thought were due to stress. The taxpayer was examined by a fellow physician and diagnosed with hypoglycemia, a condition caused by low blood sugar. A special diet was instituted to correct the condition.

The taxpayer cited previous case law that disallowed a medical deduction for substitute foods and beverages as a personal expense, but allowed prescribed additional foods and beverages as a medical deduction.

The court found that the diet was not prescribed by the examining physician, and that there were no additional expenses associated with the diet. Therefore, the medical deduction based on the special diet was disallowed.

Oswald “Ozzie” G. Nelson v. CIR, 1966 PH T.C. Memo & 66,224, 25 TCM 1142.

Ozzie Nelson was the principal actor in the television series entitled “The Adventures of Ozzie and Harriet.” His wife, Harriet, and their two children, David and Eric, were also actors on the program. Ozzie Nelson purchased all the clothing for the family. Some of the clothing was personal and kept at their homes. Some of the clothing was to be worn on the television show and was kept at the studio. Mr. Nelson deducted the amounts allocated to the cost of the television clothing on his income tax return as necessary business expenses. The IRS disallowed the deductions claiming that the clothes were suitable for their personal use.

The court found that the clothing was deductible because Ozzie and Harriet, who worked 12 to 13 hours a day and did not “go out” very often, had little time or occasion to use their television clothing for personal use. Further, the clothing was kept at the studio rather than their home.

I:IO8-10 Copyright © 2024 Pearson Education, Inc.

Instructor Aid I:8-1 Deductible and Nondeductible Taxes

Deductible Taxes

Nondeductible Taxes

State and local income taxes or State and local sales taxes*

Federal income taxes

Personal property taxes (ad valorem only)*

Employee’s social security taxes

General real estate taxes*

Estate tax

Business-related taxes

Gift tax Nonbusiness excise taxes Nonbusiness gasoline tax Additional Medicare tax

*All deductible income, sales, property, and real-estate taxes are subject to a $10,000 cap.

I:IO8-11 Copyright © 2024 Pearson Education, Inc.

Instructor Aid I:8-2 Charitable Contribution Limitations 60% of Adjusted Gross Income Cash Contributions 50% of Adjusted Gross Income Annual Overall Limitation 30% of Adjusted Gross Income Annual Limit on Contributions of Long-Term Capital Gain Property (held more than 12 months) and Certain Gifts to Nonoperating Private Foundations.

The 50% limit may be elected for long-term capital gain property if the adjusted basis of the property is utilized instead of the fair market value of the property.

20% of Adjusted Gross Income Annual Limit on Long-Term Capital Gain Property Contributed to Private Nonoperating Foundations.

If 30% of AGI less any contributions of long-term capital gain property to public charities is less than the 20% limit, that lower amount is the limit on long-term capital gain property contributions to private nonoperating foundations.

Any amounts exceeding the annual percentage limitations can be carried over for five years in the same percentage limitation categories.

I:IO8-12 Copyright © 2024 Pearson Education, Inc.

Chapter I:9 Losses and Bad Debts Learning Objectives After studying this chapter, the student should be able to: 1. Identify transactions that may result in losses.

2. Determine the proper classification for losses.

3. Examine the tax treatment of passive losses.

4. Identify and calculate the deduction for a casualty or theft loss.

5. Compute the deduction for a bad debt.

6. Compute a net operating loss deduction.

7. Compute the excess business loss limitation.

8. Identify tax planning considerations for losses and bad debts.

9. Identify compliance and procedural considerations for losses and bad debts.

Areas of Greater Significance The treatment of passive losses is relatively complex. Passive loss rules have greatly influenced the use of limited partnerships as an investment vehicle. The treatment of business bad debts for tax purposes can be dramatically different from financial reporting, with corresponding book to tax differences.

Areas of Lesser Significance In the interest of time, the instructor may determine that the following area is best covered by student reading, rather than class discussion: 1. Compliance and Procedural Considerations

Problem Areas for Students The following areas may prove especially difficult for students: I:IO9-1 Copyright © 2024 Pearson Education, Inc.

1. Computation of passive losses and credits.

2. Computation of the deductible amount of casualty loss.

3. Computation of the net operating loss.

Highlights of Recent Tax Law Changes The following item of tax law has changed since the 2023 edition of this chapter: 1. The limit on business losses for noncorporate taxpayers has increased to the sum of business income and gains plus $289,000 ($270,000 in 2022) if single and $578,000 ($540,000 in 2022) if married filing jointly.

Teaching Tips 1. Stress the importance of the difference between ordinary losses and capital losses.

This will reinforce the necessity of learning the rules regarding gain and loss from disposition of capital assets.

2. The passive loss rules are very complex. You may want to summarize the important points you want the students to know for examination purposes.

Lecture Outline I.

Transactions that May Result in Losses (Example I:9-1; Topic Review I:9-1) Realization is a prerequisite for a tax loss.

EXAMPLE: If a taxpayer holds stock that had a $25,000 fair market value at the beginning of the tax year and a $15,000 fair market value at the end of the tax year, no loss is recognized for tax purposes, even though the value of the stock has decreased by $10,000.

1. Sale or Exchange of Property (Example I:9-2) a. In a sale or exchange, the amount of the loss is the excess of the property’s adjusted basis over the amount realized. i.

EXAMPLE: If the taxpayer realizes $10,000 from the sale of an asset with an adjusted basis of $18,000, the realized loss is $8,000 ($10,000 - $18,000).

b. Losses incurred on the sale of personal-use property are not deductible. c. Losses on trade or business property and investment property are deductible.

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2. Expropriated, Seized, Confiscated, or Condemned Property a. Property expropriated, seized, or confiscated by a foreign government gives rise to a deductible loss only if the property is used in a trade or business or is held for investment. b. Any allowable deduction must be taken in the year of actual seizure. c. Any gain realized on seizure (compensation for seizure exceeds adjusted basis of property) would be treated under the involuntary conversion rules.

(See Chapter I:12.)

3. Abandoned Property a. Abandoned property used in a trade or business or held for investment gives rise to a deductible loss. b. The amount of the loss is the adjusted basis of the asset at the date of abandonment. c. The character of the loss is ordinary, since there is no sale or exchange.

4. Worthless Securities (Example I:9-3) a. Securities determined to be worthless in a tax year are treated as a capital loss on the last day of the tax year. i.

EXAMPLE: If a calendar-year taxpayer owns securities that become worthless on March 15, the tax treatment is to recognize a capital loss on December 31.

5. Demolition of Property a. Demolition costs are to be added to the basis of the underlying property. i.

II.

EXAMPLE: A taxpayer buys real property for $450,000 and spends $90,000 to take down existing buildings in order to construct an apartment house. The basis of the land under the apartment house is $540,000 ($450,000 + $90,000).

Classifying the Loss on the Taxpayer’s Tax Return 1. Ordinary Versus Capital Loss (Example I:9-4; Question I:9-6; Problem I:9-39) a. The classification of a loss as ordinary or capital is dependent on the type of property involved and the type of transaction involved.

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b. Losses on qualifying Sec. 1244 stock are treated as ordinary ($50,000 limitation or $100,000 for married filing jointly) rather than capital (offset capital gains plus $3,000 of ordinary income). c. To qualify as Sec. 1244 stock, the stock must: i.

Be issued and owned by an individual or partnership.

ii.

The corporation must be a domestic corporation.

iii.

The stock must be issued for cash or property and not for services.

iv.

The corporation may not have derived over 50% of its gross receipts from passive income sources during the immediately preceding 5 tax years.

v.

At the time the stock is issued, the amount of money and property contributed to both capital and paid-in surplus may not exceed $1 million.

2. Disallowance Possibilities a. Certain realized losses are disallowed in special situations, including related party transactions and wash sales. b. Other potential disallowance situations include transfers of property in exchange for stock - Sec. 351 (see Chapter I:16), like-kind exchanges (see Chapter I:12), and partnerships (both under the “at-risk” limitations and the passive loss rules).

III.

Passive Losses (Topic Review I:9-2; Instructor Aid I:9-1) 1. Computation of Passive Losses and Credits (Example I:9-5) a. Passive losses may only offset passive income, not portfolio income or active income. b. Portfolio income includes non-business dividends, interest, royalties, annuities, and certain gains and losses on property. c. Credits generated from passive activities are also limited. These credits may only offset tax liability generated by passive income.

2. Carryovers (Examples I:9-6, I:9-7) a. Unutilized passive losses may be used against future passive income or on the disposition of the passive activity interest. b. The carryover is unlimited in amount and duration.

I:IO9-4 Copyright © 2024 Pearson Education, Inc.

3. Definition of Passive Activity (Examples I:9-11, I:9-12; Question I:9-9) a. Passive activity includes any rental activity and any trade, business, or investment activity in which the taxpayer does not materially participate. b. Investments in limited partnerships generate passive losses due to the legal restrictions on limited partners’ involvement in the management of the partnership.

4. Taxpayers Subject to Passive Loss Rules (Examples I:9-13; I:9-14) a. The passive loss rules apply to individuals, estates, trusts, closely held C corporations, personal service corporations, and certain publicly traded partnerships. b. While the passive loss rules do not apply to partnerships and S-Corporations directly, the rules do apply to the owners (i.e., the partners and shareholders). c. Publicly Traded Partnerships i.

Publicly traded partnerships are generally subject to corporate taxation.

ii.

Publicly traded partnerships are those whose interests are traded on an established securities market or are readily tradable on a secondary market.

iii.

Certain publicly traded partnerships may be taxed as partnerships where the passive loss rules apply at the partner level.

5. Real Estate Businesses (Example I:9-15) a. Certain real estate professionals who “materially participate” in real estate activities will not be subject to passive activity loss limitations. b. “Material participation” for this exclusion is that the taxpayer: i.

Performs more than one half of the taxpayer’s personal services in real property trades or business, and

ii.

Performs more than 750 hours of service during the taxable year in real property trades or businesses.

iii.

If the above required services are performed as an employee, they will be counted only if the taxpayer owns at least 5% of the employer.

I:IO9-5 Copyright © 2024 Pearson Education, Inc.

c. Any loss allowed under this specific provision will not reduce AGI for the purpose of applying the special $25,000 passive loss exclusion discussed below.

6. Other Rental Real Estate Activities (Example I:9-16; Problem I:9-44) a. A $25,000 exception to the passive loss rules exists for certain individuals actively participating in real estate activities. The individual must own at least 10% of the value of the activity for the entire tax year and have an AGI less than or equal to $100,000. b. Individuals who otherwise qualify must reduce the $25,000 exception for 50% of the excess of AGI over $100,000. i.

EXAMPLE: An individual has a rental real estate qualifying passive loss of $25,000 and an AGI of $130,000. The $25,000 that could be applied against portfolio or ordinary income would be reduced by [50% × ($130,000 - $100,000)] or $15,000. Only $10,000 would be deductible currently.

c. Individuals who have an AGI equal to or exceeding $150,000 will not be eligible for a deduction under the $25,000 exception.

IV.

Casualty and Theft Losses (Topic Review I:9-3; Instructor Aid I:9-2) The deduction for personal casualty and theft losses is limited to losses incurred in a “federally declared disaster.” Casualty and theft losses of business and investment property are always deductible.

1. Casualty Defined a. A casualty loss results from an identifiable event that was sudden, unexpected, or unusual. b. Qualifying casualties include fire, flood, hurricane, tornado, hail, and cyclone.

2. Theft Defined a. Generally, criminal intent and violation of a state law are required to meet the definition of theft. b. Theft for tax purposes includes larceny, embezzlement, robbery, blackmail, extortion, and ransom.

I:IO9-6 Copyright © 2024 Pearson Education, Inc.

3. Deductible Amount of Casualty Loss (Examples I:9-19 through I:9-21) a. The deductible amount for personal use property and a partial destruction of business property is the lesser of the reduction in FMV or adjusted basis. i.

EXAMPLE: An individual taxpayer has an asset with an adjusted basis of $10,000. The fair market value of the asset is $12,000 before the fire damage and $5,000 after the fire damage. The deductible amount of the casualty loss (before statutory reductions) is $7,000 ($12,000 - $5,000 is less than the $10,000 adjusted basis).

b. In the total destruction of business property the deductible amount is the property’s adjusted basis.

4. Limitations on Personal-Use Property (Examples I:9-22, I:9-23; Question I:9-23) a. Personal-use property casualty losses are subject to two reductions: i.

Each separate casualty loss is reduced by $100.

ii.

The total of all personal casualty losses for the year is reduced by 10% of AGI.

iii.

EXAMPLE: In the current year the taxpayer has a personal casualty loss of $30,000 from a federally declared disaster with an AGI of $140,000. The loss is reduced by $100 ($30,000 - 100 = $29,900).

The remaining total loss is further reduced by 10% of AGI ($14,000) for a net deduction of $15,900.

5. Netting Casualty Gains and Losses on Personal-Use Property (Examples I:9-24, I:9-25) a. Gains and losses on personal-use property are netted separately from gains and losses on business-use property. b. Personal casualty losses that do not result from a federally declared disaster are deductible to the extent of personal casualty gains for the year.

6. Casualty Gains and Losses Attributable to Business and Investment Property a. Business and investment casualty gains and losses are treated in the Section 1231 netting process. (See Chapter I:13.) The $100 and 10% of AGI limitations are not applicable to business and investment losses.

7. Timing of Casualty Loss Deduction (Examples I:9-26, I:9-29, I:9-30; Problem I:950) a. Loss may be deductible: I:IO9-7 Copyright © 2024 Pearson Education, Inc.

V.

i.

In the year of loss (casualty) or discovery (theft),

ii.

In the year insurance proceeds are finalized, or

iii.

In the year preceding the casualty loss year for certain federally declared disasters.

Bad Debts (Topic Review I:9-4) 1. Bona Fide Debtor-Creditor Relationship (Examples I:9-31, I:9-32) a. In order to support a bad debt deduction, the underlying debt must be a valid and enforceable obligation to pay a fixed or determinable sum of money resulting from a debtor-creditor relationship.

2. Taxpayer’s Basis in the Debt (Example I:9-33) a. The creditor must have a basis in the debt for the bad debt to be deductible. i.

EXAMPLE: Jon sells inventory to Jane on credit. Jon is a cashbased taxpayer and will not include the receivable in income until paid. If Jane fails to pay, Jon will not receive a bad debt deduction because he has no basis in the receivable (i.e., he has not recognized income).

3. Debt Must be Worthless a. The taxpayer must demonstrate that the debt is worthless.

4. Nonbusiness Bad Debts (Examples I:9-35 through I:9-37) a. A non-business bad debt is treated as a short-term capital loss.

5. Business Bad Debts (Example I:9-38; Problem I:9-53) a. Partially or totally worthless business bad debts are deductible as an ordinary loss. b. Accounting for the Business Bad Debt i.

Only the specific write-off method may be used for tax purposes, even though the allowance method may be preferable for financial purposes.

c. Recovery of Bad Debts i.

Recoveries of bad debts previously written-off are income in the year received.

I:IO9-8 Copyright © 2024 Pearson Education, Inc.

6. Deposits in Insolvent Financial Institutions a. Qualified individuals can elect to treat deposits in insolvent financial institutions as a personal casualty loss.

VI.

Net Operating Losses (Example I:9-39; Topic Review I:9-5) A net operating loss generally involves business income and deductions only. Deductible casualty and theft losses will increase an NOL. 1. Computing the Net Operating Loss (Example I:9-41) a. Several adjustments are necessary to taxable income (loss) to reach net operating loss. b. Adjustments include adding back any prior year NOL deduction, certain capital loss deductions, and any excess of non-business deductions over non-business income.

2. Carryover Periods (Example I:9-44) a. NOLs arising after December 31, 2017 are allowed to be carried forward indefinitely with no carryback. b. The NOL carryover deduction in a subsequent year is limited to 80% of taxable income before any NOL deduction. c. The CARES Act allowed for a temporary 5-year carryback for tax years 2018, 2019, and 2020 without an 80% limitation on taxable income.

VII.

Excess Business Losses (Example I:9-45) 1. Excess business losses are calculated as the excess of business deductions over business income and gains plus $289,000 ($578,000 for married filing jointly).

Excess losses are carried forward and treated as NOLs.

VIII.

Tax Planning Considerations 1. Bad Debts a. Taxpayers should document their determination that a particular debt is worthless.

2. Casualties a. Documentation of fair market value is important to support a casualty loss deduction.

I:IO9-9 Copyright © 2024 Pearson Education, Inc.

Court Case Briefs Tussaud’s Wax Museums, Inc. v. CIR, 25 TCM 1081, TC Memo 1966-211.

Tussaud’s Inc. had a display at the Seattle World’s Fair using wax figures that had been leased from Stuberghs, a California corporation. Edward Hicks and Donald Crysdale, majority and minority stockholders of Tussaud’s, borrowed $6,000 from a personal friend, Edward Liersch, to be used for promotion of the display. Liersch was to receive $10,000 as repayment for the loan. Tussaud’s Inc. coincidentally paid amounts to Liersch totaling $8,100 and recorded them on Tussaud’s Inc.’s books as “Due from Ed Liersch and others.” Liersch refused to sign a note for the money he had received and Tussaud’s Inc. claimed the $8,100 as a deduction for a bad debt. This deduction was disallowed by the IRS. The IRS argued that Tussaud’s Inc. had made payments in satisfaction of Hicks’ and Crysdale’s obligation and was actually discharging that obligation. The IRS contended that Tussaud’s Inc. could have sued Liersch for the repayment. The court found that Tussaud’s Inc. had not provided adequate proof that the loan to Liersch was uncollectible and therefore worthless. While a creditor is not required to resort to legal remedies to establish the worthlessness of the debt, Tussaud’s Inc.’s unsuccessful request that Liersch sign a note was insufficient proof that the debt was worthless.

I:IO9-10 Copyright © 2024 Pearson Education, Inc.

Instructor Aid I:9-1 Passive Losses TYPES OF INCOME (1) Active Income - wages, salaries, active business income (2) Portfolio Income - dividends, interest, annuities, royalties (3) Passive Income - from:

a) any rental activity b) any trade, business, or investment in which the taxpayer does not materially participate

GENERAL RULE: Passive losses can only be used to offset passive income.

EXCEPTIONS:

(1) Real estate professionals who materially participate in real estate trade or business activities.

(2) Taxpayers actively participating in rental real estate activities with AGIs not in excess of $100,000 may deduct $25,000 of such rental real estate losses against portfolio and active income.*

*The $25,000 amount is reduced by 50% of every dollar of AGI over $100,000. The $25,000 amount is totally phased-out at AGI of $150,000.

I:IO9-11 Copyright © 2024 Pearson Education, Inc.

Instructor Aid I:9-2 Business Casualty & Theft Losses*

Qualifying Casualties

Qualifying Thefts

•

Fire

•

Larceny

•

Flood

•

Embezzlement

•

Hurricane

•

Robbery

•

Tornado

•

Blackmail

•

Hail

•

Extortion

•

Cyclone

•

Ransom

•

Southern Pine Beetles (termites do not qualify)

* Personal casualty losses are only deductible against casualty gains unless the losses are from a federally declared disaster. Personal thefts are not deductible.

I:IO9-12 Copyright © 2024 Pearson Education, Inc.

Chapter I:9 Losses and Bad Debts Learning Objectives After studying this chapter, the student should be able to: 1. Identify transactions that may result in losses.

2. Determine the proper classification for losses.

3. Examine the tax treatment of passive losses.

4. Identify and calculate the deduction for a casualty or theft loss.

5. Compute the deduction for a bad debt.

6. Compute a net operating loss deduction.

7. Compute the excess business loss limitation.

8. Identify tax planning considerations for losses and bad debts.

9. Identify compliance and procedural considerations for losses and bad debts.

Areas of Greater Significance The treatment of passive losses is relatively complex. Passive loss rules have greatly influenced the use of limited partnerships as an investment vehicle. The treatment of business bad debts for tax purposes can be dramatically different from financial reporting, with corresponding book to tax differences.

Areas of Lesser Significance In the interest of time, the instructor may determine that the following area is best covered by student reading, rather than class discussion: 1. Compliance and Procedural Considerations

Problem Areas for Students The following areas may prove especially difficult for students: I:IO9-1 Copyright © 2024 Pearson Education, Inc.

1. Computation of passive losses and credits.

2. Computation of the deductible amount of casualty loss.

3. Computation of the net operating loss.

Highlights of Recent Tax Law Changes The following item of tax law has changed since the 2023 edition of this chapter: 1. The limit on business losses for noncorporate taxpayers has increased to the sum of business income and gains plus $289,000 ($270,000 in 2022) if single and $578,000 ($540,000 in 2022) if married filing jointly.

Teaching Tips 1. Stress the importance of the difference between ordinary losses and capital losses.

This will reinforce the necessity of learning the rules regarding gain and loss from disposition of capital assets.

2. The passive loss rules are very complex. You may want to summarize the important points you want the students to know for examination purposes.

Lecture Outline I.

Transactions that May Result in Losses (Example I:9-1; Topic Review I:9-1) Realization is a prerequisite for a tax loss.

EXAMPLE: If a taxpayer holds stock that had a $25,000 fair market value at the beginning of the tax year and a $15,000 fair market value at the end of the tax year, no loss is recognized for tax purposes, even though the value of the stock has decreased by $10,000.

1. Sale or Exchange of Property (Example I:9-2) a. In a sale or exchange, the amount of the loss is the excess of the property’s adjusted basis over the amount realized. i.

EXAMPLE: If the taxpayer realizes $10,000 from the sale of an asset with an adjusted basis of $18,000, the realized loss is $8,000 ($10,000 - $18,000).

b. Losses incurred on the sale of personal-use property are not deductible. c. Losses on trade or business property and investment property are deductible.

I:IO9-2 Copyright © 2024 Pearson Education, Inc.

2. Expropriated, Seized, Confiscated, or Condemned Property a. Property expropriated, seized, or confiscated by a foreign government gives rise to a deductible loss only if the property is used in a trade or business or is held for investment. b. Any allowable deduction must be taken in the year of actual seizure. c. Any gain realized on seizure (compensation for seizure exceeds adjusted basis of property) would be treated under the involuntary conversion rules.

(See Chapter I:12.)

3. Abandoned Property a. Abandoned property used in a trade or business or held for investment gives rise to a deductible loss. b. The amount of the loss is the adjusted basis of the asset at the date of abandonment. c. The character of the loss is ordinary, since there is no sale or exchange.

4. Worthless Securities (Example I:9-3) a. Securities determined to be worthless in a tax year are treated as a capital loss on the last day of the tax year. i.

EXAMPLE: If a calendar-year taxpayer owns securities that become worthless on March 15, the tax treatment is to recognize a capital loss on December 31.

5. Demolition of Property a. Demolition costs are to be added to the basis of the underlying property. i.

II.

EXAMPLE: A taxpayer buys real property for $450,000 and spends $90,000 to take down existing buildings in order to construct an apartment house. The basis of the land under the apartment house is $540,000 ($450,000 + $90,000).

Classifying the Loss on the Taxpayer’s Tax Return 1. Ordinary Versus Capital Loss (Example I:9-4; Question I:9-6; Problem I:9-39) a. The classification of a loss as ordinary or capital is dependent on the type of property involved and the type of transaction involved.

I:IO9-3 Copyright © 2024 Pearson Education, Inc.

b. Losses on qualifying Sec. 1244 stock are treated as ordinary ($50,000 limitation or $100,000 for married filing jointly) rather than capital (offset capital gains plus $3,000 of ordinary income). c. To qualify as Sec. 1244 stock, the stock must: i.

Be issued and owned by an individual or partnership.

ii.

The corporation must be a domestic corporation.

iii.

The stock must be issued for cash or property and not for services.

iv.

The corporation may not have derived over 50% of its gross receipts from passive income sources during the immediately preceding 5 tax years.

v.

At the time the stock is issued, the amount of money and property contributed to both capital and paid-in surplus may not exceed $1 million.

2. Disallowance Possibilities a. Certain realized losses are disallowed in special situations, including related party transactions and wash sales. b. Other potential disallowance situations include transfers of property in exchange for stock - Sec. 351 (see Chapter I:16), like-kind exchanges (see Chapter I:12), and partnerships (both under the “at-risk” limitations and the passive loss rules).

III.

Passive Losses (Topic Review I:9-2; Instructor Aid I:9-1) 1. Computation of Passive Losses and Credits (Example I:9-5) a. Passive losses may only offset passive income, not portfolio income or active income. b. Portfolio income includes non-business dividends, interest, royalties, annuities, and certain gains and losses on property. c. Credits generated from passive activities are also limited. These credits may only offset tax liability generated by passive income.

2. Carryovers (Examples I:9-6, I:9-7) a. Unutilized passive losses may be used against future passive income or on the disposition of the passive activity interest. b. The carryover is unlimited in amount and duration.

I:IO9-4 Copyright © 2024 Pearson Education, Inc.

3. Definition of Passive Activity (Examples I:9-11, I:9-12; Question I:9-9) a. Passive activity includes any rental activity and any trade, business, or investment activity in which the taxpayer does not materially participate. b. Investments in limited partnerships generate passive losses due to the legal restrictions on limited partners’ involvement in the management of the partnership.

4. Taxpayers Subject to Passive Loss Rules (Examples I:9-13; I:9-14) a. The passive loss rules apply to individuals, estates, trusts, closely held C corporations, personal service corporations, and certain publicly traded partnerships. b. While the passive loss rules do not apply to partnerships and S-Corporations directly, the rules do apply to the owners (i.e., the partners and shareholders). c. Publicly Traded Partnerships i.

Publicly traded partnerships are generally subject to corporate taxation.

ii.

Publicly traded partnerships are those whose interests are traded on an established securities market or are readily tradable on a secondary market.

iii.

Certain publicly traded partnerships may be taxed as partnerships where the passive loss rules apply at the partner level.

5. Real Estate Businesses (Example I:9-15) a. Certain real estate professionals who “materially participate” in real estate activities will not be subject to passive activity loss limitations. b. “Material participation” for this exclusion is that the taxpayer: i.

Performs more than one half of the taxpayer’s personal services in real property trades or business, and

ii.

Performs more than 750 hours of service during the taxable year in real property trades or businesses.

iii.

If the above required services are performed as an employee, they will be counted only if the taxpayer owns at least 5% of the employer.

I:IO9-5 Copyright © 2024 Pearson Education, Inc.

c. Any loss allowed under this specific provision will not reduce AGI for the purpose of applying the special $25,000 passive loss exclusion discussed below.

6. Other Rental Real Estate Activities (Example I:9-16; Problem I:9-44) a. A $25,000 exception to the passive loss rules exists for certain individuals actively participating in real estate activities. The individual must own at least 10% of the value of the activity for the entire tax year and have an AGI less than or equal to $100,000. b. Individuals who otherwise qualify must reduce the $25,000 exception for 50% of the excess of AGI over $100,000. i.

EXAMPLE: An individual has a rental real estate qualifying passive loss of $25,000 and an AGI of $130,000. The $25,000 that could be applied against portfolio or ordinary income would be reduced by [50% × ($130,000 - $100,000)] or $15,000. Only $10,000 would be deductible currently.

c. Individuals who have an AGI equal to or exceeding $150,000 will not be eligible for a deduction under the $25,000 exception.

IV.

Casualty and Theft Losses (Topic Review I:9-3; Instructor Aid I:9-2) The deduction for personal casualty and theft losses is limited to losses incurred in a “federally declared disaster.” Casualty and theft losses of business and investment property are always deductible.

1. Casualty Defined a. A casualty loss results from an identifiable event that was sudden, unexpected, or unusual. b. Qualifying casualties include fire, flood, hurricane, tornado, hail, and cyclone.

2. Theft Defined a. Generally, criminal intent and violation of a state law are required to meet the definition of theft. b. Theft for tax purposes includes larceny, embezzlement, robbery, blackmail, extortion, and ransom.

I:IO9-6 Copyright © 2024 Pearson Education, Inc.

3. Deductible Amount of Casualty Loss (Examples I:9-19 through I:9-21) a. The deductible amount for personal use property and a partial destruction of business property is the lesser of the reduction in FMV or adjusted basis. i.

EXAMPLE: An individual taxpayer has an asset with an adjusted basis of $10,000. The fair market value of the asset is $12,000 before the fire damage and $5,000 after the fire damage. The deductible amount of the casualty loss (before statutory reductions) is $7,000 ($12,000 - $5,000 is less than the $10,000 adjusted basis).

b. In the total destruction of business property the deductible amount is the property’s adjusted basis.

4. Limitations on Personal-Use Property (Examples I:9-22, I:9-23; Question I:9-23) a. Personal-use property casualty losses are subject to two reductions: i.

Each separate casualty loss is reduced by $100.

ii.

The total of all personal casualty losses for the year is reduced by 10% of AGI.

iii.

EXAMPLE: In the current year the taxpayer has a personal casualty loss of $30,000 from a federally declared disaster with an AGI of $140,000. The loss is reduced by $100 ($30,000 - 100 = $29,900).

The remaining total loss is further reduced by 10% of AGI ($14,000) for a net deduction of $15,900.

5. Netting Casualty Gains and Losses on Personal-Use Property (Examples I:9-24, I:9-25) a. Gains and losses on personal-use property are netted separately from gains and losses on business-use property. b. Personal casualty losses that do not result from a federally declared disaster are deductible to the extent of personal casualty gains for the year.

6. Casualty Gains and Losses Attributable to Business and Investment Property a. Business and investment casualty gains and losses are treated in the Section 1231 netting process. (See Chapter I:13.) The $100 and 10% of AGI limitations are not applicable to business and investment losses.

7. Timing of Casualty Loss Deduction (Examples I:9-26, I:9-29, I:9-30; Problem I:950) a. Loss may be deductible: I:IO9-7 Copyright © 2024 Pearson Education, Inc.

V.

i.

In the year of loss (casualty) or discovery (theft),

ii.

In the year insurance proceeds are finalized, or

iii.

In the year preceding the casualty loss year for certain federally declared disasters.

Bad Debts (Topic Review I:9-4) 1. Bona Fide Debtor-Creditor Relationship (Examples I:9-31, I:9-32) a. In order to support a bad debt deduction, the underlying debt must be a valid and enforceable obligation to pay a fixed or determinable sum of money resulting from a debtor-creditor relationship.

2. Taxpayer’s Basis in the Debt (Example I:9-33) a. The creditor must have a basis in the debt for the bad debt to be deductible. i.

EXAMPLE: Jon sells inventory to Jane on credit. Jon is a cashbased taxpayer and will not include the receivable in income until paid. If Jane fails to pay, Jon will not receive a bad debt deduction because he has no basis in the receivable (i.e., he has not recognized income).

3. Debt Must be Worthless a. The taxpayer must demonstrate that the debt is worthless.

4. Nonbusiness Bad Debts (Examples I:9-35 through I:9-37) a. A non-business bad debt is treated as a short-term capital loss.

5. Business Bad Debts (Example I:9-38; Problem I:9-53) a. Partially or totally worthless business bad debts are deductible as an ordinary loss. b. Accounting for the Business Bad Debt i.

Only the specific write-off method may be used for tax purposes, even though the allowance method may be preferable for financial purposes.

c. Recovery of Bad Debts i.

Recoveries of bad debts previously written-off are income in the year received.

I:IO9-8 Copyright © 2024 Pearson Education, Inc.

6. Deposits in Insolvent Financial Institutions a. Qualified individuals can elect to treat deposits in insolvent financial institutions as a personal casualty loss.

VI.

Net Operating Losses (Example I:9-39; Topic Review I:9-5) A net operating loss generally involves business income and deductions only. Deductible casualty and theft losses will increase an NOL. 1. Computing the Net Operating Loss (Example I:9-41) a. Several adjustments are necessary to taxable income (loss) to reach net operating loss. b. Adjustments include adding back any prior year NOL deduction, certain capital loss deductions, and any excess of non-business deductions over non-business income.

2. Carryover Periods (Example I:9-44) a. NOLs arising after December 31, 2017 are allowed to be carried forward indefinitely with no carryback. b. The NOL carryover deduction in a subsequent year is limited to 80% of taxable income before any NOL deduction. c. The CARES Act allowed for a temporary 5-year carryback for tax years 2018, 2019, and 2020 without an 80% limitation on taxable income.

VII.

Excess Business Losses (Example I:9-45) 1. Excess business losses are calculated as the excess of business deductions over business income and gains plus $289,000 ($578,000 for married filing jointly).

Excess losses are carried forward and treated as NOLs.

VIII.

Tax Planning Considerations 1. Bad Debts a. Taxpayers should document their determination that a particular debt is worthless.

2. Casualties a. Documentation of fair market value is important to support a casualty loss deduction.

I:IO9-9 Copyright © 2024 Pearson Education, Inc.

Court Case Briefs Tussaud’s Wax Museums, Inc. v. CIR, 25 TCM 1081, TC Memo 1966-211.

Tussaud’s Inc. had a display at the Seattle World’s Fair using wax figures that had been leased from Stuberghs, a California corporation. Edward Hicks and Donald Crysdale, majority and minority stockholders of Tussaud’s, borrowed $6,000 from a personal friend, Edward Liersch, to be used for promotion of the display. Liersch was to receive $10,000 as repayment for the loan. Tussaud’s Inc. coincidentally paid amounts to Liersch totaling $8,100 and recorded them on Tussaud’s Inc.’s books as “Due from Ed Liersch and others.” Liersch refused to sign a note for the money he had received and Tussaud’s Inc. claimed the $8,100 as a deduction for a bad debt. This deduction was disallowed by the IRS. The IRS argued that Tussaud’s Inc. had made payments in satisfaction of Hicks’ and Crysdale’s obligation and was actually discharging that obligation. The IRS contended that Tussaud’s Inc. could have sued Liersch for the repayment. The court found that Tussaud’s Inc. had not provided adequate proof that the loan to Liersch was uncollectible and therefore worthless. While a creditor is not required to resort to legal remedies to establish the worthlessness of the debt, Tussaud’s Inc.’s unsuccessful request that Liersch sign a note was insufficient proof that the debt was worthless.

I:IO9-10 Copyright © 2024 Pearson Education, Inc.

Instructor Aid I:9-1 Passive Losses TYPES OF INCOME (1) Active Income - wages, salaries, active business income (2) Portfolio Income - dividends, interest, annuities, royalties (3) Passive Income - from:

a) any rental activity b) any trade, business, or investment in which the taxpayer does not materially participate

GENERAL RULE: Passive losses can only be used to offset passive income.

EXCEPTIONS:

(1) Real estate professionals who materially participate in real estate trade or business activities.

(2) Taxpayers actively participating in rental real estate activities with AGIs not in excess of $100,000 may deduct $25,000 of such rental real estate losses against portfolio and active income.*

*The $25,000 amount is reduced by 50% of every dollar of AGI over $100,000. The $25,000 amount is totally phased-out at AGI of $150,000.

I:IO9-11 Copyright © 2024 Pearson Education, Inc.

Instructor Aid I:9-2 Business Casualty & Theft Losses*

Qualifying Casualties

Qualifying Thefts

•

Fire

•

Larceny

•

Flood

•

Embezzlement

•

Hurricane

•

Robbery

•

Tornado

•

Blackmail

•

Hail

•

Extortion

•

Cyclone

•

Ransom

•

Southern Pine Beetles (termites do not qualify)

* Personal casualty losses are only deductible against casualty gains unless the losses are from a federally declared disaster. Personal thefts are not deductible.

I:IO9-12 Copyright © 2024 Pearson Education, Inc.

Chapter I:10 Depreciation, Cost Recovery, Amortization, and Depletion Learning Objectives After studying this chapter, the student should be able to: 1. Explain the general concepts of tax depreciation and cost recovery.

2. Calculate amortization for intangible assets and distinguish between amortizable and non-amortizable assets.

3. Apply cost and percentage depletion methods and summarize the treatment for intangible drilling costs.

4. Identify tax planning considerations for depreciation.

5. Identify compliance and procedural considerations for depreciation.

Areas of Greater Significance Depreciation and cost recovery rules have changed several times over the past years.

Knowledge of these rules is important to determining the results of operations and in making investment decisions.

Areas of Lesser Significance In the interest of time, the instructor may determine that the following area is best covered by student reading, rather than class discussion: 1. Treatment of Intangible Drilling and Development Costs

Problem Areas for Students The following areas may prove especially difficult for students: 1. Recognizing when and how depreciation limits on automobiles apply.

2. Applying depreciation and depreciation recapture rules to listed property.

3. Reporting cost recovery, depreciation, depletion, and amortization.

I:IO10-1 Copyright © 2024 Pearson Education, Inc.

