Deductions for the Costs of Earning Income Flashcards
Beatrice has $100k in cash. She uses the $100k to purchase vacant land, which retains its value throughout the year. Should she get an immediate deduction for the cost of the land? (Consider why or why not by thinking about the Haig-Simons definition of income.)
Wealth goes down 100k, then up 100k; no worse off from Haags Simon: no deduction
Joey owns a successful little café. He spends $100k operating the café in the current year. These are operating costs that don’t produce any particular asset, like land. Should he be able to deduct the costs immediately? (Consider why or why not by thinking about the Haig-Simons definition of income.)
Deduction because no asset increase with cash loss
Henry decides to start a taxicab business. As a result, in year 1, he uses $50k to buy
vacant land, $100k to purchase taxicabs, and $75k to buy gasoline (all the gas is used in year 1). The $50k land retains its value throughout the year. The taxicabs decline in value by 10% (as a result of the wear and tear from use) over the course of the year. What, if any, deductions should Henry be allowed? (Consider your answers in light of the Haig-Simons definition of income.)
Is he worse off? Yes
Gas is an operating expense
No deduction on land
Which of these require capitalization?
- Cabs (has value beyond the taxable year in which its purchased) - Could get 10% depreciation deduciton each year (but his basis goes down 10k first year)
- Land (has value beyond the taxable year in which its purchased) - Recovers this basis later, when he sells it
- Not gas (all used up by end of year) - So, immediate deduction
If a taxpayer purchases a building that will be used as a rental building, must the cost of the building be capitalized or can it immediately be deducted?
Capitalize it, because it will result in income past the taxable year
Building is a wasting asset, because won’t be able to rent it out forever without putting more money into it
There’s a presumption of life for rental buildings of 39, 1/2 years (Section 168)
If a taxpayer actually builds the rental building, must the taxpayer capitalize the construction costs or can they immediately be deducted?
Still be capitalized; doesn’t matter whether you purchase the building or you build it yourself
While the taxpayer is constructing the building in #5, an accident occurs and part of the building falls down. The taxpayer decides to scrap that part of the building and make the building smaller. Can the taxpayer deduct the costs of that part of the building?
No, because that’s just the cost of building that building
By analogy, what if Encyclopedia Britannica decided to scrap certain portions of the manuscript they hired outside writers to compose? Should they be able to deduct the cost for those portions of the manuscript?
no, will still have to capitalize the chapters
Imagine a taxpayer was building four buildings in four different cities. One building is destroyed and is scrapped. Can the taxpayer deduct the cost of that building?
Can probably take a loss for it in Section 165 (for the one scrapped bulding), but depreciate for the other buildings
four distinct projects
Imagine that the encyclopedia the outside writers produce for Encyclopedia Britannica is in four volumes. Encyclopedia Britannica realizes that one of the volumes is unacceptable and decides to scrap it. Can Encyclopedia Britannica deduct the cost of that volume?
Probably it is all part of one project. Will have to capitalize it into the basis of the manuscript.
if not one project, may be able to take it as a loss
What was Encyclopedia Britannica v. Commissioner?
Appellee publisher hired a third party to write a book and then treated its advances to the third party as ordinary and necessary business expenses deductible in the current year under 26 U.S.C.S. § 162(a). Appellant Commissioner of Internal Revenue assessed deficiencies on the ground that the advances were capital expenditures. The tax court found for appellee. On appeal, the court reversed. Appellee’s advances to the third party were nonnormal and nonrecurrent. Appellee’s expenditures were unambiguously identified with the book written by the third party.
Book is a wasting asset, so depreciation deduction allowed
What is 167 about?
there should be a reasonable allowance for wear and tear on property used in T/B or used for the production of income
What is 263 about? What types of property does it apply to?
capitalization of assets that produce income beyond the taxable year; shouldn’t get immediate deductions in improvements to those types of property; instead get depreciation deductions over time, and increase basis for eventual sale
all types of property
If I have a rental building, and my adjusted basis in the building at beginning of a span of years is 80k, what is the yearly deduction I can take on the property? What happens in year 41? What happens when I sell it in year 50? What kind of method of allocating depreciation deductions is this called?
