Wednesday, January 16, 2013

Uniform Capitalization UNICAP § 263A

 What are the Uniform Capitalization UNICAP § 263A Rules?

The UNICAP rules deny taxpayers immediate deduction for costs of producing property that taxpayer will use in its business or sell as inventory.  Costs that must be capitalized (or added to the cost of inventory) include depreciation on equipment used in producing the property, employee’s wages allocable to production of the property, and an appropriate share of the rent and utilities expenses of the facility where property is produced. § 263A is for tangibles. This better matches expenses other related income and avoid un-wanted deferral of taxes by IRS.

If § 263A applies to property, they the must apply direct and indirect costs allocated to the property. A taxpayer cannot capitalize a cost if it would not be otherwise deductible. Same limitations in other deduction rules apply, for example the entertainment 50% limitation.

Direct v. Indirect Costs under UNICAP rules and Section 263A

Direct Costs = Materials and labor directly attributable to some specific property produced are CAPITALIZED.

Indirect Costs = ALWAYS HAVE TO CAPITALIZE. Includes rent, utilities, insurance, an indirect labor costs, compensation that can’t be attributed, quality control and inspection, certain taxes on production facilities, costs of soliciting contracts to make property, hazardous waste costs, and storage costs.

Costs that are never capitalized – Selling and distribution expenses, overall management costs, research and development, deductible losses (§ 165), income taxes, product liability insurance, and strike costs. Even if they are arguable attributable to creating or buying some piece of tangible property.

Mixed- Service Costs – They are indirect business admin costs. Much in the same way that the regulations dictate that they must allocate indirect costs. They say that mixed service costs, some of them to pieces of property and deduct others. Statutory Formula.

How much do these costs directly benefit the making or buying of tangible property and how much do they not? Then split up. Split between deductibility.  Personnel, Payroll departments, Security Departments.

Qualified Creative Exceptions. § 263A(h) – includes a personal efforts requirement, but does not mean that the taxpayer has to physically create the art in question. THINK ARTISTS.  If they are doing something, it probably qualifiedunder 263A(h)- Not performing detailed design work, then does not qualify because he not exerting effort.

Section 162 Reasonable Compensation

What does the IRS consider reasonable compensation?

§ 162(a)(1) allows for “a reasonable allowance for salaries or other compensation for personal services actually rendered.”

This section often comes into play because the double taxation of corporations. If the officers and executives of a corporation are substantially identical with its major shareholders, a temptation may arise to distribute some of the earnings of the corporation under the label of additional compensation for services, rather than under the dividend label to save on taxes.

The reduction in dividend tax lessens that tax advantage of compensation over dividends, but in many situations a significant tax advantage for compensation remains. There are several exception for performance related compensation. However, what is reasonable compensation for the IRS is subject to lots of debate between the taxpayer and IRS on audit.

To find what is reasonable compensation, look at the market return. If investors are obtaining a high rate of return, executives should be compensated. Courts approach it many different ways. No indication how any of the factors should be weighed. Courts are not human resource departments. The test is unpredictable and leads to arbitrary conclusion.

No Super Personnel Department for Closely Held Corporation. The primary purpose of § 162(a)(1), which is to prevent dividends (or in some cases gifts), which are not deductible from corporate income, from being disguised as salary, which is. The IRS limits the amount of salary that a corporation can deduct from its income primarily in order to prevent the corporation from eluding the corporate income tax by paying dividends but calling them salary because salary is deductible and dividends are not.

Unreasonable compensation cases with can get very sticky. This is a lot like valuation, and courts rely heavily on expert testimony. How do you figure out if the compensation is reasonable? The IRS can really go after companies for unreasonable compensation and appeals might be necessary.

Tuesday, January 15, 2013

Rev. Rul. 92-80 Advertising Costs

How does INDOPCO ruling affect the treatment of advertising costs as business expenses, which were generally deductible under § 162?


INDOPCO does not affect the treatment of advertising costs under § 162. These costs are generally deductible under that section even though advertising may have some future effect on business activities, as in the case of institutional or goodwill advertising. Maintain good image with public.

