understanding federal income taxation
TRANSCRIPT
UNDERSTANDINGFEDERAL INCOMETAXATION
Fifth Edition
J. Martin BurkeProfessor of Law EmeritusUniversity of Montana School of Law
Michael K. FrielProfessor of Law and Director, Graduate Tax ProgramUniversity of Florida Levin College of Law
Copyright © 2016
Carolina Academic Press, LLC
All Rights Reserved
ISBN: 978–1–5221–0348–6 (print)
Library of Congress Cataloging-in-Publication Data
Names: Burke, J. Martin, author. | Friel, Michael K., author.
Title: Understanding federal income taxation / J. Martin Burke, Professor of Law Emeritus, University of
Montana School of Law; Michael K. Friel, Professor of Law and Director, Graduate Tax Program.
Description: Fifth edition. | Durham, North Carolina : Carolina Academic Press, 2016. | Series:
Understanding series | Includes bibliographical references and index.
Identifiers: LCCN 2016013217 (print) | LCCN 2016013545 (ebook) | ISBN 9781522103486 (alk. paper) |
ISBN 9781522103493 (ebook)
Subjects: LCSH: Income tax--Law and legislation--United States.
Classification: LCC KF6369.85 .B87 2016 (print) | LCC KF6369.85 (ebook) | DDC 343.7305/2--dc23
LC record available at https://lccn.loc.gov/2016013217
Carolina Academic Press, LLC
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Durham, NC 27701
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Printed in the United States of America
(2016–Pub.426)
Dedication
To Jackie and Jonathan
and My Mother and Father
— MKF
To My Mother and Father
and My Eleven Brothers and Sisters
— JMB
iii
Preface
As experienced tax professors, we know that students encountering the complexities of
the tax code for the first time are often frustrated by its difficulties and look to their
casebooks or to supplemental material for an adequate overview of the principles and
policies underlying federal income tax law and for a detailed explanation of the
interpretation and application of pertinent provisions of the Internal Revenue Code. Thus,
such overviews and explanations have been principal features of the authors’ casebook,
Taxation of Individual Income. This book in turn adapts material from Taxation of
Individual Income for those students using other casebooks who seek such supplemental
material to assist them in their study. We have specifically designed this book to
supplement other casebooks used in traditional courses in federal individual income
taxation.
This book consists of forty-four chapters with each chapter addressing a basic topic in
individual income taxation, e.g., the taxation of personal injury awards, the interest
deduction, installment sales. Because the provisions of the Internal Revenue Code are
necessarily at the heart of tax study, we have included in each chapter a part or all of the
Code section(s) pertinent to the specific topic. Likewise, the chapters contain summaries
of leading cases and relevant administrative rulings as well as numerous examples
explaining the application of the law.
For students in law schools or business programs, we suggest that, before turning to
this book, students first read the cases and other materials assigned by their professors.
With that reading as background, students should then read the corresponding materials
in this book to acquire a broader overview of the area including the development of the
law related to a specific topic.
While this book is designed primarily for students, we recognize that it may also prove
valuable to the general practitioner. Before representing a client in a divorce or some
property transaction, the attorney may be well advised to read the chapter(s) relevant to
the representation. Not only will this book provide the attorney with helpful overviews of
the tax law related to a client matter, it will also serve as a tool for locating cases and
other relevant authority.
In sum, we have written this book as a basic guide for students studying the tax law for
the first time and for general practitioners handling transactions with an individual
income tax dimension. A word of caution: neither this guide nor any casebook or
supplemental material should be viewed as a substitute for careful reading of the Internal
Revenue Code. Lawyers and accountants must ultimately base their decisions on the
Code and the judicial and administrative interpretations of the Code. Our hope is that this
book will aid in the study of the Code and the application of its provisions.
v
Acknowledgments
We are indebted to a number of people for their assistance in the development of this
book. We have benefitted greatly from the comments and suggestions by our colleagues
and our students at the University of Montana School of Law and the University of
Florida College of Law, and we wish to acknowledge their help and that of our tax
colleagues at other law schools. We are also indebted to Linda Kirby of the University of
Florida College of Law. Her assistance and support in the preparation of this manuscript
were indispensable, and for that we are most grateful and appreciative.
