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FEDERAL INCOME TAXATION OUTLINE

VIEWS: 25 PAGES: 151

									FEDERAL INCOME TAXATION OUTLINE
TAX POLICY: THEORIES AND CONCEPTS .....................................................................................................5
TAX COMPUTATION SUMMARY ......................................................................................................................5
        I.         Tax computation.........................................................................................................................................5
WHAT IS INCOME? .................................................................................................................................................6
        I.         Definitions of Income .................................................................................................................................6
              a.       Section 61 .............................................................................................................................................................. 6
              b.       The Haig-Simons definition ............................................................................................................................... 6
              c.       Judicial definitions............................................................................................................................................... 6
        II.        Form of Receipt, Generally .........................................................................................................................6
              a.       The doctrine of "constructive receipt." .............................................................................................................. 6
        III.           Fringe Benefits .......................................................................................................................................7
              b.       Fringe benefit tax policy concerns ..................................................................................................................... 7
              c.       General rule: Section 61 and fringe benefits .................................................................................................... 8
              d.       Tax expenditure fringe benefits ......................................................................................................................... 8
              e.       Work-Related Fringe Benefits ............................................................................................................................ 9
              f.       Meals and Lodging ............................................................................................................................................ 13
              g.       Property transfers as compensation (Section 83) ........................................................................................... 15
        IV.        Below-Market Loans ................................................................................................................................. 16
              a.       Section 7872 ........................................................................................................................................................ 16
        V.         Imputed Income ........................................................................................................................................ 17
        VI.        Non-Work income .................................................................................................................................... 18
              a.       Gifts ..................................................................................................................................................................... 18
              b.       Bequests .............................................................................................................................................................. 19
              c.       Government transfer payments ....................................................................................................................... 20
              d.       Prizes, Awards and Scholarships .................................................................................................................... 20
        VII.           Capital Appreciation and Recovery of Capital ..................................................................................... 21
              b.       Capital Recovery and Basis .............................................................................................................................. 21
              c.       Realization .......................................................................................................................................................... 28
              d.       The Realization requirement as a constitutional imperative ....................................................................... 28
              e.       When is income realized? ................................................................................................................................. 29
        VIII.          Annuities ............................................................................................................................................. 31
              c.       I.R.C. § 72 ............................................................................................................................................................ 33
              d.       Tax arbitrage and annuities: I.R.C. § 264 ....................................................................................................... 35
        IX.        Life Insurance ........................................................................................................................................... 36
        X.         Treatment of Debt..................................................................................................................................... 38
              a.       In General ........................................................................................................................................................... 38
              b.       Illegal Income ..................................................................................................................................................... 38
              c.       Discharge of Indebtedness income .................................................................................................................. 41
              d.       Borrowing and basis.......................................................................................................................................... 45
        XI. Damages and Sick Pay ............................................................................................................................. 52
        XII.  Tax-Exempt Interest: I.R.C. § 203—State and Municipal bonds ...................................................... 54
DEDUCTIONS AND CREDITS ........................................................................................................................... 57
      I.   Overview .................................................................................................................................................. 57
    BUSINESS EXPENSES................................................................................................................................................ 59
      I.   Tax Code Provisions: I.R.C. §§ 162 & 212, generally ............................................................................. 59
              a.       I.R.C. § 162: Trade or Business Expenses ....................................................................................................... 59
              b.       I.R.C. § 212: Expenses for Production of Income .......................................................................................... 60
              c.       § 162 and § 212 compared................................................................................................................................. 60



                                                                                                                                                                                                  1
    II.        "Ordinary and Necessary" ....................................................................................................................... 61
          a.       What is ordinary and necessary? ..................................................................................................................... 61
  III.    Reasonable Allowances for salary ........................................................................................................ 63
  IV. Public Policy Exceptions .......................................................................................................................... 67
  V. Lobbying Expenses ................................................................................................................................... 69
  VI. Domestic Production Deduction .............................................................................................................. 69
  VII.    Employee Business Expenses: The Structural Treatment of Deductions ........................................... 70
DISTINGUISHING PERSONAL AND BUSINESS EXPENSES ........................................................................................ 72
  I.   General ..................................................................................................................................................... 72
          a.       Nature of the distinction ................................................................................................................................... 72
          b.       Policy issues ....................................................................................................................................................... 72
          c.       Statutory Architecture....................................................................................................................................... 72
          e.       Tests for Distinguishing .................................................................................................................................... 73
          f.       Working Condition Fringe v. Deductible Business Expense ....................................................................... 76
          g.       Public Employees .............................................................................................................................................. 76
          h.       Domestic Services and Child Care .................................................................................................................. 77
    II.        Travel Away From Home ......................................................................................................................... 78
          b.       "While away from home"—food and lodging ............................................................................................... 78
          c.       Transportation ................................................................................................................................................... 80
          d.       Limitations.......................................................................................................................................................... 82
    III.           Meals and Entertainment .................................................................................................................... 83
          a.       General ................................................................................................................................................................ 83
          b.       Statutory architecture: I.R.C. § 274 ................................................................................................................. 83
    IV.        Home Offices ............................................................................................................................................ 85
          c.       I.R.C. § 280A ....................................................................................................................................................... 85
CAPITALIZATION .................................................................................................................................................... 86
  I.   General ..................................................................................................................................................... 86
          a.       The distinction between expenses and capital expenditures ....................................................................... 86
          b.       The impact of the capitalization requirement ................................................................................................ 87
    II.        Capitalization, Retirement, and IRAs ...................................................................................................... 89
          a.       Code Architecture.............................................................................................................................................. 89
          b.       Roth IRAs v. Traditional IRAs ......................................................................................................................... 89
    III.           The distinction between deductible expenses and capital expenditures ............................................... 90
          a.       Code Architecture.............................................................................................................................................. 90
    IV.        The Acquisition and disposition of assets ................................................................................................. 91
          a.       General Rules ..................................................................................................................................................... 91
          b.       Effects of Capitalization .................................................................................................................................... 91
          c.       Acquisition and capitalization under the tax code........................................................................................ 91
          d.       Borrowing costs ................................................................................................................................................. 91
          e.       Costs of construction ......................................................................................................................................... 91
          f.       Capitalization to avoid conversion ................................................................................................................. 92
          g.       Costs of disposition ........................................................................................................................................... 92
          h.       Costs of demolition ........................................................................................................................................... 92
    V.         Acquisition of Intangible Assets or Benefits ............................................................................................. 92
          c.       General rules/principles .................................................................................................................................. 93
          d.       Hostile v. Normal takeover .............................................................................................................................. 94
          e.       Transaction costs................................................................................................................................................ 94
          f.       Expenses for new businesses & Section 195 ................................................................................................... 95
  VI. Deductible Repairs v. Nondeductible Rehabilitation or Improvements ................................................... 96
  VII.     Environmental Cleanup ...................................................................................................................... 97
JOB SEARCH AND EDUCATION EXPENSES.............................................................................................................. 97
  I.    Job-Seeking ............................................................................................................................................... 97
  II. Education Expenses .................................................................................................................................. 98
OPTIONS TO DEDUCT ........................................................................................................................................... 101
DEPRECIATION, AMORTIZATION AND DEPLETION ............................................................................................. 101



                                                                                                                                                                                           2
        I.         Depreciation, generally ........................................................................................................................... 101
        II.        Depreciation: Code Architecture ........................................................................................................... 103
              d.       I.R.C. § 197: Amortization of intangibles ..................................................................................................... 105
        III.   Depletion ........................................................................................................................................... 105
    INTEREST............................................................................................................................................................... 107
      I.   General ................................................................................................................................................... 107
              c.       What is interest?............................................................................................................................................... 108
        II.        Specific Types of interest ........................................................................................................................ 109
              a.       Business ............................................................................................................................................................ 109
              b.       Investment ........................................................................................................................................................ 109
              c.       Interest on Tax-Exempt Income ..................................................................................................................... 112
              d.       Personal Interest .............................................................................................................................................. 112
              e.       Home Mortgage Interest................................................................................................................................. 113
              f.       Interest on Education Loans ........................................................................................................................... 113
        III.     Arbitrage, Abuse, and Shams ............................................................................................................ 114
        IV.  Inflation and interest .............................................................................................................................. 114
    LOSSES .................................................................................................................................................................. 115
      I.     General ................................................................................................................................................... 115
              b.       When is there a loss? ....................................................................................................................................... 115
              c.       The Amount of the Loss.................................................................................................................................. 115
        II.        Business v. Nonbusiness (but profit-seeking) losses .............................................................................. 116
        III.          Personal Losses .................................................................................................................................. 116
        IV.        Loss Limitations and Bad Debts ............................................................................................................. 118
              a.       Property losses ................................................................................................................................................. 118
              b.       Transactions between related taxpayers....................................................................................................... 119
              c.       I.R.C. § 1091: Wash Sales ............................................................................................................................... 119
              d.       Capital Losses .................................................................................................................................................. 119
              e.       "Straddles" ........................................................................................................................................................ 120
        V.         Tax Shelters ............................................................................................................................................ 120
              a.       Section 183 and Tax Shelters .......................................................................................................................... 120
              b.       I.R.C. § 465: At-Risk Rules ............................................................................................................................. 120
              c.       I.R.C. § 469: Passive Loss Limitations .......................................................................................................... 120
        VI.        Bad Debts ............................................................................................................................................... 121
              a.       I.R.C. § 166 ........................................................................................................................................................ 121
              c.       The Trade or Business of Lending ................................................................................................................. 122
              d.       Loans to family and friends ........................................................................................................................... 122
              e.       Validity of indebtedness ................................................................................................................................. 122
              f.       Loan Guarantees .............................................................................................................................................. 122
              g.       Political Contributions .................................................................................................................................... 122
              h.       Voluntary Cancellation ................................................................................................................................... 123
    PERSONAL DEDUCTIONS ...................................................................................................................................... 123
      I.  The standard deduction .......................................................................................................................... 123
              a.       Purpose ............................................................................................................................................................. 123
              b.       I.R.C. § 63: Taxable Income defined ............................................................................................................. 123
        II.        Personal Exemption and Child Credit .................................................................................................... 124
              a.       I.R.C. § 151: Allowance of Deductions for Personal Exemptions ............................................................. 124
              b.       I.R.C. § 24: The Child Credit.......................................................................................................................... 125
        III.          I.R.C. § 32: The Earned Income Tax Credit ..................................................................................... 126
        IV.        Personal Itemized Deductions ................................................................................................................ 126
              c.       Taxes.................................................................................................................................................................. 127
              d.       Charitable Deductions .................................................................................................................................... 129
              e.       Medical Expenses ............................................................................................................................................ 133
WHOSE INCOME? ............................................................................................................................................... 135
    TAXATION OF THE FAMILY................................................................................................................................... 135



                                                                                                                                                                                               3
       I.       General ................................................................................................................................................... 135
       II.      I.R.C. § 1: Taxable Units ....................................................................................................................... 135
       III.        Children ............................................................................................................................................. 137
           c.        The "Kiddie Tax" .............................................................................................................................................. 137
       IV.      Divorce ................................................................................................................................................... 138
           b.        Alimony and Support ..................................................................................................................................... 138
   ASSIGNMENT OF INCOME..................................................................................................................................... 139
CAPITAL GAINS AND LOSSES ....................................................................................................................... 140
   CAPITAL GAINS .................................................................................................................................................... 140
     I.   Mechanics ............................................................................................................................................... 140
     II. Policy of Preferential Treatment............................................................................................................. 141
     III.   I.R.C. § 1221: Definition of Capital Asset ........................................................................................ 141
           a.   I.R.C. § 1221 ...................................................................................................................................................... 141
           b.   Exception: assets "held by the taxpayer primarily for sale in the ordinary course of his trade or
           business." ..................................................................................................................................................................... 142
       IV.      Depreciable Property and Recapture ...................................................................................................... 144
           a.        I.R.C. § 1231(a): Property Used in the Trade or Business and Involuntary Conversions ...................... 144
           b.        Recapture .......................................................................................................................................................... 145
     V. Derivates, Hedging and Supplies ........................................................................................................... 146
   NONRECOGNITION TRANSACTIONS..................................................................................................................... 147
     I.  Non-recognition, generally ..................................................................................................................... 147
     II. I.R.C. §§ 1031 & 1033: Like-Kind Exchanges ....................................................................................... 148
           a.        I.R.C. § 1031 ...................................................................................................................................................... 148
           b.        Involuntary Conversions ................................................................................................................................ 150
       III.          Sales of Principle Residences ............................................................................................................. 151




                                                                                                                                                                                            4
TAX POLICY: theories and concepts




TAX COMPUTATION SUMMARY

    I.      Tax computation
            a. Step One: Determine Gross Income1
                    i. Note items specifically included in gross income
                           1. See I.R.C. §§ 71 - 90
                   ii. Determine excluded income
                           1. See I.R.C. §§ 101 - 140
                  iii. Determine capital gains
                           1. See I.R.C. Subchapter P
                  iv. Determine gains from property
                           1. See I.R.C. Subchapter O
            b. Step Two: Determine adjusted gross income2
                    i. Take account of the taxpayer's trade or business expenses
            c. Step Three: Determine taxable income3
                    i. Subtract the personal exemption
                           1. See I.R.C. § 151
                   ii. Subtract either the
                           1. standard deduction; or
                           2. itemized deductions
                                  a. See I.R.C. §§ 67-68; 161 – 221. But see §§ 261-280(H)
                                      (noting items that are nondeductible)
            d. Step Four: Determine baseline tax liability
                    i. Apply the tax rate schedules in § 1 to taxable income
            e. Step Five: Calculate total tax liability
                    i. Subtract applicable tax credits
                           1. See I.R.C. §§ 21 – 54
                                  a. Note that some credits are refundable and others are
                                      not
            f. The Alternative Minimum Tax (AMT)
                    i. The AMT is imposed whenever it is greater than the regular tax for
                       which the taxpayer would otherwise be liable.
                   ii. See I.R.C §§ 51 – 59.


1 See infra p. XX. See also I.R.C. § 61
2 See infra p. XX. See also I.R.C. § 62 (defining adjusted gross income as gross income less certain costs of
earning income and various other items).
3 See infra p. XX. See also I.R.C. § 63 (defining taxable income as adjusted gross income minus the

taxpayer's personal exemption plus the greater of (a) the standard deduction or (b) itemized deductions.


                                                                                                           5
WHAT IS INCOME?

    I.       Definitions of Income
             a. Section 61
                     i. "Gross income means all income from whatever source derived."
             b. The Haig-Simons definition
                     i. "Personal income may be defined as the algebraic sum of (1) the
                        market value of rights exercised in consumption and (2) the change
                        in the value of the store of property rights between the beginning
                        and end of the period in question."4
             c. Judicial definitions
                     i. Eisner v. Macmober (1920)
                            1. "Income may be defined as the gain derived from capital,
                               from labor, or from both combined, provided it be
                               understood to include profit gained through a sale or
                               conversion of capital assets."
                    ii. Commissioner v. Glenshaw Glass Co.
                            1. "Accessions to wealth, clearly realized, and over which the
                               taxpayers have complete dominion."
                            2. Graetz: "This definition stands for the proposition that
                               'income' should be broadly construed in the absence of a
                               specific congressional directive to the contrary."5
                            3. This definition allows examinations of gross income to be
                               divided into three categories6
                                   a. What constitutes a "gain?"
                                   b. When is income "clearly realized?"
                                   c. When is the source of the income relevant?
    II.      Form of Receipt, Generally
             a. The doctrine of "constructive receipt."
                     i. Income is constructively received—and subject to taxation—if it is
                        made available to the taxpayer but the taxpayer decides to defer
                        actual receipt.
                            1. This assumption holds unless a statute expressly provides
                               otherwise.
             b. Generally, Section 61 makes no distinction between cash and income "in
                kind."
                     i. See Reg. § 1.61-2(d)(1)



4 Graetz, 90.
5 Graetz, 91.
6 Chirelstein, 12.




                                                                                        6
                      1. if compensation is paid in the form of property or services,
                          the fair market value of the property or services is included
                          in income.
              ii. See Reg. § 1.61-2(d)(2)(i)
                      1. If property or services are transferred as compensation to an
                          employee or independent contractor for less than fair market
                          value, the difference between the amount paid for the
                          property and its fair market value is compensation that must
                          be included in income
                              a. Basis of the property is the amount paid for the
                                  property plus the amount included gross income.
             iii. See Old Colony Trust Co. v. Commissioner (1929) where Supreme
                  Court held that money provided to an employee for the purposes
                  of paying that employee's taxes was taxable income.
       c. Tax-inclusive rates v. tax-exclusive rates
               i. The federal income tax is imposed on a "tax inclusive" basis: the
                  amount of the tax owed is included in the amount of taxable
                  income to which the tax rates are applied.
                      1. If the federal tax was on a "tax-exclusive" basis, then
                          taxpayers would deduct their federal taxes from adjusted
                          gross income.
III.   Fringe Benefits
       a. Generally
               i. The term "fringe benefits" is used to describe in-kind benefits
                  transferred to an employee.
       b. Fringe benefit tax policy concerns
               i. The current tax code creates an incentive to provide fringe benefits
                  in lieu of cash compensation
              ii. Equity concerns
                      1. Horizontal equity
                              a. Even if two persons have the same income, if one gets
                                  more of their income in fringe benefits, they are better
                                  off because those fringe benefits are tax-free.
                      2. Vertical equity
                              a. Untaxed fringe benefits are more valuable, and more
                                  available, to employees in higher tax brackets (and to
                                  certain industries and professions)
             iii. Efficiency
                      1. The tax advantages of fringe benefits leads employers to
                          offer, and employees to accept, wage and benefit packages
                          that they really don't want (the employee, for instance,
                          might want cash instead).



                                                                                        7
                               2. creates a deadweight loss—economic value is lost because
                                  the tax creates incentives for sub-optimal forms of
                                  compensation
                      iv. Complexity
                               1. It is difficult to distinguish between in-kind compensation
                                  from goods or services related to an employee's work that
                                  also provide the employee incidental economic benefits.
                               2. creates somewhat arbitrary distinctions between non-cash
                                  compensation that is excludable and that must be included.
                 c. General rule: Section 61 and fringe benefits
                        i. Section 61 provides that "gross income means all income from
                           whatever source derived, including, (but not limited to) the
                           following items: (1) compensation for services, including . . . fringe
                           benefits."
                               1. Fringe benefits are included in income unless Congress
                                  has explicitly provided otherwise. See Reg. 1.61-21(a)(2) ("to
                                  the extent that a particular fringe benefit is specifically
                                  excluded from gross income pursuant to another section of
                                  subtitle A . . . that section shall govern the treatment of that
                                  fringe benefit. . . . The fact that another section of subtitle A .
                                  . .addresses the taxation of a particular fringe benefit will not
                                  preclude section 61 and the regulations thereunder from
                                  applying, to the extent they are not inconsistent such other
                                  section."
                       ii. Reg. 1.61-21
                               1. (a)(3): "A fringe benefit provided in connection with the
                                  performance of services shall be considered to have been
                                  provided as compensation for such services."7
                 d. Tax expenditure fringe benefits
                        i. Tax "expenditures," generally
                               1.
                       ii. Employer-provided Health Insurance
                               1. Policy considerations
                               2. Section 104
                                      a. Gross income does not include compensation for
                                          injuries or sickness (i.e., disability pensions, and
                                          worker's compensation)
                                      b. Note that sick pay is taxable
                               3. Section 106




7   See infra, p. 6.


                                                                                                   8
                                    a. "Except as otherwise provided in this section, gross
                                        income of an employee does not include employer-
                                        provided coverage under an accident or health plan."
                   iii. Retirement Income
                            1. Sections 401-404 and 410-416 provide favorable tax
                                treatment for qualified pension, profit-sharing and stock
                                bonus plans.
                    iv. Life insurance
                            1. "Generally, if the employer pays life insurance premiums on
                                the life of an employee and the employee's estate or family is
                                the beneficiary, the employer's premium payments are
                                income to the employee. See, e.g., Frost v. Commissioner, 52
                                T.C. 89 (1969)."8
                            2. Section 79
                                    a. Premiums for life insurance are excludable if
                                             i. The insurance is for less than $50,000; and
                                            ii. The plans do not discriminate in favor of key
                                                employees.
                     v. Education Benefits
                            1. Section 127
                                    a. Only applies to the first $5,200 of such assistance.
                    vi. "Cafeteria plans"
                   vii. Dependent Care Assistance
               e. Work-Related Fringe Benefits
                      i. Definitions
                            1. Reg. § 1.61-21(a)(4)(2): Employee
                                    a. "for convenience the term 'employee' includes any
                                        person performing services in connection with which
                                        a fringe benefit is furnished . . ."
                            2. Reg. § 1.61-21(a)(5): Employer
                                    a. "For convenience, the term 'employer' includes any
                                        provider of a fringe benefit in connection with
                                        payment for the performance of services, unless
                                        otherwise specifically provided in this section."
                     ii. General concerns
                            1. Graetz: general principles for distinguishing "working
                                condition benefits" from "in-kind compensation."
                                    a. The "benefit of the employer" principle
                                             i. Is there a substantial non-compensatory
                                                business purpose for providing the good or
                                                service?

8   Graetz, 101.


                                                                                            9
                                       b. Is the benefit related to the employee's work and
                                          ordinarily useful to someone in the employee's
                                          position?
                               2. Valuation
                                       a. Chirelstein: "In General . . . economic benefit is
                                          measured in objective terms for tax purposes;
                                          individual preferences, real or feigned, are treated as
                                          irrelevant."9
                                       b. The "benefit of the employer" principle
                                               i. Can be justified on the grounds that it would
                                                  be impossible to account for the discounted
                                                  value of "benefits" forced upon an employee as
                                                  part of his or her job (i.e., food and lodging).10
                                                  It would also be infeasible to tax the "consumer
                                                  surplus" for employee who value the benefits
                                                  more than their fair market value.
                                              ii. Example: Benaglia v. Commissioner
                                                      1. Here, the manager of a resort was given
                                                         luxury accommodations and meals so
                                                         that he could perform his duties. The
                                                         court held that it was non-taxable
                                                         because the services were provided for
                                                         the convenience of the employer. Thus,
                                                         even though the manager may have
                                                         subjectively benefited from the fringe
                                                         benefit, because we can't take account of
                                                         the discount of the manager's forced
                                                         consumption, we don't tax it (out of
                                                         administrative convenience).
                                       c. Reg. § 1.61-21(b): valuation of fringe benefits
                                               i. Non-excludable fringe benefits are taxed at
                                                  "fair market value."
                                              ii. "In general, fair market value is determined on
                                                  the basis of all the facts and circumstances.
                                                  Specifically, the fair market value of a fringe
                                                  benefit is the amount that an individual would
                                                  have to pay for the particular fringe benefit in
                                                  an arm's length transaction."
                       iii. Benefits from non-employers



9   Chirelstein, 20.
10  Chirelstein, 21.


                                                                                                 10
       1. benefits provided for the convenience of a prospective
           employer or for that employer's business, are excludable.
               a. See United States v. Gotcher in which the Fifth Circuit
                  held that exclusions are not limited to those
                  enumerated and that a trip to Germany paid for by a
                  foreign car dealership was not taxable income
                  because the trip was designed to benefit the
                  corporation, not the taxpayer.
iv. Benefits to non-employees (benefits to spouses of employees)
       1. See United States v. Disney where the Ninth Circuit held that
           reimbursements for travel expenses incurred by Roy
           Disney's wife during his business travels were includable in
           gross income, but deductible as business expenses under §
           162 because the wife assisted the husband's performance of
           business duties.
       2. But see Meridian Wood Products Co. Inc. v. United States where
           the Ninth Circuit denied deductions under § 162 because the
           wife's purpose was only to socialize, not to serve the
           interests of the business.
       3. See I.R.C. § 274(m)(3)
               a. Provides that travel expense are deductible for a
                  spouse of an employee only if there is a bona fide
                  business purpose and the expense would otherwise
                  have been deductible.
       4. See Reg. § 1.132-5(t)
               a. Allows      employee      to    exclude      a   spouse's
                  reimbursement for travel, even when the employer
                  cannot deduct the spouse's expenses so long as the
                  spouse's presence had a bona fide business purpose.
 v. Section 132: Excludable fringe benefits
       1. § 132(a)(1) & (b): no-additional cost service
               a. Requirements
                       i. "such service is offered for sale to customers in
                          the ordinary course of the line of business of
                          the employer in which the employee is
                          performing services"
                             1. The regulations add the word
                                 "substantial"—the service must be
                                 offered for sale to the customers in the
                                 ordinary course of the line of business of
                                 the employer in which the employee is
                                 performing substantial services. See Reg.
                                 § 1.132-2(a)(i).


                                                                        11
              ii. the employer incurs no substantial additional
                  cost
                      1. "cost" includes revenue that is foregone
                          because the service is provided to an
                          employee rather than to a non-
                          employee. Reg. § 1.132-2(a)(5)
                      2. "Whether        an     employer    incurs
                          substantial additional costs must be
                          determined without regard to any
                          amount paid by the employee for the
                          service." Reg. § 1.132-2(a)(5).
       b. Example: excess capacity services
               i. "Services that are eligible for treatment as no-
                  additional cost services include excess capacity
                  services such as hotel accommodations . . ." See
                  Reg. § 1.132-2(a)(2)
       c. Example: reduced price and cash rebates
               i. The exclusion applies "whether the service is
                  provided at not charge or at a reduced benefit.
                  [It] also applies if the benefit is provided
                  through a partial or total cash rebate of an
                  amount for the service."
       d. This fringe cannot discriminate in favor of highly
          compensated employees. Reg. § 1.132-2(a)(4).
2. § 132(c): qualified employee discount
3. § 132 (d): working condition fringe
       a. Definition
               i. "A 'working condition fringe' is any property
                  or services provided to an employee of an
                  employer to the extent that, if the employee
                  paid for the property or service, the amount
                  paid would be allowable as a deduction under
                  section 162 or 167."
       b. See Reg. 1.132-5
4. § 132(e): de minimis fringe
       a. Definition
               i. "In general, the term 'de minimis fringe' means
                  any property or service the vale of which is
                  (after taking into account the frequency with
                  which similar fringes are provided by the
                  employer to the employer's employees) so
                  small as to make accounting for it



                                                               12
                               unreasonable         or        administratively
                               impracticable."
            5. qualified transportation fringe
                    a. See I.R.C. § 132(f)
            6. qualified moving expense reimbursement
                    a. See I.R.C. § 132(g)
            7. qualified retirement planning services
                    a. See I.R.C. § 132(m)
            8. qualified military base realignment and closure
                    a. See I.R.C. § 132(n)
            9. Situations in which section 132 does NOT apply
                    a. Reg. § 1.132-1(f)
                            i. Section 132 does NOT apply if the tax
                               treatment of a particular fringe is expressly
                               provided for in another section.
            10. Note 132(o): "The Secretary shall prescribe such regulations
                as may be necessary or appropriate to carry out the purposes
                of this section."
f. Meals and Lodging
      i. Section 119
            1. Meals are excludable when
                    a. The meals are furnished on the business premises
                    b. The meals are furnished for the convenience of the
                        employer
            2. Lodging is excludable when
                    a. The lodging is furnished on the business premises of
                        the employer
                            i. See Adams v. United States in which the Court of
                               Claims held that a company owned-house
                               used by the head of a corporation was
                               excludable from income, though it was
                               separated from the main business office,
                               because the house served important business
                               functions and was therefore part of the
                               business premises.
                                   1. See also Lindeman v. Commissioner in
                                      which Tax Court held that house
                                      provided to the manager of a large hotel
                                      was excludable from income, even
                                      though the house was across the street
                                      from the hotel, because the taxpayer
                                      performed significant duties for his
                                      employer from the house.


                                                                            13
                     ii. But see Dole v. Commissioner in which the First
                         Circuit refused to exclude from income lodging
                         provided by a wool manufacturer even though
                         the employees needed the housing to be "on
                         call" because the lodging was about one mile
                         from the factory.
              b. The lodging is furnished for the convenience of the
                  employer
              c. The employer is required to accept such lodging as a
                  condition of his employment.
       3. "Convenience of the Employer"
              a. the meals or lodging must be provided for a
                  "substantial noncompensatory business reason. Reg.
                  1.119-1 (a)(2). This requirement is not met if the meals
                  are furnished to promote morale or to attract
                  prospective employees.
       4. Examples
              a. See Benaglia v. Commissioner where the Board of Tax
                  Appeals held that meals and lodging provided to the
                  manager of a luxury resort were excludable because
                  they were provided for the benefit of the employer
                  (the manager was required to have a continuous
                  presence at the hotel)
ii. The valuation problem and the control principle
       1. How do we determine the value of meals and lodging
          provided to an employee when the employee is forced to
          consume them (i.e., even though the meals and lodging are
          provided as part of the job, what do we do if the employee
          gets a subjective benefit?)
              a. Arguably, the inability to answer this question is
                  what led to section 119—we can't subjectively value
                  the discount of forced consumption.
       2. See Commissioner v. Kowalski where the Fifth Circuit held that
          cash meal allowances provided to a New Jersey State trooper
          were not excludable from income under section 119 because.
              a. But see Sibla v. Commissioner in which the Ninth
                  Circuit held that cash payments by firefighters to
                  purchase food used to stock the firehouse kitchen was
                  excludable. The court noted that it did not believe
                  that Kowalski categorically denied exclusions from
                  income for cash used to buy meals.
              b. Together, these two cases suggest that the vital
                  element in determining excludability is the


                                                                       14
                        employee's     degree   of   control   over    the   meal
                        allowance.
     iii. Section 107
             1. Excludes from income the rental value of a home provided
                 to a "minister of the gospel" or a rental allowance paid for
                 such a home.
g. Property transfers as compensation (Section 83)
       i. General rule: When an employee receives property in exchange for
          services, the employee must include in gross income
             1. the fair market value of the property minus any amount
                 paid for the property.
             2. NOTE: the value of the property at this point is taxable as
                 ordinary income, not as a capital gain.
      ii. Risk of substantial forfeiture
             1. Defined (I.R.C. § 83(c))
                     a. "The rights of a person in property are subject to a
                         substantial risk of forfeiture if such person's rights to
                         full enjoyment of such property are conditioned upon
                         the future performance of substantial services by any
                         individual."
             2. If the property is subject to a substantial risk of forfeiture
                 and is non-transferrable, then the property is still treated as
                 owned by the transferor and no income is realized by the
                 transferee.
                     a. This non-realization rule is waiveable by the
                         transferee (he or she may include the value of the
                         property in income at the time of the transfer even if
                         non-transferable and subject to risk of substantial
                         forfeiture.
     iii. Treatment of stock options under § 83
             1. Section applies only to stock options with a "readily
                 ascertainable fair market value"
                     a. the value of an option is generally not ascertainable
                         unless the option is actively traded on an established
                         securities market. Reg. § 1.83-7
             2. Section 83 does not apply to incentive stock options as
                 defined in section 422.




                                                                               15
   IV.    Below-Market Loans
          a. Section 7872
                 i. Generally
                        1. § 7872(c): Scope
                               a. Gift Loans
                               b. Compensation-related loans
                               c. Corporation-Shareholder loans
                               d. Tax avoidance loans
                               e. Other below market loans
                                      i. § 7872 applies to the extent provided by
                                         regulations if the interest arrangements have a
                                         significant effect on any Federal tax liability of
                                         the lender or borrower.
                               f. Loans to qualified continuing care facilities
                               g. § 7872(i)
                                      i. The Secretary has the authority to issue
                                         regulations exempting transactions from § 7872
                                         so long as the interest arrangements have no
                                         significant effect on any federal tax liability.
                                         This is the corollary of the rule above.
                        2. De Minimis exception
                               a. § 7872 (c)(2) & (3): this section does not apply to any
                                  gift loan that does not exceed $10,000 or to a
                                  compensation-related and corporate shareholder
                                  loans that do not exceed $10,000
                        3. § 7872(e): Below-market loan is defined
                               a. A demand loan in which the interest rate is less than
                                  the applicable federal rate in effect under section
                                  1274(d)
                               b. A term loan in which the amount loaned exceeds the
                                  present value of all payments due under the loan.
                ii. § 7872(a): Gift and demand loans
                        1. Re-characterizes the loan to reflect economic reality.

