Chapter 5 (Acct. 341)

Capital Additions Capital Recoveries

*Capital Additions* these are also called capital expenditures, they are expenditures that add to the value or prolong the life of property or adapt the property to a new or different use. Capital additions increase the basis a repair is not an addition capital expenditures are distinguished from deductible expenses as ordinary and necessary business expenses. *Capital Recoveries* these are things like deductions for casualty losses, cost recovery, and depreciation. These reduce the basis the most common form of capital recovery is the deduction for depreciation or cost recovery

What is The Difference Between Capital and Ordinary Taxes?

*Capital Gains* consistently taxed at lower rates than ordinary gains

Community Property vs Common Law Property Basis

*Community Property* if the decedent and the decedent's spouse own property under community property laws, one half of the property is included in the decedent's gross estate and its basis to the surviving spouse is its FMV. The surviving spouse's ½ share is also adjusted to FMV *Common Law Property* In a common law state, one half of the jointly owned property is included in the decedent's estate and is adjusted to its FMV, the survivors share of the jointly held property is not adjusted

Influence of the Courts Corn Products Refining Co. & Arkansas Best Corporation

*Corn Products Refining Co.* here the Supreme Court gave a landmark decision when it determined that the sale of futures contracts related to the purchase of raw materials resulted in ordinary, rather than capital gains and losses . § So the Corn Products company manufactured products made from grain corn and they purchased futures to ensure an adequate supply of raw materials. Delivery of the corn was accepted and unneeded contracts were later sold, and corn contended that any gains or losses on the unneeded contracts should be capital because futures are customarily viewed as security investments which qualify as capital assets. But the supreme court said that these transactions represented an integral part of the business for the purpose of protecting the company's manufacturing operations and the gains and losses should therefore be ordinary in nature § so because of this case, it has been interpreted an exception to the definition of a capital asset when the asset is purchased for business purposes *Arkansas Best Corporation* § here the Supreme Court ruled that the motivation for acquiring assets is irrelevant to the question of whether assets are capital assets Arkansas was a BHC and it sold shares of a bank's stock that had been acquired for the purpose of protecting its business reputation. So relying on the corn products doctrine, the company deducted the loss as ordinary. But the Supreme Court ruled that the loss was capital because the stock is within the broad definition of a capital asset

Fair Market Value (FMV) vs. Amount Realized vs. Adjusted Basis

*Fair Market Value* this is the price at which property would change hands between a willing buyer, and a willing seller, neither being under any compulsion to buy or sell the FMV of the property given is easier to determine than the FMV of the property received, so you can use the FMV of the asset given to determine the FMV generally selling expenses reduce the amount of property realized *Amount Realized* this is the money received + FMV of other property received + debt assumed by the buyer minus any fees or sales commissions paid by the seller *Adjusted Basis* the initial basis of property depends on how the property is acquired. Most property is acquired by purchase and therefore its initial basis is the cost of the property. However, if it is acquired from a decedent, its basis to the estate/heir is the FMV either on the date of death, or if the alternate valuation date is elected, six months from the date of death Initial Basis + Capital Additions - Capital Recoveries = Adjusted Basis

To be a sale or exchange, the transaction must be _____ , transactions between ___________ are closely scrutinized

1. Bona Fide = real and genuine 2. Related Parties

Basis for Property Received as a Gift (3) How Does Gift Tax Affect the Basis?

1. If the FMV of the gifted property at the time of the gift is greater than the donor's basis, the donee's basis is the same as the donor's basis (take HC) 2. If the FMV of the gifted property at the time of the gift is less than the donor's basis (HC) then the donee has a DUAL BASIS for the property. So any amount sold for a loss uses the FMV, and any amount sold for a gain uses the donors basis *Gift Tax* if the donor pays gift tax, the donee's basis is increased by a portion of the gift tax if the FMV of the property exceeds the donor's basis on the date of gift.