Taxpayers can immediately deduct promotional material that is given out to potential customers. Same thing for package design. However, trademarks are capital costs. Remember to capitalize the cost of the trademark. Deduct the package design but capitalize the facilitation of hiring the lawyer for the trademark.  EVEN PAYING FOR MARKETING STRATEGY IS DEDUCTION.

Only in the unusual circumstance where advertising is directed towards obtaining future benefits significantly beyond those traditionally associated with ordinary product advertising or institutional goodwill advertising, must costs of that advertising me capitalized. What are benefits beyond advertising?

Advertising costs that create a separate and distinct asset must be capitalized. If there is ad campaign, but the only reason is to get admitted to a business organization. There is no other purpose but to create a separate and distinct asset. Make someone argument that you got something else.

Monday, January 14, 2013

IRS Trade or Business

What is the IRS definition of a Trade or Business?

Look at differences between a profit seeking activity and a trade or business. Harder to show than something was necessary and ordinary. TRADE=BUSINESS

TEST: To be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity and that the taxpayer’s primary purpose for engaging in the activity must be for income or profit. A sporadic activity, hobby, or amusement diversion does not qualify.

BROAD DEFINITION: Business is a very comprehensive term and embraces everything about which a person can be employed. In deciding whether an activity is a trade or business, courts need to examine the facts on a CASE-BY-CASE BASIS, looking into whether the taxpayer devoted his full-time efforts towards the activity on a regular, continuous, and substantial basis

Allowance of a deduction constitutes something of a congressional blessing, an indication that Congress regards the expenditure in question as worthy and appropriate for the taxpayer to do. A finding of “necessity” cannot be made, however, if allowance of the deduction would frustrate sharply defined national or state policies proscribing particular types of conduct, evidence by some governmental declaration thereof.

The test of non-deductibility always is the severity and immediacy of the frustration resulting from allowance of the deduction. The flexibility of such a standard is necessary if we are to accommodate both the congressional intent to tax only net income, and the presumption against congressional intent to encourage violation of declared public policy.

POLICY: § 162 business expense deduction should not encourage taxpayers to violate the law.

Personal Residence Deduction Requirements 163


Qualified Residence Income- Section 163- Itemized Deduction - Taxpayers are allowed to deduct most interest on mortgages that are secured by their personal residence. Very important politically because many people do it.

Personal Residence Deduction Requirements: § 163(h)(3)

FIRST, the number of personal residence is limited to two. § 163(h)(4)(A)(ii). Second home only qualifies if it used 15 days a year. Married couples may deduct one each.

SECOND, the home in question must secure the mortgage loan whose interest obligation the taxpayer seeks to deduct.

THIRD, the mortgage loan must be either “acquisition indebtedness” or “home equity indebtedness." Acquisition Debt is essentially a purchase-money mortgage, used either to buy or build the residence. 1,000,000 or 500,000. Home Equity Debt is any debt secured by a residence that is not acquisition indebtedness. $100,000 Cap. Equity=  FMV-Outstanding Mortgage

A taxpayer who has sufficient equity in the residence may borrow against that equity, use the proceeds for any purpose whatever, and still deduct the interest on the debt.

There is criticism about the vertical equity problem. The rich get more subsidy than the poor in this manner. Lots of people take this exemption. Maybe the Federal Government is losing too much REVENUE on the program.  Economic distortion problem. From the political perspective, lots of people bought their homes calculating their purchases with the interest deduction. All these rules apply to mobile homes.

Finally, the loan amounts generating deductible interest (but not directly the interest itself) are limited by dollar-level maximums: Interest with respect up to $1 millions of acquisition indebtedness can be deducted, as can interest with respect for up to $100,000 of home equity debt. These numbers have not been adjusted recently.

Saturday, January 12, 2013

Casualty Loss Deduction Section 165

Casualty Losses – Only Personal Loss Deduction Allowed

§ 165(a) – Losses incurred in a trade or business, or in activities engaged in for profits, are generally deductible. POLICY: The usual justification is that income tax should reach only the net income from business and profit-seeking activities, not gross receipts from those activities. 

