Income Tax Vocabulary
Adjusted Gross Income.
“Above the Line” Deductions.
Excise Tax. A tax imposed on the manufacture, sale or use of goods (e.g. cigarette tax),
or on an occupation or activity (e.g. license tax).
Group-term life insurance
Tax cost. See Reg. § 1.61-2(d)(2)(i)
Rule of 72. 72 / r = t (time is the time, in years, it takes investment to double)
Realization event v. Recognition event
Would § 132 make Gotcher come out any differently?
How does the “income effect v. substitution effect” debate relate to imputed income?
Are recourse and non-recourse loans treated differently? If so, how?
Why is business goodwill treated as zero basis?
Code and Regulations Considered
62 U.S.C. … Section Title Notes
§ 61 Gross income defined Definition of GI
Tax Expenditure Fringe Benefits
§ 104 Compensation for injuries or Workman’s comp, etc. excluded from
§ 106 Contributions by employer to E’er-provided disability or medical
accident and health plans “insurance” excluded from GI; one of
the largest tax expenditures ($91 BN)
§ 105 Amounts received under Benefits paid under e’er’s accident and
accident and health plans health “insurance” excluded from GI.
§§ 401-404, Favorable tax treatment for some
410-419 retirement income (e.g. qualified
pension, profit-sharing and stock bonus
§ 129 Day care
§ 79 Group-term life insurance Premiums paid by e’er for group term
purchased for employees life insurance excluded up to $50,000
Work-Related Fringe Benefits
§ 132 Certain fringe benefits Some fringe benefits excluded from GI
Meals and Lodging
§ 119 Meals or lodging furnished for Excluded from GI; meals must be on
the convenience of the premises, lodging must be on the
employer premises, and a condition for
§ 102 Gifts
§ 274 (b) Gifts Exception If donor gift was originally deductible,
then donee cannot exclude gift
§ 74 Prizes and Awards
§ 117 Scholarships
§ 1001 Determination of Amount of Gain = amount realized minus basis
and Recognition of Gain or
§ 1012 Basis of Property – Cost Basis usually = cost to taxpayer
Reg. § 1.61- Compensation paid other than If services are paid for in property
2(d)(2)(i) in cash FMV of property included in GI
§ 1015 Basis of property acquired by Carryover basis, or transferred basis
§ 1014 Basis of property acquired Basis of decedent’s property is FMV of
from a decedent property at time of decedent’s death
Old Colony Trust Co. v. Commissioner Payment of taxes by e’er
(S.Ct. 1929) included in GI
United States v. Gotcher (5th Cir. 1968) Incidental benefit to taxpayer
arising out of primary purpose
to benefit payor, excluded in GI
Criteria For Evaluating Taxes
1. Equity. Tax should not impose significantly different burdens on those in similar
a. Horizontal equity. Those in the same economic circumstance (e.g. same
income, consumption, wages, wealth), should pay same tax.
b. Vertical equity. Those with greater ability to pay tax (e.g. greater income,
etc.), should pay greater tax (e.g. regressive, progressive).
c. Perception of equity. If tax system is not perceived as fair, noncompliance
will be widespread.
a. Interference with behavior. Tax is efficient when it interferes as little as
possible with people’s economic behavior (e.g. incentives to engage work,
savings, domestic or foreign investment, risk taking or consumption).
b. Promotion of economic growth. Tax is efficient when it promotes
economic growth, and inefficient when it inhibits such growth.
c. Intended beneficiaries. Tax is efficient when it wholly benefits intended
taxpayers, and does not benefit unintended third parties,
d. Deadweight Loss. Tax is efficient when the intended beneficiary does not
receive less than the government loses in tax revenue (i.e. no deadweight
e. Administrability. Tax is efficient where the cost of raising the tax is less
than the benefit received by society.
f. Allocation of resources in society
3. Complexity (not a separate norm)
a. Equity. Complex rules are inefficient because
i. Educational differential. Taxpayers may have unequal abilities to
understand or manipulate tax rules
ii. Wealth differential. Wealthier citizens are better able to turn tax
ambiguities and complicated rules to their advantage in minimizing
iii. Rewards aggressive adversaries. Ambiguity and uncertainty have
a tendency to reward the most aggressive adversaries in a self-
assessment system of reporting income tax liability where only a
small percentage of returns filed each year are audited by IRS.
b. Efficiency. Complex rules are inefficient because
i. Opportunity cost. Taxpayers must divert time from other activities
in order to calculate their taxes (or pay professionals to do so)
ii. Bureaucratic cost. Government must maintain a large agency to
interpret rules and enforce compliance.
c. Three Types
i. Rule complexity. Problems of understanding and interpreting the
law (i.e. statutes, administrative rules (regulations and rulings) and
ii. Compliance complexity.
1. Problems of keeping required records and filling out the
2. Problems of government’s ability to administer the law
iii. Transactional complexity. Problems when taxpayer’s organize
their affairs to minimize taxes.
1. Poll Tax (a.k.a. head tax)
i. Vertical equity. Lacking, because people with different “ability to
pay” were not tax differently.
i. Behavior. Behavior would not be affected, unless people moved
ii. Administrability. Easy to administer (except for Siamese twins)
i. Not possible in U.S., because unconstitutional (b/c not
proportional by state)
a. No tax on savings (savings are not part of tax base)
b. e.g. 401k (where savings are not taxed).
a. Definition. Hegg-Simons / Comprehensive / Economic definition of
income. I = C + S+ (“income equals consumption plus savings increase)
b. Savings are part of tax base.
c. It should in theory tax all savings, but there are exceptions (e.g. 401k) of
the legislature’s choice.
How are savers taxed more than consumers with an income tax? Because savers
are taxed on income, plus increase on savings.
What is Income
1. Form of Receipt (generally all forms included in GI)
a. Gross income means income from whatever source derived, including
compensation for services. § 61(a)(1).
b. Old Colony Trust Co. v. Commissioner (1929). E’er promised to pay
E’ee’s state and federal income taxes. Court held that payment of tax by
e’er was in consideration of the services rendered by e’ee, and was a gain
derived by e’ee from his labor; discharge by a third person of an
obligation (to pay taxes, in this case) constitutes income.
2. Fringe Benefits (can be excluded from GI)
a. Tax expenditures fringes (§§ 104-106)
i. Compensation for injuries or sickness (workman’s comp,
compensatory damages, etc.)
ii. E’er contribution to accident and health plans
iii. Amounts received under accident and health plans
b. Work related fringes (§ 132)
i. no-additional cost service
ii. qualified employee discount
iii. working condition fringe
iv. de minimis fringe
v. qualified transportation fringe
vi. qualified moving expense reimbursement
vii. qualified retirement planning services
viii. qualified military base realignment and closure fringe
i. Acquiescence. Fringe benefits in many cases long understood by
IRS (and also e’er and e’ee) as not giving rise to income
ii. Forced consumption. E’er sometimes forces e’ee to consume (e.g.
retail clothing business requires salespersons to wear clothing that
company is selling to public) .
iii. Restricted choice. E’er sometimes restricts goods and services e’ee
1. Horizontal equity. Violated, b/c $15,000 cash, and $10,000
cash and $5,000 fringe benefits are taxed differently,
despite same economic position
2. Vertical equity. Violated, b/c fringe benefits have
historically been more available to e’ee’s in higher tax
1. Deadweight Loss. Possibly inefficient, b/c e’ee may value
fringe benefit less than it cost e’er to supply it, but may
choose it anyway, because it is still preferable to cash (e.g.
no additional cost services)
1. Rule complexity. It is difficult to categorize income into
“in-kind compensation” (taxable) and “working condition
benefits (sometimes untaxable). (§ 132 attempts to alleviate
i. United States v. Gotcher (1968). German Manufacturer
(Volkswagen) gave taxpayer (a potential investor) and taxpayer’s
wife 12-day expense-paid trip to Germany to tour the
manufacturer’s facility. Held: If “dominant purpose” or “primary
business purpose” of the expense is to benefit the payor, and only
“incidental” personal benefit, then the benefit to the taxpayer is not
included in income. Factors: 1) taxpayer had no choice but to go,
2) taxpayer’s lack of control over $ (Glenshaw), and 3) payor’s
purpose/motive was to benefit itself. Taxpayer’s wife, however,
had to include benefit in income, because her presence was not
a. § 132 does not apply to part
3. Meals and Lodging
a. Meals and lodging furnished to e’ee (as well as his spouse and
dependents), for the convenience of the e’er are excluded from GI. Meals
must be furnished on the business premises, and lodging must be accepted
on the business premises as a condition of his employment. § 119.
i. “Convenience of the e’er.”
a. Being on call
b. Having to perform work-like functions
ii. Condition of employment
1. Must be in contract
iii. On premises
1. Line drawing problems
1. Cash v. Kind
2. Fireman’s mess
i. Forced consumption; E’er-provided lodging and meals, though
consumption, may never have been purchased by e’ee at fair
i. If not included in 119 and 132, Regulations state that you’re taxed
i. Benaglia v. Commission (B.T.A. 1937). Manager of deluxe
Hawaiian resort allowed exclusion for certain type of e’er-provided
lodging and meals.
ii. Commissioner v. Kowalski (S. Ct. 1977). E’er (State of New
Jersey) gave e’ee (N.J. State Trooper) cash meal-allowance.
1. Majority. Held: In order to be excluded from GI, meals
must be furnished in-kind, and not by cash-allowances.
Dissent. 1) § 119 does not exclude cash, as opposed to in-
kind, meal allowances; thus cash meal allowances are not
invalid; 2) the business premises of the State of N.J. are
wherever the trooper happen to be; thus meals were
furnished “on the premises.”
4. Imputed income
a. Definition. The benefits derived from labor on one’s own behalf (shaving
oneself) or benefits from the ownership of property (owning, not renting,
housing) excluded from GI
i. Valuation difficulty. How can one value shaving oneself? What
happens if one does a bad job? How about valuing leisure?
c. Relation to fringe benefits
i. Similar in that it increases in taxpayer’s in-kind wealth, but
different benefit arises from taxpayer himself, as opposed to e’er.
i. Illustrates that income tax is, generally, a transaction tax
ii. Common law rule; not in Code
5. Gifts (excluded from GI; § 102)
a. Commissioner v. Duberstein (S.Ct. 1960)
1. Donor gives donee a Cadillac car because donee had been
helpful in suggesting customers to donor.
ii. Holding (test for “gift”)
1. If intent is “attached and disinterested generosity” gift
2. Attached and disinterested generosity is a question of fact
(based on the application of the “fact-finding tribunal’s
experience with the mainsprings of human conduct to the
totality of the facts of each case”)
b. Rationale (for excluding gifts)
i. Valuation. It’s difficult to value a gift
i. Tax Shifting. W/ progressive rate structure, donors may shift some
tax to lower-income taxpayers (e.g. children)
d. Congressional Response
i. § 274 (b). If donee excludes gift from income, donor cannot do so
i. Political Contributions
1. Excluded to the extent expenses used for political campaign
ii. Government gifts (welfare) (in-kind gifts, e.g. national defense)
1. Most government benefits and other welfare payments are
2. No national in-kind gifts have ever been taxed
6. Prizes and Awards (generally included in income) (§ 74)
a. The Gold Watch Exception
i. 274j; 274b1; 74(c); 102 donor gets deduction; donee gets
7. Scholarships (generally excluded) (§ 117)
i. Scholarship (Reg. § 1.117-6(c)(3))
1. payments made by family member not excludable
ii. Qualified Scholarships (§ 117(b))
1. Qualified tuition and related expenses excludable
iii. Qualified tuition (§ 117(d))
1. College tuition of professors’ children excludable
i. Horizontal Equity
1. Benefit of state school taxed differently than non-state
2. Student loans must be paid in after-tax dollars
a. If you win a lifetime supply of peanut butter, which
you hate, do you have to tax it?