Questions to Ask When Classifying a Gain or Loss (3)

1. What type of property has been sold or exchanged? 2. When has the sale or exchange occurred? 3. What is the holding period for the company?

Gift Tax Increase in Basis Formula

[(Built in Gain / Amount of Gift) x Gift Tax Paid] + Basis Built in Gain = FMV - Donor's Basis

Real Property Subdivided for Sale Exceptions? (4)

a taxpayer who engages in regular sales of real estate is considered to be a dealer, and any gain or loss recognized is ordinary rather than capital. A special relief is provided in Sec. 1237 for nondealer, noncorporate taxpayers who subdivide a tract of real property into lots, part or all of the gain may be treated as a capital gain if the following are satisfied: 1. During the year of sale, the non-corporate taxpayer must not hold any other real property primarily for sale in the ordinary course of business 2. Unless the property is acquired by inheritance or devise, the lots sold must be held by the taxpayer for a period of at least 5 years 3. No substantial improvement may be made by the taxpayer while holding the lots if the improvement substantially enhances the value of the lot 4. The tract or any lot may not have been previously held primarily for sale to customers in the ordinary course of the taxpayers trade or business unless such tract at that time was covered by section 1237 section 1237 has a primary advantage that potential controversy with the IRS is avoided as to whether a taxpayer who subdivides investment property is a dealer. And this section does not apply to losses

Non-Business Bad Debt When May It Be Deductible?

bad debt losses from nonbusiness debts are deductible only as short term capital losses (STCLs), regardless of when the debt occurred. And a nonbusiness bad debt is deductible only in the year in which the debt becomes totally worthless

Why Not Tax Changes in Fair Value?

because until an item is sold you never know if it will be at a gain or a loss. If an item is currently at a loss, it still has the ability to turn it around and become a gain by the time the asset is sold also, the government abides by the "Wherewhithal to Pay" concept, that someone who may have a gain in the fair value doesn't necessarily have the amount in their hand so they cannot really pay

Uniform Capitalization Rules

businesses must capitalize certain costs in connection with inventory, such as DM, DL, MOH. But this rule also affects property other than inventory if the property is used in a taxpayers trade, or business, or in an activity engaged in for profit, so even taxes paid or accrued in connection with the acquisition/disposition of property increases/decreases the cost/realized amount

All Recognized Gains/Losses Have to Be Classified as What?

capital or ordinary

Holding Period for Stocks What if Option is Exercised?

if a shareholder receives nontaxable stock dividends or stock rights, the holding period of the stock received as a dividend or the stock rights received includes the holding period for the stock owned by the shareholder. However, if the stock rights are exercised, the holding period for the stock purchased begins with the date of exercise

Worthless Securities Who Has to Prove that the Security is Worthless? What if the Worthless Security is in an Affiliated Company What is an Affiliated Company? (2)

if any security that is a capital asset becomes worthless during the year, any loss is treated as a loss from the sale or exchange of a capital asset on the last day of the tax year *Who Has to Prove that the Security is Worthless?* whether a security has become worthless during the year is a question of fact, and the taxpayer has the burden of proof to show evidence of worthlessness *Securities in Affiliated Companies* if the security that becomes worthless is a security in a domestic affiliated corporation owned by a corporate taxpayer, the worthless security is not considered a capital asset, so this is treated as an ordinary loss. *Affiliate Company* An affiliated corporation is one where the parent corporation must: 1. Own at least 80% of the voting power of all classes of stock and at least 80% of each class of nonvoting stock. 2. The sub must be engaged in the active conduct of an operating business as opposed to being a passive investment company (so more than 90% of its aggregate gross receipts should be from sources other than passive types of income such as royalties, dividends, and interest)

Retirement of Debt Instruments

if debt is RETIRED, it is treated as being an exchange a small amount of bond discount is sometimes converted to capital gain, but if the discount is large enough to be classified as an original issue discount, the discount must be amortized and included in gross income for each day the debt instrument is held for both cash and accrual method taxpayers.

