Income Tax I
Bogdanski
Fall 2005
Sample Answers to Question 1
Exam No. 9200 – See .pdf file here.
Exam No. 9938
The Trust
Tom receives capital income from the dividends paid to him by the trustee. Although the trust is a gift from a decedent and would normally be exempted from gross income, the income produced by gifts is taxable. Irwin v. Gavit. The gains are capital and taxed at a lower rate than ordinary income even though they are not the product of a sale of exchange, because § 1(h)(11) specifically includes corporate dividends as capital gains. However, the dividends are a special class of capital income and may not be offset by any capital losses Tom may incur while receiving the trust income.
Tom might have requested that the dividends be retained by the trust and paid to him every five years. In this scenario, he might still have the same capital income because of constructive receipt of the dividends. A taxpayer has constructive receipt when income is specifically set apart for him so that he may draw upon if he had given notice of his intent to do so. It is not clear whether the trustee must abide Tom’s request to either hold or disperse the income. But, since the trustee has defaulted to payment, if Tom requested the trustee to hold the income, he would presumably have the right to request disbursement annually as an alternative, and that right would make the dividends constructively received by Tom every year, even if he instead demanded the trustee to hold them until 5 years had passed—the election does not change Tom’s liability.
The sale
of Condo to Connie.
Tom’s sale of the condo is to Connie produces ordinary income under § 1001. Income is produced because Tom realizes an economic benefit from the sale of the condo, property that he developed as a dealer in condos. The income is not capital because Tom does not hold the land as investment, but instead develops units for sale to customers. See 1221(a) (excluding land held by dealer for sale to customers). Tom realizes a gain on the transaction that is income to him. Although Tom may wish to take advantage of the “Gross Profit Ratio” installment sale method in § 453 to spread his income across the years that Connie’s note is payable, Tom is not eligible for § 453 as a dealer of condos. Therefore, Tom must use the closed cash method to compute his gain from the sale under § 1001 (the open method is not available because the note to Tom has ascertainable fair market value). Under the closed cash method, Tom’s amount realized in the year of the sale is the cash received plus the fair market value of the promissory note (100,000 + 160,000), which totals $260,000. Tom’s gain is the amount realized at $260,000 minus his basis of $200,000,[1] equals $60,000 ordinary income. Tom can then create a basis in the promissory note for the $40,000 remainder of the gain that he will realize (total gain of $100,000 from sale price of $300,000 minus $200,000 basis) and pay the gain across the next ten years. The interest Connie pays on the note will be ordinary income to Tom. The mortgage that Connie gives Tom to secure the note does not affect Tom’s income or tax liability from the transaction.
The
business run out of the detached dwelling
The tax consequences of Tom’s office are more tricky. Tom would like to deduct his home office expenses as an above-the-line business expenses under § 162. However, the amount at stake here includes only depreciation, maintenance expenses, insurance, utility bills and other miscellaneous items—the big costs of property taxes, and any mortgage interest, are already deductible to Tom personally under § 164 and § 163(h)). In order to make a § 162 deduction for the home office, Tom must satisfy the principle place of business test: exclusive use on a regular basis. Tom can argue that he regularly meets with clients to satisfy the first prong. On the exclusivity prong Tom can argue that the dwelling is separate from his home, and therefore excluded from his personal use. On the bad side (for Tom’s deduction), his poker games may qualify as personal use. Tom can argue that business discussions occur during every game, but the presence of friends, and the entertainment nature of the games detract from the business use. Because the exclusivity tests is very rigid (no personal use whatsoever is allowed), Tom should probably not deduct the games. As his attorney, I would advise him to begin having the games in his home (where drink is still deductible (See below for business entertainment discussion) and then he could pass the exclusive business use test for his office and begin deductions.
In addition to the ongoing use, Tom might most wish to deduct the conversion of the garage to his office. This could arguably qualify as a start up capital expenditure that would be subject to ACRS § 168, or maybe even a write-off under § 179. It appears, at the time of this problem, that Tom has already converted the garage, and so would no longer be eligible for the capitalization and deductions or the write off.
