Homework2w

Chapter 4

Gross Income

OBJECTIVES

After completing  Chapter 4 , you should be able to:

1. Define and distinguish among the various concepts of income: economic, accounting, and legal.

2. Recognize the various items included in gross income.

3. Determine when items are included in income.

4. Understand the rules governing alimony.

5. Differentiate alimony from child support.

6. Comprehend the rules for recapturing alimony.

7. Understand the rules governing the discharge of indebtedness for both solvent and insolvent taxpayers.

OVERVIEW

Gross income, according to the Internal Revenue Code, includes all income unless specifically exempted by law. This comprehensive definition requires a more probing discussion of what must be included in income. Further, we must concern ourselves with “how much” must be included in income and what portion of total income may be excluded.

The Concept of Income

A frustrating characteristic of the English language is that a single term can be used to express a variety of concepts. Take the concept of income: economists, the courts, and accountants use this term, but for each, the definition imparts a singular view.

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ECONOMIC INCOME

The economic concept of income is more general than the accounting definition. The most commonly accepted definition of economic income is that of J. R. Hicks. He defines economic income as being “the maximum amount a person can consume during a week and still expect to be as well-off at the end of the week as he was at the beginning.” J. R. Hicks, Value and Capital (Oxford: Clarendon Press, 1946), p. 172. This assumes that there were no capital contributions or withdrawals during the period measured. The economist’s definition is not practical for tax purposes because the concept of “well-being” is not capable of objective measurement. The economic concept of income places a heavy emphasis on the future. No objective rules exist for determining well-being at any moment in time. Economists must deal in terms of real wealth, which includes holding gains and losses rather than monetary wealth alone. H. C. Simons maintained, “The precise, objective measurement of income implies the existence of perfect markets from which one, after ascertaining quantities, may obtain the prices necessary for routine valuation of all possible inventories of commodities, services, and property rights.” Personal Income Taxation (Chicago: University of Chicago Press, 1921), p. 50. Since no such markets exist where the necessary prices for valuation may be obtained, the economic concept is an inappropriate measure of taxable income.

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THE LEGAL/TAX CONCEPT OF INCOME

The legal concept of income is also less precise than that of the accountant. Congress has not defined income, but has specified how particular items of income are to be taxed. The concept of income has crystalized through a series of court cases. The legal concept is different from the economic and accounting concepts. Gross income includes “all income from whatever source derived” unless specifically exempted by law. Code Sec. 61(a).

Eisner v. Macomber

In the case of Eisner v. Macomber, 1 USTC ¶32, 252 U.S. 189, 40 S.Ct. 189 (1920), the Supreme Court dealt at great length with the problem of defining income. The Court stated:

After examining dictionaries in common use . . . , we find little to add to the succinct definition adopted in two cases arising under the Corporation Tax Act of 1909 . . . “Income may be defined as the gain derived from capital, from labor, or from both combined,” provided it be understood to include profit gained through sale or conversion of capital assets. . . .

Here we have the essential matter: not a gain accruing to capital; not a growth or increment of value in the investment; but a gain, a profit, something of exchangeable value, proceeding from the property, severed from the capital, however invested or employed, and coming in, being “derived “—that is, received or drawn by the recipient (the taxpayer) for his separate use, benefit and disposal; that is income derived from property.

The same fundamental conception is clearly set forth in the Sixteenth Amendment—”incomes, from whatever source derived”—the essential thought being expressed with a conciseness and lucidity entirely in harmony with the form and style of the Constitution.

Like the accountants’ concept, the legal concept does not embrace holding gains or losses. The legal definition of income is close to the accountants’, but not identical, as will be highlighted in the remainder of the chapter.

EXAMPLE 4.1

Rachel owned 300 shares of Imperial Soap which she purchased for $1,000. She sold the stock this year for $1,200. Rachel realized a gain of $200, not the $1,200 proceeds she received from the sale. Only the $200 is included in gross income. The $1,000 is Rachel’s return of capital.

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ACCOUNTING INCOME

The accountant desires to measure income over a specified period of time. Income, from an accounting point of view, is the excess of revenues over the costs incurred in producing those revenues. The emphasis for the accountant is on completed transactions. Therefore, unlike the economist, the accountant does not recognize holding gains. The accountant deals exclusively with objectively measurable forms such as monetary transactions.

Realization of Income

As in financial accounting all gains must be “realized” before they are includible in income. This usually occurs at the time of an arm’s-length transaction.

EXAMPLE 4.2

Tom Spears buys a parcel of real estate for $100,000 in 2002. In 2020, he has it appraised and finds that the property’s market value is $150,000. He has a paper gain of $50,000, but he has no taxable income. Later in 2020, he sells the property for $150,000, at which time the income is “realized” and “recognized.”

Under the accrual method of accounting, income is recognized when a transaction is consummated. Under the cash method of accounting, income is recognized only when cash is received. The cash method and accrual method of accounting are discussed in  Chapter 13 . To prevent cash basis taxpayers from choosing the year in which to recognize income, the Internal Revenue Service applies the constructive receipt doctrine.

Economic Benefit, Constructive Receipt, and Assignment of Income Doctrines

This chapter discusses three doctrines: the economic benefit doctrine, the constructive receipt doctrine, and the assignment of income doctrine. The doctrines focus on the following questions: what is income, when is it taxable, and to whom is it taxable?

In determining “what” is income and “when” an item must be included in the taxable income of a cash basis taxpayer, two concepts were conceived: the economic benefit doctrine and the constructive receipt doctrine. Over time the courts have tended to blur the distinction between these two doctrines. F. Bowden, 61-1 USTC ¶9382, 289 F.2d 20 (CA-5 1961), reversing 32 TC 853 (1959).

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ECONOMIC BENEFIT DOCTRINE

The economic benefit doctrine addresses the “what” and the constructive receipt doctrine addresses the “when.” Any amount of compensation granted or paid to the individual for services rendered, be it cash, bonus, profit sharing, compensation in kind, or any other ingenious method of payment, must be included in gross income. Gross income is defined under the broad language of Code Sec. 61(a) of the Internal Revenue Code as “all income from whatever source derived.” Thus, taxable income may consist of cash, receivables, property, land, or any other form of economic benefit.

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CONSTRUCTIVE RECEIPT DOCTRINE

The second doctrine, that of constructive receipt, was defined in the case of Ross. In this case, the Circuit Court of Appeals stated that the doctrine of constructive receipt was conceived “in order to prevent the taxpayer from choosing the year in which to reduce it (income) to possession.” L.W. Ross, 48-2 USTC ¶9341, 169 F.2d 483 (CA-1 1948).

The Regulations explain the doctrine of constructive receipt, based upon the fact that income is:

credited to [the taxpayer’s] account, or set apart for him, or otherwise made available so that he may draw upon it at any time. . . . However, income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions. Reg. §1.451-2.

A distinctive feature of the constructive receipt doctrine is that it affects only cash basis taxpayers, since they are deemed to have received income prior to the time of actual receipt. Because the accrual basis taxpayer is assumed to have recognized income at the moment it is “earned,” there is no need to apply the constructive receipt doctrine. It is of no consequence if an individual refuses compensation. The courts have ruled that once the individual has an “absolute right” to the compensation, the amount of the remuneration must be included in the taxpayer’s income. However, where the individual has only a conditional right, the courts hold that no present income was received. Generally, any compensation granted to an individual to which the individual has an absolute right is regarded as constructively received income. The taxpayer must include in current income any amounts of compensation which the taxpayer has refused to accept.

EXAMPLE 4.3

Leah was an employee of Loss Leaders Inc. On December 2, 2020, Loss Leaders announced a year-end bonus for all employees. Checks would be available for pickup at the cashier’s desk December 29, 2020. Leah called in sick on December 29, 2020, and she did not stop by the cashier’s desk until January 5, 2021. Leah must include her bonus on her 2020 tax return. She had a right to the bonus on December 29, 2020. It is immaterial that she chose not to collect her bonus on December 29, 2020.

As between the two doctrines, economic benefit and constructive receipt, logically the applicability of the economic benefit doctrine comes first. If the taxpayer has not received economic benefit, then it is not necessary to determine whether the taxpayer is in constructive receipt of income. Now that the concepts of “what” is income and “when” an item must be included in taxable income have been explained, it is necessary to determine “to whom” the income is taxable.

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ASSIGNMENT OF INCOME DOCTRINE

The assignment of income doctrine means that income is taxed to the individual who earned it, even if the right to the income has been transferred to another individual prior to recognition. Compensation, interest, rents, dividends, and other forms of income usually must be included in the gross income of the recipient. A tax problem arises when an individual attempts to limit tax liability by assigning income. For example, a taxpayer has the employer forward a portion of the salary to one of the taxpayer’s creditors instead of to the taxpayer. The taxpayer would have to recognize this as income inasmuch as the taxpayer received benefit from the proceeds and had control of the income.

In Helvering v. Horst, 40-2 USTC ¶9787, 311 U.S. 112, 61 S.Ct. 144 (1940), the Supreme Court ruled that a father who gave his son interest coupons, detached from bonds prior to their maturity, was liable for the tax on the interest even though the interest was received by his son. The Court stated:

Income is “realized” by the assignor because he, who owns or controls the source of income, also controls the disposition of that which he could have received himself and diverts the payment from himself to others as the means of procuring the satisfaction of his wants. The taxpayer has equally enjoyed the fruits of his labor or investment and obtained the satisfaction of his desires whether he collects and uses the income to procure those satisfactions, or whether he disposes of his right to collect it as the means of procuring them.

In the preceding case, if the father wished to avoid the tax liability, he would have had to transfer the property which produced the income.

Generally, the courts have felt that a person should not be allowed to reduce tax liability by the voluntary assignment of income. This is referred to as the “fruit-of-the-tree” doctrine. Income (fruit) is taxable to the individual who has earned it. Thus, assignment of income will be disregarded, for tax purposes, unless the source of the income (tree) is also assigned. In Lucas v. Earl, 2 USTC ¶496, 281 U.S. 111, 50 S.Ct. 241 (1930), the Court stated that the “fruit” may not be “attributed to a different tree from that on which it grew.”

If a person only has physical possession over the income of another person, he or she has no tax liability. Regardless of whether or not the person received it as an agent or creditor, it is taxed to the owner of the property. The rules which govern the assignment of income apply both to income from property as well as to income from services.

EXAMPLE 4.4

Jack Smith owns a warehouse complex and assigns the rents to his daughter Linda. Jack remains liable for the tax on the rental income, even though Linda is receiving the rental income.

 

EXAMPLE 4.5

Linda Katz, a recent college graduate, earns $450 per week. In an effort to repay a college loan to her uncle she assigns half of her pay to him. Linda is taxed on the full $450 per week.

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COMMUNITY PROPERTY INCOME

The question of tax liability for married persons filing separate returns arises frequently during discussions concerning to whom is income taxable. Various states treat this problem differently so that there is no solution which is universally applicable. The existence of community property laws in several states requires treatment of tax liability which is significantly different from those states in which there are no community property laws.

In the eight community property states (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, and Washington), all property acquired by a husband and wife after marriage is considered as owned by them in community, and, as such, is referred to as community property. Any income from these properties is automatically considered joint or community income, and if taxpayers are filing separate tax returns, the income would be shared equally between them on their separate returns. In 1985, Wisconsin implemented a marital property act; therefore, for federal income tax purposes it is considered a community property state. In 1998, Alaska became a community property state. Alaska adopted an optional system, whereby a couple can choose to opt-in to the community property system.

Property acquired before marriage or inherited by one spouse during marriage is considered to be that spouse’s separate property. In California, Arizona, Nevada, New Mexico, Washington, and Wisconsin, any income from these separate properties is considered separate income; thus, if the spouses are filing separately, the income would not be shared and would be reported on that spouse’s separate return. This is called the “California Rule.” Conversely, in Texas, Idaho, and Louisiana, income from these separate properties is considered community income; thus, if the spouses are filing separately, the income would be shared between them on their separate returns. This is called the “Texas Rule.”

Section 66 of the Internal Revenue Code sets forth a specific rule for treatment of community income where the spouses live apart. Section 66 was passed by Congress in 1980 and was effective 1981 and thereafter. The need for this section arose because in community property states each spouse is liable for one-half the tax on income. Generally, when spouses are living apart, the spouse that earns the income will keep it.

If two individuals are married to each other at some time during a calendar year, but live apart for the entire tax year, do not file a joint return, and one or both have earned income, none of which is transferred between them, the following rules cover the reporting of income on their separate tax returns:

1. Earned income (other than trade or business income and partnership income) is treated as income of the spouse who rendered the personal services.

2. Trade or business income is treated as the husband’s income unless the wife exercises substantially all of the management and control of the business.

3. Community income derived from the separate property of one spouse is treated as the income of such spouse.

4. All other community income is taxed in accordance with the applicable community property law. Code Sec. 879(a).

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TENANCY BY THE ENTIRETY

If property is held by a married couple as tenants by the entirety, all income from the property must be included by the husband in his return or must be shared equally by husband and wife, depending on state law. In states which have abolished the common law rule, such as Delaware, Florida, Indiana, Maryland, Michigan, Missouri, New York, Oregon, Pennsylvania, and the District of Columbia, one-half of the income is reported on the husband’s tax return and one-half on the wife’s tax return.

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JOINT TENANTS AND TENANTS IN COMMON

Parties holding property as joint tenants each report income from the property in direct proportion to their interest in the property. When one of the parties dies, the interest in the property is automatically passed to the surviving joint tenant. Upon the death of a tenant in common, the deceased’s interest is automatically transferred to the heirs. Parties holding property as tenants in common are taxed on their proportionate share of income based on their contribution of ownership of the property.

Items Included in Gross Income

Having discussed the concept of income, what it is, when it is taxable, and to whom it is taxable, attention now will be focused on the types of items which are included in gross income.

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LIST OF INCOME ITEMS

As has been explained, the concept of income is broad and general. Section 61(a) of the Code simply lists fifteen items which must be included in gross income. Remember, gross income is in no way limited to these fifteen income items.

1. Compensation for services, including fees, commissions, fringe benefits, and similar items

2. Gross income derived from business

3. Gains derived from dealings in property (discussed in  Chapters 10 – 12 )

4. Interest

5. Rents

6. Royalties

7. Dividends

8. Alimony and separate maintenance payments (Provision was stricken for any divorce or separate maintenance instrument executed after December 31, 2018)

9. Annuities (discussed in  Chapter 5 )

10. Income from life insurance and endowment contracts

11. Pensions

12. Income from discharge of indebtedness

13. Distributive share of partnership gross income

14. Income in respect of a decedent

15. Income from an interest in an estate or trust

Section 61(a) clearly points out that gross income is not limited to these items, but that these are merely the most typical sources of income. It is irrelevant whether or not the above items are received in money, goods, or services. Note that items such as gifts or inheritances are not included. On the other hand, illegal gains such as gambling gains and income from swindling or extortion must be included in income. Sections 71–90 of the Internal Revenue Code concern themselves with items to be included as gross income. Obviously there are a number of items that are specifically exempted from gross income.  Chapter 5  discusses these items. They can be found in Sections 101–139 of the Internal Revenue Code.

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COMPENSATION FOR SERVICES

All compensation received by the individual is included in gross income. This would include salary, bonuses, tips, commissions, director’s fees, and any other amounts received for personal services. This compensation is taxed when received and not when earned unless the individual reports income under the accrual method. Generally, the individual includes as income the fair market value of property received. If the taxpayer receives corporate stock as compensation for services, the fair market value of the stock, at the time of transfer, must be included in gross income.

EXAMPLE 4.6

Charlotte Moss, a cash basis taxpayer, received a paycheck on Friday, January 2, 2021. The pay period covered is for the previous two weeks’ work. This money is included on her 2021 tax return, not her 2020 return. However, if Charlotte had had the option of receiving her paycheck on December 31, 2020, by simply requesting it, then, under the constructive receipt doctrine, her salary would have been taxed in 2020.

Year-end bonuses are included in the tax return for the year they are received. Voluntary payments such as severance pay and Christmas bonuses also must be included. Meals and living quarters which an employee receives constitute gross income unless they are furnished for the convenience of the employer. Further, they must be furnished on the employer’s premises. With respect to lodging, it must be a condition of employment. See  ¶5185  for a complete discussion of meals and lodging as compensation.

EXAMPLE 4.7

Charlotte’s employer, IBC Inc. informed employees on December 15, 2020, that a 5 percent cash bonus, based on 2020 earnings, would be paid to all employees on February 9, 2021. Charlotte would have to include her bonus in her 2021 tax return.

Bartering is becoming a more common practice in the United States today. Bartering is the exchange of your property or services for another’s property or services. The fair market value of property or services received must be included in gross income.

EXAMPLE 4.8

Robert Jones, owner of Jones’ Dry Cleaning, was discussing his income tax problems with one of his best customers, Sam Owen. Sam is an accountant and is self-employed. During the course of their conversation, they struck a deal. Jones would do all of Owen’s cleaning and Owen would do Jones’s accounts and tax returns. No money would exchange hands. In this instance, both Jones and Owen must include in their income the fair market value of services received.

Small items given by the employer to the employee, such as a turkey at Thanksgiving or a ham at Christmas, are not taxable to the employee even though the employer is allowed a deduction for the item as a business expense. However, a small cash stipend, such as a $20 bill at Christmas or a gift certificate, would be considered as taxable and includible in gross income.

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COMPENSATION V. GIFT

Section 102(a) explicitly excludes the value of property acquired by gift from being included in gross income. However, Section 102(b) does not exclude the income earned on the property after it is received.

In determining whether or not a payment or transfer is in the form of compensation or a gift, the Supreme Court has said that it is necessary to consider all the relevant surrounding circumstances and especially to determine the intent of the parties involved. A.G. Bogardus, 37-2 USTC ¶9534, 302 U.S. 34, 58 S.Ct. 61 (1937). The Fifth Circuit Court of Appeals said that a gift is “not intended as a return of value or made because of any intent to repay another what is his due, but bestowed only because of personal affection or regard or pity, or from general motives of philanthropy or charity.” C. Schall, 49-1 USTC ¶9298, 174 F.2d 893 (CA-5 1949).

A payment or transfer can be considered compensation by one party and a gift by the other. However, the Supreme Court stated in Bogardus:

The statute definitely distinguishes between compensation on the one hand and gifts on the other hand, the former being taxable and the latter free from taxation. The two terms are, and were meant to be, mutually exclusive; and a bestowal of money cannot, under the statute, be both a gift and a payment of compensation.

When determining if the payment was compensation or a gift, the courts look to see if the transferor took a tax deduction for the payment. If the transferor did, then it indicates that the payment was meant to be compensation. On the other hand, if the transferor did not take a tax deduction for the sum, it is not conclusive, but it is evidence that a gift was intended. The mere fact that an employer was not legally obliged to make a payment is not, in itself, evidence of a gift. Code Sec. 102(c).

In the landmark case of Duberstein, the Supreme Court reiterated the statement that a gift proceeds from “detached and disinterested generosity.” M. Duberstein, 60-2 USTC ¶9519, 363 U.S. 278, 80 S.Ct. 1190 (1960). Duberstein received a Cadillac from the president of a company with whom he had done business for quite some time. Duberstein had on several occasions given business leads to this other company. Naturally, the Commissioner insisted Duberstein must include the fair market value in gross income and Duberstein insisted it was a gift. The Supreme Court stated:

despite the characterization of the transfer of the Cadillac by the parties and the absence of any obligation, even of a moral nature, to make it, it was at bottom a recompense for Duberstein’s past services, or an inducement for him to be of further service in the future.

The Duberstein case concludes with the general premise that corporations ordinarily just do not make gifts without receiving some economic benefit in return.

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JURY DUTY PAY

Jury duty pay must be included in gross income. However, any jury duty pay remitted to an employer in exchange for compensation for the period the employee was on jury duty is deductible from gross income. Code Sec. 62(a)(13).

Virtual Currency

Virtual currency is a digital representation of value that functions as a medium of exchange, a unit of account, or a store of value. In some environments it operates as real currency. The largest digital currencies are, Bitcoin, Ethereum, Ripple, Bitcoin Cash and EOS.

A taxpayer who receives virtual currency as payment for goods and services must include in gross income the currency’s fair market value. If a taxpayer successfully mines virtual currency the currency’s fair market value is includible in gross income. Virtual currency that has an equivalent value in real currency is referred to as “convertible” virtual currency. Bitcoin is an example of a convertible virtual currency.

EXAMPLE 4.9

Joe works for Small Enterprise, Inc. On November 30th Joe receives his paycheck. His employer pays him in virtual currency. The fair market value of the virtual currency is included in Joe’s gross income. The virtual currency paid as wages is subject to tax withholding, FICA, FUTA and must be reported on Form W-2.

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PRIZES AND AWARDS

Gross income includes amounts received as prizes and awards from radio and television give-away and quiz shows, lotteries, door prizes, and awards from contests. Where the prize or award is not made in money but in the form of property, the fair market value of such property must be included in gross income.

Scientific and Charitable Prizes and Awards

Prizes and awards in the fields of science, charity, and the arts (such as the Pulitzer Prize and the Nobel Peace Prize) are includible in gross income unless the recipient assigns the prize or award to a governmental agency or tax-exempt charitable organization. This assignment must be made prior to the recipient’s using the item that is awarded. To be eligible for the exclusion the recipient (1) must have been selected without any action on the recipient’s part to enter the contest and (2) must not be required to render any substantial future services as a condition to receiving the prize or award. Code Sec. 74(b). If a proper assignment is made, none of the winnings need be included in the recipient’s gross income. However, the recipient is not allowed a charitable contribution deduction.

Employee Achievement Awards

Employee awards for length of service or safety achievement are excludable from gross income by the employee and are deductible by the employer if they are awarded as part of a meaningful presentation, and:

1. The awards do not exceed a total of $400 for all nonqualified plan awards received by any one employee during the tax year, or

2. The awards do not exceed $1,600 for all qualified plan awards received by any one employee during the tax year.

However, the $1,600 limitation applies in the aggregate. Thus, the $400 limitation and the $1,600 limitation cannot be added together to allow deductions exceeding $1,600. Code Sec. 274(j)(2).

A qualified plan award is one awarded as part of an established written plan or program by the employer that does not discriminate in favor of highly compensated employees. An employee achievement award will not be considered a qualified plan award if the average cost of all employee achievement awards provided by the employer during the tax year exceeds $400. The average cost does not include awards of nominal value. Code Sec. 274(j)(3)(B). The following example illustrates the tax status of employee achievement awards.

The Tax Cuts and Jobs Act requires that the award be tangible personal property, but cannot include cash, gift cards, cash equivalents, gift coupons, gift certificates (unless the choice is from a limited array of items), vacations, meals, lodging, tickets to sporting or theatre events, stocks, bonds, or other securities. This is effective after December 31, 2017.

EXAMPLE 4.10

Ben Smith received three employee achievement awards during 2020. Two were qualified awards of a tennis racket valued at $200 and a television/stereo valued at $1,300. The third was a nonqualified award of a briefcase valued at $250. Ben’s employer satisfies all the requirements for qualified plan awards. Inasmuch as Ben’s total of awards received exceeds $1,600, he must include the excess $150 ($1,750 – $1,600) in gross income.

A length of service award does not qualify if it was received by an employee within the first five years of employment or if the recipient received a length of service award within the previous four years. Safety achievement awards cannot be given to more than 10 percent of the employees. Managers, administrators, clerical employees, and other professional employees are not eligible for safety achievement awards.

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SCHOLARSHIPS AND FELLOWSHIPS

Generally, gross income does not include any amount received as a qualified scholarship by an individual who is a degree candidate at an educational organization. A qualified scholarship is the amount received by a degree candidate that is excludable up to the aggregate amount incurred by the candidate for tuition and course-related expenses, such as books, supplies, and equipment. No exclusion is allowed for room, board, or incidental expenses. Also, no exclusion is allowed if payments received are a result of services.

Non-degree candidates must include in income scholarships and fellowships. The exclusion provision applies only to degree candidates. Under special rules the exclusion provision extends to tuition reductions provided for the education of employees of an educational institution. The rules do not affect the exclusion for employer-provided educational assistance to an employee (see  ¶5201 ).

EXAMPLE 4.11

Mary Smart is a full-time undergraduate student at State University. Mary is an honor student and received a $3,000-per-year scholarship. The scholarship award pays for Mary’s tuition ($2,000), books ($200), equipment ($300), and incidental expenses ($500). Mary would have to include in her gross income only the $500 for incidental expenses.

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GROSS INCOME DERIVED FROM BUSINESS

Gross income is defined by the Code as including gross income derived from a business. Gross income means total sales revenues less cost of goods sold, plus income from investments and any other incidental income. The Regulations state that gross income shall be determined as follows:

without subtraction of selling expenses, losses or other items not ordinarily used in computing costs of goods sold . . . . The cost of goods sold should be determined in accordance with the method of accounting consistently used by the taxpayer. Reg. §1.61-3(a).

EXAMPLE 4.12

The income statement of ABC, a manufacturing enterprise, shows the following information:

Gross Sales		$195,000
Less: Cost of Goods Sold:
Inventory, January 1	$30,000
Purchases	160,000
Goods Available for Sale	$190,000
Less: Inventory, December 31	45,000
Cost of Goods Sold		$145,000
Gross Profit (Gross Income)		$50,000

The taxpayer, in this example, would include $50,000 in gross income. The net profit or loss of a business is determined by subtracting from gross profit (income) all selling, as well as general and administrative, expenses. Continuing on from the previous calculations:

Gross Profit (Income)		$50,000
Less: Selling Expenses	$12,000
General and Administrative
Expenses	8,000
Total Operating Expenses		$20,000
Net Profit (Income)		$30,000

In the determination of penalties and additional tax due to the omission of items of income, gross income is defined in Code Sec. 6501(e)(1)(A)(i) as total income received or accrued “prior to diminution by the cost of such sales.”

Single Proprietorships, Partnerships and S Corporations

Under The Tax Cuts and Jobs Act, as with sole proprietorships, partnerships, and S corporations may deduct up 20 percent of domestic qualified business income. The deduction is not allowed for all sole proprietorships, partnerships, or S Corporations. Certain service trades are excluded. This provision is effective for tax years beginning in 2018 and will sunset after 2025. In  Chapter 8 , there is a more detailed discussion of the 20 percent deduction for qualified business income.

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PARTNERSHIPS AND S CORPORATIONS

Partnerships and S corporations are not taxed, but their taxable income is taxed to the individual partners or shareholders. Each partner or shareholder absorbs a proportionate share of the firm’s income, whether or not distributed. An S corporation is a small business corporation desiring not to be taxed at the corporate level. A corporation desiring S corporation status must meet various requirements, including valid stockholder approval of S status.

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INTEREST

Interest received by a taxpayer or credited to the taxpayer must be included in gross income. Interest income includes interest on bank accounts, loans, notes, corporate bonds, and U.S. savings bonds. Interest income received on obligations of states, territories, or a possession of the United States is generally wholly exempt from taxation.

EXAMPLE 4.13

Leo Lionstone has a savings account at First National Bank that pays him interest on June 30 and December 31 of each year. In 2020, $25 of interest income was credited to his account in June and $28 of interest income on December 31. Even though Leo makes no withdrawals during the year, he must include $53 of interest income in his 2020 gross income. He had an absolute right to the money; therefore, he must recognize the income.

A cash basis taxpayer reports interest income when received. Interest earned on bank accounts is considered received, under the constructive receipt doctrine, when credited to the account. An accrual basis taxpayer reports interest income as it accrues. Interest on U.S. Series EE savings bonds may be reported each year or the taxpayer may elect to report the entire amount in the year that the bond matures. Once the taxpayer chooses a method, all of the taxpayer’s Series EE savings bonds must be reported in the same manner. Code Sec. 454.

Banks and other financial institutions often hand out inexpensive gifts, such as flashlights, tote bags, or mouse pads, to attract new deposits or induce customers to add to their existing accounts. Under a IRS revenue procedure, a noncash gift is a de minimis premium, and thus taxfree, if it does not have a value of more than $10 for a deposit of less than $5,000, or $20 for a deposit of $5,000 or more. The value is based on the cost of the premium to the financial institution. The financial institution that hands out such a gift is not required to treat it as interest for information-reporting purposes. Rev. Proc. 2000-30.

Below-Market Interest Loans

A below-market interest demand loan is defined as a demand loan with an interest rate below the applicable federal short-term rate. For many years, individuals have been making use of below-market interest rate loans. This was especially popular among family members. To remedy this tax-avoidance scheme, the Tax Reform Act of 1984 imputed interest on interest-free or below-market demand and term loans. A demand loan is defined as any loan payable in full on demand of the lender. A term loan is a below-market loan if the amount loaned exceeds the present value of all payments due under the loan. Imputed interest is computed by using the statutory federal rate of interest. The federal rate is adjusted monthly and published by the IRS. In an effort to simplify the computation of forgone interest on below-market demand loans, the IRS established a “blended annual rate.” For the year 2019, the blended annual rate was up to 2.42 percent compared to 2.03 percent in 2018. The IRS usually announces the blended annual rate for each year during the summer.

Section 7872(c), relating to loans with below-market interest rates, applies to:

1. Gift loans;

2. Compensation-related loans;

3. Corporation-shareholder loans;

4. “Tax-avoidance” loans (i.e., tax avoidance being the principal purpose of the loan); and

5. Other below-market loans in which the interest arrangements have a significant effect on federal tax liability.

A below-market loan is treated as a gift, dividend, contribution to capital, payment of compensation, or other payment depending on the substance of the transaction. For below-market loans that are not gift loans, “forgone interest” may be deductible by the borrower and must be included in the lender’s gross income. In an employer-employee relationship it is treated as additional compensation. With respect to a corporation-shareholder relationship it is treated as if the corporation paid a dividend. The forgone interest on a gift loan is treated as a taxable gift. Forgone interest may be defined as the additional interest which would have been paid had the loan been granted at “the market rate” rather than at the artificially low rate created for the below-market rate loan.

Gift, Employee, and Commercial Loans

The rules for below-market loans do not apply to:

1. Gift loans between individuals if:

a. the aggregate outstanding amount of loans between such individuals does not exceed $10,000, and

b. the loan is not attributable to the purchase or carrying of income-producing assets; or

2. Compensation-related or corporation-shareholder loans if:

a. the aggregate outstanding amount of loans between the borrower and the lender does not exceed $10,000, and

b. the avoidance of federal tax is not a principal purpose of the loan. Code Sec. 7872(c).

Special rules exist for gift loans between individuals that do not exceed $100,000. The imputed interest is limited to the borrower’s net investment income for the tax year. However, if the borrower uses the proceeds for investment purposes and the borrower’s investment income is in excess of $1,000, interest is imputed. If the borrower has net investment income of $1,000 or less for the year, the borrower’s net investment income is deemed to be zero.

Some loans are specifically excluded from the rules for below-market loans, such as:

1. Loans made available by lenders to the general public on the same terms and conditions;

2. Loans subsidized by a federal, state, or municipal government that are made available to the general public;

3. Certain employee-relocation loans;

4. Loans to or from a foreign person, unless the interest would be effectively connected with the conduct of a U.S. trade or business and not exempt from U.S. tax under an income tax treaty; and

5. Loans on which the interest arrangement can be shown to have no significant effect on the federal tax liability of the lender or the borrower.

If a taxpayer structures a transaction to be similar to a loan not subject to the rules and one of the principal purposes of structuring the transaction is the avoidance of federal tax, the loan will be considered a tax-avoidance loan and subject to the rules for below-market loans.

Whether an interest arrangement has a significant effect on the federal tax liability (item 5, above) will be determined by all the facts and circumstances. Some factors to be considered are:

1. Whether items of income and deduction generated by the loan offset each other;

2. The amount of such items;

3. The cost of complying with the below-market loan provisions if they applied; and

4. Any reasons, other than taxes, for structuring the transaction as a below-market loan.

These rules apply to term loans made after June 6, 1984, and to demand loans outstanding after that date.

Bond Transactions

When a bond is sold between interest dates and the accrued interest is added to the selling price, the seller must recognize the interest as income. All interest earned from the date of purchase is taxable to the buyer.

EXAMPLE 4.14

Aaron Adams purchases a $1,000 bond of the Rhody Corporation from Baron Ziegler at face value. Interest is paid at a rate of 6 percent on April 1 and October 1. The bond was purchased on June 1 for $1,015 ($15 representing accrued interest). Baron, the seller, must report $15 as interest income. On October 1 Aaron will receive $30 interest of which $15 ($30 – $15) will be taxable.

“Flat” Basis Bonds

Occasionally, a taxpayer will buy a bond with defaulted interest included in the purchase price. In this case, the entire amount is considered a capital investment. However, if after the purchase date interest accrues on the bond, this would be considered interest income when received. Recovery of defaulted interest on a flat bond results in no income. All interest in excess of basis, but less than the face amount of the bonds, is taxable as a capital gain.

EXAMPLE 4.15

Aaron Adams purchases a $1,000 bond of the Rhody Corporation for $700 “flat.” Interest is paid at the rate of 6 percent on April 1 and October 1. On June 1, when Adams bought the bond, there was $105 accrued interest in default. On October 1, Adams received $120 interest from Rhody Corporation. The $105 of defaulted interest is considered a return of investment and the $15 ($120–$105) is interest income. Adams’s basis in the bond is now $595 ($700–$105).

¶4395

RENT AND ROYALTY INCOME

Rental income is the amount received by the owner of property for allowing someone else to use it. Rental income must be included in gross income. All expenses incurred by the landlord (i.e., depreciation, taxes, repairs, and other ordinary and necessary expenses attributable to the rental property) are deductible from gross income. If the tenant instead of paying rent pays off obligations of the landlord, then this amount must be included in the gross income of the landlord. However, the landlord may deduct these expenses if they would otherwise be deductible. For example, if the tenant pays the property taxes in lieu of rent, the landlord may deduct this sum from gross income. However, the landlord may deduct this sum from gross income in the year received, whether the taxpayer is on the cash or accrual basis, but anticipated expenses may not be deducted until actually paid. The tenant, if rent is paid in advance, is not allowed a tax deduction for rent expense until the year in which the payment is due even though the cash basis is used. Rent received in advance is always taxable when received.

Security deposits received from tenants are not included in gross income if they are to be returned to the tenant. If the security deposit is to be used as a final payment of rent, then it is advance rent and must be included in gross income when it is received.

EXAMPLE 4.16

Makayla rents an apartment for $1,000 per month. Eric, the landlord, requires Makayla to put down a $500 security deposit. If there is no damage to the apartment when Makayla moves out her security deposit will then be returned. Eric does not include the $500 in his gross income because the security deposit is to be returned.

Royalty income received for allowing someone the use of copyrights, patents, licenses, and rights to oil, gas, or other mineral properties is includible in gross income.

Lessee Improvements

Improvements made by the lessee are not income to the lessor either at the time the improvements are made or upon termination of the lease. Code Sec. 1019. Gain or loss will be recognized only at the time the property is sold.

However, where the lessee makes repairs which are the responsibility of the lessor or makes improvements in lieu of rent, the lessor has rental income to the extent of the market value of the improvements.

EXAMPLE 4.17

Robert Wolf entered into a 50-year lease with Cleveland Inc. on January 7, 1995. Wolf remodeled the building at a cost of $50,000. The building has a book value of $20,000 to Cleveland Inc. In 2020, Wolf defaulted and Cleveland Inc. took back the building. The improvements made by Wolf are not income to Cleveland Inc. in 2020. Only when the building is sold would Cleveland Inc. recognize gain on the improvements.

