PART ONE: INTRODUCTION

Chapter 1.ORIENTATION
A. A Look Forward
B. A Glimpse Backward
C. The Income Tax and the United States Constitution
D. The Tax Practitioner’s Tools
 Sources of federal income tax law:
1. Internal Revenue Code of 1986, (28 U.S.C.)
2. Treasury Regulations
a. Legislative
b. Interpretive
3. Revenue Rulings and Procedures
4. Rulings and Determination Letters
5. Judicial Opinions
E. Tax Policy Considerations
F. The Road Ahead

PART TWO: IDENTIFICATION OF INCOME SUBJECT TO TAXATION

Chapter 2. GROSS INCOME: THE SCOPE OF SECTION 61
A. Introduction to Income
 Gross income is all income from whatever source derived.
B. Equivocal Receipt of Financial Benefit
 Money that is found must be declared ordinary income.
o It must be reported in the year that it is reduced to undisputable
possession.
 An employer’s payment of income taxes assessed against an employee
constitutes additional ordinary income.
 Money received as exemplary or punitive damages are reportable as gross
income; restitution damages are not.
 Conversion of travel credits (FF Miles) into cash results in taxable income.
C. Income Without Receipt of Cash or Property
 A taxpayer must not declare rental income for a building that it owns and
occupies.
 Free use of corporate property by its sole shareholders as their personal
residence constitutes gross income to them.

Chapter 3. THE EXCLUSION OF GIFTS AND INHERITANCES

A. Rules of Inclusion and Exclusion
 Gross income includes the receipt of any financial benefit which is:
o Not a mere return of capital
o Not accompanied by a contemporaneously acknowledged obligation to
repay
o Not excluded by a specific statutory provision
o Not within the concept of a tax-free fringe benefit
B. Gifts
 1. The Income Tax Meaning of Gift
 If payment is in return for services rendered, it is irrelevant that the
donor derives no benefit from it; the payment is not a gift—it is income.
 The mere absence of a moral or legal duty to make a payment, or the
lack of economic incentive to do so, does not, in and of itself, show a
gift.
 Whether a transfer amounts to a gift depends on consideration of all
the facts surrounding the transfer.
 A gift exists if it proceeds from a detached and disinterested generosity,
out of affection, respect, admiration, charity, or like impulses.
2. Employee Gifts
 An employee shall not excluded from gross income any amount
transferred by or for an employer to , or for the benefit of, an
employee.
C. Bequests, Devises, and Inheritances
 Gross income does not include property received by devise, bequest, or
inheritance.
 Money received in compromise of rights under a will contest is not ordinary
taxable income. (Estate taxes still apply).
 A bequest made to satisfy a contractual obligation still constitutes ordinary
taxable income under § 61 of the I.R.C.
o Use the Duberstein “intent test.”

Chapter 4. EMPLOYEE BENEFITS

A. Exclusion for Fringe Benefits
 Some fringe benefits are specifically excludable
o Group term life insurance up to $50,000 per year
o Accident and health insurance paid by employer
o No-additional cost service; a service usually offered for sale to
customers where the employer incurs no additional cost in providing
the service.
o Qualified employee discounts:
 Products – sold at cost
 Services – rendered at 20% discount
o Working condition fringe benefit
o De minimis benefit
o Tuition reduction* with some exceptions
B. Exclusions for Meals and Lodging
 The value of employer-furnished lodging may be excluded from gross income
when the taxpayer controls the employer corporation. Three conditions must
be met:
o The lodging is on the business premises of the employer
o The employee is required to accept such lodging as a condition of his
employment
o The lodging is furnished for the convenience of the employer

Chapter 5. AWARDS
 A. Prizes
 Gross income includes amounts received as prizes and awards (with exceptions).
 If an employee is required to go on a trip for business purposes, the value of the
trip does not represent taxable income to the employee.
B. Scholarships and Fellowships