Donor Donee Tax §
1 Taxable Taxable 2
2 Non-taxable Taxable 1 § 102(c)
3 Taxable Non-taxable 1 §§ 102(a);
4 Non-taxable Non-taxable 0 §§ 274(j);
Income as Gain on the Disposition of Property
1. Investment (capital, or “basis”)
2. Value (appreciation)
Basis = investment = after-tax $ = tax history
1. Original basis
a. Cost (§ 1012)
b. Carryover (§ 1015) (donor’s basis transferred to donnee)
c. FMV (§1014, 1015 loss)
i. 1015. For purposes of determining loss, basis is FMV
ii. Trick question: what happens when basis = 100; FMV = 80; sold =
90 no gain, no loss
iii. 1014. Property that passes at death gets FMV at death; so
appreciation may escape taxes
1. Policy proposals
a. Death becomes realization event
b. Make gain/loss carryover
a. Original basis § 1016
i. For capital expenditures (more after tax dollars)
ii. For loss depreciation (less after tax dollars)
3. Recovery of Basis
a. Sales offset
i. §§ 1001 – AR – basis
b. Deductible loss § 105
c. Depreciation § 167
4. Partial allocation of basis/appreciation
a. Three methods of return of capital
i. Basis recovered last
ii. Basis recovered first
iii. Proportional recovery of basis (this is chosen by X regulation)
5. Hort v. Commissioner (S.Ct. 1941).
6. Realization Requirement
i. Why tax dispositions of property (realizations of wealth);
1. It’s difficult to value assents that are not transferred
1. Hardship of taxpayer, who has to pay tax on asset he has
not (yet) converted into cash
1. Interference w/ behavior
a. Realization affects choice of ppl’s assets
1. Vertical Equity
a. Non-taxable assets are usual held by wealthy
2. Cherry picking
d. Cesarini v. United States (N.D.Ohio 1969)
1. Taxpayer found cash in piano
1. Treasure trove was “reduced to undisputed possession”
1. Key distinction: Severability v. Bargain Purchase
e. Haverly v. United States (7th 1975)
1. Elementary school principle received $400 of textbooks
2. Did not report in income
3. took charitable donation
1. Donation of unsolicited samples demonstrates “complete
f. Eisner v. Macomber (S.Ct. 1920)
1. Corporation distributed a stock dividend
1. Are stock dividends taxable NO
1. Stock dividends are like an increase in stock price, not like
a cash dividend
1. The question is timing
2. Battle of similarities
v. Dissent (Brandeis)
1. Congress has incorporated Macomber into statute (§ 305)
and provides that dividends of “common on common” are
not taxable, but other kinds of tax dividends (e.g. dividends
of preferred stock) are taxable; thus Macomber is confined
to the simple case of “common on common” distributions.
2. Note computation of stock dividends
g. Cottage Savings Ass’n v. Commissioner (S.Ct. 1991)
1. Basis of bank’s assets (i.e. loans) were 6.9, but FMV were
2. Regulatory agency
1. In order for a realization event to take place, exchange must
be “materially different” properties, defined as “legally
1. Corporate reorganizations
a. § 368. some transactions are not “recognized”
No further assignment for tomorrow – think about appreciation and return of capital for
annuities and life insurance
§ 1001 – recognition and realization
Recognized Income Non-recognized income
FMV basis carryover basis
Fully deductible expenses v. Capital expenditures
Finish Part 4, including Tufts
Annuities (§ 72)
Exclusion ratio. Numerator is your investment; denominator is the expected payment
you’re going to receive (life expectancy multiplied by period payment)
I noted that the computation for annuities is more favorable than for CDs
Deferred annuities (§ 72(e)).
1) Advantage of tax free buildup; but you can’t take out capital while
it’s building up. This is a penalty provision.
2) Treats unusual things as income: (e.g. if you take loan against
3) 72(e)(4)(c). Transfers as gifts
1. Term Insurance. (§ 101)
a. Bet with company as to whether you will live or die during a set period
b. Premiums are lower when young (less change you’ll die)
c. Premiums are higher when old (more chance you’ll die)
d. No investment component
2. Whole life insurance
a. Premium stays the same during the entire duration (so that beginning of
contract let to “inside buildup” – more $ than risk for company)
i. “Inside buildup” not currently taxed
ii. Ability to get your insurance coverage with before-tax $
c. § 7702. Requires that insurance policy has a significant amount of
protection or insurance element, and is not simple and investment vehicle
with a wraparound of insurance
d. § 1014; §102
e. Cash surrender value
1. Taxed at preferential rate
a. E.g. top bracket of capital gains is 15% (§ 1(h)
c. Reflects inflation
e. Incentive for savings
3. Capital gains and income taxed at same rate (1986-1990)
Cancellation of Indebtedness
Collins v. Commissioner (2d Cir. 1993)
Monday Finish Pt. 4;
4(a) (business damages)
Effect of various kinds of obligations on the determination of taxable income
Cancellation of Indebtedness
Factor: no consentual obligation to repay
Policy: Consentual loans are likely to repaid; nonconsentual loans are not
No consentual obligation to repay Taxable
o Ponzi Scheme
Consentual obligation to repay (on loaner) Not taxable
Kirby Lumber. Assets were “freed up” because of the “forgiveness of loan” or
“repurchase of loan,” or “retired obligations.”
o Variation. (Solvency is relevant, but only in a limited way.) But whether
or not taxpayer is solvent after transaction, he would have cancellation of
indebtedness income. § 61, § 108
o § 108(a)(3). To the extent that taxpayer is insolvent, the amount excluded
shall not exceed amount of insolvency
Tax attributes (net operating costs, carryover loss, etc.) constricted
Chapter 11 workouts has no such limitation; some argue that this
pushes cases into bankruptcy
o 105(e)(5). Purchase price reduction.
o Farmers, real estate developer, student loans (108(f))
Relation between Basis (§ 1012) and Obligations; b/w Basis and Amount Realized
o Self finance (equals basis); and “soft-money” financing (financing from
bank; financing from seller) all have full amount in basis.
o Interest payments on mortgage: paid in after-tax dollars; but no change in
basis, since all the basis was provided up-front, and assumption was that
you were going to make the payments [?]
o Tufts v. Comm’r. IRS gives you credit for payments with basis supplied
o Recourse Loans
o Non-recourse loans
Joint ventures. How so?
Option. Mortgagor has choice to continue, or not.
Return of Capital
o Taxation on mortgages
If you pay off some of the mortgage, why does basis stay
the same? Because you had been given a credit earlier.
Crane and Tufts
Special Rules § 465. Taxpayer limited in amount of current
deductions he can take, to the amount that he is at risk
(amount invested in the property, or amount that he is
liable). This eliminates the taxpayer’s ability to defer the
Bifurcation Approach (O’Connor)
o Property and Loan transactions treated separately
Woodsam. There is no realization event…
Estate of Franklin. Operates as a common law limitation on the use
of non-recourse debt to generate basis. § 465 is a statutory
limitation…In this abuse case, taxpayer was not given any basis.
[or was taxpayer given basis of FMV]
o Business Context
Lost Profits. Taxable, because you would have been taxed on
Punitive Damages. Taxable, because of similarity to treasure trove
Goodwill (Ratheon). Taxable, because goodwill is an asset, and
Next week Homework
§ 104, personal damages (10 minutes)
Detour to tax exempt interests (Section 6, quickly); refreflect on tax expenditures
All of Section 7
Raytheon test for taxability of damages: “In lieu of what were the damages awarded?”
o Like finding $ in piano
o Lost profits
o Damages to assets (damages to goodwill) (more complicated test, which
was at issue in Ratheon)
Question 1. What’s the basis?
Self-created goodwill is usually zero
What if the taxpayer received lump sum, without
Courts usually accept party’s characterizations
o Physical (including lost profits)
o Theoretical Examples (hypothetical tort injury)
1. Physical injury
2. Lost wages
3. Pain and suffering. Pain and suffering compensation replaces
good-health, which is non-taxable. On the other hand, if pain and
suffering replaces leisure, it would be taxed.
4. Interest (lost time value of money)
But § 104 replaced Raytheon analysis
See also Murphy. (Douglas Ginsberg). Taxation of damages for emotional distress.
Tax Exempt Interest. § 103
Tax Taxable Amt. Retained State and Benefit to Cost to Federal
Bracket by T After Tax Local Bond State Government
50% 10% 5 7% 3 5
30% 10% 7 7% 3 3
0% 10% 10
Tax exemption on loans are examples of a tax expenditure
Ault argued that it was both inefficient and inequitable
Limits on § 103: Private activity bonds
Can you identify the norm in the tax expenditure budget?
Static or dynamic basis? Should we take the positive economic effects of less
taxes into account?
We have seen that S and C should be paid with after-tax dollars
We have seen that the cost to make money should be paid with before-tax dollars
So T should be able to deduct business expenses
o What is the distinction between business and personal expenses?
o Which deductions are tax expenditures
Welch v. Helvering
Agent T paid creditors on behalf of principle, to maintain his
Is payment an “ordinary and necessary” expense
Payment is to maintain goodwill is a form of consumption, a
personal element, and therefore taxable.
“Ordinary” means usual, and “necessary” means not personal.
Ault suggested that maintenance really means savings
Gilliam v. Commissioner
Artist travels to exhibition on plane; goes crazy on plane
Incurs legal expenses
Is lawsuit ordinary?
Joint causation (
o In mixed business and personal matters, the test is “the origin of the
Finish Section 7 (read e’ee business expenses carefully, because it’s irrational)
Read 8A and 8B
Reasonable Allowance for Salaries (§ 162(a)(1))
1. Statutory rule
2. Common law test for reasonableness
a. Multifactor Test (disparaged under Exacto Spring)
i. Type and extent of the services rendered
ii. Scarcity of qualified employees
iii. Qualifications and prior earning capacity of employee to business
iv. Net earning of the employer
v. Prevailing compensation paid to employees with comparable jobs
vi. Peculiar characteristics
b. Independent Investor Test (Exacto Spring)
i. Look at rate of return (adjusted for risk) with shareholder is
getting; see if it’s comparable to others similar corporations; if it is,
then allowance is presumptively reasonable
a. Usually applies only to closely held corporations, not to public
4. Rationale for “Reasonableness” Requirement
a. Prevents corporations from disguising dividends as salary (and thus
availing themselves of single taxation)
5. Contra “Reasonableness” Requirement
a. Administrability. Creates judicial “suprapersonnel department.” Exacto
Spring Corp. v. Commissioner.
6. 162(m) – performance conditions
Expenses Contrary to Public Policy
1. Section 162(c), (f), (g).
a. Congress entered the field and clarified common law rules
b. These have dominated the field
2. Common law rule
a. Section 162 deductions (for ordinary and necessary business expenses) are
disallowed only where deduction “would frustrate sharply defined national
or state policies proscribing particular forms of conduct” (e.g. fines and
penalties). Commissioner v. Tellier.
3. Rationale for disallowing deductions for public policy limitations
a. Allowing deductions for criminal penalties “removes the sting” from the
a. Section 280(e) (disallowance for drug dealers) (Congress is just posturing)
Employee Business Expenses
Theoretically, being an e’ee is a business; thus, it should be deductible.
