Federal Income Tax: A QuickStudy Laminated Law Reference [3 ed.] 9781423240044, 1423240049

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ADMINISTRATION

Including all statutory changes made by Pub. L. No. 115-97 (2017 tax act); Pub. L. No. 115-123 (Bipartisan Budget Act of 2018); and Pub. L. No. 115-141 (Consolidated Appropriations Act, 2018)

• INTERNAL REVENUE SERVICE (IRS)

(a) Can order payment or refund (b) Can grant declaratory relief for certain matters, such as tax-exempt status iii. No jury trial iv. Elective small case procedure [§7463] (a) Available for disputes of $50,000 or less (b) Decision not precedent and no appeal v. Judges are based in Washington, DC, but hear cases locally B. U.S. District Court i. Jury trial available ii. Tax paid first; litigate for refund [§7422] C. U.S. Court of Federal Claims i. No jury trial ii. Tax paid first; litigate for refund [§7422] iii. Generally sits in Washington, DC 6. Appellate court litigation A. U.S. Circuit Courts of Appeals i. Appeals from trial courts ii. Federal Circuit takes Court of Federal Claims appeals iii. Circuit Court for taxpayer’s residence takes Tax Court and District Court appeals [§7482] iv. Choice between trial courts influenced by Circuit Court precedents B. U.S. Supreme Court can take appeals from Circuit Courts

1. Agency within Treasury Department responsible for enforcing tax laws A. Tax forms, instructions, publications, and rulings available at www.irs.gov B. Website links to other sources of law

• INTERNAL REVENUE CODE (IRC) 1. Codification of most federal tax laws 2. Title 26 of U.S. Code (U.S.C.)

• ADMINISTRATIVE PRONOUNCEMENTS

1. Treasury Regulations A. Interpret and implement IRC [§7805] i. Issued by Treasury Department; drafted by IRS ii. Regulation numbers include relevant IRC § numbers B. Title 26 of Code of Federal Regulations (CFR) 2. Published Revenue Rulings A. Officially published IRS interpretation of the tax law B. Give facts, IRS view of the tax result, and brief explanation C. Published in weekly Internal Revenue Bulletin D. Precedential value: Not limited to specific taxpayer who sought ruling 3. Private Letter Rulings (PLRs) and Technical Advice Memoranda (TAMs) A. Taxpayer can request a PLR regarding a contemplated transaction, unless the issue is purely factual or is on an IRS “no ruling” list B. During audit, IRS agent can request a TAM on completed transaction C. No precedential value [§6110(k)(3)] D. Ruling effective for the requesting taxpayer only if the facts are accurate

• JUDICIAL DOCTRINES & INTERPRETATION CONVENTIONS

1. Court doctrines may deny tax benefits of tax-motivated transactions 2. Commonly used doctrines: A. Sham transaction: Transaction never took place (sham in fact) or occurred but lacked economic substance (sham in substance) B. Economic substance: Transaction had no economic substance independent of federal tax benefit i. Congress codified that economic substance exists only if transaction changes taxpayer’s economic position and has a substantial nontax purpose [§7701(o)] C. Step transaction: Treat a series of steps as a single integrated transaction when: i. Steps are undertaken to achieve ultimate result (end result test); ii. Steps are so interdependent that an individual step is meaningless without others (interdependence test); or iii. At first step, there was a binding commitment to complete remaining steps (binding commitment test) D. Business purpose: Disregard a transaction if there is no business purpose other than tax benefit and transaction lacks economic substance E. Substance over form: Ignores transaction’s form and looks to its underlying substance 3. Judicial interpretation of IRC, regulations, and rulings A. Look to plain meaning of statute B. May consider legislative intent C. Final regulations issued with notice and comment receive Chevron deference [Mayo Found. for Med. Educ. & Research v. U.S.] D. Proposed regulations treated as litigating position E. Less (or no) deference for rulings

• TAX CONTROVERSY STEPS

1. Different procedures for overpayments and underpayments A. Taxpayer can recover an overpayment by filing a claim or bringing suit in District Court or Court of Federal Claims [see also 28 U.S.C.] B. Taxpayer can dispute a government claim for payment by bringing suit in Tax Court C. Taxpayer may sue for attorneys’ fees if government’s position is unjustified [§7430] 2. Statute of limitations A. Statute of limitations is generally 3 years after return is filed [§6501(a)] B. Statute of limitations is 6 years if taxpayer omits more than 25% of gross income [§6501(e)] i. Overstating basis is an omission for this purpose [§6501(e)(1)] C. Statute of limitations for credit and refund claims can be suspended for mental or physical impairment [§6511(h)] 3. Notice of right to hearing is required before levy [§6330] 4. Administrative appeal to IRS A. Taxpayer is entitled to explanation of process B. Appeals procedures are designed to reduce litigation [§7123] 5. Trial court litigation: Burden of proof may shift to government [§7491] A. U.S. Tax Court i. Taxpayer who gets a 90-day letter can litigate without first paying the disputed tax [§6213] ii. Jurisdiction generally limited to review of deficiencies asserted by IRS

PERSONAL INCOME TAX DEFINITIONS • INCOME

2. Items directly reducing income: No general presumption that anything is deductible; no deduction unless provided by the IRC 3. Allowable expenses and losses subtracted from gross income: A. Deductions for all taxpayers [§§161–199] B. Deductions for individuals [§§211–223] C. Deductions for corporations [§§241–249] D. Items not deductible in whole or part [§§261–280H] E. Individual must choose standard deduction or itemization for many items [§63(a)–(b)] 4. Personal exemptions [§§151–152] A. Deduction for taxpayer, spouse, and dependents [§151(b)–(c)] B. For tax years before 2026, deduction for personal exemptions is 0 [§151(d)(5)(A)]