Highlights of Recent Tax Law Changes The following items of tax law have changed since the 2023 edition of this chapter: 1. The maximum amount of the annual Sec. 179 deduction has increased to $1,160,000 ($1,080,000 in 2022) with a phase-out beginning at $2,890,000 of qualified property placed in service ($2,700,000 in 2022).

2. Bonus depreciation has decreased to 80% (100% in 2022).

3. The maximum MACRS deduction for passenger automobiles has increased. (See page I:10-14.)

4. The maximum Sec. 179 deduction on an SUV with a GVWR exceeding 6,000 pounds has increased to $28,900 ($27,000 in 2022).

Teaching Tips Compare and contrast depreciation/cost recovery in the year of disposition for the various methods. Students may have a problem differentiating between the different disposal rules.

Lecture Outline I.

Depreciation and Cost Recovery (Instructor Aid I:10-1) 1. General Considerations (Examples I:10-1, I:10-2) a. Depreciation/cost recovery methods must be used on a consistent basis from year to year, and the adjusted basis of the asset must be reduced by depreciation/cost recovery allowed or allowable. i.

EXAMPLE: The taxpayer acquires business equipment for $50,000. During the first three years of operation, $35,600 of depreciation is allowed (and allowable). At this time the equipment has a $14,400 adjusted basis ($50,000 - $35,600) for purposes of calculating gain or loss on disposition.

b. The depreciable basis of property converted from personal use is the lower of the taxpayer’s adjusted basis or the FMV at the date of conversion.

2. Depreciation Methods (Example I:10-6; Table I:10-1; Topic Review I:10-1; Question I:10-4; Problems I:10-26, I:10-27) a. Most personal property is cost recovered using a 3-year, 5-year, or 7-year useful life. The accelerated rates are based on a 200% declining balance

I:IO10-2 Copyright © 2024 Pearson Education, Inc.

with a conversion to straight-line, a half-year convention, and no salvage value. b. Residential rental property is cost recovered over a 27 1/2-year period, and other real property is cost recovered over a 39-year period, both on a straight-line basis. c. Longer cost recovery periods are provided under the alternative depreciation system. The alternative depreciation is mandatory for E&P calculations and alternative minimum tax.

3. Section 179 Expensing Election (Example I:10-9) a. Taxpayers may elect to expense up to $1,160,000 per year of qualifying tangible personal business property. b. Taxpayers purchasing qualifying property with a cost exceeding $2,890,000 will lose $1 of potential Sec. 179 expensing for every dollar of qualifying property acquired over $2,890,000.

4. Bonus Depreciation (Example I:10-10) a. 80% bonus depreciation on qualifying tangible personal property is effective for property placed into service in 2023. b. Any Section 179 expensing is taken first, bonus depreciation next, and then the regular MACRS depreciation on the remaining basis.

5. MACRS Restrictions (Examples I:10-21, I:10-23, I:10-26; Table I:10-3; Topic Review I:10-2; Question I:10-8; Problem I:10-39) a. MACRS restrictions exist for personal use property, listed property, and luxury automobiles. b. The portion of an asset’s cost related to personal use is not depreciable. c. If business usage of an asset is 50% or less, the alternative depreciation system must be used. d. Personal automobiles are subject to a limitation on annual MACRS deductions. An adjustment is also made if a personal automobile is leased. i.

EXAMPLE: The taxpayer buys a Porsche for $90,000 in January 2023, which is to be used 100% for business purposes. The taxpayer could calculate any Section 179 expensing deduction, bonus depreciation, and MACRS depreciation. However, automobile restrictions limit annual depreciation to $12,200 ($20,200 if bonus depreciation is used) in the first year.

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II.

Amortization (Question I:10-16) Intangibles are amortized using the straight-line method.

1. Sec. 197 Intangibles (Examples I:10-29, I:10-30) a. Examples of Sec. 197 intangible assets subject to 15-year amortization are acquired goodwill, customer lists, licenses, and covenants not to compete. b. Section 197 applies only to intangible assets that are acquired in connection with the acquisition of a trade or business or a substantial portion of a trade or business.

2. Classification and Disposition of Intangible Assets (Example I:10-32) a. For gain purposes on disposition, Sec. 197 assets are treated under the depreciation recapture rules (Sec. 1245 and 1250). A loss on a Sec. 197 asset is not recognized if other intangibles from the same acquisition transaction are retained. Such a loss would be added to the basis of the remaining intangible assets.

3. Research and Experimental Expenditures (Example I:10-33; Table I:10-4) a. R&E expenditures in tax years ending before January 1, 2022 may be deducted currently, capitalized and amortized over 60 months or more, or capitalized and written off when project is abandoned or is worthless. b. R&E expenditures in tax years beginning after December 31, 2021 must be capitalized and amortized over 60 months beginning in the middle of the taxable year in which they are incurred. c. Potentially deductible research expenses or capitalized research expenses must be reduced by the full amount of any research and development credit taken for the same expenses. An election is available to reduce the R&D credit instead of the R&D expenses. (See Chapter I:14.)

4. Computer Software (Examples I:10-34, I:10-35) a. Taxpayer-developed software that is considered R&D is treated under Sec. 174. b. The treatment of acquired computer software depends on whether it is part of the hardware cost or purchased separately. c. Leased or licensed computer software is generally expensed as costs are incurred.

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III.

Depletion, Intangible Drilling, and Development Costs 1. Depletion Methods (Examples I:10-36, I:10-37) a. Taxpayers deduct the larger depletion amount calculated using the cost depletion method and the percentage depletion method. b. Cost depletion is calculated by dividing the adjusted basis of the natural resource by expected quantity to be extracted. This per-unit cost is multiplied by the units sold during the applicable tax year. c. Percentage depletion is calculated by multiplying the statutory depletion percentage (e.g., 15% for gas and oil) by the gross income generated by the natural resource.

2. Treatment of Intangible Drilling and Development Costs (Example I:10-38) a. IDCs may either be capitalized or deducted currently as an expense. b. The decision of whether to capitalize or expense will be dependent on the taxpayer’s current position (profit or loss) and the taxpayer’s expectation of profit or loss for future tax years.

IV.

Tax Planning Considerations 1. Alternative Depreciation System Under MACRS (Example I:10-39) a. Taxpayers in a loss position may be better off selecting the alternative depreciation system over the regular MACRS rules. b. This approach will stretch out the time for depreciation deductions.

2. Use of Units of Production Depreciation a. Taxpayers may exclude property from the MACRS system if the property is depreciated under the units of production method or any other method not using years as the base.

3. Structuring a Business Combination a. The buyer will want to allocate as much of the purchase price as possible to tangible depreciable assets. b. Tangible depreciable assets will result in larger depreciation deductions.

The next best alternative would be to allocate to amortizable Sec. 197 assets (e.g., goodwill).

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V.

Compliance and Procedural Considerations 1. Reporting Cost Recovery, Depreciation, Depletion, and Amortization Deductions (Example I:10-40; Figures I:10-1 and I:10-2) a. Cost recovery, depreciation, and amortization are reported on Form 4562.

The total is carried to either Schedule C (for trade or business) or Schedule E (for rental property). b. Cost recovery and depreciation are reported under the rules in effect at the time of asset acquisition. Subsequent law changes do not affect the cost recovery or depreciation of assets acquired before the effective date of the new law.

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Court Case Briefs John J. Sexton and Eileen J. Sexton v. CIR, 42 T.C. 1094 (1964); acq. 1970-1 C.B. xvi.

The taxpayer, a garbage and refuse dump operator, was allowed to depreciate a hole in the ground.

He had purchased land with clay pit excavations that were to be used as dumps. The purchase price for the land with the pits exceeded the salvage value, which was the estimated sale price of the land after the pits were filled in. The court held that the holes’ usefulness gradually would be exhausted as they were filled in, and the taxpayer was permitted to depreciate the air space in the holes. The depreciable cost basis of the air space was the excess of the purchase price over the salvage value.

E. Cody Laird and Joanne H. Laird v. U.S., 40 AFTR 2d 77-5489; 77-2 USTC & 9569 (5th Cir., 1977).

The purchase of the Atlanta Falcons professional football team franchise along with player contracts and other intangible assets such as television rights was made for $8,500,000. Of this amount approximately $7,700,000 was reported as paid for the players’ contracts. Depreciation deductions were taken for the players’ contracts, but were disallowed by the IRS. E. Cody Laird, as part owner of the team, argued that the purchase price attributable to the player contracts should be depreciated over their estimated useful lives, or in the alternative, that the purchased right to receive television revenues under a four-year contract should be amortized over its useful life of four years. Treas. Reg. ‘167(a)-3 permits the amortization of intangibles that can be separately valued which have limited useful lives which can be determined with reasonable accuracy. The IRS argued that the player contracts were mass assets incapable of separate valuation with indefinite useful lives and that the purchased television rights did not have a definite useful life but extended indefinitely into the future.

The court held that the player contracts were not governed by the mass asset rule because they could be separately valued and had a limited useful life that had been estimated with reasonable accuracy. The taxpayer was permitted to depreciate the player contracts over their useful lives, but the value of the player contracts was adjusted downward to $3,035,000. However, the court ruled that the purchased television rights had an indefinite life even though no renewal option existed.

The court considered that televised NFL football was a national tradition. Consequently, no amortization deduction was permitted for the purchased television rights.

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Instructor Aid I:10-1 Real Property Recovery Periods Date Placed in Service

Recovery Period

After 1980 and before March 16, 1984

15 years

After March 15, 1984, and before May 9, 1985*

18 years

After May 8, 1985, through December 31, 1986*

19 years

After 1986 - Residential Rental Property**

27 1/2 years

After December 31, 1986, through May 13, 1993 - Other Than Residential Rental Property**

31 1/2 years

After May 13, 1993 - Other Than Residential Rental Property**

39 years

*Low income housing placed in service during this period is still allowed to use a 15-year recovery period. **Only straight-line method available.

I:IO10-8 Copyright © 2024 Pearson Education, Inc.

Chapter I:10 Depreciation, Cost Recovery, Amortization, and Depletion Learning Objectives After studying this chapter, the student should be able to: 1. Explain the general concepts of tax depreciation and cost recovery.

2. Calculate amortization for intangible assets and distinguish between amortizable and non-amortizable assets.

3. Apply cost and percentage depletion methods and summarize the treatment for intangible drilling costs.

4. Identify tax planning considerations for depreciation.

5. Identify compliance and procedural considerations for depreciation.

Areas of Greater Significance Depreciation and cost recovery rules have changed several times over the past years.

Knowledge of these rules is important to determining the results of operations and in making investment decisions.

Areas of Lesser Significance In the interest of time, the instructor may determine that the following area is best covered by student reading, rather than class discussion: 1. Treatment of Intangible Drilling and Development Costs

Problem Areas for Students The following areas may prove especially difficult for students: 1. Recognizing when and how depreciation limits on automobiles apply.

2. Applying depreciation and depreciation recapture rules to listed property.

3. Reporting cost recovery, depreciation, depletion, and amortization.

I:IO10-1 Copyright © 2024 Pearson Education, Inc.

Highlights of Recent Tax Law Changes The following items of tax law have changed since the 2023 edition of this chapter: 1. The maximum amount of the annual Sec. 179 deduction has increased to $1,160,000 ($1,080,000 in 2022) with a phase-out beginning at $2,890,000 of qualified property placed in service ($2,700,000 in 2022).

2. Bonus depreciation has decreased to 80% (100% in 2022).

3. The maximum MACRS deduction for passenger automobiles has increased. (See page I:10-14.)

4. The maximum Sec. 179 deduction on an SUV with a GVWR exceeding 6,000 pounds has increased to $28,900 ($27,000 in 2022).

Teaching Tips Compare and contrast depreciation/cost recovery in the year of disposition for the various methods. Students may have a problem differentiating between the different disposal rules.

Lecture Outline I.

Depreciation and Cost Recovery (Instructor Aid I:10-1) 1. General Considerations (Examples I:10-1, I:10-2) a. Depreciation/cost recovery methods must be used on a consistent basis from year to year, and the adjusted basis of the asset must be reduced by depreciation/cost recovery allowed or allowable. i.

EXAMPLE: The taxpayer acquires business equipment for $50,000. During the first three years of operation, $35,600 of depreciation is allowed (and allowable). At this time the equipment has a $14,400 adjusted basis ($50,000 - $35,600) for purposes of calculating gain or loss on disposition.

b. The depreciable basis of property converted from personal use is the lower of the taxpayer’s adjusted basis or the FMV at the date of conversion.

2. Depreciation Methods (Example I:10-6; Table I:10-1; Topic Review I:10-1; Question I:10-4; Problems I:10-26, I:10-27) a. Most personal property is cost recovered using a 3-year, 5-year, or 7-year useful life. The accelerated rates are based on a 200% declining balance

I:IO10-2 Copyright © 2024 Pearson Education, Inc.

with a conversion to straight-line, a half-year convention, and no salvage value. b. Residential rental property is cost recovered over a 27 1/2-year period, and other real property is cost recovered over a 39-year period, both on a straight-line basis. c. Longer cost recovery periods are provided under the alternative depreciation system. The alternative depreciation is mandatory for E&P calculations and alternative minimum tax.

3. Section 179 Expensing Election (Example I:10-9) a. Taxpayers may elect to expense up to $1,160,000 per year of qualifying tangible personal business property. b. Taxpayers purchasing qualifying property with a cost exceeding $2,890,000 will lose $1 of potential Sec. 179 expensing for every dollar of qualifying property acquired over $2,890,000.

4. Bonus Depreciation (Example I:10-10) a. 80% bonus depreciation on qualifying tangible personal property is effective for property placed into service in 2023. b. Any Section 179 expensing is taken first, bonus depreciation next, and then the regular MACRS depreciation on the remaining basis.

5. MACRS Restrictions (Examples I:10-21, I:10-23, I:10-26; Table I:10-3; Topic Review I:10-2; Question I:10-8; Problem I:10-39) a. MACRS restrictions exist for personal use property, listed property, and luxury automobiles. b. The portion of an asset’s cost related to personal use is not depreciable. c. If business usage of an asset is 50% or less, the alternative depreciation system must be used. d. Personal automobiles are subject to a limitation on annual MACRS deductions. An adjustment is also made if a personal automobile is leased. i.

EXAMPLE: The taxpayer buys a Porsche for $90,000 in January 2023, which is to be used 100% for business purposes. The taxpayer could calculate any Section 179 expensing deduction, bonus depreciation, and MACRS depreciation. However, automobile restrictions limit annual depreciation to $12,200 ($20,200 if bonus depreciation is used) in the first year.

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II.

Amortization (Question I:10-16) Intangibles are amortized using the straight-line method.

1. Sec. 197 Intangibles (Examples I:10-29, I:10-30) a. Examples of Sec. 197 intangible assets subject to 15-year amortization are acquired goodwill, customer lists, licenses, and covenants not to compete. b. Section 197 applies only to intangible assets that are acquired in connection with the acquisition of a trade or business or a substantial portion of a trade or business.

2. Classification and Disposition of Intangible Assets (Example I:10-32) a. For gain purposes on disposition, Sec. 197 assets are treated under the depreciation recapture rules (Sec. 1245 and 1250). A loss on a Sec. 197 asset is not recognized if other intangibles from the same acquisition transaction are retained. Such a loss would be added to the basis of the remaining intangible assets.

3. Research and Experimental Expenditures (Example I:10-33; Table I:10-4) a. R&E expenditures in tax years ending before January 1, 2022 may be deducted currently, capitalized and amortized over 60 months or more, or capitalized and written off when project is abandoned or is worthless. b. R&E expenditures in tax years beginning after December 31, 2021 must be capitalized and amortized over 60 months beginning in the middle of the taxable year in which they are incurred. c. Potentially deductible research expenses or capitalized research expenses must be reduced by the full amount of any research and development credit taken for the same expenses. An election is available to reduce the R&D credit instead of the R&D expenses. (See Chapter I:14.)

4. Computer Software (Examples I:10-34, I:10-35) a. Taxpayer-developed software that is considered R&D is treated under Sec. 174. b. The treatment of acquired computer software depends on whether it is part of the hardware cost or purchased separately. c. Leased or licensed computer software is generally expensed as costs are incurred.

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III.

Depletion, Intangible Drilling, and Development Costs 1. Depletion Methods (Examples I:10-36, I:10-37) a. Taxpayers deduct the larger depletion amount calculated using the cost depletion method and the percentage depletion method. b. Cost depletion is calculated by dividing the adjusted basis of the natural resource by expected quantity to be extracted. This per-unit cost is multiplied by the units sold during the applicable tax year. c. Percentage depletion is calculated by multiplying the statutory depletion percentage (e.g., 15% for gas and oil) by the gross income generated by the natural resource.

2. Treatment of Intangible Drilling and Development Costs (Example I:10-38) a. IDCs may either be capitalized or deducted currently as an expense. b. The decision of whether to capitalize or expense will be dependent on the taxpayer’s current position (profit or loss) and the taxpayer’s expectation of profit or loss for future tax years.

IV.

Tax Planning Considerations 1. Alternative Depreciation System Under MACRS (Example I:10-39) a. Taxpayers in a loss position may be better off selecting the alternative depreciation system over the regular MACRS rules. b. This approach will stretch out the time for depreciation deductions.

2. Use of Units of Production Depreciation a. Taxpayers may exclude property from the MACRS system if the property is depreciated under the units of production method or any other method not using years as the base.

3. Structuring a Business Combination a. The buyer will want to allocate as much of the purchase price as possible to tangible depreciable assets. b. Tangible depreciable assets will result in larger depreciation deductions.

The next best alternative would be to allocate to amortizable Sec. 197 assets (e.g., goodwill).

I:IO10-5 Copyright © 2024 Pearson Education, Inc.

V.

Compliance and Procedural Considerations 1. Reporting Cost Recovery, Depreciation, Depletion, and Amortization Deductions (Example I:10-40; Figures I:10-1 and I:10-2) a. Cost recovery, depreciation, and amortization are reported on Form 4562.

The total is carried to either Schedule C (for trade or business) or Schedule E (for rental property). b. Cost recovery and depreciation are reported under the rules in effect at the time of asset acquisition. Subsequent law changes do not affect the cost recovery or depreciation of assets acquired before the effective date of the new law.

I:IO10-6 Copyright © 2024 Pearson Education, Inc.

Court Case Briefs John J. Sexton and Eileen J. Sexton v. CIR, 42 T.C. 1094 (1964); acq. 1970-1 C.B. xvi.

The taxpayer, a garbage and refuse dump operator, was allowed to depreciate a hole in the ground.

He had purchased land with clay pit excavations that were to be used as dumps. The purchase price for the land with the pits exceeded the salvage value, which was the estimated sale price of the land after the pits were filled in. The court held that the holes’ usefulness gradually would be exhausted as they were filled in, and the taxpayer was permitted to depreciate the air space in the holes. The depreciable cost basis of the air space was the excess of the purchase price over the salvage value.

E. Cody Laird and Joanne H. Laird v. U.S., 40 AFTR 2d 77-5489; 77-2 USTC & 9569 (5th Cir., 1977).

The purchase of the Atlanta Falcons professional football team franchise along with player contracts and other intangible assets such as television rights was made for $8,500,000. Of this amount approximately $7,700,000 was reported as paid for the players’ contracts. Depreciation deductions were taken for the players’ contracts, but were disallowed by the IRS. E. Cody Laird, as part owner of the team, argued that the purchase price attributable to the player contracts should be depreciated over their estimated useful lives, or in the alternative, that the purchased right to receive television revenues under a four-year contract should be amortized over its useful life of four years. Treas. Reg. ‘167(a)-3 permits the amortization of intangibles that can be separately valued which have limited useful lives which can be determined with reasonable accuracy. The IRS argued that the player contracts were mass assets incapable of separate valuation with indefinite useful lives and that the purchased television rights did not have a definite useful life but extended indefinitely into the future.

The court held that the player contracts were not governed by the mass asset rule because they could be separately valued and had a limited useful life that had been estimated with reasonable accuracy. The taxpayer was permitted to depreciate the player contracts over their useful lives, but the value of the player contracts was adjusted downward to $3,035,000. However, the court ruled that the purchased television rights had an indefinite life even though no renewal option existed.

The court considered that televised NFL football was a national tradition. Consequently, no amortization deduction was permitted for the purchased television rights.

I:IO10-7 Copyright © 2024 Pearson Education, Inc.

Instructor Aid I:10-1 Real Property Recovery Periods Date Placed in Service

Recovery Period

After 1980 and before March 16, 1984

15 years

After March 15, 1984, and before May 9, 1985*

18 years

After May 8, 1985, through December 31, 1986*

19 years

After 1986 - Residential Rental Property**

27 1/2 years

After December 31, 1986, through May 13, 1993 - Other Than Residential Rental Property**

31 1/2 years

After May 13, 1993 - Other Than Residential Rental Property**

39 years

*Low income housing placed in service during this period is still allowed to use a 15-year recovery period. **Only straight-line method available.

I:IO10-8 Copyright © 2024 Pearson Education, Inc.

Chapter I:11 Accounting Periods and Methods Learning Objectives After studying this chapter, the student should be able to: 1. Explain the rules for adopting and changing an accounting period.

2. Explain the differences between cash, accrual, and hybrid accounting.

3. Determine what costs must be included in inventory.

4. Identify the amount of income to be reported from special accounting methods.

5. Compute the amount of imputed interest in certain transactions.

6. Determine the tax treatment that results from changes in accounting methods.

7. Describe tax planning considerations for accounting periods and methods.

8. Describe compliance and procedural considerations for accounting periods and methods.

Areas of Greater Significance The chapter areas of inventory costing and installment sales may have the most widespread usage for the student. Many manufacturing and sales organizations need expertise in the area of inventory costing. Installment sales rules are especially important in real estate transactions.

Areas of Lesser Significance In the interest of time, the instructor may determine that the following area is best covered by student reading, rather than class discussion: 1. Compliance and Procedural Considerations

Problem Areas for Students The following areas may prove especially difficult for students: 1. Determination of inventory cost.

I:IO11-1 Copyright © 2024 Pearson Education, Inc.

2. Installment sales method calculation.

3. Imputed interest computation.

Highlights of Recent Tax Law Changes The following items of tax law have changed since the 2023 edition of this chapter: 1. The gross receipts threshold for adopting the cash method and the completed contract method has increased to $29 million ($27 million in 2022).

2. The maximum amount of the annual Sec. 179 deduction has increased to $1,160,000 ($1,080,000 in 2022).

3. The principal threshold for avoiding imputed interest has increased to $6,734,800 ($6,289,500 in 2022).

4. The principal threshold for avoiding accrual of imputed interest has increased to $4,810,600 ($4,492,500 in 2022).

Teaching Tips 1. The students may already be familiar with inventory costing from financial accounting courses. Concentrate on the tax differences in inventory costing (e.g., uniform capitalization rules).

2. Spend some time on the installment sales method and imputed interest as these are important tax planning tools.

Lecture Outline I.

Accounting Periods (Examples I:11-2, I:11-3; Topic Review I:11-1) Annual accounting periods are used to measure taxable income. The taxable year may be a calendar year or a fiscal year under certain restrictions. Partnerships, S corporations, and personal service corporations have special restrictions on utilization of a fiscal year.

Utilization of a 52-53-week year (e.g., tax year ending on the last Friday of December) is also allowed.

1. Required Payments and Fiscal Years (Examples I:11-4, I:11-6) a. As calendar-year tax years are required for more entities, the year-end reporting crunch for tax professionals increases.

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b. Under certain conditions, partnerships, S corporations, and personal service corporations may elect a taxable year that results in a deferral of three months or less. c. All trusts (except tax-exempt) are required to report on the calendar year.

2. Changes in the Accounting Period (Example I:11-7; Questions I:11-4, I:11-8) a. In some instances the taxpayer can change accounting periods without IRS approval, but generally IRS approval is required. b. In cases where IRS approval must be obtained, the taxpayer must establish a substantial business purpose (non-tax) for the proposed accounting period change. c. Situations where IRS approval is not necessary include: i.

Conformity between newly married spouses

ii.

Change to a 52-53-week year ending in the same calendar month as the prior tax year

iii.

Conformity between financial reporting year and tax year

iv.

Certain corporations that have not changed accounting periods within 10 years

3. Returns for Periods of Less than 12 Months (Examples I:11-8 through I:11-10; Problem I:11-39) a. A taxpayer may be required to file a short period return for the first or final tax year, or when an accounting method changes. b. Taxpayers changing from one accounting period to another must annualize their taxable income. The resulting tax calculation will eliminate any potential bracket benefit for including less than a full year of income. c. Annualization starts with modified taxable income (taxable income for the short period utilizing itemized deductions only). Modified taxable income is grossed-up by multiplying it by 12 divided by months in short period. The tax is then calculated on this grossed-up number. The resulting tax is reduced by multiplying it by months in short period divided by 12.

II.

Overall Accounting Methods (Example I:11-11; Topic Review I:11-2) Accounting methods are used to determine the tax year in which income and expenses are reported.

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1. Cash Receipts and Disbursements Method (Examples I:11-12, I:11-13) a. Cash basis taxpayers report income for the tax year in which payments are actually or constructively received. Expenses are generally deducted in the year paid. Prepaid expenses which have a life that extends substantially beyond the end of the tax year are required to be capitalized and amortized. b. Most individuals and many service businesses utilize the cash receipts and disbursements method.

2. Accrual Method (Question I:11-20) a. Accrual basis taxpayers report income and deduct expenses under the allevents and economic performance tests. b. The all-events test is met when all events have occurred to fix the taxpayer’s right to receive the income and the amount of income can be determined with reasonable accuracy. The all-events test for deductions is met when the liability is established and the amount of expense can be determined with reasonable accuracy. c. Economic performance occurs when the property or services are actually rendered by the other party. d. EXAMPLE: A cash method taxpayer would deduct state income tax when paid, regardless of the tax year involved. An accrual method taxpayer would deduct state income tax expense for the tax year involved, whether paid or not.

3. Hybrid Method a. Taxpayers who use either the cash method or accrual method of accounting for determining gross income must use the same method for determining expenses. b. The hybrid method is the least used method by taxpayers of the three major overall accounting methods.

III.

Inventories (Problem I:11-43; Instructor Aid I:11-1) 1. Determination of Inventory Cost (Example I:11-19) a. Generally, taxpayers value inventory at the lower of cost or market (replacement cost). i.

EXAMPLE: If a taxpayer’s cost in an item is $50/unit and replacement cost is $45/unit, the tax valuation of these inventory

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items would be $45/unit. This test would normally be applied to each item of inventory. b. Taxpayers who have elected LIFO must value inventory at cost. c. The regulations require inventory costing determined under the Uniform Capitalization rules for taxpayers with average gross receipts for the three preceding years exceed $29 million and specifically delineate the expenses that must be included: i.

Direct labor and materials

ii.

Manufacturing overhead, including: 1.

2.

3.

4.

5.

6.

7.

Factory repairs and maintenance Utilities Rent Insurance Small tools Tax depreciation Factory administration and officers’ salaries related to production 8. Taxes (other than income) 9. Quality control and inspection 10. Rework 11. Scrap 12. Spoilage 13. Current and past service costs of pension and profit-sharing plans 14. Service support (i.e., purchasing, payroll, and warehousing costs) 2. LIFO Method a. LIFO is preferable for tax purposes in inflationary periods as it matches the highest costs against revenues. b. Record-keeping for LIFO is difficult, but simplified methods are available including “dollar-value” pools and governmental price indexes.

IV.

Special Accounting Methods (Topic Review I:11-3) There are special accounting methods applicable to transactions that cover multiple tax years.

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1. Long-Term Contracts (Examples I:11-21, I:11-22; Instructor Aid I:11-2) a. Under complex rules, long-term contracts may be accounted for under the percentage-of-completion method, completed contract method, or modified percentage-of-completion method. Any contact accounted for using the percentage-of-completion method or a combination method is subject to a look-back interest adjustment calculated on any excess of the tax that would have been paid if actual costs would have been known over the tax that was paid utilizing estimated costs. b. The restrictions on the completed contract method are increasing over time (i.e., it is increasingly more difficult to qualify to use the completed contract method). This method is currently available only to companies whose average gross receipts for the three preceding tax years are $29 million or less, for construction contracts that are expected to take 2 years or less to complete, and for certain other taxpayers for home construction contracts.

2. Installment Sales Method (Example I:11-23; Question I:11-24; Problem I:11-47; Instructor Aid I:11-3) a. When any disposition of property for a gain occurs where at least one payment is received after the taxable year of disposition, the installment sale rules apply. The income is reported over the period payments are received, unless the taxpayer elects out of the installment method. b. The gross profit percentage (Gross Profit/Contract Price) is multiplied by the collections of principal in any tax year to determine recognized income.

All depreciation recapture must be recognized in year of disposition. c. The gain to be recognized on the disposition of installment obligations is the excess of the amount realized over the adjusted basis of the obligations.

The adjusted basis of the installment obligations can be calculated as follows: i.

Face Amount × (100% - Gross Profit Percentage)

d. Generally dealers in personal property may not use the installment method for installment sales. e. Special rules apply to installment sales for more than $150,000 and installment sales between related parties.

3. Deferred Payment Sales (Example I:11-28) a. If a taxpayer elects out of the installment method or a loss is involved, the deferred payment sales rules are applicable to determine the amount and timing of recognized gain or loss. Generally, the entire gain or loss is recognized in the year of sale.

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b. Indeterminate market value of the installment obligations (an unlikely event) can result in basis recovery before any income recognition.

V.

Imputed Interest (Example I:11-30; Topic Review I:11-4; Problem I:11-51) The tax law imputes interest in a deferred payment contract where no interest or a low rate of interest is provided. The effect of interest imputation is to reallocate characterization of payments from principal to interest.

1. Imputed Interest Computation (Example I:11-31) a. If imputed interest is required, the applicable federal rate may be substituted by the IRS for the contractual rate.

2. Accrual of Interest (Example I:11-32) a. In most situations, imputed interest is reported as it accrues. b. Imputed interest can be reported on the cash method in the following situations: i.

Sales of personal residences

ii.

Certain farm sales for $1,000,000 or less

iii.

Transactions with total payments of $250,000 or less

iv.

Related party land sales for $500,000 or less

v.

Certain sales with principal of $4,810,600 or less if borrower and lender jointly elect

3. Gift, Shareholder, and Other Loans (Example I:11-33) a. Imputed interest may also be applicable to gift loans, corporationshareholder loans, compensation-related loans, and other tax avoidance loans. b. In these types of loan situations, the lender is treated as returning the imputed interest to the borrower, resulting in possible gift tax consequences, dividend treatment, or compensation. c. Special rules exist for gift loans totaling $100,000 or less, and certain other below-market loans totaling less than $10,000.

VI.

Changes in Accounting Methods (Example I:11-34) 1. Generally, an accounting period is chosen by using it on the tax return for the first year in which the method is applicable.

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a. IRS approval is generally required to change accounting methods. b. However, taxpayers may change to LIFO inventory without prior IRS consent.

2. Amount of change (Example I:11-35) a. Generally, a change in accounting methods results in duplications or omissions of income or expense items.

3. Reporting the Amount of the Change (Example I:11-36) a. The period over which the accounting method change is reported depends on: i.

The amount 1. Changes of $3,000 or less must be reported in the year of change.

ii.

Whether the change was voluntary or involuntary 1. Several alternative methods are available for reporting involuntary changes (more than $3,000).

2. Voluntary changes must be reported over a period not to exceed 4 years.

3. Voluntary changes of $25,000 or less may be reported in the current year.

4. Obtaining IRS Consent a. The necessity of obtaining IRS approval is not always clear. i.

VII.

EXAMPLE: It is unclear whether a taxpayer must obtain prior IRS approval to change only financial reporting (in light of book and tax conformity requirements) and to change from an incorrect accounting method (e.g., cash method for purchases and sales of inventory) to a correct method (e.g., hybrid or accrual).

Tax Planning Considerations 1. Accounting Periods a. Remaining opportunities to control tax years should be investigated carefully.

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b. Short initial and termination years may result in tax benefit due to the utilization of lower tax brackets.

2. Accounting Methods a. Accounting methods should be selected carefully to avoid unfavorable tax consequences on an accounting change. i.

EXAMPLE: LIFO for inventory in inflationary times and cash method for service businesses may reduce tax. Such elections should be made on the initial return.

3. Installment Sales a. Installment sales treatment will normally be selected for qualifying sales, but low income or loss tax years may suggest current recognition. i.

VIII.

EXAMPLE: If a taxpayer expects a net operating loss in the current year, he may want to elect out of the installment method to offset the entire gain in the current year.

Compliance and Procedural Considerations 1. Reporting Installment Sales (Figure I:11-1) a. Form 6252 is used to report income from installment sales.

2. Procedures for Changing to LIFO (Example I:11-37) a. Form 970 should be filed notifying the IRS of a change to the LIFO method. b. Advance IRS approval is not necessary to change to LIFO.

I:IO11-9 Copyright © 2024 Pearson Education, Inc.

Court Case Briefs Howard F. Brunton v. CIR, 1982 PH T.C. Memo & 82,166, 43 TCM 956.

The taxpayers, who owned rental property, used a cash basis method of accounting for all receipts and some expenses, but used an accrual method basis of accounting for all real estate tax expenses.

On their federal income tax return, the Bruntons claimed expense deductions for unpaid real estate taxes for which they were liable. The IRS disallowed the use of the accrual method for the real estate taxes and claimed that Mr. Brunton was a cash basis taxpayer.

Sec. 466(a) states that taxable income is to be computed using the method of accounting that the taxpayer regularly uses to compute his income in keeping his books unless the taxpayer’s method does not clearly reflect income. The regulations in Sec. 1.446-1(c)(1)(iv)(a) further provide that a taxpayer “who uses the cash method of accounting in computing gross income ... shall use the cash method in computing expenses ...” Consequently, the Tax Court disallowed the expenses of the real estate taxes that had not actually been paid.

James E. Mahon v. CIR, 1987 PH T.C. Memo & 87,449, 54 TCM 439.

Mr. Mahon, a retired colonel of the United States Air Force, filed a return electing “married filing separate return” status. His wife also filed a return electing “married filing separate return” status.

They each included in their separate returns one-half of his wages and retirement income and onehalf of her retirement income. Each attached to their returns a “Declaration of Policy for Income Tax Payment,” which stated their perception that all their income was “joint income, equally shared, and the withheld taxes are jointly and equally paid, although the W-2s were issued in only one of our names ...” The IRS issued a notice of deficiency, claiming that Mr. Mahon failed to report one-half of his income.

The Mahons claimed that they had always thought of themselves as a team and that she had “earned” one-half of his income as a member of that team. The court, however, argued that “one of the primary principles of our income tax system is that income should be taxed to the one who earns it.” Regardless of the taxpayer’s belief that the income was attributable to both himself and his wife, the entire amount of his wages and his retirement income was paid to Mr. Mahon for services performed by Mr. Mahon.

I:IO11-10 Copyright © 2024 Pearson Education, Inc.

Instructor Aid I:11-1 Inventory Costs

Inventory Valuation Methods 1)

Cost (Must be used with LIFO cost-flow method)

2)

Lower of cost or market (each item valued separately)

Cost Flow Assumptions 1)

FIFO (first-in, first-out)

2)

LIFO (last-in, first-out): includes specific goods method, dollar-value method, and simplified method

3)

Average cost

I:IO11-11 Copyright © 2024 Pearson Education, Inc.

Instructor Aid I:11-2 Long-Term Contract Accounting Methods Completed Contract Method

Net income from contract reported in year of completion.

Only available for (1) Contracts expected to take two years or less to complete, AND where taxpayer’s average gross receipts for the three preceding tax years is $29 million or less, and (2) Certain home construction contracts.

Percentage of Completion Method

Percentage of expected net income reported in each year of contract based on estimated percentage of completed work.

Any taxpayer may use.

Percentage of Completion - Capitalized Cost Method

90% of a contract’s net income accounted for under percentage of completion method and 10% accounted for under taxpayer’s regular method of accounting (e.g., completed contract method).

Only available for (1) Contracts entered into before July 11, 1989, and (2) Certain residential construction contracts.

Modified Percentage-of-Completion Method

Percentage-of-completion method is utilized only after a minimum cumulative estimated total cost of 10% has been incurred.

Any taxpayer may use.

I:IO11-12 Copyright © 2024 Pearson Education, Inc.

Instructor Aid I:11-3 Installment Method

If a transaction qualifies for the installment method, the appropriate gross profit percentage is multiplied by the receipts under the contract during the year to determine the gross income from the contract for the year.