§ 262(a) provides a general casualty loss rule that no deduction shall be allowed “for personal living, or family expenses” The tax rules disallowing for deductions for gradual loss in wealth in effect presume conclusively that the amount by which the value of an asset is diminished over time is itself the best measure of the consumption value enjoyed by the taxpayer over the same period.

§ 165(c)(3) will allow you to claim a casualty loss deduction.

Casualty Loss Requirements:

A deductible casualty loss has had to be a SUDDEN and somewhat dramatic event. § 165(c)(3) – FIRE, STORM, SHIPWRECK. OTHER CASUALTY, OR THEFT, SOMETHING SUDDEN

§ 165(h)(1) - Even if the property damage is a result of an acceptable sort of casualty, a casualty loss deduction is allowed only if and to the extent that the taxpayer’s loss exceeded $100.

§ 165(h)(2) which provides that the total amount of a taxpayer’s casualty losses for the year is deductible only to the extent is exceeds 10% of the taxpayer’s AGI in the same year. Sometimes specific exceptions to waive rules.

§ 165(h)(2)(B)- If the casualty gains exceed casualty losses, the gains are treated as capital gains and the losses are treated as capital losses.

Steps for Calculating the Deductions – Lesser of Adjusted Basis or Loss! 


  1. For each piece of property damaged, begin with FMV of the property before casualty.
  2. Subtract the value of the property after the casualty.
  3. Compare the result with the adjusted basis of the property, taking the lesser of the two numbers as the tentative casualty loss.
  4. Subtract the amount of any recoveries from tortfeasors or insurance coverage.
  5. Once that process is complete for each piece of property damaged in the casualty, the tentative casualty losses are added; and 
  6. Casualty gains if any, and statutory $100 deductible are subtracted for each casualty,
  7. If the taxpayer suffered more than one casualty, the steps above must be repeated for each piece of property in each additional casualty suffered. 
  8. Once the gains and loses from each casualty are computed, the taxpayer adds them together, then subtracts 10 percent of AGI. 1. That is the amount allowed for the deduction. 2. Check to see if this is bigger than the standard deduction.




Thursday, January 10, 2013

State and Local Tax Deduction

State and Local Tax Deductions 

History and Rationale of State and Local Tax Deduction - Best justified as a concession to Federalism. The Federal Government recognizes by this deduction that state and local governments have their own revenue needs. They can get money how they please. Consents to assess federal taxes only against the income that remains after state and local governments have exacted their assessments. POLICY: Equality issues if states provide different services and assess different kinds of taxes.

What Kind of State and Local Taxes are Deductible

Generally, § 164 provides that:
State and local income taxes, OR Sales tax , PICK ONE Real property taxes, and Personal property taxes are deductible, as are a few less general types of tax

For example: Interest imposed on real property, for the general public welfare. Then it is property tax and is deductible. Distinguish from fees that increase that value of the property assessed. Allows foreign taxes, this is controversial. Not a lot of wealth taxes, other countries do. What kinds of wealth taxes are deductible?

§ 164(b)(1) taxes must be on the value of something, not the weight or use for example. Presumably the idea is to allow deduction only of taxes imposed for a general-revenue raising purposes, rather than to recoup for externalities such as increased road costs due to the use of heavy vehicles

§ 164(c)(1) disallows deductions for assessments that tend to increase the value of the property assessed. For example, fees for new sidewalks or other improvements around a house that would increase its value for resale.f. What do we mean by tax: taxes and fees. There is a big distinction. Taxes are charges for primarily raising state revenue

NO FEES FOR USE or STATE PRIVILEGE! For example access to parks or a state university. These are not the type of state and local taxes that are deductible on a federal return. 

Tuesday, January 8, 2013

Ordinary and Necessary Business expenses

§ 162 says that deductions shall be allowable for all ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.An ordinary expense is one that is normally to be expected in view of the circumstances facing the business, and a “necessary” expense is one that is appropriate and helpful to the business.

