Cost Recovery

Question 1

What is the key provision for cost recovery?

Answer 1

162 allows the deduction of ordinary and necessary expenses incurred in connection with a trade or business

Question 2

What does ordinary mean in 162?

Answer 2

Short term benefit (if you use it up in this tax year or next tax year, then it’s ordinary)
Ordinary does NOT mean commonplace

Question 3

What does necessary mean in 162?

Answer 3

appropriate and helpful in the business
Welch v Helvering drew an analogy to McCulloch v Maryland and the necessary and proper clause
(court’s won’t usually second guess the judgment of the businesspeople making the decisions)
This is necessary to police the line between business expenditures and personal expenditures

Question 4

What is the guiding principle of expensing

Answer 4

Match expenditures as closely as possible to the associated revenues (Rev Rul 94-38). For this reason, environmental remediation expenditures are always expensible (rev from polluting was in the past so expensing today is as close as we can get)

Question 5

What was so revolutionary about INDOPCO?

Answer 5

Birfurcates the expensing analysis
1) Is this expensable this year? (must be ordinary and necessary) (if there is no long term benefit then expense it - the long term benefit of not getting sued might be long term)
2) IF NOT, where should I capitalize this expense?
(do not change answer to 1 based on 2. Maybe you add to basis)

Question 6

Why did everyone hate INDOPCO?

Answer 6

it meant they had to wait a long time to recover the costs of capitalized expenditures (if they could recover them at all)

Question 7

What are the INDOPCO rules?

Answer 7

They are products of lobbying that exempt expenditures segments from INDOPCO (and this make them immediately epensible)

Question 8

What is the core (fact specific) holding of INDOPCO?

Answer 8

expenditures by a target in a friendly deal are capitalized

the bifurcated process also stands - just need to check for industry carveouts

Question 9

What is the failed business doctrine?

Answer 9

If you spend money toward a venture that is either shut down pre-launch or launches and then fails, the expenditures on that project are deductible
(this is because there is no long-term benefit so the necessary and ordinary requirements of 162 are met

BUT if you spend $ researching 10 locations for a store and end up moving forward with 1, you can’t expense 9/10ths. You capitalize all into the one store

Question 10

When are capitalized costs recovered?

Answer 10

Might be recovered gradually in depreciation, might be recovered all at once when property is sold, might never be recovered

Question 11

What is the main case that says repairs are deductible as expenses?

Answer 11

Midland Empire Packing (not great logic but still)

Question 12

What makes Midland so great for taxpayers?

Answer 12

If you classify an expenditure as a repair, you can expense it immediately regardless if it has a long term benefit

Question 13

Why is Midland’s theory not great?

Answer 13

The idea that you can expense something with long term benefit undermines our understanding of the ordinary requirement in 162

Question 14

When is an expenditure a repair?

Answer 14

An expenditure is a repair if 1) it does not add to the value of the property (as measured pre-break) AND 2) the expenditure does not extend the expected life of the property BUT if you are repairing a condition that existed prior to the taxpayer’s acquisition of the property

Question 15

What would Abrams rather have instead of the Midland deduction for repair expenses?

Answer 15

Allow the firm to take a 165 loss when the break happens (which would allow them to deduct the value of the loss from basis) and capitalize the $ spent on the repair

The only difference between the Abrams method and the Midland method is that the 165 loss is capped at the basis in the property

Question 16

Can you take the midland repair expense deduction and also claim the loss under 165?

Answer 16

No, if you do a midland repair expense, you cannot also deduct a 165 loss

Question 17

What is the Norwest Project Rule?

Answer 17

If an expenditure is made as part of capital improvement, it must be capitalized (even if in isolation, it could be expensed)

Question 18

Can you automatically expense all leases and capitalize all purchases?

Answer 18

No. The same 162 rules apply no matter if you call it a lease or a sale (ordinary and necessary)

Question 19

Is there a high difference in the decision between a lease and a purchase?

Answer 19

Probably not (See estate of Starr v Commissioner - sprinkler provider was leasing custom installed sprinklers) - if the tax code was perfect, there would be no difference

Question 20

How much of the cost of a lease can you deduct each year? How much of the cost of a purchase can you deduct each year?

Answer 20

If lease, can expense the portion of the lease payment that is used in the current year (can’t expense the whole amount paid automatically - mind 162)

If sale, can expense depreciation and any interest if it’s an installment sale (interest on an installment sale is the difference between the sum of the payments and the cash purchase price)

Question 21

How to parse a sale form a lease

Answer 21

Purchaser retains title at the end of a sale. Leassor retains title at the end of a lease. If a lease is for the entire useful life of the asset, it starts to look like a sale

Remember, if a party has the right to do something and the economic incentive to do it, tax law presumes they will do it (so if you want something to look like a lease, don’t set a buyout price at less than what FMV will be)

Question 22

What does the theoretical idea of depreciation look like?

Answer 22

It’s non-uniform (if income is uniform) where the depreciation increases each year (because the value of the property is declining by the value of the furthest out cash flow and compounding makes it non-uniform)

Question 23

What are the 4 factors that should affect depreciation in an ideal tax system and why do we not use them?

