Federal Income Tax
I. Computing Tax Liability
A. First, figure Gross Income - § 61 - All income from whatever source derived.
B. Next take allowable expenses (ie. trade or business expenses) from Gross Income in
order to compute Adjusted Gross Income - § 62; (individuals can take personal and
dependency deductions - § 151; indivduals can either take the standard deduction or
C. Next take either itemized deductions or standard deduction in order to get Taxable
Income - § 63
D. Finally, apply the taxable income to the tax tables in order to find tax; at this point,
you may subtract any allowed Credits in order to figure Tax Liability
II. What Is Income?
Keep in mind that problems of efficiency, equity, and complexity arise in the income tax
Equity issues deal with fairness of tax among different tax-payers
horizontal equity - A & B have similar incomes but different tax liability
vertical equity - A & B have different abilities to pay
Efficiency issues deal with the effect taxation has on economic reality. In a tax free
world, would transactions be carried out in the same way as they are with taxation?
Complexity deals with adminstrative costs and theoretical distinctions
A. Compensation for Services
1. Definition of Income
a. “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 the end of the
period in question.” (Haig-Simons Definition p. 107)
b. “All accessions to wealth, clearly realized, and over which the
taxpayers have complete dominion.” Glenshaw Glass (commenting on
Congress’ intent in § 61 to include broadly income from whatever source
2. Form of Receipt
a. Old Colony Trust Co. v. Commissioner (U.S. 1929) p. 109
Employer agreed to pay $600,000 income tax on company president’s
$1 million salary. Question of whether the payment of taxes constituted
further income arose. Court found that “[t]he payment of the tax by the
employers was in consideration of the services redered by the employee,
and was a gain derived by the employee from his labor. The form of the
payment is expressly declared to make no difference.” The discharge of
obligations by a third person is a receipt.
B. Fringe Benefits
1. Work-Related Fringe Benefits § 132; Congress has chosen to exempt some
fringe benefits from taxation, even though they serve as employee compensation.
This can lead to problems of equity (not all employers are as well situated to
provide payment in the form of benefits), efficiency (excessive fringe benefits
throw off the system of cash distribution), and complexity (1)hard to distinguish
between non-cash compensation and incidents of employment, and (2)Congress
refuses to recognize that all non-cash income should be taxable). Fringe benefits
fall into the following categories:
-qualified employee discount
-working condition fringe
-de minimis fringe
-qualified transportation fringe
-qualified moving expense reimbursement
Most of the § 132 provisions contain discrimination bans (benefits must be
available to all employees, not just the highly compensated)
United States v. Gotcher (5th Cir. 1968) p. 122
VW company sent Gotcher and his wife to Germany as a promotion to encourage
Gotcher to buy into a local VW dealership. Gotcher was taken to tour plants and
received a great deal of info on VW. His wife was a tourist. Court employed a
two-part test to determine whether or not something was income under § 61; first,
there must be an economic gain; second, the gain must primarily benefit the
taxpayer personally. In this case, the court said that VW was the primary
beneficiary of Gotcher’s trip, but that Mr. Gotcher was a third-party beneficiary of
his wife’s trip. He had to pay taxes on her portion.
2. Meals and Lodging § 119
Section 119 provides for the exclusion from gross income of meals and lodging
provided to the employee and his family, but only if done so for the convenience
of the employer and on the business premises. Must be a substantial, non-
compensatory purpose. There is no discrimination provision.
“Business Premises Test” -p. 130- look to function rather than location. In some
cases, employees have been able to exclude rent paid by employer even though the
homes were located away from primary business premises. This is only allowed,
though, when the home serves important business functions.
Comm’r v. Kowalski (US 1977) p. 127
NJ state troopers received meal-allowance. Court held that they could not deduct
the meal allowance under § 119. Held that it would only cover value of actual
meals, and not their cash equivalent. Court found that in order to get the
exclusion, the meals must be necessary to the employer’s convenience. This is
different than § 162 “ordinary and necessary.” According to Shuldiner, the
problem with the trooper’s case in Kowalski was that they got the money whether
they ate the meals or not. Even if they stayed home sick, they still got the cash.
That looks a lot like compensation.
Christey v. United States (8th Cir. 1988) p. 129
In Christey, the court allowed a deduction to state troopers for meals they were
required to eat in restaurants located on the highways they patrolled. This
deduction came under § 162(a) ordinary and necessary business expenses.
Benaglia v. Comm’r (BTA 1937) p.20 in Chirelstein
Manager of luxury hotel in Hawaii allowed to exclude the cost of a luxury suite
which he occupied with his wife at the hotel. Also excluded cost of meals
consumed at the hotel. Taxpayer claimed that he was required to live there by the
owners of the hotely so that he could keep an alert eye on things. Emphasis on
3. Payments of Property - § 83
“[I]f a person receives property in return for the performance of services, and if
the property is non-transferable or subject to a substantial risk of forfeiture at the
time of transfer, then the property is treated as still owned by the transferor and no
income is realized by the transferee. When the forfeiture risk is removed or the
property becomes transferable, the fair market value of the property at that time,
less any amount originally paid for it, is includable in income by the person who
performed the services.” General Rule in Graetz p. 132. In other words, income
counted when property vests.
