Federal personal income taxation test prep
Prof. Joondeph, Santa Clara University School of Law, Spring 2007; written byJoseph J. Wang,
I.Non-cash Benefits
A.Employer-provided Food & Lodging
1.§119. Meals or Lodging given by employer to employee
a)Exclude from employee income if given…
(1)By employer to employee, his spouse, or his dependents;
(a)Must be in-kind, not by 3rd party
(2)For convenience of employer;
(a)For a substantial noncompensatory business reason
(i)E.g. employee is on-call
(3)On business premises of employer.
(a)Place of employment of employee
b)Acceptance of Lodging must be a condition of employment
c)Employment contract or State statute does not determine exclusion
B.Fringe Benefits
1.§132. Fringe Benefits are not included in employee income
a)No-Additional Cost Service
(1)Line-of-business requirement
(2)Non-discrimination requirement
(3)Extends to spouse and dependent children
b)Qualified Employee Discount
(1)Goods are excludable up to gross profit percentageServices are excludable up to 20% of price for customers
(2)Line-of-business requirement
(3)Non-discrimination requirement
(4)Extends to spouse and dependent children
c)Working Condition Fringe
(1)Had employee paid, he would deduct as business expense or as depreciation
d)De Minimis Fringe
(1)Non-discrimination requirement
e)Qualified Transportation Fringe
(1)Vanpool or Transit Pass, up to $65/month. Parking, up to $100/month
(2)Discrimination ok!
f)On-Premises Gyms
(1)Operated by employer
(2)Substantially all use is by employees, spouses, and dependent children
g)Qualified Retirement Planning Services
(1)Non-discrimination requirement
2.§129. Dependent Care Spending Accounts
a)Employer-provided contributions up to $5k excluded from employee income
3.§125. Cafeteria plans
a)Employer-provided benefits excluded from employee income
(1)Use-or-lose. §125(d)(2)(A)
4.§79. Group-term life insurance purchased for employees
a)First $50k of coverage is excluded from employee income
5.§106. Health insurance
a)Benefits to employee, spouse, & dependents excluded from employee income
b)Employer get deduction
C.Frequent-flyer Credits
1.Personal travel is excluded from employee income (part of purchase price)
2.Employee travel isexcluded. IRS will not 'assert a deficiency'
D.Barter Exchanges
1.§61. Services exchanged are included in employee income at FMV
a)But not informal swap of noncommercial similar services. Reg. §1.6045-1
II.Windfalls Gifts
A.Windfalls
1.Compensatory damages are included in income (Replacement Principle)
2.Punitive damages are included in income
a)Income derived from any source whatsoever. Glenshaw Glass
B.Gifts Inheritances
1.§102(a). Gifts and Inheritances are excluded from donee income
a)Gift proceeds from "detached and disinterested generosity." Duberstein
2.§102(c). Employers cannot give employees gifts, compensation only.
3.§274(b). Business gifts are deductible up to $25 per donee per year
C.Tips Transfer Payments
1.Tips are income
2.Welfare (TANF) is not income
3.Medicaid and Medicare is not income
4.Social Security is 0%-85% included in income
5.Unemploymentbenefits are income (Replacement Principle)
D.Transfers of Unrealized Gains Losses
1.§1001. Gain Realized = Amt. Realized - Adj. Basis
2.§1015. Basis of property acquired by gift. Taft v. Bowers
If donee hasGAIN… / If donee has LOSS…FMV up at transfer / Carry-over basis / Carry-over basis
FMV down at transfer / Carry-over basis / FMV at transfer
3.§1014. Basis of property acquired from decedent = FMV at death
E.Gifts of Divided Interests
1.§102(b). All basis goes to recipient of underlying property. Irwin v. Gavit
a)Interest income is income, even if principal was given to someone else
III.Recovery of Capital
A.Capital Gains Losses
1.Losses only offset Gains, except $3k of loss can offset ordinary income
a)Short-term: held 1 yr or less, taxed at ordinary income rate
b)Long-term: held over 1 yr, taxed at capital gain rate, 20% max
2.Reg. §1.61-6(a). Equitable Apportionment of Capital Gain Property
a)Sale of each portion is treated as separate transaction
(1)Gain is determined at time of sale
(a)Cf. Inaja: Capital gains are income, but if apportionment is impracticable, recognition of income is deferred until entire basis has been recovered. [obsolete]
3.§72. Annuities
a)No recognition of income until payments begin
b)Payments are partially excludable from income, up to 100% of basis
(1)Exclusion ratio = Amount invested / Expected return
(2)If annuitant dies, his estate can deduct remaining unrecovered basis
4.Gambling Gains and Losses
a)Gambling Gains are income
b)§165(d). Gambling Losses only offset gambling gains in same year
5.§165. Losses are deductible if not compensated
a)Loss = Adj. Basis
b)For individuals, deduction is limited to:
(1)Losses from Trade or Business
(2)Losses from transaction for Profit
(3)Losses of Property arising from Fire, Storm, Shipwreck, Other Casualty, or Theft
B.Recovery of Loss (e.g. Damages)
1.Two-Step Inquiry
a)Is the recovery income under §61?