Below-market           X
                                    $100,000
                                                                     Y
loan
7872(a)(1)(B)--                     $10,000
Interest              X                                          Y

7872(a)(1)(A)—                      $10,000
context               X                                         Y
specific
transaction


                                                                                        16
                                   a. The lender reports interest income on his or her tax
                                      return
                                   b. The borrower has either a gift, a demand loan, a
                                      dividend, income, etc. depending on the context.
       V.      Imputed Income
               a. Defined
                      i. "a flow of satisfactions from durable goods owned and used by the
                         taxpayer, or from goods and services arising out of ht personal
                         exertions of the taxpayer on his own behalf. Imputed income is
                         non-cash income or income in kind. But all non-cash income, or
                         income in kind, is not . . . imputed income. For example, where
                         income in kind is received in return for services rendered, we have
                         an ordinary market transaction without a transfer of cash but with
                         a direct monetary valuation implied. . . [The] distinguishing
                         characteristic [of imputed income] is that it arises outside of the
                         ordinary processes of the market."11
                     ii. Examples
                             1. You purchase a home and live in it. You live in the home
                                 tax free, even though you would have income if you had
                                 leased the home to a tenant.
               b. Section 61 and imputed income
                      i. In Morris v. Commissioner the Board of Tax Appeals held that the
                         value of farm products consumed by the owners of the farm is not
                         income. The court grounded its decision on the assumption that
                         Congress did not intend to tax this kind of compensation.
                             1. But see Dicenso v. Commissioner, where the owner of a grocery
                                 store was required to include in income the value of
                                 groceries used for home consumption.
               c. Policy implications
                      i. Inefficiency
                             1. Causes taxpayers to make economic choices they would not
                                 make in a tax-free world
                             2. Examples
                                     a. You purchase a home even though you would rather
                                        rent
                                     b. You paint your own house rather than hire someone
                                        to do it (even though you are terrible at painting
                                        houses and make more money doing something else)
                     ii. Horizontal equity



11   Graetz, 126.


                                                                                          17
                   1. two similarly situation individuals may be taxed at different
                       rates.
                   2. Example: Both spouses of AB work outside the home and
                       earn $50,000. They hire a housekeeper. Only one spouse of
                       couple CD works outside the home and earns $40,000. The
                       other spouse works as a housekeeper. AB is taxed more
                       even though there is no economic difference between the
                       two couples
           iii. Vertical equity
                   1. Poorer people are often forced to rent rather than buy.
VI.   Non-Work income
      a. Gifts
             i. Section 102(a): General Rule
                   1. "Gross income does not include the value of property
                       acquired by gift, bequest, devise, or inheritance."
            ii. What constitutes a gift?
                   1. In Commissioner v. Duberstein the Supreme Court held that
                       "[a] gift in the statutory sense . . . proceeds from a detached
                       and disinterested generosity, our of affection, respect,
                       admiration, charity or like impulses. And in this regard, the
                       most critical consideration, as the court has agreed in the
                       leading case here, is the transferor's intention."
                   2. Section 102(c)
                           a. The general rule "shall not exclude from gross income
                               any amount transferred by or for an employer to, or
                               for the benefit of, an employee."
           iii. Section 274(b): deduction of the costs of a gift
                   1. No business deduction [under 162 or 212] for "any expense
                       for gifts made directly or indirectly to any individual to the
                       extent that such expense, when added to prior expenses of
                       the taxpayer for gifts made to such individual during the
                       taxable year, exceeds $25."
           iv. Tips
                   1. Tips are taxable income. Reg. 1.61-2(a)
                   2. See Olk v. United States in which the 9th Circuit held that
                       "tokes" received by a craps dealer from casino patrons were
                       income.
            v. Political contributions
                   1. Political contributions are not taxable to a political candidate
                       so long as they are used for the expenses of a political
                       campaign and not for personal use.
           vi. Gifts of Property
                   1. Section 1015(a)


                                                                                   18
                   a. General Rule
                           i. A gift of property acquired after December 31,
                              1920 shall has the donor's basis.
                   b. Loss transfer barrier
                           i. if the basis of the gift property is greater than
                              the property's fair market value, then for the
                              purpose of determining loss the basis shall be the
                              fair market value.
                                  1. See infra p. 19-20
                   c. Basis unknown
                           i. If the donee cannot determine the property's
                              basis, then the basis is the fair market value.
             2. Gifts between spouses
                   a. Handled by section 1041 and NOT 1015
                   b. Section 1041
                           i. No gain or loss is recognized on a transfer of
                              property to a spouse
                          ii. The transferee's basis in the property is the
                              same as the transferor's.
b. Bequests
       i. Section 1014(a)
              1. General
                     a. "[T]he basis of property in the hands of a person
                        acquiring the property from a decedent or to whom
                        the property passed from a decedent shall, if not sold,
                        exchanged, or otherwise disposed of before the
                        decedent's death by such person be fair market value
                        of the property at the date of the decedent's death."
                     b. Death is not a realization event
                             i. But note exceptions in Section 691
      ii. Section 1014(e)
              1. states that property acquired by the decedent within one
                  year of the decedent's death shall have a basis equal to the
                  decedent's adjusted basis in the property (Not FMV)
     iii. 1014(f)
              1. Section 1014 does not apply to anyone who dies after
                  December 1, 2009.
     iv. Section 1022 Special Rule: Proper acquired from decedent dying
          after December 31, 1009
              1. Purpose
                     a. The step-up basis rule of §1014 is repealed effective
                        December 31, 2009, replaced by a modified carryover
                        basis provision


                                                                             19
                            2. General rule: Property acquired from a decedent dying after
                                12/31/09 is treated as a gift, the basis of which is the lesser of
                                    a. the decedent's adjusted basis; or
                                             i. under this section, basis is increased to a
                                                maximum of $1,300,000.
                                    b. the fair market value of the property at the date of the
                                        decedent's death.
                            3. See also infra p. 20 (for discussion of adjusted basis)
               c. Government transfer payments
                      i. General rule
                            1. The IRS has an administrative policy of excluding most
                                government benefits and welfare payments from taxation
                                (even though they are probably income under the statutes).12
                     ii. Unemployment compensation
                            1. Section 85: General rule
                                    a. "In the case of an individual, gross income includes
                                        unemployment compensation."
                    iii. Social Security Payments
                            1. A portion of social security payments are taxed under
                                Section 86
                            2. Section 86
                                    a. Gross income includes social security benefits in an
                                        amount equal to the lesser of (A) one half of the social
                                        security benefits received during the taxable year, or
                                        (B) one half of the excess described in section 86(b)(1).
               d. Prizes, Awards and Scholarships
                      i. Section 74: Prizes and Awards
                            1. "Except as otherwise provided in this section or section 117
                                (relating to qualified scholarships), gross income includes
                                amounts received as prizes and awards.
                            2. Charity exception
                                    a. if the prize is given to charity it may be excluded
                                        from gross income so long as
                                             i. The prize recipient was selected without any
                                                action on his part to enter the contest or
                                                proceeding
                                            ii. The recipient is not required to render
                                                substantial future services as a condition to
                                                receiving the prize or award; and
                                           iii. The prize or award is transferred by the payor
                                                to a governmental unit or organization

12   Graetz, p. 134.


                                                                                               20
                                       described in paragraph (1) or (2) of section
                                       170(c)
                    3. Employee achievement award exception
                            a. Gross income does not include the value of an
                               employee achievement award if the cost to the
                               employer of the award does not exceed the amount
                               allowable as a deduction for the award ($400).
             ii. Section 117: Qualified Scholarships
                    1. General Rule
                            a. Gross income does not include any amount received
                               as a qualified scholarship by an individual who is a
                               candidate for a degree at an education organization
                               described in section 170(b)(1)(A)(ii)
                    2. Exceptions
                            a. Any portion of a "scholarship" received for teaching,
                               research or other services required as a condition for
                               receiving the scholarship is NOT excludable.
                            b. Any amount used to pay for room and board is also
                               non-excludable
VII.   Capital Appreciation and Recovery of Capital
       a. Calculating Present Value
       b. Capital Recovery and Basis
              i. Section 61
                    1. Gross income includes all income from whatever source
                        derived. This includes gains from capital
                    2. Section 61(a)(3) includes gains derived from dealings in
                        property.
             ii. History and theoretical underpinnings
                    1. In order to tax gains or losses the tax system must take into
                        account the money already invested in the property.
                            a. "Whatever difficult there may be about a precise and
                               scientific definition of 'income,' it imports . . .
                               something entirely distinct from principal or capital
                               either as a subject of taxation or as a measure of the
                               tax; conveying rather the idea of gain or increase. . . .
                               In order to determine whether there has been gain or
                               loss, and the amount of the gain, if any, we must
                               withdraw from the gross proceeds an amount
                               sufficient to restore the capital value that existed at
                               the    commencement        of   the    period    under
                               consideration. Doyle v. Mitchell Brothers Co. (S. Ct.
                               1918).
                    2. Three ways to account for costs


                                                                                     21
               a. Immediately deductible expenses
               b. Capitalization
                     i. The purchase price or cost is taken into account
                        only when the asset is sold or exchanged (no
                        immediate expense)
               c. Depreciation
                     i. Period deductions are allowed to account for
                        the capital's cost.
iii. Gain
        1. Section 1001(a)
               a. Gain = Amount Realized – adjusted basis
        2. Section 1001(b)
               a. Amount realized = money received + fair market
                    value
        3. Section 1001(c): Recognition
               a. The entire amount of the gain or loss, determined
                    under this section, on the sale or exchange of property,
                    shall be recognized.
        4. See also infra p. 44 (noting the inclusion of a discharge of
           liabilities in amount realized under Reg. § 1.1001-2).
iv. Losses
        1. General Rule: the loss may be carried over to other income
        2. Exception: Gifts under section 1015(a)
               a. When the basis is greater that the fair market value of
                    the property at the time of the gift, then for the purpose
                    of determining loss, the basis is the fair market value
                    of the property
               b. Example
                         i. Facts
                               1. Basis = $1,000
                               2. FMV = $600
                        ii. Result under 1015(a)
                               1. If gain, basis = $1,000
                               2. If loss, basis = $600
                    Sale                   Gain                   Loss
                    1200                   200                    0
                    1000                   0                      0
                    800                    0                      0
                    600                    0                      0
                    500                    0                      100
                               3. This rule makes it very difficult to
                                   transfer losses.
               c. See also supra p. 15-16


                                                                           22
 v. Basis
       1. Section 1012
             a. "The basis of property shall be the cost of such
                 property."
       2. "Cost"
             a. Graetz: This is true even if the buyer over- or under-
                 pays for the property.
                      i. "Where a bargain purchase is in substance a
                         substitute for salary, the amount of price
                         reduction is included in income and purchaser
                         is created as acquiring the asset for fair market
                         value. The cost basis of the asset would then
                         be its recharacterized purchase price.
             b. Cost generally means the value of the property
                 received
                      i. See Philadelphia Park Amusement Co. v. United
                         States where the Court of Claims held that
                         where the value of the property given up
                         differs from the value of the property received,
                         the taxpayer's basis in the property received is
                         its value.
       3. Basis of property acquired by gift
             a. See supra p. 16
       4. Basis of property acquired by decedent
             a. See supra p. 16-17
vi. Adjusted Basis
       1. Section 1011(a)
             a. "The adjusted basis for determining the gain or loss
                 from the sale or other disposition of property,
                 whenever acquired, shall be the basis adjusted as
                 provided in section 1016."
       2. Section 1016: Adjustments to Basis
             a. General Rule
                      i. "Proper adjustment in respect of the property
                         shall be made for
                             1. expenditures
                             2. receipts
                             3. losses
                             4. other items properly charged to capital
                                 account
                     ii. For any period since February 28, 1913, proper
                         adjustment shall also be made for
                                    a. Exhaustion


                                                                       23
                                       b. Wear and tear
                                       c. Obsolescence
                                       d. Amortization
                                       e. Depletion
                               2. to the extent of the amount
                                       a. allowed       as    deductions    in
                                           computing        taxable     income
                                           (ITEMIZED deductions) under
                                           this subtitle or prior income tax
                                           laws
                                       b. resulting in a reduction for any
                                           taxable year of the taxpayer's
                                           taxes under this subtitle, or prior
                                           income, war profits, or excess-
                                           profits tax laws, but not less than
                                           the amount allowance under this
                                           subtitle or prior income tax laws.
               b. Default depreciation method: 1016(a)(2)(B)(flush
                   language)
                        i. "Where no method has been adopted under
                           section 167, the amount allowable shall be
                           determined under the straight line method."
               c. Other depreciation notes
                        i. I.R.C. § 167
                               1. Basis on which exhaustion, wear and
                                   tear, and obsolescence are to be allowed
                                   is the adjusted basis in section 1011 (by
                                   extension—1016).
                       ii. See also infra p. XXX on depreciation
               d. Exceptions to general rule
                        i. No adjustments to basis for
                               1. taxes or carrying charges in I.R.C. § 266
                               2. Expenditures described in I.R.C. § 173
               e. Special rule for property acquired from a decedent
                   dying after December 31, 2009
                        i. See I.R.C. § 1022
                       ii. See supra p. 17
vii. Allocation of basis
        1. General issue
               a. How should the tax code account for partial transfers
                   of property? If the transfer income is entirely
                   allocated to basis, then the taxpayer can defer the
                   realization of that income. If the basis cannot be


                                                                           24
          allocate until final disposition of the property, then
          gross income is accelerated
2. Reg. § 1.61-6: General rule
      a. Provides that when a portion of property is sold, the
          basis must be allocated among the parts
      b. Example 2
               i. Facts
                      1. taxpayer purchases filling station with
                          adjoining used car lot for $25,000. FMV
                          of filling station is $15,000. FMV of car
                          lot is $10,000. Five years later taxpayer
                          sells filling station for $20,000 when
                          $2,000 has been depreciated.
              ii. Allocation of basis
                      1. Gain = $7,000 ($20,000 -[$15,000-2,000])
                      2. The basis must be allocated to each
                          portion of the property
3. Difficulties in allocation
      a. When it is impossible to allocate basis in a reasonable
          way, the consideration received on the sale may be
          credited against basis for the entire property.
               i. See Inaja Land Co. v. Commissioner where court
                  allocates the income from a settlement arising
                  out of the pollution of a river for which the
                  taxpayer had purchased fishing rights, may be
                  allocated entirely to basis.
      b. Stock
               i. If a taxpayer cannot adequately identify the lot
                  of stock (the price at which it was purchased)
                  which he is selling or transferring the stock, the
                  stock sold will be charged against the earliest
                  lots of stock acquired by the taxpayer to
                  determine gain or loss. See Reg. § 1.1012-1(c)(1)
      c. Part sale-party gift
               i. General rule: Reg. §1015-4
                      1. the initial basis of the transferee is the
                          greater of the amount paid by the
                          transferor for the property or the
                          transferor's basis under §1015.
                      2. the transferor's gain is equal to the
                          amount realized minus the adjusted
                          basis.
              ii. Losses: Reg. §1015-4


                                                                 25
                                                   1. No loss is sustained when the amount
                                                      realized is less than the adjusted basis.
                   viii. Basis allocation, "interest carve-outs" and realization: Hort v.
                         Commissioner
                            1. Holding
                                   a. In Hort v. Commissioner the Supreme Court held that
                                       an amount received for the cancellation of a lease
                                       could not be allocated to basis and must be included
                                       in gross income.
                                   b. I.R.C. § 167(c)(2) codifies this holding
                                            i. "If any property is acquired subject to a lease
                                                   1. no portion of the adjusted basis shall be
                                                      allocated to the leasehold interest
                                                   2. the entire adjusted basis shall be taken
                                                      into account in determining the
                                                      depreciation deduction (if any) with
                                                      respect to the property subject to the
                                                      lease.
                                   c. I.R.C. § 167(e): general rule against interest carve-
                                       outs
                                            i. General rule
                                                   1. No depreciation deductions are allowed
                                                      for a "term interest"13 in property for
                                                      any period during which the remainder
                                                      interest in the property is held.
                                           ii. Exception: § 167(e)(2)
                                                   1. If this section disallows depreciation
                                                      that would otherwise be available, the
                                                      taxpayer shall decrease basis in the
                                                      property by the amount of the
                                                      depreciation deductions.
                                                   2. the basis of the remainder is increased by
                                                      the    amount       of the      disallowed
                                                      deductions
                                                          a. but not by a tax-exempt
                                                             organization
                            2. Allocation of basis: temporal divisions of property
                                   a. Nature of Hort's property
                                            i. Hort actually had two pieces of property



13Defined in I.R.C. § 1001(e)(2) as (A) a life interest (B) an interest in property for a term of years or (C) an
income interest in a trust.


                                                                                                              26
                                                   1. The revenue stream of rent under the
                                                       lease
                                                   2. The remainder interest in the property
                                           ii. The court concludes that purchasing the
                                               revenue stream in its entirely simply
                                               substitutes for rent—which would be included
                                               in income.
                                     b. Realization difficulty
                                            i. Issue: When can basis be allocated?
                                                   1. Shuldiner suggests that the key to the
                                                       result here was the fact that the taxpayer
                                                       retained the remainder interest.14
                                                   2. Example: property purchase with lease
                                                           a. Facts
                                                                   i. FMV = $10,000
                                                                  ii. Rent is $1,000 year
                                                                 iii. Rate = 10%
                                                           b. Divide into two pieces of
                                                              property: the rental stream (for
                                                              one year) and the remainder
                                                                   i. Rental steam: $909 (PDV)
                                                                      [1,000/ 1 +.10]
                                                                  ii. Remainder: $9091 (PDV)
                                                                      [10,000/ 1+ .10]
                                                                 iii. This makes it clear that the
                                                                      $1,000 really consists of
                                                                      $909       in     unrealized
                                                                      appreciation     on      the
                                                                      remainder and $91 in
                                                                      rental payments.
                                                           c. The problem with allocation basis
                                                              across time is the realization
                                                              requirement.      By splitting the
                                                              property in two (temporally), the
                                                              taxpayer acquires present income
                                                              for the future steam and gets the
                                                              unrealized gain on the property.
                                     c. Note that Hort is the example that actually disproves
                                        the rule: the result does not reflect economic reality


14 Hort v. Commissioner: "We may assume that petitioner was injured insofar as the cancellation of the
lease affected the value of the realty. But that would become a deductible loss only when its extent had been
fixed by a closed transaction."


                                                                                                          27
                            i. In Hort the taxpayer was forced to pay a tax on
                               unearned income—the payment was for
                               cancellation of the lease, not for the revenue
                               stream.
c. Realization
      i. General
             1. Nature of issue
                    a. I.R.C. § 61 taxes all gains from whatever source
                        derived. In a perfect income tax, annual gains
                        property would be taxed as accessions to wealth.
                        However, courts have interpreted the Internal
                        Revenue Code to include a realization component—
                        the gains are recognized only when "realized."
             2. Purpose of realization requirement
                    a. The realization requirement is founded on the
                        doctrine of administrative convenience. Without it,
                        three insurmountable problems would arise
                             i. The administrative burden of annual reporting
                            ii. The difficulty and cost of determining asset
                                values annually
                           iii. The potential hardship of obtaining funds to
                                pay taxes on accrued but unrealized gains (the
                                liquidity problem)
                    b. The realization requirement also contributes to the
                        political legitimacy of the code—it would be difficult
                        to tax "paper" gains.
             3. Criticism of realization requirement
                    a. It is relatively easy to value some assets annually (i.e.,
                        stocks).
                    b. Liquidity cannot be a major concern
                             i. We tax in-kind benefits
                    c. Equity problems
                             i. Horizontal equity
                                    1. Taxpayer A earns $1,000 in salary.
                                       Taxpayer B owns a building that
                                       appreciates in value by $1,000. A is
                                       taxed immediately, B is taxed only when
                                       the gains are "realized."
                                    2. the incentive to acquire assets that
                                       produce unrealized gains distorts
                                       investment decisions.
d. The Realization requirement as a constitutional imperative
      i. Eisner v. Macomber


                                                                              28
             1. In Eisner the court held that a stock dividend is not taxable
                as income under the Sixteenth Amendment until the
                taxpayer sells the stock
     ii. Doubts about the constitutional nature of the realization
         requirement
             1. The Supreme Court has not overruled Eisner, but it has
                limited the decision to its facts.
                   a. See Cottage Savings Association v. Commissioner, noting
                       that the realization doctrine is based on
                       administrative convenience
                   b. See also Helvering v. Horst (saying same as above).
e. When is income realized?
      i. Economic benefit reduced to "undisputed possession"
             1. Income is realized when the taxpayer demonstrates his
                "complete dominion" over an asset or when an economic
                benefit is reduced to "undisputed possession."
                   a. See Cesarini v. United States where the Court held that
                       $5,000 found in an old piano was includible in gross
                       income under § 61. The income was realized in the
                       year in which it was reduced to "undisputed
                       possession."
                            i. Treasure troves: Reg. § 1.61-14
                                  1. "Treasure trove, to the extent of its value
                                      in United States currency, constitutes
                                      gross income for the taxable year in
                                      which it is reduced to undisputed
                                      possession."
                                  2. Note that this regulation would apply if,
                                      for example, the Cesarinis had found a
                                      diamond ring in their piano instead of
                                      cash
                           ii. "Accidental" income
                                  1. In United States v. Irvin, 67 F.3d 670 (8th
                                      Cir. 1995), the court held that the
                                      plaintiff, who had just been discharged
                                      from the army, received gross income in
                                      the amount of $836,939.19 when he
                                      accidentally received a check in that
                                      amount from the army.
                                  2. But Graetz notes that he would be
                                      entitled to a deduction when the money
                                      was paid back.



                                                                             29
                                    b. See Haverly v. United States where the court concluded
                                       that a high-school principle who received free
                                       textbooks from publishers received gross income
                                       when he gave those books to the library and took a
                                       charitable deduction.
                                           i. Here, the deduction was the realization
                                              event—it marked the moment in which the
                                              taxpayer's accession to wealth was clearly
                                              evident.
                                          ii. The court notes that the IRS could tax the
                                              samples directly when received, but has made
                                              an administrative decision not to.
                                    c. See Eisner v. Macomber in which the Supreme Court
                                       held that the receipt of a stock dividend was not
                                       income under the Sixteenth Amendment until the
                                       stock was sold.15
                                                  1. But see Helvering v. Bruun, 309 U.S. 461
                                                     (1940), where the court held that a
                                                     landlord received income when, at the
                                                     end of a lease, he came into possession
                                                     of a capital improvement built by a
                                                     tenant.
                                                  2. OVERTURNED by I.R.C. § 109
                                                         a. "Gross income does not include
                                                            income (other than rent) derived
                                                            by a lessor of real property on the
                                                            termination      of     a     lease,
                                                            representing the value of such
                                                            property attributable to buildings
                                                            erected or other improvements
                                                            made by the lessee.
                                          ii. Stock Dividends: I.R.C. § 305(a)
                                                  1. "Except as otherwise provided in this
                                                     section, gross income does not include
                                                     the amount of any distribution of the
                                                     stock of a corporation made by such

15 The court's dicta indicates that a key issue was the fact that a cash dividend could be used for any
purpose, whereas a stock dividend remained part of the company and was not subject to the taxpayer's
individual ownership and control: "[A]n actual cash dividend, with a real option ot the stockholder
either to keep the money for his own or to reinvest it in new shares, would be as far removed as possible
from a true stock dividend, such as the one we have under consideration, where nothing of value is taken
from the company's assets and transferred to the individual ownership of the several stockholder and
thereby subjected to their disposal."


                                                                                                      30
                                               corporation to its shareholders with
                                               respect to its stock."
              ii. The "material difference" requirement: exchange of property as a
                  realization event
                     1. Reg. § 1001-1(a)
                             a. "[G]ain or loss realized from the conversion of a
                                property into cash or from the exchange of property
                                differing materially either in kind or extent, is treated as
                                income or as loss sustained."
                             b. When is the exchanged property "materially
                                different"?
                                     i. See Cottage Savings Association v. Commissioner
                                        where the Supreme Court held that a taxpayer
                                        realizes a gain or a loss on the exchange of
                                        property when the exchanged properties
                                        embody "legally distinct entitlements."
                     2. Potential scope of Cottage Savings
                             a. Some commentators believed that Cottage Savings
                                would require the realization of income for any
                                change to a debt instrument.
                             b. Reg. § 1001-3(e)(2)(ii)(a)
                                     i. A debt instrument is "significantly modified" if,
                                        for example, the parties agree to change the
                                        yield by more than a quarter of 1%.
VIII.   Annuities
        a. Generally
               i. What is an annuity?
                     1. An annuity is a contract whereby the taxpayer pays a lump-
                         sum of money in return for a promise to pay a certain sum at
                         pre-determined intervals
                     2. Annuities are often keyed to life expectancy
        b. Basis Recovery for annuities: three options
               i. Basis, generally
                     1. A taxpayer's basis in an annuity is the taxpayer's initial
                         lump-sum investment in the annuity.
                     2. The question that arises here is what portion of the periodic
                         payments is basis recovery and what portion is income.
              ii. Option 1: Basis recovered first
                     1. Historical treatment
                             a. Before I.R.C. § 72, this was the method used for taxing
                                annuities. The argument was that, since you might
                                not have any income, you should not be taxed until



                                                                                         31
                you definitely begin to receive payments in excess of
                the investment.
            b. See Burnet v. Logan, 283 U.S. 404 (1913) (holding that
                royalties from oil production should be allocated to
                basis under the terms of an oil lease until the
                transaction is closed).
       2. Operation
            a. Under this method, the taxpayer would not be taxed
                on the annuity income until the aggregate receipts
                equaled the amount paid.
                                              Initial     Basis         Ending
                    Year         Payment      Basis       Recovery      Basis      Income
                    1            100.00       267.30      100.00        167.30     0.00
                    2            100.00       167.30      100.00        67.30      0.00
                    3            100.00       67.30       67.30         0.00       32.70
                    Total        300.00                   267.30                   32.70
                    PDV          267.30                   239.85                   27.45


       3. Effect
               a. Allowing the taxpayer to recover her basis first would
                  allow the taxpayer to defer the payment of income.
iii. Option 2: The Bank Account method
       1. Operation
               a. Under this method, the taxpayer would be taxed for
                  the interest accruing on the taxpayer's investment.

                      Starting                  New                      Ending     Principal
            Year      Balance      Interest     Balance    Withdrawal    Balance    Withdrawn
            1         267.30       16.04        283.34     -100.00       183.34     83.96
            2         183.34       11.00        194.34     -100.00       94.34      89.00
            3         94.34        5.66         100.00     -100.00       0.00       94.34
            Total                  32.70                   -300.00                  267.30
            PDV                    29.67                   -267.30                  237.63
      2. Effect
              a. Under the bank account method, the taxpayer's tax
                 liabilities are accelerated. The taxpayer pays more tax
                 (taking PDV into account).
              b. Note that this is the only method that corresponds to
                 economic reality.
iv. Option 3: Straight line allocation over the expected life
      1. Operation
              a. Under this method, the entire amount that is expected
                 to be received is compared to the amount paid for the
                 annuity. A ratable portion of each payment received



                                                                                      32
                       is then excluded from income such that the taxpayer
                       will have recovered his basis when the final payment
                       is received
                    b. Example
                            i. Investment in contact: $267.30
                           ii. Expected return; $300.00
                          iii. Exclusion ratio: 89%
                                               Basis
                        Year        Payment    Recovery   Income
                        1           100.00     89.10      10.90
                        2           100.00     89.10      10.90
                        3           100.00     89.10      10.90
                        Total       300.00     267.30     32.70
                        PDV         267.30     238.17     29.13


           2. Effect
                 a. This method occupies a middle ground between the
                     basis recovery first method and the bank account
                     method—the taxpayer's taxable income is spread
                     evenly throughout the life of the annuity.
      v. Comparison
                     Open          Section   Bank
            Year     Transaction   72        Account
            1        0.00          10.90     16.04
            2        0.00          10.90     11.00
            3        32.70         10.90     5.66
            Total    32.70         32.70     32.70
            PDV      27.45         29.13     29.67
             1. As noted above, the taxable income is greatest under the
                bank account method, and least under the open transaction
                method.
c. I.R.C. § 72
        i. General rule: § 72(a)
               1. "Except as otherwise provided in this chapter, gross income
                  includes any amount received as an annuity (whether for a
                  period certain or during one or more lives) under an
                  annuity, endowment or life insurance contract."
       ii. The Exclusion ratio: § 72(b)
               1. This section excludes from gross income a portion of gross
                  income equal to the ratio of the expected return of the
                  contact to the investment in the contract.
                      a. Example




                                                                          33
              i. See supra "Option III":           $267.30 (initial
                 investment)/$300 (expected return) = 89%
                 (exclusion ratio)
2. Mortality gains and losses: § 72(b)(2) & (3)
     a. Generally
              i. Life expectancy
                     1. I.R.C. § 72(c)(3)
                            a. "Expected return" is determined
                                from the life expectancy of the
                                individual, computed according
                                to actuarial tables provided by
                                Treasury.
                     2. Reg. § 1.72-9
                            a. provides life expectancy tables
                                for use in calculating the
                                exclusion ratio
                            b. Note that an annuity contract
                                entered into after June 1986 is
                                subject to the unisex tables (tables
                                V – VIII)
                                    i. The table overestimates
                                       the lives of men, giving
                                       them a higher exclusion
                                       ratio and a lower tax rate
                                       than they would have
                                       under a gender-based
                                       table.
             ii. What are mortality gains and losses
                     1. A mortality gain exists when the
                        annuitant lives longer than expected
                        and continues to receive income
                        payments that exceed the expected
                        return
                     2. A mortality loss occurs when the
                        annuitant dies earlier than expected and
                        does not receive the expected return on
                        the investment
     b. Tax treatment of mortality gains
              i. Mortality gains are taxed, in their entirety, as
                 ordinary income. See I.R.C. § 72(b)(2)
     c. Tax treatment of mortality losses




                                                                 34
                             i. Mortality losses may be deducted up to the
                                 amount of the unrecovered investment. See
                                 I.R.C. §72(b)(3)
                    d. Conceptual problems/issues
                             i. Over the long term, mortality gains and losses
                                 represent a revenue-neutral issue for Treasury.
                                 Why tax them?
                                     1. Under this system, the lucky taxpayer
                                         who exceeds life expectancy is suddenly
                                         taxed at a higher rate.
                            ii. The old system, in which mortality gains and
                                 losses were untaxed, was taxpayer-friendly
                                 without affecting government revenues.
     iii. Deferred annuities
             1. Tax-free interest treatment
                    a. When a taxpayer purchases a stream of income at a
                         point far in the future, she is not taxed on the interest
                         that accrues on her initial investment. See I.R.C. §
                         72(b)
             2. Early withdrawal penalties
                    a. Cash withdrawals before the annuity starting date are
                         included in gross income to the extent that the cash
                         value of the contract exceeds the initial investment.
                         See I.R.C. § 72(e)
                    b. Cash withdrawals before the age of 59½ are subject to
                         a penalty of 10% of the amount withdrawn being
                         included in income.
             3. Treatment of explicit interest
                    a. If the contract includes an express agreement to pay
                         interest, the interest payments are included in gross
                         income
d. Tax arbitrage and annuities: I.R.C. § 264
       i. General principle
             1. When a tax rule exists that does not correspond to economic
                 reality, it is possible to create a situation in which the
                 taxpayer is under-taxed.
             2. Here, the bank-account method of annuity taxation is the
                 only method that corresponds to economic reality.
      ii. Shuldiner's annuity "tax shelter"
             1. Section 72 provides for a straight-line recovery of basis—
                 some income is deferred later than it otherwise would have
                 been.
             2. Operation of tax shelter