GROSS PROFIT PERCENTAGE Realized gain not otherwise required to be recognized in = the year of sale* ÷ Contract price CONTRACT PRICE = Gross sales price - Liabilities assumed by buyer + Any excess of liabilities assumed over the adjusted basis of the subject property** *Secs. 1245 and 1250 recapture are required to be recognized in the year of sale. **Any excess of liabilities assumed over the adjusted basis is treated as a receipt in the year of sale.

I:IO11-13 Copyright © 2024 Pearson Education, Inc.

Chapter I:11 Accounting Periods and Methods Learning Objectives After studying this chapter, the student should be able to: 1. Explain the rules for adopting and changing an accounting period.

2. Explain the differences between cash, accrual, and hybrid accounting.

3. Determine what costs must be included in inventory.

4. Identify the amount of income to be reported from special accounting methods.

5. Compute the amount of imputed interest in certain transactions.

6. Determine the tax treatment that results from changes in accounting methods.

7. Describe tax planning considerations for accounting periods and methods.

8. Describe compliance and procedural considerations for accounting periods and methods.

Areas of Greater Significance The chapter areas of inventory costing and installment sales may have the most widespread usage for the student. Many manufacturing and sales organizations need expertise in the area of inventory costing. Installment sales rules are especially important in real estate transactions.

Areas of Lesser Significance In the interest of time, the instructor may determine that the following area is best covered by student reading, rather than class discussion: 1. Compliance and Procedural Considerations

Problem Areas for Students The following areas may prove especially difficult for students: 1. Determination of inventory cost.

I:IO11-1 Copyright © 2024 Pearson Education, Inc.

2. Installment sales method calculation.

3. Imputed interest computation.

Highlights of Recent Tax Law Changes The following items of tax law have changed since the 2023 edition of this chapter: 1. The gross receipts threshold for adopting the cash method and the completed contract method has increased to $29 million ($27 million in 2022).

2. The maximum amount of the annual Sec. 179 deduction has increased to $1,160,000 ($1,080,000 in 2022).

3. The principal threshold for avoiding imputed interest has increased to $6,734,800 ($6,289,500 in 2022).

4. The principal threshold for avoiding accrual of imputed interest has increased to $4,810,600 ($4,492,500 in 2022).

Teaching Tips 1. The students may already be familiar with inventory costing from financial accounting courses. Concentrate on the tax differences in inventory costing (e.g., uniform capitalization rules).

2. Spend some time on the installment sales method and imputed interest as these are important tax planning tools.

Lecture Outline I.

Accounting Periods (Examples I:11-2, I:11-3; Topic Review I:11-1) Annual accounting periods are used to measure taxable income. The taxable year may be a calendar year or a fiscal year under certain restrictions. Partnerships, S corporations, and personal service corporations have special restrictions on utilization of a fiscal year.

Utilization of a 52-53-week year (e.g., tax year ending on the last Friday of December) is also allowed.

1. Required Payments and Fiscal Years (Examples I:11-4, I:11-6) a. As calendar-year tax years are required for more entities, the year-end reporting crunch for tax professionals increases.

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b. Under certain conditions, partnerships, S corporations, and personal service corporations may elect a taxable year that results in a deferral of three months or less. c. All trusts (except tax-exempt) are required to report on the calendar year.

2. Changes in the Accounting Period (Example I:11-7; Questions I:11-4, I:11-8) a. In some instances the taxpayer can change accounting periods without IRS approval, but generally IRS approval is required. b. In cases where IRS approval must be obtained, the taxpayer must establish a substantial business purpose (non-tax) for the proposed accounting period change. c. Situations where IRS approval is not necessary include: i.

Conformity between newly married spouses

ii.

Change to a 52-53-week year ending in the same calendar month as the prior tax year

iii.

Conformity between financial reporting year and tax year

iv.

Certain corporations that have not changed accounting periods within 10 years

3. Returns for Periods of Less than 12 Months (Examples I:11-8 through I:11-10; Problem I:11-39) a. A taxpayer may be required to file a short period return for the first or final tax year, or when an accounting method changes. b. Taxpayers changing from one accounting period to another must annualize their taxable income. The resulting tax calculation will eliminate any potential bracket benefit for including less than a full year of income. c. Annualization starts with modified taxable income (taxable income for the short period utilizing itemized deductions only). Modified taxable income is grossed-up by multiplying it by 12 divided by months in short period. The tax is then calculated on this grossed-up number. The resulting tax is reduced by multiplying it by months in short period divided by 12.

II.

Overall Accounting Methods (Example I:11-11; Topic Review I:11-2) Accounting methods are used to determine the tax year in which income and expenses are reported.

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1. Cash Receipts and Disbursements Method (Examples I:11-12, I:11-13) a. Cash basis taxpayers report income for the tax year in which payments are actually or constructively received. Expenses are generally deducted in the year paid. Prepaid expenses which have a life that extends substantially beyond the end of the tax year are required to be capitalized and amortized. b. Most individuals and many service businesses utilize the cash receipts and disbursements method.

2. Accrual Method (Question I:11-20) a. Accrual basis taxpayers report income and deduct expenses under the allevents and economic performance tests. b. The all-events test is met when all events have occurred to fix the taxpayer’s right to receive the income and the amount of income can be determined with reasonable accuracy. The all-events test for deductions is met when the liability is established and the amount of expense can be determined with reasonable accuracy. c. Economic performance occurs when the property or services are actually rendered by the other party. d. EXAMPLE: A cash method taxpayer would deduct state income tax when paid, regardless of the tax year involved. An accrual method taxpayer would deduct state income tax expense for the tax year involved, whether paid or not.

3. Hybrid Method a. Taxpayers who use either the cash method or accrual method of accounting for determining gross income must use the same method for determining expenses. b. The hybrid method is the least used method by taxpayers of the three major overall accounting methods.

III.

Inventories (Problem I:11-43; Instructor Aid I:11-1) 1. Determination of Inventory Cost (Example I:11-19) a. Generally, taxpayers value inventory at the lower of cost or market (replacement cost). i.

EXAMPLE: If a taxpayer’s cost in an item is $50/unit and replacement cost is $45/unit, the tax valuation of these inventory

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items would be $45/unit. This test would normally be applied to each item of inventory. b. Taxpayers who have elected LIFO must value inventory at cost. c. The regulations require inventory costing determined under the Uniform Capitalization rules for taxpayers with average gross receipts for the three preceding years exceed $29 million and specifically delineate the expenses that must be included: i.

Direct labor and materials

ii.

Manufacturing overhead, including: 1.

2.

3.

4.

5.

6.

7.

Factory repairs and maintenance Utilities Rent Insurance Small tools Tax depreciation Factory administration and officers’ salaries related to production 8. Taxes (other than income) 9. Quality control and inspection 10. Rework 11. Scrap 12. Spoilage 13. Current and past service costs of pension and profit-sharing plans 14. Service support (i.e., purchasing, payroll, and warehousing costs) 2. LIFO Method a. LIFO is preferable for tax purposes in inflationary periods as it matches the highest costs against revenues. b. Record-keeping for LIFO is difficult, but simplified methods are available including “dollar-value” pools and governmental price indexes.

IV.

Special Accounting Methods (Topic Review I:11-3) There are special accounting methods applicable to transactions that cover multiple tax years.

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1. Long-Term Contracts (Examples I:11-21, I:11-22; Instructor Aid I:11-2) a. Under complex rules, long-term contracts may be accounted for under the percentage-of-completion method, completed contract method, or modified percentage-of-completion method. Any contact accounted for using the percentage-of-completion method or a combination method is subject to a look-back interest adjustment calculated on any excess of the tax that would have been paid if actual costs would have been known over the tax that was paid utilizing estimated costs. b. The restrictions on the completed contract method are increasing over time (i.e., it is increasingly more difficult to qualify to use the completed contract method). This method is currently available only to companies whose average gross receipts for the three preceding tax years are $29 million or less, for construction contracts that are expected to take 2 years or less to complete, and for certain other taxpayers for home construction contracts.

2. Installment Sales Method (Example I:11-23; Question I:11-24; Problem I:11-47; Instructor Aid I:11-3) a. When any disposition of property for a gain occurs where at least one payment is received after the taxable year of disposition, the installment sale rules apply. The income is reported over the period payments are received, unless the taxpayer elects out of the installment method. b. The gross profit percentage (Gross Profit/Contract Price) is multiplied by the collections of principal in any tax year to determine recognized income.

All depreciation recapture must be recognized in year of disposition. c. The gain to be recognized on the disposition of installment obligations is the excess of the amount realized over the adjusted basis of the obligations.

The adjusted basis of the installment obligations can be calculated as follows: i.

Face Amount × (100% - Gross Profit Percentage)

d. Generally dealers in personal property may not use the installment method for installment sales. e. Special rules apply to installment sales for more than $150,000 and installment sales between related parties.

3. Deferred Payment Sales (Example I:11-28) a. If a taxpayer elects out of the installment method or a loss is involved, the deferred payment sales rules are applicable to determine the amount and timing of recognized gain or loss. Generally, the entire gain or loss is recognized in the year of sale.

I:IO11-6 Copyright © 2024 Pearson Education, Inc.

b. Indeterminate market value of the installment obligations (an unlikely event) can result in basis recovery before any income recognition.

V.

Imputed Interest (Example I:11-30; Topic Review I:11-4; Problem I:11-51) The tax law imputes interest in a deferred payment contract where no interest or a low rate of interest is provided. The effect of interest imputation is to reallocate characterization of payments from principal to interest.

1. Imputed Interest Computation (Example I:11-31) a. If imputed interest is required, the applicable federal rate may be substituted by the IRS for the contractual rate.

2. Accrual of Interest (Example I:11-32) a. In most situations, imputed interest is reported as it accrues. b. Imputed interest can be reported on the cash method in the following situations: i.

Sales of personal residences

ii.

Certain farm sales for $1,000,000 or less

iii.

Transactions with total payments of $250,000 or less

iv.

Related party land sales for $500,000 or less

v.

Certain sales with principal of $4,810,600 or less if borrower and lender jointly elect

3. Gift, Shareholder, and Other Loans (Example I:11-33) a. Imputed interest may also be applicable to gift loans, corporationshareholder loans, compensation-related loans, and other tax avoidance loans. b. In these types of loan situations, the lender is treated as returning the imputed interest to the borrower, resulting in possible gift tax consequences, dividend treatment, or compensation. c. Special rules exist for gift loans totaling $100,000 or less, and certain other below-market loans totaling less than $10,000.

VI.

Changes in Accounting Methods (Example I:11-34) 1. Generally, an accounting period is chosen by using it on the tax return for the first year in which the method is applicable.

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a. IRS approval is generally required to change accounting methods. b. However, taxpayers may change to LIFO inventory without prior IRS consent.

2. Amount of change (Example I:11-35) a. Generally, a change in accounting methods results in duplications or omissions of income or expense items.

3. Reporting the Amount of the Change (Example I:11-36) a. The period over which the accounting method change is reported depends on: i.

The amount 1. Changes of $3,000 or less must be reported in the year of change.

ii.

Whether the change was voluntary or involuntary 1. Several alternative methods are available for reporting involuntary changes (more than $3,000).

2. Voluntary changes must be reported over a period not to exceed 4 years.

3. Voluntary changes of $25,000 or less may be reported in the current year.

4. Obtaining IRS Consent a. The necessity of obtaining IRS approval is not always clear. i.

VII.

EXAMPLE: It is unclear whether a taxpayer must obtain prior IRS approval to change only financial reporting (in light of book and tax conformity requirements) and to change from an incorrect accounting method (e.g., cash method for purchases and sales of inventory) to a correct method (e.g., hybrid or accrual).

Tax Planning Considerations 1. Accounting Periods a. Remaining opportunities to control tax years should be investigated carefully.

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b. Short initial and termination years may result in tax benefit due to the utilization of lower tax brackets.

2. Accounting Methods a. Accounting methods should be selected carefully to avoid unfavorable tax consequences on an accounting change. i.

EXAMPLE: LIFO for inventory in inflationary times and cash method for service businesses may reduce tax. Such elections should be made on the initial return.

3. Installment Sales a. Installment sales treatment will normally be selected for qualifying sales, but low income or loss tax years may suggest current recognition. i.

VIII.

EXAMPLE: If a taxpayer expects a net operating loss in the current year, he may want to elect out of the installment method to offset the entire gain in the current year.

Compliance and Procedural Considerations 1. Reporting Installment Sales (Figure I:11-1) a. Form 6252 is used to report income from installment sales.

2. Procedures for Changing to LIFO (Example I:11-37) a. Form 970 should be filed notifying the IRS of a change to the LIFO method. b. Advance IRS approval is not necessary to change to LIFO.

I:IO11-9 Copyright © 2024 Pearson Education, Inc.

Court Case Briefs Howard F. Brunton v. CIR, 1982 PH T.C. Memo & 82,166, 43 TCM 956.

The taxpayers, who owned rental property, used a cash basis method of accounting for all receipts and some expenses, but used an accrual method basis of accounting for all real estate tax expenses.

On their federal income tax return, the Bruntons claimed expense deductions for unpaid real estate taxes for which they were liable. The IRS disallowed the use of the accrual method for the real estate taxes and claimed that Mr. Brunton was a cash basis taxpayer.

Sec. 466(a) states that taxable income is to be computed using the method of accounting that the taxpayer regularly uses to compute his income in keeping his books unless the taxpayer’s method does not clearly reflect income. The regulations in Sec. 1.446-1(c)(1)(iv)(a) further provide that a taxpayer “who uses the cash method of accounting in computing gross income ... shall use the cash method in computing expenses ...” Consequently, the Tax Court disallowed the expenses of the real estate taxes that had not actually been paid.

James E. Mahon v. CIR, 1987 PH T.C. Memo & 87,449, 54 TCM 439.

Mr. Mahon, a retired colonel of the United States Air Force, filed a return electing “married filing separate return” status. His wife also filed a return electing “married filing separate return” status.

They each included in their separate returns one-half of his wages and retirement income and onehalf of her retirement income. Each attached to their returns a “Declaration of Policy for Income Tax Payment,” which stated their perception that all their income was “joint income, equally shared, and the withheld taxes are jointly and equally paid, although the W-2s were issued in only one of our names ...” The IRS issued a notice of deficiency, claiming that Mr. Mahon failed to report one-half of his income.

The Mahons claimed that they had always thought of themselves as a team and that she had “earned” one-half of his income as a member of that team. The court, however, argued that “one of the primary principles of our income tax system is that income should be taxed to the one who earns it.” Regardless of the taxpayer’s belief that the income was attributable to both himself and his wife, the entire amount of his wages and his retirement income was paid to Mr. Mahon for services performed by Mr. Mahon.

I:IO11-10 Copyright © 2024 Pearson Education, Inc.

Instructor Aid I:11-1 Inventory Costs

Inventory Valuation Methods 1)

Cost (Must be used with LIFO cost-flow method)

2)

Lower of cost or market (each item valued separately)

Cost Flow Assumptions 1)

FIFO (first-in, first-out)

2)

LIFO (last-in, first-out): includes specific goods method, dollar-value method, and simplified method

3)

Average cost

I:IO11-11 Copyright © 2024 Pearson Education, Inc.

Instructor Aid I:11-2 Long-Term Contract Accounting Methods Completed Contract Method

Net income from contract reported in year of completion.

Only available for (1) Contracts expected to take two years or less to complete, AND where taxpayer’s average gross receipts for the three preceding tax years is $29 million or less, and (2) Certain home construction contracts.

Percentage of Completion Method

Percentage of expected net income reported in each year of contract based on estimated percentage of completed work.

Any taxpayer may use.

Percentage of Completion - Capitalized Cost Method

90% of a contract’s net income accounted for under percentage of completion method and 10% accounted for under taxpayer’s regular method of accounting (e.g., completed contract method).

Only available for (1) Contracts entered into before July 11, 1989, and (2) Certain residential construction contracts.

Modified Percentage-of-Completion Method

Percentage-of-completion method is utilized only after a minimum cumulative estimated total cost of 10% has been incurred.

Any taxpayer may use.

I:IO11-12 Copyright © 2024 Pearson Education, Inc.

Instructor Aid I:11-3 Installment Method

If a transaction qualifies for the installment method, the appropriate gross profit percentage is multiplied by the receipts under the contract during the year to determine the gross income from the contract for the year.

GROSS PROFIT PERCENTAGE Realized gain not otherwise required to be recognized in = the year of sale* ÷ Contract price CONTRACT PRICE = Gross sales price - Liabilities assumed by buyer + Any excess of liabilities assumed over the adjusted basis of the subject property** *Secs. 1245 and 1250 recapture are required to be recognized in the year of sale. **Any excess of liabilities assumed over the adjusted basis is treated as a receipt in the year of sale.

I:IO11-13 Copyright © 2024 Pearson Education, Inc.

Chapter I:12 Property Transactions: Nontaxable Exchanges Learning Objectives After studying this chapter, the student should be able to: 1. Examine the tax consequences arising from a like-kind exchange.

2. Determine whether gain from an involuntary conversion may be deferred.

3. Determine when a gain resulting from the sale of a principal residence is excluded.

4. Describe tax planning considerations for nontaxable exchanges.

5. Describe compliance and procedural considerations for nontaxable exchanges.

Areas of Greater Significance Familiarity with the like-kind exchange rules is very important in major real estate transactions. The chapter topic with the most widespread potential use is the exclusion of gain available on the sale of a personal residence.

Areas of Lesser Significance In the interest of time, the instructor may determine that the following area is best covered by student reading, rather than class discussion: 1. Compliance and Procedural Considerations

Problem Areas for Students The following areas may prove especially difficult for students: 1. The determination of recognized gain and adjusted basis in a like-kind exchange when mortgages are involved.

2. The determination of recognized gain in an involuntary conversion when the full proceeds are not reinvested.

I:IO12-1 Copyright © 2024 Pearson Education, Inc.

Highlights of Recent Tax Law Changes No items of tax law have changed since the 2023 edition of this chapter.

Teaching Tips 1. The concept of like-kind exchanges is very difficult for students. The more examples you can use (with simple numbers), the better the students seem to grasp the material.

2. Make sure the students understand the provisions that are mandatory (Sec. 1031) and elective (Sec. 1033). You may want to spend some time on planning to avoid the mandatory provisions.

3. Reemphasize the importance of calculating realized gain or loss first, then recognized gain or loss, then characterization, and finally adjusted basis and holding period of the newly acquired property.

Lecture Outline I.

Like-Kind Exchanges (Examples I:12-1, I:12-2; Topic Review I:12-1) Property qualifying for a like-kind exchange must be real property located in the U.S. held for investment or for use in a trade or business. The like-kind exchange treatment is mandatory if the transaction meets the statutory requirements.

1. Like-Kind Property Defined (Examples I:12-4, I:12-6; Problem I:12-26) a. Like-kind property refers to the nature and quality of the property and not its grade or quality. b. Exchanged property must be of the same class. c. Certain property (including inventory and securities) does not qualify for like-kind exchange treatment. IRC Sec. 1036 provides for exchange treatment for different types of stock in the same corporation.

2. A Direct Exchange Must Occur (Example I:12-9; Question I:12-5) a. A direct exchange must generally occur, not a conversion into proceeds with a subsequent purchase. b. Certain interdependent transactions may receive exchange treatment even though there is no direct exchange (e.g., sale to dealer immediately followed by purchase from dealer).

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c. A three-corner exchange (where one party buys property to exchange) is respected under the like-kind exchange rules.

3. Three-Party Exchanges (Examples I:12-10, I:12-11) a. Three parties may be involved in a simultaneous or non-simultaneous likekind exchange and still qualify for gain deferral. b. This format is most effective when there is a cash buyer and a seller who does not want to recognize gain currently. Finding a suitable exchange property may be difficult.

4. Receipt of Boot (Examples I:12-13, I:12-15, I:12-18) a. Gain is recognized to the extent of boot received, limited by the realized gain. No loss is ever recognized on like-kind property. However, a loss will be recognized on any boot given which has an adjusted basis exceeding its fair market value. b. Boot is any kind of non-qualifying property (e.g., cash and relief of mortgage liability). c. If both properties are encumbered with debt, the mortgages are offset to determine if there is net boot.

5. Basis of Property Received (Examples I:12-19, I:12-21, I:12-22) a. The basis of qualifying property received in a like-kind exchange is the basis of property given up less boot received plus gain recognized. For properties with a deferred gain, the new property’s basis will be its FMV less deferred gain. For properties with a deferred loss, the new property’s basis will be the FMV plus deferred loss. b. The basis of non-qualifying property (boot) received in a like-kind exchange is the property’s fair market value.

6. Exchanges Between Related Parties (Example I:12-23) a. Like-kind treatment between related parties is disallowed if either party disposes of the property within two years of the exchange. The gain(s) will be recognized in the year of subsequent disposition. Exceptions exist for dispositions due to death, involuntary conversion, or for non-tax avoidance purposes.

7. Transfer of Non-Like-Kind Property (Examples I:12-24, I:12-26) a. Gain or loss on non-qualifying property transferred pursuant to the like-kind exchange is recognized by the transferor.

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8. Holding Period for Property Received (Example I:12-27) a. The holding period of like-kind property received includes the holding period of the like-kind property given up. b. The holding period for non-qualifying property (boot) begins with the date of the exchange.

II.

Involuntary Conversions (Examples I:12-28, I:12-29; Topic Review I:12-2; Problem I:12-35; Instructor Aid I:12-1) Gains from involuntary conversions may be fully deferred if the full amount of the proceeds is invested in qualifying replacement property within a certain period and an election is made to defer the gain. Losses on involuntary conversions are fully recognized.

1. Involuntary Conversion Defined (Example I:12-31; Question I:12-12) a. Involuntary conversions include theft, seizure, requisition, condemnation, or destruction of property. The conversion may be total or partial.

Disposition of property under actual threat of condemnation also qualifies. b. Gains arise from insurance proceeds exceeding the property’s adjusted basis for casualties and thefts. Gains also arise from governmental proceeds exceeding the property’s adjusted basis for condemnations.

2. Treatment of Gain Due to Involuntary Conversion into Boot (Examples I:12-32 through I:12-34; Question I:12-14) a. Gain is recognized on involuntary conversions to the extent proceeds exceed replacement cost of qualifying property, limited to realized gain. i.

EXAMPLE: A taxpayer realizes $50,000 of gain on an involuntary conversion where she received $160,000 of insurance proceeds. If she makes a qualifying replacement for $140,000, the taxpayer must recognize $20,000 of gain ($160,000 proceeds less $140,000 replacement cost).

b. Adjusted basis of replacement property is replacement cost less unrecognized gain. i.

EXAMPLE: In the above example the taxpayer would have a basis in the replacement property of $110,000 ($140,000 cost less $30,000 unrecognized gain).

c. Severance Damages (paid by government on condemnation for a decline in value of the retained property) reduce adjusted basis of remaining property.

If severance damages exceed the remaining adjusted basis, gain is recognized.

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3. Replacement Property (Examples I:12-37 through I:12-39) a. Generally, replacement property is required to be similar or related in service or use to the converted property. i.

EXAMPLE: A stolen delivery truck used in the taxpayer’s trade or business would need to be replaced with some type of delivery vehicle to qualify for gain deferral.

b. If real property used in a trade or business or held for investment is condemned, it may be replaced under the less restrictive like-kind standard. c. Rental property may be replaced under the taxpayer-use test where the only requirement is that the owner lease the replacement property also. d. Business or investment property involuntarily converted as a result of a presidentially-declared disaster can be replaced with any tangible business property.

4. Obtaining Replacement Property (Example I:12-41) a. Generally the taxpayer must purchase the replacement property. b. Indirect purchase may be allowed by purchasing 80% control of a corporation owning qualifying replacement property.

5. Time Requirements for Replacement (Examples I:12-43, I:12-44) a. The normal replacement period is two years after the end of the tax year in which the involuntary conversion gain is realized. b. Condemned real property held for use in a trade or business or for investment can be replaced within three years after the end of the tax year in which the involuntary conversion gain is realized.

III.

Sale of Principal Residence (Examples I:12-45 through I:12-47) Individuals may exclude up to $250,000 of realized gain on the sale of a principal residence, assuming that certain conditions are met. Married taxpayers filing jointly may exclude up to $500,000 on a similar transaction. Taxpayers are required to have owned and occupied the principal residence in at least two of the last five years. No loss is recognized on the sale of a personal residence.

This IRC Sec. 121 exclusion is available at any age, and no replacement residence is required. Any realized gain in excess of the exclusion is recognized as capital gain. Any recognized gain on the sale of a principal residence is considered to be investment income, so that gain may be subject to the 3.8% tax on net investment income due to the so-called Medicare tax on higher income taxpayers. (See Chapter I:5.)

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1. Determining the Realized Gain (Example I:12-48) a. Realized gain is the amount by which the amount realized exceeds the adjusted basis of the principal residence.

2. Adjusted Basis of Residence (Example I:12-49) a. The adjusted basis of the residence at the time of sale is the original basis (i.e., cost, gift, inheritance) plus capital improvements less any allowable depreciation or casualty loss.

3. Multiple Use of Exclusion (Example I:12-50) a. The IRC Section 121 exclusion is now generally available once every two years.

4. Principal Residence Defined (Example I:12-51) a. A taxpayer has only one principal residence, but it can be a condominium, houseboat, or house trailer. b. If a taxpayer owns multiple residences, facts and circumstances are analyzed on a case-by-case basis to determine which residence is the taxpayer’s principal residence.

5. Sale of More Than One Principal Residence Within a Two-Year Period (Examples I:12-53, I:12-54) a. A pro rata exclusion may be available for sales which do not meet the twoyear rules if the multiple sales are due to a change in employment, health, or unforeseen circumstances.

6. Nonqualified Use After 2008 (Example I:12-59) a. In situations where the taxpayer converts rental real estate into the taxpayer’s personal residence, the gain allocable to periods of post-2008 nonqualified use is subject to taxation, rather than being excluded.

7. Involuntary Conversion of a Principal Residence (Example I:12-62) a. Gains on the involuntary conversion of a principal residence may be treated under the involuntary conversion rules, the gain exclusion rules, or a combination of both.

IV.

Tax Planning Considerations 1. Avoiding the Like-Kind Exchange Provisions (Example I:12-63)

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a. Taxpayers in certain situations (e.g., potential losses) may want to avoid like-kind exchange treatment. i.

EXAMPLE: Taxpayer owns a grocery store with an adjusted basis of $1,200,000 and a fair market value of $1,000,000. If the taxpayer trades the grocery store for a new grocery store, no loss can be recognized under the like-kind exchange rules. The taxpayer may be better off by selling the store outright so that the loss can be deducted.

2. Sale of a Principal Residence (Example I:12-64) a. Careful planning should be done to take full advantage of the principal residence gain exclusion. i.

EXAMPLE: If a taxpayer owns multiple residences, the taxpayer should occupy the residence that is most likely to be sold at a gain as his/her principal residence.

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Court Case Briefs Barry E. Moore and Deborah E. Moore v. CIR, TC Memo 2007-134.

In 1988, the Moores purchased a vacation home, which the family used on weekends from mid-April to Labor Day for recreational purposes. In 1999, they agreed to purchase another vacation home closer to their principal residence. In 2000, the Moores sold the first vacation home and acquired the second. The Moores asserted that the transaction constituted a tax-free, like-kind exchange under Sec. 1031 because they purchased the second vacation home as an investment property expecting to realize profit on its eventual sale. However, the Moores used both vacation homes exclusively for recreational purposes and never rented or offered to rent either vacation home to third parties. Tax Court concluded that the property was not held for investment and failed to satisfy the requirements for a like-kind exchange.

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Instructor Aid I:12-1 Involuntary Conversions

QUALIFYING EVENTS: •

Casualties

•

Thefts

•

Condemnations

QUALIFYING REPLACEMENT PERIODS: •

Three years after the end of the tax year in which the involuntary conversion gain is realized for condemned real property held for productive use in a trade or business or for investment (e.g., if the involuntary conversion gain is realized on February 5, 20X3, a qualified replacement must occur by December 31, 20X6).

•

Two years after the end of the tax year in which the involuntary conversion gain is realized for any other involuntary conversions (e.g., if the involuntary conversion gain, other than on qualifying condemned real property, is realized on February 15, 20X3, a qualified replacement must occur by December 31, 20X5).

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Chapter I:12 Property Transactions: Nontaxable Exchanges Learning Objectives After studying this chapter, the student should be able to: 1. Examine the tax consequences arising from a like-kind exchange.

2. Determine whether gain from an involuntary conversion may be deferred.

3. Determine when a gain resulting from the sale of a principal residence is excluded.

4. Describe tax planning considerations for nontaxable exchanges.

5. Describe compliance and procedural considerations for nontaxable exchanges.

Areas of Greater Significance Familiarity with the like-kind exchange rules is very important in major real estate transactions. The chapter topic with the most widespread potential use is the exclusion of gain available on the sale of a personal residence.

Areas of Lesser Significance In the interest of time, the instructor may determine that the following area is best covered by student reading, rather than class discussion: 1. Compliance and Procedural Considerations

Problem Areas for Students The following areas may prove especially difficult for students: 1. The determination of recognized gain and adjusted basis in a like-kind exchange when mortgages are involved.

2. The determination of recognized gain in an involuntary conversion when the full proceeds are not reinvested.

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Highlights of Recent Tax Law Changes No items of tax law have changed since the 2023 edition of this chapter.

Teaching Tips 1. The concept of like-kind exchanges is very difficult for students. The more examples you can use (with simple numbers), the better the students seem to grasp the material.

2. Make sure the students understand the provisions that are mandatory (Sec. 1031) and elective (Sec. 1033). You may want to spend some time on planning to avoid the mandatory provisions.

3. Reemphasize the importance of calculating realized gain or loss first, then recognized gain or loss, then characterization, and finally adjusted basis and holding period of the newly acquired property.

Lecture Outline I.

Like-Kind Exchanges (Examples I:12-1, I:12-2; Topic Review I:12-1) Property qualifying for a like-kind exchange must be real property located in the U.S. held for investment or for use in a trade or business. The like-kind exchange treatment is mandatory if the transaction meets the statutory requirements.

1. Like-Kind Property Defined (Examples I:12-4, I:12-6; Problem I:12-26) a. Like-kind property refers to the nature and quality of the property and not its grade or quality. b. Exchanged property must be of the same class. c. Certain property (including inventory and securities) does not qualify for like-kind exchange treatment. IRC Sec. 1036 provides for exchange treatment for different types of stock in the same corporation.

2. A Direct Exchange Must Occur (Example I:12-9; Question I:12-5) a. A direct exchange must generally occur, not a conversion into proceeds with a subsequent purchase. b. Certain interdependent transactions may receive exchange treatment even though there is no direct exchange (e.g., sale to dealer immediately followed by purchase from dealer).

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c. A three-corner exchange (where one party buys property to exchange) is respected under the like-kind exchange rules.

3. Three-Party Exchanges (Examples I:12-10, I:12-11) a. Three parties may be involved in a simultaneous or non-simultaneous likekind exchange and still qualify for gain deferral. b. This format is most effective when there is a cash buyer and a seller who does not want to recognize gain currently. Finding a suitable exchange property may be difficult.

4. Receipt of Boot (Examples I:12-13, I:12-15, I:12-18) a. Gain is recognized to the extent of boot received, limited by the realized gain. No loss is ever recognized on like-kind property. However, a loss will be recognized on any boot given which has an adjusted basis exceeding its fair market value. b. Boot is any kind of non-qualifying property (e.g., cash and relief of mortgage liability). c. If both properties are encumbered with debt, the mortgages are offset to determine if there is net boot.

5. Basis of Property Received (Examples I:12-19, I:12-21, I:12-22) a. The basis of qualifying property received in a like-kind exchange is the basis of property given up less boot received plus gain recognized. For properties with a deferred gain, the new property’s basis will be its FMV less deferred gain. For properties with a deferred loss, the new property’s basis will be the FMV plus deferred loss. b. The basis of non-qualifying property (boot) received in a like-kind exchange is the property’s fair market value.

6. Exchanges Between Related Parties (Example I:12-23) a. Like-kind treatment between related parties is disallowed if either party disposes of the property within two years of the exchange. The gain(s) will be recognized in the year of subsequent disposition. Exceptions exist for dispositions due to death, involuntary conversion, or for non-tax avoidance purposes.

7. Transfer of Non-Like-Kind Property (Examples I:12-24, I:12-26) a. Gain or loss on non-qualifying property transferred pursuant to the like-kind exchange is recognized by the transferor.

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8. Holding Period for Property Received (Example I:12-27) a. The holding period of like-kind property received includes the holding period of the like-kind property given up. b. The holding period for non-qualifying property (boot) begins with the date of the exchange.

II.

Involuntary Conversions (Examples I:12-28, I:12-29; Topic Review I:12-2; Problem I:12-35; Instructor Aid I:12-1) Gains from involuntary conversions may be fully deferred if the full amount of the proceeds is invested in qualifying replacement property within a certain period and an election is made to defer the gain. Losses on involuntary conversions are fully recognized.

1. Involuntary Conversion Defined (Example I:12-31; Question I:12-12) a. Involuntary conversions include theft, seizure, requisition, condemnation, or destruction of property. The conversion may be total or partial.

Disposition of property under actual threat of condemnation also qualifies. b. Gains arise from insurance proceeds exceeding the property’s adjusted basis for casualties and thefts. Gains also arise from governmental proceeds exceeding the property’s adjusted basis for condemnations.

2. Treatment of Gain Due to Involuntary Conversion into Boot (Examples I:12-32 through I:12-34; Question I:12-14) a. Gain is recognized on involuntary conversions to the extent proceeds exceed replacement cost of qualifying property, limited to realized gain. i.

EXAMPLE: A taxpayer realizes $50,000 of gain on an involuntary conversion where she received $160,000 of insurance proceeds. If she makes a qualifying replacement for $140,000, the taxpayer must recognize $20,000 of gain ($160,000 proceeds less $140,000 replacement cost).

b. Adjusted basis of replacement property is replacement cost less unrecognized gain. i.

EXAMPLE: In the above example the taxpayer would have a basis in the replacement property of $110,000 ($140,000 cost less $30,000 unrecognized gain).

c. Severance Damages (paid by government on condemnation for a decline in value of the retained property) reduce adjusted basis of remaining property.

If severance damages exceed the remaining adjusted basis, gain is recognized.

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3. Replacement Property (Examples I:12-37 through I:12-39) a. Generally, replacement property is required to be similar or related in service or use to the converted property. i.

EXAMPLE: A stolen delivery truck used in the taxpayer’s trade or business would need to be replaced with some type of delivery vehicle to qualify for gain deferral.

b. If real property used in a trade or business or held for investment is condemned, it may be replaced under the less restrictive like-kind standard. c. Rental property may be replaced under the taxpayer-use test where the only requirement is that the owner lease the replacement property also. d. Business or investment property involuntarily converted as a result of a presidentially-declared disaster can be replaced with any tangible business property.

4. Obtaining Replacement Property (Example I:12-41) a. Generally the taxpayer must purchase the replacement property. b. Indirect purchase may be allowed by purchasing 80% control of a corporation owning qualifying replacement property.

5. Time Requirements for Replacement (Examples I:12-43, I:12-44) a. The normal replacement period is two years after the end of the tax year in which the involuntary conversion gain is realized. b. Condemned real property held for use in a trade or business or for investment can be replaced within three years after the end of the tax year in which the involuntary conversion gain is realized.

III.

Sale of Principal Residence (Examples I:12-45 through I:12-47) Individuals may exclude up to $250,000 of realized gain on the sale of a principal residence, assuming that certain conditions are met. Married taxpayers filing jointly may exclude up to $500,000 on a similar transaction. Taxpayers are required to have owned and occupied the principal residence in at least two of the last five years. No loss is recognized on the sale of a personal residence.

This IRC Sec. 121 exclusion is available at any age, and no replacement residence is required. Any realized gain in excess of the exclusion is recognized as capital gain. Any recognized gain on the sale of a principal residence is considered to be investment income, so that gain may be subject to the 3.8% tax on net investment income due to the so-called Medicare tax on higher income taxpayers. (See Chapter I:5.)

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1. Determining the Realized Gain (Example I:12-48) a. Realized gain is the amount by which the amount realized exceeds the adjusted basis of the principal residence.

2. Adjusted Basis of Residence (Example I:12-49) a. The adjusted basis of the residence at the time of sale is the original basis (i.e., cost, gift, inheritance) plus capital improvements less any allowable depreciation or casualty loss.

3. Multiple Use of Exclusion (Example I:12-50) a. The IRC Section 121 exclusion is now generally available once every two years.

4. Principal Residence Defined (Example I:12-51) a. A taxpayer has only one principal residence, but it can be a condominium, houseboat, or house trailer. b. If a taxpayer owns multiple residences, facts and circumstances are analyzed on a case-by-case basis to determine which residence is the taxpayer’s principal residence.