Tom also would like to deduct the cost of drinks and cigars he provides at the games as business entertainment. To do so, he must satisfy the requirements of § 274, which require records (no estimates allowed), and either a direct relationship between the entertainment and business or a bonafide business discussion and a reasonable association. Tom’s best shot is for the latter option. Tom holds business discussions over the game, and the presence of business associates arguably satisfies the “reasonable relationship test.” However, the presence of friends tends to undermine the business nature of the poker games. Congress passed the 50% rule in part to account for the blurry nature of these transactions. § 274(n)(1)(B). Therefore, Tom can probably safely deduct 50% of the costs of drinks and cigars for the poker games above-the-line so long as he has records of the amounts spent.
Finally, Tom would like to deduct
his gambling losses. However, they are
only deductible against gambling winnings as a below-the-line, personal
itemized deduction under § 165(d). If
Tom tracks and reports his winnings as income (as he should), and he itemizes
his deductions (which he should if he has a mortgage on his house), then he can
deduct losses up to the total winnings amount (presumably all winnings since he
regularly loses) on his tax return.
Exam No. 9550
Trust
Gross income means income from whatever source derived. §61(a). Glenshaw defined it as an undeniable accession to wealth, clearly realized, and over which the taxpayer has complete dominion. A gift by a dead donor is not a realizing even under §1001. §102(a). Nor is death a realizing event under §1001. This means no income to the recipient and no deduction to the donor. for property acquired by reason of death, the donee’s basis is the FMV of the property on the date of the donor’s death. The donee does not get the donor’s basis. However, gifts that produce income are taxable under §102(b). If the property, the trust in this case, is given to someone else, Tom’s children in this case, and Tom is given a life interest in the income that property produces, Tom also has taxable income (which is not offset by any of the basis from the property itself). Irwin. Accordingly, in this case, Tom gets no basis since it’s simply a life interest. Tom is required to pay tax on the full amount of interest earned and is not allowed to use any of the property’s basis to offset the income. Even if Tom sells his life interest to a 3rd party, he still doesn’t get to use the basis (unless the entire interest – both Tom’s life interest and Tom’s children’s future remainder interest – are sold together) because the basis is disregarded under §1001(e). Is Tom’s income ordinary income or capital gain? Normally corporate dividends would be considered ordinary income as they are analogous to interest, but today they’re treated as a LT capital gain. §1(h)(11). They get a preferential rate, but can’t be offset by capital losses. This is technically a violation of the general principle that there must be a sale or exchange.
Condo sale
Gains from sale of property are income (but if TP holds on to property and value goes up, there is no constructive receipt of income because TP will not have any legal right to money until he actually sells property.). Here, there is a sale of the property, so there is a realizing event. Gain = [amount realized]-[adjusted basis]. §453 governs installment sales, which is defined when at least 1 payment is received after close of taxable year in which disposition occurred. Here, there are payments for next 10 years. The installment method (each payment is treated as partly a return of basis and partly gain) is the default method of accounting for any gain if there is an installment sale. The TP has the option to elect out under §453(d) and dealers are ineligible.
Here, Tom is a dealer, so he won’t receive the benefit of the installment method. Either the closed method (preferred by IRS) or open method (preferred by TP) will apply. Here, the key issue is whether the promissory note is capable of valuation. If it’s very speculative, then apply open method (allows treatment similar to Inaja). Under reg. 1.1001-1(a), only in rare and extraordinary circumstances will a transaction be determined impossible to value, and open transaction be allowed. Under warren Jones, there must be no other way to put a number on its value. To get the open method, Tom would have to prove that the promissory note had no FMV. If he fails to prove this, he’s stuck with closed method. In this case, the FMV of the promissory note is given as $160k, so Tom will need to use the closed method (accrual method or cash method depends on which method he uses). Assuming he is on the cash method, first calculate his amount realized (which includes any money received and the FMV of property received). Here, he got $100k cash and a promissory note with FMV of $160k – for a total of $260k. His basis is his cost of $200k, so he has a gain of $60k. The remaining gain of $40k will be spread over the 10 years. None of the non-recognition transactions apply, so this is gain is taxed now. He’ll want to count this as a capital gain for the lower tax rate. To achieve this, there must be a sale/exchange of a capital asset. Here, there is a sale, but the question is whether the condo is a capital asset under §1221(a). Land held for investment is, but inventory and land held by a dealer for sale to customers are not. Since Tom is a dealer, this will probably be included as ordinary income.
Interest he receives on note is ordinary income when received. Had this been accrual, Tom would be taxed on the entire gain $100k ($300k-$200k) up front. Taking the mortgage back will not affect the result since it’s not a realizing event.