                                                                               35
                        a. Borrow money and purchase an annuity
                        b. The borrowed money will be taxed on the bank
                           account method—you may, under certain tax
                           provisions, deduct the interest (accruing under the
                           bank account method).
                        c. The lent money, however, is taxed on a straight-line
                           method
                   3. Consequence
                                  Invest:   Borrow:
                                  Section   Bank      Tax
                         Year     72        Account   Shelter
                         1        10.90     -16.04    -5.14
                         2        10.90     -11.00    -0.10
                         3        10.90     -5.66     5.24
                         Total    32.70     -32.70    0.00
                         PDV      29.13     -29.67    -0.54
                             a. The results are even more dramatic when the annuity
                                is deferred
             iii. Section 264 disallows the deductions that would allow this scheme
                  to work
IX.   Life Insurance
      a. What is life insurance?
               i. "Term" life insurance
                     1. A term insurance policy promises to pay the insured a
                         specified sum should the insured die during a certain period
                         of time, in return for payments.
                     2. Essentially, the insured is gambling that his life expectancy
                         is shorter than the insurance company believes it to be.
              ii. "Whole" life insurance
                     1. A whole life insurance policy promises to pay the insured a
                         specified sum at the insured's death in return for payments
                         throughout the life of the insured.
             iii. Both term and whole life insurance have a pure insurance element
                  and a savings element
                     1. Insurance component
                             a. You buy a life insurance policy in which the insurance
                                company promises to pay $5,000 if you die anytime in
                                the next 5 years. You die the next day. Here, your
                                life was "insured" with a guaranteed sum
                     2. Savings component
                             a. You buy whole life insurance. Normally, the annual
                                premium of term insurance would rise to account for
                                the increased risk of death. With whole insurance,
                                the initial payments are quite high compared to the


                                                                                   36
                         risk—here, the payments exceed the actuarial cost of
                         term insurance. The excess amount is deposited as a
                         cushion for when the insured dies.
b. Theoretical and policy issues
        i. The savings element of life insurance is untaxed. Why?
              1. Shuldiner's answer is that it would really be impossible to
                 tax—a pure income tax does not tax risk.
                     a. Example
                              i. Facts
                                     1. τ = 33%
                                     2. premiums= $100
                                     3. insurance = $100,000
                             ii. No-tax
                                     1. In this world, the insured receives a
                                         deduction for each $100 payment
                            iii. Tax
                                     1. Here, since the tax rate is 33%, any
                                         taxpayer who wants to receive $100,000
                                         at death would purchase $150,000
                                         insurance policy with payments of $150.
  Term           life No Tax                   Pre Tax (1/3)       After tax (1/3)
  insurance
  Premium              100                     150                 100
  Insurance            100000                  150000              100000
  You live             0                       0                   0
                            iv. Because some will live and some will lose,
                                 treasury comes out even whether there is a tax
                                 or not.
c. Tax treatment of life insurance: I.R.C. § 101
        i. General Rule: § 101(a)
              1. gross income does not include amounts received under a life
                 insurance contract if paid because of the death of the insured
       ii. Agreements to maintain life insurance proceeds
              1. § 101(c)
                     a. If there is an agreement to pay interest on the
                         proceeds from the life insurance contract, the interest
                         payments are included in gross income.
              2. § 101(d)
                     a. if the life insurance keeps the proceeds of a life
                         insurance contract in return for a promise to pay an
                         even larger sum to the beneficiary at a later point in
                         time, Treasury pro-rates the proceeds and includes it
                         in the beneficiary's gross income


                                                                              37
           iii. Abusive "life-insurance" contracts
                   1. The insurance element of a contract must be "genuinely
                       present" and "significant." Congress has acted to prevent
                       taxpayers from receiving tax-free treatment of interest for
                       contracts that don't really have a life insurance component
                          a. See Graetz p. 170
                   2. I.R.C. § 7702A(b)
                          a. Abusive life insurance policies are called "modified
                              endowment contracts" and do not receive preferential
                              tax treatment
                          b. The basic test for determining whether a policy is a
                              modified endowment contract looks to the amount of
                              the premiums paid in the first seven years and asks
                              whether that amount paid is greater than what would
                              have been paid had the contract provided for paid-up
                              future life insurance benefits after seven level
                              premiums.
                          c. See also I.R.C. § 72(e)
                   3. Borrowing against insurance policy
                          a. Taxpayers who borrow from their life insurance
                              policies are not taxed on the loan proceeds—the form
                              of the transaction is respected. I.R.C. § 72 (e)(4)(A).
X.   Treatment of Debt
     a. In General
             i. Definition of loan
                   1. Collins v. Commissioner: "Loans are identified by the mutual
                       understanding between the borrower and lender of the
                       obligation to repay and a bona fide intent on the borrower's
                       part to repay the acquired funds."
            ii. Tax treatment of loans
                   1. General rules
                          a. A borrower does not realize income upon the receipt
                              of a loan.
                          b. A lender does not deduct the amount of a loan as a
                              loss and does not realize income when the principal is
                              repaid.
                   2. Rationale
                          a. Loans are not taxed because there is no change in the
                              net worth of either party—one person receives money
                              but simultaneously receives a liability (the promise to
                              pay it back).
     b. Illegal Income
             i. General issue


                                                                                  38
                          1. How should the tax law react when an individual embezzles
                              funds but claims that they were only "borrowed" and thus,
                              not subject to taxation.
                          2. This is really a question about how the tax law should
                              respond to non-recourse debt. In general, non-recourse
                              debt, like recourse debt, is untaxed.
                    ii. Doctrinal development
                          1. United States v. Sullivan
                                  a. The Supreme Court held that gains arising out of
                                      illegal activity are not necessarily excludable from
                                      gross income—the origin of the income is irrelevant
                                      for tax purposes.
                                  b. The Supreme Court also held that the requirement
                                      that illegal income be disclosed on a tax return does
                                      not violate the Fifth Amendment
                          2. James v. United States16
                                  a. The Supreme Court held that all unlawful gains are
                                      taxable.
                          3. Gilbert v. Commissioner
                                  a. The Second Circuit held that money taken from a
                                      corporation by its President and used to purchase the
                                      stock of another company, on margin, was not
                                      includible in the President's gross income, despite the
                                      lack of a loan agreement, because (1) the President
                                      expected "with reasonable certainty" to repay the
                                      sums, (2) he believed the withdrawal would be
                                      approved by the company board and (3) he made
                                      prompt assignment of assets to secure the amount
                                      that he owed.
                          4. Collins v. Commissioner
                                  a. The Second Circuit held that a ticket vender and
                                      computer operator at an Off-Track-Betting parlor
                                      received gross income of $38,105 when he took
                                      $80,280 in betting tickets but only won $42,175.
                                  b. The court also held that the $38,105 could not be
                                      deducted as a loss under I.R.C. § 165(d) because
                                      gambling losses could only be offset against gambling
                                      winnings.


16Overturning Commissioner v. Wilcox (holding that, since an embezzler is legally obligated to return the
funds, an embezzler, like a legitimate borrower, realizes no income upon receipt of the cash) and Rutkin v.
United States (distinguishing an extortionist from an embezzler and concluding that the former must
include ill-gotten gains in gross income).


                                                                                                        39
               c. Distinguishes Gilbert because that case involved a
                   situation in which the taxpayer believed "with
                   reasonable certainty" that he would be able to repay
                   the money taken.
iii. General legal principles
       1. Taken together, the above cases indicate that the criminal
           taxpayer realizes income when he acquires an economic gain
           from his nonconsensual "borrowing" and there is no
           "reasonable certainty" that the money can be repaid.
iv. Special rules for losses: I.R.C. § 165(c) and (d)
       1. § 165 (c)
               a. Limits individual loss deductions to
                        i. Losses incurred in a trade or business
                       ii. Losses incurred in a for-profit transaction
                      iii. Losses of property not covered as casualty
                           losses in 165(h) but arising out of fire, storm,
                           shipwreck or theft.
       2. § 165 (d)
               a. General rule
                        i. Wagering losses:       losses from "wagering
                           transactions" can only be deducted to the
                           extent of the gains from the transactions.
                               1. Reg. § 1.165-10 provides that the losses
                                  are only allowed to the extent of gains in
                                  the taxable year.
                       ii. See Collins v. Commissioner (holding that
                           taxpayer was not entitled to gambling loss
                           deduction when he borrowed $80,000, won
                           $42, 175 and lost $38,105).
                      iii. See Zarin v. Commissioner (holding that
                           taxpayer was not allowed to deduct almost $3
                           million in gambling losses because the debt
                           and its discharge occurred in different years)
               b. Purpose
                        i. Recognizes the consumption value of gambling
                       ii. Gambling losses would be difficult to prove—
                           taxpayers could take unearned deductions.
 v. Policy issues
       1. Enforcement of criminal law for tax purposes
               a. In United States v. Baggot, the Supreme Court refused
                   to allow the United States's to obtain the grand jury
                   transcripts and documents created during a tax-fraud



                                                                         40
                        investigation, for use in an audit to determine tax
                        liability.
             2. Enforcement of tax laws to target criminals
                    a. See Rutkin v. United States (Black, J., Dissenting)
                            i. Criticized the court for taxing income acquired
                                from extortion because
                                    1. it     allowed      the    government        to
                                        appropriate sums that had originally
                                        belonged to the victim
                                    2. pursuing the taxes is a wasteful expense
                                    3. the practice gives the government more
                                        power to punish purely local crimes.
c. Discharge of Indebtedness income
       i. Discharge of indebtedness, in general
             1. General rule
                    a. If a borrower's debt is paid by another party, the
                        borrower must include the amount paid in gross
                        income. Cf. Old Colony Trust Co. (holding that
                        taxpayer must include his employer's payments of his
                        tax liability in gross income).
                            i. See      also     I.R.C.    61(a)(12)     (specifically
                                enumerating "income from discharge of
                                indebtedness" as includible in gross income).
             2. Rationale
                    a. The taxpayer realizes income when the loan is not
                        repaid because the taxpayer's liability disappears—he
                        has realized an accession to wealth.
      ii. When is there a "debt" that has been discharged?
             1. Definitions of loan
                    a. See supra p. 38. (citing definition in Collins v.
                        Commissioner)
                    b. Enforceability
                            i. There can be no "discharge of indebtedness"
                                income if there is no debt, and there is no debt
                                if the a loan is legally unenforceable. See Zarin
                                v. Commissioner, 916 F.2d 110 (3d Cir. 1990).
                                    1. Note that this decision overturned the
                                        tax      court's     determination        that
                                        enforceability was irrelevant to tax
                                        liability, citing United States v. James
     iii. Realization of discharge of indebtedness income
             1. The "freeing up of assets" approach



                                                                                   41
             a. The taxpayer realizes discharge of indebtedness
                  income when he acquires the gain of freed up assets
                  that would otherwise have been required to pay the
                  debt.
             b. See United States v. Kirby Lumber Co. (holding that a
                  corporations re-purchase of its bonds at less than par
                  was a clear gain subject to taxation).
             c. See also Zarin v. Commissioner, 92 T.C. 1084 (1989)
                  (citing Kirby Lumber in support of argument that
                  gambler received income when he received chips
                  from a casino in the amount of $3,435,000 and later
                  paid a settlement of only $500,000).
iv. Discharge of Indebtedness: I.R.C. § 108
       1. Exclusions from gross income: I.R.C. § 108(a)
             a. Gross income does not include discharge of
                  indebtedness income if
                       i. The discharge occurs in a chapter 11
                          bankruptcy
                      ii. The discharge occurs when the taxpayer is
                          insolvent
                             1. "insolvent" means "the excess of the
                                 liabilities over the fair market value of
                                 assets." I.R.C. § 108(d)(3)
                     iii. The debt is qualified farm indebtedness
             b. The exclusion is only equal to the amount of the
                  insolvency
       2. Adverse consequences of exclusion under § 108(a): I.R.C. §
          108(b)
             a. When a taxpayer excludes gross income under §
                  108(a), the following is reduced by the amount
                  excluded
                       i. Net operating losses from previous year are
                          reduced (so deduction limited)
                      ii. Basis in property
                             1. See also I.R.C. § 1017
                                     a. § 1017 (a): confirms rule that
                                          amount excluded from income
                                          under 108(a) reduces the basis in
                                          property.
                                     b. § 1017(b)(3): The basis is reduced
                                          only in depreciable property if the
                                          taxpayer elects the reduction in
                                          108(b)(5).


                                                                          42
                                      i. See     note      below—a
                                         taxpayer would prefer to
                                         take a reduction in the
                                         basis of non-depreciable
                                         property.
                       2. The taxpayer may elect to take
                           reductions in basis as to opposed to
                           reductions elsewhere under 108(b)(5).
                              a. But note that because the
                                  taxpayer must take a reduction in
                                  the basis of depreciable property,
                                  she may decide not to make the
                                  election because otherwise she
                                  might be able to reduce the basis
                                  in non-depreciable property and
                                  continue to take deductions in
                                  the present.
       b. The reduction in operating losses, the minimum tax
           credit, foreign tax credit carryovers, and passive
           activity losses and carryovers is to be 33 1/3 cents per
           $1 excluded.
3. Discharge of qualified real property business indebtedness:
   I.R.C. § 108(c)
       a. General rule: the amount excluded under 108(a)(1) is
           applied to reduce the basis of depreciable real property
           held by the taxpayer.
       b. Limitations
                i. The amount excluded may not exceed the
                   aggregate adjusted bases of the depreciable real
                   property held by the taxpayer immediately
                   before the discharge. I.R.C. § 108(c)(2)(B)
4. Definitions: I.R.C. § 108(d)
       a. "Indebtedness"
                i. means any indebtedness for which the
                   taxpayer is liable or
               ii. subject to which the taxpayer holds property
              iii. See also Zarin v. Commissioner (3d Cir.) in which
                   court holds that a legally unenforceable loan is
                   not "indebtedness" under § 108.
       b. "Depreciable property" I.R.C. § 108(d)(b) I.R.C. §
           1017(b)(3)(B)
                i. "any property of a character subject to the
                   allowance for depreciation, but only if a basis


                                                                 43
                 reduction under subsection (a) would reduce
                 the amount of depreciation or amortization
                 which otherwise would be allowable for the
                 period immediately following such reduction.
5. General rules for discharge of indebtedness income: I.R.C. §
   108(e)
      a. No other insolvency exception: I.R.C. § 108(e)(1)
      b. Lost deductions: I.R.C. § 108(e)(2)
              i. Income is not realized to the extent that
                 payment of the liability would have been
                 allowed as a deduction.
             ii. This makes sense because the IRS would not
                 have the tax receipt anyways (this can be
                 thought of as an administrative provision)
      c. Purchase price reduction: I.R.C. § 108(e)(5)
              i. Three statutory requirements
                     1. the debt must be that of a purchaser of
                        property to the seller which arose out of
                        the purchase of the property
                     2. the taxpayer must be solvent (and not in
                        chapter 11) when the debt reduction
                        occurs
                     3. except for the section, the debt reduction
                        would have been discharge of
                        indebtedness income
             ii. Requirements derived from legislative history.
                 See Zarin v. Commissioner:
                     1. the price reduction must result from an
                        agreement between the purchaser and
                        the seller (not because of statute of
                        limitations)
                     2. there has been no transfer of debt by the
                        seller to a third party
                     3. there has been no transfer of the
                        purchased property from the purchaser
                        to a third party
            iii. In Zarin v. Commissioner the Tax Court held (I)
                 that gambling chips were not "property" under
                 108(e)(5) and (II) that a settlement of $500,000
                 for gambling debts of $3,000,000 was not a
                 purchase price adjustment to the price of the
                 gambling
      d. Corporate debt to shareholder: I.R.C. § 108(e)(6)


                                                               44
                           i. If a shareholder forgives a debt owed to him by
                               the corporation, the corporation is treated as
                               having paid an amount equal to the basis of
                               the debt
                          ii. This will usually result in no discharge of
                               indebtedness income to corporation
                    e. Corporate stock issued in exchange for debt: I.R.C. §
                       108(e)(8)
                           i. A solvent corporation realizes discharge of
                               indebtedness income when it issues stock to
                               cancel its debt.
                    f. Discharge of indebtedness treated as gift
                           i. The statute is silent: this would have to be
                               determined from the context of the transaction
                    g. Discharge of indebtedness or salary
                           i. This would have to be determined in context.
                          ii. In some situations, you might prefer to have
                               the payment classified as discharge of
                               indebtedness income so that you can take
                               advantage of Section 108
                    h. Student loan forgiveness: I.R.C. § 108(f)
                           i. Excludes from gross income the discharge of
                               student loans if the discharge was conditioned
                               on working in a certain profession
d. Borrowing and basis
       i. Basis problems/concepts
             1. How should the tax system take borrowed money into
                 account when computing basis and amount realized?
      ii. Types of debt
             1. Recourse debt
                    a. This type of debt occurs when the borrower is
                       personally liable for the repayment of the debt
             2. Nonrecourse debt
                    a. This type of debt occurs where the borrower is not
                       personally liable—the lender can look only to the
                       assets that secure the debt for payment.
                           i. Here, the lender assumes the risk that the
                               property securing the loan will fall in value.
     iii. Tax treatment of discharge of non-recourse debt
             1. Doctrinal development
                    a. Crane v. Commissioner
                           i. Rule



                                                                          45
             1. In Crane v. Commissioner the Supreme
                  Court concluded that a loan, whether
                  recourse or Nonrecourse, is included in
                  the basis of the asset it finances.
      ii. Rationale
             1. This rule creates parity between a
                  purchaser who borrows from a bank
                  and pays the seller cash and a purchaser
                  who uses seller financing.
     iii. Effects
             1. Depreciation deductions
                      a. This rule allows the taxpayer to
                          take depreciation deductions for
                          costs that the taxpayer has not
                          paid
b. Commissioner v. Tufts
       i. General rule
             1. In Commissioner v. Tufts the Supreme
                  Court concluded that a taxpayer who
                  sells a property subject to a nonrecourse
                  mortgage must include the unpaid
                  balance of the mortgage in the
                  computation of the amount realized
                  when the unpaid amount of the
                  nonrecourse mortgage exceeds the fair
                  market value of the property sold.
             2. Graetz notes that "Tufts should be
                  understood as holding only that a
                  taxpayer must treat a nonrecourse
                  mortgage consistently when he accounts
                  for basis and amount realized."
                      a. See     Estate    of    Franklin  v.
                          Commissioner in which the Ninth
                          Circuit held that where the
                          amount of the mortgage exceeds
                          the fair market value of the
                          property securing it when the
                          debt was first incurred, the
                          mortgage is not included in the
                          basis and thus will not be
                          included in the amount realized
                          upon     disposition      (probably
                          foreclosure). See infra p. 46.


                                                          46
                                            ii. Rationale
                                                    1. Crane was not based on economic
                                                       benefit, but on the desire to treat
                                                       recourse and nonrecourse debt similarly
                                                    2. The court focuses on the obligation to
Example:
    Facts                                             repay the loan, not on the fact that the
         o Debt = $12,000                              taxpayer could take deductions from the
         o FMV= $10,000                                basis.
         o Basis = $7,000              c. General rules/principles
    Nonrecourse debt in Tufts               i. For tax purposes, both recourse and
         o AR – B                               nonrecourse loans are treated similarly: both
         o $12,000 - $7,000 = $5,000            are included in the basis of the property.
    Recourse debt under Tufts                      1. Criticism
         o AR (FMV) – B                                    a. Recourse and nonrecourse debt
         o $10,000 - $7,000 = $3,000                           are not really treated the same.
         o SEPARATELY, there is             ii. NOTE THAT I.R.C. § 7701(g) CHANGES THE
           $2,000 of discharge of               RESULT OF TUFTS
           indebtedness income                      1. I.R.C. § 7701(g) provides that the fair
         o See Reg. § 1.001-2(c)(8)
                                                       market value of property shall be
                                                       treated as being not less than the amount
                                                       of any nonrecourse indebtedness to
                                                       which the property is subject.




                                                                                             47
                                                     iii. Justice O'Connor's concurrence in Tufts
   Shuldiner suggests that, in these situations, the        1. Justice O'Connor would split the
    rules for ordinary income and gains on property              transaction in two
    end up converging on the same result anyways                     a. Property transaction
        o Example 1                                                         i. The fair market value on
                 Facts                                                        the date of the acquisition
                         Debt = $100,000                                      is the basis in the property.
                         Deprecation = $20,000                            ii. Fair market value on the
                         Adjusted Basis = $80,000                             date of disposition is used
                         FMV - $80,000                                        to calculate the amount
                 Nonrecourse loan (Tufts majority)                            realized (in this case, a
                         Gain = AR – Adjusted basis                           loss).
                         Gain = $20,000                             b. Discharge of indebtedness
                 Nonrecourse loan (O'Connor)                               i. The taxpayer acquires cash
                         Gain = $0                                            from the mortgagee.
                         COD = $20,000                                    ii. When the property is
                               o But under O'Connor                            transferred for less than
                                   you could claim that
                                                                               the debt, the taxpayer
                                   this was a basis
                                                                               acquires      discharge    of
                                   reduction under §
                                   1017                                        indebtedness income
                               o OR, if the non-                     c. This treatment accounts for the
                                   recourse debt is                     fact that the types of income at
                                   seller-financed, you                 issue are treated differently by
                                   could say that this                  the tax code: one is a capital gain
                                   amount is simply a                   (or loss) and one is ordinary
                                   purchase price                       income.
                                   reduction                 2. Problem's with O'Connor's analysis
                 Recourse loan                                      a. O'Connor assumes that the
                         COD = $20,000                                 amount of the debt above the fair
                         BUT, I.R.C. § 1017(b)(3)(F)                   market value of the property is
                           provides for real property                   cancelled. That was not the in
                           indebtedness
                                                                        Tufts.
                                                                     b. The rules for property gains and
                                                                        discharge      of      indebtedness
                                                                        converge to reach the same result
                                                                        anyways.
                                     2. Policy issues
                                              a. Who should receive depreciation deductions when
                                                  property is secured with a nonrecourse loan?
                                                       i. In general, the tax code provides for
                                                          accelerated deductions. This means that it
                                                          might be possible for the owner of property


                                                                                                         48
                         purchased with non-recourse debt to receive
                         deductions in excess of his investment in the
                         property.
                     ii. If, instead, the lender received the deductions,
                         we might expect the economic benefit to
                         manifest itself in lower interest rates.
                    iii. Someone gets this benefit. Shuldiner suggests
                         that there are no real compelling arguments
                         either way).
iv. Acquisition and Disposition of property encumbered by debt:
    Statutory treatment
       1. See generally supra p. 18-21
       2. Reg. § 1001-2
              a. General rule (Tufts)
                      i. "The amount realized from a sale or other
                         disposition of property includes the amount of
                         liabilities from which the transferor is
                         discharged as a result of the sale or disposition.
              b. Discharge of indebtedness
                      i. Amount realized does not include income from
                         discharge of indebtedness when a recourse
                         loan is secured with property
              c. Special rules
                      i. Foreclosure by a nonrecourse lender is a
                         realization event—the borrower is discharged
                         from the liability
 v. Real Estate Tax Shelters: Estate of Franklin v. Commissioner
       1. Real estate tax shelters, generally
              a. By purchasing property through nonrecourse debt
                  and then taking deductions, the property owner is
                  able to acquire a tax benefit at no cost
              b. Example (10 year sale and lease-back)
                      i. Assumptions
                              1. assume straight line depreciation
                     ii. Consequences
                              1. At disposition
                                    a. Gain = AR – adjusted basis
                                             i. Adjusted basis = purchase
                                                price – deprecation
                                            ii. Under     Tufts,   Amount
                                                realized equals the amount
                                                of the debt. Here, that



                                                                        49
                                                                        amount is zero because the
                                                                        debt = price
                                                      2. During ten years
                                                              a. Total income would be the rent
                                                                 over the ten years
                                                              b. Total deductions would be the
                                                                 deductions from interest and
                                                                 depreciation
                                                              c. Net income would be (Rent –
                                                                 Income) + (Gain – Depreciation)
                                                                     i. This would be 0
                                                              d. BUT, the present value of the
                                                                 deductions is greater than the
                                                                 present value of the gain from the
                                                                 property. So, in the end, you get
                                                                 a net deduction.17
                                2. Estate of Franklin v. Commissioner
                                      a. In Estate of Franklin v. Commissioner the Ninth Circuit
                                           held that a taxpayer ought not be permitted
                                           deductions on a property purchased from the owners
                                           using nonrecourse debt and then leased back to the
                                           owners in such a way as to offset the debt payments.
                                               i. Estate of Franklin seems to hold out the rule that
                                                  depreciation is based not on ownership but on
                                                  investment—the court attributed importance to
                                                  the fact that the owners of the property never
                                                  acquired equity in the property (because the
                                                  purchase price was inflated and the
                                                  nonrecourse mortgage contained a large
                                                  "balloon" payment at the end of the lending
                                                  period).
                                      b. Tax code provisions relating to the abuse in Estate of
                                           Franklin
                                               i. I.R.C. § 461(g)

17   Example
       1. Facts
              a.    P = $1,000
              b.    Discount rate = 10%
              c.    τ = 70%
              d.    capital gains τ = 35%
       2. Results
              a.    PDV (gains) = $385 * 35% = $135
              b.    PDV (depreciation) = $615 * 705 = $430
              c.    Net deduction = 230 $300


                                                                                                 50
                             1. allows homeowners to deduct prepaid
                                 mortgage points.
                             2. The service takes the position that
                                 refinancing a mortgage with points that
                                 are nondeductible requires those points
                                 to be spread over the life of the home.
                     ii. Tax Penalties
                             1. I.R.C. § 6662: penalty for overvaluation
                                 of property
                             2. I.R.C. § 6663: penalty for fraud
                    iii. I.R.C. § 465: "at risk rules"
                    iv. I.R.C. § 469: passive loss rules
                             1. See infra, Losses, p. XXX
             c. A note on prepaid interest
                      i. Shuldiner notes that the "prepaid" interest
                         doesn't make any sense conceptually.
                     ii. Example
                             1. Facts
                                     a. You give $1,000, and immediately
                                        receive $100 back.
                                     b. Just a little while later, the $1,000
                                        is returned.
                             2. This can be characterized in two ways
                                     a. You can say that their was a loan
                                        with $100 of prepaid interest.
                                     b. You can say that there was a loan
                                        of $900, repaid for $1,000.
                                             i. Economically,            this
                                                characterization       makes
                                                more sense
                    iii. See also Knetsch v. United States, infra p. XXX
vi. Borrowing, basis and realization: other issues
       1. Borrowing in excess of basis
             a. In Woodsam Associates Inc. v. Commissioner the Second
                 Circuit held that a loan, even when secured only by
                 untaxed appreciate on property, does not constitute
                 realized income to the borrower—the borrowing is
                 not a realization event.
             b. Shuldiner criticizes this result
                      i. There is no liquidity problem
                     ii. There is no valuation problem
       2. Post-acquisition indebtedness



                                                                          51
                          a. Here, the taxpayer borrows more money on the
                              property through a second mortgage or an equity
                              loan.
                                  i. This second debt is not included in basis under
                                     I.R.C. § 1012 (because not part of the cost of
                                     acquisition)
                                 ii. If the money is used to finance improvements
                                     on the property, then basis would be increased
                                     under I.R.C. § 1016
                          b. On disposition of the property, the outstanding
                              amount of the indebtedness would be included in the
                              amount realized.
                    3. Contingent liabilities
                          a. A contingent loan is not included in basis because it is
                              unclear whether the borrower will ever actually make
                              payments. Estate of Franklin; Rev. Rul. 78-29, 1978-1
                              C.B. 62.
          vii. Part sale/ part gift
                    1. General rule
                          a. Transfer of property by gift is not a realization event.
                    2. Exception
                          a. If the donee transfers consideration—including the
                              assumption of a liability of the donor—there is a part
                              sale, part gift.
                          b. In Diedrich v. Commissioner the Supreme Court held
                              that the transfer of stock on condition that the donees
                              pay the federal gift tax owed by the donor resulted in
                              gross income to the donor to the extent that the gift
                              tax exceeded the donor's basis.
XI.   Damages and Sick Pay
      a. General
             i. The nature of the injury determines the tax consequences to the
                taxpayer.
            ii. Personal damages must be distinguished from business damages
                because the former get preferential treatment.
      b. Policy Issues (Graetz p. 214)
      c. Commercial/Business damages
             i. General rule/guiding principles
                    1. The tax consequences of a compensatory damages award of
                       reimbursement depend on the tax treatment of the item for
                       which the reimbursement is intended to substitute.
            ii. Examples
                    1. Damages in antitrust


                                                                                  52
                       a. Recoveries that represent a recovery of lost profits are
                          income.
               2. Damages for lost goodwill
                       a. Often, the taxpayer will have no basis in goodwill, so
                          the entire amount recovered is realized income.
               3. Compensation for loss of property with adjusted basis
                       a. The amount of income equals the amount received
                          minus the adjusted basis.
      iii. Punitive damages are entirely taxable. See Commissioner v. Glenshaw
           Glass, 348 U.S. 426 (1955)
      iv. I.R.C. § 1033: involuntary conversions
               1. If the taxpayer loses a factory and receives damages, he
                   would not normally be able to replace the factory because
                   the damages would be taxed.
               2. Section 1033 fixes this problem by providing a non-
                   recognition rule.
d. I.R. C. § 104: General exclusion of personal injury damages from income.
        i. General rule
               1. "The amount of any damages (other than punitive damages)
                   received on account of personal physical injuries or physical
                   sickness" is excluded from gross income.
               2. Note that § 104(a)(2) allows for the exclusion of damages
                   whether they are paid in lump sum or as periodic payments.
                       a. If the interest is unstated in the periodic payments, it
                          will be untaxed. See Graetz 212.
       ii. Exceptions (if an exception, then includable in income)
               1. The personal v. business distinction
                       a. Requirement that the damages be for personal injury
                               i. I.R.C. § 104(a)(2) expressly requires that the
                                  injuries be "personal"
                       b. See supra for treatment of business damages. See infra
                          p. XXX for more on the business/personal distinction
                          in the context of I.R.C. § 162.
               2. "Physical" injury
                       a. The legislative history indicates that damages for
                          physical injury or sickness resulting from emotional
                          distress are not excluded
                       b. damages for emotional distress resulting from
                          physical injury may be excluded.
               3. Amounts attributable to deduction allowed under I.R.C. §
                   213.
                       a. I.R.C. § 213
                               i. General notes


                                                                               53
                                           1. § 213 is only available as a below-the-
                                              line deduction.
                                   ii. I.R.C. § 213 does not apply when the medical
                                       costs are paid by an insurance company.
            iii. Employer-purchased insurance proceeds
                     1. I.R.C § 104(a)(3) provides that amount received through
                        accident or health insurance for personal injuries are
                        included in income.
                     2. I.R.C. § 105(b)
                            a. Gross income does not include amounts received
                                through employer-provided health insurance if the
                                amounts are paid directly to the taxpayer to
                                reimburse medical costs NOT allowed as deductions
                                under § 213.
                     3. I.R.C. § 106
                            a. Provides that the gross-income of the employee does
                                not include employer-provided coverage under an
                                accident or health plan.
       e. Personal injury damages included in income
              i. Lost wages
             ii. Pain and suffering
            iii. Punitive damages
       f. Damages paid in the form of property
              i. If damages are paid in property, the full-market value of the
                 property is included in basis.
       g. Murphy v. Internal Revenue Service, 493 F.3d 170 (D.C. Cir. 2007)
              i. General Holding
                     1. In Murphy the D.C. Circuit, en banc, vacated an earlier
                        decision in which it had declared I.R.C. § 104(a)(2)
                        unconstitutional on that physical damages do not constitute
                        income under the 16th Amendment and did not fit under
                        any of the other taxing provisions in Article I.
             ii.
XII.   Tax-Exempt Interest: I.R.C. § 203—State and Municipal bonds
       a. General exclusion of interest from state and local bonds: I.R.C. § 103
              i. I.R.C. § 103: "Except as provided in subsection (b), gross income
                 does not include interest on any State or local bond."
             ii. Exceptions
                     1. "private activity" bond not qualified under § 141
                            a. A private activity bond is one for which more than
                                10% of the proceeds are used for a private business
                                use and for which more than 10% of the principal or



                                                                                  54
                                 interest payments are secured by an interest in a
                                 private business. See I.R.C. § 141 (a)-(b)
                       2. Arbitrage bond defined under § 148
                             a. See infra on tax arbitrage
                       3. Bond not in registered form under § 149
                             a. This was done to prevent states and municipalities
                                 from creating unregistered bonds that would
                                 essentially function as currency.
         b. Policy issues
                i. The subsidy to state and municipal governments
                       1. Section 103 acts as a subsidy to state and local governments:
                          they can pay lower rates of interest on their debt than a
                          corporate bond of comparable risk.
                       2. Example
                             a. Facts
                                      i. National (τn) = 50%
                                     ii. Municipal (τm) = 30%
                                    iii. Local (τl) = 10%
                                    iv. T (Tax rate) = 1 – τ
                                     v. Tax Exempt (TE) = T (1-τ)
                             b. Resulting tax situation
                    Taxable                Tax Exempt         Implicit tax rate18
Long-term           5.55%                  4.12               26
Short Term          4.97%                  3.51%              29%

                           3. Why not simply give a direct subsidy to the states and
                               municipalities?
                                   a. Under this scheme the costs of the subsidy are
                                      hidden—they are not included as a line on the
                                      budget.
                    ii. Distributional aspects of the tax exemption
                           1. In order to attract middle-income taxpayers, states and
                               municipalities offer higher interest rates. This results in
                               high-income taxpayers receiving significantly greater tax
                               benefits
                   iii. Crowding out
                           1. Subsidizing the municipal bond rate might also lead to
                               "crowding out"—money is invested in municipal bonds
                               rather than in private investments (which are more efficient).
              c. Tax arbitrage
                     i. Two types of bonds

18   τ = 1 – TE/T


                                                                                          55
                           1. General obligation bond
                                 a. A general obligation bond is one for which the state
                                     assumes liability—it assures the bond with its full
                                     faith and credit.
                           2. Revenue bond
                                 a. A revenue bond is a bond for a specific project (i.e., a
                                     toll road) which will be paid back from the project's
                                     revenue.
                    ii. State/Local government arbitrage
                           1. Without limits on the tax-free status of the bonds,
                              municipalities could essentially print money.
                                 a. Example: a municipality issues a $1,000 bond at 7%
                                     interest. This would get them $30 in income. Could
                                     they multiply this by a factor of a billion? Let's say
                                     the municipality tries to issue a $trillion bond. There
                                     credit would probably not be enough to sustain this.
                                          i. To get around this, the municipalities could
                                             use the money they get from the bond to buy
                                             treasury bonds from the federal government.
                                             They can then use the interest from the federal
                                             bonds to pay their own debt. Essentially, they
                                             back their bonds with the full faith and credit
                                             of the Federal government.
                                 b. Sections 103 and 148 prevent this.
                                          i. Section 103 excepts "arbitrage" bonds from tax-
                                             free status.
                                         ii. Section 148 defines arbitrage bond.
                                                 1. Essentially, an arbitrage bond is a bond
                                                     used to purchase other debt at a higher
                                                     yield
                   iii. Bondholder arbitrage
                           1. Bondholder arbitrage occurs when an investor borrows at a
                              commercial rate and invests at a tax-exempt rate. 19
                           2. Example
                                 a. Facts
                                          i. τ = 50%
                                         ii. Commercial Interest Rate = 10%
                                        iii. Tax Exempt Rate = 7%
                                        iv. So, interest deduction on $10 is worth $5.
                                 b. Arbitrage


19This is profitable because the investor might be able to deduct his interest payments on the commercial
debt. See infra, p. XXX


                                                                                                      56
                          Pre-Tax                       After-tax
Borrow at                 10%                           5%
Invest at                 7%                            7%
Profit margin             -3%                           2%
                      3. Tax Code solution: Section 265(a)(2)
                              a. I.R.C. § 265(a)(2)
                                      i. No deduction shall be allowed for "Interest on
                                         indebtedness incurred or continued to
                                         purchase or carry obligations the interest on
                                         which is wholly exempt from the taxes
                                         imposed by this title"
                              b. Policy issues
                                      i. Allowing the arbitrage would simply bid up
                                         the price of the municipal bonds, lower the
                                         spread and decrease the after-tax interest rate
                                         on the bonds—the market would correct for
                                         the problem.
                                     ii. 265(a)(2) thus seems unnecessary. In fact, it is
                                         rarely enforced.
         d. Constitutional issues
               i. Federal Power
                      1. Recent decisions of the Supreme Court had made it clear
                         that the Constitution grants Congress the power to repeal
                         the tax exemption in state and local bonds. South Carolina v.
                         Baker (1988) (upholding congressional statute requiring that
                         bonds be issued in registered form in order to acquire tax-
                         free status).
              ii. Dormant Commerce Clause
                      1. If I have time, perhaps note the case here.