Business Deduction and Other (Reg. § 1.62 + § 62(a)(2)
Standard Deduction (lump sum ~ 3,000)
- OR -
o Charitable contributions
o medical expenses
§ 212 investments (rather that for business purposes)
Unreimbursed e’ee business expenses
o Two exceptions
§ 67(b) – misc. itemized deductions 2% floor (amounts to
unreimbursed e’ee business expenses)
§ 68 – most itemized deduction; 3% phase out over $100,000
(a.k.a. “hair cut”)
Mixed Business Expenses (Expenses w/ Business and Personal Character)
Chirtelstein and Bittker (no basic analytical framework)
o Business and Personal elements are inextricably intertwined
Halperin (basic analytical framework exists)
o If cost = benefit, then no deduction (it’s all consumption) (paid in after tax
o If cost was greater than benefit, or if benefit was below the cost, then the
difference between them should be deductible (paid in before tax dollars)
Pevsner v. Commissioner (U.S. 5th 1980) (Yves St. Laurent e’ee)
Taxpayer was e’ee at upscale clothing boutique
E’ee required to expensive clothes
There were no restrictions on wearing clothes outside of work
Are taxpayer’s clothes entitled to “ordinary and necessary”
business expense NO
o Test (3 part)
Clothing is of type specifically required as condition of
No adaptable to general usage as ordinary clothing
No so word
If clothes are generally suitable for outside wear (they were here),
then cost to taxpayer = benefit to taxpayer
Clothes are “all or nothing” – if you meet the test, you get the
entire deduction; if not, you get no deduction
o “Inherently personal” decision to have children no deduction
o Credit (because congress wants to encourage this conduct)
o Employer provided benefit (excluded from income)
Moss v. Commissioner (T.C. 1983) (expensive lunches)
Partner at law firm required to eat lunch in fancy restaurant
Partner was reimbursed
Partner tried to deduct reimbursement
Were expenses “ordinary and necessary business expense”? No
Daily meals inherently personal expense
To qualify as deduction, meal must be “different from or in excess
of that which would have been made for the taxpayer’s personal
purpose.” Sutter v. Commissioner (T.C. 1953)
274(n). If cost of meal is directly accounted to other party, the
person who paid for meal gets entire deduction; 50% limitation
applies only to the client
162 + 274(n) + moss = my own meals while working are not
deductible (even if I’m working with partners), but if I am meeting
with clients (274(n)) and that really A) business-related, and B)
substantiated, then amt. is deductible in principle, but limited to
Two types of meals
o Meals with clients
o Meals away from home
McCable v. Commissioner (2nd Cir. 1982) (commuting expenses for police officer
Taxpayer, a police officer, was required to carry revolver at all
times in city
Most direct path to city was via NJ, but he couldn’t get permit so
he had to travel around it, so he took his car
Were taxpayer’s commuting expenses deductible No
o See also
Fausner v. Commissioner (p. 1973)
o You are lawyer, and drive to work, and then to 3 diff. courts. What’s
If you are in “work status” then you are not in “travel expenses”
but “transportation” expenses
o What if you drive directly to court?
Occasionally / temporarily that’s okay
o Suppose lawyer lives and works in BOS, but has to try case in Chicago,
where I stay in 6 months.
Getting to Chicago, living in Chicago, 50% of meals in Chicago
(suppose you come home for weekend? Unclear but likely
Indefinite (not deductible; anything over a year, says
Finish entertainment and travel; read first part of capital expend. On “economics of
deferral” (287-294); make chart of mixed business-personal expenses how rules answer
the question of how cost = benefit; do those answers make sense, or are they arbitrary?
October 16, 2006 – we talked about congressional fraud “phasing out” stuff. Phase outs
can create very high rates. How?
Meals Travel Clothes Childcare
Moss None Commuting Nothing Normal None None (but
Client lunch 50% Away All1 Special All
Away from 50% Foreign Special Convenience
home rules of employer
Passed on costs 100% Tools Some
(e.g. to client) (but payer
Deduction v. Exclusion
Working condition fringe (goes above the § 162 = reimbursed e’ee expenses
line = like a reimbursed employee business
expense --) no 2% floor or §268 phase out)
See § 162 (“lavish and extravagant”)
So called “surrogate taxation”
§ 119 = meals and lodging fully excludable Meal = none
Housing = none
§ 129 child Housing = none
§280A (a) – Deals with two different situations. Both of which involved mixed business
and personal costs as they relate to a personal residence
1) Summer house - I use part of the time and rent part of the time – we are NOT going to
look at this
2) Hypo (this is what we need to know) – Study where professor grades papers etc,
sometimes watches TV.
This portion (the study) is 25% of the square feet of the house
§ 280A(c). Exception.
1. “Regularly and exclusively”
2. Condition of employment
3. principal place of business
4. income comparison
pro rata share of sq. footage, insurance, heating, lighting, telephone bill, cost of cleaning
Commissioner v. Soliman (S.Ct. 1993)
So far we have been considering the “necessary” prong of the “ordinary and
Now we’re going to turn to the ordinary: is it a capital expenditure?
Hypo: 300 gross revenue (100 vacation + 100 cost of producing income + 100
investment). Between the vacation and the cost of producing income, it’s an “all or
nothing” question; between the cost of producing income and investment, it’s a
question of “timing”)
Variables: PV, FV (how much owed at end of period), n (number of periods the interest is
compounding), i (interest). If you have three of these, you can always derive the fourth
Other ways to think about this: 1) interest free loan, 2) yield exclusion
Don’t worry about technical rules on depreciation
Capital Expenditure v. Currently deductible business expense
o Timing of deductions:
o Currently deductible business expenses are paid with before tax
dollars; capital expenditures are paid with after tax dollars
Capital Expenditures Currently Deductible Business Expenses
Paid with after tax dollars Paid with before tax dollars
Deferral of Tax
There are four ways to think about the value of tax deferrals
Interest free loan
Reduces the PV of later taxes (reduction of tax rates or tax forgiveness)
Yield exemption (immediate deduction / yield exemption equivalence)
o Joint venture analysis. If the taxpayer can currently expense now, it
has the effect of exempting the yield on his own investment. See
MIT’s Cary Brown.
o Basis of initial investment is zero; on sale of asset, he must be taxed on
o HYPO. Suppose asset generated capital gain lower tax rate at end;
this is called “conversion,” because instead of requiring the “full”
amount to be repaid, only a portion does.
Relation of consumption tax, and a tax on wages
Acquisition of asset (capitalized)
Woodward v. Commissioner (S.Ct. 1970)
o Change in charter that gave majority shareholders obligation to buy shares
o Majority shareholders incurred A) legal, and B) I-Banker expenses
o Gilmore (basic inquiry is looking to origin of expenses)
o Origin is in the acquisition process, therefore part of expenses of aquiring,
which have to be capitalized
o Protecting your patent to stop infringement v. ____
o You hire construction worker to build building Capitalized
o You build building yourself capitalize
See Idaho Bulldozer
See § 263(a)
Taxpayer doesn’t get value of currently-deductible expense
Reduce otherwise preferential capital gain
Investment banking and legal fees
Taxpayer tried to deduct fees now, on theory of Lincoln Savings (if
expenditures create a separate and independent asset, then they
have to be capitalized), that is, that asset is the same
Supreme court affirms lower court’s reasoning that Lincoln
Savings may say that separate and independent asset is enough, but
Indopco says that that is sufficient, but not necessary
Other way to satisfy capitalization is that it provides “more than an
incidental future benefit”
Remuneration for executives looking for acquisitions
Investigative expenses (before Board decides to make acquisition)
(deductible), and acquision-associated expenses (capitalized)
Is a hostile take-over different from friendly-takeover
Hostile – you are protecting the assets that you have
Friendly – like Indopco
But law is in flux
Expansion of existing business (deduction), so long as you’re not
getting into a new busiss. Bryercliff Candies. Vitality unclear after
In principle, capitalized expense
But at some point, you are in business, and costs going
forward, this should be deductible
Separate and distinct intangible
o Congressional Response
195. Book isn’t correct, supplement is. If taxpayer is not yet in
business, and incurs expenses that otherwise would have been
deductible over a 15 year period.
This represents a compromise. How?
o How does reasoning of Indopco affect 195 test?
Indopco eviscerates 195, because there are not any expenditures
that can pass 195 test
Rev. Rule 99-23. Clafies whether and when getting into business
can be capitalized and amortized under 195, and that operating
business is deductible
HYPO. Suppose you own hotel. In hotel, college students trash room. Should those
expenses be deductible or capitalized. Deductible, bc ordinary or necessary expense.
HYPO. Suppose you own hotel. You pay ppl. to build and paint the hotel. Capitalized,
HYPO. Suppose you own hotel. Magazine says fashion changes, so you re-paint rules.
Finish depreciation; capital expenditures
§ 162, § 263, § 1012
§ 195, 197, 248
Deductible Capital Expenditure
Protecting asset already have clear title to Acquire (Woodward)
De minimis Substantial
Rev. Ruling 2001-4 (heavy maintenance visit on airplanes)
Deductible Expenses Capitalized Expenditures
Protecting asset Acquiring asset
Not extending useful life Extending the useful life
De minimus Substantial
One year rule
195 (startup costs). Amounts can be deducted over a fixed period
197. same thing for acquired intangibles; gives arbitrary useful life of 15 years
1248. organizational expenses
Usually depreciation applies to physical assets, and real useful life
Usually amortization applies to arbitrary period
Deductible expenses Deductible expenditures
New employment in same trade or business Looking for new trade or business (like
(like maintaining business) improving business)
Not out of work for a substantial period Out of work for a substantial period
(protecting asset) (acquiring asset)
Getting job for the first time (acquiring
What is a “trade or business”
o MBA-type executive jobs. Probably a trade or business
o Holding a political office is not a trade or business (Estate of Rockefeller)
Rev. Rule. 63-77 (costs of going to interview not deductible, but not includable if
paid for by employer; so law students do not have to file amended returns)
Rev. Reg. 1.162-5
o If you’re maintaining skills in an existing trade or businss, you can deduct
o If you’re protecting skills (continuing education courses), you can deduct
o See p. 1107
“inseparable aggregate” of personal and business expenses are not
Paragraph b2 and b3 (expenses required to meet educational expenses, or which
qualify you for a business)
o Minimial educational requiring is like still aquring something (not
o Meeting qualifing exams is, again, like acquiring something
o Objective, not objective standard
Wassenaar v. Commisioner
Student should have first get established in a trade or business
before getting his LLM at NYU tax school
o Taxpayer’s Reasoning
Student styled himself as “legal problem solver”, and thus was
“continuing” his job doing that
In Wassenaar, student must have had other income, to offset it
Business v. Personal
Recovery of Capital Expenditures
What is the difference in recoveries between a building and a bond? One looses value
over its useful life, the other does not. So it would cost more to net X amount in the asset
that is loosing value. Note that this is the case, despite the fact, in a market sense, the
depreciable asset might increase in value.
Difference systems of recovering capital (slow fast)
Sinking fund Straight line declining balance 150% dec. bal. 200% dec. bal special expense (immediately deductible)
o Sinking fund. Slower at beginning than end; because [insert theory]
o Straight line. Allocating the basis over the period
o Declining balance. More deductions in the beginning, and less at end
o Special. Even if asset has 20 year useful life, you can recover over 5 years
o Expense. Immediately deductible
o Recovery for real estate is 39 years, and straight line
o Machines can be put in 5, 7, etc. year periods, and declining balance
o If double declining balance method, special rule resulting at the end in
straight line method after a while
All interest material
First 3 of losses, XII, A, B and C
In computing the depreciation, what do you need to know?
Classification of assets
Type of recovery
HYPO. You buy land and building for 1,000,000.
o Land is assumed not to have a determinable useful life not depreciable
o Building is depreciable
o Building has life of 39 year
Type of recovery
o Method of recovery is straight-line
o There are conventions for first year, depending on personal or real
o You can treat, e.g. elevator, as a separate asset
Equipment / “component part depreciation”
Type of recovery
Double declining balance method
Classification, recovery period and type of recovery changes, due to Congress’s
desire to incentivize certain behavior (e.g. real estate investment). This is a type of
Analysis can be based on
o Extent of approximation to economic depreciation
o Fairness / efficiency / complexity analysis
There’s two types of things in the world: things you can talk about, and things you can
Theory: taxpayer buys same good in two different markets, where the price is different. T
can make a profit by buying and selling asset, even though the economic value of the
asset is the same.
Congress became aware of this problem, and promulgated “recaputure rules,” or those
that, where gain represents previously-taken deductions (or put another way, if the
deduction was taken too fast), T had to take ____ as ordinary income. We will not go into
detail on the recapture rules.
Interest paid in connection with a profit seeking activity should be deductible, because
interest is really the cost of renting money (like renting a machine, a building, or the
services of an employee). In principle, it ought to be deductible as a cost of producing
income. Even without § 163, you’d think it would be deductible.
But while interest can be viewed of rent on money, it’s different from rent on machine.
You know what the machine does, and having the machine allows you to “trace” (see
Reg. 1.163-8T) the money you spent on it. Money is different in that it is “fungible” –
you can use it interchangeably, and it can be used to support all the taxpayer’s activities,
both personal and business.
As a theoretical matter, interest that relates to non-business activities should not be
deductible. See § 163(h).
Analysis. § 163(a) 163(h)(1) 163(h)(2)(a), (b) and (d)
Identification of Personal Interest v. Business Interest
“Allocation.” Money is fungible allocate the interest expense over all T’s
assets and activities. Look at T’s interest; X% of assets are business, X% are
personal half interest is business, and half is personal
“Stacking.” Give priority to where interest is paid out would be deemed to go.
