Law School Resources

Freeland Chapter 1: Orientation

I.       A Look Forward

II.    A Glimpse Backwards

A.     The Income Tax and the Constitution

1.      Power to Tax – Article 1, Section 8, Clause 1 – vests Congress with "…the power to lay and collect Taxes, Duties, Imposts and Excises."

2.      Limits on Power to Tax – Article 1, Sec 2, Cl 3 and Sec 9 Cl 4 require that Direct Taxes be Apportioned  among the several states.

3.      16^th Amendment – provides that Taxes shall NOT be s:t the Rule of Apportionment

IV. Tax Practitioner's Tools

A.     Legislative Materials – IRC

B.     Administrative Materials

1.      Regs issued by Treasury Dept

2.      Rulings –

a.       Private Letter Rulings – may be relied upon by the person to whom it is issued. For Others, it provides Guidance.

b.      Revenue Rulings

C.     Judicial Materials – Where Taxpayer may take their case

1.      Tax Court

a.       Devoted solely to Tax cases

b.      Do NOT have to Pay alleged Deficiency prior to filing

c.       "90-day Letter" from IRS is key – must file w/in 90 Days after Mailing of Deficiency Letter (i.e. Date on the IRS 90-day Letter)

·        If Tax Court filing sent postage prepaid (properly addressed to Wash, DC), Postmark on Mailing to tax Court determines if this date is met.

d.      Non-Jury Trial

e.       Appeal goes to Ct of Appeals for the taxpayer's District (11^th Circ for Ala) per the Golson case, Tax Ct MUST follow the Appellate Courts holding for the T's District

2.      Federal District Ct

a.       Must Pay Deficiency and sue for refund

b.      Jury Trial Available

c.       Appeal goes to Ct of Appeals for the taxpayer's District (11^th Circ for Ala)

NOTE: Per Flora 362 US 145, if entire Deficiency NOT paid, MUST go to Tax Court UNLESS tax is a Divisible Tax, such as Trust Fund tax  (i.e payroll tax w/held)

3.      Court of Fed'l Claims

a.       Must Pay Deficiency and sue for refund

b.      Non-Jury Trial

c.       Appeal goes to Ct of Fed'l Appeals

 NOTE: Per Flora 362 US 145, if entire Deficiency NOT paid, MUST go to Tax Court UNLESS tax is a Divisible Tax, such as Trust Fund tax  (i.e. payroll tax w/held)

Chpt 28: Procedure and Professional Responsibility

I.       Overview

A.     Administrative Procedures

1.      Types of IRS Examinations

a.       Correspondence Audit

b.      Office Exam

c.       Field Exam

2.      Civil Deficiency Controversies

a.       30-Day Letter  -

·        Form letter from IRS which states the proposed adjustments with Examining Agent's report

·        Customary, but NOT Required

·        T can request an Administrative Review – this is necessary in order for T to have later ability to recover legal fees in lawsuit in which T prevails

b.      90-Day Letter – "Ticket to the Tax Court"

·        IRS Letter formally assessing Deficiency

·        Mandatory for 90-Day letter to be sent by IRS to T; letter MUST state the final date by which T can file petition in Tax Court

·        Use Certified Mailing Receipt/Overnight Delivery Receipt to prove that petition as timely filed, and properly mailed to Tax Court

c.       Other Timing Issues

·        Form 870 waiver to 90-day Letter (very rare to do this)

·        Form 872 – extends the statutory time period under which the IRS can assess a deficiency (if T doesn't extend, IRS will assess deficiency on all issues raised)

3.      Administrative Finality

a.       Form 656 Settlement Offer & Compromise 

·        IRS usually enters when doubt as to Liability and/or Collection exist

b.      Form 866  Closing Agreement – sets the Liability ;

c.       Form 906 defines  issues that are Resolved

B.     Judicial Procedures

1        Tax Court

2        Federal District Ct

3        Court of Fed'l Claims

4.      Burden Of Proof – initially on T

a.      However SHIFTS to IRS for Factual Issues where T:

(1)   Introduces Credible Evidence;

(2)   Substantiates any item Required to be Substantiated by IRS;

(3)   Maintains all records; and,

(4)   Cooperates with Reasonable requests of IRS – including exhausting ALL Administrative Remedies within the IRS

C.     Collection of Taxes

1.      Regular Collections – after proper assessment IRS has 10 years within which to Collect the Taxes

II.    Special Rules Applicable to Deficiency Procedures

A.     Timing Rules, Interest and Penalties

1.      3 years after T files the T/R, whether or not timely filed for the year

·        If T/R filed PRIOR to its due date, deemed filed on its Due Date

2.      6 years, if T has Omitted Income in excess of 25% of the Gross Income reported

·        BUT if T discloses his tax position, 3 year S of L applies

3.      Unlimited, if Fraudulent T/R, of no T/R Filed

4        Penalties Related to Filing

a.       Failure to File Return – 5% /month; maximum of 25%

b.      Failure to Pay Taxes shown on T/R – ½% /month; maximum of 25%.

B.     Innocent Spouse Rules – IS doesn't have to follow a Divorce Decree (for example which states that one party is liable for the taxes)

1.      Innocent Spouse allowed relief to a party who has filed a Jt T/R IF:

a.       Understatement of tax Attributable to erroneous items of Other Spouse;

b.      Innocent Spouse did NOT know OR have Reason to Know of such Understatement;

c.       Taking all of the Facts and Circumstances into account, it is Inequitable to hold the Innocent Spouse liable for the deficiency attributable to the Understatement.

C.     Statute of Limitations for filing of Refund by T

1.      Within 3 years of Filing of Return (or its Due Date if filed early) OR

2.      If later, 2 years from the date upon which the Tax was paid.

Freeland Chapter 2: Gross Income: The Scope of Section 61

I.    Introduction to Income: The term “income” in the Code has a unique meaning that differs from the meaning of income in other contexts.

II.  Equivocal Receipt of Financial Benefit

A.  Breadth of Section 61

1.   Section 61 includes income from all sources, unless the taxpayer can point to an express exemption. Cesarini v. United States. [Money Found in Piano = Income to finder]

a.   So long as there is an economic benefit to the taxpayer, the income need not have come into his possession. Old Colony Trust v.  Commissioner.

2.   Illegal activity: Gains from illegal activity are Gross Income. James v. United States.

B.   Definition of Gross Income: Gross income is an accession to wealth, clearly realized, and over which the taxpayer has complete dominion.  Commissioner v. Glenshaw Glass Co.

II.  Income Without a Receipt of Cash or Property (Imputed Income)

A.  Imputed income is basically any product of your own exertions that you yourself consume (e.g., The fair market value of the tomatoes you grew, and then ate).

1.   Imputed income is not “income” under the Sixteenth Amendment, and thus is generally not taxable. Helvering v. Independent Life Ins. Co.

B.   Bartering

1.   Exchange of services: In a transaction where services, not money, are exchanged, the FMV of the services received is Includable as Gross Income. RR 79-24.

2.   If a service is exchanged for goods, then the fair market value of the goods is includable as gross income. Revenue Ruling 79-24.

C.  Closely Held Corporations & Imputed Income:

1.   Financial benefits received from one’s wholly-owned corporation are not imputed income, and

2.   They must be included as gross income. Dean v. Commissioner.

Freeland Chanter 3: The Exclusion of Gifts and Inheritances

I.    What to Include, What to Exclude

B.   Section 102 Internal Revenue.

1.   Excludes from GI any property received as a Gift, bequest, devise, or Inheritance. Section 102(a).

·        KEY is Intent of Donor in determining if Gift or Income

2.   Does not exclude from income any income produced by the property that is given. Section 102(b) (1).

3.   Does not exclude the gift of an income. Section 102(b) (2).

II.  Gifts

A.  What Section 102(a) Int.Rev.Code means by Gift. Per Commissioner v. Duberstein:

1.   A Gift proceeds from a detached and disinterested generosity out of affection, respect, admiration, charity, or like impulses.

2.   The Critical consideration in determining whether a transfer is a gift is the Intent or Motive of the donor.

3.   The trier of fact makes this determination on a case-by-case basis.

B.   Gifts to Employees

1.   Initially Section 102 Int.Rev.Code did not address the question of whether transfers from employer to employee that were called gifts were excludable from income under the Sec.

2.   This was addressed by the addition of Section 102(c ). Employee gifts:

(a)  In General. -Subsection (a) shall not exclude from gross income any amount transferred by or for an employer to, or for the benefit of, an employee.

3.   There are exceptions to this for de minimus fringes. Section 132(e)

4.   Some employee achievement awards are excluded from gross income under Sec 74(c).

III. Inheritances: What Section 102(a) Int.Rev.Code means by inheritance

A.  Congress apparently meant for inheritance to be understood broadly in that though they have tinkered with the language they have not made any move to limit the definition.

B.   When an heir receives a payment as the result of settling their contest of a will, they receive that money because of their status as a heir and thus it is to be considered an inheritance for purposes of Section 102(a). Lyeth v. Hoey.

C.  A bequest made in a will for the purpose of satisfying an agreed compensation for services rendered is not excluded from income under Section 102(a)  Wolder v. Commissioner.

Freeland CHAPTER 4: EMPLOYEE BENEFITS

I.    Exclusions for Fringe Benefits

A.  Generally

1.   Fringe benefits are incidental benefits in an employment context given in a form other than cash.

2.   Generally, gifts from an employer to an employee are includible as gross income.

a.   But if the “gift” falls withing 132, there is no gross income and nothing has to be accounted for.

3.   Policy

a.   Congress thought it unfair to tax someone who is paid in cash, while leaving untaxed the person who is paid in products or services.

(1)  However, Congress also realized that fringe benefits are sometimes for the benefit the employer, and not intended as additional compensation.

(2)  For example, a clothing retailer may offer a discount to employees so that they are encouraged to "show off” the newest fashions.

B.   A No Additional Cost Service is Excludable from Gross Income. I.R.C. 132 (a) (1).

1.   A No Additional Cost Service is a service provided by an employer to an employee:

2.   Non-Discriminatory basis.

3.   Coverage

a.   The no-additional cost service applies to services given to retired and disabled employees, widows of former employees, and the spouses and dependent children of current employees. I.R.C. 132(h).