Chapter 6. GAIN FROM DEALINGS IN PROPERTY

A. Factors in the Determination of Gain
 Generally, the basis of property is the cost thereof, including the cash or
property given up to obtain the asset.
B. Determination of Basis
1. Cost as Basis
 The basis of property is the value of the property received in a taxable
exchange.
 Attorneys’ and brokers’ fees and like costs spent in acquiring property
are added to the cost basis of the property.
 Tax-detriment rule: Cost basis includes any income charged to a
taxpayer acquiring property for lower than cost; i.e. if a taxpayer
purchases $25 worth of company stock for $10, they receive $15 as
income, and that income is added to the $10 basis of the stock, resulting
in a total basis of $25 for the $25 stock.
2. Property Acquired by Gift
 A done assumes the donor’s basis in property acquired by gift.
 A donor is exempt from taxation if they make a gift of property.
 Transfers contingent upon certain circumstances or in consideration of
contracts are not gifts.
3. Property Acquired Between Spouses or Incident to Divorce
 A gain or loss will not be recognized on a transfer of property between
spouses, or former spouses, provided that the transfer is merely
incident to divorce.
4. Property Acquired From a Decedent
 Generally, the basis of property passing by way of inheritance becomes
the fair market value of the property at the time of the decedent’s
death.
C. The Amount Realized
 The amount realized is the total amount of money received in the transaction
plus the fair market value of any property received in the transaction.
 A corporation can realize a taxable gain when it pays stock bonuses to
employees.
 Basis is NOT equal to net value of a property less an unassumed mortgage.
 A mortgagor not personally liable on a mortgage and sells the property subject
to that mortgage realizes a benefit equal to the amount of the mortgage as well
as the additional consideration received.
 RESTATED FROM ABOVE – A seller of property subject to nonrecourse debt
realizes an amount that includes the debt assumed by the purchaser.
  The Crane rule, illustrated in the previous two bullet points, also applies to
situations where a property’s nonrecourse mortgage exceeds the value of the
property disposed of.

Chapter 7. LIFE INSURANCE PROCEEDS AND ANNUITIES

A. Life Insurance Proceeds
 Benefits paid on a life insurance policy by reason of the insured’s death are not
taxable under I.R.C. 101, subject to:
o Installment payments
o Cash surrender value
B. Annuity Payments
 The part of the payment that represents a return of capital is not income,
however interest is.

Chapter 8. DISCHARGE OF INDEBTEDNESS

 When a debtor obtains forgiveness of a debt absolutely or for a payment below
the face amount of the debt, the extent of the debt forgiven is income to the
debtor.
 Retirement of a debt for less than face value (repurchasing bonds at a discount)
represents income to the debtor.
o Exceptions:
 Insolvent debtors
 Gifts (Personal or family relationship required)
 Contributions to capital (by shareholders)
 Compromises of disputed claims
 The settlement of a contested liability does not result in income from discharge
of indebtedness.

Chapter 9. DAMAGES AND RELATED RECEIPTS

A. Introduction
B. Damages in General
 Social Security DISABILITY, Workers’ Compensation, and Welfare benefits are
excluded from gross income.
 Social Security RETIREMENT benefits are taxable up to 85% depending on AGI.
 A settlement received for injury to goodwill is not taxed as income. (Treated as
a return of capital).
C. Damages and Other Recoveries for Personal Injuries
 Damages recovered by judgment or settlement because of physical ailments,
(personal injuries or sickness), are specifically excluded from gross income by
the I.R.C.
 Punitive damages are included in gross income.

Chapter 10. SEPARATION AND DIVORCE

A. Alimony and Separate Maintenance Payments
1. Direct Payments
 Alimony payments are deductible by the payor and are gross income to
the payee.
  In order for alimony to be taxable, these requirements must be met:
o The payment is received by or on behalf of a spouse under a
separation instrument.
o The instrument does not designate the payment as a non-
alimony payment
o In the case of a decree of legal separation or divorce, the parties
are not members of the same household at the time of
payment.
o There is no liability to make any payment in cash or property
after the death of the payee spouse.
o The payment is not child support.
o The payment must be in cash.
 Taxpayers are required to include in income excess alimony payments
made during the first two years after the divorce—EXCESS FRONT
LOADING
o Start with excess Year 2 recapture:
 Actual Year 2 payments – (Actual Year 3 payments +
$15,000)
o Then go to Year 1 payments:
 Actual year 1 payments – (((Actual Year 2 payments –
excess Year 2 recapture) + Year 3 payments)/2 +
$15,000)
o Include both amounts recaptured in Year 3’s income.
 Payments made in excess of $10,000 must be made for 6 years after
separation, barring death or marriage of either spouse.
2. Indirect Payments
 Payments made merely to maintain property owned by the payor
spouse and used by the payee spouse are not indirect alimony
payments. They are only indirect payments if the payor spouse has no
legal interest.
B. Property Settlements
 Payments that do not qualify under §71 as alimony payments are either
property settlements or child support. Both alternatives have neutral
tax consequences.
C. Other Tax Aspects of Divorce
1. Child Support
 Child support payments are not deductible by the payor spouse.
 Any payment contingent upon the status of a child is a child support
payment. (Child marries, age of majority, etc.)
2. Alimony Payments Made by a Third Party
 Annuity payments are taxed by the payee as ordinary income. Payor
may not deduct the lump sum payment to initiate the annuity.
 Trust income is taxable income to the grantor when it is used for the
support of any beneficiary whom the grantor is legally obligated to
support. Income paid to a divorced or separated spouse shifts the tax
burden to the beneficiary.
Chapter 11. OTHER EXCLUSIONS FROM GROSS INCOME (SKIP)

