Income Tax I
Bogdanski
Fall 2008

Sample Answers to Question 2

Exam No. 9901

Howard as an avid snowmobile rider and entrant of numerous races may try to argue that he is involved in the sport for profit and thus should be allowed to take a deduction for all business losses under §162. In making this argument, Howard, the dentist, will try to argue this is not a hobby by showing his primary intent under §183 because he is not presumed to be involved in a business having not made a profit 3 out of the last 5 years as required by §183(d). Howard could argue that he has expertise, spent substantial amounts of money and time in carrying on this activity. However, this argument is likely to fail. Howard is not a full time professional snowmobile rider, instead he is a dentist who likes to ride snowmobiles. It seems very unlikely that Howard’s primary intent is profit and not the pure thrill and joy he gets out of racing. Because this is a hobby Howard can only deduct his hobby losses from his hobby income. Thus, it appears he will have to pay taxes on his ordinary gross income from the prizes he received, under §74, that will exceed all of his expenses from his hobby.

Under §183 even though his hobby is not for profit §183(b)(2) allows Howard a deductions as if he were engaged in a for profit business up to his gross income. So in determining the types of expenses that Howard could deduct one must treat it like a business and look for the “ordinary and necessary” business expenses. It is likely that Howard will be able to deduct most if not all of his expenses. If Howard was a for profit snowmobile rider it seems likely that it would be “ordinary and necessary” to purchase fuel, insure and maintain the snowmobiles much like one would have to do with a car. Because this isn’t a car he will not be able to take the standard per mile rate and instead will have to keep records of his costs for the snowmobiles. The snowmobiles themselves will likely be a capital expenditure because they provide a benefit for over a year and thus will have to be depreciated over time. However, like a truck, they should be eligible for ACRS and thus he will be able to take a fairly large deduction in the first year. The expenses of transporting himself and gear to the races may raise a question. Here he is always traveling and like a traveling salesman may always be “away from home.” However, if he has a home track or location where he practices this could likely be considred his home. Thus while his commutes to this primary location would not be deductible, travel to the events likely would be.

To determine how much Howard will be able to deduct for the fixing of his snowmobile we must first determine if this is a repair or improvement. It appears that this is clearly an improvement to the snowmobile. Howard has improved his fuel-efficiency and essentially built a brand new snowmobile. Even if part of the process is a repair when it is incidental to a full overhaul and improvement all expenses will be included as an improvement. Because this is a improvement, this is a capital expenditure and thus not currently deductible. Howard will add the expense of his work to the basis of his asset and depreciate it over the time set by the Code.

While Howard will get a deduction over the course of the life of the snowmobile, he will likely end up losing more money in the end because of his early withdrawal from his qualified retirement plan. While his age is unclear, the fact that he is out riding snowmobiles it is likely that he is not 59-1/2 years old and thus will be facing a penalty for early withdrawal. If this is the case Howard will have to include the amount taken out as ordinary gross income, as well as be subject to a penalty of 10% under §72(t).

While Howard places illegal bets and would like to not report these as income, this is not an option. Illegal income is ordinary gross income and if he fails to report it he is committing another crime. Assuming this is a legal by Howard to Todd Howard would be taxed as if used the property to “satisfy a debt.” Thus he would have gross income under §1001a for the sale of property. It does not matter that this was to pay off a debt he still received a gain.

Originally, Howard would have had paid no tax on the stock because he received them as a gift from his mother. His original basis would have been her carry-over basis of $1,500. His basis in the property would only be 1,300 at the time of the sale. Thus the “sale” to Todd would result in a $300 capital loss under §1015. This would be a capital loss because it is the sale of stocks. His loss would only be 300 because if the donors basis (Howard’s Mother) is higher than the FMV at the time of the gift the FMV will be the basis for determining the loss. Because this is a capital loss Howard will only be able to deduct it against his capital expense.

Of course by doing all of this Howard is showing that he is involved in illegal gambling. He may try to claim that his wager, which would be his basis, was 1000 and thus should be able to deduct this expense. If he does make this claim, Howard will need some form of receipt to show that this wager and transfer occurred. Additionally, Howard will be only be able to deduct this gambling loss against his gambling winnings in the current tax year.

Exam No. 9868

I. Hobbies: Snowmobiling Expenses and Prizes

Howard started out snowmobiling as a hobby. Expenses for the purpose of personal enjoyment, like snowmobiling, are not deductible. (§ 262). However, once a hobby (or other activity not engaged in for profit) begins to make the taxpayer profit, those expenses are deductible against the hobby’s losses, (§ 183(b)(2)), and it would be a miscellaneous deduction under § 67 subject to a 2% floor in aggregate of miscellaneous deductions. Prizes are income under Glenshaw Glass and § 74b, because all economic benefits are income unless some narrow exceptions apply. Those exceptions do not apply to Howard’s prize money, so that money is taxable to him as ordinary income.