4.   A no-additional cost service can be also be offered as a rebate or through reimbursement. Treas. Reg. 1.132-2.

C.  A Qualified Employee Discount is Excludable from Gross Income.I.R.C. 132(a)(2).

1.   A qualified employee discount is a discount with respect to qualified property or services that does not exceed:

a.   The gross profit percentage of the price at which the property is being offered by the employer to customers;

(1)  Gross profit percentage is calculated by dividing the dollar difference between the aggregate sales and aggregate cost by dollar amount of aggregate sales [(Aggregate sales Aggregate cost) / Aggregate sales].

OR

b.         20% of the price at which the service is offered customers.

2.   Qualified property or services

a.   Are those (other than real property) which are offered for sale to customers in the ordinary course of the line of business in which the employee works. 132(c) (4).

3.   The qualified employee discount is also subject to the non-discriminatory limitation.

4.   Coverage

a.   The discount may be given to retired and disabled employees, widows of former employees, and the spouses and dependent children of current employees. 132(h).

5.   The discount can be offered as a partial rebate, and can be offered at purchase or through reimbursement. Treas. Reg. 1.132-3.

D.  A Working Condition Fringe is Excludable from Gross Income. I.R.C. 132 (a) (3).

1.   This includes any property or service provided to an employee that would otherwise be deductible by the employee if he had to pay for it.  I.R.C. 132 (d).

a.   For example, an employee who gets reimbursed for his business expenses, may exclude the reimbursement from gross income because the expenses would be deductible anyway.

E.   A De Minimis Fringe is Excludable from GI per I.R.C. 132 (a) (4).

1.   This is any property or service that is small enough to make accounting for it impracticable. I.R.C. 132(e).

a.         Employer provided coffee, water, etc.

II.  Exclusions for Meals & Lodging

A.  The value of Meals and Lodging that are provided to an employee for the Employer’s Convenience is Excludable from GI. I.R.C. 119.

B.   Meals

1.   To qualify for the exclusion meals must be offered on the Business Premises.

C.  Lodging

1.   To qualify for the exclusion the Lodging must be offered:

a.   For the Convenience of the Employer;

b.   On the Business Premises; AND

c.   As a Condition of Employment.

2.   Condition of Employment and Convenience of Employer

a.   The terms of the employment contract are not determinative of these issues and the IRS may scrutinize the situation to determine whether the lodging is really a condition of employment and for convenience of employer or just a pretext (substance over form). Herbert G.  Hatt.

b.      Often, the IRS will scrutinize these contracts in a closely-held corporation. 

Freeland CHAPTER 5: AWARDS

·         

·        I.    Prizes

A. For Prizes unrelated to employment to be Excludable from GI, 4 Requirements must be met. I.R.C. 74.

1    The prize must be made in Recognition of religious, charitable, scientific, educational, artistic, literary, or civic achievement.

2    The recipient must have been Selected without any action on his part to enter the contest or proceeding.

3    The recipient is Not Required to render substantial future services.

a.   But an appearance or short speech is thought to be permitted.

4.   The prize is Transferred by the payor to a governmental unit or a recognized Charity pursuant to a designation made by the recipient.

a.   Basically, the money cannot come under the control or dominion of the recipient.

·                     

·                     

·        II.  Employee Achievement Awards – Sec 74(c)

·         

A. Employee Achievement Awards are Excludable from income if the cost to the employer of the award does not exceed $400 if not part of an established award program, $1,600 if part of an established award program. I.R.C. 74.

1.   Section 274 sets forth the requirements for an Employee Achievement Award:

a.   The award must be an item of Tangible Property - Gift Certifcate is NO GOOD

b.   The award must be given by Employer for either Length of Service or Safety achievement;

(1)   Length of Service Awards CANNOT be given within the first 5 years of Employment, and can be given to the same employee only once every five years.

(2)   Safety Achievement Awards cannot have been given to more than 10% of the employees, nor given to managers, clerks, administrators, or professionals.

c.   The award must be given as part of a meaningful presentation, and the award must be given under conditions that do not create a likelihood that it is disguised compensation.

2.   If an award does not meet the requirements of 74 it may still be excludable from gross income as a de minimus fringe benefit under 132, provided the requirements of that section are met.

·                     

·                     

·                    III.       Scholarships & Fellowships

A.  Amounts received as a “Qualified Scholarship” by an individual who is a candidate for a degree at an educational institution are Excludable from gross income. I.R.C. 117(a).

1.      A qualified scholarship includes any Amounts Received for: Tuition and Enrollment Fees, Books, Supplies and Equipment. I.R.C. 117(b) (2).

2.      Amounts received for Rent (Room and Board) are NOT Excludable from GI.

3.      Expressly NOT Excludable from GI are amounts received as payment for teaching, research, or other services required as a condition to the scholarship. I.R.C. 117 (c).

a.   Thus, a qualified scholarship can be granted by an employer, but only if there is no requirement that the recipient continue to work for the employer.

B.   Any reduction in tuition provided to an Employee of an Educational organization for education below the graduate level is Excluded from gross income. Requirements:

1.   The plan cannot be discriminatory in that it is only for highly compensated employees.

2.   The student must be the employee.

a.   The term “employee” includes an employee of the institution, spouses and dependents of employees, and graduate students who perform services. I.R.C. 117(d) (2).

3.   The Award must be from the educational institution itself.

Freeland CHAPTER 6: GAIN FROM DEALINGS IN PROPERTY

·         

·        I.    Factors in the Determination of Gain

A. Generally

1.      Gross income includes gains derived from dealings in property.I.R.C. 61 (a) (3).

2.      The gain from the sale or other disposition of property is the excess of the amount realized over the adjusted basis, and the loss is the excess of the adjusted basis over the amount realized. I.R.C. 1001.

a.       The Amount Realized is the sum of any money plus the fair market value of any other property received. I.R.C. 1001(b).

b.      The adjusted basis for determining a gain or loss is the cost basis, adjusted as provided in 1016. I.R.C. 1011.

(1)   The Cost Basis is the cost of acquiring the property. I.R.C. 1012.

(2)   Adjustments to the cost basis must be made for various deductions allowed with respect to the property. I.R.C 1016.

3.   There is a presumption that all gains realized are recognized, but losses are not recognized unless there is a specific section so providing.

·                     

·        II.  Determination of Basis

A.  Cost as Basis

1.      The basis of property is the cost of such property. I.R.C. 1012.

B.   Property Acquired by Gift

1.   If property is acquired by Gift, the Basis is the same as it was in the hands of the donor or last preceding owner by whom it was not acquired by Gift. I.R.C. 1015.

a.       Carryover basis whereby the donee takes the donor’s basis in the property.

2.   Appreciation

a.       Any appreciation in the property that occurred while in the hands of the donor does not affect the basis in the stock. Taft v. Bowers.

b.      For example, if the donor bought stock at a cost to him of $1,000, and the stock is valued at $2,000 when the gift is made, the donee takes a basis of only $1,000.

(1)  But the donee does get a step us in basis for any taxes paid, and attributable to the appreciation.

3.   Definition of Gift

a.   To determine whether a gift has been made, courts and the IRS will focus on the substance of the transaction, not just the label given by the parties. Farid-Es-Sultaneh v. Commissioner. [Contingent Gift Situation]

C.  Property Acquired Between Spouses OR Incident to Divorce.

1.   The general rule is that No Gain or Loss is Recognized on a transfer of property from an individual to a spouse, or former spouse if incident to divorce. I.R.C. 1041.

a.   In these types of transfers the property is treated as if it were acquired by gift.

b.   The Basis of the transferee is the adjusted basis of the transferor.

2.   A Transfer is Incident to Divorce IF it occurs within I year after the date on which the marriage ceases, OR is related to cessation of marriage.

a.   It is presumed that transfers are~ related to the cessation of a marriage if they occur within 6 years and are pursuant to a written decree or agreement. Reg. 1.1041-1T(b).

3.      Sec 1041 does not cover transfers twix spouses pursuant to a Pre-Nuptial Agreement.

4.      Policy Underlying 1041

a.       Spouses file joint returns so they are I taxpayer

b.      A married couple is one economic entity, thus it makes no sense to tax a “transfer” between the same entity.

c.       Spouses in different states may be treated differently, so 1041 provides a uniform federal law.

5.   1041 is really a deferral because there will be a gain or loss when the transferee spouse sells to a third party.

D.  Property Acquired From Decedent

1.      A person who acquires property from a Decedent has a Basis in the property equal to the FMV of the property at the Time of Death. I.R.C. 1014(a)(1).

·        EXCEPTION: if the decedent received the property within a year of his death, and the estate transfers it back to the original owner, the original owner keeps original basis. 1014(a).

·                     

·                     

·        II.  Amount Realized

A.  The amount realized from the sale or other disposition of property is the sum of any money received plus the fair market value of any other property received. I.R.C. 1001(b).

B.   Relief of Indebtedness

1.   The relief of indebtedness is considered “other property received” under 1001.

2.   If you transfer appreciated property in satisfaction of a legal obligation there is a taxable gain equal to the difference between the amount of the legal obligation and the adjusted basis in the appreciated property. International Freighting Corporation, Inc. v. Commissioner.

a.   For example, if you buy stock at a cost of $1,000, and a year later you transfer the stock to cancel a debt of $2,000, you have realized a gain of $1,000.

·        The transfer of the Nonrecourse Mortgage is treated as if the transferor had transferred a loan on which he was personally liable, EVEN where Mortgage is > FMV Property. 

Freeland CHAPTER 7: LIFE INSURANCE PROCEEDS AND ANNUITIES

·         

·        I.    Life Insurance

A.  The proceeds of Life Insurance received by reason of the insured’s death are Excludable from GI . I.R.C. 101(a).

1.   Policy Underlying the Exclusion

a.       It is crass to “tax death” above and beyond the estate tax provisions.

b.      Tax liabilities would be enormous because insurance is often paid in lump sum.

c.       Congress wants to encourage the purchase of life insurance.

d.      The exclusions are administratively convenient because there are several facets to life insurance payments (premiums, interest, .benefits, etc.), which can be taxed or excluded with little difficulty.

