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TAX CODE – KEY PROVISIONS



Code Section

§61 Gross Income Defined – all income from whatever source derived

§61, 71-89 Items Specifically Included in Gross Income (not a comprehensive list)

 §71 – Alimony

 §72 – Annuities

 §74 – Prizes and Awards

 §79 – Group term life insurance purchased for employees

 §82 – reimbursement for moving expense

 §83 – Property Transferred in Connection with Performance of Services

 §85 – Unemployment Compensation

 §86 – Social Security and Tier 1 railroad retirement benefits

§101-134 Items Specifically Excluded from Gross Income (not a comprehensive list)

 §101 – Certain Death Benefits

 §102 – Gifts and Inheritances

 §103 – Interest on State and Local Bonds

 §104 – Compensation for injuries or sickness

 §104 – Amounts received under accident and health plans

 §106 – Contributions by employer to accident and health plans

 §108 – Income from discharge of indebtedness

 §117 – Qualified Scholarships

 §119 – Meals and Lodging furnished for the convenience of the employer

 §121 – exclusion of gain from sale of principal residence

 §125 – cafeteria plans

 §127 – educational assistance programs

 §129 – dependent care assistance programs

 §132 – certain fringe benefits

 §135 – Income from United States Savings Bonds used to pay higher education tuition and fees

§62 Adjusted Gross Income Defined – look here for above the line deductions

 62(a)(1) – Trade and business deductions

 62(a)(2) (A) – Reimbursed Employee expenses

 62(a)(3) – Losses from sale or exchange of property

 62(a)(4) – Deductions attributable to rents and royalties

 62(a)(6) – pension plans of self-employed

 62(a)(7) – retirement savings

 62(a)(10) – alimony

 62(a)(15) – Moving expenses

 62(a)(16) – medical savings accounts

 62(a)(17) – interest on education loans

§63 Taxable Income defined – look here for below the line deductions

 63(c) – Standard deduction – for non itemizers

 63(d) –Itemized deductions

 63(e) – election to itemize

§151 Allowance of Deductions for Personal Exemptions

 In 2001 – personal exemption is $2900, in 2000, was $2000

 §151(d)3 – personal exemption gets phased out once reach certain income level

 §151(d)4, companion provision, inflation adjustment -- in the case of any taxable year, the dollar

amount shall be increased based on the cost of living adjustment

§152 Dependent Defined – taxpayers also entitled to exemption for each dependent (includes children,

grandchildren, parents and other relatives, and unrelated members of taxpayer’s household, more than ½ of

whose support for taxable yr provided by taxpayer);

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§162 Trade or Business Expenses – there shall be allowed as a deduction all the ordinary and necessary expenses

paid or incurred during the taxable year in carrying on any trade or business . . .

 deduction may be above the line or below the line

§163 Interest – There shall be allowed as a deduction all interest paid or accrued within the taxable year on

indebtedness

 deduction is limited

 may be above the line or below the line

§212 Expenses for Production of Income – In the case of an individual, there shall be allowed as a deduction all

the ordinary and necessary expenses paid or incurred during the taxable year

 for the production or collection of income

 for the management, conservation or maintenance of property held for the production of income or

 in connection with the determination collection or refund of any tax

 deduction may be above the line or below the line

§67 2% Floor on Miscellaneous Itemized Deductions – In the case of an individual, the miscellaneous itemized

deductions for any taxable year shall be allowed only to the extent that the aggregate of such deductions

exceeds 2% of any adjusted gross income.

 If your expense is not on the list in §67, by default it is a miscellaneous itemized deduction and thus

subject to the floor.

 Deductions not subject to the floor include (not comprehensive):

o interest - § 163

o casualty losses -- §165(a)

o taxes - § 164 (state, local, and property)

o charitable contributions -- §170, §642(c)

o medical expenses - § 213

o moving expenses - § 217

o annuity mortality losses - § 72(b)(3)

§64 Ordinary income defined – any gain from the sale or exchange of property which is neither a capital asset

nor property used in a trade or business.

§65 Ordinary loss defined – any loss from the sale or exchange of property which is not a capital asset.









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I. INTRODUCTION



A. Five Steps of Computation of Income Tax Liability

1. Calculate gross income (§ 61) -- statute lists a non-inclusive list of sources included in gross income.

 Includes compensation, fringe benefits, dividends, royalties, annuities, income from insurance,

discharge of indebtedness income, pensions, income from an interest in an estate or trust.

 If it is included in gross income, will be found in §61, 71-89 of the code.

 Does not include excluded categories which are found in §101-134 of the code

2. Subtract "above-the-line" deductions (enumerated in § 62). The resulting figure is known as adjustable

gross income (AGI).

 The deductions include:

 ordinary and necessary business expenses - § 162

 reimbursed business expenses - § 62(a)

 expenses of performing artists - § 62(b)

 losses from sale or exchange of property - § 161 & § 62(a)(3)

 alimony by payor - § 215

 It’s above the line if in § 62. With § 162, 212, and 163 it depends.

3. Subtract "below-the-line" deductions (the sum of personal exemptions, § 151) and the larger of either:

 standard deduction; or

 itemized deductions (start with §§ 63 and 67).

 § 67 – affects ONLY miscellaneous itemized deductions -- 2% floor of adjusted gross

income

 You only deduct the amount by which your total miscellaneous itemized

deduction are larger than 2% of your AGI

 Non-Miscellaneous Itemized Deductions - § 67(b):

 interest - § 163

 casualty losses -- §165(a)

 taxes - § 164 (state, local, and property)

 charitable contributions -- §170, §642(c)

 medical expenses - § 213

 moving expenses - § 217

 annuity mortality losses - § 72(b)(3)

 § 68 – 3% haircut – affects ALL itemized deductions

 Reduce your itemized deductions by lesser of:

 3% of excess of your AGI above 100K (MFJ, HoH, Single), 50K MFS.

(adjusted for inflation)

 OR 80% of all of your itemized deductions otherwise allowable. (you

always get at least 80% of your deductions)

 Phased out between 2005 and 2010

 Lots of deductions don’t get hit § 68(c):

 Medical expenses under § 213

 Investment Interest § 163(d)

 Casualty & theft loss § 165

The resulting figure is taxable income.

4. Apply the tax rate schedules (found in § 1) to taxable income to determine tentative tax liability.

5. Subtract from tentative tax liability any available tax credits (bearing in mind the important distinction

between deductions -- deductions reduce income, while credits directly reduce tax liability). The remaining

amount is final tax liability.

 Credits include Hope and Lifetime Learning (§25A), child care credit (§21(a)), disability and old

age (§ 22), tax withheld (§ 31), and earned income in the case of low-income taxpayers (§ 32).









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B. Introduction to Tax Terminology and Themes

I. TERMINOLOGY AND DEFINITIONS

 income tax -- taxable income multiplied the appropriate tax rate, reduced by allowable tax credits

 taxable income -- gross income minus certain deductions

 gross income -- "all income from whatever source derived," including wages, commissions, dividends,

discharges of indebtedness, etc.

 Congress has specifically excluded some receipts -- for example, certain fringe benefits such as

health insurance -- from gross income

 includes not only cash by services, property and payments to third parties on the taxpayer's behalf,

securities, real estate, works of art, etc.

 amount of gain is the price at which the taxpayer sold the property over the price at which she

purchased the property

 basis -- the portion of sales proceeds that the taxpayer may recover w/o incurring tax

liability

 adjusted basis -- purchase price adjusted upward of downward to reflect subsequent

expenditures or tax benefits attributable to the asset

 loss -- if the adjusted basis exceeds the sale price

 realization -- when gains and losses are taken into account, i.e. when they are

realized by sale or disposition of property

 deductions -- the subtraction of certain expenditures in the computation of taxable income

 adjusted gross income -- certain expenses (generally business expenses) subtracted from gross

income

 "above the line"

 any deductions made here do not affect tax liability

 taxable income -- personal or dependency exemptions plus either the standard deduction or

itemized deductions subtracted from adjusted gross income

 standard deduction -- a flat amount specified by the Code that varies with marital status,

which the taxpayer may deduct regardless of actual expense

 itemized deductions -- all allowable deductions other than the deductions allowable in

arriving at adjusted gross income and the personal exemptions

 deductible personal expenses are itemized deductions (e.g. home mortgage

interest, medical expenses, charitable deductions)

 if taxpayers are entitled to itemized deductions in excess of the standard

deduction, they will claim itemized rather than standard

 capitalized expenditure -- an expenditure that is added to the taxpayer's adjusted basis in the

property with respect to which the expense was incurred

 cannot be deducted immediately in the year paid or accrued

 some can be recovered over a period of years by means of annual deductions for

depreciation or amortization; and

 some only upon sale of the asset (when they will serve to reduce the gain, or

increase the loss, realized)

 capital gains/losses -- special treatment arising from the sale of certain (usually investment)

property held for a certain period

 long-term capital gains are taxed at more favorable rates than ordinary income

 capital gains are treated favorably by the Code

 capital losses are deductible to a more limited extent than ordinary losses

 deductions of capital losses are limited

 tax rates -- taxes are calculated according to one of four tax-rate tables that depend on filing status

 4 filing statuses -- (i) married filing jointly; (ii) married filing separately, (iii) head of household,

or (iv) single

 progressive -- rate of tax applied to individual income increases as income increases

 average rate -- rate of tax applicable to taxable income as a whole

 marginal rate -- rate of tax applicable to the last dollar of taxable income

 becomes important when income or deductions move the taxpayer into a

different marginal bracket







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 can effect the strategy of reporting income or deductions in a given year, in

attempts to maximize present discounted value of assets

 alternative minimum tax -- imposes a tax at a rate of 26% on AMT income up to $175,000 and

28% on the excess

 a broader income tax base that is reduced by fewer deductions, exclusions and credits

than the regular tax base

 credit -- a direct reduction in tax

 vs. a deduction, which represents a reduction in taxable income that, in turn, reduces tax liability

by the amount of the allowable deduction multiplied by the taxpayer's marginal rate

 thus, a deduction is of greater dollar value to taxpayers with greater taxable income,

while a credit provides similar reductions in tax to ALL taxpayers

 most are nonrefundable, which means that only offset tax liability

 tax liability -- amount owed by the individual in taxes

 tentative tax liability -- amount owed before credits are applied

 final tax liability -- amount owed after credits are applied

 incidence -- a question of who bears the economic burden of the tax (rather than who is statutorily liable

for the tax or who writes the check)

 economic incidence -- who is worse off, because of the tax



II. EQUITY, EFFICIENCY, AND SIMILARITY

horizontal equity -- we should tax like people alike

 a fairness question -- two people in similar situations should be treated the same

efficiency -- taxes should not create inefficiencies in the economy

 though, some taxes can be used to shift behavior (e.g., liquor or cigarette taxes)

 want to minimize the extent that taxes create inefficiencies









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II. INCOME & EXCLUSIONS FROM INCOME



A. Income Generally

I. DEFINITIONS OF INCOME



Definitions of Income

consumption + change in wealth = income -- personal income may be defined as the

algebraic sum of

Haig-Simons a. the market value of rights exercised in consumption and

definition b. the change in value of the store of property rights between the beginning and end

of the period in question





§ 61 definition "all income from whatever source derived"



Eisner v. Macomber (1920) (abandoned) -- the gain derived from capital, from labor, or

from both combined, provided it be understood to include profit gained through a sale or

conversion of capital assets

Supreme Court

definitions Commissioner v. Glenshaw Glass Co. (1955) -- undeniable accessions to wealth, clearly

realized, and over which the taxpayers have complete dominion; Congress applies no

restrictive labels and thus income should be broadly construed in the absence of a

specific legislative directive to the contrary





ii. COMPENSATION FOR SERVICES

Any income viewed as compensation for services will be included in general income.



Old Colony Trust Co. v Commisioner (S. Ct., 1929)

Facts

The income taxes of the president of the American Woolen Company were paid by the corporation. The gov't argues

that that payment should be counted as income.

Holding

A taxpayer, have induced a third party to pay his income tax or having acquiesced in such payment as a discharge of

an obligation owed to him, must count such payment as income and pay corresponding taxes.

 "the discharge by a third person of an obligation is equivalent to receipt by the person taxed"

 payment is compensation (income derived from capital or labor; Eisner v. Macomber) --

contracted and agreed upon

 not a gift

 if a gift, not income (though, current Sec 102(c) makes gifts from employers not

exempt)

 or a tax upon a tax



Clark v Commissioner -- lawyer gives advice on filing a return, lawyer gives bad advice and lawyer gives client the

difference

 court determines not income

 IRS follows this decision



PROPERTY given/purchased by employer:

Reg. 1.61-2(d): if extra compensation is in the form of property, it is still income.

o Fair market value of property will be included in income.

o If purchase property from employer at less than FMV, the difference between the price paid and the fair

market value is considered to be salary

 Compensation = difference between FMV and amount employee paid for property





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 Basis = amount paid + any amount included in compensation.

o If you sell property, then get FMV of property when given as compensation, don’t want to double tax –

once for compensation and a second time for income on sale.

o Same rules follow when services are provided as compensation.





B. Fringe Benefits

I. FRINGE BENEFITS GENERALLY

a. Definition of Fringe Benefits

Fringe Benefits -- a term used loosely to describe in-kind benefits transferred to an employee

 can be additional compensation (e.g., all-expenses paid vacation); or

 can be essential to the performance of the employee's job (e.g., chalk used by teacher)

 Generally included as income (§ 61), but many are excluded from income, mainly b/c Congress

has chosen to treat them specially for policy reasons (e.g., health and pension)



b. Problems with Fringe Benefits

1. Equity?

 two potential equity problems

i. horizontal equity -- two people earning the same amount should not get more benefits

b/c they work in different industries

ii. vertical equity -- higher-income employee gets better fringe benefits than a lower-

income employee

 is this really a problem

 if broken down in percentages, the lower-income person may get more

of a tax-break on less money

 have to look at incidence -- how the benefit gets priced out in the market

 it's very hard to draw equity conclusions w/o looking at incidence -- a large empirical

question that may not be answerable

2. Efficiency?

 employers, through fringe benefits, get involved in decisions that they wouldn't otherwise be

involved in/inefficient for them to be involved in

 however, as a society, we may prize certain spending that the market wouldn't normally provide

for (health insurance, childcare, etc.)

 fringe benefit exclusions would encourage spending where it would not necessarily fall in

a free market



c. Code Provisions

 Employer-Provided Health Care Benefits

 § 106 -- excludes employer contributions to accident and health plans from the gross income of

employees

 § 104 -- excludes compensation for injuries or sickness in the form of workers' comp., disability

pensions, annuities received as a result of military, foreign or public health service, and disability

payments received by gov't employees for injuries attributable to terrorist attacks

 § 105 -- excludes benefits paid under accident/health plan for the medical expenses and families as

well as for permanent disfigurement or "loss of use of a member or function of the body"

 sick pay, however, is taxable; as are lump sum payments to employees on the termination of

health/accident plan

 Life Insurance

 (life insurance premiums excludable if under $50,000)

 generally, premium payments on life insurance paid by an employer are income to the employee

(Frost v. Commissioner)

 however, § 79 allows an aggregate of $50k on premiums for group term life insurance paid by an

employer to be excluded

 any cost in excess of $50k is subject to tax

 Education Benefits







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 § 127 -- an employee can exclude up to $5,250 a year for amts paid by her employer under a

"qualified educational assistance program" -- includes tuition, fees, and books

 Dependent Care

 § 129 -- excludes payments made by an employer for the care of dependents of its employees

 limited to $5,000/year ($2,500 for married couples filing separately)

 Cafeteria Plans

 cafeteria plans -- plans that allow employees to select from a group of employer-provided taxable

and nontaxable fringe benefits

 § 125 -- excludes employer contributions to nondiscriminatory cafeteria plans (can't be

concentrated on key employees)

 constructive receipt -- delaying payment of some income to avoid tax liability over a

certain period

 if offered and delayed, you are deemed to have actually received it and have to

pay taxes

 cafeteria plans (Sec 125) allow for fringe benefits to be excluded from

constructive receipt rules

 you can pick and choose; solves the problem of constructive receipt

 ―however, income is not constructively received if the taxpayer's control of its

receipt is subject to substantial limitations or restrictions.‖

 Misc. -- § 132 -- excludes the following:

 no-additional-cost service

 includes "excess capacity" fringe (Reg. 1.32-2(a)(2))

 e.g., hotel rooms, transportation (empty seats), telephone services

 cash rebates (Reg. 1.32-2(a)(3))

 qualified employee discount

 merchandize -- excluded to the extent it does not exceed the employer's gross profit

percentage; does not extend to real property or personal property of a kind commonly

held for investment

 services -- excluded to the extent it does not exceed 20% of the selling price of the

services to non-employee customers (no gross profit percentage restriction)

 working condition fringe (excluded if would be allowable under § 162 or § 167)

 distinguished from "in-kind compensation" in that working condition fringes are usually

regarded as primarily for the benefit of the employer and therefore not includable in the

income of the employee

 de minimis fringe

 all or nothing

 special allowances made for meals

 qualified transportation fringe

 no constructive receipt (132(f)(4))

 qualified moving expense reimbursement

 qualified retirement planning services

 qualified military base realignment and closure fringe

 athletic facilities

 qualified tuition reduction

 on-site gym (132(j))

 Nondiscrimination Rules -- generally, all employees must be treated the same; can't give fringe benefits to

key employees or highly compensated ones (§ 132(j))

 Reg. § 1.132-1(f) -- if the tax treatment of a particular fringe benefit is expressly provided for in another

section of the Code, § 132 (except for § 132(e) (de minimis)) do not apply



II. WORK-RELATED FRINGE

Generally, the problem with work-related fringe is in the valuation of the personal benefit vs. the business benefit.

 how do we value the business benefit (B) vs. the personal benefit (P) in relation to the cost

o if P >/= C, then clearly should be taxable

o but when P + B > C, we don’t know how much P compares to C







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o can't divide B and P clearly here

 control -- the less control the employee has, the less P he is likely to be getting; whereas the less control

the employer has, the less likely it is that there is much B



Exclusions from gross income are not limited to the enumerated exclusions. Income is taxable to the extent the

portion is personal and not for legitimate business purpose

US v. Gotcher (5th Cir. 1968)

Facts

Gotcher and his wife received an all-expense-paid trip to Germany, worth $1372.30, paid for, in part, by his

employer, Economy Motors, and, the remainder, Volkswagon of America and of Germany. The Commissioner

determined that the trip was income, and the district court reversed, holding that the cost of the trip was not income

or, in the alternative, was income and deductible as an ordinary and necessary business expense.

Holding

Mr. Gotcher's cost was not income, but Mrs. Gotcher's was. Mrs. Gotcher's half ($686.15) was, therefore, not

deductible.

 IRS claimed that only way to get out of § 61 was a stated statutory exclusion

 District Court is wrong

 § 61 should be broadly interpreted and non-compensatory gains can constitute gross

income

 exclusions from gross income are not limited to the enumerated exclusions

 economic gain under § 61 has two distinct requirements:

 there must be an economic gain

 the gain must primarily benefit the taxpayer personally

 meals and lodging economic gain?

 not if such meals and lodging are primarily for the convenience of the employer

 "the dominant purpose of the trip is the critical inquiry, and some pleasurable features will not

negate the finding of an overall business purpose"

 "economic benefit will be taxable to the recipient only when the payment of expenses serves no

legitimate business purpose"

***§ 274(c) – explicit rule for foreign travel, now required to allocate expenses between business and personal

when trip is outside the U.S. ***



III. MEALS AND LODGING

§ 119 -- An employee may exclude from income "the value of any meals ... furnished to him .. by his employer for

the convenience of the employer, but only if ... the meals are furnished on the business premises of the employer ...."

 basically a codification of Benaglia

 must be:

 at the convenience of employer

 more than half for meails § 119(b)(4)

 on the premises of the employer (meals). § 119(a)(1)

 required as a condition of the employer (lodging). § 119(a)(2)

 in kind, not a cash payment or reimbursement (but see Silba – firefighters)

 No anti-discrimination rules



a. Meals

Meals furnished to employee, dependent or spouse for convenience of employer and served on business premises

are excluded from income.

 Convenience of employer met where there is a substantial noncompensatory purpose

 If excluded from income under §119, will be excluded under §132(e)(2)

 If not excluded under §119, consider deductibility under §162 (trade or business expenses); if deductible,

then will be a working condition fringe under §132(d)

 See also §274(n) – deduction denied for ½ all meals to employer because is hard to determine whether

purpose of meal is business or personal (more on this later).









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 If employee must pay fixed charge for meal, under § 119(b)(3), allowed to exclude from income an

amount equal to the fixed charge, applies only if the employee must pay whether or not meals are

consumed – Sibla – firefighter case.



Commissioner v. Kowalski (US, 1977)

Facts

State trooper argued that a daily meal allowance (1) fell under § 119; or, in the alternative, (2) falls under the

common law's allowance for meals and lodging when "for the convenience of the employer"

Holding

§ 119 specifically applies only to meals furnished on the business premises of the employer

 specifically omits cash allowances for meals

 court reads § 119 to say that meal must be in kind, not in cash (but see, Sibla)

 Sibla holds that Kowalski is mostly concerned with unrestricted cash

 statute supersedes common law

Does Kowalski overrule Gotcher on the point of exclusions from gross income not being limited to the enumerated

exclusions in §§ 101-140?

 "In the absence of a specific exemption..." (p. 118)

 stress that it doesn't say a specific statutory exemption

 not saying as much as it appears they are saying

 ultimately consistent with Gotcher



Rejects in-kind requirement of Kowalksi - fixed payment can be excluded (codified in 119(b)(3))

Sibla v Commissioner (9th Cir 1980) -- firefighters were required to eat meals at the firehouse; firemen went to the

store and bought food and prepared meals on site; is the meal tax free?

 court views it as a cash advance rather than a meal in kind, but concludes that Kowalski was only

concerned with cash allowances over which the taxpayer has complete dominion

 "We do not believe that the Court intended to rule that an allowance other wise excludable

simply b/c it was paid in cash"

 be wary about reading Kowalski as requiring the employer to actually furnish the meal

 voucher system, etc. may be OK

Christey v US (8th Cir. 1988) -- permitted state troopers to deduct as ordinary and necessary business expenses under

162(a) the costs of meals that they were required to eat at public restaurants adjacent to the highway while they were

on duty – didn’t use 119’s exclusion rule

 Necessary -- does the business think that it was needed for the business to run/legitimate business

reason?

 but this would be a below-the-line deduction -- only good if the taxpayer itemizes



b. Lodging

Lodging excluded from income if (1) employee is required to accept as a condition of employment, it is on the (2)

business premises, and for the (3) convenience of the employer. 119(a)

 Must have a reasonable noncompensatory purpose to qualify as a fringe.

 Rule of thumb is that if business benefit is large enough relative to cost, than will not be taxed.



(allowed to exclude lodging from income because it was purely for convenience of the employer)

Bengalia v. Commissioner (Board of Tax Appeals, 1937)

Facts

Hotel manager's meals and lodging were supplied by the hotel. Argued that it was purely for the convenience of his

employer, and any benefit to employee was incidental.

Holding

If purely for the convenience of an employer, value of meals and lodging is not income to the employee.

Dissent (Arnold)

Not necessary and solely for the benefit of employer, but for mutual benefit, and, to the extent it benefited employee,

taxable income



IV. SECTION 83 – PROPERTY TRANSFERRED FOR PERFORMANCE OF SERVICES









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§ 83 -- provides additional authority for taxing benefits received by a taxpayers in connection with the performance

of services

 where a taxpayer is permitted to purchase services or property at a price below fair market value b/c the

seller, in turn, is compensating the purchaser for services, the purchaser has gross income in the amount

of the discount. § 83(a)

 if a person receives property in return for the performance of services, and if the property is nontransferable

and subject to a substantial risk of forfeiture at the time of transfer, then the property is treated as still

owned by the transferor and no income is realized by the transferee

o When to include as income?  (a) when the forfeiture risk is removed or the (b) property

becomes transferable, the fair market value of the property at that time, less any amount

originally paid, is includable in income by the person who performed the services

 Once the property vests (and forfeiture risk is removed) the taxpayer must include the

basis of the property in his income.

 Basis = FMV at time of vesting – any amount paid for the property.

 All or nothing approach – assume value is zero until it vests

 Cannot value ―possibility‖ of earning $ later

o property is subject to a "substantial risk of forfeiture" if full enjoyment of the property is

conditioned upon future performance of substantial services by an individual. § 83(c)

o a taxpayer may, however, elect to include property in gross income when received even though it

is subject to a substantial risk of forfeiture. § 83(b)

 the employer is entitled to take a deduction under § 162 for the compensation in the year

in which the employee includes the property in income. § 83(b)

 So the election is a bad deal if you are not sure property will vest or if you would prefer

to minimize the capital gains you pay later on.

 The election is a good deal if you are sure property will vest and you want to pay lower

capital gains.





C. Interest-Free Loans

I. TREATMENT OF LOANS GENERALLY

General rule is that loans at the market rate are not treated as income because liability to repay offsets the receipt.



II. EXCEPTION FOR LOW-INTEREST OR INTEREST FREE LOANS (§ 7872)

§ 7872 - If an employer may make a low-interest or interest free loan to an employee, the employee is seen as

having received an economic benefit equal to the market rate of interest she would have paid

o Example:

 A gives a 10K loan to B at market interest rate –10%. B ―pays‖ interest to A of 1K. A

―gives‖ B gift/refund equal to interest paid by B (1K). No money changes hands.

Structured in this way, A has income of 1K. A also will incur $1000 of gift tax.

 Instead, to avoid tax consequences, A loans $10,000 to B at zero% interest. A will have

no income and no gift tax.

 However, §7872 says can’t get around tax consequences by dropping interest

rate to zero. Will treat the cash flows in second scenario in the same way as in

the first although they will not be characterized in the same way.

 Foregone interest is a transfer from the lender to the borrower and

interest retransfer from the borrower to the lender.

o seen as if the employer paid the employee additional wages, which the employee then remitted to the

employer as interest on the loan. (a)(1)(A) & (B)

 (A) transferred from the lender to the borrower; and

 don't tell us how to tax it b/c it is context-specific (fact-driven): gift?, salary?, dividend?

(see Hypos below)

 (B) retransferred by the borrower to the lender as interest.

o applies to below-market loans that are characterized as gift loans, compensation-related loans, corporate-

shareholder loans, and tax-avoidance loans. § 7872(c)









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 there is a core group that are in, but (c)(1)(E) allows the agency to bring in any loan that has a

significant effect on any Federal tax liability of the lender or borrower

 demand loan -- any gift loan or a loan payable on demand

o a below-market demand loan is one in which the interest payable on the loan is less than the

applicable federal rate. § 7872(f)

 for each taxable year the loan is outstanding, the amount of interest that would have been payable if the

interest rate had been the AFR is treated as if it had been transferred by the lender to the borrower and the

retransferred to the lender as interest. § 7872(a)

 E.g.: I load 200,000 and charge 2% interested instead of usually 5%; 5% - 2% = 3%; 3% of 200,000 =

6,000 = forgone interest





III. EXCEPTIONS TO THE EXCEPTION

 $10,000 de minimis exception for gift loans between individuals, though that does not apply to loans

attributable to the loans directly attributable to the purchase or carrying of income-producing assets. §

7872(c).

 if does not exceed $100,000, another exception -- the amount treated as retransferred to the borrower to the

lender as of the close of any year shall not exceed the borrower's net investment income for such year. §

7872(d)

o in here to help parents make loans to children for education, down-payment for a home, business

start-up, etc.





D. Imputed Income

Imputed Income -- the benefits derived from labor on one's own behalf or the benefits from ownership of property

 Income derived from the use of household durables such as a personal residence, car, or television set, and

income from the performance of services for one’s own or one’s family’s benefit (plumber fixes his own

pipes).

 economists argue that it should be taxed, but difficult to determine how it would be done

 Reasons why imputed income should be taxed:

 Equity – people with tax free imputed income (e.g. Service providing spouses)

are better off because don’t have to pay for their services, while other people

have to earn more wages (and be taxed on those wages) in order to pay for the

same services.

 Efficiency – if two people have the same ability to pay, we should not tax one

who chooses more leisure less than one who chose to apply their ability to do

income-producing work (which benefits the economy).

 Imputed income is excluded from income under §61.

 Reasons for excluding imputed income:

 Conceptual difficulty with taxing imputed income -- line drawing problems.

 Allows for administrative efficiency.

 Valuation Problems.

 Privacy intrusion for IRS to determine value of your services/how much you value things.

 Exception in barter exchanges – income is imputed and included in income so there is no

incentive for people to engage in non-cash exchanges in order to avoid taxes.

 Alleviates efficiency concerns which arise when move away from non-cash economy.



Morris v. Commissioner (BTA 1928) -- the value of farm products consumed by the owners of the farm is

not income

 But see, Dicenso v. Commissioner (BTA 1928) -- the owner of a grocery store must

include in income groceries used for home consumption

Rev Rule 79-24, 1979 CB 60 -- when people exchange services for services, they both have gross income

equal to the FMV of the services

 IRS does not usually enforce these









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E. Gifts and Bequests

I. GIFTS AND BEQUESTS GENERALLY

§ 102(a) – exclude from gross income the value of property acquired by gift, bequest, devise, or inheritance

 Donor is taxed instead of donee.

 § 274(b) -- no deductions for any expense for gifts made directly or indirectly to any individual to the

extent that such expense, added to all other gifts to the same individual, exceeds $25

§102 (b) – must include as gross income any income from property given as a gift referred to in 102(a)



Possible ways to tax gift income:

Donor Donee Analysis

No deduction Exclude gift from Law for most gifts. Our system because donor is more

(taxed) income (no tax) likely to be in a higher tax bracket.

No deduction Taxed on gift as Don’t do this because would be 2 full levels of tax

(taxed) income (taxed)

Exclude from Taxed on gift as Law for Alimony. Gave the $, but someone else

income (no tax) income (taxed) should pay tax.

Exclude from Exclude gift from This would be a huge implicit-subsidy for gift-giving,

income (no tax) income (no tax) no tax, could make reciprocal gifts and evade tax.

This is the deal with charitable gifts.



II. WHEN IS SOMETHING A GIFT?



a. Employer-Employee Gifts



102(c) -- the gift exclusion does not apply to any transfer from an employer to an employee; a personal relationship

is irrelevant

 family relationship exception (proposed Reg. 1.102-1(f)(2) - if related, 102(c) will not apply if transfer of

money is "substantially attributable" to family relationship and not to employment relationship

 §274(b) – Employers can’t deduct more than $25 in any year for gifts to employees



gift: something that is made where transferor’s intention proceeded from detached and disinterested generosity –

lies with trier of fact

Commissioner v. Duberstein (US 1960)

Facts

Two cases:

i. Commissioner v. Duberstein -- a Cadillac was given to Duberstein by Berman b/c D. had been helpful in

suggesting customers to B. CoA held that this was not income, reversing the Tax Court

ii. Stanton v. US -- taxpayer was given a gratuity of $20,000 from his employer, Trinity Church, upon

retirement. CoA held that this was income, reversing the District Court

Holding

Determination as to whether something is a gift, meaning that the transferor's intention proceeded from detached

and disinterested generosity, lies with the trier of fact

 under the statute, a gift proceeds from a "detached and disinterested generosity" "out of

affection, respect, admiration, charity or like impulses"

 the mere absence of legal or moral obligation to make payment does not make a payment

a gift

 the most critical consideration, then, is the transferor's intention

 donor's characterization is not determinative; court must make an objective inquiry into

whether it actually is a gift

 must be reached by a consideration of all the factors

 thus, characterization properly lies with the trier of fact -- if jury, "reasonable men;" if

judge (or Tax Court), "clearly erroneous"

 lower courts must rely on "experience with the mainsprings of human conduct"

and "informed experience in human affairs"







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 The cases in hand

 Duberstein -- b/c the Tax Court in Duberstein was not clearly erroneous, the CoA should

not have reversed

 Stanton -- b/c it is not clear how the District Court reached its determination, remanded

for further findings of fact and clearer record





b. Bequests

Excluded from income under § 102

 Exception -- §691(a) – Income in respect of a decedent

o involves situations in which income was not taxed to the decedent even though most of the events

leading to the realization of income occurred before the decedent's death

 Bequest is included in gross income of estate or beneficiary, whoever receives it.