(1)Replacement Principle - replace post-tax money or pre-tax money?
(a)"In lieu of what were the damages awarded?" Raytheon
(i)Replacement of lost profits is income
(ii)Compensation for loss of good will, in excess of its cost, is income
(iii)Donor payment of donee's income tax is income to donee. Old Colony
(iv)Recovery of post-tax money is not income. Clark
(2)Erroneous Tax Returns
(a)If an event changes facts after year-end, account in year of event
(i)E.g. recovery of a loss previously deducted in prior year
(b)If no event (reporting error), file an amended return for prior year
(i)Statute of Limitations: Refunds must be claimed within 3 yrs
b)If yes, is it excluded from income?
(1)§104(a)(2). Non-punitive damages "on account of personal physical injuries or physical sickness" are excluded from income. ["Brass Ring" Rule]
(a)ALL damages due to PHYSICAL injury or sickness are excluded from income
(i)Even if paid to 3rd party (e.g. loss of consortium)
(ii)But not if already deducted (e.g. per §213 medical expenses)
(b)Emotional distress due to physical injury or sickness is excluded from income
(i)Emotional distress unrelated to physical injury or sickness isincluded in income
(a)Even if accompanied by physical symptoms
(ii)But medical care due to emotional distress is excluded from income
(c)Huge Case: Murphy (rehearing pending)
(i)Compensatory damages are not income if they are "a substitute for [a] normally untaxed personal ... quality, good, or 'asset.'"
(a)§104(a)(2) is unconstitutional in taxing damages for mental distress and loss of reputation, since no distinction for mental and emotional injuries existed when 16th Am was adopted
(b)Treats health and well-being like basis
Implies fair wages should not be taxed, since wages recover basis in oneself
This would practically abolish income tax, so Murphy will likely get reversed
(2)§104(a)(3). Medical insurance proceeds are excluded from income
(a)§105. Medical insurance proceeds are included to extent employer paid premiums
(3)§104(a)(1). Workers compensation payments are excluded from income
C.Debt Relief
1.Loan proceeds are not incomeLoan repayments are not deductible
2.§61(a)(12). Discharge of indebtedness is income
a)Bargain sale
(1)Conditioning a gift on donee's payment of tax recognizes gain from partial sale
(a)Partial Sale at FMV to pay off debt. Remainder is Gift. Diedrich
(b)Gain recognized = Tax -Adj. basis in gift
b)§1011(b). Bargain sale to charity
(1)Adj. basis = Old basis x (Amt. realized / FMV)
(2)Gain realized = Amt. realized - Adj. basis = Amt. realized (1 - Old basis / FMV)
c)§108(a). If insolvent or bankrupt, debt relief is excluded from income
d)Debt transferred with property is income to the transferor. Crane
(1)Even if property worth less than debt. Tufts
(a)Non-Recourse Loans
(i)Debt Relief is part of proceeds from Property Sale. Gain is capital gain
(b)Recourse Loans - O'Connor's Bifurcation Approach
(i)Property Sale at FMV: Gain is capital gain
(ii)Debt Relief = Debt - FMV: Gain is ordinary income
IV.Timing Problems in Investment Gains & Losses
A.Realization Requirement: Accession Realization Recognition
1.Realization is exchange of "legally distinct entitlements." Cottage Savings
B.Express Nonrecognition Provisions
1.§1033. Involuntary Conversions
a)Conversionto similar property within 2 yrs
(1)No gain is recognized
b)Conversion to money or non-similar property
(1)Gain recognized = lesser of Amt. recovered but not reinvested within 2 yrs in similar property, or Gain realized
(2)TP may elect to recognize all gain
c)New Basis = Cost of New property - unrecognized gain from Old property
2.§1031. Exchanges of "Like-Kind" Property
a)Exchanged properties must be used in Business or for Investment
(1)All real property is "like-kind" property
b)Straight Exchanges
(1)No Gain or Loss recognized for either party
(2)New basis = Old basis
c)Exchanges with Boot
(1)TP Receiving Boot (partial cash out)
(a)Gain recognized = lesser of Gain realized, or FMV of boot rec'd