2.   The proceeds are Excludable only if the Insured Dies.

a.   Amounts received under a life insurance contract on the life of an insured who is terminally or chronically ill are treated as if received by reason of death.

(1)  EXCEPTION: For the Chronically Ill, only life insurance payments sufficient to cover the cost of medical expenses incurred are treated as if received by reason of death; for the terminally ill, all monies received under a life insurance policy are excludable from gross income. I.R.C.  101(g) (3).

b.   If a life insurance policy is sold to a viatical settlement provider a person who is licensed in the business of trading life insurance contracts by a terminally or chronically ill person, the amount realized from the sale is excludable from gross income. I.R.C. 101(g) (2).

(1)  Note that the viatical settlement provider does not get to take advantage of the 101 exclusion when the insured dies

3.   Eligible Beneficiaries

a.   Any named beneficiary may take advantage of exclusion.

b.   If a corporation takes a life insurance policy out on a key employee, it may exclude the proceeds received by reason of the employee’s death.

B.   Interest payments made on the amount excludable under 101 are GI.  101{c)

1.   This rule anticipates a situation where the beneficiary leaves the policy amount with the insurance company, and relegates himself to receiving only interest payments.

C.  A beneficiary who takes life insurance payments over time, may Exclude from gross income an amount that is apportioned equally over the amount of years .the payments are to be made; any payment received above that amount is gross income. I.R.C. 101{d).

1.   For example, if a beneficiary is entitled to a $100,000 life insurance payment, but decides to take an annuity under which the insurance company will pay $5,000 for the next 25 years, the amount that the beneficiary may exclude from gross income each year under 101 is represented by the fraction $100,000/25yr, or 4k/yr.

a.   But if the beneficiary dies before the end of the expected term, the estate does not get to deduct a loss on the unrecovered portion.

·        II.  Annuities

A.  Generally

1.   An annuity is an arrangement under which a person buys the right to future payments.

2.   There are three common classes of annuities.

a.   Under a single-life annuity, the annuitant receives fixed payments for life, after which all payments cease.

b.   A self-and-survivor annuity provides fixed payment to the annuitant for life, after which payments are made to another.

c.   Under a joint-and-survivor annuity, payments are made to two individuals while alive, and then payments are made to the survivor.

B.   Exclusion From Gross Income

1.   Any portion of the annuity payment attributable to the investment is excluded from gross income. I.R.C. 72{b).

a.   The portion of the annuity payment which is Excludable from GI is determined by the following Ratio: (Investment Amount) divided by (Expected Return).

(1) The Expected Return is the product of each payment amount and the number of payments {Payment amount No. of payments).

(1) If the annuitant dies prior to the termination of the payments, the annuitant’s estate is allowed a deduction equal to the unrecovered portion of the investment. I.R.C. 72{b) {3) {A).

2.   Where the annuity contract calls for a refund of any investment {premiums) not recovered by the annuitant, the value of any potential refund determined by the annuitant’s life expectancy is subtracted from the “investment in the contract,” decreasing the excludable ratio. I.R.C.  72 {c).

a.       The refund itself, however, is not taxed, for it is merely a return of capital. 

Freeland CHAPTER 8: DISCHARGE OF INDEBTEDNESS

·         

·        I.    Gross income Includes income from the Discharge of Indebtedness. I.R.C. 61 {a) {12).

A.  If you settle a legal obligation for less than the amount of the obligation, the difference becomes Taxable Income.

·        Examples:

1.      Person settles $10K debt by giving the creditor a painting worth $8k, which has a Basis of $5K to debtor.

·        Debtor recognizes $2K from Discharge of Indebtedness; also recognizes $3K gain from disposition of the painting (FMV less AB)

2.   A company that issues bonds with a face value of $100 and retires those bonds by repurchasing them for $95 each, recognizes gross income of $5 per every bond repurchased. U.S. v. Kirby.

3.   The settlement for less than face value of an Unenforceable Obligation is NOT Gross Income. Zarin v. Commissioner.

(a)    Per Footnote 9 (p 169 in book), Casino chips are property which is NOT Negotiable and may NOT be used to gamble or for any other purpose outside the Casino where they were issued.

·         

·        II.  Exceptions to 61(a) (12)

A.  Under 108(a) (1) there are 4 Exceptions to the general rule that Discharge of Indebtedness is Includable in GI.

1.   There is no gross income if the discharge occurs in Bankruptcy.

2.   There is no gross income if the discharge occurs when the taxpayer is Insolvent.

a.   The amount of the exclusion is limited to the extent of the taxpayers insolvency.

3.   There is no gross income if the indebtedness discharged was incurred directly with the operation of a farm. 108{a) (1) {C).

4.   There is no gross income if the debt was incurred in connection with Real Property used in a Business or Trade. 108(a) (1) {D).

B.   Under 108{b) (2), a taxpayer who elects to Exclude a discharge under sections 108{a) (1) (A), (B), or (C), must reduce tax attributes in the following order:

1.      Net Operating Loss

2.      General Business Credit

3.      Minimum Tax Credit

4.      Capital Loss Carryovers

5.      Basis in the property of the taxpayer

6.      Passive activity loss and credit carryovers.

C.  The discharge of a debt owed to the seller of property a purchase-money debt is treated merely as a reduction in price by the seller. I.R.C.  108 (e) (5).

1.   However, the debtor must reduce his basis in the property in an amount equal to that of the discharge.

D.  The discharge of indebtedness can also be excluded as a gift. I.R.C. 102.

Freeland CHAPTER 9: DAMAGES AND RELATED RECEIPTS

I.        Introduction: Damages for physical injury and sickness are accorded express congressional treatment in the Code, but other types of damages must be dealt with by courts under general tax principles.

·                     

II.     Damages in General

A.  In order to determine whether a damage recovery is gross income, the nature of the injury must be identified.

B.   Damages are Taxable as Gross Income IF they are recovered in Lieu of Taxable Income. Raytheon Production Corporation v. Commissioner.

·        i.e. Lost Wages; Compensation for Conversion of an Asset

1.   For instance, if a plaintiff recovers damages attributable to lost profits, the recovery is taxed as if it were profits; but if damages are awarded for a loan default, the damages attributable to the principal are not taxed, because that is a mere return of capital.

·        III. Damages & Other Recoveries for Personal Injury

2.   Punitive damages for Wrongful Death are excluded if they are the only form of wrongful death recovery available. I.R.C. 104 (c). Ala is only state with Wrongful Death determtn

3.   If a Personal Injury settlement provides for Annual Payments that include interest, the interest is also Excludable under 104(a) (2) .Rev.  Rule. 79-313.

a.   The rationale is that the interest is mere compensation for the present value of money, which would not be taxed if the settlement payment were in one lump sum.

Freeland CHAPTER 10: SEPARATION AND DIVORCE

·        I.    Alimony and Separate Maintenance Payments

A.  Direct Payments

1.   Alimony payments are Included in the GI of the recipient, and Deducted from the gross income of the payor. I.R.C. 71(a), 215.

a.   In conjunction, Sections 71 and 215 act as an income splitting device.

2.   For a payment to be considered “Alimony” for tax purposes, 5 Reqmnts M/B met.

a.   The payment must be in the form of Cash.- NOT Property; or Prom Notes

(1)   Checks and like instruments are considered cash, but promissory notes do not qualify for income splitting.  .

b.   The payment must be pursuant to a Divorce or Separation Instrument.

(1)   A divorce or separation instrument includes a Decree of divorce OR Separate Maintenance or a Written Instrument incident to such a decree. 71(b) (2) (A).

(2)   A written separation agreement also qualifies as a separation instrument. I.R.C. 71(b) (2) (B).

(3)   A decree for support is considered a separation instrument. I.R.C. 71 (b) (2) (B).

c.   The divorce or separation instrument CANNOT designate the payment as anything Other Than Alimony.

(1)  The parties are permitted to characterize “alimony” as something else in order to forego income splitting.

d.   The parties may not live in the same household IF they are divorced or legally separated pursuant to a Decree at the time the payment is made.

e.   The liability for alimony payment must Cease upon the death of the Recipient, and there may be no other payment obligation thereafter.

(1)  The instrument cannot require alimony for a specific period of time if there is no provision providing for the cessation of alimony upon death of the recipient spouse.

(2)  But if local law requires that alimony cease upon death of the recipient, then no provision for cessation is needed in the instrument.

3.   Property Settlements and Recapture

a.   Although not expressly mentioned anywhere in the Code, 71 is intended to apply only to payments for spousal “support.”

(1)  This principle can be inferred from both, the requirement that alimony be paid in cash, and the fact that no income splitting is provided for property transferred incident to a divorce or separation.

b.   To prevent parties from characterizing property settlements as alimony through the use of large cash payments, the Code provides for the recapture of excess payments made in the first few years following the divorce or separation i.e., “Front Loading.”

(1)  In a nutshell, the Front Loading provisions prevent a party from making enormous “Alimony” payments the first two years after the divorce or separation, with a substantial drop off in the third year.

B.  Indirect Payments  can qualify as Alimony IF made to Outside 3^rd Party

1.   Alimony payments made to third parties are anticipated by 71, for it requires that Alimony be “received by (or on behalf of) a spouse.”

a.   The potential for abuse arises when the payor controls the payment and is receiving a benefit therefrom.

(1)  For example, a person making alimony payments can make payments to payee’s landlord, but not if the payor is the landlord or owns an interest in the property.

a.       Payments made on a life insurance policy by the payor spouse will likely be considered alimony if the payee spouse owns the policy and is the irrevocable beneficiary. I.T. 4001.

·         

·         

·        II.  Property Settlements - Property Settlements Pursuant to a Divorce

A. Property settlements pursuant to a divorce are treated as tax neutral events (gifts) 1041.

1.   A transfer is Incident to Divorce IF it occurs within 1 year after the date on which the marriage ceases, or is related to cessation of marriage.

a.   It is presumed that transfers are related to the cessation of a marriage IF they occur within 6 years and are pursuant to a written decree or agreement.

(1)   Those that occur 6 years after the divorce are presumed to be not incident to the divorce.

