Tax.docx

Unit I Why is tax important A Normative functions of tax i Pay for public goods Military cops roads etc ii Redistribute wealth A Public value judgments Too few or too many wealthy people How much should we tax care of less fortunate How is power allocated B Make social policy decisions through tax system Pensions Use tax system as incentive for corporations to provide B Non-normative function Provide incentives dis-incentives for certain kind of behavior a Tax has major economic incentive gov t can use to affect econ behavior b Use tax system to get people to purchase certain investments c Make something more profitable by decreasing tax low income housing d Tax is a tool to get agendas through the tax system C Income Income No definition in code is statutory creature How to calculate tax liability a Gross receipts exclusions gross income i Gross income all income from whatever source derived b Gross income deductions taxable income i Deductions cost of producing income or some expenses which C has chosesn to let you deduct even though you aren t producing income charitable medical ii Personal Dependency deductions standard or itemized A Taxable income x tax rate tentative tax B Tentative tax credits Tax liability Credits and deductions are same thing economically but code treats differently D Rate Structure Changing rate structure and changing deductions what we choose to tax accomplish same thing economically Graduated progressive rates So different dollars are taxed differently i i e - K - K - K K ii Flat tax rate those that have more would pay more iii Progressive those that have more should pay at a higher rate iv Brackets Refers to the rate the last dollar a TP earns is taxed at E How to interpret code General interpretive regulation Cts usually uphold Administrative announcements by IRS a Revenue ruling Ruling by IRS on a particular point of law i Position gov t going to take if litigate case ii Not binding on gov t gov t can choose not to follow at their peril b Revenue procedure c Private letter ruling i Advantage If get favorable letter ruling have essentially BOught insurance for your client no major corporate transaction goes forward w out a letter ruling all Fortune co s audited ii Disadvantage If get negative letter ruling and go forward with transaction going to get audited Cases a Deficiency letter days to figure out what going to do i Pay and fight Refund litigation District ct ii Pay and don t fight Tax ct iii Fight b Tax Ct rulings i Decision by tax ct judge T C ii Tax Ct Memo T C M Case which only has factual issues not much precedential value How to evaluate tax system a Equity i Vertical equity A Those that have more should pay more ii Horizontal equity A Equals should pay equal taxes if get tax right then equals pay the same B Have to be able to define income in order to decide if people are equals C Problems Equitable if take people not in statute and clump with group that is What happens when statute is silent b Efficiency i Efficiency costs Taxes are non-neutral w respect to changing people s behavior and thus the allocation of resources ii Assume that every tax changes behavior and efficient tax is does so as minimally as possible A One exception When C uses tax intentionally to change behavior Is this efficient Is change good or bad C made policy decision to affect efficiency of taxes Tax preferred asset One that gets better than normative treatment c Simplicity Administrability i Voluntary tax system can t have rules that are un-administrable ii If rule too complex People won t comply A Rule complexity Rule so complex average person can t understand B Transaction or planning complexity Rule simple but people change behavior in order to take advantage of so gives rise to complex trans C Complexity can be inequitable b c TP s with equal abilities to pay may have different tax burdens b c of their unequal abilities to understand or manipulate tax rules d Tax can never be Efficient Equitable and Simple Unit II Compensation Fringe benefits biggest problem w compensation Taxing fringe benefits is an issue of equity could run life through fringes and tax base would disappear a Why do we excuse any fringe benefits Want to tax discretionary dollars b Income Dollars that come in that can be consumed any change in wealth Ex A earns K K in cash B earns K gets in-office daycare worth K a If A and B are the same have to tax day care A earns K B earns K yellow pad a If they are the same don t tax yellow pad b If B is better off than A have to tax yellow pad A earns K for teaching B cleans toilet at Port Authority gets scrub brush a By standard of income these two are the same b c scrub brush like yellow pad doesn t measure into ability to pay C has said that there are some fringes that are included or excluded if don t fall in these categories go back to and decide if part of compensation or not Fringe Benefits and Compensation Problem E a summer associate at a law firm received the following Which are should be subject to tax and in what amount Her NYC income taxes are paid by the firm Assume she earns K and the NYC tax rate is i What is compensation Old Colony Trust Co v Commissioner Compensation includes any tax employer pays you Gen rule Compensation is whatever employers pay you for your services doesn t matter what form in takes Why don t we make rule that compensation is whatever is in your paycheck Inequitable b c tax base would shrink b c everyone would ask for compensation in a form i e stocks that wouldn t be taxed De minimis fringe On days when she works past p m dinner is provided Suppose in the alternative She is given a voucher to use at one of ten neighBOrhood restaurants Meals or lodging furnished for the convenience of employer voucher for specific restaurants compensation b c not furnished on bus premises Meal eaten off employers premises If voucher was occasional a couple of times year then would be de minimis and exempt Dinner is catered in the firm dining room by a fancy French restaurant which costs the employer per person but is worth only to her In order to be excluded under has to be on premises for the convenience of employer as defined in regs Convenience of employer Some non-compensatory reasons so not trying to give them extra compensation i e want them to stay and work She is given supper money of which she uses to buy a sandwich to eat at her desk Commissioner v Kowalski - Even though eaten on premises for convenience of employer cash payment or cash reimbursement not excludable under The monthly fee at the New York Sports Club and a Dial-a-Car account for travel to and from the firm NYSC j Excludes on-premises gyms NYSC not on premises not operated by employer not used substantially by employees of employer so not excluded is part of compensation under Dial-A-Car acct Qualified transportation fringe f Depends on if car used by Dial-A-Car counts as a commuter highway vehicles which under f B it is not so only way it could be excluded was if it was de minimis for convenience of employer i e if not safe to take subway Why does C say employer can t pay for Dial-A-Car but can pay for qualified parking B c for most of country parking isn t an additional benefit enough space so not going to tax BUT paying for cab for most of country is unusual so going to treat it as compensation Tickets to Mets game when no client or partner wants them De minimis - excludes occasional sporting event tickets but not season Need to frequency of tickets Trick w de minimis is distinguishing compensatory transfer from non-compensatory but tax preferred benefit Evaluation Efficiency a Encourages employers to provide meals on bus premises in problem choose French dinner most expensive but most A-T benefit Equity a A and B BOth make K if B gets K in meals BOth are taxed at same rate i Inequitable A has to pay for their food out of pocket so are making less than B so less ability to pay A has K to consume B has K to consume meals ii Equitable Don t want to tax things that are essential to performing job over which TP has no discretion over If tax things that have discretion over which are provided in kind create inequity in people who get cash as opposed to in kind benefit so C who got K in cash would be taxed the same as B who only got K in cash If no discretion is worth less than cash Simplicity a If going to tax in-kind benefits have to put a value on them would end up having to use objective rather than subjective measure of value E No additional cost services b - - Problem Problem a b a To get b exclusion need to i Service needs to be in ordinary course of business for employer AND ii Employer incurs no additional cost b Airline employee meets BOth of these criteria gen counsel for widget co doesn t i e De minimis deduction for lawyer NO b c needs to be small dollar amt Hard to acct for ii d Working condition fringe NO b c not for convenience of employer c Evaluation i Why did C decide to draw line at line of business Harder to provide for compensatory fringe benefits if are forced to stick to your line of business Political is form of tax preferred compensation Efficiency gains Society is better off if fill plane so if let B go as well not create a reason for co to do something they normally wouldn t have done airline not going to change behavior if limit fringe to something they would have produced regardless of tax benefit going to be empty seat one way or another this is example of efficiency trumping equity ii Equity A has salary of K and fringe of K in free air travel B has salary of K If A and B have econ income of K then are treating inequitably A and B don t have same income b c market could be taking into acct the fact that A gets fringe b c are giving non-taxable compensatory income salary is going to be lower K in flights not worth K in cash so if taxed the flights then would be treating A unfavorably compared to B for admin reasons C decided to just not tax flight b c too hard to determine what actual benefit to specific employee is Problem c d Law student being flown to interviews a No or a exemption b c not an employee employer relationship b If can t find exclusion Go back to i compensation includes services to be rendered being rendered have been rendered ii Gotcher Left in world of common law fringe benefit Econ benefit taxable to recipient only when the payment of expenses serves no legitimate corporate purpose Law student would not be taxed b c serves legit corporate purpose Spouse would be taxed b c their presence serves no legit corporate purpose G Property transferred in connection with performance of services Problem No exclusion b c when sell to him not under bus premises of employer No exclusion i No c Qualified employee discount fringe b c specifically excludes real property ii j anti-discrimination rule can t offer benefits to top and not BOttom So compensation K b c paid mil for mil apt i Gen rule a FMV-amt paid taxable income when no longer a risk of substantial forfeiture i e when prop vests so in case of this problem after years of working for co c Substantial risk of forfeiture rights of person are condition upon future performance of substantial services ii b election Can elect to pay difference b tw FMV and amt paid in year that get prop iii Pros of taking b election Because FMV of apt could go up and would have to pay more in taxes h Employee often has no choice b c if employee takes election then employer gets to take a deduction iv Cons of taking b election If elect and then FMV goes down or don t meet conditions and have to forfeit not going to get a refund on taxes TVM Can invest money III Unit III Imputed income gifts A Problem Barter exchanges a A house-sits for B In exchange for the use of B s apartment for month A waters the plants walks the dog etc The apartment rents for K month Who has income and how much a A has income b c in laBOr income have no cost so whatever you receive as compensation for services is deemed taxable - d b Lodging for convenience of employer i If you were B you would require A to live there thus exempting him from any tax ii A maid living with fam is exempt under c Gift under i For gift have to act out of disinterested generosity i e house-sitting for parents best friend girlfriend d Market exchange i A s income is FMV of what A gets problem is can t value this b c is less than K b c don t get unfettered use of the apt If can t value what A gets then value what B gets e Fringe i No b c transfer of prop too big to be a fringe f a Rent is GI i Rent payment received for use of property ii If rent is taxable but dog walking not than everyone would pay in services so services for services must be taxable as well iii Have to tax barter exchanges i e property for services or else erode tax base iv Utility it as to be worth K to B or else he wouldn t enter into trans Imputed Income b A works overtime and earns each day She uses the money to pay B to walk her dog each evening C never works overtime and walks his own dog each evening Who has should have GI a A s income in compensation for services a i A spending on dog-walker consumption can t deduct what you spend on consumption ii Have to have b c otherwise everyone would spend everything they made OR would have a tax on saving only either way would erode tax base b B s income compensation for services a c C s income b c is imputed income