PART THREE: IDENTIFICATION OF THE PROPER TAXPAYER

Chapter 12. ASSIGNMENT OF INCOME
A. Introduction
 There are both mandatory and elective assignments of income.
B. Income from Services
 A contract with a spouse does not prevent income from vesting for tax
purposes.
 When a taxpayer, by anticipatory assignment, makes a gift of the interest or
compensation that he is entitled to receive at a future date in return from his
present services, he realizes taxable income.
 Performing a gratuitous service results in no taxable income.
 Performing a service for a non-profit organization, such as a university, and
having the income generated assigned to the non-profit organization results in a
successful shifting of the tax burden.
C. Income from Property
 When an owner of bond interest coupons transfers them to another person
before maturity, he realizes taxable income. (Bonds were tied to the coupon,
and thus the bondholder is tied to the income from the coupons).
 A beneficiary can avoid taxation on trust income by assigning his interests in the
trust to others.
 A shareholder may assign his rights to future stock dividends for value (i.e. sell
them) in order to minimize his taxes.
 When a taxpayer uses other parties as mere instrumentalities on a sale, they
incur a taxable income of the entire amount, despite title passing to other
parties.
 When a gift is made of a right to collect income in the future, the donor is taxed
on the amount of the right to collect the income that has accrued as of the date
of the gift.

Chapter 13. INCOME PRODUCING ENTITIES (SKIP)

PART FOUR: DEDUCTIONS IN COMPUTING TAXABLE INCOME

Chapter 14. BUSINESS DEDUCTIONS
A. Introduction
 In order to claim a deduction, taxpayers must find a specific section in the I.R.C.
that allows the deduction.
B. The Anatomy of the Business Deduction Workhorse: Section 162
 I.R.C. § 162: All the ordinary and necessary expenses paid or incurred during the
taxable year in carrying on a trade or business are deductible.
1. “Ordinary and Necessary”
 Payments made by a taxpayer to creditors of a bankrupt former
employer are not ordinary and necessary, and are considered capital
outlay for development of goodwill.
  Paying debts without obligation is extraordinary.
2. “Expenses”
 A building improvement that does not add to the useful life or value of
the building should not be capitalized; it is deductible as an ordinary and
necessary expense.
 Expenses for new buildings or for improvements that add value or life to
an already existing building are not deductible, and are capitalized
expenses.
 Expenditures that benefit a taxpayer for an indefinite period of time
into the future, but do not create or enhance a separate and distinct
asset, cannot be deducted as ordinary and necessary expenses.
 Expenses incurred for the purposes of changing a corporate structure
for the benefit of future operations are not ordinary and necessary.
3. “Carrying On” Business
 Travel expenses involved in traveling to find a business to purchase and
operate are not deductible as ordinary and necessary expenses.
 Ordinary and necessary expenses must be tied to an already existing
business.
C. Specific Business Deduction
1. “Reasonable” Salaries
 Salaries of employees are a ordinary and necessary business
expense.
 There is a 7 factor test to determine reasonable salaries:
i) Type and extent of services rendered
ii) Scarcity of qualified employees
iii) Qualifications and prior earning capacity of the
employee
iv) Contributions of the employee to the business
v) Net earnings of the employer
vi) Prevailing compensation to comparable jobs
vii) Peculiar characteristics of the employer’s business
 There is an independent advisor test to determine reasonable
salaries. Under this test, compensation is considered
reasonable when the employer’s unrelated investors are still
earning a reasonable return on their investment.
 Salaries based on percentage of income profits are deductible,
even if unreasonable, if it is found that there was an impartial
free bargain arranging the salary agreement.
2. Travel “Away from Home”
 I.R.C. § 162(a)(2) allows the deduction of expenses for traveling, meals,
and lodging while “away from home” and “in the pursuit of a trade or
business.”
 § 162 does not allow for deductible travel expenses for employees that
do not maintain a permanent home.
 Three conditions must be satisfied to received a § 162 deduction:
i) The expense must be reasonable and necessary
ii) The expense must be incurred in pursuit of a business
 iii) The expense must be incurred “while away from home”
 A taxpayer may claim as a deduction the duplicative living expenses
caused by having two businesses that require him to spend a substantial
amount of time in each of two widely separate places.
 Meals and lodging are deductible only when the taxpayer is away from
their residence tied to the principal place of business for that tax year.
 A taxpayer away from home may deduct the cost of meals only if the
trip requires that he stop for sleep or rest.
 A taxpayer is entitled to deduct his transportation, food, and lodging if a
job assignment at a distant location is temporary.
 Transportation between home and business is not deductible.
 Transportation between business and another business is deductible.
3. Necessary Rental and Similar Payments
 I.R.C. § 162(a)(3) provides that rental payments for the use of property
belonging to another are a deductible business expense.
 A lease that provides for a renewal of the lease with nominal payments
is equivalent to a sale and is a capital expenditure.
4. Expenses for Education
 Educational costs that either qualifies the taxpayer for a new trade or
business, or that constitute the minimum educational requirement for
qualification in their job, are never deductible.
 Educational expenses that meet the express requirements of the
employer or the law as a condition to retain employment or increase
compensation may be deducted.
 Educational expenses required of a teacher to renew their certificate
are deductible as expenses of carrying on a trade or business.
 Education that maintains or improves skills required by employment is
also deductible.
D. Miscellaneous Business Deductions
1. Introduction
 Common miscellaneous deductions:
o Business meals and entertainment (must be directly related to
the conduct of active trade or business) – 80%
o Entertainment facilities (dues) – 100% if necessary
o Summer homes used as a residence for at least 14 days –
Prorated
o Uniforms – 100% if necessary and not usable as regular clothing
o Advertising (signs) – Depreciated over the life of the sign
o Political contribution – Only deductible by individuals
o Professional organization dues – 100%
o Child care – 35% for children under age 13; Cannot exceed
$3,000 individual/$6,000 couple
2. Business Losses
 I.R.C. § 165(c)(1) permits an individual to deduct any loss incurred in a
trade or business.
 Losses must be realized and evidenced by a closed transaction or fixed
by an identifiable event.
 E. Depreciation
1. Introduction
 I.R.C. § 167 allows a depreciation deduction for a reasonable deduction
for the exhaustion, wear, and tear of assets (i) used in a trade or
business or (ii) held for the production on income.
 Intangible assets may be depreciated unless their useful life is indefinite.
 Date of initial use determines method of depreciation:
o Before 1981: Non-ACRS
 (Cost of the asset – salvage value) distributed over the
life of the asset
 Any reasonable method is acceptable:
 Straight-line Method
 Declining Balance Method
 Sum of the years digits method
o 1981-1986: Old ACRS
 Shortest recovery period
o 1987 and after: ACRS
 Longer recovery period than old ACRS
 Land is not depreciable. Buildings have a useful life of 39 years, unless it
is residential rental property, which has a useful life of 27.5 years.
 Depletion is the deduction for “wasting” assets (gas, oil, etc.) for losses
incurred in use or exploration.
o Cost method
o Percentage method
 In figuring gain or loss on the sale of property used partly for business
and partly for pleasure, the cost basis and sale price must be allocated
to reflect the percentage of business use.
 A tangible asset suffering wear and tear can be depreciated, even
though the asset’s useful life cannot be determined.
o This applies only if the asset is used, and not held for
investment purposes.
o This also applies even if the asset appreciates. (Old desks or
musical instruments, etc.)
2. Special Depreciation Rules on Personal Property
3. Special Rules on Realty