Garage
Tom runs his r/e biz out of his detached garage. This is likely not a hobby under §183 since he seems be making a profit judged by his deal w/Connie. If he could show a profit for 3 out of last 5 years (including taxable year in question), there is a rebuttable presumption that activity engaged in is engaged in for profit, so that related expenses are deductible under §162. §183(d). Reg 1.183-2 lists factors to consider in determining whether hobby or biz activity. Again he made money w/his real estate business, so probably a biz.
An individual who uses part of his house for business cannot deduct any expenses under §162 unless the principle place of business test is satisfied. What’s at stake? Property taxes, mtg interest are always deductible, so we’re looking at depreciation, maintenance expenses, insurance premiums, utility bills, etc. A TP may deduct §162 biz expenses for any part of his dwelling that is: (1) exclusively used, (2) on a regular basis, for (3) principle place of biz for TP or meeting w/clients, customers, or patients in the normal course of trade or biz. Absolutely no personal use is allowed – any personal use of area will disallow biz expense deductions (meaning TP can only deduct taxes and mtg interest). Here, the garage is detached from house so not likely that kids or rest of family use it. Plus he regularly meets w/clients and contractors there. However, he occasionally has a group of friends and biz contacts for poker game. This may show that he uses it for other than biz, even though they talk shop while Tom looses his money. However, since he invites friends over, who are probably not business contacts, it doesn’t appear that he is using the garage exclusively for biz. Therefore not likely that he’ll be able to deduct expenses (unless he can argue that his gambling hobby is a business and therefore space is mixed use.)
Is this a
business entertainment expense subject to 50% rule? Entertainment, amusement or recreation
expenses are deductible business expenses if TP can show: (1) directly related to taxpayer’s business
or (2) bona fide biz discussions either before or after the fun and reasonable
association between the fun and the active conduct of TP’s trade or biz. §274(a)(1).
Here, poker isn’t directly related to r/e biz, so biz discussions happen
before or after the fun and there is an association between the fun and TPs
biz. TP is not required to show the
discussion to be entitled to deduction for biz
entertainment expenses.
§271(a)(3). Is Tom just inviting
his biz contacts to deduct the leaded beverages/cigars, or do they have legit
biz discussions? In
Gambling – if you win, it’s included in gross income. Gain is a/r (winnings) – a/b (wager). Gambling losses are only deductible (miscellaneous itemized deduction) against gambling winnings in same year. §165(d). Plus need to prove losses – so need to keep journal of losses. In this case, he doesn’t appear to have any winnings to offset his loses, so not deductible. In addition, not deductible against is other income – such as that from condo sale. Gambling as biz vs Hobby? Probably a hobby since doesn’t make money. However, does he have a profit motive? Maybe indirectly by inviting biz contacts, but it seems the profit motive would need to be directly related to the activity – so he needs to win from gambling.
Exam No. 9132
The Trust
Tom received the trust as a gift from his mother in her will. Gifts, whether during the donor’s lifetime or not, do not result in income to the recipient under 102. Since Tom received the trust as a bequest in his mother’s will, his basis will be the fair market value at the time of the gift under 1014. This means that there is no taxable gain at the time of the gift. However, any additional earnings from this gift will be taxed when Tom receives them. Once a gift starts to earn income, the income is taxed. In this case, Tom is paid a dividend from the stocks each year. This dividend will be taxable gain to Tom. Stock dividends are treated like capital gain under 1(h)(11), so this income will be taxed to Tom at the lower capital gains rate each year.
When Tom dies, the trust is to terminate and the stocks will go to his children. Since this will be an inheritance, the basis of the stocks in the hands of Tom’s children will be the fair market value at the time of his death (or if they choose to value the estate for estate tax purposes on an alternate date, the date at this time will be their basis) under 1014. Tom (or his estate) will not have to pay for any increase in value of the stocks that occurred during his lifetime aside from the gain due to the dividends.
Condominium
Since this is the sale of real estate with payment to be received over several years, Tom may try to use the installment method. The installment method allows a taxpayer to recognize only part of each payment received as taxable gain each year and allows part of each received payment to be the recovery of basis. To determine the amount of each payment that is recovery of basis, you simply calculate the percentage that the basis has to the entire cost and multiply this percentage by each payment as it comes in. In this case, the applicable percentage would be $200,000/$300,000 = .667. However, the installment method is not available in the case of a dealer disposition. This is defined in 453(l) as “any disposition of real property which is held by the taxpayer for sale to customers in the ordinary course of the taxpayer’s trade or business.” Tom is a real estate developer and regularly builds condos and sells them to the public, so the sale of the condo would qualify as a dealer disposition, making the installment method unavailable to Tom.