1. Gross income [§§61, 71–90, 101–140] A. Starting point for computing the tax base B. Income not excluded from taxation C. Income from whatever source derived D. Construed broadly 2. Exclusions [§§71–90, 101–140] A. Items Congress has exempted from taxation B. Construed narrowly 3. Adjusted gross income (AGI) [§62] A. Gross income less deductions listed in §62 B. §62 does not itself make an item deductible 4. Taxable income [§63] A. Gross income less all deductions B. Amount against which tax rates are applied to compute tax

• CREDITS [§§21–53]

1. Direct reductions in tax liability A. Dollar of credit saves dollar in tax, whereas dollar of deduction saves only dollar multiplied by tax rate B. Many credits have dollar limits or phase out as AGI rises; some require basis adjustments

• DEDUCTIONS

1. Most deductions reflect current or prior expenditures of money A. Accrual taxpayers may be able to deduct future outlays 1

Personal Income Tax (continued )

C. Inflation adjustments apply to some credits 2. Many credits are tied to specific outlays: A. Dependent Care Credit [§21]; to facilitate employment; limited to 20%–35% of employment-related dependent care expenses up to $3,000 for 1 dependent and $6,000 for 2 or more dependents B. Adoption Credit [§23] for qualified adoption expenses of up to $13,850 in 2018 subject to income phase out; if adopted child has special needs, $13,850 credit in 2018 regardless of expenses [§23(a)(3)] C. Child Tax Credit [§24] for tax years before 2026 credit of up to $2,000 per qualifying child under 17 (up to $500 non-refundable credit for dependents other than qualifying child); subject to income phase out; maximum refundable credit per child is $1,400 D. Education credits [§25A] i. American Opportunity Tax Credit up to $2,500 in first 4 years of postsecondary education expenses per eligible student; subject to income limits ii. Lifetime Learning Credit of 20% of qualified tuition and related expenses up to $10,000; maximum of $2,000 credit per return; income limits E. Saver’s Credit for contribution to retirement plan or IRA [§25B]; 50%, 20%, or 10% of contributions up to $2,000; limited by AGI F. Earned Income Credit [§32]: Refundable credit; requires earned income from job or taxpayer’s business; subject to AGI phase out and investment income

limits; credit percentage increases with number of children with maximum credit percentage of 45% for 3 or more children G. Residential energy efficient credit [§25D] for expenses for qualified solar electric property expenditures and qualified solar water heating expenditures for property placed in service through 2021, at applicable percentages. H. Business credits to provide incentives for low-income housing, energy investments, rehabilitation expenditures for historic structures, etc. 3. Refundable credit can generate a refund in excess of actual tax 4. Nonrefundable credit can only offset tax

• BASIS [§§1011–1023]

1. A key concept in income taxation 2. Investment in property for tax purposes A. Sum of nondeductible capital expenditures with respect to asset B. Adjusted for subsequent events, such as depreciation and improvements [§1016] 3. Basis is generally taxpayer’s cost [§1012] A. Special rules for gifts, inheritance, certain exchanges, etc. B. Allocation rules for stock held in brokerage accounts and dividend reinvestment plans [§1012(c)–(d)] 4. No gross income on disposition unless proceeds exceed basis [§§61(a)(3), 1001] A. Loss deductible only if IRC § authorizes [§§165–166]

GROSS INCOME • CONCEPTS

1. Gross income includes accretions to wealth (net of cost of goods sold and basis of property sold), unless excluded by an IRC § A. Computed before any deduction for related expenses B. Can include cash, other property, receipt of services, and debt relief 2. No requirement that gross income be earned from labor or capital A. Congress intended to exert its taxing power to fullest [Comm’r v. Glenshaw Glass Co.] B. Even punitive damages, illegal income, and treasure trove are gross income [Reg. §1.61-14(a)] 3. Income (and deductions) can be reallocated when same interests control multiple taxpayers [§482] 4. Security deposits are not gross income [Comm’r v. Indianapolis Power & Light Co.] A. Distinguished from prepayments for services, rent, etc. B. Factors include obligation to repay that is nominally absolute, treatment on recipient’s books, and paying interest on deposit

• INCOME FROM SERVICES [§61(A)(1)]

1. Attributed to the actual service provider [Lucas v. Earl] A. Child’s services income taxable to child even if state law gives it to parent [§73; Reg. §1.73-1(a)] B. Don’t impute value of services one performs for oneself as gross income 2. Barter exchange of services is gross income to each party to the exchange A. Value: What service provider would charge in an arm’s-length transaction 3. Taxation can be deferred when compensation in property subject to substantial risk of forfeiture [§83] A. Substantial risk of forfeiture if right to property is conditioned on performance of substantial future services i. Conditioning on nonperformance (e.g., noncompete clause) might also qualify [Reg. §1.83-3(c)] B. Employee can elect to report gross income in year of receipt even if substantial risk of forfeiture i. Employee cannot deduct loss if property is ultimately forfeited [§83(b)] ii. Gain accruing after employee reports property as gross income can qualify as capital gain C. Employer can’t deduct until year employee reports property as gross income [§83(h)] 4. Fringe benefits taxed unless exclusion section applies

• PRIZES & AWARDS [§74]

1. General rule is that prizes and awards are gross income A. Recipient not eligible for §102 gift exclusion 2. Limited exclusion for prizes directed to charity [§74(b)] A. Prize granted for literary, artistic, civic, etc., achievement

B. Prize winner did not enter contest or render services 3. Limited exclusion for employee achievement awards [§74(c)] 4. Prize received as qualified scholarship excluded [§117]