·        This is a Rebutable Presumption

·         

·         

·        III. Other Tax Aspects of Divorce

A.  Child Support

1.   Child support payments carry no tax advantages with them; they are not deductible by the payor.

a. The policy rationale is that there is a moral and legal obligation to pay child support, so Congress does not need to encourage it.

2.   Types of Child Support Payments

a.   Payments specifically designated as child support in a written divorce or separation instrument.

(1)  In the case of these payments it is easy to determine what qualifies for income splitting under 71 & what does not.

b.   Payments not specifically designated as child support but reduced upon happening of some contingency relating to the child (marriage, reaching majority, et al.) and designated in the written instrument.

c.   Payments not designated as child support but are reduced on the happening of some contingency related to the child, but not designated in the written instrument.

Freeland. CHAPTER 11: OTHER EXCLUSIONS FROM GROSS INCOME

·         

·        I.    Gains From the Sale of Principle Home

A.  Background

1.   There has always been a favorable treatment towards this type of gain for several reasons:

a.   It seems inappropriate to tax people upon the sale of their home because they usually do so to change jobs, accommodate a growing family or doWnsize after reaching retirement, all circumstances that are often out of the taxpayer’s control.

b.   A home is the largest asset in many taxpayers’ estate, and taxing a sale would create an large increase in tax liability.

B.   New Rules

1.   Generally speaking, gross income does not include the gain from the sale or exchange of a principle residence. I.R.C. 121.

(1)  Whether a residence is “principle” is determined by the intent of the taxpayer.

b.   Limitations

(1)  The amount of gain excluded from gross income on any sale shall not exceed $250K. I.R.C. 121(b) (1) .

(a)  In the case of joint returns the exclusion limit is $500K if:

i.    There is a joint return for the year of the sale.

ii.    Either spouse meets Ownership requirement

iii.   Both spouses meet the Use requirements

iv.   Neither spouse is ineligible for the benefits because of a previous exclusion within the last two years.

(2)  Exclusions are limited to one every two years.

c.   The Ownership and use requirements, as well as 2 year limitation do not apply if:

(1)  The sale or exchange occurred due to a change in place of employment, health, or unforeseen circumstances.

(a)  In which case the portion of the $250,000 ($500,000 for joint returns) that may be excluded is the shorter of the actual ownership and use during the prior five years or the time between the prior and current sale to two years.

Freeland CHAPTER 12: ASSIGNMENT OF INCOME

·         

·        I.    Introduction

A.  The Progressive Tax System: The progressive tax system taxes higher income individuals at higher rates. I.R.C. 1.

B.   For this reason individual taxpayers often attempt to transfer some income to another individual in a lower income bracket, thus lowering the total tax liability.

·         

·         

·        II.  Income From Services

A.  The person who earns and has the right to receive income cannot transfer tax consequences by assigning a portion of it prior to its receipt to another individual. Lucas v. Earl.

B.   A taxpayer DOES have the right to make an anticipatory renunciation of income and avoid any tax liability, IF he neither receives income nor directs its disposition. Giannini v. Cmsr

C.  The executor of an estate may waive his right to receive statutory commissions without incurring an income tax liability. Rev. Rul. 56-472.

1.   If the waiver is not executed prior to the performance of services, there must be some evidence of an intent to render the services gratuitously. Rev. Rul. 66-167.

D.  Amounts received for services performed by a faculty member or a student of the university’s school of law under the clinical programs and turned over to the university are not includable in the recipient’s income. Rev. Rul.  74-581.

·         

·         

·        III. Income From Property

B.   Exceptions

1.      But income can be successfully Assigned for tax purposes if the Assignor does NOT Own the property which produced the income.                         per Blair v.  Commissioner.

2.      The owner of income producing property may also assign income from the property for Valid Consideration in an arm’s length transaction.  Estate of Stranahan v. Cmsr. – Watch out for Sham Transaction

a.   In other words, income from property may not be assigned gratuitously for tax purposes, but it may be sold in a valid transaction.

3.   If the owner of income producing property transfers both the Property and the Income therefrom, he has shifted the tax consequences to the recipient.

a.   Courts and the IRS will look to the substance of a transaction to determine whether property is being transferred, or if merely income therefrom is being assigned. Susie Salvatore.

·        Sale by one person CANNOT be transferred for tax purposes as a sale by another person by transfer of the property to tem before the sale and using the other person as a conduit for the sale.

·        Anticipatory Assignment WON”T work, where the transaction has been arranged before the transfer.

C.  Income Earned But Not Realized

1.      If income from property has been properly assigned by sale, transfer of the underlying property or otherwise, and income has been earned or matured, but not received or realized on the date of assignment, the income is taxable to the assignor. RR. 69-102.

2.      For example, if the owner of corporate stock sells the shares after a dividend has been announced but not paid, the seller of the stock is taxed on the dividend.

Freeland CHAPTER 13: INCOME PRODUCING ENTITIES

I.    Introduction

A.     Just as it provides an incentive to assign income between different individuals, the progressive tax encourages taxpayers to utilize partnerships, corporations, and trusts to fragment income.

B.   Partnerships

1.   Partnerships are not taxable entities, rather the income generated by the partnership is taxed proportionately amongst the individual partners. I.R.C. 701.

1.      The major issue that arises in the context of partnerships occurs when a family unit attempts to distribute income amongst the different family members by forming a "partnership" between individual family members.

C. Corporations

1.      Corporations are taxable entities subject to progressive rates applicable only to them.

2.      A small business may elect to be an S corporation, which is not subject to tax - the shareholders instead are taxed ratably for each taxable year. I.R.C. 1366.

·        Can have up to 75 shareholders

·        Sub-S Election MUST BE Unanimous

·        NOT Effective for tax year UNLESS Filed within 75 days of Incorporation or the beginning of the tax year

D. Trusts

1.      The tax imposed on income from a trust depends on the facts and circumstances surrounding the trust.

a.       The scheme upon which trusts and estates are taxed is based upon two seemingly inconsistent principles.

(1)   Trust income is to be taxed only once on its way to the beneficiaries.

(2)   Beneficiaries are to be taxed on the amounts of trust income that are paid or payable to them.

(a)    The inconsistency is resolved by allowing the trust a deduction on amounts required to be paid to beneficiaries. I.R.C. 651.

2.      Types of Trusts

a.   A "simple trust" is one that is required to distribute all its income currently.

(1) It is a mere conduit for the payment of income to beneficiaries.

b.   A "complex trust" is one where the income may be accumulated, and all or part of the income may be taxed to the trust, and none or only a portion taxed to the beneficiaries.

3.   Distributable Net Income (D.N.I.)

a.       D.N.I. is basically the trust's net income for the year, and may be taxed entirely to the trust, entirely to the beneficiaries, or partly between the two.

b.      D.N.I. also serves to characterize the income, so that distributions consist of ratable portions of each kind of income, some of which may be tax-free; e.g., a gift to the trust passed on to the beneficiaries.

II. Trusts and Estates

A. Courts have adopted special rules concerning Grantor Trusts / Revokable Trusts (where Testator has the Power to Modify, Alter or Revoke the Trust)

1.      Grantor who retains the Power to Modify, Alter or Revoke the Trust will be taxed on the Trust’s income. Carliss v Bowers.

2.      The Grantor of a trust who retains sufficient interest in the Corpus, may, under 61(a) be deemed the owner of the trust and taxed on trust income. Helvering v. Clifford.

B.     Congress has provided special rules for so called "grantor trusts" those set up by an individual for the benefit of third parties, usually family members.

1.      The grantor is treated as owner of any portion of a trust in which he has a reversionary interest in the corpus or income, if the value of the interest exceeds 5% of the value of the portion of the trust in which he has an interest. I.R.C. 673.

2.      The grantor of a trust is taxed on the income if the grantor or a nonadverse party one who essentially does not have a beneficial interest in the trust which he has the power to affect has the power to determine who will receive the income from the trust. I.R.C. 674.

3.      the grantor is also treated as owner of the trust if he holds administrative powers that are usually not consistent with normal fiduciary rules. I.R.C. 675.

a.   For example, if the grantor has the power to borrow funds from the trust without interest or security. I.R.C. 675(2) .

4.   Income that is paid from the trust for the benefit of the grantor is also taxable to the grantor. I.R.C. 677. This section is particularly aimed at payments to a spouse.

5.   Third persons with the power to obtain the corpus or income for themselves, or who have held such power and now retain dominion or control, may also be taxed on the income from the trust, provided the grantor is not deemed owner of the trust under one of the above rules I.R.C. 678.

III. Partnerships

A.     The Bona fide Good Faith Intent of the parties determines whether a partnership has been validly formed for tax purposes. Commissioner v. Culbertson.

B.     In order to combat the uncertainty involved with this subjective analysis, Congress has enacted several safe-harbors that protect a partnership from attack by the IRS. 704(e) which recognizes as a Partner in a Family P/S one who “Owns a Capital Interest in a P/S in which Capital is a Material Income Producing Factor.”

·        If fact situation does not meet this, look to Culbertson Good Faith Test

Freeland CHAPTER 14: BUSINESS DEDUCTIONS

I. Introduction

A. Deductions are said to be a matter of "Legislative Grace."

1.      Therefore, a taxpayer must find a Code provision that specifically authorizes the deduction sought.

B.   Deductions are amounts subtracted from gross income, with the difference giving the taxpayer his "taxable income." I.R.C. 63.

C.  Business deductions are aimed only at taxpayers, individuals or corporations, engaged in a trade or business.

1.      The Code allows deductions for all ordinary and necessary expenses paid or incurred in carrying on a trade or business. I.R.C. 162{a) .

II. The Anatomy of the Business Deduction Workhorse: Section 162

A. "Ordinary and Necessary" -

1.   While a necessary expense is one that is appropriate and helpful, ordinary expenses are those that are common and accepted in the taxpayer's particular trade or business. Welch v. Helvering.

B.   "Expenses"

1.      Expenditures that produce benefits lasting beyond the taxable year are generally capital expenses and are non-deductible. INDOPCO, Inc. v. Commissioner.

2.      Expenses made pursuant to remodeling projects are capital expenses that cannot be deducted, even if the expenses were deductible if isolated from the project as a whole. Norwest Corporation and Subsidiaries v.Commissioner.