 

EXAMPLE 4.18

Robert Wolf and Cleveland Inc. agreed that Mr. Wolf would make improvements to the building amounting to $10,000. In exchange for making these improvements, Cleveland Inc. will not charge Mr. Wolf rent of $10,000 in 2020. In this case, Cleveland Inc. has $10,000 of rental income for 2020.

Lease Cancellations and Bonuses

Bonuses received for the granting of a lease are considered rental income. Also, payments received by a landlord to cancel or modify a lease must be included in gross income. However, payments made to a tenant to cancel a lease are considered as “amounts received in exchange for such lease or agreement.” Code Sec. 1241. Further, Section 1241 applies to amounts received for the cancellation of a distributor’s agreement if the distributor has a substantial capital investment in the distributorship. Usually, the payment received by a tenant results in capital gain income because the lease is considered a capital asset (see  ¶12,155 ).

¶4401

DIVIDEND INCOME

The term “dividend” means “any distribution of property made by a corporation to its shareholders out of its earnings and profits.” Code Sec. 316(a). In the above definition, dividends were defined in terms of “property.” The term property is defined as “money, securities, and any other property.” Code Sec. 317(a). Notice, it does not include stock or rights to acquire stock.

The American Taxpayer Relief Act of 2012 raised the top marginal federal tax rate on dividends to 20 percent, up from 15 percent. For 2020, the 20 percent tax rate applies to individuals whose income exceeds $441,450 (individuals), $496,600 (filing jointly) and $469,050 (heads of households). Taxpayers whose income level is below the above stated amounts will be taxed at a maximum rate of 15 percent. Taxpayers whose taxable income does not exceed $40,000 (single), $80,000 (filing jointly), and $53,600 (heads of household) then their dividend income will be subject to a zero percent rate.

The Tax Cuts and Jobs Act taxes qualified dividends based on taxable income.

EXAMPLE 4.19

Clifford, a single taxpayer, has taxable income of $100,000. Included in this amount is $5,000 of qualified dividends. Clifford’s marginal tax rate is 24 percent. However, on the dividend income of $5,000, his tax rate is 15 percent.

Distributions from a corporation in the form of a dividend only come after they have been authorized by the board of directors. The distribution may take the form of cash or other assets, but a true dividend must come from earnings accumulated after February 28, 1913. Code Sec. 316; Reg. §1.316-1. Retained earnings are the corporation’s taxable income that has been retained in the business and not previously distributed. Usually, the directors, when desiring to make a distribution to the stockholders, award cash. Basically there are two common types of dividends:

1. Cash

2. Stock (dividends and rights)

Cash Dividend

When dealing with dividends, one must be cognizant of four dates:

1. Declaration

2. Record

3. Payment

4. Receipt

EXAMPLE 4.20

The board of directors of the Rhody Corporation declares on March 3, 2020, a cash dividend of $1.00 per share to be paid on May 27, 2020, to each stockholder of record as of April 28, 2020. The stockholder received the dividend on June 9, 2020. The four dates in the example were:

1. Declaration Date—March 3, 2020

2. Record Date—April 28, 2020

3. Payment Date—May 27, 2020

4. Receipt Date—June 9, 2020

Anyone who owns shares of stock of Rhody Corporation on April 28, 2020, is entitled to a $1.00 per share cash dividend. Therefore, the market value of the stock from March 3 until April 28 should reflect the $1.00 per share dividend. If a share of stock is sold on May 5, 2020, the stockholder still will receive the dividend because he or she was a shareholder on the date of record. The person receiving the cash dividend must recognize dividend income for that amount. However, corporate dividends received by individuals are taxed at a maximum rate of 15/20 percent. The shareholder having the unqualified right to demand payment must recognize taxable income. Reg. §1.301-1. The date the dividend is received by the taxpayer, not the date the dividend is declared, determines taxability. Unlike accrued interest income on bonds, no part of the purchase may be allocated to dividend income.

Although from a theoretical viewpoint in the above example, the $1.00 dividend can be identified from the purchase price, in reality this is not always the case. With interest on bonds, the interest can be readily determined at any time. A person who has a stockbroker collect the dividend is still required to pay tax on it under the rules of the constructive receipt doctrine. Also, if a dividend is declared and a person dies before the payment date, the dividend income is not included in the final income tax return, but in the estate income tax return. M. Putnam Est., 57-1 USTC ¶9200, 352 U.S. 82, 77 S.Ct. 175 (1956).

Mutual Funds

Individuals holding an interest in a mutual fund may receive any combination of three types of distribution: ordinary dividends, return of capital, and capital gains dividends. Taxpayers are notified within 45 days after the close of the tax year of the distribution into the above three classes from dividends distributed during the year. For example, the stockholders will be informed of the portion of the dividends received to be treated as a long-term capital gain. Further, they will be apprised of the portion of the mutual fund’s established capital gains they must report as long-term capital gains even though the company has retained them. Ordinary dividends of a mutual fund are reported as dividend income to the recipient.

Life Insurance and Annuity Contracts

Dividends on life insurance and annuity contracts are excludable from gross income and are considered a reduction in the cost of the policy. Code Sec. 301. If it is a fully paid-up life insurance policy and the dividend exceeds the net premiums paid, then the excess is fully taxable. Also, once payment of the proceeds under the contract has commenced, then any dividend received is fully taxable.

EXAMPLE 4.21

Leah Lambert and her husband receive the following dividends during 2020:

	Leah	Husband
Able Auto Parts	$300
Get Rich REIT		$450
Canadian Exploration	$250
Live Long Insurance		$200

For the year 2020, all of the above-listed dividends are includible in gross income except the dividend from Live Long Insurance, which is considered a reduction in premium cost. Therefore, Leah has $550 of dividend income and her husband has $450 in dividend income, for a total of $1,000. This total amount of $1,000 must be included in gross income.

 

EXAMPLE 4.22

Leah and her husband purchased a 10-year endowment policy. The policy commences payments on January 1, 2021. Therefore, any dividends issued by the company in 2020 would not be taxable. Any dividends issued by the company after January 1, 2021, would be fully taxable.

EXAMPLE 4.23

Assume in  Example 4.21  that Leah and her husband paid $25,000 for the policy. Over the years, they had received $2,200 in dividends. Therefore, their basis in the policy is $22,800 ($25,000 – $2,200).

The above rules concerning life insurance and annuity contracts apply regardless of whether the taxpayer receives the dividend in cash or lets it accumulate to purchase additional insurance.

Stock Dividends

A stock dividend is defined as a distribution by a corporation of its own stock, including treasury stock. Reg. §1.305-1. Stock dividends usually are not included in the gross income of the recipient. However, there are certain exceptions to this rule. They are as follows:

1. Distributions in lieu of money. If the stockholder has the option of receiving stock in lieu of money, then the corporate distribution is taxable to the recipient.

2. Disproportionate distributions. If some shareholders receive property and other shareholders receive stock so as to alter the individual stockholder’s proportionate interest in the corporation, then the distribution is included as gross income.

3. Distributions of common and preferred stock. If some stockholders receive common stock and other stockholders receive preferred stock, then the distribution is considered part of gross income.

4. Distributions on preferred stock. A stock dividend on preferred stock is taxable to the recipient unless it increases the conversion ratio of convertible preferred stock made specifically to take into account a stock dividend or stock split on the convertible preferred stock in which case it is tax free. Code Sec. 305(b)(4).

5. Distributions of convertible preferred stock. A distribution of convertible preferred stock is taxable to the recipient unless it can be proven to the Commissioner that the individual stockholder’s equity in the corporation remains constant.

Upon receipt of a nontaxable stock dividend, the stockholder must allocate the original cost over all the shares the stockholder presently owns.

EXAMPLE 4.24

Aaron Adams owns 100 shares of Rhody Corporation common stock which he purchased for $11 per share in 2010 for a total cost of $1,100. Rhody Corporation pays a 10 percent stock dividend in June 2020, and Aaron receives 10 shares (10 percent of 100 shares) of stock. Therefore, he now owns 110 shares of stock and his basis is $1,100 or $10 per share ($1,100/110 shares). At the time any of the 110 shares is sold, its basis is $10 per share.

 

EXAMPLE 4.25

If, in  Example 4.23 , instead of receiving the common stock, Aaron received 20 shares of Rhody Corporation preferred stock as a stock dividend and it had a fair market value of $10 per share and the 100 original shares of Rhody Corporation common stock at this time had a fair market value of $2,000, then the following computations would be necessary:

Computations:
Basis of original stock	$1,100
Fair market value of original stock	$2,000
Fair market value of the new preferred stock	200
Fair market value of preferred and common	$2,200
Basis of original 100 shares after stock dividend 1,100 × 2,000/2,200	$1,000
Basis of new stock after the dividend 1,100 × 200/2,200	$100

To determine whether or not the sale should be treated as a long-term capital gain, the date when the original shares were purchased is the controlling factor. To be classified as a long-term gain, a capital asset must be held for more than one year. For 2020, the tax on capital gains is a maximum of 20 percent if held greater than 12 months (28 percent for collectibles and section 1202 gains) and the taxpayer’s income is over $441,450 if single, $496,600 for joint filers.

The new shares take on the basis of the old shares. If lots of the old shares were purchased on different dates and the dividend shares cannot be identified with any particular lot, then the new shares take the basis of the earliest purchased stock. Reg. §1.1012-1(c).

Stock Rights

A stock right is defined as a distribution by a corporation to its shareholders of rights to purchase corporate stock. Usually, the shareholder has a right to buy the stock at less than fair market value. Therefore, the stock rights have a market value. The stockholder receiving the rights has three alternative courses of action. The stockholder may exercise, sell, or hold the stock rights.

If the market value of the stock rights is less than 15 percent of the market value of the stock with respect to which it is distributed, then the basis of the rights is zero unless the shareholder irrevocably elects to allocate the basis between the stock and the rights. Code Sec. 307(b)(1). Where the market value of the rights is 15 percent or greater, the basis must be allocated between the stock and rights according to their respective values on the date on which the rights are distributed to the stockholder, not the record date. In  Chapter 10 , at  ¶10,125 , a full discussion appears on the allocation of basis for taxable and nontaxable stock rights.

¶4451

DIVORCE AND SEPARATION

The Tax Cuts and Jobs Act provides that for divorce and separate maintenance agreements executed or modified after December 31, 2018, alimony and separate maintenance payments are not included in the gross income of the payee are not deductible by the payor1. Divorce or separate maintenance agreements executed or modified prior to 2019 follow the rules outlined below.

There are two sets of rules depending on when the divorce took place. The first set is for divorces occurring before 1985 and the second set is for divorces occurring after 1984.

Pre-1985 Agreements

Although this is an old law, some individuals are still covered by it. Prior to the Tax Reform Act of 1984, Code Sec. 71 defined alimony as a series of support payments received after divorce or legal separation. If the following four conditions exist, then the recipient must include the alimony payments in gross income and the person making the payments is entitled to a tax deduction for adjusted gross income. The conditions are as follows:

1. Payments are required under the terms of the decree of divorce or separate maintenance or a written separation agreement or a decree of support.

2. Payments must be to discharge the legal obligation of support.

3. Payments must be periodic.

4. Payments must not be for child support.

 

The following payments would not qualify:

1. Lump-sum settlements,

2. Payments not required under the decree or agreement,

3. Payments not arising out of a marital relationship (repayment of a loan), and

4. Payments made before the decree.

Alimony and separate maintenance payments received by the taxpayer are included in gross income. Further, the payer is allowed a tax deduction in the year the payment is made.

Post-1984 Agreements Through December 31, 2018

Payments under instruments executed after December 31, 1984, but before 2019, that meet the following requirements are deductible as alimony:

1. Payments must be made in cash.

2. Payments must be made under a divorce or separation instrument.

3. Parties must live in separate households after a divorce or separation decree is entered.

4. Alimony must end at the payee’s death.

5. Parties involved may not file a joint return.

6. Payments must not be for child support.

A special feature was added that the parties could designate by written agreement payments otherwise qualifying as alimony payments as excludable by the payee and nondeductible by the payer. Code Sec. 71(b)(1)(B).

The Tax Reform Act of 1986 changed only a few rules with respect to divorces. However, because of the lower tax rates tax planning for pending divorces is essential.

Alimony Termination on Payee’s Death

Under the 1986 law, the requirement that the “instrument must state” that payments must terminate on the payee’s death has been repealed. Either the state law or the divorce instrument must state that the payments must terminate at payee’s death. This amendment is effective for divorce or separation instruments executed after December 31, 1984.

Front-Loading Limitation

The Tax Reform Act of 1986 fixed the amount of annual payments exempt from recapture at $15,000. The front-loading requirement under the recapture rules was set at three post-separation years.

Recapture Rules

Under the revised recapture rules the tax treatment of past payments has been changed to require the inclusion of previously deducted alimony or separate maintenance payments in income. The revised recapture rules also allow the recipient spouse, who previously included the alimony in income, to deduct the recaptured amount.

Under the recapture rules adopted by the Tax Reform Act of 1986, payments will be recaptured if:

1. Payments made in the second post-separation year exceed the payments in the third post-separation year by more than $15,000, and/or

2. Payments made in the first post-separation year exceed the average of (the alimony payments of the second post-separation year and the third post-separation year less the year 2 recapture) by more than $15,000.

The excess amounts in the first and second post-separation years only may be recaptured in the third post-separation year. The following examples illustrate the alimony recapture rules.

EXAMPLE 4.26

Bob and Mary Barnsen were divorced on January 13, 2018. Mary pays Bob the following amounts of alimony under the terms of her divorce decree.

Year	Amount
2018 (1st post-separation year)	$70,000
2019 (2nd post-separation year)	40,000
2020 (3rd post-separation year)	20,000

Mary computes her amount to be recaptured as follows:

Year 2 Calculation	Amount
Payments in the second year	$40,000
Less: Payments in the third year	20,000
	20,000
Less: $15,000	15,000
Amount of second-year payments subject to recapture in 2020	$5,000

The amount of second-year payments used in computing the recapture for the first post-separation year is $35,000 ($40,000 – $5,000).

Year 1 Calculation	Amount
Payments in the first year	$70,000
Less: Average payments made in the second and
third year (($35,000 + $20,000) ÷ 2)	27,500
	$42,500
Less: $15,000	15,000
Amount of first-year payments subject to recapture in 2020	$27,500

In calculating the recapture account for the first year, only $35,000, rather than $40,000, is treated as paid in the second year. This is because the average of payments made in the second and third years does not include the $5,000 payment made in the second year that is recaptured in the third year. Bob has gross income of $70,000 and $40,000 in 2018 and 2019, respectively. In 2020, the recapture of $32,500 exceeds the $20,000 alimony received; therefore, Bob has a deduction of $12,500. Mary deducts alimony of $70,000 in the first post-separation year and $40,000 in the second. In year three, she must recapture $32,500 ($5,000 + $27,500) which exceeds her third year payment of $20,000. Therefore, she has income of $12,500 in 2020.

 

EXAMPLE 4.27

Bill and Alice Bailey were divorced on January 6, 2018. Bill makes the following alimony payments to Alice under a divorce decree.

Year	Amount
2018 (1st post-separation year)	$50,000
2019 (2nd post-separation year)	18,000
2020 (3rd post-separation year)	0
Year 2 Calculation
Payments in the second year	$18,000
Less: Payments in the third year	0
	$18,000
Less: $15,000	15,000
Amount of second-year payments subject to recapture in 2020	$3,000
Year 1 Calculation
Payments in the first year	$50,000
Less: Average payments made in the second and third year (($15,000 + $0) ÷ 2)	7,500
	$42,500
Less: $15,000	15,000
Amount of first-year payments subject to recapture in 2020	$27,500

In calculating the recapture amount for the first year, only $15,000, rather than $18,000, is treated as paid in the second year. This is because the average of payments made in the second and third years does not include the $3,000 payment made in the second year that is recaptured in the third year.

Bill will show $30,500 as income on his 2020 tax return and Alice will show a tax deduction of $30,500 on her 2020 tax return.

Bill deducts as alimony $50,000 in 2018 and $18,000 in 2019 and Alice includes in her gross income $50,000 and $18,000 in those two years.

Exceptions to the Recapture Rule

There are three exceptions to the recapture rule (in addition to the $15,000 floor).

1. Payments cease by reason of death or remarriage prior to the end of the third post-separation year.

2. Payments received under a temporary support order before the divorce or separation.

3. Payments pursuant to a continuing liability to pay a fixed part of your income from a business or property or from compensation for employment or self-employment.

If the payer stops or reduces the amount of alimony or separate maintenance during any of the first three post-separation years for any other than the above listed reasons then the payments are subject to recapture.

EXAMPLE 4.28

Randy Reeves is required under the terms of a divorce decree to make payments to Candy of $50,000 in 2018, $30,000 in 2019, and $35,000 in 2020. Randy makes the first payment in 2018 and one-half the second payment when Candy remarries. Randy immediately stops making alimony payments. The recapture rule does not apply.

Post-2018 Agreements

Divorce and legal separation agreements entered into after 2018 provide that the payor receives no tax deduction for alimony paid and the payee includes none of the alimony received in gross income.

Dependent Child

Although the personal exemption has been suspended between 2018 and December 31, 2025 the custodial parent is eligible for head of household filing status, the earned income credit, and the child and dependent care credit.

TAX BLUNDERS

1. Bob and Judy were divorced in December 2018. After the divorce Judy will be in the 24 percent tax bracket, and Bob will be in the 12 percent bracket. Judy insisted on paying Bob $20,000 per year as alimony. Bob wanted to receive $10,000 as alimony and $10,000 as child support. Bob will be the custodial parent. In this case it would benefit Judy to pay Bob’s tax on the additional $10,000 alimony. She will save $1,200 by counting all $20,000 as alimony ($2,400 tax savings less $1,200 payment of Bob’s tax on $10,000).

2. The lower tax rates drastically reduce the net after-tax value for alimony payments. The payer’s net after-tax cost of alimony increases as the individual’s tax bracket decreases.

Assume Frank and Robin Forkes were divorced in 1982. Frank makes annual alimony payments of $15,000. In 1987, Frank had $90,000 of taxable income, which placed him in the 38.5 percent tax bracket. Therefore, his net after-tax cost for alimony was $9,225. In 2020, with the same taxable income his after-tax cost for alimony payments increased to $11,400 because Frank is in the 24 percent tax bracket in 2020.

Legal Fees

Legal fees incurred in arranging the divorce settlement are not deductible. The payer-spouse cannot deduct any legal fees for the arrangement of the divorce or for the adjustment of alimony payments.

Payment in Arrears

Payments of amounts in arrears are deductible when paid. When a lump-sum settlement occurs for payment in arrears, even this is deductible.

Medical and Dental Expenses

Payments made for medical and dental expenses of the payee-spouse by the payer-spouse must be included in the gross income of the payee-spouse if they qualify as alimony. In addition, the payee-spouse is allowed to deduct these two expenses if the payee-spouse itemizes deductions. Recall, alimony will not be deductible for divorces after December 31, 2018 nor will it be includible in the payee's gross income.

Payments made for medical expenses of children of divorced parents may be deducted by the spouse making the payment. In this case, the children will be treated as dependents of both parents.

Transfer of Property Between Spouses

Under prior law, property transfers between divorcing spouses were taxable when they involved the release of support or marital rights. The 1984 tax law provides that no gain or loss will be recognized for property transfers between spouses during marriage, or former spouses incident to a divorce on transfers taking effect after July 18, 1984. The basis the property will carry is the same in the hands of the receiving spouse as it was in the hands of the transmitting spouse. Incident to a divorce means the transfer must occur within one year after the marriage ceases or is related to the cessation of the marriage.

EXAMPLE 4.29

Tom and Roberta Thorne are finishing up the terms of their divorce settlement. Roberta insists Tom turn over to her stock Tom purchased three years ago at a cost of $5,000. The current fair market value of this stock is $9,000. Under the pre-1985 tax law, Tom would have a $4,000 taxable gain, but under the 1984 tax law, the transfer of property between spouses results in no tax liability. Roberta will assume the stock with a tax basis of $5,000.

Child Support

Payments made by one spouse which are specifically identified for the support of minor children are not taxable to the other spouse and are not deductible by the first spouse. The support must be for the children of the parent making the payment. The custodial parent is entitled to the exemption unless he or she signs a waiver.

EXAMPLE 4.30

By the terms of the divorce settlement, Bob Barter is directed to pay alimony of $1,600 per month and child support of $800 per month. Assume that $800 per month is more than 50 percent of the child’s support. Bob is not allowed an exemption for support of his child. The custodial parent is entitled to the exemption. The $800 is not included in income nor deductible by Bob.

When the instrument sets forth one amount for alimony and one amount for child support and a particular payment is less than the total of the two, the payment will first apply towards the child support. Child support payments, if in arrears, must be paid before any future amounts may be considered as alimony.

Where the divorce decree, for example, requires the husband to pay $1,000 a month to his divorced wife and $500 a month for the support of a minor child and the husband pays only $500, it is nevertheless considered to be payment for the support of the child. Reg. §1.71-1(e).

Reporting Requirements

The taxpayer paying alimony must furnish the payee’s taxpayer identification number on the tax return. Code Sec. 215(c). A $50 penalty in a calendar year will be levied for failure to comply with the reporting requirement unless it can be shown that failure to comply was due to reasonable cause and not to willful neglect. Code Sec. 6724(d)(3).

¶4485

DISCHARGE OF DEBT

When a debt is cancelled for a consideration, in whole or in part, the debtor realizes taxable income for the amount of the debt discharged. Code Sec. 61(a)(12). For example, if the debtor performed a personal service for the creditor and the debt was fully or partially cancelled, the debtor would have to realize as income the cancelled amount as compensation for services. Reg. §1.61-12(a).

Creditor’s Gifts

If a creditor gratuitously cancels a debt, then the amount forgiven is not income but a nontaxable gift. Code Sec. 102(a). The Supreme Court ruled that the cancellation of a debt by the creditor for “no consideration” is a gift and, therefore, no taxable income is involved. Helvering v. American Dental Co., 43-1 USTC ¶9318, 318 U.S. 322, 63 S.Ct. 577 (1935). However, where consideration of any kind or amount is given for cancellation of the debt, it may be extremely difficult to prove the cancellation was gratuitous.

Bankruptcy and Insolvency

Generally, income from a nongratuitous discharge of indebtedness is includible in gross income unless it is excludable under Code Sec. 108. For discharges after 1986, two types of exclusions are provided in the following priority order (Code Sec. 108(a)):

1. The discharge occurs in a bankruptcy case under Title 11 of the U.S. Code.

2. The discharge occurs when the taxpayer is insolvent outside of bankruptcy. An insolvent taxpayer is one who has an excess of liabilities over the fair market value of assets immediately prior to the discharge. The exclusion is limited to the insolvent amount.

Discharge or reduction of debt in bankruptcy does not generate income. If the debt was incurred in connection with property used in a trade or business, the amount of debt that was discharged reduces certain tax attributes that could otherwise provide benefits in the future. Section 108(b)(5) allows the taxpayer to elect to apply any portion of the cancellation of debt to reduce the basis in depreciable property before reducing other tax attributes. This election by the taxpayer is available regardless of whether the debt is evidenced by a security. If the taxpayer does not elect to reduce the basis in depreciable property, then the amount excluded from gross income (the portion of the debt that was cancelled) reduces tax attributes in the order given in Code Sec. 108(b)(2)):

1. Net operating losses and carryovers

2. General business credit

3. Capital loss carryovers

4. Reduction of basis of the property of the taxpayer

5. Foreign tax credit carryovers

 

Tax attributes other than credit carryovers are reduced one dollar for each dollar of debt discharge excluded. Code Sec. 108(b)(3)(A). Where a taxpayer excludes income from the discharge of indebtedness in a Title 11 bankruptcy case or the discharge occurs when the taxpayer is insolvent and the taxpayer is required to apply such excluded income to reduce its tax attributes, the reduction for post-1986 tax years in foreign tax credit, research credit, and the general business credit carryovers is to be made at a rate of 33 1/3 cents per dollar excluded. Code Sec. 108(b)(3)(B).

An insolvent taxpayer is allowed to exclude from gross income any discharge of indebtedness except that the amount excluded cannot exceed the amount by which the taxpayer is insolvent. Code Sec. 108(a)(3).

EXAMPLE 4.31

Mike Merchant has assets of $50,000 and liabilities of $85,000. If one of Mike’s creditors forgives him of $40,000 worth of debt, then Mike must recognize $5,000 ($50,000 – ($85,000 – $40,000)) of taxable income.

Mortgage Debt Forgiveness

The Mortgage Forgiveness Debt Relief Act of 2007 offers distressed homeowners with a limited tax exclusion for debt forgiveness and mortgage insurance payments. Generally, homeowners will be able to exclude up to $2 million of mortgage debt forgiveness. This exclusion is available from January 1, 2007 through 2020. A taxpayer whose principal residence has declined in market value will be able to refinance the loan without incurring a tax on the debt forgiveness. The Emergency Economic Stabilization Act of 2008 extended this provision for three more years. The American Taxpayer Relief Act of 2012 extended this provision through December 31, 2013. The Tax Increase Prevention Act of 2014 extended this provision through December 31, 2014. The PATH Act of 2015 extended mortgage debt forgiveness for the years 2015 and 2016. Congress has extended this provision for 2017 as part of the Bipartisan Budget Act. The Further Consolidated Appropriations Act, 2020 extends this provision through 2020.

Purchase Money Debts

If a debt owed to the seller for the purchase of property is reduced by the seller, then no income is recognized by the purchaser. The reduction is a purchase price adjustment, not a discharge in indebtedness. Consequently, the purchaser recognizes no income even though the obligation has been reduced. In order for this rule to apply, there must be a “pure” cancellation of indebtedness income; the only relationship between the parties must be that of debtor and creditor, and the debt forgiveness must not simply be the method by which the creditor makes a payment to the debtor for services or property. Code Sec. 108(e)(5).

Corporate Debts

A shareholder’s gratuitous forgiveness of the corporation’s indebtedness or cancellation of the corporation’s indebtedness to the shareholder is usually considered a contribution of capital to the corporation to the extent of the principal debt. Code Sec. 108(e)(6); Reg. §1.61-12(a).

EXAMPLE 4.32

Benjamin Warren is sales manager and shareholder of Cleveland Widget Inc. The company is in bankruptcy and Benjamin has not been paid for several months. Benjamin agrees to cancel the debt for the unpaid wages. Cleveland Widget Inc. recognized no income; instead, the cancellation is treated as a contribution of capital. Benjamin, who is on the cash basis, recognizes no income from the unpaid wages.

Student Loans

A special income exclusion applies to the discharge of all or part of a student loan under a governmental agency student loan program if, pursuant to the loan agreement, the discharge is made because the individual works for a specified period of time in certain geographical areas for certain classes of employers (e.g., as a doctor or nurse in a rural area). Code Sec. 108(f). The amount of the loan that is forgiven is excluded from gross income.

KEYSTONE PROBLEM

Roy and Ann are students at one of the country’s finest state universities and wish to marry in the near future. Roy has inherited a potato farm from his late grandfather. Both have scholarships and part-time jobs. They will receive as gifts, property (a small house), and some stocks and bonds. Further, both have cash from savings and investments (about $10,000). Roy is also in debt ($5,000) to his uncle for a defunct rock band he had started as a freshman. His uncle will forgive the debt if Roy marries and settles down. The young couple have come to you for advice on financial planning. What are the principal considerations you feel they would need to take into account in planning their financial future? What steps would you advise them to take in setting up their affairs? Consider such concerns as terms of property ownership, whether to file a tax return jointly or separately, whether to choose the cash or accrual basis for paying tax, how to minimize tax liability, and other factors which you feel are relevant to the problem.

Stock Option Plans

¶4601

RESTRICTED STOCK PLANS

Stock or other property that is transferred by an employer as compensation for services rendered but that, when received, is subject to certain restrictions that affect its value, is governed by the rules contained in Code Sec. 83. As a general rule, the value of any property transferred in connection with services rendered is taxable as compensation, whether the property is goods, common stock, a partnership interest, or any other property. An exception is provided for unsecured, unfunded promises to pay. Code Sec. 83(a); Reg. §1.83-3(c).

Property Substantially Vested

The property is taxable whenever the right to it is “substantially vested,” which means it is either transferable or not subject to a substantial risk of forfeiture. It is to be valued without regard to any such restriction unless it is one that will never lapse. Code Sec. 83(a)(1).

EXAMPLE 4.33

A corporation, through its bonus plan, gave one of its vice-presidents 2,660 shares of common stock with a value of $76,000 at the time. There were no conditions attached. The vice-president has compensation of $76,000 with an offsetting deduction to the corporation. The result would be the same if the stock were transferred directly to a trust for the vice-president’s minor children. If the vice-president had to pay $26,000 for the stock, only $50,000 is taxable. His basis is $76,000. A subsequent sale will result in a short- or long-term capital gain or loss. If the stock is subject to a substantial risk of forfeiture, e.g., it is nontransferable for five years, no income results until the restriction lapses.

The general rule is that compensation results if property is transferred “in connection with” services rendered. Thus, it does not matter whether:

1. Services are rendered as an employee or independent contractor.

2. The property was transferred by the employer or another person, such as a shareholder.

3. The property was transferred to the compensated person or to anyone else, e.g., a beneficiary, a trust, a corporation, or other agent. Any income received, e.g., dividends, before the property is substantially vested is also treated as compensation.

If the property is sold before it is substantially vested, ordinary income results in the amount of the proceeds. But if the property is forfeited before it is substantially vested, no tax loss is incurred (except for amounts paid). If the property is forfeited after it is substantially vested and the value was reported as compensation, an ordinary loss results. Reg. §1.83-1(b)(1) and (2). This could happen if the property was transferable, but subject to a substantial risk of forfeiture.

Property Not Substantially Vested

If property transferred in connection with services rendered is not “substantially vested,” i.e., it is subject to a substantial risk of forfeiture, an election may nevertheless be made to include the current fair market value of the property in gross income. Code Sec. 83(b). The election is irrevocable and must be filed with the IRS within 30 days with a copy to the employer. Making the election locks in a basis equal to the fair market value included in gross income and starts the holding period running. Section 83(h) includes a matching principle: The employer’s deduction is taken whenever the property is included in the employee’s gross income and in the same amount.

There are two advantages of making the election:

1. Any future appreciation will qualify as a capital gain, historically taxed at rates lower than ordinary income.

2. The appreciation between the date of transfer and the date of substantial vesting is not taxed until the eventual disposition of the property in a taxable sale or exchange.

3. There will be no self-employment tax on the increase in value.

EXAMPLE 4.34

Cornelius Track received $5,000 worth of stock from his employer on condition that he worked in the same position the next four years, which he did. At the time the stock vested it was worth $12,000. Cornelius waited another six years before selling the stock for $19,000. If Cornelius did not make the Section 83(b) election, he would have taxable compensation of $12,000 when the stock vested (with an offsetting deduction to the employer), and an additional $7,000 of capital gain in the year of sale. Had he made the election he would have had $5,000 of compensation up front (offsetting deduction to the employer), no income at the time of vesting, and $14,000 of capital gain at the sale 10 years after the initial transfer.

The disadvantages of making the Section 83(b) election include the early outlay of cash to pay tax as well as the unavailability of a loss deduction should the property be forfeited before it becomes substantially vested.

The election should therefore be made only if the property has good appreciation potential and it is likely that any required conditions will be met.

Substantial Risk of Forfeiture A substantial risk of forfeiture exists if a person’s rights to full enjoyment of such property are conditioned upon the future performance of substantial services by an individual. Code Sec. 83(c). The following are examples of substantial risks of forfeiture:

1. The property must be returned unless earnings go up.

2. Substantial services must be rendered.

3. A successful completion of “going public” is a condition.

Conditions not constituting substantial risks include:

1. The person is being discharged for cause or for committing a crime.

2. The person accepts a job with a competitor.

3. The employer must pay the full market value upon forfeiture.

PLANNING POINTER

An executive receives $20,000 worth of restricted stock from his employer, conditional upon five years of service. Under the general rules, the executive will have no income for five years, at which time the then fair market value will be ordinary income. If the executive signs a promissory note for $20,000, he can make a Section 83(b) election without recognizing income. This will start the holding period running and lock in a basis of $20,000. Five years later, the corporation tears up the note, resulting in $20,000 of compensation to the executive and a business deduction of $20,000 to the corporation. If the stock is sold for $50,000 upon the lapse, for example, then or later, the executive will report a long-term capital gain of $30,000. In the absence of a note and the election, the full $50,000 would have been ordinary income (with an offsetting deduction to the employer).

¶4615

INCENTIVE STOCK OPTION (ISO) PLANS

On incentive stock option (ISOs) is a statutory stock option arrangement, replacing the restricted and qualified stock option provisions that previously existed. The term “incentive stock option” means an option granted by a corporation to an individual to purchase stock of the corporation if certain requirements are met. Code Sec. 422(b). The employee must have received the option for some reason connected with employment and must remain employed by the corporation (including a parent or subsidiary) issuing the option from the time of issuance until three months before it is exercised (one year in the case of a disabled employee).

Incentive stock options may be received and exercised by the employee of a corporation without recognizing any gross income. Income is reported only after a taxpayer disposes of the stock. However, for purposes of computing the alternative minimum tax, the taxpayer generally must include the amount by which the fair market value of the stock exceeds the exercise price at the time the taxpayer’s rights to the stock are either freely transferable or not subject to a substantial risk of forfeiture. Code Sec. 56(b)(3).

The employee must hold the stock for a minimum of two years after the option is granted and for one year after the option is exercised. If the requisite holding period is not met, the bargain element (value less exercise price) is ordinary income to the employee in the year of sale with an offsetting deduction to the employer. The value on exercise becomes the employee’s cost basis. The sale will result in short- or long-term capital gain or loss under the general rules. If the requisite holding period is met, long-term capital gain or loss on the disposition of the stock will be realized to the extent of the difference between the option price and the amount for which the stock is sold.

EXAMPLE 4.35

On April 1, Year 1, Gumballs, Inc. granted Juan an ISO to purchase 1,000 shares of its stock for $30 a share (its fair market value) for the next five years. On March 28, Year 2, Juan exercised the option and paid $30,000 when the stock sold for $42 a share. On September 17, Year 3, Juan sold the stock for $57,000. Gumballs, Inc. receives no deduction upon grant, exercise, or sale. Juan reports a long-term capital gain of $27,000. For purposes of the alternative minimum tax only, he has an adjustment item in the year of exercise of $12,000 ($42,000 – $30,000). Had Juan sold the stock for $53,000 on March 31, Year 3, the special two-year holding period would not have been met. As a result Juan, in Year 3, would have had $12,000 of ordinary income and $11,000 of long-term capital gain. He still would have an AMT adjustment item of $12,000. In Year 3, the year of the sale, Gumballs, Inc. would have compensation expense of $12,000 in this case.

PLANNING POINTER

Long-term capital gains generally are taxed at a maximum of 20 percent. Meeting the holding period requirements of the ISO would also be advantageous to the shareholder if the shareholder had capital losses that would otherwise not be deductible and have to be carried over. The shareholder meeting the holding period requirements would also cause the corporation to lose the compensation deduction. Therefore, the employer should, if necessary, offer a cash bonus to employees who are still in a position to violate the one- or two-year holding period, so as to secure a deduction for the employer. The bonus, after taxes, must, of course, be less than the tax savings resulting from the compensation deduction.

For options to qualify as ISOs the following requirements must be met:

1. The term of the option may not exceed 10 years.

2. The option price must be no less than the fair market value of the stock on the date of issuance.

3. The option must be transferable by inheritance only.

4. The option plan must specify the aggregate number of shares that may be issued and the employees eligible to receive the option.

5. The option must be granted within 10 years of the earlier of the date of adoption of the plan or the date it was approved by the shareholders.