Chapter 15. DEDUCTIONS FOR PROFIT-MAKING, NONBUSINESS ACTIVITIES

A. Section 212 Expenses
 I.R.C. § 212 provides that an individual taxpayer is entitled to deduct expenses
paid or incurred:
i) For the production or collection of income
ii) For the management, conservation, or maintenance of property held for
the production of income
iii) In connection with the determination, collection, or refund of any tax
 Under § 212, personal investment activities of a taxpayer constitute carrying on
a business for purposes of deducting expenses.
  Legal expenses incurred in defending title to property are not ordinary and
necessary expenses, and are not deductible.
 There needs to be a proximate relationship between a deductible non-business
expense and the production of income or management of income producing
property, unless the subject involves a proxy fight involving corporate stock.
 Legal charges incurred in a suit to set aside a pre-nuptial agreement are not
deductible.
 Legal charges incurred in a suit to secure alimony ARE deductible, as alimony is
taxable income, and legal expenses involved to produce taxable income are
deductible.
B. Charges Arising Out of Transactions Entered Into for Profit
 Losses on the sale of a personal residence are not deductible, with certain
exceptions.
 Concerning a building once used as a residence, but later offered for rent or
sale:
o Depreciation deductions can be taken when efforts are made to rent the
property.
o Deductions may also be made for maintenance and conservation of the
property, when efforts are made to rent the property.
o A taxpayer may not deduct a long-term capital loss arising from the sale
of the property.
 A residential property is converted into an income-producing property if it is
abandoned and offered for sale, but not rent, with a reasonable expectation of
profit.

