Income
Tax I
Bogdanski
Fall 2010
Sample Answers to Question 1
Exam No. 6145
The Seminar Tuition
Carly’s tuition for the seminar is a nondeductible personal expense under § 262, therefore it has no federal income tax consequences, other than that she must pay the $500 out of after-tax income. If Carly could show that the seminar was a business expense, it would be an above-the-line deduction under §§ 162 and 62 because she is a self-employed physician. However, given that the title of the seminar indicates a personal benefit to Carly that has little to do with business necessity, it is doubtful that it has the requisite “ordinary and necessary” character to qualify as a business expense. Furthermore, it is unlikely to qualify as a deductible education expense because it would not seem to maintain or improve skills required by her business (cosmetic surgery), nor is it likely to be required by law per Reg. § 1.162-5.
The Laser
Equipment
Assuming that the laser equipment was the only equipment that Carly deducted under § 179, she would have been able to deduct the entire $120,000 currently in the year of its purchase because its cost was below the § 179 dollar limit. Carly’s § 179 deduction of the laser equipment allowed her to deduct the entire cost of the equipment in the year she bought it, rather than having to depreciate it over time as would normally be required by §§ 167 and 168. Because Carly deducted the entire cost of the equipment, her basis in the equipment was reduced to zero.
Although normally allowing
someone to borrow equipment would not likely give rise to recognized income,
especially if done out of detached and disinterested
generosity, here Carly received a benefit in exchange
for allowing
The
Settlement
Depending on how the $135,000 settlement is allocated, it can result in differing results for Carly. The general rule on damages is to look at what they replace. Here, the damages could replace property (the laser), income (lost profits), or nothing (punitive damages). If the damages replace the laser, they are treated as a § 1001 transaction and Carly would have a gain of her amount realized minus her basis in the laser. Here, if the entire amount is allocated to property, her gain would be $135,000 because her basis was reduced to zero under the § 179 election. Furthermore, $120,000 of that amount would be taxed as ordinary income under § 1245, dealing with depreciation recapture for depreciated equipment. The additional $15,000, however, would be taxed as a capital gain. Given that the laser was only worth $120,000 when she bought it, however, it is questionable whether the settlement would be entirely allocated to the laser.
Additionally, if the previous deduction under § 179 resulted in a tax benefit to Carly when she took it and if the current settlement produces a result that is fundamentally inconsistent with the previous deduction, under the tax benefit rule she will have to report the amount that she deducted previously as income in the current year. The settlement payment may not be fundamentally inconsistent, though, if she must comply with § 1245’s depreciation recapture rules because she would be paying ordinary income taxes on the amount previously depreciated, which is the same effect that the tax benefit rule has.
If the settlement amount is not completely attributed to the laser, however, whatever amount of the settlement is attributable to lost profits is taxed as ordinary income, as well as any amount attributable to punitive damages under Glenshaw Glass. Because the settlement agreement doesn’t appear to have allocated the lump sum payment, ordinarily a court would look at the intent of the payor in settling the case. Normally, the defendant just wants to settle the case to get rid of all of the claims so this may not be helpful. Alternatively, a court could look at the proportion of damages sought in the lawsuit to the actual settlement amount and allocate it accordingly; either way the entire settlement is income to Carly; none of it qualifies for the exclusion for physical injuries under § 104.
Despite this large accession to wealth, Carly should at least be able to deduct her attorney fees. Because she is the plaintiff in the lawsuit and recovery is gross income to her, her fees in getting the income are deductible. Furthermore, the deduction will likely be an above-the-line deduction because it is attributable to her trade or business under § 62(a)(1).
The New Laser
If Carly’s settlement payment is in fact attributed to the laser, she can avoid recognizing the previously-discussed gain if she makes an election under § 1033. Because she replaced the laser with like-kind equipment within 2 years of its involuntary conversion, and spent the entire settlement amount (and then some) on the new equipment, she would not be required to report any gain. However, she would not get a cost basis under this provision; she would only get a carryover basis from the original laser, which, as also previously discussed, is zero. She would also have to add the $5,000 broker fee into the equipment’s basis, which would then be subject to depreciation over the laser’s applicable recovery period.
Exam No. 6626
Carly’s income from performing cosmetic surgery is ordinary income, taxable in the year she receives it. Cosmetic surgery costs are not deductible medical losses under § 213 for her clients.
The expense for the Seminar is not deductible as an education expense because it is personal under § 262. It does not improve or maintain skills required for her business as a surgeon. She may, however, receive some imputed income from the event if she enjoys it. Imputed income is not taxed. She can try to deduct the $500 as a business expense, since she did some networking and talked with another physician there. This argument may not be successful, however, unless this was an ordinary and necessary expense. It may not have been necessary, since the seminar’s title makes it seem personal, focused towards gullible individuals rather than businesses. It may be ordinary, however, in the sense that it is not a capital expenditure.