DEDUCTIONS AND CREDITS

   I.    Overview
         a. Recurring themes and issues
                i. The nature of the federal tax system
                      1. Not allowing a deduction for business expenses would turn
                          the income tax into a consumption tax. See infra, p. XXX
                      2. The income tax is a tax on net income, not gross income—the
                          expenses of producing income must be deductible.
               ii. Deductions as a matter of legislative grace
              iii. Credit v. Deduction



                                                                                      57
               1. A credit saves a dollar of taxes—it is the same for every
                   taxpayer
               2. A deduction saves the taxpayer a fraction of a dollar,
                   depending on the tax bracket.
      iv. Policy issues
               1. deductions often function as a tax subsidy for certain
                   behaviors
       v. Limitations on deductions
               1. Personal deductions
                      a. Generally, the tax code allows a deduction only for
                          business expenses.      However, the dividing line
                          between business and personal is often hard to find
               2. Capital expenses
                      a. For certain items, we require that taxpayer's capitalize
                          their expense rather than take an immediate
                          deduction.
               3. Public policy limitations
                      a. For example, we do not allow a deduction for fines
                          imposed for violating the law, even if the fine was
                          incurred in the course of business.
               4. Taxable Year
                      a. Generally, a taxpayer can use deductions only to the
                          extent of her income for the taxable year
               5. Timing
                      a. Whether a cost is expensed or capitalized has a
                          enormous tax consequences
                      b. Depreciation also has a significant impact on
                          temporal tax liability.
b. "Substantive" sections
        i. I.R.C. §§ 151 – 153: Personal exemptions
       ii. I.R.C. § 162: "Ordinary and Necessary" business expenses
               1. See infra p. XXX
               2. See also I.R.C. § 262: Personal expenses
     iii. I.R.C. § 163: interest
               1. See infra p. XXX
      iv. I.R.C. § 164: Taxes
               1. See infra p. XXX
       v. I.R.C. §§ 167, 168, 197: Depreciation and amortization
               1. See infra p. XXX
      vi. I.R.C. § 212: For Profit Activities
               1. See infra p. XXX
     vii. I.R.C. § 263A: Capitalization
               1. See infra p. XXX


                                                                              58
        c. "Structural " sections
                i. General
                       1. These code sections determine whether a deduction will be
                           "above the line" or "below the line"
                       2. Importance of distinction
                              a. "Above the line" deductions can be taken without
                                  limit
                              b. "Below the Line" Deductions are subject to limitation
                                       i. Must be greater than standardized deduction
                                      ii. May be subject to restrictions on miscellaneous
                                          itemized deductions
                                             1. two percent floor
                                             2. three percent haircut
                                     iii. itemized deductions are eventually phased out
               ii. I.R.C. § 62: The definition of adjusted gross income
              iii. I.R.C. § 63: Standardized or Itemized deductions?
              iv. I.R.C § 67:        Two Percent Floor on Miscellaneous Itemized
                   Deductions
               v. I.R.C § 68: Phaseout of Itemized deductions
                       1. Note that this effectively increases the marginal tax rate

Business Expenses

  I.    Tax Code Provisions: I.R.C. §§ 162 & 212, generally
        a. I.R.C. § 162: Trade or Business Expenses
               i. I.R.C. § 162 in structural context
                      1. "Trade and Business" deductions are "above the line"
                             a. I.R.C. § 62(a)(1)
                      2. Other Above the Line Deductions
                             a. I.R.C. § 62(2): Trade or Business Deductions for
                                 employees
                                      i. I.R.C. § 62(a)(2)(A): Reimbursed Employee
                                         Expenses
                                             1. But see also § 62(c) (limiting
                                                 reimbursement arrangements)
                                     ii. I.R.C. § 62(a)(2)(B): Expenses for "qualified
                                         performing artists"
                                             1. See § 62(b)
                                    iii. I.R.C. § 62(a)(2)(C): Expenses of Officials
                                    iv. I.R.C. § 62(a)(2)(D): Expenses for Elementary
                                         and Secondary School teachers
                                             1. See also § 62(d)



                                                                                      59
                              v. I.R.C. § 62(a)(2)(E): Expenses for members of
                                  Armed Forces Reserve
                      b. I.R.C. § 62(a)(3): Losses from sale or exchange of
                          property
                      c. I.R.C. § 62(a)(4): Deductions for rents and royalties
                      d. I.R.C. § 62(a)(5): Deduction of Life Tenants and
                          beneficiaries
b. I.R.C. § 212: Expenses for Production of Income
        i. History
               1. In Higgins v. Commission (1941) the Supreme Court held that
                   an investor could not treat the management of his own
                   investments as a trade or business.
               2. Section 212 was an attempt to overrule Higgins.
       ii. I.R.C. § 212 in structural context
               1. Section 212 expenses may be either below or above the line.
                      a. In general, they will be below the line.
                      b. If a section 212 expense is below the line, it will be a
                          miscellaneous itemized deduction
               2. Above the line Section 212 expenses
                      a. Expenses of renting out property (that do not rise to
                          the level of a trade or business).
      iii. I.R.C. § 212 in substance
               1. Individuals may deduct the "ordinary and necessary"
                   expenses paid or incurred in the taxable year for
                      a. The production nor collection of income
                      b. Property management
                      c. Determining, collecting, or refunding a tax
c. § 162 and § 212 compared
        i. How to distinguish between trade or business expense and an
           income-producing activity
               1. What is a "trade or business"?
                      a. There is no clear definition.
                               i. In Commissioner v. Groetzinger the Supreme
                                  Court held that a professional gambler engages
                                  in a trade or business if "involved in the
                                  activity with continuity and regularity" and
                                  with the primary purpose of earning income or
                                  profit.
                              ii. The taxpayer cannot simply call something a
                                  "trade or business" and make it so—the courts
                                  will look beyond the label.           Levin v.
                                  Commissioner (1987)
                      b. Guiding principles


                                                                              60
                                   i. Should be an activity engaged in with
                                      continuity and regularity
                                  ii. The primary motive should be a desire for
                                      profit
            ii. Structural differences
                   1. Application
                          a. Section 162 applies to a trade or business
                          b. Section 212 applies only to individuals
                   2. Section 62 sorting
                          a. Section 162 expenses are above the line
                          b. Section 212 expenses are generally below the line,
                              miscellaneous itemized deductions.
II.   "Ordinary and Necessary"
      a. What is ordinary and necessary?
             i. Code References
                   1. Substantive
                          a. I.R.C. § 162(a)
                                   i. General rule
                                         1. A deduction is allowed for
                                                a. Ordinary and necessary expenses
                                                b. Paid or incurred in the taxable
                                                    year
                                                c. In carrying on
                                                        i. Start up expenses cannot
                                                           be deducted—the business
                                                           must      already    be   in
                                                           existence
                                                       ii. But see § 195 (allowing
                                                           amortization of certain
                                                           start up expenses)
                                                d. a trade or business
                          b. I.R.C. § 212
                                   i. Also contains the requirement that expenses be
                                      "ordinary and necessary."
                                  ii. Reg. § 212-1(d)
                                         1. Requirements        for     ordinary   and
                                             necessary
                                                a. Must be reasonable in amount
                                                b. Must bear a reasonable and
                                                    proximate       relation   to   the
                                                    production or collection of
                                                    taxable income.
            ii. Doctrinal development


                                                                                    61
        1. In Welch v. Helvering the Supreme Court held that denied a
           deduction to a taxpayer who had paid off the debts of an old
           bankrupt company in order to improve his reputation and
           ability to get clients. The court explained that "the standard
           set up by statute is not a rule of law; it is rather a way of life.
           Life in all its fullness must supply the answer to the riddle."
        2. In Gilliam v. Commissioner the Tax Court denied a deduction
           for the expense of a criminal defense lawyer used to defend
           the taxpayer from charges arising from violent behavior on
           his plane ride to an art show.
iii. Synthesis/Summary
        1. Necessary
               a. Necessary simply means "appropriate and helpful."
                   Welch v. Helvering.
               b. In determining whether an expense was appropriate
                   or helpful, courts use a subjective standard—they
                   look to see whether the taxpayer through they would
                   be appropriate and helpful. Welch v. Helvering
        2. Ordinary
               a. Three principles/themes
                        i. Ordinary means non-capital
                               1. Welch v. Helvering
                                       a. Noted that the expense was like a
                                          capital asset—the desire to
                                          receive good will
                               2. See I.R.C. § 263(A)
                               3. See infra p. XXX
                       ii. Ordinary means non-personal
                               1. Welch v. Helvering
                                       a. Noted that the expenses were
                                          incurred     to    improve      the
                                          taxpayer's own standing and
                                          credit.
                               2. See I.R.C. § 262
                               3. See infra p. XXX
                      iii. Ordinary means not uncommon or bizarre
                               1. The expense must not be unusual and
                                   related to the peculiar quirks of an
                                   individual. Gilliam
                               2. The cost should further the trade or
                                   business
iv. Purpose of the ordinary and necessary requirement



                                                                           62
                     1. Shuldiner suggests that the "ordinary" requirement is really
                        trying to distinguish between personal and business
                        expenses.
       b. Specific expenses
              i. Legal expenses
                     1. The "origin of the claim test"
                            a. Expenses for litigation are deductible if the origin of
                               claim lies in the conduct of the trade or business.
                            b. In United States v. Gilmore the Supreme Court used
                               this test to deny a legal expense deduction to a
                               taxpayer who claimed that the legal fees—incurred in
                               a divorce—were necessary to save his business.
                     2. Expenses to defend criminal charges that did not result in a
                        loss of employment are not deductible if the conduct that
                        gave rise to charges did not arise in the course of business.
             ii. Payments to third parties
                     1. When payments to a third party are made to protect a
                        business, they may be deductible (notwithstanding
                        intimations to the contrary in Welch)
III.   Reasonable Allowances for salary
       a. Code Reference
              i. Substantive
                     1. I.R.C. § 162(a)(1) specifically allows, as an ordinary and
                        necessary business, a deduction for "a reasonable allowance
                        for salaries or other compensation for personal services
                        actually rendered."
             ii. Structural
                     1. Above-the-line
                            a. I.R.C. § 62 makes this an above the line deduction
                               because it is a "trade or business" deduction.
       b. "Reasonable" allowances
              i. Case treatment
                     1. The seven-factor test of reasonableness
                            a. The test (described in Exacto Spring Corporation v.
                               Commissioner)
                                    i. The type and extent of the services rendered
                                   ii. The scarcity of qualified employees
                                  iii. The qualifications and prior earning capacity
                                       of the employee
                                  iv. The contributions of the employee to the
                                       business venture
                                   v. The net earnings of the employer



                                                                                   63
             vi. The prevailing compensation paid to
                  employees with comparable jobs
            vii. The prevailing compensation paid to
                  employees with comparable jobs
           viii. Peculiar characteristics of the job
      b. Criticism
               i. The test is non-directive: there is no indication
                  of how the factors should be weighed
              ii. The factors do not bear a clear relation to each
                  other or to the purpose of s 162(a)(1)
            iii. The test invites courts to set themselves up as
                  super personnel departments.
             iv. Because the test is non-directive, it leads to
                  arbitrary decisions
              v. The unpredictability of the test imposes great
                  risk       on     corporations       determining
                  compensation for employees
2. The McCandless Rule
      a. The Rule
               i. Failure to pay a dividend necessarily means
                  that an employee's salary has been inflated
                  even if the salary seems reasonable. Charles
                  McCandless Tile Service v. United States (Ct. Cl.
                  1970)
      b. Criticism
               i. Investors may have many sound business
                  reasons not to pay a dividend, including a
                  desire to reinvest profits.
3. The "independent investor" test
      a. The Test
               i. Under this test, the court looks to see whether
                  the salary paid to an employee generates a
                  return.
              ii. When the investors in a company are receiving
                  a fair higher return than they had any reason to
                  expect, the salary receives a presumption of
                  reasonableness
            iii. Factors dissolving the presumption
                      1. where a company's returns are not due
                          to the employee's contributions
             iv. Factors supporting the presumption
                      1. independent assessment and levying of
                          the salary by owners who have no


                                                                64
                                      incentive to disguise a dividend as
                                      salary
                    b. Criticism
                            i. This simply asks the court to be a super
                               investment bank instead of a super personnel
                               department.
             4. Synthesis/Summary
                    a. Note that the Tax Court continues to use the seven-
                       factor test.
                    b. Factors to consider
                            i. Whether       the    corporation,    despite   its
                               profitability, has never issued a dividend.
                                   1. The McCandless rule has been criticized
                                       but still remains.
                           ii. Whether       the     money      given   has     a
                               "compensatory"        intent    (versus    simple
                               distribution of excess profits).
                          iii. Whether the corporation's investors receive a
                               reasonable rate of return in their personnel
                               investment.
                    c. Improper accumulation of Surplus
                            i. Note that I.R.C. §§ 531-537 provide for a
                               scheme to deal with extreme accumulations of
                               assets.
      ii. Purpose of the reasonableness requirement
             1. Historical origins
                    a. Shuldiner notes that if § 162(a)(1) did not exist,
                       taxpayer would probably still be able to deduct
                       reasonable salaries as a business expense.
                    b. The provision was originally added during World
                       War I to reduce the excess profits tax
             2. The "reasonableness" test
                    a. § 162(a)(1) currently serves as a check on taxpayer
                       attempts to re-characterize non-deductible expenses
                       as deductible "salary."
c. Tax treatment of recipient
       i. Current approach
             1. The "reasonableness" test is really a way to make sure that a
                transaction is characterized in an appropriate way for tax
                purposes—not necessarily as the taxpayer characterizes it.
                    a. See Smith v. Manning (payments made by owner to
                       daughter who worked in the business that were held



                                                                              65
                        to be unreasonable could not be treated as excludible
                        gifts because there was no donative intent.)
      ii. Shuldiner
             1. The correct approach is not to look at whether the
                compensation received is "reasonable." Instead, the court
                should be consistent: allow a deduction for salary, but not
                one for the portion of the amount that can be designated as a
                gift, etc.
d. "Reasonable" allowances: specific situations
       i. Unreasonable rent payments
             1. this is not provided for by statute
             2. Generally, in this situation a court will recharacterize the
                transaction to reflect its substance
      ii. Repayment of Unreasonable Salary
             1. The Eight Circuit has concluded that a repayment agreement
                is evidence of unreasonableness. Charles Schneider & Co. v.
                Commissioner (8th Cir. 1974).
     iii. Executive Compensation
             1. Closely held v. Publicly held corporations
                    a. In practice, the problem of salary being disguised as
                        dividends is more likely to occur in closely held
                        corporations in which there are fewer checks
                    b. While the statute makes no distinction, the IRS never
                        challenges the salaries of CEOs of big corporations.
                        Corporate governance mechanisms, independent
                        directors, and shareholder rights, along with the stock
                        market itself, are seen as correctives.
             2. "Certain Excessive Employee Remuneration:"             I.R.C. §
                162(m)
                    a. Section 162(m) denies a deduction for compensation
                        in excess of $1 million paid to the CEO or the four
                        most highly compensated employees of a publicly-
                        held corporation UNLESS the compensation is
                        performance based.
     iv. Undercompensation
             1. In the case of an S-Corporation or a partnership, there might
                be an incentive to undercompensate in order to shift income
                from a high-bracket shareholder to a related shareholder or
                partner.
             2. The Service has authority to prevent this.
                    a. I.R.C. §§ 706, 1366(e).
      v. Payments other than salary



                                                                            66
IV.   Public Policy Exceptions
      a. Tax Code References
              i. I.R.C. § 162(c), (f),(g): expenses not deductible for reasons of public
                 policy
                     1. Illegal payments to government officials or employees
                     2. Bribes and kickbacks
                     3. Fines and Penalties
                     4. Treble damage payments under the Antitrust laws
             ii. I.R.C. § 280E
                     1. Drug trade
                             a. No deduction allowed for any amount paid or
                                incurred during the taxable year in carrying on any
                                trade or business when the trade or business consists
                                of trafficking in controlled substances
      b. Scope
              i. Illegal businesses, generally
                     1. The Supreme Court has held that illegal businesses are to be
                         taxed the same as legal businesses. United States v. Sullivan
                     2. The court has expressed severe doubts about the propriety
                         of using the tax code to punish criminal violations.
                             a. See United States v. Tellier ("To deny a deduction for
                                expenses incurred in the unsuccessful defense of a
                                criminal prosecution would impose such a burden in
                                a measure dependent not on the seriousness of the
                                offense or the actual sentence imposed by the court,
                                but on the cost of the defense and the defendant's
                                particular tax bracket. We decline to distort the
                                income tax laws to serve a purpose for which they
                                were neither intended nor designed by Congress.")
             ii. Congressional Intent
                     1. Congress intended that the public policy limitations in § 162
                         be the exclusive grounds for denying a deduction. This
                         severely limits judicial discretion in making a public policy
                         exception.
                     2. See Reg. § 1.162-1(a): "A deduction for an expense which
                         would otherwise be allowable under section 162 shall not be
                         denied on the grounds that allowance of such deduction
                         would frustrate a sharply defined public policy."
            iii. General Standard: When should a public policy exception be
                 recognized?
                     1. United States v. Tellier: A public policy exception should only
                         be recognized when



                                                                                     67
                    a. Allowance of the deduction would "frustrate sharply
                        defined national or state policies proscribing
                        particular forms of conduct
                    b. The public policy must be a national or state policy
                        evidenced by governmental declaration
                    c. "the test of nondeductibility always is the severity and
                        immediacy of the frustration resulting from the
                        allowance of the deduction."
c. Substantive Exceptions
       i. Criminal Defense
             1. Expenses for criminal defense ARE deductible when
                    a. It meets the "origin of the claim" test
             2. See United States v. Tellier (allowing a deduction for the
                expense of hiring a criminal defense attorney to defend
                against securities fraud, noting that no public policy is
                violated when taxpayer exercises his constitutional right to
                be represented by an attorney).
      ii. Fines
             1. I.R.C. § 162(f): disallows any deduction for a fine imposed
                for violation of the law
             2. Courts, however, have distinguished between compensatory
                and punitive fines. Compensatory fines are deductible.
                    a. See Reg. § 1.162-21(b)(2) (compensatory fines are not
                        "fines" or "penalties" under § 162).
                    b. See Tank Truck Rentals v. Commissioner (denying a
                        deduction for fines incurred for violating
                        Pennsylvania weight limitations for trucks).
                    c. But see True v. United States (denying a deduction for a
                        fine that had "deterrent and retributive" functions
                        even if it also had compensatory and remedial
                        aspects.)
     iii. Payments to third parties
             1. Where payments to a private party are akin, or in lieu of, a
                fine, a deduction is not allowed.
                    a. Examples
                             i. Restitution to victims of fraud
                            ii. Court-order charitable donations
     iv. Other:
             1. Losses
                    a. Losses under § 165 that would frustrate sharply
                        defined national or state policies proscribing
                        particular types of conduct.



                                                                            68
      V.      Lobbying Expenses
              a. Code References
                    i. I.R.C. § 162(e)20
              b. Summary of general rules/principals
                    i. General Rule
                           1. The general rule is that lobbying expenses are
                               nondeductible.
                   ii. Exceptions
                           1. Lobbying expenses for local legislation
                           2. de minimis—in house expenditures that do not exceed
                               $2,000
              c. Constitutional Limitations
                    i. See Graetz 244
              d. "Advertising"
                    i. See Graetz 244
      VI.     Domestic Production Deduction
              a. Code Reference
                    i. I.R.C. § 199
                           1. General Provision
                                   a. Provides that a taxpayer may take a deduction equal
                                      to 9% of the lesser of
                                           i. Taxable income
                                          ii. "qualified production activities"
                                                 1. generally: manufacturing, production,
                                                     extraction.
                                                 2. This     is   a    somewhat    arbitrary
                                                     designation
                           2. Phase-out
                                   a. The amount of the deduction is phased in until the
                                      full 9% applies in 2010
                           3. Limitations
                                   a. The deduction cannot exceed 50% the amount paid in
                                      wages for the taxable year
              b. General notes
                    i. Purpose of Section 199
                           1. U.S. taxpayers are subject tax on their worldwide income.

20   General Rule: No deduction is allowed for any amount paid or incurred in connection with
      1. Influencing legislation
      2. Participating in, a political campaign or on behalf of a candidate for public office
      3. Any attempt to influence the general public, or segments thereof with respect to elections,
          legislative matters or referendums
      4. A direct communication with an executive branch official to influence official actions



                                                                                                 69
                    2. Businesses thought this put them at a competitive
                         disadvantage, since many foreign corporations are not taxed
                         that way.
                             a. Congress responded with a provision to benefit
                                 exports. This was declared illegal by the WTO
                             b. Congress responded to this with a much broader
                                 deduction for domestic production intended to
                                 reduce tax rates on manufacturing.
             ii. Criticism
                    1. Shuldiner notes that this is ill-advised. It is very difficult to
                         define "manufacturing." This leads to a lot of arbitrary line-
                         drawing.
                    2. Economic distortion
                             a. Businesses will often try to inflate the price of their
                                 manufacturing operations to transfer profits from
                                 their sales divisions.
                    3. The arbitrariness of the definition of manufacturing creates a
                         lot of expensive litigation.
VII.   Employee Business Expenses: The Structural Treatment of Deductions
       a. General
              i. Statutory Flow
                    1. Step one: § 162
                             a. determine whether the expense is ordinary and
                                 necessary to carry out the trade or business
                             b. Step 1.5—are there limitations on the deductible
                                 business expense? (i.e., § 274—only 50% of food
                                 deductible)
                    2. Step two: § 62
                             a. Determine whether the expense is above or below the
                                 line
                    3. Step Three: §67
                             a. Determine whether a below-the-line expense is a
                                 "miscellaneous itemized deduction"
       b. Employee Expenses under § 162
              i. The expense must be part of a trade or business, not personal.
             ii. See infra, p. XXX-XXX
       c. Itemized Deductions under §§62, 68
              i. Reimbursements
                    1. Reimbursed expenses are subtracted from gross income
                         (above the line). § 61(a)(2)(A).
                             a. The reimbursement itself can be initially included in
                                 income and then offset with the deduction, or the
                                 entire transaction can be ignored. Reg. § 1.62-2(c)(4)


                                                                                     70
             2. Unreimbursed expenses are available only if the taxpayer is
                 an itemizer.
                     a. If an expense is reimbursable, but is NOT reimbursed,
                        the expense is nondeductible. Cavitt v. Commissioner
     ii. Purpose of the distinction
             1. administrative simplicity/efficiency
                     a. Having the employer reimburse the employee makes
                        it more likely that the expense was actually business
                        related.
             2. Note that the expense must still be "reasonable and
                 necessary"
d. Miscellaneous Itemized Deductions
      i. I.R.C. § 68
             1. Defines miscellaneous itemized deductions by exclusion. A
                 miscellaneous itemized deduction is NOT
                     a. Interest (§ 163)
                     b. Taxes ( § 164)
                     c. A casualty or theft loss (§ 165)
                     d. A charitable donation (§ 170)
                     e. A medical expense (§ 213)
                     f. An impairment-related expense
                     g. An estate tax (§ 691(c))
                     h. A deduction allowed in connection with personal
                        property used in a short sale
                     i. A mortality gain (§ 72)
                     j. Etc—see § 67(b)
             2. The 2% floor
                     a. I.R.C. § 67(a)
                             i. To deduct a miscellaneous itemized deduction,
                                the aggregate of the deduction must exceed 2%
                                of AGI
                     b. Purpose
                             i. Revenue creation
                                   1. § 67 either increases the effective tax rate
                                       or limits deductions, depending on how
                                       you want to characterize it.
                     c. Effect
                             i. Below the floor
                                   1. If you are below the 2% floor, then this
                                       provision does not affect your tax rate,
                                       but it does affect your ability tot take
                                       deductions.
                            ii. Above the floor


                                                                               71
                                          1. If you are above the floor, your
                                             deductions are limited, so your AGI—
                                             and potentially your tax rate—may be
                                             increased.
                      3. The 3% "haircut"
                            a. I.R.C. § 68
                                    i. Limits the total amount of certain deductions
                                       for high-bracket taxpayers
                                   ii. The mechanics
                                           1. Threshold: $100,000 (indexed)
                                           2. Itemized deductions are reduced by 3%
                                              of the excess AGI over the threshold.
                                           3. Reduction cannot exceed 80% of the
                                              deductions

Distinguishing Personal and Business Expenses

   I.    General
         a. Nature of the distinction
                i. Importance
                       1. The income tax is a tax on net income—this requires that the
                           expenses of producing that income be deducted.
                       2. If personal expenses were deductible, the income tax would
                           be severely undermined. It would essentially tax only
                           savings at that point.
               ii. Arbitrary nature
                       1. Because it is difficult to separate personal from business
                           consumption, the IRS often relies on somewhat arbitrary
                           bright lines.
                       2. At other times, Congress simply decides to allocate the
                           personal and business elements by fiat
                               a. Example: I.R.C. § 274(n) (limiting meal deductions to
                                  50%)
         b. Policy issues
                i. Equity
                       1. Certain occupations will find it easier to make deductions
                       2. Higher income taxpayers would have more opportunities
                           for deduction.
               ii. Efficiency
                       1. Allowing personal deductions would distort economic
                           decision making by encouraging spending on consumption.
         c. Statutory Architecture
                i. I.R.C. § 162(a)


                                                                                    72
              1. allows a deduction for "ordinary and necessary business
                  expenses paid or incurred ruing the taxable year"
      ii. I.R.C § 262(a)
              1. "Except as otherwise expressive provided in this chapter, no
                  deduction shall be allowed for personal, living or family
                  expenses."
     iii. I.R.C. § 274
              1. Expressly disallows certain deductions.
              2. See infra p. XXX
     iv. I.R.C. § 280A
              1. Regulates expenses for business uses of a home
              2. see infra p. XXX
      v. I.R.C. § 280F
              1. disallows deductions for "luxury" automobiles
              2. see infra p. XXX
d. The relationship between §§ 162 and 262
       i. Hantzis v. Commissioner
              1. "Section 262 of the Code. . . declares that except as otherwise
                  provided in this chapter, no deductions shall be allowed for
                  personal, living or family expenses." Section 162 provides
                  less of an exception to this rule than it creates a separate
                  category of deductible business expenses."
      ii. Moss v. Commissioner
              1. "In closes contests it is essential to bear in mind that the
                  provisions of § 262 take priority over section 162."
e. Tests for Distinguishing
       i. Clothing
              1. In Pevsner v. Commissioner (5th Cir. 1980) the Court, adopting
                  an objective test, disallowed a deduction for the purchase of
                  expensive Yves St. Laurent clothing, purchased by an
                  employee as required by her employer.
                      a. Three-part test (Donnelly v. Commissioner)
                              i. Clothing is deductible as a business expense
                                 only if
                                    1. the clothing is of a type specifically
                                         required as a condition of employment
                                    2. it is not adaptable to general usage as
                                         ordinary clothing
                                    3. it is not so worn
                      b. The objective test
                              i. "Under an objective test, no reference is made
                                 to the individual taxpayer's lifestyle or
                                 personal taste.       Instead, adaptability for


                                                                             73
                           personal or general use depends upon what is
                           generally accepted for ordinary street wear."
 ii. "Inherently Personal" Standard
        1. Some courts have disallowed deductions after concluding
            that they are "inherently personal"
                a. See Fred W. Amend v. Commissioner (7th Cir. 1971)
                    (disallowing deduction for payments by business
                    made to a minister for business advice based on
                    personal prayer).
iii. "For profit" standard: Hobby Losses and § 183
        1. General
                a. The hobby loss provision prevents a taxpayer from
                    deducting losses incurred in activities that are really
                    personal in nature (i.e., mud wrestling).
                b. The tension here is between § 165 and § 183
                        i. § 165 allows a deduction for losses incurred in
                           a trade or business.          § 183 disallows a
                           deduction for any activity engaged in "not for
                           profit."
        2. I.R.C. § 183
                a. General Rule
                        i. "In the case of an activity engaged in by an
                           individual or an S corporation, if such activity
                           is not engaged in for profit, no deduction,
                           attributable to such activity shall be allowed. . .
                           ."
                       ii. Reg § 1.183-1(d)(1): What is an activity?
                               1. Determined by taking all of the facts
                                   and circumstances into account
                                      a. The most significant facts
                                               i. Degree of organizational
                                                  and               economic
                                                  interrelationships       of
                                                  various undertakings
                                              ii. The business purpose
                                                  served by carrying on
                                                  various       undertakings
                                                  separately or tighter in a
                                                  trade or business or
                                                  investment setting
                                             iii. The similarity of the
                                                  various undertakings



                                                                           74
                                           2. Generally, the commissioner accepts the
                                               taxpayer's characterization of several
                                               activities as either one activity or as
                                               separate activities
                                                   a. This is not acceptable where it is
                                                       artificial  and      cannot    be
                                                       reasonable supported
                                           3. Multiple activities
                                                   a. If the taxpayer is engaged in two
                                                       or more separate activities,
                                                       deductions and income from
                                                       them are not aggregated for
                                                       applying section 183
                                           4. Farms
                                                   a. Where land is purchased for
                                                       speculation, but farming also
                                                       occurs, the holding of the land
                                                       and the farming are considered
                                                       one activity only if the farming
                                                       educes the net costs of carrying
                                                       the land.
                                   iii. Reg. § 1.183-1(d)(2): Allocation of expenses
                                           1. If the taxpayer is engaged in more than
                                               one activity, an item of deduction or
                                               income may be allocated between two
                                               or more of the activities.
                              b. Exceptions
                                     i. Deductions that would be allowed without
                                        regard to profit-seeking21
                                    ii. Deductions that would be allowed for profit-
                                        seeking activities, but only if the activity was
                                        actually engaged in for profit and only to the
                                        extent that the gross income from the activity
                                        exceeds the deductions
                              c. Not for profit defined
                                     i. Defines the terms as any activity other than
                                        one for which expenses would be deductible
                                        under § 162 and § 212.
                              d. Presumption



 Notes that this is a pro-taxpayer provision. It allows a deduction for expenses
21


occurred in a not-for-profit exercise (i.e., real property taxes on a farm).


