1. The two issues involved are whether the payment should be made and, if made, is it deductible. If made to the representatives of a U.S. company, it would be a bribe. Not only would it be nondeductible, it could result in criminal charges. If the payment is made to the representative of the foreign company, more than likely, it would be an accepted trade practice in that country. In this case, since the payment would not violate the U.S. Foreign Corrupt Practices Act of 1977, it would therefore be deductible. p. 4-8

2. Only c., the price paid for drugs purchased for resale. Whether the business is legal or illegal, cost of goods sold is allowed as a reduction from total sales in arriving at gross income from the business. Thus, cost of goods sold is treated as a negative income item rather than as a deduction. pp. 4-9 and 4-10

3. From a legal perspective, Cardinal is responsible for having the drivers break the law by speeding. The speeding fines that are levied are therefore not deductible by Cardinal. On the other hand, the salaries paid to the suspended drivers are deductible by Cardinal.

• The potential danger to the general public of such excessive speeding.
• Requiring or encouraging employees to break the law and rewarding them for doing so.
• Business standards being subordinated to the demands of others.

4. No, a deduction is not permitted for political contributions. p. 4-9

5. Carmine, Inc. may not deduct any of the political contributions (i.e., the $300,000, $350,000, and $6,000). Generally, lobbying expenditures cannot be deducted. However, the exception which applies to influencing local legislation applies to the $5,000 payment to the Williamsburg law firm to lobby members of the Williamsburg City Council. Therefore, Carmine, Inc. may deduct $5,000. pp. 4-9 and 4-10

6. The tax issue is whether Ella will be able to deduct the loss on the sale of Peach, Inc. stock. If the relative is a § 267 related party, the realized loss to Ella will be disallowed. Otherwise, the realized loss will be recognized by Ella.

Under these facts, the timing of the gift to the other relative has no effect on the sales transaction. However, if the facts were different and Ella were selling an asset other than stock (e.g., land that has declined in value) to her controlled corporation, then relevant additional tax issues would be whether the gift relative is a related party or not for constructive ownership purposes and the timing of the gift (i.e., whether the gift is made before or after the asset sale). pp. 4-12 and 4-13

7. The following are considered to be related parties:

• Mother.
• Sister.
• Granddaughter.

The nephew, aunt, cousin, and corporation are not related parties under § 267. For the corporation to be a related party, the shareholder must own more than 50 percent (directly or indirectly) of the stock. pp. 4-12 and 4-13

8. a. Drew and Cassie are trying to use the salaries to reduce the taxable income of Thrush to zero ($800,000 - $400,000 - $300,000 - $100,000). By so doing, they can avoid the potential for double taxation.

b. If the salaries paid to the children are deemed reasonable, Thrush's taxable income is reduced to zero. Each of the children will report gross income of $25,000.

The more likely result is that a substantial portion of the $100,000 salary payments will be labeled as unreasonable compensation. In this case, Thrush's taxable income will be increased by the amount of unreasonable compensation. Each of the children will report gross income equal to the amount labeled reasonable compensation. Drew and Cassie will have additional dividend income equal to the amount of the unreasonable compensation.

10. Even though Jenny decides not to pursue the expansion of her restaurant chain into another city, the investigation expenses of $20,000 are deductible. Because Jenny is in the restaurant business, all investigation expenses associated with the restaurant business are deductible in the year paid or incurred. Since Jenny was not in the hotel business, she can deduct only part of the investigation expenses for the hotel. Because she does open the hotel, she can amortize the $15,000 of investigation expenses over a 60-month period, beginning with December, the month in which the business is started. Therefore, she also may deduct $250 ($15,000 / 60 months) in the current year, for a total of $20,250. pp. 4-11 and 4-12

11. a. Janet's $8,000 loss ($32,000 amount realized - $40,000 adjusted basis) is not deductible due to § 267. Example 19

b. If sold for $42,000, Fred's recognized gain is $2,000 [$42,000 (sales price) less $32,000 (basis), reduced by the $8,000 loss that previously was not allowed to Janet].

If sold for $28,000, a $4,000 loss [$28,000 (sales price) less $32,000 (basis)] is recognized by Fred. The $8,000 loss that was realized by Janet is not deductible by either Janet or Fred and is lost permanently.