C. "Carrying On" Business

1. Section 162 does NOT allow a deduction for expenses incurred in Entering a Trade or Starting a Business. Morton Frank.

a.   But if the taxpayer elects, Start-Up Expenditures can be amortized treated as deferred expenses, deductible over a period of at least five years. I.R.C. 195.

(1)   To be eligible for a 195 deduction, the taxpayer must actually have started the business, and the expenses must be of the type allowable under 162, i.e., "ordinary and necessary."

(2)   Start-up expenses not amortized under 195, must be capitalized or treated as a nondeductible expense.

(3)   Upon disposition of the business, a taxpayer may deduct those start-up expenditures that were amortized, but not previously deducted.. 195 {b) {2) .

2.   Individuals Engaged in a Trade or Business as Employees

a. Although an individual cannot deduct expenses incurred in entering a trade or business, he may deduct expenses incurred in searching for a new job within a trade or business that he is engaged in. I.R.C. 162.

(1)   But if a substantial period of time elapses between cessation of the taxpayer's previous employment and his efforts to find new employment, the Treasury will not allow the deductions on the ground that the taxpayer is not "carrying on a trade or business." Rev. Rul. 75-120.

b.      Section 162 deductions are not allowed for expenses incurred in looking for a first job, or entering a new trade or business.

III. Specific Business Deductions

A. Reasonable Salaries

1.   The Code allows a deduction for reasonable salaries and compensation for services rendered. I.R.C. 162(a) (1) .

a.   The reasonableness of an employment contract is usually challenged only in the context of closely-held corporations or family owned businesses. Harolds Club v. Commissioner.

2.   The Code creates a presumption against the deduction of generous severance packages, known as "golden parachutes," to the extent the payment exceeds employee's "base amount" the average annual income received by the employee over the preceding five years. I.R.C. 280G.

a.   The deduction is disallowed only:

(1)   W/r/t officers, shareholders, highly compensated employees. 280G(c);

(2)   If the payment is contingent on a change of ownership. 280G(d) (3); and

(3)   If the aggregate payments exceed three times the employee's base amount. I.R.C. 280G(b)(2)(A)(ii).

b.   The presumption may be rebutted through evidence clearly and convincingly establishing the payment was for services to be rendered on or after the change in ownership, or services actually rendered before the change in ownership. I.R.C. 280(b) (4).

c.   Code provides for various exceptions to the golden parachute rule for retirement and pension type plans. I.R.C. 280(b) (6) .

3.      Publicly held corporations are limited to a $1 million deduction for salaries paid to CEOs, or any employee who is one of the four highest compensated employees. I.RC 162(m) (1)

B.   Travel "Away from Home"

1.   The Code specifically provides a deduction for travel expenses incurred while away from home in pursuit of a business or trade. I.R.C. 162(a)(2).

a. These deductions are allowed in order to offset duplicated living expenses.

(1) A itinerant taxpayer with no permanent home may not deduct travel expenses. Rosenspan v. U.S.

b.   An individual can have only one "home" for tax purposes. Andrews v. Cmmr.

c.   A taxpayer is not treated as being "away from home" if the period of employment lasts over one year. I.R.C. 162(a) .

2.   Commuting Expenses

a.   Generally speaking, the costs of commuting between a taxpayer's residence and his place of business are nondeductible. Treas. Regs. 1.162-2(e),1.262-1(b)(5).

(1) Commuting expenses are deductible if:

(a)    A taxpayer incurs expenses when going between his residence and a temporary work location outside the metropolitan area where the taxpayer lives and normally works. Rev. Rul. 94-47;

(b)   A taxpayer has one or more regular work locations away from his residence and incurs expenses in traveling between his residence and any temporary work location in the same trade or business. Rev. Rul. 94-47; or

(c)    The taxpayer's residence is his principle place of business and the taxpayer incurs expenses in going between the residence and another work location in the same trade or business, regardless of whether the work location is temporary or regular. Rev. Rul. 94-47.

(2) A work location will be deemed temporary if it is realistically expected to last less than one year, and in fact does last for less than one year. Rev. Rul. 99-7.

(a)    If the work location is realistically expected to last for more than one year, but actually lasts for less than one year, the location will not be deemed temporary.

(b)   If the work location is realistically expected to last for less than one year, but that expectation changes, the work location will be treated as temporary up until the expectations changed.

C. Necessary Rental and Similar Payments

1. The Code allows a deduction for rentals or other payments required to be made as a condition to the continued use or possession of business property to which the taxpayer has not taken title or in which he has no equity. I.R.C. 162 (a) (3) .

a.       A taxpayer may not seek business deductions for necessary. rental payments if the rental or lease agreement is, in substance, a sale. Starr's Estate v. Commissioner.

b.      Intrafamily gift and leaseback arrangements that create the need for a business to make rental payments will be scrutinized to determine whether the transaction has no business purpose or whether the taxpayer retained substantial control over the property, in which either case there will be no deduction allowed. White v. Fitzpatrick.

D. Expenses for Education

1.      Education expenses incurred to fulfill the requirements of a taxpayer's employment or profession are deductible as necessary and ordinary business expenses. Hill v. Commissioner: Treas. Regs. 1.162-5(a) (2)

2.      A taxpayer may deduct education expenses incurred in maintaining or improving his professional skills. Coughlin v. Commissioner; Treas. Regs. 1.162-5(a) (1) .

IV. Miscellaneous Business Deductions

A. Introduction

1.   Business Meals and Entertainment

a.   Although business meals and entertainment expenses may be deducted as ordinary and necessary expenses, the Code imposes some limitations and requires substantiation with respect to such expenses.

(1) The expenses must be either "directly related to" or "associated with" the taxpayer's trade or business. I.R.C. 274(a) (1) (A) .

(a)    "Directly related to" means that business must go on during the entertainment or meal.

(b)   "Associated with" requires the business be conducted immediately preceding or following the entertainment.

(2) Only 50% of the meal & entertainment expenses can be deducted. 274 (n) (1) .

(a) The 50% limitation applies to any deductible meal.

i. For example, meals eaten on a business trip are subject to the 50% limitation.

(b) The meals cannot be lavish or extravagant. .I.R.C. 274 (k) (1) (A) .

(c) The 50% limit applies to the face value of any ticket to an entertainment event. I.R.C. 274(1) (1) (A) .

(3) The taxpayer claiming the deduction must be present. I.R.C. 274(k)(1)(B).

b.   The cost of entertainment facilities is expressly non- deductible.

(1)   Entertainment facilities include sky boxes, and social and athletic clubs among others. I.R.C. 274(a) (1) (B) .

(2)   But costs related to the use of such facilities are deductible if they meet th~ requirements of 162 and the limitations of 274.

(a) For example, 50% of the cost of a reasonable business meal eaten at the taxpayer's country club may be deducted, even though the country club dues are non-deductible.

2.   Uniforms: The cost of acquiring/maintaining a uniform required for the taxpayer's employment is deductible if the uniform is one that is not suited for general use.

3.   Advertising: Unless they are used to acquire a capital asset, advertising expenses are deductible iD.the year they are incurred or paid. Treas. Reg. 1.262-1(b)(8).

4.   Dues: Dues paid to organizations that directly relate to a business are deductible. Treas. Regs. 1.162-20(c) (3) .

5.   Lobbying Expenses: As a general matter, expenses incurred in petitioning government or any similar activity are nondeductible. I.R.C.162 (e) (1) .

B. Business Losses

1. A deduction is allowed for losses incurred in a trade or business. I.R.C 165.

a.       To be deductible, the loss must be connected with some realizing event, i.e., a sale. Treas. Regs. 1.165-1(b) .

b.      A taxpayer may not deduct losses sustained on account of the demolition of a structure which the taxpayer owns. I.R.C. 280B.

V. Depreciation

A.  Introduction

1.   The Code treats depreciation as an operating expense, allowing deductions for the exhaustion, wear and tear, and obsolescence of property used in a business or trade. I.R.C. 167, 168.

a.   Prerequisites for Deduction

(1)   The property must be used in a business or trade, or be held for the production of income, i.e., rental property.

(2)   The deduction can be claimed with respect to property that will be consumed or wear out.

(a) Unimproved real property is non-depreciable. Treas. Regs. 1.167(a) (2) .

b.   Useful Life Concept

(1) Under the prior depreciation system, a taxpayer was required to identify the useful life of depreciable property, then take deductions over the length of that useful life.

(a) The Accelerated Cost Recovery System (ACRS) in place today virtually eliminates this concept. I.R.C. 168(b) (4) .

c.   Depreciation Methods

(1) The "straight-line" method allows equal deductions to be taken over the useful life of the property.

(a) For example, if the taxpayer has a basis of $1000 in machinery with a useful life of 10 years, after which the value of the machinery is zero, the taxpayer is allowed an annual deduction of 10% of the basis.

(2) Under the "declining balance" method a uniform rate of deduction is applied to the unrecovered basis in the property.

2.   The Relationship of Depreciation to Basis

a.   A taxpayer's basis in depreciable property is annually reduced in an amount equal to the allowable deduction, whether the taxpayer chooses to claim the deduction or not. I.R.C. 1016(a) (2) .

3.   The Accelerated Cost Recovery System (ACRS)

a.   The ACRS applies to most tangible depreciable property. I.R.C. 168{a) .

{1) When applicable the ACRS is mandatory, if inapplicable 167 is used.

b.   Recovery Periods: In place of "useful life" the ACRS allows taxpayers to recover depreciation over "recovery periods," which are predetermined by Congress. I.R.C. 168{c) .

c.       Depreciation Methods: The ACRS applies both the "straight-line" and "declining balance" methods, depending on the type of property for which depreciation is sought.

d.      Anti-Churning Rules: The ACRS prohibits a taxpayer from bringing within the current ACRS property they or related persons used prior to the current system, if the current system allows for more accelerated deductions.  168 (e)(4),(f)(5)

e.       Useful Life: {l)Under the ACRS, property need not depreciate in value in order for deprecation deductions to be claimed, rather the focus is on whether the property is subject to exhaustion, wear and tear, or obsolescence. simon v. Commissioner.