Wolder v Commissioner (2nd Cir. 1974)—attorney contracted to perform legal services for client during her

lifetime in exchange for a promise to bequeath him certain shares of stocks or their equiv.

 taxable compensation -- parties merely agreed to postpone payment for legal services

 distinguished from United States v Merriam (US 1923)-- a bequest made to an executor in lieu of comp.

was excludable, stating the test was not whether the testator gave the legacies for services, but whether

legatees had to perform services in order to earn the bequests

 C.f. Rev Rul. 67-275, 1967-2 C.B. 2 and Miller v. Commissioner (TCM 1987) -- taxable income if

testator states that bequest is payment for services



c. Basis in Property...

1. Acquired by Gift

§ 1015 -- the basis of property for computing gain in the hands of a donee shall be the same as the basis in the

hands of the donor

 commonly known as "carryover basis" or technically as "transferred basis"

o exception: if basis is over fair market value, the basis for determining loss is fair market value

 creates two basis: one for loss (basis is FMV); one for gain (basis is donor’s basis)

 creates an intermediate region where there is neither gain nor loss

 donor can use donee's loss to offset gain on the asset; loss disappears

 general reluctance to allow people to transfer losses

o HYPO: Gift-giver's basis is $1000, but fair market value is $600.

 sold for $500; Gain - $0; Loss - $100

 sold for $600; Gain - $0; Loss - $0

 sold for $800; Gain - $0; Loss - $0

 sold for $1000; Gain $0; Loss - $0

 sold for $1200; Gain $200; Loss - $0

 reflects congressional determination not to tax accrued income at the time of a gift, but to preserve

the basis so that the tax is triggered upon subsequent disposition

 basis for determining loss -- either the donor's basis or the fair market value at the time of the gift,

whichever is lower

 Taft v Bowers (US 1929) -- upheld the constitutionality of requiring the donee to pay tax on the

gain accrued by the donor

 if taxpayer cannot establish the donor's basis (after attempting to get it from that source) the basis

will be the fair-market value at the date the property was acquired by the donor. § 1015(a)

 basis for gifts between spouses determined under § 1041(b)(2), not this section. § 1015(e).



2. Acquired from a Decedent

§ 1014 -- the basis of property acquired from a decedent is "the fair market value of the property at the date of the

decedent's death"

 result is a "stepped-up" (or stepped-down) basis for the transferee, and the accrued gain (or loss)

on the property will never be subject to income tax (or available to reduce tax).

 becomes regulated under § 1022 after Dec 29, 2009







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provides a "modified" carryover basis - minimum basis equal to FMV or $1.3mm, whichever is

smaller

d. Transfer Tax

Transfer Tax -- Lifetime gifts are cumulative:

 every year you make a gift, a tax liability is imputed

 Second year, make another gift, we add all the gifts together with the first year and compute the

total liability

 Transfer tax system uses lifetime system of accounting instead of annual system of accounting



Gift Tax liability Gift year one Tax paid Gift plus previous

gifts

0-100,000 0% 50,000 0

100-200K 10% 100,000 10,000 150,000

> 200 50% 850,000 400,000 1,000,000

410,000

- 5,000

405,000



 Exceptions:

 Unlimited spousal exception – no death tax to spouse

 Every year there is a $10,000 exception per donor per donee, indexed for inflation (but has not

changed yet)

 Lifetime credit – think of exemption equivalent to the credit

 No tax on charitable gifts

 What does the 2001 act do?

 1,000,000 exemption in 2002

 by 2009, exemption up to 3,500,000

 in 2010, exemption goes back to 1,000,000 which is what it was in 2000



III. GOVERNMENT TRANSFER PROGRAMS

The IRS has ruled that Social Security payments, unemployment comp., benefit payments to the blind and other

assistance payments are not includable in gross income

 "disbursement from a general welfare fund in the interest of the general welfare are not includible in gross

income."

o no statutory authority for any of this

 but, Congress can choose to tax such benefits

o § 85 -- taxing unemployment payments – not taxed if under $2,400

o § 86 -- taxing a portion of Social Security payments;

 (a)(1) an amount equal to the lesser of:

1. 50% of SS benefits received during the taxable year, or

2. 50% of the excess over a base amount

 why 50% -- only taxed on the piece that employer put in; you've

already been taxed on the part you put in, so doesn't make sense to tax

again

 (a)(2) Additional amount, if the amount in (a)(1)(A) exceeds the adjusted base amount,

the amount shall be equal to the lesser of

1. the sum of--

 85% of such excess, plus

 the lesser of the amount determined under paragraph (1) or an amount

equal to 50% of the difference between the adjusted base amount and

the base amount of the taxpayer

2. 85% of the SS benefits received during the taxable year

 why 85% -- adds interest to the original 50%



Bannon v Commissioner (TC 1992) -- taxing a mother on state assistance received on behalf of her disabled adult







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daughter.



IV. PRIZES, AWARDS, AND SCHOLARSHIPS

i. Prizes and Awards

The recipient of a prize or award generally includes the prize in income, even if the transfer was gratuitous

 Reg. § 1.102-1(a) -- the gift exclusion under § 102 does not apply to prizes and awards

 § 74 (b) -- certain prizes are excludable if the they are not retained by the recipient:

o must be in recognition of religious, charitable, scientific, educational, artistic, literary or civic

achievement;

o recipient must have taken no action to enter the contest;

o the recipient must not be required to render substantial future services; and

o the prize or award must be transferred to charity



ii. Scholarships

Can exclude amounts used by a degree candidate for "qualified tuition and expenses." § 117.

 qualified expenses:

o tuition and fees for enrollment

o fees, books, supplies, and equipment required for the course of study

 not excludable:

o room and board

o any portion received for teaching, research or other required services. § 117(c)

o athletic scholarship that require the participation in a particular sport





F. Capital Recovery and Recovery of Basis

Need to decide when to tax gain from capital 

 realization doctrine—wait until realization of gain

How to figure out how much gain?

 Basis – device tax law uses to keep track of cost



I. PRESENT VALUE COMPUTATION

Present Value Computations

Future payment

 Present value 

(1  rate of return ) num berof y earsdeferral

 Future value = x (1 + r) (where R is the interest rate/rate of return)

 See Graetz, pp. 826-29, for present and future value tables

 Best to deduct now and pay tax later (defer income) because $ today is worth more than $

tomorrow.



II. CAPITAL APPRECIATION AND RECOVERY OF BASIS

a. Recovery of Capital Generally

The Code allows for tax-free recovery of capital; in other words, you are only taxed on your gain, not your initial

investment

 gross income means the total sales less the costs of goods sold. Reg. § 1.61-3(a)

 absent any statutory provision authorizing an offset against gross receipts, the income concept implies a

deduction for the cost of goods sold. Doyle v. Mitchell Bros. Co. (US 1918)

o "must withdraw from the gross proceeds an amount sufficient to restore the capital value that

existed at the commencement of the period under consideration.‖

 income includes "gains derived from dealings in property." § 61(a)(3)

o gain -- the excess of the amount realized from the sale over the taxpayer's basis for the property.

§ 1001.

o amount realized -- the sum of any money received plus the fair market value of the property

(other than money) received from the sale or other disposition of property. § 1001(b)

o basis -- cost to the taxpayer, unless otherwise provided. § 1012







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 the technical mechanism by which taxpayers are allowed to recover their capital

investment when they sell property

 if cash, basis is cash paid

 if property is received in exchange for services, basis is fair market value of the property

received. Reg § 1.61-2(d)(2)(i)

 if bargain is a substitute for salary, services or dividends, then exception does

not imply

 if property is a gift, basis carries over (carry-over basis) § 1015

o realization -- rather than requiring a taxpayer to estimate the change in value of his assets in a

given year, the Code generally taxes only realized gains (usually when property is sold)



b. When to recover?

1. Some expenditures for the production of income are treated as immediately deductible expenses; costs are

said to be "expensed."

2. Other assets may be depreciated/amortized -- periodic deductions allowed for the asset's cost.

o set up to accelerate depreciation in order to increase investment in capital goods

3. Other expenses must be capitalized -- the purchase price or cost is taken into account only when the asset

is sold or exchanged (e.g. stocks).







Example: Buy an asset for $10K that will produce $3K of income.

Immediately Year 1 Year 2 Year 3 Year 4 Year 5

Expense

Gross Income 3K 3K 3K 3K 3K

Deduction 10K 0 0 0 0

Net Income (-7K) 3K 3K 3K 3K

Depreciation

Gross Income 3K 3K 3K 3K 3K

Deduction 2K 2K 2K 2K 2K

Net Income 1K 1K 1K 1K 1K

Capitalized (cost is taken into account when sold/exchanged)

Gross Income 3K 3K 3K 3K 3K

Deduction 0 0 0 0 0

Net Income 3K 3K 3K 3K (-7K)

***Taxpayers will always prefer the first option – delay of income recognition and acceleration of

deductions. IRS will always argue for the third.***



iii. DETERMINATION OF BASIS (ALLOCATED BASIS)

a. Basis In the Code

§1012 -- The basis of property is its cost, except as otherwise provided.

 Cost – depreciation + capital investments = Basis

 Simple rule: Where the taxpayer receives property in exchange for cash or services, the basis is

the fair market value of the property received. (Reg. §1.61-2(d)(2)(i). It is as if the employee had

received compensation in cash and had used the cash to purchase the property.

 If property purchased at less than FMV, purchaser takes cost basis and is not taxed on

gain until disposes of property at FMV.

 Events subsequent to the acquisition of property may require adjustments to basis before gain or

loss is determined. See §§ 1001(a), 1011, 1016.

§1016 – Adjusted Basis – reflects capitalized expenditures, untaxed receipts, and certain losses, depreciation.

o capitalized expenditures, untaxed receipts, and certain losses are reflected as adjustments to basis.

§ 1016(a)(1)

o depreciation also requires adjustments to basis. § 1016(a)(2)

o in general, adjustments increase basis to reflect capital expenditures and reduce basis to reflect the

tax benefits allowed to taxpayers while they hold the property







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o Where taxpayer acquires property in exchange for property, the exchange is usually viewed as a

realization event and any gain/loss will be recognized. Cost is generally the value of the property

received.

o Where bargain purchase is in substance a substitute for salary, amount of price reduction should

be included in income and purchaser should be treated as acquiring asset for FMV.

 Cost basis of asset would be recharacterized purchase price, amount paid, plus amount

included in income as salary (e.g. employee permitted to purchase $100 stock for $80,

taxed on $20, income and basis would be $100).

§1015 – Basis in Gifts and Bequests – recipients get carry-over basis (i.e. recipient’s basis is same as donor’s basis

before the transfer) unless there is a loss, in which case, get donor’s basis or FMV, whichever is lower at the time of

the gift. If you get a loss, it won’t transfer unless later get a gain.

 Basis rules for gifts permit transfer of tax on accrued gains to donee, but not transfer of tax benefit

of losses.

§1014 – Stepped-up basis for heir’s basis in bequest of property. Donee gets basis at FMV of property at time of

death. Death is not treated as a realization event, so appreciated value of asset is never taxed as income.

§1022 – treatment of property for decedent dying after Dec. 31, 2009

 Shall be treated as transferred by gift. Basis shall be the lesser of the adjusted basis of the

decedent, or the FMV of the property at date of death.

 Partial step-up -- $1,300,00 1022(b) + $3,000,000 for a spouse 1022(c)

 §1022(d)(2) – Fair market value limitation

Basis in Exchange of Property – you get the basis of the property you receive

 it’s considered a disposition generally (Cottage Savings)

 you realize any gain right away, so you don’t get it again when you sell

 so basis in new property = FMV of the property received, NOT what you gave up for it

(Phila. Park Amusement Co. v. US)





b. Basis Allocation (Part Sale of Property)

Buy a building and land; original basis is payment, but also need to know basis in both building and land; why?

 different depreciation values -- need to allocate basis between different part

 Could apply amount realized against basis for entire property and not report any gain until

aggregate amount realized exceeds entire basis.

 Could allocate basis of whole between part sold and part retained in some reasonable manner and

compare amount realized with portion of total basis allocated to part sold.

 How do we actually do this? Reg. § 1.61-6

o when a part of a larger property is sold, the cost or other basis of the entire property shall equitably

apportioned among the several parts, and the gain realized or loss sustained on the part sold is the

difference between the selling price and the cost or other basis allocated to such part

 allocated at the time of purchase. Reg. § 1.61-6 -- Example (2)

 When you can't allocate reasonably (easement, rights on land) -- basis first approach

o consideration (easement, rights on land) received on the sale may be credited against basis for the

entire property

o Foster v. Commissioner -- taxpayer receives an amount for an easement that affects the entire

property

 basis of entire property is reduced by the amount paid/consideration for the easement

o Gladden v. Commissioner -- courts are more willing to require you to recognize a gain for a

voluntary transaction

 person bought land with water rights that had not yet vested

 rights vested; person sold water rights

 Court said taxpayer should allocate some basis to the water rights -- taxpayer had to

figure out how much unvested water rights were worth

o Inaja Land Co. v. Commissioner -- courts may be more generous to taxpayer if situation is

involuntary

 pollution killed fish, taxpayer received settlement, court said settlement was not gain and

is allocated to basis

 Part Sale, Part Gift. Reg. §1.1015(a)





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o where a transfer of property is in part a sale and in part a gift, the unadjusted basis of the property

in the hands of the transferee is the sum of --

i. Whichever of the following is greater:

1. The amount paid by the transferee for the property, or

2. The transferor's adjusted basis for the property at the time of transfer, and

ii. The amount of increase, if any, in basis authorized by § 1015(d) for gift tax paid.

 If it is not possible to establish donor’s basis, basis will be FMV at date property acquired by

donor.

 For determining loss, basis is never greater than FMV at time of transfer.

 Charity -- allocation of basis between gift and sale portions must be in proportion to their

respective values. § 170(e); § 1011(b); Reg. § 1011-2.

 this because charity will realize the gain b/c don't pay taxes



Hort v. Commissioner (US 1941)

Facts

In 1933, Hort received $140,000 as consideration for cancellation of lease (15 years, $25,000/yr., 10 years left) in a

building that was devised to him by his father some years earlier. The question is whether this amount is income and

whether Hort sustained a loss through cancellation of the lease.

Holding

The amount received for the cancellation of the lease must be included in gross income in its entirety

 the payment was a substitute for the rent reserved in the lease

 NOT a return of capital

 the lease was "property" and thus the amount received for cancellation settlement (which

was in essence a "sale" of the property) was not "capital" but income

What is Hort's basis in the lease? Is his entire basis (implicitly in the opinion) allocated to the land and building and

not at all the lease?

 current law -- no portion of the basis of property acquired subject to a favorable lease may be

allocated to the lease. § 167(c)(2).

 purchase of a lease only, however, does give the purchaser a basis in the lease equal to the

amount paid

Does Hort get the right result?

 Was there a loss?

 almost certainly

 Why don't we permit it?

o Realization requirement

 "We may assume that petitioner was injured insofar as the cancellation of the lease affected the value of the

realty. But that would become a deductible loss only when its extent had been fixed by a closed transaction."



 Can only allocate basis if you give up a portion of all that you have.

o So if you own only income stream, then can allocate basis when give away some of that income

stream.

o If own income stream and underlying residual, can allocate basis if you give up interest in residual

and income stream (e.g. buy 4 acres land for $1K and sell 1 acre for $500 minus $250 of basis.

Allocate basis according to FMV of each part and amount realized applies only to basis of part

sold.).



How to compute gain/loss?

 Hort: Loss = Value - Amount Realized

 § 1001: Loss = Basis - Amount Realized

 Cert: "whether 'in computing net gain or loss for income tax purposes, a taxpayer [can] offset the value of

the lease canceled against the consideration received by him for the cancellation'"

 example: Buy for $500,000 (basis), value increases to $1mm, then property drops to $600k

o should you have gain of $100k or loss of $400k?

 only the latter if we also account for the gain of $500k; missing amount in gain MUST be

taxed at some point







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 the way the code works is that the $1mm is irrelevant; don't care about the path

Should we be able to allocate basis?

 Hort: 2 pieces of property: 1) rent (right now) and 2) remainder (into the future)

 Court: no offset for basis; § 61(a)(5); payment is in lieu of rent/substitute for rent

o includes prepayment of rent

o includes amount received from negotiation

o includes judgment from litigation

Why not gain?

 § 61(a)(3) -- "Gains derived from dealings in property"

 Why does (a)(5) (rent) trump (a)(3) (gains)?

Are payments for lease always rent?

 sell rental property

o What determines price?

o Am I permitted to use basis?

 Purchase right to receive rent for five years.

o Then sell? Use basis?

o Don't sell? Can I amortize (deduct the cost of it over the five year life)?

Why not allocate basis?

 looking at property in one point in time; when you start chopping property across time, we get nervous

about allocating basis, b/c tax system rules do not work well through time (due to realization requirement



G. Realization Requirement

i. REALIZATION AND TIMING GENERALLY

Realization -- there is some triggering event such that we recognize the gain

 Recognition -- whether we're going to include it this year's income

 three justifications (according to US Treasury):

1. the administrative burden of annual reporting

2. the difficulty and cost of determining asset values annually

3. the potential hardship of obtaining the funds to pay taxes on accrued by unrealized gains



The Timing Option -- The realization requirement is inherently asymmetric

 generally, the taxpayer gets to choose when there is a realization event; the IRS does not choose

 taxpayers will choose to defer gains and recognize losses

 a series of responses from the Code

o capital loss exception - can't take capital losses unless you have capital gains (§ 1211)

o Wash Sales (substantially identical securities or stock) -- § 1091

o Straddle (when taxpayers own property with offsetting positions) -- § 1092

o mark to market rules -- abolishes realization requirement for certain taxpayers (§ 475) and certain

types of investments/contracts (§ 1256)



Take-home: View of realization requirement has shifted from Constitutional requirement to administrative doctrine.

 Eisener: Realization requirement is a Constitutional question; about Congress’s fundamental

ability to tax

 Cottage Savings: Realization is a doctrine of administrative convenience.

 Severance definition has also changed

o Moved from dictionary definition to plain, popular meaning of accession to wealth

o Used to matter if it was subject to business risk, but not any more

 Even so, Cottage Savings cites Eisner with approval

 Court is not recognize this shift

ii. THE CASE LAW

a. Treasure Troves

Treasure troves constitute gross income for the taxable year in which it comes into undisputed possession.



Cesarini v. US (US District Court, ND Ohio, 1969) (affm'd 6th Cir. 1970)

Facts







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In 1964, the Cesarinis found $4,467 in cash in a used piano they had bought for $15 in 1957. They paid the tax on

the sum in their original return and sued for a refund, claiming the windfall was not includable in gross income

under § 61

Holding

Because there is no specific exemption and Rev.Rul. 61 1953-1, Cum.Bull. 17 contains express language covering

the found money (even though it's probably not even necessary under the broad reading of § 61), the "treasure

trove" is income

 a "treasure trove," to the extent of its value in US currency, constitutes gross income for the

taxable year in which it is reduced to undisputed possession



b. Unsolicited ―Gifts‖



Haverly v. US (7th Cir. 1975), p 151

Facts

Principal gets deduction for giving text books given to him, unsolicited, by publishers to the school library, without

having ever claimed the books as income.

Holding

When the intent to exercise complete dominion over unsolicited samples is demonstrated by donating those

samples to a charitable institution and taking a tax deduction therein, the value of the samples constitutes gross

income.

 not going to say if it would be income if deduction never happened -- that question is not before the court

 IRS only seems to be concerned with "double-dipping," and that is their prerogative

 Like Cesarini, more of a gross income under § 61 case than a realization case

 Not saying the gift is a realization event

 not saying that, by selling it, he has realized gain

 "the only question is whether the value of the textbooks received is included within 'all

income from whatever source derived'"



c. No Realization, No Income?

Eisner codified in 305(a) – ―gross income does not include the amount of any distribution of the stock of a

corporation made by such to its shareholders with respect to its stock.‖



Eisner v Macomber (US 1920)

Facts

Macomber received a stock dividend which was taxable as income under the Revenue Act of September 8, 1916. He

argues that this taxation is unconstitutional under the meaning of income in the Sixteenth Amendment.

Holding

Neither under the 16th A nor otherwise has Congress the power to tax without apportionment a true stock dividend

as income to the stockholder

 does not meet the realization requirement -- it is a capital increase, not income

 income -- the gain derived from capital, from labor, or from both combined

 "not a gain accruing to capital; not a growth or increment of value in the

investment; but a gain, a profit ... proceeding from the property, severed from

the capital, ... and coming in, being derived -- that is, received or drawn by the

recipient (the taxpayer) for his separate use, benefit and disposal..."

 stockholder has not received anything out of the company's assets for his separate use or

benefit

 3 Possible results for extra dividend allocation:

 Retain it

 taxable? no

 Cash dividend

 taxable? yes

 Stock dividend

 taxable? no

 Does a realization event ever make you richer?







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 NO -- it's simply the time we choose to measure how much richer you have become

 Gov't here is arguing that the dividend is a good measure of how much richer you've become due

to the stock

 Court answers that a stock dividend, by itself, hasn't made you richer -- the important

measure is how long you've held it, change in value, etc.; mere fact of more stock is not a

good measure

 Did the statute tax it?

 YES -- no one is arguing against this – the issue is whether taxing this is Constitutional



Helvering v. Bruun (US 1940)

Facts -- long-term lease, improvements on land, tenant defaults, landlord gets land back

Holding -- landlord had income when he gains possession of the building

 is there a realization event?

 Eisner -- no, not separated from capital

 Bruun court dismisses Eisner as not relevant; reduces Eisner holding to its facts

 § 109 overturns Bruun result -- the landlord does not include in income on the termination of the

lease the value of any improvements constructed by the lessee

 § 1019 -- landlord's basis is unaffected, so that the value of the improvements is

recaptured on disposition b/c a lower basis yields increased gain (or decreased loss)



d. Materially Different Standard

Cottage Savings Ass'n v. Commissioner (US 1991), p 159

Facts

S&L sold a group of mortgages for "substantially identical" mortgages held by other lenders, and deducted the

difference as a loss. Commissioner argues that there was no there was no disposition of property under § 1001(a)

b/c the properties exchanged were not "materially different"

Holding

Under § 1001(a), an exchange of property gives rise to a realization even so long as the exchanged properties are

"materially different" -- that is, so long as they embody legally distinct entitlements

 b/c the participation interests exchanged by Cottage Savings and the other S&L's derived from

loans made to different obligors and secured by different homes, the exchanged interests did

embody legally distinct entitlements

 materially different standard -- properties are different in the sense that is "material" to the

Internal Revenue Code so long as their respective possessors enjoy legal entitlements that are

different in kind or extent

 Reg. 1.1001-1(a) – for there to be a realization event, must be an exchange of

materially different sorts of assets. Question then is whether different sets of loans are

materially different.

 Ex. if exchange stocks, materially different, but perhaps not if exchange wheat

futures.

 Look at characteristics of things exchanged, not their value.

 a legal, rather than economic, test

 Reg. 1.1001-3 – makes easier to renegotiate instrument, redefined materiality. New

standard permits change in debt instrument without triggering a sale/exchange.

 Phellis, Marr, and Weiss cases -- stocks in reorganized corporation are "materially

different" if new corporation is registered in a new state (Phellis, Marr -- NJ to Del;

Weiss -- Ohio to Ohio)



How to measure "materially different"?

 ex post differences, but no ex ante differences (lottery ticket example -- all the tickets are fundamentally the

same before the lottery, but are different post-lottery (one wins))

 Tests proposed:

o Economic/Market Test (IRS) -- look to the market -- if the market view these two things as

fungible, then there is no real difference









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 look to a variety of factors -- attitudes of the parties, the evaluation of the interests by the

secondary mortgage market, and the views of the industry

o Legal Entitlement (Tax Payer) -- look to see if there is a change in legal entitlement (here would

be -- loans made to different borrowers and secured by different property)

 justified with Phellis and Marr

 Shuldiner thinks this justification is nonsense

 why does court really prefer -- judges are better at determining legal change,

rather than market changes

Debt Modification and Cottage Savings

 Reg. 1.1001-3 --backed off from Supreme Court standard; has to be a significant modification

o Reg. 1.1001-3 makes it easier to renegotiate instrument, redefined materiality. New standard

permits change in debt instrument without triggering a sale/exchange



H. Annuities and Life Insurance

i. ANNUITIES

Annuity -- when a person transfers money or other property and receives from the transferee a promise to pay

certain sums at intervals, most likely measured over a life or lives

 Central question: how do we know which dollars are income, and which are basis recovery

 for tax purposes, the annuitant has income to the extent he received more than he paid for the annuity

o the investment in the annuity is his "basis"

a. Term Annuity – i.e. for 5 years want $1000/month. Several possible approaches.

o Basis recovery first/Open transaction approach – this was the old way to do it. Taxpayer

prefers this deferred taxation. Don’t begin recognizing income until your basis in the annuity’s

purchase price is paid off. Tremendously taxpayer friendly. Allows for significant deferral of

income.

 Burnett v Logan (US 1931) – where ―open transaction approach‖ comes from, though

dealing with an oil investment, rather than annuities

o 3% rule – this was prior statutory approach. Here you were assumed to have an annual income of

3% of your purchase price. Once your basis has been recovered, all additional payments count as

income.

o Exclusion ratio – this is the law – what §72 says to do – Set an exclusion ratio where the

numerator is the investment in the contract and the denominator is the expected return. (§72(b)).

 This ratio remains constant through the life of the loan, and for every payment, payment

* exclusion ratio is the recovery of capital, and payment * (1-exclusion ratio) is taxable

income.

 § 72 taxes a portion of each annuity payment, and treats the remaining portion as a

recovery of payment

 the amount of payment excluded from income is determined by the exclusion

ratio, where the numerator is the investment in the contract and the denominator

is the expected return. § 72(b)

 a straight-line depreciation deduction

 exclusion ratio = investment/expected return

o Bank Account Treatment – this is what Shuldiner likes – You are treated as if you deposited

your investment in the contract in a bank account and withdraw the fixed amount of the annuity

from the bank each year. The bank is assumed to pay a certain rate of interest (market rate?)

 Basically have a self-amortizing loan which = the present value of all annuity payments.

Set an interest rate of return (IRR), then the portion of each payment = AIP*IRR is

income. Remainder is recovery of capital.

 This accelerates the recognition of income, since the earlier balances are

necessarily larger.



Table IV – Bank Account Treatment

Year Starting Interest New Withdrawal Ending Principal

Balance Balance Balance Withdrawn

1 267.30 16.04 283.34 100 183.34 83.96







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2 183.34 11.00 194.34 100 94.34 89.00

3 94.34 5.66 100.00 100 0.00 94.34

Total 32.70 300 267.30

PDV 29.67 267.30 237.63





Table V – Comparison Table VI – Making a Tax Shelter*

Open Bank Invest: Borrow:

Year Transaction Section Account Year Sec. 72 Bank Tax

72 Account Shelter

1 0.00 10.90 16.04 1 10.90 - 16.04 - 5.14

2 0.00 10.90 11.00 2 10.90 - 11.00 - 0.10

3 32.70 10.90 5.66 3 10.90 - 5.66 5.24

Total 32.70 32.70 32.70 Total 32.70 - 32.70 0.00

PDV 27.45 29.13 29.67 *Prevented by § 264



b. Life Annuity -- aggregate amount to be received is based on the life expectancy of the person or persons

whose lives measure the period of the annuity. § 72(c)(3)

o §1275(a)(1) & Reg. 1.72-9 (table ages), §72(c) – often look to tables on life expectancies to

calculate out life annuities (we use the unisex table).

 when the annuitant outlives that life expectancy, he is said to have a mortality gain on

which he is taxed. § 72(b)(2).

 Shuldiner points out that under new system, women will pay more and men will

pay less -- women are now getting lower averaged life exclusion ratios

 when the annuitant dies prior to the expectancy, he is said to have mortality loss and is

able to deduct his unrecovered investment on his last income tax return. § 72(b)(3).

 Deferred annuities -- taxpayer pays for an annuity where payments would begin at a later date; amount

grows in interest until the beginning of payout

o interest is not taxed until he receives payment. § 72(b)

o withdrawals before the annuity starting date is treated as income to the extent that the cash value

of the contract exceeds the owner's investment. § 72(e)

 when cash is withdrawn, interest is taxed first

 additionally, a penalty is imposed on amounts withdrawn before retirement. § 72(q)

 10% if the amount includible in income



ii. LIFE INSURANCE

a. Two Elements and Types of Plans

1. pure insurance -- protection against the even of death during the period of coverage

o term insurance -- the insured pays a premium in return for which a specified sum will be paid to

his survivors upon death

 premium goes up as you age

 essentially a gamble of the insurance premium on the odds that the insured will live

through the period covered by the insurance

 no deduction or loss if you lose the bet. § 101(a)

 receipt of the insurance is not taxable if you win the bet (no income). § 101(a)

2. savings element -- premium is invested into a reserve and earns interest

o ordinary life insurance -- involves payment of a uniform annual premium throughout the life of

the insured and matures of death; though cost at end of life would be high, premium is covered

through savings and the fact that premiums exceed the actuarial cost of insurance in the early years

of the policy

 Other types:

o universal life insurance -- where a person simultaneously purchases a contract for life insurance

and deposits a sum w/ the insurance company









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 on a monthly basis, the company deducts from the amount deposited that month's

premium (plus "loading and administrative fees") and then credits the insurer's account

with the investment income on the balance

o variable life insurance -- the premiums paid are invested in the stock market by the life insurance

co. and the proceeds payable on the death of the insured vary depending upon the success of the

investments



b. Taxation (§ 101)

 amounts paid "by reason of the death of the insured" are not subject to income tax. § 101(a).

o proceeds received upon the termination of a cash value policy through surrender, rather than b/c of

death, are taxable to the extent that they exceed the total cost of the policy

 this means the owner of a life insurance policy can offset the personal cost of insurance

against the interest earned on the savings

 or, stated in another way, a policy-holder can reduce his interest income for tax purposes

by the amount of his personal expenditure for insurance protection (up to the limit of the

interest income earned)

 as a practical matter, taxpayers are not taxed annually on the investment income earned under a life

insurance contract, even when amounts are withdrawn prior to death

 §101(c) – have to include interest payments made on insurance proceeds that have not been fully

distributed to beneficiary; in other words, if policy is paid out and beneficiary does not get all $ and instead

someone else holds $ in exchange for interest, that interest must be included in income.

o If amounts excluded are held under agreement to pay interest, those payments are taxed.

o Essentially treats non-term life insurance like an annuity.

 terminally ill insureds can get the insurance pay-out tax free at the end of their lives to help pay for medical

costs, etc. § 101(g)

 risk is an essential element to the tax break

o can't eliminate risk with annuity contract (Rev Rul. 65-67, 1965-1 C.B. 56)

o Helvering v. Le Giese -- "risk shifting and risk distributing" are the heart of insurance

Why don't we tax life insurance?