How Long is an Asset Held to be Long Term or Short Term?

if the asset is held for one year or less the gain or loss is classified as short term capital gain (STCG) or a short term capital loss (STCL). And if held for more than one year (LTCG or LTCL)

Options

if the owner of an option exercises it, the amount paid for the option is added to the purchase price of the property acquired if the optioned property is a capital asset, the option is treated as a capital asset w/ a capital gain or loss if the call is exercised, the writer adds the option price and the stock together, if not, they just write the option price

Definition of What Isn't (5) vs. Is a Capital Asset (2)

instead of defining what a capital asset is, they define what a capital asset ISN'T. So here is a list of items that AREN'T capital assets 1. Inventory or property held primarily for sale to customers in the ordinary course of a trade or business 2. Property used in the trade or business and subject to the allowance for depreciation provided in section 167 or real property used in a trade or business 3. Accounts or notes receivable acquired in the ordinary course of a trade or business for services rendered or from the sale of property described in item 1 4. Supplies of a type regularly used or consumed in the ordinary course of a trade or business 5. Other assets *What Is a Capital Asset* 1. Personal Use Property 2. Investment Property

Capitalization of Interest Requirements for the Real Property (3)

interest on debt paid or incurred during the production period to finance production expenditures incurred to construct, build, install, manufacture, develop, or improve real or tangible personal property must be capitalized *Requirements for the Real Property* 1. Must have a long useful life (at least 20 years) 2. An estimated production period exceeding one year and, 3. A cost exceeding $1,000,000 the production period starts when production of the property begins, and ends when the property is ready to be placed in service, or is ready to be held for sale

Dealers in Securities Type of Income? Capital or Ordinary? When Must Identification Occur? What Must Happen to Securities at the EOY?

normally a security dealer's gain on the sale or exchange of securities is ordinary income. But Section 1236 provides an exception for dealers in securities if the dealer clearly identifies that the property is held for investment. The security must not be held primarily for sale to customers in the ordinary course of the dealer's trade or business at any time after the close of the day of purchase. *When Must Identification Occur?* This act of identification must occur before the close of the day on which the security is acquired *What Must Happen to Securities at the EOY?* Securities must be marked to market at the end of each year

Tax Planning Considerations

o Selection of Property to Transfer by Gift = there are many tax reasons to make gifts of property, for example, to get rid of income producing property to someone in a lower tax bracket. It is generally preferable to make gifts of properties that are expected to significantly increase in value during the post gift period before the donors death, any increase in value after the date of the gift are not included in the donor's gross estate. It is not advantageous to make a gift of property that has a basis greater than its FMV because the donee's basis for determining a loss is the FMV. The excess of the donors basis over the FMV at the time of the gift may never generate any tax benefit for the donor or the donee, therefore the donor should sell the asset and make a gift of the proceeds if the loss on the sale is deductible. The effect of gift taxes paid by the donor on the donee's basis for property received is also another reason why it may be more advantageous to give appreciated property rather o Selection of Property to Transfer at Time of Death = an integral part of gift and estate planning is the selection of property to be transferred to family members and others during the taxpayers lifetime and upon death. Usually taxpayers find it advantageous to retain highly appreciated property in their estates and transfer such property at death to the taxpayers heirs because the basis will be increased to its FMV at the date of death. Investment and business assets that have declined in value should normally be sold before death to obtain an income tax deduction for the loss. If the property is not sold or otherwise disposed of before death, the basis of the inherited property is reduced to its FMV

Patents Requirement for Patent to be Capital Asset Definition of a Holder Who Cannot be a Holder?