                                                                                     75
                            i. If gross income from the activity exceeds
                               deductions for the activity for 3 or more of the
                               taxable years in a period of 5 consecutive
                               taxable years, it is presumed to be "for profit."
             3. Plunkett v. Commissioner
                    a. In Plunkett v. Commissioner (Tax Ct. 1984), the Court
                        held that the taxpayer could not deduct losses
                        associated with mud-racing because the profit
                        potential was low and unrealistic, but allowed a
                        deduction for truck-pulling activities because the
                        taxpayer had a bona fide objective of making a profit.
                            i. Reg. § 1.183-2(b):         Nine-Factor tests to
                               determine whether an activity is engaged in for
                               profit
                                  1. The manner in which the taxpayer
                                      carries on the activity
                                  2. The expertise of the taxpayer or his
                                      advisors
                                  3. The time and effort expended by the
                                      taxpayer in carrying on the activity
                                  4. The expectation that the assets used in
                                      the activity may appreciate in value
                                  5. The success of the taxpayer in carrying
                                      on other similar or dissimilar activities
                                  6. The taxpayer's history of income or loss
                                      with respect to the activity
                                  7. The amount of occasional profits, if any,
                                      which are earned
                                  8. the financial status of the taxpayer
                                  9. whether elements of personal pleasure
                                      or recreation are involved
                           ii. The Dreicer Standard
                                  1. "Did the individual engage in the
                                      activity with the actual and honest
                                      objective of making a profit?"
                                  2. This standard is objective—it looks at all
                                      of the facts and circumstances
f. Working Condition Fringe v. Deductible Business Expense
      i. § 132(a)(3) allows for the exclusion of a working condition fringe,
          defined as a property or service that would be deductible by the
          employee under § 162.
g. Public Employees
      i. General rule: a trade or business must be profit-seeking.


                                                                             76
     ii. Exception: public employees
             1. In Frank v. United States (9th Cir. 1978) the Court allowed
                Franke to deduct expenses incurred as an unpaid aid to a
                United States Senator.
h. Domestic Services and Child Care
      i. I.R.C. § 21: Expenses for Household and Dependent Care Services
         Necessary for Gainful Employment
             1. Provides a NONREFUNDABLE tax credit
                    a. Who qualifies?
                            i. Those with one or more "qualifying
                               individuals"
                           ii. I.R.C. § 21 (b)(1): qualifying individual
                                   1. Dependent less than 13 years old
                                   2. Dependent who is physically or
                                       mentally incapable of caring for himself
                                       who has the same principal place of
                                       abode as the taxpayer for MORE than ½
                                       the taxable year
                                   3. The spouse of the taxpayer if the same
                                       conditions as above are met
                          iii. Those with "employment-related expenses"
                                   1. See I.R.C. § 21(b)(2)
                                   2. See Brown v. Commissioner (employment
                                       motive must be present, but need not be
                                       exclusive or dominant motive).
             2. Amount of Credit
                    a. Credit Amount Ceilings
                            i. One dependent: $3,000 of expenses * 35% =
                               $1,050
                           ii. More than one: $6,000 * 35% = $2,100
                    b. Expense limitation
                            i. Cannot exceed the LESSER of
                                   1. An individual's earned income
                                   2. The earned income of a spouse
             3. Phaseout
                    a. Threshold: $15,000 or less
                    b. Maximum credit percent: 35% * (dependent care
                       expenses)
                    c. Phaseout amount: 1% per $2,000
                    d. Ceiling: Taxpayer with income of $43,000 will receive
                       credit for 20% of dependent care expenses
             4. Policy issues



                                                                            77
                            a. Very few people are likely to be able to take
                               advantage of the credit because of its nonrefundable
                               nature—it is unrealistic to expect someone making
                               $15,000 a year to spend $6,000 on child care!
                    5. Cross-reference
                            a. The maximum amount of the dependent child care
                               credit under § 21 is reduced by amounts excluded
                               from income under § 129
            ii. I.R.C. § 129: Dependent Care Assistance Programs
                    1. General
                            a. Allows an employee to exclude up to $5,000 from
                               income for dependent care services provided during a
                               taxable year by an employer.
                    2. Limitation
                            a. The amount excluded cannot exceed the LESSER of
                               earned income of the employee in the taxable year or
                               the earned income of the employee's spouse in the
                               taxable year
                    3. Dependent care assistance program
                            a. See I.R.C. § 129(d)
II.   Travel Away From Home
      a. General Rule for Transportation and commuting expenses
             i. The "costs" of being an employee (clothes, commuting, food at
                work) are usually not deductible.
            ii. Justification
                    1. Your decision to live in a certain place is a personal decision
                        because work places are
      b. "While away from home"—food and lodging
             i. I.R.C. § 162(a)(2)
                    1. "There shall be allowed as a deduction all the ordinary and
                        necessary expenses paid or incurred during the taxable year
                        in carrying on any trade or business including traveling
                        expenses (including amounts expended for meals and
                        lodging other than amounts which are lavish or extravagant
                        under the circumstances) while away from home in the
                        pursuit of a trade or business."
            ii. Purpose of deduction
                    1. § 162(a)(2) is intended to distinguish everyday living
                        expenses from those incurred by business travel.
                    2. To mitigate the burdens of a taxpayer who must maintain
                        two abodes—to ease the burden of duplicative expenses.
           iii. The overnight rule



                                                                                   78
      1. In United States v. Correll (1967) the Supreme Court upheld
          the commissioner's rule that the phrase "away from home"
          does not include any trip not requiring "sleep or rest" no
          matter how far away the taxpayer travels.
iv. Temporary job doctrine
      1. Where a taxpayer leaves for a temporary job at another
          location, the taxpayer's regular residence is treated as his
          home, as long as the temporary job is not expected to last
          longer than one year.
 v. What is a "home"?
      1. IRS's position
              a. "home" for the purposes of § 162(a)(2) is the
                 taxpayer's principle place of business.
      2. In Hantzis v. Commissioner (1st Cir. 1981) the Court held that
          a law student whose lived with her husband in Cambridge
          during the school year, could not deduct the costs of
          traveling to and living in New York to work as a legal
          secretary.
              a. The Flowers test
                     i. A traveling expense is deduction ONLY if it is
                           1. Reasonable necessary
                           2. Incurred while away from home
                           3. Necessitated by the exigencies of
                               business
              b. "While away from Home"
                     i. The court holds that to be "away from home in
                        the pursuit of a trade or business" the taxpayer
                        must establish
                           1. A business relation to the place claimed
                               as home
                           2. A business relation to the location of
                               temporary employment
                           3. That the relation is sufficient to support
                               a finding that the duplicative expenses
                               are necessitated by business exigencies.
      3. Second Circuit approach
              a. You home is, indeed, your home: the focus is on
                 whether the expenses are incurred in the pursuit of a
                 trade or business.
      4. No regular abode
              a. No deduction. James v. United States (9th Cir. 1962)
vi. Two-earner families



                                                                     79
             1. The decision not to live separately from a spouse is
                considered personal, even if the taxpayer incurs significant
                travel costs in pursuit of a trade or business that takes place
                mostly in another city.
c. Transportation
       i. General rule
             1. Transportation expenses may be deducted when the
                taxpayer is away from home for business (see above).
             2. The cost of commuting from home to work is a
                nondeductible personal expense. Reg. § 1.162-2(e).
      ii. Purpose of general rule
             1. The work location is fixed and the decision to live beyond
                walking distance is a personal choice. Commissioner v.
                Flowers (1946)
     iii. Commuting
             1. McCabe v. Commissioner
                    a. In McCabe v. Commissioner the Court held that a police
                       officer could not deduct his commuting expenses
                       when his business required that he carry a gun but,
                       because the State of New Jersey would not allow a
                       permit, he was required to take a longer route
                            i. The Flowers Test
                                   1. must be reasonable and necessary
                                   2. must be away from home
                                   3. must be incurred in pursuit of business
                           ii. The court held that the expense was not
                               incurred in the pursuit of business-rather, it
                               was incidental to the taxpayer's decision to live
                               in a suburb.
             2. Tools of the trade
                    a. In Fausner v. Commissioner (1973) the Court held that a
                       taxpayer may deduct the extra expense incurred for
                       transporting job-required tools to and from work, so
                       long as the costs are allocated between business and
                       personal expense.
                    b. Revenue Ruling 75-380: necessity means appropriate
                       and helpful.
             3. Working and driving
                    a. In Pollei v. Commisioner (10th Cir. 1989) the Court held
                       that a police officer who begins active patrol when
                       she departs from work may deduct the costs of
                       driving to and from work
             4. Commuting to temporary employment


                                                                             80
                  a. Rev. Rul. 99-7
                          i. A taxpayer may deduct daily transportation
                             expenses incurred in going between the
                             taxpayer's residence and a temporary work
                             location outside the metropolitan area where
                             the taxpayer lives and normally works.
                                 1. Generally, the expense incurred in going
                                    to a temporary work location within the
                                    metropolitan area is a nondeductible
                                    commuting expense
                         ii. If a taxpayer has more than one regular work
                             location, the taxpayer may deduct daily
                             transportation expenses incurred in going
                             between the taxpayer's residence and a
                             temporary work location in the same trade or
                             business.
                        iii. If a taxpayer's residence is the taxpayer's
                             personal place of business, the taxpayer may
                             deduct daily transportation expenses incurred
                             in going between the residence and another
                             work location in the same trade or business.
 iv.    Transportation between multiple business
           1. When a taxpayer has two businesses, the service concludes
              that one of them is "home" (the principal place of business)
              and the other is a minor place of business—expenses can
              only be deducted for the latter.
  v.    Mixed personal/business trips
           1. If a trip is for mixed business and personal reasons, travel
              costs are deductible only if the trip is primarily for business
              reasons.
           2. See United States v. Gotcher, supra, p. XXX
 vi.    Employer-provided transportation
           1. If an employer pays for commuting expenses, the payments
              generally constitute gross income
                  a. § 132(d) does not apply because the amount would
                      not be deductible if paid by the employee
           2. Regulations allow for the provision of transportation to
              employees if the transportation is furnished due to unsafe
              conditions.
vii.    Luxury Expenses
           1. See I.R.C § 280F
viii.   Foreign Conventions/Travel
           1. I.R.C. § 274


                                                                          81
                   a. § 274(c): travel
                          i. Provides that no deduction is allowed for the
                             portion of expenses no allocable to the trade or
                             business (under regulations issued by
                             Treasury)
                         ii. Exceptions
                                  1. travel that does not exceed one week
                                  2. the portion of time not allocated to the
                                     trade or business is less than 25% of
                                     total time traveled
                   b. § 274(h): conventions
                          i. No deduction is allowed for expenses allocable
                             to a convention outside North America unless
                             it is just as reasonable to hold the meeting
                             outside North America as it is inside.
                         ii. Factors taken into account
                                  1. the purpose of the meeting and its
                                     activities
                                  2. the purposes and activities of the
                                     sponsoring groups
                                  3. the residence of the active members of
                                     the sponsoring groups and the places at
                                     which other meetings have been held.
d. Limitations
       i. I.R.C. § 274(d): Substantiation
              1. No deduction is allowed under 162 or 212 for
                      a. Traveling expense
                      b. Entertainment
                      c. Amusement
                      d. Recreation
                      e. Gifts
                      f. Listed property
              2. Unless the taxpayer substantiates the expenses with
                  adequate records to corroborate the taxpayer's own
                  statement.
      ii. I.R.C. § 274(m): Additional limitations on travel expenses
              1. No deductions for
                      a. Luxury water transportation
                      b. Travel as education
                      c. Travel expenses for a spouse on business unless
                             i. The spouse is an employee
                            ii. The travel of the spouse is for a bona fide
                                business purpose


                                                                          82
                                  iii. The expense would otherwise be deductible by
                                       the spouse
                                  iv. See United States v. Gotcher, supra, p. XXX
III.   Meals and Entertainment
       a. General
               i. Business/Personal
                      1. The problem with meals and entertainment used for
                         business purposes is that there will always be a personal
                         consumption element.
              ii. Fringe Benefits
                      1. Note that a meal or business that is not deductible under §
                         162 may be excludable under § 132 as a fringe benefit (or
                         under § 119 as a meal furnished for the convenience of the
                         employer.
       b. Statutory architecture: I.R.C. § 274
               i. § 274(a): Entertainment, Amusement and Recreation
                      1. No deduction is allowed for an amusement, entertainment
                         or recreation activity unless the item was directly related to a
                         substantial and bona fide business discussion
                      2. no deduction allowed for club dues
              ii. § 274(e): miscellaneous
                      1. a deduction may be allowed for the following if otherwise
                         provided for in the code
                             a. food and beverages for employees
                             b. expenses treated as compensation
                             c. reimbursed expenses
                             d. recreation expenses for employees
                                    i. But see Danville Plywood Corporation v. United
                                       States (Fed. Cir. 1990) (not allowing a
                                       deduction for a Mississippi River Cruise to the
                                       Super Bowl after concluding that the purpose
                                       of the trip was for business rather than
                                       employees).
                             e. Exployee business meetings
                             f. Meetings of business leagues
                             g. Expenses for items made available to public
                             h. Entertainment sold to customers
                             i. Expenses includible in income of persons who are not
                                employees.
             iii. § 274(g): entertainment facilities
             iv. § 274(k): business meals
                      1. No deduction allowed unless
                             a. The expense is not lavish or extravagant


                                                                                      83
                      b. The taxpayer is present at the furnishing of the food
                          or beverages
        v. § 274(l): Limitations on entertainment tickets
               1. Deduction limited to the face value of the tickets
       vi. § 274(n)
               1. Any deduction for food and beverage and an entertainment,
                  amusement or recreation, is limited to 50% of the item's cost
               2. Purpose
                      a. This is an allocative rule—simply allocates 50% of the
                          cost to personal expenses and 50% to business
               3. applies to meals while away from home
               4. if the taxpayer is reimbursed, the 50% limitation applies to
                  the person who makes the reimbursement.
                      a. If the taxpayer is unreimbursed, the 50% limitation
                          still applies, as well as the § 67 limitation.
c.   Moss v. Commissioner
        i. In Moss v. Commissioner (Tax Ct. 1983) the Court held that a partner
           at a Chicago law firm could no deduct the costs of a daily business
           lunch under § 162, even though the lunches were concede to have a
           business purpose because the taxpayer could not establish that the
           expense was "different from or in excess of that which would have
           been made for the taxpayer's personal purposes.
               1. The Sutter test
                      a. A deduction is permissible where the expense is
                          "different from or in excess of that which would have
                          been made for the taxpayer's personal purpose."
                          Sutter v. Commissioner (Tax Ct. 1953).
d.   Employer-subsidized meals
        i. Note that meals provided "for the convenience of the employer" are
           excluded from gross income under § 119.
       ii. See supra p. XXX
e.   Meals with clients
        i. When is a business meal "directly related" to business?
               1. The legislative history implies that the meal is directly
                  related if
                      a. the taxpayer has more than a general expectation of
                          deriving income or a specific business benefit
                      b. the taxpayer has engaged in business discussions
                          during or directly before or after the meal or
                          entertainment
                      c. the principal reason for the expense was the active
                          conduct of the taxpayer's trade or business.
f.   The taxpayer's meal


                                                                            84
              i. The portion of the taxpayer's meal that costs more than he would
                 normally spend on himself is deductible. The service only seeks to
                 enforce this rule in cases of abuse. Rev. Rule. 63-144
      g. Reform
              i. Equity concern
                     1. The deduction for meals and entertainment expenses are
                        generally thought to be captured by mostly high-income
                        taxpayers who can take advantage of business opportunities.
             ii. Reforms are usually opposed by restaurant employee unions.
IV.   Home Offices
      a. General
              i. In Commissioner v. Soliman (1993) the Court held that an
                 anesthesiologist could not deduct the cost of a room used
                 exclusively as an office for administrative tasks
                     1. "principal place of business"
                            a. no objective, clear formula
                            b. two primary considerations
                                    i. the relative importance of the activities
                                        performed at each business location
                                   ii. the time spent at each place
                            c. The point where services are delivered is given great
                                weight
             ii. Congress responded to Soliman by amending § 280A
      b. "Exclusive use"
              i. A home office expense may be deducted if a room is divided off
                 spatially, but not if the room is divided temporally—the office must
                 be used exclusively for business.
      c. I.R.C. § 280A
              i. Purpose
                     1. Prior law often allowed a business deduction for expenses
                        attributable to the home even though no additional costs
                        resulted from the business use.
                     2. the various standards applied by the court and the IRS were
                        considered confusing to taxpayers
             ii. General Rule
                     1. No deduction is allowed for the used of a dwelling unit
                        which is also used by the taxpayer during the taxable year as
                        a residence
            iii. § 280A(c): Requirements for deduction
                     1. Must be used exclusively and on a regular basis
                            a. As the principal place of business for a trade or
                                business



                                                                                  85
                                      i. PPB="a place of business which is used by the
                                         taxpayer for the administrative or management
                                         activities of any trade or business of the
                                         taxpayer if there is no other fixed location of
                                         such trade or business where the taxpayer
                                         conducts      substantial   administrative   or
                                         management activities of such trade or
                                         business."
                             b. As place used by patients, client, or customers in
                                  meeting or dealing with the taxpayer in the normal
                                  course of his trade or business
                                      i. If a separate structure, must be used in
                                         connection with trade or business.
              iv. Limitations on deduction
                     1. 280A is limited to the costs of running the home office
                         (utilities and depreciation)
                     2. Home mortgage interest is allocated between the personal
                         and business use
                     3. I.R.C. § 280A(c)(5)
                             a. Ceiling on deduction
                                      i. The deduction cannot exceed the excess of
                                             1. Gross income derived from the use – the
                                                 deductions allocable to the use
                             b. Carryover
                                      i. Any amount not deducted can be taken into
                                         account as a deduction in the next year.
               v. vacation homes
                     1. Definition
                             a. A vacation home is a dwelling unit used by the
                                  taxpayer for more than 14 days or 10% of the number
                                  of days the unit is rented.
                             b. Expenses are pro-rated and deducted up to the
                                  amount of the rent reduced by interest and taxes
   V.    Synthesis/Summary

Capitalization

   I.    General
         a. The distinction between expenses and capital expenditures
               i. Capitalization
                      1. When an expense is "capitalized" it is added to the basis of
                      2. These expenses are then recovered when the asset is sold or
                          through depreciation/amortization


                                                                                     86
      ii. Expenses
             1. Expenses (i.e., most expenses under § 162) are immediately
                 deducted—the cost is recovered immediately.
     iii. This distinction is really about time, but it is extremely significant.
b. The impact of the capitalization requirement

       i. General importance: tax deferral
             1. Why capitalization is necessary to avoid imposing a
                consumption tax
                    a. All savings and investment would be subtracted from
                        receipts to determine consumption during the year.
                        Without a capitalization requirement, investment
                        would be immediately deductible.
             2. Capital gains
                    a. If long-term capital gains are treated preferentially,
                        but long-term capital losses are restricted, then
                        conversion of a cost from capital gains to expense or
                        vice-versa will affect the total tax burden.
             3. Value of tax deferral
                    a. See Graetz, 288-289 (showing the value of deferred
                        income)
                    b. The total value of the tax deferral will depend on
                        three factors
                             i. Tax rates
                            ii. Interest rates
                           iii. Length of the deferral
      ii. The value of the tax deferral: three characterizations
             1. Equivalence to a tax-free loan
                    a. Example
                             i. facts
                                    1. τ = 50%
                                    2. Asset = $100
                                    3. Time = 10 years
                            ii. Result
                                    1. Savings if immediately expensed: $50
                                    2. Amount realized when asset sold: $100
                                    3. It is as if the taxpayer received a loan of
                                       $50 for ten years
             2. Equivalence to a reduction of tax rates or tax forgiveness
                    a. Example
                             i. facts
                                    1. τ = 50%
                                    2. Asset = $100


                                                                               87
                                            3. Time = 10 years
                                            4. Tax free loan = 50$
                                     ii. Result
                                            1. If the taxpayer places $27.92 of the $50
                                                in a bank account at 12% interest, he will
                                                have $50 at the end of ten years (after
                                                withdrawing money each year for taxes
                                                on interest income).
                                            2. The ten-year deferral is thus worth
                                                $27.92. $22.08 is forgiven.
                                            3. The effective tax rate decreases from
                                                50% to 27.9%
                       3. Equivalence to a tax-free return on investment
                             a. If investment costs are immediately deducted instead
                                of capitalized and recovered over time, the income
                                from the asset will be tax free.
                             b. Assumptions
                                      i. Constant tax rates
                                     ii. The deduction can be taken immediately
                                    iii. Tax savings is invested at a return equal to the
                                         original investment
                             c. Example
                                      i. Facts
                                            1. Bond: $1000
                                            2. Bond income: $100 a year
                                            3. Bond interest rate: 10%
                                            4. τ: 33%
                                                    a. As a result, yield on the bond
                                                        should only be 6.7%
                                     ii. Basic tax treatment
Interest income                                                     Yield
No tax          100             100                100              10%
Tax             67              67                 67               6.7%
                                    iii. Tax treatment with immediate deduction
Interest Income                                                     Yield
Pre-tax         1000            100                100              10%
Tax             333             33                 33
After tax       667             67                 67               10%
                                    iv. Immediate deduction, with gross-up (tax
                                         saving invested)
                                            1. Gross-up: 1/ 1-τ [3/2(1500)]
Interest Income                                                     Yield
Pretax          1500            150                150              10%


                                                                                       88
Investment of (500)             (50)              (50)
tax saving
Your share of 1000              100               100               10%
investment

                                      v. Essentially, the government has co-invested in
                                         the asset.
                             d. Example 2: Losses
                                      i. Facts:
                                             1. Total investment: $10,000
                                             2. τ = 50% ($5,000)
                                             3. Return on investment: $2,000
                                     ii. Results
                                             1. Intuitively, a loss of $8,000.
                                             2. But amount realized = $2,000 – 0 =
                                                 $2,000 (because costs were not included
                                                 in basis)
  II.   Capitalization, Retirement, and IRAs
        a. Code Architecture
               i. I.R.C. § 25B: Low Income Retirement Credit
              ii. I.R.C. § 72(t): Tax Penalty for Early Distribution
             iii. I.R.C. § 219: Retirement Savings
             iv. I.R.C. § 408A: Roth IRAs
              v. I.R.C. § 408: IRAs
        b. Roth IRAs v. Traditional IRAs
               i. See attached table
              ii. Which is preferable?
                      1. Conventional IRA: deduct at higher tax rate and then
                          withdraw later at a lower tax rate (when you retire)
                      2. Roth IRA: No deduction when at higher rate, but tax-free
                          withdrawal.
                             a. So whether this is preferable will depend on your
                                  predictions for future tax rates. (if you think they will
                                  be lower in future, better to take deduction now).
             iii. Limitations
                      1. § 408A(c)(2)
                             a. Limits the contribution to $4,000. Since a deduction is
                                  not immediately taken, this means that the
                                  government does not "co-invest" with you—your
                                  share of the investment is thus larger.
                      2. Income limitations
                             a. Roth IRA phaseout



                                                                                        89
                                    i. The IRA is phased out for single taxpayers
                                       with income between $95,000 and $110,000 (or
                                       $150,000- $160,000 if married filing jointly)
III.   The distinction between deductible expenses and capital expenditures
       a. Code Architecture
              i. I.R.C. § 263: Capital Expenditures
                     1. General Rule
                            a. No deduction allowed for "any amount paid out for
                               permanent improvements or betterments made to
                               increase the value of any property or estate."
                     2. Exceptions
                            a. Mines
                            b. R&D
                            c. Soil and water conservation
                            d. Fertilizer
                            e. Expenditures for handicapped access
                            f. Etc.
             ii. I.R.C. § 263A: Capitalization of certain expenses
                     1. Applicable Property
                            a. Real and tangible property produced by taxpayer
                            b. Property acquired for resale
                                    i. Cross-reference: § 1221(a)(1)
                     2. Expenses capitalized
                            a. "direct costs"
                            b. proper share of "indirect costs"
                     3. Exceptions
                            a. Capitalization not required for personal use assets
                            b. Capitalization is not required for research and
                               development expenses under § 174
                     4. § 263A(f)Interest
                            a. Requires the capitalization of interest allocable to
                               property with a long useful life, a production period
                               exceeding two years, or a cost exceeding $1,000,000
                               and one year.
                            b. Effect
                                    i. This prevents an immediate deduction of
                                       interest from income.
                                  ii. § 263A(f)(2): No borrowing
                                           1. If you do not borrow to finance the
                                              construction, this rule looks at all other
                                              debt and capitalizes the interest your
                                              paid for other debt—this is an
                                              imputation rule.


                                                                                     90
      b. Important questions/principles
              i. What is the nature of the asset?
                     1. tangible v. intangible
             ii. What is the connection with the asset?
                     1. is the cost "direct" or indirect
            iii. Nature of the cost
                     1. internal or external
IV.   The Acquisition and disposition of assets
      a. General Rules
              i. "The cost of acquisition, construction, or erection of buildings,
                 machinery, and equipment, furniture and fixtures, and similar
                 property having a useful life substantially beyond the taxable year"
                 is to be capitalized. Reg. § 1.263(a)-2(a)
      b. Effects of Capitalization
              i. Capitalization reduces capital gains (because it increases basis).
             ii. Investors under § 212 and capitalization
                     1. A deduction would for a business expense would be a
                         below-the-line miscellaneous itemized deduction. If the
                         taxpayer is not an itemizer or below the 2% floor, then
                         capitalization is preferable because it allows some recover of
                         cost.
      c. Acquisition and capitalization under the tax code
              i. In Woodward v. Commissioner (1970) the Court held that a business
                 must capitalize the costs of litigating in federal court over the value
                 of stock, because the stock had to be valued before the company
                 could be acquired.
                     1. Court notes Reg. § 1.263(a)-2(a), providing that the cost of
                         acquisition of property having a useful life substantially
                         beyond the taxable year is capital expenditure
                     2. Court also uses an "origin of the claim" test to determine that
                         the litigation expenses were a cost of acquisition
      d. Borrowing costs
              i. Example: You borrow to purchase stock. Is the interest part of the
                 "cost of acquisition"?
                     1. I.R.C. § 163(d):       creates a special matching rule for
                         investment interest
                     2. Note that matching the interest expense to the annual return
                         does not work well when there is no dividend.
             ii. The general rule is that the interest is a current expense
      e. Costs of construction
              i. The depreciation deductions that would otherwise be taken for
                 equipment used in the construction of an asset must instead be
                 capitalized. Commissioner v. Idaho Power Co. (1974) ("Construction-


                                                                                     91
               related depreciation is not unlike expenditures for wages for
               construction workers. The significant fact is that the exhaustion of
               construction equipment does not represent the final disposition of
               the taxpayer's investment in the equipment; rather, the investment
               in the equipment is assimilated into the cost of the capital asset
               constructed).
                   1. See I.R.C. § 263A
     f. Capitalization to avoid conversion
            i. Negative Tax Rates and capitalization
                   1. If an expense is immediately deducted, it offsets ordinary
                       income. When the asset is disposed of, the taxpayer has a
                       higher amount realized than she would have had the
                       expense been capitalized—and this income is taxed at the
                       preferential rate for capital gains. The combination of these
                       two effects can lead to a negative rate of taxation!
                           a. Example: see Graetz p. 300
           ii. Despite this effect, a taxpayer's desire to achieve the above outcome
               is not prohibited outright. Instead, courts look at such a transaction
               with closer scrutiny.
     g. Costs of disposition
            i. When an asset is disposed of, the costs of that disposition are
               capitalized, thus reducing the amount realized.
     h. Costs of demolition
            i. I.R.C. § 280B
                   1. Requires capitalization of expenses or losses for demolition
                       into the basis of the land.
           ii. Criticism
                   1. If you build a temporary structure on the land and then
                       demolish it, you have added to the basis of the land without
                       meaning to—this is the wrong answer.
     i. Costs of title defense or recovery
            i. Expenses incurred in the defense or perfection of title or property
               must be capitalized. Reg. §§ 1.263(a)-2, 1.212-1(k)
V.   Acquisition of Intangible Assets or Benefits
     a. Two main questions
            i. When should a future benefit require capitalization?
           ii. If there is a future benefit what transaction costs facilitating the
               creation of the asset should be capitalized?
     b. Case treatment
            i. Cases
                   1. In INDOPCO v. Commissioner (1992) the Court held that
                       investment banking and legal fees incurred by the target



                                                                                  92
                company in the court of a friendly takeover should be
                capitalized under § 263
                    a. Court says that deductions are the exception to a
                       capitalization norm
                    b. The creation of a separate and distinct asset may be
                       sufficient, but is not necessary for capitalization
                    c. Court focuses on the realization of benefits in future
                       years
             2. In PNC Bancorp v. Commissioner (3d Cir 2000) the Court
                allowed a deduction for loan origination costs because, the
                court concluded, those costs were recurring and did not
                provide a future benefit and were not used to create a
                separate and distinct asset.
                    a. Criticism
                           i. Shuldiner criticized the outcome in this case
                               because the loan origination costs often did
                               produce a future benefit—the credit reports
                               acquired provided advice that did have a
                               future benefit. Also, the bank did create a
                               separate and distinct asset—the loans
                               themselves, which could easily be transferred.
c. General rules/principles
      i. Separate and Distinct
             1. Rule/principle
                    a. Expenditures need not create or enhance a "separate
                       and distinct asset" in order to be capitalized.
                       INDOPCO
             2. Definition of "separate and distinct"
                    a. "a property interest of ascertainable and measurable
                       value in money's worth that is subject to protection
                       under applicable State, Federal or foreign law and the
                       possession and control of which is intrinsically
                       capable of being sold, transferred or pledged. . .
                       separate and apart from a trade or business." Reg. §
                       1.263(a)-4(b)(3)
     ii. Future benefit
             1. Whether an asset will produce a future benefit is an
                important consideration in determining whether the cost of
                acquiring that asset should be capitalized. INDOPCO.
             2. However, the IRS has repeatedly narrowed the definition of
                "future benefit"
                    a. A future benefit does not automatically imply
                       capitalization (i.e., advertising, promotions).


