Income Tax I
Bogdanski
Fall 2016

Sample Answers to Question 2

Exam No. 6563

Status of F's business

F's food truck is presumptively a business under 183(d) because it has been profitable for at least 3 of the last five years: 2013, 2014, and 2015. This is important for F because it allows her to deduct a wide range of expenses under 162 above the line, including her rent paid to the land owner, and the cost of equipment, salaries, etc.

Deductibility of repairs, amortization of improvement

F can deduct the cost of repairing her stove on her 2016 taxes: repairs are currently deductible, but improvements must be amortized. Arguably, replacing the fridge is such an improvement. F would want to argue that replacing the fridge amounts to a repair because she can do no more with the property than she could before: it worked, and now it doesn't, and she made it work again. That said, a fridge creates long-term benefits and has an expected life of more than one year, so its cost is likely to need to be depreciated. Had F consulted with me before purchasing a new fridge, I would have advised her to arrange for a 1031 exchange so whatever basis remained in her old fridge could have been transferred over to the new one.

Rick's labor costs can be deducted immediately if these are repairs. If they are improvements, labor costs can be added to the asset's basis and depreciated along with the asset. The fridge, if depreciable, would likely be depreciated on a double decling balance method, which is explained in greater detail below in relation to the replacement food cart.

2016 losses

F's 2016 return shows net operating losses in the amount of $25,000. These losses can be carried forward or backward, and would usually be carried backwards first per 172(a), which would allow F to refile her 2014 and 2015 tax returns and perhaps increase her refund amount from those years. If any losses remain after carrying them back, F could carry them forward for up to 20 years. F could choose to carry her losses only forward per 173(b)(3), but unless she expects to be in a higher bracket in the future, this would be a strange choice. Luckily for F, her high 2016 losses might effectively cancel out her impermissible IRA withdrawals.

Because F's business is her food cart, these losses can go against her income: they are not passive losses. Upon F's death, her NOLs died with her.

Withdrawal from IRA

F's early withdrawal from her IRA might be regular income, depending on the exact nature of the withdrawal and the type of plan in which she participates. Because she's withdrawing before she turns 59 and a half, these are early withdrawals, subject to certain penalties.

If F's plan is a section 408, nondeductible IRA, then part of the withdrawal is taxable and subject to a penalty. If her plan is a ROTH IRA, which also does not allow for deduction of current contributions, then her withdrawal is not income as long as her withdrawals do not exceed her principal contributions. If they include earnings, then it's taxable income and also subject to a penalty. If her plan is a traditional IRA, then her withdrawal is ordinary income, and also subject to a 10% penalty.

Destruction in fire, involuntary conversion

The destruction of F's food cart is an involuntary conversion under 1033, and is treated as something like an "involuntary sale." As her adjusted basis is $10,000 and she has received a payment for $40,000, F has realized a gain of $30,000--but per 1033(2), that gain is not recognized because she reinvested the funds received into similar property within two years of the close of the calendar year in which she received the insurance settlement. (End of 2017 to end of 2019 includes November 2019.) This realized, but not recognized, amount is excluded from F's gross income: if it were not, it would be a capital gain as a food truck is a capital asset under 1001.

Because F has casualty insurance, she could not elect to take a deduction under 165, even though the fire does appear to meet that section's other requirements: it was sudden, unexpected, physical, and definitely more than $100/10 percent of F's AGI.

Basis in new food cart

Under 1033(b), F's basis in her new food cart is her old basis of $10,000 plus her investment of $20,000, giving her a basis of $30,000. If F had replaced her old food cart for one with an equivalent price, then her basis would remain unchanged, but the additional funds invested go to basis, no matter if she borrowed the money. No facts suggest she did--but it's possible!

Amortization and depreciation of new cart

Because a food cart is a long-lived asset, F cannot currently deduct the entire cost of her investment: instead, she must spread it over the cost of several years. As a food cart is personal property, it is eligible for the double-declining balance method, which will allow F to more quickly deduct the cost of the food cart. In this case, F cannot deduct the entire FMV of the cart because her basis is only a small part of the FMV thanks to the insurance settlement and 1033(b)'s carry over basis provisions. Food carts are probably 7-year property, but I'm not 100% sure of that--the section below assumes that they are.