Since the default for rental buildings is 40 years, then take pro rata of 80/40=2, so 2k each year.
No more depreciation deductions, so whatever I make in income is all income.
All gain when I sail it
“the straight line method”
Does land depreciate? What happens when you buy land with a building on it? Are there any other non-wasting assets?
No
Separate basis for land and building
Goodwill (no amortization for that - which is the term for depreciation on intangible assets)
When is the basis of non-wasting assets recovered?
at sale
What would have been the result in Encyclopedia if they had done it in-house? Is this the right result?
all the expenses would have just been 162 deductible - current deduction
maybe not; since they make income over years from what’s done that year, but administrability says you got to take it the deduction now
What is 263A do?
can’t take current deduction for salaries to employees who work on projects that make income over years
have to take costs of various salaried employees, and divide them up into different activities
What about repairs and maintenance generally? What is the repair doctrine?
As a general rule, taxpayers may take a current deduction for amounts spent on repair and maintenance of property, whereas the cost of improvements to property must typically be capitalized (i.e., added to the basis of the property and recovered through depreciation deductions).
It’s an exception to the capitalization requirements of 263, that require capitalization of expenses that produce income over years; repair is immediately deductible
What was Midland Empire? What are the taxpayer’s two arguments?
Petitioner, a meat-packing corporation, by lining the walls and floor of its basement with concrete, sought to protect it from the seepage of oil spilled on the ground by a neighboring refinery. The oil nuisance threatened continued operation of the packing plant. The purpose of the expenditure for the concrete liner was not to prepare the plant for operation on a changed or larger scale, nor to make it suitable for new or additional uses, but only to permit petitioner to continue the use of the plant, and particularly the basement, in normal operation. Held, the expenditure for lining the basement walls and floor was essentially a repair and as such is deductible as an ordinary and necessary business expense under section 23 (a) of the Internal Revenue Code.
- Ordinary and necessary business expense under 162
- 165(a) loss
Imagine that, in Midland Empire Packing Co., there had been no oil seepage necessitating the concrete lining. Instead, the taxpayer installed the concrete lining to provide better insulation, thereby allowing the meat to “keep” longer. Should the taxpayer be permitted an immediate deduction for the cost of the lining?
No, this is an improvement, which should be capitalized
In Year 1, Liza purchases an apartment building (a “wasting asset”) for $100k. It declines in value $20k each year for 5 years. Liza is allowed to depreciate the building on a straight-line method (creating a $20k depreciation deduction each year for 5 years). In Year 6, Liza spends $100k on the building, restoring it to its shape at the time of purchase. After the final depreciation deduction is taken, what is Liza’s basis in the building? When Liza spends $100k in Year 6, is she able to deduct the $100k?
0, no, she has to capitalize it (which makes her basis 100k which decreases in straight line method)
Sampson owns a barn, which he purchased for $50k. It is damaged by a tornado, and he fixes it at a cost of $10k. May he deduct the expense of purchasing the barn immediately, or must he capitalize it? When he repairs the barn, can he deduct the cost immediately as a repair or must he capitalize it? Would Sampson be eligible for a casualty loss under § 165(c)? If Sampson is eligible for a casualty loss under § 165(c), do you think he can take both a casualty loss and a deduction for the repairs? Describe the tax treatment if Sampson takes the casualty loss deduction under §165. Describe the tax treatment if, instead, Sampson takes a repair deduction under § 162(a).
Has to capitalize the cost of the building
Yes, he can deduct the repair, because he’s just making it whole - can’t increase it worth from before the tornado, though
Yes probably under 165(c)(1), (2), or (3), but has to meet 10% AGI floor and subtract 100 if under (3)
No
Immediate deduction (at yearly tax date) for repair deduction; same for 165 loss
What are Oh’s general principles about when something is a repair and when something is an improvement? (3)
- Expenses are deductible when the value of building is unchanged at end
- If useful life of building is extended, building increases in value (before the unexpected event probably), or makes it suitable for other uses, then must be capitalized.