(b)No Loss recognized
(c)New basis = Old basis + Gain recognized - FMV of boot rec'd
(2)TP Transferring Boot (increased investment)
(a)No Gain or Loss recognized
(b)New basis = Old basis + FMV of boot paid
3.§121. Exclusion of Gain from Sale of Principal Residence
a)Single - up to $250k in gain may be excluded from incomeMarried - up to $500k of gain may be excluded from income
(1)Principal Residence for 2 of 5 preceding yrs
(2)Available for 1 sale every 2 yrs
(3)Decreased Exclusion if time requirement not met
(a)Available if sale due to: change in place of employment, health, or unforeseen circumstances
(b)Exclusion Ratio = lesser of Months of residence/24, or Months since last sale/24
C.Recognition of Losses
1.§165(a). Deduction for Capital Losses
a)Reg. §1.165-1(d). Losses must be deducted in year sustained
(1)Only for closed and completed transactions fixed by identifiable events
(2)No loss sustained if reasonable prospect of recovery exists (e.g. insurance)
2.§172. Deduction for Net Operating Loss
a)Deduction = Carryovers + Carrybacks
(1)Carryovers = Loss moves tosubsequent 20 years
(2)Carrybacks = Loss moves topreceding 2 years
b)Must deduct as early as possible
c)Must deduct as much as possible (up to taxable income)
d)For individuals, non-business deductions only offset non-business income
3.§1259. Constructive Sales for Appreciated Financial Positions
a)If substantially all risk is eliminated of future gain or loss, treat like a sale
(1)Prevents "short against the box" stock sales
4.§441. Period for computation of taxable income: calendar or fiscal year
(1)Strict year-to-year accounting. Sanford & Brooks
D.Claim of Right Doctrine - income is taxed, then disgorged
1.§1341. Restoration of substantial amount held under Claim of Right
a)Claim of Right elements:
(1)Received funds without restriction
(2)Treats funds as own
(3)Concedes no offsetting obligation
b)Deduction allowable for disgorging funds included in income in prior year
(1)Deduction must be over $3k
c)TP may elect either:
(1)Deduction in current tax year, or
(2)Refund from year of inclusion
E.Tax Benefit Rule - loss is deducted, then item is found
1.§111. Recovery of Tax Benefit items
a)If TP took deduction, subsequent nix includes amount of deduction in income
(1)Inclusionary Aspect
b)If TP did not benefit from a deduction, subsequent nix has no effect
(1)Exclusionary Aspect
F.Constructive Receipt & Economic Benefit
1.Only applies to Cash-accounting
2.Constructive Receipt
a)TP realizes income when he has power to reduce a payment to cash
(1)Payment is subject to will and control of TP. Amend
3.Economic Benefit
a)TP realizes income when funds irrevocably set aside for him, beyond reach of payor's creditors
b)Deferred Compensation is income if: Minor
(1)Future benefits can be valued; and
(2)Contributions are secured from payor's creditors, or non-forfeitable by payee
4.Reg. §1.451-2. Constructive Receipt of Income
a)Credited to TP account
b)Set apart for TP
c)Made available so TP can draw upon it at any time, or could have done so by giving notice of intent
(1)But not if subject to "substantial limitations"
5.§83. Property Transferred for Services Performed
a)Gain is included in income when property 1st transferable or non-forfeitable
(1)TP may elect to include in income in year of receipt
b)Non-Statutory Stock Options
(1)If FMV is not readily ascertainable, §83 does not apply
(a)No tax consequences at grant. Taxed at exercise
(2)If FMV is "readily ascertainable" (rare). Cramer
(a)Gain is included in income when option becomes transferable or non-forfeitable
(b)Optionee may elect to include in income in year of grant
(c)Deduction for grantor when optionee gets taxed
6.Retirement Plans
a)Non-Qualified
(1)Taxed using general tax rules, e.g. §83
(2)Employer gets deduction in year employee gets taxed
b)§401(k). Qualified
(1)Contributions (up to $15k in 2006) are tax-free. Account earns interest tax-free. Distributions are taxed as ordinary income.