Very T-favorable rule, will be that interest income will first go to income
generating assets, and only thereafter go to personal consumption. The other way
around, the stacking could go first to person interest (detrimental to T) and only
then to business interest.
“Tracing.” This is the real law. See 1.163-8T. Look and see where the proceeds of
the loan, in fact, ended up. This is very favorable to T, because the T who as both
assets and borrowings can structure his affairs to make sure that the interest goes
into the asset most favorable for tax purposes.
o Checks are in first-in, first-out basis.
o 15 day rule. Allows T, regardless of flow of funds, to designate where he
wants the funds to go.
o ???. If proceeds of loans go to different things, and loan…
Do tracing rules work?
for the most part yes
Sham and Transactions with no “Economic Purpose”
Knetsch v. U.S. (S.Ct. 1960)
o Fee = 4,000
o Bought 4,000,000 annuities, which pay 2.5% To pay for loans, borrowed
4,000,000 at 3.5% with non-recourse loans.
Loan generated 140,000 (3.5%), but annuity only yielded 100,000.
o Borrowed 100,000 at 3.5% = 3,500
o He thus spent 47,500
o In return, he was able to deduct interest expense (143,500) against income.
Assuming he is in the 50% bracket, the tax savings to him would be
o So he’s up 24,250.
o Did transaction create indebtedness? Yes
o Is “tax avoidance” a valid motivation? Yes. See Gregory v. Helvering
o Did transaction “appreciably affect his beneficial interest except to reduce
his tax.” No sham (aka window dressing, hocus pocus)
Tax avoidance purpose
Economic Substance (potential profitability)
Little or no chance to make a profit
Little or no risk to T
o Tax avoidance is valid motive
o But does that mean that anything goes? No, b/c if “hocus-pocus” then no
o It’s not easy to distinguish between sham / hocus-pocus and legitimate tax
o Business purpose v. tax avoidance purpose (relative weights)
o “Economic substance” – is there a potential to make profit independent of
tax deductions. How much? Does it matter if rate is “locked in” or if it
could change if other factors intervened.
o This is a hot topic right now: See KPMG case and Circular 230
Is there a “possibility” of T making $? Yes, if the interest rate dropped below
What’s the difference in approach between majority and dissent. Does that make sense?
Look at interest deduction; read 163(d); look at interst and inflation
Read: All materials on losses; realistically, we won’t get beyond casualty losses
163A – All interest deductible
o Trade or business interest
163H – Significant limitations
163D Investment interest – deduction allowed
o You don’t have to look at investment income from this particular asset,
but from all the income that you have
o You look at all the interst you have, traced to indebtedness [know this]
o States general rule that expenses, including interest, which arise in
o No deduction allocable to income which is exempt from tax
o You can’t deduct interest/expenses from other countries
o Foreign income
o Basic principle in (a)(1)
The litigated word is “allocable”
o Special rule in (a)(2)
You can’t borrow, and use the proceeds to buy municipal bonds,
take deduction for interests, and at same time take deduction for
interest on § 103.
“Purchase or carry” – “tracing” approach. See Regs.
o If inflation, lender gets less back
o So they should pay less tax
o If inflation, borrower has to pay less back
o So they should pay more tax
Inflation is a problem for countries which have 100% or 200% inflation
If you see proposals for indexing gain-side of equation, you must also index the
loss-side. Otherwise, there would be a huge tax shelter. How? [learn this]
We might increase basis to account for inflation
o This would make sense
We have already seen basis recovery at sale of asset, which offsets gain; we also looked
at depreciation and amortization deductions, which gives a ratable cost recovery over a
period. Final method of cost recovery for losses.
o How do you calculate loss? Whatever it is, it doesn’t exceed T’s basis in
property, because only T’s basis was paid in after-tax dollars.
o HYPO. Basis is 1000; asset appreciates to 1200; T looses 500. What can T
deduct? There are three scenarios (does the totem pole burn from the top
down, or bottom up). The regulations treat the casualty from coming from
the basis first. This is favorable to T. See 1.165-7(b). The alternative is the
loss coming from appreciation first (in our case, 200), and only after that
will 300 of basis being destroyed. This would be pro-Government. Finally
you could do it in percentage terms.
What is a realization event for losses?
o Sale / disposition
o Usually some kind of identifiable event, other than simply a decline in
o Other then obsolescence, or wearing-out
E.g. casualty losses (fire, storm, etc.). See 165(c).
What are the limitations on losses (these are not entirely rational or systematic)
o Business loss.
165(a)(1). These are taken “above the line”;
172 – net operating loss net carry-back or carry-forward
o Transactions entered into for profit. 165(a)(2)
These are not personal expenses, but do not rise to the level of a
business (e.g. casual rent for property)
Rent is above the line
Other is below the line
Do not qualify for carry-forward
o Personal losses (casualty losses) 165(a)(3); 165(h)
These have to be taken below the line
Subject to limitations of 165(h)
Plunkett v. Commissioner (T.C. 1984)
o Mud-racing (income 400; property -200; maintenance -350; net loss 150
o Truck-pulling (same)
Casualty losses; § 183; tax shelters
Personal deduction material – Monday and Tuesday
Trade/Business Transactions entered Held for production of Personal
into for profit income
Expense § 162 § 212 (below the line) In general, non-
(wrong from theoretical deductible, but § 183
point of view); subject can allow for some
to 2% floor deductions
Loss Deductible, below the § 105(c)(2) – §§ 165(c)(3); 165(h)
line, § 105(c)(1) rents/royalties are taken (casualty losses)
above the line; some
other kinds taken below
Casualty Losses (§ 165(c)(3))
There is something, special, extraordinary, and sudden are casualty losses
Deductions for loss, is, in general limited to T’s basis
Problems (Malibu) were taken care of by this section, making 165(c)(3)
applicable in very few situations
Next we consider deductions for non-profit seeking activities (like casualty losses)
Computation of Casualty Loss
HYPO. Pay 1000 for residence; residence now worth 750; residence is now destroyed.
You had 250 of consumption, so loss = 750. we already saw we can’t take loss over basis
(because extra value was not realized, never been included in income). What if the
building was not residence, but business? Entire 1000 is deductible.
Bad Debs § 166
Business bad debts, or debts arising in a trade or business, are allowed in full. Unlike
other types of losses, T can take a tax deduction, as long as he has written off the portion
of the debt for accounting purposes (i.e. there doesn’t have to be a realization event, like
a casualty, to be eligible for a deduction).
For other losses that aren’t incurred in a trade or business, it’s restricted to a short-term
capital gain. Any bad debt that that’s not a business bad debt is a “restricted short-term
Capital losses, and capital gains are also subject to special rules, and in very general
terms, capital losses can only be deducated against capital gains (not ordinary income)
In subsection d (§ 166(d)), gambling losses can only be deducted against capital gains.
Rationale is that gambling is a personal consumption expense.
HYPO. Stamp collector (hobby) gets tired of collecting, and sells stamps for profit. Can
he deduct the profit? No. See Reg. 1.212. All expenses are consumption, and you are
taxed on the gain. Know how to compute this.
This brings us to § 183 (Activities not engaged in for profit)
In Plunkett v. Commissioner T had hobby, and had losses. T had no “actual and honest
attempt to make a profit” (Dreicer v. Commissioner). But T’s other activity, truck-
pulling, was not a hobby, but was engaged in for profit. Can he deduct losses? Yes. But
what is the relevance of stacking here?
The elements of a tax shelter are as follows:
Deferral. There is value to be able to deductions earlier rather than later
Leverage. Using someone else’s money to make investment, taking advantage of
rules that allow you to take the deduction as if it were your own money
Conversion. The ability to convert the deductions taken against ordinary income.
We say this in the context of depreciation…f
How does the tax law respond to these transactions?
Sham. See Knesh. Business purpose…
Reporting information and penalties. Steps IRS has taken to require T to report
transactions that look like shelters. Also, through Circular 230, limiting
exculpatory effect of legal opinions.
“At risk” rules. See § 465. These rules limit ability of T, in circumstances of
Knetch, to get current deductions with leverage which is non-recourse.
Passive Activity Rules. We will not look at these in detail. These say that even in
transaction is not entered into to profit, it is of a certain kind, and the T I not
materially involved in the project, then like 163d and 183, passive activity losses
can only be deducted to the extent of the profit of the project.
Get through all material on personal deductions
Look at handouts
Charitable contributions and medical
Up to this point, we have been looking at activities that were, by definition, profit-
seeking activity (trade or business, costs of producing income, transaction entered into for
profit, etc.). But we haven’t tried to define what was a profit seeking activity. Section 183
and Plunkett (truck-pulling case) help us define what profit-seeking meant, and how
much “greed” was required. One might think that non-profit-seeking activities might be
labeled “consumption,” but that is not the case: looking at § 183(b), one can deduct
business-related activity, to the extent that such income exeeds….
Computation of Deductions for Personal Expenditures
1. First, deduct “above line” expenses, which are similar to (but not exactly the same
as) business expenditures. This results in AGI. This latter step is important to get
everyone level. [How?]
2. Second, take standard deduction (standard statutory amount, adjusted for
inflation), or itemized deduction (every other deduction that code allows, except
those taken above the line, and except those deductions taken for personal
i. Simplicity. Rather than T taking individual amounts, T just took
1. Contra. But it’s not that simple, because one would have to
compute both before choosing one, unless it is very clear.
~75% of people take standard deduction (people who live
in cities with high municipal and state tax rates itemize
deductions, as do people who make charitable
ii. Provide Bottom Layer of Income that is not subject to tax. This
functions as a “zero bracket”
i. What is the relationship between above the line deductions, and the
below the line itemized deduction? If you take an itemized
deduction, you disqualify yourself for some above the line
ii. How is the above/below the line irrational in some cases?
c. Standard Deduction
d. Itemized Deduction
i. Unreimbursed employee expenses, and 212, are subject to 2%
floor in § 67.
ii. Subject to phase out. § ???.
e. Deduction for personal exemptions (§§ 151, 152)
1. Zero Bracket for Everyone. From one perspective, you can
look at this as a zero bracket; that is, until T’s income is
over a certain amount, he doesn’t have to pay any taxes.
Put still another way, until he reaches a certain amount, his
claim to the income is superior to the government’s. But
family size is also taken into account.
2. Freeing up the poor from taxes. It’s not appropriate to put
people in tax net that don’t meet a certain level. But it
doesn’t do this significantly.
1. Married - Spouse
i. Children under 19
ii. Children who are students under 24
iii. Other dependents living in the household
b. Must pay for over 50% of support
3. Personal exemptions, together with standard deduction,
represent two of the principal mechanism by which poor
are relieved of tax liability.
4. We will not go into this in detail
3. Third, calculate taxable income by multiplying income by applicable tax rates
4. Fourth, subtract credits from tax liability
a. Difference between credit and deduction
i. “Upside Down Effect.” Providing an $X deduction results in
greater benefit to T’s who pay more taxes
ii. An X% credit, on the other hand, will not affect zero bracket T’s,
unless refunds are available. The percentage is not credited against
tax rate or liability, but against the $ that the government wants
ppl. to spend. So credits will not make any difference between
people in, for example, 30% and 50% tax brackets.
b. Often subject to phase out
c. Usually, though not always, not refundable.
d. Economically, most important credit is the “earned income credit,” (§ 32)
which is given to family which qualify (single families, or those with
children) and is refundable, so that if family has no income, they get
income from government. This is phased out as income increases. We will
not worry about details of amount. This has the most impact in removing
some from tax liability.
i. We won’t pay much attention to the details of this, but note that it
is extremely complicated. If you think about the people that the
statute is addressed to, namely the people at the bottom of the tax
distribution, it is very hard for them to comply. In fact, as the book
points out, many who are eligible for the credit, will not avail
themselves of the credit, due to complications.
State, Local and Foreign Taxes (§ 164).
o These are deductible
o Applies to property taxes, whether or not the property is used for business;
but if used for business, the deduction can be taken above the line
o With respect to Reg. 1.62-2(d) – income tax must always be taken below
o Sales Tax. Again, an aspect of federalism. There is no theoretical
argument for deducting sales tax. If you’re a state’s right person, you
might argue that the state is indirectly favoring states that had income tax,
or incouraging states to have an income tax, rather than a sales tax. There
is one state that has a sales tax, and not an income tax…[Texas?]
o Foreign tax. Creditable.