On the double declining balance method, F can deduct 2/7 of her total basis in each year, with the one caveat that the convention will limit her initial deduction to some degree. Without applying the convention, F's first year deduction would be her basis multiplied by 2/7, or $8571.

Because F purchased the food cart in November, during the last three months of the year, she is likely stuck with the mid-quarter convention under 168(d)(3). If this section does not apply, then she would get to use the half year convention. If she takes the mid-quarter convention, she'll get very little in the first year. If she takes the half year convention, she can take half of $8571 in the first year. In either case, her second year deduction would be quite large, as she'd take 2/7 of whatever basis remains. This would continue until the seventh year, when she'd switch to straight line.

F could elect out of the double declining balance method and take straight line deductions on her property under 168(a)(3)(D), but there's no reason to do so. If she did this, she could deduct 1/7 of her basis every year, or about $4200. In the end, it makes no difference in the total number of dollars F pays--but because of the time value of money, F should try to pay less now.

Nature of Nikhil's inheritance

Stepped up basis

No matter how F chose to depreciate the food cart, N takes the asset with a stepped up basis equal to its FMV per 1014. Because death is not a realizing event, there are no tax consequences for N when he inherits the food cart, and none to F's estate, at least as far as this course is concerned.

N is not subject to 1014(e)'s exception to stepped up basis: even though F held the truck for less than a year, she bought it, she didn't get it as a gift from N.

Sale

N has no realized gain on his sale, thanks to his stepped up basis. He realizes $52k on the sale, but his stepped-up basis is the FMV of the cart--which we are told is $52k--so all he's done on the sale is recover "his" basis. Thanks, Farah. Notably, N could also elect to use an alternative valuation date under 2032 or 2032A, if the value has fluctuated at all. This sale thus results in $52,000 of untaxed windfall to N: it would be a capital gain if it were taxed at all.

Exam No. 6626

1. Farah's Salary and expenses

The income that Farah takes from the food cart is ordinary income, taxable in the year that she receives money. Her salary would also be a deductible business expense under S162. Also any taxes that Farah has to pay (like a food liscense) will be an above the line deduction for Farah. The rent that she pays to the land owner would also be a S162 deduction which she could take above the line. Anything that is ordinary and necessary to run the business can be deducted under S162 above the line.

2. Repair of Stove and Replacement of refrigerator

When the stove stoped working, and Farah calls in her appliance guy to fix it, the event might be considered as a repair, and can be deducted as a current business expense above the line under S162, rather than as a capital expenditure. The repair of the oven does not seem to be a long term benefit. The repair was only to the extent to get the oven working again, and did not improve or increase the value of the oven above what Farah paid for it. Further, Rick only repaced several parts in the oven, which means while the oven may work a while longer than it would have, it is equally likely that some other old part might fail. Therefore Farah can deduct the cost of the repair of fixing the oven as an above the line business expense in the year that she incured it (2016).

The refridgerator replacement however does not qualify as a repair. When purchasing new equipment for her business, even though it is to replace an existing piece of equipment, it is a capital expenditure to Farah and the cost will be put into the basis of the refrigerator and she will have to depreciate the expense as time goes by. Since she will have use for the refrigerator for over 1 year, without taking certain elections, the IRS forces Farah to depreciate it. It is not known wether the basis will stay in the refrigerator, or whether it should be added to the basis of the food card. I believe that it should be just added to the basis of the foodcart as it would probably be one of those refrigerators that aren't regularly used at home, and are made to fit in a foodcart. Alternatively, Farah could use a 179 election to expense the capital expendeture up to a $500,000 aggregate in the year that she incured it. More on 179 and Depreciation Infra.

3. Business Loss and Withdrawl of IRA Hobby Loss

Farah has a net operating loss of $25,000. This amount could offset business income up to 20 years foward, starting at year 1, or Farah could elect to carry the losses back to her more profitable years 2 years back. If Farah carries the deduction back,she must offset income against the earliest year first (Farah can't just choose to deducting it only against the highest earning year). She can offset business income to the amount that she lost ($25,000) and the IRS will send her a check for the difference. This would be an ordinary loss, and able to be offset by ordinary income.