                                                                          93
     iii. Matching rule
              1. One-year guidepost
                      a. Where an expenditure is expected to produce income
                         over a period of time rather than in the current
                         taxable year, capitalization is the standard practice.
                      b. This helps insure that income and expenses in the
                         taxable year are matched to determine net income.
              2. costs should be matched with revenue
              3. Reg. § 1.263(a)-4(f): permits deduction of payments who
                 benefits last 12 months after the taxpayer first realizes the
                 benefit or the end of the year in which the payment was
                 made—whichever is shorter.
     iv. Nonrecurring expenditure
              1. An expense that is non-recurring is more likely to require
                 capitalization. Encyclopedia Britannica Inc. v. Commissioner
                 (7th Cir. 1982).
d. Hostile v. Normal takeover
       i. Is the cost of defending against a hostile takeover an ordinary and
          necessary business expense or is it rehabilitation that must be
          capitalized?
              1. cf. rules for title defense (must be capitalized)
              2. If you believe that fending off the takeover was for the good
                 of the company, then it would have a future benefit
              3. But if you believe that the hostile takeover attempt simply
                 reduced the value of the company, then defending it is akin
                 to a repair.
                      a. See A.E. Staley Manufacturing Co. v. Commissioner (7th
                         Cir. 1997) (allowing deduction for legal costs of
                         unsuccessfully fighting hostile takeover.)
e. Transaction costs
       i. Costs that "facilitate" the acquisition of an intangible asset must be
          capitalized.
      ii. Exceptions:
              1. Overhead costs: internal v. external expenses
                      a. Overhead costs, including the expense of an in-house
                         staff used in acquisitions, may generally be expensed.
                      b. See PNC Bancorp v. Commissioner (3d Cir. 2000)
                         (allowing the "normal and routine" expenses of loan
                         origination costs to be deducted).
                      c. See Wells Fargo v. Commissioner (allowing deduction
                         for the costs of seeking a target for acquisition)
                              i. Shuldiner believes that the costs of finding
                                  targets—even when not acquired—should be


                                                                             94
                              part of the cost of acquisition because
                              eliminating targets has a future benefit.
     iii. External costs
              1. In Dana Corp v. United States (Fed. Cir. 1999) the Court held
                  that a retainer paid to a law firm each year to prevent that
                  law firm from advising an opposing company in a hostile
                  takeover was to be capitalized when the corporation finally
                  used the law firm to help acquire a company. The court said
                  that the focus was on the transaction, not the motive for
                  incurring the legal fee.
                     a. The question whether the retainer should be
                         expensed as part of the costs of defending against
                         takeover or capitalized as part of the acquisition is
                         essentially one of allocation.
                     b. Court does not look at "origin of the claim." Instead,
                         it looks at the cost of the current transaction.
f. Expenses for new businesses & Section 195
       i. The issue
              1. Is the expense incurred to maintain an existing business
                  (deductible under § 162) or to change or expand to a new
                  business (capitalized)?
      ii. General rule
              1. Start-up expenses incurred prior to entering the business
                  must be capitalized. I.R.C. § 195(a)
     iii. I.R.C. § 195 deduction
              1. Allows a deduction of up to $5,000 in start-up costs
              2. Phaseout
                     a. Threshold: $50,000
                     b. Ceiling: $55,000
                     c. Reduced dollar-for-dollar for amount over $50,000
     iv. Capitalization of intangibles
              1. Taxpayer may elect to amortize expenses over a five year
                  period.
              2. Costs capitalized include those that would be deductible if
                  incurred in connection with an existing trade or business
                     a. This includes costs of determining whether to enter a
                         new business
                     b. BUT does NOT include the costs of seeking a specific
                         business
g. Author's expenses
       i. § 263A exempts writer, photographers and artists from the
          capitalization requirement



                                                                           95
VI.   Deductible Repairs v. Nondeductible Rehabilitation or Improvements
      a. General
            i. Reg. § 1.162-4: General rule
                   1. Deductible
                          a. Costs that do not materially add to the value of
                             property AND
                          b. that do not appreciably prolong the life of the asset
                             AND
                          c. keep the asset in an ordinarily efficient operating
                             condition
                   2. Capitalized or depreciated
                          a. Replacements       that    arrest    deterioration and
                             appreciably prolong the life of the property
           ii. Guiding principles
                   1. "To determine whether costs should be classified as capital
                      expenditures or as repair and maintenance expenses it is
                      appropriate to consider the purpose, the physical nature,
                      and the effect of the work for which the expenditures were
                      made." American Bemberg Corp. v. Commissioner (6th Cir.
                      1948)
                   2. Reg. § 1.263(a)-1(b)
                          a. Capital expenditures are those that
                                 i. Add to value or substantially prolong life
                                ii. Adapt property to a new or different use
                   3. "General plan of rehabilitation, modernization and
                      improvement"
                          a. "Where an expenditure is made as part of a general
                             plan     of    rehabilitation,    modernization,   and
                             improvement of the property, the expenditure must
                             be capitalized, even though, standing alone, the item
                             may be classified as one of repair or maintenance."
                             United States v. Wehrli (10th Cir. 1968).
                                 i. This is a case-by-case determination.
                   4. Extension of life or material increase in value
                          a. "An expenditure which returns property to the state it
                             was in before the situation prompting the expenditure
                             arose, and which does not make the relevant property
                             more valuable, more useful, or longer lived is usually
                             deemed a deductible repair."
                                 i. The key is to look at the condition of the asset
                                    immediately before the repair.
      b. Revenue Ruling 2001-4
            i. Three situations


                                                                                 96
                       1. Situation 1: A heavy-duty repair that does not extend the
                           useful life of an airplane and did not require extensive
                           replacements
                               a. Deducted
                       2. Situation 2: a heavy duty repair that does not extend the
                           useful life of the airplane but that involves replacement of
                           skin panels and addition of some new features
                               a. Allocated between deductions and capitalization
                       3. Situation 3: Heavy duty repairs that are party of a
                           comprehensive plan of rehabilitation, that extend the useful
                           life of the aircraft and that involved extensive replacement of
                           skin panels and the addition of new features
                               a. completely capitalized.
                ii. See Graetz p. 316-317
   VII.   Environmental Cleanup
          a. Revenue Ruling 94-38
                 i. Soil remediation expenses need not be capitalized because they
                    bring land back to its state before contamination.
          b. Land purchase
                 i. Revenue Ruling 94-28 has not been extended to cases where the
                    taxpayer purchases contaminated property. There, the expenses
                    are not for maintenance, but to make the property usable.

Job Search and Education Expenses

   I.     Job-Seeking
          a. Revenue Ruling 75-120
                  i. Expenses incurred in seeking new employment in the same trade or
                     business are deductible under § 162 if they are directly connected
                     wit the trade or business
                 ii. Expenses are not deductible if the individual is seeking
                     employment in a new trade or business, even if employment is
                     secured.
                iii. If unemployed, the trade or business consists of the services
                     performed in the last job (and there must not be substantial
                     discontinuity between the time of the past employment and the
                     seeking of new employment)
          b. "New trade or business"
                  i. Tax Court approach
                        1. "If substantial differences exist in the tasks and activities of
                            various occupations or employments, then each such
                            occupation or employment constitutes a separate trade or
                            business."


                                                                                        97
      c. Expenses of seeking public office
             i. Non-deductible.
            ii. See Gratez p. 321
II.   Education Expenses
      a. General
             i. Reg. § 1.162-5
                    1. Education expenditure are deductible as ordinary and
                        necessary business expenses if the education
                           a. Maintain or improves skills required by the
                               individual in his employment or other trade or
                               business
                           b. Meets the express requirements of the individual's
                               employer, or the requirements of applicable law or
                               regulations, imposed as a condition to the retention of
                               the individual of an established employment
                               relationship, status, or rate of compensation."
      b. The business/personal distinction
             i. The regulations distinguish business and personal education
                expense by determining whether the education leads to
                qualification for a new trade or business
      c. When does a trade or business begin?
             i. In Wassenaar v. Commissioner (Tax Ct. 1979) the Court rejected
                deduction for the costs of acquiring an LLM in taxation because the
                taxpayer, a recently graduated law student, as not in an established
                trade or business when he took the classes. The law student had
                not yet taken the bar.
            ii. But in Ruehmann v. Commissioner (1971) the Court determined
                that an individual could deduct the costs of a Harvard LLM, begun
                within months of graduation law school. The taxpayer had started
                a job in the law right after graduation.
      d. Minimum educational requirements
             i. This is usually determined according to the standards of the
                employer, rather than the profession.
                    1. See Toner v. Commissioner (allowing a deduction for the costs
                        of a taking classes while employed as a private school
                        teacher when the employer required that teachers have a
                        bachelor's degree).
      e. What is a "new" trade or business?
             i. McEuen, Zhang
      f. Travel Expenses
             i. Travel expenses incurred for education are not deductible. §
                274(m)(2)
      g. Employer Subsidies


                                                                                   98
               i. I.R.C. § 127
                      1. Up to $5,200 may be excluded from an employee's income
                          for the costs of an educational assistance program
              ii. I.R.C. § 117
                      1. excludes "qualified scholarships" from income.
       h. General Education Deduction
               i. I.R.C. § 222
                      1. Allows a deduction of up to $4,000 for tuition and related
                          expenses
                      2. Must not be a dependent
                      3. Must be below income ceiling
                      4. This is an above-the-line deduction. § 62(a)(18)
III.   Special Education provisions
       a. Tuition Deduction
               i.
       b. I.R.C. § 530: Educational Savings Accounts
               i. General Requirements
                      1. Must be cash contribution
                      2. Can only be up to $2,000 a year
                      3. before the child turns 18
                      4. trustee must be a bank or someone else designated by
                          Secretary
                      5. no part of the trust assets can be invested in life insurance
                      6. the assets of the trust cannot be commingled
                      7. any balance to the credit of the beneficiary must be
                          distributed within 30 days of the beneficiary's 30th birthday
              ii. Requirements of money used
                      1. Must be used to pay for qualified education expenses
             iii. Benefits
                      1. tax-free status
             iv. Phaseout
                      1. Phaseout amount = contribution * (MAGI - $95,000)/ $15,00
                      2. Phaseout range
                              a. Single: $95,000 - $110,000
                              b. Married: $190,000 - $220,000
              v. Tax treatment of distributions
                      1. General distribution
                              a. same as an annuity under § 72
                              b. Amounts of income not used for qualified education
                                 expenses are subject to an additional 10% tax
                      2. Distribution for qualified education expenses
                              a. Excluded from gross income



                                                                                    99
                      b. If qualified education expenses are less than the
                          amount distributed, the expenses are deemed to come
                          proportionately from invested capital and income.
      vi. § 530(d)(2)(C): coordination with Hope, LLC and Qualified
           Tuition.
c. I.R.C. § 529: Qualified Tuition Program
        i. General
               1. Under these plans, a person contributes to an account that
                  will be used to pay college tuition at any university or
                  purchases tuition credits at a designated university. Both
                  the earnings and the distributions are exempt from the
                  income of the beneficiary and the contributor.
               2. There is income limitation
               3. a taxpayer can claim a Hope or LLC and exclude proceeds
                  under § 529 so long as the distribution is not used to pay
                  expenses for which the credit was claimed.
d. I.R.C. § 25A: Hope and Lifetime Learning Credits
        i. § 25A(b): Hope Credit
               1. Generally
                      a. The credit is NONrefundable
                      b. The credit is indexed for inflation
                      c. Per student rather than per taxpayer
               2. § 25A(b)(1): The Credit
                      a. Allows for a credit of up to $1500 (100% of first $1,000
                          and 50% of next $1,000).
               3. § 25A(b)(2): limitations
                      a. Credit only allowed if you have not taken it in two
                          prior years
                      b. Must be a ½ time student
                      c. Only allowed for first two years of post-secondary
                          education
                      d. The credit is denied for a student convicted of a drug
                          offense
       ii. § 25A(c): lifetime learning credit
               1. Generally
                      a. The credit is NONrefundable
               2. § 25A(c)(1)
                      a. Amount equal to 20% of qualified tuition that does
                          not exceed $10,000
               3. § 25A(c)(1)
                      a. Applies to any course of instruction at an eligible
                          education institution.
                      b. Per taxpayer rather than per student


                                                                             100
                iii. Phaseout of eligibility for both credits
                         1. Phaseout = Credit Amount * (MAGI - $40,000)/ $10,000
                         2. Phaseout ranges (adjusted for inflation)
                               a. Single: $40,000 -
                               b. Married:
                iv. Coordination
                         1. The Hope and Lifetime learning credits cannot be taken for
                            the same student in the same year
                         2. Amounts that qualify under both expenses are allocated to
                            the HOPE credit first.
         e.   Scholarships and Employer-Provided Assistance
         f.   Student Loan Interest
         g.   U.S. Savings Bonds
                  i. § 135
         h.   See Graetz p. 422

Options to Deduct

   I.    Costs for which the taxpayer can either expense or capitalize
         a. I.R.C. § 173: Circulation Expenses
         b. I.R.C. § 174: Research and Development
         c. I.R.C. § 175: Soil and Water Conservation
         d. I.R.C. § 198: Environmental Remediation Costs
         e. I.R.C. § 179A: Qualified Clean Fuel Vehicles
         f. I.R.C. § 189: Fertilizer
         g. I.R.C. § 190: Expenses of accommodating for handicapped

Depreciation, Amortization and Depletion

   I.    Depreciation, generally
         a. Purpose of deprecation
               i. Allocates the costs of an asset over an appropriate period of time
         b. How to measure proper depreciation
               i. Economic depreciation as ideal
                      1. Economic depreciation would allow a deduction for the
                         actual decline in an assets value during the taxable period.
                      2. Advantages
                             a. This would produce least amount of distortion
                             b. Would properly measure net income during the
                                 period
                      3. Disadvantages
                             a. Conflicts with realization requirement
                             b. Impossible to administer


                                                                                  101
                    c. Would not allow for the current subsidy
      ii. General terms/methods of depreciation
             1. General terms
                    a. Depreciable base
                           i. This is the basis of the property, determined
                              under § 1011
                          ii. See supra p. XXX
                    b. Depreciation rate
                           i. This is a function of the method of depreciation
                              and the recovery period.
                    c. Salvage value
                           i. The amount a taxpayer would expect to
                              recover when she stops using the asset for the
                              production of income
                          ii. NOTE:       Congress ignores this because of
                              frequent controversies over its value.
             2. Methods of depreciation
                    a. Straight line
                           i. The costs of an asset is allocated in equal
                              amounts over its useful life.
                    b. Declining balance method
                           i. Allocates a larger portion of costs to early
                              years.
                          ii. A constant percentage is used, but it is applied
                              to the amount remaining after depreciation in
                              previous years
             3. Determining the recovery period
                    a. General
                           i. This is necessarily an estimate.
                          ii. For administrative convenience, this must be
                              determined when the asset is placed in service
                    b. Method one
                           i. Look at the length of time that similar assets
                              have been used by the taxpayer
                    c. Method two
                           i. Look to the average length of time that similar
                              assets have been used throughout the
                              economy.
                    d. Method three
                           i. Look to the average length of time that similar
                              assets have been used in the particular
                              industry.
c. Start up Expenses


                                                                          102
              i. See I.R.C. § 195
             ii. See supra p. XXX
      d. Recapture
              i. When a taxpayer takes depreciation on property and then sells it,
                 the taxpayer may too much gain.
             ii. I.R.C. §§ 1245(personal property), 1250 (real property
                     1. Provides that certain amounts of amount realized are to be
                         considered ordinary income rather than capital gains
      e. Personal Use allocation
              i. Deductions may only be taken for depreciation of assets used in a
                 trade or business. If an item is used for both business and personal
                 use, the basis must be allocated between personal and business
                 uses. Depreciation is only allowed from the business basis. Reg. §
                 1.167(g)-1.
      f. Land
              i. Land is not depreciable. (note, however, that resources on or in the
                 land may be depleted).
      g. Antiques
              i. The IRS's position is that antiques are not depreciable because they
                 do not have a determinable useful life defined by the physical
                 condition of the art work. Rev. Rul. 68-232
             ii. But see Simon v. Commissioner in which the court allowed
                 professional musicians to depreciate two 19th century violin bows
                 they had purchased for $30,000 and $21,500. (graetz p. 336-337)
      h. Luxury Automobiles
              i. I.R.C. § 280F
                     1. Limits depreciate on luxury automobiles
                            a. See §280F(a)(a)(A)
                     2. luxury automobiles are defined by weight.
      i. Depreciation as a subsidy
              i. The acceleration of deprecation under MACRS understates income,
                 providing an incentive to invest in depreciable assets.
II.   Depreciation: Code Architecture
      a. I.R.C. § 167: Depreciation
      b. I.R.C. § 168: MACRS
              i. General
                     1. Three Steps
                            a. Determine depreciation method
                            b. Determine Recovery period
                                   i. Determine property classification
                            c. Determine Convention
                     2. Salvage value = 0
                     3. Depreciation methods summary


                                                                                 103
                 3, 4, 7, 10-year 15,     20-year Residential
                 property         property        Rental Property
Depreciation     Greater of:      Greater of:     Straight-line
method
                 1.      Double- 1.        150%
                 declining       declining
                 balance         balance

                  2. straight line    2. straight line
       ii. § 168(b): Depreciation methods
               1. Double-declining balance/straight line
                       a. Example
                               i. Car worth $100. 5 years.
                              ii. This means 20% per year
                                     1. Year 1 (1/2 year convention)
                                             a. $100 * 20% = $20
                                     2. Year 2
                                             a. $80 * 40% = $32
                                     3. Year 3
                                             a. $48 * 40% = $19.20
                                     4. Year 4
                                             a. 28.80 * 40% = $11.52
                                     5. Year 5 (switch to straight line)
                                             a. $11.52
                                     6. Year 6 (1/2 year)
                                             a. 5.76

       iii. § 168(d): Conventions
                1. Conventions, generally
                       a. The convention is used to determine appreciation
                          allowed when the property is not in used for the
                          entire year.
                2. General rule is ½ year convention
                       a. ½ of year's depreciation is allowed in year of
                          acquisition and disposition, regardless of whether the
                          asset is actually used.
                3. Exceptions
                       a. Real property: mid-month convention
                       b. Last quarter exception
                              i. Where a substantial amount of depreciable
                                  property is purchased in the last quarter, a
                                  mid-quarter convention applies.
       iv. § 168(e): Classifications of property


                                                                            104
       c. I.R.C. § 179: Election to Expense
               i. General
                      1. This section permits a deduction for up to $125,000 of
                         tangible business property where the taxpayer's annual total
                         investment in the property is $500,000 or less.
                      2. Any excess over $500,000 is subject to normal depreciate
                         rules
                      3. This is adjusted for inflation
       d. I.R.C. § 197: Amortization of intangibles
               i. General
                      1. The rule now is that intangible assets may be amortized so
                         long as the asset's useful life can be determined with
                         reasonable accuracy.
                             a. In Newark Morning Ledger Co. v. United States (1993)
                                 the Court allowed amortization of a newspaper
                                 subscriber list because the list could be valued and
                                 had a limited life that could be ascertained with
                                 reasonable accuracy.
              ii. § 197(a): General Rule
                      1. "197" intangibles are amortized on a straight-line basis over a
                         15 year period.
             iii. § 197(f): special rules
                      1. If a § 197 intangible is disposed of, no loss is recognized.
                         The taxpayer can, however, adjust the bases of other 197
                         intangibles
                      2. This sets up a "basket" approach
             iv. Non-197 intangibles
                      1. The rule now is that intangible assets may be amortized on a
                         straight-line basis over the course of 15 years so long as the
                         asset's useful life can be determined with reasonable
                         accuracy. Reg. § 167(a)-3
III.   Depletion
       a. I.R.C. § 611: Allowance of deduction for depletion
               i.
       b. Methods
               i. Cost depletion
                      1. Estimates the total amount of natural resource in the
                         property and allows deduction of its cost in property to each
                         year's extractions.
                      2. Example
                             a. Facts
                                     i. Estimated total oil: 1,000,000 barrels
                                    ii. Removed barrels: 100,000


                                                                                    105
                               iii. Basis is $5,000,000
                               iv. 10% of the oil was removed.
                        b. Result under cost depletion
                                 i. 10% * $5,000,000 = $500,000
                 3. Adjustments are made if the initial estimate is wrong
                 4. See I.R.C. § 612
         ii. Percentage depletion
                 1. Allows the depreciation of a specific percentage of the gross
                     income from the property without regard to the recovery of
                     cost. It remains deductible even when basis has been
                     recovered.
                        a. Example
                                 i. Facts
                                       1. You harvest 100,000 barrels of oil
                                       2. They sell at 10$ a barrel
                                       3. total income is $1,000,000. You deduct a
                                            certain percentage of this amount.
                        b. The net present value of these deductions can be quite
                            high
                 2. See I.R.C. § 613: Percentage depletion, generally
                 3. See also I.R.C. § 613A: limitations for oil and gas wells
c.   Water
          i. Cost depletion has been allowed for water when it is shown that
             the water will not be replaced. See United States v. Shurbet (5th Cir.
             1965)
d.   Intangible Drilling Costs
          i. Intangible expenses associated with drilling an oil well—i.e., labor,
             fuel, repairs, hauling, and supplies—may be immediately deducted
             or capitalized and recovered through depletion.
e.   Recapture
          i. I.R.C. §1254
                 1. provides that some intangible drilling expenses deducted
                     will be recaptured as ordinary income when the property is
                     sold
f.   Specific Tax Incentives
          i. I.R.C. § 617: Exploration and Development expenditures
         ii. I.R.C. § 616(a): Mine Development expenditures
        iii. I.R.C. § 193: Tertiary injectants
        iv. I.R.C. § 194: Reforestation




                                                                               106
Interest

   I.      General
           a. How should interest be treated
                  i. Economic nature of interest
                        1. Interest as the return on negative assets
                                a. Under a pure income tax, interest would be
                                   deductible: the interest deduction is the return on a
                                   "negative asset" (the debt liability)
                                b. Example
                                        i. Facts
                                               1. Loan: $100,000 at 10%
                                                      a. Interest: $100
                                               2. Treasury bond at 10%
                                                      a. Income: $100
                                       ii. In this example, you are not better off because
                                           of your interest income—you real income is
                                           zero
                                c. Shuldiner says that this is the correct, economic way
                                   to think of interest
                        2. Interest as the cost of consumption
                                a. Some analysts think of interest as simply part of the
                                   cost of consumption, no more deductible than the rest
                                   of the item's price.
                                b. See infra p. XXX, "personal interest"
           b. "Tracing" Interest
                  i. The tax treatment of interest is often dependent on the purpose of
                     the loan giving rise to the interest. Since money is fungible, this is
                     almost impossible
                 ii. Treasury regulations
                        1. Generally, the regulations determine the purpose of an
                            interest expense by tracing loan proceeds to their use. The
                            expenditure of the loan proceeds—and not the security of
                            the debt—governs.
                        2. Bank Accounts
                                a. When loan proceeds are intermingled in a bank
                                   account, the regulations provide that expenditures
                                   from the account are deemed to have been made first
                                   from borrowed funds, and then from unborrowed
                                   funds, and proceeds from different loans are used in
                                   the order that the loan proceeds are deposited.


                                                                                       107
c. What is interest?
      i. Generally
             1. Definitions
                     a. "The amount which one has contracted to pay for the
                        use of borrowed money." Old Colony Railroad v.
                        Commissioner (1992)
                     b. "Compensation for the use or forbearance of money."
                        Deputy v. du Pont (1940)
             2. Form or substance?
                     a. Courts are generally reluctant to characterize as
                        interest payments that are not labeled as such: when
                        interest is unstated, it is usually not taxed as income
                        or allowed as a deduction.
                             i. This is dealt with via the Original Issue
                                Discount rules
                     b. Credit card fees
                             i. Not deductible interest (but may be deductible
                                under § 162)
                     c. Late payments
                             i. Courts generally hold that this is a fee—a
                                payment for the costs of collection.
                     d.
     ii. Distinguishing interest from other types of income
             1. Debt v. Equity
                     a. Inflation makes it even more difficult to tell whether
                        payments are for equity or debt
                     b. Form or Substance?
                             i. Form
                                   1. In United States v. Mississippi Chemical
                                      the Court held that mandatory "stock
                                      purchases" were really investments,
                                      even      though     they    were     non-
                                      transferrable and not worth their face
                                      value.
                            ii. Substance
                                   1. In Knetch v. United States the Court
                                      refused to allow a deduction for interest
                                      on indebtedness, concluding that the
                                      only purpose of a complicated
                                      transaction was to reduce taxes. The
                                      court refused to accept the form of the
                                      transaction.
             2. Corporate debt v. equity


                                                                            108
                            a. I.R.C. § 385
                                    i. Allows the secretary to promulgate regulations
                                       distinguishing debt in a company from stock in
                                       the company.
                     3. Interest v. Principal
                            a. The timing problem: money is fungible so it can be
                                seen as either interest of principle.
                                    i. See Estate of Franklin, supra p. XXX
                            b. "prepaid" interest
                                    i. see supra p. XXX
                            c. unstated interest
                                    i. This is dealt with under the Original Issue
                                       Discount Rules
                                           1. See I.R.C. §§ 1271-1278
                     4. Equity-kicker loans
                            a. Some arrangements provide that a lender will receive
                                a portion of the amount realized upon disposition of
                                the property.
                                    i. Is this a loan or a co-investment?
                                   ii. The cases generally emphasize the intent of the
                                       parties to enter into a debtor/creditor
                                       relationship.
                            b. Lender v. Owners
                                    i. Who gets to depreciate from the basis and how
                                       much?
                                   ii. Often, by matching lenders with interest
                                       income and borrowers with interest expenses
                                       and depreciation the correct result is reached
                                  iii. When one of the actors is tax exempt, however,
                                       courts are more cautious and less willing to
                                       accept the parties' characterization.
II.   Specific Types of interest
      a. Business
              i. Interest on indebtedness used to operate a trade or business is
                 deductible. § 163(a)
             ii. Exceptions
                     1. interest that must be capitalized into the cost of producing
                        an asset
            iii. Passive loss rules
                     1. See I.R.C. § 469
      b. Investment
              i. Problems with investment interest



                                                                                  109
1. Property acquired with interest is often taxed incorrectly
   because taxpayer can often take deductions for interest AND
   depreciation. This allows for tax arbitrage when the rates
   different.
2. § 163(d)(1): Basket approach
       a. Purpose
                i. This section acts as an anti-arbitrage rule.
               ii. Example
                       1. Suppose you have $3,000 of interest on a
                           debt. If you buy stock with the debt that
                           appreciates, but pays no dividend, then
                           you get deductions for the interest and
                           deferred income at a preferential rate.
                       2. 163(d) prevents this by matching income
                           and interest. BUT, now we have the
                           problem of figuring out whether the
                           debt was really used for investment.
                               a. See supra p. XXX
              iii. This section will disallow some legitimate
                   interest expense deductions.
       b. § 163(d)(1): Matching approach
                i. Deduction for investment interest cannot
                   exceed net investment income.
       c. § 163(d)(2): Carryforward
                i. If interest cannot be deducted under §
                   163(d)(1), the taxpayer can treat it as
                   investment interest accrued in the succeeding
                   year.
       d. § 163(d)(4): Net Investment Income
                i. Net investment income does NOT include net
                   capital gains or dividends, unless the taxpayer
                   elects to forgo the 15% preferential rate
                       1. See I.R.C § 1(h)(2) (net capital gains
                           decreased by the amount taken into
                           account as investment income under
                           this section).
                       2. See I.R.C. § 1(h)(11)(D)(i) ("qualified
                           dividend income shall not include any
                           amount which the taxpayer takes into
                           account as investment under § 164(d))
               ii. A taxpayer can now elect to treat their
                   dividends as capital gains. I.R.C. § 1(h)(11)
              iii. Example


                                                                110
1. Year One
      a. Facts
               i. $2,000 of capital gain
              ii. $2,000 of interest on loans
                  for investments
      b. Two choices
               i. Keep the capital gains
                     $2,000 * 15% = $300 in
                        taxes
              ii. Elect to treat the capital
                  gains        as     ordinary
                  investment income
                     $2,000 of ordinary
                        income
                     $2,0000 deduction
                     net income = 0 * 35%
                        = 0 in taxes
2. Year Two
      a. If no year two, then you should
          have elected to treat the capital
          gains as ordinary income
      b. Facts
               i. $0 of interest on loans for
                  investments
              ii. $2,000 investment income
      c. If you did not elect to treat capital
          gains as ordinary income in the
          last year, then the interest income
          that was not deduction last year
          can be carried forward
               i. $2,000      of    investment
                  income - $2,000 of interest
                  on loans = $0
      d. If you elected to keep your
          preferential capital gains, then
          there is no carryforward
               i. $2,000 of income * 35% =
                  $700 in taxes
3. Whether you will want to elect to forgo
   the capital gains preference depends on
   whether you will have investment
   income in the next year and whether



                                          111
                                           you can take advantage of the
                                           carryforward.
       ii. Distinction between business and investment
               1. Dealers
                       a. Are involved in the trade or business of being a
                           dealer. This is ordinary income not subject to § 163(d)
                       b. See also I.R.C. § 475 (mark-to-market rules eliminating
                           realization requirements).
               2. Traders
                       a. Those 'whose profits are derived from the 'direct
                           management of purchasing and selling.'" § 163 does
                           not apply
               3. Investors
                       a. Those who are engaged in the production of income,
                           intrest in the long-term growth potential of stocks.
c. Interest on Tax-Exempt Income
        i. I.R.C. § 264(a)(2)
               1. Prevents deducting interest for borrowing used to purchase
                   an annuity or life-insurance contract
       ii. I.R.C. § 265(a)(2)
               1. Prevents deductions of interest on indebtedness to purchase
                   bolds that yield tax-exempt interest
      iii. I.R.C. § 461(g)
               1. Requires that the taxpayer allocate and deduct prepaid
                   interest over the loan period.
               2. Exception for points on a home mortgage.
d. Personal Interest
        i. Why is personal interest disallowed?
               1. In a pure income tax, it would not be taxed—it is part of the
                   cost of carrying a negative asset.
               2. Could be thought of as an anti-arbitrage provision
                       a. Example: a taxpayer purchases a car using debt.
                           Income from the use of the car would not be taxed
                           (because imputed).
       ii. I.R.C. § 163(h)
               1. General Rule
                       a. No deduction is allowed for personal interest
               2. Definition
                       a. Personal interest is anything OTHER than
                                i. Interest paid or incurred in a trade or business
                               ii. Investment interest
                              iii. Interest that would be deductible in connection
                                   with a § 469 passive activity


                                                                               112
                            iv. Qualified residence interest
                             v. Interest of deferred estate tax payments
                      b. Interest on an income tax deficiency is personal
                         interest.
e. Home Mortgage Interest
       i. Note that the regulations promulgated for home mortgage interest
          are out of date.
      ii. I.R.C. § 163(h)(3)
              1. Acquisition indebtedness
                      a. Defined
                              i. Used to acquire, construct or substantially
                                 improve a qualified residence. The loan must
                                 be secured by the residence
                      b. Limitation
                              i. $1,000,000 (unindexed)
              2. Home equity indebtedness
                      a. Defined
                              i. "any indebtedness secured by a qualified
                                 residence to the ext the aggregate amount of
                                 such indebtedness does not exceed the fair
                                 market value of the residence reduced by the
                                 amount of acquisition indebtedness.
                      b. Limitation
                              i. $100,000 (unindexed)
              3. Two residences may be used for deductions
f. Interest on Education Loans
       i. I.R.C. § 221: Interest on education loans
              1. § 221(a)
                      a. Allows a deduction for "qualified education loans."
                      b. This deduction is above the line
              2. § 221(b): limitations
                      a. Maximum
                              i. maximum amount deductible is $2,500.
                      b. Phaseout
                              i. Begins at $50,000
                             ii. (MAGI - $50,000)/$15,000
      ii. Third-party payments
              1. If a person who is not legally obligated to do so pays the
                  interest on behalf of the taxpayer who owes the interest, the
                  third party is treated as making a gift to the child, who is
                  then treated as paying the interest and gets the requisite
                  deduction. Reg. § 1.221-1(b)(4)(i)



                                                                           113
III.   Arbitrage, Abuse, and Shams
       a. What is "indebtedness?"
                i. Objective tests: "Sham transactions"
                       1. In Knetsch v. United States, the Court held that transaction
                          between Knetsch and the Sam Houston Life Insurance
                          Company in which Knetsch purchased annuity bonds after
                          receiving a loan from the company had no other purpose
                          than to reduce taxes. As such, it was a "sham transaction"
                          for which the taxpayer was not allowed a deduction.
                              a. The court focused on the definition of "indebtedness"
                                      i. "Knetsch's transaction with the insurance
                                         company id not 'appreciately affect his
                                         beneficial interest except to reduce his tax."
                                     ii. Here the supreme court used an objective test,
                                         focusing on the purely economic nature of the
                                         transaction—the question is not the motive of
                                         the taxpayer but the intent of the statute.
                                            1. Cf. Estate of Franklin (in which court uses
                                                a subjective test to determine what the
                                                motive of the transaction was).
               ii. Subjective tests: tax avoidance motives
                       1. In Goldstein v. Commissioner the court held that a taxpayer
                          who won $140,000 in a contest and subsequently borrowed
                          money at 4% interest to buy treasury bonds at 1.5% interest
                          had engaged in a transaction with no other purpose than to
                          secure a deduction.
                              a. Instead of looking at whether there was real
                                 indebtedness (here there was), the court reads a for-
                                 profit requirement into § 163.
                       2. In Lifschultz v. Commissioner the Court noted that in
                          examining an agreement involving the purchase and
                          repurchase of Treasury bills, that "financing transactions will
                          merit respect and give rise to deductible interest only if there
                          is some tax independent purpose to the transaction."
       b. Three ways to combat "tax shelters."
                i. Inquire into whether there is really indebtedness. Estate of Franklin
                   v. Commissioner
               ii. Invalidate the entire transactions on the grounds that it lacks
                   economic purpose. Knetsch v. United States
              iii. Recharacterize the transaction to reflect its economic reality (i.e., the
                   "prepaid interest" in Estate of Franklin).
IV.    Inflation and interest
       a. Inflation is not accounted for under the income tax


                                                                                        114
                 i. This is one of the justifications for MACRS
         b. Inflation results in an overstatement of interest income and deductions
                 i. Traditionally, it was believed that this was washed out because
                    both sides of the transaction are taxed equally incorrectly.
                ii. But because of the progressive nature of the tax system, borrowers
                    are likely to save more than creditors, so the tax consequence is
                    negative.
         c. Inflation also pushes people into higher tax brackets.