Rationale. This is the price you pay of doing business in a state.
o Contra. You are getting benefits as well, such as roads and police. This is
a type of consumption that you are buying, and thus should be something
you ought not to get a deduction for.
o Contra. Federalism. The federal government might also give a credit for
the state tax. [Huh?]
Federalism. Federal tax po
Property taxes are deductible. This includes property taxes with respect to assets
that are used for non-profit-seeking activity (e.g. property taxes by homeowners).
This, coupled with 163H, and no tax to owner-occuped housing, gives great
benefit for home-ownership.
On business property, regulations state that those taxes can be deducted above the
line. So T can take these deductions, plus the standard deduction.
Income tax. All income taxes are deductible on 164, but only below the line. This
counts for business income as well. Ault thinks that this is wrong as a theoretical
International tax. Replaces US tax
o Credit v. Deduction
HYPO. I give $50 to an individual who stops me on the street. Deduction? No. Give has
to be given to a “qualified individual.” § 170.
HYPO. Can I take charitable deduction for tickets to fireman’s ball? Charitable
contribution has to be reduced by benefit 170(f). In some cases, the value of the benefit is
so great that no deduction will be given. See Hernandez (court disallowed deduction for
Scientology services because they provided quid pro quo). But IRS backed off, and now
deduction is given.
The Problem of Appreciated Property - § 170(e)
HYPO. Charitable Gift to BC: Cash or Asset? (40% tax bracket)
Before Tax Cost Tax Benefit Net Cost to BC
Cash 10,000 4,000 6,000 10,000
Asset (basis of 2,000; FMV 10,000 7,200 (8000 appreciation X 2,800 (10,000 – 10,000
10,000; 8,000 appreciation) 40% = 3,200; + 4000) 4,000 – 3,200)
The problem here is that __???___. The statutory response was § 170(e). This says that
amount of charitable contribution depends on 1) what property is given, 2) who the
property is given to, and 3) what happens to the property. This section provides that
deduction can be limited.[John, how?]
So there is an incentive to donate securities (e.g. stocks) given to private charities. [John,
In enacting 170(e), Congress considered limiting basis in all cases, but the Universities
NB: You can’t reduce your income in one year by over 50%; but you can carry-forward.
I noted that people who used standard deduction were not able to avail themselves of this;
and that the higher bracket you are in, the more incentive you have to give.
Effect of Tax Rate on Charitable Giving
Gift Tax benefit Net Cost to T Notes
40% 1,000 400 600
20% 1,000 200 800
20% 750 150 600 T will give less,
if he wants the
same net cost
To alleviate this problem, there have been proposals: such as matching donations on the
part of the government
Interesting Case: 170(f)(12) (selling used cars)
Defining Medical Care. § 213
Consumption as Medical Care.
Problem of Normal Consumption which is attendant to medical care (suppose you are in
the hospital, and have to eat…are the meals deductible? Yes, but you could make a good
argument that they were)
You could try to apply the mixed analysis (we saw this in mixed personal and business
expenses, and also in the charity analysis [I think]). This is what happens in the
swimming pool cases. There the deduction of the cost of the swimming pool, is reduced
by the appreciation in the property. This is the same thing with non-capital expenditure
medical expenses. The excess consumption in the medical case are not deductible
Medical Care as Consumption
HYPO. Doctor recommends shopping to an people-hate. Congress has disallowed
deductions for cosmetic surgery (there are line drawing issues here)
Casebook authors love this topic.
7.5% Floor – Protection on Catastrophic Losses Only
Finally, note the 7.5 floor. Medical expenses cannot be deducted, except to the extent that
they exceed 7.5% of AGI. In this way, they allow deductions for catastrophic losses only.
As a matter of policy, then, periodic checkups and preventative care are not deductible.
This is analogous to the casualty loss provisions, which also has a floor.
Cf. § 105 (Amounts Received under accident and health plans), 106 (Contributions by
Employer to Accident and Health Plans). If T is not operating under 213, but has an
employer-provided health plan under 105 and 106, there is no 7.5 floor, and all the
expenses are covered. So there is a disparity of tax treatment here.
If you buy a health policy yourself, though, the premiums are deductible in principle, but
in practice, they will never be greater than the 7.5% floor. So you’ll get no benefit from
the federal government.
Ault thinks that the connotation between health and tax policy is problematic and
I.The Taxable Year
1. pp. 637-643 (stop at "B").
B.The Tax Benefit Rule
1. pp. 644-652
C.The Claim of Right Doctrine
1. pp. 653-657
D.Net Operating Losses
1. pp. 659-660 (stop at "B").
II.Methods of Accounting
A.Cash Method - Receipts
1. pp. 664-671
B.Cash Method - Payments
1. pp. 674-679
C.The Accrual Method - All Events Test
1. pp. 682-683
D.Accrual of Income
1. pp. 684-689 (Omit "C" on pp 688).
E.Advance Payments – look back at how we treat loans
1. pp. 689-696 (Omit "A" on pp 696).
2. pp. 697 (starting with "B") - 698.
Why is accounting important?
- Time value of money
- 3 year statute of limitations, assuming taxpayer files appropriate returns
- There may be a matter of different rates in different years
What is the relation between tax accounting rules, and financial accounting rules?
Two methods of accounting
Fundamental difference is that in cash basis, one ignores accounts receivable and
accounts payable. The accrual basis takes billing into account.
What happens when the two sides of transactions operate on different methods of
accounting? We will spend time with this.
Annual Accounting Period
Rationale – there has to be some period within which income and deductions are
taken together. This period is usually a year, although T can alter it (producing a
Burnet v. Sanford & Brooks
You might want to compare to Rayheon – were expenditures capital in nature, in which
case he would have basis.
Contrast Sanford & Brooks’ annual accounting approach, with one that is transactional.
See § 172 – T can carryback and carryforward losses, beyond the accounting period in
which the loss arose. Losses can be carried back for 2 years, and can carry losses
forward for 20 years. So there is a 23 year period here, that with respect to businss losses
the annual account principle gives way to broader notion that allows for a temporal
Now we will look at situations where annual accouting period is set aside, in favor of a
Deduction in Year 1 – Receipt in Year 2. In a classic case, if you get a tax benefit
in a previous year, you may owe that benefit in a late year. This is the tax benefit
rule. § 111.
No tax benefit rule. Year 2 is not recoverable, because there was no benefit in
As long as there is any benefit in the previous year (e.g. 15%), there will be tax in the
Hillsboro National Bank v. Commissioner and United States v. Bliss
The tax benefit rule will “cancel out” an earlier deduction only when a careful
examination shows that eh later event is indeed fundamentally inconsistent with the
premise on which the deduction was initially based.
Instead of a recovery, there is an event which is “fundamentally inconsistent” with the
original deduction, then that is taxed.
Business use to personal use
Hillsboro fact pattern
In these cases, there has been a deduction, and then repayment.
We now move to there be a receipt in the first year, and a deduction in the later year. See
United States v. Skelly Oil Co.
Receipt (year 1) Payment (year 2)
Loan No deduction
Claim of right § 1341
§1341. Very taxpayer-favorable section. If there is a claim of right in Year 1, and then in
Year 2 it turns out that T did not have the right to the income, T has an option: T can
either exclude item in year 1, and not take a deduction in year, or alternatively, include
the item in year 1, and take a deduction in year two. T gets the best of both worlds in
All of things [172, § 1341, Skelly, Arrowsmith, Hillsboro] have in common that they are
deviation from strict annual accounting expressed in Sanford & Brooks – you have to
look over all the years.
United States v. Skelly Oil Co. fashions another exception to strict annual accounting,
relying on Arrowsmith, which said that if a transaction in an earlier year was being
treated as a capital gain transaction, that in the appropriate circumstances, the taxes…[???
In next two classes, we will look at “cash basis on income side” and “cash basis on
deduction side” and then do the same thing on the accrual basis.
Cash Basis Accrual
Income Deduction Income Deduction
In kind “Paid” “All events” All events
Constructive receipt Pre-payment Advance payment Economic performance
Economic benefit / cash Capital expenditure
(Rev. Rule. 8-52; Barter
Constructive receipt. HYPO: What about accrued interest from bank? See Reg. ???.
Carter. Carter was arguing constructive receipt (usually it is the government arguing
constructive receipt). Carter was unemployed; got a job in Sept. 1974 but didn’t receive
income that he was supposed to. Instead, the income was received in 1976. He’s arguing
that he earned the income in Year 1, therefore I ought to be taxed in Year 1. The
government says no, you didn’t have the income in Year 3.
HYPO. Employee gets contract. See Rev. Rule. 60-31. Controls timing in employment
situations. Says that if money is not in fact received, there will not be a constructive
receipt, and the gove rnment will not speculate whether the employer was going to pay
the $ or not.
HYPO. Employee gets signed note, that outlines schedule of payments. Generally, an
unfunded promise to pay in the future is not income to a cash-basis taxpayer, because that
is the difference between a cash-basis taxpayer and a accrual basis taxpayer.
HYPO. Same as above, except instead of unfunded promise to pay, but that funds are
placed in escrow. There, the T has an appreciable benefit.
HYPO. “Rabbi Trust.” Unsecured promise, no economic receipt.
HYPO. Barter Club. You have the right to ask not for cash, but for a bartering right. This
constitutes economic benefit.
HYPO. Checks. Are checks the same as notes?
HYPO. Credit cards. When does the deduction take place? At purchase? When merchant
was paid? On statement? Payment to merchant is not promise to pay in the future, but
actual payment by your agent (credit card company) on your behalf.
HYPO. Credit cards offered by merchant himself. Book glosses over the distinction
between this and the hypo immediately above.
NB. The cash basis gives a lot of control to T. He can control the payment (year 1 or year
2), and he can control receipt (he can control when he sends his bill). T’s can take
advantage of this. In extreme cases, government will make the argument that the cash
basis method didn’t accurately reflect income with ________.
Boylston Markets Ass’n. T pays 4,000 for insurance. Treats it as a pre-payment of 1000
in year, and takes 1,000 deduction in years 1, 2, and 3. In year 4, government argues no
deduction in year four. Presumably, the statute of limitations has run. Ault thinks this
case is a good example of the government’s litigation policy blinding it to the larger
picture. Thinks that if the government had won case, it would have been bad for the
government, because ______.
Farmers. Can use the cash method where other T’s can’t. As a result, there were a
lot of tax shelters built around limited participation in farm companies, where a
lot of fees were pre-paid to get current deductions based on Boylston Markets,
such as the Pecan scheme.
Pre-Paid Interset. T would pre-pay 5 years of interest. In § 461(g), Congress
restricted those, and puts those T’s on the accrual-basis.
There are some important implications for the cash basis T:
Method of accounting in general terms, but doesn’t use all accounting rules (e.g.
formatting of reserves which reduce current income)
Income. When all events have taken place that will fixed the amount of income. So
obligation to pay constitutes income.
Is there sufficient doubt about collectability to prevent accrual. This is a fact-
Hallmark Cards. Hallmark shipped Valentines Day card before Jan. 1, but title did
not pass until after Jan. 1. IRS says that you are deviating from your normal
practices. The government argues that the transaction took place…. Court says
that the company can do anything it wants, so long as the practice is consistent.
Advance Payment. There is a long history of cases involving the tax implications of
prepayments. In Schulte (discussed in RCA; dance payment case, 40 lessons paid in
advance; court held that statistical analysis can’t be effective). In RCA, the court ruled
that the T’s method of accounting did not accurately reflect income. Ault thinks that the
court was being motivated, principally, that the relation between the government and
taxpayer is different than the relation between the parties, and T’s ability to pay taxes. If
T has the cash now, the government wants it now. (p. 694) Advance payments are taxable
currently, despite the fact that T might not have the money to pay the tax. Ault thinks that
the SC’s treatment of these cases are not sound, because _____. Regulations are stricter
than court. There are more liberal rules in court _____.