Chapter 16. DEDUCTIONS NOT LIMITED TO BUSINESS OF PROFIT-SEEKING ACTIVITIES

A. Introduction
B. Interest
 Payments for the use of borrowed money are deductible.
 The only types of interest deductions now allowed by individual taxpayers are
home mortgage interest and qualified educational expenses.
 Interest deductions for home mortgage include deductions for “points” which is
basically prepaid interest.
 Interest deductions are disallowed for: (i) interest paid on money borrowed to
purchase tax-exempt or municipal bonds, (ii) Interest paid on property under
construction.
 Now, interest is imputed to low interest and interest free loanstaxpayer has
realized income equal to the federal rate (less any low interest paid), but then
takes a deduction for the amount of the total interest.
C. Taxes
 I.R.C. § 164allows a taxpayer to deduct various state and local taxes, including
income taxes, real and person al property taxes, and gasoline taxes. Also,
business deductions may be available for excise taxes and Social Security taxes
paid on employees.
 Whoever maintains legal title to a property can deduct property taxes paid on
the property. A taxpayer cannot deduct property taxes paid on a property they
do not own.
 D. Bad Debts, Charitable Contributions and Casualty and Theft Losses

Chapter 17. RESTRICTIONS ON DEDUCTIONS (SKIP)

Chapter 18. DEDUCTIONS FOR INDIVIDUALS ONLY

A. The Concept of Adjusted Gross Income
 Adjusted gross income (AGI) is equal to gross income less above the line
deductions.
B. Moving Expenses
 I.R.C. § 217 allows an employee or self-employed individual to deduct expenses
incurred in moving himself and his family. Deductions are limited to
transportation of household goods, personal effects, and travel. The new job
site must be more than 50 miles further from the old home than the old job site
was.
C. Extraordinary Medical Expenses
 I.R.C. § 213 provides a limited deduction “for the diagnosis, cure, mitigation,
treatment, or prevention of disease, or for the purpose of affecting any
structure or function of the body.” Only expenses in excess of 7 ½% of AGI are
deductible.
 The cost of a capital improvement to property for medical reasons is deductible
only for the amount the expenditure exceeds the increased value to the capital
asset.
 The costs of a weight-loss program are deductible if the program is
recommended by a physician to treat a specific disease (obesity included). Meal
costs along with diet programs are not deductible.
 Cosmetic surgery is excluded from deductions unless it is to correct an injury,
disease, or congenital anomaly.
D. Qualified Tuition and Related Expenses
 Qualified expenses for tuition above the line deduction include costs of
enrollment or attendance at an eligible educational institution of higher
education for the taxpayer or a dependant.
E. Personal and Dependency Exemptions
 A spouse is never considered a dependent of the other spouse for tax purposes.
 A taxpayer may always claim an exemption for themselves, and may claim
additional exemptions for being over 65 and/or blind.
 Additional exemptions may be claimed for dependents.
o Taxpayer must provide over have of support for dependent to claim
deduction; usually goes to custodial parent.
o Can be apportioned over multiple taxpayers if several people contribute
to the dependent’s support.
F. The Standard Deduction
 Once AGI has been determined, the taxpayer has the option of either:
i) Itemizing the deductions from adjusted gross income
ii) Claiming the standard deduction
 When a litigant recovers monetary damages or settlement that constitute gross
income, the portion of the judgment/settlement that is paid as attorney’s fees is
also considered gross income of the taxpayer.
 PART FIVE: THE YEAR OF INCLUSION OR DEDUCTION
Chapter 19. FUNDAMENTAL TIMING PRINCIPLES
A. Introduction
 Cash Method of Accounting
o Income is recognized when received
o Deductions are recognized when paid
 Accrual Method of Accounting
o Income is recognized when earned
o Deductions are recognized when incurred
 I.R.C. § 446 provides that taxpayers shall compute taxable income in either way,
although the method must clearly reflect income.
B. The Cash Receipts and Disbursements Methods
 A taxpayer can affect the taxable year by either accelerating or postponing
receipt of income or payment of expenses.
1. Receipts
 A taxpayer receives income for that day, even if they receive a check
after banking hours.
 A note received as evidence of outstanding debt, not as payment for the
debt does not constitute income at the time of receipt.
 A solvent obligor’s promise to pay, if unconditional, assignable, not
subject to setoffs, and is of a kind that is frequently transferred to
lenders or investors, is taxable as if it had already been received.
 If a cash-basis taxpayer has an unqualified right to money or property
plus the power to obtain it, it is thought to be so much under his control
that he has constructive possession, and it is income for that tax year.
2. Disbursements
 A cash-basis taxpayer is allowed to deduct the pro-rata portion of
prepaid insurance costs for that year.
 Mortgage points are treated as prepaid interest and are amortized and
deducted over the life of the loan.
 In contrast to constructive possession, there is no corresponding
doctrine of constructive payment.
C. The Accrual Method
1. Income Items
 An accrual-based taxpayer cannot reduce income if a person obligated
to pay defaults. He may later take a bad debt deduction, but it does not
reduce income.
 Under accrual method, income is based on the right to receive income,
not the actual receipt of income.
 In a court judgment, a taxpayer received income from the U.S.
government the year of the judgment, not the year in which Congress
appropriated funds for payment.
 If funds from a corporation are held by a receiver and then returned,
the corporation is taxed on the income in the year the income is
 returned (because it is not entitled to the corporation until the
receivership is over).
 Prepaid income is included in gross income in the year it is received.
 Prepaid income is taxable when received, though deferment will be
allowed if it is the only proper way to account for the income.
2. Deduction Items
 “Reserves” are used to deduct future expenses associated with present
unearned income that must be accounted as present income according
to the accrual method.
o Laws have now changed so that the only practical use of
reserves is in bad debts.
D. Forced Matching of Methods
 Related parties are prohibited from claiming losses, expenses, and interest
deductions.
 In addition, related parties must use the same type of accounting method, i.e.
accrual or cash.
 A lessor and a lessee must also use the same type of accounting method for the
lease transaction.