• INCOME PRODUCED BY PROPERTY

1. Gift of income produced by property A. Donor taxed if ownership retained i. Bondholder was taxed on the interest that he gave away shortly before it became due [Helvering v. Horst] B. Donee taxed if ownership transferred [Blair v. Comm’r], even if in trust C. Taxpayer taxed on income if taxpayer has the power to control its destination without giving up the underlying source that produces it 2. Rents A. Gross income to lessor [§61(a)(5)] B. Improvements made by lessee are not gross income to lessor either when made or upon termination of a lease, unless the improvements are disguised rent [§109] i. Lessor acquires no basis in the improvements [§1019] C. Deposit excluded if made to secure covenants and not advance rent 3. Interest A. Generally gross income [§61(a)(4)] B. Interest from obligations issued by state and local government bodies is excluded [§103] i. Qualifying bonds must be registered [§149] ii. Interest from nonqualified private activity, arbitrage, or advance refunding bonds is not excluded [§§141, 148, 149(d)] C. §7872 applies if interest charged is below market or none charged i. Below market if the stated interest is less than the “applicable federal rate” ii. Interest income will be imputed to lender D. Taxed as accrued for discount instruments [§1272 et seq.] 4. Dividends [§61(a)(7)] A. Corporation’s distributions to shareholders come first out of earnings and profits and are considered gross income [§301(c)(1)] i. Distributions exceeding earnings and profits are treated first as basis reduction of stock and then as capital gain [§301(c)(2)–(3)] ii. Reduced tax rate on dividends received; rate applied to dividends varies based on taxpayer’s income [§1(h)] B. Pro-rata stock dividends and splits i. A distribution of a corporation’s own stock to its shareholders in proportion to their previous stock holdings is not gross income [§305(a)] ii. Merely a subdivision of an investment into smaller units iii. Shareholder’s basis for original shares is allocated among the old and new shares [§307] iv. No exclusion for stock in lieu of cash or other 2

devices to reallocate shareholder interests [§305(b)] 5. Annuities [§72] A. An annuity contract typically involves the payment of premiums by the investor either periodically or in a lump sum B. Commencing with the “annuity starting date,” the investor or designated beneficiary receives a series of periodic payments i. Payments can end by death of annuitant or term of years C. Annuity payments consist generally of 2 parts: i. Nontaxable return of investment (capital) based on the exclusion ratio ii. Taxable interest

• SALES & EXCHANGES OF PROPERTY

1. Gain or loss is the difference between amount realized (if any) and adjusted basis [§1001(a)] A. Computed only if there is a “realization event,” such as a sale B. Most realization events involve the receipt of money, property, or services or involve debt taken over by transferee 2. Gain if amount realized exceeds basis as adjusted for depreciation and improvements 3. Exclusion for gain on principal residence of up to $250,000 if single and $500,000 if married [§121] A. Principal residence is usually where taxpayer spends majority of taxpayer’s time B. Exclusion generally requires at least 2 years of ownership and use i. Partial exclusion allowed for certain early sales ii. Special rules for use by former spouse iii. Exclusion available every time taxpayer qualifies C. No requirement to reinvest proceeds in new residence D. No exclusion if residence acquired in like-kind exchange in 5 years preceding sale [§121(d)(10)] E. No exclusion for gain allocated to nonqualifying use after December 31, 2008 [§121(b)(5)] F. Surviving spouse can obtain full $500,000 exclusion if certain requirements are met [§121(b)(4)] 4. Other gains included in gross income in year of transfer A. Can defer gain on installment sale of qualifying property [§453] i. At least 1 payment must occur after taxable year of disposition 5. Gain can be postponed for nonrecognition transactions A. Nonrecognition of gain is mandatory for some transactions and elective for others i. Gain recognized to extent of disinvestment and receipt of “boot” ii. Boot: Cash or other property that can’t be received tax-free yet is received as part of an otherwise tax-free exchange B. Special basis rules apply to replacement property

C. Like-kind exchanges for business and investment real property not held primarily for sale [§1031] i. No gain or loss is recognized if business or investment real property is exchanged solely for like-kind real property ii. Gain, but not loss, is recognized if boot is received iii. “Like-kind” refers to the nature, character, or class of the property, not to grade or quality (a) Even improved for unimproved real estate (or a 30-year or longer leasehold for a fee) qualifies [Reg. §1.1031(a)-1(c)] D. Compulsory and involuntary conversions [§1033] i. No gain is recognized when property is converted into property similar or related in service or use ii. Can elect similar outcome if taxpayer receives cash and acquires replacement property iii. Examples are theft, seizure, destruction, and condemnation iv. Special rules for government takings and federally declared disasters E. No gain or loss on transfers to spouse or to ex-spouse incident to divorce [§1041] i. Transfers within 1 year after marriage ends are incident to divorce ii. Later transfers may qualify if related to cessation of marriage iii. Transfers more than 6 years after marriage ends are presumed not related to cessation of marriage

(a) Taxpayer may rebut presumption by showing factors that prevented earlier transfer [Reg. §1.1041-1T(b)] F. “Wash sales” of stock or securities [§1091] i. Loss not recognized if taxpayer acquires substantially identical property within 30 days before or after disposition 6. Distinctions between exclusion and nonrecognition of gain A. Exclusion provisions: Gain is permanently excluded from gross income B. Nonrecognition provisions: Gain is recognized in future when transferor sells the replacement property i. Recognition is by transferee for property received in divorce 7. Interaction of nonrecognition and death A. Death is not a recognition event B. Decedent does not report previously unrecognized gain or loss C. Beneficiary who receives the property also reports no gain or loss i. Basis rules, generally fair market value (FMV) at death, eliminate unrecognized gain and loss [§1014]