Necessary means “appropriate and helpful” in the development of the taxpayer’s business. A requirement that a business show the absolute necessity of its expenses, in other words, would put the IRS in the position of reviewing every business decision to ensure that no money was spent unnecessarily.

Ordinary Expense-  The question of whether expenditure is “ordinary” has been more controversial in the development of the business deduction.  "Ordinary” means something that is “normal, usual, or customary” in the trade or business in which the taxpayer is engaged. Commonplace and used up in the course of a year. NOT CAPITAL EXPENSE.

The Principal function of the term “ordinary” is to clarify the distinction, often difficult, between those expenses that are currently deductible and those that are in the nature of capital expenditures, which, if deducible at all, must be amortized over the useful life of the asset.

There could be a public policy exception for some types of ordinary and necessary business expenses under § 162.

More Business Tax Information:

What are IRS Ordinary and Necessary Business Expenses

Saturday, December 29, 2012

IRS Tax Penalties

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What kinds of penalties are out there?
1.     Failure to file returns § 6404(1)
2.     Failure to pay § 6651(a)-(b)
a.     .5% of the tax on return plus extra .5% for each month In addition to interests, up to 25% percent
b.     Cannot deduct these as a business expense. POLICY: Congress enacted these rules to stop borrowing money from the government.
3.     Accuracy of Filings- § 6662
a.     Negligence of Substantial Understatement
b.     20% of any understated tax on your return
c.     Understating your tax liability
                                               i.     Negligence- Must make reasonable attempt
                                             ii.     Substantiality- Reckless
                                            iii.     Substantial Valuation Problem- overstating how much you gave, doing stuff with assets.
4.     Frivolous Returns- § 6702
a.     Tax protesters and people with positions the IRS deems frivolous
b.     Waste of time. Constitutional position is considered frivolous $5,000 fine
5.     Civil Fraud (Evading Taxes)- § 6663
a.     Use any legal means to reduce tax liability.  Avoiding taxes is fine. Evading taxes is bad.
b.     The government has burden to show more than a taxpayer is trying to reduce tax liability
                                              i.     Clear and Convincing evidence that the deficiency is due to intentional evasion. False material representations. INTENT TO EVADE TAX
                                             ii.     Concealing bank accounts, failure to cooperate, lack of good books and record. Experience and knowledge, more you know, more likely you knew what you were doing.
6.     Failure to Withhold § 6672
a.     Employers who fail to withhold. 100% of the amount not withheld
7.     Promoting Tax Shelters § 6700
a.     100% of gross income derived from the activity
8.     Penalty for aiding other tax payers understate. § 6701
a.     Both provisions are similar.
Criminal Tax Penalties - Not Big Enough to Deter Tax Evasion.
1.     Criminal Fraud §  7201
a.     People who are criminally hiding from taxes
b.     Guilty of Felony because violation of known legal duty
2.     Criminal Lying Penalty § 7206
a.     Fine or up to 3 years in jail.
3.     Exception § 6404(f)
a.     Immunity if you get bad advice from the IRS, you get immunity. Must be acting on good faith
b.     If you didn’t file 5% of the unpaid tax for the year, plus penalty for continued delinquency. Rises if your failure to file is deliberate.

Basic Federal Tax Concepts and Terms

Below is some basic terminology that deals with basic federal income tax issues. A better understanding of these terms will help with the filing of a business tax return on a personal 1040 return.

Tax Income Exclusions – THINK SOURCE

A tax allowance takes the form of an exclusion if qualification for the allowance depends on the source of an economic benefit. To some extent, the more favorable treatment of exclusions may be explained by their lower visibility. Harder to track and report to the IRS.

Deductions- THINK USE

An allowance takes the form of a deduction if it depends solely on the use of the funds by the taxpayer. Deductions appear as entries on tax returns, while exclusions do not.  The higher visibility of deductions makes them more obvious targets than exclusions, when Congress is in the mood to impose limitations on tax benefits. Current tax deductions are currently in in flux.