4.   The Related Concept of Depletion

a.   In the case of natural resources, the Code provides a deduction for the depletion of the resources as they are excavated, mined, or logged. I.R.C. 611.

5.   Depreciation deductions may be claimed on property that is subject to business and personal use, but only to the extent the property is used for business purposes; all other tax attributes must be allocated between personal and business use. Sharp v.US

B.   Special Depreciation Rules on Personal Property

1.      Taxpayers who qualify for the current ACRS have available to them alternative methods of depreciation. I.R.C. 168{b), {g) .

2.      Half-year convention

a.   For depreciation purposes, property is treated as having been placed in service during the midpoint of the year.

{1) So the taxpayer is allowed only a half-year deduction in year one.

b.   Taxpayers are prevented from taking advantage of the rule by purchasing -eqpt near the end of the year. I.R.C. 168{d) {3) {A) .

3.      Bonus Depreciation: Taxpayers are allowed an additional deduction on some types of property that qualify for ACRS treatment in the year the property is acquired. I.R.C. 179.

4.      Other ACRS Limitations: The Code imposes limitations on the depreciability of luxury cars, property used for entertainment or recreation, telecommunications equipment, and computer not used exclusively for business. I.R.C. 280F.

C. Special Rules on Realty

1.   Real property that is eligible for depreciation deductions is divided into two types: residential rental property and non-residential rental property.

a. Under the ACRS both types of properties are subject only to the straight line depreciation method and both have lengthy recovery periods. I.R.C. 168.

2. Congress has provided special incentives for investments in older property and low-income housing. I.R.C. 42, 46, and 47.

Freeland CHAPTER 15:

I.    Ordinary and necessary nonbusiness expenses incurred in collecting or producing income, or in managing, conserving or maintaining income-producing property are deductible § 212.

A.  § 212 was enacted because expenses incurred in managing personal business, like invest-ments, are not deductible under § 162’s provision for deduction of expenses incurred in carrying on a business. Higgins v. Commissioner.

B.   Deductions under § 212 are subject to the same limitations and restrictions as deductions under § 162.

1.   Thus, litigation expenses incurred in de-fending or protecting income-producing property are not deductible because they are not ordinary and necessary .Bowers v.  Lumpkin.

a.   The ordinary and necessary requirement is not a strict, technical one, however.  The requirement is satisfied when the expenses are adequate, helpful and nec-essary in light of real life circumstances.  Bowers v. Lumpkin.

2.   A showing of a proximate relationship between the nonbusiness expense and the income is not necessary in the Fifth Circuit.  surasky v. U.S.

3.   Such a showing is required by the Internal Revenue Service and in other circuits, however. Revenue Ruling 64-236.

C.        Personal expenses are not deductible. § 262.

1.   Thus, legal expenses incurred defending a claim that arises out of one’s personal life, even if it may have some affect on income-producing property, are not deductible.  Mayer J. Fleischman.

a.   Courts apply a but/for origin of claim test to determine if a claim arises out of one’s personal life or out of business or income-producing activities. For example, if the claim would not exist but for the personal relationship, expenses incurred in litigating that claim are personal and not deductible.

b.   Legal expenses incurred in collecting income, such as alimony, however, may be deducted as nonbusiness expenses, because the daim arises out of collecting income. Meyer J. Fleischman.  !. Expenses incurred in transactions entered into for profit are also deductible.

II   Expenses Incurred in Transactions entered into for Profit are also Deductible

A. A loss resulting from sale of property for less than it was purchased is not deductible, how-ever, unless the property constitutes a trans-action entered into for profit and is not a personal residence. William c. Horrmann. 

1 .A personal residence may be converted to a transaction entered into for profit by showing more than mere abandonment, like abandonment followed immediately by demolition or renting. William c. Horrmann.

2.   It is not necessary to show the property was offered for rent before being sold in order to show a personal residence was converted into a transaction entered into for profit.  Lowry

a.   The key question in determining whether a personal residence has been converted into a transaction entered into for profit is to look at whether, in light of all the circumstances, the taxpayer had an expectation of profit. Lowry v. U.S.

Freeland CHAPTER 18:

I.    Adjusted gross income is a means of equalizing taxable income between individuals based on the source of their respective income.

A.     Equalization is necessary to enable the standard tax table to be used to ascertain an indi-vidual’s tax liability while accounting for the way in which the individual earns his money as compared to others. Senate Finance Committee Report No.885

B.     In computing an individual’s adjusted gross income, two types of dedll~ions are used: above the line, those deductible before apply-ing the standard or itemized deduction [§ 62], and below the line, those deductible as the standard or item dedctns [all others not listed in § 62].

II. Moving expenses are Deductible above the line.[See § 62(a)(15).]

A. Under § 217, moving expenses may be de-ducted provided the distance between the taxpayer’s former residence and new work-place is more than fifty miles than the dis-tances between the taxpayer’s former resi-dence and old workplace and the taxpayer is employed at least 39 weeks of the first twelve months at the new location.

B.   Moving expenses include amounts paid to pack, ship, transport, insure and store the taxpayer’s possessions and the cost of mov-ing, excluding meals, which the taxpayer’s employer did not reimburse.

III. Amounts paid for the taxpayer’s, the taxpayer’s spouse or dependents’ medical care are deductible under § 217.

A.     Medical care includes amounts paid for the diagnosis, cure, mitigation, treatment or prevention of disease and for transportation primarily for and essential to the diagnosis, cure, mitigation treatment and prevention of disease.

B.     Expenditures that constitute a permanent addition to a home are deductible as medical expenses only insofar as they do not increase the value of the home over the amount ex-pended. Raymon Gerard.

C.     Food and lodging expenses incurred en route to a place of medical treatment, but not after arriving, are deductible as medical expenses.  Montgomery v. Commissioner.

1.   Reasonable lodging expenses and 50% of food expenses paid while receiving treat-ment from a hospital on an in-patient basis are deductible under § 213(d)(2).

D. Amounts paid for qualified long-term care of a taxpayer, the taxpayer’s spouse or dependents is also deductible.

E.   In some inStances where the nature of the taxpayer’s work clearly requires a medical expense be incurred to insure sufficient per-formance or where goods or services pur-chased are primarily used for work and the IRS Code anO’”Regulations are silent on their deductibility, such expenses, although medical in nature, may qualify as business expenses under § 162.

IV. In addition to specific deductions available to individual taxpayers, § 151 provides exemptions for the individual taxpayer, his spouse and any dependents.

A.     The personal exemption, available to the individual taxpayer and his spouse without restriction, is a set deduction that is subtracted from the taxpayer’s adjusted gross income to determine the taxable amount. The amount of the exemption is determined on an annual basis in relation to the Consumer Price Index.

B.     To claim a dependent exemption, the tax-payer must show that the person claimed as a dependent is a blood relative, adopted or foster child, or an unrelated ihdividualliving as part of the taxpayer’s household, that the taxpayer provides over one-half of the sup-port for the person claimed as a dependent, and the person claimed does not have gross income over the amount of the exemption allowed.

1.   The gross income requirement is waived if the dependent is the taxpayer’s child and is under nineteen or a full-time student under twenty-four .

V. An individual taxpayer may also take advantage of the standard deduction provided for in § 63, so long as he does not itemize deductions other than those listed in § 62.

A. The standard deduction is a set amount, usually equal to ten percent of the taxpayer’s adjusted gross income, that is determined by the Code based upon the taxpayer’s status as single, head of household, married, blind or elderly.

B.   It is available without restriction if the tax-payer does not take advantage of itemized deductions, those not listed in § 62.

Freeland CHAPTER 19:

.

I.    Introduction

A. A taxpayer’s federal income tax Is computed by defining a net income figure, referred to as tax-able income, for a specific twelve month period called the taxable year .

1.   A taxable year generally ends on the last day of the last month in a twelve month period. Most taxpayers use the calendar year as their taxable year, though other periods may be used as well. 

2.   Once an accounting period or taxable year is chosen, a taxpayer must get, the IRS’ permission to change to a different periOd.

3.   Under a concept known as the integrity of the taxable year, each year stands alone and tax liability for two different tax years are com-puted independent of one another.  a. For example, if a person receives a $3,000 bonus that is claimed as income in one year, but due to an accounting mistake has to return half of the money in a subsequent year, the tax consequences are dealt with in the subsequent year.  b. The tax return for the year of inclusion will not be adjusted in a subsequent year.

B.   When it is determined that a particular item must be taken into account in computing a person’s tax liability, the question arises as to when it should be taken into account-in which taxable year should the item be recognized?

1    .Reporting an item of income or making a deduction in one taxable year as opposed to another can, in some cases, have significant tax consequences.

2.   For example, a taxpayer’s tax rate may be higher in year two than it was in year one.  Also, substantive tax laws may change from year to year, and the statute of limitations is tied to what year an item is included.

C.  The tax period in which a person reports income or claims a deduction is directly affected by the accounting method that a particular taxpayer employs.

1.   There are a number of available accounting methods. IRC § 446. The two most commonly employed methods are the cash receipts and disbursement method (generally used by indi-viduals) and the accrual method (generally used by businesses).

2.   The cash method takes an item of income into account at the time it is received. Deductions are taken into account at the time cash or property is paid.  a. Some taxpayers are specifically prohibited from using the cash method of accounting. i.e. tax shelters can never use cash method accounting, and most corporations cannot use it as well.

3. The accrual method accounts for income at the time the taxpayer becomes entitled to that income (even if no cash has been received).  The amount must be capable of determination with reasonable accuracy .Deductions are counted at the time an obligation to pay be-comes fixed (even if nothing has been paid).

4. A person is not limited to one accounting me-thod. For example, a person can use the cash method for her individual income and use the accrual method at the same time for her business. However, one entity (person or business) cannot use two accounting methods simultaneously.

5.      Permission must be obtained from the IRS for a person or business to change accounting methods, and in many cases a legitimate business purpose supporting the change must be shown.

6.      For the most part. a deduction that is available to a cash method taxpayer is similarly available to an accrual method taxpayer .