i Imputed income services you perform for yourself Equity problem A and C the same Don t tax b c of admin if started to tax imputed income slippery slope privacy issues compliance problem Inefficiency Are encouraging C not to work and A not work an extra hour changing behavior ii Consequences in laBOr market Encourage people to do things for themselves they may not want to do or they are no good at doing market should be sorting out behavior not C Do not tax doing something for yourself don t tax leisure but DO tax entering work force leisure becomes more valuable commodity b c is tax preferred iii Most sig form of imputed income imputed rental value of owner occupied homes D Between compensation and gifts Duberstein a Facts Berman gave Duberstein a Cadillac b c Duberstein helpful in recommending customers to Berman No prior arrangement for compensation and Duberstein did not expect to be paid for recommending clients i Situations where payments have been made in context w bus overtones i e employer making a payment to a retiring employee businessman giving something of value to another b-man who has helped his business b Conclusion whether a transfer amounts to a gift is one that must be reached on consideration of all the factors left to trier of fact and appellate ct not to overrule unless no reasonable man could reach same conclusion c Holding Despite no obligation to make gift of Cadillac it was recompense for Duberstein s past services or an inducement for future services Misc a i Support provided by family members like intra-family gifts not included in GI ii IRS excludes most gov t benefits and welfare payments from income iii ways to treat gift under an income tax Gift might be deducted from the income of the donor and included in the income of the donee taxing person who uses for gift for personal consumption Gift might be included in the income of the donor and also in the income of the donee taxing person who can make gift AND taxing person who uses gift for consumption double taxation Gift might be included in the income of the donor but excluded from the income of the donee what we do b c donor s usually in higher tax bracket and better able to pay AND most common donee s are our kids don t want to tax giving to your kids Problem A panhandler travels the subway collecting coins in his cup Does he have GI a i Need to determine whether gift was for compensation for services i e panhandler was playing sax OR disinterested generosity ii only way to determine whether panhandler has legal income is to find out intent of donor donee s tax consequences hang on donor s intent b Duberstein controls in range of cases where not compensation but not a gift C left to discretion of cts to determine what is and is not a gift in these scenarios c Admin problem w taxing gifts i Where transfer money w out record no basis ii If tax all gifts have to record everything and create enormous incentive for dnor to give everything to donee E Gifts and scholarship provisions Problem R receipt T tax V education value A Gift B Support LaBOr C D Scholarship E State school F Couch potato G Employer paid education R K K K K K K K T - - K - - imputed income K - - c V K K K-T K K K i Usually transfer b tw parents and kids are gifts but not always they can enter into employee employer relationships ii i Scholarship does not have to be paid by university can be paid by rd parties BUT scholarship has to be reasonably broad based your Mom can t create scholarship explicitly for you iii Equity i C and E C clearly has income under Can argue that E already paid taxes we don t tax state school education b c it is a public good creates admin problem if taxed all gov t benefits would owe more than could afford to pay Need to ask if everyone has value Unit IV Capital appreciation and recovery of cost of capital A Concept of basis Basis usually cost very rough def a Doesn t matter if over under paid for prop acct for disparity on disposition b If receive prop in exchange for services basis of prop is FMV - d i Ways TP accounts for costs a Deductible expenses Immediately deductible costs are expensed b Capitalized expenses Purchase price taken into acct only when asset is sold or exchanged c Depreciation Periodic deductions allowed for asset s cost Allocation If want to sell part of prop a Apply AR against the basis for the entire prop and not report any gain until the aggregate AR exceeds her entire basis OR b Allocate the basis of the whole b tw the part sold and the part retained in some reasonable manner and compare the AR w the portion of the total basis allocated to the part sold Adjusted Basis AB Reflects history of asset in the hands of the TP a Capital expenditures b Depreciation Hort v Commisioner a No portion of the basis of property acquired subject to a favorable lease may be allocated to the lease so if it is cancelled doesn t reduce basis c B Realization Gains Losses in prop only recognized when there is a realization event Realization requirement huge benefit to TP b c TVM a Why keep realization requirement Alt would be periodic tax of accrued G L i Admin burden ii Difficult and cost of determining asset values annually iii Potential hardship of obtaining the funds to pay taxes on accrued but unrealized gains b Why change realization requirement Alt would be to value assets annually i Some assets easy to evaluate annually i e securities ii In-kind benefits present same problems in admin and valuation and we do not exempt them iii Violates equity Ex A earns K in salary B owns building that inc in value from K to K they BOth have K in economic income but only A has K in taxable income iv Inefficient b c creates incentive to acquire assets that produce unrealized and therefore untaxed appreciation c If a gain i TP argues that there has been no realization defer tax liability to some point in the future ii Gov t argues there has been realization event so can get taxes Problem for gov t is that if in one case argue there has been a gain TP can use as precedent in another case where there has been a loss gov t loses b c TP gets deduction d If a loss i TP argues there has been a realization wants to take loss now ii Gov t argues no realization Problem Determining where a realization event has occurred - Lucky Cesarini purchases a house in October for K a In April she discovers that there are several thousand tulip bulbs in the yard realization event i Gov t argument Value of tulips are income to TP under ii TP argue Value of tulips were included in purchase price she purchased house and all the ground so no realization event iii Cesarini v United States Facts TP purchased piano and found cash in it yrs later Issue Is this part of income Holding Yes under and treasure trove reg cash rule iv Why do we have to tax cash If don t tax cash when find it then never going to get tax In case of non-cash i e tulips going to have nd opportunity to tax when she sells tulips or house House now worth K so when sell have to report K that can tax OR when sell tulips have to report K in GI v Bargain purchase If C had BOught piano thinking it was a bad piano and then found out it was a really expensive rare piano Not tax b c paid for X a piano and got X C paid for X and got X Y cash concept of severability more likely to have a realization event if find cash or gold or diamonds in piano with land is less likely b c if pay for land tulips aren t as severable in realm of possible expectation form land as gold in piano b While digging in garden C discovers an underground stream with gold nuggets in it In the following year she sells the nuggets for K In the alternative she donates the nuggets to charity i TP argument That underground stream was included in purchase price of house so when sell then need to figure out basis was if can t figure very hard out then say that was K and then report nothing just reduce basis of house to K then if sell house for K have to report K gain there still a pro-TP position ii Gov t argument Not in realm of possible expectation to find gold nugget stream realization event treasure trove reg - - FMV of nuggets AR When sell nuggets for K report nothing b c already paid tax at time of realization event when include an item in income it is assigned a basis so won t pay tax on it twice iii Haverly v United States Facts Principal sent unsolicited textBOoks by publishers he donated them to library and took a charitable deduction Issue Do textBOoks income under TextBOoks not gifts under b c not disinterested generosity on part of publishers Holding When intent to exercise complete dominion over textBOoks is shown by taking charitable deduction income under all income whatever source derived iv Why would ct want to say that realization occurred on discovery rather than subsequent sale Admin gov t makes sure it gets TVM favorable to gov t if tax upon discovery Simplicity If argue that speculation value of finding in piano include in price becomes evidentiary question have to litigate everything c Suppose c takes the gold nuggets in b to a dealer and has them valued at K She includes them in GI for the year of discovery Two years later she again has them valued and discovers they have fallen in value to K The dealer believes this is a temporary blip due to world gold prices and that they will go up in value again in a few months He arranges for her to swap the nuggets for a bundle of nuggets held by B that he has also valued at K i Cottage Savings Ass n v Commissioner Facts Bank exchanged its interests in one pool of res mtg for w another banks interests in res mtg Issue Does this a realization event Holding YES b c material difference in prop exchanged ii Precedent If gov t argues every time that there is gain then TP going to be able to use cases as precedent against gov t Sometimes better for gov t to recognize loss in order to be able to recognize more gains iii What is material difference Change in legal entitlements If swap shares in different co s i e Sun for Microsoft or swap Class A for Class B stock of same co Arms length transaction C Annuities How do we acct for costs recognize when there is profit coming in over time When person transfers money or other property and receives from the transferee a promise to pay certain sums at intervals the amt paid annuity purchase future income stream a Clearly an annuity if period of payment is measure by a life or lives i Seller will use table of average life expectancies to decide what you should pay for such an annuity premium ii Determine amt of premium by Indiv s life expectancy Return the ins co expects b May be an annuity if it is for fixed period of years Annuity v Bank Acct - Problem a A is contemplating investments One is the purchase of an annuity for K It will pay her K yr for yrs Alternatively she will deposit K in a bank acct paying interest This will permit her to withdraw K yr for ears after which the balance in the acct will be zero a Non-tax world i Investor would be indifferent b c get same return on each investment b c they are same economic transaction ii In equitable tax system these investments should be taxed the same b Tax system prefers annuities TVM issue i Tax system treats annuities as K profit divided equally over years so make K yr compromise b tw TP and gov t arguments on how to treat TP argument Should be taxed K in Y b c first years just getting investment back Gov t argument TP still has rights to his principle and first years are profit ii makes no econ sense why Bank acct have to be taxed according to interest that you make each year presumably annuity co is doing something similar with your So Y K IR make what are taxed on compared to K with annuity In a bank acct are taxable income economic income not true with annuity Annuity TP friendly in first years bank acct in last years b c principle fallen so interest is less than K iii Why do we have simplicity c Shouldn t compare bank acct and annuity why i Ideally a tax preference creates a short term shift in capital investment to annuities in response bank is going to raise their IR so once again no difference in investments but doesn t work out perfectly and annuity still preferred Life expectancy Would it make any difference if the annuity will pay her K yr for the rest of her life and her life expectancy is years a The annuity is betting she won t live years and she is betting she will b If A lives years i Y - taxed on b c are recouping investment ii Y on are taxed K b c investment has been recouped and is pure income mortality gain c If A dies w in years i b are taxed yr on years that got K year she died she gets to deduct rest of investment mortality loss ii Annuity wins b c gets to keep excess interest d No tax advantage if live longer than are supposed to or die sooner than are supposed to Deferred annuities a TP purchases an annuity w payment to begin at some point in the future i e retirement i Period b tw purchase date and date when annuity payments begin interest accrues but it is not taxable to TP until he receives payment - b ii Amts withdrawn before retirement Under prior law withdrawal treated as a return of capital and tax-free until TP s entire investment was recovered e Treats cash withdrawals before annuity starting date as income to the extent the cash value of the contract exceeds owner s investment q Imposes penalty on amts withdrawn before