• CONTRACTUAL ARRANGEMENTS

1. Alimony A. For divorce or separation agreements executed

after Dec. 31, 2018, alimony not gross income to recipient and not deductible by payor B. Child support not gross income to recipient and not deductible by payor 2. Insurance proceeds A. Business interruption proceeds taxable B. Compensation for normal living expenses taxable [§123] C. Compensation for property damage that exceeds adjusted basis is gain 3. Debt discharge [§108] A. Gross income unless covered by exclusion for Title 11, insolvency, certain farm or business debts, purchase price adjustment, or certain student loans i. Taxpayer is insolvent when amount of debt exceeds value of assets (a) Contingent debt is ignored unless taxpayer establishes it is more likely than not taxpayer will have to pay it [Merkel v. Comm’r] B. Current exclusion usually requires giving up future benefits (e.g., tax attributes or property basis) C. Initial borrowing is not gross income because of offsetting obligation to repay i. Failure to repay results in gross income if no exclusion applies (a) Debtor who retired bonds for less than amount borrowed had gross income [U.S. v. Kirby Lumber Co.]

EXCLUSIONS • GENERAL RULE

G. Qualified moving expenses not excludible for tax years before 2026 (except for members of armed forces on active duty) 9. Cafeteria plan [§125] A. Employee can select among taxable and certain tax-free benefits i. Health care spending accounts benefit exclusion limited to $2,500/year adjusted for inflation (limit of $2,650/year for 2018) B. Gross income only if taxable benefit selected 10. Workers’ compensation [§104(a)(1)] A. Exclusion for amounts under workers’ compensation acts for personal injury or sickness B. Gross income to extent attributable to medical expense deductions taken in earlier year

1. Anything that is income is gross income unless specific IRC § states otherwise [§61]

• FRINGE BENEFITS PROVIDED TO EMPLOYEES

1. Excluded even if employer deducts A. Exclusion may be limited to employees who aren’t owners B. Exclusion may require that benefit not disproportionately discriminate in favor of highly compensated employees C. Written plan may be required 2. Group term life insurance [§79] A. The cost per employee of up to $50,000 of coverage is excluded B. If above $50,000, refer to age-based table [Reg. §1.79-3] 3. Health and accident plans A. Employer-provided health and accident plan is excluded [§106] B. Benefits not taxed if reimbursing for medical expenses [§105(b)] i. Wage continuation payments are taxable ii. Permanent injury payment excluded if unrelated to time away from work [§105(c)] C. Employer plans and benefits cannot cover nonprescription drugs other than insulin 4. Meals and lodging furnished on business premises [§119] A. If for “convenience of employer”: i. Substantial noncompensatory reason [Reg. §1.119-1(a)(2)] ii. All meals qualify if more than 50% of employees receiving meals do so for “convenience of employer” [§119(b)(4)] iii. After 2025, no deduction to employer for meals for “convenience of employer” [§274(o)] B. Furnished in kind, not cash reimbursement [Comm’r v. Kowalski] C. Lodging necessitated by demands of job D. Clergy’s housing allowance excluded [§107] 5. Employer-provided educational assistance programs for employees, up to $5,250/year [§127] A. Need not be job related but limited to tuition, fees, books, and supplies 6. Dependent care assistance up to $5,000/year [§129] 7. Adoption assistance programs provided by employer up to $13,810 (for 2018) with income phase out [§137] 8. Miscellaneous fringe benefits [§132] A. No additional cost to employer i. Airline employees in unsold seats B. Employee discount limited to profit margin on product or 20% of normal fee for service C. Working condition fringe benefits i. Items employee could deduct if paying own costs D. De minimis fringe benefits i. Value of property or service is so small that accounting for it is unreasonable ii. Copy machine use and picnics for employees and guests E. Qualified transportation i. $175/month adjusted for inflation ($260/month for 2018) for transit pass and commuter highway vehicle ii. $175/month adjusted for inflation ($260/month for 2018 for qualified parking F. Qualified benefits related to retirement planning and military base closing

• PERSONAL

1. Life insurance proceeds [§101] A. Tax-free if received because insured died or is terminally or chronically ill B. Exceptions: i. If proceeds are payable in installments, interest received is gross income [§101(c)] ii. Purchaser of policy for consideration excludes only consideration paid if purchaser is not insured or in certain business relationships with insured iii. Transfer that is reportable policy sale [§101(a)(3)] iv. Proceeds of certain employer-owned policies [§101(j)] C. If policy sold or surrendered, may be both ordinary income and capital gain [Rev. Ruls. 2009-13, 2009-14] D. Premium cost not deductible [§264] 2. Gifts and inheritances [§102] A. Property received tax-free if gift, bequest, devise, or inheritance B. Donor’s primary motive is “detached and disinterested generosity” [Comm’r v. Duberstein] i. Transfers by employer to employee ineligible [§102(c)] ii. Definition for income and gift taxes may differ [Farid-es-Sultaneh v. Comm’r] C. If donee sells for more than basis, donee may be taxed on gain i. Inter vivos gift: Generally donor’s basis [§1015] carryover ii. Testamentary gift: Generally value at donor’s death [§1014] step up or down D. Transfer to spouse treated as gift [§1041] i. Even if spouse gives consideration ii. Even if to ex-spouse if incident to divorce 3. Scholarships [§117] A. Amounts received as “qualified scholarships” are excluded i. Must be degree candidate at an educational institution ii. Exclusion only for required tuition, fees, books, and supplies iii. Scholarship is payment to aid student in pursuing studies 4. Exclusions for educational benefits subject to limits: A. Qualified tuition programs [§529] B. Coverdell Education Savings Accounts [§530] C. Interest from U.S. government bonds used for education [§135] 5. Government welfare A. Most benefits are excluded B. Unemployment compensation is taxable [§85] 6. Damages and insurance benefits [§104] A. Compensatory damages for personal physical injuries or sickness are excluded [§104(a)(2)]

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iii. Emotional distress damages if not attributable to physical injury C. Damages received for lost business profits are taxable D. Amounts received for injury to property are gross income (gain) if proceeds exceed basis i. May be able to postpone gain recognition by replacing property [§1033] 7. Energy conservation subsidies [§136] A. Provided by a public utility B. To customers installing “energy conservation measures”

i. ii. iii. iv.