Since Tom cannot use the installment method, his other options are either an open or a closed transaction. Tom would have to pay less tax under an open method; however it is very difficult to get open transaction treatment. Open transaction treatment is unavailable when there is an uncertain fair market value for the property, which is not the case here. Tom will be stuck with the closed transaction method.
The closed transaction method says that the amount realized in a sale is the money received plus the fair market value of any property received (such as the promissory note). This will lump the gain in the year of the sale, and then the rest of the gain will be recovered equally over the payment period. In Tom’s case, the amount realized will be the $100,000 cash down payment + the fair market value of the promissory notes, which is $160,000, for a total of $260,000. Since Tom had a cost of $200,000 for the condo, this is his basis, and the amount of the gain in this case is the amount realized ($260,000) – the adjusted basis ($200,000), which is $60,000. Since Connie will also be paying $20,000/year for ten years, a portion of this will have to be considered gain as well. Since there are an additional $40,000 of the purchase price that must eventually be considered gain, each year 1/10 of that will be recognized as gain ($4,000). If Tom were not a real estate developer, all of this would be capital gain because it is a result of the sale of real property. However, capital gain does not include property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business. Since Tom sells condos all the time, it would seem that this sale would not qualify for capital gains and would be treated as ordinary income.
Tom is also entitled to receive interest payments on the mortgage each year. The interest payments will also be income to Tom, and will have to be included in his ordinary income.
Office
Tom runs the real estate business out of a detached building behind his personal residence. Expenses for a home office are deductible, but only if it satisfies certain conditions. Under 280A, expenses for a home office are only deductible if it is a portion of a dwelling unit that is exclusively used on a regular basis as the principal place of business for any trade or business, as a place of business which is used by patients, clients, or customers in meeting or dealing with the taxpayer in the normal case of his trade or business, or in the case of a separate structure which isn’t attached to the dwelling unit, in connection with the taxpayer’s trade or business. A dwelling unit is defined in 280A(f)(1), and includes all structures or other property appurtenant to such dwelling unit.
In this case, we have a detached building that used to be a garage that is behind his personal residence. This would probably be included in the definition of a dwelling unit because it is a structure appurtenant to his home. If this is the case, then if the building is used for any purpose other than business, Tom will not be permitted to take a deduction. Although Tom regularly meets with clients and customers there, he also sometimes has friends and business contacts over for poker games. Tom claims that business is discussed over these games, so he may be able to argue that this is a meeting with clients in the normal case of his trade or business. If he is successful, then he will be permitted to take a deduction for all expenses for his office.
It also appears that Tom has two separate rooms in the detached building. If he is not able to take a deduction for all of the costs, he can probably deduct the costs for the office portion of the building because it is exclusively used on a regular basis as the principal place of business. It may be difficult for him to allocate costs, but it will probably suffice to simply divide the costs for the other building in half.
Since any deductions will be business expenses, they will be deductible against ordinary income.
Poker
When Tom has his friends and business contacts over for poker, he pays for drinks and cigars at the game. Under 271(a)(1), a deduction is allowed if a taxpayer can show that it is directly related to or is something that directly precedes or follows a bona fide business discussion. Since Tom discusses business during these games, it may be sufficient for him to claim a deduction. However, 274(n) limits deductions for meal and entertainment expenses to 50% of their cost. The drinks definitely would be limited by this provision, and the cigars can probably be classified as entertainment, so they will be limited as well
Tom also apparently loses money during his poker games. Gambling losses are generally only deductible against gambling gains. However, if Tom can show that it is somehow an ordinary and necessary business expense, then he can claim a deduction. It seems like a bit of a stretch to say that this is ordinary and necessary, however it is an expense directly related to a bona fide business discussion, so he will probably be permitted to take this as a deduction as well. This will also be limited to 50% of the cost because it is an entertainment expense.
If Tom claims these deductions, they will be ordinary and necessary business expenses, making them deductible against ordinary income.
Created by: bojack@lclark.edu
Update: 23 Jan 06
Expires: 31 Aug 06
[1] Tom might also wish to deduct the costs of building the condo at the time of sale, which he would be required to roll into the basis of the condo under UNICAP (§263a), and which he has presumably already included in his $200,000 basis.