retirement D Insurance Certain death benefits a Proceeds of life insurance contracts payable by reason of death General rule GI does not include amts received whether in a single sum or otherwise under a life insurance contract if such amounts are paid by reason of the death of the insured Term insurance Insured pays a premium in return for which a specified sum will be paid to his survivors in the event of his death pay year to year a Ins co wins if insured outlives his life expectancy b You win if you die w in period of life expectancy Ordinary life insurance You pay a premium every year until you die Under do NOT tax proceeds of ins policy is this tax preferred a Investment portion of tax policy is tax preferred i If take premium and invest it in bank Are taxed from interest accrued on in bank Don t get taxed on interest accruing on premiums b In order to get insurance investment vehicle have to purchase insurance portion - gamble i If win ins bet and die early don t report gain If pay less premiums than payout gain C doesn t tax b c feel sorry for winners in ins game ii If lose insurance bet and outlive life expectancy don t get to deduct your losses If pay more premiums than payout loss c Is a wash for gov t - Unit V Transactions from Borrowed income a Income from discharge of indebtedness Income from discharge of indebtedness A Loan income Problem In unable to BOrrow from Resorts Z BOrrowed K from a local bank and lost it all gambling in a month a Not taxable under a b c isn t income i When get loan inc is your wealth inc is your assets ii No inc in net worth b c have inc in liability no inc in net income iii For a loan don t tax the debtor when he receives and don t offset it when you pay it back The bank made every effort to collect but ultimately agreed to accept a K payment to settle the debt What result to Z a Income under a i Spend K to get rid of entire K liability K in income ii If this was gift then not taxable Suppose in the alternative that Z declared bankruptcy and the entire debt was discharged a No income under b Why do you get a tax break of not having to pay taxes income received on discharge of indebtedness if you are bankrupt or insolvent i Practical If bankrupt don t have to pay taxes anyways ii If don t discharge tax liability then can t start w clean slate when get out of bankruptcy B Discharge of Indebtedness Balance sheet analogy a Taxation is appropriate when net worth of TP is increased by the cancellation of indebtedness Liability is erased w out decreasing assets b Taxation may not be warranted if there is no inc in net wroth Loan will be repaid a No need to tax when received loan proceeds b c have to pay back and if don t pay back then failure to repay taxable event Zarin v Commissioner TC a Facts Z owed million on his line of credit at a casino Casino settled for him to repay K IRS asserted discharge of indebtedness of around million b Z s arguments why not income i Income from Discharge of Indebtedness Debt instruments not enforceable under NJ law so not a loan and therefore couldn t have income from discharge of this loan If no loan then can t report a discharge ii Settlement should be treated as purchase price adjustment and exempted from GI under e iii Loan was gambling winnings so could deduct as losses but can only deduct losses if you can report gambling winnings Why do we not let TP report all of gambling losses but do let them report all of stock losses When gov t lets you write of losses is basically subsidizing them gov t wants to subsidize investment in the stock market not in gambling Chances of cheating to get deduction high go to track and pick up losing cards Problem In Z managed to convince Resorts to extend him additional credit of K After a gambling spree Z ends up with K that he gives to Resorts and settles the debt for that amount What result to Z a Depends on what Cir you are in rd cir not a loan not enforceable and he doesn t have to report anything b Why should this be taxable i Is a loan doesn t matter where he got it from He didn t report when he got it b c he thought he had a corresponding liability that it was a loan You treated it as loan so ct should treat it as a loan and you should you have to report income received if part of loan was discharged ii If don t treat it as a loan then he is getting consumption that he didn t pay for The fact that loan wasn t fungible shouldn t matter b c if he didn t want to take terms of loan didn t have to If not a loan then need to report income when you get it Problem Z received K of credit lost it all but paid Resorts back a Z is out of pocket the amt of the loan but can t write off C Purchase-money If the seller of specific property reduces the debt of the buyer arising out of the purchase the reduction is treated by BOth parties as an adjustment of the purchase price e a This section doesn t apply if purchaser is insolvent or bankrupt seller has transferred the debt to a rd party b Similar to contested liability doctrine c If have mtg and L reduces liability discharge of indebtedness not treated as purchase price adjustment Problem Suppose Resorts drafts an agreement that each gambler signs It says that in exchange for a marker the gambler is purchasing property i e chips The price of each chip is and if BOught with the marker the must be paid in full unless Resorts subsequently agrees to reduce the purchase price Z obtains a substantial amt of chips for K loses and Resorts eventually agrees to accept K What result to Z a Doesn t have to report b c Resorts is just adjusting the purchase price of the property that Z BOught from them C Illegal income Collins v Commissioner a Loan requires mutual understanding b tw B and L of obligation to repay and BOna fide intent on B s part to repay loan b TP has income when acquires lawfully or unlawfully w out consensual recognition express or implied of an obligation to repay Problem Suppose Z finds himself sitting next to someone who is very drunk and who has a large pile of chips a Z takes chips worth K from drunk w out anyone suspecting anything and loses them all gambling i Z needs to put K of income on return The fact that gain arises out of illegal activity does not result in its exclusion from income Disclosure of illegal income on tax return doesn t violate th Amendment against self-incrimination b c don t have to disclose where got income from If they eventually find you you have tax liability on top of criminal liability b Z takes the chips b ut he says to the drunk If I win I ll pay you back He loses it all i If it was loan then no income ii If no loan income For tax purposes Both sides have to agree to loan can t be unilateral For TVM purposes want to say wasn t a loan b c then person who took has to pay taxes on all of it not just the portion that they have to recoup if they catch him embezzler Unit VI Tax Expenditures Interest on state and local Bonds a Exclusion GI does NOT include interest on any State or local BOnd A Tax expenditure TE Deviation from normative tax that provides some sort of econ incentive to private sector either to individuals or entities TE and direct budget outlay are the same thing economically a EX C wants to levy taxes at rate provide everyone could be limited group w of meat fed meant grant i Direct budget outlay Make meat available in kind C would give voucher to TP i e food stamp Don t distribute meat don t put in budget Give TP in cash so there AI goes up to tax at around left in cash and to spend on meat If want everyone to have in meat need a tax provision saying that is not taxed All direct budget outlays must come with some kind of tax provision Either gross up outlay so they get extra to pay tax OR don t tax Trad answer is don t tax gov t outlays ii Tax system are economically similar ways for people to have in cash for meat and in taxes Exclusion C has in GR in exclusions so GI tax at so end up paying in taxes have left in discretionary cash and for meat Prob is don t know if really are going to spend on meat Deduction Same economics as exclusion except is a deduction Would this provision exist in perfect normative income tax system Question need to ask if determining if a provision is a TE a None of above examples are normative are subsidies B Direct budget outlay DBO v Tax expenditure Similarities a Neither are normative b Are intended to benefit some but not all Differences a TE not usually open to people that don t pay taxes would have to create neg income tax to give everyone a TE DBO are for everyone b TE don t show up in nat l budget are basically hiddent i Joint Ctee on Taxation and Treasury Dept publish Budget of TE but isn t official or adopted by C ii Tax penalty provision that would punish someone by taxing on them on more than their econ or normative income C doesn t publish budget of tax penalties but there are plenty of examples c Easier w DBO to give more to less wealthy i TE is worth more to wealthy then poor b c brackets upside down subsidy Good if are trying to encourage people to invest in some particular asset i e low income housing rich have the capital Bad if are trying to give meet or cheese b c poor will the subsidy more than the wealthy In DBO easy to limit who can get In TE very hard to limit who gets d Transaction costs higher with DBO i Gov t has to lay out cash as opposed to not collecting ii DBO some agency of fed gov t has to provide in-kind benefit iii W TE transfer trans costs to private sector and TP e Compliance costs i DBO agency that administers benefit also ensures that purpose of DBO being met ii TE IRS has to ensure i e that is really being spent on meat Huge problem for IRS b c have to become knowledgeable in areas outside of their expertise area f Discretion i More discretion to TP with respect to what he does with TE i e what they are going to spend money on ii TE gives more discretion on WHEN to take advantage of subsidy g Certainty i DBO gov t knows exactly how much money they will be spending ii TE gov t not going to know how much it costs until people file returns How many people are going to take advantage of TE To what extent people are going to use it Don t know what tax bracket the people are in that are going to use it Gov t uses dynamic calc assumes that the number of people that bought meat today will remain the same but TE will change people s behavior and affect price of meat Political Considerations a TE budget less transparent i C can talk about TE as giving as opposed to DBO where talk about spending ii In reality both are spending b Religion expenditure can only be run through the tax system b c of separation b tw church and state i e making religious orgs and donations to them tax-exempt c Less oversight of TE i Gives TP more freedom as to how is spent ii Where gov t doesn t want to get involved in oversight choose TE C Tax-exempt Bonds In normative tax system would tax gov t bonds TE C could have accomplished same thing by giving directly to cities munic a Why would choose over DBO i States control their own subsidy depending on how many bonds they issue Huge fight in C if it were a DBO Gov t using market to monitor amt of sub if IR that banks give will provide TP with higher A-T rate than going to go to bank not munic banks always going to have to compete with munic so create equilibrium b Why would choose DBO over i If DBO then would be limited amt TE creates uncertainty b c don t know of bonds that are going to be issues How much gov t is subsidizing IR ii TE is very inefficient market never sits still when there is a tax advantage b c brackets If K city bond at K corporate bond at - which are you going to invest in If are in bracket going to choose city bond b c A-T rate of return is Corporate bond Earn goes to taxes left with City bond Earn AT and BT rate of return the same If are in bracket going to be indifferent b c A-T rate of return is on both investments City will set at IR b c can t clear market w only bracket TP s Inefficient b c gov t is foregoing in revenue to give city a benefit of Does violate equity or efficiency a Inefficient b c changes people s behavior b Equity i Market can take care of TP s b c capitalize tax pref ii Market CANNOT perfectly capitalize tax pref for everyone those in brackets tax-exempt orgs horizontal inequity - iii Vertical inequity not paying at right rate If are in bracket if get city bond only paying tax at Once TE gets into code really hard to get out b c market takes into acct expectations people make investments based on tax preferences Unit VII Deductions Trade or business expenses - Business expenses - Compensation for personal services - Treatment of excessive compensation - Illegal bribes and kickbacks - Fines and penalties A Intro to deductions Why allow deductions a Some deductions like are necessary to measure income correctly i We have to allow people to deduct the cost of producing income b c the word implies net rather than gross income ii Constitution forbids taxing us on gross receipts b categories i Spend in trade or business enterprise that has intention of making profits - deduct ii Spend of income producing activity maybe deduct iii Spend on personal consumption can t deduct if expenditure is inherently personal in nature Trebilcock v Commissioner Deductions and Exclusions a Same thing economically b TP may prefer exclusion rather than deduction b c limits B Business