vii
Table of Contents
Chapter 1 INTRODUCTION TO FEDERAL INCOME TAX . . . . . . . 1
§ 1.01 A BRIEF HISTORY OF FEDERAL INCOME TAX . . . . . . . . . . . . . . . . 1
§ 1.02 RESOLUTION OF TAX ISSUES THROUGH THE
JUDICIAL PROCESS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
[A] Trial Courts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
[1] The Tax Court . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
[2] Federal District Courts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
[3] The United States Court of Federal Claims . . . . . . . . . . . . . . . . . . . . 3
[B] Appellate Courts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
[C] Selection of Forum . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
§ 1.03 COMPUTATION OF TAX LIABILITY . . . . . . . . . . . . . . . . . . . . . . . . . 5
[A] Basic Questions Addressed by an Income Tax System . . . . . . . . . . . . . . 5
[B] Evaluating Tax Liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
[1] Gross Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
[2] The Concept of Adjusted Gross Income . . . . . . . . . . . . . . . . . . . . . . . 7
[3] Deductions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
[4] Calculating Adjusted Gross Income . . . . . . . . . . . . . . . . . . . . . . . . . 11
[5] Taxable Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
[a] Itemize or Elect Standard Deduction . . . . . . . . . . . . . . . . . . . . . . 12
[b] Section 67: The 2% Floor on Miscellaneous Itemized Deductions . . 12
[c] The Section 68 Overall Limitation on Itemized Deductions . . . . . . 13
[d] Personal Exemptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
[e] Calculating Taxable Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
[6] Tax Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
[7] Credits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
§ 1.04 CONCLUSION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Chapter 2 GROSS INCOME CONCEPTS AND LIMITATIONS . . . . 17
§ 2.01 THE SEARCH FOR A DEFINITION OF INCOME . . . . . . . . . . . . . . . . 17
§ 2.02 INCOME REALIZED IN ANY FORM . . . . . . . . . . . . . . . . . . . . . . . . . 20
§ 2.03 REALIZATION, IMPUTED INCOME AND BARGAIN PURCHASES . 21
[A] The Realization Requirement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
[B] Imputed Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
[C] Bargain Purchases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
ix
Chapter 3 THE EFFECT OF AN OBLIGATION TO REPAY . . . . . . 29
§ 3.01 LOANS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
§ 3.02 CLAIM OF RIGHT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
§ 3.03 ILLEGAL INCOME . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
§ 3.04 DEPOSITS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
Chapter 4 GAINS DERIVED FROM DEALINGS IN PROPERTY . . 39
§ 4.01 COMPUTING GAIN DERIVED FROM DEALINGS IN PROPERTY . . . 39
§ 4.02 TAX COST BASIS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
§ 4.03 IMPACT OF LIABILITIES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
[A] Impact on Basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
[B] Impact on Amount Realized . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
§ 4.04 BASIS OF PROPERTY ACQUIRED IN TAXABLE EXCHANGES . . . . 46
Chapter 5 GIFTS, BEQUESTS AND INHERITANCE . . . . . . . . . . . . 51
§ 5.01 EXCLUSION OF GIFTS FROM INCOME . . . . . . . . . . . . . . . . . . . . . . 51
[A] The Nature of a Gift . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
[1] Employer-Employee “Gifts” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
[2] Business Gifts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
[B] The Nature of a Bequest or Inheritance . . . . . . . . . . . . . . . . . . . . . . . . 54
[C] Statutory Limitations on the Exclusion — Section 102(b) . . . . . . . . . . . 55
§ 5.02 BASIS OF PROPERTY RECEIVED BY GIFT, BEQUEST OR
INHERITANCE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
[A] Gifts of Appreciated Property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
[B] Gifts of Property — Basis in Excess of Fair Market Value . . . . . . . . . . 59
[C] Basis of Property Received by Bequest or Inheritance . . . . . . . . . . . . . 61
§ 5.03 PART-GIFT, PART-SALE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64
Chapter 6 SALE OF A PRINCIPAL RESIDENCE . . . . . . . . . . . . . . . 67
§ 6.01 OWNERSHIP AND USE REQUIREMENTS . . . . . . . . . . . . . . . . . . . . 67
§ 6.02 AMOUNT EXCLUDABLE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73
§ 6.03 EXCLUSION FOR TAXPAYERS FAILING TO
MEET CERTAIN REQUIREMENTS . . . . . . . . . . . . . . . . . . . . . . . . . . 75
§ 6.04 LIMITATION ON EXCLUSION FOR DEPRECIATION CLAIMED . . . 78
§ 6.05 PRINCIPAL RESIDENCE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79
§ 6.06 CONCLUSION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81
Chapter 7 SCHOLARSHIPS AND PRIZES . . . . . . . . . . . . . . . . . . . . 83
§ 7.01 PRIZES AND AWARDS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83
[A] Prizes and Awards Generally Taxable . . . . . . . . . . . . . . . . . . . . . . . . . 84
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[B] Employee Achievement Awards Exempt . . . . . . . . . . . . . . . . . . . . . . 84
§ 7.02 QUALIFIED SCHOLARSHIPS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87
[A] Limitation of Exclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87
[B] Scholarships as Compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88
[C] Tuition Reduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89
[D] Educational Assistance Programs . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90
[E] Gifts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91
Chapter 8 LIFE INSURANCE, ANNUITIES, AND INDIVIDUAL
RETIREMENT ACCOUNTS . . . . . . . . . . . . . . . . . . . . . . 93
§ 8.01 LIFE INSURANCE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93
[A] Exclusion of Mortality Gains . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93
[B] Death of the Insured . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96
[C] Accelerated Death Benefit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96
[D] Surrender for Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97
[E] Interest Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98