However, § 83 also contains an election. The tax-payer can elect to count the
property as income upon receipt. That way, any appreciation in value will be
taxed as capital gain at realization rather than as income when the property vests.
4. Tax Expenditure Fringes
a. Life Insurance Policy Purchased by Employer - usually includable in
income, unless the employer or a charity is named as the beneficiary; also,
sometimes a limited amount of group term life insurance
($50,000)purchased by the employer can be excluded. See § 79, which
includes a non-discrimination component.
b. Compensation and Insurance for Injuries and Sickness - employer paid
or provided health insurance or health care is generally exlcludable from
gross income. See §§ 104 & 105 and pp. 133-134.
c. Moving Expenses - reimbursement by employer generally included in
gross income under § 82, unless deductible under § 217.
d. Dependent Care - payments made by employer for employee’s
dependent care excludable from employee’s income up to $5000/yr ($2500
for married individuals filing separately). See § 129.
e. Cafeteria Plans - when employees can choose from a variety of benefits,
they can still get their exclusions (provided that none of the choices are
cash or taxable benefits and that the benefits are non-discriminatory). See
C. Interest-Free Loans - treated as if lender lent borrower the money required to pay
back to the lender the market rate of interest. The foregone interest is then treated as a
gift, dividend, contribution to capital, or compensation, depending on the circumstances
(court will look at the economic realities of the loan in order to determine principal
purpose). Loans of less than $10,000 are generally exlcuded if the forgone itnerest is a
gift and if the loan proceeds are not used for business or investment purposes (unless one
of the primary purposes of the transaction is tax avoidance). See § 7872.
D. Imputed Income - benefits derived from labor on one’s own behalf or the benefits
from the ownership of property. Economists typically believe that imputed income
should be taxed, but Congress has made no attempt to do so as yet due to practical
difficulties. The most common example of imputed income occurs when someone owns
a house. They therefore do not have to pay rent. This amount is considered to be
imputed income. Some believe that non-taxation of imputed income causes inequities
and inefficiencies (ie. A works over-time and earns $5, which he pays to B to walk his
dog; C leaves work at quitting time and walks her own dog. A will be taxed on that $5,
but C will not).
E. Income Not From Work
1. Gifts and Bequests
§ 274(b): those covered under § 162 and § 212 cannot deduct gifts in excess of
§ 102(c): gifts transferred by employer to or for benefit of employee cannot be
excluded from gross income (require context of employment relationship)
Proposed Regulation § 1.102-1(f)(2): § 102(c) does not apply to amounts
transferred between related parties
a) Commissioner v. Duberstein (U.S. 1960)
Duberstein suggested customers to car dealer, who gave him a Cadillac in
return. Stanton acted as church manager and comptroller; board voted him
a gift of $25,000 when he retired.
Court defines “gift” as something given from disinterested, detached
generosity; out of affection, respect, admiration, charity or like impulses
Court looks to the totality of the facts and disregards common law definition
of a gift (as a voluntary transfer--that’s not enough here)
Problem with Duberstein: allows some room for donee to exclude gift from
income and for donor to deduct gift from income (Congress passes § 274(b)
and § 102(c) to try to close this gap)
Court says if payment proceeds from constraining force of moral duty or
from the expectation of future benefit, it is not a gift (Shuldiner says do not
take this at face value; probably wouldn’t apply to a gift to your
grandmother out of moral duty)
Wolder v. Commissioner (2nd Cir. 1974): in taxing the attorney who
promised a lifetime of legal service in exchange for a bequest upon his
client’s death, the court distinguished Merriam, which held that a bequest
made to an executor in lieu of compensation was excludable from income.
Test in Wolder: is the bequest a compensation for services rendered?
Unified Gift & Estate Tax (see § 1015)
Tax is on the donor, not the recipient
Taxed on aggregate transfers to date: every year you make a transfer,
you are given credit for all gifts you’ve ever given and are taxed on that
minus tax on transfers you’ve already paid
Upon death, add up lifetime transfers, figure out tax and pay
Eliminates incentive to make lifetime transfers rather than bequests
100% spousal exclusion for benefits (see § 1041(b)(2))
Also, $10,000 per year allowance per person (for donor or donee)
Lifetime tax credit of $192,000 per parent in transfers to children
(equivalent to about $600,000 in gifts?):
EX: If wife about to die, she should leave some of $ to kids so it is
tax-free under the credit and give the rest to her husband. When
her husband dies he will transfer it to the kids and they will get
another credit to apply to the gift.