Chapter 20. HOW INELUCTABLE IS THE INTERGRITY OF THE TAXABLE YEAR? (SKIP)

PART SIX: THE CHARACTERIZATION OF INCOME AND DEDUCTIONS

Chapter 21. CAPITAL GAINS AND LOSSES
A. Introduction
 The current statute taxes most net capital gain at a 15% rate
 A 5% capital gains rate applies to taxpayers in the 10% and 15% ordinary income
tax brackets.
 Reasons for favorable treatment of capital gains:
o Bunching of income in a single year  higher tax rates
o Effect of inflation
o “Lock-in” effect on investors
o Overall chilling effect on investments
o Effect of interest rates
 Whether a gain or a loss is subject to special treatment as “capital” is dependent
upon:
1) Whether it arises in a transaction involving a “capital asset”
2) Whether the capital asset has been the subject of a “sale or exchange”
3) How long the taxpayer has “held” the asset
 There are three aspects that separate capital gains from ordinary gains:
1) A disposition of a capital asset may involve only a continuation of an
investment in a different form
2) Gain said to be realized may merely or largely reflect only changes in the
overall price structure
3) The gain may have been some time in making, questioning the fairness
of recognizing all of the profit in only one taxable year
B. The Mechanics of Capital Gains
  The net Short Term is then netted against the net Long Term.
 If there is an overall net capital gain, follow this section.
 A short term capital asset is one that is held for up to one year.
 A long term capital asset is one that is held more than one year.

Short Term Capital Gain Long Term Capital Gain

- Short Term Capital Loss - Long Term Capital Loss
-------------------------------- --------------------------------
Net Short Term Gain/Loss Net Long Term Gain/Loss

Net Long Term Gain/Loss

+/- Net Short Term Gain/Loss
------------------------------------
Net Capital Gain/Loss

If there is an overall net capital gain consisting of a net short term gain
combined with (net long term gain or net long term losses less than short term
gain), the net capital gain is treated as ordinary income.
 If there is an overall net capital gain consisting of a net long term gain combined
with (a net short term gain or a net short term loss less than long term gain), the
amount is added to ordinary income, and then a deduction is allowed that
brings the long term capital gains down to percentage rates set by the I.R.C.
o 28% Rate
 Collectibles; i.e. art, antiques, gems, coins, stamps, alcoholic
beverages
o 25% Rate
 Unrecaptured § 1250 gain
 Depreciable real property
o 15% Rate
 Most long term capital assets; i.e. stocks, bonds, investment
land
o § 1(a)-(e) 10 & 15% Rates
 Capital is taxed at this level when it should be taxed at a higher
level, but the taxpayer has inadequate ordinary income
o Zero Percent Rate
 Bracket shifting, the same as § 1(a)-(e) 10 & 15% Rates, only for
different circumstances
 Net capital gains are treated as they are the last taxable income received.
 Corporations compute net capital gains the same way as normal taxpayers;
however, there is no preferential tax treatment for corporate net capital gains.
C. The Mechanics of Capital Losses
 The net Short Term is then netted against the net Long Term.
 If there is an overall net capital loss, follow this section.
 A short term capital asset is one that is held for up to one year.
 A long term capital asset is one that is held more than one year.

Short Term Capital Gain Long Term Capital Gain

 - Short Term Capital Loss - Long Term Capital Loss
-------------------------------- --------------------------------
Net Short Term Gain/Loss Net Long Term Gain/Loss

Net Long Term Gain/Loss

+/- Net Short Term Gain/Loss
------------------------------------
Net Capital Gain/Loss