What alternatives might there have been for the taxpayer in RCA to remove the
obligation from paying taxes in Year 1, despite the fact that he has the tax? Set up a
“reserve” for the future costs involved in earning this income. You can deduct this
United States v. General Dynamics. Injury services provided insurance filed
insurance approved insurance paid. Court imposed tax, using the “all events test.”
Over a strong dissent, we still don’t know if they’re going to be filed, so we don’t yet
know whether the obligation to pay has been accrued.
Implications of Time Value of Money
Hypo. Company has accident. Company and plaintiff agree that damage is 1M. Company
says to plaintiff: “I won’t pay you today, but in 10 years, I’ll pay 3M” (i.e. 12%
compounded interest). The company wants to currently take a 3M deduction.
In Ford (p. 710), one of the few that the government actually won, the court pointed out
that it would actually be better off if they got into these types of accidents, because they
could arrange “structured settlements.” Utilizing the time value of money, they would
actually be better off!
Congress responded by § 461(h), the “economic performance doctrine” which puts some
T, as those with structured settlements, on the cash basis. In other expenses where the
expenses have been incurred, T has to defer deduction until expense actually taken.
An alternative would be to tax T on the present value on the amt. to be paid in the future.
This is, in fact, used in certain situations (e.g. mining, deforestation cases; nuclear power
plant decommisioning). This is generally done when income is severely distorted.
So 461, “all events” are not deemed to have taken place until “economic performce” has
This finishes up the accounting materials.
Finish accounting materials in II
Read III.A and § 83
Read all material on Assignment of income (III)
Lucas v. Earl. Tax avoidance purpose? No. He has no control over it. Significance:
Income from serves are taxed to the person who earns them .
HYPO. Suppose I work for myself; suppose I work for my child; suppose I work for a
charity, and instead of taking fee, I let charity have the fee I would have collected. Does
law of agency come into play?
Revenue Ruling . Tax professor teaching clinic. He can’t keep the money, because of
federal regulations. Treasury says that it would normally be income, but that there are
sometimes “special circumstances” in which it’s not.
HYPO. Enter prize, if you win, the prize money goes to someone else. Court said that it
was “so far in advance” of actual event, you could treat it as income belong to the person
who got the prize, not the person who earned. The terms of the context were such that the
person who earned it could never get it. Court says this is unlike Lucas, because the
earner never had the right to get the income in the first place.
Income from Property
If the T gives the property away, then the income from the property taxable to the person
who owns the property. We’re not talking about the property from himself, because that
is a gift.
Blair, Shaffner, Horst – is T shifting the tax liability of the property, or the tax liability
from the income on the property.
HYPO (Executive Compensation). Suppose Employer gives Employee a share of stock.
Is e’ee taxed on it? Yes. He will be taxed on sale of stock.
Question – How do options work, outside employment context???
HYPO. E’er gives e’ee option; exercise price 110; FMV at time of transfer is 100;
§ 83. In the case of options, option is only includable in income when received, if it has a
readily ascertainable value.
Option grant Option sale transfer Restriction sale
(price 100) exercise lapses
FMV 100 150 400 100 150 400
0 150 750
§ 83(b) 100 0 300
§ 83(b) is extremely important in high-tech startups. There, you make the 83b election,
arguing that there is little or no value to the option. Then you get the discounted capital
Income from Property Itself
Law in this area is principally provided by cases, and old cases at that
Blair. Stands for the principle that if you make what you might call a vertical slice
of the property, which includes more than right to receive income, then that would
be effective to transfer the incidence to the tax,
Contract Blair with Shaffner (T had right to get $, and he transferred for one year
the right to get the $, and could make the decision each year how much of the
income he wanted to assign). The court said that this wasn’t effective to transfer
the taxability of the income; you can’t horizontally slice off a portion of the
property you were going to receive for the year, even if the transferee would have
some fiduciary rights for that year.
We will look more at this later
Horst (father kept principal of $100 bond, and took a $10 coupon off, transferred
it to son). Is son $10 taxable on income? Transfer is more like Shaffner than Blair
– he is keeping the rights that the bond gives him; he is transferring only the
interest. Under general assignment of income principles, he ought to get taxed,
not child. But Horst goes off on metaphysics. It could have only been handled on
a transfer of income basis. But soon the metaphysics (pleasure dad got from
giving $ to son) became a dead letter – now it stands only for the transfer of
o Who will be taxable on the $10? You should look at the relative values of
what the father keeps, and what the son gets to find out how each should
be treated. See §1286. The statute comes to a different result that Horst,
allocating the income based on present value principles.
Hyman. Is the rights to the exploitation of the patent, a separate aspect of the
property that he can transfer? Or cannot he not transfer the income independently
from the patent. Court said case was close, but that it was closer to Blair than
Shaffner, because he is getting something besides the right to the income.
o HYPOS. Manuscript shifting example. Rights to certain geographical
area? Give to my son, so he can publish? Give X years of royalties to son?
Go into capital gains materially deeply. Read, in new assignment sheet, § A thru E. We
will probably get through most of that.
“There’s a wonderful dispute going on right now”
Rationale for treating capital gains preferably. 1) Capital gains are not income, because
they are not recurrent. Ault thinks that this is merely defining away the problem; 2)
Philosophical difference between land and income from land; 3) in a progressive rate
structure, the progressive rates make a big difference if you have a lot of income in one
year, and less in another year. Without special treatment of capital gains, income would
be “bunched” in one year. The problem is this is that there are better ways to prevent
bunching; 4) favorable rate is only a result of inflation. But problem with this is that it is
not an accurate measure of inflation; 5) to give people an incentive for investment, but
why should there be an incentive to invest in a company which doesn’t give dividends
Ault thinks that the preference for capital gains is at odds with progressively.
§ 1221. Ault thinks the statutory structure is odd, because “capital assets” are defined as
what they are not.
§ 1221(a)(1). Distinguishes inventory held “primarily for sale to customers in the
ordinary course of trade of business.”
Dual Purposes. Malat v. Riddell (S.Ct.1966). T had land, which he sold. Was the land a
capital asset, or not? Statute analyzed the T’s purpose: was it held “primarily for sale”
(not capital asset) or not (capital asset). Problem was that T had “dual purpose.” Defined
“primarily” as “of first importance” or “principally.” But this doesn’t solve the problem.
So courts look at “surrogate factors” for determining whether capital asset exists:
Frequency of sales. If this is the only real estate that I have sold, this is a sign of
capital asset. If I have a lot of sales, then it’s more likely not capital asset.
Development of Property (e.g. subdividing land). This would make you look more
like a business.
“Busy-ness” Test. If T puts a lot of work into the property, then that starts to look
like a business.
How Long Property is Held. If held for longer, then the more it looks like it’s
being held as an investment.
Can asset be (dis)aggregated from/with T’s other assets.
Is it held primarily for customers? (in context of sales of stock of securities). In
this industry, there is a distinction between traders and dealers (like investment
Bramblett v. Commissioner (5th 1992). Significance of case is not so much its
precedential value; rather, it is used to show how “factual determinative” these cases are.
In short, just know the factors, and how to apply them.
Today, it is common to try to 1) pre-sell the land (before it’s developed) and 2) to create
sister organizations to do the sales, and for another organization to do the investment.
HYPO. Buy machines for 1000, basis reduced to 700, sell machines to 500. (Your
business is not buying/selling machines, but using them to make widgets.) This shows
that you were not taking depreciation fast enough. You could argue that 500 ought to be
an ordinary loss, since it’s a depreciable property used in the course of a trade or
business, and you’re just getting the depreciation right.
HYPO. Buy machines for 1000, basis reduced to 700 through depreciation, sold for 1100.
The tax treatment is 400 income; 300 of which is ordinary income (because you took
depreciation before) and 100 of which is treated as a capital gain at a preferential rate. §
1245 (with respect to personal property, such as machines, etc.)
§ 1231. Depreciable property used in a trade or business. The first thing that happens is
that this property is taken out of § 1221 (including real property – business, land and
machines) and gived special treatment in 1231. this corresponds to the idea that if
property is sold for a gain, then it is taxed at a preferable rate (capital asset rate); if at a
loss, then it is sold at a preferable rate (ordinary rate)
But depreciable real estate is an exception. They apply only to the excess of depreciated
realization over straight line depreciation. Today….Congress loves real estate developer.
See 1250. But 1250 has nothing to oepratate on now.
HYPO. Two plants basis is 1000. One goes up to 1100. One goes down to 900. how
should I be taxed if I do this in the same year; how about if loss is in year 1, and gain in
Finish capital gains material on Tuesday.
We saw one exception to the “everything is capital asset” definition in 1221 that
(inventory, stock in trade, or property held for sale…). See § 1221.
A second aspect of capital gains occurs when T is clearly in a trade or business, and he
has a machine in his business that he uses to produce the widgets, and that he bought the
machine at 180, took depreciation for 150, forming a basis of 130, and then sold the asset
for 200. He thus has 50 of gain (sale price minus adjusted basis). How should it be taxed?
If you just read 1221(a)(1) you would say that this is not inventory, therefore it is a
capital asset, therefore all of the gain (50) is capital gain entitled to the preferential rate.
But then we identified the fact that of that 50 of gain, 30 of it doesn’t really represent
economic gain, but represents during the period T was using the asset, he was taking
depreciation on the asset (the depreciation being conceptually founded on the idea that
the asset was actually declining in value and would ultimately be useless; this was
offsetting income in his ordinary business), and it didn’t seem appropriate to give him the
deductions. This is what section 1245 does with respect to tangible property, where the
income must be recaptured as ordinary income.
Situation 1 – Machine Situation 2
Price paid = 180 180
Depreciation (adjusted basis) = 30 (150) (30) 150
Sale Price = 200 130
Gain (sale minus adjusted basis) = 50 (200 minus 150) Loss (sale minus adjusted basis) = (20)
But 30 is taxed as ordinary income under §1245; Theoretically, you should deduct 20 against ordinary
20 is taxed at favorable capital gain rate (it’s the fruit, not income, because you didn’t depreciate fast enough. This
the tree) is the result that the Code comes to. 1221(a)(2), 1231
This doesn’t apply to real estate, which is taxed at 28% (§
If you did both in the same year (and they were the only transaction you had), you would
have 30 in ordinary income, and since you have 20 in capital gain, and 20 in capital loss.
1231 forces the 20 in capital loss. T would prefer take 20 in ordinary loss. As a tax
planner, you would want to do a straddle: sell the second property in year 1, for ordinary
loss; sell the first property in year 1 for a capital gain profit.
To fix, see 1231(c): in deteriining whether you get capital gains treatment on the gains
sale, under this section, T has to look back for 5 years and see if there are any 1231 losses
in those years; if there were, then T doesn’t get capital gain treatment on gain. But T can
do it the other way around: sell the gain property first, and then sell the loss property in
the next year, and get roughly the same result, but congress really wans’t upset about this.
3000 limitation [how does this apply????].
HYPO (Involuntary Conversion) . Suppose the property in this situation is destroyed by
fire, and I collect 200 on the insurance proceeds. You would still have worry about
recapture of 30, because this is a disposition under § 1245. What about the gain of 20?
Theoretically, it should be taxed as an ordinary asset. See table above. But actually, it’s
taxable as an capital gain. See § 1231.
Note the difference between the year that these gains/losses are incurred. If in the same
year, everything is put together in 1231, which has the effect of netting them (though not
technically netting them). Ault thinks this netting procedure (firepot, hodgepot) is
unnecessary complicated. If it’s in two different years, then…
That’s 1231. This can be theorized as the second set of exceptions to 1221, the first being
____. There are other exceptions, such as those these are taken out of 1221, and are
therefore not capital assets. For example, copyrights are all going to be ordinary. On the
other hand patents can get capital gain treatment, even for corporations that have patents
Cases (statutory gloss on these interpretive losses)
Suppose you have a manufacturer company, and manufactures something that you need
raw materials for. Suppose the company has to set its prices that its ultimately going to
sell its products for a long time in advance. Suppose that a raw material is, say, sugar, and
the value of sugar can go up and down in the market. But as with most commodities you
can buy an option on the sugar for a fixed price for delivery on a fixed date. Suppose that
T, to help it establish its prices, bought a so-called futures contract giving it the right, but
not the obligation to purchase the sugar. Suppose that the company paid 5 for the option
contract to buy the sugar at 50. Now suppose that the value of the sugary at the delivery
date is 125. Suppose the company bought for 50, and then sold it ultimately for 200.