 Possible arguments:

 We want to encourage investment in insurance; a subsidy

 It is taxed elsewhere; a substitute

 Sympathy -- we don't want to tax widows and orphans

 Shuldiner -- it doesn't matter whether we tax it

 HYPO: The tax rate is 1/3rd. Premium is $100. Insurance pay-out: $100,000 (see chart

below)

 In a nontax world -- invest $100, get back either: $100k (win); $0 (lose).

 In a tax world -- deduction of $100 in year premium is paid.

 but, you buy more insurance in this world. $150 in premium; pay-out of

$150,000

 in after-tax terms, it all comes out the same

 pure income tax system does not tax risk



Why It Doesn’t Matter If We Tax Life Insurance

No Tax Taxed Pre-Tax After Tax

Premium $100 Premium $150 $100 (after

deduction)

Insurance $100,000 Win (die) $150,000 $100,000

$0 Lose (live) $0 $0

Amt. Realized (AR) Premium + Interest

- Basis Premium

Interest



Amt. Realized (AR) Premium + Interest – Term Insurance

- Basis Premium







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Interest – Term Insurance





I. Treatment of Debt

i. ILLEGAL INCOME

a. Illegal Income Generally

 General rule – illegal income is included in income/taxable under §61

 Not fair to tax people who make money legally but not those who make money illegally

 Distinguished from loans:

o with loans there is an understanding that the borrower will repay.

o with illegal income (e.g. embezzlement) there is no repayment expectation (i.e. no simultaneously

occurring liability giving rise to a net increase in wealth).



Collins v. Commissioner (2nd Cir 1993)

Facts -- Employee at the OTC punched himself $80,280 in betting tickets on the computer. Ended up $38,105 behind

for the day. Argues that the $80,280 should not be taxable as income, and was in fact a loan.

Holding -- Loans are identified by the mutual understanding between the borrower and lender of the obligation to

repay and a bona fide intent on the borrower's part to repay the acquired funds

 Characterization of Income

 IRS argues income is the amount he ended up being down, $38,105, but characterizes it as

gambling income

 Courts reasoning

 $80,000 in theft income; returns $42,000

 $38,000 in net theft income

 James v. US -- all unlawful gains are taxable; a taxpayer has received income when she "acquires

earnings, lawfully or unlawfully, w/o consensual recognition, express or implied, of an obligation

to repay w/o restriction as to their disposition‖

 Collins activities give rise to gross income, as it was a nonconsensual misappropriation of his

employer’s property without its knowledge or permission

 larceny of any kind resulting in an unrestricted gain of moneys to a wrongdoer is a taxable

event

 Gilbert v Commissioner does not apply (president/director of company used corporate

money to acquire stake in rival corporation without approval from board)

 not income under James b/c:

i. expected with reasonable certainty to repay sums taken

ii. believed withdrawals would be approved by the corporate board

iii. made prompt assignment of assets sufficient to secure the amounts he

owed

 facts evidenced consensual recognition



Sullivan (US 1927) -- a criminal enterprise (bootlegging) should be taxed just like a legal business

 no reason to treat criminal enterprises more leniently than legal enterprises

 See § 280(e) -- no deduction for drug dealers

 Generally, can take deduction (unless clearly frustrates policy)

 Is this a good idea?

 counterargument - gets the IRS involved in enforcing criminal law (Black's dissent in

Rutkin)



b. Embezzlement and Extortion

Sticking point is the question of treatment of loans:

 Rutkin (US 1952) -- holds that an extortionist, unlike an embezzler, was obligated to pay tax on his ill-

gotten gains b/c he was unlikely to be asked to repay the money

o leaves law on embezzlement in "murky state"

 James (US 1961) -- all unlawful gains are taxable

o overrules Rutkin on embezzlement







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 Can you claim a loss?

o § 165(a) -- there shall be allowed as a deduction any loss sustained during the taxable year and not

compensated for by insurance or otherwise

o § 165(c)(2) -- in the case of an individual, the deduction under subsection (a) shall be limited to

(2) losses incurred in any transaction entered into for profit, though not connected with a trade or

business

 non-business losses are disfavored

o what about paid back in same year?

 Collins suggests is that there is no income there, period; treat it like a loan

 is there an inclination to treat caught embezzlement as a loan?

o Buff v Commissioner (2d Cir 1974) -- embezzler who confessed and signed an agreement to repay

does not make it a loan

 the mere act of signing consent could not be used to escape tax liability

 court in Collins distinguishes this from Gilbert

 embezzling of non-cash: taxed at FMV at time of receipt



c. Gambling

 § 165(d) -- losses from wagering transactions shall be allowed only to the extent of the gains from such

transactions

 why do we have it?

o not clear



ii. TAX TREATMENT OF LOANS

 Principal of loan

o a borrower does not realize income upon receipt of a loan, regardless of how the proceeds are used

 similarly, there is no deduction when he makes principal payments on the loan

o a lender does not have a deductible loss upon making a loan and does not realize income on the

repayment of the loan principal

 the repayment is recovery of capital

o makes sense b/c there is no change in net worth for either party

 the decrease in the lender's assets is offset by the borrower's promise to pay

 merely an exchange of property in the form of a sum of money now for a promise to

repay that sum at future date

 Interest on loan

o Debtor may deduct interest payments.

o Creditor must include interest payments as income.

 Recourse debt

o Borrower is personally liable for repayment of debt.

o Upon default, lender can look not only to any asset securing the debt, but also to borrower’s other

assets for repayment.

o Clear that recourse debt is not income when issued.

 Entered into legally-enforceable promise to repay.

 Merely exchanging your future repayment for cash today; not a taxable event.

 Non-Recourse debt – Borrower is not personally liable for repayment of debt, lender can obtain

satisfaction of obligation only from property securing debt.

o Less clear -- not obliged to repay, so could argue that this should be recognized as income.

 Courts have held though that people act as if they have to repay and so treat non-recourse

debt in the same way as recourse.

 Discharge/Cancellation of Indebtedness

o if debt it subsequently cancelled, however, for less than its face value, the borrower is considered

to have income. § 61(a)(12)

o where the original consideration for the borrower's debt is not cash equal to the face amount of the

debt, the courts have had difficulty determining if there is cancellation of indebtedness income.

See Zarin v. Commissioner.









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US v Kirby Lumber Co. (US 1931)

Facts

Kirby issued bonds for approx $12mm for which it received their par value. It later (in the same year) purchased

some of the same bonds at less than par, the difference being $137,521.30 (in essence, buying back the debt in the

market). US says the difference is taxable income.

Holding

If the corporation purchases and retires any of such bonds at a price less than the issuing price or face value, the

excess of the issuing price/face value over the purchase price is gain or income for the taxable year

 Emily’s two theories go here (timing and dominion reasoning)

 here taxpayer made a clear gain

 61(a)(12) is the codification of this holding

 Kirby realized within the year an accession to income, if we take words in their plain popular

meaning

 (a broader, looser view of income than Eisner, where Holmes said a similar thing in the

dissent)



Zarin v. Commissioner of Internal Revenue (TC 1989)

Facts -- After racking up $3,435,000 in gambling debt, paid through bad checks and markers, Zarin made a deal to

pay the casino $500k. IRS says the difference is income from forgiveness of indebtedness.

Holding -- An increase in wealth from the cancellation of indebtedness is taxable where the taxpayer received

something of value in exchange for the indebtedness; gain is the amount that is "freed up" by not having to pay the

lender

 taxpayer did receive value at the time he incurred the debt and only his promise to repay the

value received prevented taxation of the value received at the time of the credit transaction

 when a portion of the obligation to repay is forgiven, § 61(a)(12) kicks in

 Enforceability -- the enforceability of the debt under NJ law is not determinative for Federal

income tax purposes

 legal enforceability of an obligation to repay is not generally determinative of whether

the receipt of money or property is taxable. James v. US

 Disbuted Debt -- Zarin's defenses (not a loan b/c Zarin could not be legally compelled to pay)

are overcome by:

 the stipulation of the parties that, at the time the debt was created, petitioner agreed to

and intended to repay the full amount (so was a loan), and

 the conclusion that he received full value for what he agreed to pay

 i.e. over $3mm worth of chips and the benefits of a "valued gambling patron"

of casino

 Deductibility of Gambling Losses -- cannot offset losses with income from discharge of

gambling debt

 § 165(d) -- losses from wagering transactions shall be allowed only to the extent of the

gains from such transactions

 Reg. 1.165-10 -- wagering losses shall be allowable as a deduction but only to the

extent of the gains during the taxable years from such transactions

 Purchase Money Debt Reduction -- for a reduction of a debt to be treated as a purchase price

adjustment (§ 108(e)(5)), the following conditions must be met:

 the debt must be that of a purchaser of property to the seller which arose out of the

purchase of such property;

 the taxpayer must be solvent and not in bankruptcy when the debt reduction occurs; and

 the debt reduction would otherwise have resulted in discharge of indebtedness income

 the value received by petitioner in exchange for the credit extended by the casino does

not constitute the type of property to which § 108(e)(5) was intended to or reasonably

can be applied

 opportunity to gamble is not, in the usual sense of the words, be "property"

transferred from a seller to a purchaser

 refers to tangible property (though may apply to some types of intangibles)

Dissents







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Tannenwald -- b/c the debts were unenforceable under NJ law, there was no freeing up of assets when they were

discharged

 in all the cases involving cancellation of indebtedness, the taxpayer had, in a prior year when the

indebtedness was created, received a nontaxable benefit clearly measurable in monetary terms

which would remain untaxed if the subsequent cancellation of the indebtedness were held to be

tax free

 the concept that petitioner received his money's worth from the enjoyment of using the

chips (thus equating the pleasure of gambling with increase of wealth) produces the

incongruous result that the more a gambler loses, the greater his please and the larger

the increase in his wealth

Jacobs -- petitioner realized income only to the extent of the value of chips received in the year in question

 the result reached by the majority is tantamount to taxing petitioner on his losses

 the chip income is gambling gains; losses can be deducted to the extent of gains

Ruwe -- § 108(e)(5) is applicable -- petitioner did acquire property from casino



Subsequent History

 3d Cir. —OVERTURNS TAX COURT –b/c Zarin’s loan was unenforceable under NJ law, he did’t have

a loan under 108(d)(1), so he couldn’t have discharge of indebtedness.

o BUT: Ct of Appeals WRONG—just b/c it’s not debt under 108(d)(1) does not mean you can’t

have discharge of indebtedness income b/c still listed generally under section 61.

 definition in 108 is only for that provision, which carves out exceptions, and thus the

definition under 61 could include more than what’s in 108(d)(1)



Exceptions to Cancellation of Indebtedness rule

 §108(a): A cancellation of debt is not taxable where:

o the taxpayer bankrupt. § 108(a)(1)(a)

o or is insolvent. § 108(a)(1)(b)

 Can forgive the debt in excess of your assets; amount equal to your assets is income. §

108(a)

 Parkford v. Commissioner (9th Cir. 1943) -- salary paid to an insolvent individual is

income

 §108(b) details the preferential order in which 108(a) exclusions are applied to reduce tax attributes

o the quid pro quo for nonrecognition is that the taxpayer must reduce certain tax benefits (for

example, net operating loss carryovers) or the basis in his property for the amount of the debt

cancellation. § 108(b)

o with a credit, the reduction shall be $0.33&1/3 for each dollar. § 108(b)(3)(B)

 puts credits on par with other losses and marginal tax rate (assumes your tax rate is 1/3rd)

 §108(e)(2) – Lost Deductions – excludes from income the discharge of a debt if its payment would have

given rise to a deduction

o e.g. if bank forgives interest on mortgage, is as if took deduction and gave it back. (Might ha0ve to

itemize for this provision to apply)

o sort of an administrative provision -- puts the taxpayer in the same position he would have been in

had the discharge of the debt been included in income and a deduction allowed for it

 §108(e)(5) – Purchase Price Reduction – reduction in price owed to seller for purchase of property (not

services) not treated as a discharge of indebtedness (which is includible in income).

o Reduction does not affect income.

o Following conditions must be met (from Zarin):

 the debt must be that of a purchaser of property to the seller which arose out of the

purchase of such property;

 the taxpayer must be solvent and not in bankruptcy when the debt reduction occurs; and

 the debt reduction would otherwise have resulted in discharge of indebtedness income

o should it cover services?

 Shuldiner thinks it should, but not clear

 §108(e)(6) – Corporate Debt to Stockholder – if stockholder forgives debt owed by corporation, as if the

corporation satisfied debt with amount of money equal to stockholder’s basis in debt.







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 §108(f)(1)—Student Loan – Gross income does not include any amount from the forgiveness of certain

student loans, provided forgiveness is contingent on the student's working for certain period of time in

certain professions for any of a broad class of employers. § 108(f)

 § 1017 – Rules for adjusting basis where there is a discharge of indebtedness under § 108 (b)(2)(E), (b)(5)

(election to apply reduction first against depreciable property), and (c)(1) (treatment of discharge qualified

real property business indebtedness)



iii. THE ACQUISITION AND DISPOSITION OF PROPERTY ENCUMBERED BY DEBT

a. Determining Basis

Determining Basis -- Where a taxpayer purchases an asset for cash, the basis, is easily determined -- it is equal to

cash paid

 where a taxpayer finances acquisitions with debt, however, basis of such assets must be determined to

assess the tax consequences

o such as depreciation deductions and the amount realized upon disposition of such assets

The Code

 § 1012 – The basis of property is its cost, except as otherwise provided.

 § 1011 – allows for adjustments to basis to determine gain or loss

 § 1016 – allows for adjustments to basis for depreciation

o § 1016(a)(2) and improvements -- need to adjust your basis for depreciation even if you declined

to take depreciation deduction.

 If you could decide to defer depreciation, could decide when to take deduction and code

does not generally allow you to elect when deductions are taken.

 § 1001 – determination of amount and recognition of gain or loss

o gain = excess of amount realized over the adjusted basis.

 g = AR-AB

o loss = excess of adjusted basis over amount realized.

 l = AB-AR

Loans and Basis -- Generally allowed to include amount of a loan in basis and then to take deductions on that basis.

 Loan amount is initially included in basis under the assumption that you will later pay it back.

 When no longer have to pay it back (e.g. buyer buys property and assumes loan), need to account for

discharge of loan.

 Need to know basis to calculate gains/losses when property sold and to calculate depreciation over the life

of the property (§ 1016).



b. Recourse v. Nonrecourse Debt

Two types of borrowing

1. recourse debt -- where the borrower is personally liable for repayment of the debt

2. nonrecourse debt -- where the borrower is not personally liable and the lender can look only to assets that

secure the debt for repayment

o the lender can obtain satisfaction of the obligation ONLY from the property securing the debt

o if the value of the property, when the debt becomes due, is inadequate to satisfy the debt, the

lender suffers the loss

Tax treatment of recourse v. nonrecourse debt

 Crane v. Commissioner (US 1947) -- recourse and nonrecourse debt are treated alike

o a loan, recourse or nonrecourse, is included in the basis of the asset it finances

 Benefits to taxpayer:

o if the property is eligible for depreciation deductions, including the borrowed amount in basis

enables a taxpayer to recover costs that she has not yet paid or assumed directly

o if the money for borrowing the property is borrowed through a nonrecourse mortgage for which

the taxpayer has no personal liability, it may be possible for her to recover through depreciation

putative acquisition costs for which she may never have to put up any of her own money

o although the amount of the outstanding debt will be included in the taxpayer's amount realized

upon an eventual sale (offsetting the earlier depreciation deductions, the taxpayer still enjoys the

time value of the depreciation deductions)









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Crane v. Commissioner (US 1947)

Facts -- Taxpayer inherited an apartment building subject to a nonrecourse mortgage equal to the value of the

property. She originally calculated her basis as equal to the value of the building w/o reduction for the mortgage.

Over the course of six years, she deducted about a tenth of this figure as depreciation, made no payments on the

mortgage, and in the face of foreclosure, sold the building, still subject to the mortgage, for a small cash sum.

 Claims nonrecourse debt should not have counted in calculating her basis and that the amount she

realized on the sale should not include her relief from the mortgage obligation

Holding -- When calculating basis, a taxpayer must treat a nonrecourse mortgage as equivalent to a cash investment

and that, in determining the amount realized upon a disposition of property, the taxpayer must include relief from the

obligation to repay a mortgaged nonrecourse debt

 Crane's basis was FMV at the time of her husband's death, adjusted for depreciation in the interim

 the amount realized is net cash received plus the amount of the outstanding mortgage

assumed by the purchaser

 consistency argument -- excluding the non recourse debt from the amount realized would

result in permitting Crane to recognize a tax loss unconnected with any actual economic

loss

 economic benefit argument -- Crane obtained an economic benefit from the purchaser's

assumption of the mortgage identical to the benefit conferred by the cancellation of

personal debt

 b/c the value in the property exceeded the amount of the mortgage, it was in

Crane's economic benefit to treat the mortgage as a personal obligation

 causes trouble in Tufts

***effect of the case was to increase and accelerate the amount of depreciation deductions allowed to owners of

property financed by any kind of debt (recourse OR nonrecourse)***



HYPOS

Ex 1.: 100,000 recourse debt, 50,000 cash, buy building for $150,000, basis = 150,000

 Depreciate  30,000 – adjusted basis (§1016) = $120,000

 Sell property  140,000

o 100,000 cash to pay debt, 40,000 in pocket  gain of 20,000 (even though net loss = 10,000 cash –

this is because of the deduction for depreciation)

 20,000 Gain – 30,000 Depreciation = - 10,000 net

Ex. 2: 100,000 recourse debt secured by a mortgage, 50,000 cash, buy building for $150,000, basis = 150,000

 Does not change the facts

Ex. 3: 100,000 secured non - recourse debt, 50,000 cash, buy building for $150,000 , basis = 150,000

 Does not change the facts – get this result from Crane

 Crane tells us non-recourse debt is the same as a recourse debt



Reg. 1.001-2: Discharge of liabilities – amount realized from sale of property includes amounts of liabilities from

which transferor is discharged as a result.

 Reg. 1.001-2(4)(ii) – if property subject to recourse debt is sold and buyer agrees to pay debt, seller

discharged of debt and must include it in gains regardless of whether or not bank holds seller personally

liable for debt.

 However if seller has already had debt reduced and had discharge of indebtedness income (under

62(a)(12) or 108), this amount was already taxed and is not included in amount realized. Reg.

1.1001-2(2)

 Reg. 1.001-2(4)(i) – sale of property that secures non-recourse debt discharges transferor from liability.

Have to include amount discharged in amount realized.





Commissioner v. Tufts (US 1983)

Facts -- Taxpayers (partnership) borrowed $1.85M non-recourse for apartments. Took out $450K in depreciation

deductions, which reduced basis to $1.4M. Unable to operate building profitably, and having repaid none of loan

principal, sold property to another investor who paid them nothing, but took the building subject to the mortgage. At

the time, FMV was not greater than $1.4M adjusted basis. Taxpayers argued no more than $1.4M should be included







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in their amount realized and so had no recognizable gain.

Holding – Rule of Crane applies when the unpaid amount of the nonrecourse mortgage exceeds the FMV of the

property sold (codified in 7701(g)).

 Court found taxpayers had realized full unpaid balance of mortgage debt and must recognize

$450K gain because understanding of obligation to pay the full amount.

 When obligation relieved, realized value under §1001(b).

 treats nonrecourse mortgage as a true loan (not as a "joint investment" between mortgagor and

mortgagee)

 Sale price must include the amount of debt forgiven or assumed for less than face value.

 Cannot use mortgage value in assessing basis and then leave it out of assessing amount

realized.

 To permit taxpayer to limit realization to FMV would be to recognize tax loss without economic

loss.

 Symmetry here, but no economic benefit -- incentive is to walk away, not to sell.

 Liability would be the same if left mortgage out of basis and amount realized, but by

including it, can take advantage of the time value of depreciation deductions.

Concurrence (O'Connor) -- Suggests that transfer of excessively mortgaged property might be viewed as two

aspect event, consisting of:

1. sale of asset itself (apartment building) for $1.4 FMV and

2. use of constructive proceeds ($1.4M) to satisfy taxpayers debt of $1.85M,

 Effect would be that sale would generate no taxable gain, but debt repayment would be cancellation

of indebtedness (this would be ordinary gain, majority view would be capital gain (lower rate)).

 Shuldiner says O’Connor fails because different transaction.

 Note this is how recourse loans are treated. Difference between outstanding value on property and

the FMV is considered discharge of indebtedness or ordinary income (§ 108).

Takehome Points:

 Where lender writes down debt, result is cancellation of indebtedness income. Rev. Rul 91-31.

 Court claims recourse and non recourse are treated the same. Is that true?

o Shuldiner says no

o Ex. 1: Buy land and building subject to recourse debt of 12k; FMV is 10k; basis is 7k (took

depreciation)

 If recourse debt, gain of 3k and discharge of indebtedness of 2k. Bifurcate the transaction.

 But, under Tufts, you just have a gain of 5k (nonrecourse debt, the whole debt, even when

it’s greater than FMV, is ordinary income).

 B/c capital and ordinary income are taxed differently, not the same



Borrowing Money Against Property Already Owned

HYPO: Basis - $300k; FMV - $1m; Borrow - $800k (NR)

 is this a recognition event?

 no -- Woodsam Assoc. v. Commissioner (2nd Cir 1952) -- court held that a loan, even

when secured only by untaxed appreciation in property, does not constitute realized

income to the borrower; borrowing is not a realization event

 what if you then give a gift subsequent to the debt? What are the tax consequences?

 part sale/part gift -- the amount realized is the amount of the nonrecourse debt

 Diedrich v. Commissioner (US 1982)



Estate of Franklin v. Commissioner (9th Cir 1976)

Facts

Doctors formed a partnership to buy inn for $1.2mm in non-recourse debt. Paid $75k in "prepaid interest" and leased

back to sellers who paid all expenses for upkeep/ownership and paid rent to doctors equal to interest payments

doctors made. Option for Doctors to pay a balloon payment at the end of 10 years of the difference between the

remaining purchase price (forecast as $975k) and any mortgages outstanding against the property or simply walk

away, forfeiting only their $75k interest payment.

 Doctors took interest deductions on debt and depreciation deductions on $1.2M under Crane.

Losses used to offset gains made as doctors.







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 No cash flow in this transaction -- "Rent (Income) = Interest (Deduction)" in every year so

no net +/- effect.

Holding

Because the purchase price far exceeds any reasonable estimate of the FMV of the property at the time of sale, there

was no equity and thus there was no true debt

 Taxpayers could have artificially inflated basis (i.e. tack on another zero) to claim larger depreciation

deductions -- not allowed.

 Where there is no equity, will not treat as real debt (opposed to Crane and Tufts, where act as if

investment will pay back). Nonrecourse like Tufts, so there is no cancellation of indebtedness.

 an inadequately secured nonrecourse loan generally is too contingent to merit characterization as

indebtedness, cannot include any portion of loan as an acquisition cost includable in bases

 In effect, a tax shelter was created here – this is now illegal (see Passive Loss rules in §469).

 Test – look at objective reality at beginning of transaction and see if buyer really intends to buy.

o If value of property drops so that is less than mortgage, apply Tufts reasoning.

o Where it is not close, will ignore subjective test, where it is close, and there may reasonably have

been a bad bargain, will still use a subjective test.

 Option Analysis

o Call option -- pay upfront premium; has termination date and strike price

 a legal right to purchase the property at this date (termination) for this price (strike)

 premium here: $75k

 termination date: date of balloon payment

 strike price: $975k

 but, b/c taxpayers don't characterize it as an option, Court says that's not how they are

going to view it (respect the form of the deal)

 Taxation of Options:

o HYPO: A building

o $10k premium to buy for $100k in 1 year

 if option expires worthless, can claim a loss for premium

 if option is exercised, no immediate tax consequences

 basis in building: 110k (premium + amt paid)

 any gain would be deferred until buyer sells the building

 if option is cash settled (seller buys buyer out of the option), then income = cash

settlement - premium

 sell option for $25k, income of 15k

 Prepaid interest – cannot deduct for prepaid interest. §461(g))

o no real difference between borrowing $1000 and prepaying $100 and borrowing $900, so can only

deduct interest over period for which it was allocated.

o If you prepay interest, must allocate for time where interest would have accrued.

 ***Exception -- §461(g)(2) does allow for deduction on mortgage points (form of prepaid

interest).

Depreciation

 Who gets to depreciate?

o under Franklin, nobody

 a draconian rule, according to Shuldiner

 Penalties— how to solve the problem from Estate of Franklin

o if you underpay tax, there shall be added tax equal to 20% of portion of underpayment

o § 6662 says penalty goes up if there’s a significant over-valuation of the property.

o § 6663 is an additional fraud penalty.

o also: § 465 at-risk rules, § 469 passage loss rules





J. Damages and Sick Pay

Damages -- the nature of the injury for which compensation is made determines the tax consequences of the

damages received by the taxpayer.









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 it is thus essential to distinguish between business and personal damages, b/c the Code provides preferential

treatment for certain damages



i. DAMAGES TO BUSINESS INTERESTS

 the tax consequences of a compensatory damages award or reimbursement depend on the tax treatment of

the item for which the reimbursement is intended to substitute

o Recovery for destruction of a building—treated as sale or exchange of the building

 § 1033: involuntary conversions—if property is compulsorily or involuntarily converted

into property similarly related in service or use or into money that’s re-invested, you

don’t realize any gain (have 2 years to re-invest the money, and basis in new property

rebuilt is the same as the old property).

 reason = otherwise you wouldn’t have enough money to rebuild the building—wouldn’t

be fair.

o Damages for Injury to Good Will -- recovery for injury to good will is not taxable as it

represents a return of capital

 but where the realization of any cash made over the cost or other basis of the good will

prior to the illegal interference is gain and thus taxable income

o Lost Profits -- where the taxpayer receives an amount to compensate for lost profits, he has no

basis and thus the entire amount is taxable

 see Raytheon Production Corp. v. Commissioner (1st Cir 1944) -- recovery for lost

profits are income

o Puntitive Damages -- punitive damages are entirely taxable

 See Glenshaw Glass Co. -- money received as exemplary damages for fraud must be

included in gross income

 BUT, if taxpayer can prove that actual injury exceeds damage award, then do not have to

attribute it to punitive damages

o Settlement Damages – depends on what it is for

 where the taxpayer receives an amount to compensate him for the loss of property that

has an adjusted basis, the amount of income equals the amount by which the amount

received exceeds his adjusted basis

 Allocation of Damages: You can allocate between compensation for lost profits and

recovery of basis, but you cannot attribute to capital more than the adjusted basis of the

assets involved in the suit

 § 186 -- taxpayers may reduce taxable damages to reflect earlier losses that they have not been able to

deduct fully

o intended to prevent injured parties who could not realize the benefit of loss deductions from being

exposed to full tax liability for the compensation they received

o allows a deduction in the amount of the lesser of the compensation received (minus legal

expenses) or the unrecovered losses sustained from the injury

 recoveries may be deducted only in the amount of actual economic injury



ii. DAMAGES FOR PERSONAL INJURY

 "the amount of any damages received (whether by suit or agreement or whether as lump sums or periodic

payments) on account of personal physical injuries or illness" is excluded from income. § 104(a)(2)

 limited to physical injury in 1996 -- amounts received for defamation, sexual harassment, age

discrimination, racial discrimination, and the like (some of which were previously excludable) are

now taxable

 before change, S. Ct. determined that personal injury meant tort-like damages

 Sex discrimination case -- Under Burke could only get lost wages.

 Congress then amended § 104(a)(2) provision to allow for full range of

damages

 Age discrimination cases – workers took position that would have had an age

discrimination claim, and that severance pay in settlement of that claim and

should be excluded. Courts have been unsympathetic to that position









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 Schleier – clear age discrimination case – court said damages were

not on account of personal injuries. In a normal case, have a personal

injury, because of that have lost wages.

 Back pay received on account of age discrimination was not on account

of personal injury (although injury may have been suffered)

 nor is emotional distress to be treated as "physical injury" or "sickness" (though damages not in

excess of the amount paid for medical care attributable to emotional distress are excludible)

 Murphy -- whistleblower whose emotional distress led to physical injury

 Court rejects this argument -- award was for emotional damage, not physical

injury

 Shuldiner says court was sloppy -- just b/c it is not excluded under § 104 doesn't

automatically make it income; still need to look to see if § 61 applies



Lost Wages and Sick Pay

 an award for lost wages arising out of physical injury is excludible under the provisions. Rev. Rul. 85-97

 lost wages paid for by tortfeasor are excluded in income. 104(a)(2)

o Shuldiner says does not fit in with rest of doctrine

 Sick pay IS TAXABLE -- just like regular salary

o not excluded under 104(a) or 105(b)

o includes lost wages



Medical Expenses & Insurance and Accident Plans

 Medical Expenses are generally excluded from income

o paid for by yourself—get deduction below-the-line (213)—also must exceed 7.5% of AGI

 § 104 - Compensation for Injuries or Sickness

o paid for by employer—excluded from gross income (104)

o paid for by tortfeaser—excluded from income (104(a)(2))

o paid by self-purchased health insurance—excluded from income (104(a)(3))

o § 104(a)(5) – Amounts received to victims of violent attacks determined to be terrorist attacks by

Secretary of State not included in income

 only helps U.S. Government employees and while working abroad

 does not apply to victims of domestic terrorism

 § 105 – Amounts received under Accident and Health Plans

o Lost wages while sick (sick leave) – Taxable -- § 105(a)

o Medical expenses paid by employer-provided health insurance plan – excluded under § 105(b)

(would be included under § 105(a))

o 10,000 per arm – excluded under § 105(c)

 § 106 – Contributions by employer to accident and health plans

o Employer buys insurance – excluded under §106

o You buy disability insurance – not excluded under §105, excluded under §104(a)(3) (amounts

received through accident or health insurance)



K. Tax-Exempt Interest

i. TAX EXEMPT BONDS GENERALLY

§ 103 -- generally excludes from income interest on state and local obligations

 allows state and local gov'ts to pay lower rates of interest on their debt than that paid on similar

taxable corporate bonds (of comparable risk)

 municipal bonds are sometimes said to be subject to an implicit tax -- interest rate is lower than

taxable corporate bonds of equal risk, reflecting the tax advantage

 historically, the ratio of yields on tax-exempt issues to taxable issues has generally been about

75% (though it has been as high as 92% in individual years).

 Constitutional implications

 South Carolina v. Baker (US 1988) -- court upheld provision that taxes interest on state and local

bonds unless bonds issued in registered form. Rejected argument that statute interfered with state’s









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right to borrow, made borrowing more expensive, and therefore impaired exercise of sovereign

powers.

 Original constitutional justifications for tax-exemption having been eliminated, exemption remains as a

federal subsidy to the states for their activities.

 Allows state and local governments to pay lower rates of interest on their debt then that paid on

taxable corporate bonds.