Credits- THINK REFUND

A credit directly reduces tax liability, while a deduction or exclusion reduces tax liability only indirectly – by reducing taxable income. Unlike a one dollar deduction which reduces taxable income by one dollar, a one dollar credit reduces tax liability by one dollars. Credits, like exclusions, but unlike many deductions, are allowed regardless of whether one itemizes deductions or claims the standard deduction.  Because of this, you would prefer the credit to the even if your marginal tax rate was greater than 20 percent, if you claim the standard deduction.

REMEMBER: The marginal rate is what matters for taxpayer decision making and planning strategies. You can apply the marginal rate by the amount of a deduction to see exactly how much money you don’t need to pay in taxes because of the deduction.

Information About Top Tax Deductions

Sunday, December 23, 2012

Alternative Minimum Tax Calculations

Alternative Minimum Tax

This is a tax at a flat rate lower than the highest regular rate that applies to an expanded tax income base.  It is compromised out of the AMTI,AMTI is adjusted to eliminate the benefits of many allowances allowed.  AMT was designed to prevent people from taking advantage of the tax system. Congress relies heavily on interest groups that are attached to particular exclusions Moral is important in the tax system because the system relies on voluntary compliance. If people feel that other people are not paying taxes,  then people won’t pay.Taxpayers calculate regular liability and tentative AMT, then pay the bigger one.

Alternative Minimum Tax- Taxable Income if Adjusted For:

1. Depreciation schedules for AMT purposes are different, 168 schedules do not apply. Use less generous depreciation methods. Preferences for investors with minerals

2. Tax exempt bonds. Private activity bonds. If the activity is not government but public enough, then the income is tax exempt. Airports, sewage facilities, certain housing Public/Private project. For AMT, this income is not exempt

3. Installment sales. For AMT, if the installment sale is to a customer, the taxpayer has to take full price under the contract into income for AMT purposes. The generous installment rules don't apply to stuff sold.

3. Misc. Itemized Deductions. Investment Expenses. Not deductible at all for AMT purposese.   

4. Disallows certain expenses that we could deduct immediately For example, 174 – research costs For AMT, these all must be amortized, capitalize

5. NOLs- under AMT, they are different.

6. Incentive Stock Options- When you exercise option, you pay income that you include in AMT.   Income = excess of the FMV over the option price

7. Medical Expenses. For AMT, it changes to 10% of AGI

8. Under §1202 – Sale of Small Business Stock. You can exclude half gain. For AMT, you can exclude 7%

9. Home mortgage interest. Acquisition debt, used to acquire or rebuild a residence. Don't get this deduction under Alternative Minimum Tax.

10. Personal and dependency exception. No standard deduction. No exemptions


Members of congress all want to do something about the AMT. the problem keeps growing and more and more people get pulled in. Widespread sentiment that it is wrong and change is needed. People like the idea of the AMT. Warren Buffet said that people with income over 1 million should pay some set fixed amount that a middle taxpayer pays. Big AMT with Big Exemption. Variety of options, lots of plans for a permanent fix. The next most likely thing is index the whole framework for inflation. Allow dependency exemptions for the purpose of AMT. Not fair to subject large families to AMT. Change the exemption for medical expenses or just repeal the Alternative Minimum Tax all together.


Saturday, December 22, 2012

Long and Short Term Business Goals

Why is the business environment short term oriented? 

It seems that there a few main reasons that many business remained focus on short terms goals. Managerial Incentives tend to focus on pay and rapid promotion. This seems to place pressure on employees to work towards quick pay offs. It seems managers in European countries are more focused on long-term growth and stability than their American counterparts.

How can organizations become more focused with long term goals? 

More training and corporate socialization is one method the texts describes for increasing management focus with long term goals. Making employees they are employed for the long term increases and sense of well being within a company. By building social obligations and investing in employee growth will lead to better long term financial results for a company.

Wednesday, December 12, 2012

Why do small businesses choose not to export?