5. Sale of More Than One Principal Residence Within a Two-Year Period (Examples I:12-53, I:12-54) a. A pro rata exclusion may be available for sales which do not meet the twoyear rules if the multiple sales are due to a change in employment, health, or unforeseen circumstances.

6. Nonqualified Use After 2008 (Example I:12-59) a. In situations where the taxpayer converts rental real estate into the taxpayer’s personal residence, the gain allocable to periods of post-2008 nonqualified use is subject to taxation, rather than being excluded.

7. Involuntary Conversion of a Principal Residence (Example I:12-62) a. Gains on the involuntary conversion of a principal residence may be treated under the involuntary conversion rules, the gain exclusion rules, or a combination of both.

IV.

Tax Planning Considerations 1. Avoiding the Like-Kind Exchange Provisions (Example I:12-63)

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a. Taxpayers in certain situations (e.g., potential losses) may want to avoid like-kind exchange treatment. i.

EXAMPLE: Taxpayer owns a grocery store with an adjusted basis of $1,200,000 and a fair market value of $1,000,000. If the taxpayer trades the grocery store for a new grocery store, no loss can be recognized under the like-kind exchange rules. The taxpayer may be better off by selling the store outright so that the loss can be deducted.

2. Sale of a Principal Residence (Example I:12-64) a. Careful planning should be done to take full advantage of the principal residence gain exclusion. i.

EXAMPLE: If a taxpayer owns multiple residences, the taxpayer should occupy the residence that is most likely to be sold at a gain as his/her principal residence.

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Court Case Briefs Barry E. Moore and Deborah E. Moore v. CIR, TC Memo 2007-134.

In 1988, the Moores purchased a vacation home, which the family used on weekends from mid-April to Labor Day for recreational purposes. In 1999, they agreed to purchase another vacation home closer to their principal residence. In 2000, the Moores sold the first vacation home and acquired the second. The Moores asserted that the transaction constituted a tax-free, like-kind exchange under Sec. 1031 because they purchased the second vacation home as an investment property expecting to realize profit on its eventual sale. However, the Moores used both vacation homes exclusively for recreational purposes and never rented or offered to rent either vacation home to third parties. Tax Court concluded that the property was not held for investment and failed to satisfy the requirements for a like-kind exchange.

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Instructor Aid I:12-1 Involuntary Conversions

QUALIFYING EVENTS: •

Casualties

•

Thefts

•

Condemnations

QUALIFYING REPLACEMENT PERIODS: •

Three years after the end of the tax year in which the involuntary conversion gain is realized for condemned real property held for productive use in a trade or business or for investment (e.g., if the involuntary conversion gain is realized on February 5, 20X3, a qualified replacement must occur by December 31, 20X6).

•

Two years after the end of the tax year in which the involuntary conversion gain is realized for any other involuntary conversions (e.g., if the involuntary conversion gain, other than on qualifying condemned real property, is realized on February 15, 20X3, a qualified replacement must occur by December 31, 20X5).

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Chapter I:13 Property Transactions: Section 1231 and Recapture Learning Objectives After studying this chapter, the student should be able to: 1. Understand the basic tax treatment for Sec. 1231 transactions.

2. Identify Sec. 1231 property.

3. Understand the tax treatment for Sec. 1231 transactions.

4. Apply the recapture provisions of Sec. 1245.

5. Apply the recapture provisions of Sec. 1250.

6. Understand recapture provisions for corporations.

7. Describe other recapture applications.

8. Describe tax planning considerations for Sec. 1231 assets.

9. Describe compliance and procedural considerations for Sec. 1231 assets.

Areas of Greater Significance Due to differences between ordinary income treatment and capital gain treatment and between ordinary losses and capital losses, Secs. 1231, 1245, and 1250 distinctions have considerable importance.

Areas of Lesser Significance In the interest of time, the instructor may determine that the following areas are best covered by student reading, rather than class discussion: 1. History of Sec. 1231 2. Conservation and Land Clearing Expenditures 3. Intangible Drilling Costs and Depletion 4. Tax Planning Considerations

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Problem Areas for Students The following areas may prove especially difficult for students: 1. The Sec. 1231 netting process.

2. Calculation of appropriate Sec. 1245 recapture.

3. Calculation of appropriate Sec. 1250 recapture and unrecaptured Sec. 1250 gain.

Highlights of Recent Tax Law Changes The following items of tax law have changed since the 2023 edition of this chapter: 1. The income levels for tax rates for ordinary income, long-term capital gains, dividend income, and the kiddie tax have increased. (See Quick Reference.)

2. The maximum amount of the annual Sec. 179 deduction has increased to $1,160,000 ($1,080,000 in 2022) with a phase-out beginning at $2,890,000 of qualified property placed in service ($2,700,000 in 2022).

Teaching Tips 1. Remind the students that Sec. 1231, 1245, and 1250 are merely characterization provisions. The recognized gain or loss must be calculated first. Then the correct characterization provision is applied only to recognized gain or loss.

2. The two levels of netting for Sec. 1231 characterization purposes are difficult for many students. The use of a flow chart (see Instructor Aid I:13-1) helps the students see the appropriate analysis.

Lecture Outline I.

Overview of Basic Tax Treatment for Sec. 1231 1. Net Gains (Example I:13-1) a. Generally, net Sec. 1231 gain is treated as net long-term capital gain. b. However, if the taxpayer has had net Sec. 1231 losses in any of the previous five taxable years, the current year’s net Sec. 1231 gain may be treated as ordinary to the extent of the previous unrecovered net Sec. 1231 losses.

2. Net Losses (Examples I:13-3, I:13-5) a. Net Sec. 1231 loss is treated as ordinary loss.

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b. This net ordinary loss treatment is not subject to the $3,000 limitation applicable to net capital losses.

3. Tax Rate for Net Sec. 1231 Gain (Examples I:13-6, I:13-7) a. Net Sec. 1231 gain is recharacterized as ordinary income under the fiveyear look back rule in the following order:

II.

i.

Unrecaptured Sec. 1250 gain (25% rate).

ii.

Net Sec. 1231 gain (generally subject to the 15% or 20% rate).

Section 1231 Property 1. Section 1231 Property Defined a. Sec. 1231 property is generally property used in a trade or business (real property or depreciable property) that has been held more than one year.

2. Real or Depreciable Property Used in a Trade or Business (Examples I:13-10, I:1313; Question I:13-1) a. Exceptions to the general rule (property generating ordinary income) are inventory, publications of the U.S. government, copyrights, literary, musical or artistic compositions, and letters or memorandums. b. Sec. 1231 property is expressly excluded from the tax definition of capital assets. c. Property which would qualify as Sec. 1231 property except that it does not meet the holding period requirement (i.e., the property is held one year or less) is treated as ordinary income property. d. An election can be made to treat the cutting of lumber as the sale of a Sec. 1231 asset. The gain or loss is computed by comparing the FMV of the timber with its adjusted basis for depletion purposes. If the timber is subsequently sold for more or less than its FMV at cutting, such gain or loss is ordinary. e. Coal or domestic iron ore is considered a Sec. 1231 asset. f. Livestock held for draft, breeding, dairy, or sporting purposes is Sec. 1231 property. Cattle and horses, however, must be held more than 24 months to receive Sec. 1231 treatment. g. Unharvested crops sold with the land at the same time and to the same person are considered Sec. 1231 property. If this treatment is appropriate, the associated crop production costs are capitalized rather than expensed.

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3. Condemnations (Example I:13-14) a. Gains or losses from condemned Sec. 1231 property and non-personal condemned capital assets are treated as Sec. 1231 gains and losses. b. To the extent that gain is recognized after application of the involuntary conversion deferral rules, the gain is included in the Sec. 1231 netting process.

4. Other Involuntary Conversions (Example I:13-15; Question I:13-25) a. A net gain on Sec. 1231 property arising from casualties and thefts is treated as Sec. 1231 gain (requiring further netting), but a net loss on Sec. 1231 property arising from casualties and thefts is treated as ordinary. b. EXAMPLE: If a taxpayer has a net loss of $50,000 from business casualties and thefts, that net loss is taken as ordinary with no further effect on Sec. 1231 transactions. If a taxpayer has a net gain of $30,000 from business casualties and thefts (after application of the involuntary conversion gain deferral rules), that gain is netted with other types of Sec. 1231 gains and losses to determine the net overall result.

III.

Procedure for Sec. 1231 Treatment (Examples I:13-16, I:13-17; Problems I:13-33, I:13-38; Instructor Aid I:13-1) 1. The following steps are necessary to determine Sec. 1231 treatment: a. All non-personal casualty and theft gains and losses (other than from ordinary income assets) are netted. If the total is a net loss, there is ordinary treatment. If the total is a net gain, the amount is included in the regular Sec. 1231 netting. b. Determine the net amount of Sec. 1231 gain or loss by including net gain from step 1 above, condemnation gains and losses from Sec. 1231 assets and non-personal capital assets, and gains and losses from the sale or exchange of Sec. 1231 assets. c. If this netting results in a net gain, the gain is treated as a net long-term capital gain, unless there are unrecaptured Sec. 1231 ordinary losses during the prior five-year period. To the extent there are unrecaptured Sec. 1231 ordinary losses during the prior five-year period, the current year net Sec. 1231 gain will be treated as ordinary. d. If the netting results in a net loss, it is treated as ordinary.

2. Remember that depreciation/cost recovery recapture must be calculated before the Sec. 1231 gain or loss can be computed.

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IV.

Recapture Provisions of Sec. 1245 (Examples I:13-19, I:13-20; Topic Review I:13-1; Question I:13-10; Problem I:13-41) 1. A gain from the disposition of Sec. 1245 property is treated as ordinary to the extent of depreciation/cost recovery taken, limited by the realized gain. a. EXAMPLE: If a taxpayer has realized/recognized gain of $20,000 on the disposition of a Sec. 1245 asset and had taken $15,000 of depreciation/cost recovery related to the asset, the taxpayer would recognize $15,000 of Sec. 1245 ordinary income and $5,000 of Sec. 1231 gain.

2. Purpose of Sec. 1245 (Example I:13-21) a. The purpose of Sec. 1245 is to recapture ordinary deductions as ordinary income. b. Sec. 1245 is a characterization provision only (i.e., does not create or add to recognized gain) and does not apply to losses.

3. Section 1245 Property (Examples I:13-22, I:13-23) a. The most common example of Sec. 1245 property is depreciable personal property. b. Commercial real property acquired between 1981 and 1986 which was subject to ACRS is subject to Sec. 1245 recapture. If straight-line depreciation was elected for this type of property, Sec. 1250 recapture rules apply.

V.

Recapture Provisions of Sec. 1250 (Topic Review I:13-2; Problem I:13-49) 1. Purpose of Sec. 1250 a. The purpose of Sec. 1250 is to convert a portion of the gain on sale of certain depreciable real property into ordinary income. b. Sec. 1250 recapture can be avoided by using straight-line depreciation or holding property until accelerated depreciation equals straight-line depreciation (usually at the end of the recovery period).

2. Section 1250 Property Defined (Example I:13-26) a. Section 1250 property is depreciable real property not covered by the Sec. 1245 recapture rules. b. Sec. 1250 recapture is not required on any real property acquired after 1986, since only straight-line depreciation is allowed on such assets.

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3. Unrecaptured Section 1250 Gain a. Unrecaptured Sec. 1250 gain is taxed at a 25% rate: The definition of unrecaptured Sec. 1250 gain is the amount of gain (not otherwise treated as ordinary) which would be taxed as ordinary if Sec. 1250 recaptured all depreciation, not just additional depreciation.

4. Depreciable Real Property Placed in Service Before 1981 (Example I:13-30) a. Pre-1981-acquired real estate may be subject to Sec. 1250 recapture on the excess of accelerated depreciation taken over straight-line depreciation, depending on the date of acquisition and holding period.

5. Depreciable Real Property Placed in Service after 1980 and Before 1987 (Example I:13-33) a. ACRS nonresidential real estate (acquired between January 1, 1981 and December 31, 1986) is subject to Sec. 1245 recapture, unless straight-line recovery was elected. b. ACRS residential rental property is subject to Sec. 1250 recapture on all recovery deductions taken in excess of straight-line recovery, limited by realized gain.

6. Depreciable Real Property Placed in Service after 1986 (Example I:13-35) a. Sec. 1250 recapture is not required on any real property acquired after 1986, since only straight-line depreciation is allowed on such assets. b. Unrecaptured Sec. 1250 gain is taxed at a 25% rate: The definition of unrecaptured Sec. 1250 gain is the amount of gain (not otherwise treated as ordinary) which would be taxed as ordinary if Sec. 1250 recaptured all depreciation, not just additional depreciation.

7. Low Income Housing a. Qualified low-income housing may have less Sec. 1250 recapture than other residential rental property. b. In addition, a low-income housing credit and rapid amortization of rehabilitation expenses may be available.

VI.

Additional Recapture for Corporations (Example I:13-37, Problem I:13-57) 1. Under Section 291, corporations are subject to additional recapture in the amount of 20% of the excess of what would be recaptured under Sec. 1245 over the actual Sec. 1250 recapture.

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a. EXAMPLE: If a corporate taxpayer sold a commercial building with a resulting $200,000 realized/recognized gain, and had taken $150,000 of straight/line depreciation related to the building, it would recognize $30,000 of Sec. 1250 ordinary income (20% × $150,000) and $170,000 of Sec. 1231 gain. An individual under the same facts would have no Sec. 1250 recapture, but would have net unrecaptured Sec. 1250 gain taxed at 25%. The concept of unrecaptured Sec. 1250 gain is not applicable to corporations.

VII.

Recapture Provisions - Other Applications (Instructor Aid I:13-2) 1. Gifts of Property Subject to Recapture (Example I:13-38) a. No recapture is recognized by the donor in a gift situation, but the recapture potential passes to the donee.

2. Transfer of Property Subject to Recapture at Death (Example I:13-40) a. Any recapture potential ceases on the death of the owner. The recipient takes an income tax basis equal to the fair market value of the property on the date of death or alternate valuation date.

3. Charitable Contributions (Example I:13-41) a. The amount of the charitable contribution is reduced by the recapture potential, but the recapture is not recognized. i.

EXAMPLE: A taxpayer contributing property with a FMV of $50,000 which is subject to $10,000 of Sec. 1245 recapture would be allowed a deduction of only $40,000 ($50,000 less $10,000 recapture). No gain would be recognized.

4. Like-Kind Exchanges (Example I:13-42) a. Any gain recognized in a like-kind exchange is first recaptured to the extent applicable.

5. Involuntary Conversions (Example I:13-44) a. Any gain recognized on an involuntary conversion is first recaptured to the extent applicable.

6. Installment Sales (Example I:13-45) a. In an installment sale all the recapture income (whether Sec. 1245 or Sec. 1250), limited by realized gain, must be recognized in the year of the sale. i.

EXAMPLE: The taxpayer sold property under an arrangement qualifying for the installment method for a $100,000 realized gain I:IO13-7 Copyright © 2024 Pearson Education, Inc.

and had $90,000 of associated Sec. 1245 recapture. The taxpayer would recognize the $90,000 Sec. 1245 gain in the year of sale, even if she received no proceeds in the year of sale.

7. Section 179 Expensing Election (Example I:13-47) a. Recapture of amounts expensed may be necessary if an expensed asset is converted to personal use. The amount recaptured would be the excess of the expensed amount over the allowable depreciation to the date of conversion.

8. Conservation and Land Clearing Expenditures (Example I:13-48) a. Deductions for conservation and land clearing expenses may be recaptured if the farmland is disposed of within 10 years.

9. Intangible Drilling Costs and Depletion (Example I:13-49; Problem I:13-62) a. IDC deducted in excess of cost depletion (limited by realized gain) may be recaptured on the sale of oil and gas properties. b. For post-1986 disposition of geothermal, oil, gas, or other mineral properties, recapture may be required for both IDC and depletion. The recapture may not exceed the realized gain.

10. Gain on Sale of Depreciable Property Between Related Parties (Examples I:13-51, I:13-52; Problem I:13-63) a. Gain recognized on a sale or exchange between related parties is ordinary income if the property was depreciable. b. Related persons include a controlled corporation (>50%), a controlled partnership (>50%), entities which are controlled by the above-described controlled entities, and trusts in which the taxpayer or spouse are beneficiaries. The attribution rules of Sec. 267 apply.

VIII.

Compliance and Procedural Considerations 1. Reporting Sec. 1231 Gains and Losses on Form 4797 (Figure I:13-1) a. Sec. 1231 gains and losses are reported on Parts I and II, Form 4797.

2. Reporting Gains Recaptured as Ordinary Income on Form 4797 (Figure I:13-2) a. Recapture income is reported on Part III, Form 4797.

3. Reporting Casualty or Theft Gain or Loss on Form 4684 (Figure I:13-3)

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a. Casualty or theft gains or losses from Sec. 1231 assets are reported on Section B, Form 4684.

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Court Case Briefs Desilu Productions Inc. v. CIR, 1965 PH T.C. Memo & 65,307, 24 TCM 1695.

Lucille Ball Arnaz and Desi Arnaz formed Desilu Productions, Inc. in 1951 for the purpose of producing television films for their own account. The company had its own facilities and a complete staff for carrying out this enterprise. The company received rental income related to the films it produced from the licensing to networks and the relicensing to individual television stations. With the exception of the sale of films in connection with a stock redemption in 1956, the company had not sold any other films. In 1962, Desilu Productions sold 13 films to CBS and reported the gain from the sale as a capital gain pursuant to Sec. 1231. The IRS determined that the gain was ordinary income because the films were held primarily for sale in the ordinary course of business and were not susceptible to capital gain treatment.

The evidence demonstrated that the sale was the result of failed negotiations to relicense the 13 films.

The court held that the films were subject to capital gain treatment under Sec. 1231 because the primary business of Desilu Productions Inc, was producing films and licensing them to networks and not the sale of films. “The nature of the petitioner’s business is no mystery.”

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Instructor Aid I:13-1 Section 1231 Netting

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Instructor Aid I:13-2 Types of Recapture

Depreciation / Cost Recovery

Sec. 1245 and 1250*

Expensing Election

Sec. 179

Conservation and Land Clearing Expenditures

Sec. 1252

Intangible Drilling Costs

Sec. 1254

Related Parties

Sec. 1239

* Corporations experience ordinary income recapture on real property under Section 291. Individuals experience unrecaptured 1250 gains on real property because the Section 1250 provisions generally no longer apply.

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Chapter I:13 Property Transactions: Section 1231 and Recapture Learning Objectives After studying this chapter, the student should be able to: 1. Understand the basic tax treatment for Sec. 1231 transactions.

2. Identify Sec. 1231 property.

3. Understand the tax treatment for Sec. 1231 transactions.

4. Apply the recapture provisions of Sec. 1245.

5. Apply the recapture provisions of Sec. 1250.

6. Understand recapture provisions for corporations.

7. Describe other recapture applications.

8. Describe tax planning considerations for Sec. 1231 assets.

9. Describe compliance and procedural considerations for Sec. 1231 assets.

Areas of Greater Significance Due to differences between ordinary income treatment and capital gain treatment and between ordinary losses and capital losses, Secs. 1231, 1245, and 1250 distinctions have considerable importance.

Areas of Lesser Significance In the interest of time, the instructor may determine that the following areas are best covered by student reading, rather than class discussion: 1. History of Sec. 1231 2. Conservation and Land Clearing Expenditures 3. Intangible Drilling Costs and Depletion 4. Tax Planning Considerations

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Problem Areas for Students The following areas may prove especially difficult for students: 1. The Sec. 1231 netting process.

2. Calculation of appropriate Sec. 1245 recapture.

3. Calculation of appropriate Sec. 1250 recapture and unrecaptured Sec. 1250 gain.

Highlights of Recent Tax Law Changes The following items of tax law have changed since the 2023 edition of this chapter: 1. The income levels for tax rates for ordinary income, long-term capital gains, dividend income, and the kiddie tax have increased. (See Quick Reference.)

2. The maximum amount of the annual Sec. 179 deduction has increased to $1,160,000 ($1,080,000 in 2022) with a phase-out beginning at $2,890,000 of qualified property placed in service ($2,700,000 in 2022).

Teaching Tips 1. Remind the students that Sec. 1231, 1245, and 1250 are merely characterization provisions. The recognized gain or loss must be calculated first. Then the correct characterization provision is applied only to recognized gain or loss.

2. The two levels of netting for Sec. 1231 characterization purposes are difficult for many students. The use of a flow chart (see Instructor Aid I:13-1) helps the students see the appropriate analysis.

Lecture Outline I.

Overview of Basic Tax Treatment for Sec. 1231 1. Net Gains (Example I:13-1) a. Generally, net Sec. 1231 gain is treated as net long-term capital gain. b. However, if the taxpayer has had net Sec. 1231 losses in any of the previous five taxable years, the current year’s net Sec. 1231 gain may be treated as ordinary to the extent of the previous unrecovered net Sec. 1231 losses.

2. Net Losses (Examples I:13-3, I:13-5) a. Net Sec. 1231 loss is treated as ordinary loss.

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b. This net ordinary loss treatment is not subject to the $3,000 limitation applicable to net capital losses.

3. Tax Rate for Net Sec. 1231 Gain (Examples I:13-6, I:13-7) a. Net Sec. 1231 gain is recharacterized as ordinary income under the fiveyear look back rule in the following order:

II.

i.

Unrecaptured Sec. 1250 gain (25% rate).

ii.

Net Sec. 1231 gain (generally subject to the 15% or 20% rate).

Section 1231 Property 1. Section 1231 Property Defined a. Sec. 1231 property is generally property used in a trade or business (real property or depreciable property) that has been held more than one year.

2. Real or Depreciable Property Used in a Trade or Business (Examples I:13-10, I:1313; Question I:13-1) a. Exceptions to the general rule (property generating ordinary income) are inventory, publications of the U.S. government, copyrights, literary, musical or artistic compositions, and letters or memorandums. b. Sec. 1231 property is expressly excluded from the tax definition of capital assets. c. Property which would qualify as Sec. 1231 property except that it does not meet the holding period requirement (i.e., the property is held one year or less) is treated as ordinary income property. d. An election can be made to treat the cutting of lumber as the sale of a Sec. 1231 asset. The gain or loss is computed by comparing the FMV of the timber with its adjusted basis for depletion purposes. If the timber is subsequently sold for more or less than its FMV at cutting, such gain or loss is ordinary. e. Coal or domestic iron ore is considered a Sec. 1231 asset. f. Livestock held for draft, breeding, dairy, or sporting purposes is Sec. 1231 property. Cattle and horses, however, must be held more than 24 months to receive Sec. 1231 treatment. g. Unharvested crops sold with the land at the same time and to the same person are considered Sec. 1231 property. If this treatment is appropriate, the associated crop production costs are capitalized rather than expensed.

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3. Condemnations (Example I:13-14) a. Gains or losses from condemned Sec. 1231 property and non-personal condemned capital assets are treated as Sec. 1231 gains and losses. b. To the extent that gain is recognized after application of the involuntary conversion deferral rules, the gain is included in the Sec. 1231 netting process.

4. Other Involuntary Conversions (Example I:13-15; Question I:13-25) a. A net gain on Sec. 1231 property arising from casualties and thefts is treated as Sec. 1231 gain (requiring further netting), but a net loss on Sec. 1231 property arising from casualties and thefts is treated as ordinary. b. EXAMPLE: If a taxpayer has a net loss of $50,000 from business casualties and thefts, that net loss is taken as ordinary with no further effect on Sec. 1231 transactions. If a taxpayer has a net gain of $30,000 from business casualties and thefts (after application of the involuntary conversion gain deferral rules), that gain is netted with other types of Sec. 1231 gains and losses to determine the net overall result.

III.

Procedure for Sec. 1231 Treatment (Examples I:13-16, I:13-17; Problems I:13-33, I:13-38; Instructor Aid I:13-1) 1. The following steps are necessary to determine Sec. 1231 treatment: a. All non-personal casualty and theft gains and losses (other than from ordinary income assets) are netted. If the total is a net loss, there is ordinary treatment. If the total is a net gain, the amount is included in the regular Sec. 1231 netting. b. Determine the net amount of Sec. 1231 gain or loss by including net gain from step 1 above, condemnation gains and losses from Sec. 1231 assets and non-personal capital assets, and gains and losses from the sale or exchange of Sec. 1231 assets. c. If this netting results in a net gain, the gain is treated as a net long-term capital gain, unless there are unrecaptured Sec. 1231 ordinary losses during the prior five-year period. To the extent there are unrecaptured Sec. 1231 ordinary losses during the prior five-year period, the current year net Sec. 1231 gain will be treated as ordinary. d. If the netting results in a net loss, it is treated as ordinary.

2. Remember that depreciation/cost recovery recapture must be calculated before the Sec. 1231 gain or loss can be computed.

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IV.

Recapture Provisions of Sec. 1245 (Examples I:13-19, I:13-20; Topic Review I:13-1; Question I:13-10; Problem I:13-41) 1. A gain from the disposition of Sec. 1245 property is treated as ordinary to the extent of depreciation/cost recovery taken, limited by the realized gain. a. EXAMPLE: If a taxpayer has realized/recognized gain of $20,000 on the disposition of a Sec. 1245 asset and had taken $15,000 of depreciation/cost recovery related to the asset, the taxpayer would recognize $15,000 of Sec. 1245 ordinary income and $5,000 of Sec. 1231 gain.

2. Purpose of Sec. 1245 (Example I:13-21) a. The purpose of Sec. 1245 is to recapture ordinary deductions as ordinary income. b. Sec. 1245 is a characterization provision only (i.e., does not create or add to recognized gain) and does not apply to losses.

3. Section 1245 Property (Examples I:13-22, I:13-23) a. The most common example of Sec. 1245 property is depreciable personal property. b. Commercial real property acquired between 1981 and 1986 which was subject to ACRS is subject to Sec. 1245 recapture. If straight-line depreciation was elected for this type of property, Sec. 1250 recapture rules apply.

V.

Recapture Provisions of Sec. 1250 (Topic Review I:13-2; Problem I:13-49) 1. Purpose of Sec. 1250 a. The purpose of Sec. 1250 is to convert a portion of the gain on sale of certain depreciable real property into ordinary income. b. Sec. 1250 recapture can be avoided by using straight-line depreciation or holding property until accelerated depreciation equals straight-line depreciation (usually at the end of the recovery period).

2. Section 1250 Property Defined (Example I:13-26) a. Section 1250 property is depreciable real property not covered by the Sec. 1245 recapture rules. b. Sec. 1250 recapture is not required on any real property acquired after 1986, since only straight-line depreciation is allowed on such assets.

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3. Unrecaptured Section 1250 Gain a. Unrecaptured Sec. 1250 gain is taxed at a 25% rate: The definition of unrecaptured Sec. 1250 gain is the amount of gain (not otherwise treated as ordinary) which would be taxed as ordinary if Sec. 1250 recaptured all depreciation, not just additional depreciation.

4. Depreciable Real Property Placed in Service Before 1981 (Example I:13-30) a. Pre-1981-acquired real estate may be subject to Sec. 1250 recapture on the excess of accelerated depreciation taken over straight-line depreciation, depending on the date of acquisition and holding period.

5. Depreciable Real Property Placed in Service after 1980 and Before 1987 (Example I:13-33) a. ACRS nonresidential real estate (acquired between January 1, 1981 and December 31, 1986) is subject to Sec. 1245 recapture, unless straight-line recovery was elected. b. ACRS residential rental property is subject to Sec. 1250 recapture on all recovery deductions taken in excess of straight-line recovery, limited by realized gain.

6. Depreciable Real Property Placed in Service after 1986 (Example I:13-35) a. Sec. 1250 recapture is not required on any real property acquired after 1986, since only straight-line depreciation is allowed on such assets. b. Unrecaptured Sec. 1250 gain is taxed at a 25% rate: The definition of unrecaptured Sec. 1250 gain is the amount of gain (not otherwise treated as ordinary) which would be taxed as ordinary if Sec. 1250 recaptured all depreciation, not just additional depreciation.

7. Low Income Housing a. Qualified low-income housing may have less Sec. 1250 recapture than other residential rental property. b. In addition, a low-income housing credit and rapid amortization of rehabilitation expenses may be available.

VI.

Additional Recapture for Corporations (Example I:13-37, Problem I:13-57) 1. Under Section 291, corporations are subject to additional recapture in the amount of 20% of the excess of what would be recaptured under Sec. 1245 over the actual Sec. 1250 recapture.

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a. EXAMPLE: If a corporate taxpayer sold a commercial building with a resulting $200,000 realized/recognized gain, and had taken $150,000 of straight/line depreciation related to the building, it would recognize $30,000 of Sec. 1250 ordinary income (20% × $150,000) and $170,000 of Sec. 1231 gain. An individual under the same facts would have no Sec. 1250 recapture, but would have net unrecaptured Sec. 1250 gain taxed at 25%. The concept of unrecaptured Sec. 1250 gain is not applicable to corporations.

VII.

Recapture Provisions - Other Applications (Instructor Aid I:13-2) 1. Gifts of Property Subject to Recapture (Example I:13-38) a. No recapture is recognized by the donor in a gift situation, but the recapture potential passes to the donee.

2. Transfer of Property Subject to Recapture at Death (Example I:13-40) a. Any recapture potential ceases on the death of the owner. The recipient takes an income tax basis equal to the fair market value of the property on the date of death or alternate valuation date.

3. Charitable Contributions (Example I:13-41) a. The amount of the charitable contribution is reduced by the recapture potential, but the recapture is not recognized. i.

EXAMPLE: A taxpayer contributing property with a FMV of $50,000 which is subject to $10,000 of Sec. 1245 recapture would be allowed a deduction of only $40,000 ($50,000 less $10,000 recapture). No gain would be recognized.

4. Like-Kind Exchanges (Example I:13-42) a. Any gain recognized in a like-kind exchange is first recaptured to the extent applicable.

5. Involuntary Conversions (Example I:13-44) a. Any gain recognized on an involuntary conversion is first recaptured to the extent applicable.

6. Installment Sales (Example I:13-45) a. In an installment sale all the recapture income (whether Sec. 1245 or Sec. 1250), limited by realized gain, must be recognized in the year of the sale. i.

EXAMPLE: The taxpayer sold property under an arrangement qualifying for the installment method for a $100,000 realized gain I:IO13-7 Copyright © 2024 Pearson Education, Inc.

and had $90,000 of associated Sec. 1245 recapture. The taxpayer would recognize the $90,000 Sec. 1245 gain in the year of sale, even if she received no proceeds in the year of sale.

7. Section 179 Expensing Election (Example I:13-47) a. Recapture of amounts expensed may be necessary if an expensed asset is converted to personal use. The amount recaptured would be the excess of the expensed amount over the allowable depreciation to the date of conversion.

8. Conservation and Land Clearing Expenditures (Example I:13-48) a. Deductions for conservation and land clearing expenses may be recaptured if the farmland is disposed of within 10 years.

9. Intangible Drilling Costs and Depletion (Example I:13-49; Problem I:13-62) a. IDC deducted in excess of cost depletion (limited by realized gain) may be recaptured on the sale of oil and gas properties. b. For post-1986 disposition of geothermal, oil, gas, or other mineral properties, recapture may be required for both IDC and depletion. The recapture may not exceed the realized gain.

10. Gain on Sale of Depreciable Property Between Related Parties (Examples I:13-51, I:13-52; Problem I:13-63) a. Gain recognized on a sale or exchange between related parties is ordinary income if the property was depreciable. b. Related persons include a controlled corporation (>50%), a controlled partnership (>50%), entities which are controlled by the above-described controlled entities, and trusts in which the taxpayer or spouse are beneficiaries. The attribution rules of Sec. 267 apply.

VIII.

Compliance and Procedural Considerations 1. Reporting Sec. 1231 Gains and Losses on Form 4797 (Figure I:13-1) a. Sec. 1231 gains and losses are reported on Parts I and II, Form 4797.

2. Reporting Gains Recaptured as Ordinary Income on Form 4797 (Figure I:13-2) a. Recapture income is reported on Part III, Form 4797.

3. Reporting Casualty or Theft Gain or Loss on Form 4684 (Figure I:13-3)

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a. Casualty or theft gains or losses from Sec. 1231 assets are reported on Section B, Form 4684.

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Court Case Briefs Desilu Productions Inc. v. CIR, 1965 PH T.C. Memo & 65,307, 24 TCM 1695.

Lucille Ball Arnaz and Desi Arnaz formed Desilu Productions, Inc. in 1951 for the purpose of producing television films for their own account. The company had its own facilities and a complete staff for carrying out this enterprise. The company received rental income related to the films it produced from the licensing to networks and the relicensing to individual television stations. With the exception of the sale of films in connection with a stock redemption in 1956, the company had not sold any other films. In 1962, Desilu Productions sold 13 films to CBS and reported the gain from the sale as a capital gain pursuant to Sec. 1231. The IRS determined that the gain was ordinary income because the films were held primarily for sale in the ordinary course of business and were not susceptible to capital gain treatment.

The evidence demonstrated that the sale was the result of failed negotiations to relicense the 13 films.

The court held that the films were subject to capital gain treatment under Sec. 1231 because the primary business of Desilu Productions Inc, was producing films and licensing them to networks and not the sale of films. “The nature of the petitioner’s business is no mystery.”

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Instructor Aid I:13-1 Section 1231 Netting

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Instructor Aid I:13-2 Types of Recapture

Depreciation / Cost Recovery

Sec. 1245 and 1250*

Expensing Election

Sec. 179

Conservation and Land Clearing Expenditures

Sec. 1252

Intangible Drilling Costs

Sec. 1254

Related Parties

Sec. 1239

* Corporations experience ordinary income recapture on real property under Section 291. Individuals experience unrecaptured 1250 gains on real property because the Section 1250 provisions generally no longer apply.

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Chapter I:14 Special Tax Computation Methods, Tax Credits, and Payment of Tax Learning Objectives After studying this chapter, the student should be able to: 1. Calculate the alternative minimum tax.

2. Describe self-employment income and compute the self-employment tax.

3. Describe the various business and personal tax credits.

4. Describe and compute the premium tax credit.

5. Explain the mechanics of the federal withholding tax system and the requirements for making estimated tax payments.

6. Describe tax planning considerations for AMT, tax credits, and payment of taxes.

7. Describe compliance and procedural considerations for AMT, tax credits, and payment of taxes.

Areas of Greater Significance The areas of alternative minimum tax, self-employment tax, payment of tax, child care credit, and lifetime earning credit may have the widest application.

Areas of Lesser Significance In the interest of time, the instructor may determine that the following areas are best covered by student reading, rather than class discussion: 1. Tax Credit for the Elderly and Disabled 2. Tax Credit for Rehabilitation Expenditures 3. Business Energy Tax Credits 4. Disabled Access Credit 5. Earned Income Credit 6. Provisions Related to Health Insurance I:IO14-1 Copyright © 2024 Pearson Education, Inc.

Problem Areas for Students The following areas may prove especially difficult for students: 1. The alternative minimum tax calculation.

2. Calculation of the credit for increasing research activities.

Highlights of Recent Tax Law Changes The following items of tax law have changed since the 2023 edition of this chapter: 1. The AMT basic exemption, phase-out thresholds, and tax rate brackets have increased. (See page I:14-3.)

2. The ceiling amount for paying the full amount of payroll taxes has increased to $160,200 ($147,000 in 2022).

3. The Adoption Credit has increased to $15,950 ($14,890 in 2022), and it phases out beginning at an AGI of $239,230 ($223,410 in 2022).

4. The threshold for the refundable portion of the child tax credit has increased to $1,600 per qualifying child ($1,500 in 2022).

5. The AGI ceilings on all rates for saver’s credit have increased. (See page I:14-17.)

6. The income levels for tax rates for ordinary income, long-term capital gains, dividend income, and the kiddie tax have increased. (See Quick Reference.)

7. The foreign earned income exclusion increased to $120,000 ($112,000 in 2022).

Teaching Tips 1. The alternative minimum tax calculation is difficult, but the basic concepts need to be mastered by the students to properly plan for clients.

2. There are several complex credits discussed in this chapter. You may want to concentrate on those that occur most frequently (i.e., child and dependent care credit, certain general business credits).

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Lecture Outline I.

Alternative Minimum Tax (Example I:14-1) The current alternative minimum tax (AMT) applies only if the calculated AMT exceeds the taxpayer’s regular tax liability. Most taxpayers do not pay AMT because of the liberal exemption and insufficient tax preferences.