6. If the employee owns more than 10 percent of the company, the option price must be at least 110 percent of the market value and its term may not exceed five years. Code Sec. 422(b) and (c).

To the extent that the aggregate fair market value of stock with respect to which ISOs are exercisable for the first time by an individual during any calendar year exceeds $100,000, such options are not considered ISOs. Code Sec. 422(d). Further, an option granted after 1986 will not be treated as an ISO if the terms of the option at the time it is granted provide that it will not be treated as an incentive stock option. Code Sec. 422(b).

¶4625

EMPLOYEE STOCK PURCHASE PLANS

An employee stock option plan is, generally, one permitting employees to buy stock in the employer corporation at a discount. Options issued under an employee stock purchase plan qualify for special tax treatment. Code Sec. 423. No income is recognized under such a plan at the time the option is granted; the recognition is deferred until stock acquired under the plan is disposed of.

If stock acquired under such a plan is disposed of after being held for the required period, the employee will realize ordinary income to the extent of the excess of the fair market value of the stock at the time the option was granted over the option price. Any further gain is a capital gain. If the stock is disposed of when its value is less than its value at the time the option was granted, the amount of ordinary income will be limited to the excess of current value over the option price.

An employee stock purchase plan must provide that only employees may be granted options and must be approved by the stockholders of the granting corporation within 12 months before or after the date the plan is adopted. Code Sec. 423(b). Other conditions that must be met either by the plan or in the stock offering are:

1. The option price may not be less than the smaller of (a) 85 percent of fair market value of the stock when the option is granted or (b) 85 percent of the fair market value at exercise.

2. The option must be exercisable within five years from the date of grant where the option price is not less than 85 percent of the fair market value of the stock at exercise. If the option price is stated in any other terms, the option must not be exercisable after 27 months from the date of the grant.

3. No options may be granted to owners of five percent or more of the value or voting power of all classes of stock of the employer or its parent or subsidiary.

4. No employee may be able to purchase more than $25,000 of stock in any one calendar year.

5. The option may not be transferable (other than by will or laws of inheritance) and may be exercisable only by the employee to whom it is granted.

6. If the exercise price was less than the value of the stock upon grant and the option was exercised, the employee may have compensation income (with an offsetting deduction by the employer) upon disposition, including a transfer at death. The compensation equals the lesser of fair market value at grant or at exercise, less the exercise price, and is added to the stock basis. There is no offsetting deduction by the employer.

EXAMPLE 4.36

Brenda Tripper was given a Section 423 option to buy 500 shares of Zoom, Inc. stock for $45 a share when it was selling for $51. She exercised the option two years later when the stock was selling for $58 and sold the stock after another three years for $71 a share. The lesser of $58 or $51, less $45 a share, or $6 a share, is compensation in the year of sale, i.e., $3,000. Brenda’s basis is increased by $6 a share to $51. Thus, her long-term capital gain is $20 per share ($71 – $51), or $10,000. If Brenda had died, rather than sold the shares, her final return would show $3,000 in compensation but no capital gain. (Her basis increase of $6 a share would be irrelevant, since her death results in a fair market value basis.)

Qualified Equity Grants

A qualified employee of a privately held company may elect to defer recognizing income in the amount attributable to the qualified stock received from the employer in the year the stock vests or the year that it is received. This change became effective, for years beginning after 2017, with the passage of the Tax Cuts and Jobs Act.

A qualified employee must agree to the election. The employer must report on the employee’s Form W-2 the amount covered by the election.

¶4655

NONSTATUTORY STOCK OPTION PLANS

The term “nonstatutory stock options” refers to those options that do not qualify for the favorable tax treatment accorded options that are covered by a specific Code provision as are qualified stock options, incentive stock options, employee stock purchase plans, and restricted stock options. Code Secs. 421-425. While statutory options generally are not taxed until the taxpayer disposes of the options and any gains on the dispositions are taxed at capital gains rates, nonstatutory stock options usually are taxed at ordinary income rates at the time they are granted, the options being considered compensation for services rendered by the employee. Generally, if an option is acquired under a nonstatutory program, the employee may be taxed when (1) the option is granted, (2) the option is exercised, (3) the option is sold, or (4) the restrictions on the disposition of the option-acquired stock lapse. Reg. §1.83-7(a).

EXAMPLE 4.37

Joseph Barkin is granted a nonmarketable, nonstatutory option to buy 10,000 shares of his employer’s stock at $40 per share for five years at the time the stock is selling for $36 per share. Four years later, Joseph exercises the option when the stock is selling for $47 per share. Joseph has no income, and his employer receives no deduction at the time the option is granted. Upon exercise of the option, Joseph has ordinary compensation of $70,000, the bargain element, and his employer receives a corresponding deduction. Joseph’s basis in the stock is $470,000. Upon a later sale, Joseph generates a short- or long-term capital gain or loss with the holding period starting at the time the option is exercised.

The taxation of a nonstatutory stock option will depend upon the date when the option was granted. Generally, if the nonstatutory option was granted after April 21, 1969, its taxation will be determined by Code Sec. 83 and Reg. §1.83-7. Thus, if the option has a readily ascertainable fair market value at the time it is granted in connection with the performance of services, the person who performed the services realizes compensation either (1) when the rights in the option become transferable, or (2) when the right in the option is not subject to a substantial risk of forfeiture. If the option does not have an ascertainable fair market value at the time when it is granted, taxation occurs when the right to receive the stock is unconditional. The difference between the option cost and the fair market value of the stock at the time the optionee has a right to receive it is taxed as compensation.

SUMMARY

· The economic benefit doctrine and the constructive receipt doctrine were conceived to explain what constitutes income and when an item of income is taxable.

· Under the accrual method of accounting, income is recognized when a transaction is consummated; under the cash method of accounting, income is recognized only when cash is received or constructively received.

· Section 61(a) of the Internal Revenue Code provides a list of 15 items that are includible in gross income. Gross income, however, is not limited to these items. (See checklist on the next page.)

· Several rules, including the alimony recapture rules, govern when alimony payments should be included in the recipient’s gross income and when they are deductible by the payer. Alimony will no longer be deductible by the payer nor includible in the payee's gross income for divorce agreements and separate maintenance agreements entered into after December 31, 2018.

· Alimony is support payment made from one spouse to the other after divorce or legal separation. Child support consists of payments made by one spouse that are specifically identified for the support of minor children. Alimony and child support payments are subject to different tax treatments.

· When a debt is cancelled for a consideration, the debtor realizes taxable income for the amount of the debt discharged. Special rules govern the discharge of indebtedness for insolvent taxpayers.

Chapter 5

Gross Income—Exclusions

OBJECTIVES

After completing  Chapter 5 , you should be able to:

1. List the items specifically excluded from gross income.

2. Distinguish between exclusions and deductions.

3. Determine the nontaxable portion of life insurance and annuities.

4. Determine the nontaxable portion of Social Security benefits.

5. Distinguish between taxable and nontaxable interest income.

6. Determine the tax status of various fringe benefits.

7. Understand the tax status of various educational assistance plans.

OVERVIEW

Section 61(a) of the Internal Revenue Code defines gross income as including “all income from whatever source derived.” It includes all income unless expressly exempted by law. The exempted classes are referred to as “exclusions from gross income.” This chapter discusses those items that have been specifically excluded from gross income. In addition to several cash considerations, a major portion of the chapter will be dedicated to a discussion of various types of fringe benefits. Finally, the tax status of these elements of income and their relative value to employees will be discussed.

No matter what the type of job, taxes take a significant portion of each weekly or monthly paycheck. Therefore, the proper arrangement of income to derive the greatest benefit from sources which are includible and excludable in gross income is of great importance.

Sections 101 through 139 of the Internal Revenue Code list “Items Specifically Excluded from Gross Income.” Selected sections are as follows:

Sec. 101.	Certain death benefits
Sec. 102.	Gifts and inheritances
Sec. 103.	Interest on state and local bonds
Sec. 104.	Compensation for injuries or sickness
Sec. 105.	Amounts received under accident and health plans
Sec. 106.	Contributions by employer to accident and health plans
Sec. 107.	Rental value of parsonages
Sec. 108.	Income from discharge of indebtedness
Sec. 109.	Improvements by lessee on lessor’s property
Sec. 110.	Qualified lessee construction allowances for short-term leases.
Sec. 111.	Recovery of tax benefit items
Sec. 112.	Certain combat zone compensation of members of the Armed Forces
Sec. 115.	Income of States, municipalities, etc.
Sec. 117.	Qualified scholarships
Sec. 118.	Contributions to the capital of a corporation
Sec. 119.	Meals or lodging furnished for the convenience of the employer
Sec. 120.	Amounts received under qualified group legal services plans
Sec. 121.	Exclusion of gain from sale of principal residence
Sec. 122.	Certain reduced uniformed services retirement pay
Sec. 123.	Amounts received under insurance contracts for certain living expenses
Sec. 125.	Cafeteria plans
Sec. 126.	Certain cost-sharing payments
Sec. 127.	Educational assistance programs
Sec. 129.	Dependent care assistance programs
Sec. 130.	Certain personal injury liability assignments
Sec. 131.	Certain foster care payments
Sec. 132.	Certain fringe benefits
Sec. 134.	Certain military benefits
Sec. 135.	Income from United States savings bonds used to pay higher education tuition and fees
Sec. 136.	Energy conservation subsidies provided by public utilities
Sec. 137.	Adoption assistance programs
Sec. 138.	Medicare Advantage MSA
Sec. 139.	Disaster relief payments
Sec. 139A.	Federal subsidies for prescription drug plans
Sec. 139B.	Benefits provided to volunteer firefighters and emergency medical responders.
Sec. 139D.	Indian health care benefits
Sec. 139E.	Indian general welfare benefits
Sec. 139F.	Certain amounts received by wrongfully incarcerated individuals
Sec. 139G.	Assignments to Alaska native settlement trusts
Sec. 140.	Cross references to other Acts

Note that the items listed are exclusions from gross income. Do not confuse exclusions from gross income with deductions from gross income, a subject discussed in later chapters. Basically, an exclusion does not appear on the individual’s tax return, whereas deductions must appear. It should be noted that even though some income sources may be considered exclusions and are not reported on an individual’s 1040 tax return, they may still be subject to tax (i.e., a gift which requires a gift tax return by the donor). This chapter provides an overview of commonly encountered exclusions. Not all types of exclusions are discussed in this chapter. For example, Sections 107 and 118 are not discussed. The exclusions from income which will be discussed more fully include cafeteria plans, life insurance, fringe benefits, and retirement plans.

Common Exclusions from Gross Income

¶5001

GIFTS AND INHERITANCES

A gift, bequest, or inheritance is excluded from gross income. Code Sec. 102(a). Therefore, it follows that the donor does not receive a tax deduction for the property transmitted. A gift transpires when there is a valid transfer of property from one individual to another for no consideration. If property received by gift or inheritance later produces income, the income is taxable. Although the recipient of a gift pays no tax on receipt of the gift, the donor may be required to pay a transfer tax, known as the gift tax.

¶5015

LIFE INSURANCE PROCEEDS

Generally, life insurance proceeds received by the beneficiary are not included in gross income if such amounts are paid by reason of death of the insured. Code Sec. 101(a)(1). Premiums on life insurance policies are not deductible by the insured; therefore, it logically follows that the proceeds from the policy would be excluded from gross income. It is immaterial who the beneficiary is or whether the policy was part of a “group” life insurance plan or was individually purchased. If, however, the payment is delayed and the total amount when received includes some interest, the interest is taxable.

When the proceeds are received for reasons other than death, such as surrender of a life insurance policy, the insured is allowed to recover tax free the amount actually paid for the contract. Code Sec. 72(e)(2)(B). If the cost of the policy exceeds the proceeds, the loss is not deductible. London Shoe Co., Inc., 35-2 USTC ¶9664, 80 F.2d 230 (CA-2 1935), cert. denied, 298 U.S. 663, 56 S.Ct. 747.

In computing the premiums paid under the policy, all dividends received must be subtracted from the amounts paid in.

EXAMPLE 5.1

Ralph Rogers surrendered an endowment policy and received $25,000 from the insurance company. Over time, Ralph had paid in $14,500 in premiums. He must recognize $10,500 ($25,000 – $14,500) of income. He may exclude from income only the amount of his total premiums paid.

Amounts received under a life insurance contract after December 31, 1996, on the life of the insured, terminally or chronically ill individual may be excluded from gross income.

¶5025

SALE OF RESIDENCE

Gross income may not include all the gain realized from the sale or exchange of a principal residence. The gain to be excluded is limited to a maximum of $500,000 ($250,000 for married individual filing a separate return). For detailed discussion, see  Chapter 11 .

¶5035

RECOVERY OF TAX BENEFIT ITEMS

Gross income includes amounts received that were part of an ealier year deduction or credit. This is considered a recovery and generally must be included in gross income in the year received. Common types of recoveries are refunds, such as state tax tax refunds, and reimbursements or rebates.  Chapter 8 ,  ¶8115 , discusses state income tax refunds and the tax benefit rule.

¶5055

RETIREMENT INCOME

Historically, Social Security benefits, both monthly and lump-sum, had been excluded from tax. The exclusion extended to benefits received under the Railroad Retirement Act. Benefits received from retirement systems of other countries are not excluded from the federal income tax.

A portion of the Social Security benefits or railroad retirement benefits must be included in taxable income for taxpayers whose provisional income exceeds a base of $25,000 for a single taxpayer ($32,000 for a married taxpayer filing a joint return and zero for a married person filing a separate return). Provisional income equals modified adjusted gross income plus one-half the Social Security benefits received. Modified adjusted gross means adjusted gross income plus interest on tax-exempt bonds, interest on U.S. savings bonds used to pay higher education tuition and fees, employer adoption assistance, the interest deduction on higher education loans, the deduction for qualified education expenses, and the foreign income exclusion. The amount of Social Security benefits includible in taxable income is the lesser of one-half of the benefits or one half of the excess of the taxpayer’s provisional income over the base.

EXAMPLE 5.2

Bill and Linda Peterson, both over age 65, have the following sources of income:

Interest Income (taxable)	$26,000
Dividend Income	4,000
Net Rental Income	6,000
Adjusted Gross Income	$36,000
Social Security Benefits	$15,000
Computations:
Adjusted Gross Income	$36,000
1/2 of Social Security Benefits	7,500
Provisional Income	$43,500
Base Amount for Married Couple	32,000
Excess	$11,500
50 Percent of Excess	$5,750

Of the $15,000 Bill and Linda received in Social Security benefits, they must include $5,750 in their gross income. Remember, the maximum amount to be included in gross income is the lesser of 50 percent of the “excess” or 50 percent of the Social Security benefit received.

EXAMPLE 5.3

Assume the same facts as in  Example 5.2 , except that Bill and Linda also have $9,000 of interest income from tax-exempt bonds.

Computations:
Adjusted Gross Income from  Example 5.2	$36,000
Plus: Tax-Exempt Interest	9,000
1/2 of Social Security Benefits	7,500
Provisional Income	$52,500
Less: Base Amount for Married Couples	32,000
Excess	$20,500
50 Percent of Excess	$10,250

In this instance, Bill and Linda must include $7,500 in their gross income. This is because 50 percent of their Social Security benefits is the maximum amount that can be included in gross income.

Social Security benefits are taxable to the individual who receives the benefits. Therefore, if a child receives Social Security benefits, the benefits are taxable to the child using the same formulas that are discussed above.

The Revenue Reconciliation Act of 1993 created a second threshold for years after 1993. This second threshold applies to taxpayers with provisional income greater than $34,000 for a single taxpayer and $44,000 for a married taxpayer filing a joint return. Taxpayers with provisional income exceeding the second threshold will be taxed up to 85 percent of their Social Security benefits.

Taxpayers with provisional income exceeding these amounts will include the lesser of:

A. 85 percent of the taxpayer’s Social Security benefits, or

B. the total of the following calculation:

1. 85 percent of the amount that provisional income exceeds the new threshold amounts, plus

2. the smaller of: (a) the amount of Social Security benefits included under prior law; or (b) $4,500 for an unmarried taxpayer, or $6,000 for married taxpayers filing jointly.

Married taxpayers filing separate returns have no base amount and must include in gross income the lesser of: (a) 85 percent of their Social Security benefits; or (b) 85 percent of their provisional income. For illustrations when provisional income exceeds the thresholds, see  Examples 5.6  through  5.9 .

EXAMPLE 5.4

Linda, a single taxpayer, has AGI of $26,000 and Social Security benefits of $8,000. Linda’s provisional income is $30,000 and she must include in her AGI $2,500 of her Social Security benefits. Inasmuch as her provisional income is below the threshold amount ($34,000), she includes in AGI the lesser of 50 percent of her Social Security benefits or one-half the excess of combined income over the base.

EXAMPLE 5.5

Philip and Linda, a married couple filing a joint return, have AGI of $30,000 and Social Security benefits of $14,000. Therefore their provisional income is $37,000. Philip and Linda must include in their AGI $2,500 of their Social Security benefits. Inasmuch as provisional income, $37,000, does not exceed the threshold amount ($44,000), only $2,500 is included in the AGI of Philip and Linda.

EXAMPLE 5.6

Pat, a single taxpayer, has AGI of $36,000 and she received $10,000 in Social Security benefits. Pat’s provisional income is therefore $41,000. Pat must include in her AGI $8,500 of her Social Security benefits. This is computed as follows:

A. $10,000 × 85% = $8,500

B. [($41,000 – $34,000) × 85%] + $4,500 = $10,450

EXAMPLE 5.7

Steve and Marla, a married couple filing a joint return, have AGI of $50,000 and Social Security benefits of $14,000. Steve and Marla have provisional income of $57,000. They must include $11,900 of their Social Security benefits in their gross income. This is computed as follows:

A. $14,000 × 85% = $11,900

B. [($57,000 – $44,000) × 85%] + $6,000 = $17,050

EXAMPLE 5.8

Ron, a single taxpayer, has AGI of $32,000 of income and $8,000 of Social Security benefits. Ron’s provisional income is $36,000 and he must include $5,700 of his Social Security benefits in his income. This is computed as follows:

A. $8,000 × 85% = $6,800

B. [($36,000 – $34,000) × 85%] + $4,000* = $5,700

* $8,000 × 50% = $4,000 maximum includible under prior law

 

EXAMPLE 5.9

Norm and Pat, a married couple filing a joint return, have AGI of $40,000 and Social Security benefits of $12,000. Norm and Pat have provisional income of $46,000 and they must include $7,700 of Social Security benefits in their AGI. This is computed as follows:

A. $12,000 × 85% = $10,200

B. [($46,000 – $44,000) × 85%] + $6,000* = $7,700

* $12,000 × 50% = $6,000 maximum includible under prior law

¶5075

INTEREST ON GOVERNMENT OBLIGATIONS

Savings Bonds

Interest earned on United States savings bonds is fully taxable. On Series EE bonds, no interest per se is paid each year, but the bond is issued at a discount and each year increases in value until maturity. The difference between the purchase price of the bond and the redemption value is taxable interest income. Cash basis taxpayers have the choice of reporting interest income on a yearly basis or reporting all interest income when the bonds finally mature, while accrual basis taxpayers must accrue the increase in the redemption value each year as interest. If cash basis taxpayers exercise the election to report the interest currently, all such bonds owned by them must be similarly treated for all subsequent years.

Taxpayers who elected to defer recognizing income until the bonds mature may change their method of reporting income to a yearly basis without permission from the IRS. However, in the year of change all interest accrued to date, not previously reported, must be included in gross income.

Series EE bonds were first issued in 1980. Prior to 1980, Series E bonds were issued. Series HH bonds replaced Series H bonds in 1980, as well. Series HH and Series H bonds are treated identically for tax purposes. August 2004 was the last date that Series HH bonds were issued. After that date taxpayers were no longer able to reinvest series HH bonds or exchange series EE bonds for HH bonds. These bonds are issued at face value and interest is paid twice a year by check. Cash basis taxpayers must report interest income in the year it is received.

Taxpayers who owned Series E bonds prior to 1980 and did not report interest income on a yearly basis could trade their E bonds for Series H bonds and not realize taxable income unless they received cash on the trade. The same rules hold for Series EE bonds as for Series HH bonds today. On the E/EE bonds, the taxpayer defers the recognition of income until the taxpayer disposes of the bonds or they mature. Then the taxpayer reports as interest income the difference between the redemption value and the total cost of traded bonds, plus any amount received at the time of trade.

EXAMPLE 5.10

Robert and Mary Moore had the following interest income in 2020:

1. Interest on Series EE bonds, $300

2. Interest on bank savings account, $400

Robert and Mary have taxable interest income of $700. If they elect, they can defer the recognition of income on the Series EE bonds until the bonds mature. In that case, then total interest to be included in gross income totals $400.

Educational Savings Bonds

A tax exclusion is provided for interest earned on U.S. savings bonds used to finance the higher education of the taxpayer, the taxpayer’s spouse, or dependents. Code Sec. 135. The bonds must have been purchased after December 31, 1989, and the exclusion is available only to the individual who purchased the bonds. The purchaser of the bonds must have reached the age of 24 and be the sole owner of the bonds. The bonds must be redeemed during the same tax year in which the qualified educational expenses are incurred by the taxpayer, the taxpayer’s spouse, or any dependents.

Qualified higher education expenses include tuition and fees, net of scholarships and other tuition reduction amounts. Qualified higher education expenses must be further reduced by expenses taken into account for the American Opportunity Tax Credit and Lifetime Learning credits. Books, supplies, room and board and expenses incurred for sports, games, or hobbies other than as part of a degree program are not covered.

The key to computing the exclusion is the amount of qualified higher education expenses that the individual incurs in the year the bonds are redeemed. If these expenses exceed the aggregate redemption amount (principal plus interest), then all of the interest may be excluded, subject to an income-linked phase-out discussed below. If the redemption amount is larger than the qualified educational expenses, however, the exclusion is reduced on a pro rata basis.

EXAMPLE 5.11

During 2020, Mary Adams, age 50, redeems Series EE bonds and receives $5,000 of principal and $2,500 of accrued interest. Mary’s daughter attends college and has qualified expenses of $8,000. Mary may exclude from her gross income the entire $2,500 of interest.

EXAMPLE 5.12

Same facts as in  Example 5.11 , except Mary’s daughter incurred only $6,000 in qualified expenses. Mary may exclude from gross income only $2,000. This is calculated as follows:

Percentage Exclusion × Series EE Interest = Interest Exclusion

Percentage Exclusion = $6,000/$7,500 = 80%

Interest Exclusion $2,500 × 80% = $2,000

The exclusion for accrued interest is subject to phaseout provisions. The phaseout ranges for 2020 are as follows:

Filing Status	Modified AGI
Married filing jointly	$123,550—$153,550
Single (including head of household)	$82,350—$97,350

Married individuals filing separately are not eligible for the exclusion.

For those falling within the phaseout range, the amount of interest otherwise excludable will be reduced (but not below zero) by multiplying that interest by a fraction that is determined by dividing the excess of modified AGI (that is, the excess of modified AGI over the bottom figure of the phaseout range) by the number of dollars in the phaseout range ($30,000 for joint returns and $15,000 for single taxpayers).

EXAMPLE 5.13

Same facts as in  Example 5.11 , but also assume that Mary is a single mother and that her modified AGI is $94,350. Mary may exclude from her gross income $500. This amount is computed as follows:

$2,500 – ($2,500 × $12,000/$15,000) = $500

The $12,000 is the excess of modified AGI over the phaseout range.

State and Municipal Bonds

Interest received on state and local government bonds is generally excludable from gross income. Code Sec. 103(a). The term “state or local bond” means an obligation of a state or political subdivision, and the term “state” includes the District of Columbia and any possession of the U.S. Code Sec. 103(c). Tax-exempt bonds are an attractive investment for many well-to-do investors because the after-tax return on such bonds is considerably higher than taxable bonds.

EXAMPLE 5.14

Kayla, a highly paid corporate executive, was in the 37 percent marginal tax bracket. She was contemplating buying some bonds, but could not decide whether to buy corporate bonds, paying 12 percent interest, or a municipal bond, paying 9 percent. Since Kayla is in the 37 percent marginal tax bracket, the 12 percent corporate bond nets Kayla only 7.56 percent. Therefore, the 9 percent tax-free interest income from the municipal bonds is a better decision.

EXAMPLE 5.15

Sam Roberts, a well-to-do banker, has the following securities in his portfolio:

1. One $5,000, 10 percent corporate bond, annual interest income, $500

2. Ten shares of ABC Inc. stock, no dividends paid

3. One $10,000 bond issued by the Port Authority of N.Y. in 2008 at 6 percent

4. Dividend on life insurance policy, $100

5. One $10,000, 5 percent State of Ohio bond issued in 2007, annual interest, $500

Of the items listed above, the interest on the corporate bond must be included in gross income. The shares of stock paid no dividend; therefore, there is no dollar amount to be included in gross income. However, if a dividend had been paid, it would have been includible in Sam Roberts’s gross income. The $600 interest on the Port Authority bond is fully tax-exempt as is the interest on the State of Ohio bond. The life insurance dividend is considered a reduction in premium and is not includible in gross income.

Interest received on state or local bonds is generally excludable from gross income when bond proceeds are used exclusively for traditional government purposes. However, interest on state and local bonds used to benefit other persons is not tax free when it is from (1) private activity bonds that are not exempt, (2) state or local bonds that have not been issued in registered form, or (3) arbitrage bonds.

Private Activity Bonds

Private activity bonds are issued by state and local governments to help finance private business. Private activity bonds that qualify for tax exemption include (1) exempt-facility bonds (e.g., proceeds used to finance airports, water facilities, waste disposal facilities, electric energy or gas facilities), (2) qualified mortgage bonds (proceeds used to finance certain owner-occupied residences), (3) qualified veteran’s mortgage bond (issued only by five states), (4) qualified small issue bonds (face amount of bond issue is $1 million or less), (5) qualified student loan bonds, (6) qualified redevelopment bonds (proceeds used to redevelop blighted areas), or (7) qualified tax-exempt organization bonds. Code Sec. 141(e). Tax-exempt interests received by the taxpayer is not included for the regular tax computation but is included in the alternative minimum tax calculation.

Registered Bonds

In order to restrict the number of long-term bearer obligations and to maintain liquidity in the financial markets, certain obligations must be issued in a registered form in order to be tax-exempt. This applies to certain bonds issued after August 15, 1986. A registration-required bond means any bond other than a bond which (1) is not of a type offered to the public, (2) has a maturity (at issue) of not more than one year, or (3) is issued abroad with safeguards to ensure that the obligations are sold and resold only to persons who are not U.S. persons and that no interest or principal is payable to any U.S. person. Code Sec. 149.

Arbitrage Bonds

Arbitrage bonds are generally denied tax-exempt status unless a special tax or rebate is paid to the United States. Code Sec. 148. Arbitrage bonds are used for speculative purposes by state or local issuing authorities. A bond issue becomes an arbitrage issue if the proceeds are used to buy other obligations, frequently federal obligations, that have a higher yield than the state issue.

Employee Benefits

¶5101

FRINGE BENEFITS

In the United States today fringe benefits are a very significant part of the worker’s compensation package. Compensation experts maintain that approximately one-third of a worker’s gross compensation is composed of fringe benefits. From a tax viewpoint, there are two types of fringe benefits: statutory and nonstatutory. A statutory fringe benefit is specifically excluded by some provision of the law. An example of a statutory fringe benefit would be employees’ accident and health plans, which are covered by Section 105 of the Internal Revenue Code. A nonstatutory fringe benefit is one not specifically mentioned in the law. An example of a nonstatutory fringe benefit is free parking for employees. In an effort to clear the air concerning fringe benefits, the Tax Reform Act of 1984 codified the tax treatment of a number of nonstatutory fringe benefits. Gross income specifically does not include:

1. No-additional-cost services

2. Qualified employee discounts

3. Working condition fringe benefits

4. De minimis fringe benefits (property or service, the value of which is so small as to make the accounting for it unreasonable or administratively impracticable)

Nondiscrimination rules, as set forth in Section 132, must be met for the above-listed fringe benefits.

The Tax Cuts and Jobs Act affected fringe benefits in several ways. The most prominent are, limiting the deduction for meals and lodging, disallowing the deduction for entertainment, limiting moving expenses, creating a new credit for employer-paid family and medical leave, and disallowing the employer deduction for employee transportation to and from work except to ensure the safety of the employee.

No-Additional-Cost Services

The value of no-additional-cost services provided to employees or their spouses or dependent children by employers is excludable from income. This exclusion applies whether the service is provided directly for no charge, at a reduced price, or through a cash rebate of all or part of the amount paid for the service. Reg. §1.132-2. In order for the exclusion to apply, however, the employer must not incur any significant additional costs in providing the service to the employee (disregarding any amounts paid by the employee for the service) and the service provided to the employee must be one that is offered for sale to customers in the ordinary course of the line of business of the employer for which the employee is working.

For determining whether a fringe benefit qualifies as an excludable no-additional-cost service, transportation of passengers by air and transportation of cargo by air are treated as the same service. Thus, an employee performing services in the air cargo industry may receive air travel as a no-additional-cost service. This also includes passenger travel provided through reciprocal agreements with other airlines. Code Sec. 132(h)(8).

In determining the cost of a service, the employer must include revenue that is forgone because the service is provided to an employee rather than to a nonemployee.

EXAMPLE 5.16

Regional Airlines provides its employees with seats on flights it runs. Assuming Regional provides these seats only if, at the time the plane is ready to depart, there are empty seats for the employees to occupy, no cost is attributed to this service because of forgone revenue. However, if Regional permits its employees to book no-additional-cost seats in advance of a flight’s departure and then does not offer these seats for sale to the public, forgone revenue would be attributed to the cost of providing this benefit.

In addition, an employer must include the cost of labor incurred in providing no-additional-cost services to employees for purposes of determining whether substantial additional costs have been incurred. However, labor cost is not included if the services are merely incidental to the primary services being provided.

The no-additional-cost services exclusion is available to employees of one employer for services provided to them by an unrelated employer (another employer not under common control) under a reciprocal arrangement between the two employers. For the services to qualify they must be: (1) of the same type, (2) under a written reciprocal agreement between employers, and (3) no substantial additional cost to either employer.

An employee working for an employer in multiple lines of business is limited to the line of business of the employer for which the employee works. For example, a company that owns both an airline and a hotel could not offer an employee of the airline a free hotel room. However, an important exception exists to employees who service more than one line of business. Therefore, the C.E.O. of the company or the V.P. for Finance could exclude fringes from both lines of business since they both render service to both businesses.

Examples of no-additional-cost services are excess capacity services such as hotel accommodations, telephone services, and transportation by aircraft, train, bus, subway, and cruise line.

Services that are not eligible for treatment as no-additional-cost services are nonexcess capacity services such as the use of a stock brokerage firm or a mutual fund to purchase stock or an interest in the mutual fund. However, if you receive nonexcess capacity services, the value of the benefit may be a qualified employee discount.

Qualified Employee Discounts

Certain employee discounts provided to employees on the selling price of qualified property or services of the employer are excludable from gross income. In order to be excludable, the discounts must be available to employees on a nondiscriminating basis. The employee discount may not exceed the gross profit percentage normally offered by the employer to customers. In the case of qualified services, the excludable amount cannot exceed 20 percent of the price offered to nonemployee customers.

EXAMPLE 5.17

Abigail’s Cut-Rate had total sales of $1,000,000 for 2020. The cost of merchandise for this period was $500,000. Therefore, the gross profit percentage was 50 percent. The employees were offered a 60 percent discount on merchandise purchased from the company. In this case, the employees had to include 10 percent of the value of the merchandise they purchased in their gross income.

EXAMPLE 5.18

Mary Ray works for a computer manufacturer. She bought a portable computer from a local computer store and received the usual employee discount. Mary also received a one-year parts and labor warranty. Normally, the computer shop does not give one-year warranties on machines. Mary need not include the value of the discount in her income but she must include the value of the warranty.

The value of the discounts can be excluded from the income of officers, owners, or highly compensated employees only if these discounts are made available on substantially the same terms to each member of a group of employees which is defined under a reasonable classification set up by the employer that does not discriminate in favor of officers, owners, or highly compensated employees. Code Sec. 132(j).

Working Condition Fringe Benefits

The fair market value of any property or service provided to an employee by an employer as a working condition fringe benefit is excludable from the gross income of the employee to the extent that the employer can deduct the costs as an ordinary and necessary business expense.

The following are examples of working condition fringe benefits that would be excludable:

1. Value of use of an employer-provided car or plane for business purposes

2. Subscriptions to business periodicals by an employer for employees

3. Safety precautions provided by an employer for employees

4. Employer expenditures for on-the-job training or travel by an employee

5. Fair market value of the use of consumer products manufactured for sale to nonemployee customers but provided to employees for product testing and evaluation outside the employer’s workplace

Qualified Transportation Fringe Benefits

Prior to the passage of The Tax Cuts and Jobs Act, employers could deduct four types of transportation expenses: transportation from home to work in a commuter highway vehicle, transit passes, qualified parking, and qualified bicycle commuting reimbursements. With the passage of The Tax Cuts and Jobs Act, employers will no longer be able to deduct expenses paid or incurred after December 31, 2017, for the above listed items for travel between the employee’s residence and place of employment, except as necessary to ensure the employee’s safety. An employee may continue to exclude from income the value of transportation benefits received except for qualified bicycle benefits which are includible in the employee’s income for tax years beginning after December 31, 2017 and before 2026.

Employees may exclude from income up to $270 per month (for 2020) for transit passes received from the employer. Also employer-provided parking valued at up to $270 per month may be excluded from gross income.

De Minimis Fringe Benefits

De minimis fringes result when the value of the property or service provided to the employee is so minimal that accounting for it would be unreasonable. Examples of de minimis fringes include:

1. Typing of personal letters by company secretaries

2. Occasional personal use of the company copying machine

3. Occasional parties or picnics for employees

4. Traditional holiday gifts (small fair market value)

5. Coffee and donuts furnished to employees

6. Occasional supper money or taxi fare due to overtime work

While many of these employee benefits are typically not included in an employee’s gross income, in most circumstances, the employer is allowed a deduction for costs incurred.

Any cash benefit or its equivalent (such as the use of a company credit card) cannot be excluded as a de minimis benefit under any circumstances. In addition, season tickets to sporting or theatrical events, the commuting use of an employer-provided car or other vehicle more than once a month, membership in a private country club or athletic facility, and use of employer-owned or leased facilities, such as an apartment or hunting lodge, for a weekend are never excludable as de minimis fringe benefits.

Prior to the Tax Cuts and Jobs Act, meals provided by the employer were fully deductible if they are a de minimis fringe benefit. A de minimis eating facility can be located on or near the employer’s business operation and the revenue generated from the eatery usually equals or exceeds its direct operating costs. Under the Tax Cuts and Jobs Act, an employer may deduct only 50 percent of the costs for food and beverages for employees at an eatery that qualified as a de minimis fringe benefit after December 31, 2017. No deduction will be allowed for employer-provided meals that are excludable by the employee as a de minimis fringe benefit after 2025.

¶5115

GROUP-TERM LIFE INSURANCE

An employee is allowed to exclude from gross income all of the cost of a group-term life insurance policy provided by an employer if the face amount of the policy does not exceed $50,000. Code Sec. 79. When over $50,000 of group-term life insurance is purchased, the cost of the premium for the amount of insurance over $50,000 must be included in compensation of the employee.

The $50,000 coverage limitation is eliminated and the total cost of group-term life insurance coverage in any amount is excluded from the gross income of the employee where (1) the employee is disabled, (2) the employer is directly or indirectly the beneficiary of the insurance, or (3) a charitable organization is the sole beneficiary. Some retired employees may also be entitled to a full exclusion.