 Generally, capital losses are deductible only from or against capital gains.
 Capital losses, whether long-term or short-term, offset capital gains, long-term
or short-term, dollar for dollar.
 If a taxpayer has both short term and long term capital losses, short term losses
are used in deductions first.
 For noncorporate taxpayers, capital losses in excess of capital gains can be
deducted from ordinary income, but only to a limited extent ($3,000).
o Any capital loss remaining after the ordinary income deduction can be
carried forward forever; however it must retain its original character as
long term or short term capital loss.
o In addition, the $3,000 ordinary income deduction can be taken every
year
 Corporate taxpayers can carry back losses 3 years, and forward 5 years, but
there is no ordinary income deduction.
D. The Meaning of “Capital Asset”
1. The Statutory Definition
 Capital gains and losses are derived only from the sale or exchange of
property constituting a “capital asset.”
 All of a taxpayer’s property are capital assets except:
o Inventory
 Any gain or loss from items held for sale to customers in
the course of ordinary business are ordinary income.
o Accounts & Notes receivable
o Assets used in a trade or business (excluding § 1231 assets)
o Artistic, musical, or literary compositions if held by the creator
or someone who received by the creator by gift or inheritance
o Certain stock options
o Certain government bonds
 Even though a property is intended to be held for investment purposes,
when it is subdivided, and those subdivisions are sold frequently, the
sale of that land becomes continuous and in the normal course of
business. Profits resulting from those sales are taxed as ordinary
income.
 Note the difficult interpretation of “primarily” for the holding of
property per § 1221(1).
E. The Sale or Exchange Requirement
 A sale or exchange must take place to recognize a capital gain or loss.
o The payment of a judgment was also held to be a capital loss.
  A trust payment can be considered a sale or exchange.
 A judgment realizing a settlement on bad debt is not a sale or exchange.
F. The Holding Period
 The holding period begins the day after acquisition and ends on the day of
disposal.
 Property acquired from decedent is always considered a long term capital asset.
 If the acquired capital asset retains the previous owner’s basis, or is lower than
FMV, the new owner’s holding period “tacks” to the previous owner. (i.e. gift,
bequest, devise)
G. Judicial Gloss on the Statute
1. “Income” Property
 When a lessor receives cash compensation to terminate a lease term
early, that payment is immediately recognized as ordinary income.
 The sale of a leasehold that has been maintained for at least one year is
considered a sale of a capital asset.
 Assignment with consideration of an annuity resulting from lottery
winnings is considered ordinary income.
2. Correlation With Prior Transactions
 In a number of occasions, transactions have been classified as capital or
ordinary because they were related to previous transactions.
 Transactions of separate tax years may be integrated for purposes of
classifying one of them as capital or ordinary.
 A deduction based on a court ordered refund was only allowed up to
the amount that it was included in profits. (i.e. only ~$300k was
included in profits of a ~$500k payment; only the ~$300k can be
deducted, not the entire ~$500k).
H. Statutorily Created Capital Gain and Loss Consequences
1. In General
 Congress has statutory provisions that classify items as capital or not
capital assets: §§ 1234 – 1324A, §1241, §1253, §1271
2. Section 1231 Recharacterization
 Non-business property becomes property used in a trade or business
when owners of a property, for lack of a buyer, are forced to rent it for a
fairly continuous period.
 Real property and depreciable property used in a trade or business is a
non-capital asset, and includable in ordinary profits/losses.
 The sale of a sole proprietorship does NOT result in a capital gain or
loss.
 A partnership interest that is sold IS a capital asset.

Chapter 22. CHARACTERIZATION ON THE SALE OF DEPRICIABLE PROPERTY (SKIP)

 §1221(2): Property used in trade or business, of a character subject to depreciation, or real
property used in a trade or business are not treated as capital assets.
 However, §1231: Gains on disposition of §1221(2) property will be treated as a capital asset.
 Firepot Calculation:
  Losses from theft, fire, storm, or other casualties that exceed gains are treated as
ordinary losses. If §1231 gains still remain, they are brought into the Hotchpot
calculation.
 Hotchpot Calculation:
 Gains and losses from the firepot calculation are added to dispositions of long-term
capital assets. If losses exist, they are ordinary losses; if gains exist, they are treated as
long-term capital gains.
 Inventory for sale to customers does not qualify under §1231.

Chapter 23. DEDUCTIONS AFFECTED BY CHARACTERIZATION PRINCIPLES (SKIP)