Losses

   I.    General
         a. There are two types of losses
               i. Property losses
                      1. See I.R.C. § 165
              ii. Operating losses
                      1. See I.R.C. § 183 (hobby losses)
                      2. See I.R.C. § 172 (net operating losses)
         b. When is there a loss?
               i. Realization
                      1. The realization requirement: gains and losses are recognized
                          only when there is a realization event.
                      2. A casualty is often treated as a realization event, even if it
                          does not result in a total loss.
              ii. Worthless property
                      1. When can a taxpayer deduct the loss of an item that has
                          become worthless?
                             a. I.R.C. § 165(g)
                                     i. General rule: "If any security which is a capital
                                        asset becomes worthless during the taxable
                                        year, the loss resulting therefrom shall, for the
                                        purposes of this subtitle, be treated as a loss
                                        from the sale or exchange, on the last day of
                                        the taxable year, of a capital asset."
                                    ii. Objective test
                                            1. In Boehm v. Commissioner the Court held
                                                that a loss on a security was sustained
                                                when the security actually became
                                                worthless, not when the taxpayer had a
                                                good-faith belief that the security was
                                                worthless.
         c. The Amount of the Loss
               i. I.R.C. § 165(b)


                                                                                     115
                      1. The basis for determining the amount of a deduction for a
                          loss is the adjusted basis of the property.
II.    Business v. Nonbusiness (but profit-seeking) losses
       a. I.R.C. § 165(c)(1)
               i. Allows a deduction for losses incurred in a trade or business.
              ii. This is deductible from gross income as an above-the-line
                  deduction. I.R.C. § 62(a)(2)
             iii. These losses can also be carried forward and backward under § 172.
       b. I.R.C. § 165(c)(2)
               i. Allows a deduction for losses incurred in any transaction entered
                  into for profit.
              ii. Above-the-line: sales or exchanges of property and rents or
                  royalties
             iii. Below-the-line: Any other loss under this section
                      1. They may also be capital losses whose deductibility is
                          further limited.
       c. Business v. Nonbusiness
               i. In Yerkie v. Commissioner the Court concluded that a repayment by
                  an embezzler to his employer was not a loss incurred in a trade or
                  business.
              ii. In Reese v. Commissioner the Court concluded that the losses on a
                  general contract for constructing a manufacturing plant of a
                  company for which the taxpayer was the president, treasurer,
                  chairman of the board and the principal stockholder was not
                  engaged in the trade or business of contracting (he was instead, an
                  investor.
III.   Personal Losses
       a. General
               i. General Rule
                      1. Personal loss deductions are generally disallowed.
              ii. Purpose of general rule
                      1. The general assumption is that losses of personal property
                          represent consumption.
             iii. Criticism
                      1. This isn't taken into account elsewhere in the code
                              a. Example: You buy a car for $10,000. You consume
                                  $2,000 and then sell it for $12,000. You would be
                                  taxed on $2,000 of gain, not $4,000.
       b. Mixed-use property
               i. When property is used for both personal and business purposes,
                  losses must be allocated between the different uses.
                      1. Example
                              a. Facts


                                                                                 116
                           i. You purchase a boat for $40,000
                          ii. ¼ is used for business. ¾ are used for personal
                              reasons.
                         iii. The business basis is $10,000. The personal
                              basis is $30,000.
                         iv. Business basis is depreciated by $8,000
                          v. Total basis is $32,000
                         vi. The boat is sold for $28,000
                    b. Results
                           i. The business portion was depreciated by
                              $8,000. It has a basis of $2,000.
                          ii. The business-side amount realized was $7,000
                              ($28,000/4).
                         iii. You have a gain of $5,000 on the business side.
c. Casualty Losses
       i. General Treatment under § 165
             1. I.R.C. § 165(c)(3)
                    a. Allows a deduction for losses arising from fire, storm,
                        shipwreck, or other casualty, or form theft.
             2. I.R.C § 165(h): treatment
                    a. Limitations
                            i. The loss must exceed $100
                    b. Matching
                            i. Deductions for casualty losses equal to
                               casualty gains are deductible from gross
                               income
                    c. Excess losses
                            i. Casualty losses that exceed casualty gains are
                               limited to the amount that exceeds 10% of
                               adjusted gross income.
                    d. The deduction is a below-the-line deduction.
             3. "Other" casualty
                    a. The cases suggest that the loss must be sudden and
                        unforeseen
                            i. Some courts have allowed the deduction even
                               when the taxpayer is negligent so long as there
                               is not sign of willfulness. Krahmer v. United
                               States.
                    b. Suddenness is necessary, but not sufficient
                            i. The courts also seem to require actual physical
                               damage.
      ii. Amount of the loss
             1. Reg. § 1.165-7(b)


                                                                          117
                           a. The amount is the lesser of the adjusted basis or the
                              (fair market value immediately before the casualty –
                              the fair market value immediately after the casualty).
                   2.   Example 1: General
                           a. You buy a car for $10,000. It's fair market value is
                              $6,000. You can only deduct the $6,000 FMV.
                   3.   Example 2: Gifts
                           a. You buy a car for $10,000. It depreciates to $6,000.
                              You then give it away as a gift and it appreciates to
                              $8,000. Here, you must split the basis
                                   i. The giftee has a basis of $10,000 for gains and
                                      $6,000 for losses. See I.R.C. § 1015
                   4.   Example 3: unrealized appreciation
                           a. You purchase a painting for $10,000. It is actually
                              worth $100,000. The painting perishes in a fire. The
                              loss is only $10,000. This makes sense because you
                              have not paid taxes on the $90,000 gain.
                   5.   Example 4: Loss with insurance
                           a. You purchase a building for $100,000. After taking
                              $40,000 of depreciation deductions, the building has
                              an adjusted basis of $60,000. The building itself has
                              appreciated to $150,000. The building is destroyed
                              and you receive insurance of $50,000. What is the
                              loss?
                                   i. The loss was $60,000. Since you cannot deduct
                                      the insurance proceeds, the total casualty loss
                                      is $10,000
                   6.   Example 5: Partial loss
                           a. You own a painting with a fair market value of
                              $100,000 and a $10,000 basis. It receives $15,000 of
                              damage. The loss can be offset against basis—you get
                              a $10,000 loss (as opposed to allocating the loss to the
                              unrealized gain upon disposition).
      d. Insurance
             i. See Graetz p. 379.
IV.   Loss Limitations and Bad Debts
      a. Property losses
             i. Abuses of the realization requirement
                   1. In Fender v. United States the Court refused to allow loss
                       deductions resulting from a trust's sale of hard-to-transfer
                       bonds to a bank in which the trust had only a 40.7% interest
                       on the grounds that the transaction had no other purpose
                       than to secure the deduction.


                                                                                  118
                      a. The court also noted that the loss was not "genuine" in
                           the sense that there was no real risk of being unable to
                           recover the loss
b. Transactions between related taxpayers
        i. I.R.C. § 267
               1. Disallows a deduction for losses incurred in transactions
                   between related taxpayers.
               2. § 267(d): Allows for recovery of otherwise disallowed loss
                      a. A seller's loss under § 267 is generally lost
                           permanently because the purchaser's basis for
                           computing loss when he sells property is his cost.
                      b. This section allows the purchaser to increase his basis
                           for determining gain by the seller's disallowed loss.
                               i. Example
                                      1. You buy property for $1,000. You sell it
                                         to a brother for $600. His basis is $600.
                                      2. He sells for $400loss of $200
                                      3. He sells for $800$400 loss from
                                         original transaction can be used to offset
                                         gains.
               3. Purpose of § 267
                      a. Prevents abuses of the realization requirement by
                           making sure that someone has really disposed of the
                           property.
                      b. Also helps to limit valuation problems that would
                           otherwise be prevalent
                      c. § 267(a)(2) provides a matching rule to prevent abuses
                           by taxpayer on different tax accounting rules.
c. I.R.C. § 1091: Wash Sales
        i. Disallows a loss from a sale preceded or followed by the purchase
           of substantially identical securities within a 30-day period.
       ii. The basis of the stock purchased is the basis of the stock sold, plus
           any additional amount—losses are deferred rather than lost
           forever.
      iii. Limitations
               1. Applies only to losses—not to gains
               2. The securities must be "substantially identical"
d. Capital Losses
        i. I.R.C. § 165(f)
               1. Limits losses to those provided for in §§ 1211 & 1212
       ii. I.R.C. §§ 1211 & 1212
               1. Limits capital losses to the extent of capital gains plus $3,000.



                                                                               119
                    2. capital losses not allowed in current year may be carried
                        forward or backward indefinitely.
     e. "Straddles"
             i. Described
                    1. A straddle occurs when the taxpayer acquires offsetting
                        positions in related assets. The taxpayer sells the losing
                        assets and retains the gains—losses are accelerated and gains
                        are deferred.
            ii. I.R.C. § 1092
                    1. Limits the deduction of losses from straddles to the amount
                        by which losses exceed unrecognized gains on offsetting
                        assets.
           iii. I.R.C. § 1256: Mark-to-Market rules
                    1. Under this rule, contracts held by the taxpayer at the end of
                        the taxable year are treated as sold—gains and losses are
                        recognized.
V.   Tax Shelters
     a. Section 183 and Tax Shelters
             i. General
                    1. Courts have used the "not for profit" language of section 183
                        to prevent deductions for losses.
            ii. In Fox v. Commissioner the court stated that a primary profit motive
                was necessary to deduct a loss under § 165(c)(2), taking the position
                that, notwithstanding the fact that many situations in which
                transactions are motivated by tax laws, the court should determine
                whether the loss is one that Congress would have intended to allow
                as a deduction under § 165(c)
     b. I.R.C. § 465: At-Risk Rules
             i. I.R.C. § 465(a)
                    1. Prevents deduction for losses on an investment in which the
                        taxpayer did not have an amount at tirks.
            ii. A taxpayer is considered at risk only to extent of
                    1. investment of cash in the activity
                    2. adjusted basis of property contributed to the activity
                    3. debt on which the taxpayer is personally liable for
                        repayment
                    4. net fair market value of personal assets that secure
                        nonrecourse borrowings.
           iii. A taxpayer is not at risk when he is guaranteed reimbursement.
     c. I.R.C. § 469: Passive Loss Limitations
             i. Purpose




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                     1. Intended to prevent taxpayers from using losses derived
                         from tax shelter investments to reduce taxes on earned
                         income and on investment income.
             ii. General operation
                     1. Basket approach
                            a. Aggregate deductions from passive activity may be
                                used only to offset the income from these activities.
                     2. I.R.C. § 469(c): Definition of passive activities
                            a. Conduct of a trade or business in which the taxpayer
                                does not materially participate
                            b. Rental activities
                     3. "Material participation"
                            a. I.R.C. § 469(h):       material participation must be
                                regular, continuous and substantial.
                            b. Reg. § 1.469-5T: tests for determining whether
                                material participation exists
                                    i. See Graetz p. 406
                            c. "Significant participation activities"
                                    i. See Reg. § 1.469-1(f)(2)(i)(C)
                     4. Rental activities
                            a. See Reg. § 1.469-1(e)(3)
                     5. "Activity"
                            a. If activity is defined narrowly, it is difficult for a
                                taxpayer to show material participation. But a
                                narrow definition would also make it easy to dispose
                                of the activity and get a deduction for suspended
                                losses under § 469(g)
                            b. Activity is indemnified according to the facts and
                                circumstances
                     6. Coordination with § 465
                            a. Section 465 as threshold
                                    i. In general, whether a loss is subject to the
                                       passive loss limitations depends on whether
                                       the at-risk requirements under § 465 have been
                                       met
                     7. Capital gains
                            a. Passive loss and capital gains rules are applied
                                simultaneously
                            b. See Reg. § 1.469-1(d)
VI.   Bad Debts
      a. I.R.C. § 166
              i. I.R.C. § 166(a)



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                1. Allows a deduction for any debt that becomes worthless in
                    the taxable year.
        ii. I.R.C. § 166(b): Amount of loss
                1. The amount of the loss for a bad debt is the adjusted basis.
       iii. I.R.C. § 166(d): Nonbusiness debts
                1. Nonbusiness bad debts are treated as short-term capital
                    losses.
                        a. Capital losses can only be offset to the extent of
                            capital gains + $3,000.
       iv. §§ 165 and 166 are mutually exclusive. Spring City Foundry Co. v.
            Commissioner.
b.   The Dominant business motivation requirement
         i. See Graetz p. 411-412
c.   The Trade or Business of Lending
         i. In Estate of Bounds v. Commissioner the Court rejected the taxpayer's
            claim that his lending activities were sufficiently extensive and
            continuous to place him in the business of lending money because
                1. the activities did not occupy a substantial amount of time
                2. the activities were not advertised
                3. the taxpayer did not maintain a separate office or books and
                    records.
                4. the taxpayer did not describe himself as a lender on his tax
                    returns.
d.   Loans to family and friends
         i. See Reg. § 1.166-1(c)
                1. treats losses on debts to friends or family members as gifts.
e.   Validity of indebtedness
         i. Reg. § 1.166-1(c): A debtor-creditor relationship must exist base
            don a valid and enforceable obligation to pay a fixed or
            determinable sum of money.
        ii. No deduction is allowed for a debt that is worthless when acquired.
            Putnam v. Commisioner
f.   Loan Guarantees
         i. A taxpayer who sustains a loss from guaranteeing a loan is treated
            in the same manner as a taxpayer who sustains a loss from a loan
            that she made directly.
        ii. Payments on loan guarantees based on personal motivation are not
            deductible. Reg. § 1.166-9
g.   Political Contributions
         i. See I.R.C. § 271 (disallowing deductions for worthless debts owed
            by a political party)




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         h. Voluntary Cancellation
                i. A taxpayer who voluntarily cancels a debt is not entitled to a bad
                   debt reduction.
         i. Timing
                i. A taxpayer must determine when a debt becomes worthless.
               ii. § 6511(d) provides a seven year statute-of-limitations for refund
                   claims based on the deduction of bad debts.

Personal Deductions

   I.    The standard deduction
         a. Purpose
                i. Two rationales
                       1. The standard deduction is a substitute for itemized
                           deductions—it is a simplification measure.
                              a. When itemized deductions are designed to encourage
                                  specific behaviors, the simplification rationale of the
                                  standard deduction and the Congressional incentives
                                  policy come into conflict.
                       2. The standard deduction is an adjustment of the tax rate: the
                           standard deduction, combined with the personal
                           exemptions, creates the floor under which Congress has
                           determined that no income should be taxed.
         b. I.R.C. § 63: Taxable Income defined
                i. I.R.C. § 32(c): the standard deduction
                       1. Amounts
                              a. MFJ=$6,000
                              b. HOH=$4,400
                              c. Single, MFS=$3,000
                       2. Marriage "penalty"/bonus
                              a. The current tax code eliminates the marriage penalty
                                  until 2011
                              b. In fact, there is now a marriage bonus—the marriage
                                  standard deduction is twice the single deduction even
                                  if only one spouse is working.
                       3. Additional amounts for the deduction are allowed for the
                           aged and the blind.
                       4. Dependents
                              a. The standard deduction of an individual who can be
                                  claimed as a dependent is limited to the greater of:
                                       i. $500 (indexed for inflation)
                                      ii. $250 + Earned Income
         c. Filing status


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              i. Five possibilities
                     1. married filing jointly (MFJ)
                     2. married filing separately (MFS)
                     3. surviving spouse
                     4. head of household (HOH)
                     5. single
             ii. Filing MFJ is generally advantageous
II.   Personal Exemption and Child Credit
      a. I.R.C. § 151: Allowance of Deductions for Personal Exemptions
              i. General
                     1. This section allows a personal exemption of $2,000 (indexed
                         for inflation)
                     2. This exemption may taken for the taxpayer, an the
                         taxpayer's spouse and dependents
                     3. Despite the exemptions, these taxpayers must still pay the
                         Social Security Wage Tax of 15%
             ii. I.R.C. § 152: Dependents
                     1. Qualifying Child
                             a. Does not have to be a child
                             b. Four tests for qualification
                                      i. Relationship
                                            1. must be child or a descendant of the
                                                child, a brother, sister, stepbrother,
                                                stepsister or a descendant of such
                                                relative.
                                     ii. Age
                                            1. Must be 18 or under, unless student (23)
                                    iii. Personal place of abode
                                            1. Must have the same principal place of
                                                abode as the taxpayer for at least ½ the
                                                taxable year
                                    iv. Support
                                            1. The qualifying child must not provide
                                                over ½ of their own support.
                                            2. If more than half of child's support
                                                comes from government assistance, then
                                                this qualification will not be met.
                             c. Qualifying child as dependent of more than one
                                 taxpayer
                                      i. See § 152(c)(4)
                     2. Qualifying Relative
                             a. Three tests
                                      i. Relationship test


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                                    1. Somewhat broader than child test—
                                        includes a member of the household
                                        with the same principal place of abode
                                        for more than ½ the year
                             ii. Gross income test
                                    1. The qualifying relative must have
                                        income less than the exemption amount
                            iii. Support
                                    1. the qualifying relative must not provide
                                        over ½ of her own support.
               3. Dependents can not themselves have dependents
      iii. § 151(d): Phaseout for high-income taxpayers
               1. Threshold amounts
                     a. MFJ=$150,000
                     b. HOH=$125,000
                     c. Single=$100,000
                     d. MFS=$75,000
               2. For every $2,500 ($1,250 for MFS) over the threshold, the
                  exemption is decreased by 2%
               3. Phaseout range
                     a. $150,000 - $275,000
               4. Effects
                     a. Over this range, the marginal tax rate is increased by
                          1% (a "rate bubble")
                     b. Not indexing the numbers has the effect of shrinking
                          the phase-out range and of increasing the tax rate in
                          that range.
               5. The phase-out is itself phased out
                     a. See § 151(d)(3)(E)
               6. Purpose of the phase-out
                     a. If the purpose of the exemptions is to differentiate
                          based on family size, the rate bubble will be
                          counterproductive: families with large numbers of
                          dependents will have a higher marginal tax rate in the
                          phase-out range
                     b. But if the exemptions are simply a part of the "zero
                          bracket" then the phase-out does not hurt
                          progressivity—progressivity is measured by average,
                          and not marginal, tax rates.
      iv. § 151(e): Divorced parents
b. I.R.C. § 24: The Child Credit
        i. Allows for a partially refundable credit of $1,000 per child
           (unindexed)


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                       1. This reverts back to $500 in 2010
                       2. The child must be a qualifying child (see above) under the
                           age of 17
               ii. Phase-out
                       1. Threshold amount (MAGI)
                               a. MFJ=$110,000
                               b. Single=$75,000
                               c. MFS=$55,000
                       2. Mechanics
                               a. Reduced by $50 for every $1,000 over the threshold
              iii. Partial refund
                       1. The partial refund is essentially a refund of the taxpayer's
                           social security taxes
III.   I.R.C. § 32: The Earned Income Tax Credit
       a. Nature/purpose
                i. This is a fully refundable credit.
               ii. It was originally intended to reduce the burden of social security
                   taxes on the poor
              iii. Now, the EITC is seen as a negative income tax guaranteeing a
                   certain minimum standard of living.
       b. Eligibility
                i. Anyone with a qualifying child
               ii. Anyone without a qualifying child who
                       1. lives in the united states for more than ½ the year
                       2. is between the ages of 25-64
                       3. is not a dependent
       c. The Credit
                i. The credit is a percentage of earned income.
                       1. See § 32(b)(1)
               ii. The taxpayer receives a credit equal to the credit percentage of the
                   taxpayer's earned income that does not exceed a specified amount
                       1. The credit is phased out when the taxpayer reaches a certain
                           income—the phaseout percentage is also proscribed.
                       2. Note that the credit percentage range is a negative tax rate;
                           the phase-out rate is then the taxpayer's marginal tax rate in
                           the phase-out range
       d. § 32(c)(2): Earned Income
                i. Must be earned (wages, salary, etc) and not interest or dividends.
IV.    Personal Itemized Deductions
       a. I.R.C. § 68: Limitations on Itemized Deductions
                i. General
                               a. § 68 imposes a limitation on itemized deductions of
                                   the lesser of


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                              i. 3% of the AGI over $100,000(indexed)
                             ii. 80% of the amount of itemized deductions
                                 otherwise allowable.
      ii. Effects of 3% haircut
              1. Shuldiner: this is often described as a phase-out, but it's
                  really a surtax of 1%.
              2. When this is combined with the personal exemption phase-
                  outs, the marginal tax rate is increased by 5%
              3. On the margin, itemized deductions are still fully usable,
                  even when the 3% haircut applied—it simply means that
                  AGI is taxed at a higher rate (deductions are worth 35%,
                  additional AGI is taxed at 36%)
     iii. The 80% limitatoins
              1. The reduction in the itemized deductions cannot exceed 80%
                  of the deductions
              2. Effects
                      a. Empirically, very few people are affected by this.
                      b. For individuals who are affected, every $1 of itemized
                         deductions is only worth $0.20.
                      c. This is really a limitation on itemized deductions (as
                         opposed to simply a surtax on AGI).
     iv. Phaseout of limitations
              1. 2006 & 2007 reduced by 2/3
              2. 2008 & 2009reduced by another 1/3
              3. The 3% limitation ends in 2010
b. Limitations on Miscellaneous Itemized Deductions: Tax Consequences
c. Taxes
       i. I.R.C. § 164: Taxes
              1. § 164(a): General Rule
                      a. A taxpayer may deduct
                              i. State, local, and foreign real property taxes
                             ii. State and local personally property taxes
                            iii. State, local, foreign, income, war profits, and
                                 excess profits taxes
                            iv. Etc
                      b. The taxes are deductible regardless of whether they
                         were incurred in pursuit of a trade or business.
              2. Structural
                      a. The deduction for taxpayers is a below-the-line
                         deduction, but is not a miscellaneous itemized
                         deduction.
              3. State, local and foreign taxes on real property



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               a. § 164(c)(1): deduction allowed only for taxes imposed
                  on interests in real property—not for taxes assessed
                  against local benefits. See Graetz p. 424.
               b. Tenants may not deduct payments of property taxes
                  passed on to them by their landlords. Rev. Rule. 79-
                  180. This is the so-called "renters tax."
       4. State and Local Taxes on Personal Property
               a. Reg. § 1.164-3(c):        must meet three criteria for
                  deduction
                       i. Tax must be ad valorem or based on annual
                          value
                      ii. Tax must be imposed on annual basis
                     iii. Tax must be on personal property
       5. State, Local and Foreign Income, War Profits and Excess
           profits Taxes
               a. I.R.C. § 275
                       i. Prevents deductions for payroll taxes under
                          Social Security
                      ii. Employers can deduct their matching
                          contributions, but only if incurred in the course
                          of a trade or business
                              1. The self-employed may also deduct ½ of
                                  their social security taxes
       6. Capitalization requirement
               a. § 164(a): "any tax which is paid or accrued by the
                  taxpayer in connection with an acquisition or
                  disposition of property shall be treated as part of the
                  cost of the acquired property or, in the case of a
                  disposition, as a reduction in the amount realized on
                  the disposition."
               b. This does not apply to
                       i. State, local, and foreign real property taxes
                      ii. State and local personal property taxes
                     iii. State, local, foreign, income, war profits, and
                          excess profits taxes
       7. The AMT
               a. May prevent deductions for state and local real or
                  personal property taxes or income taxes.
       8. Tax refunds
               a. If the taxpayer later receives a refund for their state
                  and local taxes, they must include that refund in
                  income.
ii. Policy issues


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             1. See Graetz p. 426-427
d. Charitable Deductions
      i. Policy issues/Purpose
             1. Charity is itself a form of consumption
                    a. Under this view, there should be no deduction.
             2. Amounts given to charity will not be consumed by the
                taxpayer
                    a. Some have argued that this supports the deduction—
                       there is no consumption by the taxpayer.
             3. Efficiency
                    a. Does the charitable deduction actually encourage gift-
                       giving? It depends
                    b. See Graetz. P. 428
     ii. I.R.C § 170
             1. § 170(a): General Rule
                    a. There shall be allowed as a deduction any charitable
                       contribution payment made in the taxable year. The
                       contribution must be verified according to
                       regulations.
             2. § 170(c): Definition of Charitable contribution
                    a. A charitable deduction is a gift to
                            i. A state or government to help the public
                           ii. A corporation, trust, fund, or foundation
                               organized in the United States and operated
                               exclusively for religions, charitable, scientific,
                               literary, or educational purposes or to foster
                               national or international amateur sports
                               competition
                                   1. No part of the gift can guarantee the
                                       benefit of a particular individual
                                   2. Cannot be used for lobbying
                          iii. A post or organization for war veterans
                          iv. A domestic fraternal society but only if used
                               exclusively for religious, charitable, scientific,
                               literary or educational purposes
                           v. A cemetery owned and operated for the benefit
                               of its members
             3. § 170(b): Limitations
                    a. Individual limitations
                            i. Generally, deductions may not exceed 50% of
                               adjusted gross income
                           ii. Gifts of appreciated property are limited to
                               30% of adjusted gross income


                                                                             129
       4. § 170(d): Carryovers
               a. If contributions exceed the limitations in 170(b), they
                  may be carried over and deducted over the course of
                  the next five years. But the carryover in each year
                  must be the lesser of
                       i. 50% of AGI – charitable deductions
                      ii. OR
                              1. In the first year
                                      a. the amount of the excess
                              2. in years 2, 3, 4, 5
                                      a. the portion of the excess not
                                         otherwise treated as a charitable
                                         deduction
       5. § 170(f): Exceptions
               a. No deduction is allowed for
                       i. Gifts of a remainder interest in property
                      ii. Property transferred in trust unless certain
                          conditions are met. 170(f)(2)(B)
               b. No deduction if payment was intended to influence
                  legislation
               c. 170(f)(8): Substantiation
iii. When is a transfer to a charity a contribution?
       1. In Hernandez v. Commissioner (1989) the Court held that
          payments to the Church of Scientology for "auditing" and
          "training" were not deductible payments to a charity because
          the payment was made with the expectation of a quid pro
          quo., even if that quid pro quo is an intangible religious
          benefit.
               a. Impact of Hernandez
                       i. Congress added § 170(f)(8), stating that the
                          receipt of intangible religious benefits must be
                          substantiated.
       2. The Duberstein standard
               a. Many courts rely on the Duberstein test—"detached
                  and disinterested generosity"—in order to meet the
                  requirements of a charitable deduction
       3. Seats at college sporting events
               a. § 170(l) allows an 80% deduction when the
                  contribution makes the donor eligible to receive
                  athletic tickets.
       4. Gifts to schools/nursing homes
               a. Private religious schools
                       i. Rev. Rul. 83-104. See Graetz p. 437


                                                                      130
               b. Nursing homes
                      i. In Estate of Wardwell v. Commissioner (1962) the
                         court allowed a deduction for a charitable
                         contribution to a nursing home, even though
                         the taxpayer later received reduced rent,
                         because the gift, when made, was motivated by
                         generosity.
       5. Gifts earmarked for individuals
               a. In Davis v. United States the Court denied parents of
                  missionaries of the Church of Jesus Christ of Latter-
                  Day Saints a deduction for payments used to support
                  the missionary activities of their children.      They
                  payments were made directly to the children, though
                  supervised by the Church.
       6. Gifts of services
               a. A person may not deduct the value of services
                  rendered to a charitable institution, but they may
                  deduct out-of-pocket expenses incurred in connection
                  with donating services.
               b. Contributions of blood cannot be deducted.
       7. Substantiation
               a. 170(f)(8): Substantiation requirements
                      i. General rule
                             1. No deduction is allowed for a
                                contribution of $250 or more unless the
                                taxpayer substantiates the contribution
                                by     a    contemporaneous       written
                                acknowledgement of the contribution
                                by the donee organization.
                     ii. The organization must provide a good-faith
                         estimate of any goods or services provided to
                         the donor (so, for instance, a taxpayer doesn't
                         take a donation of $500 after winning a church
                         raffle that provides for a vacation worth
                         $1000).
iv. Gifts of appreciated property
       1. Generally, a taxpayer may deduct the full fair market value
           of appreciated property.
       2. I.R.C. § 170(e): limitations
               a. Application
                      i. Applies, generally, to all contributions of
                         property that would produce ordinary income
                         or short-term capital gain if sold.