 Conversion formula:

 Tax yield (for taxable bonds) x (1-tax rate) = tax-exempt yield

 Problem is that exemption has different value to different taxpayer at different rates.

 If tax rate is 50%, tax-exempt yield at 5%, if bonds sell at 7% ―leakage‖ goes to high income

purchaser.

 These bonds are especially attractive to higher bracket taxpayers because may not need to borrow to take

advantage of these.

o Assume corporate bonds paying 10% interest and there are three classes of people – A: 50%

bracket, B: 30% bracket, C: 10% bracket

 To get highest bracket (A) to prefer state bonds to corporate bonds, municipal bonds

would have to pay 5.1% interest since they are paying 50% tax on interest received for

corporate bonds, effective after-tax interest rate they receive is 5%

 To get B to prefer state bonds, would have to pay 7.1%, because bondholders only get

7% after tax rate on corporate bonds

 If all bonds could be bought by A, state could offer 5.1% bond and all of subsidy would

go to state.

 As an empirical matter, not enough people in A group to sell all of tax exempt

bonds, so to sell the entire issue, state has to attract B group of investors by

giving them a 7.1% interest rate.

 Thus the rich get a 2% subsidy and state only gets a 3% subsidy.

 Who is the break even taxpayer?

 Rate exempt = Rate tax x (1-tax rate).

 Long Term Rates: Tax = 5.55%; Exempt = 4.12%

 What is the implicit "break-even" tax rate?

 About 26% (T(1-t)=TE; t = 1 - (TE/T))

 Short Term Rates: Tax = 4.97%; Exempt = 3.51%

 29% break even tax rate.



ii. ARBITRAGE

 Problems when have a piece of the market taxed differently from the rest.

 General Obligation Bond – bond secured by full faith and credit of municipality or state.

 The more general obligation bonds a municipality issues, the greater risk they will default, so will

have to pay out a higher interest rate to bondholder.

 Revenue Bond – bonds paid out of proceeds of underlying project (e.g. bond for turnpike will be paid out

of tolls collected), municipality would use this to avoid the problem of compiling risks which is endemic to

general obligation bonds.

 With revenue bonds, the only risk involved is the risk associated with the revenue of the

underlying projects.

 These bonds are capped by § 146(B) (volume cap for state agencies).



a. Private activity bonds -- § 141 exception (but are taxable under alternative minimum tax). Only government

municipal bonds are exempt.

 Assume C wants to borrow at 6%, not 10%.

o Get government to borrow $ and lend it to me.

 $ funneled to private and not government purpose.

 Don’t want to allow this because municipality uses $ for roads, schools, etc. cannot shift

its gain to private business, this is tax arbitrage.

 Congress limited their use when:









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o more than 10% of the proceeds is for direct or indirect use in a trade or business of anyone other

than a gov't unit; or

o more than 5% of the proceeds of the issue is used to make or finance loans to entitites other than

state or local govt's. § 141(b)

 § 103(b)(1) – allows exemptions for certain qualified private activity bonds (§141(e) -- §146(a) puts a

volume cap on these bonds.



b. Arbitrage bonds—are taxable under 103(b)

 148 -- arbitrage bond - bond where proceeds are used directly or indirectly to buy another bonds or other

investment w/ a higher yield (back to back debt)

o 148 imposes restrictions on these bonds so that in most cases the interest is not tax-free under

103(b)(2).

o if municipality cheats and does this anyway—have to pay rebate back to gov of excess they earned

over what they paid (148(f))

 holder arbitrage -- buy at regular high interest rate and invest in state/local bonds at lower tax-exempt

rate—you end up w/ a net gain or interest—

o under 265(a)(2) disallows interest deductions on borrowing to purchase or carry tax-exempt bonds

 If borrowed at 10% to buy 7% bonds, and in 50% bracket, locks in a 2% gain

 ex: deduct $10 in interest; tax savings is $5

 Pre-Tax -- 10% borrow; 7% invest

 After-Tax -- 5% savings; 7% invest

 2% gain

 too attractive.

o also: 163(d) disallows interest deductions on borrowing to purchase growth stocks that yield little

or no current investment income.

o also: 265(a)(1) generally prohibits deduction of expense used to produce tax-exempt income, (just

tax-exempt income statutorily defined, so not imputed income).

 also Rev. Rul. 87-102 –so you can’t deduct the interest you pay on a regular bond if you

then use the money you borrowed from that bond to buy a tax-exempt municipal bond,

and don’t pay taxes on the interest you generate from that bond.



NSUMMARY:



INCLUDIBLE VS. EXCLUDIBLE INCOME ITEMS

The following shows whether certain items are includible or excludible as income to the recipient:



INCLUDIBLE EXCLUDIBLE



 Compensation for services  Meals and lodging for employer’s

convenience



 Gratuities and tips  Gifts and inheritance



 Most interest payments  Interest on state and local bonds



 Punitive damages  Damages for personal physical injury



 Spousal support  Child support



 Cancellation of indebtedness  Repayment of indebtedness



 Prizes  Contribution to capital









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 Gambling winnings  Life and medical insurance recovery



 Earnings for illegal activities  Recovery of cost of annuity contract









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III. DEDUCTIONS AND CREDITS



A. Generally

i. OVERVIEW OF THE CODE

 Tax not on gross income, tax on NET INCOME

o therefore, expenses of producing income must be deductible

 limitations

o personal expenses

 one of the major problems is distinguishing bet. business and personal expenses

o capital expenses

 do not allow deductions/expense for capital expenses; allow you to depreciate/amortize

over time

o public policy limitations

 ex. fines are not deductible

 additional deductions (allow when we really shouldn't)

o tax subsidies

a. Principal Substantive Sections

 162 -- ordinary and necessary business expenses

 163 -- interest

 164 -- taxes

 165 -- losses

 167/168/169 -- depreciation/amortization

 212 -- for profit activities



b. Principal Structural Provisions

 62 -- definition of adjusted gross income (above the line or below)

 63 -- standard deduction or itemized deductions

 67 -- 2% floor on miscellaneous itemized deductions

 68 -- phase-out of itemized deductions (really just an increase in the marginal tax rate)



ii. DEDUCTIONS

Deductions -- reduce gross income to taxable income by subtracting allowable deductions

 § 162 -- the deduction for ordinary and necessary business expenses...

o pair or incurred...

 paid in the case of a cash-basis taxpayer

 accrued in the case of an accrual-basis taxpayer

o during the taxable year...

o in carrying on...

 must have already started

 cannot deduct start-up expenses

 but see § 195 – can amortize certain start-up expenses

o any trade or business...

 separates from personal activities

 also separates from investment and sporadic profit-making activities that do not rise to

the level of business

o examples – rent, salaries, insurance, supplies, advertising, utilities, etc.

o essential if we are to tax net income

 other deductions are not necessary to obtain accurate measurement of net income, but rather are tax

subsidies for certain activities and investments

o example -- § 190 -- immediate write-off for expenses to remove barriers to handicapped and

elderly

 certain deductions are difficult to categorize

o example -- whether charitable deduction and medical deduction are subsidies or whether they are

needed to properly determine net income







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 closely related to exclusion from income; both remove amounts from taxable income

o but, taxpayers will often prefer exclusions b/c of limitations imposed on deductions

o easier for corporations to compute deductions than it is for individuals

 Steps for individual computation:

o Subtract those deductions allowable in reducing gross income to "adjusted gross income" (AGI),

as defined in § 62

o Reduce AGI to "taxable income" by subtracting the larger of

 standard deduction; or

 "itemized deductions"

 in some cases, fully allowable

 in others, allowable only to the extent of certain related types of income or only

to the extent they exceed certain floors (typically, specified percentages of AGI)

 certain deductions ("miscellaneous itemized deductions") are subject to further

limitation -- only the amount of misc. itemized deductions that exceeds 2% of

the AGI may be deducted (the 2% floor). § 67(a).

 high income taxpayers have some itemized deductions disallowed (alternative

minimum tax). § 68

 effective through 2009



iii. CREDITS

Credits -- a dollar of tax credit saves a dollar of taxes (whereas a dollar of deduction saves a fraction of that amount,

depending on the tax bracket)

 typically only allowable for a specified percentage of the expenditure that qualifies for the credit



iv. TIMING OF DEDUCTIONS AND CREDITS

 generally, a taxpayer can use deductions only to the extent of her income for the taxable year (with some

exceptions allowing for carry-over)

 same with credits

 thus, one of the major issues in connection w/ deduction is timing

o esp. with deductions relating to capitalization of costs and their recovery, such as through

depreciation allowances

o in fact, acceleration of a deduction may be equivalent to a full or partial exclusion of the income

generated by the deductible expense



v. LEGAL TREATMENT

 courts often state that deductions should be narrowly construed

o "an income tax deduction is a matter of legislative grace and the burden of clearly showing the

right to the claimed deduction is on the taxpayer"



B. Business Deductions

i. ORDINARY AND NECESSARY

a. Ordinary and Necessary Business Deductions (§ 162)

§ 162 -- primary provision for deductions for expenses or losses incurred by a business

 allows deduction for "all the ordinary and necessary expenses...

o paid or incurred...

o during the taxable year...

o in carrying on...

o any trade or business..."

o ex. employee wages, annual insurance premiums on business assets, office rent, utilities

 3 general questions emerge:

o To what extent does the phrase "ordinary and necessary" imply that there is a class of

nondeductible business expenses?

o What distinguishes a trade or business expense from a personal expense?

o What separates a deductible expense from a capital outlay?









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Welch v. Helvering (US 1933), p 222

Facts

Welch's grain company went bankrupt and had a discharge from its debts. Welch obtained a new contract and began

paying back the debts of his former business, in order to reestablish reputation and good will. He sought to deduct

them from his income and "ordinary and necessary" expenses, but the Commissioner and courts rejected his

argument.

Holding

For a business deduction, expenditure must be both necessary AND ordinary -- reputation is more akin to a capital

asset and not an ordinary expense in the operation of a business

 must be ordinary and necessary -- many necessary payments are charges upon capital

 necessary -- appropriate and helpful; not essential

 taxpayer gets to decide this

 ordinary does not mean payments habitual or normal in the sense that a taxpayer makes them often



Shuldiner argues that "ordinary" really means the following (three tests):

 non-capital expenditure

o Commissioner found that the payments in controversy came closer to capital outlays

 presumption that Commissioner is right and burden is on taxpayer to prove it isn't

o many necessary expenses are chargeable upon capital

o reputation and learning are akin to capital assts, like the good will of an old partnership, and not an

ordinary expense in the operation of business

 "reputation and learning are akin to capital assets, like the good will of an old partnership"

 business, rather than personal

o "ordinary" is used by courts to distinguish between business and personal expenses

o "his own standing and credit"

o analogies

 family name clouded by theft

 wants to enrich his culture/education to improve business

o capital and personal are intertwined when we discuss human capital

 not uncommon/bizarre

o common and accepted

 ordinary b/c we know from experience that payments for such a purpose are the common

and accepted means in a particular situation in the life of the group, the community, of

which the individual is a part

o erratic

 the instance is not erratic, but is brought within a known type

o "strain of constancy within it"

o "many bizarre analogies"

o Is this test just shorthand for personal or capital?



- Court in Deputy v. DuPont (US 1940) -- ordinary - common or a frequent occurrence in the type of business

involved, regardless of the frequency of occurrence in the life of the individual; necessary - appropriate and helpful

for the development of the taxpayer's business.

- Jenkins v. Commissioner – payment of other’s debts are deductible if made to protect payor’s own business

- Friedman v. Delany – payment not deductible when made out of moral obligation. (lawyer made payment on

behalf of client for settlement, lawyer felt moral obligation even though not legally enforced; court denied)



Gilliam v. Commissioner (TCM 1986)

Facts -- Petitioner, a renowned artist and instructor of art, was traveling to Memphis to lecture when he flipped out in

the plane. Contends that he is entitled to deduct the amounts paid in defense of the criminal prosecution and in

settlement of the related civil claim under § 162, arguing that expenses for litigation arising out of an accident which

occurs during a business trip are deductible as ordinary and necessary business expenses. Commissioner argues that

criminal charges are not directly connected with his trade or business.

 C.f. Dancer v. Commissioner (TC 1980) (driver of automobile for business purposes has accident

that results in injuries to child and relevant expenses are deductible business expenditure).







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Holding – Petitioner’s expenses are not ordinary expenses of his trade or business

 not ordinary for people in this trade or business to be involved in such altercations (thus,

distinguishable from Dancer)

 the travel was not itself the conduct of petitioner's trade or business

 expenses are not cost of transportation



US v. Gilmore (US 1963) -- legal expenses incurred in contesting a divorce property settlement did not originate in

business or trade but in marital relationship

 "origin of the claim" test -- claim must originate in business or trade in order to deduct litigation

expenses



Legal Expenses

 TEST = Origin of the claim (Gilmore)

 Crim charges = look at origin of the government’s charges.

o Rule = taxpayers may only deduct costs of defending against prosecutions that stem from

profit-seeking activities (Rev. Rul. 1.212-1(d))

 Comm v. Tellier: deduction allowed for successful defense against securities act

violations by underwriter

 Hylton v. Comm: no deduction for successful defense against murder charges resulting

from domestic dispute.

o Expenses to deduct against crim charges that would result in loss of job are NOT deductible

if conduct that gave rise to charges did not arise in course of business.

 Nadik v. Comm: airline pilot could not deduct legal expenses in defending assault and

battery charges even though conviction would result in loss of license b/c the charges

arose out of disputes w/ his former wife.





b. § 212 Exception

§ 212 -- permits individuals to deduct "ordinary and necessary" expenses stemming from income producing

activities that do not qualify as a trade or business

 Congressional response to Higgins v. Commissioner (US 1941)

o an investor could not treat the management of his own investments as a trade or business and

therefore could not deduct the salaries of his assistants, office rent, and similar outlays

 differs from § 162 in two important respects

o § 212 only applies to individuals

 only a deduction from AGI to obtain taxable income

 consequently, taxpayer must have itemized deductions that exceed the standard

deduction to take advantage of the provision

o SOME § 212 expenses are miscellaneous itemized deductions and thus are subject to the 2% floor

 true only if below the line

 thus, important to determine whether activity is a "trade or business" or "income-producing activity" --

o phrase "trade or business" appears in over 800 subsections but never defined by Code

o Commissioner v. Grotzinger (US 1987) -- a professional gambler engages in a "trade or business"

if "involved in the activity with continuity and regularity" and with the primary purpose of

earning income or profit, even if there is no sale of goods or services

 sporadic activity, hobby, or an amusement diversion does not qualify as trade or business

o must be "reasonable business expectations" -- Levin v. Commissioner (7th Cir. 1987).

 § 165(a) & (c) -- permits deductions for losses incurred in a trade or business or in a profit-seeking activity

 in practice, distinction with § 162 can become blurred



ii. REASONABLE ALLOWANCE FOR SALARY

§ 162(a)(1) – reasonable allowances for salaries and other compensation for personal services are deductible as

ordinary and necessary.

 Limit to reasonable allowances because of 2 concerns:









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o Nomenclature: Don’t want to be able to deduct as ―salary‖ things that are not really salary

(dividends)

 Does it matter to the employee whether income is a dividend or salary?

 There will be some tax cost to employer if individual is paid in salary because of

payroll taxes, but the savings to the corporation overwhelms this cost.

o Overcompensation of employees: Don’t want to pay more than deserve/more than the work

justifies/cannot pay unreasonable salary to siphon off dividends



Limitations on Salary Deductions

§ 162(m) – another limitation on salaries -- denies deduction for amount an executive’s compensation is over $1M,

unless performance-based. Payments to retirement plans or fringe benefits are not subject to limitation

§ 280(G) – Golden parachutes: limit to deduction taken for payments to key employees when ownership of

corporation changes.

 Parachute is excessive if present value of payment is greater than three times employee’s average salary for

past five years.

 Excess over 3x of average is not deductible.



Exacto Spring Corporation v. Commissioner (7th Cir. 1999)

Facts

Exacto paid its CEO, cofounder, and principal owner, Heitz, $1.3m and $1m in salary in 1993 and 94, respectively.

IRS says amount is excessive.

Holding

Independent Investor Test is the method tell if a salary is unreasonable.

 Flawed tax court method cited 7 factors:

1. type/extent of services rendered,

2. scarcity of qualified employees,

3. goals/prior earning capacity of employee,

4. contributions of employee to business venture,

5. net earnings of employer,

6. prevailing contribution paid to employees with comparable jobs,

7. peculiar character of employer’s business.

 Posner says judges are not qualified to determine reasonableness, that factors are vague and not

properly weighted against each other.

 tax court should not be a sort of "super-personnel department"

 Independent investor test – reasonable rate of return to be gotten by investor, then no reason to

think siphoned off salary. Rebuttable presumption that salary is reasonable.

 Uses indirect market test: see corporation as having contract with manager for services

 higher rate of return for company = more salary manager can demand.

 Ultimately allows deduction, though admits test is imperfect

 possibility that salary is hidden dividend not a problem with publicly traded

corporations, because by definition independent investors.



Problem with trusting the market to work this out?

 Generally, in a closely-held corporation, no way for market to distinguish between what taxpayer should

set as dividends and what she should set as salary

o if there are independent shareholders, then this might change -- shareholders would (or at least)

have recourse w/n general corporate law

 would create market constraint

o can't assume in this instance that corporate law is working properly

Posner’s rule is not as clean or clear-cut as he presents

 admits as much at the end -- still need to look into intent, etc.

o just trying to shift the center of gravity here, not totally eliminate consideration of multiple

factors



Smith v. Manning (3d Cir. 1951) -- payments made by owner to daughters who worked in the business that were

held to be unreasonable could not be treated as excludible gifts b/c there was no donative intent





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 Shuldiner -- other way to do this -- tax income to father and treat transfer of non-salary as gift

o Smith v Manning probably does not stand as a general proposition



 Dexsil Corp. v. Comm: agrees w/ independent investor test

o if earnings on equity remain at level that would satisfy independent investor, there’s strong

indication that management is providing compensable services and that profits are not being

disguised as salary.

 If compensation is found to be unreasonable:

o shareholder is taxed on the receipt of dividend under 61(a)(7)

o payment to family member would not be treated as excludible gift b/c donor wouldn’t have the

requisite disinterested generosity (Shuldiner disagrees though—he thinks should be allowed to be

a gift if father has daughter on payroll and pays her too much)

 Court have general power to re-characterize a transaction by its substance.

o Charging too much for rent for same purpose—statute doesn’t say anything about this, but court

could say it was excessive rent, and re-characterize it as something else

 Absence of dividends:

o failure to pay dividends is important (but not conclusive) factor.

 reasonable return on capital is not actually required (Rev. Rul. 79-8), but courts see

absence of dividends as troubling.

 should not be conclusive b/c investors may prefer that corp. retain and reinvest earnings

instead of giving dividends.

 Challenging under-compensation: (dividends disguised as salary)  yes service can challenge this

too.

o ex: Senator Edwards had an S-corp (just one level of tax), so tax burden same whether paid as

dividend or salary, except salary is subject to payroll taxes. he decided to pay only 400k as salary

and 5 million as dividends (to save the medicare taxes on salary), as opposed to putting all 5.4m as

salary.

 Rent deductions can also be disallowed if they are excessive.

o payments denominated as rent but that are actually dividends are not deductible

o deductions for excessive rent paid to a related lessor are disallowed (Mackinac Island Carriage

Tours v. Comm)



C. Public Policy Limitations

i. IN THE CODE

 Reg. 1-162-1(a): deduction for expense which would otherwise be allowable under §162 shall not be

denied on grounds that allowance of such deduction would frustrate sharply defined public policy.

 also payments to private parities akin to fines, like forced restitution or charitable contributions.

 § 162(f) – can’t deduct fines paid to government in violation of law

o civil as well as crim penalties are included in this (Reg. 1.162-21(b)(1)

o compensatory damages are NOT fines or penalties (Reg. 1.162-21)(b)(2)

o could argue fine only to disgorge the profits is NOT a fine or penalty.

o liquidated damages are not fines or penalties (Mason & Dixon Lines v. US)

 §162(c) – can’t deduct bribes to public officials

o 162(c)(1): bribes or kickbacks paid to public officials

o 162(c)(3): bribes or referral fees for Medicaid and Medicare patients

o 162(c)(5): any other illegal bribe, kickback, or payment under any law if such law is generally

enforced and it subject payor to criminal penalty or loss of license or privilege to engage in trade

or business.

 §162(g) – can’t deduct 2/3 of any treble damages paid when convicted of antitrust violations

 §280(e) – can’t deduct any expenses related to drug activity

 §165 – limit on deductability of losses that would frustrate sharply defined national or state policies

proscribing particular types of conduct, payments that would not pass muster under §162 should not be

deductible under §165



ii. THE CASE LAW







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Commissioner v. Tellier (US 1966)

Facts

Taxpayer convicted of securities and mail fraud wants to deduct legal fees as ordinary and necessary expenses.

Question of whether expenses incurred by taxpayer in unsuccessful defense of criminal prosecution may qualify for

deduction under § 162(a) – ordinary and necessary expenses.

Holding

Court should not read in public policy exception to disallow a deduction unless (1) Congress has specifically declared

such exception or (2) frustrates sharply defined and articulate government policy

 e.g., Congress specifically stated that deduction not allowed for pursuit of certain kind of business.

 legal fees for business activities exactly the sort of ordinary and necessary expenses Welch

anticipated

 irrelevant that activities are illegal; no support for such a reading in the Code

 federal income tax is a tax on net income, not a sanction against wrongdoing

 can deduct expenses incurred in carrying on illegal activities (bookies can deduct rent),

apply normal ordinary and necessary test to see if expense was incurred in carrying on

trade/business.



Disallowing Deduction

Tank Truck Rentals v. Commissioner (US) -- Allowance of deduction for fines incurred by overweight trucks

driving through PA would undermine PA weight limit policy, no deduction allowed.

 One argument: Not really a fine, just a way for PA to collect $, like a license fee or a toll. If a toll,

why not deduct? But the court wouldn’t look at this in this way.

 What about deduction of legal fees for challenging the fines? Under Tellier, would be permissible

to deduct them.

 general rule is that the fine has to be putative rather thank compensatory

Hoover Express Co. v. Comm – disallowed deductions for fines and penalties for violating state penal statutes



Allowing the Deduction

Commissioner v. Sullivan (US) -- sustained the allowance of a deduction for rent and wages paid by the operators of

a gambling enterprise, even though both the business itself and the specific rent and wage payments were illegal

under state law



D. Lobbying Expenses

§ 162(e) – Lobbying is generally not deductible, certain exceptions: at state or local level

 De Minimis -- Creation of new asset, Clear future benefit, Right thing is to match current

expense to future income

 Three stages:

i. investigating acquisition of new business (before you’ve identified the new company) = amortized

under 195

ii. consummating purchase of new business (start-up costs and pre-opening expenses once have

identified the company) = capitalized into the acquisition of the asset

iii. operating the new business = deductible







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 Richmond Television Corp v. US (4th Cir. 1965)– Court required capitalization of job training and related

expenses incurred before co. obtained operating license from FCC; ct held not carrying on trade or business

(deductible under 162) until licensed

 § 195 – allows taxpayer to deduct up to $5k of start-up expenses in the year the business begins

o deduction is phased out and eliminated if expenses exceed $55k.

o remaining expenses deducted over a 15-year period

o expenses to purchase intangible assets of an existing business can be amortized over a 15-year

period

 alternatively, taxpayers may elect to amortize certain start-up expenses over a five-year

period

 includes expenditures in connection w/ the investigation or creation of an active

trade or business that would be deductible if incurred in connection with the

operation of an existing trade or business. § 195(c)(1)

 question of when an active trade or business begins is left to the regulations. §

195(c)(2)

o costs incurred in the attempt to acquire a specific business are capital in nature and thus must be

capitalized w/o eligibility for amortization under 195. Rev. Rul. 99-23, 1999-10 C.B. 998.

 Expenses of an Ongoing Business -- Problematic – bank opens new branch – expansion of existing

business or new business? Courts have not required capitalization of existing business expansion. Cases are

mixed. Unsettled area of the law.

o Expansion of existing business = currently deductible

o Acquisition of new business = capitalized.

 ex: bank enters into credit card business when they never issued credit cards before—ct.

said credit card is new way of doing letter of credit, which banks have been doing for

years, so not a new business but mere continuation.

 ex: NCNB, Central Texas---deal w/ new branches—circuit split.

 NCNB Corp. v. US (4th Cir. 1982) = new branches are merely expansions of

existing business, so costs of setting up new branches can be deducted

 Central Texas Savings and Loan Assoc. v. US (5th Cir. 1984) and Ellis

Banking—disagree—whether it’s a new branch that you’ve created or purchase

of another bank doesn’t matter, it must be capitalized.

 Post-Indopco—Fidelity case = setting up another mutual fund—ct. said that’s not

expanding ongoing business, said that each new mutual fund is a new business so

expenses must be capitalized. (Tax Court opinion, not appealed)

o BUT: costs to acquire a specific business are capital so must be capitalized w/out eligibility for

amortization under 195 (Rev. Rul. 99-23);

o interest, taxes, research and development expenses are deductible immediately under 163, 164,

and 174



iv. DEDUCTIBLE REPAIRS V. NONDEDUCTIBLE REHABILITATION OR IMPROVEMENTS

The general rule:

 Repairs: expensed.

 Improvements, rehabilitation: capitalized.

Test is whether the improvements prolong the asset’s life beyond its initial assessed life, and whether they add to the

asset’s basis. 1.162-4.

o See also 1.263(a)-2—improvements are example of capital expenditure.

 RR 94-12, repairs still deductible following INDOPCO.

o Had been fear that INDOPCO might affect this, b/c repair has future benefit



Rev Rule 2001-4 -- looks to depreciable life schedule to gauge whether you are prolonging or maintaining.

 Aircraft have to redo/heavy maintenance every 8 yrs to remain operation and comport with industry

standards and regulations

 Looks at 3 cases:

i. Heavy maintenance -- 8 yrs., $2mm out of $15mm. None of the work resulted in a material

upgrade and retained the relative value of the aircraft. Did not extend useful life.

 May expense -- normal maintenance expenditure





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ii. Same work, but did more extensive work on the "skin panels" that materially added to the value

of the airframe and added new features.

 May expense heavy maintenance, but

 must capitalize the cost of replacing the skin panels and the additions and upgrades of

the features

iii. Work was done with the purpose of increasing its reliability and extending the plane's useful life.

 Capitalize all of it.

 Way to test if ruling is reasonable:

 Are the costs to make up for past costs that are not accounted -- if so, deduct

 If for past costs that have already been accounted for (bringing above where it should be by

straight-line depreciation (cannot bring it back to where it was when it was new)) – not permitted

to deduct



 American Bemberg Corp. v. Commissioner (TC 1948)– to determine whether capital expense or repair

and maintenance expenses, ―it is appropriate to consider the purposes, the physical nature, and the effect of

the work for which the expenditures were made.‖

 Illinois Merchants Trust Co. v. Commissioner (BTA 1926) – replacements, alterations, improvements or

additions that appreciably prolong the life of the property, materially increase its value, or make it

adaptable to a different

o See also US v. Wehrli (10th Cir. 1968) – expenditures individually deductible as repairs may

together constitute a general plan of improvment



Environmental clean-up costs -- if land is polluted, there is clearly a future benefit if it is cleaned. But what are

the tax consequences of cleanup?

 Rev. Rul. 94-98 -- costs to cleanup hazardous waste is deductible

o need not be capitalized b/c they merely brought the land back to its state before the condition arose

that created the need for expenditure

o however, cost of containment systems, etc. must be capitalized

 Note that this approach appears to be only right for original owner—subsequent purchaser who comes in

to clean up should capitalize.

o Seller gets their loss when they sell property for reduced cost, take into account/recognize costs of

polluting when go to sell.

o Buyer's perspective is purely future benefit.

o Can be better to capitalize in cases where immediately deductible expenses are personal (can’t

take the deduction)

 Ex. Better to take cost of roof repair into basis of house b/c can’t take deduction

 Government wants to encourage clean-up, but the rule does not really act as a subsidy for cleanup b/c it’s

the right rule economically.



Option to Deduct or capitalize:

 Circulation Expenses for periodical: 173

 Research and Experimental Expenditures: 174

 Soil and Water Conservation expenditures: 175

 Environmental Remediation costs: 198

 Qualified Clean Fuel Vehicles: 179A

 Expenditures by Farmers for Fertilizer: 180

 Costs of removing architectural and transportation barriers for handicapped and elderly: 190

o When you would capitalize = if have no income against which to take a deduction.

 266 allows capitalization rather than deduction for interest, taxes, or carrying charges on property



v. JOB SEARCH AND EDUCATION EXPENSES

a. Job Search

Revenue Ruling 75-120 – job seeking expenses in same trade or business are deductible under §162 if directly

connected with such trade or business as determined by all objective facts and circumstances (below the line

deduction).







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 If unemployed, trade or business consists of services performed for past employer unless there is a

substantial lack of continuity since time of past employment

 Not allowed if seeking employment in new trade/business; not deductible for individual seeking

employment for the first time

o These are also not deductible under § 212(1) – below the line deduction, only applies to expenses

incurred with respect to an existing profit seeking endeavor not qualifying as a trade or business.

Public Office Expenses -- Expenses of seeking public office are not deductible; b/c each public office is distinct so

never in trade or business of public office

 McDonald v. Comm’r (US 1944) -- Court held state judge could not deduct assessments that had to be paid

to political party organization for election campaign; seeking office expenses nondeductible



b. Deductibility of Education Expenses

Reg. 1.162-5(a)(1): education expenses deductible as ordinary/necessary if:

1. maintain or improve skill in present trade/business; or

2. meet express requirements of employer, or the requirements of applicable law or regulations.

 Can't deduct if (1.162-5(b)(2)):

1. will qualify her for a new trade or business

 if the education qualifies the taxpayer to perform significantly different tasks and

activities than could be performed before the education, then the education qualifies the

taxpayer for a new trade or business

 Education that qualifies taxpayer for a new trade/business not deductible even if taxpayer

never intended/never entered new business.

 Because are not yet in the trade or business for which education is a cost.

 Change in duties does not constitute a new trade or business if the new duties constitute

the same type of work

2. meets minimal education standards

 Have to meet one of the positive requirements and can't meet either of the negative restrictions

o negatives trump the positives

 cannot deduct or amortize – education is an inseparable mix or personal and capital

 1.162-5(d): travel as education is not deductible unless you take classes or something similar. Don’t want

the taking in culture along the Seine excuse. See also §274(m)(2)

 Davis v. Commissioner (TC 1976) -- whether an education expenditure qualifies a taxpayer for a new trade

or business requires a "common sense" approach

o If substantial differences exist in the tasks and activities of various occupations or employments,

then each such occupation or employment constitutes a separate trade or business

 What happens to the expense of a bar review course when employer pays for it?

o Not within the trade or business until pass the bar

o Why for lawyers, teachers, etc. changing states may be considered new trade/business

 But are often allowed to amortize a licensing thing; general education is the problem

o Is it a working condition fringe under §132?

 could not be deducted under §162, but what about 167?