For a group-term policy to be covered by Code Sec. 79, it must not discriminate in favor of highly compensated employees. It is perfectly acceptable to have a group plan where coverage is directly proportional to salary.

The cost of group-term life insurance provided to an employee during any taxable period for inclusion in the employee’s gross income is to be determined under the uniform premium table method. Under this method the cost of group-term life insurance protection in excess of the excludable amount is determined on the basis of uniform premiums by five-year age brackets. The age of the employee for purposes of the age brackets used in the table is the employee’s age on the last day of the tax year. The amount that must be included under the uniform premium table is generally less than the actual cost of the insurance. If the employee contributes an amount to purchase group-term life insurance, the amount is subtracted from what would otherwise be included in the employee’s gross income.

EXAMPLE 5.19

Nine Lives Corp. purchased group-term life insurance for all its employees. The company pays 100 percent of the premiums for all employees, equal to twice the employee’s salary. Otto Olson, age 52 and vice president of Nine Lives, earns $37,500 per year. Therefore, the company paid premiums on a $75,000 group-term policy. For an individual 50–54 years of age, the premium is assumed to be $2.76 (see  Table 1 ) per $1,000 of coverage.

Total coverage	$75,000
Tax-free group insurance	50,000
Insurance subject to tax	$25,000
Cost per thousand dollars per year of insurance for 52-year-old	$2.76
Taxable income to Otto (25 × $2.76)	$69

Table 1. UNIFORM PREMIUMS FOR $1,000 OF GROUP-TERM LIFE INSURANCE PROTECTION
5-Year Age Bracket	Cost Per $1,000 of Protection for 1-Month Period
Under 25	$ .05
25 to 29	.06
30 to 34	.08
35 to 39	.09
40 to 44	.10
45 to 49	.15
50 to 54	.23
55 to 59	.43
60 to 64	.66
65 to 69	1.27
70 and above	2.06
Source:  Table 1 , Reg. §1.79-3(d)(2).

 

EXAMPLE 5.20

Assume in  Example 5.19 , that Otto contributes 50 cents per thousand dollars of protection per year. The amount includible in his gross income is $31.50 ($69 cost of $75,000 coverage less employee contribution of $37.50).

A company may have a group term life insurance plan where the employee pays the entire premium. If the employees are charged a uniform premium, it is still possible that some of the older workers will be subject to tax on coverage over $50,000.

EXAMPLE 5.21

Alfred Ajax is 62 years old and elects group-term insurance of $100,000 and there are no employer contributions. His employer established a uniform rate of $.25 per $1,000 per month. Alfred would have to include $96 in his gross income. The cost of the coverage over the $50,000 group policy is $396 ($0.66 × 12 months × 50). Alfred’s annual contribution is $300 (.25 × 12 months × 100).

PLANNING POINTER

The fact that premiums on group-term insurance for coverage of over $50,000 are taxable to the employee need not mean that such compensation is not valuable. Usually group plans are far more attractive than policies that can be obtained individually, and therefore, may be extremely beneficial as part of a total employee compensation package.

¶5125

ANNUITIES

An annuity is a contract that pays a fixed income at set regular intervals for a specific period of time. The amount of income depends upon the premium paid, the life expectancy of the annuitant, and the number of years payments are to be received. When payment is received as an annuity under an annuity, endowment, or life insurance contract, the amount received generally consists of two separate parts: (1) a nontaxable return of the annuitant’s investment in the contract and (2) a taxable amount representing a gain on the investment (interest). Code Sec. 72(a).

Under special rules for the taxation of amounts received as an annuity and paid out for reasons other than the death of the insured, the tax-free portion of annuity income is spread evenly over the annuitant’s lifetime. This annuity method is not limited to payments that are to be received during the taxpayer’s lifetime. It also applies to payments that are to be made for a prescribed number of years.

Exclusion Ratio Formula

The excludable portion of an annuity payment is the annuity payment times the exclusion ratio. The exclusion ratio is the “investment in the contract” divided by the “expected return” under the contract as of the “annuity starting date.” These terms are further defined below. The formula for determining the excludable portion may be stated as follows:

The following example illustrates the computation of the exclusion ratio.

EXAMPLE 5.22

Makayla Perez purchased an annuity contract that provided for payments of $100 per month. She paid $12,650 for the annuity. Makayla’s expected return under the contract is assured to be $16,000.

Annual annuity payments	($100 × 12)	$1,200
Investment in the contract	12,650
Expected return	16,000
Exclusion ratio	$12,650	79.1%
	$16,000
Monthly exclusion	($100 × 79.1%)	79.10
Monthly amount to be included in gross income	20.90

Once the exclusion ratio is determined, one of two sets of rules is applied depending on the taxpayer’s annuity starting date.

1. Annuity starting date before 1987. The exclusion ratio is applied every year there is a payment, regardless of whether the annuitant lives beyond the life expectancy. If this happens, the annuitant may exclude, over the life of the contract, more than the cost. On the other hand, if the annuitant dies at an age earlier than that of the life expectancy, the total of the yearly exclusions will be less than the cost.

2. Annuity starting date after 1986. The exclusion ratio is applied to payments until the total exclusions equal the investment in the contract. All later payments are fully taxable. On the other hand, if the annuitant dies before the investment in the contract is fully recovered tax free through the annuity exclusion, an itemized deduction is provided for the last tax year in an amount equal to the unrecovered portion of the investment.

Annuity Starting Date Defined

The annuity starting date is the first day of the first period for which an amount is received as an annuity under the contract. The first day of the first period for which an amount is received as an annuity is the later of (1) the date upon which the obligations of the contract become fixed or (2) the first day of the period that ends on the date of the first annuity payment.

EXAMPLE 5.23

Henry Li purchased a deferred single life annuity on January 1, 2020, payable in monthly installments on the first of each month, beginning August 1 of that year for the preceding calendar month. The August 1 payment is for the period beginning July 1. The annuity starting date is July 1.

Investment in the Contract Defined

The investment in the contract is, generally, the total amount of premiums or other consideration paid for the contract less amounts, if any, received prior to the annuity starting date that are excludable from gross income. Accordingly, if a taxpayer paid premiums of $5,000 for an annuity contract and had recovered $1,000 tax free as of the annuity starting date, the investment in the contract for purposes of the exclusion ratio formula would be $4,000. Once payments have started and the tax-free amount of each annuity payment is determined then any increases in annuity payments are fully taxable.

Expected Return Under the Contract

The expected return under the contract is limited to amounts receivable as an annuity or as annuities. If no life expectancy is involved (as in the case of installment payments for a fixed number of years), the expected return is found by multiplying the total amount payable from the annuity installments by the number of payments to be received. Code Sec. 72(c)(3); Reg. §1.72-5(c) and (d).

To determine the expected return under contracts involving life expectancy, actuarial tables prescribed by the IRS must be used (see  Tables 2 – 6  following  Example 5.29 ). The tables provide a multiplier (based on life expectancy) that is applied to the annual payment in order to obtain the expected return under the contract. This procedure can become quite complex since annuities may be based, variously, on one life, joint lives only, joint lives and continuing to the last survivor, and for life or term certain.

Single Life Annuities

To demonstrate the general principles note the following example of a single life annuity.

EXAMPLE 5.24

Marvin Mariner retires at age 65. His annuity contract provides for him to receive $100 per month for life. His total premiums under the policy had been $14,400.

Annual annuity payment	($100 × 12 months)	$1,200
Multiple from  Table 2 , Age 65		20.0
Expected return	($1,200 × 20.0)	$24,000

Marvin had an investment cost of $14,400 in the annuity and an expected return of $24,000. Therefore, the exclusion ratio was $14,400/$24,000 = 60%. Since he receives $1,200 a year, he may exclude from gross income $720 ($1,200 × 60%). Where payments are made quarterly, semiannually, or annually, the applicable multiple shown in  Table 5  may be used.

If Marvin received his first semiannual payment six full months after the annuity starting date, the adjusted multiple would be 19.8 (20.0 – .2). If Marvin were to receive $600 six months after his annuity starting date, his expected return would be $23,760 ($1,200 × 19.8). See  Table 5 .

Joint and Survivor Annuities

Under a joint and survivor annuity two individuals receive periodic payments for life. Some policies adjust the amount of the payment after the death of the first annuitant.

EXAMPLE 5.25

Robert and Betty Moss purchased a joint and survivorship annuity contract. The contract provided for the couple to receive $200 per month for life. Upon the death of one spouse, the surviving spouse would continue to receive $200 per month. Robert Moss was 69 years old and his wife was 66. The cost of the policy was $36,825.

Computations:
Annual annuity payments	($200 × 12)	$2,400
Multiple from  Table 3		22.9
Expected return	($2,400 × 22.9)	$54,960
Investment in annuity contract		$36,825

Annual exclusion

($2,400 × 67%)

$1,608

 

EXAMPLE 5.26

Assume the same facts as in  Example 5.25 , except that when the first spouse dies the surviving spouse will receive only $150 per month. The cost of the annuity is $29,450.

Computations:
Multiple from  Table 3 , Ages 69 and 66		22.9
Multiple from  Table 4		13.1
Expected return after first death	($1,800 × 22.9)	$41,220
Expected return differential after first death	($600 × 13.1)	$7,860
Expected return from annuity		$49,080
Cost of annuity		$29,450

Therefore, while both individuals are alive they can exclude $120 ($200 × 60%) per month. After the death of one spouse, the exclusion will be only $90 ($150 × 60%).

 

EXAMPLE 5.27

Assume the same facts as in  Example 5.26 , except that Robert purchases the annuity and the annuity contract provides that if Robert dies first, Betty will receive only $150 per month instead of $200. The cost of the annuity is $29,450.

Computations:
Multiple from  Table 3		22.9
Multiple from  Table 2		16.8
Multiple applicable to second annuitant		6.1
Expected return (first annuitant)	($2,400 × 16.8)	$40,320
Expected return (second annuitant)	($1,800 × 6.1)	$10,980
Expected return from annuity		$51,300

Therefore, while both individuals are alive, they can exclude $114.80 ($200 × 57.4%) per month. After the death of Robert, the exclusion will be $86.10 ($150 × 57.4%) per month.

EXAMPLE 5.28

Assume the same facts as in  Example 5.27 , except that Robert purchases the annuity and the annuity contract provides that if Betty dies first, Robert will receive only $150 per month instead of $200. The cost of the annuity is $29,450.

Computations:
Multiple from  Table 3		22.9
Multiple from  Table 2		19.2
Multiple applicable to second annuitant		3.7
Expected return (first annuitant)	($2,400 × 19.2)	$46,080
Expected return (second annuitant)	($1,800 × 3.7)	$6,660
Expected return from annuity		$52,740

Therefore, while both individuals are alive, they can exclude $111.60 ($200 × 55.8%) per month. After the death of Betty, the exclusion will be $83.70 ($150 × 55.8%) per month.

Employee Annuities

If the employer paid in all of the cost of the pension or annuity, the payments received by the employee are fully taxable to the employee. If the employee made contributions, the total amount that an employee may exclude from income is the total amount of the employee’s contributions. The employee uses the exclusion ratio until the investment in the contract is recovered. Thereafter, all proceeds are included in income. Also, if the employee’s benefits cease prior to the date the employee’s total contributions have been recovered, the amount of unrecovered contributions is allowed as a deduction on the annuitant’s last tax return.

The Small Business Job Protection Act of 1996 provides for a simplified method for determining the portion of an annuity distribution from a qualified retirement plan.

Refund Annuities

When payments are received under a guaranteed refund provision, the value of such payments reduces the investment in the contract. Obviously, where a refund has been received, an adjustment to the “investment in the contract” must be made so as to determine the excludable portion. The adjustment required to the “investment in the contract” is determined as follows:

1. Divide maximum amount guaranteed by the amount to be received annually and round off to the nearest whole year.

2. Refer to the actuarial table entitled “Percent Value of Refund Feature” to determine the appropriate percentage figure to be employed (see  Table 6 ).

3. Multiply percentage found in the table by the smaller of (a) original investment in the contract, or (b) the total amount guaranteed.

4. Subtract the amount determined in Step 3 from the original “investment in the contract.”

The following example illustrates the above provisions.

EXAMPLE 5.29

Joseph Jacobs, 65, purchased for $25,000 an immediate installment refund annuity, payable $100 per month for life. The contract provided that, in the event the husband did not live long enough to recover the full purchase price, payments were to be made to his wife until the total payments under the contract equaled the purchase price. Joe’s investment in the contract adjusted for the purpose of determining the exclusion ratio is computed in the following manner:

Investment in Contract
Cost of the annuity contract (investment in the contract, unadjusted)	$25,000
Amount to be received annually	$1,200
Number of years for which payment guaranteed ($25,000 divided by $1,200)	20.8
Rounded to nearest whole number of years	21
Percentage located in  Table 6  for age 65 (age of the annuitant as of the annuity starting date) and 21 (the number of whole years)	20%
Subtract value of the refund feature to the nearest dollar (20% of $25,000)	$5,000
Investment in the contract adjusted for the present value of the refund feature without discount for interest	$20,000
Monthly Exclusion
Adjusted investment in contract	$20,000
Annual payments	1,200
Multiple from  Table 2 , Age 65	20.0
Expected return ($1,200 × 20)	24,000

Monthly exclusion (83.3% of $100)

$83.33

IRS Actuarial Tables

Gender-neutral annuity tables used to compute that portion of an annuity that is includible in gross income have been adopted. These tables apply to amounts received as an annuity after June 30, 1986.

Table 2. ORDINARY LIFE ANNUITIES—ONE LIFE—EXPECTED RETURN MULTIPLES
Age	Multiple	Age	Multiple
57	26.8	72	14.6
58	25.9	73	13.9
59	25.0	74	13.2
60	24.2	75	12.5
61	23.3	76	11.9
62	22.5	77	11.2
63	21.6	78	10.6
64	20.8	79	10.0
65	20.0	80	9.5
66	19.2	81	8.9
67	18.4	82	8.4
68	17.6	83	7.9
69	16.8	84	7.4
70	16.0	85	6.9
71	15.3	86	6.5
Source: Table V, Reg. §1.72-9.

Table 3. ORDINARY JOINT LIFE AND LAST SURVIVOR ANNUITIES—TWO LIVES—EXPECTED RETURN MULTIPLES
Age	65	66	67	68	69	70	71	72	73	74
65	25.0	24.6	24.2	23.8	23.4	23.1	22.8	22.5	22.2	22.0
66	24.6	24.1	23.7	23.3	22.9	22.5	22.2	21.9	21.6	21.4
67	24.2	23.7	23.2	22.8	22.4	22.0	21.7	21.3	21.0	20.8
68	23.8	23.3	22.8	22.3	21.9	21.5	21.2	20.8	20.5	20.2
69	23.4	22.9	22.4	21.9	21.5	21.1	20.7	20.3	20.0	19.6
70	23.1	22.5	22.0	21.5	21.1	20.6	20.2	19.8	19.4	19.1
71	22.8	22.2	21.7	21.2	20.7	20.2	19.8	19.4	19.0	18.6
72	22.5	21.9	21.3	20.8	20.3	19.8	19.4	18.9	18.5	18.2
73	22.2	21.6	21.0	20.5	20.0	19.4	19.0	18.5	18.1	17.7
74	22.0	21.4	20.8	20.2	19.6	19.1	18.6	18.2	17.7	17.3
75	21.8	21.1	20.5	19.9	19.3	18.8	18.3	17.8	17.3	16.9
76	21.6	20.9	20.3	19.7	19.1	18.5	18.0	17.5	17.0	16.5
77	21.4	20.7	20.1	19.4	18.8	18.3	17.7	17.2	16.7	16.2
78	21.2	20.5	19.9	19.2	18.6	18.0	17.5	16.9	16.4	15.9
79	21.1	20.4	19.7	19.0	18.4	17.8	17.2	16.7	16.1	15.6
80	21.0	20.2	19.5	18.9	18.2	17.6	17.0	16.4	15.9	15.4
Source: Table VI, Reg. §1.72-9.

Table 4. ANNUITIES FOR JOINT LIFE ONLY—TWO LIVES—EXPECTED RETURN MULTIPLES
Age	65	66	67	68	69	70	71	72	73	74
65	14.9	14.5	14.1	13.7	13.3	12.9	12.5	12.0	11.6	11.2
66	14.5	14.2	13.8	13.4	13.1	12.6	12.2	11.8	11.4	11.0
67	14.1	13.8	13.5	13.1	12.8	12.4	12.0	11.6	11.2	10.8
68	13.7	13.4	13.1	12.8	12.5	12.1	11.7	11.4	11.0	10.6
69	13.3	13.1	12.8	12.5	12.1	11.8	11.4	11.1	10.7	10.4
70	12.9	12.6	12.4	12.1	11.8	11.5	11.2	10.8	10.5	10.1
71	12.5	12.2	12.0	11.7	11.4	11.2	10.9	10.5	10.2	9.9
72	12.0	11.8	11.6	11.4	11.1	10.8	10.5	10.2	9.9	9.6
73	11.6	11.4	11.2	11.0	10.7	10.5	10.2	9.9	9.7	9.4
74	11.2	11.0	10.8	10.6	10.4	10.1	9.9	9.6	9.4	9.1
75	10.7	10.5	10.4	10.2	10.0	9.8	9.5	9.3	9.1	8.8
76	10.3	10.1	9.9	9.8	9.6	9.4	9.2	9.0	8.8	8.5
77	9.8	9.7	9.5	9.4	9.2	9.0	8.8	8.6	8.4	8.2
78	9.4	9.2	9.1	9.0	8.8	8.7	8.5	8.3	8.1	7.9
79	8.9	8.8	8.7	8.6	8.4	8.3	8.1	8.0	7.8	7.6
80	8.5	8.4	8.3	8.2	8.0	7.9	7.8	7.6	7.5	7.3
Source: Table VI A, Reg. §1.72-9.

Table 5. MULTIPLE ADJUSTMENTS

If the number of whole months from the annuity starting date to the first payment date is—

0–1

2

3

4

5

6

7

8

9

10

11

12

And payments under the contract are to be made:

Annually

+0.5

+0.4

+0.3

+0.2

+0.1

0

0

–0.1

–0.2

–0.3

–0.4

–0.5

Semi-annually

+ .2

+ .1

0

0

– .1

– .2

…

…

…

…

…

…

Quarterly

+ .1

0

– .1

…

…

…

…

…

…

…

…

…

Source: Reg. §1.72-5(a)(2)(i).

Table 6. PERCENT VALUE OF REFUND FEATURE
Years— Age	21	22	23	24	25	26	27	28	29	30
55	8	9	9	10	11	12	13	14	15	16
56	9	9	10	11	12	13	14	15	16	18
57	9	10	11	12	13	14	15	17	18	19
58	10	11	12	13	14	16	17	18	19	21
59	11	12	13	15	16	17	18	20	21	22
60	12	14	15	16	17	19	20	21	23	24
61	14	15	16	17	19	20	22	23	25	26
62	15	16	18	19	20	22	23	25	27	28
63	16	18	19	21	22	24	25	27	29	30
64	18	19	21	23	24	26	28	29	31	33
65	20	21	23	25	26	28	30	31	33	35
66	21	23	25	27	28	30	32	34	35	37
67	23	25	27	29	31	32	34	36	38	40
68	25	27	29	31	33	35	37	38	40	42
69	28	29	31	33	35	37	39	41	43	44
70	30	32	34	36	38	40	42	43	45	47
71	32	34	36	38	40	42	44	46	47	49
72	35	37	39	41	43	45	46	48	50	51
73	37	39	41	43	45	47	49	51	52	54
74	40	42	44	46	48	50	51	53	54	56
75	42	44	46	48	50	52	54	56	57	58
76	45	47	49	51	53	54	56	58	59	60
77	47	50	51	53	55	57	58	60	61	62
78	50	52	54	56	57	59	61	62	63	64
79	53	55	56	58	60	61	63	64	65	66
80	55	57	59	60	62	63	65	66	67	68
Source: Table VII, Reg. §1.72-9.

¶5140

ADOPTION EXPENSES

There is a tax credit for up to $14,300, for 2020, for adoption expenses per child, where such expenses are paid or incurred by the taxpayer’s employer under a qualified adoption assistance program. This exclusion is available for all children, with or without special needs. However, individuals who adopt a special needs child are entitled to the maximum credit irrespective of expenses paid or incurred by the taxpayer. In 2020, that would be $14,300. To be eligible, the child must be under the age of 18. Qualified adoption expenses include ordinary and necessary adoption expenses, court costs, attorney fees, and other expenses incurred for the principal purpose of the legal adoption of an eligible child. This exclusion is available for tax years beginning after 1996. An exclusion for adoption expenses must be coordinated with the adoption credit. (See  ¶9031 .) The employer-provided adoption expenses are available to eligible taxpayers who have modified adjusted gross income below $214,520. The exclusion is phased out between an adjusted gross income of $214,520 and $254,520.

If the adoption involves a citizen or resident of the United States, then the expenses are excludable from gross income in the year incurred. If the adoption involves a non-U.S. child, then the expenses are excludable in the year the adoption is finalized. The dollar limit is per child; it is not an annual limit.

EXAMPLE 5.30

Ron and Roberta begin adoption proceedings in 2020 for an infant through a U.S.-based agency. During 2020, they incurred $3,000 of legal fees. During 2021, they incur $2,000 of additional adoption fees, and on November 16, 2021, they finalize the adoption. The $5,000 in expenses were incurred through Ron’s employer’s adoption assistance program. Ron and Roberta have $80,000 of adjusted gross income in 2021. They may exclude from gross income the $3,000 in 2020 and $2,000 paid by Ron’s employer in 2021.

EXAMPLE 5.31

Carlos and Olivia, a married couple, adopt a special needs child in 2020. They are entitled to a tax credit of $14,300 regardless of their actual expenses incurred. To claim a credit for a special needs child, the couple must file a joint return.

¶5145

COMPENSATION FOR INJURIES AND SICKNESS

The law specifically excludes from gross income:

1. Amounts received under workers’ compensation acts as compensation for personal injuries or sickness

2. Amount of any damages received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal injuries or sickness

3. Amounts received for personal injuries or sickness through accident and health insurance which the worker purchased

4. Amounts received as a pension, annuity, or similar allowance for personal injuries or sickness resulting from active service in the armed forces of any country or in the Coast and Geodetic Survey or the Public Health Service, or as a disability annuity payable under the provisions of Section 808 of the Foreign Service Act of 1980

5. Amounts received as disability income attributable to injuries incurred as a direct result of violent attack which the Secretary of State determines to be a terrorist attack and which occurred while such individual was an employee of the United States engaged in the performance of official duties outside the United States (Code Sec. 104(a))

Note the above-mentioned exclusions from gross income under workers’ compensation acts cover occupational injury and sickness. Nonoccupational injuries and sicknesses are not covered. Further, payments received in excess of applicable workers’ compensation laws are not excludable. However, benefits received under an accident and health insurance plan due to taxpayer’s contributions are excludable from gross income. “No fault” insurance disability benefits received under the owner’s insurance policy are excluded from gross income as well.

EXAMPLE 5.32

Lucy Kim worked for Cleveland Inc. for many years and was covered by workers’ compensation and an accident and health plan that she personally purchased. On April 15, Lucy was seriously injured when a light fixture fell and broke her neck. She collected $4,000 for medical expenses incurred and $3,000 from her insurance company for her lost wages. Lucy may exclude from her gross income both the $4,000 received for medical expenses incurred and the $3,000 from her insurance company.

Damages compensating an injured person for personal injuries or sickness are excludable from gross income. These damages are often excludable even when measured by the amount of wages that might have been earned but for the injuries. Damages received for nonphysical injuries are not excludable from gross income. However, an exclusion from gross income is allowed to the extent damages received are used to pay medical expenses attributable to emotional distress.

Punitive damages are taxable as ordinary income, regardless of whether or not they are derived from physical or nonphysical injury. This restriction is effective for amounts received after August 20, 1996, but does not apply to punitive damages awarded in wrongful death actions if applicable state law in effect on September 13, 1995, provides that only punitive damages may be awarded.

Damages received from actions based on age, injury to reputation, emotional distress, race, or sex discrimination violations are includible in gross income if the tort occurred after August 20, 1996.

EXAMPLE 5.33

Mary Castro was seriously injured in an automobile accident. The driver of the other car was charged and convicted of reckless driving. Mary received the following payments.

Reimbursement for medical and hospital expenses	$6,500
Loss of income reimbursement due to accident	2,500
Punitive damages	8,000
Payments for pain and suffering	3,000
Total payments received	$20,000

From the above payments, Mary includes the $8,000 received for punitive damages in her income.

The entire amount of damages received by the individual in connection with physical injuries or physical sickness are excludable from income. See Rev. Rul. 85-97. Where the awards by the court, or, for that matter, the damages received in an out-of-court settlement, are really for lost profits in a business, then the amounts are excluded from income if the award is received on account of a personal physical injury. When reimbursement for medical expenses incurred is received, the individual cannot take an itemized deduction for the same expenses. Further, if, for example, the taxpayer incurred medical expenses in 2020 and deducted them on the 2020 tax return and in June 2021 received reimbursement for the same expenses, the reimbursement must be included in gross income to the extent of the previous deduction.

¶5155

ACCIDENT AND HEALTH PLANS

Benefits received by an employee under an accident and health plan where premiums are paid by the employer are excludable from gross income if they come under the following conditions:

1. Permanent injury or loss of bodily function if amounts are paid on the nature of the injury and not on work time lost by employee

2. Reimbursement for medical expenses of employee, spouse, or dependents (Code Sec. 105(b) and (c))

To qualify the plan must not discriminate in favor of highly compensated executives, shareholders, or certain officers. Further, reimbursements are deductible only to the extent of actual medical expenses.

EXAMPLE 5.34

Bea Safe was seriously injured while working on the job in June 2020. During the course of the year she received the following payments on account of her injury:

Workers’ compensation	$750
Medical expense reimbursement	6,000
Damages for loss of limb	10,000

In the example, all three items are excluded from gross income.

The premiums the employer pays to fund an accident and health plan for employees are not taxed to the employee. It is immaterial whether or not payment is for an insured plan. Further, the plan can cover the employee for personal injuries or sickness, the employee’s spouse, or any dependents. Code Sec. 106; Reg. §1.106-1.

It does not matter if the employer contributions for health and accident insurance are purchased as a group policy or an individual policy. However, if the policy provides for benefits beyond health and accident insurance then only the portion of the employer’s contribution associated with the health and accident insurance is excluded.

Amounts received by the employee for sickness or injury through the employer-paid health and accident plan are excluded from gross income as long as they are for medical care reimbursement. Amounts paid under the plan that are not medical care reimbursement must be included in the employee’s gross income.

¶5165

QUALIFIED LONG-TERM CARE INSURANCE

After 1996, qualified long-term care insurance contracts are generally treated as accident and health insurance contracts. Amounts received as benefits under the contract may be excluded from gross income as amounts received for personal injury or sickness.

¶5185

MEALS AND LODGING

Meals furnished to an employee or the employee’s family are considered compensation to the employee. However, employees may exclude the value of meals furnished by the employer if (1) the meals are furnished on the business premises of the employer, and (2) they are furnished for the convenience of the employer. Code Sec. 119(a)(1). For example, a waitress in a luncheonette works from 6 a.m. to 2 p.m. Her employer provides for her breakfast and lunch at the luncheonette free of charge. Further, she is required to have her meals on the premises. Under the circumstances, the meals are not income to the waitress. If the waitress had the right to free lunches on her days off, they would be included in her gross income.

The value of lodging may be excluded from gross income if (1) the lodging is on the employer’s premises, (2) the lodging is for the convenience of the employer, and (3) the employee must accept the lodging as a condition of employment. Code Sec. 119(a)(2). Normally such lodging is provided for employees who must be available to respond to emergencies, as in the case of ambulance drivers. The required lodging must be a condition of employment to be excluded from gross income. If the above tests are not met, the value of the meals and lodging is income to the employee. Reg. §1.61-2(d)(3).

The Tax Cuts and Jobs Act does not modify Section 119.

EXAMPLE 5.35

Dr. Bruce Lee works at Metro General Hospital and is required to be on the premises because he is on call from Friday at 6:00 p.m. to Monday at 8:00 a.m. Dr. Lee is not required to report the value of meals and lodging received while on duty.

Qualified campus lodging furnished by an educational institution to faculty and other employees may be eligible for exclusion from gross income where an adequate rental is charged. For rental to be considered adequate, applicable appraisal tests must be met. Code Sec. 119(d).

¶5195

CAFETERIA PLANS

Cafeteria plans are employer-sponsored benefit packages that offer employees a choice between taking cash and qualified benefits (such as accident and health coverage or group-term life insurance coverage). Code Sec. 125; Reg. §1.125-1. No amount is included in the gross income of a cafeteria plan participant solely because he or she may choose among the benefits of the plan; but, if the participant chooses cash, it would be includible in gross income as compensation. If qualified benefits are chosen, they are excludable to the extent allowed by the law.

The cafeteria plan must limit its offering of benefits only between cash and qualified benefits to employees. A qualified benefit is any benefit that is not includible in the gross income of the employee by reason of an express provision of the law. The only taxable benefit that a cafeteria plan may offer is cash. The menu of items in the plan might include such nontaxable benefits as group-term life insurance, disability benefits, and accident and health benefits. This is not meant to be an exhaustive list of benefits includible in a cafeteria plan. Other fringes which may be included are dental plans, vacation days, and qualified dependent care assistance. Unused benefits from one plan year may not be accumulated by an employee and carried over to succeeding years.

However, the following plans have been expressly prohibited from inclusion: qualified scholarships (Code Sec. 117), educational assistance programs (Code Sec. 127), or excludable fringe benefits (Code Sec. 132). An exception is made for employer contributions to profit-sharing or stock bonus plans under a qualified cash or deferred arrangement as defined by Code Sec. 401(k)(2). The beauty of the cafeteria approach to fringe benefit management is that the employer is allowed a tax deduction for providing the fringe benefits offered in the plan while the employee participants recognize no income if they choose the nontaxable benefits. Further, the employees select fringe benefits they desire and need and not benefits of no interest to them or benefits already available to their spouses.

Participation in the cafeteria plan must be restricted to employees. Under a written plan participants choose among two or more benefits consisting of cash and statutory nontaxable benefits. Further, the rules must be the same for all employees. The plan must not discriminate in favor of highly compensated individuals, shareholders owning more than 5 percent of the voting power or value of the stock, or certain key employees. Unless the cafeteria plan meets the above-stated anti-discrimination rules, the highly paid individuals or shareholders must include in gross income the maximum benefits they are entitled to receive. However, the plan will remain intact for the participants not included in the prohibited class. Code Sec. 125(b) and (e).

The reporting requirements for cafeteria plans are quite stringent. Employers must report to the IRS the name and address of and the amount of benefits provided to highly compensated employees. Also, they must report the number of highly compensated employees, along with a list of the number eligible to participate in the plan, the number who actually participate, and the amount of fringe benefits includible in income, and the total cost of the plan during the year.

EXAMPLE 5.36

Ralph Jones works for Lorain Inc. and earns $30,000 per year. His employer has a basic cafeteria plan. Prior to the beginning of the benefit year, the employee must select the coverage desired. Ralph may choose among the following: $2,000 in cash or medical coverage up to $2,000 for the year, group-term life insurance, and day care facilities. Any unused benefit is forfeited. Therefore, if Ralph selects medical coverage and uses only $1,200, he forfeits the remaining $800.

Why choose medical coverage over cash? If Ralph chooses to receive the $2,000 in cash, he will immediately be taxed on the amount. Then, when he purchases a medical plan, he would be using after-tax dollars. Usually, group plans are considerably less expensive than privately purchased plans. By selecting group medical coverage, Ralph recognizes no income; therefore, he is selecting a nontaxable benefit plan with before-tax dollars. Remember this risk—if Ralph does not use all of his $2,000 covered medical expenses, he loses the dollars.

PLANNING POINTER

Cafeteria plans prove quite advantageous for married couples. If both spouses work for companies having cafeteria plans, they should arrange their affairs so as to provide themselves with full coverage. Typically, married couples find themselves with two medical plans and no dental plan. Cafeteria plans correct this drawback and are of great benefit to families.

¶5201

EDUCATIONAL ASSISTANCE PLANS

Payments of up to $5,250 per year received by an employee for tuition, fees, books, and supplies under an employer’s assistance program may be excluded from gross income. Code Sec. 127. Any excess is includible in the employee’s gross income and is subject to employment and income tax withholding.

The Economic Growth and Tax Relief Reconciliation Act of 2001 extended the exclusion to include graduate education. The graduate education exclusion became effective after December 31, 2001. This provision applies whether or not the educational courses are work-related. The Tax Relief Act of 2010 extends these provisions through December 31, 2012. The American Taxpayer Relief Act of 2012 extends permanently the exclusion of up to $5,250.

Expenses disallowed because they exceed the $5,250 limit may be excludable if they meet the working condition fringe benefit rules under Code Sec. 132. Excludable assistance payments may not cover tools or supplies that the employee retains after completion of the course or the cost of meals, lodging, or transportation. Although the courses covered by the plan need not be job-related, courses involving sports, games, or hobbies may be covered only if they involve the employer’s business. Reg. §1.127-2(c).

The plan must be written. The employer may pay the expenses directly, reimburse the employees for their expenses, or provide the education directly. The plan need not be funded and prior approval of the plan by the IRS is not required, but the plan must not discriminate in favor of highly compensated employees. Further, not more than 5 percent of the total amount paid out during the year may be paid to or for employees who are shareholders or owners who own at least 5 percent of the business. An employer who maintains an educational plan must maintain records and file a return with respect to the plan. Code Sec. 6039D.

¶5215

TUITION REDUCTION PLANS

Qualified tuition reductions (QTRs) made available to employees (and their families) of qualified educational institutions are excludable from the employee’s gross income. A QTR is the amount of reduction in tuition for education that is furnished by an educational institution to an employee (or an employee’s dependent children or certain other individuals) provided certain requirements are met. The tuition reduction must be for education below the graduate level. Code Sec. 117(d). However, under a special rule, tuition reduction benefits paid to graduate teaching and research assistants employed by qualified educational institutions may be excluded from gross income. Code Sec. 117(d)(5).

Qualified Tuition Program

A qualified tuition program (QTP), also known as a Code Section 529 Plan, is a program that allows an individual to purchase tuition credits or make cash contributions to an account on behalf of a beneficiary for payment of qualified higher education expenses. Generally for years after 2001, no amount is included in gross income of a beneficiary or contributor with respect to any distribution from a QTP used by qualified education expenses.

The PATH Act of 2015 expands the definition of qualified higher education expenses to include computer equipment and technology for the years beginning in 2015. To receive this tax benefit the program must be established by a state government or agency.

The Tax Cuts and Jobs Act expands the definition qualified institution under Code Section 529. Under the new law, participants may draw up to $10,000 per year to attend public, private, or religious elementary or secondary schools. The $10,000 per year is for each student attending school. The new law is effective after December 31, 2017. The Further Consolidated Appropriations Act, 2020 further expanded qualified tuition programs to include registered apprenticeship programs. The $10,000 for certain expenses is a lifetime exclusion. Qualified higher education expenses continue to be acceptable.