D. According to Treas. Reg. § 1.446-1(a)(2), “no method of accounting is acceptable unless. ..it clearly reflects income.” It is this principle that limits a person or business’ ability to choose between the available accounting methods.  1. Treas. Reg. § 1.446-1 (a)(2) further states that “ [a] method of accounting which reflects the consistent application of generally accepted accounting principles. ..will ordinarily be regarded as clearly reflecting income, provided all items of gross income and expense are treated consistently from year to year.”

E.   There is a concept in accounting of “matching” income to expenses related to the production of that income when computing a taxpayer’s taxable income. Expenditures are matched against in-come that is to be reported in the taxable year.  The tax system requires adherence to this concept whenever possible.

II. The Cash Method of Accounting: Cash Receipts and Disbursements

A. Receipts

1.   A cash method taxpayer includes income in the year it is received. Income may be in the form of cash, check (treated as the same as cash), or property.

2.   Under the cash method of accounting, the value of a check actually received is includable in the year of receipt, even if the check can not be converted to cash until the following year.  As such, the receipt of a check is deemed a recognition of income. Charles F. Kahler. 

3.   Promissory notes or other evidence of indebt-edness received as payment for services consti-tute income to the extent of their fair market value. However, a note received only as an evidence of indebtedness, and not as payment, will not be regarded as income at the time of receipt. Williams v. Commissioner.  a. In Williams, th~ court determined that an unsecured promissory note, which has no fair market value, is not the equivalent of cash and as such is not includable in a cash me-thad taxpayer’s income in the year of re-ceipt.

4.   A readily marketable agreement (obligation/promise) to make future payments that qualifies as the equivalent of cash is taxable upon receipt as cash had it been received by the taxpayer instead of the obligation. Cowden v. Commissioner.

a.   An obligation is a cash equivalent if

·        (1) The obligor is solvent,

(2)   There is an assignable and unconditional promise to pay, not s:t setoffs, AND

(3)   The obligation is of a type normally trans-ferable to lenders at a discount not sub-stantially greater than the prevailing pre-mium for money.

5. Even when a taxpayer does not have the physi-cal item of income in her hands (actual receipt), it may be that the taxpayer is deemed to have constructively received the income, and is therefore liable for the tax due on that income.  Paul v. Hornung.

a.   Constructive receipt occurs when income is credited, set apart, or otherwise made available to a taxpayer unless the taxpayer’s control of its receipt is subject to substantial limitations or restrictions. Income Tax Reg. § 1.451-2(a).

b. The idea behind the principle of constructive receipt is that if income is made available to a taxpayer, and the only thing that keeps her from collecting the income is her own action (or inaction), then the income is received and must be taxed; a taxpayer cannot turn her back on income to avoid taxes.

B.   Disbursements

1.      Generally speaking, a cash method taxpayer can only take a current deduction for expenses actually paid during the taxable year .

2.      However, when expenses relate to the creation of an asset which has a useful life substantiaJly beyond the taxable year (a capital asset), tax-payers are required to prorate those expenses and may not take the full deduction for the expense in the year of actual payment. Com-missioner v. Bolyston Market Ass’n. 

a.   For example, if a taxpayer pays $1,000.00 in the year 2001 for a three year insurance policy on real property (that is a capital asset), she must allocate the $11000.00 over the three year term of the policy and deduct the corresponding pro rata share each year. 

3.      In some situations, the IRC specifically provides for the deductibility of expenses by cash method taxpayers. One such situation is covered by IRC § 461 (g). 

a.       IRC § 461 (g)(1) requires that taxpayers who employ the cash method of accounting allocate deductions for prepaid interest to the specific periods to which those deduc-tions relate (i.e., prorate the value of prepaid interest over the life of the loan). 

b.      There is one exception to this requirement, however, which is codified in IRC § 461 (g)(2). As stated in Cathcart v. Commis-sioner, that section provides that the general rule contained in subsection (g)(1) does not apply when cash method taxpayers prepay points (a processing fee paid at the time the loan is taken out) on their home mortgages (whether incurred to purchase or improve a home) with funds not obtained from the lender (i.e., the funds come from their own pockets). Those who qualify for this excep-tion are entitled to deduct the entire amount of prepayment in the:. year in which it is paid.  See also Rev. Rul. 8i~2.

4.   Though the law recognizes a doctrine of con-structive receipt, there is no doctrine of con-structive payment; deductions are only permit-ted when they are actually paid. Vander Poel, Frands & Co., Inc.—

5.   A charitable contribution made’ in the form of a check is deductible in the taxable year in which it is delivered to the charity provided it is hon-ored and paid and there are no restrictions as to the time and manner of payment. Rev. Rul.  54-465.

6.     A payment for a deductible expense made to a third-party with a bank-issued credit card is a deduction when the charge is made. A pay-ment made to the issuer of the credit card (e.g., a department store credit card) is not deduct-ible when charged, but only upon payment of the credit card bill.

III. The Accrual Method of Accounting

A. Introduction

1 .  The accrual method of accounting recognizes income at the time the taxpayer becomes entitled to that income. Deductions are coun-ted at the time an obligation to pay becomes fixed (even if nothing has been paid).

B.   Income Items

1.   For the accrual method taxpayer. income is included in gross income when the right to receive such income is fixed and can be deter-mined with reasonable accuracy. Spring City Foundry Co. v. Commissioner; Reg. ‘§ 1.451-1 (a). 

a.   When an accrual method taxpayer receives a judgment in court, and no appeal is gran-ted, the taxpayer must include the amount of the judgment in his or her income for the year of the judgment, even if the money is not actually received until a different year.  Rev. Rul. 70-151.

2.   Under the claim of right doctrine, a taxpayer with a claim of right over an amount earned must generally include that amount in income in the year the claim of right accrues, which is not necessarily the year the amount is earned.  North American Oil Consolidated v. Burnet. 

a.       For example, cash received as an advance payment of rent must be included in income in the year received, even if it is not used until later on when the money is earned. If the advance payment is intended as a secu-rity deposit, it is not included in gross in-come. New Capital Hotel, Inc. 

b.      However, in the Seventh Circuit, taxes due on prepayments for services can potentially be deferred by an accrual taxpayer until the services are rendered if they are to be ren-dered on a fixed schedule. Artnell Co. v.  Commissioner .

C. Deduction Items

1.   A taxpayer who uses the accrual method of accounting is permitted, under the IRC, to deduct interest in the year in which liability accrues. When the interest to be deducted is interest on a deficiency in tax, accrual occurs in the year in which liability for the deficiency is determined. Rev. Rul. 57-463. 

a.   If a taxpayer enters into an agreement with the government, however, that permits deferred installment payments of the amount assessed (deficiency, penalties, and interest) and additional interest on the deferred payments, interest accruing on those deferred payments may be deducted as the liability for each accrues.

2.   In 1956 the Fifth Circuit in Schuessler v. Com-missioner held that when the use of a reserve account accurately reflects a taxpayer’s income on an annual accounting basis, the tax code permits its use. In doing 50, the court permitted a taxpayer to take a deduction in one year for expenses going to services to be rendered in a later year. 

a.       Schuessler was decided in 1956. and since that time the law has changed. Specifically.  IRC § 461 (h)(5) now precludes the use of reserve accounting except in situations ex-pressly permitted by the Code. 

b.      Under § 461 (h). a taxpayer may not take a deduction until the taxpayer has completed his or her end of the transaction.

IV The Forced Matching of Methods

A.     Introduction

1 .  Sometimes the fact that two taxpayers who engage in a transaction with one another use different accounting methods will lead to a situation in which the: tax consequences of the transaction do not properly reflect its substance. 

2.   Sometimes. in response to such situations.  Congress will enact rules that dictate the ac-counting method that the taxpayers can use (so that there is uniformity). Two of these types of statutes are IRC §§ 267(a)(2) and 467

B.   IRC § 267(a)(2).

1.   IRC § 267(a)(2) deals with the situation where an accrual method taxpayer owes deductible interest to a cash method taxpayer. The ac-crual method taxpayer is permitted to deduct the interest when it becomes due, regardless of whether it is paid. As such. it becomes possible that a deduction can be taken by the debtor without a corresponding inclusion of income on the part of the creditor .

2. IRC § 267(a)(2) requires that in such a situa-tion, the accrual method taxpayer becomes, with respect to that interest, a cash method taxpayer. This means that the debtor can only take a deduction upon actual payment of the money owed.

C. IRC § 467 .

1.   RC § 467 applies in situations involving a multi-year lease of property where, as a result of front-loading (bulk of payment paid in first few years) or back-Ioading (bulk of payment paid in last few years), an accrual method lessee is taking deductions at times different from a cash method lessor (the lessee is deduct-ing an equal amount for rent on a yearly basis while the lessor is not necessarily collecting that same amount every year).

2.   RC § 467 I for all intents and purposes, makes both parties accrual method taxpayers for the rental transaction (called a “Section 467 Rental Agreement). As such, periodic rental payments are deemed paid and received, and for those that are not in actuality paid, interest is charged

Freeland CHAPTER 20

I. The Integrity of the Taxable Year

A. The Internal Revenue Code (IRC) and our federal income tax system are based on the theory of a single-year tax system. The single-year tax sys-tem is based upon the idea that an accounting of items of income and expense should be made on an annual basis (a regular, periodic interval).  B. The single-year tax system is beneficial to the government because it allows the government to know when necessary revenue will be produced.  It is also beneficial to the taxpayer because it allows the taxpayer to know...~hen exactly an accounting will be required, thus giving the tax-payer adequate preparation time.

C. In most situations, the single-year system is strictly adhered to such that once a return is filed for a year, adjustments and amendments will not be made to that return to compensate for events that occur in later years.

II. Restoration of a Taxpayer’s Previously Taxed Income A. When a person is overtaxed, the IRS has an .obligation to return to the taxpayer a refund in the amount in excess of the proper tax.  B. Also, when a person reports a certain amount of income on her tax return, but later, for some reason, is required to return a portion of the income daimed, she is entitled to receive some tax relief from the government. The difficult question is how will that relief be returned.