 132 thus excludes expenses that are immediately deductible and expenses that could be

depreciated over time



Wassenar v. Commissioner (TC, 1979)

Fact -- Taxpayer tried to deduct masters of law in taxation expenses (tuition, books, fees, meals, lodging, etc.) under

ordinary and necessary education expense

Holding -- Expenses are not deductible b/c taxpayer was not engaged in trade or business of being an attorney at the

time the expenses were incurred and was not, therefore, maintaining or improving the skills of such trade or business

 deductions allowed for educational expenditures which maintain or improve skills required in trade or

business -- a question of fact

o taxpayer must be established in the trade or business at the time expense are incurred

o must be uninterrupted continuity

o must bear a direct and proximate relation to taxpayer's established trade or business

 no deduction if the education is part of a program of study leading to qualifications for new trade or

business. 1.162-5(b)(3)





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o cannot deduct expenses for a base level/qualifying level of education.

o Question is fact specific – what determines base level depends on occupation.



Ruehmann v. Commissioner (TC 1971) – Law Student passed GA bar after his 2nd year. Wants to deduct costs of

3L year as additional education. Also wants to deduct costs of LLM degree. IRS argues that 3L year is disqualified

under §1.162-5(b)(2) – minimum educational requirements.

 LLM degree was deductible under 1.162-5(c) but only because he had worked as a lawyer prior to the LLM

degree.

o Had he not worked, he would not have been able to deduct the LLM (even though it was not a

minimum educational requirement) because he would not have been in the trade or business yet.

o The ct. says that it is not enough to work during the summer after law school.



The Deductibility of MBA’s



Zhang v. Commissioner (TC, 2003)

Facts -- taxpayer worked in consulting, got MBA, and then worked as associate in investment bank. Deducted cost of

MBA.

Holding -- because education expenses do not fall into either category of deductible expenses under the regs,

petitioner is not entitled to deduction

 Two deductible education expenses:

a. maintains or improves skills required in employment

b. meets express requirements of the individual's employer or applicable law

 MBA (1) was too general/broad to solely maintain or improve specific skills required in taxpayer's

employment and (2) was too tenuously connected to employee's previous business



McEuen v. Commissioner (TC, 2004)

Facts -- taxpayer was employed in two separate "analyst" positions at respective investment banks. Earned MBA at

Kellogg, and took job in executive training program. Claims deductions for education as ordinary and necessary.

Holding -- because deduction is disallowed, under both disallowance tests, no deduction

 The expenditures are not deductible if a taxpayer is pursuing a course of study that:

1. meets minimum education requirements for qualification in that employment, or

 determined from a consideration of such factors as the requirements of employer, the

applicable law and regulations, and the standards of the profession, trade, or business

involved

2. will qualify her for a new trade or business

 if the education qualifies the taxpayer to perform significantly different tasks and activities

than could be performed before the education, then the education qualifies the taxpayer for

a new trade or business

 MBA is (1) required for associate position at investment bank and (2) gave taxpayer new skills that qualified

taxpayer for new trade or business



c. Specific Education Provisions

***See chart for mechanics

Education Credits

 §25A – Hope and lifetime learning credits

 Cannot take both at once for the same student – §25A(c)(2)(A) and 1.25A-1(b)

 Hope Credit allows credit for first 2 yrs of college; 100% for first $1K, 50% for second $2K; like $1.5K

scholarship designed more for middle class.

o Wealthy phased out of Hope; increases marginal rate; §25A(d)

 Amount limits are indexed, but phase-out range is not

 Lifetime Learning Credit is 20% up to $10K (basically a $2K max)

o HYPO: $80K AGI, tuition of >$10,000

 $2k of credit

o HYPO 2: Add $10,000 of income

 PHASE-OUT: $10k extra/$20k = 50% x 2000 = $1000 (amount you lose in credit);

$1000 is 10% of $1k





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 effect of the phase-out is to raise your marginal tax rate (though only if you are within the

window of receiving the credit)

 Cannot deduct under § 222 at the same time



Educational IRA/Savings

 §530(a) -- Coverdell – education IRA account shall be exempt from taxation, but subject to taxes imposed

by §511 (relating to imposition of tax on unrelated business income of charitable organizations).

 §135 – savings bonds for education

 §529 – qualified state tuition programs, just modified to include state and private tuition plans, like Roth

IRA, excluded from income when take out money for education.

 Money put away tax free – very beneficial

 Both contribution and distribution are excluded in income

 And can use both credits and IRA (though not for the same expenses in the same year)



Scholarships and Employer Provided Assistance

 §117: gross income does not include qualified scholarship by individual who is candidate for degree at

educational organization in §170(b)

 §127: gross income does not include amts paid or expenses incurred by employer for educational assistance

to employee if assistance is furnished pursuant to (b); $5250 max exclusion



Student Loan Interest

 §221: in case of individual, deduction allowed for taxable year amount equal to interest paid by taxpayer

during taxable year on any qualified education loan

 Above the line deduction –

 if parent pays the interest; treated as gift and student gets the deduction. Reg 1.221-1(b)(4)(i).

 §62(a)(17): deduction on interest on education loans



vi. OPTION TO DEDUCT OR CAPITALIZE

No notes on this – Emily got anything?



vii. DEPRECIATION

a. Generally

§167 – permits as depreciation deduction on a reasonable allowance for exhaustion, wear and tear (including

reasonable allowance for obsolescence) of assets used in trade/business and held for the production of income.

 Deduction designed to allow taxpayers to treat as expense in determining taxable income in allocable part

of cost of business or investment assets that have limited life.

o No depreciation allowance is provided for assets acquired for personal use.

 Movement towards accelerated depreciation

o accelerated depreciation actually works to increase PDV of assets

 ends up ultimately working as a subsidy

 Congressional goal is to encourage investment in useful assets

 To actually compute depreciation: Refer to depreciation tables (page xv of code book)

o Once figure out what kind of property it is, should be easy to apply depreciation table



b. Depreciation Methods

 Economic depreciation – this is the ideal, neutral as to asset choice; simply measures true decline in the

value of an asset over the course of a year.

o However, because it is too difficult to figure out the true decline in value each year, the code does

not use economic depreciation.

o Would be administratively infeasible.

 Straight line method – cost of an asset is allocated in equal amounts over its useful life.

o Estimate useful life of asset, determine cost of asset, subtract salvage value which will receive at

the end and divide that amount by the useful life.

o Rate of depreciation under straight-line is the reciprocal of the useful









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 Declining Balance method (a type of accelerated depreciation)– allocates a larger portion of the cost to

the earlier years and a lesser portion to the later years; constant percentage is used, but it is applied each

year to the amount remaining after the depreciation of previous years has been charged off

o Double Declining Balance – take twice as much percentage each year; take 200% of what you

would otherwise get of straight-line method and then apply declining balance method

o Inflation problems can justify using accelerated depreciation because if inflation after year of

purchase, value of depreciation deduction will decline over time.

 Can’t depreciate until actually put into use

 Congress has never made companies switch systems after statutory changes – so there are multiple methods

in use right now

 Only owner can depreciate – the owner is the one who enjoys economic benefits and bears the economic

burden of decline



c. Modified Accelerated Cost Recovery System (MCARS)

Depreciable assets are assigned to one of eight recovery classes with lives of 3-39 years. See §168 (e) for

classification.

 Have to find:

i. Applicable Recovery Period

ii. Applicable Depreciation Rate

iii. Applicable Convention

 1st step = classify the property under 168(e) depreciable assets assigned to one of eight broad

recovery classes—very short periods.

 classes vary in useful lives from 3-39 years

 ex: residential property = 27.5 years, commercial real property = 39 years

 ex: communication, airlines, office furniture, etc., car (5 years)

 downside = having general classes distorts decisions w/in a certain class—you encourage people

to buy more of the long-lived assets and less short-lived assets w/in the group.

 2nd step = determine applicable recovery period for that property

 168(c) = this is same as useful life of property

 5-year property, gets recovered over 5 years

 3rd step = Depreciation Rates

 3, 5, 7, and 10 year classes = start w/ double declining and then switch to straight line when

that starts producing larger deduction.

 (168(b)(1): start depreciating by double-declining balance then taxpayer switches to

straight line method that allocates cost ratably over the remaining recovery period in year

which that method produces a larger deduction

 15 and 20 year classes = depreciated using 150 percent declining balance method, with switch to

straight line method in year straight line recovery produces a larger deduction

 (168(b)(2). permits full recovery of basis.

 real estate --39 years and straight line depreciation (168(b)(3)

 Election to use straight line = Taxpayer may elect to use straight line in any class of property

(168(b)(3)(d) and (b)(5)

 but you can’t cherry-pick—have to do election for whole class of assets

 election is irrevocable

 IN ALL CASES—salvage value not taken into account (168(b)(4))

 salvage value = amount taxpayer would expect to recovery when he stops using the asset

for production of income

 Tables show depreciation schedule for various assets—don’t have to calculate it. Table

on page XV

 If no special rule for the asset—look at 168(e) and see what the class life by old tables is

equivalent to for new tables.

 4th Step = Conventions Measures of time of acquisition and disposition

 168(d): personal property –half-year convention = one-half year’s depreciation is allowed in

both year of acquisition and disposition, regardless of how early or late in year taxpayer got or

sold the property







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 provides advantage to purchase property late in the year

 168(d)(3) mid-quarter convention if more than 40% of purchase of depreciable property

placed in service in the last quarter of the year—a mid-quarter convention applies—property

deemed purchased at mid-point in quarter

 for real property—mid-month convention—taxpayer takes one half a month’s depreciation for

month of acquisition and disposition. (168(d)(2)); reason = it’s bigger transaction and you don’t do

it as much so not burdensome to apply



d. Misc. Depreciation Issues

 Recapture – Happens when depreciation is too rapid and go to sell depreciated property.

o §1245 and §1250 provide that certain amounts previously deducted as depreciation will be

recaptured as ordinary income rather than capital gain when depreciable property sold. More on

this below.

 Land -- Don’t depreciate it – not expected to decline in value, won’t wear out . . . not depreciable under

Reg 1.167(a)-2;

o when land and bldg bought together, purchase price must be allocated b/w land and bldg in

proportion to respective FMV

 Intangibles - §168 only applies to tangible property. Big issue with intangibles in takeovers of businesses.

Huge effort to carve off intangibles (e.g. customer list, trained workforce in place) which were distinct from

goodwill

 Houston Chronicle (1973) -- was able to demonstrate that old subscriber list had value apart from

goodwill, and that value decayed over time.

 Because newspaper was defunct, was an argument that customer list had become less

valuable. Taxpayers won the case.

 Newark Morning Ledger (1993)-- Supreme Court said could depreciate these types of assets as

long as could be valued and had a limited useful life.

 § 197 -- Amortization of intangibles: most intangibles, including goodwill, amortized on straight

line basis over 15 yr period; does not apply to any intangible created by taxpayer unless created in

connection w/acquisition of trade/business.

 passed after Newark, put issue to rest

 does not apply to assets that do have a useful life

 if you can’t separate by useful life, take all intangible assets as a group and amortize over

15 years.

 § 197(f)(i)(A) -- if we dispose of a § 197 intangible asset,

 (i) no loss shall be recognized by reason of such disposition (or worthlessness);

and

 (ii) appropriate adjustments to the adjusted bases of such retained intangibles

shall be made

 §179 – Election to expense certain depreciable business assets – generally applies to small businesses.

o Permits taxpayer to elect to deduct immediately up to $125K of cost of tangible business property

where annual total investment in qualified property less than $500k.

 Any excess is subject to usual depreciation rules, but simultaneously phased-out dollar

for dollar (eats into your $125k dollar for dollar)

o Effect is to permit many small businesses to deduct cost of business assets rather than capitalize

 Luxury Automobiles -- § 280F limits the amount of depreciation that can be taken on luxury automobiles

 did not initially apply to SUV's; amended but still favorable (deduction under 179 far exceeds the

limitation on other luxury automobiles under 280F)

 Antiques -- generally not depreciable (Rev. Rul. 68-232, 1968-1 C.B. 79); but, in certain circumstances,

can depreciate useful value of antique

o Simon v. Commissioner (T.C. 1994) -- allowed to depreciate two antique violin bows

 for property to be depreciable it must "suffer exhaustion, wear and tear and obsolescence"

 Property for Personal Use= NOT depreciable

o NO depreciation for property used only for personal use

o mixed use for personal and income-producing purposes –you allocate basis btwn the business and

personal uses.







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o if personal use property converted to business use—basis for depreciation is the lesser of the FMV

of property at date of conversion or property’s adjusted basis (Reg. 1.167(g)-1)







viii. DEPLETION

§ 611 provides for a ―reasonable allowance for depletion according to the peculiar conditions in each case.‖

 Depletion allowances are used in situations where it is difficult to determine what portion of property has

been removed from the ground and sold and what has been retained – generally applies to mineral or oil

and gas exploration and development.

 Governed by §§ 611-613A.

 Subject to recapture rules of § 1254



Two Methods:

 Cost depletion – estimates the total amount of natural resource in the property and allows deduction of its

cost in proportion to each year’s extractions; look at amount of oil remaining and how much taking in a

year…take a deduction for the amount used

o Has been allowed for water. See US v. Shurbet (5th Cir. 1965) (taxpayer took cost depeltion for

water used in Southern High Plains).

o As your basis changes, your actual amount for depletion changes b/c you take percentage of

current basis and not original basis (curve instead of straight line)

o If your estimate proves wrong, you can adjust depletion for that year; look at actual basis and your

current estimate of future production (just change that estimate – do not have to go back through

the previous years and change)

 Percentage depletion (§613) – allows the deduction of a specified percentage of the gross income from the

property year after year without regard to the recovery of cost (not for manufacturing and processing, just

for extracting). It remains deductible even after the basis (capital actually invested) has been recovered.

o Limited to 50% of the taxable income from the property for minerals other than oil and gas

o Because percentage depletion permits a taxpayer to deduct more than actual cost, it provides a

subsidy for the activities to which it applies and a stimulus to natural resource exploration and

development.

 Only a subsidy if the present value exceeds the cost depletion level

 Is not necessarily better than cost depletion, but historically has been the case.

 1975 – percentage depletion was repealed for oil and gas wells of major oil companies.

 Independent domestic oil and gas producers may use percentage depletion for 1,000

barrels of average daily production at a 15% rate

 Must have an ―economic interest‖ in the minerals to get a depletion deduction (includes owners, lessees,

but not licensees)

 See US v. Swank (US 1981) -- a lessee under a mineral lease that could be terminated w/o cause

by the lessor on 30 days notice has an economic interest

 C.f. Missouri River Sand Co. v. Commissioner (8th Cir. 1985) (a licensee who simply

has the right to extract the minerals does not have an economic interest)

 Intangible Drilling Costs:

o Can be immediately deducted or capitalized; taxpayer’s choice. § 263



H. Interest 

In a broad sense, interest should be deductible, as it represents a reduction in your net worth without

corresponding consumption.

o Shuldiner thinks we should look at indebtedness like a negative asset

o go out and borrow $1k (borrowing at 10%) and use it to buy Treasury Bond (paying

10%)

 Net would be $0 ($100 in income - $100 deduction on debt)

o Interest does not represent consumption

o this is the approach the Code used to take, irrespective of business or personal debt, etc.

 However, there are practical reasons why we want to know whether money paid is actually interest.







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o

Timing -- when dealing with debt, no way to tell if dollar is interest or principal

 taxpayers can manipulate this to their advantage

o Also, the tax code does not always tax assets correctly and if liabilities (interest) are taxed

correctly, while assets are not, the door is left open for tax arbitrage.

 Over or Understated Interest (§7872; sale of property)

 Dead-equity questions-- b/c corporations can deduct interest but not dividends, need to

know if something is debt or equity

 Property acquired by debt is frequently taxed incorrectly b/c realization requirements and

other rule

Two Classic Arbitrage:

 Using loan to buy stock that doesn’t pay dividends; allowing deduction on interest and deferring income

 Using debt to buy something that gets immediately expense; get deduction on interest and get to expense it



i. INTEREST IN GENERAL

a. In the Code

§ 163(a) -- generally, interest is deductible.

o However, the rest of § 163 whittles down the scope of deductible interest:

 investment interest, business interest, and home mortgage interest are deductible

 personal interest is not deductible

 passive interest may or may not be deductible; deductible to the extent that it offsets

passive gains.

1. Business Interest (§163(a))

 Business Interest -- interest on indebtedness used to operate a trade or business is a cost to the taxpayer of

doing business and thus is deductible like any business expense. §163(a).

o except when the interest is required to be capitalized (e.g. when allocable to asset that taxpayer is

constructing).



2. Investment Interest (§163(d))

 Investment interest -- deduction of interest on debt incurred by individuals to purchase or carry

investment property is limited to net investment income (with indefinite carry-forward of interest

disallowed under this provision). §163(d)

o §163(d)(3)(A): links debt with activity so properly allocable to property held for investment.

Matches investment expenses to investment income.

 Doesn’t work perfectly:

 First you borrow to buy stock; stock becomes worthless, no realized gain; can’t

take deduction; but I really did lose money. Bad result.

 Say you have a lot of money in bank producing taxable interest; borrow to buy

growth stock; offset interest in bank account with interest in the loan. Bad result

– should have just taken money account.

o §163(d)(4): Net investment income is total investment income less investment expenses.

 §163(d)(4)(B)(iii): gives you the option to recharacterize capital gains as ordinary

investment income.

 Pro: allows you to increase the amount of investment income against which you

can match investment interest.

 Con: cannot then claim preferential capital gains tax rate on the amount elected.

§1(h)(2).

 So if you borrowed to finance investments but your portfolio did poorly, you cannot

generate a loss -- the best you can do is have no tax on your investment income.

o Interest incurred in connection with passive activity is not treated as investment interest, but is

instead subject to the rules of §469 which limit deductibility of passive losses..

o §163(d) says dividends are not included in investment income unless taxpayer elects to include

them and forgo the preferential capital gains treatment

 Dividends cannot offset losses – this changes your calculation

 The way this can help – you have net income of $0 and lots of business deductions you

can take advantage of carry-forward rule by including dividends in investment income







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o At what point can you get around 163(d) by saying you are in a business and thus deducting under

162?

 divide people into three categories

 dealers -- in trade or business of being a dealer; get ordinary income (475 -- get

rid of realization rule all together and tax on mark-to-market basis) (think

Goldman, etc.)

 traders -- somebody who's in market for short-term swings; in trade or business,

but get capital gains treatment

 investors -- not in trade or business; get capital gains treatment; subject to

163(d)

 See Estate of Yaeger v. Commissioner (2d Cir. 1989) (two

fundamental criteria distinguishing traders from investors are length of

holding period and source of the profit)

 why focus on length of holding period?

 "The activity of holding securities for length of time to

produce interest, dividends, and capital gains fits the abuse

targeted by §163(d): investing for postponed income and

current interest deduction." Yaeger.

3. Personal Interest (§163(h))

 Personal Interest -- §163(h)—personal non-business interest is not deductible.

o Defined by omission to include any interest otherwise deductible under §163 that is not a) interest

paid or incurred in connection with trade or business (not including for this purpose trade/business

of performing services as employee), b) investment interest, c) interest that would be deductible in

connection with §469 passive activity, d) qualified residence interest (as defined in §163(h)(3)), e)

interest on certain deferred estate tax payments, and f) educational interest

 How do we know the interest falls into one of the categories?

o statute doesn't really help

 trade or business -- "properly allocable"

 investment interest -- 163(d)(3)(a) -- "properly allocable"

 passive loss -- 469(l)(4) -- "leave to regulations" -- regs. say "properly

allocable"

 home mortgage interest -- has to be secured by home -- 163(h)(3)

 education -- "solely used"

 Plenty of opportunities to game the system here

o Ex 1: Taxpayer with a small business that generates some income

 borrow money and use it purely for the business; take profits from

business and use for personal use; laundered the loan through business,

though totally legitimate

o Historically personal interest was fully deductible, deduction eliminated in 1986 (see home

mortgage exception)

 Things like interest on a personal auto loan, credit card interest, now all considered an

additional cost of the items purchased.

o §163(h)(1) interest on income tax deficiency is personal interest.

 in legislative history and case law

 Why disallow interest deduction? Obligation to pay income tax is personal obligation

 Is this an anti-arbitrage provision? Yes, you shouldn’t get a deduction if you are deferring

tax on the income, and consumption is income (in a sense). If you buy a car, can use car

which is in some sense use of income.

 Interest on Education Loans (§221) allows deduction for interest on student loans. (§221 does not use

tracing rules, presumption loan used for educational expenses – pro-taxpayer rule)

o certain taxpayers take above-the-line deduction for up to 2,500 of interest paid on education loans.

o indebtedness must be incurred to pay for college expenses for taxpayer, spouse, or dependent.

o expenses do not include scholarships, amounts received from educational assistance programs, or

distributions from education savings account.

o deduction is phased out for single taxpayers w/ income of 50k to 65k, for married 100k to 130k.

(221)





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o if someone not legally obligated to pays interest on behalf of taxpayer, it’s treated as gift to

taxpayer, who then is treated as paying the interest and gets the deduction (Reg. 1.221-1(b)(4)(i))



b. The Home Mortgage Exception

 Home Mortgage Interest – Major exception to disallowance of personal interest.

o Congress allowed this deduction to encourage homeownership (preference over renters).

o Doesn’t matter if recourse or nonrecourse.

o Allows for two types of deduction:

 Acquisition indebtedness: interest deductible on up to $1M of debt used to acquire,

construct or substantially improve either principal residence (sale of principal residence =

no tax on gain under §121) or second home (sale = tax on gain under §121), debt must be

secured by the home (can’t take out loan on 1st home to buy 2nd – 2nd home must secure

2nd loan)

 Acquisition must be secured, used to acquire, up to $1mm (not indexed)

 limit reduced as principal is repaid on loan and refinancing does not increase.

§163(h)(3)(B)

 Home equity indebtedness: interest may be deductible on home mortgage equity

indebtedness up to $100K, regardless of purpose or use of loan, as long as debt does not

exceed FMV of home, must be secured by residence but up 100k can be used for

anything. §163(h)(3)(C).

 Must be secured, up to $100k (not indexed).

 Loan may be taken out to pay down personal credit cards and would still be

deductible.

 Red flag – regulations still match old rules on home mortgage interest (old rule

was could borrow up to basis)

 Don’t look to regs for guidance here.

o Restrictions:

 Tracing required – rule is what secures the loan (not the usual rule)

 Refinancing is OK – still home mortgage interest after refinance. Cannot deduct points on

refinancing though.

 Qualified residence may be vacation home, but must choose one home to get the

deduction.

 Only up to $1M of acquisition debt, plus another $100K in home equity indebtedness -->

max $1.1M -- §163(h)(3)(B)(ii)

 Not indexed – in real terms this has dropped by 50%



c. Tracing Funds

 5 ways to administer method of deciding what gets deducted:

1. proportionally based on assets or expenditures – too burdensome

2. or stacking (prioritize one category) – also too burdensome

3. what secures the loan – the test for home mortgage interest

4. arbitrary percentage (like 50% business meal rule)

5. tracing using facts and circumstances – approach actually used by Service

 How do I know whether interest is personal interest? How can I see if it is business, passive or investment

interest?

o Need to trace funds to their source.

 first-in/

o Variety of interest provisions limit interest deductions based on purpose of loan; since $ is

fungible, no correct way to determine w/certainty purpose for which funds borrowed

 Temp.Reg 1.163-8T: tracing principles for allocation of loan proceeds to specific

purposes

 8T(c)(4) -- Special rule allows taxpayers to designate any expenditure made

within 15 days of the borrowing as the specific use of the funds

 Temp.Reg 1.163-10T(n): definition of qualified residence interest

o Are tracing rules good? Tracing rules are manipulable (such as through commingled funds)

o Are there alternatives? Alternative = security rules (????)





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o Refinancing rule – new loan has the same character as the original loan









ii. TAX ARBITRAGE

Tax arbitrage arises when assets eligible for favored tax treatment are acquired w/debt

o negative rate of tax achieved when taxpayer can obtain both interest deduction and equivalent of

0% tax rate on income from asset purchased w/debt



 Interest disallowance provisions permit wealthy taxpayers to obtain relatively greater benefits from tax-

favored assets b/c can acquire tax-favored assets by liquidating existing assets



Arbitrage Bond Mechanics – Why Current Rule May Be Unfair...

Corporate bond pays 10% Municipal bond pays 6.5%

interest interest

After-tax consequences for 6.5% interest 6.5% interest

35% taxpayer (because must pay 35% tax on the (because municipal bonds are not

10%) taxable)



Borrow at 5% to purchase the Can take a 5% interest deduction, § 265(a)(2) prevents an interest

bond the bond making the net interest you pay deduction for the 5% paid on the

3.25% (because 35% x 5% = loan

1.75%, the amount you will save

in tax because of the deduction)

5% - 1.75% = 3.25%



Net position 3.25% gain (after-tax gain from 1.5% gain (non-taxable interest

bond minus post-deduction from bond minus non-deductible

interest paid on loan) interest paid on loan)

6.5% - 3.25% = 3.25% 6.5% - 5% = 1.5%



 Deduction of interest expended to earn tax-exempt or tax-preferred investment income has long been

controversial; limited deductions in several contexts:

o § 264: forbids deduction of interest on borrowing with regards to certain life insurance or annuity

contracts

o § 265(a)(2): prohibits deduction of interest on indebtedness to purchase or hold bonds that yield

tax-exempt interest

o §§ 1277 and 1282 defer deduction of interest on indebtedness to purchase or hold certain bonds

purchased at discount until interest income from bond taxed at maturity or upon disposition

o § 163(d): limits deduction of investment interest to investment income

o § 461(g): deductions of prepayments of interest restricted

o §263A(f): interest incurred in connection w/construction of certain types of real property and

tangible personal property must be capitalized and amortized



iii. SHAM AND ―NO ECONOMIC PURPOSE‖ TRANSACTIONS

Problem: Borrowing an amount against an asset that allows you to take interest deductions every year on the debt,

and defer the income (hence defer the tax) from the asset until much later provides big tax savins to the taxpayer

 Reason is present value of amount you’ll need to satisfy the tax later for the income is much less than

the value of the deductions you’ll take today

 Even bigger tax savings if you keep borrowing the proceeds from the asset every year

o This is what Knetsch



Knetsch v. U.S. (US 1960)







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Facts – Taxpayer created tax shelter with annuities. Bought single premium deferred annuity, funded by loan from

the company that sold to him. Prepays interest on loan and takes deductions immediately. Annuity was to grow by

$100k each year. Every year, he borrows back $99k and prepays interest on that amount and deducts (so the annuity

would never really pay out).

Taxpayer does not get deduction because there was nothing of substance to be realized by Knetsch beyond a tax

deduction (no tax on a deferred annuity until it is paid out.) (like Franklin). Never built up any equity in annuity.

Was a flaw in the tax system, because defer income on annuities and keep loan interest current because is deductible

when paid. Problem of matching income and interest.

 Deal -- buy high, sell low; make up difference in volume (w/r/t years and present value issues)

o problem is on asset side of transaction: annuities increase in value, not taxed until annuity

payments begin (deferred annuity)

 in all the years of accumulating value, no tax

 on the debt side, can be accelerating deduction, while paying no tax on interest income

 b/c an annuity, present value difference is exacerbated – won’t pay back in 30 years, so

huge tax savings

 problem is really the borrowing against increase in annuity and deducting prepaid interest

immediately

Holding -- If the only purpose of transaction is to get tax deductions, transaction will not be upheld.

 District court looked to motive (subjective test), but the Supreme Court focused on whether what was done

was what the statute intended (more objective than subjective).

 Not a clear motive test, although it remains a factor.

 If the only purpose is to get tax deductions, transaction will not be upheld.

 §264 – says cannot deduct interest used to purchase single premium annuity contract. Kills loophole

Knetsch tried to exploit

o §264(a) – if borrow to buy annuities, don’t get benefit of claiming interest deductions, out of

pocket is ok.



Goldstein v. Commissioner (2nd Cir. 1966) – Taxpayer prepaid interest on treasury bonds in year where she won

Irish Sweepstakes. Tried to deduct prepayment in order to offset tax hit on sweepstakes (sweepstakes would push

her up into a high tax bracket). Court found there was no sham, but disallowed the interest deduction on the

grounds that there was no purposive reason for the prepayment other than to secure a deduction.

 How do we tell there is no purposive reason other than a deduction? – rejected idea that she had a profit

motive.

o Read into language of §163 a business purpose requirement.

 So under § 163, motive of tax avoidance is not permissible.



 Why all the fuss?

o If I can get a deduction now, and defer the income for a long period of time; transaction is of

tremendous value to me

 Courts are not consistent in definition of sham:

o Douglas -- sham is hocus pocus; this is a real transaction, thus not a sham

o Estate of Franklin -- not worried about motivation ("motivation goes to sham")

 What if Knetsch borrowed the money, not from the annuity company, but from the bank?

o it's less clear that this court would have disallowed the transaction

o but, Goldstein is 3rd party debt, and Court disallowed it

 Shuldiner is just unsure that THIS court would have disallowed it

o definitely disallowed by 264(a)(2), if it is clear that money was explicitly borrowed to pay for the

annuity

 but, the more you separate it, the harder it is for the Service to track it

 but, the more you separate it, the less likely it is that the bank would grant the loan

 Some courts have found no need to determine if transaction were ficticious, so long as there was no

economic motive

o See Lifschultz v. Commissioner (2d Cir. 1968) (court found it unnecessary to determining if bond

purchase was genuine b/c there was no realistic opportunity for profit)









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o See also, Sheldon v. Commissioner (T.C. 1990) ("financing transactions will merit respect and

give rise to deductible interest only if there is some tax-independent purpose of the transaction")

 Should you be able to deduct prepaid interest as interest?

o Historically tax law respected form of deduction and allowed you to deduct it.

o Does the transaction really represent a loss of income? No. (e.g. no real difference b/w borrowing

$1000 and prepaying $100 and borrowing $900, so can only deduct interest over period for which

allocated)

 if you prepay, must allocate for time that interest would have accrued.

o § 461(g) – now makes prepaid interest non-deductible.

 The only exception to this rule is the deductibility of mortgage points. § 461(g)(2).





iv. WHAT IS INTEREST?

Interest - "the amount which one has contracted to pay for use of borrowed money." Old Colony RR Co. v.

Commissioner (US 1932).

 "compensation for the use or forbearance of money." Deputy v. DuPont (US, 1940).

 Courts have frequently said that whether a payment is compensation for the use or forbearance of money is

a factual determination, and that the labels or terminology used by the parties is not controlling.

o Con Ed v. US (2d Cir 1993) – NYC allowed Con Ed to prepay real estate taxes, Con Ed

characterized transaction as loan to the city and the city paid them back with interest (difference

was the discount for prepaying); since the borrower was municipality, Con Ed tried to exclude the

discount as tax exempt interest

 Ct. said discount was compensation for early payment and not interest

 Taxpayer was by the ―form‖ of the transaction, which was not a loan

o Albertson’s v. – deferred paying employees under agreement to pay them more later; ct. said not

interest

o Credit card annual fees are not interest. Rev Rul 2004-52.





Is there equity or is there debt?

 Distinguishing Debt from Equity: lender-borrower relationships must be distinguished from other

relationships and deductible payments of interest must be distinguished from nondeductible payments of

principal

o use substance over form analysis to decide.

 but see US v. Mississippi Chemical Corp. (US 1972) (emphasizing form over substance)

-- Graetz criticizes as noneconomic result

 Corporate Debt from Equity: § 385 authorizes Treasury to prescribe by regulation how to ascertain

whether interest in corporation is stock or debt; but Treasury has never issued final regulations under § 385;



Assuming there is debt, what part of debt is interest? What is principal?