Lost wages even though wages normally taxable Pain and suffering Medical expenses, unless previously deducted Similar rules for insurance policy benefits [§104(a)(3)] (a) Employer-provided policy benefits have different rules [§105] B. Other tort damages are taxable i. Damages to reputation or for discrimination ii. Punitive damages even if related to physical injury

DEDUCTIONS • GENERAL

B. Other deductions are taken only if the taxpayer itemizes deductions i. Itemized deductions include most deductible personal expenses such as home mortgage interest, charitable contributions, and medical expenses (a) Many personal itemized deductions are limited, such as:

B. Self-employed can deduct health insurance as business expense, up to earned income [§162(l)] 1. Issue of possible deductibility is raised if a taxpayer C. Travel away from home deductible if temporary expends cash, uses property, or sustains losses assignment does not exceed 1 year [§162(a)(2)] A. There is no general presumption that anything i. Tax home usually based on business contacts, is deductible not location of residence B. Nothing is deductible unless an IRC § states ii. Substantiation rules for travel, meals, and gifts that a deduction is allowed [§274(d)] 2. Deductions can be categorized in different ways (i) Individuals may deduct either State D. Home office [§280A] A. Type of activity (e.g., trade or business, income and local income or sales taxes and real i. Regular, exclusive use tests producing or entered into for profit, or personal) property taxes but aggregate deductions ii. Time spent and importance of activities B. Expense or loss cannot exceed $10,000/year [§164(b)(6)] E. Business gifts: Deduction limited to $25 per C. Position on the tax return (ii) Medical expenses are deductible only to recipient [§274(b)] 3. Type of activity extent they exceed 10% of AGI (7.5% of F. Employee achievement awards A. Trade or business entitled to more deductions AGI for 2018) [§213(a) & (f)] i. Employer can deduct award cost [§274(j)] than other activities (iii) Personal casualty losses only deductible if ii. Maximum annual deduction per employee is i. Requires continuous, regular activity with attributable to federally declared disaster $400 ($1,600 if qualified plan) primary intent to make a profit [Comm’r v. and only to extent exceed 10% of AGI Groetzinger] (a) Qualified plan award requires written, [§165(h)] B. Income-producing activity entitled to most C. Taxpayers who do not itemize take a standard nondiscriminatory plan deductions allowed to a business [§212(1) & (2)] iii. Award must be given as part of a meaningful deduction based on filing status i. Deductions allowed for investors engaged in D. presentation Taxpayers may deduct personal exemptions income-producing activities that were not whether they itemize or take standard deduction G. Entertainment and meals: No deduction for characterized as businesses entertainment expenses except 50% of otherwise • TRADE OR BUSINESS EXPENSES [§162] ii. Deductions had been disallowed by case law allowable deductions allowed for meals [§274] 1. Can deduct ordinary and necessary expenses [Higgins v. Comm’r] paid or incurred during the tax year in carrying 4. Most unreimbursed employee outlays are itemiii. Not eligible for some business deductions ized deductions [§62] on any trade or business (e.g., §179 deduction) A. Ordinary expense: Customary or usual in that • QUALIFIED BUSINESS INCOME PASSC. For personal activities, can deduct only items business THROUGH DEDUCTION [§199A] covered by a specific IRC § B. Necessary expense: Helpful in developing and 1. Deduction of up to 20% of qualified business i. Some business and income-producing outlays maintaining the business income (QBI) from U.S. pass-through (sole have personal aspects (e.g., entertainment) C. Taxpayer can have more than 1 trade or business proprietorship, S corporation, partnership, or ii. They are often subject to stricter substani. Even being an employee is a trade or business trust or estate) tiation rules than other business and income- D. Transactions between related parties scrutinized A. For taxpayers with taxable income at or below producing expenses E. Fines, bribes, penalties, and most lobbying $315,000 joint or $157,500 single, deduction is 4. Expense versus loss not deductible even if ordinary and necessary lesser of (1) 20% of QBI, qualified REIT diviA. Expense generally refers to a particular outlay [§162(c), (e), (f)], payments for settlements dends, and qualified publicly traded partnership i. If deductible expenses for an activity exceed related to sexual harassment or abuse not income or (2) 20% of taxpayer’s taxable income its income, the activity has a net loss deductible if subject to nondisclosure agreeminus capital gains ii. Most expenses require certainty, but some (e.g., ment [§162(q)] For taxpayers with income above the depreciation) are deducted based on formulas i. Many other provisions limit or deny business B. $315,000/$157,500 thresholds, deduction may be B. Loss generally refers to a completed transaction deductions [§§262–280H] limited if business is a specified trade or business, (e.g., sale of property, theft of property) F. Capital expenditures not currently deductible by W-2 wages paid by the business, and the unad5. Position on tax return [§263] justed basis of certain property used in the busiA. Some deductions are subtracted from gross i. Rent is recharacterized if disguised purchase ness. Limitations phased in for joint filers with income to reach AGI [§62] [§162(a)(3)] i. Deductible whether taxpayer itemizes or takes 2. Deductible items include salaries, travel, rent, taxable income between $315,000 and $415,000 the standard deduction and other filers between $157,500 and $207,500 utilities, insurance, etc. ii. Often referred to as “above the line” deductions 3. Special rules (thresholds adjusted for inflation after 2018) iii. Most such deductions are deductions of a self- A. Education expenses [Reg. §1.162-5] • RETIREMENT SAVINGS (DEDUCTED employed business owner i. Maintains or improves skills required in PRE-AGI) (a) Also includes deductions to produce rents current business 1. IRA deduction limitation of $5,500 per person or royalties, student loan interest allowed ii. Does not meet minimum requirements of [§219], inflation adjusted; additional $1,000 for by §221, and losses from sales of property business or qualify for a new business persons age 50 and up