Basis is 55. sale price is 200. So 145 in ordinary income.
But suppose T reads § 221. What he does is sell the option, and then go out in the market
and buy the sugar I need to make my produces. So I’ll have a higher cost for the products,
and will take profit in the option. Why would he want to do this? Because the sale of the
option is a capital asset in principel (1221 – “capital asset except) and
He would thus be able to convert a portion of his income (ordinary income) into capital
gains. This is exactly what T did. Treasury then came in and argued that this asset was
not a capital asset because it was “an essential part of T’s business,” and therefore despite
what the statute says, and despite the fact that it did not fit into any of the exception under
1221, it should be treated as an ordinary asset, and the gain should be ordinary. See Corn
Products. This case represented a judicial gloss on the statutory definition, which was
bottomed on some sort of notion on “intergrality to the T’s business.”
But Treasury has to be careful what it wishes for. It won this case on it’s theory, but think
about the opposite case. Suppose this was an asset that had down in value. T could take
an ordinary deduction for this loss. That was the law for a long time. The cases where this
typically came up were manufacture has a subcontractor that it works with; it invest in
the stock of the subcontractor; the sub goes bankrupt, and T says that this is an ordinary
loss because it had to do this to do business.
But all of this came to an end in Arkansas Best. There the court reviewed history, and
held that the statute means what it says, that there is not “intergrality” of bueinsss
component. What the statue says is inventory. If it’s not inventory, then it’s capital. So
this case has put an end to this “extra-intergality” argument.
The second argument, that we’ll deal with briefly, is Hort. There, T had no basis in lease,
and therefore can’t claim the loss. But even if T can’t claim the loss, there’s still the
question of how T will be taxed – capital gain or ordinary gain. Court said that it was
substitute for rent, and thus capital asset. But the problem is that as a general principle,
simply incanting that X is a substitute for future income doesn’t help – everything, even
the building, might be said to be a substitute for future income
If right to income has a short term; if there’s no real way that it will fluctuate in value,
and if the right to the income is carved out from a larger right and then sold separately,
then courts will be inclined to apply Hort-like analysis.
If the asset is all that he has, he disposes of all of it, and that there is volatility in price,
then courts are more likely to say that that can get capital gains treatment.
Williams v. McGowlin. Can “the business” be an asset? And thus all the compoents of a
business are capital assets? If you own proprietorship, then assets must be broken down.
On the other hand if it’s a partnership, then not. § 731 (sale of a partnership is a capital
asset, qualifing for capital gain). Also, if stock, then not.
Finish Capital Gains material (very quickly)
Read all II. (like-kind exchcanges and involuntary converstiosn)
Williams v. McGowin. Allocates purchase price to various assets in the pot (e.g. land,
inventory, machine, good will)
Land He wants gives him an Would like a lot
asset he can’t allocation to the land,
depreciate, and can’t because it’s going to
cover his costs until be capital asset (and
he sells it preference capital
Machine 1231 asset more neutral;
depreciable fairly quickly,
Goodwill Seller wants to How fast is the goodwill
allocate here. Evin if depreciable. A few years
basis is going to be 0 ago, it was not depreciable
because it is self-
created good will
Covenant Would want it here, Almost certainly This would be depreciable.
not to because it’s ordinary income to
compete depreciable. the seller; little as
Service is not bound by parties decisions. But case law says that if the parties have
different interests, it will generally respect the taxpayers decisions. But 197 says that all
intangibles, including goodwill, are depreciable over a 15 years. So the parties will want
to allocate as much as possible to goodwill. The buyer is indifferent (he’ll amortize the
covant and good will under 197 at the same rate) whereas the seller will get preferential
treatment on the goodwill, but not on the covenant not to compete. So the parties
wouldn’t have adverse tax interests.
Rules for allocation in general are set out in § 1060 (which we didn’t look at), which says
that both parties must disclose the allocations that were made. In other words, the
government must be on notice of the allocations.
Last two requrimetns for preferential rates: sale or exhange; holding period.
Sale or Exchange. Technical requirement, doesn’t come up that much. Suppose building
burns down, and you get proceeds. We saw that 1231, in the case of involuntary
conversation, will be treated as a sale or exchange. But on the other side, under 165, if a
stock or security becomes worthless (and it’s a capital asset), then it’s not being disposed
of as a sale or exchange. Maybe it could qualify as a regular loss. But statute supplies the
necessary sale or exchange provisions in ______. Some case law says that there is no
capital gains treatments for ____ becoming collectible. The smart taxpayer would just
sell the policy before it became collectible.
Holding Period. The final question is the holding period. One of the primarily purposes
of capital gains is to distinguish between investment and speculation, the holding period
becomes important. Right now it’s a year. You have to be careful in the application of
this rule; in the first case, the capital asset has to be held for “more than a year” (so
holding it for a year doesn’t count), and when to start. The holding period doesn’t begin
during the day of acquisition, but you do count the day of disposition. If you acquire on
Jan. 1, and sell on Jan. 1 of the next year, you will have held the asset only one year
(because it starts on Jan. 1). To qualify, you must sell on Jan. 2. then you’ll get “more
than one year.”
Tacking. § 123. For purposes of determining whether the holding period has been met, in
transactions where T takes an asset from someone else, T also takes the donor’s holding
period. See also 1015, 1023.
Economic Income. - broadest
Realization. 1001 (amount realized minus basis, and must be recognized) - narrower
Recognition - narrowest
So we will are now looking at transactions that are realized, but not recognized.
§ 1031. T doesn’t have to recognize gain/loss if _____; ensures that gain/loss that T
doesn’t recognize is not eliminated, but is only deferred. T has basis for new property
basis he had for old property.
Basis FMV Cash Gain Rec New Basis
A 4000 4000 1000 1000 1000
B 2000 3000 0 0
Transfer Subject to Mortgage (§ 1031(d)).Where a property is being transferred subject
to a mortgage, that that will be treated as cash. That means it being treated as boot.
Property must qualify for 1031 treatment. The language is stock in trade or other
property exchange primarily for sale. Stock bonds and notes are not included
.doens’t apply to interests in partnerships. What’s left is property held in trade or
business or for invetsmetn – basially just real estste and tangible personal
Then the property it’s exchanged for must be for a “like kind.” There, the statute,
as interpreted by the Regs is quite libery – looking towards quality of the
property, not to its use. So you can exhcnage an apartment building for vacant
land. They would qualify as like-kind propertys, and 1031 could be applicable
o Live-stock of different sexes are not of the same kind.
HYPO: Property; Basis 100, FMV 1000; don’t want to sell. Someone approaches
me and says I’ll pay you 1000 for property, and I say to him thanks but I don’t
want to pay tax, and B, I want to keep my property. He says to me, just stay right
there, I’ll take my 1000, I’ll buy a pience of property, and I’ll exchange my
property for your property. I don’t have to pay taxes, I still stay invested in real
estate, and other guy gets my real estate. Everyone is happy!
o But you have to identify one of several properties within 45 days, and
transactions must close within 6 months.
o There are 1031 companies that basically have properties available to do
these 1031 exchanges
From a policy point of view, you can ask yourself why this generous deferral of
tax is allowed – not taxing it currently is valuable? Sometimes it’s said that there
are problems of valuation. But every time you have boot, you have valuation.
Ault talked a lot about mergers – difference between exchange stocks and cash
HYPO (§ 1233): Factory; Basis 500; FMV 1000; Property burns down; Insurance
pays 1500 cash (at this point involuntary conversation capital asset); suppose
you immediately reinvest by building a new factor.
o Under 1233, if T invests in “like-kind” property, he can defer the gain. If it
didn’t reinvest all of it, he would be taxed on the amount not invested
10 more minutes on § 1233, and then § 121; then move on 728-34; 723-28
HYPO Basis = 1000; destroyed by fire; Insurance = 1500.
Raytheon [what is the significance of this case]
Gain = 500; Taxed as capital gain 1231 (involuntary conversation)
What is an argument for not taxing the 500
o It’s a forced realization
So § 1033 allows you to reinvest the proceeds
o Property must be “similar or related in service or use”
Case law and regulations go into some detail on this
Basis. T must reduce basis by $500, because this represented gain
of before-tax dollars
Suppose property A is replaced with property B
Comparing 1031 and 1033
Similarity. The boot in 1031 is equivalent to the failure to reinvest in 1033
Difference. In 1033, you can get cash, without having current recognicaiton, but
the condition on that cash is that you have to reinvest the cash within the statutory
period. On the other hand, you can’t get cash at all. If you get cash for a scintilla
of time, you’re going to get recognition
§ 121. Exclusion of gain from sale or principal residence
For a while, sale of residence was like 1033, in that you could turn around and
reinvest in another house, and your realization would be deferred
Unlike 1031 and 1033, 121 provision isn’t a deferral of tax, but is instead an
exemption from tax
Present Value and § 1271
PV, FV, n, i.
o If you have three variables, you can always derive the fourth
When analyzing these problems, there are two issues
Congress originally said T should be taxed currently, even though
he was on the cash basis, and never received the cash
Finally, Congress said in § 1271 that OID would have to be
included by the holder of the bond, and deducted currently by the
issuer of the bond.
This determines the redemption price of the bond, and the
issue price of the bond, and thus the OID is taxed presently
Taxpayer who holds the bond adjusts his basis every year,
adding to it, so that when he redeems the bond at the end of
the year, there’s no gain.
If someone purchases the bond from T, he steps into T’s
Ordinary income versus capital gain
Congress originally denied capital gain treatment of OID
HYPO. T1 has basis in property of 75; contracts with T2, to pay T1 133 in three years.
Why might T1 have wanted to K in that way? To 1) defer the income, and 2) characterize
the income as capital gain. But court might say that you are playing with the value of the
property. You might say that the value of the property is only 100; thus only 25 is capital
gain; the remainder is interest. To do this, Congress knows the FV and n. It also can
assume i. So Congress through § 1274 can derive PV. It will allow 25 of capital gains at
This can be favorable to T, because the Federal rate will always be low (because it won’t
HYPO. I issue a bond which bears stated interest of 10% at a time when interest rates are
10%. This obligation is not issued as OID, because if we apply section 1271…. But
suppose then that interest rates go down, and the value of the bond goes up. What’s going
to happen? Someone will pay more for the bond than what it was issued for. In these
circumstances, the statute doesn’t worry about timing, but it does worry about character.
1276 says that that income does not qualify as capital gain; it has to be treated as ordinary
income. With respect to market discount (moving of interest rate after bond was issued),
there is a timing question that code resolvese in favor of the taxpayer; but there’s also a
characterization questions that 1276 says that the bond is not capital gain, but ordinary
So market discount is a sort of halfway house.
Tomorrow, we’ll consider the problem on TWEN. We won’t start taxation of the family.
We’ll go back over this in the context of the problem I passed out. 7872, installment
sales; go over the model exam question on website
November 21, 2006
BOAT HYPO. If X promises Y his boat (basis is 100,000) in 10 years, what are the tax
consequences? You must impute present value (issue price)
Year Adjusted Issue Price Interest
1 376,889 38,631
2 415,520 42,590
… … …
10 1,000,000 623,611
Timing – 10 years
Character-interest income – taxable currently (and deductible currently on the
other side of the transaction)
Gain. At year 10, there will be a realization of 276,889. This gain can be deferred
(under the installment method) and is capital gain (because it represents the sale
of the boat).
Market Discount. HYPO. I issue a bond with adequate stated interest. But then suppose
the interest rates go up, and the bond thus becomes less valuable. What will happen if a
third party buys the bond? The interest stream is, of course, taxed as interest as it comes
it. In addition, you theoretically might treat the discounted bond as “Original issue
discount.” But the statute doesn’t do that: with respect to “market discount,” _____ but
on the other hand T isn’t prevented from converting interest income to capital gain. See §
1276. (you can defer the gain until the end, but it has to be taxed as ordinary income.)
You can think of this as a compromise approach. The key here is that the discount has
been created on the market, by interest rates changing in the market. From the point of
view of the purchaser, economically this reflects the same thing, but Congress chose only
to take away the capital gains treatment, but not the _______.