expenses Deductions only ordinary and necessary expenses in connection with a trade or business a Questions to consider i To what extent does the phrase ordinary and necessary imply that there is a class of nondeductible expenses ii What distinguishes a trade or business expense from a personal expense iii What separates a deductible expense from a capital outlay b Welch v Helvering i Holding Paying debts of another even if it is to maintain bus reputation is not ordinary expense not deductible ii Ordinary must be common of frequent occurrence in the type of bus involved iii If payments are made to protect TP s own business then are deductible Permits indiv to deduct ordinary and necessary expenses stemming from income producing activities that do not qualify as trade bus a Only applies to indiv applies to bus b TP must have itemized deductions that exceed standard in order to take iii Subject to limitation Problem X co manufactures and distributes the SockLocater It has sales of million X co has five SH One is A the founder of the corporation and now its CEO who was paid million last year You have been asked to render an opinion as to the deductibility of A s salary a Make a list of additional information you need from X Co before you can render an opinion i Look for obvious facts that this is a dividend and see if the co is zeroed out when bonuses are distributed to SH who are also employees Dividends are taxed twice salary only taxed once Corp generally prefer to pay salary b c can deduct rather than dividends ii If co is publicly traded m excessive remuneration doesn t apply if not a publicly traded crop iii What A does and how active he was in management iv Are SH family Incentive to make a gift of the salary Overcompensate the employee in the lower bracket Putting fam member of corporate payroll may permit the TP to make support payments out of pre-tax income Under a corp can deduct a reasonable amt of salary if they can pay you and deduct your salary thus decreasing taxable income they will pay you more v Schenk thinks that if non-family non-dividend gov t not going to nd guess a salary Can justify a high salary if someone makes the returns Can argue that market rate is too low high for an indiv vi Exacto Spring Corp v Commisioner Indirect market test Corporation conceptualized as a K in which owner of assets hires a person to mange them The owner pays the manager a salary and in exchange the manager works to inc the value of the assets that have been entrusted to his management that increase can be expressed as rate or return to the owner s investment The higher the rate of return that a manager can generate the greater salary he can command If the rate of return is extremely high difficult to prove that the manager is being overpaid b What steps if any would you suggest that X Co take to make sure the deduction will not be challenged i Show that profits exceeded expectations ii Have B approve salary rebuts inference of bad faith iii Have co pay dividends Ct think absence of dividends troubling are instead just paying profits out in salary Independent investor test If co s earnings on equity when viewed in relation to such factors as the co s overall performance and levels of compensation remain at a level that would satisfy an indep investor there is strong indication that management is providing compensable services and that profits are not being siphoned out of the co disguised as salary iv factor test rejected by Posner but applicable in some cts type and extent of services rendered scarcity of qualified employees qualifications and prior earning capacity of the employee contributions of the employer to the bus venture net earnings of the employer prevailing compensation paid to employees w comparable jobs peculiar characteristics little shady c How would your answer to a and b change if X Co were a publicly held corporation Should the answer change i m tax penalty wouldn t include in normative income tax Denies a deduction for compensation in excess of million paid to CEO or four most highly compensated employees of a publicly held corp unless the compensation is performance based payments to qualified retirement plan and fringe benefits not subject to limitation Well advised corps have no problem getting around b c of performance based loophole ii Is appropriate Inefficient provision b c changes behavior but doesn t raise additional revenue Many groups exempt non-publicly traded indiv athletes horizontal inequity d What if over time A has been paid only a year but X Co has issued more stock to A which has increased exponentially i Does apply Only if there are restrictions on how long he had to hold stock It was discounted employee purchase then tax under but appreciation over time will go untaxed Stock options attractive b c defer employee tax liability and corp has no stake in it Problem A runs a bootlegging operation in Bourbon County Kentucky Which of the following expenses are deductible a The raw materials i e corn barrels bottles i Tax code doesn t care if bus is legal or illegal still subject to taxes if it is a for profit venture ii U S v Sullivan b Suppose in order to improve business A throws regular weekend parties in which he serves his moonshine i Ads are explicitly deductible - ii Must show that marketing is w in the reasonable line of bus Parties are consumption can t rely on self-reporting b c no one going to report Cts have ruled that some things are inherently personal c A bribe paid to a revenue agent to ignore the illegal business i Explicitly disallowed c if it is illegal under law then not deductible Tax penalty d When he is caught A pays a fine of K i f disallows fine paid for breaking the law ii If paid damages or payments to rd party for a violation of law of for violating private rules is deductible unless payments are akin to a fine iii Restitution made to victims of fraud or theft not deductible where repayment is punitive iv Company that makes court-ordered charitable contribution in lieu of a criminal fine may not take a bus deduction under or charitable under b c not gratuitous e The fee paid to an atty to defend when A is charged with running a moonshine operation Does it matter if he is convicted i Not deductible if charges are personal and not directly related to trade or bus Gilliam tax penalty ii Tellier Can deduct expenses of defending yourself from defending from criminal prosecution that stem from profit seeking activities - C didn t want to create tax penalty b c There is always the chance that you are innocent Right to an atty more basic and we don t want to violate f The cost of lobbying local legislators A s Cmen and newspaper advertising advocating changing liquor laws i Lobbying only deductible if directly related to producing income in trade or bus ii e Can deduct cost of lobbying local officials not C iii Lobbying through newspaper ads institutional advertising is deductible as long as you don t mention specific leg g Would your answer to any of the above change if A sold drugs rather than moonshine i No b c both illegal Unit VIII Employee Business Expenses Expenses for household and dependent care services necessary for gainful employment Trade or business expenses Adjusted gross income defined -percent floor on miscellaneous itemized deductions Expenses for production of income Disallowance of certain entertainment etc expenses - Traveling expenses - Expenses for education - Professional expenses - c Contributions dues etc - Reporting and substantiation of certain business expenses of employees A Statutory framework Taxable income a Def of income b Definition of AGI i List of above the line deductions ii AGI Gross income Above the line deductions c Def of taxable income AGI larger of itemized or standard deduction - exemptions Determining amt of deduction a Any specific statutory authority that allows the deduction b Is the deduction above or below the line - i If deduction above the line subtract in full Generally business deductions are above the line A Reimbursed expenses are deductible above the line so TP can take even if he takes standard deduction Above the line is deductible in determining AGI ii If deduction below the line need to determine if it is miscellaneous or non-misc - Misc deductions A are included in itemized deductions B Only get to deduct miscellaneous expense if it is above of AGI - Virtually no one takes C Why eliminates a lot of bookkeeping Lets politicians avoid repealing deductions which is politically unpopular D Examples of misc that we will consider Un-reimbursed employee bus expenses Tax prep fees Investment expenses not connected to rental unit Non-misc deductions A not subject to limitation but only wealthy take b c for most people standard is more B Examples Interest Taxes Medical Expenses Annuity losses Charity Gambling losses Casualty losses c Compare itemized and standard deduction and take whichever is greater Equity a Example i A has pays out of pocket for Bar dues Econ income is taxable income is b c bar dues is an allowable deduction but doesn t exceed of AGI ii B is reimbursed for Bar dues Econ income is paid bar dues Taxable income b c reimbursement is above the line iii C has bard dues paid directly by employer in kind benefit Econ income is paid bar dues d working condition fringe b c C would have been able to take deduction under so doesn t need to include in AGI b Paying out of pocket for bus expense and being reimbursed in compensation always makes you worse off i A B C all the same in terms of econ income but B worse off for tax purposes equity problem ii Inefficiency Tax code encourages reimbursing expenses or including them as in-kind benefits so employees seek to have expenses paid directly or reimbursed behavior they wouldn t do if wasn t for tax code iii If pay expense out of pocket is always harder to prove that it is ordinary and nec bus expense c Credit v deduction i If you can deduct K value of credit is K marginal tax rate ii Econ benefit of K credit K iii Credits are preferred to deductions unless your tax liability is less than your credit iv Credits are used to ensure that everyone has same benefit but cannot help poor who have no liability B Ordinary and Necessary Line between personal consumption and expenditure to further bus a If provided by employer i Include or exclude from income of employee b If paid for by employee i Deduct as bus expense or not deduct as consumption c Always a certain amt of consumption in bus exp but admin impossible to divide so look for primary purpose i Can always make argument that it is nec to eat obtain housing and take vacations in order to produce income ii Some C has decided to say not deductible pass certain amt i e child care cap Child care credit a Problem a Couple pays K yr for babysitter to take care of their child i Argument that it is wholly deductible b c is necessary cost of producing income they couldn t go to work and produce income unless someone was taking care of their child ii creates cap on child care so wasn t intent of C that this was wholly deductible TP w AGI of K or less can offset tax liability by Liability reduced one percentage point for each K of AGI until it reaches K for TP s with incomes above K b Why cap child care deduction i To draw the line b tw personal consumption and bus expense In parent home no credit if only parent works b c then childcare is seen as unnecessary consumption d b deduction can t exceed earned income of lower paid spouse so if don t work then earned income and can t have any deduction ii Creates incentive to care for own child b c treats some of childcare as consumption Tax expenditure - For person who works hr week and pays for childcare for A For rich who would pay for childcare anyways Tax penalty For anyone who absolutely needs child care for all hours worked A Poor excluded from credit altogether b c don t make enough B Deduction not enough for poor to enter market Changes incentive to enter market b c imputed income of caring for your own child is not taxed c Employer provided daycare exempt under Clothing a Problem b i In absence of def from C regarding what ordinary and nec means w regard to a specific item cts have to create a def or test ii part test for clothing Type specifically required General usage wears outside of work A Doesn t matter if you would or want to wear outside of work is what objective person would think iii Are certain kinds of clothing that are deductible Uniforms b Why don t we want whatever you wear to work to be deductible i of income spending on consumption not going to be taxed Cts IRS have crafted rule that leans heavily toward no deduction A Even for people who get deduction is an itemized deduction so subject to rule Reflects view that clothing is viewed as consumption If allowed to deduct all clothing that wear to work b c couldn t produce income if didn t wear clothes then have slippery slope argument b c everything food etc could be argued same way ii If had rule that can never deduct clothing Would be tax penalty for people who have to wear uniforms iii What about work giving employee a uniform If employee could have taken deduction if it was a uniform nec for safety etc then employee doesn t have to include in income under d Better for employee b c not subject to limitation c Pevsner v Comm i Employee of YSL not allowed to