¶5235

DEPENDENT CARE ASSISTANCE PROGRAMS

An employee receiving dependent care assistance payments provided under an employer’s written nondiscriminatory plan generally may exclude such payments from gross income. Code Sec. 129. The exclusion for employer-provided dependent care assistance is limited to $5,000 a year ($2,500 in the case of a separate return by a married individual). Also, the exclusion is subject to an earned income limitation. Thus, an unmarried taxpayer may not exclude from gross income more than his or her earned income for the tax year, and a married taxpayer may not exclude more than the lesser of his or her earned income or the spouse’s earned income. In applying the earned income test for a married taxpayer, the earned income of an incapacitated or student spouse is deemed to be $250 per month if one qualifying dependent is involved or $500 if two or more qualifying dependents are involved.

The employer’s plan must be for the exclusive use of its employees and must not discriminate in favor of employees who are officers, owners, or highly compensated employees or their dependents. The purpose of the service provided must be to enable an individual to work. An employee who excludes the value of child or dependent care services from income may not claim any income tax deduction or credit with respect to such amounts.

Qualifying expenses include amounts paid for household services and care of the qualifying person. A qualifying person is any child under age 13, a disabled spouse, or any disabled person, provided that the qualifying person is a dependent of the taxpayer. The person who provides the care may not be the taxpayer’s spouse or a person claimed by the taxpayer as a dependent. Further, if the taxpayer’s child provides the care, the child must be age 19 or older by the end of the tax year.

The exclusion for employer-provided dependent care assistance may not be claimed unless the taxpayer reports the dependent care provider’s correct name, address, and taxpayer identification number on the tax return. The exclusion may be claimed even though the information is not provided if it can be shown that the taxpayer exercised due diligence in attempting to provide this information. Code Sec. 129(e)(9). Similar information reporting requirements also apply to employers that provide dependent care programs for their employees. The exclusion for dependent care assistance programs must be coordinated with the dependent care credit. ( Chapter 9 )

¶5255

MILITARY BENEFITS

Qualified military benefits are excluded from gross income. Qualified military benefits are benefits that are received either in cash or in kind by members of the armed services or their dependents by reason of military service and that, as of September 9, 1986, were excludable from gross income by law, regulation, or administrative practice. However, the personal use of a car is not excludable as a qualified military benefit. Code Sec. 134.

Military retirement pay based on years of service and/or age must be included in gross income. Code Sec. 61(a)(11). However, veterans’ benefits administered by the Veterans Administration are excludable from gross income. This includes amounts paid to veterans or their families in the form of educational, training, or subsistence allowances, disability compensation and pension payments for disabilities, and veterans’ pensions.

TAX BLUNDERS

1. Harry and Rachel are both retired and have $33,500 of interest income and receive social security benefits of $12,000. This year they decided to redeem two Series EE bonds with accumulated interest of $3,500 each. This transaction boosts their provisional income to $46,500. Since they passed the $44,000 threshold, the proceeds from the sales of the second bond required them to include in gross income a larger portion of their social security benefits. Harry and Rachel should cash one bond in year one and one bond in year two.

2. Robert is single and collects social security. This year his provisional income exceeded $34,000. It was composed of $32,000 of interest income and $12,000 of social security benefits. In an effort to reduce his taxes, he sold several of his taxable bonds and bought tax-exempt bonds. This did not solve his problem. In the calculation of provisional income, tax-exempt interest income is included.

3. Orange County, Inc. provided their employees with a physical fitness center on their premises. They decided in a cost cutting move to close the center and buy memberships for all their employees and their families at the local fitness club. This was cheaper for Orange County, Inc. than maintaining their own facility. By closing their facility and buying memberships in a health club, the company could no longer treat the expenditure as a de minimis fringe benefit. The employees now had income for the cost of the membership.

KEYSTONE PROBLEM

Commonwealth Medicine Company, a hospital supply firm, has had difficulty attracting new personnel, particularly at the executive level. They feel that the company is competitive in the area of salary, but that total compensation packages should be examined more carefully. Of course, many factors will determine the final list. However, you are asked to examine one consideration in developing these packages, which is to reduce the tax impact on the employee. Therefore, you wish to devise a plan that will provide benefits for employees that will not be included in their taxable income. Include in your examination the concept of cafeteria plans. Also investigate the consequences of limiting the plans to selected levels of personnel.

SUMMARY

· Sections 101 through 139 of the Internal Revenue Code list “Items Specifically Excluded from Gross Income.”

· A portion of Social Security benefits must be included in taxable income for taxpayers who meet certain requirements described by the Revenue Reconciliation Act of 1993.

· A tax exclusion is provided for interest earned on U.S. savings bonds used to finance the higher education of the taxpayer, the taxpayer’s spouse, or the taxpayer’s dependents.

· Certain employee discounts provided to employees on the selling price of qualified property or services of the employer are excludable from gross income, provided that the discount meets certain qualifications.

· Cafeteria plans offer employees a choice between taking cash and qualified benefits, which are any benefits that are not includible in the gross income of the employee by reason of an express provision of law.

· Educational assistance plans are subject to a number of tax status rules for determining exclusion.

CHECKLIST

 

Exclusions from Gross Income

 

Accident and Health Insurance Proceeds

Annuities (amounts contributed by taxpayer)

Awards for Noncompetitive Achievements

Bequests and Devises

Car Pool Receipts

Casualty Insurance Proceeds

Child Support Payments

Cost-of-Living Allowances Paid to U.S. Employees Stationed Outside the U.S.

Damages Received for: Personal Injuries or Sickness

Disability and Death Payments

Dividends on Life Insurance

Educational Assistance Plans

Federal Employees’ Compensation Act Payments

Federal Income Tax Refunds

Fringe Benefits (group plans, premiums paid by employer)

Gains: Sale of Residence (up to $500,000)

Gifts, Bequests, and Inheritances

Group-Term Life Insurance (if coverage is up to $50,000)

Inheritances

Interest on Tax-Free Securities

Lessee’s Improvements

Life Insurance Proceeds

Long-Term Care Insurance

Meals and Lodging (for convenience of employer)

Military Allowances

Old Age, Disability, and Survivor’s Payments (Social Security Actor Railroad Retirement Act)

Payments to Beneficiary of Deceased Employee

Political Campaign Contributions (limited)

Railroad Retirement Act Pensions

Rental Allowance of Clergymen

Scholarships (limited amount)

Social Security Payments (depending on gross income)

Tuition Paid by Employer (job-related only)

Veterans’ Benefits

Workers’ Compensation and Similar Payments

Chapter 6

Deductions: General Concepts and Trade or Business Deductions

OBJECTIVES

After completing  Chapter 6 , you should be able to:

1. Name the four categories of deductions allowable to individual taxpayers: (1) trade or business deductions, (2) production of income deductions, (3) losses, and (4) personal deductions.

2. Identify the types of losses that may be deducted in computing a taxpayer's taxable income.

3. Discuss criteria for determining whether taxpayer expenditures are deductible.

4. Explain common business deductions, such as advertising, salaries and wages, fringe benefits, bad debts, etc.

5. Identify allowable business deductions related to capital expenditures, such as depreciation, amortization, depletion, repairs, and improvements, etc.

6. Understand the restrictions on the deductibility of business start-up costs.

7. Discuss allowable deductions for transportation, travel, business meals, and student loan interest.

OVERVIEW

Deductions allowable to individual taxpayers fall into four categories: trade or business deductions, production of income deductions, losses, and personal deductions. This chapter examines the general concepts of taxation underlying each of these categories of allowable deductions for individuals and includes an introduction to trade or business deductions, including allowable deductions for transportation, travel, and meals.

Section 162 allows as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. Although Code Sec. 162 appears to be all-inclusive in allowing all business expenditures as tax deductions, the requirements for the deductibility of business expenditures place well-defined limitations on business deductions. For this reason, a basic knowledge of allowable business deductions is of value to an informed businessperson.

With some notable exceptions, trade or business deductions are the same for all business taxpayers regardless of whether the business is organized as a corporation, partnership, or sole proprietorship. Although the income tax form used to report deductions is different, the allowable deductions generally are the same. This chapter is concerned mainly with business deductions as they appear on a sole proprietor’s Schedule C, which is filed with the IRS as part of the taxpayer’s individual income tax return.

Categories of Allowable Deductions

¶6001

CLASSIFICATION OF TAX DEDUCTIONS

Generally speaking, four categories of expenses may be deductible by individual taxpayers:

1. Trade or business expenses. Deductions applicable to trade or business (Code Sec. 162).

2. Expenses incurred for the production of income. Deductions related to the production of investment income including those incurred: (1) for the production or collection of income; (2) for the management, conservation, or maintenance of property held for the production of income; and (3) in connection with the determination, collection, or refund of any tax (Code Sec. 212).

3. Deductions for losses. In addition to expenses incurred in trade or business activities, and investment (production of income) activities, taxpayers are allowed to deduct certain losses incurred on the sale or other disposition of property used in a trade or business activity or an investment activity. Losses related to property used for personal purposes are generally not deductible unless incurred in a federally declared disaster area.

4. Personal expenses. Most personal expenses are not deductible. A number of exceptions, however, have been created by Congress over the years allowing taxpayers to claim itemized deductions for a variety of personal expenses. Other personal expenses are allowable as “adjustments” to gross income, which have the same effect as deductions.

¶6101

DEDUCTIONS “FOR” vs. “FROM” AGI

Once the deductibility of an item is established, the tax formula for individuals requires that the deduction be classified as either a deduction for adjusted gross income (AGI) or a deduction from AGI (itemized deduction). In short, the deduction process requires that two questions be asked. First, is the expense deductible? Second, is the deduction for or from adjusted gross income (AGI)?

Classification is significant for several reasons. First, itemized deductions may be deducted only to the extent they exceed the standard deduction. Thus, a taxpayer whose itemized deductions do not exceed the standard deduction receives no tax benefit from his/her itemized deductions. In contrast, deductions for AGI may be claimed in addition to the standard deduction (or itemized deductions if greater).

A second reason for properly classifying deductions concerns the treatment of certain itemized deductions. Medical expenses, for example, are deductible only to the extent they exceed 7.5% of the taxpayer’s adjusted gross income. Charitable contributions are subject to a ceiling, rather than a floor, based on AGI. As discussed in  Chapter 8 , depending on the type of property contributed, the charitable contributions deduction cannot exceed 20, 30, 50, or 60% percent of AGI. Thus, classification of a deduction as “above the line” (i.e., “for” AGI) reduces AGI and may indirectly affect the deductible portion of other expenses which are deducted “below the line” (i.e., “from” AGI).

EXAMPLE 6.1

Jamie Dean owns and operates a small business. During 2020, she paid property taxes of $20,000 and suffered a personal casualty loss of $10,000. The casualty loss was incurred in a federally declared disaster area and was therefore deductible. She also had other itemized deductions in an amount above the standard deduction. Her adjusted gross income, before considering the above expenses, was $90,000. If the property taxes are deductible “from” AGI, she will be allowed to deduct $1,000 of her casualty loss (the amount by which the $10,000 loss exceeds 10% of her AGI). However, if she can deduct the property taxes “above the line” (“for” AGI), her adjusted gross income will be $70,000 and her deductible casualty loss will increase by $2,000 (10% of the $20,000 reduction in AGI) to $3,000. Deducting the property taxes “for” rather than “from” AGI reduced Jamie’s taxable income by $2,000.

Aside from the effect on AGI, taxpayers also have an incentive to classify non-personal expenses as business deductions “for” AGI. If the taxpayer can properly deduct such expenses as business expenses deductible “for” AGI, the full amount of the expense will be deductible. Otherwise the expense may not be deductible at all.

Adjusted gross income for Federal income tax purposes also serves as the tax base or the starting point for computing taxable income for many state income taxes. Several states do not allow the taxpayer to itemize deductions. Consequently, misclassification may also affect the taxpayer’s state income tax liability.

Still another reason for properly classifying expenses concerns the self employment tax. Under the Social Security and Medicare programs, self employed individuals are required to make an annual contribution based on their net earnings from self employment. Net earnings from self employment include gross income from the taxpayer’s trade or business less allowable trade or business deductions attributable to that income. Failure to properly classify a deduction as a deduction for AGI attributable to self employment income will increase the taxpayer’s self-employment tax liability.

¶6115

DEDUCTIONS “FOR” AGI

Code Secs. 62, 162, and 212 govern “above the line” deductions allowable in computing AGI (i.e., deductions “for” AGI). Deductions for AGI are listed in  Table 1 :

Table 1. DEDUCTIONS “FOR” AGI
Trade or business deductions (e.g., expenses of a sole proprietorship or self-employed business person, including farmers, normally reported on Schedules C or F of Form 1040)
Losses from sale or exchange of business or investment property (reported on Schedule D of Form 1040, or on Form 4797)
Deductions attributable to rents or royalties (reported on Schedule E of Form 1040)
Educator expenses for books, supplies, equipment, etc. up to $250
Certain employee business expenses (reported on Form 2106):
	Expenses that are reimbursed by an employee’s employer (and included in the employee’s income);
	Certain business expenses of reservists;
	Expenses incurred by a qualified performing artist
	Expenses incurred by an official of a state or local government who is compensated on a fee basis
Deductions for eligible contributions to Health savings accounts (HSAs)
Moving expenses for certain active duty military employees
Deduction for employer portion (50%) of self employment tax paid by self employed persons
Deductions for contributions to Individual Retirement Accounts, self-employed SEP, SIMPLE or other qualified retirement plans
Deduction for health insurance premiums for eligible self-employed taxpayers
Deductions for penalties imposed for premature withdrawal of funds from a savings account
Alimony payments in connection with pre-2019 divorce decrees
Deduction for qualified payments of student loan interest and qualified tuition and fees paid during the taxable year

As noted in  Table 1 , taxpayers can deduct expenses incurred in operating a business, farm, or rental real estate or who have royalty income “above the line” on Schedules C (Profit or Loss from Business), E (Supplemental Income and Loss), or F (Profit or Loss from Farming). Deductible expenses related to these activities include tax preparation expenses to the extent attributable to preparing the above Schedules to accompany Form 1040. Rev. Rul. 92-29, 1992-1 CB 20. The same holds true for expenses incurred in resolving tax controversies, including expenses relating to IRS audits of business or rental activities. All other tax preparation or related expenses are non-deductible.

¶6125

DEDUCTIONS “FROM” AGI—ITEMIZED DEDUCTIONS

As seen above, relatively few non-business expenses are deductible for AGI. Most personal expenses are not deductible, but those that are must be deducted from AGI as itemized deductions. Most investment expenses, as well as most job-related expenses of employees, in contrast, are generally not deductible.

Trade or Business Deductions

¶6201

OVERVIEW—CODE SEC. 162

Code Sec. 162(a) governs the deductibility of trade or business expenses. The statute reads, in part, as follows:

In General.—There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including—

1. (1) a reasonable allowance for salaries or other compensation for personal services actually rendered;

2. (2) traveling expenses (including amounts expended for meals and lodging other than amounts which are lavish or extravagant under the circumstances) while away from home in the pursuit of a trade or business;

3. (3) rentals or other payments required to be made as a condition to the continued use or possession, for purposes of the trade or business, of property to which the taxpayer has not taken or is not taking title or in which he has no equity.

Although Code Sec. 162(a) specifically enumerates three items that are deductible, the primary importance of the provision in its general rule that all “ordinary and necessary” expenses of carrying on a trade or business are deductible. This is true, with some exceptions, whether the taxpayer is a sole proprietor, a partner in a partnership, or a corporation. The income tax form used to report the deductions is different, but the allowable deductions are generally the same. Common trade or business deductions allowable to a sole proprietor and reported on Schedule C of Form 1040 are listed in  Table 3 .

Table 3. COMMON BUSINESS DEDUCTIONS ALLOWABLE TO SOLE PROPRIETOR—REPORTED ON SCHEDULE C OF FORM 1040 (Subject to various limitations)

Advertising

Bad debts from sales or services

Bank service charges

Car and truck expenses

Commissions

Cost of goods sold

Depletion

Depreciation

Dues and publications

Employee benefit programs

Freight charges

Insurance

Interest on indebtedness

Legal and professional services

License fees

Office expenses

Pension and profit-sharing plans

Rent on business property

Repairs

Supplies

Taxes

Travel and meals (limited)

Utilities and telephone

Wages

¶6205

GENERAL CRITERIA

An examination of the language of Code Sec. 162 indicates that an expenditure must satisfy four criteria to be properly classified as a trade or business expense:

1. It must be related to carrying on a trade or business activity;

2. It must be ordinary and necessary;

3. It must be reasonable; and

4. It must be paid or incurred during the taxable year.

 

If an expenditure satisfies all four of the above requirements it will generally be deductible as a trade or business expense. However, it should be noted that in some cases other provisions in the Code may operate to prohibit or limit a deduction otherwise allowable under Code Sec. 162. For example, an expense may be ordinary, necessary, and related to carrying on a trade or business, but if it is also related to producing tax-exempt income, Code Sec. 265 prohibits a deduction. Similarly, Code Sec. 164 allows a deduction only for state, local and foreign income taxes; federal income taxes are not deductible. These limitations, and others, will be discussed later in this chapter. For now, we turn to a further analysis of the four criteria required by Code Sec. 162.

¶6215

EXPENSE MUST BE INCURRED IN A TRADE OR BUSINESS ACTIVITY

Whether an expense is deductible depends in part on the type of activity in which it was incurred. A deduction is authorized by Code Sec. 162 only if the expenditure is paid or incurred in an activity that constitutes a trade or business. The purpose of this requirement is to deny deductions for expenses incurred in activities that are primarily personal in nature. For example, the costs incurred in pursuing “hobby” activities, such as collecting antiques or racing automobiles, normally would be considered nondeductible personal expenditures. Of course, this assumes that such activities do not constitute a trade or business. (The rules governing the deduction of “hobby” losses are discussed in more detail in  Chapter 7 ).

The Code provides few clues as to when an activity will be considered a trade or business activity rather than a personal activity. Over the years, however, two criteria have emerged from the many court decisions addressing the issue. The first requirement that must be satisfied in order for an activity to be treated as a trade or business activity is a legitimate profit motive. Doggett v. Burrett, 3 USTC ¶1090, 12 AFTR 505, 65 F.2d 192 (CA-D.C., 1933). In other words, for the taxpayer’s expenses to be deductible, they must be motivated by a genuine hope for a profit.

EXAMPLE 6.2

Don Feen is an avid bowler. He is a member of several bowling leagues and often bowls in tournaments. During the past year, he won $1,200 in prize money from his tournament play. He spent $3,500 on travel, bowling supplies and entry fees for tournaments. Although he incurred a net loss of ($2,300) in his bowling activity, he does not mind. He does not bowl with the intent of making a profit. Accordingly, none of his bowling expenses are deductible, although he must report the income of $1,200.

The second requirement imposed by the courts before an activity qualifies as a trade or business activity relates to the level of the taxpayer’s involvement in the activity. Business status requires both a profit motive and a sufficient degree of taxpayer involvement in the activity to distinguish the activity from a passive investment. No clear guidelines have emerged indicating when a taxpayer’s activities rise to the level of carrying on a business. The courts, however, generally have permitted business treatment where the taxpayer has devoted a major portion of time to the activities or the activities have been regular or continuous. Grier v. U.S., 55-1 USTC ¶9184, 46 AFTR 1536, 218 F.2d. 603 (CA-2, 1955).

EXAMPLE 6.3

Charles Green owns multiple rental units, including several condominiums and townhouses. He manages his rental properties entirely by himself. His management activities include seeking new tenants, supplying furnishings, cleaning and preparing the units for occupancy, advertising, and bookkeeping. In this case, Charles’ involvement with the rental activities is sufficiently continuous and systematic to constitute a business. Edwin R. Curphey, 73 TC 766 (1980). If the rental activities were of a more limited nature, they might not qualify as a trade or business. The determination ultimately depends on the facts of the particular situation.

EXAMPLE 6.4

Helen Thompson owns a sizable portfolio of stocks and bonds. Her managerial activities related to these securities consist primarily of maintaining records and collecting dividends and interest. She rarely trades in the market. Her activities are those normally associated with a passive investor, and accordingly would not constitute a trade or business under Code Sec. 162. Higgins v. Comm., 41-1 USTC ¶9233, 25 AFTR 1160, 312 U.S. 212 (UCSC, 1941).

On the other hand, if Helen had a substantial volume of transactions, made personal investigations of the corporations whose stock she was interested in purchasing, and devoted virtually every day to such work, her activities could constitute a trade or business. Samuel B. Levin v. U.S., 79-1 USTC ¶9331, 43 AFTR2d 79-1057, 597 F.2d 760 (Ct. Cls., 1979). Ultimately, whether an activity qualifies as a trade or business depends on the specific circumstances of the taxpayer’s activity.

¶6225

EXPENSE MUST BE ORDINARY AND NECESSARY

The second test for deductibility is whether the expense is ordinary and necessary. An expense is ordinary if it is normally incurred in the type of business in which the taxpayer is involved. Deputy v. DuPont, 40-1 USTC ¶9161, 23 AFTR 808, 308 U.S. 488 (USSC, 1940). This is not to say that the expense is habitual or recurring. Dunn and McCarthy, Inc. v. Comm., 43-2 USTC ¶9688, 31 AFTR 1043, 139 F.2d 242 (CA-2, 1943). In fact, the expense may be incurred only once in the taxpayer’s lifetime and be considered ordinary. The test is whether other taxpayers in similar businesses or income producing activities would customarily incur the same type of expense.

EXAMPLE 6.5

Pete has been in the newspaper business for 35 years. Until this year, his paper had never been sued for libel. However, this year, the paper was sued by a citizen whose alleged crimes were covered in a front-page story. To protect the reputation of the newspaper, Pete incurred substantial legal costs related to the libel suit. Although the paper has never incurred legal expenses of this nature before, the expenses are ordinary since it is common in the newspaper business to incur legal expenses to defend against such charges.

It is interesting to note that the “ordinary” criterion normally becomes an issue in circumstances that are, in fact, unusual. For example, in Goedel, 39 B.T.A. 1 (1939), a stock dealer paid premiums for insurance on the life of the President of the United States, fearing that his death would disrupt the stock market and his business. The Court denied the deduction on the grounds that the payment was not ordinary but unusual or extraordinary.

A deductible expense must be not only ordinary, but also necessary. An expense is necessary if it is appropriate, helpful, or capable of contributing to the taxpayer’s profit seeking activities. The necessary criterion, however, is rarely applied to deny a deduction. The courts have refrained from such a practice since to do so would require overriding the judgment of the taxpayer. The courts apparently feel that it would be unfair to judge currently whether a previous expenditure was necessary at the time it was incurred.

It should be emphasized that not all necessary expenses are ordinary expenses. Some expenses may be appropriate and helpful to the taxpayer’s business but may not be normally incurred in that particular business. In such cases, no deduction is allowed.

EXAMPLE 6.6

James Kincaid was the sole owner of Kincaid Corporation when it went bankrupt three years ago. A number of creditors lost significant amounts of money due to the bankruptcy. This year, James set up a new business and incorporated it as the Second Time Around Corporation. In order to establish good credit, James had the new corporation pay in full all the former creditors of Kincaid Corporation who lost money in the previous bankruptcy. James had no legal obligation to make these payments. The Second Time Around Corporation deducted these payments on its tax return as ordinary and necessary business expenses. James could argue that the payments made to the former creditors of Kincaid Corporation were necessary payments in order to establish credit for the new corporation, but he probably would have difficulty establishing that the payments were ordinary since they were not typical expenditures that would be made by other taxpayers in a similar situation. Example based on facts in Welch v. Helvering, 3 USTC ¶1164, 290 US 111, 54 S.Ct. 8 (1933). However, see Harold L. and Temple M. Jenkins v. Commissioner, 47 TCM 238, TC Memo 1983-667 for a case where the deduction was allowed in similar circumstances. Although the IRS disagreed with this decision, it chose not to appeal (AOD 1984-022, March 23, 1984).

TAX BLUNDER

In  Example 6.6 , James Kincaid made business payments that were, in his opinion, necessary business expenditures. They were not, however, ordinary business expenditures. If James had discussed his plans with a competent tax adviser before making the payments, he may have taken a different course of action.

¶6235

EXPENSE MUST BE REASONABLE

The third requirement for a deduction is that the expense be reasonable in amount. An examination of Code Sec. 162(a) reveals that the term “reasonable” is used only in conjunction with compensation paid for services (e.g., a reasonable allowance for salaries), and in practice the reasonableness standard is most often applied in situations involving salary payments made by a closely held corporation to a shareholder who also is an employee. In these situations, if the compensation paid exceeds that ordinarily paid for similar services—that which is reasonable—the excessive payment may represent a nondeductible dividend distribution. The distinction between reasonable compensation and dividend income is critical because dividends, unlike salaries, are not deductible by the corporation, although both are taxable to the recipient.

EXAMPLE 6.7

Joann Mason is the president and sole owner of Sign Corporation. During the year, Sign Corporation paid Joann a salary of $300,000. Sign Corporation claimed a tax deduction on its tax return for the full salary payment. The Internal Revenue Service (IRS), when auditing Sign Corporation’s tax return, could argue that the salary payment to Joann was unreasonable in amount and that a portion of it should be treated as a disguised dividend. The rationale behind the IRS’s argument is that dividend payments are not an allowable deduction for a corporation. It may be that by paying an unreasonably high salary to Joann, Sign Corporation was attempting to get a tax deduction for a payment which, in effect, was a nondeductible dividend payment. The same logic could also apply to unreasonably large lease payments and rental payments to stockholders in closely held corporations.

The courts have held, however, that reasonableness is implied in the phrase “ordinary and necessary.” Lincoln Electric Co., 49-2 ustc ¶9388, 176 F.2d 815 (CA-6 1949), cert. denied, 338 U.S. 949, 70 S.Ct. 488. Thus, although the reasonableness standard is most frequently applied to issues surrounding taxpayer compensation, it is applicable in determining the deductibility of all types of expenditures.

EXAMPLE 6.8

Larry Gill purchased a race car which he used to advertise his closely held company. In addition to driving and maintaining his own car, he also sponsored another driver. Over a two-year period, his company spent $75,000 maintaining Larry’s race car and $6,000 to sponsor the other driver. The Tax Court ruled that such advertising was ordinary and necessary, but that the amounts expended on his own car were not reasonable – given the relatively small cost of sponsoring another driver, the $65,000 spent on his own car constituted an excessive, and thus unreasonable, expenditure for advertising. The excess of the amounts spent by Mr. Gill’s company on his own car over those spent to sponsor the other driver were reclassified as nondeductible dividends to Mr. Gill. Gill v. IRS, 67 TCM 2311, TC Memo 1994-92, aff’d CA-6, 96-1 USTC ¶50,138.

PLANNING POINTER

In order to lessen the chance of a tax deduction being considered unreasonable by the IRS, the officials of a closely held corporation should substantiate the reasonableness of deductible payments made to owners of the corporation. The reasonableness of an expenditure could be substantiated by documenting similar payments made to shareholder employees by other closely held corporations of comparable size and type. If other comparable businesses are paying similar amounts, the reasonableness of the payments would appear more plausible.

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EXPENSE MUST BE PAID OR INCURRED DURING THE TAXABLE YEAR

Code Secs. 162 and 212 both indicate that an expense is allowable as a deduction only if it is “paid or incurred during the taxable year.” Use of both terms, “paid” and “incurred,” is necessary because the year in which deductions are allowable depends on the method of accounting used by the taxpayer. Code Sec. 461(a). The term paid refers to taxpayers using the cash method of accounting while the term incurred refers to taxpayers using the accrual method of accounting. Accordingly, the year in which a deduction is allowed usually depends on whether the cash or accrual method of accounting is used.

Determining when other expenses, such as taxes and bad debts, are incurred is dependent on the nature of the underlying transaction, and the extent to which the expense may be recoverable.

Accrual Method Taxpayers

An accrual method taxpayer deducts expenses when they are incurred. Code Sec. 461(h) provides that for this purpose, an expense is considered incurred when the all events test is satisfied and economic performance has occurred. Two requirements must be met under the all events test: (1) all events establishing the existence of a liability must have occurred (i.e., the liability is fixed); and (2) the amount of the liability can be determined with reasonable accuracy. Therefore, before the liability may be accrued and deducted it must be fixed and determinable.

EXAMPLE 6.9

In Hughes Properties, Inc., 86-1 USTC ¶9440, 58 AFTR2d 86-5015, 106 S. Ct. 2092 (USSC, 1986), an accrual method corporation owned a gambling casino in Reno, Nevada. The casino operated progressive slot machines that paid a large jackpot about every four months. The increasing amount of the jackpot was maintained and shown by a meter. Under state gaming regulations, the jackpot amount could not be turned back until the amount had been paid to a winner. In addition, the corporation had to maintain a cash reserve sufficient to pay all the guaranteed amounts. At the end of each taxable year, the corporation accrued and deducted the liability for the jackpot as accrued at year end. The IRS challenged the accrual, alleging that the all events test had not been met, and that the amount should be deducted only when paid. It argued that payment of the jackpot was not fixed but contingent, since it was possible that the winning combination may never be pulled. Moreover, the Service pointed out the potential for tax avoidance: the corporation was accruing deductions for payments that may be paid far in the future, and thus—given the time value of money—was overstating the amount of the deduction. The Supreme Court rejected these arguments, stating that the probability of payment was not a remote and speculative possibility. The Court noted that not only was the liability fixed under state law, but it also was not in the interest of the taxpayer to set unreasonably high odds, since customers would refuse to play and would gamble elsewhere.

Cash Method Taxpayers

Determining when a cash method taxpayer has paid an expense is generally not difficult. A cash method taxpayer “pays” the expense when cash, check, property, or service is transferred. Neither a promise to pay nor a note evidencing such a promise is considered payment. Consequently, when a cash method taxpayer buys on credit, no deduction is allowed until the debts are paid. However, if the taxpayer borrows cash and then pays the expense, the expense is deductible when paid. For this reason, a taxpayer who charges expenses to a credit card is deemed to have borrowed cash and made payment when the charge is made. Thus, the deduction is claimed when the charge is actually made and not when the bank makes payment or when the taxpayer pays the bill. Rev. Rul. 78-39, 1978-1 CB 73. When the taxpayer pays by mail, payment is usually considered made when the payment is mailed (i.e., dropped in the post office box). Rev. Rul. 73-99, 1973-1 CB 412.

Restrictions on Use of the Cash Method

A cash method taxpayer generally deducts expenses when paid. Without restrictions, however, aggressive taxpayers could liberally interpret this provision to authorize not only deductions for routine items, but also deductions for capital expenditures and other expenses that benefit future periods (e.g., supplies, prepaid insurance, prepaid rent, and prepaid interest). To preclude such an approach, a number of limitations have been imposed on use of the cash method of accounting.

Provisions of both the Code and the Regulations limit the potential for deducting capital expenditures, prepaid expenses, and the like. For example, Code Sec. 263 provides that no current deduction is allowed for a capital expenditure, such as the costs of purchasing equipment, vehicles, and buildings. These costs must be recovered over the useful life of the acquired property, through the allowance for depreciation.

The Regulations—at least broadly—deal with other expenditures that are not capital expenditures per se but that benefit future periods. According to the Regulations, any expenditure resulting “in the creation of an asset having a useful life which extends substantially beyond the close of the taxable year may not be deductible when made, or may be deductible only in part.” Reg. §1.446-1(a)(1). In this regard, the courts agree that “substantially beyond” means a useful life of more than one year. Martin J. Zaninovich, 69 TC 605, rev’d in 80-1 USTC ¶9342, 45 AFTR2d 80-1442, 616 F.2d 429 (CA-9, 1980). Perhaps the simplest example of this rule as so interpreted concerns payments for supplies. Assuming the supplies would be exhausted before the close of the following tax year, a deduction should be allowable when payment is made. In regard to other prepayments, however, the application of this principle has spawned a hodgepodge of special rules.

Prepaid Rent

The 9th Circuit Court of Appeals’ decision in Zaninovich above held that prepayments for rents or services may be deducted in the year paid when two conditions are present: (1) the period for which the payment is made does not exceed one year following the end of the current tax year, and (2) the taxpayer is contractually obligated to prepay an amount for a period extending beyond the close of the year. Martin J. Zaninovich, supra. If either of these conditions is not satisfied, advanced payment of rent is not deductible until the subsequent year(s).

EXAMPLE 6.10

Rick Hatfield, a farmer, is a cash method calendar-year taxpayer. In 2020, he leased farm land for the twenty-year period December 1, 2020 to November 30, 2040. The lease agreement provides that annual rent for the period December l to November 30 is payable on December 20 each year. The yearly rent is $24,000. On December 20, 2020, Rick paid the $24,000 rental for the next year. The prepayment is deductible because it is for a period not exceeding a year and Rick is obligated to pay for the entire year in advance on December 20. However, if the lease agreement required only monthly rentals of $2,000 each (instead of an annual payment of $24,000), only $2,000 would be deductible (representing the rent allocable to the month of December) because the remainder of the payment was voluntary. Bonaire Development Co., 82-2 USTC ¶9428, 679 F.2d 159 (CA-9, 1983), aff’g, 76 TC 789 (1981).

Prepaid Insurance

Prepayments of insurance premiums normally are not deductible when paid. Instead, the IRS holds that this expense must be prorated over the period actually covered by the insurance policy. Rev. Rul. 70-413, 1970-2 CB 103. However, the “one year” exception noted above with respect to prepaid rent may also apply here.

EXAMPLE 6.11

On December 15, 2020, Thelma purchased an insurance policy covering theft of her inventory. The policy cost $3,000 and covered the period 2021-2023. Thelma may not deduct any portion of the cost of the insurance policy in 2020. The cost will be deductible $1,000 per year in each of the next three years.

Prepaid Interest

Code Sec. 461(g) expressly denies the deduction of prepaid interest. Prepaid interest must be capitalized and deducted ratably over the period of the loan. The same is true for any costs associated with obtaining the loan. The sole exception is for “points” paid for a debt incurred by the taxpayer to purchase his or her principal residence. “Points” are a form of prepaid interest often charged to a borrower by a mortgage lender as a condition of making the loan. For example, a mortgage lender may charge 1.5 “points,” or 1.5 percent of the amount being borrowed, as a fee to grant a mortgage loan. Points paid by a taxpayer to obtain a mortgage to purchase his or her principal residence can be deducted in the year paid. This treatment does not apply to points paid on a loan incurred to refinance the taxpayer’s existing mortgage. The IRS has ruled that points paid on refinancing must be capitalized and amortized over the life of the loan the same as other types of prepaid interest. Rev. Rul. 87-22, 1987-1 CB 146.

EXAMPLE 6.12

Karen applied for a loan for the purchase of a new house priced at $200,000. The bank agreed to extend a loan of 80% of the purchase price, or $160,000 (80% of $200,000) for thirty years at a cost of two points (two percentage “points” of the principal balance of the loan). Thus, she must pay $4,000 (2% of $200,000) to obtain the loan. Assuming it is established business practice in her area to charge points in consideration of the loan, the $4,000 in points (prepaid interest) are deductible in the current year. However, if the house is not Karen’s principal residence, then the points must be deducted ratably (amortized) over the 30 year loan period. Similarly, if the loan had been incurred to refinance the original mortgage on the home, the points would not be currently deductible, but would be amortized over the term of the loan (30 years in this case).

Other Prepayments

Perhaps the Service’s current view of the proper treatment of most prepayments is best captured in a ruling concerning prepayment for animal feed. In this ruling, the taxpayer, a cattle rancher, purchased a substantial amount of feed prior to the year in which it would be used. The purchase was made in advance because the price was low due to a depressed market. The IRS granted a deduction for the prepayment because there was a business purpose for the advanced payment, the payment was not merely a deposit, and it did not materially distort income. Based on this ruling and related cases, prepayments normally should be deductible if the asset will be consumed by the close of the following year, there is a business purpose for the expenditure, and there is no material distortion of income. Rev. Rul. 79-229, 1979-2 CB 210.