[F] Transfer for Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99
[G] Group-term Life Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
§ 8.02 ANNUITIES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101
§ 8.03 INDIVIDUAL RETIREMENT ACCOUNTS . . . . . . . . . . . . . . . . . . . . 104
[A] Deductible IRAs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105
[B] Nondeductible IRAs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106
[C] Roth IRAs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106
Chapter 9 DISCHARGE OF INDEBTEDNESS . . . . . . . . . . . . . . . . 109
§ 9.01 HISTORICAL BACKGROUND . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109
§ 9.02 SPECIFIC RULES GOVERNING EXCLUSION . . . . . . . . . . . . . . . . . 111
[A] Discharge of Indebtedness When Taxpayer Is Insolvent . . . . . . . . . . . 111
[1] Case Law Pre-1980 Bankruptcy Tax Act . . . . . . . . . . . . . . . . . . . . 111
[2] The Insolvency Exclusion Under Section 108 . . . . . . . . . . . . . . . . . 112
[B] Discharge of Qualified Real Property Business Indebtedness . . . . . . . . 115
[C] Discharge of Indebtedness on Principal Residence Before
January 2017 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116
[D] Purchase-Money Debt Reduction for Solvent Debtors . . . . . . . . . . . . 117
[E] Acquisition of Indebtedness by Person Related to Debtor . . . . . . . . . . 119
[F] Discharge of Deductible Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119
[G] Discharge of Certain Student Loans . . . . . . . . . . . . . . . . . . . . . . . . . 120
§ 9.03 DISPUTED OR CONTESTED DEBTS . . . . . . . . . . . . . . . . . . . . . . . . 121
§ 9.04 DISCHARGE OF INDEBTEDNESS AS GIFT,
COMPENSATION, ETC. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123
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§ 9.05 INAPPLICABILITY OF SECTION 108 TO GAIN REALIZED
ON TRANSACTIONS INVOLVING DISCHARGE
OF INDEBTEDNESS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124
Chapter 10 COMPENSATION FOR PERSONAL PHYSICAL
INJURY AND PHYSICAL SICKNESS . . . . . . . . . . . . . . 125
§ 10.01 INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125
§ 10.02 DAMAGES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126
[A] Business or Property Damages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126
[B] Exclusion for Damages Received on Account of Personal
Physical Injuries or Physical Sickness . . . . . . . . . . . . . . . . . . . . . . . . 127
[C] Supreme Court Limitations on Section 104(a)(2) . . . . . . . . . . . . . . . . 130
[1] What is a “Personal Injury”? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130
[2] When are Damages Received “On Account Of” a Personal Injury? . . 130
[D] Restricting the Exclusion to Physical Injury or Physical Sickness . . . . 132
[1] Distinction Between Physical and Non-Physical Injuries . . . . . . . . . 132
[2] Personal Physical Injury or Physical Sickness . . . . . . . . . . . . . . . . . 134
[3] Emotional Distress . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135
[4] Recoveries by Individuals Other than Individuals Suffering
Personal Physical Injury or Physical Sickness . . . . . . . . . . . . . . . . . 137
[E] The Current Regulations and the Definition of “Damages” . . . . . . . . . 138
[F] Punitive Damages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139
[G] Allocation of Awards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140
[H] Periodic Payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141
§ 10.03 PAYMENT UNDER ACCIDENT AND HEALTH
INSURANCE POLICIES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142
§ 10.04 PREVIOUSLY DEDUCTED MEDICAL EXPENSES . . . . . . . . . . . . . 145
§ 10.05 WORKERS’ COMPENSATION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146
§ 10.06 CERTAIN DISABILITY PENSIONS . . . . . . . . . . . . . . . . . . . . . . . . . 146
Chapter 11 FRINGE BENEFITS . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147
§ 11.01 MEALS AND LODGING . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147
[A] The Treatment of Meals and Lodging Prior to 1954 . . . . . . . . . . . . . . 147
[B] Section 119 — Meals or Lodging Furnished for the
Convenience of the Employer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148
§ 11.02 FRINGE BENEFITS AND SECTION 132 . . . . . . . . . . . . . . . . . . . . . . 151
[A] No-Additional-Cost Service . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151
[B] Qualified Employee Discount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155
[C] Working Condition Fringe . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158
[D] De Minimis Fringe Benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159
[E] Qualified Transportation Fringe . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160
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[F] On-Premises Gyms and Other Athletic Facilities . . . . . . . . . . . . . . . . 161
§ 11.03 VALUATION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162
Chapter 12 BUSINESS AND PROFIT SEEKING EXPENSES . . . . . . 163
§ 12.01 BUSINESS DEDUCTIONS — SECTION 162 . . . . . . . . . . . . . . . . . . . 163
[A] The Expense Must be “Ordinary and Necessary” . . . . . . . . . . . . . . . . 164
[1] Is the Expense “Ordinary”? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164
[2] Is the Expense “Necessary”? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168
[3] “Reasonable” Salaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 170
[4] Clothing Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174
[5] Public Policy Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175
[6] Lobbying Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176
[B] “Carrying On a Trade or Business” . . . . . . . . . . . . . . . . . . . . . . . . . . 177
[1] What Constitutes a “Trade or Business”? . . . . . . . . . . . . . . . . . . . . 177
[2] The “Carrying On” Requirement . . . . . . . . . . . . . . . . . . . . . . . . . . 178
[3] Section 195 and the Amortization of Certain Pre-Operational
or Start-Up Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180
[4] Application of the “Carrying On” Requirement to Employees . . . . . 182
§ 12.02 SECTION 212 DEDUCTIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185
Chapter 13 CAPITAL EXPENDITURES . . . . . . . . . . . . . . . . . . . . . . 187
§ 13.01 DEDUCTIBLE EXPENSE OR CAPITAL EXPENDITURE? . . . . . . . . 187