deduct costs of clothing she had to purchase b c were suitable for everyday usage even if she didn t want to wear them everyday Inherently personal standard a Trebilcock v Comm Ct said all benefits provided by ministers are inherently personal Exception for public employees a Frank v US In general trade or bus expense must be profit-seeking but cts have carved out limited exception for public employees where position entailed a definite work assignment and was not undertaken as a tax dodge C Travel Expenses Transportation Lodging and Food Problems c d e Transportation a - e Costs of commuting not deductible i Exceptions Unless start working from the minute you step outside of your house can t deduct commute A Pollei Police officers who begin their jobs when drive from home to stationhouse can deduct B Are taxi driver and are using their car as part of their job and performing the job while in the car Rev Ruling permits deduction for portion of commute allocable to excess cost of commuting w work implements Temporary Employment A Can deduct daily transportation expenses incurred in going b tw TP s res and temporary work location Unsafe conditions Employer can pay for commute if unsafe to RP to walk or take public transportation ii Commisioner v Flowers Expenses incurred as a result of commuting from home to work are personal and not deductible under iii McCabe v Commisioner Decision to reside in place where makes commute more expensive is personal decision and not deductible iv Equity Is this rule fair for people who cannot afford to live where they work i e domestic worker A Does spent on commuting consumption B Argument that market will compensate through wages C Impossible to draft equitable administrable rule that won t erode tax base Problem c Car services allows him to produce income but IRS has decided that can t parse out what is consumption and what is legit bus expense for commuting so just doesn t allow any of it not possible to enforce rule if say that only deduct if working everyone would say they were working Gen test for deductibility Flowers a Expense must be a reasonable and nec traveling expense b Expense must be incurred while away from home i United States v Correll In order to deduct food and lodging while away from home have to stay overnight Want to let TP deduct duplicative costs having to pay rent at home and for hotel Incur additional costs on food that want to let TP deduct A lot of consumption on bus trips that IRS lets go for admin reasons ii Temporary Employment Doctrine When TP has job away from home If expect temp employment to last year Not deductible b c home no longer where residence is b c no longer and bus reason to maintain res there is personal choice If expect temp employment to last year Deductible A If at some point expectation changes and is going to be longer than year than at that point expense no longer deductible Hantzis v Commisioner TP who pursues temporary employment away from the location of his usual residence but has no bus cnx w that location is not away from home A Can t deduct summer job iii Home for tax purposes is TP s principal place of bus If no reg home than no deduction If multiple bus then home where principal bus is c Expense must be incurred in pursuit of business D Entertainment and Bus Meals a Can deduct if i TP has more than a gen expectation of deriving income or a specific bus benefit ii TP engaged in bus discussions during or directly before or after the meal or entertainment iii principal reason for the expense was active conduct of TP s bus b Can t deduct cost of meals w colleagues b c not explicitly generating income c TP can deduct cost of their lunch w client b c not practical to eat pb j while client eats sirloin social lubricant function to bus lunches Huge TE for salespeople d Aims to limit martini lunches i Limits foreign travel c foreign conventions h ii Unless is a is big loophole Can get around entertainment expenses bball games by talking about bus right before or by saying is directly related to bus social lubricant theory Unit IX Timing of Deductions look at reading Capital expenditures A Capitalization and inclusion in inventory costs of certain expenses Adjustments to basis Depreciation Accelerated cost recovery system a - Tangible property a - When depreciation deduction is allowable - Nontrade or nonbusiness expenses a - Capital expenditures in general a - Amts paid to acquire create or enhance intangible assets A Expenses deducted when paid expensing If are able to deduct something immediately benefit bracket expenditure a TP would always prefer to deduct immediately b Why don t we always let TP deduct when she incurs cost of purchasing asset i Doesn t always reflect economic income ii Similarly not allowing to deduct asset until disposed of not accurate of economic income either b c are not accounting for cost of producing income when sell asset not going to be worth as much as when bought it What kind of expenditures should be expensed a Assets that only produce income in the year of acquisition in real life there are a lot of exceptions in the code b Supplies that will run out c Salary that produce income in this year most salaries are expenses for employer pay salary and their services produce income this year d Rentals e Inventories i Special category specific rules ii If not going to turn over in one year can t expense B Deducted over time as they produce income Capitalized and depreciated TVM Not worth as much as immediate deduction What kind of assets should be depreciated amortized a Assets that produce income over time and wear out i Machinery ii Buildings iii Pre-paid insurance that lasts more than one year b c produces benefit that extends more than one year iv Mineral rights treat separately Assets that disappear v Patent copyright idea Can use to produce income for finite amt of time C Accounted for when the asset is sold Capitalized and NOT depreciated If deduct cost of purchasing asset when sell deduction not going to be worth as much to you as if you could take it on the date you purchased b c of TVM will have to discount to see what deduction really worth a If force TP to capitalize and not depreciated asset that should be depreciated i TP is losing opportunity to invest this ii Gov t is picking up opportunity to invest your for you b Accelerating cost Taking asset that should be capitalized w or w out dep and expensing i Accelerating a deduction to take sooner than is normative is huge benefit to TP ii Deferring income is always beneficial to TP iii Accelerated deduction Expensing asset that should be depreciated Deferred income A When gov t allows to defer income Interest free loan If have K in income bracket gov t let you defer income K loan When capitalize asset gov t takes into account depreciation so when useful life of asset is over will recoup the K loan B Accelerating deduction accomplishes same thing economically as changing tax rate If have bracket and can deduct K now or in years in future asset produces K in income If take K deduction now have to pay K in years If discount rate is need to put in now to have K in years PV FV i n If don t take deduction now have to pay taxes on K today So either pay K today or today Effective tax rate amt of taxes paid income No deduction tax rate K K K deduction tax rate K C C would rather accelerate a deduction than change a tax bracket b c less transparent iv Expensing something that should be accounted for only on disposition Not taxing income from asset in essence making it tax exempt A Normative example If acquire asset for K that has rate of return so will produce K year until the end of time In tax free world Pre-tax rate of return after tax rate of return flat tax world After tax rate of return should be B If allowed to expense this asset Benefit Marginal tax rate amt of expenditure K K Exactly the same as gov t giving you a check for K A-T K b c still have to pay on income produces A-T B-T this should only happen in system that imposes no income tax Allowing TP to expense item that should be accounted for upon disposition same thing as subsidizing cost w cash or making income tax exempt Gov t is creating incentive When gov t creates incentive is sharing in investment C IRA If put in IRA are allowed to deduct immediately Pay taxes when withdraw it all IR bracket K in wages in IRA FV Taxed when withdraw so pay of get to take home A-T If put K in Citibank going to be taxed at o of wages initially so only get to put in FV Expensing accelerating deduction better then exempting yield over time IRA b c no transition issues law could change over time v If C wants to encourage investments in computers how can we do so i Credit TP for a portion of the price of a computer Computer makes income purchase for K in income if give credit for of purchase price out of pocket cost going to be K with a rate of return Have raised rate of return so someone who couldn t buy before now can ii Computer depreciable asset so reduce useful life to Expensing Have essentially made the computer a tax-free investment iii Exclude the income Are making the P-T and A-T the same Are treating like a tax exempt bond iv Subsidize portion of cost non-tax system incentive What kind of assets should be accounted for only upon disposition a Assets that cannot be accounted over period of use usually b c don t depreciate or lose value so are assigned a basis cost that is offset against amount realized upon disposition i Land A Assume that land doesn t depreciate B Can collect income over time but will have same thing at end as beginning or at least won t have less ii Antiques artwork collectibles don t decline in value over time and are likely to go up in value iii Stocks A Don t depreciate in value B Market may change value at end of the day but still have stock iv Name Trademark Goodwill A Assets where we cannot say what finite period that are going to produce income is going to be v Residence Personal assets A Assets that don t produce taxable income B Produces economic income imputed income that isn t taxable vi Asset can move from category to A Personal asset residence that turn into income producing asset rental vii When require a bag of assets have to treat each one separately A If buy a residence land underneath to rent Residence depreciates Land is capitalized and accounted for at disposition viii Costs of constructing a capital asset included in basis A D Problems Problem Problem X Co is a dot com that runs a b-to-b Website on which it sells consulting services How should T account for i e expense capitalize or capitalize and depreciate the cost of the following outlays a X has employees and an annual payroll of million i In general employees salaries can be deducted A during the taxable year salaries are ordinary a nec cost of doing trade or bus during taxable year ii INDOPCO There is a future benefit to be received from employees so can t deduct but service not going to pursue this for admin reasons unless it s a major item i e specific project working on where no fees were paid for years wouldn t be able to deduct salary for all years A Capitalization requirement concerned with accurately matching a TP s income and expenses to measure net income B Capitalization accompanied by a recovery of capital as the income is earned is thought to reflect each year s income more accurately than immediate deduction of the expenditure For expenditures that do not involve the acquisition construction or manufacture of a separate asset capitalization is sometimes required if the expenditure is expected to produce income beyond year in which expenditure occurred if economic benefit exhausted in one year that deduction results in proper measure of net income C One-year rule Automatic deduction if expenditure provides benefit that has useful life of less than one year Capitalization may or may not be required if expenditure provides benefit lasting longer than one year b In X purchased computer at a cost of K i A In general if expense will produce income and has useful for longer than year then can t deduct B Computer going to have useful life for longer than year so is capital expenditure A override ii Capitalize and depreciate under A Assign basis of K and depreciate over useful life B Useful life Any special exceptions iii d A ii computer software if its not custom defined in e A i can be depreciated in year A allows you to depreciate cost in year B Can t get to unless it is item you capitalize c In X constructed an office building and incurred the following expenses Construction falls under A prop that has purchased falls under C put A in code to create parity b tw buying building and constructing one otherwise would be inefficient b c code would encourage construction which is absence of A could potentially be expensed - as opposed to buying buildings i The cost of acquiring the land on which the factory was built as well as lawyers fees to quiet title was million A Land has to be capitalized real estate is cap asset B k Atty fees to quiet title have to be capitalized By quieting title are adding to value of land and are a necessary cost to acquire property why you can t expense By attaching to land can t take them into acct until disposition ii The cost of construction supplies cement nails wood etc was million A Building is depreciable while land must wait to be