Taxes

Most taxes incurred by a trade or business (with the exception of federal income taxes) are deductible as business expenses. Federal income taxes are not deductible on the federal income tax return since the return is being prepared to compute the amount of federal income taxes due.

Payroll taxes paid by an employer are fully deductible, but taxes withheld from employee wages such as federal, state, or local income taxes and F.I.C.A. taxes are not. The latter type of tax expense (withholdings from employees’ wages) is not incurred by the employer, but by the employee. Accordingly, the employer is not allowed a deduction for these expenditures.

Similarly, while property taxes are generally deductible by the taxpayer who pays them, if real property is sold during the year, the property taxes related to the property must be allocated between the buyer and the seller based on the number of days during the tax year that each party held the property. Code Sec. 164(d). The seller is treated as paying the tax up to, but not including, the date of sale. This allocation is required regardless of which party actually pays the property tax and regardless of the method of accounting used by the two parties. The rationale is that the buyer incurs the property tax for the period during which he or she owns the property. To the extent that tax has previously been paid by the seller, a portion of the purchase price paid by the buyer is treated as compensation for the buyer’s share of the previously paid property tax. The seller, having been reimbursed for this portion of the property taxes, is allowed to deduct only the portion attributable to the period during which he or she owned the property, and the buyer deducts the rest.

EXAMPLE 6.13

On October 1, Joe purchased a tract of land from Kelly for $138,000. Kelly had previously paid annual property taxes on the land in the amount of $8,030. Assuming a 365 day year, Joe has owned the land for 92 days (Oct. 1 through Dec. 31), and Kelly for 273 days. Thus, $2,024 of the property tax for the year of the sale is allocable to Joe (92 days/365 days). Joe, not Kelly, will be allowed to claim a deduction for this portion of the annual property taxes, and the deemed selling price of the land will be $135,976 ($138,000 - $2,024). Note that while Kelly will be allowed to deduct only $6,006 of the property taxes paid during the year (the part deemed to be “incurred” by her), she will also be deemed to have sold the land for only $135,976 (rather than the $138,000 actual selling price), reducing any gain she may recognize on the sale by an amount equal to the foregone property tax deduction.

Bad Debts

The determination of whether a bad debt loss has been incurred can be difficult. Several issues must be considered. First, the taxpayer must be able to establish that an actual debt existed. This is generally rather easy for business debts, but can be quite difficult for debts between family members, friends, or other related parties. If the nature of the underlying transaction is not a valid debt – for example, if the taxpayer did not really intend to collect the debt, or if collection was to occur only in the event that the borrower was able to repay the loan, the transaction will be recharacterized as a gift rather than a loan and no deduction will be allowed.

The second issue to be considered is the amount of the loss, if any, actually incurred. Generally speaking, the amount of a bad debt deduction is limited to the adjusted basis of the debt in the hands of the taxpayer. This creates an issue for businesses with accounts receivable generated from the sale of goods or services. For a business taxpayer using the cash method of accounting, receivables are generally not recognized for tax purposes because income is recorded only when cash is collected. Since the income from the receivables has yet to be realized, no loss is incurred in the event the receivables are not collected. Stated in accounting terms, the receivables have no adjusted basis; as a result, income is recognized when the receivables are collected. If they are not collected, neither income nor loss is recognized.

EXAMPLE 6.14

On September 16, 2020, Roscoe Accounting Services, a cash method taxpayer, sold $300 of accounting services to Ron on credit. In October, Ron declared bankruptcy and did not pay any of the $300 debt to Roscoe. Since Roscoe uses the cash method of accounting, income is not recognized for tax purposes until cash is collected and, therefore, its accounts receivable have a zero basis. Roscoe is not entitled to a bad debt deduction for the $300 bad account receivable since the receivable has a zero basis for tax purposes.

Finally, assuming the taxpayer has a tax basis in a valid debt, the taxpayer must be able to establish that the debt is not collectible. A business bad debt deduction can be taken by proving only partial worthlessness of a business debt but full worthlessness of a personal must be proven in order to claim a nonbusiness bad debt deduction. Worthlessness of a debt is established by reviewing the facts existing in each case. Reg. §1.166-2(b). The debtor’s bankruptcy, death of the debtor, or unsuccessful court action against the debtor to collect the debt may be indications of the worthlessness of a debt. A taxpayer does not necessarily have to take legal action against a debtor to prove worthlessness of a debt. The facts may suggest that legal action would not have resulted in recovery of any of the debt.

Business Bad Debts

The deductibility of a bad debt further depends on the character of the underlying debt. Generally speaking, business bad debts are deductible by the taxpayer from gross income as an ordinary business expense in the year they become either partially or wholly worthless. (If the debt is not wholly worthless, only the amount not expected to be collected can be deducted.) Non-business bad debts, in contrast, can be deducted for tax purposes only if the debt is completely worthless. Moreover, worthlessness of a nonbusiness bad debt is always treated as a short-term capital loss and is subject to the $3,000 limitation applicable to the deduction for net capital losses (discussed in greater detail in  Chapter 12 ). Code Sec. 166(d)(1)(B).

In contrast, when a taxpayer can demonstrate that a business debt has become wholly or partially worthless, the taxpayer can claim a deduction from gross income (i.e., a deduction “for” AGI) for the full amount not expected to be collected. A business debt is a debt (1) created or acquired in connection with the taxpayer’s trade or business, or (2) the worthlessness of which has been incurred in the taxpayer’s trade or business. Reg. §1.166-5(b). Amounts advanced to a corporation in exchange for a bond, debenture, note or other evidence of indebtedness are investments, rather than business debts. Accordingly, the partial or total worthlessness of such investments is not deductible as a business bad debt (although it may be deductible as a nonbusiness bad debt). Similarly, amounts advanced to a corporation by a shareholder to be used by the corporation to pay its debts are not business loans, regardless of how they are structured.

EXAMPLE 6.15

Susan owes $1,000 to the Sioto Lumber Company, an accrual method taxpayer, for lumber purchased from the company. Sioto Lumber Co. estimates that it will eventually collect from Susan only $300 of the $1,000 debt. Since the debt to Sioto is a business debt, Sioto is entitled to a $700 bad debt deduction this year for partial worthlessness of the business debt.

A cash method taxpayer can deduct a business bad debt only if an actual cash loss has been sustained or if the amount to be deducted was previously included in income. Nearly all accrual method taxpayers must use the specific charge-off method to deduct business bad debts; the reserve method for computing and deducting bad debts may be used only by small banks and thrift institutions. Under the specific charge-off method, when a specific debt, or portion thereof, becomes worthless, it is written off as an ordinary deduction for tax purposes.

Since the tax treatment accorded business bad debts and nonbusiness bad debts differs, the taxpayer must show that the dominant motivation in making the loan was business related in order to obtain the more favorable tax treatment. Specific charge-off is based on actual worthlessness and is not applicable merely because the taxpayer gives up attempts to collect. A worthless debt arising from unpaid rent, interest, or a similar item is not deductible unless the income that such item represents has been reported for income tax purposes by a taxpayer using the accrual method of accounting.

Nonbusiness Bad Debts

Nonbusiness bad debts are debts that are not created or acquired in connection with a trade or business. Loans to relatives and friends are the most common type of nonbusiness debt. Nonbusiness bad debts can be deducted for tax purposes only if full worthlessness of the debt has been determined and then only by the specific charge-off method. The deduction is allowed in the year when full worthlessness takes place, regardless of how old the debt is. In contrast to a business bad debt which is deductible as an ordinary loss in the year incurred, a nonbusiness bad debt deduction is always treated as a short-term capital loss and is subject to the $3,000 limitation applicable to the deduction for capital losses (discussed in greater detail in  Chapter 12 ). Code Sec. 166(d)(1)(B).

EXAMPLE 6.16

Clara owes $1,000 to Mike on a personal loan. Mike estimates that he will only collect $300 of his $1,000 loan to Clara. Mike is not entitled to a $700 bad debt deduction at this time since total worthlessness must be proven before a bad debt deduction can be taken for a nonbusiness bad debt. If Clara paid $300 to Mike and the remaining $700 of debt is subsequently determined to be worthless, a $700 nonbusiness bad debt deduction can then be claimed by Mike since total worthlessness of the remaining debt has been established.

Expenses Incurred for the Production of Income

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CODE SEC. 212—PRODUCTION OF INCOME OR PROTECTION OF ASSETS

In 1942, Congress enacted Code Sec. 212 allowing for the deduction of expenses related to the “production or collection of income.” The purpose of the statute is to allow deductions for expenses incurred in profit-seeking activities even if they did not rise to the level of a trade or business. Code Sec. 212 essentially allows taxpayers to deduct expenses incurred in investment activities as well as business activities. Under Sec. 212, the question of deductibility (assuming the other requirements discussed above are met) is effectively reduced to a single important question: Is the expense related to an activity engaged in for profit?

Prior to the Tax Cuts and Jobs Act (2017), production of income expenses were deductible if they were incurred:

1. For the production or collection of income;

2. For the management, conservation, or maintenance of property held for the production of income; or

3. In connection with the determination, collection, or refund of any tax.

 

Generally speaking, expenses related to the production of income consist primarily of those expenses incurred in rental and investment activities as well as tax planning and compliance expenses. Following passage of the Tax Cuts and Jobs Act 2017 (TCJA), expenses associated with rent or royalty income are the only investment expenses that are deductible by individuals and these must be deducted “above the line” (on Schedule E). The deduction for other investment expenses has been suspended until 2025.

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TAX PLANNING AND COMPLIANCE EXPENSES

Expenses incurred by individual taxpayers in connection with the determination, collection, or refund of any tax were previously deductible under Code Sec. 212 as nonbusiness expenses. Under the TCJA, however the deductions for miscellaneous ‘itemized’ deductions were suspended for the period 2018-2025. Accordingly these expenses are no longer deductible unless they are related to a taxpayer’s trade or business activities. For businesses, the cost of having a tax return prepared by a CPA or tax service is deductible as are fees paid for tax planning advice, or for contesting a tax liability in court.

Deductions for Losses

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CODE SEC. 165

Code Sec. 165 establishes the general framework governing the deductibility of losses. This statute permits a deduction for the following categories of losses so long as they are not compensated for by insurance or otherwise (for example by settlement of a lawsuit):

1. Losses incurred in a trade or business (deductible without limitation);

2. Losses incurred in transactions entered into for profit, though not connected with a trade or business (deductible as capital losses); and

3. Losses of property not connected with a trade or business if such losses are incurred in a federally declared disaster area (deductible as itemized deductions, subject to certain limitations discussed in  Chapter 8 ).

Losses cannot be deducted unless attributable to a closed and completed transaction. Mere declines in value or other unrealized losses cannot be deducted. Normally, for the loss to qualify as a deduction, the property must be sold, abandoned, or scrapped. In some cases, (e.g., stock in a bankrupt company), a taxpayer may not be able to sell property because it has become completely worthless. In such cases, if the taxpayer can demonstrate the worthlessness of the property, a deduction will be allowed for the loss. The amount of the loss for tax purposes cannot exceed the taxpayer’s basis in the property.

Note that personal losses—other than those attributable to a federally declared disaster—are not deductible. For example, a loss incurred on the sale of a personal residence is not deductible.

EXAMPLE 6.17

Janet owns 100 shares of Clinton Corporation stock which she purchased on January 4, 2020, for $84 per share. On December 31, 2020, Clinton Corporation stock was selling at $52 per share. Janet cannot deduct the $32 per share decline in value on her 2020 tax return since it is an unrealized loss. Janet would have to sell her stock before year end in order to recognize a loss for tax purposes.

Examples of losses that can be deducted by individual taxpayers are listed in  Table 4 . Tax losses are discussed in greater detail in  Chapter 7 .

Table 4. LOSSES DEDUCTIBLE ON AN INDIVIDUAL’S TAX RETURN (SUBJECT TO VARIOUS LIMITATIONS)

Losses deductible for AGI

Business net operating loss carryforward

Business or investment-related casualty or theft loss

Loss on sale or exchange of business property

Loss on sale or exchange of investment property

Worthless securities

Losses deductible from AGI

Gambling losses but only to extent of gambling winnings

Personal casualty losses attributable to presidentially declared disaster events

Other Allowable Deductions “For” AGI

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BUSINESS INVESTIGATION START-UP AND ORGANIZATIONAL COSTS

Business investigation expenses are costs incurred in seeking and reviewing prospective businesses prior to reaching a decision to acquire or enter any business. For example, expenses incurred to analyze potential markets, products, the availability of workers, transportation facilities, etc. before entering into a new business would constitute business investigation expenses. Once the taxpayer has decided to enter the new business, additional costs may be incurred for pre-opening advertising, employee training, lining up distributors, suppliers, or potential customers, legal and accounting fees, etc. These expenses, incurred after the decision to acquire a business, but before such business actually begins operations, are called “start-up” expenses.

For many years, the deductibility of business investigation and start-up expenses depended on whether the taxpayer was “carrying on” a business at the time the expenditures were incurred: a taxpayer investigating or starting new operations in his or her current business, investigation and start up costs are wholly deductible in the year paid or incurred. The Colorado Springs National Bank v. U.S., 74-2 USTC ¶9809, 34 AFTR2d 74-6166, 505 F.2d 1185 (CA-10, 1974). The deduction is allowed whether or not the taxpayer ultimately decides to expand his/her business. York v. Comm., 58-2 USTC ¶9952, 2 AFTR2d 6178, 261 F.2d 421 (CA-4, 1958).

EXAMPLE 6.18

Selma owns and operates an ice cream shop on the north side of the city. A new shopping mall is opening on the south side of the city, and the developers have approached her about locating a second ice cream shop in their mall. Last year, Selma paid a consulting firm $1,000 for a survey of the potential market on the south side. Because Selma was in the ice cream business when the expense was incurred, the entire $1,000 is deductible whether or not she decides to open a second ice cream shop in the southside mall.

This rule often forced taxpayers to litigate to determine whether a business existed at the time they incurred investigation and/or start-up expenses. If the taxpayer could not establish the existence of a business, the expenditures normally were treated as capital expenditures with indeterminable lives. Morton Frank, 20 TC 511 (1953). As a result, the taxpayer could only recover the expenditure if and when he or she disposed of or abandoned the business.

Code Sec. 195, implemented in 1980, eliminated this problem, allowing taxpayers to elect to deduct up to $5,000 of start-up expenditures in the tax year in which their trade or business begins. The $5,000 amount must be reduced by the amount by which the start-up expenditures exceed $50,000. The remainder of any start-up expenditures must be amortized over a 180-month period beginning with the month in which the active trade or business begins. It is important to recognize that Code Sec. 195 is elective. Expenses for research and development, interest payments, and taxes are not considered start up expenditures. Code Sec. 195(c)(1). Consequently, these costs are not subject to Code Sec. 195 and may be deducted under normal rules.

EXAMPLE 6.19

Jerry, a calendar year, cash method taxpayer, recently graduated with a degree in restaurant, hotel and institutional management. Jerry paid an accountant $1,200 in September to review the financial situation of a small restaurant he was thinking of buying. In December, Jerry purchased the restaurant and began actively participating in its management. Jerry may deduct the full $1,200 accountant’s fee on his tax return for the current year as a start-up expenditure.

EXAMPLE 6.20

Until February, Carlos Aguirre worked for a home builder in Ohio. In March, he left his job and started his own construction company. While his new offices were under construction, he set up shop in a trailer on the construction site. He hired two outside sales representatives who began establishing their customer networks, and an architect to work in the design phase of the business. He paid a printer to print brochures for the new company, and began advertising in local media. All told, he spent $45,000 on these items before the new company opened its doors to the public. Under Code Sec. 195, he can deduct the first $5,000 of these expenses, and must amortize the remaining $40,000 over 180 months beginning in the first month the company begins doing business. Assume the company began actual business operations in July. Carlos’ deduction for start-up expenses in its first year of operations will be $6,333, consisting of the $5,000 first-year deduction plus $222.22 per month ($40,000 ÷ 180 months) for 6 months (July—December). Note that if Carlos had spent $52,000 in start-up expenses, rather than $45,000, the amount deductible in the current year would have been only $3,000 plus $272.22 ($49,000 ÷ 180 months) per month for 6 months. The $5,000 first year deduction would be reduced by the excess of total start-up expenses incurred over $50,000.

As suggested above, the taxpayer must enter the business to qualify for amortization. No deduction is allowed for costs incurred to investigate a new business that the taxpayer decides not to pursue.

Similar rules apply to “organizational” expenses incurred in forming a new corporation [Code Sec. 248] or partnership [Code Sec. 709(b)]. The first $5,000 of such expenses may be deducted on the corporation’s or partnership’s first tax return, with any amounts in excess of $5,000 amortized over 180 months. As with start-up expenses, the $5,000 deduction is reduced (but not below zero) by the amount by which total organizational expenditures exceed $50,000. Organizational expenditures include expenditures for legal and accounting services, filing fees paid to the state for legal recognition of the new entity, expenditures on directors’ fees paid to temporary directors, and expenditures on organizational meetings of directors, shareholders or partners.

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BUSINESS GIFTS

Code Sec. 274(b) allows a deduction for business gifts in amounts up to $25 per recipient per year. The expenses are deductible “for” AGI as business expenses for self-employed taxpayers. A business gift normally does not have to be included in the gross income of the recipient. The following items are specifically excluded from the definition of business gifts:

1. Items costing $4 or less which have the name of the taxpayer permanently imprinted on them

2. Signs, display racks, and other promotional materials to be used on the business premises of the recipient; and

3. Tangible personal property awarded to an employee by reason of length of service or safety achievement that does not exceed $400 in value (nonqualified plans) or $1,600 in value if awarded according to a qualified plan award where the average award does not exceed $400.

EXAMPLE 6.21

During the current year, the salesperson for ABC Vending Co. gave the owner of Video Games Co. a total of five bottles of high-quality wine as business gifts at various times during the year. The five bottles of wine were purchased by ABC Vending Co. for a total of $150. Since all the wine was given to the same recipient, ABC Vending Co. is entitled to a maximum deduction of $25 for the business gifts. The remaining $125 cost of the gifts is not deductible for tax purposes. Note that had the five bottles of wine been given to five different customers, ABC could have deducted $125 for the gifts ($25 times five customers).

¶6535

TRANSPORTATION EXPENSES

Transportation expenses are defined for tax purposes as the costs of transporting a taxpayer from one location to another when the taxpayer is not travelling away from home overnight for business. Reg. §1.62-1(g). Transportation expenses include air fares, taxi fares, automobile expenses, parking fees, turnpike tolls, etc.

Transportation expenses of a self-employed taxpayer are deductible for AGI as trade or business expenses. Commuting expenses associated with travel from home to work and back have generally been held to be nondeductible expenses. The length of commute is considered a matter of personal preference and therefore irrelevant for tax purposes.

EXAMPLE 6.22

Jason Rinaldo owns two retail stores in in neighboring cities. He manages the day-to-day operations of both stores on a daily basis. The closest store to his home is 10 miles. His commute from home to that store and back is not deductible. However, travel between the two stores is a business expense. Assume that, on average, he travels 80 miles a day driving from home to one store and traveling between stores. Since his commute from home to the closest store is 10 miles, one-fourth (20 commuting miles divided by 80 total miles) of his travel expenses are not deductible as a business expense.

Computing Automobile Expenses

Automobile expenses are deductible as transportation expenses if incurred in connection with a trade or business. Two methods are available for computing automobile expenses: the taxpayer can keep records of the actual operating costs of the automobile, including an allowance for depreciation, or, in certain instances, can deduct a standard mileage rate.

If the taxpayer uses the actual operating cost method of determining deductible automobile expenses, records must be kept of the actual costs of operation of the automobile, which include gas, oil, repairs, insurance, depreciation, licenses, and other costs. The taxpayer deducts the portion of these expenses that applies to the business use of the automobile.

The other method for calculating automobile expenses is the standard mileage rate method. Under this method, the taxpayer keeps track of the number of miles driven in the car in connection with his or her business activities and claims a standard cost per mile. For 2020, the standard mileage rate is 57.5 cents per mile. Parking fees, tolls, and state and local property taxes paid on the automobile can be deducted in addition to the standard mileage rate. However, other actual expenses (gasoline, repairs, depreciation, etc.) cannot. In lieu of depreciation, taxpayers using the standard mileage rate must reduce the tax basis of the automobile by 27 cents per business mile. Notice 2020-05, January 1, 2020.

Note that the standard mileage rate cannot be used if the taxpayer has previously used the actual expense method and claimed a depreciation deduction in excess of straight line in the first year the automobile was used for business. The reverse is not true, however; a taxpayer opting to use the standard mileage method in the first year the auto is used for business may change to the actual operating costs method in a subsequent year.

PLANNING POINTER

The actual cost method of calculating automobile expenses will usually result in a larger deduction for tax purposes than the standard mileage rate method. The disadvantage of the actual cost method as compared to the standard mileage rate method is the additional recordkeeping requirements that are required.

¶6545

TRAVEL EXPENSES

Code Section 162(a)(2) allows a deduction for all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including travel expenses incurred while the taxpayer is away from home overnight. Travel expenses consist of the costs of transportation (airfare, taxi fare, etc.), amounts spent for meals and lodging other than amounts which are lavish or extravagant under the circumstances, and other incidental expenses such as laundry and dry cleaning expenses. Self-employed taxpayers deduct travel expenses for AGI as trade or business expenses. No deduction is currently allowed for employees.

To be deductible, travel expenses must be incurred while the taxpayer is “away from home” overnight. Overnight does not mean a full 24-hour period, but a period substantially longer than a normal work day where it is reasonable to need sleep or rest to meet normal job requirements. Rev. Rul. 75-168, 1975-1 CB 58.

EXAMPLE 6.23

Linda James, a CPA, drives from Columbus, Ohio to Cincinnati, Ohio, a distance of 100 miles, on Thursday night in order to attend a business meeting in Cincinnati on Friday morning at 9 a.m. The meeting ends at 11 a.m. and Linda drives back to Columbus. Linda can deduct the travel expenses related to her trip even though it did not cover a 24-hour period.

The travel deduction is available for taxpayers who incur expenses to engage in business at locations distant from the taxpayer’s “tax home.” For this purpose, however, a taxpayer’s tax home is deemed to be located at the location of the taxpayer’s “principal place of business.” If a taxpayer chooses to live in an area other than where he or she works, that choice is deemed to be a personal preference not mandated by business considerations. In such cases, no deduction is allowed for costs incurred in travel between the taxpayer’s residence and his or her principal place of business.

Questions regarding the location of a taxpayer’s “home” for tax purposes often arise in two situations. The first is when a taxpayer works in more than one location. In such cases, the IRS considers the following three factors in determining which of the taxpayer’s multiple work locations is his or her “principal” place of business: (1) length of time spent at each location; (2) degree of business activity at each location; and (3) amount of income derived from each location. The more important location when measured against these three criteria is the taxpayer’s principal place of business. No deduction is allowable for travel to that location.

EXAMPLE 6.24

Larry Robinson, a single taxpayer, works as a CPA in Cleveland, Ohio, from June through October each year and works as a CPA in Miami, Florida, from November through May. Larry makes approximately $120,000 from his work in Cleveland and approximately $135,000 from his work in Miami. Which area is Larry’s tax home, Cleveland or Miami? Consideration of the length of time spent at each location indicates Miami as the tax home (seven months versus five months). Amount of income derived from each location also indicates Miami as the tax home ($135,000 versus $120,000). Since Miami is Larry’s tax home, living costs in the Miami area are not deductible on Larry’s tax return. Travel expenses incurred when traveling to and from and working in Cleveland are deductible as temporary living expenses. Another factor to consider in this case is that the IRS might argue that Larry has two tax homes, Cleveland and Miami. This position can be refuted, however, if Larry can demonstrate that his living expenses in Cleveland duplicate some of the living expenses he incurs in Miami. Apartment or motel expenses incurred in Cleveland if Larry also maintains an apartment in Miami are duplicate living expenses.

Questions also arise when the taxpayer’s business requires that he or she work in a distant location for a lengthy period of time. A deduction for travel expenses, including duplicate living expenses (lodging, utilities, food, etc.) is available where the work away from the taxpayer’s home is temporary—i.e., where it is not indefinite (i.e., unknown) and it does not last for more than one year. Even if the taxpayer does not incur duplicate living expenses, he or she may take a business deduction for daily transportation expenses paid or incurred in traveling between the taxpayer’s residence and a temporary work location, regardless of the distance traveled. Rev. Rul. 90-23, 1990-1 CB 28. Because the alternative work location is temporary, travel between the taxpayer’s home and that location is not treated as a commuting expense, which is ordinarily nondeductible. Note that this deduction is not currently allowed for employees, only for taxpayers conducting their own trade or business activities.

Where the assignment is not temporary, however, no deduction for travel from the taxpayer’s residence to his or her work location is allowed. If the assignment is indefinite, or lasts more than one year, the assigned location becomes the taxpayer’s principal place of business. A taxpayer cannot deduct the cost of meals and lodging while performing duties at a principal place of business, even though the taxpayer maintains a permanent residence elsewhere. Congress did not intend to allow as a business expense those outlays that are not caused by the exigencies of the business but by the action of the taxpayer in having a home, for the taxpayer’s convenience, at a distance from the business. Such expenditures are not essential for the conduct of the business and were not within the contemplation of Congress, which proceeded on the assumption that a person engaged in business would live within reasonable proximity of the business. Barnhill v. Commissioner, 148 F.2d 913 (4th Cir. 1945), 1945 CB 96; Commissioner v. Stidger, 386 U.S. 237 (1967), 1967-1 CB 32.

Combining Business and Personal Travel

Travel expenses are deductible for tax purposes if a taxpayer is away from home in pursuit of a trade or business including employment activities and attending a convention. A person may, however, combine personal activities such as sightseeing with a business trip. If the primary purpose of the trip is business, travel expenses including all transportation expenses are deductible as business expenses even though some time is spent on personal activities. Any direct costs associated with the personal activity, however, are not deductible. If the primary purpose of the trip is personal, travel expenses are not deductible even though some business activities are conducted during the trip. Direct costs of any business activity conducted on a personal trip such as renting a car to attend a business meeting are deductible by the taxpayer. Costs associated with taking a spouse along on a business trip are not deductible unless it can be shown that the presence of the spouse had a business purpose. Reg. §1.162-2(c).

More restrictive travel requirements apply to travel outside of the United States. Travel expenses, including transportation expenses incurred on foreign trips, must be allocated between business and personal activities unless travel outside of the United States does not exceed seven days or time attributable to personal activities is less than 25 percent of the total travel time. Code Sec. 274(c). Additional travel restrictions apply to attendance at foreign conventions and attendance at business meetings on cruise ships. Code Sec. 274(h).

Substantiation of Travel Expenses

Taxpayers must substantiate expenditures for travel and transportation expenses by adequate records or by sufficient evidence corroborating the taxpayer’s statements as to (1) amount, (2) time and place, (3) business purpose, and (4) business relationship to the taxpayer. Taxpayers must have documentary evidence for any lodging expense while traveling away from home and for any other expenditure of $75 or more, except transportation charges, if documentary evidence is not readily available.

¶6570

STUDENT LOAN INTEREST

Interest payments on student loans are deductible “above-the-line.” That means that a taxpayer can deduct the interest whether or not he or she itemizes deductions. Eligible taxpayers may deduct up to $2,500 of interest expense on a qualified education loan under Code Sec. 221. The deduction is phased out for single taxpayers with adjusted gross income between $70,000 and $85,000 and for joint filers with adjusted gross income between $140,000 and $170,000. Married taxpayers filing separately may not take the deduction. Also, an individual is not entitled to the deduction if the taxpayer can be claimed as a dependent by another taxpayer for the tax year beginning in the calendar year in which the individual’s tax year begins.

EXAMPLE 6.25

In 2020, Jamie paid $1,800 interest on a qualified education loan. Her modified AGI (AGI before subtracting deductions for education expenses, domestic production activities, and the foreign earned income exclusion) was $76,000. Jamie is single, so her deduction for qualified student loan interest is phased out by the ratio of her excess AGI ($6,000), divided by $15,000 (the difference between $70,000 and $85,000). In this case, her deduction for student loan interest is reduced by 40% ($6,000/$15,000). Note that unlike other phase-out provisions of the Code, the phase-out rules for student loan interest apply to the deduction itself, rather than to the limitation on that deduction. Jamie would have been entitled to an $1,800 deduction (the lesser of the interest actually paid or $2,500). Reducing this deduction by 40%, she will be allowed a deduction of $1,080 (60% times $1,800).

To be eligible for the deduction the education loan must be used to pay for any of the following expenses: tuition, fees, room and board, books and supplies, or other related expenses.

¶6575

HEALTH INSURANCE AND HEALTH SAVINGS ACCOUNTS

The tax law has long allowed employers to treat costs incurred for employee health insurance as a fringe benefit, deductible by the employer but not taxable to the employee. This beneficial treatment of employer health insurance plans is designed to make health insurance affordable and to increase the portion of the population that is covered by health insurance. To equalize the tax treatment of self-employed taxpayers and employees, Code Sec. 162(l)(6) allows self-employed taxpayers to deduct premiums paid for health insurance above the line, as a deduction in computing AGI. For those taxpayers who are not self-employed, health insurance premiums are deductible as part of the itemized deduction for medical expenses, discussed in  chapter 8 .

The Internal Revenue Code also provides incentives for taxpayers to self-insure. To this end, Code Sec. 223 allows taxpayers who are covered by so-called “high deductible” plans to establish a “Health Savings Account” (HSA). HSAs, similar to IRAs, allow taxpayers to make tax-deductible contributions to an account which will be allowed to accumulate tax-free and fund future medical expenses of the taxpayer and/or dependents. The account is designed for taxpayers who are covered only by “high-deductible” health insurance plans. The premiums on high-deductible insurance plans are much lower than for more standard insurance coverage. Eligible taxpayers (or their employers) can use the difference to fund their HSAs. These plans provide particular advantages for those taxpayers who do not expect to use the full amount in the account for medical expenses since the unspent balance remaining in the account belongs to the taxpayer.

Health insurance plans typically require the insured to pay for a portion of the cost of his or her medical care (the “deductible” amount), with the insurance company paying for costs in excess of this amount. As the name implies, a “high deductible” plan is one where these “deductible” amounts are high relative to more standard insurance plans. Note that the term “deductible” in this context refers not to the tax treatment of the insurance premiums, but to the amount of medical expenses that will not be covered by insurance (i.e., that will be “deducted” from the insurance reimbursement).

Self-employed taxpayers can claim a deduction “for” AGI for HSA contributions up to $7,100 for 2020. Rev. Proc. 2019-25, IRB 2019-22, May 28, 2019. The contribution limit is $3,550 if the taxpayer has “self-only” coverage as opposed to family coverage. Individuals who have reached the age of 55 may contribute an additional $1,000 beyond these limits each year. Taxpayers working for small employers (typically under 50 employees) may exclude a like amount of employer contributions to their HSAs as nontaxable fringe benefits. A “high deductible plan” for purposes of HSA eligibility is a plan with an annual deductible of at least $1,400 for self-only coverage or $2,800 for family coverage, and which limits the taxpayer’s annual “out-of-pocket expenses” (deductibles, co-payments, but not premiums) to no more than $6,900 for self-only coverage or $13,800 for family coverage. Taxpayers whose health insurance plans do not meet these requirements may not make contributions to an HSA, nor can taxpayers who are eligible for Medicare. Likewise, taxpayers who do not have health insurance may not make contributions to an HSA.

HSA distributions are tax-free to the extent used to pay qualified medical expenses of the taxpayer or his or her dependents. Distributions for non-medical purposes are fully taxable. Moreover, in addition to the income tax, taxable distributions are also subject to a 10% penalty unless made after the beneficiary reaches the age of 65, dies, or becomes disabled. Medical expenses paid with HSA distributions cannot be deducted by the taxpayer. Note that one benefit of HSA accounts is that they can serve double duty as retirement accounts: distributions received after the taxpayer reaches age 65 are taxable, but are not subject to the 10% penalty.

Limitations on the Deductibility of Expenses

¶6701

CERTAIN DEDUCTIONS LIMITED OR DISALLOWED

Some provisions of the Code specifically prohibit or limit the deduction of certain expenses and losses despite their apparent relationship to the taxpayer’s business or profit seeking activities. These provisions operate to disallow or limit the deduction for various expenses unless such expenses are specifically authorized by the Code. As a practical matter, these provisions have been enacted to prohibit abuses identified in specific areas. Several of the more fundamental limitations are considered below.

¶6715

BUSINESS INTEREST EXPENSE

Under new limitations implemented by the Tax Cuts and Jobs Act of 2017, the deduction for business interest expense is limited to 30 percent of the taxpayer’s “adjusted taxable income” for the taxable year, plus the amount of any business interest income reported by the taxpayer for the year. The limitation for automobile dealers is further increased by the amount of interest expense paid on debt used to acquire the dealership’s inventory (Floor Plan Financing).

The primary component of the interest expense limitation is 30 percent of adjusted taxable income. For this purpose, adjusted taxable income is defined as taxable income computed without regard to:

1. (1) any item of income, gain, deduction, or loss which is not properly allocable to a trade or business;

2. (2) any business interest expense or business interest income;

3. (3) the amount of any net operating loss deduction; and

4. (4) any deduction allowable for depreciation, amortization, or depletion.

5. (5) Section 199A deduction.

Note that the limitation on the deductibility of business interest expense does not apply if average annual gross receipts for the three taxable years ending with the prior taxable year do not exceed $26 million. Thus, the limitation will apply primarily to large taxpayers.

EXAMPLE 6.26

Aiden, Inc. operates a large real estate development company. For 2020, the company had income and expenses as follows:

Gross rents	$28,000,000
Operating expenses (utilities, maintenance, wages, etc.)	(14,000,000)
Interest expense	(7,400,000)
Depreciation	(2,850,000)
Total before taxes	$ 3,750,000

Assume that Aiden’s average gross receipts for the prior three years exceeded $26 million. The company’s adjusted taxable income is computed without regard to its business interest expense deduction, and without regard to depreciation. Thus, its adjusted taxable income will equal $14,000,000, and its allowable deduction for interest expense will be limited to $4,200,000 (30% × $14,000,000).

Carryforward of Disallowed Interest

Any business interest expense not allowed as a deduction for any taxable year may be carried forward indefinitely. In carryforward years, business interest will be deductible on a first-in, first-out basis. This means that interest carried forward from a prior year will be deductible before interest actually paid in the carryforward year.

EXAMPLE 6.27

Spartan Corp’s 2020 business interest expenses exceeded its limitation by $3,000,000. For 2021, the company reported the following items of income and expense:

Gross receipts	$38,000,000
Operating expenses (utilities, maintenance, wages, etc.)	(14,000,000)
Interest expense	(7,400,000)
Depreciation	(2,850,000)
Total before taxes	$13,750,000

Spartan’s 2021 adjusted taxable income was $24,000,000, and its business interest expense limitation was equal to 30% of this amount, or $7,200,000. Its total business interest expense was $10,400,000 (current year interest expense of $7,400,000, plus $3,000,000 carried forward from 2020). It will be able to deduct $7,200,000, and will carry $3,200,000 forward to 2022. The entire carryforward will be deemed to come from 2021 because the carryforward from 2020 is deducted before the interest expense paid in 2021.