Howard’s snowmobile is a capital asset, because it is property he owns that is not listed as an exception to § 1221. As a personal-use asset, Howard is entitled to capital gains on income her received from his snowmobile, but losses from a personal-use asset are not deductible. Therefore, even though Howard got to the point where he won more than he spent, he could not deduct his snowmobiling expenses against his hobby gains or at all.

Howard could argue, like in Nickerson v. Commissioner, that snowmobiling has become more than a hobby. He intends to make money off racing, and therefore he should be entitled to depreciate the cost of his snowmobiling expenses, as well as deductions where allowable. For now, Howard cannot claim a presumption that his snowmobiling is for profit because he has only has profits exceeding losses for one year, and the presumption requires 3 or more taxable years in 5 consecutive years ending with the current tax year. The 9-part, intent-based test in § 1.183-2(b) of when an activity is for profit gives Howard a fighting chance.

II. Snowmobile Overhaul: Capital Expenditures

As discussed above, Howard’s snowmobile is a capital asset, and his costs related to the snowmobile are capital expenditures. To be able to depreciate the cost of his snowmobile, Howard must show it wears out over time (clearly it does), and that it is used to produce income. It is not clear if this test of producing income follows the test outlined in § 1.183-2(b). If so, Howard can make an argument but probably is not on strong footing.

If Howard can show his snowmobile is used to make income, he can take depreciation deductions spread out over the number of years in the Accelerated Cost Recovery System (ARCS) as designated in the chart of applicable recovery period in § 168(e)(3). Because his snowmobile is personal property, Howard would have a choice of method between the Straight line method of depreciation and the Double-declining balance method. (§ 168)(g)(2) The latter provides a larger allowable deduction upfront and so is usually the better choice for a taxpayer.

Under the Double-declining method, Howard’s annual deduction for the first year would be: (adjusted basis divided by total number of years in the period) times two. The annual percentage would vary as his basis decreased. The amount of Howard’s deduction would also be subject to the mid-year convention in § 168(d)(1), such that he could take only half of the amount calculated above in the first year. This convention was created in recognition that taxpayers who buy property at the end of the year should not be entitled to a full-year depreciation, but taxpayers who buy property at the beginning of the year should not lose an entire year of depreciation. The mid-year convention was a compromise for administrative simplicity and fairness. Indeed, the entire ARCS rule is a benefit to taxpayers, who previously had to depreciate capital assets over their actual life. From the government’s perspective, it is an inventive for taxpayers to buy new property more often, which stimulates the economy.

In the second year of Howard’s depreciation, he would begin with his remaining basis and run the formula again. This method continues until the last year, when Howard would switch to the straight line method. Under the straight line method, Howard’s annual deduction would be his adjusted basis divided by the number of years remaining in the period (1), so effectively it would be the amount of his adjusted basis.

Again, if Howard can show his snowmobile meets the income-producing requirement of for depreciation, he would be entitled (in 2008 only) to a bonus depreciation of 50% extra to the overall basis of his property in the first year, and then normal depreciation for the rest of his basis. Or, under § 179, he could write off his snowmobile (tangible property) up to an amount of $250,000, as long as its basis is below $800,000. Therefore, Howard could skip the entire process of depreciation. But he could not write off expenses related to the property, because § 179 applies to tangible property only.

Howard might want to argue that his overhaul to his snowmobile is a repair, because then those repairs might be deductible. (Reg. § 1.162-4) However, repairs in the nature of replacements, as Howard’s overhaul surely was, must be capitalized and depreciated. Howard would probably not be subject to UNICAP rules in § 263A, unless his improvements to the snowmobile are characterized as making a snowmobile (producing tangible personal property), so he will not have to capitalize direct and indirect costs related to his snowmobile. He can deduct them under § 212 as capital losses from investments to make a profit.

III. Qualified Retirement Plan: Early Withdrawal

Howard’s choice to take money of his qualified retirement plan to soup up his snowmobile is an impermissible reason for withdrawal. The money will be taxed as ordinary income, and he will have to pay penalties.