accounted for at disposition CANNOT put in basis of land B A Have to capitalize direct costs of construction Cost of construction supplies are solely attributable to this asset put into basis of building and depreciate over time iii Salary of K paid to construction workers and annual salary of K paid to corporate counsel who among other duties negotiated the purchase of the land and materials for the factory and handled all employee benefit questions related to the construction A Construction workers salary Direct cost under put into basis If want to create parity b tw buying and constructing building have to capitalize cost of construction b c when buy purchase price includes all costs of construction If allowed to expense under wouldn t get parity B Gen counsel In theory it is cost of producing building and portion of his time he spent working on building should be allocated to basis of building under A a Salary of gen counsel is ordinary and nec under so incentive to say that didn t work on building or attribute as small amt of time as possible to it Having to include a portion of his salary has no basis to X co b c of TVM would like to deduct as ordinary and nec expense Admin costs If cost is too small or too hard to calculate Service not going to pursue iv A backhoe purchased on for K and used in solely to construct the building A Possible ways to acct for cost of backhoe Add K to cost of building as construction cost Didn t cost K in backhoe to build building WRONG Only would do this if backhoe was exhausted after construction no value left Capitalize and depreciate cost over life of backhoe Backhoe can t have own acct b c then cost of backhoe required to build building not being capitalized WRONG Capitalize cost of backhoe for year into building Add depreciation for one year into cost of building IDAPCO RIGHT ANSWER Analogous to cost of rental fees direct cost of construction if had rented backhoe instead of bought it B What happens to backhoe after building done If sell for K the have K of income b c added K in depreciation to basis of building Use backhoe to build a new building which takes ears Add K in depreciation to new building and basis of backhoe now K Y Use backhoe to pick up garbage on daily basis Take normal depreciation deduction Example of asset moving categories from capitalization on disposition to depreciation d X also acquires new custom software for K which is expected to be useful for years It pays an independent contractor K to train its employees to use the software i Custom software Capitalize under if it weren t custom could deduct under A Intangible asset a - c xiv If intangible not listed then probably don t have to capitalize BUT Are intangibles not covered by this Reg Intangibles that can construct i e movies Capitalize under A Intangibles whose income is produce in this year i e patent that only produced income for one year ii Cost to train employees A Need to know How long are you going to use the software If more than year than training costs gong to produce income beyond ord and nec How long are employees going to work there If are improving the value of the employee than can deduct under ord and nec If add or improve to cost of something that is deductible than improvement is deductible B Is person performing training included in package deal with software If in a package service going to say that it is all an intangible and training should be treated as acquisition cost and capitalized Lawyer should tell them to split up cost of training and cost of software Rev Ruling - Can deduct training cots Example of TP friendly position no normative position for this ruling No one can challenge standing of rev ruling fact that you are a TP not enough to challenge need to show direct personal loss When IRS succumbs to lobbying pressure it just becomes law e X decides that it would like to improve its position by acquiring a competitor It hires an i-bank to advise it about two possible acquisitions including the value of their stock and to conduct due diligence It decides to pursue an acquisition of Y Co and the i-bank helps to negotiate the purchase price It pays the bank a K fee X s in house legal negotiates the purchase and X estimates that K in overhead costs for that department were allocable to the acquisition X Co paid million for the Y Co stock i I-bank fees A Intangible have to capitalize under a - e A Trick is to figure out when are actually pursuing trans Have to capitalize after send target a letter of intent or day B approves If pay ibank before send letter can expense if pay after then have to capitalize B Inherently facilitative amts a - e B Certain amts are inherently facilitative and have to pay regardless of if they come before or after dates in A Inherently Facilitative Activities performed in determining value of target negotiating or structuring the trans preparing and reviewing transactional documents preparing and reviewing regulatory filings obtaining reg approval securing advice of tax consequences securing a fairness opinion obtaining SH approval conveying prop b tw parties ii Stock purchase Intangible under a - c i B only can acct for cost on disposition of stock Present value of basis in stock is iii Gen Counsel fees a - e i Adopts position in Wells Fargo All in house costs in reorganizations M A work can be expensed B Can only expense if it is in house simplifying convention Structurally no different if out source M A work or do it in house violation of equity so Corp s get in house M A lawyers Inefficient change behavior If pay iv If deal falls apart Take abandonment deduction Have already capitalized at least inherently facilitative costs Deduct in year deal fell apart v Hostile takeovers Gen can deduct b c does not create a new asset or add future value vii Expenses with respect to a New Business Generally pre-opening expenses doctrine applies and have to capitalize A Expenditures related to determine whether to enter a new business are investigatory costs and can be amortized under B Costs incurred in the attempt to acquire a specific business are capital in nature and must be capitalized without eligibility for amortization viii Advertising costs generally can be expensed even if last more than one year - f On November X pays K to obtain property insurance policy w year term What different would it make if each November X Co paid K for a policy beginning on Dec and lasting year i mth exception As long as whole policy doesn t last more than year can expense admin exception ii If buy yr term Capitalize over life deduct each year a - d g In X discovers a major leak in the roof of its original building that results from standing water that is attributable to the poorly designed pitch of the roof T hires a contractor to install a waterproofing layer on top of the original roof for a cost of K i a - a Are restoring property for which an allowance has been made in the form of a deduction for depreciation h X purchases a collectible painting by a well-known modern artist which is hung in its reception area i No deduction b c tangible prop under a T purchases an asset on January for K The asset produces of GI each year for give years and then becomes worthless a If economic depreciation were taken by T what would be T s depreciation and net income for each of the five years Compare economic depreciation to straight line depreciation spreadsheet i in income doesn t represent actual income is their gross receipts ii Need to offset cost to get to taxable income iii Economic depreciation A Declining value of asset Fraction of cost of long-lived asset that is attributable to each year To get declining value have to use present value of cash flow Declining value depends on discount rate B If use econ depreciation than taxes should have no affect on behavior b c A-T B-T cut by nominal tax rate iv Straight line depreciation A Have to assume that costs are equal every year that you hold the asset makes no sense economically B Huge tax advantage b c can shift tax liability into the future TVM advantage are front-loading dep C Gov t is basically giving you an interest free loan D Who wouldn t purchase asset that have to use straight line dep on Someone who expects their bracket to shift upward so wouldn t want front-loaded dep Corp that wasn t going to make any money until end of assets life To take advantage of straight line dep need income to offset Asset w straight-line dep has value itself b c tax advantage could be used in a merger b Why do you suppose this form of depreciation is not currently used by the code i Discount rate nec for econ dep not immutable fact going to be impossible to determine income stream accurately ii Admin nightmare every valuation would become a controversy for service b c TP s appraiser going to low ball every time iii Real reason is we intentionally get dep wrong in order to provide incentives A By subsidizing rate of return we raise the rate of return T is a TP who at all relevant times in the bracket T acquires an asset in August for a purchase price of K that will be useful in T s business for years The salvage value of the asset that is the FMV of the asset at the end of its useful life is K a Under current law how would T recover his cost Assume the asset has a class life of nine years and T makes and election under c and under k i In order to depreciate asset need to classify what kind of asset it is A Personalty B RE C Intangibles ii Personalty machinery A Determine depreciable basis determined under B Determine salvage value treat as according to b C Determine recovery period Theoretical answer is useful life assigns a class life Class life term of art Most machinery is yr prop this asset is D Determine dep method different methods apply to different prop d declining balance declining balance Straight line E Apply convention d simplifying convention year for most machinery is tax advantage b c if buy on Dec get to take dep for year even though didn t actual machine iii Determining depreciable basis A Overrides HUGE ADVANTAGE Allows you to expense certain amt that would otherwise be depreciated Expensing is like making portion of asset tax-exempt C created in order to benefit small bus There is cap on total amt of assets can acquire in one year K Can expense up to K Applies only to tangible personalty encourage small bus to purchase equipment Who would not elect under Someone who has essential losses start-up B k Bonus depreciation Allowed to depreciated of basis in year accelerated depreciation iv Applying to problem a K asset A Expense K under B Exempt K under k C Depreciate under b declining balance K K for Y Declining balance take constant declining basis method recovery period for machinery is take of basis k as depreciation each year all machinery takes Convention is so take K of basis in Y D Y Basis Cost expense k exemption Y depreciation K K K Don t take year convention b c Y had for whole year E Y Basis - K AB F Y Basis G Y Basis Tractor method Each year take the current adjusted basis and divide equally over period of years that asset has left not the same thing as straight line depreciation Switch to tractor method in st year that it is more than double declining then you are stuck with that method can t switch back W yr prop going to switch in Y Tractor method AB in Y and years left Depreciation would be Dep under tractor more so take that H Y Basis convention Remaining basis b What amt of income or loss would T report if he sells the asset at the beginning of year three for K i Anytime dispose of an asset compare amount realized AR w adjusted basis AB ii AB at Y K need to know convention assume year would take in dep AB iii AR K AR Gain of iv Why do we have a gain for tax purposes even though prop went down in value A B c gov t allowed us to take more dep than actual declining value of asset B Tax advantage Got interest free loan of for years TVM c IN what way would your answer change in the asset was RE i Dep RE using straight line method A Recovery period for res RE years non-res RE years B Convention mid-month Presumed to have bought in the middle of the month that actually bought So if bought in August deemed to have bought on Aug months of depreciation for that years C If K asset using straight line depreciation and sell in Y Don t get deduction b c RE is a cap expense Don t get k deduction b c recovery period longer than years k So have years of depreciation Get to depreciate yr K Total depreciation is G L d In what way would your answer change if the asset was goodwill that was acquired as part of the purchase price of a business i Intangibles are depreciated under ii Depreciable according to straight line method for years A useful life of asset is irrelevant B Get credit for whole month that you purchased asset e If C wanted to use the recovery system to provide an incentive for T to invest in this asset how could it do so Consider provision relating to capitalization depreciable base recovery period salvage value depreciation method and conventions i Appreciate an item that should only be accounted for under disposition ii Expense an item that should be capitalized iii How should it be normatively done what it should be What is it under current law If wanted to create incentive how do you do it A Depreciable base Incentive would be to allow a person to recover more than