¶6725

HOBBY EXPENSES AND LOSSES

A taxpayer must establish that he or she pursues an activity with the objective of making a profit before any related expense is deductible as a business expense. When the profit motive is absent, the deduction is governed by Although Sec. 183 limits the deductibility of expenses associated with so-called hobby activities to the revenues (if any) generated therefrom, those expenses which would otherwise be allowed are classified as miscellaneous itemized deductions. The Tax Cuts & Jobs Act of 2017 suspended the deductibility of miscellaneous itemized deductions until 2026. Thus, no deduction is allowed for any expenses incurred from the conduct of activities deemed by the IRS to constitute “hobbies,” where the taxpayer lacks a genuine intent to make a profit. The factors considered by the IRS and the courts in determining whether a taxpayer’s activities rise to the level of a trade or business rather than a hobby are explained further in  Chapter 7 .

¶6735

PERSONAL DEDUCTIONS

Personal, living, and family expenses are not deductible on a tax return unless expressly permitted. Code Sec. 262.  Table 6  summarizes the general types of personal expenses and how they are treated for tax purposes.

Although many personal expenditures are not deductible for tax purposes, there is some logic and rationale behind allowing a deduction or credit for certain personal expenditures on an individual’s tax return. Some personal deductions are allowed as tax deductions because they are involuntary payments which place a burden on the taxpayer’s finances and inhibit the ability to pay income taxes. Deductions allowed for medical and dental expenses, and certain casualty losses fall into this category. Other personal deductions and credits are allowed in order to encourage certain types of behavior on the part of taxpayers. For example, the allowance of a charitable deduction for tax purposes encourages the giving of gifts to charity and thereby promotes the public good. The deduction for state and local income taxes lessens to some degree the problems associated with double and triple taxation of the same income.

Table 6. TYPICAL PERSONAL EXPENDITURES DEDUCTIBLE OR NOT DEDUCTIBLE ON TAX RETURN (SUBJECT TO VARIOUS LIMITATIONS)
Expenditures deductible for AGI
Alimony paid in connection with divorce before 2019	Interest paid on qualified education loans
Individual retirement accounts (IRAs) (limited)	Penalty on early withdrawal of savings
	Jury duty fees paid to employer
Expenditures deductible from AGI (itemized deductions)
Charitable contributions	Medical and dental expenses
Gambling losses (to extent of gambling winnings)
Interest expense (limited)	State and local taxes up to $10,000
Expenditures eligible for tax credit
Adoption expenses	Tuition, books and other course expenses
Child and disabled dependent care expenses
Expenditures not deductible
Commuting expenses	Household living expenses
Depreciation on property held for personal use	Life insurance premiums
Funeral expenses	Political contributions
Losses on sales of property held for personal purposes (e.g., house, car, etc.)	Employee business expense

The disallowance of personal expenditures by Code Sec. 262 complements the general criteria allowing a deduction. Recall that the general rules of Code Secs. 162 and 212 permit deductions for ordinary and necessary expenses incurred in a profit seeking activity. Where the taxpayer’s motive is personal, rather than for profit, no deduction is allowed. Some of the items specifically disallowed by Code Sec. 262 are summarized in the last section of  Table 6 .

EXAMPLE 6.28

Gary is the president of a local bank. Last year, he was charged with driving while intoxicated. He hired a good lawyer at a cost of several thousand dollars, and the charges were dropped. Gary may well have lost his job at the local bank had the charges been made public. He certainly would have lost his job had he been convicted. Nonetheless, his legal fees are not deductible since the underlying cause of his legal difficulties was personal and not related to his trade or business of working at the bank.

 

PLANNING POINTER

Tax work performed for a business by a CPA and legal work performed by an attorney may be of importance to the business and, at the same time, be of personal significance to the owner of the business. To the extent possible, fees associated with the business portion of a professional service should be kept separate from the personal portion of a professional service on any billing prepared by a professional person rendering a professional service. Documentation of the business portion of a professional service versus the personal portion may be beneficial in substantiating a business tax deduction for professional services.

¶6745

PUBLIC POLICY RESTRICTIONS

Although an expense may be entirely appropriate and helpful, and may contribute to the taxpayer’s profit seeking activities, it is not deductible if the allowance of a deduction would frustrate well-defined public policy. The courts established this longstanding rule on the theory that to allow a deduction for expenses such as fines and penalties would encourage violations by diluting the cost of the penalty. Hoover Motor Express Co., Inc. v. U.S., 58-1 USTC ¶9367, 1 AFTR2d 1157, 356 U.S. 38 (USSC, 1958). Historically, however, the IRS and the courts were free to restrict deductions of any type of expense where, in their view, it appeared that the expenses were contrary to public policy—even if the policy had not been clearly enunciated by some governmental body. As a result, taxpayers were often forced to go to court to determine if their expenditures violated public policy.

Recognizing the difficulties in applying the public policy doctrine, Congress amended Code Sec. 162, adding provisions which are specifically designed to limit its use. The rules identify and disallow a deduction for specific types of expenditures considered contrary to public policy. Specifically, Code Sec. 162(f) disallows deductions for fines, penalties, and illegal payments.

Fines and Penalties

Under Code Sec. 162(f), no deduction is allowed for any fine or similar penalty paid to a government for the violation of any law.

EXAMPLE 6.29

Taylor is a sales representative for an office supply company. While calling on customers this year, she received parking tickets totaling $100. No deduction is allowed for payment of these tickets because the violations were against the law.

EXAMPLE 6.30

Upon audit of Murray’s tax return, the IRS determined that he neglected to report $10,000 of tip income from his job as a waiter, resulting in additional tax of $3,000. Murray was also assessed a negligence penalty on his tax return for intentional disregard of the rules. The penalty—20% of the tax due—is not deductible.

Under Code Sec. 162(g), the term “fines” includes any amounts paid in settlement of the taxpayer’s actual or potential liability for a fine, penalty, or related charge. For example, if a company agrees to pay a settlement to the government in order to avoid being fined or penalized, the settlement is treated as a nondeductible fine or penalty for tax purposes. This is true even if the company admits no wrongdoing. Note, however, that while payments in settlement of potential fines or penalties are not deductible, payments incurred to remedy the underlying problem that resulted in the dispute are deductible. Reg. §1.162-21(c) Example (3). For example, if a company is fined $100,000 and ordered to clean up a site following an environmental accident, the costs of cleaning up the site are deductible, while the $100,000 fine is not.

Similarly, no deduction is allowed for two thirds of treble damage payments made due to a violation of antitrust laws. Reg. §1.162-21(b). Thus, only one third of damages paid for violation of government antitrust provisions is deductible; the remaining two-thirds is treated as a fine or penalty for which no deduction is allowed.

Illegal Kickbacks, Bribes, and Other Payments

Code Sec. 162(c) also disallows any deduction for four categories of illegal payments:

1. Kickbacks or bribes to U.S. government officials and employees if illegal;

2. Payments to governmental officials or employees of foreign countries if such payments would be considered illegal under the U.S. Foreign Corrupt Practices Act;

3. Kickbacks, bribes, or other illegal payments to any other person if illegal under generally enforced U.S. or state laws that provide a criminal penalty or loss of license or privilege to engage in business; and

4. Kickbacks, rebates, and bribes, although legal, made by any provider of items or services under Medicare and Medicaid programs.

Kickbacks or bribes not described above will be deductible if the taxpayer can demonstrate that they are ordinary and necessary.

EXAMPLE 6.31

Randy travels all over the world, looking for unique items for his gift shop. Occasionally when going through customs in foreign countries, he is forced to “bribe” the customs official to do the necessary paperwork and get him through customs as quickly as possible. These so-called grease payments to employees of foreign countries are deductible unless they violate the Foreign Corrupt Practices Act. In general, such payments are not considered to be illegal.

Expenses of Illegal Business

Expenses incurred in conducting an illegal business are generally deductible. Max Cohen v. Comm., 49-2 USTC ¶9358, 176 F.2d 394 (CA-10, 1949) and Neil Sullivan v. Comm., 58-1 USTC ¶9368, AFTR2d 1158, 356 U.S. 27 (USSC, 1958). Similar to the principle governing taxation of income from whatever source derived, the law imposes income tax on all income earned without regard for the lawfulness of the activity from which the income is generated. To accurately measure that income, deductions are generally allowed. No deduction is allowed, however, if the expense itself constitutes an illegal payment (e.g., bribery of governmental officials). In addition, Code Sec. 280E creates another significant exception to this policy, prohibiting the deduction of any expenses related to trafficking in controlled substances (i.e., drugs).

EXAMPLE 6.32

In a 2007 Tax Court case (Californians Helping to Alleviate Medical Problems, Inc. v. Commissioner, 128 TC 173, No. 14, May 15, 2007), the IRS challenged the deductions claimed by a corporation in connection with its activity of purchasing medical marijuana and distributing it to its members suffering from AIDS and other debilitating diseases. The corporation in question was formed to provide caregiving services to its members, who paid a membership fee to join the organization. A secondary purpose was to provide its members with medical marijuana and to instruct them on how to use medical marijuana to benefit their health. Members were prohibited from reselling marijuana obtained from the corporation, and violation of this prohibition resulted in expulsion of the member from the group.

The IRS initially disallowed any deduction for expenses incurred by the organization, including those incurred in purchasing the medical marijuana distributed to its members. The Service argued that such expenses were not deductible under Code Sec. 280E, as the corporation was engaged in the activity of trafficking in a controlled substance. The Service subsequently acknowledged that the company’s cost of goods sold (i.e., the cost of purchasing the marijuana) was deductible, leaving as the sole issue before the court the question of whether the company’s other expenses were deductible. The state of California had legalized the use of marijuana for medical purposes in 1996; such use, however, remained illegal under federal law. The court ruled that Code Sec. 280E did apply to expenses incurred in the distribution of marijuana to the corporation’s members, but not to expenses incurred in performing the company’s other caregiving services. An allocation of expenses between these two activities was required, and only those expenses allocable to the distribution of medical marijuana were disallowed. See also Olive v. Commissioner, 139 TC 2, August 2, 2012. Note that in 2018, the Tax Court disallowed a deduction for a portion of cost of goods sold in addition to operating expenses incurred by a California marijuana dispensary. Patients Mutual Assistance Collective Corp, 151 TC No. 11, November 29, 2018.

Note that because the distribution, sale or consumption of marijuana is illegal under federal law, these expenses remain nondeductible even in states that have legalized marijuana. The denial of deductions for operating expenses applies only to drug trafficking—as noted above, expenses in other illegal activities are fully deductible.

¶6755

LOBBYING AND POLITICAL CONTRIBUTIONS

Although expenses for lobbying and political contributions may be closely related to the taxpayer’s business, Congress has traditionally limited their deduction. These restrictions usually are supported on the grounds that it is not in the public’s best interest for government to subsidize efforts to influence legislative matters.

Lobbying

Expenses incurred to influence local, national or state legislation (including the costs of hiring lobbyists to represent the taxpayer in these matters) are not deductible. This prohibition is extended to the costs of any direct communication with executive branch officials in an attempt to influence official actions or positions of such official. A de minimis exception allows taxpayers with $2,000 or less of in-house expenditures to claim a deduction.

Likewise, no deduction is allowed for any expenditure incurred to influence the general public on legislative matters, elections, or referendums, whether the issue is a local, state, or national issue. Code Sec. 162(e)(2). The Internal Revenue Service has suggested the following examples of nondeductible lobbying activities aimed at influencing the public:

1. Advertising in magazines and newspapers concerning legislation of direct interest to the taxpayer. Rev. Rul. 78-112, 1978-1 CB 42. This prohibition presumably extends to radio and television as well. However, expenses for “goodwill” advertising presenting views on economic, financial, social, or similar subjects of a general nature, or encouraging behavior such as contributing to the Red Cross, are deductible. Reg. §1.162-20(a)(2).

2. Preparing and distributing to a corporation’s shareholders pamphlets focusing on certain legislation affecting the corporation and urging the shareholders to contact their representatives in Congress. Rev. Rul. 74-407, 1974-2 CB 45, as amplified by Rev. Rul. 78-111, 1978-1 CB 41.

EXAMPLE 6.33

Wanda owns a restaurant in Austin, Texas. Legislation has been introduced by the City Council to impose a sales tax on food and drink sold in Austin, to be used for funding a dome stadium. Wanda placed an ad in the local newspaper stating reasons why the legislation should not be passed. She testified in front of the City Council on the proposed legislation on several occasions. She also paid dues to the Austin Association of Restaurant Owners organization, which estimates that 60% of its activities were devoted to lobbying for local legislation related to restaurant owners. Although Wanda’s expenditures were all motivated by a desire to protect her restaurant profits, they are all non-deductible.

Political Contributions

No deduction is permitted for any contributions, gifts, or any other amounts paid to a political party, action committee, or group or candidate related to a candidate’s campaign. Code Sec. 162(e). This rule also applies to indirect payments, such as payments for advertising in a convention program and admission to a dinner, hall, or similar affair where any of the proceeds benefit a political party or candidate. Code Sec. 276.

¶6765

MEALS AND ENTERTAINMENT EXPENSES

Entertainment Expenses

Under prior law, taxpayers were generally allowed to deduct certain entertainment expenses if such expenses were directly related to or associated with a taxpayer’s business. For example, the cost of taking a potential client to a sports event would generally have been deductible. The Tax Cuts and Jobs Act repealed this deduction. Under the act, no deduction is allowed for expenditures related to the following:

1. (1) an activity generally considered to be entertainment, amusement or recreation,

2. (2) membership dues with respect to any club organized for business, pleasure, recreation or other social purposes,

3. (3) a de minimis fringe that is primarily personal in nature and involving property or services that are not directly related to the taxpayer’s trade or business,

4. (4) a facility or portion thereof used in connection with any of the above items,

5. (5) a qualified transportation fringe, including costs of operating a facility used for qualified parking, and

6. (6) an on-premises athletic facility provided by an employer to its employees, including costs of operating such a facility.

Meals

Unlike entertainment expenses, taxpayers are allowed a partial deduction for business meals. In general, 50 percent of the amount paid for food and beverages is deductible if those expenditures are business related. For example, reimbursements paid to employees for meal expenses incurred while traveling for business are deductible. More importantly, although entertainment expenses are not deductible, half of the expenses incurred to pay for meals with customers or potential customers are deductible as ordinary and necessary business expenses. Meal expenses include the cost of food and beverages as noted above, plus amounts paid for taxes and tips. To be deductible, meal expenses must satisfy the following criteria:

1. (1) the expense is an ordinary and necessary business expense,

2. (2) the expense is not lavish or extravagant under the circumstances,

3. (3) the taxpayer, or an employee of the taxpayer, is present during the meal,

4. (4) the meal is provided to a current or potential business customer, client, consultant or similar business contact, and

5. (5) for meals furnished during an entertainment activity, the meals must be purchased separately from the cost of the entertainment. Notice 2018-76, IRB 2018-47, October 3, 2018.

 

EXAMPLE 6.34

Linda James, an insurance agent, takes Paul Mason, president of Mason Furniture Co., to dinner in order to discuss new types of insurance coverage. Linda pays $200 for dinner, including drinks, sales tax, and tip. Linda can deduct half of this amount ($100) as a business expense. If, after the dinner, Linda takes Paul to see a professional baseball game and pays for the tickets, no portion of that cost will be deductible, regardless of the amount of business conducted during the game.

¶6775

EXPENSES AND INTEREST RELATING TO TAX-EXEMPT INCOME

Code Sec. 265 sets forth several rules generally disallowing deductions for expenses relating to tax exempt income. These provisions prohibit taxpayers from taking advantage of the tax law to secure a double tax benefit: tax exempt income and deductions for the expenses that help to produce it. The best-known rule prohibits the deduction for any interest expense or non-business expense related to tax exempt interest income. Code Sec. 265(2). Without this rule, taxpayers in high tax brackets could borrow at a higher rate of interest than could be earned and still have a profit on the transaction.

EXAMPLE 6.35

Carla, an investor in the 28% tax bracket with substantial investment income, borrows funds at 9% and invests them in tax exempt bonds yielding 7%. If the interest expense were deductible, the after-tax cost of borrowing would be 6.48% [(100% - 28% = 72%) × 9%]. Since the interest income is nontaxable, the after-tax yield on the bond remains 7%, or .52 percentage points higher than the effective cost of borrowing. Code Sec. 265, however, denies the deduction for the interest expense, thus eliminating the feasibility of this arrangement. It should be noted, however, that business expenses other than interest expense related to tax exempt interest income may be deductible.

If the income that is exempt is not interest, none of the related expenses are deductible. Code Sec. 265(1).

EXAMPLE 6.36

Eduardo operates a minor league baseball team. The team paid premiums for disability insurance under which the company would receive proceeds under the policy in the event a player is injured. Proceeds received under a disability policy are not taxable. Accordingly, the premiums on the policy are not deductible even though the policy is presumably an ordinary and necessary business expense. Rev. Rul. 66-262, 1966-2 CB 105.

Similar to the insurance premiums in the example above, Code Sec. 264 provides that no deduction is allowed for life insurance premiums paid on policies covering the life of any officer, employee, or any other person who may have a financial interest in the taxpayer’s trade or business, if the taxpayer is the beneficiary of the policy. Like the disability insurance proceeds in the preceding example, life insurance proceeds are excludible from the recipient’s taxable income. Thus, premiums paid by a business on a key-person life insurance policy where the company is the beneficiary are not deductible. In contrast, payments made by a business on group-term life insurance policies where the employees are the beneficiaries are deductible.

¶6785

RELATED PARTY TRANSACTIONS

Without restrictions, related taxpayers (such as husbands and wives, shareholders and their corporations, etc.) could arrange transactions creating deductions for expenses and losses that do not actually affect their economic position. For example, a husband and wife could create a deduction simply by having one spouse sell property to the other at a loss. In this case, the loss is artificial because the property remains within the family and their financial situation is unaffected. Although the form of ownership has been altered, there is no substance to the transaction. To guard against the potential abuses inherent in transactions between related taxpayers, Congress designed specific safeguards contained in Code Sec. 267.

Related Taxpayers

The transactions that are subject to restriction are only those between persons who are considered “related” as defined in Code Sec. 267(b). The following taxpayers are deemed to be related for purposes of Code Sec. 267:

1. The following family members – brothers and sisters (including half-blood), spouses, ancestors (i.e., parents and grandparents), and lineal descendants (i.e., children and grandchildren);

2. An individual and a corporation if the individual owns, either directly or indirectly, more than 50 percent of the corporation’s stock;

3. An individual and a partnership in which the partner owns more than a 50% interest;

4. A personal service corporation and an employee owner (whether or not he or she owns more than 50% of the corporation’s stock): a personal service corporation is a corporation whose principal activity is the performance of personal services that are performed by the employee owners;

5. Certain other relationships involving regular corporations, S corporations, partnerships, estates, trusts, and individuals.

Disallowed Losses

The taxpayer is not allowed to deduct any loss realized on a sale or exchange of property directly or indirectly to a related taxpayer (as defined above). However, any loss disallowed on the sale may be used to offset gain (if any) realized on the subsequent sale of the property by the related taxpayer to an unrelated third party.

EXAMPLE 6.37

A father owns land that he purchased as an investment for $20,000. He sells the land to his daughter for $15,000, producing a $5,000 loss. The $5,000 loss is not deductible by the father because the transaction is between related taxpayers. Assume, however, that the daughter later sells the property for $22,000. She realizes a $7,000 gain ($22,000 sales price - $15,000 basis). She is allowed to deduct the $5,000 loss previously disallowed to her father, so that she recognizes a gain of only $2,000 ($7,000 realized gain - $5,000 previously disallowed loss).

EXAMPLE 6.38

Assume the same facts as in the previous example, except that the daughter sold the property for only $19,000, rather than $22,000. In this case, she realizes a gain on the sale of $4,000 ($19,000 - $15,000). Again, she is allowed to offset this gain with the disallowed loss previously realized by her father. This reduces her taxable gain to zero. Note, however, that the $5,000 disallowed loss is used only to the extent of the daughter’s $4,000 gain. The remaining portion of the disallowed loss ($1,000) cannot be deducted.

EXAMPLE 6.39

Susan owns 100% of Equinox Corporation. She sells Equinox stock with a basis of $100,000 to her good friend Teri for $75,000, generating a $25,000 loss for Susan. Teri, in turn, sells the stock to Equinox Corporation for $75,000, thus recouping the amount she paid Susan with no gain or loss. In effect, this transaction is between Susan and her wholly owned corporation —the sale to the corporation is indirect, passing through her friend Teri. Consequently, Susan will not be allowed to deduct her $25,000 loss on the sale.

Unpaid Expenses and Interest

Prior to enactment of Code Sec. 267, another tax avoidance device used by related taxpayers involved the use of different accounting methods by each taxpayer. In the typical scheme, a taxpayer’s corporation would adopt the accrual method of accounting while the taxpayer reported on the cash method. The taxpayer could lend money, lease property, provide services, etc., to the corporation and charge the corporation for whatever was provided. As an accrual method taxpayer, the corporation would accrue the expense and create a deduction. The cash method individual, however, would report no income until the corporation’s payment of the expense was actually received. As a result, the corporation could accrue large deductions without actually making a disbursement and, moreover, without the taxpayer recognizing any offsetting income. The Code now prohibits this practice between “related taxpayers” as defined above. Code Sec. 267(a)(2) provides that an accrual method taxpayer can deduct an accrued expense payable to a related cash method taxpayer only in the period in which the payment is included in the recipient’s income. This rule effectively places all accrual method taxpayers on the cash method of accounting for purposes of deducting such expenses.

EXAMPLE 6.40

Barry owns 100% of X Corporation, which manufactures electric razors. Barry uses the cash method of accounting while the corporation uses the accrual method. Both are calendar year taxpayers. On December 27, the corporation accrues a $10,000 bonus for Barry. However, due to insufficient cash flow, X Corporation is not able to pay the bonus until January 10 of the subsequent year. The corporation may not deduct the accrued bonus this year, but must wait until next year when Barry includes the payment in his income.

EXAMPLE 6.41

Assume the same facts as above, except that X is a personal services corporation (e.g., a medical practice) in which Barry owns only 20% of the outstanding stock. The results are the same as above because Barry and X are still related parties: a personal service corporation and an employee owner.

¶6795

PAYMENT OF ANOTHER TAXPAYER’S OBLIGATION

As a general rule, a taxpayer is not permitted to deduct the payment of expenses incurred by another taxpayer. A deduction is allowed only for those expenditures satisfying the taxpayer’s own obligations or arising from such obligations.

EXAMPLE 6.42

Quentin lost his job several weeks ago. This month, he received a bill from the state for property tax on his farm. Since he did not have the money to pay the taxes, his daughter, Emily, paid them. Although Emily paid the property taxes, she will not be allowed a deduction because the property taxes were the obligation of her father.

PLANNING POINTER

Note that while Emily cannot deduct the property taxes paid on her father’s behalf in the above example, if her father itemizes deductions, he may be able to claim the deduction. In a 2010 Memorandum Decision, the Tax Court applied the “substance–over–form” doctrine to allow a taxpayer to claim itemized deductions for medical expenses and taxes paid by her mother on her behalf. The court ruled that although the taxpayer’s mother paid the expenses directly, in substance she should be treated as having transferred the funds to the taxpayer, who then transferred them to the creditors. The court noted that there was no risk of double deductions because the mother did not claim and was not entitled to either deduction. The taxpayer, who was treated as having paid the expenses with money received from her mother, was entitled to claim the deductions. Lang, TC Memo. 2010-286.

 

EXAMPLE 6.43

Percy is the majority stockholder of Rancid Corporation. During the year, the corporation had financial difficulty and was unable to make an interest payment on an outstanding debt. To protect the goodwill of the corporation, Percy paid the interest. The payment is not deductible, and Percy will be treated as having made a contribution to the corporation in the amount of the payment.

The above exception to the general rule denying a deduction for the payment of another taxpayer’s obligation is codified in the Internal Revenue Code with respect to payment of medical expenses of a dependent. To qualify as a dependent for this purpose, the person needs only to meet the relationship, support, and citizen tests. Code Sec. 213(a)(1). If the taxpayer pays the medical expenses of a person who qualifies as a dependent under the modified tests, the expenses are treated as if they were the taxpayer’s expenses and are deductible subject to limitations applicable to the taxpayer.

¶6800

CAPITAL EXPENDITURES

A capital expenditure is ordinarily defined as an expenditure providing benefits that extend beyond the close of the taxable year. It is a well-established rule in case law that a business expense, though ordinary and necessary, is not deductible in the year paid or incurred if it can be considered a capital expenditure. Normally, a capital expenditure may be deducted ratably over the period for which it provides benefits. For example, the Code authorizes deductions for depreciation or cost recovery, amortization, and depletion where the asset has a determinable useful life. Code Secs. 167, 168, 169, 178, 185, 188, and 611.

Capital expenditures creating assets that do not have a determinable life, however, generally cannot be depreciated, amortized or otherwise deducted. For example, land is considered as having an indeterminable life and thus cannot be depreciated or amortized. The same is true for stocks and bonds. Expenditures for these types of assets are recovered (i.e., deducted) only when there is a disposition of the asset through sale, exchange, abandonment, or other disposition. At that point, the cost of the asset can be offset against the amount realized (if any).

As a general rule, assets with a useful life of one year or less need not be capitalized. For example, taxpayers can write off short lived assets with small costs such as supplies (e.g., stationery, pens, pencils, calculators), books (e.g., the Internal Revenue Code), and small tools (e.g., screwdrivers, rakes, and shovels).

Capital Expenditures vs. Repairs

The general rule of case law disallowing deductions for capital expenditures has been codified for expenditures relating to property. Code Sec. 263 provides that deductions are not allowed for any expenditure for new buildings or for permanent improvements or betterments made to increase the value of property. Additionally, expenditures substantially prolonging the property’s useful life, adapting the property to a new or different use, or materially adding to the value of the property are not deductible. Reg. §1.263(a)-1(b). Conversely, the cost of incidental repairs that do not materially increase the value of the property nor appreciably prolong its life, but maintain it in a normal operating state, may be deducted in the current year. Reg. §1.162-4. For example, costs of painting, inside and outside, and papering are usually considered repairs. Louis Allen, 2 BTA 1313 (1925). However, if the painting is done in conjunction with a general reconditioning or overhaul of the property, it is treated as a capital expenditure. Joseph M. Jones, 57-1 USTC ¶9517, 50 AFTR 2040, 242 F.2d 616 (CA-5, 1957).

EXAMPLE 6.44

Lois operates her own limousine business. Expenses for a tune up such as the cost of spark plugs and labor would be deductible as routine repairs and maintenance since such costs do not significantly prolong the car’s life. In contrast, if Lois had the transmission replaced, allowing her to drive the limousine for another few years, the cost must be capitalized.

Acquisition Costs

As a general rule, costs related to the acquisition of property must be capitalized. For example, freight paid to acquire new equipment or commissions paid to acquire land must be capitalized. In addition, Code Sec. 164 requires that state and local general sales taxes related to the purchase of property must be capitalized. The costs of demolition or removal of an old building prior to using the land in another fashion must be capitalized as part of the cost of the land. Code Sec. 280B. Costs of defending or perfecting the title to property, such as legal fees, are normally capitalized. Reg. §1.263(a)-2. Similarly, legal fees incurred for the recovery of property must be capitalized unless the recovered property is investment property or money that must be included in income if received. Reg. §1.212-1(k).

Business Deductions Related to Capital Expenditures

A capital expenditure for tax purposes is an expenditure which is expected to benefit more than one tax year. Generally, capital expenditures do not qualify as tax deductions in the year the expenditures are made but must be allocated to the tax years which will receive some benefit from the expenditures. This process of allocating the cost of a capital expenditure to various tax periods is called depreciation, amortization, or depletion depending on the type of capital expenditure involved in the allocation process. The term “depreciation” is usually connected with tangible (physical presence) property, “amortization” with intangible (no physical presence) property, and “depletion” with natural resources.

¶6801

DEPRECIATION OF TANGIBLE PROPERTY

Depreciation is the process of allocating the cost of a tangible asset to expense over its estimated useful life. To be depreciable, tangible property must have a limited life. Tangible property can be divided into two parts: real property and personal property. Real property is land, land improvements, buildings, and building improvements. Land does not have a limited life; therefore, it does not qualify for depreciation. Personal property is usually business machinery and equipment and office furniture and fixtures. The term “personal property” should not be confused with property owned by an individual for personal use.

A tax deduction for depreciation of the cost of tangible property has been allowed for tax purposes since the inception of the federal income tax in 1913. In 1981, the tax depreciation system was dramatically changed and simplified by adoption of the Accelerated Cost Recovery System (ACRS).

Accelerated Cost Recovery System (ACRS)

ACRS applies to most tangible property, new or used, placed in service for business or investment purposes after 1980 and before 1987. Property which is not eligible for ACRS includes property placed in service before 1981, property depreciated using a method not expressed in terms of years (units of production method), property which is amortized, and certain public utility property. Code Sec. 168(e). ACRS was substantially modified by the Tax Reform Act of 1986. Thus, most tangible property placed in service after 1986 must now be depreciated under the Modified Accelerated Cost Recovery System (MACRS).

Modified Accelerated Cost Recovery System (MACRS)

MACRS applies to most tangible property, new or used, placed in service for business or investment purposes after 1986. The general MACRS rules classify property based on class life for purposes of determining the applicable depreciation method, the applicable recovery period, and applicable convention. Absent an election out of MACRS, the IRS-established class lives must be used to determine the applicable MACRS recovery period even when the taxpayer may prefer a longer period. Rev. Proc. 87-56, 1987-2 CB 674, clarified and modified by Rev. Proc. 88-22, 1988-1 CB 785; IRS Letter Ruling 9015014, January 9, 1990. Salvage value is disregarded in computing the MACRS deduction. Asset recovery classifications are provided by statute. Code Sec. 168(c).

1. 3-year property. This class includes over-the-road tractor units, dies, molds, and small tools.

2. 5-year property. This class includes autos, light-duty trucks, computers, and office equipment, such as typewriters, or calculators.

3. 7-year property. This class includes most manufacturing equipment, furniture, and fixtures.

4. 10-year property. This class includes mainly public utility property.

5. 15-year property. This class includes public utility personal property.

6. 20-year property. This class includes public utility personal property.

7. 27.5-year property. This class includes residential rental property.

8. 39-year property. This class includes nonresidential real property, such as office buildings, hotels, shopping centers, warehouses, and manufacturing facilities.

9. 50-year property. Railroad gradings or tunnel bores.

MACRS also specifies the standard cost recovery method for each of the above asset classes. The cost of property in the 3-, 5-, 7-, and 10-year classes is recovered using the 200 percent declining-balance method of depreciation. Fifteen- and 20-year assets are depreciated using the 150 percent declining-balance depreciation method. The cost of 27.5-year and 39-year real property assets is recovered using the straight-line depreciation method. For all asset classes, the cost of the property or unadjusted basis is not reduced by salvage value in making the depreciation computation. When the declining-balance method is used, a switch to the straight-line method is allowed at the appropriate time to maximize the tax deduction.

Instead of computing MACRS depreciation in the above manner, optional MACRS depreciation tables are available for taxpayer use. These tables contain annual percentage depreciation rates which can be applied to the unadjusted basis of property in each tax year. An example of a MACRS depreciation table for 3-, 5-, 7-, 10-, 15-, and 20-year life property is shown in  Table 7 .

Averaging Conventions for Depreciation

Under MACRS, a half-year averaging convention applies to personal property. Under this convention, property placed in service or disposed of during a taxable year is considered placed in service or disposed of at the midpoint of that year.  Table 7  uses the half-year convention. A mid-quarter convention applies when more than 40 percent of the cost of all personal property is placed in service during the last quarter of the taxable year. Under the mid-quarter convention, personal property is treated as placed in service (or disposed of) in the middle of the quarter in which it was actually placed in service. An example of a MACRS depreciation table for 5-year and 7-year property under the mid-quarter convention is shown in  Table 8 . In determining whether 40 percent of the aggregate basis of MACRS property is placed in service during the last three months of a tax year, property placed in service and disposed of within the same tax year is disregarded. Code Sec. 168(d)(3). For real property, both residential and nonresidential, depreciation is based on the number of months the property is in service during the taxable year with a midmonth convention applying in the first month of service and in the last month of service. The averaging convention that is used in the year when property is placed in service must also be used in the year when the property is disposed of.

Table 7. MACRS DEPRECIATION TABLE
General Depreciation System
Applicable Depreciation Method: 200 or 150 Percent
Declining Balance Switching to Straight Line
Applicable Recovery Periods: 3, 5, 7, 10, 15, 20 years
Applicable Convention: Half-year
	and the Recovery Period is:
	3-year	5-year	7-year	10-year	15-year	20-year
If the Recovery Year is:	the Depreciation Rate is:
1	33.33	20.00	14.29	10.00	5.00	3.750
2	44.45	32.00	24.49	18.00	9.50	7.219
3	14.81	19.20	17.49	14.40	8.55	6.677
4	7.41	11.52	12.49	11.52	7.70	6.177
5		11.52	8.93	9.22	6.93	5.713
6		5.76	8.92	7.37	6.23	5.285
7			8.93	6.55	5.90	4.888
8			4.46	6.55	5.90	4.522
9				6.56	5.91	4.462
10				6.55	5.90	4.461
11				3.28	5.91	4.462
12					5.90	4.461
13					5.91	4.462
14					5.90	4.461
15					5.91	4.462
16					2.95	4.461
17						4.462
18						4.461
19						4.462
20						4.461
21						2.231
Source: Rev. Proc. 87-57, 1987-2 CB 117,  Table 1 .
Table 8. MACRS 5-YEAR AND 7-YEAR RECOVERY RATES (Mid-Quarter Convention)
	Placed in Service During:
	1st Quarter	2nd Quarter	3rd Quarter	4th Quarter
Year	5-Year	7-Year	5-Year	7-Year	5-Year	7-Year	5-Year	7-Year
1	35.00%	25.00%	25.00%	17.85%	15.00%	10.71%	5.00%	3.57%
2	26.00	21.43	30.00	23.47	34.00	25.51	38.00	27.55
3	15.60	15.31	18.00	16.76	20.40	18.22	22.80	19.68
4	11.01	10.93	11.37	11.97	12.24	13.02	13.68	14.06
5	11.01	8.75	11.37	8.87	11.30	9.30	10.94	10.04
6	1.38	8.74	4.26	8.87	7.06	8.85	9.58	8.73
7		8.75		8.87		8.86		8.73
8		1.09		3.34		5.53		7.64

EXAMPLE 6.45

In 2020, Max Book Company, a calendar year taxpayer, purchased the following assets:

1. April 10—Business equipment, cost $28,000, salvage value $3,000

2. July 7—Car, cost $14,000, salvage value $2,000

3. September 12—Office building, cost $85,000

Ignoring the Section 179 deduction and bonus depreciation, MACRS depreciation for 2020 on these assets would be:

Depreciation
1. Business equipment ($28,000 cost × 14.29% from  Table 7 ) (7-year life, 200% DB)	$4,000
2. Car ($14,000 cost × 20% from  Table 7 ) (5-year life, 200% DB)	2,800
3. Office building ($85,000 cost/39-year life × 3 1/2 months/12 months) (straight-line depreciation)	636
Total	$7,436

EXAMPLE 6.46

Refer to the previous example and assume the business equipment purchased in April 2020 was instead purchased in November 2020. Based on these facts, depreciation on all personal property purchased in 2020 would be based on the mid-quarter convention since more than 40 percent of all personal property placed in service was placed in service during the last quarter of the taxable year. MACRS depreciation for 2020 on the assets in the example above would now be:

Depreciation
1. Business equipment ($28,000 cost × 3.57% from  Table 8 ) (7-year life, 200% DB) (or $28,000 × 3.57% from  Table 8 )	$1,000
2. Car ($14,000 × 15% from  Table 8 ) (5-year life, 200% DB)	2,100
3. Office building (Same as  Example 6.50 )	636
Total	$3,736

¶6805

ALTERNATIVE MACRS SYSTEM

MACRS deductions are reduced for certain property by requiring that an alternative MACRS method, based on the Asset Depreciation Range System (ADR) class lives, be used for (1) tangible property used predominantly outside the United States, (2) tax-exempt use property, (3) tax-exempt bond-financed property, (4) property imported from a foreign country for which an Executive Order is in effect because the country maintains trade restrictions or engages in other discriminatory acts, and (5) property for which an alternative MACRS election has been made (see below). Mixed-use property (property used for both business and personal purposes) that is used 50 percent or more for personal use is also required to be depreciated under the alternative MACRS rules. Code Sec. 168(g). Under the alternative MACRS rules, the applicable depreciation method for all property is the straight-line method. The deduction is computed by applying the straight-line method (without regard to salvage value), the applicable convention, and the applicable prescribed longer recovery period for the respective class of property.