1. AMT Computation a. Alternative minimum taxable income (AMTI) consists of taxable income plus tax preference items, certain nondeductible losses, personal exemptions plus or minus other adjustments for different AMT calculations of certain taxable income items. The statutory tax base is AMTI less applicable exemption.

2. AMT Tax Rates and Brackets a. AMT is calculated using a 26% tax rate times a statutory tax base of $220,700 or less. A 28% tax rate is used for amounts in excess of this amount.

3. AMT Exemption Amount (Example I:14-3; Question I:14-1; Problem I:14-43) a. The AMT exemption amount is $126,500 for married filing jointly; $81,300 for single, and $62,250 for married filing separately. The exemption amount is reduced for certain high-income taxpayers.

4. AMT Tax Preference Items (Example I:14-4) a. AMT tax preferences include excess depreciation over straight-line and taxexempt interest on certain private activity bonds. b. Not all tax preferences generate AMTI (e.g., tax-exempt interest is not part of AMTI except for tax-exempt interest on certain private activity bonds).

5. AMT Adjustments (Examples I:14-5, I:14-6) a. AMT adjustments include limitations on itemized deductions and adjustments due to timing differences (i.e., different timing for long-term contracts, depreciation, and research expenses). b. Itemized deductions not qualifying for reduction of AMTI include state, local, and foreign income taxes, real and personal property taxes, and home mortgage interest that is not qualified housing interest.

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II.

Self-Employment Tax (Examples I:14-8 through I:14-10; Topic Review I:14-1) 1. Employees and their employer pay FICA, while self-employed individuals pay a comparable amount in self-employment tax. a. The net self-employment tax rate is 15.3% on the first $160,200 of selfemployment earnings. b. The self-employed taxpayer must also pay 2.9% of self-employment income in excess of $160,200 as additional Medicare insurance. c. Individuals with self-employment earnings of $400 or more are subject to self-employment tax. Rates vary with the tax year involved. d. The taxpayer receives a trade or business deduction for 50% of OASDI plus the Medicare tax. e. An additional 0.9% hospital insurance tax is applicable to all earned income for certain high AGI taxpayers. This tax is not deductible for self-employed individuals.

2. What Constitutes Self-Employment Income (Example I:14-13) a. Self-employment income includes total earnings from a sole proprietorship, partnership income (distributive share plus guaranteed payments), director fees, and taxable research grants.

III.

Personal and Business Tax Credits (Topic Review I:14-2; Instructor Aid I:14-1) 1. Use and Importance of Tax Credits a. Tax credits may be used to implement tax policy objectives, such as: i.

Increase employment: Work Opportunity Credit

ii.

Encourage research and development: Credit for Research Activities

iii.

Provide tax relief for low income taxpayer: Earned Income Credit

2. Value of a Credit Versus a Deduction (Example I:14-14) a. The value of a deduction is dependent on the taxpayer’s marginal rate, but a credit reduces tax liability dollar for dollar.

I:IO14-4 Copyright © 2024 Pearson Education, Inc.

3. Child and Dependent Care Credit (Examples I:14-16, I:14-18, I:14-19; Question I:14-22; Problem I:14-48; Instructor Aid I:14-2) a. A 20-35% credit (depending on AGI) is available for qualifying employment-related child care expenses. b. The maximum expenses for calculation are $3,000 for a single qualifying dependent and $6,000 for multiple qualifying dependents. Maximum qualifying expenses are limited by an individual’s earned income. Amounts are also reduced for any income exclusion from a qualified dependent care assistance program. i.

EXAMPLE: The taxpayer expends $8,000 in child care for two children, ages 4 and 6. The taxpayer’s AGI (all earned income) is $50,000. The taxpayer’s child care credit is $1,200 ($6,000 maximum expenses × 20% credit rate for this AGI level).

4. Adoption Credit (Example I:14-21; Problem I:14-49) a. A credit for qualified adoption expenses is available. The general limit for the credit is $15,950. The credit is phased out ratably beginning at modified AGI of $239,230.

5. Child Tax Credit a. Taxpayers are entitled to a $2,000 credit for each qualifying child under the age of 17. Phase-outs of the credit begin at $400,000 AGI for married filing jointly and $200,000 for all other taxpayers.

6. American Opportunity Tax Credit (Problem I:14-50) a. Under certain circumstances taxpayers are allowed a $2,500 credit for tuition and fees for each qualified student. The rate is 100% of the first $2,000 of tuition/fees and 25% of the second $2,000 of tuition/fees. b. This credit is only available for the first four years of post-secondary education. c. This benefit may be reduced by the utilization of other educational tax benefits (e.g., scholarships). The benefit may also be phased-out beginning at $80,000 AGI for single taxpayers and $160,000 for married filing jointly.

7. Lifetime Learning Credit (Example I:14-22) a. Under certain circumstances taxpayers are allowed a 20% credit against a $10,000 maximum amount of tuition and fees. The limitation is applied at the taxpayer level.

I:IO14-5 Copyright © 2024 Pearson Education, Inc.

b. This credit is available for any number of years the qualifying expenses are paid. c. The phase-out rules begin at $80,000 for single taxpayers and $160,000 for married filing jointly. d. No doubling up with the AOTC credit is allowed.

8. Residential Energy Credit a. The Residential Energy Efficient Property (REEP) credit equals 30% of the cost of solar property installed on the taxpayer’s principal residence.

9. Qualified Retirement Savings Contributions Credit (Example I:14-23) a. The nonrefundable “saver’s credit” is available to encourage low- and middle-income taxpayers to save for retirement. b. The credit is calculated by multiplying the credit percentage (50%, 20%, 10%, or 0% depending on AGI) times the taxpayer’s qualified plan contributions (qualified contributions are limited to $2,000 per person for this calculation). c. Those taxpayers under 18 years of age, full-time students, and dependents on someone else’s return are not eligible for the credit.

10. Foreign Tax Credit (Problem I:14-53) a. A foreign tax credit is allowed to avoid double taxation on income subject to U.S. and foreign tax. b. Allowable FTC (Example I:14-24) i.

The foreign tax credit is limited to the lesser of foreign tax paid or the portion of U.S. tax liability attributable to income earned in foreign countries.

c. Treatment of Unused Credits i.

Unused foreign tax credits are available for a 1-year carryback and a 10-year carryover.

11. General Business Credits a. The general business credit may not exceed the “net income tax” minus the greater of (1) the tentative minimum tax or (2) 25% of the “net regular tax liability” above $25,000. Unused general business tax credits arising after 1997 are available for a 1-year-carryback and a 20-year carryforward.

I:IO14-6 Copyright © 2024 Pearson Education, Inc.

b. Work Opportunity Credit i.

Employers receive a credit of a portion of first year wages for employees belonging to targeted groups. The credit rates and wage caps depend on group. (See page I:14-20.)

c. Employer-Provided Child Care Credit (Example I:14-27) i.

Employers may be eligible for a credit based on the total of 25% of qualified child care expenses (operating and employee facility) plus 10% of qualified child care resources and referral expenditures.

ii.

The credit is limited to $150,000 annually and is also limited by the general business credit limitation.

d. Credit for Increased Research Activities i.

IV.

This credit is in the amount of 20% of the excess of qualified research expenses over a base amount. (See page I:14-22 for a discussion of the base calculation.)

Payment of Taxes (Topic Review I:14-3) 1. Withholding of Taxes (Example I:14-35; Question I:14-27) a. Generally, employers are required to withhold federal income taxes and FICA tax from employee compensation. This procedure is not necessary for independent contractors. b. Compensation for withholding purposes includes salaries, commissions, fees, bonuses, termination payments, vacation pay, and taxable fringe benefits. c. Special rules are provided for multiple employers during the same year, certain employment categories (e.g., ministers, servants), certain fringe benefits, and lump-sum pension or annuity payments.

2. Estimated Tax Payments (Question I:14-35) a. Taxpayers must make estimated tax payments on income not subject to withholding or face the possibility of underpayment penalties. b. To avoid penalties for underpaid tax, the taxpayer can: i.

Have tax due for the current year of less than $1,000

ii.

Pay 90% of the tax due for the current year (either actual or computed on an annualized basis) I:IO14-7 Copyright © 2024 Pearson Education, Inc.

iii.

V.

Pay 100% of the actual tax liability for the prior year (110% of prior year if prior year AGI exceeded $150,000).

Tax Planning Considerations 1. Avoiding the Alternative Minimum Tax a. Judicious timing of income and expense items may avoid imposition of the alternative minimum tax.

2. Avoiding the Underpayment Penalty for Estimated Tax (Example I:14-38) a. The easiest method of avoiding the underpayment penalty for estimated tax in many situations is to pay 100% of the actual prior year liability (assuming prior year AGI has not exceeded $150,000).

3. Cash-Flow Considerations a. To maximize cash flow to the taxpayer, withholding and/or estimated payments should be adjusted to avoid overpayments.

4. Use of General Business Tax Credits a. In order to achieve maximum utilization of business tax credit, the interrelationship of the various credits must be considered.

5. Foreign Tax Credits and the Foreign Earned Income Exclusion a. Taxpayers with foreign job assignments may choose between a foreign tax credit and a foreign-earned income exclusion.

VI.

Compliance and Procedural Considerations 1. Alternative Minimum Tax Filing Procedures a. Individuals compute the AMT on Form 6251.

2. Withholdings and Estimated Tax Payments (Example I:14-39) a. Taxpayer withholdings are indicated on Form W-2 or Form 1099-R for pensions.

3. General Business Tax Credits a. General business tax credits use Forms 3800, 3468, and 4255.

I:IO14-8 Copyright © 2024 Pearson Education, Inc.

4. Nonrefundable Personal Tax Credits a. The child tax credit and the credit for other dependents are reported on Form 1040, and other nonrefundable personal tax credits are reported on Schedule 3. Personal tax credits additionally require Forms 2441 and 1116 and Schedule R.

I:IO14-9 Copyright © 2024 Pearson Education, Inc.

Court Case Briefs Harry Mitchell Goldstein v. CIR, 1986 PH T.C. Memo & 86,339, 52 TCM 9.

Harry and Judy Goldstein were both employed by General Electric Company. In the winter of 1980, they explored the possibility of becoming involved with Amway, a manufacturer and distributor of various household products. They would be distributors and would enlist other relatives and friends to be distributors under them. As Amway distributors, they would receive a percentage of all sales of their own and of all sub-distributors. They did most of their recruiting activities at various social functions with their friends and relatives primarily as their targets. They were unsuccessful in recruiting additional distributors.

During 1980, they purchased $576 worth of Amway products that had a retail value of $779. Most of these products were consumed by the Goldsteins themselves with only a few being resold to customers. On their 1980 federal income tax return they showed a gross profit of $203 ($779 less $576) and claimed $32,432 worth of business expenses related to the Amway business. They also claimed a child care credit related to the Amway business.

Among other things (i.e., the $32,432 business expenses) the IRS and the Tax Court disallowed the child care credit that related to the Amway business. The Goldsteins were found not to be gainfully employed in their Amway activities and thus did not qualify for the child care credit. The child care credit is allowed for certain “employment-related expenses” which include expenses for child care of a qualified individual which are incurred to enable the taxpayer to be gainfully employed.

I:IO14-10 Copyright © 2024 Pearson Education, Inc.

Instructor Aid I:14-1 Credits GENERAL BUSINESS CREDIT •

Business energy credit

•

Work opportunity credit

•

Disabled access credit

•

Employer-provided child care credit

•

Rehabilitation expenditure credit

•

Increased research activities credit

PERSONAL CREDITS •

Adoption credit

•

Child tax credit

•

Child and dependent care credit

•

Elderly and disabled credit

•

American Opportunity Tax Credit

•

Lifetime learning credit

•

Qualified retirement savings contribution credit

•

Residential energy credits

•

Earned income credit (refundable)

OTHER CREDITS •

Foreign tax credit

I:IO14-11 Copyright © 2024 Pearson Education, Inc.

Instructor Aid I:14-2 Child or Dependent Care Credit AGI Appropriate Credit Percentage: Adjusted Gross Income $ 0 to $15,000

Applicable Percentage 35%

15,001 to 17,000

34

17,001 to 19,000

33

19,001 to 21,000

32

21,001 to 23,000

31

23,001 to 25,000

30

25,001 to 27,000

29

27,001 to 29,000

28

29,001 to 31,000

27

31,001 to 33,000

26

33,001 to 35,000

25

35,001 to 37,000

24

37,001 to 39,000

23

39,001 to 41,000

22

41,001 to 43,000

21

43,001 and above

20

I:IO14-12 Copyright © 2024 Pearson Education, Inc.

Chapter I:14 Special Tax Computation Methods, Tax Credits, and Payment of Tax Learning Objectives After studying this chapter, the student should be able to: 1. Calculate the alternative minimum tax.

2. Describe self-employment income and compute the self-employment tax.

3. Describe the various business and personal tax credits.

4. Describe and compute the premium tax credit.

5. Explain the mechanics of the federal withholding tax system and the requirements for making estimated tax payments.

6. Describe tax planning considerations for AMT, tax credits, and payment of taxes.

7. Describe compliance and procedural considerations for AMT, tax credits, and payment of taxes.

Areas of Greater Significance The areas of alternative minimum tax, self-employment tax, payment of tax, child care credit, and lifetime earning credit may have the widest application.

Areas of Lesser Significance In the interest of time, the instructor may determine that the following areas are best covered by student reading, rather than class discussion: 1. Tax Credit for the Elderly and Disabled 2. Tax Credit for Rehabilitation Expenditures 3. Business Energy Tax Credits 4. Disabled Access Credit 5. Earned Income Credit 6. Provisions Related to Health Insurance I:IO14-1 Copyright © 2024 Pearson Education, Inc.

Problem Areas for Students The following areas may prove especially difficult for students: 1. The alternative minimum tax calculation.

2. Calculation of the credit for increasing research activities.

Highlights of Recent Tax Law Changes The following items of tax law have changed since the 2023 edition of this chapter: 1. The AMT basic exemption, phase-out thresholds, and tax rate brackets have increased. (See page I:14-3.)

2. The ceiling amount for paying the full amount of payroll taxes has increased to $160,200 ($147,000 in 2022).

3. The Adoption Credit has increased to $15,950 ($14,890 in 2022), and it phases out beginning at an AGI of $239,230 ($223,410 in 2022).

4. The threshold for the refundable portion of the child tax credit has increased to $1,600 per qualifying child ($1,500 in 2022).

5. The AGI ceilings on all rates for saver’s credit have increased. (See page I:14-17.)

6. The income levels for tax rates for ordinary income, long-term capital gains, dividend income, and the kiddie tax have increased. (See Quick Reference.)

7. The foreign earned income exclusion increased to $120,000 ($112,000 in 2022).

Teaching Tips 1. The alternative minimum tax calculation is difficult, but the basic concepts need to be mastered by the students to properly plan for clients.

2. There are several complex credits discussed in this chapter. You may want to concentrate on those that occur most frequently (i.e., child and dependent care credit, certain general business credits).

I:IO14-2 Copyright © 2024 Pearson Education, Inc.

Lecture Outline I.

Alternative Minimum Tax (Example I:14-1) The current alternative minimum tax (AMT) applies only if the calculated AMT exceeds the taxpayer’s regular tax liability. Most taxpayers do not pay AMT because of the liberal exemption and insufficient tax preferences.

1. AMT Computation a. Alternative minimum taxable income (AMTI) consists of taxable income plus tax preference items, certain nondeductible losses, personal exemptions plus or minus other adjustments for different AMT calculations of certain taxable income items. The statutory tax base is AMTI less applicable exemption.

2. AMT Tax Rates and Brackets a. AMT is calculated using a 26% tax rate times a statutory tax base of $220,700 or less. A 28% tax rate is used for amounts in excess of this amount.

3. AMT Exemption Amount (Example I:14-3; Question I:14-1; Problem I:14-43) a. The AMT exemption amount is $126,500 for married filing jointly; $81,300 for single, and $62,250 for married filing separately. The exemption amount is reduced for certain high-income taxpayers.

4. AMT Tax Preference Items (Example I:14-4) a. AMT tax preferences include excess depreciation over straight-line and taxexempt interest on certain private activity bonds. b. Not all tax preferences generate AMTI (e.g., tax-exempt interest is not part of AMTI except for tax-exempt interest on certain private activity bonds).

5. AMT Adjustments (Examples I:14-5, I:14-6) a. AMT adjustments include limitations on itemized deductions and adjustments due to timing differences (i.e., different timing for long-term contracts, depreciation, and research expenses). b. Itemized deductions not qualifying for reduction of AMTI include state, local, and foreign income taxes, real and personal property taxes, and home mortgage interest that is not qualified housing interest.

I:IO14-3 Copyright © 2024 Pearson Education, Inc.

II.

Self-Employment Tax (Examples I:14-8 through I:14-10; Topic Review I:14-1) 1. Employees and their employer pay FICA, while self-employed individuals pay a comparable amount in self-employment tax. a. The net self-employment tax rate is 15.3% on the first $160,200 of selfemployment earnings. b. The self-employed taxpayer must also pay 2.9% of self-employment income in excess of $160,200 as additional Medicare insurance. c. Individuals with self-employment earnings of $400 or more are subject to self-employment tax. Rates vary with the tax year involved. d. The taxpayer receives a trade or business deduction for 50% of OASDI plus the Medicare tax. e. An additional 0.9% hospital insurance tax is applicable to all earned income for certain high AGI taxpayers. This tax is not deductible for self-employed individuals.

2. What Constitutes Self-Employment Income (Example I:14-13) a. Self-employment income includes total earnings from a sole proprietorship, partnership income (distributive share plus guaranteed payments), director fees, and taxable research grants.

III.

Personal and Business Tax Credits (Topic Review I:14-2; Instructor Aid I:14-1) 1. Use and Importance of Tax Credits a. Tax credits may be used to implement tax policy objectives, such as: i.

Increase employment: Work Opportunity Credit

ii.

Encourage research and development: Credit for Research Activities

iii.

Provide tax relief for low income taxpayer: Earned Income Credit

2. Value of a Credit Versus a Deduction (Example I:14-14) a. The value of a deduction is dependent on the taxpayer’s marginal rate, but a credit reduces tax liability dollar for dollar.

I:IO14-4 Copyright © 2024 Pearson Education, Inc.

3. Child and Dependent Care Credit (Examples I:14-16, I:14-18, I:14-19; Question I:14-22; Problem I:14-48; Instructor Aid I:14-2) a. A 20-35% credit (depending on AGI) is available for qualifying employment-related child care expenses. b. The maximum expenses for calculation are $3,000 for a single qualifying dependent and $6,000 for multiple qualifying dependents. Maximum qualifying expenses are limited by an individual’s earned income. Amounts are also reduced for any income exclusion from a qualified dependent care assistance program. i.

EXAMPLE: The taxpayer expends $8,000 in child care for two children, ages 4 and 6. The taxpayer’s AGI (all earned income) is $50,000. The taxpayer’s child care credit is $1,200 ($6,000 maximum expenses × 20% credit rate for this AGI level).

4. Adoption Credit (Example I:14-21; Problem I:14-49) a. A credit for qualified adoption expenses is available. The general limit for the credit is $15,950. The credit is phased out ratably beginning at modified AGI of $239,230.

5. Child Tax Credit a. Taxpayers are entitled to a $2,000 credit for each qualifying child under the age of 17. Phase-outs of the credit begin at $400,000 AGI for married filing jointly and $200,000 for all other taxpayers.

6. American Opportunity Tax Credit (Problem I:14-50) a. Under certain circumstances taxpayers are allowed a $2,500 credit for tuition and fees for each qualified student. The rate is 100% of the first $2,000 of tuition/fees and 25% of the second $2,000 of tuition/fees. b. This credit is only available for the first four years of post-secondary education. c. This benefit may be reduced by the utilization of other educational tax benefits (e.g., scholarships). The benefit may also be phased-out beginning at $80,000 AGI for single taxpayers and $160,000 for married filing jointly.

7. Lifetime Learning Credit (Example I:14-22) a. Under certain circumstances taxpayers are allowed a 20% credit against a $10,000 maximum amount of tuition and fees. The limitation is applied at the taxpayer level.

I:IO14-5 Copyright © 2024 Pearson Education, Inc.

b. This credit is available for any number of years the qualifying expenses are paid. c. The phase-out rules begin at $80,000 for single taxpayers and $160,000 for married filing jointly. d. No doubling up with the AOTC credit is allowed.

8. Residential Energy Credit a. The Residential Energy Efficient Property (REEP) credit equals 30% of the cost of solar property installed on the taxpayer’s principal residence.

9. Qualified Retirement Savings Contributions Credit (Example I:14-23) a. The nonrefundable “saver’s credit” is available to encourage low- and middle-income taxpayers to save for retirement. b. The credit is calculated by multiplying the credit percentage (50%, 20%, 10%, or 0% depending on AGI) times the taxpayer’s qualified plan contributions (qualified contributions are limited to $2,000 per person for this calculation). c. Those taxpayers under 18 years of age, full-time students, and dependents on someone else’s return are not eligible for the credit.

10. Foreign Tax Credit (Problem I:14-53) a. A foreign tax credit is allowed to avoid double taxation on income subject to U.S. and foreign tax. b. Allowable FTC (Example I:14-24) i.

The foreign tax credit is limited to the lesser of foreign tax paid or the portion of U.S. tax liability attributable to income earned in foreign countries.

c. Treatment of Unused Credits i.

Unused foreign tax credits are available for a 1-year carryback and a 10-year carryover.

11. General Business Credits a. The general business credit may not exceed the “net income tax” minus the greater of (1) the tentative minimum tax or (2) 25% of the “net regular tax liability” above $25,000. Unused general business tax credits arising after 1997 are available for a 1-year-carryback and a 20-year carryforward.

I:IO14-6 Copyright © 2024 Pearson Education, Inc.

b. Work Opportunity Credit i.

Employers receive a credit of a portion of first year wages for employees belonging to targeted groups. The credit rates and wage caps depend on group. (See page I:14-20.)

c. Employer-Provided Child Care Credit (Example I:14-27) i.

Employers may be eligible for a credit based on the total of 25% of qualified child care expenses (operating and employee facility) plus 10% of qualified child care resources and referral expenditures.

ii.

The credit is limited to $150,000 annually and is also limited by the general business credit limitation.

d. Credit for Increased Research Activities i.

IV.

This credit is in the amount of 20% of the excess of qualified research expenses over a base amount. (See page I:14-22 for a discussion of the base calculation.)

Payment of Taxes (Topic Review I:14-3) 1. Withholding of Taxes (Example I:14-35; Question I:14-27) a. Generally, employers are required to withhold federal income taxes and FICA tax from employee compensation. This procedure is not necessary for independent contractors. b. Compensation for withholding purposes includes salaries, commissions, fees, bonuses, termination payments, vacation pay, and taxable fringe benefits. c. Special rules are provided for multiple employers during the same year, certain employment categories (e.g., ministers, servants), certain fringe benefits, and lump-sum pension or annuity payments.

2. Estimated Tax Payments (Question I:14-35) a. Taxpayers must make estimated tax payments on income not subject to withholding or face the possibility of underpayment penalties. b. To avoid penalties for underpaid tax, the taxpayer can: i.

Have tax due for the current year of less than $1,000

ii.

Pay 90% of the tax due for the current year (either actual or computed on an annualized basis) I:IO14-7 Copyright © 2024 Pearson Education, Inc.

iii.

V.

Pay 100% of the actual tax liability for the prior year (110% of prior year if prior year AGI exceeded $150,000).

Tax Planning Considerations 1. Avoiding the Alternative Minimum Tax a. Judicious timing of income and expense items may avoid imposition of the alternative minimum tax.

2. Avoiding the Underpayment Penalty for Estimated Tax (Example I:14-38) a. The easiest method of avoiding the underpayment penalty for estimated tax in many situations is to pay 100% of the actual prior year liability (assuming prior year AGI has not exceeded $150,000).

3. Cash-Flow Considerations a. To maximize cash flow to the taxpayer, withholding and/or estimated payments should be adjusted to avoid overpayments.

4. Use of General Business Tax Credits a. In order to achieve maximum utilization of business tax credit, the interrelationship of the various credits must be considered.

5. Foreign Tax Credits and the Foreign Earned Income Exclusion a. Taxpayers with foreign job assignments may choose between a foreign tax credit and a foreign-earned income exclusion.

VI.

Compliance and Procedural Considerations 1. Alternative Minimum Tax Filing Procedures a. Individuals compute the AMT on Form 6251.

2. Withholdings and Estimated Tax Payments (Example I:14-39) a. Taxpayer withholdings are indicated on Form W-2 or Form 1099-R for pensions.

3. General Business Tax Credits a. General business tax credits use Forms 3800, 3468, and 4255.

I:IO14-8 Copyright © 2024 Pearson Education, Inc.

4. Nonrefundable Personal Tax Credits a. The child tax credit and the credit for other dependents are reported on Form 1040, and other nonrefundable personal tax credits are reported on Schedule 3. Personal tax credits additionally require Forms 2441 and 1116 and Schedule R.

I:IO14-9 Copyright © 2024 Pearson Education, Inc.

Court Case Briefs Harry Mitchell Goldstein v. CIR, 1986 PH T.C. Memo & 86,339, 52 TCM 9.

Harry and Judy Goldstein were both employed by General Electric Company. In the winter of 1980, they explored the possibility of becoming involved with Amway, a manufacturer and distributor of various household products. They would be distributors and would enlist other relatives and friends to be distributors under them. As Amway distributors, they would receive a percentage of all sales of their own and of all sub-distributors. They did most of their recruiting activities at various social functions with their friends and relatives primarily as their targets. They were unsuccessful in recruiting additional distributors.

During 1980, they purchased $576 worth of Amway products that had a retail value of $779. Most of these products were consumed by the Goldsteins themselves with only a few being resold to customers. On their 1980 federal income tax return they showed a gross profit of $203 ($779 less $576) and claimed $32,432 worth of business expenses related to the Amway business. They also claimed a child care credit related to the Amway business.

Among other things (i.e., the $32,432 business expenses) the IRS and the Tax Court disallowed the child care credit that related to the Amway business. The Goldsteins were found not to be gainfully employed in their Amway activities and thus did not qualify for the child care credit. The child care credit is allowed for certain “employment-related expenses” which include expenses for child care of a qualified individual which are incurred to enable the taxpayer to be gainfully employed.

I:IO14-10 Copyright © 2024 Pearson Education, Inc.

Instructor Aid I:14-1 Credits GENERAL BUSINESS CREDIT •

Business energy credit

•

Work opportunity credit

•

Disabled access credit

•

Employer-provided child care credit

•

Rehabilitation expenditure credit

•

Increased research activities credit

PERSONAL CREDITS •

Adoption credit

•

Child tax credit

•

Child and dependent care credit

•

Elderly and disabled credit

•

American Opportunity Tax Credit

•

Lifetime learning credit

•

Qualified retirement savings contribution credit

•

Residential energy credits

•

Earned income credit (refundable)

OTHER CREDITS •

Foreign tax credit

I:IO14-11 Copyright © 2024 Pearson Education, Inc.

Instructor Aid I:14-2 Child or Dependent Care Credit AGI Appropriate Credit Percentage: Adjusted Gross Income $ 0 to $15,000

Applicable Percentage 35%

15,001 to 17,000

34

17,001 to 19,000

33

19,001 to 21,000

32

21,001 to 23,000

31

23,001 to 25,000

30

25,001 to 27,000

29

27,001 to 29,000

28

29,001 to 31,000

27

31,001 to 33,000

26

33,001 to 35,000

25

35,001 to 37,000

24

37,001 to 39,000

23

39,001 to 41,000

22

41,001 to 43,000

21

43,001 and above

20

I:IO14-12 Copyright © 2024 Pearson Education, Inc.

Chapter I:15 Tax Research Learning Objectives After studying this chapter, the student should be able to: 1. Distinguish between closed fact and open fact tax situations.

2. Describe the steps in the tax research process.

3. Explain how the facts influence tax consequences.

4. Identify the sources of tax law and assess the authoritative value of each.

5. Consult tax services to research an issue.

6. Apply the basics of Internet-based tax research.

7. Use a citator to assess tax authorities.

8. Describe professional guidelines that CPAs in tax practice should follow.

9. Prepare work papers and communicate to clients.

Areas of Greater Significance Since this will usually be a student’s first exposure to tax research, the importance of the facts to the tax results should be discussed. Proper use of the federal tax services and the citator should be stressed at this point in the student’s learning process.

Areas of Lesser Significance In the interest of time, the instructor may omit the following area: 1. Sample Work Papers and Client Letter

Problem Areas for Students The following areas may prove especially difficult for students: 1. Understanding how to use Internet tax services and citators.

I:IO15-1 Copyright © 2024 Pearson Education, Inc.

2. Learning the authoritative value of each of the sources of tax law.

Highlights of Recent Tax Law Changes No items of tax law have changed since the 2023 edition of this chapter.

Teaching Tips 1. Example I:15-2: Use the example to emphasize to the students the importance of considering nontax objectives as well as tax objectives. (See page I:15-2.)

2. Figure I:15-1: Walk through the steps in the tax research process. As you do this emphasize to the students that the steps of the tax research process provide an excellent format for a written communication to a client or to a client file. This time you might consider going over the client communication contained in Appendix A, page A-2. (See page I:15-4.)

Lecture Outline I.

Overview of Tax Research 1. Tax research can be conducted in a number of different settings. Tax research involves solving a specific tax-related question using a number of tax law sources as they apply to the particular situation. Sample work papers demonstrating how to document the results of a research effort are included in Appendix A. In addition, this chapter discusses the AICPA’s guidelines for CPAs in tax practice, the Statements on Standards for Tax Services (reproduced in Appendix E), and Treasury Department Circular 230.

2. Client-oriented research is conducted by accounting and law firms for the benefit of their clients. It involves determining the tax consequences of a certain transaction for a given client. It is performed in: a. Closed fact or tax compliance situations. (See Example I:15-1.) b. Open fact or tax-planning situations. (See Example I:15-2.) c. Academic settings. i.

Tax policy research may be conducted by individuals in an academic setting (e.g., accounting programs, law schools, economics departments, etc.).

I:IO15-2 Copyright © 2024 Pearson Education, Inc.

II.

Steps in the Tax Research Process (Figure I:15-1) 1. Emphasis should be placed on the fact that tax research is a circular process sometimes requiring the determination of different facts, restatement of the research question, or reliance on additional authorities. There are, however, six basic steps to the tax research process: a. Determine the facts. b. Identify the issues (questions). c. Locate the applicable authorities. d. Evaluate the authorities and choose those to follow when the authorities conflict. e. Analyze the facts in terms of the applicable authorities. f. Communicate conclusions and recommendations to the client.

2. When doing tax research in the context of tax planning, the tax professional needs to keep a number of points in mind: a. The objective is not to minimize taxes per se but rather to maximize the after-tax return. b. One does not engage in unilateral transactions; thus, the tax ramifications to all parties to the contract are relevant. c. Taxes are but one cost of doing business. d. The time for tax planning is not restricted to when one enters into an investment, contract, and other arrangement, but rather the time extends throughout the life of the activity.

3. Tax research often involves a “gray area;” that is, one that does not have a clearcut, unequivocally correct solution. The issue should then be pursued through the use of a specifically tailored set of detailed questions. Tax research may also involve determining which issues need to be researched. A fairly extensive knowledge of tax law is necessary to determine which issues need to be researched.

III.

Importance of the Facts to the Tax Consequences 1. The importance of a particular set of facts to the tax results should be emphasized.

Three illustrations are presented in the chapter to demonstrate the importance of facts to the appropriate resolution. (See page I:15-6.)

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IV.

The Sources of Tax Law (Table I:15-3) The term “tax law” generally encompasses much more than just the tax statutes as enacted

by Congress. The law contains language that requires interpretation, both administrative and judicial. Administrative interpretations include Treasury regulations, revenue rulings, and revenue procedures. Judicial interpretations consist of court decisions. Tax law also consists of committee reports issued by Congress during the legislative process.

1. Legislative Process a. All tax legislation must originate in the House of Representatives. Tax bills are referred to the House Ways and Means Committee. After a bill is approved by the House Ways and Means Committee, it moves to the floor of the House for consideration. If approved by a majority of the House, it moves to the Senate. After consideration by the Senate Finance Committee, it moves to the Senate floor for approval. Usually the House and Senate bills will not be in complete agreement. The bill will then go to a Conference Committee consisting of members of both houses. A compromise will then be reached between the two versions of the tax bill. The compromise is then voted on by both houses of Congress and goes on to the President for his signature or veto. Both houses of Congress generally hold extensive hearings at which time interested parties are free to testify. The U.S. Government Printing Office publishes the statements made at hearings.

Committee Reports explaining Congress’s purpose in drafting legislation are published by the U.S. Government Printing Office and in the Internal Revenue Bulletin. Committee Reports are particularly useful in interpreting the law prior to issuance of regulations. (See Example I:15-4.)

2. Internal Revenue Code a. The Internal Revenue Code is the foundation of all tax law. It was first codified in 1939. Recodified in 1954, it has now been named the Internal Revenue Code of 1986. Whenever the law is changed, old language is deleted and new language is added. (See Figure I:15-2 for the organizational scheme of the Internal Revenue Code.)

3. Treasury Regulations a. The Treasury Department issues regulations as interpretations of the statute.

They provide examples complete with computations to assist in understanding the statutory language. Because statutory changes occur frequently, regulations are not always updated in a timely manner. When referring to a regulation, the tax advisor should consult the introductory note in order to determine when the regulation was adopted. Regulations are first provided in proposed form, and the public has an opportunity to comment and suggest changes. Proposed regulations have no more authoritative weight than the position the IRS argues for in a brief, but provide guidance on I:IO15-4 Copyright © 2024 Pearson Education, Inc.

Treasury’s interpretation of a statute. Temporary regulations (which generally are effective upon publication) are often issued soon after a major statutory change to provide guidance on procedural and computational matters. Temporary regulations have the same authoritative value as final regulations. However, they cannot remain temporary for more than a threeyear period. Temporary regulations must be issued concurrently with proposed regulations. Final regulations are drafted after the public has had time to comment on the proposed regulations. Final regulations have strong authoritative weight, and may take effect retroactive to the effective date of the statutory language they interpret. b. For changes to the Code enacted after July 29, 1996, the Treasury is generally precluded from issuing regulations with retroactive effect. In the case of final regulations, however, a regulation can be effective on the date proposed or temporary regulations are filed with the Federal Register.

Regulations issued within 18 months of the date of a change to the statute can be issued with retroactive effect. c. Regulations may also be classified as either interpretative or legislative.

Interpretative regulations are issued under the general authority of Sec. 7805 and make the statutory language easier to understand and apply. They provide illustrations about how to perform certain computations.

Legislative regulations provide rules on highly technical matters where Congress has delegated the rulemaking to the Treasury Department (e.g., consolidated tax return issues). d. Section 7805 provides that the Secretary of the Treasury has the right to prescribe regulations and to what extent they are to be applied retroactively.

Occasionally, taxpayers can successfully argue that a regulation is invalid and, consequently, should not be followed. This will occur only if the courts find that the regulation is “unreasonable and plainly inconsistent with the revenue statutes.” The courts often apply the legislative reenactment doctrine which holds that regulations finalized many years earlier and not amended by Congress through changes to the statutory language have Congressional approval. e. Regulations are cited as follows. Numbers before the decimal point indicate the general subject matter of the regulation. (See page I:15-11.) Numbers to the right of the decimal place refer to the Code section being interpreted.

Numbers to the right of that number indicate the number of the regulation.

Temporary or proposed regulations are cited as Temp. Reg. Sec. or Prop.

Reg. Sec. When providing a citation, the researcher should be as precise as possible. An example of this would be Reg. Sec. 1.165-5(i), Ex. 2(i), which refers to the first portion of Example 2 that is contained in the “i” portion of the fifth regulation interpreting Sec. 165.

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4. Administrative Pronouncements. There are a number of different means that the IRS uses for interpreting the statute. After referring to the Code and Regulations, tax advisors are likely to refer next to IRS interpretations for further authority for answering a tax question. a. Revenue Rulings i.

Revenue rulings are used to indicate the tax status of a particular transaction, which has wide taxpayer interest. They represent the viewpoint of the IRS and do not have as much authority as court cases or regulations. Approximately one hundred rulings are issued each year. A taxpayer does not have to follow a ruling if there is sufficient authority for different treatment. An IRS agent is, however, bound by the rulings. Rulings are published weekly in the Internal Revenue Bulletin (I.R.B.).

b. Revenue Procedures i.

Revenue procedures usually deal with procedural aspects of tax practice. They are first published in the Internal Revenue Bulletin.

c. Letter Rulings i.