Hypo. Suppose I have 1,000,000 in stock, and I give the dividends to my son. Interest is
taxable to the father. (See Horst, assignment of income – in this line, there is a lot that
isn’t clear, but one thing that is clear is that if I keep the tree and try to give away the
fruit, I’m going to be taxed on the fruit). What about if instead of giving the son the
dividends, I give my son a loan of 1,000,000, and with that invests in stock and receives
dividends on the stock. What is the significance of my not charging any interest on the
loan. You could treat it as a give of the interest. § 102 (gift) was not taxable to son. The
case law was that it was not a gift. Congress responded with 7872 (“below interest
loans”): in two situations (familial situations, and employer/employee situations) if there
is a loan at below interest (below, that is, the applicable federal rate) then 3 things will be
deemed to have happened: 1) father will be deemed to have made a gift to the son in the
amount of the interest for gift tax purposes (there are not income tax); son will be deemed
to have paid back to the father the applicable amt. of interest; then that interest may or
may not be applicable to the son (depending on whether how he used the loan). If he used
the loan under 163(h) that would have been deductible, then deductible, and vice-versa.
Finally, the father is deemed to have received the interest from the son. And the interest is
taxable to the father. So the interest rules that we’ve been looking at in effect create an
interest payment (deductible or not) and an interest receipt (clearly taxable) and taxing
the father on the interest receipt is related back to the original proposition of the father
transferring the investment income to the son while holding the property. Requiring him
to ___________ the income on the interest free loan is the functional equivalent of
requiring him to pay the tax on the dividends, even though those dividends are distributed
to the son.
Applicability of § 7872. If loan is below 10,000, there is no imputation. If the loan is
100,000 or less, there isn’t interest imputed beyond what the son eans on the loan. If son
uses it all for consumption, there wouldn’t be interest at all.
This same relationship would be true in the e’ee/e’er relationship.
HYPO. Basis = 60; FMV = 150, Sale = 150. Terms are adequate stated interest (we’re not
dealing with 1274); 15 a year for 10 years. It depends on the accounting method. If
accrual method, he’s taxed on entire 90 gain in year 1 (because there’s a fixed obligation
to pay). But what about cash-basis taxpayer? How much of the gain is recovery of basis.
The notion of “cash-equivalence” might say that he should be taxed on the entire gain in
year 1. You could let him receive the first 60 as basis; you could say he got profit first, or
you could do what the statute does is § 453 and apply a proportion: a fraction, the
numerator of which is the gross profit on the sale, the denominator of which is the total
contact price to be paid, or in this case 6/9.
But there are circumstances in which the installment method is prohibited: if the property
could readily be sold for cash: why are you selling it over time?
T can elect out of installment sale treatment. He will then be taxed on everything in the
If transactions total >5,000,000, T must pay interest on the deferred amount of tax.
Gift and Sale of Installment Sale. Suppose collect for a few years, and then give to my
son. That’s a realization. This is one of the few places in the code where a gift is treated
as a realization event. But what’s really happening is that I’m being allowed to deferred
the tax on the gain (and it’s only these notions about liquidity that is allowing me to defer
it). In other words, the deferral privilidges is personal to me. If I try to transfer it to son
453B says that I’ll be forced to realize all of the gain that I have not realized already. In
those circumstances, the son would step into the same circumstance as I was in, but not
have to pay anything on the gain (although he would pay tax on the interest as it accrued
Suppose that the note didn’t bear adequate stated interest. This is more complicated,
because before all the property came at the end. Now it comes piecemeal. You must do
two things: 1) figure out what the property is being sold for (by discounting the payments
T is going to receive, but instead of just calculating just one payment, you have to
compute all the payments). This will tell you the issue price, and what the gain on the
property is going to be. You then apply the OID rules to calculate the amount T must
include in income, whether the T gets payment or not. This will be added to the adjusted
issue price. You don’t have to know how to do this, but it’s fun – Prof. Ault. You first get
capital back entirely, and then divide back interest and capital.
3 more classes next week: taxation of family; material on alternative minimum tax. Read
all of this for next time. Next time, we will first go over theproblme on the website; work
on taxation of family and alternative minimum tax until I finish. The last class on
Thursday will be review. Part of the previous Weds will be review.
Taxation of the Family
Drucker v. Commissioner (2nd Cir. 1982) (husband-lawyer and wife-programmer
challenge “marriage penalty” on EPC grounds)
o Outlines history of “family unit”
If only individuals were taxed
o Community property states divide income equally between spouses
o But non-comuunity property states would tax each spouse as earned; if
spouses earned very different amounts, then there would be a big
difference in tax burden (horizontal inequity)
o Some states shifted to community property regimes
Congress responded by doubling width of single-taxpayer bracket for married
couples filing jointly; this had the effect of dividing the income equally between
o But this created a problem – couples with X income would be taxed less
than a single with X income.
Congress responded by not doubling single-taxpayer bracket, but by multiplying
it by approx. 1.2.
o This created the Drucker problem: the “marriage penalty”
The D argued EPC, but court said that Congress can apply the rate
structure (married filing separately, single, head of household [we
won’t spend time on this], married joint return)
Equal treatment of married couples, regardless of the division of income between
them. (This is what we had when we had aggregation and splitting.)
Parity between married couples and singles with same amount of income
Avoiding tax increase on marriage
In 2001, Congress responded by keeping the larger brackets, but only at the bottom of the
rate structure. So people in the lowest brackets can split. Since they can split, there’s no
tax when they marry. But in the upper brackets, there will be an effect.
Imputed income should also be taken into account.
Another approach was to provide a deduction for two worker families, to correct for the
impute income of the single-worker family.
o Go back to simple individual taxation. The notion of pooling and sharing
is not appropriate.
o Allow broader pooling. Allowing broader joint returns to any “stable
What is a “married couple” for these purposes?
Not a “sham marriage.” Revenue Ruling 76-255. Under the traditional
formulation, the state law determination controlled; but under this ruling, the
court says, following Knesh, that they will not recognize sham transactions.
Federal Defense of Marriage Act. Says that a marriage must be between a man
and a woman for tax purposes.
Other places where “marriage penalty” arises.
Standard deduction. As part of trying to eliminate the marriage penalty at lower
brackets, the standard deduction for married couple is double single deduction for
Earned Income Credit. If two ppl. qualifing for EIC marry, they may loose some
Problem of the Innocent Spouse. There is a special provision that says if an
innocent spouse had A) no knowledge of the income, and B) no benefit from the
income [this is harder to determine] the innocent spouse will not be liable for the
There is a conundrum here; there are values at stake
How to treat dependant children?
In general, they are treated as separate taxpayers
But there are limitations: if they are claimed as a dependant, you are limited in the
amount of standard deduction you can take (to 500, instead of 3,000).
Kiddie Tax (§ 1(g)). Requires unearned income (income from investments)
earned by a child under 18 has to be taxed in the child’s return, but in the parent’s
marginal rate. The rationale is to prevent income shifting form parent to child.
There is an exception: if income is only interest and dividends and under 5,000,
the parents can include that in their own return. See 1(g)(7). This counts for kid’s
paper route as well.
Alimony (right of spouse deductible Taxable
leaving marriage to receive
support for his or life from
Child support (payment by Non-deductible Non-taxable
one of the spouses to the
other spouse to support
children of the marriage)
Property Settlement Non-deductible Non-taxable
Alimony. A continued splitting of the income of the couple. They were splitting
the income as a couple, now they are no longer married but are still splitting. So
A) it should only be taxed once, and B) it should be taxed as a consumer.
Child support, on the other hand is continued support of the child. So it’s non-
deductible to the payor, and non-taxable to the payee. Same result for the property
The characterization of “alimony” or “child support” was determined by state law,
and designated in the divorce agreement. This let to lots of litigation. So Congress
amended § 71 and § 215 to provide a federal definition of alimony and child
support. under the statutory definition, alimony must be 1) paid in cash (no
property), 2) in connection with a divorce or separation agreement (to prevent
income splitting, and also to prevent voluntary), and 3), alimony payor and payee
cannot be members of the same household, and 4), payments have to end at the
death of the receiving spouse (to prevent disguised child support or property
Child support. Parties can negotiate tax consequences.
§ 71. if the parties call it alimony, and it is alimony (see specific factors), then it will be
treated as such. If alimony, then deductible by payor under 215 (above the line, so you
can take the deduction even though it’s not a business expense). If it’s child support,
however, the result will be different. See the table above.
BUT. If the “alimony” payments are “front loaded” then 1) 71(f) (insanely complicated,
but easy to get around). Just don’t have 100% alimony paid in the first year, 2) if
characterized as “alimony” but is contingent (such as termination when child reaches 18),
it will be treated as child support (thus non-deductible)
What about property settlements? From point of view of payor, it’s not deductible (it’s
not buseinss related, and viewed as a type of consumption), but for payee it’s not such an
easy question. On the one hand, you can say that the property rights are consumed by
payee, so they should be taxable; on the other hand the recipient does have an increase
power to consume, like gifts, one or the other should pay the tax, but not both, so payee
should be able to exclude it.
HYPO. Payer has basis in property of 200, FMV of 1000, transfers at 1000 to other
spouse. Person receiving property won’t be taxed on the property. But question is, what
happens to the appreciation. Prior to § 1041, the appreciation turned on state law and the
nature of state law rights. This is the Davis case. There the Supreme Coufrt said that
whether the payor did or did not realize gain on the property settlement was determined
by state law – whether the spouses rights depended on joint ownership, or whether the
rights on state law were more like a claim on the property, and this was more like the
property being transferred to satisfy the claim. If the latter, then there would be tax on the
transferor. This resulted in messy litigation. Congress responded by enacted § 1041,
which reverses Davis, when transfer is made between married persons, and also transfers
incident to diverose (persons not married, within one year) then there will be no
realization on the part of the payor, and the payee will take a carryover basis. Unlike the
case law, which put the tax on the appreciation of the payor in certain circumstances on
the payor, under 1041, the appreciation will always be on the payee. So it’s like 1015 –
no realization on the transfer, and the basis carries over. But it’s beyond 1015, because
it’s a carryover both for gain and for loss.
Property 1000 800
Finish family taxation; look at property settlements, look at ante-nuptial case; look at
Suppose transfer is not in connection with divorce, but is in connection with marital
rights. This occurs in the context of a ante-nuptial agreement. Normally this would take
place after the marriage (1041 would apply). But the Farid case is different because for
whatever reason, the transfer was made in respect of marital rights, but it was made
before the marriage took place, so even today, this fact patter would not be governed by
1041. the issue in the case was whether the wife _______. Carryover basis or FMV gift?
Court ruled it was not a gift; she was giving up her marital rights. There was a
conundrum, because if transfer was recognized by payor, then ____, but if he doesn’t
recognize the gain, and she doesn’t either, then the appreciation goes untaxed.
We have seen that there are a lot of tax expenditures. Should the people who minimize
their taxes by following the tax expenditure guidelines get rewarded? Or have to pay an
AMT. The latter. But why? Congress is concerned with the “excessive” use of tax
expenditures, and they could get at them with the AMT. There also a problem of public
reception (“GE Paid no Taxes), and this lessens confidence, which ends up with Joe
Taxpayer paying less tax.
Structure. With regard to the rate structure, there is a 62,500 exemption for married
couples. This is the “0 bracket.” After that, the tax rate is 26%. At 175,000 is goes to
28%. So it’s a tax with a big exemption, and a relatively tax rate. This is applied to
“alternative minimum taxable income.” This starts with regular taxable income, and adds
back a number of items which were excludable or deductible (accelerated deprecation,
certain stock option gains, but most importantly: state/local tax (deductible) personal
exemptions and standard deductions, and miscellaneous itemized deductions (§ 212)).
Less significant are medical deductions (only exceeding 10%), home equity interest
(163(h) is also added back. Comparing the tax from the AMT and the regular tax, you
pay the larger.
More and more people we be hit by AMT in years to come.
What could be done with the AMT?
Since the tax base is broader, it might help raise taxes
Repeal AMT? Raise the regular tax rate?
Multiple choice on a fact pattern (1/3)
Short answers like hypos we worked on in class (1/3)
Essay question (1/3)
Less is more