If sold for $36,000, there is no recognized gain to Fred [$36,000 (sales price) less $32,000 (basis), reduced by $4,000 of the $8,000 loss that previously was not recognized by Janet]. The remaining $4,000 of unrecognized loss is lost permanently as a deduction for both Janet and Fred. Examples 19 and 20

c. Willis, Davis, Raabe, Kaplan, and Engle, CPAs

June 25, 1998

Ms. Janet Saxon

32 Country Lane

Lawrence, KS 66045

Dear Ms. Saxon:

As you requested in your note, I am providing you with the tax consequences of the proposed sale of stock to your brother Fred. Although you would have a potential loss of $8,000 ($32,000 selling price - $40,000 cost), you would not be able to recognize this loss on your tax return. The tax law disallows the recognition of losses between certain related parties.

If you do sell the stock to Fred, his tax basis for calculating gain or loss on a subsequent sale by him would be his cost of $32,000. However, if he should sell it at a gain, he could use as much of your $8,000 disallowed loss as necessary to reduce his gain to zero.

From a planning perspective, you could recognize the $8,000 loss on your tax return if you were to sell the stock to an unrelated party rather than selling it to Fred.

If you would like to discuss this further, please let me know.

Sincerely,

Ellen Allen, CPA

Tax Partner

12. For purposes of the 10% limitation, Lark Corporation's taxable income is $60,000 ($100,000 - $50,000 + $10,000). The maximum charitable contribution allowed for the year, therefore, is $6,000 (10% X $60,000). The excess $1,000 not allowed can be carried over to the following year. Example 29

13. December 6, 1998

Mr. Dan Simms, President

Simms Corporation

1121 Madison Street

Seattle, WA 98121

Dear Mr. Simms:

On December 5 you asked me to advise you on the timing of a contribution to the University of Washington. My calculations show that you will maximize your tax savings by making the contribution in 1998.

If you make the contribution in 1998, you can deduct $20,000 as a charitable contribution, which will save $7,800 in Federal income tax. However, if you make the contribution in 1999, the percentage limitations applicable to corporations will limit your 1999 deduction to $10,000 ($100,000 projected profit X 10% limit). You will save $3,400 in taxes as a result of this deduction. You may carry the remaining $10,000 forward and deduct the amount in 2000. If you continue at the 1999 profit level, you will save an additional $3,400 in tax in 2000, for a total tax savings of $6,800.

This analysis makes it clear that you will save $1,000 more ($7,800 - $6,800) if you make the contribution in 1998. In addition, all of the savings will occur in 1998. If you make the contribution in 1999, you tax savings will be split between 1999 and 2000. My advice is that you should make the contribution immediately so ownership of the stock can be transferred by December 31.

Sincerely,

Alicia Gomez, CPA

pp. 4-17 and 4-18

Research and experimental expenditures do not include market or consumer surveys.

2000

No deduction based on data provided.

b. No deduction is available prior to June 2000. This is the month benefits from the project start to be realized.

2000

pp. 4-18 and 4-19

Section 1016(a)(2) provides that, if a taxpayer does not claim cost recovery deductions on property subject to cost recovery during a particular year, the asset's basis, nevertheless, is reduced by the amount of cost recovery that should have been deducted. p. 4-22

17. 1998: $4,500,000 X .321% = $14,445

p. 4-26 and Table 4-3

1. If the copier is acquired in 1999, the deduction for the year of acquisition would be $400 ($21,200 - $20,800) larger than if the copier was acquired in 1998 because of the larger statutory ceiling for the 179 expense deduction. However, by acquiring the copier in 1998, the total deductions by the end of 1999 would be larger.

pp. 4-24 to 4-26, 4-28 and 4-29, and Table 4-1

The carryforward is subject to the § 179 income limitation in the carryforward year.

pp. 4-28 and 4-29

pp. 4-28, 4-29 and Table 4-1

pp. 4-24 to 4-26, 4-28 to 4-30, and Table 4-1

23. Hoffman, Smith, and Willis, CPAs

5101 Madison Road

Cincinnati, Ohio 45227

December 20, 1997

Mr. John Johnson

100 Morningside Drive

Clinton, Mississippi 39058

Dear Mr. Johnson:

I am responding to your inquiry concerning the amount of cost recovery you may deduct in the first year of operation of a new taxi. If the automobile is purchased at the beginning of 1998 for $25,000, the total cost recovery deductions in the first year would be $19,800.

