Regulation (REG): Tax Classification, Basis, and Practice Rules
Regulation (REG) tests federal tax rules for individuals and entities, property transactions, and the ethics and legal rules that govern tax practice. Calculations matter, but so does classification: ordinary income, capital gain, recapture, and separately stated items drive the result.
Core rules
Gross income includes wages, interest, dividends, rents, and business income; exclusions include certain municipal bond interest and qualified fringe benefits. Basis is cost, adjusted for improvements and depreciation. S corporation shareholders increase basis for contributions and income, and decrease it for distributions and losses; losses are limited to basis and at-risk amounts.
Worked example
A machine costs $100,000, has $40,000 of accumulated depreciation, and is sold for $130,000. Adjusted basis is $60,000, so realized gain is $70,000. Section 1245 recapture is the lesser of depreciation taken ($40,000) or gain ($70,000), so $40,000 is ordinary income. The remaining $30,000 is section 1231 gain and is netted with other section 1231 items; if it remains net positive, it is taxed as long-term capital gain, subject to the five-year lookback for prior net section 1231 losses.
Traps
Do not treat the entire gain as capital: depreciation recapture is ordinary. Do not forget that section 1231 gains can be recharacterized by prior losses. Distributions from an S corporation in excess of stock basis are taxable gain, not a reduction of basis below zero. For tax practice, distinguish substantial authority from reasonable basis, and remember Circular 230 duties and preparer penalties under section 6694.