Deductions for the Costs of Earning Income

Question 1

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.)

Answer 1

Wealth goes down 100k, then up 100k; no worse off from Haags Simon: no deduction

Question 2

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.)

Answer 2

Deduction because no asset increase with cash loss

Question 3

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.)

Answer 3

Is he worse off? Yes

Gas is an operating expense

No deduction on land

Which of these require capitalization?

1. 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)
2. Land (has value beyond the taxable year in which its purchased) - Recovers this basis later, when he sells it
3. Not gas (all used up by end of year) - So, immediate deduction

Question 4

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?

Answer 4

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)

Question 5

If a taxpayer actually builds the rental building, must the taxpayer capitalize the construction costs or can they immediately be deducted?

Answer 5

Still be capitalized; doesn’t matter whether you purchase the building or you build it yourself

Question 6

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?

Answer 6

No, because that’s just the cost of building that building

Question 7

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?

Answer 7

no, will still have to capitalize the chapters

Question 8

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?

Answer 8

Can probably take a loss for it in Section 165 (for the one scrapped bulding), but depreciate for the other buildings

four distinct projects

Question 9

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?

Answer 9

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

Question 10

What was Encyclopedia Britannica v. Commissioner?

Answer 10

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

Question 11

What is 167 about?

Answer 11

there should be a reasonable allowance for wear and tear on property used in T/B or used for the production of income

Question 12

What is 263 about? What types of property does it apply to?

Answer 12

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

Question 13

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?

Answer 13

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”

Question 14

Does land depreciate? What happens when you buy land with a building on it? Are there any other non-wasting assets?

Answer 14

No

Separate basis for land and building

Goodwill (no amortization for that - which is the term for depreciation on intangible assets)

Question 15

When is the basis of non-wasting assets recovered?

Answer 15

at sale

Question 16

What would have been the result in Encyclopedia if they had done it in-house? Is this the right result?

Answer 16

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

Question 17

What is 263A do?

Answer 17

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

Question 18

What about repairs and maintenance generally? What is the repair doctrine?

Answer 18

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

Question 19

What was Midland Empire? What are the taxpayer’s two arguments?

Answer 19

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.

1. Ordinary and necessary business expense under 162
2. 165(a) loss

Question 20

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?

Answer 20

No, this is an improvement, which should be capitalized

Question 21

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?

Answer 21

0, no, she has to capitalize it (which makes her basis 100k which decreases in straight line method)

Question 22

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).

Answer 22

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

Question 23

What are Oh’s general principles about when something is a repair and when something is an improvement? (3)

Answer 23

1. Expenses are deductible when the value of building is unchanged at end
2. 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.
3. If there is a new separate asset, then capitalize.

Question 24

What was Starr’s Estate v. Commissioner?

Answer 24

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.

Question 25

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?

Answer 25

Should argue both sides with regard to Oh’s GP’s

Yes: it wasn’t improved, no increase in value

No: it was improved

Question 26

What is the importance of Revenue Ruling 94-38?

Answer 26

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

Question 27

What is the difference between a repair and loss deduction with regard to the basis?

Answer 27

with repair, no change in basis

with loss, must subtract from basis

Question 28

What does the 2004 Revenue Ruling give us above the 94 ruling? Why did it happen?

Answer 28

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

Question 29

What does FIFO mean?

Answer 29

First in, First out

Question 30

What does LIFO mean?

Answer 30

Last in, Last out

Question 31

Which is better when prices generally increase: FIFO or LIFO? Why?

Answer 31

LIFO, because more basis, reducing taxable income

Question 32

Why do many companies use FIFO?

Answer 32

because you’re reporting finances to shareholders, and this way you have more income

Question 33

What does capitalization really mean?

Answer 33

Adding to basis (which you get through depreciation/amortization or through sale)

Question 34

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?

Answer 34

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)

Question 35

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?

Answer 35

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

Question 36

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?

Answer 36

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

Question 37

What are the facts in Starr that make it look like an installment purchase?

Answer 37

Customizable - worthless to seller, so won’t pick it up later; can’t use it again