Laser Equipment
Carly had an initial basis in the equipment of $120,000 as her cost. § 1012. However, her § 179 election reduced her basis to zero. § 179 allows a taxpayer to treat equipment (which includes the laser) as a current ordinary business expense, up to $500,000. The depreciation deduction comes out of the equipment’s basis, which is bad for the taxpayer, but she would have gotten an immediate deduction of $120,000, which is great for her and generated a loss. For tax purposes, the equipment is now considered used up and not worth anything, so anything she gets from it will be all gain.
The agreement/barter between Carly and
Lawsuit
The damages Carly received are taxable or not depending on what the damages replaced, based on § 104. The $120,000 for converted equipment would replace lost property, and would be taxable to the extent Carly realized any gain under § 1001. The damages would be the amount realized, minus her zero basis, so the damages would all be income, and since the laser is a capital asset under § 1222, it would be a capital gain, taxed at lower rates than ordinary income (usually 15%, depending on her tax bracket). The $40,000 in lost profits would replace profits. Since profits are ordinary income, the damages that replace them are also ordinary income, taxed depending on whichever tax bracket Carly is in. The $500,000 in punitive damages would be entirely ordinary income under Glenshaw Glass, which dealt with punitive damages and said that income can be derived from any source, and windfalls are included as income.
The case settled for $135,000. The parties should allocate which portion of the settlement is for what, since there are different tax consequences for each claim. The easiest thing would be to prorate the settlement in each category based on what Carly asked for. However, this would make the bulk of her recovery punitive damages, which is all ordinary income. She should try to make as little of the settlement ordinary income as she can, and as much of it capital gain. All income from the settlement must be reported in the year she actually or constructively received the cash payment.
Attorney Fees
As plaintiff, the deductibility of her legal fees depends on what kind of relief Carly was seeking. If the relief would be gross income, the fees are deductible as the cost of doing business or earning a living. Everything Carly sought and received in the settlement is gross income, whether ordinary or capital gain, so her $25,000 in attorney fees should all be deductible as an ordinary business expense in the year the fees are paid.
New Laser
Carly paid $200,000 for the new laser and $5,000 to the broker as a finder’s fee. Both of these payments go into her cost basis of the new laser, giving her a cost basis of $205,000. This is a capital expenditure, because the laser will produce income over a period of years. Since this is a business expense, she can take depreciation deductions on her new equipment. She can take another § 179 deduction if she elects to and is eligible based on what other deductions she takes, deducting the entire $205,000 immediately as an ordinary expense and taking her basis down to zero.
Alternately, she can use ACRS (accelerated cost recovery system) depreciation under § 168. The easiest to calculate would be a straight-line deduction. She would take a deduction every year in the same amount for the recovery period of the equipment as defined in 168(c). If the equipment were 10-year equipment, for example, each year she would take $20,500 in depreciation (205,000 original basis/10). Because of the first year convention, though, she would take only half the deduction in the first year, and half on the 11th year’s tax return. The deprecation lowers her adjusted basis.
Under the Double-Declining method, she could take 2 x ((adjusted basis for the year) / (# years in period)), or 2 x 20,500 (41,000). Her second year would use the adjusted basis (205,000 – 41,000), but the same number of years. With the half-year convention, she would take only 20,500 in the first year as with the straight line method. She would switch over whenever the straight line method would give her a greater deduction. Because of the half-year convention, her second year’s deduction under this method would be the largest.
Another option would be to take bonus depreciation under § 168(k). To do this, first she would deduct half of the original basis straight off, with no half-year convention. Then, she would use the double-declining method, including the half-year convention, but starting with half the original basis (starting with 102,500 adjusted basis).
Alternately, the new laser may be an involuntary conversion under § 1033. It is like kind property under § 1031, but involuntarily exchanged. Whatever proceeds from the settlement were allocated to the loss of the laser could be used toward the new laser. However, since the first laser was considered worthless for tax purposes, having deducted all the basis already, any part of the settlement allocated to the laser was essentially a windfall.
Exam No. 6808
Education Expenses
Education expenses are permitted as an above the line business deduction against ordinary income under Section 162 when the education expenses meet the test specified in Treasury Regulation 1.162-5. Under that test, education expenses are deductible if the education maintains or improves skills required by the individual in her employment or other trade or business. Carly is a self-employed physician, so her trade or business is the medical field. Therefore, under Reg. 1.162-5, Carly is entitled to deduct education expenses that maintain or improve her skills in the medical field. Since the one-day seminar is about time and money management, it does not maintain or improve Carly’s skills in the medical field. The seminar is not specific to skills in the medical field, but general skills that are not unique to the medical field. No deduction was allowed for such general education expenses in Carroll, and so no deduction will be allowed in this case either. Therefore, Carly cannot deduct the $500 expense of attending the seminar.