§ 13.02 DEFINING CAPITAL EXPENDITURES — INDOPCO . . . . . . . . . . . 188
§ 13.03 ADMINISTRATIVE GUIDANCE: THE CAPITAL
EXPENDITURES REGULATIONS . . . . . . . . . . . . . . . . . . . . . . . . . . 191
[A] Amounts Paid to Acquire or Produce Tangible Property . . . . . . . . . . . 192
[B] Amounts Paid to Improve Tangible Property . . . . . . . . . . . . . . . . . . . 194
[1] Improvements: Historic Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194
[2] Improvements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 198
[3] Amounts Paid to Acquire or Create Intangibles . . . . . . . . . . . . . . . . 203
[4] Amounts Paid with Regard to the Sale, Removal, or
Retirement of an Asset . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 205
§ 13.04 MISCELLANEOUS ITEMS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 206
[A] Expansion Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 206
[B] Business Downsizing Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 207
[C] Employee Training Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 208
[D] Advertising Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 208
§ 13.05 PURCHASE OR LEASE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209
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Chapter 14 DEPRECIATION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 211
§ 14.01 DEPRECIATION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 211
[A] Depreciable Property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 211
[B] Recovery Period — The Useful Life Concept . . . . . . . . . . . . . . . . . . 214
[1] Historical Development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 214
[2] Current Recovery Periods — Modified Accelerated Cost
Recovery System (MACRS) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 215
[C] Depreciation Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 217
[D] Conventions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 219
§ 14.02 COMPUTING THE DEPRECIATION DEDUCTION . . . . . . . . . . . . . . 221
§ 14.03 ADDITIONAL FIRST YEAR DEPRECIATION . . . . . . . . . . . . . . . . . 224
§ 14.04 AMORTIZATION OF INTANGIBLES — SECTION 197 . . . . . . . . . . 225
§ 14.05 RELATIONSHIP BETWEEN BASIS AND DEPRECIATION . . . . . . . 225
§ 14.06 SECTION 179 — EXPENSING TANGIBLE PERSONAL PROPERTY . 226
§ 14.07 THE RELATIONSHIP OF DEBT TO DEPRECIATION . . . . . . . . . . . . 229
Excerpt From REVENUE PROCEDURE 87–56 . . . . . . . . . . . . . . . . 230
Excerpt From REVENUE PROCEDURE 87-57 . . . . . . . . . . . . . . . . 232
Chapter 15 LOSSES AND BAD DEBTS . . . . . . . . . . . . . . . . . . . . . . . 235
§ 15.01 LOSSES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 235
[A] The Business or Profit Requirement for Individuals . . . . . . . . . . . . . . 236
[1] Personal Losses Not Deductible . . . . . . . . . . . . . . . . . . . . . . . . . . 236
[2] Conversion of Personal Use Property to Income
Producing Property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 238
[B] When Is a Loss Sustained? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 239
[1] Worthless Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 240
[2] Theft Losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241
[C] Amount of the Deduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241
[1] Reimbursement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242
[2] Post-Conversion Losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242
[D] Disallowed Losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 243
§ 15.02 BAD DEBTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 243
[A] Bona Fide Debt Requirement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 244
[B] Worthlessness . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 244
[C] Business or Nonbusiness Debts . . . . . . . . . . . . . . . . . . . . . . . . . . . . 244
[D] Amount Deductible . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 247
[E] Guarantees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 248
§ 15.03 BAD DEBTS AND LOSSES: THE INTERPLAY
BETWEEN SECTIONS 166 AND 165 . . . . . . . . . . . . . . . . . . . . . . . . 248
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Chapter 16 TRAVEL EXPENSES . . . . . . . . . . . . . . . . . . . . . . . . . . . 249
§ 16.01 COMMUTING . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 249
§ 16.02 OTHER TRANSPORTATION EXPENSES . . . . . . . . . . . . . . . . . . . . . 253
§ 16.03 EXPENSES FOR MEALS AND LODGING WHILE
IN TRAVEL STATUS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 254
§ 16.04 WHERE IS THE TAXPAYER’S “HOME” FOR
SECTION 162(a)(2) PURPOSES? . . . . . . . . . . . . . . . . . . . . . . . . . . . . 256
§ 16.05 OTHER CONSIDERATIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 260
[A] Travel Expenses of Spouse . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 260
[B] Reimbursed Employee Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . 261
[C] Business-Related Meals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 262
[D] Limitations on Foreign Travel . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 263
[E] Relationship to Section 212 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 263
[F] Substantiation Requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 264
Chapter 17 ENTERTAINMENT AND BUSINESS MEALS . . . . . . . . 265
§ 17.01 BUSINESS OR PLEASURE? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 266
[A] Historical Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 266
[B] Percentage Cutback for Meal and Entertainment Expenses . . . . . . . . . 267
[C] Business Meals and Entertainment Ticket Limitations . . . . . . . . . . . . 269
§ 17.02 ENTERTAINMENT ACTIVITIES . . . . . . . . . . . . . . . . . . . . . . . . . . . 270
[A] “Directly Related” Entertainment . . . . . . . . . . . . . . . . . . . . . . . . . . . 270
[B] “Associated with” Entertainment . . . . . . . . . . . . . . . . . . . . . . . . . . . 271
§ 17.03 ENTERTAINMENT FACILITIES . . . . . . . . . . . . . . . . . . . . . . . . . . . 272
§ 17.04 SUBSTANTIATION REQUIREMENTS . . . . . . . . . . . . . . . . . . . . . . . 274
§ 17.05 EXCEPTIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 275
§ 17.06 BUSINESS MEALS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 276
Chapter 18 EDUCATIONAL EXPENSES . . . . . . . . . . . . . . . . . . . . . 281