- If there is a new separate asset, then capitalize.
What was Starr’s Estate v. Commissioner?
A fire sprinkler system was installed at taxpayer’s plant under a “Lease Form of Contract” (contract) for five years with annual rental payments of $ 1,240, but for nominal rental payments of $ 32 in each of the following five years. The whole contract was silent as to the status of the system beginning with the eleventh year. Taxpayers deducted the payments as rental expense in carrying on a trade or business under Internal Revenue Code § 23(a), 26 U.S.C.S. § 23 (a) (amended 1942). The trial court held the five payments were capital expenditures, not fully deductible rental; depreciation was allowed for each year. The court held that for tax purposes form could be disregarded for substance, and where the foreordained practical effect of rent was to produce title eventually, the rental agreement could be treated as a sale, even where the contract did not by its terms ever pass title to the “lessee.” Since the total rent paid was equivalent to a normal purchase price plus interest, the court reversed and remanded to consider allowance of an amortized interest deduction, in addition to allowance for depreciation.
Priya owns an apartment building. The building’s roof is currently in violation of the city’s safety code. Priya repairs the roof of the building to bring it into compliance with the city’s safety code. Other than any benefit from complying with the city’s safety code, the repairs do not increase the value of the building. Should the cost be deductible?
Should argue both sides with regard to Oh’s GP’s
Yes: it wasn’t improved, no increase in value
No: it was improved
What is the importance of Revenue Ruling 94-38?
if you put your land up to safety code regulations in a way that repairs it to its original value (before hazardous waste), then that’s not an improvement, so it’s immediately deductible, but if you create a new asset on the land, it should be capitalized
What is the difference between a repair and loss deduction with regard to the basis?
with repair, no change in basis
with loss, must subtract from basis
What does the 2004 Revenue Ruling give us above the 94 ruling? Why did it happen?
the introduction of 263A
even if you’re otherwise allowed a deduction, those deductions have to be capitalized into inventory; only use those deductions when that inventory gets sold
This is only important for resellers, costs of producing inventory are 263A’d also though, so soil treatment is capitalized into basis of inventory
What does FIFO mean?
First in, First out
What does LIFO mean?
Last in, Last out
Which is better when prices generally increase: FIFO or LIFO? Why?
LIFO, because more basis, reducing taxable income
Why do many companies use FIFO?
because you’re reporting finances to shareholders, and this way you have more income
What does capitalization really mean?
Adding to basis (which you get through depreciation/amortization or through sale)
What happens if I spend 50k on a soil treatment facility, 50k a year on producing 1000 widgets, and 10k in yearly depreciation towards the facility, all towards producing income with the widgets? Year one? Year two? In FIFO? LIFO? Which is better in this case?
Year one: Basis = 50k + 10k + 50k = 110k/1000 = $110 of basis/widget of widgets made in year one
Year two: 10k + 50k = 60k/1000= $60 of basis/widget of widgets made in year two
Will use year one basis/widget first
Will use year (last) basis/widget first
FIFO, because want more deductions sooner (assuming increases in costs in later years don’t throw that off)
Henry purchases a sprinkler system for his rental building. Is this an expense that
Henry can deduct immediately? Or must the expense be capitalized? What if he truly rented the sprinkler system over time?
G1: not an unexpected event -> C
G2: improved building -> C
G3: separate asset -> C
must be capitalized, will recover the basis through depreciation deductions over time
deductible
What’s different in Starr that made it go to court? What would be the results for buyer/seller if purchase? What would be the results for lessor/lessee if lease? What does the government care, assuming their in the same marginal tax bracket?
This wasn’t really a lease; it was an installment purchase (was paying for property over time)
If purchase: interest would be deductible/includable for buyer/seller
If lease: lessor would include/lessee would deduct (?)
Very little: would get installment sale gain
What are the facts in Starr that make it look like an installment purchase?
Customizable - worthless to seller, so won’t pick it up later; can’t use it again