What are some main reasons that small businesses choose not to export?

There are many advantages to exporting but small businesses may also choose not to engage in exporting for a few reasons. It may be too overwhelming for a small business to engage in international sales. A small business may not be able to handle the demands of shipping internationally, maintaining a web site in multiple languages, and receiving international payments. Lastly, managers/owners may exhibit risk aversion and a strong desire to avoid the problems associated with selling internationally. This may cause firms to decide to no expand internationally.

What are some popular customer contact techniques?

There are many ways to gain contacts and experience in international markets. For example trade shows, catalogs, international advertising agencies, and government sponsored trade missions are great ways to meet people internationally with similar ideas and businesses. Governments often sponsor events for companies looking to expand into new markets. These host governments will often introduce foreign companies to local sale representatives and distributors.

How important is the first move advantage?

This can be a very important element for a successful entrepreneurial firm. This occurs when a firm moves quickly into a new market and faces little competition. To succeed in a situation like this, the product must be be innovative and comprehensive. To be comprehensive means to exceed customer expectations in order to make it harder for competitors to compete. Overall, a small business may choose to export its products after evaluating its business model and situation.

Friday, December 7, 2012

Scholarship and Education Tax Benefits

§ 117(a) excludes from gross income “any amount received as a qualified scholarship by an individual who is candidate for a degree at a college or university. LIMITED TO TUITION, NO ROOM AND BOARD. Were services a condition to the award?

§ 117(c) Does not apply to “any amount received which represents payment for teaching, research, or other services by the student required as a condition for receiving the qualified scholarship. Certain parts of the grant might be excluded.

§ 177(d) = Qualified tuition reduction, it is like a non-compensatory scholarship. Provided to employees of education institutes for the education of the employee.

Hope Scholarship Credit § 25A(b): Equal to first 100% of the first 2,000, 25% to the second 2,000.  Now called the American Opportunity Credit. Up to $2500 for students

Life time learning credit §25A(c): Up to $2000, 20% of the first 10,000 qualified tuition expenses

Wednesday, December 5, 2012

Tax Employer Provided Health Insurance IRS

§ 106(a) excludes from the gross income of an employee the value of employer- provided health insurance coverage.

§105(b) excludes from gross income the value of benefits received under employer-provided health insurance, to the extent the benefits constitute reimbursement of medical expenses.

§ 125 provides that insurance may be provided under a cafeteria plan. Under § 125  a taxpayer who is offered a choice between cash and health insurance coverage, and who chooses insurance will not be taxed under the doctrine of constructive receipt.

Provisions exclude both premiums and benefits from the base of the income tax. For taxpayers with employer-provided health insurance, the §106 exclusion is the equivalent of an above-the-line deduction for the cost of insurance, not subject to any percent of AGI floor. Congress wants employers to provide pensions and insurance to all employees. Congress conditions tax-favored treatment for the executive’s pensions on the provisions of rank and file employees.

§ 213(a) medical expenses are deductible only to the extent they exceed 7.5 percent of adjusted gross income. Includes Insurance not from employer.

§ 162 (l) – Self-employed person can claim above the line tax deduction for insurance

Group Term Life Insurance - § 79 allows employees to exclude the value of group-term life insurance provided by their employers, for up to $50,000 of insurance.

Friday, November 30, 2012

Section 108 Discharge of Debt

Section 108(a) states debtors who are insolvent should indeed not be taxed on income from favorable discharge of debt. §108 excludes discharge of indebtedness from gross income under certain specified conditions, such as when the discharge occurs in bankruptcy or when the taxpayer is insolvent. Under ordinary taxation principles, discharge of debt would clearly fall within the broad definition of gross income provided by the IRC.

§ 108 thus provides a measure of relief for certain taxpayers who find themselves facing serious financial difficulties. Converts the exclusion into a deferral.