§ 18.01 CATEGORIZATION OF EDUCATIONAL EXPENSES . . . . . . . . . . . 281
§ 18.02 THE SKILL-MAINTENANCE OR
EMPLOYER-REQUIREMENT TESTS . . . . . . . . . . . . . . . . . . . . . . . . 282
§ 18.03 THE MINIMUM EDUCATIONAL REQUIREMENTS
AND NEW TRADE OR BUSINESS TESTS . . . . . . . . . . . . . . . . . . . . 284
§ 18.04 TRAVEL EXPENSES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288
§ 18.05 EDUCATION TAX INCENTIVES . . . . . . . . . . . . . . . . . . . . . . . . . . . 289
[A] Education Credits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 289
[B] Education Deductions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 291
[C] Education Exclusions from Income . . . . . . . . . . . . . . . . . . . . . . . . . . 291
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Chapter 19 OTHER DEDUCTIBLE PERSONAL EXPENSES . . . . . . 295
§ 19.01 MOVING EXPENSES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 295
§ 19.02 CHILD CARE EXPENSES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300
§ 19.03 LEGAL EXPENSES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 302
Chapter 20 HOBBY LOSSES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 305
§ 20.01 HISTORICAL DEVELOPMENT . . . . . . . . . . . . . . . . . . . . . . . . . . . . 305
§ 20.02 SECTION 183 ACTIVITIES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306
§ 20.03 DEDUCTIONS ALLOWABLE UNDER SECTION 183 . . . . . . . . . . . . 311
Chapter 21 HOME OFFICES, VACATION HOMES AND
OTHER DUAL USE PROPERTY . . . . . . . . . . . . . . . . . . 313
§ 21.01 HOME OFFICE DEDUCTIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 313
[A] General Background — Bodzin v. Commissioner . . . . . . . . . . . . . . . 315
[B] Enactment of Section 280A . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 317
[C] Principal Place of Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 318
[D] Convenience of Employer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 319
[E] Limitation on Amount of Deduction . . . . . . . . . . . . . . . . . . . . . . . . . 320
§ 21.02 VACATION HOME DEDUCTIONS . . . . . . . . . . . . . . . . . . . . . . . . . . 322
§ 21.03 OTHER DUAL USE PROPERTY . . . . . . . . . . . . . . . . . . . . . . . . . . . . 326
[A] Computers and Other “Listed Property” . . . . . . . . . . . . . . . . . . . . . . 326
[B] Passenger Automobiles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 329
§ 21.04 CONCLUSION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 331
Chapter 22 THE INTEREST DEDUCTION . . . . . . . . . . . . . . . . . . . . 333
§ 22.01 WHAT CONSTITUTES INTEREST? . . . . . . . . . . . . . . . . . . . . . . . . . 333
§ 22.02 DEDUCTION OF PERSONAL INTEREST . . . . . . . . . . . . . . . . . . . . . 334
[A] Qualified Residence Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 337
[B] Interest on Education Loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 341
§ 22.03 INVESTMENT INTEREST . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 342
§ 22.04 TIMING ISSUES AND LIMITATIONS . . . . . . . . . . . . . . . . . . . . . . . 345
[A] Allocation of Prepaid Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 345
[B] Capitalization of Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 347
[C] Payment Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 347
Chapter 23 THE DEDUCTION FOR TAXES . . . . . . . . . . . . . . . . . . 351
§ 23.01 HISTORICAL BACKGROUND . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 351
§ 23.02 TAXES DEDUCTIBLE UNDER SECTION 164 . . . . . . . . . . . . . . . . . 351
§ 23.03 PARTY ELIGIBLE TO CLAIM THE DEDUCTION . . . . . . . . . . . . . . 353
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§ 23.04 SPECIAL PROBLEMS ASSOCIATED WITH THE DEDUCTION OF
REAL PROPERTY TAXES AND ASSESSMENTS . . . . . . . . . . . . . . . 354
[A] Real Property Assessments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 354
[B] Apportionment of Real Property Taxes Between Buyer and Seller . . . . 355
§ 23.05 PUBLIC POLICY CONSIDERATIONS . . . . . . . . . . . . . . . . . . . . . . . 358
Chapter 24 CASUALTY LOSSES . . . . . . . . . . . . . . . . . . . . . . . . . . . 361
§ 24.01 DEFINITIONAL QUESTIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 362
[A] Casualty Losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 362
[B] Theft Losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 366
§ 24.02 TIMING OF THE LOSS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 367
§ 24.03 AMOUNT OF THE LOSS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 367
§ 24.04 INSURANCE COVERAGE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 370
Chapter 25 MEDICAL EXPENSES . . . . . . . . . . . . . . . . . . . . . . . . . . 371
§ 25.01 DEDUCTIBILITY OF MEDICAL EXPENSES . . . . . . . . . . . . . . . . . . 372
[A] Medicine and Drugs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 372
[B] Counseling Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 373
[C] Capital Expenditures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 374
[D] Meals and Lodging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 376
[E] Illegal Operations or Treatment . . . . . . . . . . . . . . . . . . . . . . . . . . . . 376
[F] Qualified Long-Term Care . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 377
[G] Transportation Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 377
§ 25.02 MEDICAL vs. PERSONAL EXPENSES . . . . . . . . . . . . . . . . . . . . . . . 378
Chapter 26 CHARITABLE DEDUCTIONS . . . . . . . . . . . . . . . . . . . . 381
§ 26.01 IN GENERAL . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 381
§ 26.02 REQUIREMENTS FOR CHARITABLE DEDUCTIONS . . . . . . . . . . . 381
[A] Who Is a Qualified Recipient? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 382
[B] What Is a “Contribution” or “Gift”? . . . . . . . . . . . . . . . . . . . . . . . . . 385
[C] Actual Payment Required . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 389
[D] Limitation on Charitable Deductions . . . . . . . . . . . . . . . . . . . . . . . . . 389
§ 26.03 CONTRIBUTION OF SERVICES . . . . . . . . . . . . . . . . . . . . . . . . . . . 392
§ 26.04 CONTRIBUTION OF APPRECIATED PROPERTY . . . . . . . . . . . . . . 392
§ 26.05 CONTRIBUTIONS OF PARTIAL INTERESTS IN PROPERTY . . . . . . 396
§ 26.06 BARGAIN SALE TO CHARITY . . . . . . . . . . . . . . . . . . . . . . . . . . . . 399
§ 26.07 SUBSTANTIATION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400