Letter rulings are initiated by taxpayers who ask the IRS to explain the tax consequences of a particular transaction. The IRS responds in a letter ruling that can be relied on only by the person requesting it. They provide insight into the current thinking of the IRS. Commerce Clearing House publishes rulings with any confidential information deleted in a separate letter ruling service.

d. Technical Advice Memoranda i.

When a taxpayer’s return is being audited with respect to a complicated, technical matter, the taxpayer may request that the matter be referred to the IRS National Office in Washington, D.C. concerning the appropriate tax treatment. The answer is issued in the form of a Technical Advice Memoranda, which is made available in the form of a letter ruling.

e. Information Releases i.

Information releases contain information about interpretations of general interest and are released to the news media throughout the United States.

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f. Announcements and Notices i.

Information releases that are more technical and aimed at tax practitioners are issued in the form of Announcements.

Announcements are often issued before temporary or proposed regulations can be issued. The IRS is bound by announcements and notices in the same way as if contained in a revenue ruling.

5. Judicial Decisions. Judicial decisions comprise an important source of tax law.

Judicial decisions are sometimes in conflict between different courts. a. Overview of the Court System (Figure I:15-3; Table I:15-2) i.

There are three trial courts - the U.S. Tax Court, the U.S. Court of Federal Claims, and the U.S. District Courts. Litigation may begin in any court, but precedent is an important factor in determining where it should begin. Cash flow also may be an important factor.

Taxes must be paid before litigation begins in the U.S. Court of Federal Claims or the U.S. District Court. After the taxes are paid, a claim for refund is filed which will be denied by the IRS. A suit for refund is then brought and, if won, a refund with interest is obtained.

A suit may be brought in the Tax Court. If lost, the deficiency plus any interest and penalties must be paid. The District Court is the only place that a jury trial is possible. Decisions can be appealed from the Tax Court and the U.S. District Court to the Court of Appeals in the taxpayer’s circuit. Appeals from the U.S. Court of Federal Claims are taken to the Court of Appeals for the Federal Circuit. A party who loses at the appellate level can ask the Supreme Court for a writ of certiorari. The Supreme Court hears only about six to ten tax cases a year. (See Figure I:15-4 for an overview of the court system.)

b. U.S. Tax Court i.

The U.S. Tax Court originated in 1942 as the successor to the Board of Tax Appeals. It hears cases only dealing with tax matters. There are 19 Tax Court judges including one chief judge. The judges are appointed by the President with the consent of the Senate for a fifteen-year term. The judges travel to cities around the United States to hear cases. Only one judge hears a particular case. The chief judge decides whether to publish each opinion as a memo or regular decision.

ii.

The Tax Court has a special policy in dealing with cases where the amount in question does not exceed $50,000 a year (i.e., small cases). Taxpayers can appear without an attorney. The cases are

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heard by special commissioners instead of one of the Tax Court judges. Decisions under this procedure cannot be appealed. iii.

The IRS has an acquiescence policy with regard to Tax Court decisions that have been decided in the taxpayer’s favor. If it wishes to go on record that it agrees with a regular Tax Court decision, it acquiesces. If it wishes to disagree with a decision, it issues a nonacquiescence. This policy is not followed in all Tax Court decisions. An acquiescence or nonacquiescence is binding on an IRS agent. If a taxpayer is audited and has taken a position which the IRS has issued a nonacquiescence, litigation will likely be the only recourse for the taxpayer.

iv.

Regular decisions of the Tax Court are published by the U.S. Government Printing Office in a bound volume known as the Tax Court of the United States Reports. Soon after a decision is made public, it is also published by Research Institute of America and Commerce Clearing House in their loose leaf reporters of Tax Court decisions.

c. U.S. District Courts i.

Each state has a district court and more populous states have several districts. Many different types of cases are heard and a taxpayer may request a jury trial. District court decisions are officially reported in the Federal Supplement (F.Supp.) published by West Publishing Co. Tax decisions are also published by Research Institute of America in the American Federal Tax Reports (AFTR) and by Commerce Clearing House in the U.S. Tax Cases (USTC).

d. U.S. Court of Federal Claims i.

The U.S. Court of Federal Claims, as reorganized in 1982 and renamed in 1992, is a national court with decisions appealable to the Circuit Court of Appeals for the Federal Circuit. U.S. Court of Federal Claims decisions were published in the Claims Court Reporter by West Publishing Co. from 1982 to 1992. These cases are now reported in the Federal Claims Reporter (Fed. Cl.). In addition, the AFTR and USTC services report these tax decisions.

e. Circuit Courts of Appeal (Table I:15-1) i.

Trial court decisions are appealable to a particular circuit court of appeals depending upon where the litigation originated. In the case of an individual, it depends upon the taxpayer’s residence on the date of appeal. In the case of a corporation, it is the principal place of business that controls. There are 11 geographical circuits, the circuit for the District of Columbia and the Federal Circuit. New I:IO15-8 Copyright © 2024 Pearson Education, Inc.

circuit court of appeals decisions are reported officially in the Federal Reporter, Third Series (F.3d) published by Thomson Reuters/West. In addition, AFTR and USTC services report these decisions. f. Supreme Court i.

A decision of an appellate court can be appealed to the Supreme Court. Unless the circuits are divided on the proper treatment of an issue or the issue is deemed of great significance, the Supreme Court will not grant certiorari. Decisions of the Supreme Court are the law of the land. If Congress does not agree with a Supreme Court decision, statutory language can be amended to reach the desired result. Supreme Court decisions are published in the United States Supreme Court Reports (U.S.) by the U.S. Government Printing Office, the Supreme Court Reporter (S.Ct.) by Thomson/Reuters/West, and the United States Reports, Lawyers’ Edition (L.Ed.) by Lawyer’s Co-Operative Publishing Co. In addition, the AFTR and USTC services report these tax decisions.

g. Precedential Value of Various Decisions i.

The Tax Court will generally rule uniformly for taxpayers, regardless of their geographical location. It is bound by Supreme Court decisions. In 1970, the Golsen rule was adopted, which provides that the Tax Court will follow decisions of the court of appeals to which a case in question is appealable.

ii.

U.S. District Court decisions have precedential value only for subsequent cases heard in the same district. District courts must follow decisions of the Supreme Court and the court of appeals to which the case is appealable.

iii.

The U.S. Court of Federal Claims must rule consistently with the Supreme Court, Circuit Court of Appeals for the Federal Circuit, and generally its own earlier decisions.

iv.

A circuit court of appeals is bound by the Supreme Court and generally earlier decisions made by that circuit.

v.

Because the courts are not always in agreement, a taxpayer can sometimes forum shop to select a court that is likely to be most favorable to the taxpayer’s position.

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6. Tax Treaties. a. The United States has treaties with a number of foreign countries. The treaties may pertain to tax and other matters. The provisions contained in a treaty in most cases override the rules contained in the Code.

7. Tax Periodicals. a. Writings of tax experts in tax periodicals can provide useful insight into provisions contained in the Code, regulations, cases, or rulings. (See page I:15-24 for a list of periodicals.) Published articles and tax service commentaries are secondary sources of authority. Primary sources of authority are the Code and administrative and judicial interpretations.

Primary authorities should be cited for relevant points. Secondary authorities (e.g., law review articles) are occasionally cited in court opinions.

V.

Tax Services (Table I:15-4) 1. Bound multivolume commentaries on the tax law are published by several publishers. These services are encyclopedic in scope and come in loose leaf form so that they can be updated. The organizational framework and frequency of updating vary. These services are now primarily accessed online.

2. Annotated tax services (organized by IRC section) include United States Tax Reporter and Standard Federal Income Tax Reporter.

3. Topical tax services include Federal Tax Coordinator 2d and Tax Management Portfolios.

VI.

The Internet as a Research Tool 1. The Internet has become the principal medium for conveying tax-related information to professionals. The most widely used Internet services are Checkpoint and CCH Intelliconnect.

VII.

Citators 1. Citators serve two functions: (1) they provide a history of the case; and (2) they list other authorities that have cited the case. The principal citators are in Checkpoint and CCH Intelliconnect.

VIII.

Professional Guidelines for Tax Services 1. Treasury Department Circular 230 describes government-imposed tax standards.

This document details standards of practice before the IRS, as well as guidelines for written advice to taxpayers.

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2. The AICPA’s Statements on Standards for Tax Services provide a standard of practice for CPAs. (See Appendix E.) IX.

Sample Work Papers and Client Letter 1. Appendix A contains a sample set of work papers including a draft of a client letter and a memo to the file describing the facts on which the research is based. While the exact format of work papers will vary slightly from firm to firm, the general content remains the same. In practice, work papers may include less detail. Each issue is researched and the applicable authorities are cited. A conclusion is then reached based on the application of the facts to the authority cited.

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Court Case Briefs The following court cases illustrate how the courts, through judicially enunciated doctrines, impact the interpretation of tax law.

Hirotoshi Yamamoto v. CIR, 73 T.C. 946 (1980), aff’d. in unpublished opinion 672 F.2d 924 (9th Cir., 1982).

Yamamoto (Y) owned 100% of the stock of P Corporation. P Corporation owned 100% of the stock of subsidiary S. S was heavily indebted to P. During 1970 and 1971, S made loans to Y. Y transferred real property to S, those transactions being recorded as sales, in exchange for cash, release of Y’s indebtedness to S and assumption of Y’s liabilities by S. Subsequently, S transferred this property to P at a price equal to S’s book value in the property. Additionally, Y purchased stock of P in exchange for cash.

Y argued that the step-transaction theory should apply to these transactions so they should be collapsed into one transaction and qualify for tax-free treatment under Internal Revenue Code Sec. 351. The court rejected this argument, stating that the rules for transfers to a controlled corporation did not apply because the property transfers and stock transfer had separate legal significance. The facts were consistent with this decision. This case involves a detailed analysis of the substance over form issue.

Evelyn F. Gregory v. Helvering, 293 U.S. 465 (1935).

Mrs. Gregory owned all of the stock of a corporation which owned 1,000 shares of stock of another corporation. To get these shares and to obtain more favorable tax treatment, a new corporation was organized and the 1,000 shares of stock were transferred to it by the old corporation in what was claimed to be a nontaxable reorganization. The new corporation then dissolved and distributed its only asset, the shares of stock, to its sole shareholder, Mrs. Gregory. Mrs. Gregory then sold the stock and reported capital gains tax treatment on the sale. The Supreme Court held that a nontaxable reorganization had not occurred since the new corporation had no relation to the business of the old corporation and was formed solely as part of a preconceived plan with no business purpose. Tax avoidance was held not to be a sufficient business purpose to permit a taxfree reorganization to occur.

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Chapter I:15 Tax Research Learning Objectives After studying this chapter, the student should be able to: 1. Distinguish between closed fact and open fact tax situations.

2. Describe the steps in the tax research process.

3. Explain how the facts influence tax consequences.

4. Identify the sources of tax law and assess the authoritative value of each.

5. Consult tax services to research an issue.

6. Apply the basics of Internet-based tax research.

7. Use a citator to assess tax authorities.

8. Describe professional guidelines that CPAs in tax practice should follow.

9. Prepare work papers and communicate to clients.

Areas of Greater Significance Since this will usually be a student’s first exposure to tax research, the importance of the facts to the tax results should be discussed. Proper use of the federal tax services and the citator should be stressed at this point in the student’s learning process.

Areas of Lesser Significance In the interest of time, the instructor may omit the following area: 1. Sample Work Papers and Client Letter

Problem Areas for Students The following areas may prove especially difficult for students: 1. Understanding how to use Internet tax services and citators.

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2. Learning the authoritative value of each of the sources of tax law.

Highlights of Recent Tax Law Changes No items of tax law have changed since the 2023 edition of this chapter.

Teaching Tips 1. Example I:15-2: Use the example to emphasize to the students the importance of considering nontax objectives as well as tax objectives. (See page I:15-2.)

2. Figure I:15-1: Walk through the steps in the tax research process. As you do this emphasize to the students that the steps of the tax research process provide an excellent format for a written communication to a client or to a client file. This time you might consider going over the client communication contained in Appendix A, page A-2. (See page I:15-4.)

Lecture Outline I.

Overview of Tax Research 1. Tax research can be conducted in a number of different settings. Tax research involves solving a specific tax-related question using a number of tax law sources as they apply to the particular situation. Sample work papers demonstrating how to document the results of a research effort are included in Appendix A. In addition, this chapter discusses the AICPA’s guidelines for CPAs in tax practice, the Statements on Standards for Tax Services (reproduced in Appendix E), and Treasury Department Circular 230.

2. Client-oriented research is conducted by accounting and law firms for the benefit of their clients. It involves determining the tax consequences of a certain transaction for a given client. It is performed in: a. Closed fact or tax compliance situations. (See Example I:15-1.) b. Open fact or tax-planning situations. (See Example I:15-2.) c. Academic settings. i.

Tax policy research may be conducted by individuals in an academic setting (e.g., accounting programs, law schools, economics departments, etc.).

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II.

Steps in the Tax Research Process (Figure I:15-1) 1. Emphasis should be placed on the fact that tax research is a circular process sometimes requiring the determination of different facts, restatement of the research question, or reliance on additional authorities. There are, however, six basic steps to the tax research process: a. Determine the facts. b. Identify the issues (questions). c. Locate the applicable authorities. d. Evaluate the authorities and choose those to follow when the authorities conflict. e. Analyze the facts in terms of the applicable authorities. f. Communicate conclusions and recommendations to the client.

2. When doing tax research in the context of tax planning, the tax professional needs to keep a number of points in mind: a. The objective is not to minimize taxes per se but rather to maximize the after-tax return. b. One does not engage in unilateral transactions; thus, the tax ramifications to all parties to the contract are relevant. c. Taxes are but one cost of doing business. d. The time for tax planning is not restricted to when one enters into an investment, contract, and other arrangement, but rather the time extends throughout the life of the activity.

3. Tax research often involves a “gray area;” that is, one that does not have a clearcut, unequivocally correct solution. The issue should then be pursued through the use of a specifically tailored set of detailed questions. Tax research may also involve determining which issues need to be researched. A fairly extensive knowledge of tax law is necessary to determine which issues need to be researched.

III.

Importance of the Facts to the Tax Consequences 1. The importance of a particular set of facts to the tax results should be emphasized.

Three illustrations are presented in the chapter to demonstrate the importance of facts to the appropriate resolution. (See page I:15-6.)

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IV.

The Sources of Tax Law (Table I:15-3) The term “tax law” generally encompasses much more than just the tax statutes as enacted

by Congress. The law contains language that requires interpretation, both administrative and judicial. Administrative interpretations include Treasury regulations, revenue rulings, and revenue procedures. Judicial interpretations consist of court decisions. Tax law also consists of committee reports issued by Congress during the legislative process.

1. Legislative Process a. All tax legislation must originate in the House of Representatives. Tax bills are referred to the House Ways and Means Committee. After a bill is approved by the House Ways and Means Committee, it moves to the floor of the House for consideration. If approved by a majority of the House, it moves to the Senate. After consideration by the Senate Finance Committee, it moves to the Senate floor for approval. Usually the House and Senate bills will not be in complete agreement. The bill will then go to a Conference Committee consisting of members of both houses. A compromise will then be reached between the two versions of the tax bill. The compromise is then voted on by both houses of Congress and goes on to the President for his signature or veto. Both houses of Congress generally hold extensive hearings at which time interested parties are free to testify. The U.S. Government Printing Office publishes the statements made at hearings.

Committee Reports explaining Congress’s purpose in drafting legislation are published by the U.S. Government Printing Office and in the Internal Revenue Bulletin. Committee Reports are particularly useful in interpreting the law prior to issuance of regulations. (See Example I:15-4.)

2. Internal Revenue Code a. The Internal Revenue Code is the foundation of all tax law. It was first codified in 1939. Recodified in 1954, it has now been named the Internal Revenue Code of 1986. Whenever the law is changed, old language is deleted and new language is added. (See Figure I:15-2 for the organizational scheme of the Internal Revenue Code.)

3. Treasury Regulations a. The Treasury Department issues regulations as interpretations of the statute.

They provide examples complete with computations to assist in understanding the statutory language. Because statutory changes occur frequently, regulations are not always updated in a timely manner. When referring to a regulation, the tax advisor should consult the introductory note in order to determine when the regulation was adopted. Regulations are first provided in proposed form, and the public has an opportunity to comment and suggest changes. Proposed regulations have no more authoritative weight than the position the IRS argues for in a brief, but provide guidance on I:IO15-4 Copyright © 2024 Pearson Education, Inc.

Treasury’s interpretation of a statute. Temporary regulations (which generally are effective upon publication) are often issued soon after a major statutory change to provide guidance on procedural and computational matters. Temporary regulations have the same authoritative value as final regulations. However, they cannot remain temporary for more than a threeyear period. Temporary regulations must be issued concurrently with proposed regulations. Final regulations are drafted after the public has had time to comment on the proposed regulations. Final regulations have strong authoritative weight, and may take effect retroactive to the effective date of the statutory language they interpret. b. For changes to the Code enacted after July 29, 1996, the Treasury is generally precluded from issuing regulations with retroactive effect. In the case of final regulations, however, a regulation can be effective on the date proposed or temporary regulations are filed with the Federal Register.

Regulations issued within 18 months of the date of a change to the statute can be issued with retroactive effect. c. Regulations may also be classified as either interpretative or legislative.

Interpretative regulations are issued under the general authority of Sec. 7805 and make the statutory language easier to understand and apply. They provide illustrations about how to perform certain computations.

Legislative regulations provide rules on highly technical matters where Congress has delegated the rulemaking to the Treasury Department (e.g., consolidated tax return issues). d. Section 7805 provides that the Secretary of the Treasury has the right to prescribe regulations and to what extent they are to be applied retroactively.

Occasionally, taxpayers can successfully argue that a regulation is invalid and, consequently, should not be followed. This will occur only if the courts find that the regulation is “unreasonable and plainly inconsistent with the revenue statutes.” The courts often apply the legislative reenactment doctrine which holds that regulations finalized many years earlier and not amended by Congress through changes to the statutory language have Congressional approval. e. Regulations are cited as follows. Numbers before the decimal point indicate the general subject matter of the regulation. (See page I:15-11.) Numbers to the right of the decimal place refer to the Code section being interpreted.

Numbers to the right of that number indicate the number of the regulation.

Temporary or proposed regulations are cited as Temp. Reg. Sec. or Prop.

Reg. Sec. When providing a citation, the researcher should be as precise as possible. An example of this would be Reg. Sec. 1.165-5(i), Ex. 2(i), which refers to the first portion of Example 2 that is contained in the “i” portion of the fifth regulation interpreting Sec. 165.

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4. Administrative Pronouncements. There are a number of different means that the IRS uses for interpreting the statute. After referring to the Code and Regulations, tax advisors are likely to refer next to IRS interpretations for further authority for answering a tax question. a. Revenue Rulings i.

Revenue rulings are used to indicate the tax status of a particular transaction, which has wide taxpayer interest. They represent the viewpoint of the IRS and do not have as much authority as court cases or regulations. Approximately one hundred rulings are issued each year. A taxpayer does not have to follow a ruling if there is sufficient authority for different treatment. An IRS agent is, however, bound by the rulings. Rulings are published weekly in the Internal Revenue Bulletin (I.R.B.).

b. Revenue Procedures i.

Revenue procedures usually deal with procedural aspects of tax practice. They are first published in the Internal Revenue Bulletin.

c. Letter Rulings i.

Letter rulings are initiated by taxpayers who ask the IRS to explain the tax consequences of a particular transaction. The IRS responds in a letter ruling that can be relied on only by the person requesting it. They provide insight into the current thinking of the IRS. Commerce Clearing House publishes rulings with any confidential information deleted in a separate letter ruling service.

d. Technical Advice Memoranda i.

When a taxpayer’s return is being audited with respect to a complicated, technical matter, the taxpayer may request that the matter be referred to the IRS National Office in Washington, D.C. concerning the appropriate tax treatment. The answer is issued in the form of a Technical Advice Memoranda, which is made available in the form of a letter ruling.

e. Information Releases i.

Information releases contain information about interpretations of general interest and are released to the news media throughout the United States.

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f. Announcements and Notices i.

Information releases that are more technical and aimed at tax practitioners are issued in the form of Announcements.

Announcements are often issued before temporary or proposed regulations can be issued. The IRS is bound by announcements and notices in the same way as if contained in a revenue ruling.

5. Judicial Decisions. Judicial decisions comprise an important source of tax law.

Judicial decisions are sometimes in conflict between different courts. a. Overview of the Court System (Figure I:15-3; Table I:15-2) i.

There are three trial courts - the U.S. Tax Court, the U.S. Court of Federal Claims, and the U.S. District Courts. Litigation may begin in any court, but precedent is an important factor in determining where it should begin. Cash flow also may be an important factor.

Taxes must be paid before litigation begins in the U.S. Court of Federal Claims or the U.S. District Court. After the taxes are paid, a claim for refund is filed which will be denied by the IRS. A suit for refund is then brought and, if won, a refund with interest is obtained.

A suit may be brought in the Tax Court. If lost, the deficiency plus any interest and penalties must be paid. The District Court is the only place that a jury trial is possible. Decisions can be appealed from the Tax Court and the U.S. District Court to the Court of Appeals in the taxpayer’s circuit. Appeals from the U.S. Court of Federal Claims are taken to the Court of Appeals for the Federal Circuit. A party who loses at the appellate level can ask the Supreme Court for a writ of certiorari. The Supreme Court hears only about six to ten tax cases a year. (See Figure I:15-4 for an overview of the court system.)

b. U.S. Tax Court i.

The U.S. Tax Court originated in 1942 as the successor to the Board of Tax Appeals. It hears cases only dealing with tax matters. There are 19 Tax Court judges including one chief judge. The judges are appointed by the President with the consent of the Senate for a fifteen-year term. The judges travel to cities around the United States to hear cases. Only one judge hears a particular case. The chief judge decides whether to publish each opinion as a memo or regular decision.

ii.

The Tax Court has a special policy in dealing with cases where the amount in question does not exceed $50,000 a year (i.e., small cases). Taxpayers can appear without an attorney. The cases are

I:IO15-7 Copyright © 2024 Pearson Education, Inc.

heard by special commissioners instead of one of the Tax Court judges. Decisions under this procedure cannot be appealed. iii.

The IRS has an acquiescence policy with regard to Tax Court decisions that have been decided in the taxpayer’s favor. If it wishes to go on record that it agrees with a regular Tax Court decision, it acquiesces. If it wishes to disagree with a decision, it issues a nonacquiescence. This policy is not followed in all Tax Court decisions. An acquiescence or nonacquiescence is binding on an IRS agent. If a taxpayer is audited and has taken a position which the IRS has issued a nonacquiescence, litigation will likely be the only recourse for the taxpayer.

iv.

Regular decisions of the Tax Court are published by the U.S. Government Printing Office in a bound volume known as the Tax Court of the United States Reports. Soon after a decision is made public, it is also published by Research Institute of America and Commerce Clearing House in their loose leaf reporters of Tax Court decisions.

c. U.S. District Courts i.

Each state has a district court and more populous states have several districts. Many different types of cases are heard and a taxpayer may request a jury trial. District court decisions are officially reported in the Federal Supplement (F.Supp.) published by West Publishing Co. Tax decisions are also published by Research Institute of America in the American Federal Tax Reports (AFTR) and by Commerce Clearing House in the U.S. Tax Cases (USTC).

d. U.S. Court of Federal Claims i.

The U.S. Court of Federal Claims, as reorganized in 1982 and renamed in 1992, is a national court with decisions appealable to the Circuit Court of Appeals for the Federal Circuit. U.S. Court of Federal Claims decisions were published in the Claims Court Reporter by West Publishing Co. from 1982 to 1992. These cases are now reported in the Federal Claims Reporter (Fed. Cl.). In addition, the AFTR and USTC services report these tax decisions.

e. Circuit Courts of Appeal (Table I:15-1) i.

Trial court decisions are appealable to a particular circuit court of appeals depending upon where the litigation originated. In the case of an individual, it depends upon the taxpayer’s residence on the date of appeal. In the case of a corporation, it is the principal place of business that controls. There are 11 geographical circuits, the circuit for the District of Columbia and the Federal Circuit. New I:IO15-8 Copyright © 2024 Pearson Education, Inc.

circuit court of appeals decisions are reported officially in the Federal Reporter, Third Series (F.3d) published by Thomson Reuters/West. In addition, AFTR and USTC services report these decisions. f. Supreme Court i.

A decision of an appellate court can be appealed to the Supreme Court. Unless the circuits are divided on the proper treatment of an issue or the issue is deemed of great significance, the Supreme Court will not grant certiorari. Decisions of the Supreme Court are the law of the land. If Congress does not agree with a Supreme Court decision, statutory language can be amended to reach the desired result. Supreme Court decisions are published in the United States Supreme Court Reports (U.S.) by the U.S. Government Printing Office, the Supreme Court Reporter (S.Ct.) by Thomson/Reuters/West, and the United States Reports, Lawyers’ Edition (L.Ed.) by Lawyer’s Co-Operative Publishing Co. In addition, the AFTR and USTC services report these tax decisions.

g. Precedential Value of Various Decisions i.

The Tax Court will generally rule uniformly for taxpayers, regardless of their geographical location. It is bound by Supreme Court decisions. In 1970, the Golsen rule was adopted, which provides that the Tax Court will follow decisions of the court of appeals to which a case in question is appealable.

ii.

U.S. District Court decisions have precedential value only for subsequent cases heard in the same district. District courts must follow decisions of the Supreme Court and the court of appeals to which the case is appealable.

iii.

The U.S. Court of Federal Claims must rule consistently with the Supreme Court, Circuit Court of Appeals for the Federal Circuit, and generally its own earlier decisions.

iv.

A circuit court of appeals is bound by the Supreme Court and generally earlier decisions made by that circuit.

v.

Because the courts are not always in agreement, a taxpayer can sometimes forum shop to select a court that is likely to be most favorable to the taxpayer’s position.

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6. Tax Treaties. a. The United States has treaties with a number of foreign countries. The treaties may pertain to tax and other matters. The provisions contained in a treaty in most cases override the rules contained in the Code.

7. Tax Periodicals. a. Writings of tax experts in tax periodicals can provide useful insight into provisions contained in the Code, regulations, cases, or rulings. (See page I:15-24 for a list of periodicals.) Published articles and tax service commentaries are secondary sources of authority. Primary sources of authority are the Code and administrative and judicial interpretations.

Primary authorities should be cited for relevant points. Secondary authorities (e.g., law review articles) are occasionally cited in court opinions.

V.

Tax Services (Table I:15-4) 1. Bound multivolume commentaries on the tax law are published by several publishers. These services are encyclopedic in scope and come in loose leaf form so that they can be updated. The organizational framework and frequency of updating vary. These services are now primarily accessed online.

2. Annotated tax services (organized by IRC section) include United States Tax Reporter and Standard Federal Income Tax Reporter.

3. Topical tax services include Federal Tax Coordinator 2d and Tax Management Portfolios.

VI.

The Internet as a Research Tool 1. The Internet has become the principal medium for conveying tax-related information to professionals. The most widely used Internet services are Checkpoint and CCH Intelliconnect.

VII.

Citators 1. Citators serve two functions: (1) they provide a history of the case; and (2) they list other authorities that have cited the case. The principal citators are in Checkpoint and CCH Intelliconnect.

VIII.

Professional Guidelines for Tax Services 1. Treasury Department Circular 230 describes government-imposed tax standards.

This document details standards of practice before the IRS, as well as guidelines for written advice to taxpayers.

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2. The AICPA’s Statements on Standards for Tax Services provide a standard of practice for CPAs. (See Appendix E.) IX.

Sample Work Papers and Client Letter 1. Appendix A contains a sample set of work papers including a draft of a client letter and a memo to the file describing the facts on which the research is based. While the exact format of work papers will vary slightly from firm to firm, the general content remains the same. In practice, work papers may include less detail. Each issue is researched and the applicable authorities are cited. A conclusion is then reached based on the application of the facts to the authority cited.

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Court Case Briefs The following court cases illustrate how the courts, through judicially enunciated doctrines, impact the interpretation of tax law.

Hirotoshi Yamamoto v. CIR, 73 T.C. 946 (1980), aff’d. in unpublished opinion 672 F.2d 924 (9th Cir., 1982).

Yamamoto (Y) owned 100% of the stock of P Corporation. P Corporation owned 100% of the stock of subsidiary S. S was heavily indebted to P. During 1970 and 1971, S made loans to Y. Y transferred real property to S, those transactions being recorded as sales, in exchange for cash, release of Y’s indebtedness to S and assumption of Y’s liabilities by S. Subsequently, S transferred this property to P at a price equal to S’s book value in the property. Additionally, Y purchased stock of P in exchange for cash.

Y argued that the step-transaction theory should apply to these transactions so they should be collapsed into one transaction and qualify for tax-free treatment under Internal Revenue Code Sec. 351. The court rejected this argument, stating that the rules for transfers to a controlled corporation did not apply because the property transfers and stock transfer had separate legal significance. The facts were consistent with this decision. This case involves a detailed analysis of the substance over form issue.

Evelyn F. Gregory v. Helvering, 293 U.S. 465 (1935).

Mrs. Gregory owned all of the stock of a corporation which owned 1,000 shares of stock of another corporation. To get these shares and to obtain more favorable tax treatment, a new corporation was organized and the 1,000 shares of stock were transferred to it by the old corporation in what was claimed to be a nontaxable reorganization. The new corporation then dissolved and distributed its only asset, the shares of stock, to its sole shareholder, Mrs. Gregory. Mrs. Gregory then sold the stock and reported capital gains tax treatment on the sale. The Supreme Court held that a nontaxable reorganization had not occurred since the new corporation had no relation to the business of the old corporation and was formed solely as part of a preconceived plan with no business purpose. Tax avoidance was held not to be a sufficient business purpose to permit a taxfree reorganization to occur.

I:IO15-12 Copyright © 2024 Pearson Education, Inc.

Chapter I:16 Corporations Learning Objectives After studying this chapter, the student should be able to: 1. Define the types of entities that can be classified as a corporation for federal income tax purposes.

2. Examine specific rules that apply to corporations.

3. Calculate the corporate income tax liability.

4. Apply the nonrecognition of gain or loss rules for corporate capitalizations.

5. Understand the significance of earnings and profits.

6. Determine the tax consequences of noncash distributions and stock redemptions.

7. Understand the tax implications of a corporate liquidation for the liquidating corporation and its shareholders.

8. Describe tax planning considerations for corporations.

9. Describe compliance and procedural considerations for corporations.

Areas of Greater Significance Since this chapter is only an initial exposure to corporations for the student, the instructor may wish to stress those topics which directly impact individual taxpayers (shareholders).

These topics include formation transactions, capitalization, earnings and profits, distributions and redemptions, and liquidations.

Areas of Lesser Significance In the interest of time, the instructor may determine that the following areas are best covered by student reading, rather than class discussion: 1. Definition of a Corporation 2. The Corporate Alternative Minimum Tax (AMT) and the Minimum Tax Credit (MTC) I:IO16-1 Copyright © 2024 Pearson Education, Inc.

Problem Areas for Students The following areas may prove especially difficult for students: 1. Shareholder tax consequences on formation.

2. Determining whether certain distributions are dividends or redemptions.

Highlights of Recent Tax Law Changes The following items of tax law have changed since the 2023 edition of this chapter: 1. The gross receipts threshold for adopting the cash method has increased to $29 million ($27 million in 2022).

2. The income levels for tax rates for ordinary income, long-term capital gains, dividend income, and the kiddie tax have increased. (See Quick Reference.)

3. The Inflation Reduction Act of 2022 introduced the book minimum tax.

Teaching Tips 1. Stress to the students that this chapter is a broad overview of corporations. More detailed analysis will be provided in a second tax course and in specialized graduate tax courses.

2. At this point in the students’ tax career, you may wish to concentrate on computation of corporate tax, specific rules applicable to corporations, and transfers of property to controlled corporations.

Lecture Outline I.

Definition of a Corporation 1. Similarities and Differences Between the Taxation of Corporations and Individuals a. Similarities i.

Calculation of corporate taxable income is similar to the calculation of taxable income for a sole proprietorship.

b. Differences between corporate taxable income and individual taxable income include: i.

No AGI or standard deduction for corporations.

I:IO16-2 Copyright © 2024 Pearson Education, Inc.

II.

ii.

Corporations have a dividend-received deduction, but individuals do not.

iii.

Limitations on charitable contributions for corporations are much more stringent than for individuals.

iv.

Corporations have a single 21% flat tax rate.

Specific Rules Applicable to Corporations (Topic Review I:16-1) 1. Capital Gains and Losses (Examples I:16-2, I:16-5) a. Net capital gain (whether short-term or long-term) is taxed as ordinary income. b. Net capital loss is subject to a 3-year carryback and a 5-year carryforward and can only offset capital gain. i.

EXAMPLE: If a corporate taxpayer has a net capital loss of $50,000 in the current year, none of it can be used to offset ordinary income in the current year. It can be carried back or forward only to offset capital gains (no offset of ordinary income).

2. Dividends-Received Deduction (Examples I:16-6 through I:16-8; Problem I:16-38; Instructor Aid I:16-1) a. The corporate dividends-received deduction varies by level of ownership if the corporation owns: i.

Less than 20% of the distributing corporation’s stock, the deduction is 50%.

ii.

At least 20%, but less than 80% ownership, the deduction is 65%.

iii.

At least 80% ownership, the deduction is 100%.

b. The applicable percentage deduction is applied to the lesser of the domestic dividends received or taxable income. If the full dividend received deduction, however, will add to or create an NOL, then the full deduction may be used.

3. Net Operating Losses (Example I:16-10) a. Corporate NOLs have an infinite carryforward. The adjustments necessary to determine an individual’s NOL are unnecessary in the corporate area, since all income and expense are business-related.

I:IO16-3 Copyright © 2024 Pearson Education, Inc.

4. Charitable Contributions (Example I:16-12) a. Corporate charitable contribution deductions are limited to 10% of taxable income (as adjusted) with a 5-year carryover.

5. Compensation Deduction Limitation for Publicly Held Corporations (Example I:16-14) a. Compensation deduction limitations ($1,000,000 per covered employee) have been enacted for certain highly compensated officers of publicly held corporations.

III.

Computation of Tax (Table I:16-2) 1. Computation of Regular Tax (Example I:16-14; Problem I:16-41) a. Corporations have a 21% flat tax rate.

2. Book Minimum Tax (Examples I:16-16 through I:16-18; Problem I:16-44) a. A new version of AMT for corporations with average annual adjusted financial statement income (AFSI) exceeding $1 billion. b. Book minimum tax is 15% of AFSI exceeding regular tax. c. AFSI is based on net income or loss in the financial statements after making certain adjustments. d. Book minimum tax creates a minimum tax credit to offset regular tax in a any year it exceeds 15% of AFSI. 3. Penalty Taxes (Examples I:16-19, I:16-20; Topic Review I:16-2; Questions I:1612, I:16-14; Instructor Aid I:16-2) a. A corporation may be subject to an accumulated earnings tax (20% rate) for retaining earnings beyond the reasonable needs of the business for the purpose of avoiding taxation on the shareholders. i.

Reasonable needs of the business include expansion, plant replacement, acquisition of another business, working capital, debt retirement, and loans to customers.

ii.

The first $250,000 ($150,000 for service corporations) of accumulated earnings is not subject to tax due to the accumulated earnings credit.

iii.

Paying sufficient dividends will defeat any liability for accumulated earnings tax.

I:IO16-4 Copyright © 2024 Pearson Education, Inc.

b. A corporation may be subject to personal holding company tax (20% rate) if 60% or more of its adjusted ordinary gross income is certain passive income (i.e., dividends, interest, rental income) and 5 or fewer individuals own more than 50% of the stock. i.

Attribution rules (both family and entity types) make it more difficult to avoid the ownership test for a personal holding company.

ii.

A corporation is not liable for the accumulated earnings tax and the personal holding company tax in the same year.

iii.

Paying sufficient dividends will defeat any liability for personal holding company tax.

4. Controlled Groups of Corporations (Example I:16-21) a. Certain corporate tax benefits are available only once for defined groups of multiple corporations (i.e., brother-sister corporations and parent-subsidiary corporations). b. Affiliated groups only receive one accumulated earnings tax credit ($150,000 for service corporations; $250,000 for other corporations). c. A brother-sister controlled group exists when five or fewer persons own (either directly or by attribution) 80% or more of the stock of a corporation, and there is common ownership of more than 50% of the total value of all classes of stock. For some corporate tax attributes, only the 50% test is required for characterization as a brother-sister group. d. A parent-subsidiary controlled group exists if a common parent corporation owns at least 80% of the stock of at least one subsidiary corporation, and at least 80% of the stock of any other component member of the controlled group is owned by other members of the controlled group.