COD= Cancellation Of Debt, may have to against tax attribute. Tax Attribute = A tax benefit, when a taxpayer goes bankrupt, they will have lots of tools at their disposal. It may have to reduce them by cancellation of debt income that they got during the year of bankruptcy. Start with NOLs, they use that COD income to reduce the NOLs, then general business credits, offset these credits.

The taxpayer who takes of advantage of § 108 loses other valuable tax perks as a result, such as the ability to carry over into future years net operating loses and tax credits in the current year.    Exception, for qualified real property indebtedness.

§ 108(a)(1)(e) – Subsidy for Home Mortgage Debt. Taxpayers can exclude from COD if its qualified property indebtedness. If you have debt you use to construct or improve residence, the residence secures that debt. Residence must be used as the principal abode. Lots of specific tax benefits available as subsidies for certain kinds of debt.

§ 108(f)(1) - Exception to COD exclusion rule for certain student debt indebtedness.  Gross income does not include any cancellation of debt income because the individual worked for certain professions. Discharge of debt for certain things. Must have broad provision about working for certain organizations, if not, you have COD. No strict geographic limits either. This term is mushy.

Tuesday, November 27, 2012

How to ensure safe internet transactions

What steps can a business take to ensure safe internet transactions?

Transacting on the internet increases the risks a company must face. Yet, there are many ways for companies to reduce this risk. Some popular safety measures that companies must take include using firewalls, encrypting data, using web-site monitoring tools, and abiding by privacy polices.

How important is a company’s privacy policy? 

A privacy policy is a very important part of any website. Consumers must be very careful about what information about them is available to companies online. To ensure customer satisfaction, any company gathering customer information should supply a privacy policy explaining how the company will use their information. This will aid consumers in their decision to give information to a company.

Saturday, November 17, 2012

Loss Sale Rules Section 1091

Under § 1091, if a taxpayer realizes a loss on the sale of stock, NO LOSS DEDUCTION is allowed if the taxpayer purchases “substantially identical stock” within a period beginning 30 days before the date of such sale or disposition and ending 30 days after such date.

Disallowed loss is preserved in the new stock, under § 1091(d)

Tax Loss Sale Rule Section 1091 Example:

Bob  purchased a share for $100 in 2011, which he sold January 20 for $80. On February 5, Bob purchased a share of the same corporation for $90. No loss from the sale is recognized under  § 1091. The basis of the new share is $110; that is, the basis of the old share ($100) increased by $10, the excess of the price at which the new share was acquired ($90) over the price at which the old share was sold ($80).

§ 267(a)(1) – Disallows any loss deduction on a sale or exchange of property between certain related parties, including a parent and child. These also must be considered along with tax loss sale rules.

§§267(b)(1)  and (c)(3) determine the relationship testb.    See 267(d). You can deduct gain by size of loss that Bob did not realize. Any gain on a subsequent resale is recognized only to the extent it exceeds the disallowed loss. Rule does not change basis of the property in the hands of the buying party. So if the buyer resells the property at a loss, the loss is not increased by the amount of the prior disallowed loss.

“Cherry Picking” and the Capital Loss Limitations of § 1211

Under § 1211(b) an individual may deduct capital losses only against capital gains and a piddling $3,000 of non-capital gain income. Under § 1212(b), losses disallowed may be carried forward.
 Congress is concerned that taxpayers might engage in “cherry picking”, which is selectively realizing losses in their investment portfolios while making a point of not realizing gains. This is how tax loss sale rules come into play frequently.