Special Election

Instead of the regular MACRS deduction, taxpayers may irrevocably elect to apply the alternative MACRS system to any class of property for any tax year and depreciate assets using the straight-line method or the 150 percent declining method of depreciation.  Table 9  lists alternative MACRS system 5-year and 7-year recovery rates (half-year convention) using straight-line depreciation. If elected, the alternative system applies to all property in the MACRS class placed in service during the tax year of the election. For residential rental property and nonresidential real property, the election may be made on a property-by-property basis.

Table 9. ALTERNATIVE MACRS SYSTEM
5-Year and 7-Year Recovery Rates
(Half-Year Convention)
Straight-Line Depreciation
Recovery Year	5-Year Property	7-Year Property
1	10.00%	7.14%
2	20.00	14.29
3	20.00	14.29
4	20.00	14.28
5	20.00	14.29
6	10.00	14.28
7		14.29
8		7.14

EXAMPLE 6.47

In September, Max Cracker Co., a calendar-year taxpayer, purchased two pieces of equipment. One piece of equipment cost $25,000 and had a salvage value of $4,000. The other piece of equipment cost $20,000 and had a salvage value of $2,000. Max Cracker Co. elects to depreciate the equipment using the alternative depreciation system and to depreciate the assets over the MACRS class lives using straight-line depreciation. Both pieces of equipment are seven-year assets under MACRS. Salvage value is ignored in the depreciation computation and only one-half-year depreciation is allowed in the year of acquisition. Thus, depreciation for the two pieces of property is $3,213 ($45,000 cost × 7.14% From  Table 9 ).

¶6815

DEPRECIATION OF REAL PROPERTY

As discussed previously, the method of depreciation used for tax purposes depends on the nature of the property being depreciated. Generally speaking, most tangible business-use property other than real estate is depreciated under MACRS using accelerated depreciation methods. Real property, in contrast, must be depreciated using the straight-line method. Realty is divided into two categories for tax purposes--residential and non-residential. Residential real estate is depreciated using the straight-line method over 27.5 years, while non-residential real estate is generally depreciated over 39 years, also using the straight-line method.

Real estate is treated as residential realty if at least 80% of the gross rental income from the building is attributable to rental income from dwelling units. Code Sec. 168(e)(2)(A). A dwelling unit is a house, apartment, etc. used to provide living accommodations on a long-term basis. Hotel or motel rooms rented on a transient basis are not dwelling units. Generally speaking, a unit is rented on a transient basis if the average rental term is less than 30 days.

As noted in  ¶6801 , depreciation of real property operates on a mid-month convention, meaning that the taxpayer takes a half-month's depreciation for the month placed in service (and the month of sale or other disposition). Thus, a taxpayer placing an apartment complex in service in the month of March will be allowed 10.5 months' depreciation, no matter what day of the month the property was actually acquired.

EXAMPLE 6.48

Kingsbury Corp. is developing an "extended stay" hotel on a parcel of real estate in a mid-sized city. The company expects to spend $20,000,000 on the project and is uncertain whether the property will be classified as residential or non-residential realty. If the building is residential real estate, the company will be allowed a deduction for depreciation of $727,273 (rounding up) per year for each full year of the property's 27.5-year depreciable life. If, instead, the building is classified as non-residential (because less than 80% of the rental income from the property is from customers staying 30 days or more), the allowable annual depreciation deduction will be only $512,821 (rounding up) over a 39-year depreciable life.

Special Rules for Qualified Improvement Property

The American Jobs Creation Act of 2004 temporarily reduced the depreciable lives of 3 categories of depreciable real estate from 39 to 15 years. The reduced depreciable life, intended as economic stimulus, applied to qualified leasehold improvement property, qualified retail improvement property, and qualified restaurant property. The shorter depreciable lives were initially applicable to qualified property investments incurred between January 1, 2004 and December 31, 2007, with the expectation that the economy would have recovered from recession by 2008. When the recession unexpectedly deepened in 2008, Congress implemented the first of a series of extensions before finally making the shorter lives permanent in December 2015. In 2017, the Tax Cuts and Jobs Act eliminated the separate definitions of qualified leasehold improvement, qualified restaurant and qualified retail improvement property and replaced them with a single category—qualified improvement property. Qualified improvement property is depreciated over 39 years using the straight-line method and half-year convention.

Congress apparently intended to extend bonus depreciation to qualified improvement property in the 2017 act, but neglected to add the appropriate language. It has signaled that it intends to pass a technical corrections bill that will include this language, but it has thus far been unable to do so. Until it does, qualified improvement property will continue to be depreciated using the straight-line method over 39 years.

Qualified improvement property is any improvement to the interior portion of a building that is nonresidential realty if the improvement is made after the date the building was placed in service. Qualified improvement property does not include any improvement for which the expenditure is attributable to enlargement of the building any elevator or escalator, or any improvement to the internal structural framework of the building.

EXAMPLE 6.49

Smith & Jones is a law firm. In July, 2020 it leased space in a multi-story building, signing a ten-year lease agreement beginning September 1, 2020. Prior to beginning operations in the building, the company paid $2,000,000 to install hard-wood flooring, wall coverings, and new lighting in the space to be used by its partners and associates. The improvements were finished in time for the company to begin using the space on September 1. Assuming the building was placed in service before the lease was signed, and that the leased space will be used by Smith & Jones, the company's 2020 and 2021 depreciation deductions will be as follows:

Cost of leasehold improvements	$2,000,000
Depreciable life (39 years × 12 months per year)	468 months
Depreciation expense per month	$4,273/mo
Allowable deduction 2020 (6 months, under half-year convention)	$ 25,641
Allowable deduction 2021 (and thereafter)	$ 51,282

¶6825

CODE SEC. 179 ELECTION TO EXPENSE CERTAIN DEPRECIABLE ASSETS

Development and General Rules

Accelerated depreciation, which increases the rate at which taxpayers are allowed to recover the costs of business-use property against their taxable incomes, is one of the easiest and most common business incentives used by Congress. In general, the faster the recovery period, the larger the tax benefit and the lower the net cost of the newly acquired property. This is particularly true for property that is purchased with borrowed money. For example, if a taxpayer pays ten percent of the cost of a new equipment purchase in the first year, and receives a tax benefit equal to 20% of the cost of that purchase, the net out-of-pocket cost in the year of purchase is negative—the tax benefits received by the taxpayer are greater than the cash paid in the year of purchase to buy the asset. The taxpayer actually receives more money in the form of tax savings than it spent to acquire the asset (in the current year). For this reason, Congress is quite fond of provisions that allow taxpayers to deduct a significant portion of the purchase price of business-use assets in the year of purchase.

An area of particular interest to Congress is Code Sec. 179, which allows taxpayers to immediately expense a portion of the cost of newly acquired depreciable property rather than depreciating it over multiple years. When first enacted, the statute allowed taxpayers to expense up to $5,000 of depreciable equipment in the year of acquisition. The cost of purchases in excess of this amount was subject to depreciation. Between 1997 and 2003, the amount that could be expensed in the first year was gradually increased to $25,000. Beginning in 2003, the Sec. 179 amount was increased to $100,000 and indexed for inflation. In 2007, the first-year deduction was increased to $125,000, and for 2008 and 2009, it was increased further to $250,000. Beginning in 2010, Congress increased the amount that could be expensed under Code Sec. 179 to $500,000, and in 2015, Congress made the $500,000 first-year expensing deduction permanent. The Tax Cuts and Jobs Act of 2017 increased this amount to $1 million and indexed it for inflation. Any purchases in excess of the amount expensed under Sec. 179 can be depreciated under MACRS. The Code Sec. 179 deduction can create a substantial incentive for businesses to purchase qualified property.

EXAMPLE 6.50

Bienvenida Corp purchased a business-use asset this year for $300,000. The company purchased the asset on credit, paying 10 percent down, and agreeing to pay off the balance due over the ensuing 5 years. The asset was fully deductible under Code Sec. 179. Assuming the company's marginal tax rate was 20%, the deduction will reduce its current year income tax liability by $60,000. It paid only $30,000 (10% × $300,000) this year to purchase the asset. Thus, the purchase actually increased the company's net cash flow this year. Of course, in future years, the additional payments against the loan will not be deductible and thus will not reduce the company's tax liability in those years.

Code Section 179 Property

The Section 179 deduction can be claimed for all purchases of “Code Section 179” property made during the taxable year. The property must be purchased but there is no requirement that it be new. Thus, the deduction can be claimed on the purchase of new or used property as long as the purchase is from an unrelated seller.

There are three categories of Code Section 179 property. The first is tangible property that is depreciable under Code Section 1245. This category includes “off-the-shelf” computer software, equipment (machines, computers, etc.), and furniture and fixtures used for business purposes. Other types of Code Section 1245 property are tangible components attached to a building structure that are not structural components of the building, such as roofing, heating ventilation and air conditioning equipment, lighting, wall coverings, fire protection and alarm systems, and security systems. To be eligible, such property and equipment must have been placed in service after the date that the nonresidential real property was placed in service.

A second category of Code Section 179 property consists of certain property used predominantly to furnish lodging or in connection with furnishing lodging. As defined in Code Section 50(b)(2), property used predominantly to furnish lodging or in connection with furnishing lodging generally refers to beds and other furniture, refrigerators, ranges, and other equipment used in the living quarters of a lodging facility such as an apartment house, hotel, or any other facility (or part of a facility) where sleeping accommodations are provided and leased. See Treas. Reg. §1.48-1(h).

The final category of Code Section 179 property includes business-use automobiles with a gross vehicle weight in excess of 6,000 pounds, although the deduction is limited to $25,900 as discussed later in this chapter.

Limitations

The Code Sec. 179 deduction is phased out as the taxpayer's equipment acquisitions exceed an overall investment limit of $2,590,000. The phase-out is dollar-for-dollar, so that the 179 deduction is reduced to zero when total eligible purchases during the tax year reach $3,630,000.

The deduction is further limited to the taxpayer's taxable trade or business income for the current year. For this purpose, trade or business income is measured before the Sec. 179 deduction and includes income and expenses from all of the trade or business activities in which the taxpayer is engaged, rather than just the income from the trade or business in which the purchased property is used. For example, a self-employed taxpayer whose spouse is employed by another business can count both the spouse's employment earnings and the net income from the trade or business in computing the taxable income limitation (assuming the taxpayer and her spouse file a joint return). To the extent the taxpayer's Sec. 179 deduction is limited by the taxable income limitation, any unused deduction can be carried forward into subsequent tax years.

EXAMPLE 6.51

In 2020, Ginger Gilmore purchased $2,690,000 in depreciable equipment for use in her commercial nursery business. The nursery’s business income before accounting for the Code Sec. 179 deduction (but after accounting for depreciation) was $750,000. Assume that Ginger had no other source of income. Ginger’s allowable deduction under Sec. 179 for 2020 was calculated as follows:

Code Sec. 179 deduction, before limitations		$1,040,000
Total investment in eligible property (current year)	$2,690,000
Overall investment limit	(2,590,000)
Reduction in Sec. 179 deduction		(100,000)
Allowable Sec. 179 deduction before application of taxable income limit		$940,000
Taxable income before Sec. 179 deduction		750,000
Allowable Sec. 179 deduction (lesser of $750,000 or $900,000)		$750,000
Sec. 179 carryover to 2021		$190,000

Note that the carryover to 2021 does not include the $100,000 phase-out reduction. Only the portion of the otherwise allowable deduction that exceeds the net taxable income can be carried forward.

¶6835

BONUS DEPRECIATION

“Bonus” depreciation, provided for the first time in 2008, is another approach used by Congress to stimulate business activity. From 2008 through 2010, Congress allowed businesses to take a “bonus” depreciation deduction equal to 50 percent of the cost of depreciable property placed in service in those years, with the remainder of the cost recovered under MACRS depreciation. Congress increased the bonus rate to 100 percent for property acquired after September 8, 2010, but allowed the rate to fall back to 50 percent beginning on January 1, 2012. The rate remained at 50 percent through September 27, 2017, when the Tax Cuts and Jobs Act (TCJA) increased it back to 100 percent. Under the TCJA, property acquired after September 27, 2017 and before 2023 will be eligible for 100 percent bonus depreciation.

Bonus depreciation, like the Code Section 179 deduction, provides an additional incentive to increase investment in depreciable property, especially since the remaining cost of the property (if any) remains eligible for accelerated depreciation under MACRS. Obviously, if a taxpayer elects to claim 100 percent bonus depreciation, there will be no additional cost to recover under MACRS.

If a taxpayer opts to claim both the Code Section 179 deduction and bonus depreciation, the Code Section 179 deduction should be claimed first, then bonus depreciation. Regulations Section 1.168-1(d)(3) Example 2.

Eligible Property

Property qualifying for the additional first-year depreciation deduction must meet both of the following requirements. First, the property must be:

1. (1) property to which MACRS applies with an applicable recovery period of 20 years or less;

2. (2) water utility property; or

3. (3) computer software other than computer software covered by section 197.

Second, the taxpayer must have acquired and placed in service within the taxable year the property for which the bonus deduction is being claimed. Like Code Section 179, bonus depreciation applies to both new and used property purchased by the taxpayer during the taxable year.

EXAMPLE 6.52

Wilder Manufacturing, Inc. purchased used equipment in August 2020 at a total cost of $1,640,000. The property is five-year depreciable property and is eligible for both the Code Section 179 deduction and 100 percent bonus depreciation. The company opted to take both of these deductions. Its 2020 depreciation deduction will be computed as follows:

Original cost of the property	$1,640,000
Code Section 179 deduction	(1,040,000)
Remaining cost	$ 600,000
Bonus depreciation (100 percent)	(600,000)
Add Section179 deduction per above	1,040,000
Total deduction for 2020	$1,640,000

Note that the company could have deducted the full $1,640,000 under the bonus depreciation rules without claiming a deduction under Code Sec. 179.

¶6845

DEPRECIATION OF AUTOMOBILES

Limitations on Depreciation of Automobiles

Calculation of depreciation expense for business-use automobiles is subject to a complex set of rules. In general, automobiles are classified as five-year property, and are eligible for both bonus depreciation and MACRS depreciation. However, the annual depreciation deductions for automobiles is subject to strict limits referred to as the "luxury automobile depreciation limitations." Under Code Sec. 280F, limitations are imposed on the amount of depreciation that may be claimed in each year of the life of a business-use automobile as indicated in  Table 10 . These limitations are adjusted each year for inflation using the automobile component of the chained consumer price index for all urban customers (C-CPI-U). The following rates apply to automobiles placed in service in 2019. Figures for 2020 were not available as this book went to press.

Table 10. DEPRECIATION LIMITS FOR BUSINESS-USE AUTOMOBILES
	Passenger Cars
First year (year in which auto is first placed in service)	$18,100
Second year	$16,100
Third year	$9,700
Fourth, fifth and all succeeding years until basis is fully recovered	$5,760
Note: vehicles can be depreciated beyond five years if they continue to be used for business purposes and the total cost has not yet been fully recovered as of the end of the fifth year.

Note that the first-year limitation includes $8,000 for bonus depreciation for newly acquired vehicles (including used automobiles). The auto depreciation amounts were substantially increased by the TCJA for automobiles purchased after 2017. Automobiles with a gross vehicle weight (GVW) in excess of 6,000 pounds are not considered to be passenger cars, nor are ambulances, taxis or limousines. Accordingly, cars and trucks with a GVW in excess of 6,000 pounds are not subject to these limitations.

Note that the amounts in  Table 10  reflect the maximum amount that can be claimed with respect to an automobile. The taxpayer's allowable deduction will equal the lesser of the limitation for the particular year or the amount calculated using MACRS and/or bonus depreciation. To compute the amount allowed under MACRS in years following the year placed in service, the IRS has provided “safe harbor” provisions under which the taxpayer treats the remaining cost of the automobile after deducting the amount allowed in the first year, as the “cost” of the car for purposes of computing depreciation for years 2-5 (or beyond if necessary to fully recover the cost of the car). Rev. Proc. 2019-13, 2019-9 IRB (2/13/2019).

EXAMPLE 6.53

In July, 2020, Genevieve purchased a new car which she used 100 percent for business purposes. She paid $60,000 for the car. For 2020, she is allowed to deduct a maximum of $18,100 with respect to the car. ( Table 10 ). In 2021 and beyond, her depreciation deductions will be determined as follows:

Original cost of the car	$60,000
Year 1 deduction (2020) using 100% bonus depreciation	( 18,100)
Remaining basis of the car	$41,900
MACRS depreciation 2021 (Table 7, year 2, five-year assets – 32%)	13,408
MACRS depreciation 2022 (Table 7, year 3, five-year assets – 19.2%)	8,045
MACRS depreciation 2023 (Table 7, year 4, five-year assets – 19.2%)	8,045
MACRS depreciation 2024 (Table 7, year 5, five-year assets – 19.2%)	8,045
MACRS depreciation 2025 (remaining cost basis, not to exceed $5,760)	4,357
Total depreciation deductions, 2020-2025	$60,000

Section 179

While Code Sec. 179 can be used to expense a portion of the cost of automobiles in the year of acquisition, the deduction is treated as depreciation expense and is generally subject to the luxury automobile depreciation limitations summarized in  Table 10 . Code Sec. 280(d)(1). Thus, taxpayers usually do not claim a Sec. 179 deduction with respect to autos because it does not increase the allowable deduction.

As noted above, however, the limitations of Sec. 280F do not apply to automobiles, trucks or vans with gross vehicle weights in excess of 6,000 pounds. Prior to 2004, these vehicles could be fully expensed under Sec. 179, subject only to the overall limitation on the annual Sec. 179 write-off. Thus, for example, a taxpayer purchasing an SUV with a gross vehicle weight in excess of 6,000 pounds in 2003 could write off the lesser of the cost of the vehicle or $100,000 in that year. This provision generated substantial criticism as it provided an incentive to automobile manufacturers to make SUVs bigger and heavier and thus less fuel efficient. In response to these criticisms, the American Jobs Creation Act of 2004 implemented an additional limitation on the Code Sec. 179 deduction for passenger automobiles with GVWs between 6,000 and 14,000 pounds.

The maximum amount that can be deducted under Sec. 179 with respect to the purchase of an automobile with GVW between 6,001 and 14,000 pounds is $25,900. Code Sec. 179(b)(5). Because the limitation is intended to apply only to non-commercial vehicles, it does not apply to vehicles designed to have a seating capacity of more than 9 persons behind the driver's seat (e.g., buses), vehicles with a cargo area of at least 6 feet in interior length (e.g., commercial trucks), or vehicles that have seating rearward of the driver's seat (e.g., delivery vans).

If a taxpayer purchases a qualified SUV at a cost greater than $25,900, the amount spent above $25,900 may be depreciated under the bonus and MACRS depreciation rules. Because the limitations under Code Sec. 280F apply only to vehicles with GVWs of 6,000 pounds or less, depreciation of the excess cost (over $25,900) of an eligible vehicle is not subject to the luxury auto limitations.

EXAMPLE 6.54

Assume it is 2024, when bonus depreciation drops to 60%, Gabrielle purchased a new SUV for $70,000. The vehicle has a gross vehicle weight of 8,000 pounds and is therefore eligible for the Sec. 179 deduction. In addition, because its GVW exceeds 6,000 pounds, the SUV is not subject to the luxury auto depreciation limitations of Code Sec. 280F. Assuming the vehicle is used 100% for business, Gabrielle will be able to deduct the following amount in 2024:

Original cost of the SUV	$70,000
Code Sec. 179 deduction *	(25,900)
Remaining basis	$44,100
Bonus depreciation (60%)	(26,460)
Depreciable basis for MACRS	17,640
MACRS depreciation ( Table 7 , 20%)	3,528
Add:   Sec. 179 deduction	25,900
Bonus depreciation	26,460
Total deduction 2024	$55,888

*  We don’t know what the inflation-adjusted deduction under Sec. 179 will be in 2024.

The language of Code Sec. 179(b)(5) provides that the $25,900 limitation applies to the cost of each SUV purchased and placed in service during the tax year. Thus, if a taxpayer purchases more than one qualified vehicle in a given year, a $25,900 deduction under Code Sec. 179 will be available for each vehicle purchased.

EXAMPLE 6.55

In 2024, when bonus depreciation drops to 60%, Mendoza Corp purchased two new SUVs for $35,000 each (total expenditure $70,000). The vehicles each had a GVW of 8,000 pounds and were therefore eligible for the Sec. 179 deduction. As in the example above, the remaining cost of each vehicle after taking the Sec. 179 deduction is eligible for both bonus and MACRS depreciation. Assuming the vehicles are both used 100% for business, Mendoza will be able to deduct the following amount in 2024:

Original cost of the SUVs	$70,000
Code Sec. 179 deduction (25,900 x 2) *	(51,800)
Remaining basis	$18,200
Bonus depreciation (60%)	(10,920)
Depreciable basis for MACRS	7,280
MACRS depreciation ( Table 7 , 20%)	1,456
Add:   Sec. 179 deduction	51,800
Bonus depreciation	10,920
Total deduction 2024	$64,176

*  The inflation-adjusted deduction amount will likely be higher in 2024.

¶6855

PROPERTY CONVERTED FROM PERSONAL TO BUSINESS USE

As noted above, conversion of property from business to non-business use will create tax issues with respect to depreciation and Code Sec. 179 deductions previously claimed. However, it is also relatively common for taxpayers to convert property from personal use to business use. For example, a taxpayer may move to another city and decide to convert his or her personal residence into rental property. Similarly, a taxpayer starting her own business may convert a personal use auto to business use property in connection with the new business.

In such cases, Reg. §1.167(g)-1 provides that the tax basis of the asset for tax purposes will be equal to the lesser of the fair market value of the property at the date of conversion to business (or investment) use or its adjusted tax basis at the date of conversion. This will be the taxpayer’s tax basis for purposes of computing depreciation expense and loss (if any) from a subsequent sale of the asset. If the asset is later sold for a profit, the original basis of the asset, adjusted for depreciation, will be used to calculate the taxable gain. With respect to depreciation, the asset will be treated as having first been placed in service in the year of conversion to business-use property. The appropriate convention will apply under MACRS (mid-year, mid-quarter, or mid-month). Note that in most cases, no deduction will be allowed under Code Sec. 179 for property converted from personal to business use. Unlike depreciation under MACRS, Code Sec. 179 applies to property “purchased” by the taxpayer from an unrelated seller during the taxable year for use in a trade or business. Code Sec. 179(d)(1) and (2). Since the conversion of property from personal to business use does not involve a purchase transaction, Code Sec. 179 will not be applicable.

EXAMPLE 6.56

Javier and Maria Gonzales purchased a new home in September, 2007 for $425,000. They used the home as their personal residence until July 2020, when Maria was transferred by her employer to another city. The real estate market had declined rather substantially and the Gonzales decided not to sell their home, but to place it on the rental market instead. They placed the home for rent on August 1, 2020. After a brief period of showing the home, it was rented in October, 2020. At that date, an independent appraisal estimated the value of the home to be $300,000. Allocating 5% of the value of the home to land, the Gonzales will be allowed to depreciate $285,000 of the home under MACRS. It is 27.5 year property and is depreciated using the mid-month convention. Moreover, it was converted to business use on August 1, 2020, the date it was placed on the rental market. It does not matter that the home was not rented until October of that year. For 2020, the Gonzales will be allowed to claim a depreciation deduction of $3,886 ($285,000 depreciable basis of the home ÷ 27.5 years x 4.5 months/12 months).

 

KEYSTONE PROBLEM

The property ledger used for tax purposes by Able Garment Co., a calendar year taxpayer, is shown below. Compute the amount of the 2020 and 2021 depreciation deductions allowable to Able Garment Co. for these assets on its tax returns based on regular MACRS depreciation percentage rates (ignore bonus depreciation and the Section 179 deduction).

Able Garment Co.
Property Ledger as of December 31, 2020
Asset	Date Purchased	Cost	Salvage Value
1. Car	Jan. 2020	$19,000	$1,000
2. Cargo van (>6,000 lbs GVW)	Mar. 2020	35,000	1,500
3. Office furniture	May 2020	14,250	1,000
4. Business equipment	July 2020	38,950	5,000
5. Building (Office)	Sept. 2020	95,000	—

¶6865

AMORTIZATION

In financial accounting, the term “amortization” is normally defined as the process of allocating the cost of an intangible asset to expense over its estimated useful life. The Code is not as precise in the use of the term “amortization.” The Regulations actually refer to the process of allocating the cost of an intangible asset to expense as depreciation instead of amortization. Reg. §1.167(a)-3. In other sections of the Code, reference is made to amortizing the cost of tangible assets, a process which is usually referred to as depreciation in financial accounting.

Intangible Assets

Intangible assets used in a trade or business and having limited useful lives subject to reasonable estimation can be amortized over an appropriate useful life. The straight-line depreciation method is used to compute the amortization deduction. Code Sec. 197 provides for a 15-year amortization period for specified intangible assets referred to as “section 197” intangibles. A section 197 intangible includes goodwill, going concern value, licenses or permits granted by a governmental agency, covenants not to compete, franchises, trademarks, trade names, patents, and copyrights.

Other Allowable Amortization Deductions

In some instances, amortization deductions are allowed for capital expenditures which are more favorable to a taxpayer than the normal depreciation allowances applicable to the property. These amortization deductions are provided to taxpayers as tax incentives to participate in investment activities which are considered to have some public interest attached to them. For example, taxpayers may elect to amortize the cost of pollution control facilities over a 60-month period. Code Sec. 169.

¶6875

RESEARCH AND EXPERIMENTAL EXPENDITURES

The term “research and experimental” expenditures (R&E) includes all experimental and laboratory costs connected with the development of an experimental or pilot model, plant process, product, formula, invention, or similar property. It does not include expenditures for ordinary testing or inspection of materials or products for quality control or for efficiency surveys, management studies, consumer surveys, advertising, or promotion. Reg. §1.174-2(a). R&E connected with a trade or business can be treated as a current deduction for tax purposes or, if elected by the taxpayer, be deferred and amortized over a period of not less than 60 months starting in the period when benefits from the R&E are first realized. Code Sec. 174(a) and (c). Subsequent changes in treatment require approval of the IRS. Any R&E involving the purchase of property which would normally be subject to depreciation such as equipment or the purchase of land cannot be deducted immediately but must be handled in accordance with its regular treatment for tax purposes. Code Sec. 174(c).

EXAMPLE 6.57

In 2020, Jones Ribbon Co. incurs R&E for the first time. R&E included the following amounts:

R&E Salaries	$350,000
R&E Materials	150,000
Total R&E	$500,000

Jones Ribbon Co. could choose to treat all R&E incurred in 2020 as a current deduction of $500,000.

If Jones Ribbon Co. elects to capitalize and amortize 2020 R&E, the monthly amortization deduction, assuming a 60-month amortization period, would be:

$500,000/60

=

$8,333.33 per month amortization in 2018 starting with the month when benefits from the R&E are first realized.

 

PLANNING POINTER

Generally, immediate expensing of R&E is advantageous to a taxpayer for tax purposes as compared to capitalization and amortization of R&E. This is true because immediate expensing results in larger tax deductions in earlier years, increasing the present value of the tax benefits.

¶6885

DEPLETION OF NATURAL RESOURCES

Depletion is normally defined as the process of allocating the cost of a natural resource to expense over its estimated useful life. For tax purposes, however, it is possible that depletion deductions for a natural resource may exceed the cost of the natural resource. Some natural resources which are subject to depletion include metals such as gold, silver, and copper, and minerals like coal, clay, sand, and oil.

The owner of a natural resource is entitled to the depletion deduction. Reg. §1.611-1(b). Land on which the natural resource is located is not subject to depletion.

Two methods are available to taxpayers for computing the depletion deduction: the cost depletion method and the percentage depletion method. The taxpayer would normally compute the proper deductions using both depletion methods and then claim the higher deduction for tax purposes. Reg. §1.611-1(a).

Cost Depletion Method

The cost depletion computation involves dividing the basis of the natural resource by the estimated units to be recovered from the natural resource to determine the depletion amount per unit. The depletion amount per unit is then multiplied by the units of the natural resource sold during the year which gives the cost depletion deduction for the tax year.

EXAMPLE 6.58

In 2020, Basil Natural Resource Development Company acquires the rights to a natural resource for $5,000,000. The estimated recoverable units from the natural resource at the time of purchase amount to 250,000 units. The depletion amount per unit is $5,000,000/250,000 = $20 depletion amount per unit. If 40,000 units of the natural resource were sold during 2020, the depletion deduction using the cost depletion method would be $800,000 (40,000 units sold during year × $20 depletion amount per unit).

Percentage Depletion Method

Percentage depletion is computed by taking a specified depletion percentage and applying it to the gross income for the year derived from the sale of the natural resource. Some depletion percentages specified in the Code include 5 percent for sand and gravel, 10 percent for coal, 15 percent for gold, silver, and copper, and 22 percent for uranium. Code Sec. 613. The deduction for percentage depletion with respect to a particular property cannot exceed 50 percent of the taxpayer’s net taxable income derived from the natural resource produced from that property (before accounting for the depletion deduction) for the taxable year.

EXAMPLE 6.59

Referring to the previous example, Basil Natural Resource Development Company sells 40,000 units of its natural resource during 2020 at an average price of $160 per unit. Assuming a specified depletion percentage of 15 percent stated for the natural resource and operating expenses of $115 per unit of natural resource, the percentage depletion deduction is computed as follows:

1. Gross income derived from natural resource
(40,000 units × $160)	$6,400,000
Code specified depletion percentage	15%
Percentage depletion deduction subject to limitation	$960,000
2. Taxable income limitation
Gross income	$6,400,000
Operating expenses before depletion (40,000 units × $115)	4,600,000
Taxable income before depletion deduction	$1,800,000
Limitation percentage	50%
Percentage depletion deduction limitation	$900,000
Percentage depletion deduction, lesser of (1) or (2)	$900,000

As mentioned earlier, a taxpayer should compare the computed cost depletion deduction with the computed percentage depletion deduction and deduct the higher amount. In the two examples, the cost depletion deduction was $800,000 and the percentage depletion deduction was $900,000. Thus, taxpayer would deduct the $900,000 percentage depletion deduction amount.

A taxpayer’s tax basis in the natural resource is reduced, but not below zero, by the amounts of depletion deductions taken by the taxpayer. If the basis of the natural resource property is reduced to zero, after being reduced by depletion deductions, depletion can still be claimed by a taxpayer using the percentage depletion method since it is not based on the cost of the taxpayer’s investment in natural resource property.

¶6901

SUBSTANTIATION OF TAX DEDUCTIONS

As noted earlier, tax deductions are allowed to taxpayers only if they are specifically authorized. In addition, taxpayers must be able to substantiate the deductions claimed on their tax returns if requested by the IRS through the audit process. Taxpayers can normally substantiate tax deductions by providing documentary evidence such as receipts, invoices, and cancelled checks. In some instances, oral testimony of the taxpayer or other persons in support of the taxpayer may be of some value. In the past, the IRS has argued in court that if a taxpayer fails to substantiate a deduction, then the entire deduction should be disallowed. In an important trend-setting case, however, the court held that if substantiation for a tax deduction was lacking but it was reasonable to assume that some amount of expense had been incurred, then it is reasonable to assume that some estimated tax deduction should be allowed. G.M. Cohan, 2 USTC ¶489, 39 F.2d 540 (CA-2 1930). The reasoning applied in the Cohan case to justify a reasonable deduction when substantiation for a deduction is lacking has become known as the Cohan rule for tax purposes. The Cohan rule applies to all tax deductions with the exception of travel and entertainment expenses, business gifts, charitable contributions, and a few other expenditures where substantiation is required before a deduction will be allowed.

EXAMPLE 6.60

Lavelle attends church each Sunday and always puts two 100-dollar bills in the church collection basket. Lavelle does not use church envelopes and does not make a charitable contribution by check. She claims charitable contributions to her church of $10,400 on her 2020 tax return. In an audit of her 2020 tax return by the IRS, Lavelle is questioned on the amount of her charitable contributions. She has no documentary evidence to support her charitable contribution deduction of $10,400. Starting in 2007, the Cohan rule no longer applies to charitable contributions and Lavelle will be denied a charitable contribution deduction due to the lack of substantiation.

TAX BLUNDER

In the above example, Lavelle should have used church envelopes and had the church notify her in writing of her total charitable contributions at the end of the year. Alternatively, had she paid her contributions by check, she would have the cancelled checks to substantiate her gifts.

A taxpayer must be able to substantiate tax deductions claimed on the return. If a tax return is audited by the IRS, documentary evidence such as invoices, paid receipts, and cancelled checks are very important in substantiating deductions. Oral evidence of other individuals may be of some value. Oral evidence of the taxpayer may also be of some value, but the IRS is certainly aware that many taxpayers, when questioned, merely declare that their deductions were computed correctly. The Cohan rule is of some use to taxpayers in that it generally provides a floor for tax deductions. The Cohan rule, however, will rarely result in a taxpayer’s being allowed a tax deduction equal to the amount originally claimed. Also, the Cohan rule is no longer applicable with respect to a number of deductions, as discussed above.

SUMMARY

· Allowable tax deductions are divided into four categories: trade or business, production of income, losses and personal. Basic personal living expenses of an individual taxpayer normally are not deductible with the exception of certain personal expenditures that have been allowed by Congress for various reasons as itemized deductions.

· In order to be deductible, trade or business expenditures must (1) be ordinary and necessary, (2) be reasonable in amount, and (3) be related to an activity which is deemed to be a trade or business. Some expenditures which meet all these requirements, however, may still be disallowed if they are contrary to public policy, or were incurred to generate tax-exempt income. Other expenses may be denied if they were incurred in connection with a personal transaction. Thus, for example, legal expenses may not be deductible even if ordinary, necessary to preserve a taxpayer’s business assets, and reasonable in amount if they are attributable to a dispute arising from a personal transaction, such as divorce. Finally, it is important to distinguish between expenses and capital expenditures. The latter are not currently deductible but must be capitalized and recovered over time.

· More common trade or business deductions allowable under the criteria discussed above include advertising, bad debts, salaries, interest payments, rental payments, insurance, and legal fees. Allowable business deductions related to capital expenditures include depreciation, amortization, and depletion. Business start-up expenditures and business gifts are restricted deductions.

· Expenses incurred to produce income must meet the same requirements as those incurred in a trade or business in order to be deductible, with the exception of the requirement that they be incurred in a trade or business activity.

· Individual taxpayers are allowed deductions for business losses, investment losses, and casualty or theft losses if incurred in an area declared a national disaster area by the federal government. Personal losses other than qualified casualty and theft losses are not deductible. With the exception of some selected expenditures, basic personal living expenses of a taxpayer are not deductible.

· Some additional factors that may affect the amount of an allowable tax deduction are tax accounting method used, substantiation of deductions, and deductible amounts paid on behalf of another taxpayer.