IV. Gambling

Gambling proceeds are treated like a sale under § 1001(a). Howard’s bet gave him a $1,000 ordinary loss. However, deductions on wagering losses are deductible only to the extent of the gains of such transactions, and proof in the form of a contemporaneous journal of losses is required. (§ 165(d)). If Howard does not have any gambling wins, he cannot take a deduction and has simply lost a grand.

V. Transfer of Stock as Payment of Debt

Howard’s transfer of appreciated property to Todd in payment of his gambling debt is treated as a sale under § 1001(a). Under § 1001(a), Howard realizes a capital loss of $300: fair market value of the stock at the time he gave it to Todd ($1,000) minus his adjusted basis in the stock ($1,300) (this basis is discussed below). Capital losses are less desirable than ordinary losses because they can be deducted only against capital gain. The rationale of this less desirable treatment for capital loss is to prevent taxpayers from selling losing stocks to realize a deductible loss without selling stocks that generate taxable income. However, even if Howard doesn’t have any capital gain in this tax year, he can deduct his first $3,000 of capital loss for the year against ordinary income under § 1211(b), and he can carry the excess loss forward.

VI. Gifts of Stock

When Howard got the stock from his mother, it was a lifetime gift, and therefore under §102(a) did not produce taxable income to Howard. When he received the stock, it was already losing money, having gone down in value from $1,500 to $1,300. This loss would not be determinative until Howard disposed of the property. If Howard sold the property for $1,500 or more, his basis would have been carryover of $1,500. (§ 1015) If he sold the property for more than $1,300 but less than $1,500, he would not have realized a gain or loss. And as occurred here, when the value continued to drop, his basis was the fair market value at the time the property was transferred to him.

Exam No. 9248

Because Howard’s primary job is as a dentist, his snowmobiling activity would likely be classified as a hobby under §183(a). Although Howard enjoys winning races and prize money, he would have a difficult time saying that his primary motive for snowmobiling was profit. Looking at Reg. §1.183’s guidance for objective factors to determine whether it’s a hobby also suggests that it’s not. Because, Howard hasn’t shown a profit for 3 of the last 5 years, he doesn’t receive a rebuttable presumption that it’s a business. So, under §193(b)(2), Howard can deduct the expenses of his hobbies only up to the income of the hobby. This year, Howard’s income from the hobby (the prize winnings) exceeded his expenses.

Under §74, prize money is ordinary income. Howard’s prize money doesn’t qualify for any of the exclusions under that section. So he would have to report the prize money as part of his gross income, then he could deduct all of his expenses for the hobby (below the line) – fuel, maintenance, insurance, and cost of snowmobiles.

Howard’s snowmobiles are capital assets as defined in §1221(a). As such, any improvements he makes to them (that significantly increase value or lengthen the life of them) would be a capital expenditure such that the amount of the improvements would go into the basis of them. If Howard sold them or otherwise experienced a realizing event, his basis in the snowmobiles would be adjusted to reflect the improvements. If, for argument’s sake, Howard’s snowmobiling were a business, he may be able to deduct the depreciation of the snowmobiles as well as the depreciation of the improvements over time under §162. Howard’s withdrawal from his qualified retirement plan will have tax consequences. No matter how old Howard is, the amount withdrawn will be taxed as ordinary income. If Howard is younger than 59½, he will also have to pay a penalty for the early withdrawal.

As for Howard’s illegal gambling losses, those are not deductible against anything because they are illegal. Had they been legal, he may have been able to deduct them against any gambling winnings §165(d). The transfer of $1,000 worth of stock to Todd, however is arguably a transfer of property, with its attendant tax consequences. Here, Howard transferred the stock to Todd for nothing in return, so it is a loss to Howard.

Originally, the stock was a gift to Howard from his mother, and Howard experienced no tax consequences at that time. Under §1015, because his mother was a “live” donor, Mamie’s $1,500 cost basis in the stock normally would have carried over to Howard at the transfer. However, because the stock suffered a loss while in Howard’s hands (FMV now $1000), Howard’s basis was actually the $1,300 FMV when Mamie transferred it to him. So, when Howard transferred the stock to Todd, Howard’s loss was: $0 amt. realized – $1,300 adj. basis = $1,300 loss. Howard could declare that as a capital loss. On the other hand, if the transfer to Todd was classified as a gift because there was no sale, there would be no positive or negative tax consequences for Howard.

Exam No. 9283

Hobby Expenses and Prizes as Income

Under IRC § 183(a) the general rule is that if an activity is not engaged in for profit, you cannot deduct the expenses. However, if an activity is for a profit, then the expenses are deductible. Generally tax payers don't have a profit motive when they engage in their hobbies. However, under IRC § 183(b) if you have a hobby, then you can deduct your hobby expenses against your hobby income if the deductions would be allowable if the hobby was for-profit.