1. In United States v. Lewis, which addresses the claim of right doctrine, the court held that the way in which relief is to be returned is by per-mitting the taxpayer to deduct the amount of repayment in the year in which it is repaid.  (The taxpayer simply wanted to recompute his tax liability for the year in which he paid too much in taxes, but the court would not permit it.) a. In holding that a deduction should be taken in the year in which money is repaid, the Supreme Court affirmed the principle of definite and specified tax accounting periods, holding that u [i]ncome taxes must be paid on income received (or accrued) during an annual accounting period.” b. The claim of right doctrine, which the Lewis court addressed in its opinion, is a rule of tax law that requires a taxpayer to report on his income tax return any income that is con-structively received in a particular year , regardless of whether or not he holds an unrestricted claim to it.

2. Internal Revenue Code (IRC) § 1341 permits the use of a second approach to the receipt of relief when money previously taxed as income must be repaid.  a. The method employed in Lewis, in which a deduction is taken in the year of repayment, is still a permissible alternative under IRC § 1341 (a)(4).  b. However, under § 1341(a)(5), a taxpayer, instead of merely taking a deduction, is permitted to reduce her tax due for the year of repayment by the amount of tax for the prior year that is attributable to the specific amount repaid. In other words, the taxpayer is given a credit (instead of a deduction) for the amount of the prior year’s tax increase that resulted from the over-reporting of gross income.  c. These respective methods are referred to as the deduction from income and the reduc-tion in tax methods. The taxpayer is permit-ted to use whichever method results in the lesser amount due.

3. Three requirements must be met if IRC § 1341 is to be applied. The three requirements are set forth in §§ 1341(a)(1), (2), and (3).  a. First, § 1341(a)(1) requires that the item earlier included in gross income have been included .’because it appeared that the taxpayer had an unrestricted right” to that item.

(1) As a result of this requirement, an embez-zler who subsequently returns his ill-got-ten gains will not qualify for the benefits of § ‘1341. (It never appears that the embezzler has a right to the money ta-ken.) b. Next, § 1341 (a)(2) carries a two part require-ment. First, a deduction must be allowable in the current year for the amount of the repayment, and second, the fact that the taxpayer did not have an unrestricted right to the item of income must have been estab-lished after the close of the taxable year in which the income was reported (i.e., there was no chance to fix the problem during the year of overpayment and over-reporting).  (1) A voluntary repayment will not satisfy the § 1341 (a)(2) requirement. A person must have no choice but to’repay the money.  (2) .’[A] judicial determination of liability [for repayment of the claimed income] is not required “ for the § 1341 (a)(2) require-ment to be satisfied. However, .’a tax-payer must [be able to] prove by a pre-ponderance of the evidence that he was not entitled to the unrestricted use of the amount received in the prior year.” Pike v. Commissioner.

(3) While the restriction on the right to the item of income must arise after the close of the year in which it was included in the taxpayer’s gross income, the cir-cumstances that formed the basis of the lack of the unrestricted right must have existed during the year of Inclusion.

(4) A subsequent agreement to return an item of income to which the taxpayer originally had an unrestricted right of use will not permit application of § 1341. Blanton v.  Commissioner [a taxpayer entered into an agreement to return excess fees after they were already received].

(a) However, as demonstrated in Van Cleave v. United States, § 1341 is avail-able for use when a taxpayer agrees to return excess fees before they are paid.  c. Finally, § 1341(a)(3) requires that .’the a-mount of [the] deduction exceed $3,000. “ (1) Thus, if the otherwise conforming repay-ment is in the amount of $3,000 or less, § 1341 is unavailable.  d. In sum, if a taxpayer included an item in gross income in one tax year, and in a subse-quent tax year becomes entitled to a deduc-tion because the item or a portion thereof is no longer subject to his unrestricted use, and the amount of the deduction is in excess of $3,000, the tax for the subsequent year is reduced by either the tax attributable to the deduction or the decrease in the tax for the prior year attributable to the removal of the item, whichever is greater. Van Cleave.  C. Both the claim of right doctrine and IRC § 1341 support the idea that the single-year tax system, under which taxes are collectable and payable at regular periodic intervals of one year (i.e., the tax accounting period is a one-year period), should be strictly adhered to such that once a return is filed for a year, adjustments and amendments should not be made to that return to compensate for events that occur in later years.

III. The Tax Benefit Doctrine

A. The tax-benefit rule permits an exclusion of recovere<t’Property from current income so long as its initial use as a deduction did not provide the taxpayer with a tax savings. When a taxpayer obtains a full tax benefit from earlier deductions, however, if those deductions are recouped, they constitute income and must be taxed as such at the tax rate which is in effect during the year in which the recovered item is recognized as income.  Alice Phelan Sullivan Corp. v. United States.  1. For example, in Alice, the corporation donated some land to charity in 1939 and 1940 and took a charitable deduction. Later the land was returned. Under the tax-benefit rule, the corporation had to include the land as income because, at the time of the donation, it ob-tained a tax benefit in the form of a charitable deduction.

B. The tax-benefit rule works as it does because of strict adherence to the single-year tax system (evidenced by the fact that a taxpayer cannot , apply the tax-benefit rule with the tax rates in place at the time of the donation, but must be taxed at the rates applicable at the time of return).

IV. Income Averaging

The concept of income averaging involves taking an individual whose income varies greatly from year to year and placing him or her on a level with one whose total income is about the same but more stable from year to year .

1. In one sense, income averaging goes against the idea of an inflexible tax year as it allows a taxpayer to earn income in one year but pay tax on it in a subsequent year.

B. Self-Averaging

1. Rev. Rul. 60-31 addresses the determination of when a taxpayer employing the cash receipts and disbursements method of accounting must include certain items in his or her gross income.  a. Pursuant to § 1.451-1 (a) of the Income Tax Regulations, “Gains, profits, and income are [generally] to be included in gross income for the taxable year in which they are actually or constructively receiv:ed by the taxpayer. “ b. With respect to a taxpayer using the cash receipts and disbursements method of ac-counting, § 1.446-1©(1)(i) provides: “Gen-erally, under the cash receipts and disburse-ments method ...all items which constitute gross income. ..are to -be, included for the taxable year in which actually or construc-tiVely received.” c. With respect to the meaning of constructive receipt of income, § 1.451-2(a) of the Regu-lations states: .’Income although not actually reduced to a taxpayer’s possession is con-structively received by him in the taxable year during which it is credited to his account or set apart for him so that he may draw upon it at any time.”

(1) A mere promise to pay that is not repre-sented by any notes or secured in any other way is not regarded as a construc-tive receipt of income.

(2) A taxpayer cannot deliberately turn his back on income made available to him and thereby pick and choose the year in which it will be reported.

(3) Nor can a taxpayer, by private agreement, postpone the receipt of income from one tax year to another .  d. In any case involving the deferral of compen-sation, a determjnation of whether the doc-trine of constructive receipt is applicable is made only after an examination of the spe-cific facts of the particular situation.  2. Although § 1.451-1 (a) of the Regulations states that income is generally “included in gross income for the taxable year in which [it is] actually. ..received by the taxpayer,” the Regulations and Rev. Rul. 60-31 do not pre-clude some deferral of income in certain situa-tions.

C. Statutory Deferred Compensation Arrangements 1. Introduction a. Under the averaging arrangement discussed in Rev. Rul. 60-31, a taxpayer can spread income forward into future years when tax rates may be lower.  b. Some statutory plans permit averaging such that compensation is deferred until retire-menl In some of these situations, money paid into a trust will not be taxed until it is removed during retirement.

2. Qualified Plans a. In order for a contribution to a trust to be non-taxed, the payment must be made to a qualified pension or profit sharing plan. To be qualified, a plan must meet the require-ments set forth in IRC § 401 (a).  b. The two most common types of qualified plans are defined contribution and defined benefit plans.

(1) In a defined contribution plan, a percent-age of an employee’s salary is contributed to an account and made available for the employee upon retirement.

(2) In a defined benefit plan, contributions are made to an account in an amount neces-sary to provide the employee with a pre-determined sum upon retirement.  c. There are two distinct tax advantages that arise from qualified plans.

(1) First, since most people are in lower tax brackets upon retirement, payments made to the employee at that time will be taxed at lower rates than they would be if taxed during the time the taxpayer was working.  (2) Second, as the trust to which the contribu-tions are made under a qualified plan is tax exempt, any gains and income earned by the trust are not subject to tax attrition.

3. Non-qualified Deferred Compensation Plans

Employer payments made to a qualified plan are tax deductible for the employer.  b. Similarly, contributions to most plans that do not qualify under the code are also generally tax deductible. , c. However, if the trust to which contributions are made is subject to claims by the em-ployer’s creditors, the contributions are not tax deductible. Nor are such contributions considered income to the employee. In such a case, the employer cannot take a deduc-tion until the money is made available to the employee.

4. Keogh Plans a. A Keogh plan is a deferral plan for self-em-ployed individuals. They are similar to quali-fied plans except the contributor takes an income deduction for payments made in-stead of an income exclusion (i.e., under a qualified plan, amounts made to the plan are excluded from the employee’s gross income).  b. Taxes are paid on money from Keogh Plans upon distribution.

5. Individual Retirement Accounts (IRA) a. An IRA is a tax-deferral arrangement set up by the individual for his or her own benefit.  Taxes are paid upon distribution, and contri-butions are deductible by the individual.  b. IRA’s typically have restrictions and penalties associated with taking distributions prior to a certain age.

6. The Roth IRA a. In a Roth IRA, contributions are not tax deductible and income generated by the contributions is not taxed. Also, certain qualified distributions from the Roth IRA are not taxed.

7. SIMPLE Plans a. A SIMPLE (Savings Incentive Match Plan for Employers) Plan is a retirement plan available to small businesses.  b. SIMPLE plans are usually IRA’s for each employee, or part of a 401 (k).

8. Incentive Stock Options a. An ISO allows an employee to purchase stock in the employer corporation at a fixed price.  b. If the option is exercised, income is recog-nized only upon the sale of the optioned stock.  v. Carryover and Carryback A. Carryover and carryback principles, which allow certain things such as business losses incurred in one year...tQ be carried forward or backward as deductions in future or prior years, are an excep-tion to the principle of the Standard taxable year.  B. Tax provisions that allow carryover or carry back are similar to other averaging provisions in that income from a profitable year is reduced to boost income in a less-than-profitable year .