Since Farah is only 44 years old at the time she withdrew money out of her IRA acount to pay her living expenses, she will pay a 10% penalty for early withdrawl. The code sections governing traditional IRA's are IRC 219 and 408. Withdrawls are ordinary income in the year that they were withdrawn so Farah will have to include that in her Gross income. Alternatiively, Farah could have taken a loan out of her IRA, in which case she would not pay a 10% penalty for early withdrawal and would pay interest back to her IRA. As long as Farah makes good faith repayment, the IRS will not look at it as a disguised withdrawl and ding her for the penalty.

If by non-deductible, the professor means a "Roth" IRA, then I think the withdrawls are not included as income upon withdrawal because the amount that Farah puts into the Roth IRA is not deductible. The 10% penalty for early withdrawal would still apply since she is not 59 1/2 yet, and she could also elect to have taken a loan out of her Roth IRA just like a traditional IRA.

Since Farah took a loss, the IRS might say that doing a food cart might be a hobby, and Farah would only be able to deduct hobby expenses against hobby income under IRC 183. The test is whether Farah intended the business to be a hobby or not, and with all the crazy food shows popping up; I'm sure there are a lot of Food carts out there just for fun. However, the court will likely hold that the food cart is not Farah's hobby. Since Farah had 3 profitable years of operation (2013,14, and 15), there is a presumption that the business is not a hobby. Furthermore, 2016 is the only year that the foodcart was not profitable, and although there was a loss, Farah showed gross income of $50,000. So this is not a hobby, and a venture for profit and the $25,000 loss can be used to offset income other than for hobby.

4. Depreciation, Capital Expendature, 179 election, 1033 involuntary conversions.

In 2017, the food car was destroyed in a fire. Farah will not be able to take a casualty loss on this because farah had casualty insurance which paid her more than her basis in her food truck 10k v 40k. The $40,000 payout minus her basis of $10k, ($30,000) is gross income to Farah in the year that she receives the check (September 2017) because she constructively held the ablility to demand payment at any time she wanted.

When Farah purchased her new food cart for $60,000 in 2019, Farah could have elected to use an IRC 1033 Involuntary Conversion. This provision allows Farah to rollover involuntary property gain into replacement property if such replacement property is procured within 2 years of the close of the first taxable year the involuntary gain is relaized. Here, her old food cart was destroyed by a fire (involuntarily?) and 2019 is within the time limit specified in the statute (the rest of 2017, 2018, and 2019). Further, the requirement that the property be similar or related in service to the use or property converted is also satisfied (food truck to food truck). Therefore, if Farah elects to do a 1033, then the gain of S50,000 will be realized, but not recognized, and only the gain for the damages exceeding the basis in the property will be recognized. In this case, the recognition amount is $30,000 ($40k Insurance payout - 10k Basis).

When Farah purchases the new foodcart, it is a capital expenditure because the foodcart's benefit lasts more than 1 year. This means that the basis of $60,000 can be depreciated per schedule (5 year schedule for trucks). Unless Farah is required to use the "straight line method," the applicable depreciation method is the "double declining balance method." Under this method, Farah deducts a portion of her basis equal to twice the percentaget that would apply to the original cost if the straight line method were used. IRC 168(b)(1)(A). Here, since $60,000 is to be depreciated in 5 years, each year, Farah can deduct $12k under the straight line method.

The double declining balance method is often used in conjunction with the half year convention 168(c) to maximize Taxpayer deductions. Under this election, the first year's deduction would be 12k (1/2 a year), then in the second year, Farah could deduct a whopping 24k. This would mean that in the first 2 years, 36k of the 60k of the basis could be deducted.

Alternatively Farah could take a bonus depreciation under IRC 168(k). Here, Farah would deduct have the basis immediatly ($30k), and then the other half of the basis (30k) would be depreciated using the double-declining method, using the half year conversion. In this way, Farah could get a lot of deduction up-front, and then have it trickle down after.

Finally, Farah could just make an IRC 179 election. Under this provision, Farah could treat the cost of any depreciable personal property (not buldings or other items of depreciable real property) aquired by purchase for use in the active conduct of Farah's business as an expense and not a capital expenditure up to $500,000 in the aggregate. Since $60k is much lower than $500,000; taking a 179 election on the foodtruck is perfectly fine. As said earlier, if the gross income of 2019 does not exceed Farah's deductions (which it probably wouldn't under a 179 election), Farah can carry it forward 20 years, or back 2 years, to offset income.