Old Laser Equipment
Section 179 allows businesses to treat a capital expenditure as a current business expense when the aggregate cost of the property is less than $250,000 in the year the property is put into service. Therefore, instead of recovering the basis of the property over an extended period through Section 168 depreciation, the business is able to immediately deduct the otherwise capital expenditure, recovering the entire basis of the property in the year it is put into service. Since Carly made a valid election under Section 179, she was able to treat her $120,000 capital expense as a current business expense, deducting the $120,000 against ordinary income in the year the property was put into service (2 years ago). Since Carly has recovered the basis of the property under Section 179, her adjusted basis in the property after her Section 179 election was $0. The Section 179 election is irrevocable, so Carly cannot alter this outcome in a later taxable year.
Settlement Payment
Whether
the $135,000 cash settlement payment is gross income to Carly
depends on the intent of the payor, here
The $120,000 property damage claim is treated as a $120,000 gain on a property transaction. Under Section 1001, the gain on a property transaction is equal to the amount realized over the adjusted basis of the property. Here, the amount realized is equal to the $120,000 claim. Carly’s adjusted basis in the laser equipment is $0, as explained above. Therefore, on this property transaction Carly has $120,000 in gain (unless this gain is excluded by another provision, Section 1033 might exclude this gain as discussed below). Any legal fees associated with this property transaction would be added to the adjusted basis of the property, reducing the taxable gain to Carly (though it is also unclear what amount of Carly’s legal fees should be allocated to this transaction). Therefore, the $120,000 claim would be included in Carly’s gross income and a settlement payment to extinguish that claim would be similarly included (again, subject to the discussion below).
The $40,000 lost profits claim is to replace gross income. Under Section 61(a), profits from conducting a business are included in gross income. Therefore, damages for lost profits and any settlement payment to extinguish a claim for lost profits would be included in gross income.
The $500,000 punitive damages claim is included in gross income. Punitive damages do not replace Carly’s income or property; they are simply an accession to her wealth. Therefore, under the Glenshaw Glass definition of gross income, the punitive damages would be includable in Carly’s gross income.
Section
104 does not change the result of any of these amounts. Section 104 allows for
exclusion from gross income of compensation for physical injury or sickness.
Since Carly did not sustain physical injury or sickness,
the damages she receives from
Since
Legal Fees
For a plaintiff, the deductibility of legal fees depends on the consequences of a successful legal claim. If a successful claim would result in amounts includable in gross income, the legal fees of a plaintiff can be deducted as a business expense under Section 162 or an income producing expense under Section 212. This result is true whether the plaintiff wins or loses.
As discussed above, Carly is pursuing damage amounts that would be included in gross income: gain on property ($120,000), profits ($40,000), and punitive damages ($500,000). Since Carly is paying legal fees in pursuit of income, the amount of the legal fees is deductible. Therefore, Carly’s legal expenses are deductible against ordinary income in the year that she incurred them.
Legal fees are subject to the 2% floor for miscellaneous deductions in Section 67 unless they are incurred for business, associated with rental property, or a discrimination suit. Carly’s legal fees are associated with her business because they involve the conversion of equipment she used in her business. Therefore, the Section 67 2% floor does not apply and Carly is able to deduct the full $25,000 in legal fees as an above the line deduction in the year she incurred them.
Legal fees associated with a property transaction are included in the basis of the property. Since it is unclear what amount of the legal fees that Carly paid are attributable to her involuntary property transaction, it is also unclear what percentage of these legal fees should be allocated to Carly’s basis in the old laser. Suffice it to say that some portion of these legal fees might be included in Carly’s basis in the old laser, affecting her Section 1001 gain on the old laser and her carryover basis in the new laser, as discussed below.
New Laser Equipment
Even
though Carly has a realized gain under Section 1001
(as discussed above) on the old laser, Section 1033 could prevent that gain
from being recognized because the conversion was involuntary. Section 1033
allows a taxpayer who has suffered an involuntary conversion to elect to
rollover the involuntary property gain into replacement property, if such
replacement property is procured within 2 years of the close of the first
taxable year the involuntary gain is realized. Section 1033 requires that the
replacement property be similar or related in service or use to the property
converted. Although the new laser is more expensive and an improved model of
the equipment, it is related in service or use to her old laser and therefore
qualifies as replacement equipment. Since Carly
purchased her new laser within 2 years of
If Carly does not make the election under Section 1033, the Section 1001 gain on the old laser will be completely recognized (any settlement payment on account of the laser will also be recognized). Since Carly had $0 adjusted basis in the old laser, this would amount to the entire amount allocable to the old laser being a recognized gain for income tax purposes. The gain would be ordinary because the laser is property used in Carly’s trade or business and subject to depreciation, so it is not a capital asset. Under this scenario, Carly’s basis in the new laser is equal to the cost of the laser, including the $5,000 fee paid to the equipment broker, for a total basis in the new property of $205,000.