section 1235 allows the holder of a patent to treat the gain resulting from the transfer of all substantial rights in a patent as LTCG. This tax treatment is more favorable than that accorded to producers of artistic and literary works *Requirement* The principal requirement for a patent being treated as a capital gain is that the holder must transfer all substantial rights to the parent, the circumstances of the whole transaction should be considered in determining whether all substantial rights to a patent have been transferred, all substantial rights to a parent have been transferred. All substantial rights have not been transferred if the patent rights of the purchaser are limited geographically within the country of issuance or the rights are for a period less than a patents remaining life *Definition of a Holder* long term capital gain treatment applies only to a holder of the patent rights. A holder is an individual whose efforts created the property or an individual who acquires the patent rights from the creator for valuable consideration before the property covered by the patent is placed in service or used *Who Cannot Be a Holder* the acquiring individual may not be related to the creator, or be the creators employer but corporations are not permitted to be holders

Lease Cancellation Payments Types of Lease Cancellations (2)

so a lease can be terminated if there is a lease cancellation payment made as consideration for the other party agreeing to terminate the lease usually. But it depends on who receives the lease payment *Types of Lease Cancellations* 1. Payment Received by Lessor = these are treated as ordinary income on the basis that the payments represent a substitute for rent. So it if included in the lessors income in the year received 2. Payment Received by Lessee = these are considered as amounts received in exchange for the lease, so if the lease is a capital asset, it is a capital gain or loss

Nontaxable Stock Rights Received

stock rights are rights to acquire shares of a specified corporations stock at a specific exercise price when certain conditions are met. If the FMV of the nontaxable stock rights received are less than 15% of the FMV of the stock, the basis of the stock rights is zero unless the taxpayer elects to allocate the basis between the stock rights and the stock owned before distribution of the stock rights. The decision to allocate the basis affects the gain or loss realized on the sale or disposition of the stock rights because the basis of the rights is zero unless an allocation is made. Furthermore, the basis of any stock acquired by exercising the rights is affected by whether or not a portion of the basis is allocated to the rights

Carryover Basis Special Rules 2010

the estate tax was eliminated for individuals dying in 2010. a modified carryover basis rule applies if the estate elects to not have the estate tax apply. A taxpayer who inherits the property will take the lesser of the decedent's basis or FMV at time of death, but the basis may be increased if the asset is appreciated. The basis may not be increased to more than the FMV, and the total amount of increase is limited to $1.3 million plus any unused built-in loss or NOL carryover, a surviving spouse may receive an additional $3 million adjustment

Recognized Gain or Loss When Are Losses Deductible? What About Losses on Personal Assets?

the amount of gain or loss actually reported on the tax return is the recognized gain or loss *When Are Losses Deductible?* losses are generally deductible if they are incurred in carrying on a trade or business, or incurred in an activity engaged in for profit, or casualty and theft losses. *What About Losses on Personal Assets?* Realized losses on the sale or exchange of assets held for personal use are not recognized for tax purposes, so a taxpayer who incurs a loss on the sale or exchange of a personal use asset does not fully recover the basis AND YOU CANNOT DEPRECIATE SOMETHING IF IT IS FOR PERSONAL RESIDENCE NOT USED IN A TRADE, BUSINESS, OR FOR THE PRODUCTION OF INCOME

Property Converted from Personal to Business Use Basis

the basis for determining depreciation is the lower of FMV or the adjusted basis of the property when the asset is transferred from personal use to an income producing use or for use in a trade or business. This rule prevents taxpayers from obtaining the benefits of depreciation to the extent that the property has declined in value during the period that it is held for personal use if a personal use asset is transferred to business use when its FMV is less than its adjusted basis, the basis for determining a loss on a subsequent sale or disposition of the property is its FMV on the date of the conversion to business use less any depreciation taken after the transfer to business use

Property Received from a Decedent Basis When Must an Estate Tax Return be Filed? When May an Alternate Valuation Date be Chosen?