 Distinguishing Interest from Principal: §163(b) allows interest deduction under certain circumstances

where carrying charges are imposed even though actual amount of interest cannot be determined.

o §216 allows tenant-shareholder in coop bldg to deduct pro rata share of interest;

o §7872 re-characterizes as interest amounts designated otherwise on variety of no-interest/below-

market interest transaction;

 Original Issue Discount Rules – look at present value of stream and the yield (internal rate of return) on

the whole thing, compute an interest based on the cash flows, then treat it like a bank account, taking the

percentage out as interest or what is left in the bank each year.

 Ex. I lend you $100, you pay me back $130 in 4 years.

o Year 1 -- $30

o Year 2 -- $20

o Year 3 – $50

o Year -- $30

o If borrower is in higher tax bracket than lender, they want the first year’s payment to be

considered interest rather than principal b/c borrower wants to take the immediate deduction









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o If lender is in higher tax bracket than borrower, they want last year’s payment to be considered

interest, b/c interest is the only part of return that is taxable (no tax on principal to lender)

o The rule figures out what the interest rate would be if that rate were constant over the four years

(complex, just understand what it does) – figure out interest, and apply in interest-first basis



Problems of Inflation

 Inflation: causes problems for income tax;

o Congress has enacted provisions to take inflation into account but none deals directly w/assets and

liabilities;

o lender can suffer real loss later when time for payback and money not worth same as it was

 We overstate interest income and we overstate interest deductions to deal with this problem.

o Better solution would be to index basis or index interest to inflation.

o Government not in a hurry to change because might be politically unpopular, people make out

from overstatement of deductions (esp. for home mortgage interest)

 Does the government lose out on this?

o lenders are in low brackets, and people are in high brackets; so much more is deducted than is

included, so it looks as if gov’t loses out

 Usual assumption is that if this is what happens, people tend to hold debt in tax-preferred

forms.

o May no longer be the case – inflation is not as high as it was.



I. Losses

i. GENERALLY

§ 165 (losses) generally permits deductions for certain losses not compensated for by insurance

 consistent with § 162 and § 212, allows deductions for losses incurred in connection with trade or

business or transaction entered into for profit. § 165(c)(1) and (c)(2) (respectively).

o but, can be important tax differences between treatment of the two

 Other losses are personal and non deductible (exceptions for certain casualty and theft losses). § 165(c)(3),

(d) and (e)

 § 165(b) -- Amount of loss deduction: loss is determined by adjusted basis of property.

o Actual loss sustained is a rule laid down by the courts and not replacement value.

 When do losses occur?

 Tax consequences only when realized.

 Time of realization is clear when property is sold, exchanged, or otherwise disposed of.

 must clearly abandon property, not just stop use

 loss deduction cannot be taken for loss of goodwill unless dispose of entire

business

 no deduction for loss of anticipated income

 However, taxpayer may dispose of property without actually suffering economic loss

where sells to related party or under obligation to repurchase.

 Also not clear when property becomes worthless.

 Casualty is a realization event.

 Courts tend to fix the time of a loss by looking to definitive or identifiable event or to conduct

indicating a closed transaction or no reasonable prospect of recovery. Look to realism and

practicality.

 Two types of losses:

 Operating losses – run a business and lose money

 Have already dealt with these in several areas:

 § 183 – hobby losses; Plunket.

 § 280A – home office, can’t take a loss

 Net Operating Losses – general rule is that if it is a trade or business then losses can be

used to offset income from other activities: no basket rule here (like §173 around

investment activities).

 net operating loss carries-forward (20 years) or carries-back (2 years) as

provided by § 172







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 Ex 1: Have a car used in business activity, accident. -- Above the line loss –

62(a)(1) deductible from gross income rather than adjusted gross income (below

the line) and therefore can be taken even if the taxpayer does not itemize

(§62(a)(2))

 Property Loss – When you buy an asset at one price and then sell it at a lower price.



ii. DISTINGUISHING BETWEEN PERSONAL LOSSES AND BUSINESS OR PROFIT-SEEKING LOSSES

 In determining deductibility of a loss, the primary motive must be ascertained and given effect

 A deduction is allowed if the property has been appropriated to income-producing purposes –

like rental property – must allot to whatever purpose is the primary purpose

 The deduction is allowed in proportion to the business or income-producing use if used for mixed personal

and business uses



a. Business vs. Non-Business Profit-Seeking Losses

 Important distinction because business losses under § 165(c)(1) generally receive more favorable tax

treatment over time than investment or transaction for-profit losses under §165(c)(2)

o Business losses benefits:

 above-the line deduction -- business activity losses deductible from gross income rather

than AGI

 generally treated as ordinary losses

 net operating loss carry-forwards (20 years) or carry-backs (2 years) as provided by §

172

 Ex 1: Have a car used in business activity, accident. -- Above the line loss –

62(a)(1) deductible from gross income rather than adjusted gross income (below

the line) and therefore can be taken even if the taxpayer does not itemize

(§62(a)(2))

o Non-Business Costs:

 § 165(c)(2) losses usually must be itemized

 Caveat: § 165(c)(2) losses are above-the-line ONLY if they result from a sale

or exchange of property or are attributable to property that produces

rent/royalties. § 62(a)(3) &(4)

 Sale or exchange language is key.

 Ex 2: Have a car used in a for-profit activity, not a trade or business, is

stolen. No sale or exchange of property 62(a)(3) – so this is not an

above the line loss

 Generally treated as capital losses



b. Personal vs. Business or Profit-Seeking Losses

 § 165 denies deduction for personal losses (other than theft/casualty).

o Corresponds to § 262 -- denying deductions for personal expenses.

 Problem of Mixed Use Property:

o When part of property is used for one purpose and part for another, or the same property is used at

different times for different purposes, losses from sale of property can be allocated between

different uses.

o Deduction allowed in proportion to business or income producing use in the same way basis in

property is allocated between personal and business uses when calculate depreciation.

o Deduction allowed where inherited property sold at loss without ever having been used as a

residence by taxpayer.

o Ex: Mixed Use Case – purchase boat for $40K, ¼ business and ¾ personal. Cannot depreciate

personal, but can depreciate business. Take 8K in depreciation, basis is now 32K. Sell for 28K.

Have 2K business basis and 30K personal basis. Hence AR would be 7K business and 21K

personal. Thus 5K business gain, and 9K personal loss. Hence 5K is taxed at ordinary income b/c

of recapture rules.

 Sharp v. U. S., (D.Del 1961), aff’d (3d Cir. 1962) --Guy with a plane used for 75% personal and

25% business. $54,000 basis in the plane – allocates to $40,500 personal and $13,500 business.

Took $13,000 in depreciation deductions





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 In case like this, must allocate amount realized in same proportion as basis and apply

100% of depreciation deductions to business portion

 Result:

 $13,000 in depreciation deductions results in $500 adjusted business basis

 No depreciation for personal use, for $40,500 stays

 Sale price of $35,000 allocated 25% and 75%

 $8,750 business: $8,250 taxable gain

 $26,250 personal: $14,250 non-deductible personal loss

 Hobby Losses

o See information on §183 and hobby losses (Plunkett) above.

 Gambling Losses

 Gambling losses only permitted to the extend of gambling gains - § 165(d)

 Professional gamblers can deduct if ―involved in the activity with continuity and regularity‖ and

with the primary purpose of earning income or profit (Commissioner v. Groetzinger, US SC

1987).

 Treated as ordinary business expenses, losses



c. Casualty Losses

Casualty Loss Exception: §165(c)(3) allows deductions for personal losses arising from "fire, storm, shipwreck or

theft."

 Deductions for casualty/theft losses equal to casualty/theft gains are deductible from gross income

 Casualty gain: recognized gain from any involuntary conversion of property, usually come from insurance

payments that exceed basis of property damaged

o Personal casualty gains must be included in gross income (if insurance exceed adjusted basis);

when gains exceed losses, §165(h)(2)(B) characterizes them as

i. all such gains shall be treated as gains from sales or exchanges of capital assets, and

ii. all such losses shall be treated as losses from sales or exchanges of capital assets

 Argument for casualty loss provision is that does not recognize personal consumption.

o Lose ability to pay taxes when lose value of property.

 Suddenness appears to be important factor (ex. termite damage not sudden). See White v. Commissioner

(TC 1967) ("events giving rise to the loss were 'sudden, unexpected, violent and not due to deliberate or

willful action'").

o may be necessary, but is not sufficient. See Charles v. Commissioner (OJ case causing property

value decline does not lead to loss b/c no physical damage to property).

 Can take deduction if loss is result of negligence, but if a result of gross negligence or intentional

 Theft is included, but cannot just be losing something (taxpayer must prove theft occurred). See Krahmer

v. US (Fed.Cir. 1987) (taxpayer must "prove that the seller defrauded him by knowingly and intentionally

misattributing" a counterfeit painting to an artist),

o deductible in the year of discovery

 Can take deduction if loss is result of negligence, but if a result of gross negligence or intentional



Limitations:

 §165(h) -- Casualty losses are subject to a 10% of AGI floor (for the total losses) (§165(h)(2)) and $100

de minimus threshold (for individual events) (subtract $100 from the loss when calculating)

o This is a big limitation – must have a very big loss.

o Casualty loss is an itemized deduction, and thus taken below the line.

 It is not subject to the 2% floor, however. § 67(b)(3)

 No deduction permitted if taxpayer does not file timely insurance claim to the extent policy would have

provided reimbursement

 Reg. 1.165-7 – amount of deduction on personal property is limited to lesser of FMV prior to the casualty

minus the FMV after casualty or the property’s adjusted basis.

o Disallow loss deduction for unrealized gains to prevent double benefit because gain never taken

into income.

o Ex 1. Taxpayer’s car completely destroyed. Paid $20K for car. At time of accident, car worth $8K.

Deductible loss = $8K, $12K considered to be already consumed.







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o Ex 2. Painting destroyed was purchased at $30K, appreciated in value to $75K. Deductible loss is

$30K, $45K was untaxed appreciation.

Steps of analysis:

1. Net casualty gains/losses (all done ATL)

2. If losses > gains, then apply $100 and 10% AGI limitations (remembering to subtract $100 from

total loss); then figure BTL deduction

3. If gains > losses, then recharacterized as sales/exchange of capital asset and include in gross

income



iii. LOSS LIMITATIONS

a. Property Losses

Related Parties:

 §267: disallows deductions for losses from sales or exchanges of property, whether direct or indirect,

between certain related people, such as family members or corporations and majority (>50%) shareholders

o seller’s loss is generally lost permanently under this provision b/c purchaser’s basis for computing

loss when sells property is his cost

o if ultimately sells property for gain, purchaser’s cost basis is increased by seller’s disallowed loss.

§267(d)

o use of intermediary does not change treatment.

o Reasons for 267?

 Really not a realization event b/c haven’t really disposed of it if still in family or sold to

corporation they own

 Don’t trust the valuation – could be part sale/part gift.

 §482: Secretary can re-allocate gross income, deductions, credits, or allowances btwn related

organizations, trades, or businesses (owned or controlled directly or indirectly by same interests) to

prevent tax evasion or to clearly reflect income

o concern is that multi-national corps. owned by the same interests (related parties) could

manufacture in another country w/ low rates then sell to US at high price, so that gain on the sale

happens at the foreign company’s low rate, and US part of company has higher basis so less gains

when they re-sell in US at higher tax rates.

o Other reason to sell to related party at higher than basis = if sell at price lower than FMV you still

understate the gain (treated as part-sale, part gift)

 normal example: basis = 600, FMV = 1000, would you ever sell it for 800? Yes to

understate the gain—don’t want to realize all the gain. (treated as part-sale, part-gift

 §1091 (Wash Sales) -- disallows loss from sale preceded or followed by purchase of substantially identical

securities (including options) within 30 day period (look up/back 30 days)

 old basis, adjusted by the price difference (New Basis = Old Basis + Change in Price (or, in other

words, New Basis = Cost + Loss))

 basis of stock purchased is that of stock sold plus any additional amount paid on

repurchase

 only to applies to losses

 Defers loss rather than eliminating it by adding loss to basis of stock purchased.

 So when that stock is sold, will have very high basis, generate smaller gains.

 Only covers securities, not all assets.

 Why securities, and not, say, houses?

 liquidity of securities market makes a wash sale easy to do

 really requires that securities be identical to be caught in the wash sale provision.

 Does not apply to bonds with different issuers.

 covers a 61 day period (day of sale + 30 days before + 30 days after)

 Why is this in the Code?

 asymmetric system which favors taxpayers w/r/t deductions; want to make it fairer for the

government

 if you momentarily sell, and then buy back, have you really had a realization

event?









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 30-day time period is arbitrary (like most bright-line rules); at some point

you’ve been exposed to enough risk in the market

 Capital Losses:

 §165(f) – only allows you to take losses as permitted by §1211 and §1212

 §1211: capital losses deductible by corporations up to capital gains; by individuals only to extent

of capital gains plus $3K ordinary income

 §1212: any capital losses not allowed in current year may be carried forward indefinitely by

individuals

 Why do we have a capital loss limitation?

 the problem is taxpayers have ability to select the timing of gains and losses

 w/o capital loss limitation, taxpayer could realize all losses while holding off all their

gains

 §163(d) (interest limitation) and §1211 prevent this

 w/o these provisions, well-advised taxpayer would never pay taxes -- would buy

a big portfolio of stocks and use losses to offset all capital gains

 § 1092 (Straddles): where taxpayer retains related assets w/unrealized gains, can use tax losses to obtain

optimum tax treatment, regardless of effect on overall economic position or economic substance of

transaction- i.e. Straddle

o One form of tax shelter

o Typical straddle: taxpayer acquires offsetting positions in commodity futures contracts (i.e. to buy

and sell wheat)

 any changes will offset each other; can obtain deferral and conversion

 To obtain deferral, sell loss leg in current tax year, while retaining gain until next year

(accelerates loss and defers gain)

o §1092 enacted to address this problem -- limits deduction of losses from straddles to amount by

which losses exceed unrecognized gains on offsetting position (complimented by mark to market

rules of §1256)

 applies to certain commodity future contracts, stock and stock option transactions where

offsetting positions are held in similar/related properties

 how to determine if two positions are offsetting? 1092(c)(2)

 presumptions when something has a substantial diminution in risk – 1092(c)(3)

 before this was enacted, service would litigate these as not-for-profit transactions

where no loss is allowed (but this was messy)

 §1256: requires certain stock and commodities be marked to market at end of year, whether or not

taxpayer holds offsetting positions

o each such contract taxpayer holds treated as if sold at year end

 gain/loss fully recognized.



Fender v. U.S. (5th Cir. 1978)

Facts – Taxpayer sets up trusts for kids. Had large capital gains from sale of stock. To offset gains, co-trustee

attempted to sell bonds that had substantially declined in value that were owned by trusts. Trust sold bonds to bank

over which trust had significant control (owned 40%, single largest block). Recognized tax loss, then, 42 days later,

trusts repurchased bonds for value plus accrued interest.

Holding -- Because of the structure of the transaction (dominion over bank), the taxpayer retained sufficient domain

over bonds to ensure that he could recapture them and not suffer economic loss.

 Rule: To take loss deduction, tax payer must show that loss was incurred by a bona fide sale (substance, not

form). Reg 1.165-1(b).

 Found taxpayers motivated by tax avoidance.

o But motive is not enough (Knetsch) -- question is, was the transaction what the statute intended?

Gregory v. Helvering (US 1935).

 even where there are no statutory limitations, the loss is not permitted b/c there was no bona fide sale

o insufficient for allowing deduction, though found neither §267 (transfer to related party) nor §1091

(wash sale) applied.

o Still, circumstances suggest there was no realization event, even though consistent with wash sale

rules.







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 bank ownership make this a controlled group, and thus suspicious b/c:

 Reason 1: timing -- was not a real realization of the loss, b/c is just sale w/n the family (267(d))

 Reason 2: valuation -- can't tell if a part-sale, part-gift exchange between family members

Class Notes:

Is the Decision Correct?

If motivation isn't enough and Fender didn't violate 267 or 1091, what's wrong?

 Control issue?

o but, if the mere ability to buy back is dispositive, you'll never get it back

 Google stock example -- could always buy it back, even if you have no control

o the real standard is 1091 -- how much risk do you have to be exposed to (30 days)?

 Shuldiner argues that this is a rule that taxpayer should be able to rely on; Shuldiner does

not think control should matter

 No real loss?

o bonds have a face of 1m, FMV is 500k; lent a million to the bank on promise of bank to pay back

in future; why would FMV go down?

 bond market as a whole has gone down b/c higher interest rates; no credit problem with

issuer

 court thinks everybody just needs to be patient -- will get their million dollars

 Court is wrong

o taxpayers have clearly suffered a loss -- every year will get less money, even though value will

eventually go up

 Ex 1. Buy Google stock for 1m, value drops down to 500k

 Ex 2. 10 yr treasury bond bought for 1m (Bond pays 1m in 10 yrs); rate is 10%; bond pays

2%; FMV is 500k

 In both examples, taxpayer could go make a million dollars in ten years (Google guy

could sell stock and invest in the treasury bond of Ex. 2

 Thus, both are the same

 Not really exposed to the market?

o Rand v. Helvering (8th Cir. 1935) -- some people have some stock, gone way down in value, sell

to employee for $10, stock goes way up in value, buy back for $10

 called parking -- haven't really held on to it; you don't get your loss and go to jail

 Not what's going on here -- sold to bank for FMV and bought back for FMV

 bank had risk of ownership when they owned it

 Entirely distinguishable

o Court could have made a more sophisticated argument -- too tough to tell if actually exposed to

market etc

 Dupont?

o Dupont v. Commissioner (3d Cir 1941)-- Dupont owns big stock portfolio, loss, goes to friend, sell

portfolios back and forth to each other, and then buy back at FMV

 why is it significant that they sold it to each other? a zero transaction cost way to do it;

didn't have to pay brokers; or question as to whether they could buy back total controlling

interest (new owners may not sell)

 but, again, Shuldiner doesn't see what's wrong here -- if they buy back at FMV, there is no

problem

 Thus, ultimately, the decision is NOT correct



b. Tax-Shelters: At-Risk and Passive Loss Rules

Tax Shelters -- an aim to generate losses that can offset or shelter other income, such as wages, interest, or

dividends that were neither produced by nor related to income produced by investment.

 Caused by failure to index certain parts of the Code to inflation

o Mostly a problem of mismeasurement of income: If allow deduction for prepaid interest

(mismeasure income), accelerated depreciation (mismeasure income), don’t take inflation into

account (mismeasure income), then openings are created for abuse









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 Often passive investments, and often structured as limited partnerships to provide investors both the

benefits of limited liability and conduit taxation (whereby income and losses of partnership are passed

through to partners).

 May either be legitimate – sometimes intentional on the part of Congress (accelerated deductions for real

estate to encourage real estate investment) -- or abusive.



Attempts to Combat Tax Shelters in the Code

§ 183 – Hobby Losses – thought would combat tax shelters b/c people were willing to jump through the §183 hoops

to get the sheltered treatment



§465 – At-Risk Rule -- only somewhat successful – w/r/t to nonrecourse financing, get basis, but only allowed to

take deductions for how much you are at risk from your own resources.

 Non-recourse debt is not considered money that puts you at risk, unless is for real estate, and then puts you

at risk so long as borrow from someone other than the seller of the property.

 465(b) – not at risk w/r/t losses for which you are guaranteed reimbursement

 Deductions reduce at risk amount; if deductions plus decrease in value reduce the at-risk figure to below

zero, you must compensate by including the offsetting amount in income under § 465(e).

 At risk = any cash invested, adjusted basis of any property you’ve invested, but you get basis

o Ex. 50K cash, 200K recourse debt, 1,000,000 nonrecourse. Basis 1.25mm. Assume 100,000

interest year 1. Assume 100,000 income year 1

o Deductions for 5 yr. straight line deduction?

 Year 1, 250,000 net deduction (20% of 1.25m) -- Could I take entire deduction? Yes,

because is lower than at risk amount of 250K (down payment + recourse debt)

 so, can offset $200k in income and interest

 Year 2, 250,000 deduction, Can I take it? No, you've used it up (no longer have anything

at risk).

 It does carry-forward, however.

 When rules originally enacted, had a very limited scope.

o Certainly did not apply to real estate. (see 465(c) -- that's why it didn't cover Estate of Franklin).

 In 1986, expanded to include real estate, but were still allowed most non-recourse debt.

o Effective in shutting down real estate rules? Don’t know because this was the same year as passive

loss rules were enacted.



§469 – Passive Loss rule -- very successful -- basically shut down the tax shelter industry, by identifying tax

shelters and throw them all into their own basket

 §469 -- If engaged in a passive activity can only deduct losses from those activities to the extent that there

is a gain from those activities (i.e. can’t use losses from passive activities to offset gains from business or

investment income) – ―basket approach‖

o Does carry-forward, but only can be used to offset future passive activity income. 469(b).

 When people engage in tax shelter activities, their involvement is basically passive (think of doctors in

Estate of Franklin -- no activity in day-to-day activity of motel; just wanted to offset doctoring profits).

 Congress said we’ll divide the trade/business world into passive and active (and investment)

o Loss from passive business cannot offset active business

o Loss from active business can offset passive business

o Allow only $3000 capital losses a year from investment. But allow active losses to offset

investment income.

 What is a passive activity? –

o 469(c)(1) conducted in trade/business that taxpayer does not materially participate in;

o §469(h)(1) -- material participation is defined as regular, continuous and substantial basis. 6

factors to show material participation (Reg. 1.469-5T):

i. > 500 hours/taxable year

ii. performs substantially all of activities involved with activity

iii. > 100 hours /year where that equals or exceeds participation of any other individual

iv. ―significant participation‖ with respect to this activity (more than 100 hours, but less than

that required for material participation) and her combined participation in all such

activities exceeds 500 hours





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v. she materially participated in the activity for any 5 of the last 10 prior taxable years

vi. she materially participated in a ―personal service‖ activity in any one of the three prior

taxable years (a trade or business in which capital is not an income producing factor)

o Alternatively, may show material participation by ―Facts and circumstances‖ that demonstrate that

she participates in the activity on a regular, continuous and substantial basis.

 Uses basket approach – divides income into certain categories or baskets and limits deductions against

that income to expenses related in some manner to the production or receipt of that income.

 469(g) – dispositions of entire interest in passive activity – A lot of tax shelter activities are timing gains,

if fully dispose of activity, there is no timing gain, loss is allowed, there is no tax shelter anymore –not a

taxable gain, would not trigger suspended losses. Less fear of fraud when are getting out of an investment.

 469(c)(2) rental activities – no matter what are included in the passive loss world.

o Exceptions:

 §469(i) -- Rental real estate – exception in the code when enacted. If were an active

participant in rental real estate, up to $25,000 losses can be used against nonpassive

income. Has phaseout provision. For individuals for small scale rental activities who

actively manage them.

 §469(c)(7) – Real estate professionals –must perform 750 hours of work in area and this

must constitute more than ½ of his services. Applies to any real property (not just rental).

 Note there is an exception for home mortgage interest -- $100,000



Order of Operations:

 First, apply At-Risk Rules;

 Then, apply Passive Loss Rules to remainder;

 But, Passive Loss Rules and Regular capital loss provision may be applied simultaneously

c. Bad Debts

The Code

 § 166(a) -- A business bad debt is deductible in full as an ordinary loss.

o (1) -- wholly worthless debt -- can take the deduction

o (2) -- partially worthless debt -- can be deducted to the extent charged off by the taxpayer on the

books

 § 166(d)(1) -- an individual may deduct a wholly worthless nonbusiness bad debt only as a short-term

capital loss

o taxpayers prefer business bad debt over nonbusiness bad debt, as the latter may only be deducted

as capital loss and only when worthless

 § 165 and § 166 -- it is sometimes advantageous for a taxpayer to attempt to achieve deduction as a § 165

loss, instead of bad debt, b/c a nonbusiness profit-seeking transaction that produces a loss may be

deductible against ordinary income under 165.

o But see Spring City Foundry Co. v. Commissioner (US 1934) (§ 165 and § 166 are mutually

exclusive)

 must be bona fide debt -- a debtor-creditor relationship must exist based on a valid and enforceable

obligation to pay a fixed or determinable sum of money. Reg. § 1-166-1(c).

 no basket rule – can offset other gains

 no deduction for claims for unpaid salary or rent, b/c such debts have zero basis b/c if paid they would be

included in income and taxed; the fact that they are not included in income and taxed is treated favorable

enough treatment. Perry v. Commissioner (TC 1989).

o No deduction allowed for a debt that was worthless when acquired. Putnam v. Commissioner (US

1956).

 Timing -- § 166(a) allows a deduction for "any debt which becomes worthless w/n the taxable year"

o presents the difficult question of determining the year in which the debt actually became worthless

o § 6511(d) - provides a special seven-year statute of limitations w/ respect to refund claims based

on the deduction of bed debts



Dominant Business Motivation









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 the question whether a bad debt resulted from a loan made for a dominant business motive typically turns

on the particular facts and circumstances, when both investment and business reasons are present. US v.

Generes (US 1972) (using a dominant motivation test).

 Trade or business of lending -- must be extensive evidence that lending is actually taxpayer's trade or

business

o Estate of Bounds v. Commissioner (TCM 1983) -- must not be intermittent transactions, but

extensive and continuous

 court looks at all the relevant factors including time spent on lending, passive contact,

advertising, maintaining a separate office, bookkeeping, and occupation listed on tax

return





J. Personal Deductions

1. Gross Income - ATL deductions = AGI

2. AGI - personal exemption - (either standard or itemized deductions) = taxable income

3. (Taxable Income x tax rate) - credits = final tax paid

 Largest itemized deductions are

o Home mortgage interest (§163(h)(3))

o State and local taxes

o Charitable deductions

 Minor itemized deductions:

o Investment interest

o Investment expenses (§212, but note some are ATL deductions)

o Casualty losses (before limit)

o Medical expenses

 § 68 (3% Haircut): where AGI is over $100k, the affected itemized deductions are reduced by 3% of the

excess of AGI over $100k; reduction cannot exceed 80%

o $200K AGI, $200K - $100K, take 3% = $3K

o this cap is independent of the amount of itemized deductions

o for most people over the threshold, their marginal rate will have really increased 1%

o does not apply to medical expenses, investment interest, gambling losses and casualty loss

o 2% floor applies BEFORE 3% haircut



i. THE STANDARD DEDUCTION

Taxpayer may either itemize or take a standard deduction.

 Standard deduction effectively acts as floor for itemized deductions (get it regardless of expenditures)



Why Have a Standard Deduction? (the two arguments)

 Administrative simplification rationale -- viewed as substitute for itemized deductions for those

taxpayers whose itemized deductions would be relatively small amounts

 Zero bracket amount rationale -- viewed as adjustment of tax rate schedules

o reflects view that no tax should be paid for incomes below certain amount since standard

deduction + personal exemption nullifies such income (creates 0% tax bracket)

o floor under which people don’t pay tax or file returns; adds to progressivity

In the Code

§63(c) – defines standard deduction as a flat amount that varies with marital status and may be taken regardless of

whether taxpayer actually had expenditures

 Different rates depending on filing status (determined by §7703) (indexed for inflation)

o Married, filing jointly – $6000

o Head of household - $4400

o Single - $3000

o Married filing separately – $3000

 Creates both marriage penalty and marriage bonus, b/c standard deduction for a married couple is

exactly twice that for two singles









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 marriage penalty (will be reinstituted in 2011) -- married filing jointly amount will be reduced to

less than two standard deductions for singles

 marriage bonus -- if only one spouse has income, standard deduction doubles simply through

marriage

 § 167 – eliminates marriage penalty, increase marriage bonus; phases in beginning in

2004, but only until 2010

 Certain taxpayers are required to itemize even if their deductions are less than the standard deduction – not

available to:

o married taxpayers filing separate returns where either spouse itemizes,

o nonresident aliens,

o U.S. citizens with income from U.S. possessions, and

o estates, trusts, common trust funds or partnerships.

 Dependents -- children were previously treated as separate deductions; now, there is a cap

o standard deduction is maximum greater of $850 or earned income + $300 if you can be claimed as

a dependant on someone else’s return. §63(c)(5)



ii. PERSONAL EXEMPTION & CREDITS

a. The Personal Exemption

Generally you get an exemption for yourself, spouse and dependents

§ 151 – for tax years beginning in 2001, the personal exemption amount under §151(d) is $2,000 (indexed for

inflation). Taxpayers are allowed to exempt this for themselves.

 Current exemption level is $3400; was set at $2000 in 1986 and indexed for inflation

 § 151(d)(2) -- After 1986, you can no longer take the personal exemption for yourself if someone else can

claim you as a dependent on their return.

o Person who actually pays support should claim the deduction, even if parent can’t take it due to

phase-out.

§ 152 – Taxpayers entitled to exemptions for dependents; dependents defined in § 152 as either qualifying child or

qualifying relative (who doesn’t need to be an actual relative)

 Qualifying child must meet relationship test, principal place of abode test, support test, and age test

(152(c))

o Age Test – 18, or under 23 if student

o Abode Test – with parents over ½ of year

o Relationship Test – child, step, or grandchild

o Support Test – the child cannot provide>50% of their own support

 other family members can provide support, as long as child’s portion isn’t more than half

 Qualifying relative (152(d)): relationship test is much broader (parents, ancestors, unrelated individuals

who are members of the household but are still your dependent, but cannot violate local law), but gross

income test (must be very low income, earning less than PE amount), and support test (must provide more

than ½ of support).

 § 152(e) – dependency exception in the event of divorce/separation allocated to parent with custody unless

they waive that right or reach an agreement



b. Phase-Outs of Personal Exemption and Itemized Deductions

Phase-Out of Personal Exemption (PEP)

§151(d) – personal exemption phased out for income above a threshold amount. (PEP)

 Phaseout based on AGI

 Threshold -- $150,000 indexed

o Once over threshold, amount is reduced by 2% of $2500 for each $2500 above threshold: hence

phaseout is 49 * $2500

o Ex. (Effect of Phase-Out): Somebody earns 150k; earns another 10k. Personal exemption 3,400,

Four units of 2500 = 8%; Will lose 8% of 3400; 8% x 3400 = $272

 Assume a 35% tax rate; $272 x 35% = $95.20 (approx $100)

 $100/$10,000 = 1%

 In current amount, phaseout effectively raises the marginal rates on high income taxpayers w/n the phase-

out range, because the phaseout applies progressively to higher incomes.

o The phase-out increases taxable rate by approximately 1%





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 which is also 1% per person; family of four = 4%

***1% is approximate based ONLY on current personal exemption amount of 3400

(½% for original 2000 personal exemption)***

 Note: phaseout is not properly indexed. Threshold element is indexed for inflation, but $2.5K not indexed.

(Phaseout faster and faster every year because of inflation).

o Effect of not indexing $2500 increments is to shrink the phase-out range and increase the

marginal rate within the phase-out range

o How do you do it?

 Take the amount you are over, divide by $2500, multiply by 2% = amount you will lose

from exemption

 Subtract that amount from personal exemption to determine amount of exemption you

can take

 Mulitply that amount by marginal rate and divide the result by the amount you are over to

determine increase on marginal due to phase-out

o Why didn’t they index? Carelessness, too complicated, or a desire to increase tax revenues over

time.