(2)Employer contributions are deductible immediately
(3)10% penalty for early withdrawal (before age 59½ )
(4)Roth 401(k) - contributions are taxed, but distributions are tax-free
c)§408. Individual Retirement Account (IRA)
(1)Contributions (up to $3k in 2006) are tax-free
(2)10% penalty for early withdrawal (before age 59½ )
(3)§408A. Roth IRA
7.§422. Incentive Stock Options
a)Taxed only at sale, as capital gain
(1)Grantee must hold option over 2 yrs & hold stock over 1 yr
(2)No built-in gain at grant (option price >= FMV at grant)
(3)Stockholders must approve plan
(4)Unexercised options must represent less than $100k FMV of stock at grant
V. Income Splitting & Taxation of Family
A.Marriage Penalty & Bonus
1.Married-filing-jointly
a)Tax = 2 x (tax on ½ combined income)
2.Single
a)Reduced tax rate schedule to partially compensate for Single's Penalty
(1)Marriage Bonus is greatest when allincome earned by 1 spouse only
(2)Marriage Penalty is greatest when both spouses earn same amount
3.Obsolete Case Law
a)Contractual income splitting is ineffective. Lucas v. Earl
b)Community property laws split income. Poe v. Seaborn
4.Proposals to Eliminate Marriage Penalty
a)Conform tax rates for all, but this would increase the Single's Penalty
b)Nix joint returns, but this would nix Marriage Bonus
c)Restore case law, but Marriage Bonus would depend on state laws
d)Let Singles file jointly with one appropriately defined partner
B.Transfers of Property & Income from Property
1.Gift of Income while retaining Reversionary Interest ("vertical slices")
a)Donor pays tax on income. Horst
(1)No underlying Co-terminating Interest gifted
2.Gift of Income without retaining Reversionary Interest ("horizontal slices")
a)Donee pays tax on income. Blair
(1)Underlying Co-terminating Interest gifted
3.Gift of underlying property transfers basis. Irwin v. Gavit
C.Divorce Settlements, Alimony, & Child Support
Payor Spouse / Payee SpouseProperty Settlement - §1041 / No deduction. Treat as gift. / No inclusion. Treat as gift.
Child Support -Davis / No deduction. Treat as FMV sale. / No inclusion. Basis is FMV.
Alimony - §71 / Deduction. / Inclusion.