Wednesday, November 14, 2012

Like Kind Exchanges Section 1031


Like-Kind Exchanges - § 1031
          i.     Basic Rule and Elements:
1.     § 1031 provides Nonrecognition of gains and losses incurred on the transfer of property in exchange for other property of “like kind”
2.     SCOPE:  § 1031(a)(1): It is limited to property that is used in a business or held for investment.
a.     There must be sign of continuous investment. Stuff cannot just sit there.
b.     LITIGATED ISSUE: The cases often turn on this requirement.
3.     EXCEPTIONS: § 1031 (a)(2): Precludes applicability of this Nonrecognition rule to several categories or property, among which are stocks, bonds, and notes; partnership interest, and inventory property. Most types of financial instruments are excluded
4.  Party claiming like-kind exchange must not be dealer in type of property exchanged.
        ii.     Policy Justification
1.     The asset is not liquid, so the taxpayer might not have cash to pay the tax on gain.
2.    Is the real justification, then, that a taxpayer who receives like-kind property should not be taxed because he has not changed the fundamental nature of his investment?
a.     Congress probably considered:
                                                                i.     Difficulty of valuation
                                                              ii.     Lack of liquidity
                                                            iii.     Continuation of the basic nature of the taxpayer’s investment.
 
      iii.     What qualifies? The LIKE KIND concept- VERY BROAD
1.  Regulations say that the concept refers to the “nature and character” of the property, and not to its “grade of quality”. BROAD WITH REAL ESTATE AND MORE LIMITED WITH OTHER ASSETS
2.     “same asset class” STANDARD
a.     The properties must be in the same asset class.
b.     Allows people to trade stuff of many different values
c.   They can be more different than properties that lack the material difference requirement for realization. SIMILAR NATURE OR CHARACTER
3.     In determining if two properties are of like kind, look first to the characterization of the properties in question.
a.     If both are real property, the answer will almost be yes.
b.   All real property is considered “like kind” for purposes of the statute, even if one is improved and the other is not, or if they are in different states.
c.     Both properties must be in the US to qualify § 1031(h)

        iv.     What qualifies as an “exchange”?
1.     Three party exchanges are OK. Someone can buy real estate from a third party, then trade it or other real estate.
2.     The IRS acknowledges that a properly structured three-party transaction such as this can qualify for Nonrecognition under § 1031.
3.     If the law did not permit such three-party exchanges, the practical significance of § 1031 would be very limited.


          v.     Boot in § 1031 transactions – Gain only recognized up to the boot for taxes
1.     Boot = Equalizing the transaction by throwing in cash. Does that mean anything thrown into the boot will spoil the transaction for § 1031 purposes?
a.     § 1031(b) says that if the taxpayer has gain on the property she transfers and receives consideration both in the for of qualified (like-kind) property and nonqualified property or cash (generally referred to as “boot” in either case), then the gain realized on the transferred property will be recognized, but only up to the amount of the boot – the amount of cash or the fair market value of the nonqualified property.
                                                                i.     It is necessary, in order to apply the rule of § 1031(b), to determine the taxpayer’s gain realized, which in turn requires a determination of the taxpayer’s amount realized – including the fair market value of the property.
                                                              ii.     Is it really possible to defend § 1031 as a response to valuation difficulties?
b.     1031(c) says that if the taxpayer has experienced a loss on the transferred property of like kind, then none of the loss is to be recognized if the consideration received is a mix of qualified and nonqualified property or cash. COMPLETE NONRECOGNITION
c.     Taxpayers with losses that they are disposing prefer not to qualify under § 1031.
 
        vi.     Basis of the acquired property in Like Kind Exchange § 1031(d)
1.     The basis of the acquired property will be an “exchanged basis” meaning that the historic adjusted basis in the transferred property will become the basis in the acquired property. Three adjustments required:
a.    Decreased by the amount of any money received (BOOT) by the taxpayer in the transaction;  In order to reflect the allocation of basis to the cash received by the taxpayer.
b.  Increased by the amount of any gain recognized by the taxpayer on the transaction;. To ensure that he is not taxed twice. The total basis to which the taxpayer is entitled is his old basis in the transferred property, plus his gain recognized on the transfer.
c.  Decreased by the amount of any loss recognized by the taxpayer on the transaction.
d.     INCREASE BASIS BY MONEY PAID. Not specified in statute: It is that the basis in the acquired property must be increased by any money paid by the taxpayer as part of the like-kind exchange.
                                                                i.     The regulations state that when additional consideration is given in a § 1031 transaction, the basis of the acquired property is the basis of the transferred property, increased by the amount of the additional consideration.
2.     POLICY: Most recognize built in gain.

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