their depreciable base letting people depreciate more than their cost If have a mtg are allowing people to appreciate a liability they haven t incurred cost of Penalty allowing people to depreciate less than their actual cost Current law allows people to depreciate more than their cost b c declining balance B Salvage value Current law TE b c treats salvage value as Biggest incentive that you could get This could be right even If wanted to create dis-incentive i e pollution Make estimates of salvage value greater than economic salvage value C Recovery period Current law Incentive b c recovery periods are shorter than actual life Get to depreciate more quicker TVM advantage Possible that for some asset class life over-estimated most err on side of assuming shorter class life Intangible class life for almost every intangible This provision is dis-incentive for computer software b c software has a useful life of less than years So if computer asset stops producing income in Y tells you to take loss AB acts as if you sold the asset disincentive b c TVM should have got more of dep up front Advantage of is simplicity no lit over what is useful life of intangible asset D Depreciation method Current law k incentive Very few assts that lose more than of value in st year Straight-line might be penalty for assets whose value is front loaded Might be disincentive for some software or intangibles E Conventions Current law Get whole year s asset no matter when you bought gives incentive to buy on Dec If have to buy on Jan then could be disincentive Normative Do depreciation by week or day Unit X Interest Deductions a Gen rule There shall be allowed as a deduction all interest paid or accrued w in the taxable year on indebtedness Expenses and interest relating to tax-exempt income d Limitation on investment interest h Disallowance of deduction for personal interest - T Allocation of interest expense among expenditures A INTRO a Normative income tax i If interest is a cost of producing income i e had to borrow to be able to produce income then should be able to deduct ii Cost of consumption should never be deductible b Tax consequences i Problem with doing in normatively is that is fungible hard to tell which portion of interest use for consumption and which portion for producing income A Deductibility of interest turns on purpose of indebtedness This question very hard to answer b c TP s borrow both to acquire new assts and keep their old ones Realization requirement that have to use loan proceeds for something before are taxed precludes taxation of annual increases in asset values Imputed returns from housing and other assets used for consumption not taxes Bus investment assets enjoy tax favored treatment B Bus interests Interest on indebtedness used to operate a trade or business cost of doing business DEDUCTIBLE except Where interest is required to be capitalized C Investment interests Deduction of interest on debt incurred by indiv to purchase or carry investment property is limited to net investment income with an indefinite carryforward d Net investment income total investment investment expenses This provision added to prevent mismatch of income and expense and conversion of ordinary income into cap gain Carryforward provision Amt of disallowed investment interest that can be carried forward to a succeeding year is not limited by TP s taxable income in current year TP can deduct more than would have been allowed if never passed Bus interest is fully deductible but if TP s activities don t rise to level of a business the interest deduction is limited to the amt of investment income D Interest to Earn Tax-exempt income ii Personal interest A Should it be taxed Interest on consumer goods consumption should tax Interest on used to purchase consumer goods should be deductible to create equity b tw those who finance consumption with debt and those who use their own assets create equity b tw person born rich and person born poor B In general h says you can t deduct personal interest Major exception is home mtg interest Allow b c home ownership is important policy goal Acquisition indebtedness Limited to million limit is reduced as principle is repaid on the loan and refinancing doesn t increase this amt unless used for acquisition or improvement if allowed refinancing then would never pay off principal b c could always deduct million in interest Home equity indebtedness Limited to K doesn t matter what purpose or use of loan is so long as debt doesn t exceed FMV TP s can borrow against residences to purchase consumer goods and circumvent elimination of deduction for consumer interest hard to catch Education loans Certain TP s can take an above-the-line deduction for up to of interest paid on education loans Have to be used for college tuition by TP spouse or dependent Phased out if single and have income over K married K iii Tracing interest A Argument that full deduction of interest should be allowed on admin grounds B Code currently requires tracing of interest to decide if it is deductible or not Inefficient b c people change their behavior game-playing is fungible people don t color code their money which what Code tells them to do iv Tax arbitrage making off tax system by doing a non-economic pre-tax transaction that after tax becomes an economic transaction profit A In normative tax system there is no possibility of tax arbitrage B Only possible if get something wrong in tax code C Come up when don t treat things consistently Include at rate so is tax-exempt then deduct the cost negative rate of tax Where Code allows immediate expensing of the cost of asset Subtle tax arbitrage when return from the asset takes the form of the use of the asset When a person has res subject to mtg interest is deductible but imputed rental income is not included in taxable income D Muni bonds Argument that they have implicit tax b c have lower rates due to their preferred status Argument that they really are just benefit to wealthy b c they can get tax-favored assets by liquidating existing assets don t have to borrow to pay for bonds E When think you have a tax arbitrage Is there specific stat authority disallowing Can you identify the arbitrage Is ct going to allow it B Problems A B C each have K in an interest-bearing acct A removes the K from the bank and purchases a home B leaves the in the bank and earns K in interest He also borrows K purchases a home and pays K interest on the debt Carmen also leaves the in the bank and earns K in interest At the end of the year she pays the K to here L for a year s rent What are the tax consequences Would these consequences be appropriate in a normative income tax If not what would they be a Comparison i Anna A Income B Deductions C Net income D Econ income K imputed income from living in house but should be K-depreciation b c house isn t always going to be on balance sheet should get some deduction of cost of producing this imputed income E Assets K house ii Bob A Income K investment income B Deductions K for interest under C Net income D Econ income K of investment income K of imputed income depreciation K interest that he has to pay on the loan he used to buy house K depreciation E Assets K in cash iii Carmen A Income K in investment income B Deductions b c rent is consumption C Net income K bad b c have to pay taxes on this D Econ income K in investment income No depreciation b c can t deduct cost of producing imputed income E Assets K in bank iv Equity A A B C have same econ income same amt of assets tax differently B How would we make them the same Tax A and B on imputed income and give B a deduction for interest Can t do that b c valuation prob that imputed income poses Let C deduct her rent Would have to treat rent NOT as consumption If treat as consumption then get into slippery slope about when allow to deduct C How could we create parity b tw B and C B is deducting interest to create parity b tw B and A Allowing B K in deduction that used to get house this is to imputed income that aren t taxing A for If disallow B s interest deduction than create parity bt w B and C D What we do our answer to equity question is that A and B have bus asset and C has consumption asset If bus asset house isn t bus asset but code treats it as such in order to encourage home ownership get parity b tw A and B If consumption asset get parity b tw B and C If thing that borrowing to purchase consumption item is bad tax system right Prob is that are treating people born with less worse than those born w it b Tax consequences Have to trace income to see if it deductible or not Tracing problem a Assume that D wants to purchase a car to be used for personal purposes and a machine to be used in his business He does not have sufficient cash and thus must borrow Assuming the interest rates are identical does it make any difference if he borrows to purchase the car or the machine YES i If buys machine with loan proceeds A Interest is deductible b c is cost of producing income b c loan proceeds being used on bus asset B If IR on loan and D is in bracket A-T Got to deduct interest of loan so cuts IR by his bracket rate Deduction is basically making item tax-exempt C If buys car No deduction A-T ii If D has K in cash borrows K b c wants to purchase K items A D has K in cash has to pay interest on K loan B To determine if interest is deductible have to determine which asst D used loan proceeds to purchase car or machine Economically this is a non-sense question b c is fungible Regs say that whichever asset you buy first you are deemed to have purchased with loan proceeds If purchase machine first use K in loan proceeds K in cash all of the interest is deductible If purchase car first use K in loan proceeds on car none of the interest is deductible b Suppose alternatively that D wants to purchase car and some securities Assuming the IR s are identical does it make any difference if he borrows to purchase the car or the securities i Are securities tax-exempt A If use proceeds to purchase tax-exempt securities muni bonds can deduct interest used to pay proceeds Might not want to do this b c if IR rate could be low enough that would make money buying bond with higher IR that is taxed ii Securities not tax-exempt A b applies There is a limitation on amt of investment interest D can deduct Can only deduct investment interest against investment income Doesn t have to be income from these particular securities Can t deduct investment interest against ordinary income Schedule basket taxation Match deduction to a particular kind of income B If have K of securities K car If D has no other investment income then tell D to make sure he purchases securities that produce income if he does then doesn t matter b c has investment income to deduct from Corporate bond Stocks that pay dividends Have to buy securities before car b c then deemed to have used loan proceeds if bought after then would be deemed to use loan proceeds on car If car is for bus purpose Tell D to purchase car first b c then no limitation on kind of securities that he can buy would be entirely deductible c Suppose alternatively that D wants to purchase a car and pay his daughter s college tuition Does it make any difference if he borrows to purchase the car or to pay the tuition Does your answer change if the interest on a tuition loan is higher than on a car loan i Need to find out D s civil status and how much he makes A Single earn over no deduction B Married earn over K no deduction C Poor don t use b c can t afford to pay interest Need capital to pay interest and can t get loan b c bad credit ratings AND Need income to deduct that isn t offset by something else Most poor take standard deduction and exemptions b c no income to offset D Provides bigger benefit to mid than low income b c benefit directly dependent on marginal tax rate ii If married couple that earns K Take loan write check to college then go buy car all interest is deductible e Do your answers to a-d make any sense E borrows K and pays IR Is the interest deductible or should it be if she uses the proceeds in the alternative ways a She invests in NYC muni bonds i If not in code tax arbitrage ii GI doesn t include income from state local bond A Wouldn t have in normative tax system B Would have in normative tax system with C Allow IR deduction for cost of producing taxable income this is cost of producing tax-exempt income shouldn t allow D If tax advantage were fully capitalized into price of muni bond would be wrong Can t fully capitalize price b c not enough people in highest bracket to clear market If raise IR to get enough people to buy to clear market wealthy going to get tax advantage and price not fully capitalized iii Could borrow to buy an asset then sell to purchase tax-exempt bonds tax arbitrage but service not going to challenge if enough time b tw trans A Arbitrage b c can deduct interest to buy bus asset then use proceeds to buy tax-exempt bond so in essence will be taxed at negative rate b c income from muni bond not included in GI AND get to deduct cost of loan b c not used to buy muni bond but used to buy bus asset b She invests in preferred stock in XYZ corp that pays dividends on common stock w no dividends held for growth i d B iii You can t include in investment income dividends that are taxed at ii If you could include dividend income in investment