DEPRECIATION DEDUCTIONS • PROPERTY USED IN BUSINESS OR TO PRODUCE INCOME • STRAIGHT-LINE METHOD [§168(B)(3)] 1. IRC allows an annual deduction of a portion of the cost or other basis of asset A. Must be used in trade or business or held for production of income B. Must be subject to wear and tear or obsolescence (e.g., land ineligible) 2. Useful lives of property determined by IRC and IRS A. Limited deduction in year of acquisition and year of disposition [§168(d)] B. Depreciation begins in year asset is placed in service C. Depreciation ends when asset is retired from service or disposed of or its basis is fully recovered 3. Bonus depreciation as stimulus measure through 2027, for qualified property with recovery period of 20 years of less, percentage of 100% (full) for property placed in service before 2023, 80% before 2024, 60% before 2025, 40% before 2026, and 20% before 2027 (different phase out for qualified property with longer recovery periods) [§168(k)] 4. Special rules for cars [§280F] 5. Deduction affects eligibility for capital and §1231 gain

1. Cost deducted equally over property’s life 2. Applicable to real property and certain §280F property A. Taxpayer can elect it for other property

• DECLINING BALANCE METHOD [§168(B)(1)–(2)]

1. Higher percentage of cost deducted in early years 2. Increase straight-line rate by 150% or 200% A. Apply rate to basis after depreciation B. Switch to straight-line when it provides larger deduction C. Used primarily for tangible property other than real estate

• ELECTIVE 1-YEAR DEDUCTION FOR COST

1. Immediate expensing of qualifying business property [§179] 2. Deduction is taken before §168 depreciation 3. The deduction is lesser of: A. Eligible costs up to $1,000,000 (inflation-adjusted after 2018) for the year B. Taxable income from all businesses for the year

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Personal Income Tax (continued )

2. Business start-up expenditures [§195] A. Up to $5,000 of outlays deductible in year business begins i. Remainder can be amortized over 180 months ii. Phaseout of immediate deduction if start-up outlays exceed $50,000

4. Deduction phases out if taxpayer spends more than $2,500,000 during the year (inflation-adjusted after 2018)

• STRAIGHT-LINE AMORTIZATION

1. Certain intangibles amortized over 15 years [§197]

TAX IMPOSED • STATUS OF TAXPAYER

B. Unmarried individual maintaining home for qualifying child or dependent i. Dependent parent may live in own home C. Certain married individuals living apart may qualify [§7703(b)] 7. Child under 18 at end of year [§1(g)] A. Net unearned income taxed at rates applicable to trusts and estates B. Also applies to certain students under age 24

1. The tax return includes aggregate income, deduction, and other tax items attributable to the taxable year for which the return is filed 2. Different rate schedules based on filing status [§1] A. Ordinary income top rate is 37% B. Top rate is the same regardless of filing status 3. Married A. Joint return [§6013] i. Not married if legal separation decree [§7703] ii. Married if spouse died during year [§7703] iii. Joint and several liability [§6013(d)(3)] (a) Relief may be provided to “innocent spouse” if lack of knowledge or inequitable to tax [§6015] B. Separate return i. Higher tax rates ii. May preserve deductions that phase out when income rises iii. Some tax benefits require filing joint return 4. Unmarried A. Higher tax rates than married filing jointly with same income 5. Surviving spouse [§2(a)] A. Eligible for joint return rates for 2 years after year of spouse’s death B. Must provide abode for qualifying individual 6. Head of household [§2(b)] A. Lower rates than unmarried

• ADDITIONAL TAXES

1. Self-employment and FICA taxes on earnings are in addition to income tax A. Some income of S corporation’s shareholder-employee may escape employment taxes i. Amount treated as business profit is not income from employment B. Medicare tax on investment income of high-income taxpayers [§1411] 2. Alternative minimum tax [§§55–59] A. Special computation of taxable income B. Goal is preventing high-income taxpayers from paying too little i. Affects taxpayers other than corporations who significantly reduce tax liability using certain exclusions, deductions, and credits C. For tax years before 2026, exemption levels of $109,400 for taxpayers filing jointly ($70,300 for single) and phaseout of exemption amount is $1,000,000 for joint filers and $500,000 for single (after 2018 indexed for inflation) 3. “Penalty” taxes for failing to acquire health insurance reduced to zero after 2018 [§5000A] A. Supreme Court upheld in 2012 [Nat’l Fed’n of Indep. Bus. v. Sebelius] 4. “Net Investment Income” tax of 3.8% on net investment income of higher income taxpayers [§1411]

CAPITAL GAINS & LOSSES • SPECIAL RULES APPLY

B. Net long-term capital loss if long-term losses exceed long-term gains 3. Overall net gains and losses A. Capital gain net income is excess of total capital gains over total capital losses B. Net capital loss is excess of total capital loss over amount allowed as deduction for year C. Net capital gain is excess of net long-term gains over net short-term losses [§1222(11)]

1. Net gains may be taxed at lower rates 2. Net losses have limits on deductibility

• GENERAL REQUIREMENTS [§1222]

1. Sale or exchange of a capital asset 2. Only gains or losses that affect taxable income are included A. Ignore unrecognized gains and losses