Personal Exemption Phase-Out Mechanics (§ 151(d))

AGI = $160,000 AGI = $160,000 AGI = $160,000 AGI = $170,000

Exemption = Exemption = Exemption = Exemption =

$2,000 $3,400 $5,000 $3,400

1. Determine $10,000 $10,000 $10,000 $20,000

Amount above

threshold

2. Determine 4 4 4 8

Number of $2,500

increments (divide

amount over

threshold by $2500)

3. Number of 8% 8% 8% 16%

increments x 2%

4. Multiply number $160 $272 $400 $544

above by

exemption to get

amount of

exemption lost

5. Multiply lost $56 $95.20 $140 $190.40

exemption by

marginal tax rate

(e. g., 35%)

6. Divide amount 0.56% 0.952% 1.4% 0.952%

over threshold by

number above to

get marginal tax

rate increase



Phaseout of Itemized Deductions (The 3% Hair-Cut)

§ 68 – places a cap on certain itemized deductions for high income taxpapyers; phaseout of itemized deductions

allowable over a threshold rate

 If over threshold of 100,000 (married filing jointly or single; indexed), the overall itemized deduction

amount will be reduced by the lesser of :

o 3% of AGI over the threshold ((AGI-$100k)* 3%) or

o 80% of itemized deductions.

o Excludes medical expenses under §213, investment interest under §163(d), and casualty or

theft losses under §165(c) - §68(c))







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 Ex.: assuming threshold $100K, if have AGI of $120K, take excess $20K, multiply by 3% = $600, so

itemized deductions would be reduced by $600.

 also effectively increases marginal rate

o Ex: Assume I have $100k on investment income; and $100k in investment interest expense

 AGI goes up by 100k, as a result, will lose 3% (3,000 in itemized deduction)

 taxable income goes up by 3k to 103k

 get a below the line deduction of 100k, leaving 3k in taxable income

 thus, effectively raises marginal rate by 1%

 Phaseout cannot reduce itemized deduction below level of standard deduction because would always elect

standard deduction rather than itemize.

o If we want to look at influence of this on people’s behavior, need to look at rule which applies.

 For most people who itemize (96% over the threshold), the 3% rule is the operative rule.

 For most people affected by the 3% (itemizers over threshold), §68 imposes a

1% ―surcharge‖ on income over the threshold – Congress did this rather than

raise tax rates (sub rosa way to raise taxes, avoided unpopular politics). (§151

was about ½% surcharge (now a 1% surcharge b/c of failure to index ))

 Would only use 80% rule if high income and few itemized deductions (rare). Why some

high income people now take standard deduction (5% high income taxpayers).

 2001 Act phases out phaseouts

o in 2006 and 2007, 1/3 phaseout disappears

o in 2008, 2009, 2/3

o in 2010, effectively repealed

o in 2011, it all comes back

o repeal may be characterized as a hidden way to cut taxes for high income taxpayers.



c. Earned Income Tax Credit (EITC) and the Child Credit

The Earned Income Tax Credit

§ 32 -- provides a refundable tax credit for wages earned by low income taxpayers

 credit is fully refundable, which means that people w/ no tax liability still receive the credit in the form of

cash payment

 a percentage of earned income, w/ both the credit percentage and earned income varying w/ number of

children

o credit increased as earned income increases until it hits a maximum amount, and then it is phased

out by a percentage of the income exceeding the phase-out amount

 To get the EITC, must satisfy three requirements:

o Must have wage earner in household

o Must be low income

o Must have children (though fams without children can get a very small credit): substantial credit

for one child, and more for two children, but no more increases after that

 FORMULA:

o (credit percentage * earned income amount) – [phase-out percentage * (AGI – phase-out amount)]



Earned Income Tax Phase-Out Mechanics

(credit percentage * earned income amount) – [phase-out percentage * (AGI – phase-out amount)]

Married couple Married couple Single/married

with 1 kid; with 1 kid; with no kids;

Steps in Calculation: $20,000 AGI $5,000 AGI $8,000 AGI

1. Calculate preliminary credit by $6,330 x 34% = $5,000 x 34% = $4,220 x 7.65% =

multiplying lesser of AGI or EI cap $2,152 $1,700 $322.83

(from § 32(b)(2)(A) by applicable

credit percentage (from § 32(b)(1)(A))



2. Calculate amount of credit phased- 15.98% x ($20,000 Not applicable, 7.65% x ($8,000 –

out by multiplying phaseout –$13,610) = because AGI is $5,280) = 7.65% x

percentage (from § 32(b)(1)(A)) and 15.98% x $6,390 = under beginning $2,720 =







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excess of AGI over phaseout amount $1,021 of range $208.08

(from § 32(b)(2)(A))



3. Amount of credit received = $2,152 - $1,021 = $1,700 $322.83 - $ 208.08 -

(preliminary credit – phaseout $1,131 = $114.75

amount)



4. Amount of marginal tax increase 15.98% Not applicable 7.65%

(Note:the effect on your marginal tax

rate in the phaseout range is always

the applicable phaseout percentage)





MARGINAL RATE INCREASE CALCULATION FOR CREDITS

 To see how much phase-out increases marginal tax rate, here, you do not have to multiply amount of

credit lost by marginal tax rate (b/c is dollar for dollar, marginal rate has already been applied)

 Just divide amount of credit lost/amount over threshold



The Child Credit

§24 -- provides a $1000 credit for every qualifying child under 17 (24(c)(1)(B))

 Phaseout: reduced by $50 for each $1000 (or fraction thereof) by which AGI exceeds the threshold amount

o Threshold amounts (unindexed): $110K for joint returns, $75K for unmarried individual, $55K for

married individual filing separate return

 this credit is partially refundable (refundable based on 15% of income; basically refunding Soc. Sec. taxes,

which are taxed at 15%); complicated provision



How to have zero tax liability (Married, filing-jointly, 2 kids):

 Standard Deduction: 10,700 (standard deduction ($5,350 x 2)

 Personal Exemption: 13,600 (personal exemption 3400 x 4)

 Child Credit: 18550 (pre-tax amount to get to post-tax $2000)

o For a married couple, the 15 percent bracket starts at $15,650. Up to that point you have owed a 10

percent tax, or $1,565. So that means you will have eaten up 1565 of your 2000 credit and have

435 left. Now how much more income will it take to eat up 435 in credit?

o That is 435 / .15 or $2900 (that must be where your 2900 figure comes from).

 So the amount of taxable income that the 2,000 credit will shelter is:

o 15,650 + 2900 = 18,550.

o Total shelter is 10,700 (standard deduction ($5,350 x 2) + 13,600 (personal exemption 3400 x 4) +

18,550 = $42,850.

 People with AGI of $42,850 or below, have zero tax liability.



iii. PERSONAL ITEMIZED DEDUCTIONS

a. Taxes

§ 164 -- permits a deduction for state, local and foreign income taxes and personal property taxes.

 Only available to itemizers (not subject to 2% floor -- § 67(b)(2))

 Why? Two theories:

o Involuntary Payment -- properly subtracted from income in determining ability to pay

o Subsidy to State and Local Govt's -- permitted because want to subsidize state and local

activities.

 Foreign income taxes treated differently under § 164

o Can take deduction if you want, but can also elect to take a credit.

o Credit primarily involves multinational corporations, but incredibly complex

o must distinguish between foreign and domestic income by applying source rules (very complex)

Sales taxes – no longer deductible for non-business activities.

 if your state has no income tax, you can elect to deduct sales taxes

Business taxes – taxes paid for business expenses generally deductible







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 but, taxes for items that need to be capitalized are included into the capitalization

o If were buying tractor for farm and there was a sales tax, can’t deduct, is part of cost of

acquisition.

 Would capitalize and depreciate along with rest of cost.

Nondeductible Taxes (§ 275) – federal income tax, Social Security Taxes, estate, inheritance, gift taxes imposed at

federal, state, and local levels are not deductible regardless of whether are personal or profit-seeking.



b. Charitable Giving

In the Code

 §170(a)– get a deduction for cash or FMV of property you donate to a charity (must itemize)

 §170(b) -- limitation on deduction – for most is a limit of 50% of AGI (congress does not want elimination

of tax liability)

o §170(b)(2) – corporation’s charitable deduction limited to 10% of taxable income.

 §170(c) -- definition of charitable contribution

 Public Charity – gets support from public, like red cross, art museum

o donations limited to 50% of income

 Private Foundations – get support from smaller group of individuals. Huston Foundation. Carnegie

foundation.

o 30% AGI restriction on deductible giving for private foundations – we don’t trust them as much,

lack public monitoring function of public charities.

 §74—prizes and awards, if all given to charity, will not be income. Gets around §178.

Why have deduction?

 If I gave it away, I can’t consume it

 Subsidy to giving

Other Options:

 Credit instead of deduction

 Matching Grant

 creation of an Office of Charitable Giving -- gov't gives the money

o problem here with religious organizations and individual choice

Quid pro quo -- was there a quid pro quo in the exchange (excluding recognition)?

 Requirement of detached and disinterested generosity. See Duberstein.

 $100 to public radio and get a $15 umbrella, should only get an $85 deduction.

 Substantiation requirement (§ 6115) -- Congress has strengthened substantiation requirements to prevent

people from understating quid pro quo and overstating a deduction.

o essentially enacts the Hernandez dissent



Hernandez v. Commissioner (US 1989)

Facts -- Taxpayer tried to deduct payments to Church of Scientology for required sessions conferring "spiritual

benefit" as charitable contributions under § 170

Holding -- Such payments are not deductible b/c they do not qualify as "contributions or gifts"

 payments are part of a quid pro quo (in return for their money, taxpayers received benefit of "auditing" and

training sessions)

o exchanges were "inherently reciprocal"

 Court wishes to avoid Establishment Clause and 1st A issues

Dissent (O'Connor, w/ Scalia) -- changes course for Court, which had previous allowed religious quid pro quo as

deductible

 difficult to separate religious benefit from actual charitable giving to religious organizations

 will need to determine the value of intangibles -- should really be all or nothing



Follow-up: A closing agreement reached some sort of deal w/ Scientology

 IRS won't reveal details of agreement

 Sklar -- wants to count part of tuition to Jewish school as religious donation; Court disallows deduction

o rejected in part by dual-payment doctrine -- if you pay for some goods or services, and also are

making donation, but the total payment is no more than usual market price for goods and services,

no deduction for the donation







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Gifts of Services

 Taxpayer cannot deduct the value of services rendered to charitable institutions.

o correct b/c you've never included the amount in income

o as if charity paid you and you gave it back

 taxpayer may deduct unreimbursed out-of pocket expenses incurred in connection with donating services

to a charitable organization.



Gifts of Appreciated Property

Taxpayer who gives appreciated property to charity doesn’t realize gain; but can deduct full FMV of appreciated

property; thus untaxed gain (effectively subsidy for donations of appreciated property); an extraordinarily generous

rule

 § 170(e): limits the general rule -- contribution of any property other than marketable securities to private

foundation gives rise to deduction generally limited to basis

o applies to:

 all contributions of property that would produce ordinary income or short-term capital

gain if sold; and

 to contributions of property that would produce long-term capital gain if sold where

 donee is private foundation, or

 where contributed property is tangible personal property unrelated to exempt

function of charity

 Contribution of property to public charity generally FMV- amount of gain that would not have been long-

term capital gain;

o charitable contributions to public charities of appreciated securities or real estate therefore are

deductible in full if would produce long-term capital gain if sold

o but if tangible property that will not be used by donee in charitable function, FMV reduced by full

appreciation (e.g. deduction for painting donated to museum, don’t get deduction of painting

donated to Greenpeace)

o ***recapture rule -- if charity sells w/n next three year (and cannot certify that they actually

intended to use it), goes back to basis***

o Note: § 170(b)(1)(d): amt of deduction for appreciated property w/long-term capital gain limited

to 30% of donor’s AGI

 To determine amount of deduction under 170(e):

o Long term capital gain?

 No? – get Basis

 Yes? – gift to Public or private?

 Private Foundation? –

 Marketable Securities (such as publicly traded stock)? Yes – FMV

 Public Charity? – intangible or tangible?

 Intangible or Real Property– FMV – biggest category of giving.

 Tangible Personal Property – related or unrelated?

 Related – FMV

 Unrelated -- Basis

 Limitation: to extent would have been ordinary income, do not get deduction (e.g. $10K rental pmts and

50% tax rate; if donate, can only take deduction of $5K and not full rental amt since would have been

ordinary income)

 If property had loss, would probably sell it to get deduction and then donate the money



c. Medical Expenses

 213(a) -- allows deductions for expenses paid during the taxable year, not compensated by insurance or

otherwise, for medical (or dental) care of the taxpayer, the taxpayer's spouse, or a dependent (as defined in

152) to the extent that such expenses exceed 7.5% of AGI

o 213(d)(1) -- defines "medical care" as including amounts paid for the diagnosis cure, mitigation,

treatment, or prevention of disease, or for the purpose of affecting any structure or function of the

body







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o amounts paid for medical insurance are also deductible, as are transportation costs incurred

primarily for and essential to medical care

o 7.5% floor limits to those taxable years when medical expenses uncompensated by insurance are

extraordinary

 Reg 1.213-1(e)(1)(ii) -- deductions under 213 are confined strictly to expenses incurred primarily for the

prevention or alleviation of a physical or mental defect or illness

o an expenditure for general health or well-being is not deductible under the section

 must be both an essential element of treatment and must not have otherwise been incurred for nonmedical

reasons. Jacobs v. Commissioner (TC 1974) (deduction for lawyer's fees in obtaining a divorce

recommended by psychiatrist)

 Deductible medical expenses:

o cost of installing and maintaining swimming pool, if for essential medical reasons and not

available without installation

 (amount of the deduction is the excess of the increase in FMV of property as a result)

o cost of birth control, vasectomy or lawful abortion

o essential transportation

o treatment for drug, alcohol, and cigarette abuse

 Not deductible:

o unnecessary transportation costs

o expenses not essential to care (golfing, dance lessons, etc.)

o therapy that coincides with other pleasurable or necessary activities (milieu therapy example)

o in-home medical attendants with traditional domestic tasks (baby nurse, housekeeper, etc.)

o cosmetic improvements

 223 -- Health Savings Accounts -- only eligible if you have high-deductible plan or no health insurances;

permitted to make certain deductible deposits into health savings account; grows tax-free









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IV. WHOSE INCOME?



A. Taxation of the Family

i. TREATMENT OF COUPLES

Even Uneven



Single A: 100, 100 B: 200, 0





Married C: 100 + 100 D: 200 + 0



How should it go?

 Tax on A = Tax on C

 Tax on B = Tax on D

 Tax on C = Tax on D

o though, maybe D > C b/c of imputed income problems; denies Horizontal Equity

 harder to argue this on pure progressivity grounds

 Tax on A < Tax on B (assuming progressive income tax)

Problem develops:

 When you want to treat C and D the same



a. Policy and Historic Treatment

Policy Questions

Should we treat a married couple differently than two individuals?

 Matters because we have a progressive tax.

 Why are they different (possible answers):

o income pooling -- married couples can pool their income and be one economic unit

o costs of children -- having children creates additional unavoidable expenses

o imputed income -- difference between a couple that both work (and pay for household chores) and

a couple where one individual works and the other does household chores should be accounted for

o costs of working -- greater costs in earning two incomes as opposed to one



Druker v. Commissioner (2d Cir. 1982, cert. denied 1983) -- taxpayers are married couple each w/earned income;

challenged marriage penalty by filing married w/separate return applying rate of unmarried individuals under §1(c)

instead of §1(d)

Holding -- Rules do not significantly interfere w/decisions to marry/did not deprive constitutional right; fact of

increased taxes places little obstacle on getting married



Historic Treatment

 Pre 1948 – married couples were treated as separate taxpayers. Began to break down.

o Common law states v. community property states (allowed spouses to split income – Poe v.

Seaborn 1930)

 Common law – 100%, 0%; much greater tax liability for higher-earning individual

 Community property – 50%, 5%, lower tax liability

 States began to adopt community property laws to avoid tax problems.

 States also allowed people to elect into community property regime (courts said had to be

mandatory community property regime)

 1948 Act: Community property was effectually joint filing, so in 1948, congress implemented joint filing in

order to do away with geographic and cross-couple differences.

o solution to horizontal equity and geographical uniformity



b. Joint Filing: The Marriage Bonus and the Marriage Penalty

Joint Filing: The Marriage Bonus and Penalty

Joint filing: Add incomes, divide by 2; compute tax and multiply by 2.





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 Joint filing has administrative arguments in favor of it -- eliminates many questions or extra steps.

 If both earning 50k, no change in tax when marry.



Marriage Bonus: Where one taxpayer in a couple earns substantially more than the other, combined tax rates will

decline if they marry, largely b/c the tax rate on the higher-earning spouse's income will be less than it would be if

he or she had remained single

 If one earns 100k and one none, there was a huge bonus when got married.

 creates huge single penalty relative to marriage bonus -- unmarried single taxpayers in higher tax bracket

than similarly situated married individuals (horizontal equity issue)



Marriage Penalty: In 1969, Congress, in response to single penalty, adopted special rate for singles – not as good

as joint filing, but penalty not as steep – singles penalty was never more than 20%

 singles never pay more than 167% of married couples

 Creates a marriage penalty for spouses who earn similar incomes -- the lower-earner's salary is taxed at a

higher marginal rate.

o compounded by the fact that taxes will increase if the standard deduction for married couples

filing joint returns is less than twice the standard deduction for two individuals

 If allow for married taxpayers to both file as single – creates inequality across couples.

 Mandatory separate filing would eliminate marriage penalty, single bonus.

o But brings in lots of complications: Who gets deductions for kids, investment interest, etc.?

o It is impossible to simultaneously address all these problems and retain a progressive income tax.

 The tax on a single person earning 200,000 must be greater than the total tax on two

single people each earning 100,000 if we are to have a progressive tax structure.

 2nd earner deduction – allowed deductions of 10% income of lower earning spouse up to $3K, gives

couple equality, but justified with imputed income argument, had effect of reducing maximum marriage

penalty to about $3K.

o 1986 repealed, justified by the fact that rates were flattened, so penalty decreased.

o but, post-86, steady increase in the top rates and brought back the marriage penalty



Effect of Joint-Filing on Marginal Tax Rates

 HYPO: imagine two worlds: separate filing and joint filing; wife is not currently working but considering

going into the market

o What is the marginal tax rate on the first dollar?

 Separate Filing: 0% or, at least, very low

 Joint Filing: the marginal rate on the last dollar earned by the spouse; very large

o Secondary Earners are much more responsive to marginal rates

 many people do not go into the job market b/c of marginal rate

 this is an efficiency question



c. The Code Today

 § 68 – threshold is the same for married and single ($100k) – huge marriage penalty.

 § 151 – less of a marriage penalty, but still there.

 2001 act:

 Standard deduction – 2 times single.

 10% and 15% brackets – 2 times single.

 Married penalty is gone for now; for people of moderate income, marriage penalty is eliminated

 big singles penalty again

 High-income people -- don't get the benefit of standard deduction, but do get benefit of wider 10%

and 15% bracket

 Low-income people -- EITC and marriage penalty was moderated, but by no means eliminated

 Innocent Spouse -- where there is an understatement of tax due to the omission of income or erroneous

deductions by one spouse and the "innocent" spouse did not and had no reason to know of the mistakes, the

innocent spouse is not responsible for the liability attributable to the errors. § 6015.

o the innocent spouse must show that he or she did not benefit from the omitted items









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o § 66 relieves a so-called innocent spouse from taxation on community income received but not

shared by the other spouse



ii. TREATMENT OF CHILDREN

a. Historical Treatment

Children used to be treated as separate.

 Got one standard deduction, personal exemption.

 Concern that the rich would hide income with their lower-bracketed kids, so in 1986, integrated children

more into family.



b. Treatment of Children Today

If parent can take exemption, child cannot -- even if parent is phased out or chooses not to take it. § 151

 If parent takes standard deduction, dependant has lower standard deduction

o §63(c)(5)(a) – standard deduction shall not exceed greater of $500 ($800 now) or the sum of $250

and such individual’s earned income.



§1(g) -- Kiddie tax. Net unearned income of children under 18 (23 if student) = taxed at parents top marginal rate

regardless of source

 net unearned income: allowed to tax twice the standard deduction at the child's rate

o net unearned income = unearned income - ($850 (standard deduction for dependent under

§63(c)(5)(A), indexed for inflation) + the greater of $850 (indexed amt.) or if kid itemizes, the

amount of itemized deductions directly connected to production of unearned income -- so, usually,

$1700)

o in most cases, unearened net income = 2 x Child's Standard Deduction ($850)

 under current law, can report 10x the standard deduction on child's earned income



iii. TREATMENT OF DIVORCE

§6013: permits a husband and wife to file joint income tax returns.

 §1.6013-4(a) provides that status as husband and wife under these sections is determined as of the lcose of

the year for two individuals having the same taxable year.

§7703: the determination of whether an individual is marries shall be made as of the close of his taxable year; except

that if his spouse dies during his taxable year such determination shall be made as of the time os such death.

 Thus, TP who marries on New Year’s eve is treated as having been married the entire year.

 In some circumstances, TP’s who are married for state law purposes are treated as if they were unmarried

for federal tax purposes (i.e. TP married to a nonresident alien can qualify for head of household.)

 Just like in other scenario’s sham transactions involving divorces will not be recognized as legitimate if the

divorce has no real economic substance other than the tax consequences.



a. Divorce and Property Settlements

Property settlements -- §1041 pure carryover basis: Recipient takes carryover basis in property equal to adjusted

basis of transferor (effectively treated as a gift). Transferee’s basis is carryover basis regardless of value of

transferred property (can transfer loss – unlike with a gift (§1015)).

 Under §1014: a transfer is treated as incident to divorce if it occurs w/n one year after the marriage ceased

or if it is related to the cessation of the marriage.

o Temp Reg. §1.1041-1T(b): transfer of property is treated as related to the cessation of the

marriage if it is made under a divorce or separation instrument and occurs not more than sic years

after the end of the marriage

o This is generally favorable to transferor’s b/c don’t recognize gain on the transfer. .



b. Alimony and Child Support

Alimony §71: permits payments (alimony or support obligations or property rights) to be treated as deductible

(above the line) so long as: (1) cash, not property or services; (2) not designated as nondeductible to payor and

nontaxable to payee; (3) parties do not live in same household; (4) no liability for any payment after death of payee;

and (5) payments do not constitute child support

 More favorable income tax regime than joint filing under marriage

 §215: Above the line deduction to payor, gross income to recipient





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o Therefore, it is a pro-taxpayer regime b/c two people taxed at individual rate of $50k each is lower

than one person who earned $100k

o Parties may elect to treat alimony payments as nondeductible to the payor and nontaxable to the

payee so that two parties will pay lowest total tax §71(b)(1)(B) – for lower bracket taxpayer who

makes payments to higher bracket recipient. Rare.

 Note: §71(f) – cannot front load alimony (make larger payments in early years). Tax consequences.

o ―Recapture‖ does not apply if annual alimony is less then $15K

 Payments are deductible as alimony only if made pursuant to a court decree or a written separation

agreement.

 Delinquent Payments:

o §71(c)(3): provides that delinquent payments by a former spouse are to be applied first against

past-due child support and then against past-due alimony. If payor fails to make payment, the

other spouse can’t take a bad debt deduction b/c she has not included the missing payments in

income, she has no basis, so not entitled to a deduction. Perry v. Commissioner.



Child support – Not income (not taxable) to payee, not deductible to payor.

 Need to distinguish payments designated for child support, which are non-deductible to the payor and non-

taxable to the payee, from alimony payments.

 §71(c): definition of child support: non-deductible child support is any amount that will be reduced (1)

upon the occurrence of events relating to the child specified in the divorce instrument, such as marriage,

graduation from school or attainment of a certain age or income level or (2) at a time ―clearly associated‖

with such an event.‖

 Incentive from payor’s point of view to recharacterize alimony as child support. Can’t do this.

 If alimony drops on certain life events (child’s marriage/graduation), then it is actually disguised child

support



B. Assignment of Income

Two basic principles:

1. Earned income is taxable to the person who earned it.

2. Income from property is taxable to the person who owns it.

Why is it important?

 b/c in progressive tax system, different rates create incentive to move income around



i. INCOME FROM SERVICES

a. Assignment of Earned Income

Earned income is taxed to the person who earned it.

 In general, income from services cannot be assigned to another entity

 Principle helps preserve the progressive tax system.



Lucas v. Earl (U.S. 1930) -- taxpayer entered into agreement prior to marriage to split all income and property with

wife as joint-tenants; results were that she was taxed at lower rate (though, not for tax avoidance purposes)

 taxpayer prevented from assigning earned income to those whose services did not produce the income

o don’t want people just assigning income to lower bracket

 "fruits must be attributed to tree from which grew"

 this particular case has been overturned by joint-filing, but the doctrine of the case (he who earns income is

taxed on it) is still very much good law



Other Assignments of Earned Income

Armantrout v. Commissioner (7th Cir. 1978) -- corporation set up Educo trust fund which paid for employers’

children for education purposes; siphoning wages of employers; IRS wanted to call this compensation, though

employees said was not

 can’t do anticipatory arrangements to avoid taxation

 income to parents when paid from trust to children

 not taxable immediately b/c until paid out to kids, substantial risk of forfeiture

 employer gets benefit of deferral







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 Why not a tax-free scholarship?

 Scholarship cannot be a quid pro quo, and here seems money is exchange for services.

 money is really going to parent, not student

 Could this be set up in a tax-free way under current law?

 §127 – educational assistance program – up to §5,250 of compensation

 But only works for employee?? Not clear (Shuldiner doesn’t know.)

 See also Saunders v. Commissioner (5th Cir. 1983) -- after Armantrout, tried to characterize educational

payments as loans; court rejected argument b/c of lack of valid debtor-creditor relationship,l generous

forgiveness of loan clauses, restriction on recipients (only went to the taxpayer, as majority shareholder and

physician), and the fact that the plan was revised after Armantrout

 Teschner v. Commissioner (TC 1962) -- contest limited to children under 17, child is designated as winner

of contest if father's entry wins, child wins and tax is attributed to child -- man could never have won prize

himself



Who is the Earner?

 Hundley v. Commissioner (TC 1967) -- payments made from signing bonus to baseball player's father

were not income to baseball player b/c was reasonable compensation for coaching and acting as agent in

contract negotiations

o amount payed to father was required to be included in taxpayers gross income, but taxpayer was

entitled to a § 162 business expense deduction of that amount

o but see Allen v. Commissioner (3d Cir. 1969) -- bonus payments to mother not deductible b/c she

had not performed any role in coaching or financial management of son's career

 US v Scott (7th Cir. 1981) -- payments made by businessman to future wife of Attorney General were

characterized as payments made to A.G. b/c jury could reasonably find that such payments were motivated

by Scott's office or in anticipation of services to be rendered



b. Agency Theory: Charities and Other "Unique Factual Situations"

"agency" theory -- where an employee performs services, is paid directly, and turns the funds over to the employer,

the employee is not taxed b/c she is an agent of the employer

 Rev. Rul. 74-581 -- though general rule is that a "taxpayer's anticipatory assignment of a right to income

derived from the ownership of property will not be effective to redirect that income to the assignee for tax

purposes," amounts that would otherwise be deemed income are not, in certain unique factual situations,

subject to the broad rule of inclusion in § 61

o in this case, amounts received for services performed by a faculty member or a student of a law

school under clinical programs and turned over to the university are not includible in the

recipient's income

Agency Theory and Religious Orders -- Rev. Rul. 76-323 -- rule does not apply to members of religious orders

who have taken vows of poverty; the members of the order are not acting as agents and must include payments

received in gross income

 are, however, allowed a charitable deduction to the extent allowable under § 170

 But see Rev. Rul. 79-132 -- the reverse if it appears from all facts and circumstances that payor of income

is looking to the religious order, and not the individual member, for the services

 a set of controversial ruling that are not easily applied



ii. INCOME FROM PROPERTY

General rule is that income from property is taxed to the owner

 Gift of property serves to shift income from the property to the transferee, but a gift of the income of

property, however, does not shift the tax



Blair v. Commissioner (US 1937): Blair has life interest in trust created by father; assigned $9k in interest (entire

property interest) during his life to his children

 As long as property assignable and has been assigned w/o reservation, assignee becomes beneficiary entitled

to all rights and is taxpayer on that income

 Court concludes valid -- considered income to assignee children

 while he is assigning fractions of what he owns to each individual child, he has ultimately

transferred all that he has -- not just streams of income.





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 Is a good transfer because he has nothing else left.



Current law: grant and trust provisions 671-79

o cannot have power to select beneficiary

o cannot deal with trust

o missed this one

o reversionary interest cannot be more than 10%



Helvering v. Horst (US 1940): Horst has coupon bond and gives to coupons to child; kept principal; only gave away

interest income (fruit, not tree); taxable to Horst

 Holder of a coupon bond is the owner of two independent and separable rights: 1) right to receive principal

of bond upon maturity and 2) right to receive interest payments in the amounts and on days specified by

coupons

o respondent had legal right to demand payment at maturity of the coupon interest and the power to

command that payment to others

o merely diverting payment of that coupon interest while holding the bond itself

o thus, retains control of the property and thus is taxable upon interest resulting from the property

 The realization event they are referring to is the giving of the gift AND then the resulting payment (not

simply the giving of the gift)

 General rule (Ripe Fruit): if you have interest that is already accrued, much more likely to tax on the

interest

o the extra-certainty of payment makes a difference in the law in this area; the more likely the

payment is to occur before disposition, the more likely it will be taxed to the donee

 Particular holding overruled by §1286 -- where a taxpayer disposes of unmatured coupons or the naked

bond, the basis of the bond is allocated bet. the retained portion and the portion sold

o the coupon and bond itself are distinguishable pieces of separate rights to different revenue

streams/income



Summary:

DEDUCTIONS



FROM GROSS INCOME FROM ADJUSTED GROSS INCOME

(ABOVE THE LINE) (BELOW THE LINE)



 Trade or business deduction  Standard Deduction

OR

 Reimbursed expenses of employees  Medical Expenses



 Capital Losses  Charitable Contributions



 Deduction from sale or exchange of  Casualty and theft losses

property



 Deductible ―nonbusiness‖ expenses related  ―Nonbusiness‖ expenses for property held

to rent of royalty income for the production of income



 Alimony  ―Nonbusiness‖ expenses—expenses of a

tax-related matter

 Moving expenses

 Other ―miscellaneous itemized deductions‖

 Interest on educational loans

 Home mortgage interest

 Contributions to Conventional IRA’s









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V. CAPITAL GAINS & LOSSES



A. Generally and Hisorical Treatment

i. GENERALLY

All gains and losses are categorized into two classes:

i. Capital

ii. Ordinary

 Taxpayers generally prefer capital gains, because they are often taxed at lower rates (currently 15%); but

 they prefer ordinary losses, which are deductible in full from ordinary income while capital losses generally

are deductible only...

o to the extent of capital gains, plus

o a limited amount of ordinary income (currently $3,000)



Table of Tax Rates on Capital Gains

5% Assets held for more than one year if otherwise taxable at 10-15%

10% If taxpayer is otherwise in the 10% bracket,

 Assets held for one year or less

 Gain to the extent of depreciation on real estate held for more than one year

 Gain on collectibles

 Gain on small business stock (§ 1202) after 50% exclusion

15% If taxpayer is otherwise in the 15% bracket,

 Assets held for one year or less

 Gain to the extent of depreciation on real estate held for more than one year

 Gain on collectibles

 Gain on small business stock (§ 1202) after 50% exclusion

15% Assets held for more than one year if taxpayer is otherwise taxable at 25% or higher rate

25% Gain to the extent of depreciation on real estate held for more than one year if the taxpayer is

otherwise taxable at 25%

25% If the taxpayer is otherwise taxable at 25% rate,

 Gain on collectibles

 Gain on small business stock (§ 1202) after 50% exclusion

25% Top rate on unrecaptured § 1250 gains

28% Gain on collectibles held for more than one year if the taxpayer is otherwise taxable at 28% or

higher rate

28% Gain on small business stock (§ 1202) after 50% exclusion if the taxpayer is otherwise taxable at

28% or higher rate



In the Code

 § 1001 – taxed on gain and loss from sale or disposition of an asset (both capital and ordinary) (broad

language)

 Congress requires that transaction meet three conditions:

a. the transaction must involve "property" that is a "capital asset"

b. the property must be transferred in a "sale or exchange"

c. the minimum holding period must be met

 Thus, for capital gain, need a sale or exchange of a capital asset held for the at least the minimum

holding period

 § 1(h) – net capital gain requirement -- 15% rate if you would be 25% or above; 5% if you would

be taxed below 25%

 § 1222(11) – defines net capital gain

 § 1222 -- requires sale or exchange

 So to get preferential rate under § 1h, must have a sale or exchange under § 1222

 Ex. If I have stock and get a dividend, there is just ordinary income







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 stock may be a capital asset, but, since there was no sale or exchange, there is no

a capital gain

 § 1211 and § 1212 penalize capital losses

 § 1211 – losses from sale or exchange of a capital asset.