Answer 23

1) The amount of future cash flows
2) the timing of future cash flows
3) The risk of those payments
4) the duration of the future cash flows
then depreciation is the decrease in the MV of the asset
It’s impossible to know all of these factors, so Congress approximates with arbitrary rules

Question 24

What are a few of the assumptions Congress has made to reduce litigation?

Answer 24

Taxpayers no longer tailor the recovery period to the asset in the hands of that particular taxpayer
Salvage value is conclusively presumed to be $0
Taxpayers no longer need to prove date placed in service because of conventions

Question 25

Remember fo depreciation, we are not going out and trying to price a used widget and then recognizing depreciation as the difference, we are holding everything constant except for the passage of time

Answer 25

The passage of time reduces future cash flows and that reduction is what we want to expense

Question 26

What are the 3 routes for depreciation of tangible assets?

Answer 26

1) The 168 category approach
2) 168k bonus depreciation
3) 179 Automatic Expensing

Question 27

What are the 3 steps in 168 category depreciation?

Answer 27

1) determine the recovery period (look at regs for class life then convert to recovery period using 168e)
2) Determine the depreciation method under 168b
3) Use the appropriate convention for date placed in service (168d)

Question 28

Describe the date placed in service conventions for 168 depreciation?

Answer 28

Mid year convention is the go to. Mid quarter convention is the anti-abuse rule and mid month convention is real estate. All property will take one year longer than the recovery period to depreciate

Question 29

What is depreciation recapture?

Answer 29

When you depreciate property you adjust your basis in it. When you then sell the depreciated property, if amt realized > adj basis, you will have a gain. That means you took too much depreciation and the gain is recapturing it. If gain > total depreciation taken.

Question 30

Is the gain on depreciated property capital gain or ordinary income

Answer 30

Recaptured depreciation is ordinary gain and any gain in excess of recaptured depreciation is capital gain.

Question 31

What do the depreciation recapture provisions also do?

Answer 31

They negate any nonrecognition provision that may apply

Question 32

Describe automatic expensing under 179

Answer 32

Taxpayer can immediately expense property that would otherwise be capitalized with 3 limitations

1) no real estate
2) property must be acquired by purchase
3) only 1M of assets can be expensed each year (and there 1M cap is reduced dollar for dollar for each dollar over 2.5M

Question 33

What is bonus depreciation under 168k

Answer 33

Full value of any asset placed into service before 1/1/23 (except for real estate) is fully deductible immediately (no cap). This means buying property is a huge tax benefit

Question 34

What is the mass asset rule?

Answer 34

If something is inextricably linked to something else that does not have a fixed and determinable useful life, the mass asset rule says that taxpayers cannot split them (so can’t generally depreciate components of an asset separately). (think customer lists being linked to goodwill in Houston Chronicle)

There is an exception for splitting real estate from non realestate

Question 35

What property can be depreciated?

Answer 35

Must have a fixed and determinable useful life and used in a trade or business for the production of income (167(a)

Question 36

What are some examples of tangible assets that cannot be depreciated?

Answer 36

Stocks and unimproved land. (if land is purchased for minerals or water, the purchase price is apportioned to the land and the minerals and you can “deplete” the minerals but not the land)

Question 37

What is the general rule for depreciating good will?

Answer 37

Goodwill is generally not depreciable because it does not have a fixed and determinable useful life (no special rule here, just normally fails the 167a test)

Question 38

What is the exclusive rule for depreciating intangible assets?

Answer 38

197b makes 197 the sole source for any potential depreciation for any property that meets the definition of “amortizable section 197 intangible” (which is almost all intangibles)

197a. Must have a fixed and determinable useful life for 15 years. If it’s a 3 year patent, still depreciate it over 15 years

Question 39

What method does 197 use to amortize intangibles?

Answer 39

Straight line

Question 40

What are startup expenses under 195?

Answer 40

any expenditure that would have been deductible if the business had been open but are incurred before it opens
(e.g.R&D, training employees, etc)

A limited portion can be expensed when incurred but that amount cannot exceed $5K see 195b1a

Question 41

What are the two requirements to expenses education expense under 1.162-5?

Answer 41

Expenditure must be either 1) maintaining or improving skills used by the taxpayer in his current trade or business OR 2) meet the express requirements imposed on the taxpayer for continuing their trade or business

But cannot 1) help taxpayer meet the min. requirements for trade or business OR 2) qualify the taxpayer for a new trade or business

Question 42

What are the two main cases for expensing education costs?

Answer 42

Carroll (Police officer studying philosophy to become a lawyer)
Duecaster (high school teacher enrolled in law school and deducted education costs as a startup expense)

Question 43

Explain why Reg 262-1b9 is arbitrary and capricious?

Answer 43

195 (Start-up expenditures) says that expenses that would have been deductible had a business been open (e.g. 162-5b3 edu expenditures) are amortizable. 1.262-1b9 stands in the way of the proper operation of 195 by calling these pre-opening edu expenditures personal (even though they are clearly profit seeking)

Question 44

What is considered a new trade or business?

Answer 44

Anything that requires a license is a new trade or business.

Question 45

Under what provision do you expense education (if you an at all)?

Answer 45

162. (there is a special reg in 1.162-5)