5. Consolidated Returns a. Parent-subsidiary controlled groups are generally eligible to file consolidated returns. b. Consolidated returns are an advantage to the extent that losses, deductions, and credits can be taken currently on a consolidated basis that would otherwise be carried over on a separate corporation basis.

I:IO16-5 Copyright © 2024 Pearson Education, Inc.

IV.

Transfers of Property to Controlled Corporations (Topic Review I:16-3) 1. Section 351 Nonrecognition Requirements (Examples I:16-23, I:16-24) a. Nonrecognition of gain is possible if a shareholder transfers property solely in exchange for stock, and all shareholders transferring property own at least 80% of the stock after the transfer. i.

EXAMPLE: If a sole shareholder transfers property with a fair market value of $100,000 and adjusted basis of $30,000 to a corporation solely in exchange for stock, neither the shareholder nor the corporation recognize gain.

2. Basis Considerations (Examples I:16-25, I:16-26) a. The basis of the transferor’s stock is the sum of the adjusted basis of all property contributed less any boot received (including relief of debt) plus any gain recognized. The boot property has a FMV basis. b. The basis of the transferred property in the hands of the corporation is the transferor’s basis plus any gain recognized. i.

EXAMPLE: In the above example, the shareholder would have a $30,000 adjusted basis in her stock. The corporation would also have a $30,000 adjusted basis in the assets.

3. Treatment of Liabilities (Examples I:16-28, I:16-29) a. The general rule is that the assumption of liabilities by the corporation does not cause recognition of gain. b. Exceptions include tax avoidance transactions, and situations where the liability assumed exceeds the adjusted basis of the transferred property.

V.

Earnings and Profits 1. Calculation of Earnings and Profits (Example I:16-30; Table I:16-3) a. Earnings and profits are the tax measure of amounts available to pay taxable dividends. b. Earnings and profits are similar to retained earnings (financial accounting) or retained taxable income but are specially calculated under statutory guidelines.

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2. Current Versus Accumulated E & P (Examples I:16-31, I:16-32) a. Distributions paid out of either current or accumulated earnings and profits are taxable as dividends.

VI.

Noncash Distributions (Problem I:16-54) 1. Tax Consequences to the Shareholders (Example I:16-34) a. The amount of the distribution is the fair market value of the property distributed, and it is a taxable dividend to the extent of earnings and profits.

2. Tax Consequences to the Distributing Corporation (Example I:16-35) a. The distributing corporation must recognize any appreciation in the distributed property as a gain on distribution.

3. Stock Redemptions (Problem I:16-57) a. A stock redemption may be treated as a dividend or as a sale or exchange. b. Special redemption rules exist for partial liquidations, estate tax redemptions, and preferred stock bailouts.

4. Determining Whether a Redemption is a Dividend or Capital Gain (Examples I:1639, I:16-40) a. Capital gain treatment is available in several situations, including a substantially disproportionate redemption and a complete termination of interest.

VII.

Corporate Distributions in Complete Liquidation (Topic Review I:16-4) 1. Tax Consequences to the Liquidated Corporation (Example I:16-41) a. Current law generally provides for recognition of gain or loss to the distributing corporation on distribution in complete liquidation.

2. Tax Consequences to the Shareholders (Example I:16-42) a. In complete liquidation, shareholders are treated as having sold or exchanged their stock.

3. Section 332: Liquidation of a Subsidiary Corporation (Example I:16-43) a. No gain or loss is recognized by either the subsidiary or the parent, if the parent liquidates an 80%-owned subsidiary. The basis of the subsidiary’s assets carries over to the parent.

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VIII.

Tax Planning Considerations 1. Capital Structure and Section 1244 a. Using corporate stock to capitalize a corporation instead of debt could result in certain losses being treated as ordinary under Section 1244 rather than as short-term capital loss (nonbusiness bad debt treatment).

2. Dividend Policy (Example I:16-44) a. Shifting payments to shareholders from dividends to deductible items (e.g., salary, rental payments) may reduce overall taxation.

3. Use of Losses a. Corporations may desire to accelerate recognition of income when capital losses or NOLs are about to expire.

4. Charitable Contributions a. Corporations should control charitable contributions to avoid the 10% limitation.

5. Dividends-Received Deduction a. Corporations should plan carefully to prevent the taxable income limitation from applying, and thereby reducing the amount of deduction.

6. Reduced Taxes on Taxpayer Stock Sales a. Certain sales of stock held five years or more will be eligible for an exclusion of gain under Section 1202(a)(1). (See also page I:4-22.)

IX.

Compliance and Procedural Considerations 1. Filing Requirements a. Corporations must file Form 1120 by the 15th day of the fourth month after the end of the tax year (i.e., April 15 for a calendar year corporation).

2. Schedule M-1 and M-2 Reconciliations (Figures I:16-1, I:16-2) a. Schedule M-1, Form 1120 reconciles financial income with taxable income. b. Schedule M-2, Form 1120 reconciles beginning and ending retained earnings.

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3. Schedule M-3 Reconciliation a. Large corporations (total assets of $10 million or more) are required to disclose detailed information about book to tax differences on Schedule M3.

4. Maintenance of E & P Records a. Maintaining records for E & P purposes is also important, even though the corporate return does not require the calculation.

I:IO16-9 Copyright © 2024 Pearson Education, Inc.

Court Case Briefs Alaska Redi-mix v. CIR, 1971 PH T.C. Memo & 69,218, 28 TCM 1165.

In July 1956, Mr. Walter Selid transferred assets to Alaska Redi-mix, Inc. in exchange for 60,000 shares of the company’s stock. Two other individuals purchased one share each. A bill of sale was executed and properly filed documenting the transfer of the assets to the corporation. Mr. Selid owned 60,000 of the 60,002 shares issued and outstanding. Subsequently, in November 1956, another individual, Mr. Derickson, transferred assets to the corporation in exchange for 30,000 shares. The corporation claimed depreciation deductions on property based on a stepped-up basis rather than a carry-over basis.

The court held that the requirements of Sec. 351 had been met in the July exchange. Sec. 351 requires that no gain or loss be recognized for assets transferred by one or more persons to a corporation solely in exchange for stock or securities, and those persons have control of the corporation immediately after the exchange. Sec. 368, in part, defines control as at least 80% of the voting power of voting stock. Mr. Selid satisfied the 80% requirement because he owned in excess of 99% of the voting stock at the time of the July transfer. Therefore, under Sec. 362 the basis of the assets transferred must be the same as in the hands of the transferor. No step-up in basis was allowed.

Warren C. Cordner and Evelyn C. Cordner v. U.S., 49 AFTR 2d 82-1353; 82-1 USTC & 9275 (9th Cir., 1982).

Warren C. Cordner, a stockholder of First Thrift Investors, received 275 $20 gold coins as a corporate dividend distribution. The taxpayer reported on his federal tax return a dividend in the amount of their face value ($5,500) rather than their fair market value ($70,936). The IRS charged the taxpayer with a dividend in the amount of their fair market value.

Sec. 301 provides that the amount of the distribution for dividend purposes is the amount of money and the fair market value of other property received. The court held that while the coins were legal tender and could be considered “money,” they had been withdrawn from circulation and had numismatic value. Consequently, the dividend was a property dividend and was taxed at fair market value.

I:IO16-10 Copyright © 2024 Pearson Education, Inc.

Instructor Aid I:16-1 Dividends-Received Deduction The following deduction percentages will be applied to the lower of domestic dividends received, or taxable income (computed without NOL, dividends-received deduction, and capital loss carrybacks)*:

50%

Recipient corporation owns less than 20% of the stock of the issuing corporation.

65%

Recipient corporation owns 20% or more, but less than 80% of the stock of the issuing corporation.

100%

Recipient corporation owns 80% or more of the stock of the issuing corporation.

*The taxable income limitation does not apply if using the full dividends-received deduction would add to or create a net operating loss.

I:IO16-11 Copyright © 2024 Pearson Education, Inc.

Instructor Aid I:16-2 Conditions for Accumulated Earnings Tax

I:IO16-12 Copyright © 2024 Pearson Education, Inc.

Chapter I:16 Corporations Learning Objectives After studying this chapter, the student should be able to: 1. Define the types of entities that can be classified as a corporation for federal income tax purposes.

2. Examine specific rules that apply to corporations.

3. Calculate the corporate income tax liability.

4. Apply the nonrecognition of gain or loss rules for corporate capitalizations.

5. Understand the significance of earnings and profits.

6. Determine the tax consequences of noncash distributions and stock redemptions.

7. Understand the tax implications of a corporate liquidation for the liquidating corporation and its shareholders.

8. Describe tax planning considerations for corporations.

9. Describe compliance and procedural considerations for corporations.

Areas of Greater Significance Since this chapter is only an initial exposure to corporations for the student, the instructor may wish to stress those topics which directly impact individual taxpayers (shareholders).

These topics include formation transactions, capitalization, earnings and profits, distributions and redemptions, and liquidations.

Areas of Lesser Significance In the interest of time, the instructor may determine that the following areas are best covered by student reading, rather than class discussion: 1. Definition of a Corporation 2. The Corporate Alternative Minimum Tax (AMT) and the Minimum Tax Credit (MTC) I:IO16-1 Copyright © 2024 Pearson Education, Inc.

Problem Areas for Students The following areas may prove especially difficult for students: 1. Shareholder tax consequences on formation.

2. Determining whether certain distributions are dividends or redemptions.

Highlights of Recent Tax Law Changes The following items of tax law have changed since the 2023 edition of this chapter: 1. The gross receipts threshold for adopting the cash method has increased to $29 million ($27 million in 2022).

2. The income levels for tax rates for ordinary income, long-term capital gains, dividend income, and the kiddie tax have increased. (See Quick Reference.)

3. The Inflation Reduction Act of 2022 introduced the book minimum tax.

Teaching Tips 1. Stress to the students that this chapter is a broad overview of corporations. More detailed analysis will be provided in a second tax course and in specialized graduate tax courses.

2. At this point in the students’ tax career, you may wish to concentrate on computation of corporate tax, specific rules applicable to corporations, and transfers of property to controlled corporations.

Lecture Outline I.

Definition of a Corporation 1. Similarities and Differences Between the Taxation of Corporations and Individuals a. Similarities i.

Calculation of corporate taxable income is similar to the calculation of taxable income for a sole proprietorship.

b. Differences between corporate taxable income and individual taxable income include: i.

No AGI or standard deduction for corporations.

I:IO16-2 Copyright © 2024 Pearson Education, Inc.

II.

ii.

Corporations have a dividend-received deduction, but individuals do not.

iii.

Limitations on charitable contributions for corporations are much more stringent than for individuals.

iv.

Corporations have a single 21% flat tax rate.

Specific Rules Applicable to Corporations (Topic Review I:16-1) 1. Capital Gains and Losses (Examples I:16-2, I:16-5) a. Net capital gain (whether short-term or long-term) is taxed as ordinary income. b. Net capital loss is subject to a 3-year carryback and a 5-year carryforward and can only offset capital gain. i.

EXAMPLE: If a corporate taxpayer has a net capital loss of $50,000 in the current year, none of it can be used to offset ordinary income in the current year. It can be carried back or forward only to offset capital gains (no offset of ordinary income).

2. Dividends-Received Deduction (Examples I:16-6 through I:16-8; Problem I:16-38; Instructor Aid I:16-1) a. The corporate dividends-received deduction varies by level of ownership if the corporation owns: i.

Less than 20% of the distributing corporation’s stock, the deduction is 50%.

ii.

At least 20%, but less than 80% ownership, the deduction is 65%.

iii.

At least 80% ownership, the deduction is 100%.

b. The applicable percentage deduction is applied to the lesser of the domestic dividends received or taxable income. If the full dividend received deduction, however, will add to or create an NOL, then the full deduction may be used.

3. Net Operating Losses (Example I:16-10) a. Corporate NOLs have an infinite carryforward. The adjustments necessary to determine an individual’s NOL are unnecessary in the corporate area, since all income and expense are business-related.

I:IO16-3 Copyright © 2024 Pearson Education, Inc.

4. Charitable Contributions (Example I:16-12) a. Corporate charitable contribution deductions are limited to 10% of taxable income (as adjusted) with a 5-year carryover.

5. Compensation Deduction Limitation for Publicly Held Corporations (Example I:16-14) a. Compensation deduction limitations ($1,000,000 per covered employee) have been enacted for certain highly compensated officers of publicly held corporations.

III.

Computation of Tax (Table I:16-2) 1. Computation of Regular Tax (Example I:16-14; Problem I:16-41) a. Corporations have a 21% flat tax rate.

2. Book Minimum Tax (Examples I:16-16 through I:16-18; Problem I:16-44) a. A new version of AMT for corporations with average annual adjusted financial statement income (AFSI) exceeding $1 billion. b. Book minimum tax is 15% of AFSI exceeding regular tax. c. AFSI is based on net income or loss in the financial statements after making certain adjustments. d. Book minimum tax creates a minimum tax credit to offset regular tax in a any year it exceeds 15% of AFSI. 3. Penalty Taxes (Examples I:16-19, I:16-20; Topic Review I:16-2; Questions I:1612, I:16-14; Instructor Aid I:16-2) a. A corporation may be subject to an accumulated earnings tax (20% rate) for retaining earnings beyond the reasonable needs of the business for the purpose of avoiding taxation on the shareholders. i.

Reasonable needs of the business include expansion, plant replacement, acquisition of another business, working capital, debt retirement, and loans to customers.

ii.

The first $250,000 ($150,000 for service corporations) of accumulated earnings is not subject to tax due to the accumulated earnings credit.

iii.

Paying sufficient dividends will defeat any liability for accumulated earnings tax.

I:IO16-4 Copyright © 2024 Pearson Education, Inc.

b. A corporation may be subject to personal holding company tax (20% rate) if 60% or more of its adjusted ordinary gross income is certain passive income (i.e., dividends, interest, rental income) and 5 or fewer individuals own more than 50% of the stock. i.

Attribution rules (both family and entity types) make it more difficult to avoid the ownership test for a personal holding company.

ii.

A corporation is not liable for the accumulated earnings tax and the personal holding company tax in the same year.

iii.

Paying sufficient dividends will defeat any liability for personal holding company tax.

4. Controlled Groups of Corporations (Example I:16-21) a. Certain corporate tax benefits are available only once for defined groups of multiple corporations (i.e., brother-sister corporations and parent-subsidiary corporations). b. Affiliated groups only receive one accumulated earnings tax credit ($150,000 for service corporations; $250,000 for other corporations). c. A brother-sister controlled group exists when five or fewer persons own (either directly or by attribution) 80% or more of the stock of a corporation, and there is common ownership of more than 50% of the total value of all classes of stock. For some corporate tax attributes, only the 50% test is required for characterization as a brother-sister group. d. A parent-subsidiary controlled group exists if a common parent corporation owns at least 80% of the stock of at least one subsidiary corporation, and at least 80% of the stock of any other component member of the controlled group is owned by other members of the controlled group.

5. Consolidated Returns a. Parent-subsidiary controlled groups are generally eligible to file consolidated returns. b. Consolidated returns are an advantage to the extent that losses, deductions, and credits can be taken currently on a consolidated basis that would otherwise be carried over on a separate corporation basis.

I:IO16-5 Copyright © 2024 Pearson Education, Inc.

IV.

Transfers of Property to Controlled Corporations (Topic Review I:16-3) 1. Section 351 Nonrecognition Requirements (Examples I:16-23, I:16-24) a. Nonrecognition of gain is possible if a shareholder transfers property solely in exchange for stock, and all shareholders transferring property own at least 80% of the stock after the transfer. i.

EXAMPLE: If a sole shareholder transfers property with a fair market value of $100,000 and adjusted basis of $30,000 to a corporation solely in exchange for stock, neither the shareholder nor the corporation recognize gain.

2. Basis Considerations (Examples I:16-25, I:16-26) a. The basis of the transferor’s stock is the sum of the adjusted basis of all property contributed less any boot received (including relief of debt) plus any gain recognized. The boot property has a FMV basis. b. The basis of the transferred property in the hands of the corporation is the transferor’s basis plus any gain recognized. i.

EXAMPLE: In the above example, the shareholder would have a $30,000 adjusted basis in her stock. The corporation would also have a $30,000 adjusted basis in the assets.

3. Treatment of Liabilities (Examples I:16-28, I:16-29) a. The general rule is that the assumption of liabilities by the corporation does not cause recognition of gain. b. Exceptions include tax avoidance transactions, and situations where the liability assumed exceeds the adjusted basis of the transferred property.

V.

Earnings and Profits 1. Calculation of Earnings and Profits (Example I:16-30; Table I:16-3) a. Earnings and profits are the tax measure of amounts available to pay taxable dividends. b. Earnings and profits are similar to retained earnings (financial accounting) or retained taxable income but are specially calculated under statutory guidelines.

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2. Current Versus Accumulated E & P (Examples I:16-31, I:16-32) a. Distributions paid out of either current or accumulated earnings and profits are taxable as dividends.

VI.

Noncash Distributions (Problem I:16-54) 1. Tax Consequences to the Shareholders (Example I:16-34) a. The amount of the distribution is the fair market value of the property distributed, and it is a taxable dividend to the extent of earnings and profits.

2. Tax Consequences to the Distributing Corporation (Example I:16-35) a. The distributing corporation must recognize any appreciation in the distributed property as a gain on distribution.

3. Stock Redemptions (Problem I:16-57) a. A stock redemption may be treated as a dividend or as a sale or exchange. b. Special redemption rules exist for partial liquidations, estate tax redemptions, and preferred stock bailouts.

4. Determining Whether a Redemption is a Dividend or Capital Gain (Examples I:1639, I:16-40) a. Capital gain treatment is available in several situations, including a substantially disproportionate redemption and a complete termination of interest.

VII.

Corporate Distributions in Complete Liquidation (Topic Review I:16-4) 1. Tax Consequences to the Liquidated Corporation (Example I:16-41) a. Current law generally provides for recognition of gain or loss to the distributing corporation on distribution in complete liquidation.

2. Tax Consequences to the Shareholders (Example I:16-42) a. In complete liquidation, shareholders are treated as having sold or exchanged their stock.

3. Section 332: Liquidation of a Subsidiary Corporation (Example I:16-43) a. No gain or loss is recognized by either the subsidiary or the parent, if the parent liquidates an 80%-owned subsidiary. The basis of the subsidiary’s assets carries over to the parent.

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VIII.

Tax Planning Considerations 1. Capital Structure and Section 1244 a. Using corporate stock to capitalize a corporation instead of debt could result in certain losses being treated as ordinary under Section 1244 rather than as short-term capital loss (nonbusiness bad debt treatment).

2. Dividend Policy (Example I:16-44) a. Shifting payments to shareholders from dividends to deductible items (e.g., salary, rental payments) may reduce overall taxation.

3. Use of Losses a. Corporations may desire to accelerate recognition of income when capital losses or NOLs are about to expire.

4. Charitable Contributions a. Corporations should control charitable contributions to avoid the 10% limitation.

5. Dividends-Received Deduction a. Corporations should plan carefully to prevent the taxable income limitation from applying, and thereby reducing the amount of deduction.

6. Reduced Taxes on Taxpayer Stock Sales a. Certain sales of stock held five years or more will be eligible for an exclusion of gain under Section 1202(a)(1). (See also page I:4-22.)

IX.

Compliance and Procedural Considerations 1. Filing Requirements a. Corporations must file Form 1120 by the 15th day of the fourth month after the end of the tax year (i.e., April 15 for a calendar year corporation).

2. Schedule M-1 and M-2 Reconciliations (Figures I:16-1, I:16-2) a. Schedule M-1, Form 1120 reconciles financial income with taxable income. b. Schedule M-2, Form 1120 reconciles beginning and ending retained earnings.

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3. Schedule M-3 Reconciliation a. Large corporations (total assets of $10 million or more) are required to disclose detailed information about book to tax differences on Schedule M3.

4. Maintenance of E & P Records a. Maintaining records for E & P purposes is also important, even though the corporate return does not require the calculation.

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Court Case Briefs Alaska Redi-mix v. CIR, 1971 PH T.C. Memo & 69,218, 28 TCM 1165.

In July 1956, Mr. Walter Selid transferred assets to Alaska Redi-mix, Inc. in exchange for 60,000 shares of the company’s stock. Two other individuals purchased one share each. A bill of sale was executed and properly filed documenting the transfer of the assets to the corporation. Mr. Selid owned 60,000 of the 60,002 shares issued and outstanding. Subsequently, in November 1956, another individual, Mr. Derickson, transferred assets to the corporation in exchange for 30,000 shares. The corporation claimed depreciation deductions on property based on a stepped-up basis rather than a carry-over basis.

The court held that the requirements of Sec. 351 had been met in the July exchange. Sec. 351 requires that no gain or loss be recognized for assets transferred by one or more persons to a corporation solely in exchange for stock or securities, and those persons have control of the corporation immediately after the exchange. Sec. 368, in part, defines control as at least 80% of the voting power of voting stock. Mr. Selid satisfied the 80% requirement because he owned in excess of 99% of the voting stock at the time of the July transfer. Therefore, under Sec. 362 the basis of the assets transferred must be the same as in the hands of the transferor. No step-up in basis was allowed.

Warren C. Cordner and Evelyn C. Cordner v. U.S., 49 AFTR 2d 82-1353; 82-1 USTC & 9275 (9th Cir., 1982).

Warren C. Cordner, a stockholder of First Thrift Investors, received 275 $20 gold coins as a corporate dividend distribution. The taxpayer reported on his federal tax return a dividend in the amount of their face value ($5,500) rather than their fair market value ($70,936). The IRS charged the taxpayer with a dividend in the amount of their fair market value.

Sec. 301 provides that the amount of the distribution for dividend purposes is the amount of money and the fair market value of other property received. The court held that while the coins were legal tender and could be considered “money,” they had been withdrawn from circulation and had numismatic value. Consequently, the dividend was a property dividend and was taxed at fair market value.

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Instructor Aid I:16-1 Dividends-Received Deduction The following deduction percentages will be applied to the lower of domestic dividends received, or taxable income (computed without NOL, dividends-received deduction, and capital loss carrybacks)*:

50%

Recipient corporation owns less than 20% of the stock of the issuing corporation.

65%

Recipient corporation owns 20% or more, but less than 80% of the stock of the issuing corporation.

100%

Recipient corporation owns 80% or more of the stock of the issuing corporation.

*The taxable income limitation does not apply if using the full dividends-received deduction would add to or create a net operating loss.

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Instructor Aid I:16-2 Conditions for Accumulated Earnings Tax

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Chapter I:17 Partnerships and S Corporations Learning Objectives After studying this chapter, the student should be able to: 1. Compare and contrast the various types of pass-through entities.

2. Determine the tax implications of forming and operating a partnership, including partnership distributions.

3. Explain the requirements for electing and maintaining S corporation status, and apply operating rules for S corporations.

4. Identify tax planning opportunities for partnerships and S corporations.

5. Comply with procedural and reporting requirements for partnerships and S corporations.

Areas of Greater Significance Students should be particularly aware of the S corporation rules and should be familiar with the relevant issues in the selection between S corporation status and C corporation status.

Areas of Lesser Significance In the interest of time, the instructor may determine that the following area is best covered by student reading, rather than class discussion: 1. Tax Planning Considerations

Problem Areas for Students The following areas may prove especially difficult for students: 1. Basis adjustments for partnership interests.

2. Tax consequences on distributions from a partnership.

3. Taxation of S corporation shareholders.

I:IO17-1 Copyright © 2024 Pearson Education, Inc.

Highlights of Recent Tax Law Changes The following items of tax law have changed since the 2023 edition of this chapter: 1. The threshold for the QBI deduction for service-related businesses, as well as the W-2 limitation, has increased to $182,100 ($170,050 in 2022) for individuals and $364,200 ($340,100 in 2022) for married filing jointly.

2. The gross receipts threshold for the deductibility of business interest has increased to $29 million ($27 million in 2022).

3. The limit on business losses has increased to the sum of business income and gains plus $289,000 ($270,000 in 2022) for individuals and $578,000 ($540,000 in 2022) for married filing jointly.

4. The gross receipts threshold for adopting the cash method has increased to $29 million ($27 million in 2022).

Teaching Tips 1. Stress to the students that this chapter is just a broad overview of partnerships and S corporations. More detailed analysis would be provided in a second undergraduate course and in specialized graduate courses.

2. Inform the students that if they are planning to take the CPA examination, both partnerships and S corporations are covered topics.

Lecture Outline I.

Types of Pass-Though Entities (Example I:17-1) 1. Partnerships 2. S Corporations 3. Limited Liability Companies (LLC) 4. Limited Liability Partnerships (LLP)

I:IO17-2 Copyright © 2024 Pearson Education, Inc.

II.

Taxation of Partnerships (Instructor Aid I:17-1) A partnership is a tax reporting entity, not a separate taxpaying entity.

1. Formation of a Partnership (Examples I:17-2, I:17-4, I:17-7; Topic Review I:17-1; Question I:17-4; Problem I:17-39) a. Generally, neither the partner nor the partnership will recognize gain or loss on the contribution of property in exchange for a partnership interest.

Receipt of a partnership interest in exchange for services will constitute ordinary income. i.

EXAMPLE: A taxpayer exchanges a piece of equipment with an adjusted basis of $10,000 and a fair market value of $20,000 for a 20% partnership interest. Neither the taxpayer nor the partnership will recognize any gain on the transaction.

b. In general, the partner’s original basis in the partnership interest will include the adjusted basis of any assets transferred plus the partner’s share of any partnership liabilities less any boot received or liabilities assumed by other partners. The pro-rata share of liabilities assumed by the other partners will increase the other partners’ basis. i.

EXAMPLE: In the above example, the taxpayer’s adjusted basis in the partnership interest is $10,000.

c. The holding period of a partnership interest generally begins on the date the interest is acquired. If Section 1231 or capital assets are contributed in exchange for the partnership interest, there is a carryover holding period. d. In general, the partnership’s adjusted basis in the transferred assets is equal to their adjusted basis in the hands of the transferor taxpayer. The transferor’s holding period also carries over. i.

EXAMPLE: In the above example, the partnership’s adjusted basis in the equipment is $10,000.

e. For financial accounting purposes, partnership formation transactions are recorded at FMV (i.e., both the assets and the capital accounts are increased by the FMV of the contributed assets.)

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f. Up to $5,000 of organizational expenses (e.g., legal and accounting fees) may be deducted in the first year with the remainder being capitalized and amortized over a period not less than 180 months. Syndication fees (i.e., brokerage and registration fees) must be capitalized, but no amortization is allowed.

2. Partnership Operations (Example I:17-9; Table I:17-1; Problem I:17-44) a. The results of partnership operations are reported on the agreed basis by the partners in two primary categories: separately stated items and partnership ordinary income or loss. b. Separately stated items reported by a partnership include Sec. 1231 gains and losses, capital gains and losses, tax-exempt interest, investment interest income and expense, charitable contributions, and guaranteed payments.

3. Special Allocations (Example I:17-10) a. Wide latitude is permitted in the allocation of partnership operations to individual partners under the partnership agreement. b. A special allocation must be supported by “substantial economic effect” unless it relates to a transfer of property by partners to the partnership.

4. Allocation of Partnership Income, Deductions, Losses, and Credits to Partners (Example I:17-11; Topic Review I:17-2) a. If there are changes in any partner’s partnership interest during the tax year, all partners are required to share partnership items based on the varying ownership interests during the year. b. Retroactive allocation of losses or deductions to newly admitted partners is not permitted.

5. Basis Adjustments for Operating Items (Example I:17-12; Topic Review I:17-2; Question I:17-12) a. Each partnership interest is adjusted to reflect the partner’s share of income and deduction items. b. Increases in basis are made for a partner’s share of partnership ordinary income and separately stated income items. c. Decreases in basis are made for a partner’s share of partnership ordinary loss and separately stated deduction items. d. A partner’s adjusted basis in the partnership interest is also adjusted for capital contributions, withdrawals, and changes in liabilities during the year.

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6. Qualified Business Income Deduction (Example I:17-13) a. Tax law allows a deduction for qualified business income from a partnership, S corporation, or sole proprietorship against taxable income (instead of AGI). b. Taxpayers can take the deduction regardless of whether they claim the standard deduction or itemized deductions. c. The purpose of the deduction is to bring the tax rates on these types of businesses somewhat in line with the flat tax rate applicable to corporations. d. The deduction is limited to the lesser of: i.

Combined qualified business income (QBI), or

ii.

20% of taxable income over net capital gain

e. This deduction is taken at the partner or shareholder level.

7. Limitation of Net Business Interest (Example I:17-14; Problem I:17-54) a. Tax law limits the deductibility of business interest (expect for small businesses with gross receipts less the $29 million) in a given year to the sum of: i.

Business interest income

ii.

30% of adjusted taxable income (computed without regard to NOL, QBI, depreciation, or other adjustments)

iii.

Floor plan financing interest for automobiles

b. The limitation is applied at the entity level.

8. Limitations of Losses and Restoration of Basis (Examples I:17-15, I:17-16) a. The utilization of partnership losses in the current year is limited by the partner’s adjusted basis in the partnership interest. i.

EXAMPLE: If a taxpayer’s share of partnership loss is $20,000 and her adjusted basis in her partnership interest is $15,000, only $15,000 of the loss can be utilized on her current year tax return.

b. Unused losses are carried forward indefinitely until the partnership adjusted basis is increased by capital contributions, allocation of partnership income, or increase in partnership liabilities.

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i.

EXAMPLE: In the above example the unused $5,000 loss ($20,000 total less $15,000 used) will be carried forward indefinitely until it can be used against an adjusted basis increase.

c. The passive loss rules and at-risk rules apply at the partner level.

9. Limitation of Excess Business Losses (Example I:17-17) a. Tax law limits business losses equal to the sum of business income and gains plus $289,000 ($578,000 for married filing jointly). b. This limitation is applied at the partner or shareholder level.

10. Transactions Between a Partner and the Partnership (Examples I:17-18, I:17-20) a. Although partners may enter into sale or exchange transactions with the partnership, losses may be disallowed, and capital gains may be recharacterized as ordinary income. i.

EXAMPLE: A taxpayer sells a capital asset to a partnership in which he owns a 60% partnership interest. If a loss of $10,000 is realized, the loss is disallowed. If a gain of $10,000 is realized, the gain is treated as ordinary rather than capital.

b. Guaranteed payments (i.e., fixed salary payments not based on profits) are ordinary income to the partner and a deduction to the partnership.

11. Partnership Distributions (Examples I:17-21, I:17-23; Topic Review I:17-3) a. Distributions of property from the partnership to a partner are generally treated as a tax-free return of basis. b. If money distributed in a nonliquidating distribution exceeds the partner’s adjusted basis in his partnership interest, gain is recognized. c. If property is distributed, the partnership interest basis is reduced by the basis of the property in the hands of the partnership. An exception may exist for marketable securities. The partner’s adjusted basis in the property is generally carried over from the partnership.

12. Sale of a Partnership Interest (Examples I:17-24, I:17-25) a. The sale of a partnership interest is generally treated as the sale or exchange of a capital asset. The amount realized on sale includes the partner’s share of liabilities which are assumed by the buyer. b. Ordinary income treatment for gain on sale may result if the partnership had unrealized receivables or substantially appreciated inventory.

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13. Optional and Mandatory Basis Adjustments (Example I:17-26) a. The partnership may elect to adjust the inside basis of partnership assets on qualifying sales or exchanges of partnership interests, and certain liquidating and nonliquidating distributions.

14. Partnership Elections a. A partnership must generally use the tax year of the partners who own a majority interest (i.e., normally a calendar year). b. Partnerships that have a corporate partner and average gross receipts of over $29 million (over a 3-year period), and tax shelters may not use the cash method of accounting.

III.

Taxation of S Corporations (Topic Reviews I:17-4, I:17-5) 1. Qualification Requirements (Examples I:17-29, I:17-30) a. Corporations with all of the following characteristics may elect S Corporation treatment: i.

Must be a U.S. (domestic) corporation.

ii.

Must not be an ineligible corporation (e.g., insurance companies and financial institutions).

iii.

Must not have more than 100 shareholders (members of a single family count as one shareholder).

iv.

Must have only individuals, estates, certain kinds of trusts, and certain kinds of tax-exempt organizations as shareholders.

v.

Must not have a nonresident alien as a shareholder.

vi.

Must issue only one class of stock.

2. Election Requirements (Example I:17-31) a. All shareholders must consent to an S corporation election. b. An election made in the prior tax year or by the 15th day of the third month of the current tax year will be effective for the current tax year. c. The IRS may treat technically invalid elections as valid if the IRS determines that is the reasonable cause for the mistake.

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3. Termination Conditions (Examples I:17-32, I:17-34; Instructor Aid I:17-2) a. A voluntary revocation by shareholders owning a majority of the shares is effective for the current year, if made by the 15th day of the third month, or can be effective for a subsequent specified termination date. b. An involuntary revocation occurs if the S corp. fails to continue to meet all the qualification requirements. The termination is effective the day of violation and may cause two short tax years (one S corporation year and one C corporation year). c. An involuntary revocation also occurs if an S corporation (that was previously a C corp. with undistributed earnings and profits) has passive income of more than 25% of gross receipts for three consecutive years. An inadvertent termination may be waived by the IRS. d. Generally, when an S election is terminated, the corporation may not elect S treatment again for five years.

4. S Corporation Operations (Examples I:17-36, I:17-37; Question I:17-29; Problem I:17-56) a. Similar to partnerships, the results of S corporation operations are reported on a pro-rata basis by the shareholders in two primary categories: separately stated items and S corporation ordinary income or loss.

5. Basis Adjustments to S Corporation Stock (Example I:17-38) a. The original basis of S corporation stock is adjusted for the shareholder’s pro rata share of ordinary income (loss), separately stated items, any capital contributions, and for distributions received.

6. S Corporation Losses and Limitations (Example I:17-41) a. The utilization of S corporation losses in the current year is limited to the total of the shareholder’s adjusted basis in the stock plus any shareholder loans. i.

EXAMPLE: A taxpayer’s share of S-corporation loss is $20,000.

The taxpayer’s adjusted basis in her stock is $10,000, and she has a loan to the S-corporation of $5,000. The taxpayer can deduct $15,000 of the loss currently ($10,000 adjusted basis plus $5,000 loan). The remaining $5,000 of loss is carried forward.

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7. Special Deductions and Limitations a. An S corporation and its shareholders are subject to the same rules as partnerships regarding the qualified business income deduction, the limitation on net business interest, and the limitation on excess business losses.

8. Other S Corporation Considerations (Examples I:17-44, I:17-45; Question I:17-35) a. For S Corporations with no accumulated E&P, distributions are return of capital to the extent of adjusted basis in the stock, with any excess distribution treated as capital gain. Gain will be recognized on appreciated assets distributed to the extent FMV exceeds adjusted basis in the hands of the S corporations. b. S Corporations must use a calendar tax year, unless they can get IRS approval for a business purpose fiscal year. c. S Corporation shareholders owning more than 2% of the outstanding stock are treated as partners for fringe benefit purposes, rather than as employees. d. Corporations electing S corporation status after being a C corporation are subject to 21% corporate tax on any realized built-in gains (i.e., appreciation in assets at the time of conversion). e. S Corporations having E&P from C Corporation years will be taxed on passive investment income exceeding 25% of its gross receipts at the corporate marginal tax rate of 21%).

IV.

Compliance and Procedural Considerations (Table I:17-2) 1. Partnership Filing Requirements and Elections a. Partnerships must file Form 1065 by the 15th day of the third month after the end of the tax year (i.e., March 15 for a calendar year partnership). b. Partnerships file Form 1065 and make certain elections on the return affecting the computation of partnership income.

2. Reporting Partnership Items on Form 1065 a. Partners receive schedule K-1 detailing their share of separately stated items and ordinary partnership income (loss).

3. S Corporation Filing Requirements and Accounting Method Elections a. S Corporations must file Form 1120S by the 15th day of the third month after the end of the tax year (i.e., March 15 for a calendar year partnership).

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4. Reporting S Corporation Items on Form 1120S a. S corporations file Form 1120S with shareholders receiving a Schedule K1 detailing their share of separately stated items and ordinary S corporation income (loss).

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Court Case Briefs Joseph C. Mann v. CIR, 1981 PH T.C. Memo & 81,864, 42 TCM 1766.