1.§1041. Transfers of Property between Spouses or incident to Divorce
a)Treated as Gift:
(1)Carryover basis
(2)No gain or loss for transfers to spouse, or ex-spouse if incident to divorce
(a)Incident to Divorce - within 1 yr of divorce OR related to divorce
(i)Related to Divorce - per divorce instrument AND within 6 yrs of divorce
2.§215. Deduction for Alimony Payments
a)Deductible for payorOrdinary income to payee
b)§71. Alimony & separate maintenance payments
(1)Requirements
(a)Cash, not property, pursuant to an "Instrument" of divorce (no oral agreements)
(b)Parties may not live in same household
(c)Payments must be for support of Ex-Spouse
(i)No payment after death
(ii)No child support - payment may not depend on contingency relating to a child (e.g. death)
(iii)Payments may be made to 3rd party (e.g. landlord, IRS), if per divorce instrument
(2)Excess Front-loaded Payments are treated in 3rd year
(a)Excess 2nd year payments = (2nd year payments) - $15k - (3rd year payments)
(b)Excess 1st year payments = (1st year payments) - $15k - ½ (2nd year payments + 3rd year payments)
(c)Total Excess is included in payor income & deducted from payee income
3.Deadbeat Dads & Moms
a)§166. Bad Debts
(1)Non-business bad debt of individuals is treated like Short-term Capital Loss
(a)TP may deduct basis
(b)Losses only offset Gains, except $3k of loss can offset ordinary income
b)No deduction for costs to cover unpaid child support. Diaz-Arguelles
(1)Not "out-of-pocket"
(a)Basis in child support is zero, sonothing to deduct (as short-term capital loss)
VI.Personal Deductions & Casualty Losses
A.Personal Casualty Loss
1.§165. Loss from Fire, Storm, Shipwreck, or other Casualty, or Theft
a)Other Casualty - ejusdem generis. Dyer
(1)"Suddenness" and Non-Foreseeability Test
(2)Gross negligence bars deduction. Blackman
b)One-hundred dollar Floor: $100 per event
c)Ten-percent Floor: Deductions allowed to extent they exceed 10% AGI
d)Deduction = (lesser of Decline in FMV, or Basis) - insurance proceeds
(1)Insured TPis required to file a timely claim!
(2)Gains from involuntary conversion are income
2.§262. No deduction for personal, living, or family expenses
3.§1016. Deductions for loss reduce basis
B.Miscellaneous Itemized Deductions
1.Deductions OTHER than:
a)Interest. Taxes. Losses. Charity gifts. Medical & Dental. Restoration of funds held per Claim of Right. Etc.
(1)E.g. unreimbursed employee expenses (e.g. copies), investment expenses
2.§67. Two-percent Floor
a)Deductions allowed to the extent they exceed 2% AGI
3.§68. Overall Limit
a)Phases out itemized deductions for AGI over $150,500 in 2007
C.Extraordinary Medical Expenses
1.§213. Deductions allowed to extent they exceed 7.5% AGI
a)Requirements
(1)Unreimbursed. Itemized. Below §68 overall limit
(2)Medical Care of TP, spouse, or dependent
(a)Diagnosis, cure, mitigation, treatment, or prevention of disease
(b)For purposes of affecting any structure or function of the body
(i)Not lawn mowing service for allergy sufferer. Taylor
(ii)Not boarding school for kids of nervous cancer patient. Ochs
D.Charitable Contributions
1.§170. Deduction for contribution to any §501(c)(3) Non-Profit Org
a)Deduction = FMV of property
(1)Hard Limit: total deductions capped at 50% AGI
(a)Carryover available for 5 yrs
(2)Capital Gain Property is capped at 30% AGI
(a)Carryover available for 5 yrs
(3)Corporations limited to 10% AGI
b)§1011(b). Bargain sale to charity
(1)Adj. basis = Old basis x (Amt. realized / FMV)
(2)Gain realized = Amt. realized - Adj. basis = Amt. realized (1 - Old basis / FMV)
E.Mixed Business & Personal Expenses
1.§162. Ordinary and Necessary Business expenses are deductible
a)Traveling expenses, not lavish or extravagant, while away from home
(1)Requirements: Flowers. Reg. 1.162-2
(a)Reasonable and Necessary (Primary Purpose is for Business). Rudolph
(b)In pursuit of Business
(c)Away From Home - if reason for 2 homes is personal, "home" is workplace. Hantzis
(i)Temporary Employment - travel deductible
(a)EXPECTED to last under 1 year (subjective)
(b)ACTUALLY lasted under 1 year (objective)
(ii)Indefinite Employment - travel not deductible
(2)Commuter fares are not deductible
(3)§274(m). No deduction for travel of spouse or dependents, unless Business
2.§274. Entertainment, Amusement, or Recreation
a)50% of Business Meals and Entertainment is deductible
(1)Business objective must require sharing a meal ("social lubrication"). Moss