If Carly makes the election under Section 1033, the Section 1001 gain on the old laser will not be recognized (any settlement payment on account of the laser will also not be recognized). Rather, the proceeds of the old laser will be rolled over into the basis of the new laser, with no gain recognized until the sale or exchange of the new laser. Under this scenario, Carly’s basis in the new laser would be equal to the cost of the new laser $205,000 minus whatever part of the cost was attributable to the Section 1001 gain on the old laser (essentially, Carly gets the $0 basis in the old laser carried over into the new laser, plus whatever extra money she had to pay to purchase the new laser). This basis would either have to be capitalized and depreciated under Section 168, or Carly could again elect to expense the basis of the laser under Section 179.
Exam No. 6831
The first transaction that we will discuss is the $500 tuition payment for the success seminar. The $500 will not be deductible as a business expense or in any other way as it is personal, living, or family expense under code section 262 and does not fit into any exclusion category. What education expenses can qualify as a business deduction is clarified by IRS REG. 1.162-5. This class does not seem to help Carly perform any better at her job, and since she is self-employed, it cannot reasonably be considered a requirement by her employer although if she argued that she might be able to deduct subsequent therapy sessions. Carly might argue that the success class helps her manage her finances and this is a skill that is requires in her business. If she could prove this, she might have a chance.
When Carly bought the first laser equipment two years ago, she made an election, under code section 179, to expense the cost of that item, therefore it has no depreciation value (no basis) and any sale of the item will be all capital gain, with no basis.
If Carly had not made this election, then the price of the equipment would be depreciable, according to IRS depreciation tables.
The exchange between Carly and
The lawsuit leads to two transactions, the final judgment and the attorney's fees. We will discuss the attorney's fees first. The attorney fee in this case will probably be deductible. The item at issue was a piece of business equipment for Carly, and she was suing a competitor in her business. While this situation pushes the limit of ordinary and necessary, under 162, recovering converted business equipment, when converted, seems to fit the mold. There is nothing personal about the situation here, as the loaning of the equipment was for business referrals and, as mentioned before, the equipment was business equipment converted by a competitor.
The final judgment is more complicated. The 135k could represent 1. lost profit 2. property replcaement or 3. punitive damages. In settlements, the court will look to the intent of the payor of the settlement to determine how the $ should be apportioned. Punitive damages are not excludable, under Glenshaw Glass, but the damages apportioned to replace property will be treated as a sake of the original property and the lost profits will most likely be treated as income, as they would have been.
Let's just imagine that the apportionment should go as follows, 100k for the property, 20k for lost profits, and 15k for punitive damages. This would result in 100k in capital gain, under code section 1231, because of the 179 election earlier, and 35k in ordinary income for Carly. If the 179 election had not been made, then the 100k would go against what was left of Carly's depreciated 120k basis and a capital gain would likely result from that theoretical transaction. If it was a loss, this would be ordinary income loss under 1231.
When Carly purchases the new equipment, she will have a 200k basis. The 5k fee for finding the equipment might qualify as a business expense because she was in need of expedited shipping to start earning money. Shipping payments and finding fees are ordinary and necessary with respect to business. However, a tax court might rule this to be the cost of buying the property and add it to the basis of the 200k property, to be depreciated along with it. This will likely come down to facts about what is ordinary in Carly's field. If fees come with every piece of equipment, then perhaps it should go to basis.
Carly may be able to expense the new laser equipment as she did with the older one. IF she elects to expense this new item, she needs to be aware of the 250k cap for expensing depreciable business assets under 179(b)(1). The deduction from this election would count against any active business conduct by Carly in this taxable year. She would also be able to carryback the deductions to past acvitve business income from 2 years prior and/or carry forward for 20 years. IF she carries back, she will have to use the deduction against he earliest year first (can't choose the highest tax bracket). Carly could also elect to have her business deduction only go forward.
Carly will be able to depreciate the value of this item according to the the IRS tables in REV PROC 87-57, or according to the half-year rule and double-declining balance methods.
Carly could elect to not recognize the apportioned amount of the settlement that she reinvested in replacement equipment as an involuntary conversion under 1033. IF she is going ot make a 179 election anyway, this would be silly as she'll be able to deduct it anyway. However, let's say 100k is apportioned as replacement, she has 50k left of her basis on the original equipment. She will be able to spend the 100k from the settlement and 100k cash, resulting in a basis of 150k in the new equipment and zero capital gain from the loss of the old piece of equipment. She could still expense the 100k that she spends on the new equipment but would lose 100k of basis in the new equipment if she did so.
All business deductions mentioned above are above the line.