The taxpayer advanced $10,200 to his partner to start a grocery store business. After being in business for two months the taxpayer’s partner closed shop, took the remaining cash, and left town, sending the taxpayer only a postcard from Reno, Nevada. The taxpayer deducted the $10,200 as an ordinary loss for a bad debt. The IRS disallowed the ordinary loss treatment and recharacterized it as a capital loss due to the sale or exchange of a partnership interest.

The Tax Court interpreted the facts yet another way. The advance was not a loan (no debtor-creditor relationship existed) so that no bad debt claim was possible. Neither was the loss entirely a capital loss resulting from the sale or exchange of the partnership interest. The court held that a $5,000 estimated portion of the $10,200 was the amount embezzled by the partner and therefore deductible as the taxpayer’s distributive share of the partnership loss. The remaining $7,200 was held a capital loss.

Jon P. Smith v. CIR, 1988 PH T.C. Memo & 88,018, 54 TCM 1535.

A manufacturing company elected to be taxed as an S corporation using the required election form, Form 2553. The president of the company timely sent the form to the IRS along with a transmittal letter signed by him. The form was signed by the shareholders of record and their spouses, but not by the president of the company. The IRS disallowed the election for subchapter S status contending that an authorized officer failed to sign the timely filed form.

The Tax Court agreed with the IRS because Regs. Secs. 1.1372-2 and 1.6037-1 required the form to be signed by an authorized officer under penalties of perjury. The court considered the perjury sanction important to aid “in assuring that true, correct and complete forms are filed with the Internal Revenue Service.”

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Instructor Aid I:17-1 Legal vs. Tax Definition of a Partnership

You can be a partnership legally, and at the same time not be one for tax purposes, if you: •

Do not meet Sec. 761(a) definition

•

Elect out under Sec. 761(a)

•

Have more corporate characteristics than partnership characteristics

•

Qualify as a publicly traded partnership treated as a corporation under Sec. 7704

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Instructor Aid I:17-2 Termination of a Valid S Corporation Election

A valid S Corporation election will be terminated in the following situations: 1. A new shareholder owning more than 50% of the outstanding stock affirmatively refuses to consent to the election.

2. Shareholders owning a majority of both voting and nonvoting stock voluntarily revoke the election.

3. The corporation fails to continue to meet the requirements for a small business corporation, i.e.: •

The corporation becomes a foreign corporation,

•

The corporation becomes a member of an affiliated group of corporations (or activates an inactive subsidiary),

•

The number of the corporation’s shareholders exceeds 100,

•

A partnership, corporation, or non-qualifying trust becomes a shareholder,

•

A second class of stock is issued, or

•

A nonresident alien becomes a shareholder.

4. The corporation (which has C corporation accumulated earnings and profits) exceeds passive income limitations each year over a 3-year period.

I:IO17-13 Copyright © 2024 Pearson Education, Inc.

Chapter I:17 Partnerships and S Corporations Learning Objectives After studying this chapter, the student should be able to: 1. Compare and contrast the various types of pass-through entities.

2. Determine the tax implications of forming and operating a partnership, including partnership distributions.

3. Explain the requirements for electing and maintaining S corporation status, and apply operating rules for S corporations.

4. Identify tax planning opportunities for partnerships and S corporations.

5. Comply with procedural and reporting requirements for partnerships and S corporations.

Areas of Greater Significance Students should be particularly aware of the S corporation rules and should be familiar with the relevant issues in the selection between S corporation status and C corporation status.

Areas of Lesser Significance In the interest of time, the instructor may determine that the following area is best covered by student reading, rather than class discussion: 1. Tax Planning Considerations

Problem Areas for Students The following areas may prove especially difficult for students: 1. Basis adjustments for partnership interests.

2. Tax consequences on distributions from a partnership.

3. Taxation of S corporation shareholders.

I:IO17-1 Copyright © 2024 Pearson Education, Inc.

Highlights of Recent Tax Law Changes The following items of tax law have changed since the 2023 edition of this chapter: 1. The threshold for the QBI deduction for service-related businesses, as well as the W-2 limitation, has increased to $182,100 ($170,050 in 2022) for individuals and $364,200 ($340,100 in 2022) for married filing jointly.

2. The gross receipts threshold for the deductibility of business interest has increased to $29 million ($27 million in 2022).

3. The limit on business losses has increased to the sum of business income and gains plus $289,000 ($270,000 in 2022) for individuals and $578,000 ($540,000 in 2022) for married filing jointly.

4. The gross receipts threshold for adopting the cash method has increased to $29 million ($27 million in 2022).

Teaching Tips 1. Stress to the students that this chapter is just a broad overview of partnerships and S corporations. More detailed analysis would be provided in a second undergraduate course and in specialized graduate courses.

2. Inform the students that if they are planning to take the CPA examination, both partnerships and S corporations are covered topics.

Lecture Outline I.

Types of Pass-Though Entities (Example I:17-1) 1. Partnerships 2. S Corporations 3. Limited Liability Companies (LLC) 4. Limited Liability Partnerships (LLP)

I:IO17-2 Copyright © 2024 Pearson Education, Inc.

II.

Taxation of Partnerships (Instructor Aid I:17-1) A partnership is a tax reporting entity, not a separate taxpaying entity.

1. Formation of a Partnership (Examples I:17-2, I:17-4, I:17-7; Topic Review I:17-1; Question I:17-4; Problem I:17-39) a. Generally, neither the partner nor the partnership will recognize gain or loss on the contribution of property in exchange for a partnership interest.

Receipt of a partnership interest in exchange for services will constitute ordinary income. i.

EXAMPLE: A taxpayer exchanges a piece of equipment with an adjusted basis of $10,000 and a fair market value of $20,000 for a 20% partnership interest. Neither the taxpayer nor the partnership will recognize any gain on the transaction.

b. In general, the partner’s original basis in the partnership interest will include the adjusted basis of any assets transferred plus the partner’s share of any partnership liabilities less any boot received or liabilities assumed by other partners. The pro-rata share of liabilities assumed by the other partners will increase the other partners’ basis. i.

EXAMPLE: In the above example, the taxpayer’s adjusted basis in the partnership interest is $10,000.

c. The holding period of a partnership interest generally begins on the date the interest is acquired. If Section 1231 or capital assets are contributed in exchange for the partnership interest, there is a carryover holding period. d. In general, the partnership’s adjusted basis in the transferred assets is equal to their adjusted basis in the hands of the transferor taxpayer. The transferor’s holding period also carries over. i.

EXAMPLE: In the above example, the partnership’s adjusted basis in the equipment is $10,000.

e. For financial accounting purposes, partnership formation transactions are recorded at FMV (i.e., both the assets and the capital accounts are increased by the FMV of the contributed assets.)

I:IO17-3 Copyright © 2024 Pearson Education, Inc.

f. Up to $5,000 of organizational expenses (e.g., legal and accounting fees) may be deducted in the first year with the remainder being capitalized and amortized over a period not less than 180 months. Syndication fees (i.e., brokerage and registration fees) must be capitalized, but no amortization is allowed.

2. Partnership Operations (Example I:17-9; Table I:17-1; Problem I:17-44) a. The results of partnership operations are reported on the agreed basis by the partners in two primary categories: separately stated items and partnership ordinary income or loss. b. Separately stated items reported by a partnership include Sec. 1231 gains and losses, capital gains and losses, tax-exempt interest, investment interest income and expense, charitable contributions, and guaranteed payments.

3. Special Allocations (Example I:17-10) a. Wide latitude is permitted in the allocation of partnership operations to individual partners under the partnership agreement. b. A special allocation must be supported by “substantial economic effect” unless it relates to a transfer of property by partners to the partnership.

4. Allocation of Partnership Income, Deductions, Losses, and Credits to Partners (Example I:17-11; Topic Review I:17-2) a. If there are changes in any partner’s partnership interest during the tax year, all partners are required to share partnership items based on the varying ownership interests during the year. b. Retroactive allocation of losses or deductions to newly admitted partners is not permitted.

5. Basis Adjustments for Operating Items (Example I:17-12; Topic Review I:17-2; Question I:17-12) a. Each partnership interest is adjusted to reflect the partner’s share of income and deduction items. b. Increases in basis are made for a partner’s share of partnership ordinary income and separately stated income items. c. Decreases in basis are made for a partner’s share of partnership ordinary loss and separately stated deduction items. d. A partner’s adjusted basis in the partnership interest is also adjusted for capital contributions, withdrawals, and changes in liabilities during the year.

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6. Qualified Business Income Deduction (Example I:17-13) a. Tax law allows a deduction for qualified business income from a partnership, S corporation, or sole proprietorship against taxable income (instead of AGI). b. Taxpayers can take the deduction regardless of whether they claim the standard deduction or itemized deductions. c. The purpose of the deduction is to bring the tax rates on these types of businesses somewhat in line with the flat tax rate applicable to corporations. d. The deduction is limited to the lesser of: i.

Combined qualified business income (QBI), or

ii.

20% of taxable income over net capital gain

e. This deduction is taken at the partner or shareholder level.

7. Limitation of Net Business Interest (Example I:17-14; Problem I:17-54) a. Tax law limits the deductibility of business interest (expect for small businesses with gross receipts less the $29 million) in a given year to the sum of: i.

Business interest income

ii.

30% of adjusted taxable income (computed without regard to NOL, QBI, depreciation, or other adjustments)

iii.

Floor plan financing interest for automobiles

b. The limitation is applied at the entity level.

8. Limitations of Losses and Restoration of Basis (Examples I:17-15, I:17-16) a. The utilization of partnership losses in the current year is limited by the partner’s adjusted basis in the partnership interest. i.

EXAMPLE: If a taxpayer’s share of partnership loss is $20,000 and her adjusted basis in her partnership interest is $15,000, only $15,000 of the loss can be utilized on her current year tax return.

b. Unused losses are carried forward indefinitely until the partnership adjusted basis is increased by capital contributions, allocation of partnership income, or increase in partnership liabilities.

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i.

EXAMPLE: In the above example the unused $5,000 loss ($20,000 total less $15,000 used) will be carried forward indefinitely until it can be used against an adjusted basis increase.

c. The passive loss rules and at-risk rules apply at the partner level.

9. Limitation of Excess Business Losses (Example I:17-17) a. Tax law limits business losses equal to the sum of business income and gains plus $289,000 ($578,000 for married filing jointly). b. This limitation is applied at the partner or shareholder level.

10. Transactions Between a Partner and the Partnership (Examples I:17-18, I:17-20) a. Although partners may enter into sale or exchange transactions with the partnership, losses may be disallowed, and capital gains may be recharacterized as ordinary income. i.

EXAMPLE: A taxpayer sells a capital asset to a partnership in which he owns a 60% partnership interest. If a loss of $10,000 is realized, the loss is disallowed. If a gain of $10,000 is realized, the gain is treated as ordinary rather than capital.

b. Guaranteed payments (i.e., fixed salary payments not based on profits) are ordinary income to the partner and a deduction to the partnership.

11. Partnership Distributions (Examples I:17-21, I:17-23; Topic Review I:17-3) a. Distributions of property from the partnership to a partner are generally treated as a tax-free return of basis. b. If money distributed in a nonliquidating distribution exceeds the partner’s adjusted basis in his partnership interest, gain is recognized. c. If property is distributed, the partnership interest basis is reduced by the basis of the property in the hands of the partnership. An exception may exist for marketable securities. The partner’s adjusted basis in the property is generally carried over from the partnership.

12. Sale of a Partnership Interest (Examples I:17-24, I:17-25) a. The sale of a partnership interest is generally treated as the sale or exchange of a capital asset. The amount realized on sale includes the partner’s share of liabilities which are assumed by the buyer. b. Ordinary income treatment for gain on sale may result if the partnership had unrealized receivables or substantially appreciated inventory.

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13. Optional and Mandatory Basis Adjustments (Example I:17-26) a. The partnership may elect to adjust the inside basis of partnership assets on qualifying sales or exchanges of partnership interests, and certain liquidating and nonliquidating distributions.

14. Partnership Elections a. A partnership must generally use the tax year of the partners who own a majority interest (i.e., normally a calendar year). b. Partnerships that have a corporate partner and average gross receipts of over $29 million (over a 3-year period), and tax shelters may not use the cash method of accounting.

III.

Taxation of S Corporations (Topic Reviews I:17-4, I:17-5) 1. Qualification Requirements (Examples I:17-29, I:17-30) a. Corporations with all of the following characteristics may elect S Corporation treatment: i.

Must be a U.S. (domestic) corporation.

ii.

Must not be an ineligible corporation (e.g., insurance companies and financial institutions).

iii.

Must not have more than 100 shareholders (members of a single family count as one shareholder).

iv.

Must have only individuals, estates, certain kinds of trusts, and certain kinds of tax-exempt organizations as shareholders.

v.

Must not have a nonresident alien as a shareholder.

vi.

Must issue only one class of stock.

2. Election Requirements (Example I:17-31) a. All shareholders must consent to an S corporation election. b. An election made in the prior tax year or by the 15th day of the third month of the current tax year will be effective for the current tax year. c. The IRS may treat technically invalid elections as valid if the IRS determines that is the reasonable cause for the mistake.

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3. Termination Conditions (Examples I:17-32, I:17-34; Instructor Aid I:17-2) a. A voluntary revocation by shareholders owning a majority of the shares is effective for the current year, if made by the 15th day of the third month, or can be effective for a subsequent specified termination date. b. An involuntary revocation occurs if the S corp. fails to continue to meet all the qualification requirements. The termination is effective the day of violation and may cause two short tax years (one S corporation year and one C corporation year). c. An involuntary revocation also occurs if an S corporation (that was previously a C corp. with undistributed earnings and profits) has passive income of more than 25% of gross receipts for three consecutive years. An inadvertent termination may be waived by the IRS. d. Generally, when an S election is terminated, the corporation may not elect S treatment again for five years.

4. S Corporation Operations (Examples I:17-36, I:17-37; Question I:17-29; Problem I:17-56) a. Similar to partnerships, the results of S corporation operations are reported on a pro-rata basis by the shareholders in two primary categories: separately stated items and S corporation ordinary income or loss.

5. Basis Adjustments to S Corporation Stock (Example I:17-38) a. The original basis of S corporation stock is adjusted for the shareholder’s pro rata share of ordinary income (loss), separately stated items, any capital contributions, and for distributions received.

6. S Corporation Losses and Limitations (Example I:17-41) a. The utilization of S corporation losses in the current year is limited to the total of the shareholder’s adjusted basis in the stock plus any shareholder loans. i.

EXAMPLE: A taxpayer’s share of S-corporation loss is $20,000.

The taxpayer’s adjusted basis in her stock is $10,000, and she has a loan to the S-corporation of $5,000. The taxpayer can deduct $15,000 of the loss currently ($10,000 adjusted basis plus $5,000 loan). The remaining $5,000 of loss is carried forward.

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7. Special Deductions and Limitations a. An S corporation and its shareholders are subject to the same rules as partnerships regarding the qualified business income deduction, the limitation on net business interest, and the limitation on excess business losses.

8. Other S Corporation Considerations (Examples I:17-44, I:17-45; Question I:17-35) a. For S Corporations with no accumulated E&P, distributions are return of capital to the extent of adjusted basis in the stock, with any excess distribution treated as capital gain. Gain will be recognized on appreciated assets distributed to the extent FMV exceeds adjusted basis in the hands of the S corporations. b. S Corporations must use a calendar tax year, unless they can get IRS approval for a business purpose fiscal year. c. S Corporation shareholders owning more than 2% of the outstanding stock are treated as partners for fringe benefit purposes, rather than as employees. d. Corporations electing S corporation status after being a C corporation are subject to 21% corporate tax on any realized built-in gains (i.e., appreciation in assets at the time of conversion). e. S Corporations having E&P from C Corporation years will be taxed on passive investment income exceeding 25% of its gross receipts at the corporate marginal tax rate of 21%).

IV.

Compliance and Procedural Considerations (Table I:17-2) 1. Partnership Filing Requirements and Elections a. Partnerships must file Form 1065 by the 15th day of the third month after the end of the tax year (i.e., March 15 for a calendar year partnership). b. Partnerships file Form 1065 and make certain elections on the return affecting the computation of partnership income.

2. Reporting Partnership Items on Form 1065 a. Partners receive schedule K-1 detailing their share of separately stated items and ordinary partnership income (loss).

3. S Corporation Filing Requirements and Accounting Method Elections a. S Corporations must file Form 1120S by the 15th day of the third month after the end of the tax year (i.e., March 15 for a calendar year partnership).

I:IO17-9 Copyright © 2024 Pearson Education, Inc.

4. Reporting S Corporation Items on Form 1120S a. S corporations file Form 1120S with shareholders receiving a Schedule K1 detailing their share of separately stated items and ordinary S corporation income (loss).

I:IO17-10 Copyright © 2024 Pearson Education, Inc.

Court Case Briefs Joseph C. Mann v. CIR, 1981 PH T.C. Memo & 81,864, 42 TCM 1766.

The taxpayer advanced $10,200 to his partner to start a grocery store business. After being in business for two months the taxpayer’s partner closed shop, took the remaining cash, and left town, sending the taxpayer only a postcard from Reno, Nevada. The taxpayer deducted the $10,200 as an ordinary loss for a bad debt. The IRS disallowed the ordinary loss treatment and recharacterized it as a capital loss due to the sale or exchange of a partnership interest.

The Tax Court interpreted the facts yet another way. The advance was not a loan (no debtor-creditor relationship existed) so that no bad debt claim was possible. Neither was the loss entirely a capital loss resulting from the sale or exchange of the partnership interest. The court held that a $5,000 estimated portion of the $10,200 was the amount embezzled by the partner and therefore deductible as the taxpayer’s distributive share of the partnership loss. The remaining $7,200 was held a capital loss.

Jon P. Smith v. CIR, 1988 PH T.C. Memo & 88,018, 54 TCM 1535.

A manufacturing company elected to be taxed as an S corporation using the required election form, Form 2553. The president of the company timely sent the form to the IRS along with a transmittal letter signed by him. The form was signed by the shareholders of record and their spouses, but not by the president of the company. The IRS disallowed the election for subchapter S status contending that an authorized officer failed to sign the timely filed form.

The Tax Court agreed with the IRS because Regs. Secs. 1.1372-2 and 1.6037-1 required the form to be signed by an authorized officer under penalties of perjury. The court considered the perjury sanction important to aid “in assuring that true, correct and complete forms are filed with the Internal Revenue Service.”

I:IO17-11 Copyright © 2024 Pearson Education, Inc.

Instructor Aid I:17-1 Legal vs. Tax Definition of a Partnership

You can be a partnership legally, and at the same time not be one for tax purposes, if you: •

Do not meet Sec. 761(a) definition

•

Elect out under Sec. 761(a)

•

Have more corporate characteristics than partnership characteristics

•

Qualify as a publicly traded partnership treated as a corporation under Sec. 7704

I:IO17-12 Copyright © 2024 Pearson Education, Inc.

Instructor Aid I:17-2 Termination of a Valid S Corporation Election

A valid S Corporation election will be terminated in the following situations: 1. A new shareholder owning more than 50% of the outstanding stock affirmatively refuses to consent to the election.

2. Shareholders owning a majority of both voting and nonvoting stock voluntarily revoke the election.

3. The corporation fails to continue to meet the requirements for a small business corporation, i.e.: •

The corporation becomes a foreign corporation,

•

The corporation becomes a member of an affiliated group of corporations (or activates an inactive subsidiary),

•

The number of the corporation’s shareholders exceeds 100,

•

A partnership, corporation, or non-qualifying trust becomes a shareholder,

•

A second class of stock is issued, or

•

A nonresident alien becomes a shareholder.

4. The corporation (which has C corporation accumulated earnings and profits) exceeds passive income limitations each year over a 3-year period.

I:IO17-13 Copyright © 2024 Pearson Education, Inc.

Chapter I:18 Taxes and Investment Planning Learning Objectives After studying this chapter, the student should be able to: 1. Apply the investment models to various investment alternatives.

2. Use the investment models to make entity choices and compensation decisions.

3. Recognize the role of implicit taxes in investment decisions.

Areas of Greater Significance Using the pass-through model and the C corporation model will give additional input to the tax entity choice decision faced by new businesses. The concept of implicit taxes will expand the students’ perspective on investment decisions.

Areas of Lesser Significance In the interest of time, the instructor may determine that the following area is best covered by student reading, rather than class discussion: 1. Implicit Taxes and Clienteles

Problem Areas for Students The following areas may prove especially difficult for students: 1. Building formulas with any complexity.

2. Making decisions about length of investment horizon and assumed before-tax rates of return.

Highlights of Recent Tax Law Changes The following items of tax law have changed since the 2023 edition of this chapter: 1. AGI limits and phase-outs for deductibility of IRA contributions and phase-out floor and ceiling for Roth IRA contributions have increased. (See page I:18-5, footnotes 2 and 3.)

I:IO18-1 Copyright © 2024 Pearson Education, Inc.

2. The minimum age for IRA withdrawals has increased to 73 (72 in 2022).

3. The maximum annual employee contribution to 401(k) plans has increased to $22,500 ($20,500 in 2022).

Teaching Tips 1. Because of the complexity of the material, it is important that the students understand the problems in the text material first before adding additional problems.

2. Since several of the later-presented models are built on the earlier-presented models, comprehension of earlier-presented models should be ascertained before proceeding with additional material.

Lecture Outline I.

Investment Models (Topic Review I:18-1) 1. The Current Model (Examples I:18-1 through I:18-4) a. The current model calculates the future value of an investment assuming that only after-tax dollars are invested and earnings are taxed currently. b. The formula for the future value of an investment under the current model is: i.

After-tax accumulation (ATA) = after-tax investment amount (AT$) × [1 + after-tax rate of return]n, where n = the number of periods (i.e., years) of investment.

2. The Deferred Model (Examples I:18-6 through I:18-8; Figure I:18-1) a. The deferred model calculates the future value of an investment assuming that only after-tax dollars are invested, that earnings grow at the before-tax rate of return because earnings are not taxed currently, and accumulated earnings are taxed at payout. Example: nondeductible IRA. b. This model can also be used to describe the after-tax growth of a capital asset that does not distribute income currently (e.g., growth stock). c. Comparisons between the current model and the deferred model will also be impacted by any penalties and the investment horizon.

I:IO18-2 Copyright © 2024 Pearson Education, Inc.

3. The Exempt Model (Example I:18-12) a. The exempt model calculates the future value of an investment assuming that only after-tax dollars are invested and that earnings are exempt from explicit taxation. The formula is really the current model formulation with an after-tax rate of return equal to the before-tax rate of return. The Roth IRA is an example of the Exempt Model.

4. The Pension Model (Examples I:18-13 through I:18-15, I:18-17) a. The pension model calculates the future value of an investment assuming that before-tax dollars are invested, that earnings grow at before-tax rate of return because earnings are not taxed currently, and the total accumulation is taxed at payout. Examples: deductible IRA, 401(k) plans, other qualified plans. (See Topic Review I:18-1 for formula.) b. The Roth IRA is preferable to the deductible IRA when current tax rates are lower than expected tax rates at distribution.

5. Multiperiod Strategies (Table I:18-2) a. Investors may want to consider multi-period strategies (i.e., using different models in different parts of the investment horizon) when investing a stream of payments versus an initial lump sum.

II.

Other Applications of Investment Models 1. Roth Conversion Decision (Examples I:18-21 through I:18-23; Instructor Aid I:181) a. An individual may roll over distributions from a traditional IRA to a Roth IRA without regard to AGI levels. b. Multiple reasons exist for preferring a Roth conversion: 2. Pass-Through Entity Versus C Corporation (Examples I:18-24, I:18-26; Table I:184; Topic Review I:18-2; Instructor Aid I:18-2) a. The pass-through model is applicable to an S corporation, a partnership, an LLC, or an LLP. The pass-through entity can reinvest the current earnings after paying only the owner’s tax at the owner’s marginal rate. b. The C corporation model assumes one shareholder and that all earnings are accumulated. A much more complex model would be necessary for periodic dividend payments. c. The pass-through model is a variation of the current model with taxation only at the owner level. The C corporation model is a variation of the I:IO18-3 Copyright © 2024 Pearson Education, Inc.

deferred model with tax at both the entity and the owner levels. Utilization of these models can assist a planner in selecting the best entity for tax and investment purposes.

III.

Implicit Taxes and Clienteles (Topic Review I:18-3) 1. Implicit Taxes (Example I:18-28) a. The market may pay a premium for tax-favored investments (e.g., municipal bonds). This premium will reduce the before-tax rate of return.

This effect is an example of an implicit tax.

2. Equilibrium Condition and Clienteles (Example I:18-29) a. The investors who benefit from a particular tax advantage are known as clienteles.

3. Risky Assets (Example I:18-30) a. To accurately compare investments, the riskless rate of return and the risk premium must be calculated.

I:IO18-4 Copyright © 2024 Pearson Education, Inc.

Court Case Briefs Jack M. Pugh v. CIR, 1981 PH T.C. Memo & 81,448 42 TCM 806.

The taxpayer claimed a deduction for a contribution to an IRA account. A portion of the taxpayer’s income was from a partnership. The taxpayer’s share of the distributable income of the partnership was comprised entirely of interest, rents, royalties, and long-term capital gains. Since none of the partnership income was earned income, as required by Sec. 408, the portion of the IRA deduction related to the partnership income was disallowed.

Harold L. Jenkins v. CIR, 1983 PH T.C. Memo & 83,667, 47 TCM 238.

Harold L. Jenkins, alias Conway Twitty of country music fame, went into the restaurant business.

He persuaded friends to invest in his corporation, Twitty Burger, Inc., which went out of business after two years. Even though he was under no legal obligation to do so, he repaid his friends the $97,000 that they had lost in the venture. The IRS argued that the payments were non-deductible gifts made out of a sense of moral obligation. Conway Twitty refuted this argument, contending that the repayments were made because of the importance of his reputation. Twitty also argued that the similarity of his name and the name of the burger business established a proximate relationship between the payments and his business.

The Tax Court rendered the following opinion: The IRS subsequently drafted Action On Decision (AOD CC-1984-002): Twitty Burger went belly up. But Conway remained true.

He repaid his investors one and all. It was the moral thing to do.

His fans would not have liked it. It could have hurt his fame.

Had any investors sued him, like Merle Haggard or Sonny James.

When it was time to file taxes, Conway thought what he would do.

Was deduct those payments as a business expense under section one-sixty-two.

In order to allow these deductions, goes the argument of the Commissioner, The payments must be ordinary and necessary to a business of the petitioner.

Had Conway not repaid the investors, his career would have been under a cloud.

Under the unique facts of this case, held: the deductions are allowed.

Harold Jenkins and Conway Twitty, they are both the same.

But one was born; the other achieved fame.

The man is talented and has many a friend.

They opened a restaurant. His name he did lend.

They are two different things – making burgers and song.

The business went sour. It didn’t take long.

He repaid his friends. Why did he act?

Was it business or friendship? Which is fact?

Business the court held. It’s deductible they feel.

We disagree with the answer but let’s not appeal.

I:IO18-5 Copyright © 2024 Pearson Education, Inc.

Instructor Aid I:18-1 Benefits of Roth Conversion •

Individual tax rates might be high enough in retirement to justify avoiding them with Roth tax-exempt income.

•

An individual can continue to make contributions to a Roth IRA after attaining age 73.*

•

Roth IRAs do not require minimum distributions once the individual attains age 73 (however, Roth 401(k) plans do retain the minimum distribution requirement).

•

Roth income does not count toward Social Security or Medicare premium thresholds.

* Since the SECURE Act removed the age limit on contributions to traditional IRAs, this prior benefit is no longer an advantage of Roth conversion.

I:IO18-6 Copyright © 2024 Pearson Education, Inc.

Instructor Aid I:18-2 Understanding the Change in Tax Status of Limited Partnerships Ownership of limited partnership interests has become less tax advantageous over time due to several factors including: •

Repeal of the investment tax credit

•

Repeal of accelerated cost recovery for real estate, along with a lengthening of the mandated straight-line cost recovery periods

•

Enactment of the at-risk rules

•

Enactment of the passive loss rules

•

Changes in the alternative minimum tax rules

•

Enactment of corporate tax rules for certain “master limited partnership interests”

I:IO18-7 Copyright © 2024 Pearson Education, Inc.

Chapter I:18 Taxes and Investment Planning Learning Objectives After studying this chapter, the student should be able to: 1. Apply the investment models to various investment alternatives.

2. Use the investment models to make entity choices and compensation decisions.

3. Recognize the role of implicit taxes in investment decisions.

Areas of Greater Significance Using the pass-through model and the C corporation model will give additional input to the tax entity choice decision faced by new businesses. The concept of implicit taxes will expand the students’ perspective on investment decisions.

Areas of Lesser Significance In the interest of time, the instructor may determine that the following area is best covered by student reading, rather than class discussion: 1. Implicit Taxes and Clienteles

Problem Areas for Students The following areas may prove especially difficult for students: 1. Building formulas with any complexity.

2. Making decisions about length of investment horizon and assumed before-tax rates of return.

Highlights of Recent Tax Law Changes The following items of tax law have changed since the 2023 edition of this chapter: 1. AGI limits and phase-outs for deductibility of IRA contributions and phase-out floor and ceiling for Roth IRA contributions have increased. (See page I:18-5, footnotes 2 and 3.)

I:IO18-1 Copyright © 2024 Pearson Education, Inc.

2. The minimum age for IRA withdrawals has increased to 73 (72 in 2022).

3. The maximum annual employee contribution to 401(k) plans has increased to $22,500 ($20,500 in 2022).

Teaching Tips 1. Because of the complexity of the material, it is important that the students understand the problems in the text material first before adding additional problems.

2. Since several of the later-presented models are built on the earlier-presented models, comprehension of earlier-presented models should be ascertained before proceeding with additional material.

Lecture Outline I.

Investment Models (Topic Review I:18-1) 1. The Current Model (Examples I:18-1 through I:18-4) a. The current model calculates the future value of an investment assuming that only after-tax dollars are invested and earnings are taxed currently. b. The formula for the future value of an investment under the current model is: i.

After-tax accumulation (ATA) = after-tax investment amount (AT$) × [1 + after-tax rate of return]n, where n = the number of periods (i.e., years) of investment.

2. The Deferred Model (Examples I:18-6 through I:18-8; Figure I:18-1) a. The deferred model calculates the future value of an investment assuming that only after-tax dollars are invested, that earnings grow at the before-tax rate of return because earnings are not taxed currently, and accumulated earnings are taxed at payout. Example: nondeductible IRA. b. This model can also be used to describe the after-tax growth of a capital asset that does not distribute income currently (e.g., growth stock). c. Comparisons between the current model and the deferred model will also be impacted by any penalties and the investment horizon.

I:IO18-2 Copyright © 2024 Pearson Education, Inc.

3. The Exempt Model (Example I:18-12) a. The exempt model calculates the future value of an investment assuming that only after-tax dollars are invested and that earnings are exempt from explicit taxation. The formula is really the current model formulation with an after-tax rate of return equal to the before-tax rate of return. The Roth IRA is an example of the Exempt Model.

4. The Pension Model (Examples I:18-13 through I:18-15, I:18-17) a. The pension model calculates the future value of an investment assuming that before-tax dollars are invested, that earnings grow at before-tax rate of return because earnings are not taxed currently, and the total accumulation is taxed at payout. Examples: deductible IRA, 401(k) plans, other qualified plans. (See Topic Review I:18-1 for formula.) b. The Roth IRA is preferable to the deductible IRA when current tax rates are lower than expected tax rates at distribution.

5. Multiperiod Strategies (Table I:18-2) a. Investors may want to consider multi-period strategies (i.e., using different models in different parts of the investment horizon) when investing a stream of payments versus an initial lump sum.

II.

Other Applications of Investment Models 1. Roth Conversion Decision (Examples I:18-21 through I:18-23; Instructor Aid I:181) a. An individual may roll over distributions from a traditional IRA to a Roth IRA without regard to AGI levels. b. Multiple reasons exist for preferring a Roth conversion: 2. Pass-Through Entity Versus C Corporation (Examples I:18-24, I:18-26; Table I:184; Topic Review I:18-2; Instructor Aid I:18-2) a. The pass-through model is applicable to an S corporation, a partnership, an LLC, or an LLP. The pass-through entity can reinvest the current earnings after paying only the owner’s tax at the owner’s marginal rate. b. The C corporation model assumes one shareholder and that all earnings are accumulated. A much more complex model would be necessary for periodic dividend payments. c. The pass-through model is a variation of the current model with taxation only at the owner level. The C corporation model is a variation of the I:IO18-3 Copyright © 2024 Pearson Education, Inc.

deferred model with tax at both the entity and the owner levels. Utilization of these models can assist a planner in selecting the best entity for tax and investment purposes.

III.

Implicit Taxes and Clienteles (Topic Review I:18-3) 1. Implicit Taxes (Example I:18-28) a. The market may pay a premium for tax-favored investments (e.g., municipal bonds). This premium will reduce the before-tax rate of return.

This effect is an example of an implicit tax.

2. Equilibrium Condition and Clienteles (Example I:18-29) a. The investors who benefit from a particular tax advantage are known as clienteles.

3. Risky Assets (Example I:18-30) a. To accurately compare investments, the riskless rate of return and the risk premium must be calculated.

I:IO18-4 Copyright © 2024 Pearson Education, Inc.

Court Case Briefs Jack M. Pugh v. CIR, 1981 PH T.C. Memo & 81,448 42 TCM 806.

The taxpayer claimed a deduction for a contribution to an IRA account. A portion of the taxpayer’s income was from a partnership. The taxpayer’s share of the distributable income of the partnership was comprised entirely of interest, rents, royalties, and long-term capital gains. Since none of the partnership income was earned income, as required by Sec. 408, the portion of the IRA deduction related to the partnership income was disallowed.

Harold L. Jenkins v. CIR, 1983 PH T.C. Memo & 83,667, 47 TCM 238.

Harold L. Jenkins, alias Conway Twitty of country music fame, went into the restaurant business.

He persuaded friends to invest in his corporation, Twitty Burger, Inc., which went out of business after two years. Even though he was under no legal obligation to do so, he repaid his friends the $97,000 that they had lost in the venture. The IRS argued that the payments were non-deductible gifts made out of a sense of moral obligation. Conway Twitty refuted this argument, contending that the repayments were made because of the importance of his reputation. Twitty also argued that the similarity of his name and the name of the burger business established a proximate relationship between the payments and his business.

The Tax Court rendered the following opinion: The IRS subsequently drafted Action On Decision (AOD CC-1984-002): Twitty Burger went belly up. But Conway remained true.

He repaid his investors one and all. It was the moral thing to do.

His fans would not have liked it. It could have hurt his fame.

Had any investors sued him, like Merle Haggard or Sonny James.

When it was time to file taxes, Conway thought what he would do.

Was deduct those payments as a business expense under section one-sixty-two.

In order to allow these deductions, goes the argument of the Commissioner, The payments must be ordinary and necessary to a business of the petitioner.

Had Conway not repaid the investors, his career would have been under a cloud.

Under the unique facts of this case, held: the deductions are allowed.

Harold Jenkins and Conway Twitty, they are both the same.

But one was born; the other achieved fame.

The man is talented and has many a friend.

They opened a restaurant. His name he did lend.

They are two different things – making burgers and song.

The business went sour. It didn’t take long.

He repaid his friends. Why did he act?

Was it business or friendship? Which is fact?

Business the court held. It’s deductible they feel.

We disagree with the answer but let’s not appeal.

I:IO18-5 Copyright © 2024 Pearson Education, Inc.

Instructor Aid I:18-1 Benefits of Roth Conversion •

Individual tax rates might be high enough in retirement to justify avoiding them with Roth tax-exempt income.

•

An individual can continue to make contributions to a Roth IRA after attaining age 73.*

•

Roth IRAs do not require minimum distributions once the individual attains age 73 (however, Roth 401(k) plans do retain the minimum distribution requirement).

•

Roth income does not count toward Social Security or Medicare premium thresholds.

* Since the SECURE Act removed the age limit on contributions to traditional IRAs, this prior benefit is no longer an advantage of Roth conversion.

I:IO18-6 Copyright © 2024 Pearson Education, Inc.

Instructor Aid I:18-2 Understanding the Change in Tax Status of Limited Partnerships Ownership of limited partnership interests has become less tax advantageous over time due to several factors including: •

Repeal of the investment tax credit

•

Repeal of accelerated cost recovery for real estate, along with a lengthening of the mandated straight-line cost recovery periods

•

Enactment of the at-risk rules

•

Enactment of the passive loss rules

•

Changes in the alternative minimum tax rules

•

Enactment of corporate tax rules for certain “master limited partnership interests”

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