PART SEVEN: DEFERRAL AND NONRECOGNITION OF INCOME AND DEDUCTIONS

Chapter 24. THE INTERRELATIONSHIP OF TIMING AND CHARACTERIZATION
A. Transactions Under Section 453
1. The General Rule
 An installment sale occurs when at least one payment of the total
purchase price is to be received after the close of the taxable year in
which the disposition occurs.
 §453 allows the gain to be spread over the payment period by requiring
a percentage of each payment to be included in the gross income in the
year of receipt.
2. Contingent Sales Price
 Installment payments are allowed when the final selling price is based
upon some contingency.
 Installment prices can be based on the maximum possible price listed in
a contract.
 Where the sales term is indefinite and there is no maximum price, an
approximate ratable basis is taken.
3. Situations in Which Section 453 is Inapplicable
 Gain or loss must be recognized in the year received for:
 Sales at a loss
 Dealer dispositions
 Recapture income
 Sale of a depreciable property to a controlled entity
 Sale of publicly traded stock or security
 Sale of personalty on a revolving credit plan
 Sales between spouses
4. Special Rules Related to Section 453
 If a liability is assumed in connection with the sale of a property, the
liability is included in the amount realized on the sale.
 To the extent the liability exceeds the adjusted basis, it is considered a
payment in the year of sale.
 A seller of installment sales obligations takes a profit/loss the normal
way by computing the FMV – basis.
  Related parties are treated differently for installment sales. When there
is an installment sale to spouses, children, grandchildren, parents, and
controlled corporations, if the buyer then turns around and sells all or a
portion of the installment property, the original seller recognizes a
corresponding gain in that year.
B. Transactions Outside of Section 453
1. Open Transactions
 If the amount realized in a transaction is unknown or uncertain, the gain
or loss is considered an “open transaction.”
 Open transactions occur only in rare and extraordinary circumstances.
 The I.R.C.’s position is that FMV of the AMOUNT REALIZED can always
be determined or reasonably estimated.
 In an open ended transaction where the amount to be received is not
determinable, the seller can recover their basis before recognizing any
profits. The profits thereafter are then treated as capital gains.
o In contrast, gains exceeding contractual FMV in closed
transactions are treated as ordinary income.
2. Closed Transactions
 To compute the gain that is recognizable each year:
o Calculate the fraction of (Gross Profit / Total Contract Price)
 Incomeyr = payroll (GP/KP)
 GP = Sale Price - Basis
o Apply that fraction to the installment payment to determine
how much of the payment is gain to the seller.
 Installment method cannot be used to spread losses over years of
payment.
 At least one payment must be received in the subsequent tax year.
 Related party rules apply to closed transactions.
 Recapture is recognized in the year of sale.
C. The Original Issue Discount Rules and Other Unstated, Hidden, and Imputed Interest
 Original Issue Discount (OID) rules insure that transactions reflect the time value
of money.
 OID rules are applied to both cash and accrual basis taxpayers.
 If one buys property from another, promising to pay money in the future, the
buyer is basically getting a loan from the seller. The “loan,” if there is no
specified interest, or interest lower than the lower rate, will have interest
imputed at the federal rate.
D. Property Transferred in Connection with Services
 A taxpayer who receives property in exchange for services performed must
include the FMV of that property in their taxable income (less any money paid
for the property, if any).
E. Income in Respect of Decedents
 Money due to a decedent will pass through to the heir, legatee, or estate as
income during that year. The recipient must declare the money as income in
respect of a decedent (IRD) for any year in which income is received. The estate
must also claim the income, but may claim a deduction in the amount of income
tax due on the IRD.
Chapter 25. DISALLOWANCE OF LOSSES (SKIP)

Chapter 26. NONRECOGNITION PROVISIONS

A. Introduction
 Even though a taxpayer incurs a gain or loss, it may not be “recognizable.”
B. Like Kind Exchanges
1. The Like Kind Exchange Requirements
 No gain or loss is recognized on an exchange when property held either
for investment or for use in a business is exchanged solely for property
of a like kind.
 Sale = Property given for money; Exchange = Property given for property
 The presence of a small amount of cash to adjust differences in value of
the properties exchanged does not prevent the transaction from being
considered an exchange.
 An exchange of improved real estate property for mineral rights is a like
kind exchange.
 Like kind exchanges do not extend to stocks, bonds, or inventory. Only
real property or property held for use in a business may be considered
in like kind exchanges (i.e. buildings, machinery, fixtures).
 When property is sold for FMV, the presence of a long-term lease-back
provision will not render the transaction an exchange.
2. Three-Cornered Exchanges
 A transaction involving 3 parties, where the was money put into escrow
of the first party, and the second party purchased land from the third
party, who then exchanged that with the first party and then got the
escrow refunded was considered a like kind exchange.
 There are now stricter rules governing amount of parties used, value of
property, and timing of identification of property.
3. Other Section 1031 Issues
C. Involuntary Conversions
 If a taxpayer replaces an involuntarily converted property within two
years after the end of the tax year of the conversion, it is a pseudo-like-
kind exchange, and the taxpayer will only be taxed to the extent that
value of the new property exceeds the old.
 When two lots are used for business in conjunction with each other,
when one lot is involuntarily converted, the other lot is also considered
to be constructively converted as well.
 The involuntary conversion of an office building and subsequent
purchase of a hotel did not constitute a like-kind exchange.
o Bowling Center  Billiard Center = NOT a like-kind exchange
o Condemnation proceedings  Refurbishing and new facilities =
LIKE-KIND exchange
o Rental warehouse  Gas station that was rented = Like-kind
exchange.
D. Other Non-recognition Provisions
 PART EIGHT: CONVERTING TAXABLE INCOME INTO TAX LIABILITY
Chapter 27. COMPUTATIONS (SKIP)

PART NINE: FEDERAL TAX PROCEDURE AND PROFESSIONAL RESPONSIBILITY

Chapter 28. PROCEDURE AND PROFESSIONAL RESPONSIBILITY (SKIP)