• HOLDING PERIOD DEFINITIONS

• SALE OR EXCHANGE

1. Holding period can exceed period of actual ownership [§1223] A. Period carried over from previous property if like-kind exchange or other nonrecognition provision applied B. Period carried over from prior owner for transfers from spouse or from ex-spouse if incident to divorce C. Period carried over from donor after inter vivos gift of appreciated property D. Period is automatically long term for property acquired from a decedent E. Period for worthless security ends at year’s end [§165(g)] F. Period is automatically short term for nonbusiness bad debt loss [§166(d)] 2. Holding period definitions apply to quasi-capital assets

1. Transfer of property other than as gift 2. Special sale or exchange treatment applies to certain events A. Casualty and theft net gains for personal use property [§165(h)] B. Loss on worthless securities [§165(g)] C. Loss on nonbusiness bad debts [§166(d)] D. Quasi-capital assets [§1231] 3. Foreclosure treated as sale or exchange

• CAPITAL ASSET

1. Defined in the negative; that is, all assets other than those excluded [§1221] 2. Most ineligible assets are business property A. Inventory, depreciable property, business real estate, and accounts receivable B. Patents, inventions, copyrights, works of art, etc., are ineligible even if creator not in trade or business C. Special rules apply to musical compositions, patents, and subdivided land [§§1221(b)(3), 1235, 1237]

• TAX RATES ON NET CAPITAL GAINS [§1(H)]

1. Tax rate lower than rate applicable to ordinary income 2. Adjusted net capital gains taxed 0%, 15%, or 20% A. Rate of 0% for taxpayers in 10% or 12% ordinary income tax brackets i. Rate of 15% for taxpayers in 22%, 24%, 32%, and 35% ordinary income tax brackets ii. Rate of 20% for taxpayers in 37% ordinary income tax bracket B. 28% top rate for sales of collectibles C. 25% top rate for gains reflecting prior straight-line depreciation on real estate D. 28% top rate for gains from qualified small business stock with 100% exclusion of such gain [§1202 gain] 3. Qualified dividends taxed like capital gains [§1(h)(11)] A. Rates of 0%, 15%, and 20% apply—depending on bracket

• QUASI-CAPITAL ASSET

1. Business and for-profit depreciable property and real estate [§1231] A. Personal use property is capital asset B. Quasi-capital asset must be held more than 1 year 2. Net quasi-capital gain may qualify for long-term capital gain treatment [§1231(a)(1)] A. Capital gain treatment limited if taxpayer reported net §1231 losses in prior 5 years [§1231(c)] 3. Net quasi-capital loss avoids capital loss limitations [§1231(a)(2)] 4. Special computations for theft or destruction of §1231 assets [§1231(a)(4)(C)]

• CAPITAL LOSS DEDUCTION LIMITS [§1211(B)]

1. Cannot exceed total capital gains plus $3,000 ($1,500 on separate return) 2. Excess loss carries over to future years [§1212(b)] 3. Capital loss limits don’t apply to: A. Losses on qualified small business stock [§1244] B. Net loss on quasi-capital assets [§1231] 4. Dividends do not increase allowable capital loss limits

• GAIN & LOSS NETTING DEFINITIONS [§1222]

1. Short-term rules apply for assets held 1 year or less A. Net short-term capital gain if short-term gains exceed short-term losses B. Net short-term capital loss if short-term losses exceed short-term gains 2. Long-term rules apply for assets held more than 1 year A. Net long-term capital gain if long-term gains exceed long-term losses

CORPORATE INCOME TAX • “C” CORPORATION

TYPES OF BUSINESSES

ii. Holder is creditor iii. Corporation can deduct interest with some limitations [§163] (a) Business interest deduction for year not to exceed sum of business interest income, 30% of adjusted taxable income, and floor plan financing interest carryforward allowed for disallowed interest. [§163(j)]

1. Entity created by law with associates and profit motive 2. Financing A. Debt (bonds and notes) i. Promise to pay interest and repay loan 5

Corporate Income Tax (continued )

(b) Limitation on business interest deduction does not apply for certain small businesses (businesses with average annual gross receipts of $25 million or less). B. Equity (common and preferred stock) i. Evidence of ownership ii. Shareholder may receive dividends [§316] iii. Dividend represents payment of earnings after expenses iv. Corporation can’t deduct dividends paid C. Issuer’s classification binds issuer and holders [§385(c)] 3. Taxation A. Basic computation much like individual’s B. Taxed at flat rate of 21% [§11]

A. Referred to as “check-the-box” regulations B. Single-owner entities disregarded as separate from owner unless they elect corporate status C. Multiple-owner entities treated as partnerships unless they elect corporate status

• PARTNERSHIP

1. Unincorporated organization established to carry on business [§§761, 7701(a)(2)] 2. Pays no tax; income and deductions allocated to partners [§§701–702] 3. Publicly traded partnership treated as a corporation [§7704]

• NONBUSINESS TRUST

1. Created by a will or inter vivos declaration to protect trust property for beneficiaries [Reg. §301.7701-4(a)] 2. Tax consequences depend on distributions A. Retained income taxable to trust [§§1(e), 641, 651, 661] B. Distributed income taxable to beneficiaries [§§652, 662] C. Estates taxed in much the same way 3. Special rules for “grantor trusts” [§§671–679] A. Rules triggered by reversions, power to control beneficial enjoyment, and power to revoke B. Rules triggered by discretionary income for grantor or spouse 4. Business trusts subject to check-the-box regulations

• “S” CORPORATION

1. 100 shareholders maximum and 1 class of stock [§1361] A. Family members treated as 1 shareholder [§1361(c)(1)] 2. “S” status must be elected by all shareholders [§1362(a)(2)] 3. Generally pays no tax, much like partnership [§1363] A. Income and deductions pass through to shareholders [§1366]