                                                                     131
             ii. Also applies to contributions of property that
                 would produce long-term capital gain if the
                 property is given to a private foundation
            iii. Also applies to personal property given to a
                 charity, that is unrelated to the exempt
                 function of the charity (e.g., diamond necklace
                 to a library).
     b. Three considerations under § 170(e)
              i. Is the recipient a private foundation or a public
                 charity?
             ii. Would the appreciation be taxed as capital
                 gains or as ordinary income
            iii. Does the gift consist of tangible property or
                 securities?
            iv. RESULT
                     1. A contribution of any property other
                         than a marketable security, to a private
                         foundation, allows a deduction equal to
                         fair market value minus capital gains or
                         ordinary income (usually, this leaves
                         just basis).
                     2. A contribution of property to a public
                         charitable organization is generally fair
                         market value minus the amount of gain
                         that would not have been long-term
                         capital gain
                     3. If the property is tangible personal
                         property that will not be used by the
                         donee in its charitable function, the
                         deduction is the fair-market value
                         reduced by the full amount of
                         appreciation
3. Application of 170(e): an example
     a. Facts
              i. Ordinary Income Tax = 35%
             ii. Capital gains tax = 15%
            iii. Property basis = $2,000
            iv. Property fair market value = $10,000
     b. Gift to charity of proceeds from sale
              i. Gain of $8,000 taxed at 15% = $1,200.
             ii. A cash deduction is worth $3,500
            iii. So the net benefit to the taxpayer is $2,300
     c. Gift to charity of property


                                                              132
                             i. A deduction worth $3,500.
                            ii. No tax paid on appreciation.
                    d. The taxpayer would thus prefer to give the property
                        outright.
                    e. BUT, when 170(e) applies:
                             i. § 170(e) reduces the deduction by the amount
                                that taxable income would be increased if the
                                gain were taxable.
                            ii. Gain is not recognized, but the charitable
                                deduction is limited to $2,000 (basis).
                           iii. If appreciated property is taxed at a
                                preferential rate, then, the taxpayer would
                                prefer to sell the property first and then give
                                the proceeds (because net benefit would be
                                $2,300).
e. Medical Expenses
      i. Policy issues: treatment of medical care, generally
             1. Contradictions
                    a. § 104 allows an exclusion from income of all medical
                        costs, without limitation
                    b. self-employed individuals can deduction the cost of
                        health insurance and medical care. (with limitations)
     ii. Structural Context
             1. a deduction under § 213 is a below-the-line deduction (but is
                 not a miscellaneous itemized deduction)
    iii. I.R.C. § 213
             1. 213(a): General allowance of deduction
                    a. A deduction is allowed for expenses paid during the
                        taxable year that are not compensated for by
                        insurance or otherwise.
                    b. The expenses must exceed 7.5% of AGI
             2. 213(b): limitations on medicine and drugs
                    a. only "prescribed drugs" or insulin are deductible.
                    b. Medical supplies that are not medicine or drugs (e.g.,
                        crutches, bandages, blood sugar tests) are deductible.
                        Rev. Rul. 2003-58
                    c. Birth Control
                             i. Birth control pills prescribed by a physician are
                                deductible. Rev. Rul. 73-200
                            ii. The costs of a vasectomy or lawful abortion are
                                deductible. Rev. Rul. 73-201.
             3. 213(d): Definitions
                    a. Cosmetic Care


                                                                             133
                      i. Cosmetic surgery is NOT deductible as
                         medical care.
                     ii. Cosmetic surgery does not include a procedure
                         to fix a congenital abnormality or a disfiguring
                         disease.
        4. Therapy
               a. See Graetz p. 451
        5. Medical Expenses v. Nondeductible personal expenses
            under § 262
               a. Rev Rul. 87-106
                        i. "[E]xpenditures for medical care allowable
                           under section 213 of the code will be confined
                           strictly to expenses incurred primarily for the
                           prevention nor alleviation of a physical or
                           mental defect or illness. An expenditure that is
                           merely beneficial to the general health of the
                           individual is not an expenditure for medical
                           care."
                       ii. "In making a capital expenditure that would
                           otherwise qualify as being for medical care,
                           any additional expenditure that is attributable
                           to personal motivation does not have medical
                           care as its primary purpose and is not related
                           directly to medical care for purposes of section
                           213 of the Code."
        6. 213(d)(1)(B): transportation
               a. Medical care includes transportation primarily for
                  and essential to medical care.
               b. Costs for care in an institution other than a hospital
                  depends on the services provided.
iv. I.R.C. § 223: Health Savings Accounts
        1. Structural Context
               a. A deduction under § 223 is an above-the-line
                  deduction.
        2. General
               a. An eligible taxpayer may claim a deduction from
                  gross income in computing AGI for the amount he or
                  she contributes to an HAS, but the total contribution
                  cannot exceed
                        i. $2, 250 for individuals
                       ii. $4,500 for families
        3. Eligibility



                                                                       134
                               a. The taxpayer must be covered under a "high-
                                  deductible" health plan, defined in 223(c)
                               b. The account must be established with a bank or
                                  approved institution
                                      i. Funds can only be used for the payment of
                                         qualified medical expenses
                                     ii. Account must be noforfeitable
                               c. Qualified medical expenses
                                      i. Defined in 213(d)
                         4. Tax advantages
                               a. Distributions from a HSA to pay for qualified medical
                                  expenses are excluded from gross income. § 223(f)(1)
                               b. Investment income on a HSA is not taxed. § 223(e)(1)
                         5. Coordination with § 213
                               a. Amounts paid or distributed from an HSA may not
                                  generate an itemized deduction under 213.

WHOSE INCOME?

Taxation of the Family

   I.    General
         a. Assignment of income
                 i. The tax code seeks to prevent the shifting of income from high-
                     bracket taxpayers to low-bracket taxpayers.
                ii. This helps to preserve the integrity of a progressive rate structure.
   II.   I.R.C. § 1: Taxable Units
         a. Generally
                 i. Taxable units
                        1. Married Individuals filing joint returns
                        2. Heads of Household
                        3. Unmarried Individuals
                        4. Married Individuals filing separate returns
                        5. Estates and Trusts
         b. § 1(b) & (c): Single Individuals
                 i. Single persons file a tax return, reporting their own taxable income.
         c. § 1(a), (d) & (f): Couples
                 i. § 7703: Marital Status
                        1. Determination of whether someone is married is made at the
                            end of the taxable year
                        2. an individual legally separated under a decree of divorce or
                            separate maintenance is not considered married.
                ii. § 6013: Joint Returns


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        1. No joint return allowed if
               a. Either husband or wife is a nonresident alien
               b. If the husband and wife have different taxable years
        2. Joint return may be made by surviving spouse.
iii. The Marriage Penalty
        1. Defined
               a. When a couple in which each spouse earns equal
                   amounts of income decide to get married, they pay
                   more in taxes than they would if they were still single
               b. This is because they often move into a higher tax
                   bracket
        2. Severity/Scope
               a. The marriage penalty is exacerbated by low income
                   taxpayers eligible for the earned income credit.
               b. The phase-out of dependency exemptions and the
                   reduction of itemized deductions are also marriage
                   penalties
               c. Marriage bonus
                        i. There is sometimes a marriage bonus if one
                           spouse makes substantially more than the
                           other.
        3. Efforts to eliminate marriage penalty
               a. Option 1: permit married couples to file separate
                   returns using the single rate schedules
                        i. This would create differences between married
                           couples based on their relative earnings and
                           whether they lives in a community property
                           state
               b. Option 2: Make the rate brackets for married filing
                   jointly twice as big for married couples as for singles
                        i. This would create a penalty for staying single
                           because two unmarried persons would pay
                           more than a married couple
               c. Option 3: a two-earner deduction
                        i. This was done in 1981, but repealed in 1986.
               d. The 2001 Marriage Penalty Relief Provisions
                        i. Increased the standard deduction for married
                           couples
                       ii. § 1(f)(8): Increased the size of the 15% bracket
                      iii. The earned income tax credit phase-out for
                           married couples was increased.
iv. Why are married couples treated differently?
        1. Gratz p. 462


                                                                       136
III.   Children
       a. I.R.C. § 73: Services of Child
               i. Under current law, a child is considered a separate taxpayer and
                  the child's earned income is NOT aggregated with the rest of the
                  family even if it is pooled to pay household expenses.
       b. Calculation if income tax liability
               i. Compute, generally, just as the adults would be.
                      1. the child is entitled to personal exemption and standard
                          deduction
              ii. The standard deduction for the child cannot exceed the child's
                  earned income if the child can be claimed as a dependent.
       c. The "Kiddie Tax"
               i. Purpose
                      1. This provision is designed to prevent high-income parents
                          or grandparents from shifting income-producing assets to
                          their lower-bracket children
              ii. I.R.C. § 1(g): Unearned Income of Child as parent's income
                      1. Tax
                             a. Net unearned income of those covered by the tax is
                                  taxed at the parent's top marginal rate, regardless of
                                  the source of the income.
                      2. Applicability
                             a. Applies to children under the age of 19
                             b. Applies to children ages 18 -24 who are full-time
                                  students.
                             c. For those 18 or over, the kiddie tax applies only to
                                  those who unearned income does not exceed one-half
                                  of the amount of their support.
                      3. Net Unearned Income
                             a. Adjusted Gross Income (minus unearned income as
                                  defined in § 911) – (standard deduction + the greater
                                  of [standard deduction or itemized deduction directly
                                  related to the production of earned income])
                                       i. This means that a minimum of $1000 (indexed)
                                          is not subject to the kiddie tax—it would be
                                          taxed at the child's marginal tax rate.
                      4. Election under § 1(g)(7)
                             a. Parents may elect to report the gross income of a child
                                  in excess of $1,000 on their own return.
                                       i. The first $500 of unearned income is still not
                                          taxed.
                                      ii. The next $500 is taxed at 10%



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                               iii. Any excess is charged at the parent's marginal
                                    rate
                          b. The election is permitted where the child has income
                             between $500 and $5,000.
IV.   Divorce
      a. Sham Divorces : rev. Rul. 76-255
             i. The IRS's position is that a divorce simply for the sake of avoiding
                income tax is a sham and is not recognized.
            ii. The service looked at all the facts and circumstances to determine if
                the divorce was simply designed to manipulate an individual's
                marital status for income tax purposes.
      b. Alimony and Support
             i. Structural Context
                    1. Alimony payments are above-the-line deductions.               §
                        62(a)(10)
            ii. I.R.C. § 71: Alimony and Maintenance Payments
                    1. 71(a): General rule
                           a. Gross income includes amounts received as alimony
                               or separate maintenance payments
                    2. 71(b): definitions of Alimony and Separate Maintenance
                        payments
                           a. Payment is alimony when:
                                    i. The payments are in cash
                                   ii. The parties do not earmark payments as
                                       nondeductible to the payor and nontaxable to
                                       the payee
                                  iii. The parties do not live in the same if they are
                                       already legally divorced or separated
                                  iv. There is no liability any payment after the
                                       death of the payee
                                   v. The payments do not constitute child support
                    3. § 71(f): Re-Computation
                           a. Purpose
                                    i. This provision limits the taxpayers' ability to
                                       structure a property settlement to qualify as
                                       alimony.
                                   ii. It also prevents a payor from "front-loading"
                                       alimony deductions as a way to defer income.
                           b. General
                                    i. Excess alimony payments must be included in
                                       the payor's gross income in the third post-
                                       separation year, with the recipient getting an
                                       off-setting deduction


                                                                                  138
                               c. Excess alimony after second year
                                      i. Second year payments/ [third year playments
                                          + $15,000]
              iii. I.R.C. § 215: Deduction for Alimony
                       1. Payments that are excludable by the alimony recipient under
                           § 71 are deductible by the payor under § 215.
              iv. Child support
                       1. Child support is nondeductible to the payor and nontaxable
                           to the payee.
               v. I.R.C. § 1041: Property Settlements
                       1. 1041(a): general rule
                               a. No gain or loss is recognized on a transfer of property
                                  from an individual to a spouse or a former spouse, if
                                  the latter transfer is incident to a divorce
                       2. 1041(b): The recipient takes a carryover basis in the property
                           equal to the adjusted basis of the transferor.
                               a. In effect, the transfer is treated like a gift.
                               b. BUT, unlike gifts in 1015, one spouse can transfer a
                                  loss to another spouse.
                       3. 1041(c): When is it incident to divorce?
                               a. When the transfer occurs within one year after the
                                  date on which the marriage ceases
                               b. Or is related to the cessation of the marriage

Assignment of Income

  I.    Income from Services
        a. General
               i. Earned income is taxable to the person who earns it
              ii. In Lucas v. Earl the court held that the salary and attorney's fees
                  earned by a taxpayer were taxable to him despite the existence of a
                  contract in which he pledged his salary to his wife as a joint tenant.
                     1. "There is no doubt that the statute could tax salaries to those
                         who earned them and provide that the tax could not be
                         escaped by anticipatory arrangements and contracts
                         however skillfully devised to prevent the salary when paid
                         from vesting even for a second in the man who earned it."
             iii. In Armantrout v. Commissioner the court held that money paid by an
                  employer into a trust fund for the children of key employees was
                  taxable to the employee and not the children.
        b. "Unique Factual Situations
               i. Rev. Rul. 74-581



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                       1. Dominant purpose of the revenue laws is the taxation of
                          income to those who earn or otherwise create the right to
                          receive it and enjoy the benefit of it when paid.
                       2. A taxpayer's anticipatory assignment of a right to income
                          derived from the ownership of property will not be effective
                          to redirect that income to the assignee for tax purposes."
                       3. But in some unique factual situations this rule is not
                          followed
                              a. Amounts received for services performed by a faculty
                                 member at a law-school clinic that are turned over to
                                 the University.
               ii. The "Agency Theory"
                       1. In assignment cases, the service looks at whether the person
                          earning the income is really just an agent of the institution to
                          which he turns over the income
   II.   Income from Property
         a. General
                i. Income from property is taxable to the owner of the property
               ii. In Helvering v. Horst the Court held that interest coupons detached
                   from a bond were taxable to the bond-holder rather than to the
                   assignees.
                       1. "The power to dispose of income is the equivalent of
                          ownership of it."
                       2. This has been overruled by § 1286
         b. Income interest in a trust
                i. In Irwin v. Gavit the Court held that the beneficiary of an income
                   interest in a trust could not exclude the gift under § 102. One
                   implication of the decision is that § 102 applies only to the
                   remainderman of a trust.

CAPITAL GAINS AND LOSSES

Capital Gains

   I.    Mechanics
         a. Casebook Approach
                i. Step One: Is this a realization event?
               ii. Step Two: Calculate gain
                      1. I.R.C. § 1001(a)
                             a. Amount Realized = Adjusted Basis = Gain
              iii. Step Three: Determine whether the gain or loss is recognized
              iv. Step Four: Determine the Character of the Gain or Loss
         b. Mechanics of Capital Gains and Losses


                                                                                      140
                i. Step One: Determine whether assets are "short term" or 'long term
                       1. § 1222(1): short term capital gain = < 1 year
                       2. § 1222(3): long term capital gain = > 1 year
               ii. Step Two: Net short-term gains against short-term losses
                       1. § 1222(5) & (6)
                              a. If short terms gains > short term losses then short
                                  term gain
              iii. Step Three: Net short-term gain or loss against long-term gain or
                   loss
                       1. § 1222(11): Net Capital Gain
                              a. Net Capital Gain = net long-term capital gain – net
                                  short-term taxable gain
                              b. This is taxed at the preferential capital gains rate. §
                                  1(h)(1)
                       2. If the net short term taxable gain > net long-term capital loss,
                          then the excess short-term gain is taxable in full as ordinary
                          income.
                       3. When the taxpayer has both a net short-term gain
              iv. Step Four: Loss limitations
                       1. I.R.C. § 1211: Limitation on Capital Loss
                              a. Where the losses exceed the gains, the excess capital
                                  loss offsets up to $3,000 of ordinary income.
                              b. Excess losses ma be carried forward indefinitely
       c. Examples:
                i. See Graetz p. 531-32
II.    Policy of Preferential Treatment
       a. See Graetz p. 533 – 38
III.   I.R.C. § 1221: Definition of Capital Asset
       a. I.R.C. § 1221
                i. § 1221(a): General
                       1. A very broad definition of capital asset, with exceptions. A
                          capital asset is property held by the taxpayer (whether or not
                          connected with his trade or business) EXCEPT
               ii. § 1221(a): Exceptions
                       1. The stock in trade or inventory of a business that is held
                          primarily for sale to customers in the ordinary course of a
                          trade or business
                       2. depreciable or real property held by its creator
                              a. See I.R.C. § 1231 (characterizing net gain on sales of
                                  depreciable or real property used in a business as
                                  capital gain and net losses on sales of such assets as
                                  ordinary losses).
                              b. See also I.R.C. § 1245 (recapturing depreciation)


                                                                                      141
             3. literary or artistic property held by its creator
             4. accounts or notes receivable in the ordinary course of the
                  taxpayer's trade or business
             5. U.S. government publications received from the government
                  at a price less than that which the general public is charged
             6. commodities derivative financial instruments held by
                  commodities derivative dealers
             7. identified hedging transactions under rules provided in
                  regulations
             8. supplies regularly consumed in the ordinary course of the
                  trade or business.
b. Exception: assets "held by the taxpayer primarily for sale in the ordinary
   course of his trade or business."
       i. In Malat v. Riddel (1966) the court defined "primarily" as "of first
          importance" or "principal" rather than simply substantial.
             1. Rationale: The word primarily is intended to differentiate
                  between profits and losses on an everyday bases and the
                  realization of appreciation in value accrued over along
                  period of time.
             2. Impact
                      a. Many courts get around Malat by saying that the
                          appropriate time to look for motive is just before the
                          sale which will be, by definition, when the taxpayer is
                          primarily interested in the sale.
      ii. Three important issues
             1. Whether the nature of the taxpayer's dealings in property
                  classify the taxpayer as a dealer who is holding the property
                  primarily for sale to customers in the ordinary course of
                  business
             2. the tax treatment when a taxpayer initially acquires property
                  as an investment, but later becomes a dealer
             3. Dual purpose cases: the taxpayer acquires property as both
                  an investment and to sell to customers.
                      a. In Bramblett v. Commissioner (5th cir. 1992) the Court
                          concluded that property acquired by a partnership,
                          sold to a corporation owned by the partnership's
                          members, and then sold by the corporation, was held
                          for investment and subject to the capital gains rate
                               i. The court emphasized the frequency of
                                  transactions (but this is not sufficient)
                              ii. Applies a seven-factor test
                                     1. See Graetz p. 547



                                                                             142
               b. Other principles used in dual-property cases (some of
                  these are in the seven-factor test)
                      i. In Adam v. Commissioner (1973) the Tax court
                         emphasized the passivity of the seller
                     ii. In Adam v. Commissioner (1973) the court also
                         noted that the activity at issue produced a
                         relatively small amount of the taxpayer's
                         income
                    iii. In Biehnharn Realty Co., Inc. v. United States
                         (1976) the Court suggested that taxpayers are
                         more likely to receive capital gains treatment if
                         they make a bulk sale, rather than a sales at
                         different times.
iii. Securities
        1. Dealer
                a. A dealer is a person who purchases the securities and
                   commodities with the expectation of realizing a profit
                   because they hope that customers will buy above cost.
                b. Dealers have customers for the purpose of § 1221
                   (and therefore cannot get capital gains treatment).
                       i. See § 1236(a) ("Gain by a dealer in securities
                          from the sale or exchange of any security shall
                          in not event be considered as gain from the sale
                          or exchange of a capital asset. . . ")
        2. Traders
                a. Traders are sellers of securities or commodities who
                   depend upon such circumstances as a rise in value or
                   an advantageous purchase to enable them to sell at a
                   price in excess of cost."
                b. Trader is in a trader or business if the trading is
                   frequent and substantial.
                c. Traders do not have customers—get capital gains.
        3. Investor
                a. Similar to a trader, but makes purchases usually
                   without regard to short-term developments that
                   would influence prices on the market.
                b. They have capital gains
        4. Election under § 1236
                a. § 1236(a)(1): gain by a dealer may be characterized as
                   capital gain if the dealer clearly identifies the security
                   as acquired for investment before the close of the day
                   it was acquired.
        5. Other solutions to the mixed-motive problem


                                                                         143
                            a. I.R.C. § 475(a)
                                     i. Puts dealers on a mark-to-market rule so that
                                        they cannot simply sell losses and hold onto
                                        gains for tax deferrals
                                    ii. Dealers can still "opt out" of this regime. §
                                        475(b)
                                   iii. Traders may "opt in" § 475(f)
IV.   Depreciable Property and Recapture
      a. I.R.C. § 1231(a): Property Used in the Trade or Business and Involuntary
         Conversions
              i. Effect
                    1. This is an extraordinary pro-taxpayer provision that allows
                        the taxpayer to get capital gains when property is disposed
                        for a gain and ordinary losses when disposed at a loss.
             ii. Applicability
                    1. Only applies to long-term assets (must have been held for at
                        least one year). § 1231(b)
                    2. Does not apply to
                            a. Property properly included in inventory
                            b. Property held by the taxpayer primarily for sale to
                               customers in the ordinary course of trade or business
                            c. A copyright, musical, or artistic composition, a latter
                               or memorandum
                            d. Government publications
                    3. BUT DOES apply to
                            a. Certain livestock, timber, coal, minerals, etc. See §
                               1231(b)(2) – (4)
                    4. § 1231 transactions: the section applies to
                            a. gains or losses from sales and exchanges of property
                               used in a trade or business
                            b. gains or loses arising from condemnations and
                               involuntary conversions or property used in a trade
                               or business
                            c. gains or losses from condemnations and involuntary
                               conversions of capital assets held in connection with a
                               trade, business or profit-seeking activity.
            iii. Mechanics of § 1231
                    1. Step One: The "Firepot"
                            a. Net the gains from casualty and theft losses
                                     i. Casualty and theft gains – losses from
                                        involuntary conversions.
                            b. If losses > gains



                                                                                  144
                           i. § 1231 DOES NOT APPLY and the losses are
                              ordinary income
                   c. If gains > losses
                           i. Both gains and losses are carried over into the
                              "Hotchpot"
             2. Step Two: The "Hotchpot"
                   a. Compare
                           i. total gains with
                                  1. total     losses    from    involuntary
                                     conversions
                                  2. And condemnation sales and exchanges
                                     of business property
                   b. If losses > gains
                           i. Gains includible and ordinary income and
                              losses deductible from ordinary income.
                   c. If gains > losses
                           i. Gains are long-term capital gains and losses
                              are long-term capital losses.
                          ii. These are then transferred to the tax return to
                              be combined with other long-term capital gains
                              and losses from other sources.
b. Recapture
       i. General Purpose
              1. When the taxpayer realizes a gain on depreciable property,
                  he has been permitted to take depreciation exceeding the
                  economic cost of holding the asset.
              2. If the taxpayer could enjoy the depreciation deductions
                  AND capital gains treatment under § 1231, he would be able
                  to convert ordinary income into capital gain.
      ii. I.R.C. § 1245
              1. Mechanics
                      a. If depreciable property is sold for more than its
                         adjusted basis, any gain not exceeding the total
                         depreciation allowed is taxed as ordinary income
                      b. Three steps
                             i. Is the transaction a sale? If so, compute
                                amount realized (§ 1001). If it is not a sale,
                                determine the fair market value of the property
                                transferred
                            ii. Determine "recomputed" basis (adjusted basis
                                of the transferred property + cumulative
                                depreciation)



                                                                           145
                                 iii. Subtract the lower of the amount in the above
                                      steps from adjusted basis.
                                 iv. The remaining amount is "recaptured"
                                      ordinary income.
                           c. Example
                                   i. Facts
                                          1. you buy for $100,000
                                          2. Depreciation of $15,000
                                          3. Adjusted Basis of $85,000
                                  ii. § 1245 applied
                                          1. You sell the property for $70,000 (loss)
                                                 a. § 1221(a)(2): ordinary loss
                                                 b. § 1231: ordinary loss
                                          2. You sell the property for $90,000
                                                 a. § 1221(a)(2): ordinary loss
                                                 b. § 1231: capital gain
                                                          i. BUT     §     1245    would
                                                             recapture as ordinary gain
                                          3. You sell the property for $105,000
                                                 a. § 1221(a)(2): ordinary gain
                                                 b. § 1231: capital gain
                                                 c. BUT § 1245
                                                          i. The first $15,000 of gain is
                                                             ordinary income (because
                                                             recaptured depreciation)
                                                         ii. The rest is capital gains
          iii. I.R.C. § 1250: Recapture rule for real property
                   1. General
                           a. Rule 1250 recaptures the excess of accelerated
                              appreciated over straight line appreciation on certain
                              real-estate.
                   2. BUT, because real property is already depreciated on a
                       straight-line basis, there is no § 1250 recapture
                           a. I.R.C. § 1(h) taxes un-recaptured § 1250 gain at a rate
                              of 25%
V.   Derivates, Hedging and Supplies
     a. What is a hedge?
            i. A hedge is used to offset risk. They can be speculated upon by
               investors and might be subject to capital gains
     b. Corn Products and Arkansas Best
            i. In Corn Products Refining Co. v. Commissioner (1955) the Court
               considered the tax treatment of corn futures used by Corn Products
               Refining to stabilize its inventory and guarantee a certain amount


                                                                                     146
                   of corn. The Court held that the futures contracts were non-capital
                   assets because they were an integral part of the profits and losses
                   generated by the business.
                       1. Note that this IRS "victory" allowed taxpayers to take
                           ordinary losses—offsetting ordinary income—that should
                           probably have been considered capital losses.
               ii. In Arkansas Best Corp v. Commissioner (1988) the Court limited Corn
                   Products. The court considered a transaction in which Arkansas Best
                   purchased stock in a bank. Some of the stock was for investment
                   purposes, some—the taxpayer asserted—was to bail the bank out
                   and protect its business reputation. The court rejected the
                   taxpayer's argument that the loss should be ordinary because it was
                   connected with their trade or business, instead emphasizing the
                   language of the statute (WHETHER OR NOT connected with a
                   trade or business) to conclude that the sock was a capital asset.
                       1. This has since been adopted by the IRS through regulations.
                       2. The Court does not completely overrule Corn Products;
                           instead, it sees the case as a broad reading of the inventory
                           exception.
         c. Post-Arkansas Best Developments
                i. I.R.C. § 1221(a)(7)
                       1. Hedging transactions clearly identified as such are not
                           capital assets
               ii. I.R.C. § 1221(a)(8)
                       1. Supplies of a type regularly used or consumed by the
                           taxpayer in the ordinary course of business are not capital
              iii. IRS Regs
                       1. Hedges of ordinary items are ordinary income under the
                           accounting rules. Reg. § 1.446-4. If you are hedging
                           inventory, it becomes part of the inventory accounting.
                       2. Reg. § 1221-2(b): definition of "hedging transaction"
                       3.

Nonrecognition transactions

   I.    Non-recognition, generally
         a. Congress has provided that certain transactions that would otherwise be
            realization events are not to be recognized for determining gain or loss.
         b. You usually see these provisions when
                 i. There is a continuity of investment
                ii. There is a hardship
               iii. The provision is intended to help stop tax avoidance



                                                                                    147
II.   I.R.C. §§ 1031 & 1033: Like-Kind Exchanges
      a. I.R.C. § 1031
               i. 1031(a)(1): General
                     1. Under this section, not gain or loss is recognized when
                         certain property held for productive use or for investment is
                         exchanged for property "of a like kind"
              ii. 1031(a)(2): Exceptions
             iii. Basis
                     1. General
                             a. When like-kind property of equal value are
                                exchanged in a non-recognition transaction, the basis
                                of the property given up becomes the basis of the
                                property received. § 1031(d)
                     2. Basis with "boot"
                             a. The taxpayer recognizes gain, but not loss, on the
                                transaction to the extent of any boot received. §
                                1031(b) & (c).
                             b. The transferred basis in the new property is decreased
                                by any money received and increased by any gain
                                recognized. § 1031(d)
                                    i. Examples
                                           1. see handout
                     3. Basis with mortgage
                             a. When a mortgage is assumed, or the property is taken
                                subject to the mortgage, the outstanding mortgage is
                                treated as cash received and is recognized as boot to
                                the extent it exceeds any mortgage the seller must
                                assume or to which the property he receives is
                                subject.
                             b. Shuldiner's notes
                                    i. Key principles: mortgage assume by other
                                       party
                                           1. A liability assumed is treated as
                                               additional amount realized for gain
                                               realization computation
                                           2. A liability assumed is treated as boot for
                                               gain recognition
                                           3. A liability assumed is treated as cash
                                               received for basis computation
                                   ii. Exceptions:
                                           1. a liability is not treated as boot to the
                                               extent that cash is also part of the
                                               exchange


                                                                                    148
                                 2. a liability is not treated as boot to the
                                    extent that you assume liability
                         iii. Key principle: liability assumed by taxpayer
                                 1. a liability assumed by the taxpayer is
                                    treated as additional cash paid for
                                    blackacre—simply added to the basis
                                    (Tufts)
iv.    What is 'like kind"?
          1. Like kind refers to the nature of the property exchanged
             rather than its grade or quality
          2. § 1031(e) has been used to infer that Congress intended "like
             kind" to have a narrower definition with respect to personal
             property (versus real property).
 v.    Multiparty Transactions
          1. The courts often focus on whether the parties intended to
             enter into a like-party exchange and whether the several
             steps in the transaction were part of a single integrated plan.
          2. Intent is important, but not dispositive
                  a. A transaction that is structured as an exchange may
                      be re-characterized as a sale if the taxpayer receives
                      not the property itself but cash that he uses to
                      purchase the property.
                  b. A taxpayer who purchases property for a like-kind
                      exchange has no gain or loss, but if there is a delay,
                      and the property appreciates, it may no longer be
                      possible to use § 1031 because at that point the
                      property is no longer being used for a business or
                      investment.
vi.    Delayed exchanges and options to receive cash
          1. What if the seller locates a buyer before finding a
             replacement property?
                  a. In Starker v. United States, the court held that a
                      taxpayer that transferred its interest in timber acreage
                      in exchange for a corporation's promise to transfer
                      suitable property within give years or pay the
                      outstanding balance in cash was eligible for § 1031
                      treatment when the property was finally delivered.
vii.   "Productive Use in a trade or Business or Investment"
          1. Investment property may be exchanged for property to be
             used in a trade or business (and vice-versa). Reg. §
             1.1031(a)-1(a).
          2. For how long after the exchange must the property be used
             for trade, business or investment?


                                                                          149
                      a. See Wagensen v. Commissioner (Graetz p. 629)
    viii. Loss transactions
              1. Where like-kind property is exchanged, § 1031 is
                  mandatory—not elective
              2. If a party wants to avoid § 1031 (to recognize a loss or to
                  obtain a fair market value basis for depreciation of the
                  property received) § 1031 can be avoided by structuring a
                  transaction as a sale and reinvestment, rather than as an
                  exchange.
     ix. Sale-Leasebacks
              1. A exchange of a fee interest in a leasehold of 30 years or
                  longer is treated as a nonrecognition exchange. Reg. §
                  1.1031(a)-1
              2. See Graetz p.630
      x. § 1031(f): Sales to Related Parties
              1. Where a taxpayer exchanges like-kind property with a
                  related party and either party disposes of the property
                  within two years, the gain on the original transfer is
                  recognized on the date of the disposition.
b. Involuntary Conversions
       i. I.R.C. § 1033
              1. General
                      a. This section permits nonrecognition of gain from
                         involuntary conversions, such as condemnation or
                         casualty.
              2. Mechanics
                      a. If property is involuntarily converted, the taxpayer
                         will not recognize gain or loss if the taxpayer uses the
                         proceeds to acquire "property similar or related in
                         service or use to the property so converted." §
                         1031(a)(1).
                             i. The nonrecognition extends only to the
                                amount realized upon conversion that does not
                                exceed the cost of the other property.
                      b. The taxpayer must acquire the property by the end of
                         the second year following the involuntary conversion.
                             i. This time limit is extended to three years for
                                condemnations or real property used for
                                business or investment.
                      c. The section is elective, if the taxpayer has received
                         money rather than property in exchange for the
                         converted property (e.g., insurance proceeds).
              3. What property has been converted?


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                             a. Rev. Rul. 59-361: The "one economic property unit"
                                standard
                                     i. "Where all the facts and circumstances show a
                                        substantial economic relationship between the
                                        condemned property and the other property
                                        sold by the taxpayer so that together they
                                        constitute one economic property unit. . .
                                        involuntary conversion treatment for the
                                        proceeds of the voluntary sale will be
                                        permitted.
                     4. When are conversions economically involuntary?
                             a. Rev. Rul. 80-175
                                     i. The event is one specified by the statute
                                    ii. The event rendered the property unfit or
                                        impractical for its intended use.
                                   iii. The property was sold and the proceeds
                                        invested in similar property.
                             b. Generally, if an event constitutes a casualty under §
                                165(c), it constitutes an involuntary conversion, but
                                the events covered by § 1033 are somewhat broader.
                     5. "Replacement" property
                             a. The "Similar Use" test
                                     i. Several courts have looked not at the two
                                        properties themselves, but at the use to which
                                        the properties were put by the taxpayer.
                                    ii. The test is whether "the taxpayer has achieved
                                        a sufficient continuity of investment to justify
                                        the nonrecognition of the gain or whether the
                                        differences in the relationship of the taxpayer
                                        to the two investments are such as to compel
                                        the conclusion that he has taken advantage of
                                        the condemnation to alter the nature of his
                                        investment for his own purposes."
III.   Sales of Principle Residences
       a. Section 121
               i. Allows the taxpayer to exclude $250,000 of gain from the sale of her
                  principal residence provided it had been used by the taxpayer as
                  such for two of the previous five years.




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