Because the car will be used as a taxi, it is not subject to the cost recovery limitations imposed on passenger automobiles. This $19,800 cost recovery assumes that your income from your taxi business before considering this cost recovery would be at least $18,500 and an election is made under § 179 to expense the maximum allowable amount. The $19,800 is calculated as follows:

If you need additional information or need clarification of our calculations, please contact me.

Sincerely yours,

John J. Jones, CPA

Partner

TAX FILE MEMORANDUM

December 20, 1997

FROM: John J. Jones

SUBJECT: John Johnson: Calculations for cost recovery in year of acquisition

John Johnson is considering purchasing an automobile at the beginning of 1998 to be used 100% as a taxi. The cost of the automobile is $25,000. John wants to know the total cost recovery deductions for the year of acquisition of the car.

Because the automobile will be used as a taxi, it is not subject to the cost recovery limitations for passenger automobiles. Therefore, John can elect § 179 expensing. In deducting the full § 179 amount of $18,500, the assumption is made that John's income from the taxi business before considering the § 179 expense will exceed $18,500. The total amount of cost recovery in the acquisition year would be $19,800, computed as follows:

pp. 4-28 to 4-30 and Table 4-1

*These cost recovery limits are indexed annually.

pp. 4-29 to 4-31, and Table 4-1

*These cost recovery limits are indexed annually.

26. Deduction for lease payments:

$430 X 6 months X 70% = $1,806

Inclusion amount:

27. Deduction for lease payments:

$430 X 12 months X 60% = $3,096

Inclusion amount:

28. Hoffman, Smith, and Willis, CPAs

5101 Madison Road

Cincinnati, Ohio 45227

October 15, 1998

Mr. Mike Saxon

200 Rolling Hills Drive

Shavertown, Pennsylvania 18708

Dear Mr. Saxon:

This letter is in response to your request concerning the tax consequences of allocating the purchase price of a business between the two assets purchased: a warehouse and goodwill.

If the purchase price of $2,000,000 is allocated $1,200,000 to the warehouse and $800,000 to goodwill, the total recovery in the first year of operations would be $82,865. Cost recovery on the warehouse would be $29,532 and amortization of the goodwill would be $53,333. If the purchase price is allocated $1,500,000 to the warehouse and $500,000 to goodwill, the total recovery in the first year of operations would be $70,248. Cost recovery on the warehouse would be $36,915 and amortization of the goodwill would be $33,333.

Therefore, under the first option, your deductions in the first year would be $12,617 greater ($82,865 - $70,248). The building is written off over 39 years, while the goodwill

is written off over 15 years. Thus, the higher the allocation to goodwill, the faster the write-off will be. Should you need more information or clarification of calculations, please contact us.

Sincerely yours,

John J. Jones, CPA

Partner

TAX FILE MEMORANDUM

October 15, 1998

FROM: John J. Jones

SUBJECT: Mike Saxon: Calculations of amount of recovery depending on the
allocation of purchase price between a warehouse and goodwill

Mike is negotiating the purchase of a business. The final purchase price ($2 million) has been determined, but the allocation of the purchase price between a warehouse and goodwill is still subject to discussion. Two alternatives are being considered. The first alternative would allocate $1,200,000 to the warehouse and $800,000 to goodwill. The second alternative would allocate $1,500,000 to the warehouse and $500,000 to goodwill. Mike wants to know the total recovery during the first year of operations from the two alternatives.

29. The issue raised is the tax treatment of a covenant not to compete versus goodwill from the perspective of Marge and Stan and the related effect of tax knowledge (or lack thereof) associated with a transaction.

31. When property is contributed to charity, the measure of the deduction is its fair market value reduced by any gain that would have been ordinary income had such property been sold [§ 170(e)(1)(A)]. Consequently, the following question must be posed: "What type of gain would Falcon Corporation have recognized if it had sold the clippings library?" If the gain would have been ordinary income, then the charitable deduction is zero. If the gain would have been long-term capital gain, the charitable deduction is $3,000,000.