• UNINCORPORATED ENTITIES

1. Business entities other than corporations and publicly traded partnerships can select tax status [Reg. §§301.7701-2, -3]

SPECIAL CORPORATE DEDUCTION RULES • ORGANIZATIONAL EXPENDITURES [§248]

MERGERS, ACQUISITIONS & RECAPITALIZATIONS 1. Requirements depend on type of reorganization A. Generally, acquiring corporation must obtain 80% or more of acquired corporation’s stock or assets i. Reshuffling existing corporation’s capital structure qualifies [§368(a)(1)(E)] ii. Mere change in name or state of incorporation qualifies [§368(a)(1)(F)] B. Stock must generally be used as consideration [§368] i. Limitations on nonstock consideration, including corporate debt, allowed [§§354, 356] ii. Special rules apply when debt is assumed [§357] C. Plan of reorganization, business purpose, and continuity of ownership interest and of business enterprise usually required [Reg. §1.368-1(b)–(e)] 2. Shareholder taxation A. Recognizes no gain or loss on old stock [§354(a)(1)] i. Limited gain recognition if property other than stock received [§356] ii. Gain may be treated as dividend up to E&P [§356(a)(2)] 3. Corporation that is party to reorganization generally recognizes no gain or loss [§361] A. Basis carries over [§362] 4. Similar rules apply to certain spin-offs of active businesses [§355]

1. Up to $5,000 deductible in year business begins A. Up-front deduction phased out if outlays exceed $50,000 2. Remainder may be deducted pro rata over 180 months 3. Comparable rules for partnership [§709]

• STOCK REDEMPTION EXPENSES [§162(K)] 1. Generally not deductible

• DIVIDENDS RECEIVED DEDUCTION

1. Limitations apply to deduction for dividends received [§§243–246A] 2. No deduction for dividends from tax-exempt corporation [§246(a)] 3. Holding period limitations apply [§246(c)]

• EXCESSIVE COMPENSATION [§§162(M), 280G]

1. Deduction limits apply to publicly traded companies, TARP payment recipients, health insurers, and companies making golden parachute payments

• OTHER DEDUCTION LIMITATIONS

1. Charitable deduction limited to 10% of taxable income, with 5-year carry forward [§170(b)(2), (d)(2)] 2. Net capital losses not deductible but carry both back and forward [§§1211(a), 1212(a)]

TAX-FREE CORPORATE FORMATION RULES • REQUIREMENTS [§351(A)]

1. Transferors control corporation after transfer A. Own 80% of voting power and of nonvoting stock [§368(c)] 2. Can receive only stock as consideration A. Some assumption of debt by corporation allowed [§357] B. Full or partial gain recognized if anything else received [§351(b)] 3. Must transfer property to corporation for stock A. Receipt of stock for services can trigger immediate tax, even for those transferring property [§351(d); Reg. §1.351-1]

• TAX CONSEQUENCES

1. Gain or loss recognition A. Shareholders recognize gain only up to “boot received” B. Shareholders recognize no loss C. Corporation recognizes no gain or loss on stock issue [§1032] 2. Basis A. Shareholder’s stock takes basis of property given up [§358] i. Adjusted if debt assumed, boot received, or gain recognized B. Corporation uses shareholder’s old basis for property [§362] C. Special rules for transfers of loss property [§362(e)] 3. Holding period carries over [§1223(1)–(2)]

CORPORATE DISTRIBUTION RULES • DIVIDEND FROM EARNINGS & 4. Corporation gain recognition same as for diviPROFITS (E&P) [§316] dend if corporation redeems using property 1. Shareholder taxation A. Taxed on money and value of property received [§301] i. Takes FMV basis for property [§301(d)] B. Distribution of corporation’s stock usually tax-free [§305] i. Carryover basis used if stock distribution [§307] ii. Holding period also carries over [§1223(4)] 2. Corporation recognizes gain if appreciated property distributed [§311(b)] 3. Corporation reduces its E&P [§312(a)]

• REDEMPTION [§§302–304, 306]

1. Corporation distributes money or property for stock 2. Redemption treated as sale or dividend, depending on extent of shift in corporateshareholder relationship 3. Shareholder taxation A. Reports gain or loss if treated as sale [§§302(a), 303(a)] B. Otherwise reports as dividend i. Adjust basis of retained stock if treated as dividend

A. E&P reduced whether sale or dividend treatment [§312(a), (n)(7)] 5. Special rules apply if redemption through related corporation [§304] and to dispositions of certain preferred stock [§306]

• LIQUIDATION [§§331–337, 346]

1. Corporation distributes money or property for all its stock 2. Shareholder taxation A. Reports gain or loss on stock [§331] i. Parent recognizes no gain or loss on 80%owned subsidiary liquidation [§332] B. Basis for property received is FMV [§334(a)] i. Parent generally takes 80%-owned subsidiary’s basis for assets [§334(b)] 3. Corporation recognizes gain or loss on distributing property [§336] A. No recognition on distribution to parent in 80%-owned subsidiary liquidation [§337] B. Loss deduction limits for distributions to related persons and carryover basis transactions [§336(d)]

U.S. $7.95 Edited by: Elena Marty-Nelson, JD

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NOTE TO STUDENT: This guide should only be used as a quick reference and supplement to course work and assigned texts. Due to its condensed format, it (1) does not include jurisdictional differences, and (2) should not be relied upon as a substitute for more comprehensive legal studies or as a substitute for professional legal advice. BarCharts, Inc., its writers, editors, and design staff are not responsible or liable for the use or misuse of the information contained in this guide. 6