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Chapter 27 LIMITATIONS ON DEDUCTIONS . . . . . . . . . . . . . . . . 403
§ 27.01 SECTION 267: LOSSES BETWEEN RELATED PARTIES . . . . . . . . . 403
[A] Section 267(a)(1) Loss Rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 403
[B] The Section 267(a)(2) Matching Requirement . . . . . . . . . . . . . . . . . . 407
[C] Other Matching Rules — Section 404(a)(5) and Section 83 . . . . . . . . . 408
§ 27.02 SECTION 265: EXPENSES RELATED TO TAX-EXEMPT INCOME . 410
[A] Section 265(a)(1) General Rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . 410
[B] Section 265(a)(2): Tax-Exempt Interest . . . . . . . . . . . . . . . . . . . . . . . 412
[C] Allocation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 414
§ 27.03 SECTION 1091: WASH SALES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 414
§ 27.04 JUDICIAL LIMITATIONS ON INTEREST DEDUCTIONS . . . . . . . . . 416
Chapter 28 CASH METHOD ACCOUNTING . . . . . . . . . . . . . . . . . . 421
§ 28.01 INCOME UNDER THE CASH METHOD . . . . . . . . . . . . . . . . . . . . . . 421
[A] In General . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 421
[B] Constructive Receipt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 422
[1] Specific Factors Affecting Application of Constructive Receipt
Doctrine . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 423
[a] Distance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 423
[b] Knowledge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 425
[c] Contractual Arrangements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 425
[d] Forfeitures or Other Penalties . . . . . . . . . . . . . . . . . . . . . . . . . . 425
[e] Relationship of the Taxpayer to the Payor . . . . . . . . . . . . . . . . . . 426
[2] Specific Exceptions to Constructive Receipt Rules . . . . . . . . . . . . . 427
[C] Cash Equivalency Doctrine . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 428
[D] Economic Benefit Doctrine . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 431
[E] Non-Qualified Deferred Compensation Arrangements . . . . . . . . . . . . 434
[F] Section 409A and Revenue Ruling 60-31 . . . . . . . . . . . . . . . . . . . . . 436
[G] Lottery Prizes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 437
[H] Prepayments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 438
§ 28.02 DEDUCTIONS UNDER THE CASH METHOD . . . . . . . . . . . . . . . . . 438
[A] In General . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 438
[B] Cash Method Prepayments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 441
Chapter 29 ACCRUAL METHOD ACCOUNTING . . . . . . . . . . . . . . 445
§ 29.01 THE ALL EVENTS TEST . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 445
§ 29.02 ACCRUAL OF INCOME . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 446
[A] General Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 446
[B] Income Prior to Receipt: Accrual Issues . . . . . . . . . . . . . . . . . . . . . . 447
[C] Receipt Prior to Earning: Prepayments . . . . . . . . . . . . . . . . . . . . . . . 450
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§ 29.03 DEDUCTIONS UNDER THE ACCRUAL METHOD . . . . . . . . . . . . . 454
[A] General Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 454
[B] Premature Accruals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 456
[C] The Economic Performance Test: Section 461(h) . . . . . . . . . . . . . . . . 457
[D] The Recurring Item Exception and the 3½ Month Exception
to the Economic Performance Test . . . . . . . . . . . . . . . . . . . . . . . . . . 460
[E] Safe Harbor Method of Accounting for Ratable Service Contracts . . . . 462
[F] Capitalization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 464
[G] Contested Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 464
§ 29.04 CHOICE OF ACCOUNTING METHODS . . . . . . . . . . . . . . . . . . . . . . 466
Chapter 30 ANNUAL ACCOUNTING . . . . . . . . . . . . . . . . . . . . . . . . 469
§ 30.01 RESTORING AMOUNTS RECEIVED UNDER
A CLAIM OF RIGHT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 469
[A] Appearance of a Right . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 472
[B] No Unrestricted Right . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 473
§ 30.02 THE TAX BENEFIT RULE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 474
[A] The “Fundamental Inconsistency” Test . . . . . . . . . . . . . . . . . . . . . . . 477
[B] Erroneous Original Deduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 478
§ 30.03 NET OPERATING LOSSES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 479
Chapter 31 CAPITAL GAINS AND LOSSES . . . . . . . . . . . . . . . . . . . 483
§ 31.01 HISTORICAL OVERVIEW . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 483
[A] Preferential Treatment for Long-Term Capital Gain . . . . . . . . . . . . . . 484
[B] Limitation on the Deduction of Capital Losses . . . . . . . . . . . . . . . . . . 487
[C] Justification for Preferential Capital Gain Treatment . . . . . . . . . . . . . . 488
§ 31.02 CURRENT LAW: SECTION 1(h) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 489
[A] Maximum Rates on Long-term Capital Gain under the Current Law . . 489
[B] The Components of Net Capital Gain: 28-Percent Rate Gain;
Unrecaptured Section 1250 Gain; and Adjusted Net Capital Gain . . . . 491
[1] 28-Percent Rate Gain: Collectibles Gain and Section 1202 Gain . . . . 492
[2] Unrecaptured Section 1250 Gain — 25% Rate . . . . . . . . . . . . . . . . 493
[3] Adjusted Net Capital Gain: 20%, 15% and 0% Rates . . . . . . . . . . . . 493
[4] Adjusted Net Capital Gain: Qualified Dividend Income . . . . . . . . . . 495
[C] Attribution of Capital Losses Included in the Computation of
Net Capital Gain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 497
§ 31.03 THE SECTION 1211(b) LIMITATION ON THE
DEDUCTION OF CAPITAL LOSSES . . . . . . . . . . . . . . . . . . . . . . . . 499
§ 31.04 DEFINITION OF CAPITAL ASSET . . . . . . . . . . . . . . . . . . . . . . . . . . 503
[A] Section 1221(a)(1): Inventory, Stock in Trade and Property Held
Primarily for Sale to Customers in the Ordinary Course of the
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Taxpayer’s Trade or Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 505
[B] Section 1221(a)(2): Property Used in the Taxpayer’s