the basis of property received from a decedent who died in a year other than 2010 is: 1. The FMV of the property at the date of the decedent's death, or 2. An alternate valuation date (AVD) which is generally 6 months after the date of death's FMV, unless the property is sold or distributed before that date. If the AVD is used, property distributed or sold after the date of the decedents death, and before the AVD has a basis equal to its FMV on the date of distribution, or the date of disposal *Estate Tax Return* but if the estate is small enough that an estate tax return is not required, the value of the property on the AVD may not be used, an estate tax return must be filed if an individual dies in 2020, and the gross estate plus any previous taxable gifts exceeds $11.58 million *When May an Alternate Valuation Date be Chosen?* the AVD may only be elected if the value of the gross estate and the amount of estate tax after credits are reduced as a result of using the AVD. This means that the aggregate value of the assets determined by using the AVD may be used only if the total value of the assets decreased during the six-month period

Nontaxable Exchanges How Do You Determine Basis? Holding Period?

the basis of the property received is determined by taking into account the basis of the property given in the exchange. If the properties are capital assets or Section 1231 assets, the holding period of the property received includes the holding period of the surrendered property. In essence, the holding period of the property given up in a tax free exchange is tacked on to the holding period of the property received in the exchange.

Holding Period Holding Period: Gift Holding Period: Property Received from Decedent

the length of time an asset is held before it is disposed of is an important factor in determining whether any gain or loss resulting from the disposition of a capital asset is treated as long term or short term. To be classified as a long term capital gain or loss the capital asset must be held for more than one year. To determine the holding period, the day of acquisition is excluded and the disposal date is included if the date of disposition is the same date as the date of acquisition, but a year later, the asset is considered to have been held for only one year. If the property is held for an additional day, the holding period is more than one year. The fact that all months do not have the same number of days is not a factor in determining the one year period *Gift Holding Period* if a person receives property as a gift and uses the donors basis to determine the gain or loss from a sale or exchange, the donors holding period is added to the donee's holding period. But if the donee's basis is the FMV of the property on the date of the gift, the donee's holding period starts on the day after the date of the gift, this situation occurs when the FMV is less than the donor's basis on the date of the gift and the property is subsequently sold at a loss *Property Received from a Decedent* the holding period of property received from a decedent is always deemed to be long term, and if the person who receives the property sells it within one year after the decedent's death, the property is considered to be held for more than one year, regardless of how long the property is actually held

Franchises, Trademarks, and Trade Names??

there was a lot of uncertainty to whether the transfer of a franchise, trademark, or trade name should be treated as a sale or exchange or licensing agreement. If the transfer is tantamount to a sale of the property, payments received should be treated by the transferor as a return on capital and capital gain, and the transferee should be required to capitalize and amortize such payments. But if the transfer represents a licensing agreement the transferor should recognize ordinary income and the transferee should receive an ordinary deduction for such payments and a transfer of a franchise, trademark or trade name shall not be treated as a sale or exchange of a capital asset if the transferor retains any significant power, right, or continuing interest with respect to the subject matter of the franchise, trademark or trade name. But if the transferor does not retain any significant power, rights, or continuing interest in the property. The transferor treats the transfer as a sale of the franchise and has the benefits of capital gain treatment, however, any amounts received that are contingent on the productivity, use, or disposition of such property must be treated as ordinary income by the transferor under section 1253 the transferee may deduct payments that are contingent on the productivity, use, or disposition of such property as business expenses. Generally, other payments are capitalized and amortized over 15 years, and in practice payments received for the transfer of a franchise are generally treated as ordinary income to the transferor and are deductible by the transferee because in most franchise agreements the transferor desires to maintain significant powers, rights, or continuing interests in the franchise operation

Nontaxable Stock Dividends Received ???

this is for if you already own stock in a corporation and they decide to give you stock dividends, so if you receive one, a portion of the basis of the stock on which the stock dividend is received is allocated to the new shares received from the stock dividend, and the cost basis of the previously acquired shares is reduced by the amount of basis allocated to the stock dividend shares. If the stock received as a stock dividend is the same type as the stock owned before the dividend, the total basis of the stock owned before is allocated equally to all shares now owned