Howard's traditional job is being a dentist, so his snowmobiling can be seen as a hobby because he takes pleasure in it. To see if Howard can deduct his hobby expenses from his hobby income, there is a 9 factor test in Reg. IRC § 1.183-2 to determine if the hobby has a profit motive. This test is only considered if a taxpayer is losing money and wants to take a big deduction. The 9 factors are the 1) manner that the taxpayer carries on the activity, 2) the expertise of the tax payer, 3) The time and effort expended by the taxpayer in carrying on the activity, 4) expectation that assets used during the activity will improve in value, 5) the success of the tax payer in similar activities, 6) taxpayer's history of income or losses related to this activity, 7) The amount of occasional profits, if any which are earned, 8)Amount of assets owned by the tax payer and 9) getting pleasure from the activity. Howard could probably meet all of these factors except for #6 because until this year he has had more losses than income from the activity. Otherwise he seems to be investing time and effort to improve his snow mobiles and he is starting to win more races.

If Howard is able to deduct some of his expenses from his snowmobiling hobby (such as fuel, insurance, maintenance, traveling to races), he will only be able to do that up to the amount of income that he has received from his hobby.

Howard's primary source of income from his hobby is prize money. He wins cash prizes from racing and this past year he won more money than he spent on expenses. Therefore, any prize money that Howard wins from racing is considered gross income under IRC § 74. This is ordinary income. Howard will be able to offset this income by claiming deductions up to the amount of his snowmobiling expenses this year.

Improvements to Howard's snow mobile

Howard's fastest snowmobile requires repairs, but instead of just repairing it, Howard decided to make some improvements, which significantly improved the value of his snowmobile. If Howard had just made the necessary repairs to keep the snowmobile running he might have been able to deduct that expense as a business expense. However, if during the course of repairs, the taxpayer decides to make improvements to the property, he may lose the ability to deduct any of the expenses.

Instead, since Howard is improving his snowmobile, he will have to claim it as a capital expenditure which he will be able to depreciate if the property produces income (we assume that he uses his fastest snowmobile to win races and receive income). Under IRC § 168 he will be able to use the double declining balance method (which allows his annual deduction to be his adjusted basis divided by the number of years he can depreciate the property times 2!) which will give him a huge deduction in the first year. The double declining method cannot be used for real property, but that is fine since a snowmobile is not real property.

Howard's basis in his snow mobile is any costs that he has put into it minus any depreciation.

Withdrawing money from a Qualified Retirement Plan

Howard chose to withdraw money out of his Qualified Retirement Plan to pay for the repairs which may have negative tax consequences. Any money pulled out of a Qualified Retirement Plan counts as ordinary income and Howard would have to pay tax on that. In addition, if Howard is less than 59 ½ years old, he will also have to pay a 10% penalty on the money that he pulls out! If Howard is more than 59 ½ years old, he will not have to pay the penalty.

Illegal Gambling

Howard decided to place an illegal bet on one of his races and he lost. If he had won the bet, he would have had ordinary income even though it was from an illegal source and he would have had to pay taxes on that income.

As for gambling, to figure out Howard's gain or loss, we subtract his adjusted basis from his amount realized. In this case he bet $1000 with no basis and he lost, so he had a $1,000 loss. However he cannot deduct this loss because gambling losses can only be deducted against gambling gains. The best that Howard can do with gambling losses is break even; he can never deduct more than he spent.

Gift of Stock from Howard's mother

Howard gave Todd stock worth $1000 to pay his bet. The Fair Market Value of the stock when he gave it to Todd was $1000 so that satisfies the bet. He received the stock from his mom so special rules for valuation apply.

Any gift that Howard receives is tax free to Howard as far as income tax goes. Howard would have been able to use a carryover basis in the stock if the value of the stock had gone up in value. That means that at the time of the transfer from Howard's mom to Howard, Howard could have taken his mom's basis in the stock. However, there is an exception when stocks go down in value while in the hands of the donor (as happened in this case since his mom's stock decreased in value from $1500 to $1300 before the transfer). In that case, Howard can use the fair market value of the property at the time of the transfer as his basis. That means Howard's basis in the stock was $1300. If Howard would have sold the stock instead of giving to Todd, he could have claimed a loss of $300 ($1300-$1000). We don't have any information about Howard's mother's wealth, but if she had been required to pay the gift tax on the girt, and Howard would have been able to use carryover basis, he would have been able to increase his carryover basis.