Trade or Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 507
[C] Section 1221(a)(3): Copyrights, Literary, Musical, or
Artistic Compositions, Etc. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 507
[D] Section 1221(a)(4): Accounts Receivable for Services Rendered or
Inventory-Type Assets Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 508
[E] Section 1221(a)(5): Certain Publications of the U.S. Government . . . . 508
[F] Section 1221(a)(8): Supplies Used or Consumed in the
Taxpayer’s Trade or Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 509
[G] Judicially Established Limits on Capital Asset Definition . . . . . . . . . . 509
§ 31.05 THE SALE OR EXCHANGE REQUIREMENT . . . . . . . . . . . . . . . . . . 513
§ 31.06 THE ARROWSMITH RULE: CHARACTERIZATION OF CERTAIN
GAINS OR LOSSES DEPENDENT ON PRIOR TAX TREATMENT
OF RELATED GAINS OR LOSSES . . . . . . . . . . . . . . . . . . . . . . . . . . 515
§ 31.07 HOLDING PERIOD . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 516
Chapter 32 QUASI-CAPITAL ASSETS: SECTION 1231 . . . . . . . . . . 519
§ 32.01 IDENTIFYING SECTION 1231 GAINS AND LOSSES . . . . . . . . . . . . 519
§ 32.02 THE HOTCHPOT ANALYSIS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 523
§ 32.03 RECAPTURE OF NET ORDINARY LOSSES: SECTION 1231(c) . . . . 526
Chapter 33 DEPRECIATION RECAPTURE . . . . . . . . . . . . . . . . . . . 529
§ 33.01 SECTION 1245 RECAPTURE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 530
§ 33.02 SECTION 179 RECAPTURE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 534
§ 33.03 SECTION 1250 RECAPTURE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 535
§ 33.04 UNRECAPTURED SECTION 1250 GAIN . . . . . . . . . . . . . . . . . . . . . 537
§ 33.05 SECTION 1239 ORDINARY INCOME . . . . . . . . . . . . . . . . . . . . . . . 539
§ 33.06 OTHER RECAPTURE PROVISIONS . . . . . . . . . . . . . . . . . . . . . . . . . 541
Chapter 34 ASSIGNMENT OF INCOME . . . . . . . . . . . . . . . . . . . . . 543
§ 34.01 THE PROGRESSIVE RATE STRUCTURE . . . . . . . . . . . . . . . . . . . . 543
§ 34.02 DEVELOPMENT OF RULES LIMITING INCOME-SHIFTING . . . . . . 544
§ 34.03 COMMUNITY PROPERTY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 546
§ 34.04 APPLICATION OF THE ASSIGNMENT OF INCOME RULES . . . . . . 547
§ 34.05 THE KIDDIE TAX . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 551
Chapter 35 BELOW-MARKET LOANS . . . . . . . . . . . . . . . . . . . . . . 559
§ 35.01 HISTORY: PRE-SECTION 7872 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 559
[A] Early IRS Attempts at Taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . . 559
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[B] Gift Tax Consequences of Interest-Free Loans . . . . . . . . . . . . . . . . . . 561
[C] Post Dean/Johnson History . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 561
§ 35.02 RATIONALE FOR SECTION 7872 . . . . . . . . . . . . . . . . . . . . . . . . . . 563
§ 35.03 OPERATION OF SECTION 7872 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 564
[A] Treatment of Term Loans Other Than Term Gift Loans . . . . . . . . . . . 566
[B] Demand Loans and Term Gift Loans . . . . . . . . . . . . . . . . . . . . . . . . 568
[C] Exceptions to the Basic Operating Rules . . . . . . . . . . . . . . . . . . . . . . 570
Chapter 36 TAX CONSEQUENCES OF DIVORCE . . . . . . . . . . . . . 573
§ 36.01 ALIMONY: GENERAL REQUIREMENTS . . . . . . . . . . . . . . . . . . . . 573
§ 36.02 CHILD SUPPORT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 578
§ 36.03 EXCESS FRONT-LOADING . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 581
§ 36.04 ALIMONY TRUSTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 586
§ 36.05 DEPENDENCY EXEMPTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 586
§ 36.06 FILING STATUS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 591
§ 36.07 PROPERTY TRANSFERS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 592
§ 36.08 SPECIAL RULES REGARDING PERSONAL RESIDENCE —
SECTION 121 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 597
§ 36.09 LEGAL EXPENSES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 599
Chapter 37 EFFECT OF DEBT ON BASIS AND
AMOUNT REALIZED . . . . . . . . . . . . . . . . . . . . . . . . . . 601
§ 37.01 CRANE v. COMMISSIONER . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 601
§ 37.02 COMMISSIONER v. TUFTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 602
§ 37.03 NONRECOURSE BORROWING AND THE SECTION 108
INSOLVENCY EXCLUSION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 606
§ 37.04 NONRECOURSE BORROWING AND APPRECIATED PROPERTY . 608
§ 37.05 IMPACT OF CONTINGENT LIABILITIES . . . . . . . . . . . . . . . . . . . . 610
Chapter 38 LIKE-KIND EXCHANGES . . . . . . . . . . . . . . . . . . . . . . . 613
§ 38.01 CONTINUITY OF INTEREST . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 614
§ 38.02 THE LIKE-KIND REQUIREMENT . . . . . . . . . . . . . . . . . . . . . . . . . . 615
§ 38.03 THE HOLDING REQUIREMENTS . . . . . . . . . . . . . . . . . . . . . . . . . . 618
§ 38.04 “SOLELY” FOR LIKE KIND PROPERTY: THE PRESENCE
OF “BOOT” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 622
§ 38.05 TREATMENT OF LIABILITIES . . . . . . . . . . . . . . . . . . . . . . . . . . . . 623
§ 38.06 BASIS CALCULATIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 624
§ 38.07 THE RELATIONSHIP BETWEEN § 267(a)(1) AND § 1031 . . . . . . . . 630
§ 38.08 SALE OR EXCHANGE? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 630
§ 38.09 THREE-WAY EXCHANGES AND DEFERRED EXCHANGES . . . . . 632
§ 38.10 REVERSE STARKER EXCHANGES . . . . . . . . . . . . . . . . . . . . . . . . . 635
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§ 38.11 EXCHANGES QUALIFYING FOR BOTH § 121 AND § 1031 . . . . . . . 636
§ 38.12 SECTION 121(d)(10) — PROPERTY ACQUIRED IN A
LIKE-KIND EXCHANGE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 638
Chapter 39 INVOLUNTARY CONVERSIONS . . . . . . . . . . . . . . . . . 641
§ 39.01 GENERAL POLICY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 641
§ 39.02 THE MANDATORY AND ELECTIVE RULES OF SECTION 1033 . . . 642
§ 39.03 INVOLUNTARY CONVERSION EVENTS . . . . . . . . . . . . . . . . . . . . 643
§ 39.04 SIMILAR OR RELATED IN SERVICE OR USE . . . . . . . . . . . . . . . . . 644
[A] Special Rule for Condemnation of Real Property Used