income and have your dividends taxed at the dividend rate then you would want to take out a loan to buy the stocks that produce dividends A If take out IR loan and get dividend on stock bracket A-T on loan if allowed to deduct is A-T on dividend if they were tax preferred Dividends are taxed at so now A-T on dividends is or so would borrow money at IR to buy stocks that produce income of - tax arbitrage c She invests in a vacation home i h Allows you to deduct interest on principal res loan vacation home mtg up to mil A Vacation home is personal consumption Codifies arbitrage Not allowed to deduct personal consumption Are allowing TP to deduct interest against non-income producing asset Rationalization Encourage people to buy home nd home if A-T is lower than total cost of home is less so someone at margin who couldn t but now can Who gets penalized if just allow deduction on principal res Cmen Retired people maybe Renters who only have mtg on vacation home new Yorkers B Home equity indebtedness If buy a home for K in cash and K mtg K is acquisition indebtedness Interest is deductible FMV goes up to K Now have equity of K K difference b tw initial FMV Home equity difference b tw value of house amt mtg Yours to do whatever you want with Acquisition indebtedness has limitations purchase house construction Creates tax incentive to own appreciated home No deduction for renters d She invests in a machine takes a election and expenses the entire cost i If elect under B-T and A-T will be A Arbitrage Purchasing bus asset with debt then exempting cost of purchase price Creating a negative tax rate Are getting a return on an asset that essentially you didn t pay for Are borrowing to buy a tax-exempt asset ii No specific provision that disallows this trans C must have known that when created people were going to do this INCENTIVE PROVISION e She uses a home equity loan to borrow the K and uses the proceeds to take a vacation At the same time she has K in a certificate of deposit earning i In non-tax world would she do this trans A NO b c would just cash out CD B Cost of interest is more than rate of return on CD C Very unlikely to take out loan when have liquid asset ii In taxable world why would you do this when you would not have before A Depends on your tax bracket B If A-T pushes IR on loan below b c tax rate lowered by deduction borrow C Example of inefficient provision b c are changing behavior f She uses the proceeds of a -year loan to purchase a remainder interest in a trust that will vest in years The remainder increases in value at per year Does it make any difference she is in the bracket or the bracket i In non-tax world would you enter into this trans A NO b c are paying more than you are getting if IR on loan is greater than ii Current tax law why would you do it A Trust only taxed when have a realization event when it vests A-T not going to be cut by bracket b c TVM B Interest Instead of being cut from to of going to fall to IR on loan would be so now would enter into this trans iii Interest needs to be deductible for this arbitrage to work A Is this investment income Possible ct might say that this is not deductible b c no investment reason to enter into trans B Knetsch Facts TP pays K in fees and takes out million loan which he use to purchase a million deferred annuity from same ins co investment income IR on debt was owed K in interest in Y and annuity only increases in value K no econ reason to enter into this trans Every year as interest accrues on loan he continues to borrow most of the interest he pays K year every year he gets to deduct interest so his bracket which was about times K so getting K deduction which presumably he had investment income to offset against There is no reason to enter this loan besides arbitrage he got K deduction ins co got K year Be suspicious of cases where have a loan and no changing hands The only way the annuity would have made money was if he lived to be K No reason to enter this trans BUT FOR tax benefits cts not going to allow Compare with other examples Same as a muni bond d expense no reason to do but for taxes c vaca home e home equity loan to finance vaca could argue that C wanted to ratify certain kind of trans even though made no econ sense f Didn t borrow from person that are purchasing asset real loan still need to ask question how much econ profit is sufficient to make it a real trans Unit XI Deductible Personal Expenses A Standard deductions Standard Deduction Can either do standard or itemize Gross income above the line deductions AGI AGI S D or itemized deductions taxable income a Flat amt that is indexed by inflation and varies with marital status that may be taken regardless of whether TP actually has expenditures i Marital status A Marriage penalty if the standard deduction for married couples is not exactly twice the standard deduction for single TP s B Marriage bonus If standard deduction is exactly twice the standard deduction then if only one spouse has income in the marriage the non-income spouse gets a deduction off of their income b c they marry C Example A in single making K Taxes are A and B are unmarried but are sharing expenses econ unit both are single and making K Taxes are each total A and B are married filing jointly each earns K Taxes are A got married and continues to earn K B earns Taxes are D Why can t we treat cases above the same no equity Progressive rates Can t treat person who makes K the same as people who each make K and aren t married b c K taxed separately where if have K first K taxed at one rate then next K taxed at higher rate So can t treat and the same Have marriage penalty for Ex in comparison to ex b c if file jointly are stacking spouses income on top of each other C has decided that it wants to treat married couples the same Have to treat the same so can t treat the same Marriage bonus for By getting married reduces tax liability b c C wants to treat married couples the sam ii Add l amts of SD are allowed for people over and blind A Included b c wanted to create parity b tw those receiving social security benefits which are excluded from GI and TP s who receive retirement income form other sources iii Standard deduction of an indiv who can be claimed as a dependent by another TP is limited to the lesser of the usual standard deduction or the greater of or the indiv s earned income c iv Have to itemize if married TP s filing separately where either spouse itemizes etc v Standard deduction has been increased to promote simplicity less people itemize Why have standard deduction A Substitute for itemized deductions for TP s whose itemized would be small Admin benefit to both IRS and TP When C creates itemized deduction as incentive provision charitable deduction creates different incentives for itemizers and non-itemizers If C creating for incentive purposes should be available to all TP s vs Simplification argument behind SD B Adjustment to the tax rate schedules Amt of standard deduction personal exemption and earned income credit reflects C s determination of the level of income below which no tax should be imposed Prob is that standard deduction personal exemption are available to wealthy TP s b Itemized deductions Specific set of expenses generally personal in nature i e Unless an indiv makes an election under this section no itemized deduction allowed ii a-b If an indiv has AGI that exceeds K K for married filing joint the amt of the itemized deduction reduced by lesser of A of the excess AGI over K or GI doesn t include Workers comp received b c of personal injuries or sickness Amt of damages received from settlement b c of personal injuries or physical sickness have to include EEID damages in GI Policy reasons for this provision Don t want to tax an award for pain and suffering prob is that there are items exempted by that aren t pain and suffering A recovery for expenses shouldn t be taxed prob is a lot of TP s can t deduct medical expenses A recovery when lose limb of human capital should not be taxed Recoveries for nontaxable items should be tax-free good health can t be taxed Wages should be untaxed so the victim will be put in the position he would have been in had there been no injury If jury can calc damages on B-T then TP going to be better off than he had been if he had never been injured and lost wages Amts received under accident or health insurance If employee makes no payments and all benefits are paid by employer amts received by employees under the plan have to be included in a B of amt of itemized deductions year Doesn t include deduction under medical Deduction for investment interest under Casualty deduction under c Standard deduction floor for itemized deductions d Major itemized deductions i Employee bus expenses ii Home interest bus interest above the line iii Certain taxes A State and local income taxes People who live in states cities with high income taxes NYC more likely to take itemized deduciton B RE taxes C CANNOT deduct Sales tax Fed taxes iv Medical Charitable deductions A Equity violation If think that charitable and medical deductions are necessary in normative tax then violation of equity to only give to people who itemize UNLESS Think that standard deduction reflects a little bit of taxes med expenses charitable donations then no violation This could never be exactly right still violate principal of equity No evidence that C thinks this is what happens Personal exemptions a d Each TP gets personal exemption of K b Dependent exemption i Get if more than of dependents support was provided by TP A defines dependent Children grandchildren parents other relatives unrelated members of TP s household who they support Unrelated dependents b Has to make principal residence w TP Idea is to exclude amt it takes for TP to subsist any amt required to pay for subsistence of anyone TP has to take care of not going to tax you if only make enough to subsist off of B Don t get if Dependent has GI to or more than exemption amt UNLESS Is a child of TP and is under or student under This exception doesn t apply if child is married and filed a joint return If child is claimed by another TP as a dependent Exemption supposed to represent amt spent on support For divorce parent who has custody gets unless they have written agreement more than of child s support furnished by public assistance Social security must be applied to recipient to determine if TP trying to deduct has really provided of their support ii Phase out d A If TP has income above threshold amt then reduce deduction for each exemption by of each over the threshold B Creates rate bubble iii Child tax credit A K credit if support child that is less than so if kids K credit B B c it is a credit it is really valuable dollar for dollar offset C Phase out D Incentive provision Subsidy for those who have children Cost of children build into dependency exemption and standard deduction Don t have to show that spend any more to get a child credit E Only refundable to certain people those whose income exceeds K c Why have personal exemptions i Setting the amt of a TP s income that should be taxed at rate A Then every TP should have the same level of personal exemption and B Phase out inappropriate C Families viewed as form of consumption no need to adjust by size ii Mechanism to exempt a subsistence level of income from taxation A Need for exemption decreases as income rises and B Flat exemption windfall for those in high brackets C Family size relevant b c exempt subsistence Earned Income Tax Credit EITC a Credit to low-income indiv who have earnings i Credit is refundable A people with no tax liability can receive a credit ii Credit is much larger if you have a child A c Qualifying child Son daughter stepchild or descendent of these indiv Brother sister step-sibling or descendent Foster child B If child could be claimed by different TP s for EITC has tie-breaking rules iii Phaseouts Potential for enormous marriage penalties b c if married only get one EITC as opposed to if not married then each indiv can have one b Policy i EITC enacted to reduce burden of social security taxes on the working poor ii Now Used A To remove people with poverty-level incomes from the income tax rolls Assure minimum standard of living to the working poor Negative tax or wage subsidy to transfer gov t benefits to working poor If favor welfare support EITC b c protects poor but has pro-work character If want to get rid of welfare tighten eligibility requirements B Provide subsidy for low-wage workers iii TP could receive advance payment of EITC through a reduction in withholding of his wages A TVM benefit but not that many take advantage why Education credits a Designed to offset cost of college tuition b Non-refundable and phased out at moderate levels of income aimed at middle-income c Hope Credit A b i TP can take credit of up to on the first K and on next K of tuition paid for first years of college for TP spouse dependent max credit ii Non-refundable not available to anyone who doesn t owe taxes really poor iii Phased out for lower mid class d Lifetime Learning Credit A c i Can be used for undergraduate or graduate education at any point in TP spouse or depend life ii Have to attend school time or be taking courses to improve acquire job skills iii Can take credit for unlimited of years iv of tuition and fees up to K v Phase out e