Realized Gain/Loss Formula Are Gains Only On Sales? What Kind of Transfer Does Not Realize a Gain/Loss? (2)

this is the proceeds - the adjusted basis, so a gain is realized when the amount realized is greater than the basis, and a loss vice versa *Are Gains Only On Sales?* gains or losses usually involve a sale, but you can also realize them on other things, like disposition or property like an exchange, theft, distribution etc. *What Kind of Transfer Does Not Realize a Gain/Loss* gains or losses are not realized when property is disposed of by gift or bequest and there must be an event for the disposition to occur, not just because FV changes

Recovery of Basis Doctrine

this states that taxpayers are allowed to recover the basis of an asset without being taxed because such amounts are a return of capital that the taxpayer has invested in the property

Arguments for the Justification for Preferential Treatment of Net Capital Gains (3)

this was first created by the Revenue Act of 1921. Many people say that capital gains do not represent income and shouldn't be taxed, while others say capital gains are no different from any other type of income and should still be taxed accordingly. A few of the common arguments are below 1. Mobility of Capital = without some form of preferential treatment, taxpayers who own appreciated capital assets may be unwilling to sell or exchange the asset if high tax rates exist, despite the presence of more attractive investment opportunities. In essence the taxpayer may be locked in to holding an appreciated capital asset instead of shifting resources to more profitable investments. While the payment of any tax creates somewhat of a "locked in" effect. The effect can be reduced by lowering the tax rate. A lower tax rate on net capital gain should reduce the taxpayers unwillingness to sell the asset and allow for more mobility of capital. 2. Mitigation of the Effects of Inflation and the Progressive Tax System = because the tax laws do not generally reflect the effect of changes in purchasing power due to inflation, the sale or exchange of a capital asset may produce inequitable results, in fact, taxes may have to be paid even where a transaction results in an inflation adjusted loss. With a progressive tax system, the failure to adjust for inflation creates an even greater distortion, however it should be noted that this distortion applies to all assets, not just capital assets 3. Lowers the Cost of Capital = by reducing the tax rate on capital gains, investors are more willing to provide businesses with capital and the cost of capital is reduced. A lower cost of capital encourages capital formation to create more jobs and improve our competitive position in the global economy. Reducing the cost of capital is particularly important for the formation and growth of small businesses

Tax Treatment of Capital Gains and Losses: Corporations How Far Can Capital Losses be Carried Back? Forward?

unlike the corporate taxpayers who may deduct up to $3,000 of capital losses from ordinary income, corporations may offset capital losses only against capital gains. *How Far Capital Losses May be Carried Back* Corporate taxpayers may carry capital losses back to each of the three preceding tax years (the earliest of the three tax years first, and then to the next two years) *How Far Capital Losses May be Carried Forward* forward for five years to offset capital gains in such years, when a corporate taxpayer carries a loss back to a preceding year or forward to a following year, the loss is treated as an STCL unlike individual taxpayers, corporations do not receive any preferential rate reductions for net capital gains, corporations are taxed on ordinary income and LTCG at a flat rate of 21%

Homogenous Property Methods (3)

usually the adjusted basis of property sold is easily identified, but problems arise when the property is homogenous, like if an investor owns lots of common stock in the same corporation purchased at different times for different prices. *Methods* here are the methods to determine the basis of what is being sold 1. If there is a way to specifically identify the shares 2. If not specific identification, use FIFO 3. For mutual fund share sales only, you can use average cost

Allocation of Basis in Basket Purchase & Common Cost

when property is obtained in one transaction but portions of the property are subsequently sold at different times 1. Basket Purchase = if more than one asset is acquired in a single purchase transaction, the cost must be apportioned to the various assets acquired. The allocation is based on the relative FMVs of the assets 2. Common Cost = this is when you buy items, and to install it there are common costs that are incurred across all the assets. You must take the proportion of the total amount paid and attribute it to each specific cost amount to see how much cost does to what product