 § 1212 – detail capital loss carryback and carryover provisions

 § 1221–capital asset defined – see below



ii. POLICY



Policy Arguments Re: Preferential Treatment of Capital Gains

Arguments in favor of preferential treatment:

General Argument Why a Problem Explanation Critic’s Response

Capital gains are not Capital gains are non- Progressive tax should Narrow view of

income recurring be imposed only on income – rejected in

recurring items and Glenshaw Glass;

should exclude problem because then

extraordinary gains income tax wouldn’t

and windfalls reflect ability to pay

Capital gains simply Capital gain due to But person is better off

reflect changes in interest interest rate compared to a person

rates fluctuations do not who has not enjoyed

make a person the same gain – more

economically better purchasing power

off

Bunching Sale of a big asset for a Lower tax rate splits Most taxpayers have

relatively low-bracket the difference; makes capital gains year after

taxpayer can result in tax rate closer to year; could solve

incorrect tax treatment regular income rate for problem for one-time

lower-bracket taxpayer seller with an

averaging mechanism

Inflation Capital gains often do not Lower tax rate is a But the right solution

Note: Graetz says bigger reflect actual changes in crude solution for the is to index basis

problem for longer-held wealth but are merely due fact that a certain

assets, but Shuldiner says to inflation portion of all gains is

the opposite is true, due to inflation

because real gains are a

higher % of total gains

for longer-held assets

Lock-in effect Right to defer gain can Preferential rate It’s unclear how big

mean people hold onto reduces tax barriers this loss is, but a major

assets even when they and shifts incentives source of the problem

would rather sell back to economically- is step-up basis at

motivated choices death

Arguments against:

 A dollar of capital gain is the same as any other dollar of economic gain

 The preferential treatment of capital gains is a great source of income tax complexity

 Capital gains preference creates too much inequity and too little "bang for the buck"



iii. HISTORICAL TREATMENT

Historically there has been a preference for capital gains (with brief hiatuses), though the means of giving preference

has fluctuated wildly

 percentage exclusion until 1986—got ordinary rate on 40% of your capital gains.

o capital gains exclusion was good for everyone (contrast with rate cap).

 1986—took off preferential treatment as a trade to get marginal rates low.

o However, capped capital gains rate at 28% (effective rate was 33%).







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 At the time that was the top marginal rate, so no preference, but as marginal rates crept

up, capital gains rate remained at 28% and preference increased.

o Note that this rate cap is of no use to low-bracket taxpayers (contrast with exclusion)

 1997 – decision to reintroduce capital gains rate in current §1(h)

o extraordinarily complex provision.

o major changes in 2003, that are due to be repealed in 2009



B. Mechanics of Capital Gains

The Long-Term/Short-Term Distinction

Capital gains and losses are subdivided into two classes:

i. Short-term

ii. Long-term



Holding period – the dividing line between short-term and long-term capital gains (currently 12 months)

 Holding period requirement fluctuates -- was recently 6 months, has been as much as 18 months and up

 § 1223 – holding period of property – provides a set of tacking rules whereby can add holding periods

across assets or people

o tacking -- give property to my son after 9 months, he holds for three months, but can count my 9

months in his total – he has 1 year.

o Basically happens in carryover type provisions – where basis is carried over

§ 1h requires net capital gain for preferential rate

 § 1222 – net capital gain defined in essence as net long term capital gain

o long term -- gain from sale or exchange of assets held for longer than one year.



Basic Netting Rules (§1222)

Two stage process:

 First establish net short-term gain or loss and net long-term gain or loss

o Net short-term gains against short-term losses.

 If short-term gains exceed short-term losses, there is a net short-term gain. § 1222(5).

 If short-term losses are greater, there is a net short-term loss. § 1222(6).

o Net long-term gains and losses in the same way

 Second, short-term gain or loss is then netted against long-term gain or loss.

o If net short-term capital gains exceed net long-term capital losses, the excess short-term gain is

taxable in full as ordinary income.

o If net long-term capital gain exceeds the net short-term capital loss, the excess (―net capital

gain") is taxed at the preferential capital gains rate.

o When taxpayer has both net short-term gain and net long-term gain,

 Net short-term gain is taxed in full as ordinary income, and

 Net long-term gain ("net capital gain") is subject to the favorable rate.

o Where losses exceed gains, excess capital loss offsets up to $3,000 ordinary income each taxable

year.

 Any excess not allowed in one year is carried forward indefinitely. §1212(b)(2)

 Losses carried forward keep their short-term/long-term character



C. What is a Capital Asset?

i. GENERALLY

a. The General Problem

The exclusions of § 1221 are intended to produce ordinary income treatment for proceeds from everyday

business activities and from personal labor and capital gains treatment for investment gains

 taxpayers have exerted great effort to structure transactions to avoid the exclusions and obtain the favorable

capital gains rate

 as a result, courts have construed the exclusions broadly (in some cases, expanding beyond the statutory

language)

o such broad interpretations have then been used by other taxpayers to obtain ordinary treatment on

transactions that might otherwise qualify as a capital asset under a narrower reading of the statute







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Problem areas:

 rental and sale mix (Malat, etc.)

 real estate holdings (Bramblett, etc.)

 securities



b. In the Code

§ 1221: defines capital asset broadly to include all "property held by taxpayers (whether or not connected with a

trade or business)" w/certain exceptions:

 § 1221(a)(1): inventory, or property held primarily for sale to customers in ordinary course of trade or

business

 § 1221(a)(2): property, used in trade or business, which is entitled to depreciation under §167 or is real

property

 § 1221(a)(3): copyright, literary, musical, artistic composition, letter or memo held by taxpayer who

created it, taxpayer for whom created if letter or memo, or taxpayer in whose hands basis is determined

 § 1221(a)(4): accts or notes receivable from ordinary course of trade or business

 § 1221(a)(5): U.S. gov’t publication

 § 1221(a)(6): any commodities derivative financial instrument

 § 1221(a)(7): any hedging transaction which is clearly identified as such on date on which acquired

 § 1221(a)(8): supplies of type regularly used or consumed by taxpayer in ordinary course of trade or

business



ii. PROPERTY HELD FOR SALE TO CUSTOMERS (§ 1221(a)(1))

§ 1221(a)(1) exempts from the defiintion of capital assets "inventory or property held primarily for sale to

customers in ordinary course of trade or business"

 § 1231(b)(1)(B) likewise excludes such assets from § 1231 treatment

 Thus, if I ―deal‖ in some good or property, I’ll get ordinary gain or loss and not capital treatment on any

sale or exchange from that good or property

o but applies only if I am engaged in a trade or business that ordinarily sells the property in

question

 In the cases, three issues predominate:

o Whether the nature of the taxpayer's dealings in property classify the taxpayer as a dealer who is

holding the property primarily for sale to customers in the ordinary course of business

o When the taxpayer acquired the property for business but then changed her purpose, whether the

change resulted in her being treated as a dealer

o Where the taxpayer has a dual purpose (e.g. to see or to rent, or to hold for appreciation or sell to

customers) or no set purpose other than money-making, which purpose controls?



Stocks and Securities -- Distinguishing Between Dealers, Traders, and Investors

 Dealer – in it for dealer markup, not long term gain. Ordinary income (not capital).

 Key element: dealers have customers

 purchase and sell for profit, not to speculate

 inventory of goods; relationship to customers and suppliers

 Mark-to-Market Rules -- §475 – dealers are taxed without regard to realization

 Problem: Investment portfolio, held for investment, can dealer get capital gains for this?

Yes.

 Causes problems, dealer can say will bought stock for investment where have a

gain and bought for business where have a loss.

 How do we solve this? Marked to market – taxed without regard to realization

 Once identified as investment; can’t change your mind. §475 has this rule.

 Not subject to §163(d)

 See also §1236 (allowing securities dealers to receive capital gains treatment on securities

they earmark as investment assets)

 Active Traders – may be so active that rise to level of trade or business. Looking for short term swings.

o Courts say are in a trade or business, but have no customers (statute says you need customers).

 b/c no customers, gains and losses are capital







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 would rather be ordinary if have losses or have short-term holding period

o Can opt into market to market treatment under §475

o Not subject to §163(d)

 not there for profit, but there for swings in market

 Investor – not in trade/business, no customers. Capital Gains and Losses. Get realization (not market to

market).

 Subject to §163(d)

Identification of Asset

 A financial firm may have all three types of activity - dealer desk, trading desk, and investment portfolio:

these are all treated differently tax-wise. But, investment branches might just give losses to dealer branches

to get ordinary loss.

o § 1236: To combat this, you must commit whether this is (1) an investment activity or (2)

business activity not allowed to take CG rates, at the outset.

o If dealer activity in business, then not CG, but if investment then CG rates apply. If never identify,

then ordinary losses can never be taken.



iii. MIXED SALE-RENTAL



Malat v. Riddell (US 1966)

Facts -- Taxpayer bought land and was going to build apt bldg to rent; would have been capital under § 1221(a),

but plans changed and sold off some parcels, so ordinary income; later sold rest of it and claimed capital b/c

claimed primary purpose was to hold for investment in apt bldg; selling remainder of land terminates joint venture

so not in ordinary course of business

 turns on meaning of primary; taxpayer’s primary motivation is key in determining whether should get

preferential rate

 IRS argues it was dual purpose; wants "primary" to mean "substantial purpose "

Holding -- The word "primarily" in 1221(a)(1) means "of first importance" or "principally," and not just

"substantial;" a "plain-meaning" reading

 purpose of §1221(a)(1) exclusion is to distinguish profits and losses "arising from the everyday operation

of a business" from those resulting from changes in "value accrued over a substantial period of time"

o in mixed-motive case (dual purpose context) must look at primary motivation to determine

whether is held for sale to customers.



Commentators hoped Malat would clarify the primary purpose issue.

 It did not because courts creatively sidestepped the rule.

Ways around Malat:

 look at motive/purpose at time of sale; will pretty much always come out as ordinary as it is tautological

that at the time of sale, the purpose is sale.

o See Continental Can Co. v. U.S. (Ct.Cl. 1970, U.S. 1970) -- made can processing machinery. Had

been rented out for 20 years and now had to sell something. Court said because are selling today,

is held for sale to customers – ordinary, not capital. Even though yesterday was not held for sale.

 "where there is a change of purpose, primary purpose is intention at the date of sale"

o See also Bynum v. Commissioner (TC 1966) (finding ordinary uncome in a real estate case and

noting, "We are not dealing with ... a dual purpose as concerned the Supreme Court in Malat, but

with a change in purpose...").

 Bifurcation of business – could say there are two businesses -- one that rents, one that sells; and sale will

always be of first importance to the sales business

o International Shoe Machine Corp. v U.S. (1st Cir. 1974) -- corporation rents out shoe-making

equipment; forced to sell some of machines; selling machines considered ordinary income under

ordinary course of business

 sales to customers were an ongoing and regular part of the business even though the

taxpayer's major source was rental of machines, and sales accounted for only 7 and 2

percent of gross revenues in the years a issue

o See also Rev Rul 80-37 -- requiring ordinary income treatment for sales of equipment to leasing

customers by a taxpayer who is "regularly engaged in the dual business of renting and selling such

equipment"





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 Ordinary course? Or exceptional or liquidation sale?

o courts seem more willing to allow capital gains treatment on sales of real estate where taxpayer

can establish that he subdivided his land merely to liquidate his investment more profitably



Bramblett v. Commissioner (5th Cir. 1992)

Facts: four men created Mesquite East and Town East, with Mesquite East a partnership purchasing land for

investment purposes, and Town East a corporation that developed land. The tax commissioner considered activities

by Mesquite East to be not CG b/c they were in the business of selling land to customers (and not primarily an

investment), and instead were ordinary gains.

 IRS's argument: partnership is 1) engaged in business of land speculation, 2) corporation was acting as the

agent of the partnership; and 3) ignore corporation and attribute all activities to the partnership

Holding: With regard to real estate, subjective factors (most importantly those of frequency or substantiality) will

determine taxpayer's relation to the trade or business, whether the asset is held primarily for sale in that business, and

the ordinariness of the sales in that course of business.

 The questions are sometimes subdivided into:

1. was he engaged in trade or business?

2. was the asset held primarily for sale in that business?

3. were sales ordinary in that course of business?

***court is not clear which question it is asking***

 Important considerations in answering these questions (the "Seven Pillars of Capital Gains")

1. Nature and purposes of the acquisition or the property and the duration of the ownership

2. The extent and nature of the taxpayer’s efforts to sell the property

3. The number, extent, continuity and substantiality of the sales

 frequency and substantiality of the sales is the most important factor

 But see, Byram (22 parcels over 3 years)

4. The extent of subdividing, developing, and advertising to increase sales (which hints towards

business-related)

5. The use of a business office for the sale of the property (which hints towards business-related)

6. The character and degree of supervision or control exercised by the taxpayer over any

representative selling the property, and

7. The time and effort the taxpayer habitually devoted to the sales

 Mesquite’s primary purpose was to purchase property for investment purposes

 Other Questions:

 Was corporation merely acting as agent of partnership?

 Court says will not assume agency simply because there is control.

 corporation must be acting like an agent – get agent’s fee, have legal authority to bind the

partnership, act in its name…none of these existed in this case

 When does form control over substance?

 Cites Frank Lyon – when the structure has genuine economic substance, is compelled or

encouraged by business or regulatory reality, and is not shaped by solely tax avoidance

motives. Justification here is desire for limited liability for development activities.

 Court won’t say this is a sham.

 Could look at the question in the other way to ask why the partnership makes

sense here.

 Shuldiner says there is no reason.



D. Depreciable Property and Recapture

***Shuldiner stresses not to sweat the details here – just get general idea***



i. DEPRECIABLE PERSONAL AND REAL PROPERTY USED IN A TRADE OR BUSINESS (§ 1231)

 § 1231: Although § 1221(a)(2) would suggest that disposition of personal or real property generates

ordinary income or loss, § 1231 allows real and depreciable property used in trade/business to yield capital

gain when disposed of at gain (held at least one yr) and ordinary loss when disposed of at loss (best of both

worlds); creates a generally favorable regime for casualty losses.

o 3 types of dispositions that may give rise to § 1231 treatment:







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1. gain/loss from sales and exchanges of property used in trade or business;

2. gain or loss arising from condemnations and involuntary conversions (i.e. casualty or

theft losses) of property used in trade or business; and

3. gain or loss from condemnations or involuntary conversions of capital assets held in

business

o §1231 requires 2-stage netting process:

1. "Firepot" -- taxpayer nets gains from casualty and theft losses (e.g. insurance) against

losses from such involuntary conversions

 if losses exceed gains, § 1231 does not apply either to losses or gains (deemed

no sale or exchange), and the losses are deductible from ordinary income

 if gains exceed losses, both gains and losses carried over to second stage of

netting process. § 1231(a)(4).

2. "Hotchpot" -- taxpayer compares total gains w/total losses from involuntary conversions

carried over from first stage ―firepot,‖ and condemnations and sales/exchanges of

business property

 if losses exceed gains, gains includible in ordinary income and losses deductible

from ordinary income

 if gains exceed losses, gains treated as long-term capital gains and losses treated

as long-term capital losses; carried over to tax return combined w/long-term

capital gains and long-term capital losses from other sources. § 1231(a)(1), (2),

& (3).

 If net gain for all §1231 property, gains and losses are capital

 If net loss for all §1231 property, gains and losses are ordinary

o § 1231 only applies to sales of business property (real property or property subject to depreciation)

that is held for more than one year

 includes timber, coal, certain livestock, equipment, minerals, and unharvested crops sold

with the land

 note recapture rules in § 1231(c) -- an attempt to stop taxpayers from getting the benefit of taking gains and

losses in separate years and thus gaming the system



ii. RECAPTURE PROVISIONS

The Problem: In an ideal world, depreciation would measure the actual decline in value of an asset, and thus a

taxpayer's basis at disposition would be FMV and a sale would not produce a gain or a loss

 But, because current depreciation rules make no real attempt to accurately measure decline in value, a

taxpayer may realize a gain or loss at disposition

 If the taxpayer were able to enjoy depreciation deductions (offsetting OI) and obtain capital gain treatment

at sale (via § 1231), she would be able to convert ordinary income into capital gain

§1245 – Personal Property -- enacted to prohibit conversion of ordinary income into capital gain on sale of

depreciable property by requiring recapture of previously deducted depreciation as ordinary income; property

subject to § 1245 is generally tangible personal property

 ordinary gain reported "pays back" excess depreciation, although taxpayer has enjoyed time value of earlier

depreciation deductions

o if any depreciable property is sold for more than adjusted basis, any gain not exceeding total

depreciation allowed is taxed as ordinary income

o also recaptures as ordinary income amounts deducted under § 179 in lieu of depreciation,

amortization deductions (such as those under § 197), and other deductions under §§ 190 or 193.

o The amount of ordinary income = (the lower of the recomputed basis (adjusted basis plus

deductions for depreciation or amoritzation) or the AR (for sales) or FMV (for transactions other

than sales)) – adjusted basis in the property

 Gain will be treated as ordinary income to the extent of total depreciation

deductions taken on the property; excess receives preferential capital gains

treatment

 A way of dealing with problem of accelerated deduction

 Recapture does not apply to certain transactions that are otherwise tax-free, including transfers by gift and

at death - §1245(b)(1), (2)









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 For like-kind exchanges, recapture is the amount of the gain recognized plus the FMV of any non-1245

property received that is not boot



Recapture Rule Mechanics (§1245)

Bought truck for $100,000; depreciated $15,000; adj. basis $85,000

Sell for $70,000 Sell for $90,000 Sell for $105,000

Loss of $15,000; § 1221(a)(2) Gain of $5,000; § 1221 says Gain of $20,000; § 1221 says

says ordinary ordinary ordinary

§ 1231 says ordinary § 1231 says capital gain § 1231 says capital gain

No recapture rules apply § 1245 recaptures the gain as § 1245 recaptures $15,000 of the

ordinary because you took too gain as ordinary (too much

much depreciation depreciation); $5,000 at capital

gains rate



§ 1250 -- Real Property -- recapture provision for real property; works similarly to 1245. Only recapture to the

amount of straight line depreciation and treat as ordinary income, and anything above this is capital gains.

 BUT, since for real property we only allow for straight line depreciation, this provision has no real effect

 However – still a partial recapture scheme -- gain up to the amount of depreciation allowed on real property

held for more than 12 months is taxed at a special capital gains rate of 25%. 1(h)

o this is more advantageous than taxing gain at ordinary rates, which can be as high as 35%, but is

not as beneficial as usual capital gains rate of 15%.



E. Derivatives, Hedges, and Supplies

i. DEFINITION/EXAMPLE OF HEDGING

Hedging: a risk management technique widely used by businesses to reduce or eliminate certain risks (such as

fluctuations in commodity prices, the relative value of different currencies, or interest rates)

 Short hedge -- attempt to lock in the price of a commodity by going into futures market and locking in a

price to sell commodity at that price in the future

o if the price is what you expected, no effect

o if higher, can sell at contractual price or sell at market price and pay money to close out contract

 Long hedge -- the buyer side of a short hedge.

Businesses use hedges to reduce risk of price fluctuation or selling right to buy fixed amounts of underlying product

at fixed price on certain date; hedging legitimate form of business insurance

o Ex. Farmer expects to have 10K bushels of corn in august, but now its June. In commodities

markets, it says that August rates will be this. If enter contract, then are set at that price, and

reduces risk. If don’t, then subject to risk of what the real price on the spot market. With the

forward contract, can use that price to sell, otherwise would have to use spot market prices (which

may be higher or lower).

 Don’t have to deliver under the contract – so can close out that forward contract for the

difference b/t the spot and commodity market price – this is the value of that contract.

 Prices: cost is 2.00, commodity market price is 2.35, spot market is 1.80. So sell

commodity contract for .55, have a .2 loss b/c now must sell on spot market, thus .35

profit.

 Tax Consequences: .20 loss would be ordinary loss; .55 gain from forward contract is CG

(could have just sold under commodity market contract and get .35 ordinary gain, but

more advantageous to do this since the .35 gain is CG)



ii. THE PROBLEM: TRUE HEDGE OR IMPERFECT HEDGE?

 Responded to by IRS stating that this is all ordinary income: no one challenged this originally, then courts

started saying that true hedges (hedge on same product that you produce) couldn’t use CG rates, but

imperfect hedges could have CG treatment (hedge on another product than what you produce)

o So what is a true hedge?

 Corn Products and Arkansas Best answer this question…



Corn Products Refining Co. v. Commissioner (US1955) – if hedge integral to business activity of the company,







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then treated as ordinary

Facts: CP was a producer of corn-related products, but the price of corn dropped significantly, and b/c of small

storage areas, CP decided to hedge against future problems like this by hedging in corn futures. CP would take

delivery on such contracts as it found necessary to its manufacturing operations and sell the remainder in early

summer if no shortage was imminent. If shortages appeared, it only sold futures as it bought spot corn for grinding:

this eliminated any risk in increases in spot corn, but did nothing to protect against price declines.

 2 arguments: Narrow hedge (did not protect against decline in prices, only price increase), not a

true hedge, or, in the alternative, were just legitimate capitalists/speculators, and hedging doctrine

did not apply.

Holding: if the hedge was directly related/integral to the business/manufacturing activity of the business, then the

purpose of securing the hedge was business related, hence it is treated as ordinary

 Court held that this was a true hedge and given ordinary income treatment

o Hedging was directly related to the manufacturing activity, and was a vital part of it – it was done

to protect manufacturing costs and secure enough corn to meet the actual need for production

o Doesn’t matter that hedge didn’t protect against decline in prices (imperfect hedge), since CP was

mostly concerned with rises in prices

 partial insurance is better than none; treats it like a true hedge; ordinary income

 Court's Reasoning -- since this section is an exception, the definition must be narrowly applied and

exclusions interpreted broadly

o Problem was the language used by court: ―integral part of business‖ meant that it was ordinary

hedge, which is broad

o created a lot of litigation; mostly factual

 Subsequently this case was used to show that ordinary losses were applicable, but seldom used to show that

ordinary gains were applicable: Arkansas Best limited the applicability of Corn Products



iii. THE SOLUTION: ARKANSAS BEST & 1221(a)(7)



Arkansas Best Corp. v. Commissioner (US 1988) – only hedging transactions that are an integral part of the

business’ inventory-purchase system fall under the exception of §1221

Facts: AB was a holding company that purchased a large portion of a bank allegedly because they wanted to protect

its business reputation and thus connected to its trade or business. This bank then went into financial distress, and

AB sold the bank stock at a large loss. AB claimed an ordinary loss of almost $10m.

Holding: Corn Products should be narrowly held to only stand for the proposition that hedging transactions that are

an integral part of a business’ inventory-purchase system fall within the inventory exclusion of §1221; reads Corn

Products as simply a broad reading of inventory exception.

 A taxpayer’s motivation in purchasing an asset (such as whether integral to business activity) is irrelevant

to the question whether the asset is ―property held by a taxpayer (whether or not connected with his

business)‖

 the asset was not an exclusion enumerated in §1221, and thus is treated as a capital asset, and should be

given such loss treatment

o to treat the statute in any other way renders the statute meaningless

o throws out about 30 years of doctrine



§1221(a)(7)

There are many other hedges other than inventory hedges: service took a narrow position

 long-hedges are capital; and short-hedges are ordinary? § 1221(a)(7)

 Regulations Issued to Clear up confusion: Hedges of ordinary items are treated as ordinary. 1.446-4 --

abolishes realization requirement w/r/t hedges, timing of hedge has to match thing you are hedging

o hedging inventory -- part of inventory

o hedging debt -- it's debt

o hedging of capital items raises issues (see Straddles)

 See Circle K: bought gas company b/c wanted source of supply for convenience store.

Had loss in stock in gas company, wanted to take ordinary loss, since it was inventory-

related.

 Ct. ruled that, yes, purchase of interest in a gas company was inventory.







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 IRS settled rather than accept the ruling -- did not want to have a ruling that said

stock, which is normally a capital asset to non-dealers, could be inventory

 1221 amended to codify the hedging regulations

o chicken feed, jet fuel, etc. get ordinary treatment

§§1256, 1092:

 corn future: enter into 2 contracts, one to buy corn, one to sell corn. No economic risk since they offset, but

this will generate a gain & loss. In Dec., take loss, then sell gain in January. This allows taxpayer to wipe

out capital gain, and maybe ordinary income. These were a big problem and were often marketed to people.

 The response to this problem:

o §1092: says that if have gain in offsetting position, then can’t take loss – loss is deferred

 (e) hedges eligible for ordinary treatment under §1221 are not subject to this rule

o §1256: takes the gain now – the loss and gain are taxed concurrently. If buying regulated futures

contract, they are marked to market: 60% long-term CG, 40% short-term CG (no market problem

with these futures since they are on a market)

 (e) hedges eligible for ordinary treatment under §1221 are not subject to mark to market

rules

o Straddle: offsetting positions with respect to personal property

o Hedges are also not subject to capital loss limitations since they are not capital: so aren’t they the

perfect investment?

 There is a second set of hedging regulations: 1446 which requires matching of gain/loss

with that which you are hedging (an accounting rule)



F. Nonrecognition Events

Nonrecognition transactions are those where the sale, exchange or disposition of property is not recognized

 recognition is usually postponed until the investment is significantly altered;

 the basis of the property disposed of becomes the basis of the property acquired, thus preserving the gain or

loss

o this deferral is very valuable



i. LIKE-KIND EXCHANGES

§1031: no gain or loss is recognized when certain property held for productive use in a trade or business or for

investment is exchanged for property ―of a like kind‖

 These are realization events but they are not taxed

 Not for personal use property. Only for businesses or investment

 If you swap with someone who does not use the property for productive use, you still get the treatment if

you use your property for productive use, but they don’t get the treatment

Types of Property Involved

 ―of a like kind‖ is easy for real property, but not for other types

o Applies primarily to land. All real estate considered like kind

o Ex: swap apartment building with another similar one: no gain or loss

 Generally financial instruments (stocks, bonds, inventory, securities) are excluded from this like-kind rule

o Limitations: §1031(a)(2): like-kind exchanges disallowed for:

 (1) stocks/bonds;

 (2) certificates of trust;

 (3) other securities;

 (4) partnership interests;

 (5) inventory;

 (6) other property held primarily for sale

The Boot

 §1031(b): Boot -- if in exchange, in addition to like-kind property, get property which is not similar (called

the "boot") realized gain is recognized to extent of boot (transferred basis in new property decreased by any

$ received and increased by any gain recognized)

o boot = cash or non-qualifying property









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Effect on Basis

 §1031(d): Basis of property disposed of becomes basis of property acquired and is decreased by any $

received and increased by any gain recognized

o Old basis – Cash + (Gain (recognized) - Loss) = new basis

o Process for basis post-transfer:

 Old basis, less FMV of boot received, plus gain recognized (gain recognized on

boot),

 less loss recognized on transaction (when the boot you transfer has FMV less than

its adjusted basis),

 plus boot paid,

 plus amount of mortgage assumed by you that was formerly on other property (if

both properties encumbered with mortgages, then cancel out and treat remaining

like above)

 * if non-cash, non-like-kind property also transferred, then allocate basis of non-

like-kind property completely to reach right answer (i.e., original basis)

 A deferral of gain, rather than an exclusion, so want to retain original basis – this is the process by which

the Code achieves that





Like-Kind Exchange & Boot Basis Example

Whiteacre Blackacre Basis Calculation (Want to Retain Original Basis)

FMV $100,000 $70,000 LK Old Basis = 20,000

Basis $20,000 $10,000 Cash + Gain = 30,000

$20,000 Non-LK - Loss = $0

- Cash = $10,000

Interim Basis = $40,000

Allocated Basis to Non-LK= $20,000

New Basis in LK = $20,000









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I. INTRODUCTION .................................................................................................................................................. 3

A. FIVE STEPS OF COMPUTATION OF INCOME TAX LIABILITY ........................................................................................ 3

B. INTRODUCTION TO TAX TERMINOLOGY AND THEMES ................................................................................................ 4

i. Terminology and Definitions ..........................................................................................................................................4

ii. Equity, Efficiency, and Similarity.................................................................................................................................5

II. INCOME & EXCLUSIONS FROM INCOME .................................................................................................... 6

A. INCOME GENERALLY .......................................................................................................................................................... 6

i. Definitions of Income ..........................................................................................................................................................6

B. FRINGE BENEFITS .............................................................................................................................................................. 7

i. Fringe Benefits Generally .................................................................................................................................................7

a. Definition of Fringe Benefits .................................................................................................................................................................... 7

b. Problems with Fringe Benefits ............................................................................................................................................................... 7

c. Code Provisions .............................................................................................................................................................................................. 7

ii. Work-Related Fringe .........................................................................................................................................................8

iii. Meals and Lodging ............................................................................................................................................................9

a. Meals .................................................................................................................................................................................................................... 9

b. Lodging ............................................................................................................................................................................................................. 10

iv. Section 83 – Property Transferred for Performance of Services .............................................................. 10

C. INTEREST-FREE LOANS ................................................................................................................................................... 11

i. Treatment of Loans Generally ..................................................................................................................................... 11

ii. Exception for Low-Interest or Interest Free Loans (§ 7872) ....................................................................... 11

iii. Exceptions to the Exception....................................................................................................................................... 12

D. IMPUTED INCOME ............................................................................................................................................................ 12

E. GIFTS AND BEQUESTS ...................................................................................................................................................... 13

i. Gifts and Bequests Generally........................................................................................................................................ 13









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