for Business or Investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 647
[B] Federally Declared Disasters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 650
§ 39.05 TIME FOR REPLACEMENT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 653
§ 39.06 PARTIAL RECOGNITION OF GAIN UNDER SECTION 1033 . . . . . . 654
§ 39.07 BASIS OF REPLACEMENT PROPERTY . . . . . . . . . . . . . . . . . . . . . . 654
§ 39.08 HOLDING PERIOD OF REPLACEMENT PROPERTY . . . . . . . . . . . . 656
§ 39.09 INVOLUNTARY CONVERSION OF PRINCIPAL RESIDENCE . . . . . 656
Chapter 40 INSTALLMENT SALES . . . . . . . . . . . . . . . . . . . . . . . . . 659
§ 40.01 STATUTORY FRAMEWORK . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 659
§ 40.02 PAYMENTS AND LIABILITIES . . . . . . . . . . . . . . . . . . . . . . . . . . . . 661
§ 40.03 RECAPTURE INCOME . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 664
§ 40.04 ELECTING OUT OF THE INSTALLMENT METHOD . . . . . . . . . . . . 665
§ 40.05 EXCLUSIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 665
§ 40.06 CONTINGENT PAYMENT SALES . . . . . . . . . . . . . . . . . . . . . . . . . . 666
§ 40.07 DISPOSITIONS OF INSTALLMENT OBLIGATIONS . . . . . . . . . . . . 668
§ 40.08 SECOND DISPOSITIONS BY RELATED PERSONS . . . . . . . . . . . . . 670
§ 40.09 SALES OF DEPRECIABLE PROPERTY TO RELATED PERSONS . . 674
§ 40.10 SPECIAL RULES FOR NONDEALERS . . . . . . . . . . . . . . . . . . . . . . . 674
§ 40.11 INSTALLMENT OBLIGATIONS AND LIKE-KIND EXCHANGES . . 676
Chapter 41 SALE OF A BUSINESS AND SALE-LEASEBACKS . . . . 679
§ 41.01 SALE OF A SOLE PROPRIETORSHIP . . . . . . . . . . . . . . . . . . . . . . . 679
[A] The Standard of Williams v. McGowan . . . . . . . . . . . . . . . . . . . . . . 679
[B] Goodwill, Going Concern Value and Covenants Not to Compete . . . . . 680
[1] Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 680
[2] Going Concern Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 681
[3] Covenant Not to Compete . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 681
[C] Tax Consequences of Allocation of Purchase Price . . . . . . . . . . . . . . 682
[1] Historic Allocation Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . 682
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[2] Section 197 — Amortization of Business Intangibles . . . . . . . . . . . 683
§ 41.02 VALUING GOODWILL, GOING CONCERN VALUE,
AND COVENANTS NOT TO COMPETE . . . . . . . . . . . . . . . . . . . . . . 687
§ 41.03 SALE-LEASEBACK . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 692
[A] Sale-Leaseback Characterized as Financing Arrangement . . . . . . . . . . 693
[B] Sale-Leaseback Characterized as a Tax-Free Exchange . . . . . . . . . . . . 694
Chapter 42 AN INTRODUCTION TO ORIGINAL
ISSUE DISCOUNT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 697
§ 42.01 ORIGINAL ISSUE DISCOUNT: INTRODUCTION . . . . . . . . . . . . . . 697
§ 42.02 OID: DEBT INSTRUMENTS ISSUED FOR CASH . . . . . . . . . . . . . . . 700
[A] Determining the Amount of OID . . . . . . . . . . . . . . . . . . . . . . . . . . . 703
[B] Current Inclusion of OID . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 704
[C] Deduction of OID . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 706
[D] Gain or Loss on Sale, Exchange or Retirement . . . . . . . . . . . . . . . . . . 706
[E] Market Discount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 708
§ 42.03 SALES AND EXCHANGES OF PROPERTY AND
SECTION 467 RENTAL AGREEMENTS . . . . . . . . . . . . . . . . . . . . . . 708
Chapter 43 LIMITATIONS ON TAX SHELTERS . . . . . . . . . . . . . . . 711
§ 43.01 THE AT RISK RULES — SECTION 465 . . . . . . . . . . . . . . . . . . . . . . 711
[A] General Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 711
[B] Operation of the at Risk Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 712
[1] Activities Subject to the at Risk Rules . . . . . . . . . . . . . . . . . . . . . . 714
[2] Determination of the Initial Amount at Risk . . . . . . . . . . . . . . . . . . 714
[3] Qualified Nonrecourse Financing . . . . . . . . . . . . . . . . . . . . . . . . . 715
[4] Adjustments to the Amount at Risk . . . . . . . . . . . . . . . . . . . . . . . . 715
§ 43.02 SECTION 469 — LIMITATION ON PASSIVE ACTIVITY
LOSSES AND CREDITS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 718
[A] Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 718
[B] Section 469 — In General . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 720
[C] Passive Activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 721
[1] Material Participation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 722
[2] Rental Activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 723
[D] Scope of Passive Activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 724
[E] Treatment of Losses and Credits . . . . . . . . . . . . . . . . . . . . . . . . . . . . 725
[F] Portfolio Income and Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . 726
[G] Exception for Active Participation in Rental Real Estate . . . . . . . . . . . 727
[H] Disposition of Taxpayer’s Entire Interest in Passive Activity . . . . . . . . 728
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Chapter 44 THE ALTERNATIVE MINIMUM TAX . . . . . . . . . . . . . 731
§ 44.01 MECHANICS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 731
§ 44.02 DETERMINING ALTERNATIVE MINIMUM TAXABLE INCOME . . 735
[A] Section 56 and 58 Adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . . . 737
[1] Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 737
[2] Limitation on Itemized Deductions, Standard Deductions
and Personal Exemptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 737
[B] Section 57 Preferences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 739
§ 44.03 DETERMINING TAX LIABILITY . . . . . . . . . . . . . . . . . . . . . . . . . . . 740
§ 44.04 CREDITS ALLOWED . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 741
Appendix A NOTE ON MISCELLANEOUS EXCLUSIONS . . . . . . . . 743
Appendix B ADDITIONAL ACCOUNTING CONSIDERATIONS . . . 749
TABLE OF CASES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . TC-1
TABLE OF STATUTES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . TS-1
TABLE OF AGENCY DECISIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . TA-1
INDEX . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . I-1
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