Incidently, Farah would not be able to deduct the first $5,000 of her startup expenses under S195(b)(1) because the amount phases out completelywhen there is capital expendeture at or over $55,000 (here, it is $60,000). Also any of the fees and operating expenses paid when Farah started her new foodcart business in "new pod" can be deducted under S162 as an above the line business expense which can be deducted even if Farah doesn't itemize.

5. Death and Property passing to Nikhil

Gifts are not income under IRC 102(a). Gross income does not include the value of property acquired by gift, bequest, devise, or inheritance. Farah doesn't seem to have more than 5.34 million dollars in her estate, so I'm sure her estate won't be paying any estate tax (wouldn't be working at a food cart if she did). When property passes from the estate to Nikhil, there is no realization of income, and any items have a stepped up basis of fair market value. Since Nikhil sold the cart for its fair market value of $52,000, and had a basis of $52,000; the gain realized is $0. The amount would be a short term capital gain/loss had there been any gain or loss.

Exam No. 6516

Because Farah is self-employed, she would potentially have a whole host of deductions she could take. I would also suggest to her that she keeps track of everything diligently. I think that sometimes with self-employed people, because they can take a lot of above the line type deductions, they may be tempted to buy something for personal use and treat it as a deduction. I'm not trying to impugn Farah's character or anything here, but I would just want to advise here to keep her receipts and be able to prove that the expenses she deducts are legitimate § 162 expenses and not § 262 personal living expenses in case the auditors come calling.

A quick, random note, I don't think that Farah could take any deduction for her commute to the pod (assuming there is one). My thinking is that she might try to claim her home as her principal place of business as I bet that's where she does a lot of her bookkeeping; but for any travel from work to home to be deducted from a PPB to a work location, that PPB has to be a legit PPB, and her I think her real job, her real place of biz, is that food cart. So she's stuck paying for her own commuting expenses just like most of the rest of us.

First of all, since the cart is her business, the rent she pays for the space is an above the line (ATL) necessary business expense. The person that owns the land would have income, and if for some reason that land owner just had this lot and had the rental income from the pods but didn't really actively manage it or anything, that income to the land owner might be a passive activity income subject to the rules of § 469.

For the several parts replacement in the stove, was this a repair, or an improvement. The stake are high. If it was a repair, that's a deduction she can take right away as necessary ordinary business expense per §162 and ATL per §62. However, if by putting in these new parts, this made it into an improvement, where these parts really extended the life or increased the value, it may be a capital expenditure, in which case the costs of those parts would be added into the basis of the stove and depreciated by the double declining method (although she could use the straight line but why would she?). If I was forced to make a conclusion here, I would say that replacing parts is just a repair. It's not like these replacement parts turned the oven into something completely new and magical; it's still an oven and presumably works the way it worked before, maybe a bit better.

The refrigerator is an easier case. No repairs here, this is straight up a new purchase, and would probably not be a capital asset per se, because I think this falls under a §1231 depreciable property category. Regardless, we don't have to worry about the capital gains or losses and recapture of depreciation yet because she's not selling it. So she buys the new refrigerate, we would figure out the years she can depreciate it; I don't have the class tables in front of me and not entirely sure if this specifically enumerated in the code under 168(e) but my guess is this would probably get like a 3 or 5 depreciation life. So take the cost, divide by the years; since this is double declining, but we have to take into account the 1/2 year convention, she won't get the full double depreciation deduction her first year, but the 2nd year will be a nice sized depreciation deduction for Farah.

Can Farah do anything useful with this $25k loss that she suffered. Absolutely. Let's look at net operating losses (NOL) and § 172. A NOL is defined at 172(c) as the excess of deductions allowed over gross income. Here, that means that Farah has a NOL of $25k. So if were living in the times of Sanford & Brooks there isn't a lot we could do with it, and it's not like we have a tax system where we pay you back for those losses. We still live in a tax world in the U.S. where every year does stand on its own 2 feet. That means that without a NOL, Farah would just lose that 25K potential loss deduction. But because of 172 she can elect to go back 2 years and forward 20 and take that loss from her previous and upcoming tax returns. She could elect to not go backwards and only take the loss forward, but that seems silly, especially because this is the first year she hasn't operated at a loss. If she goes backwards, she must go back 2 years first, apply that loss, and then go 1 year back and apply the remainder of the loss. If there is still loss left, she can then take the loss forward.