But is a "clippings library" a capital asset or ordinary income property? Under § 1221(3), a class of assets that is not capital includes "letter or memorandum, or similar property." Pursuant to Reg. § 1.1221-1(c)(2), the phrase "similar property":

... includes, for example, such property as a draft of a speech, a manuscript, a research paper, an oral recording of any type, a transcript of an oral recording, a transcript of an oral interview or of dictation, a personal or business diary, a log or journal, a corporate archive including a corporate charter, office correspondence, a financial record, a drawing, a photograph, or a dispatch.

In short, the resolution of the matter depends on whether the "clippings library" is included in the "similar property" contained in § 1221(3) and as defined by the Regulations.

In The Chronicle Publishing Company [97 T.C. 445 (1991)], the Tax Court passed on the scope of "similar property." The Court concentrated on the word "archive" as contained in the Regulations (see extract above). One of the definitions appearing in Webster's Third New International Dictionary (1981) is as follows: "... 2: public or institutional records, historic documents and other materials that have been preserved ..." The Court found that taxpayer's clippings library fell within the meaning of a archive. As a result, the clippings were deemed to be ordinary income property.

32. The facts are similar to IRS Ltr. Rul. 9126014. In this ruling, the cost of the property purchased during the last three months of the year that is expensed under § 179 is excluded in computing whether more than 40% of the aggregate bases of property was placed in service during the last three months of the year for purposes of determining the applicability of the mid-quarter convention.

Because $6,500 does not exceed $14,600, the mid-quarter convention does not have to be used.

33. The facts of this case are similar to Louis A. and Merridawn Browning v. Comm., 88-2 USTC ¶ 9666, 890 F.2d 1084 (CA-9, 1989), aff'g. 55 TCM 1232, T.C. Memo. 1988-243. In this case, the Court held that the taxpayer could not take a depreciation deduction on three violins because the taxpayer could not prove a useful life for the violins. This conclusion also was reached in Ltr. Rul. 8641006 with respect to a taxpayer's cello.

However, in two recent Tax Court cases, the Court allowed depreciation in two cases similar to Gabriella's fact pattern. In Richard L. and Fiona Simon, 103 T.C. No. 15, the Court allowed the taxpayers to depreciate two 19th century violin bows. Depreciation was allowed because the bows were: (1) tangible personal property, (2) were placed in service after 1980, (3) were used in the taxpayer's trade or business, and (4) suffered wear and tear from the taxpayer's use in the trade or business. In Brian P. and Brenda H. Liddle, 103 T.C. No. 16, the Court, following the rationale of the Simon case, allowed depreciation of a Ruggeri bass violin. The depreciation was allowed under ACRS for five-year property.

The Third Circuit Court of Appeals affirmed the Tax Court in the Liddle case. The court held that depreciation of a base violin was proper because it was an asset that was subject to exhaustion, wear and tear, and obsolescence over a period established under the accelerated cost recovery system. 94-2 USTC ¶ 50, 488, 76 AFTR2d 94-6255, 65 F.3d 329 (CA-3, 1995)

If Gabriella can meet the four-prong test as enunciated in Simon, she can probably depreciate her violin. Most importantly, she must show that the violin was used in her trade or business and that it suffered wear and tear from her use of it in her trade or business.

1. Under the regulations dealing with interest tracing, as long as borrowed funds remain deposited in a checking or savings account (whether or not the account is interest-bearing), interest expense on the money is treated as investment interest. Funds are considered to be withdrawn from checking account first from borrowed funds and then from unborrowed funds. In addition, borrowed funds are treated as withdrawn on a FIFO basis.

For Bluejay and Cardinal, the first $6,000 withdrawal is from Debt A and interest expense on the debt beginning on February 15 will be passive interest. Interest on the $6,000 prior to February 15 will be treated as investment interest.

At July 23, the account balance is $6,000-$1,000 from Debt A, $2,000 from Debt B, and $3,000 of unborrowed funds. The $4,000 withdrawal will come first from Debt A, then from Debt B, then from unborrowed funds. Thus, interest expense on $1,000 of Debt A and on the full amount of Debt B will be investment interest until July 23. Subsequent interest expense will be treated as business interest.

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