It's really a shame that Farah had to draw from her IRA at the age of 45, as I believe that an early withdrawal from an IRA before age 59.5 incurs a tax of 10% of the amount withdrawn. But I will say I'm confused as to why she chose a nondeductible IRA. I assume this to mean that this is NOT a traditional IRA or a Roth IRA. Usually the nondeductible IRAs are for people that may not have the option to choose the traditional or Roth (this can occur when a person already has an employer qualified retirement plan that they are a part of). But since Farah is self-employed, unless I'm missing something, I think she should have chosen a traditional or Roth. Anyway, at the very least she's not taxed on the increases that accrue in the account, so it's still better than a bank account where she's paying taxes on the interest that accrues every year. So I'm a little shaky on the ins and outs of the nondeductible IRA, but I believe that since she's under 59.5 she would be taxed on 10% of what she takes out. Also, her contributions are not deductible, but her withdrawals are partly included in income, so she has that to deal with as well.

Never a good thing that her business burned down, but at the very least she may avoid taxes on the insurance and buying the new cart as follows.I believe that Farah may have a non-recognition § 1033 involuntary conversion situation on her hands. The taxpayer must elect non-recognition on the tax form, and must find the replacement property within two years after the end of the year that the TP got the money. If the TP uses the entire amount to buy replacement property, there's no gain recognized. But per 1033(b)(1) the basis in the new property is the same as in the old property. So does Farah meet these requirements?

The 2-year requirement is 2-years from the END of the year in which she received the money. So she received the check September of 2017. That means she has until Dec. 31 of 2019 to buy property to replace the cart. She buys the new cart in Nov. 2019 so she just makes the cut, good for her! And since she received $40k, but paid $60k on it, she's not taxed at all on the $40k check she received from insurance.

But what is her basis in the food cart now? So I have in my outline that the basis in new property is the same as the basis in the old property. So if that's the case, she would have a basis of $10k. But where I'm a bit confused is the fact that it seems as if Farah paid $20k of her own funds for the cart. And whether she paid the $20k or borrowed it (as we know from Tufts you get basis in borrowed money), it seems as if that $20k cost basis should be added to the $10k basis that she had before. So admittedly I'm a bit stuck; she either has the $10k basis on her now $60k cart, or she has $30k basis on her now $60k cart.

Another way Farah could have done it, but I don't know that this is a good idea, is to not elect to take the 1033 involuntary conversion. She would get the $40k from the insurance, but since her basis was $10k, I believe she would then be taxed on $30k of income there. If she then decided to buy the food cart for $60k, she could use § 179 small business deduction of the entire $60k since I think that code sections allows up to $500k of depreciable basis right away. If she does that, then her basis in the food cart is $0 though. I would think that electing the involuntary conversion would still be overall more advantageous to Farah.

Finally, and I came back to this point with literally 4 minutes remaining, is I think § 165 could be invoked somehow here, since I would assume that Farah suffered a loss, and losses from the business are deductible. So it's possible that maybe she deducted the loss of the basis of the cart, but she may be stuck to a deduction that only exceeds 10% of her AGI plus $100. But again, that may just apply to personal casualty losses. Also, if she did take the business deduction loss, but then received money from insurance, she may have a tax benefit rule situation on her hands and have to actually then treat part of that insurance settlement as income.

Upon Farah's death, hopefully she had some other assets or stocks or other things that she could have passed to Nikhil. I understand as a self-employed person that she probably wasn't making a killing or anything, but anything that Nikhil got from her deceased mom would have the potential of having stepped up basis. But in terms of the food cart specifically, again we know that assets/property per § 1014 get a stepped up basis. So this helps resolve my conundrum from above about what the heck is the basis in this food cart, because we know from § 1014 that the basis is the stepped up basis which here would be the FMV. So in this 1001 transaction where Nikhil sells the cart, if the FMV upon the transfer was $52k, and since the facts state that upon Nikhil receiving the property that he promptly sells it for the $52k, then I think we can agree that the FMV upon getting it was $52k, so there's no gain realized here, amount realized of $52k minus adjusted basis of $52k equals 0.