Generation-skipping tax applies where adults try to give to
Property acquired from a decedent:
Basis of property acquired from decedent is FMV of property at time of
decedent’s death: results in “stepped-up” basis where accrued gain will
never be subjected to income tax (or “stepped-down” where loss
unavailable to reduce tax). See § 1014.
“Lock-in” effect: owners of appreciated property aware of “stepped-
up” basis given to heirs refuse to sell property prior to death.
c) Gifts of Property
Question: what is the basis when the gift is made, because the giving of a
gift is a non-recognition event?
§ 1015(a): “carry over” the adjusted basis
Technically, statute gives two kinds of basis (one for loss and one for
For purposes of determining loss, use the lesser of the carryover basis
or FMV at the time of the gift as the basis.
For purposes of determining a gain, use the carryover basis (so tax will
be triggered upon subsequent disposition).
Allows transfers of gain, but disallows transfers of loss (Shuldiner
thinks this reflects general nervousness by Congress about transferring
Donee allowed to use losses to offset future gains from the property
2. Prizes, Awards and Scholarships
Reg. § 1.102-1(c) provides that § 102 does not apply to prizes and awards (they
are counted as income)
§ 74(b) allows for exclusion of certain prizes that are given away to charities
Scholarships: § 117
Not counted as income to the extent it is used towards tuition and fees
(including books, supplies and equipment required for course of study)
Taxable to the extent used for housing, food (living expenses)
3. Political Contributions
Does not fit neatly under § 102
Why should you be able to deduct what someone else gives you to spend on your
IRS subject to 6-year statute of limitations if you understate of income; 3-year
statute of limitations if you overstate your deductions (no limitations if you don’t
Explanation? IRS on notice when you file your return
a) Cesarini v. United States (N.D. Ohio 1969)
Cesarini bought a piano for $15 in 1957, but found $4,467 in cash in it in
Found money held taxable by the court
No exclusions for “found money”, so assume it is covered by § 61 (“all
Court cites Reg. § 1.61-14, which says that “treasure trove” (to extent of its
value in U.S. currency) constitutes gross income for taxable year in which it
is reduced to undisputed possession (note that “treasure trove” refers to
more than just cash)
b) Haverly v. United States (7th Cir. 1975)
Principal of school received unsolicited book samples from publishers. He
donated them to the school’s library and claimed a charitable deduction.
Court finds that the unsolicited books received were income, because they
were an “accession to wealth”
Transaction offensive because taxpayer was not taxed on the books as
income, so allowing the charitable deduction would amount to a second
F. CAPITAL APPRECIATION AND RECOVERY OF CAPITAL
1. Present Value Computations
See Graetz, pp. 852-855, for present and future value tables
Formula for calculating future value:
FV = x (1 + r)
r is the interest rate
Formula for calculating present value:
PV = FV / (1 + r)
n is the number of years
2. Capital Recovery and Basis
See §§ 1001(a)-(c); 1011; 1012; 1014(a); 1015(a) & 1015(e); 1016(a)(1)
Ways of recovering capital spent on asset:
Expensing: immediately deducting expenses
Capitalize: wait until disposition of the asset to account for/deduct the
Mark-to-market: full accrual; each year, calculate gain and pay tax on it
Depreciation: periodic deductions are allowed for asset’s cost; cost
recovery spread out over a period of years
Basis, defined in § 1012, is generally the cost in property (not FMV, usually)
Where bargain purchase is in exchange for salary, amount of price reduction
should be included in income and purchaser treated as if acquired asset for
In exchanges of property, basis is the value of property received
See above for basis on gifts and bequests of property
Adjustments to basis: increase basis to reflect capital expenditures; reduce basis
to reflect tax benefits allowed to taxpayers while they hold property. See §
Two ways of dealing with an acquisition of property and disposition of part of it:
Apply amount realized against basis for entire property; report gain only
when aggregate amount realized exceeds entire basis.
Or, allocate basis of the whole between the part sold and the part retained in
some reasonable manner, and compare amount realized with portion of total
basis allocated to the amount sold.
Allocation of basis is routinely required when single price is paid for a
building held for investment or used in a trade or business (separate land
a) Hort v. Commissioner (U.S. 1941; p. 157)
Hort received building from his father in 1928 upon father’s death. In 1927,
Irving Trust signed long-term lease. In 1933, lessee paid Hort $140,000 to
cancel the lease. Hort claims present value of lease was $160,000, and
claims capital loss of $20,000. Hort trying to allocate basis between the real
property and the future stream of income from the lease.
Court disallows Hort’s allocation of basis; counted $140,000 as income
Basis was FMV; “stepped-up” because property was held until death (§
Court says the $140,000 is merely a “substitute” for rent; thus taxable
income under §61(a)(5): fact that it was less that what Hort expected to get
does not change its status as income
EX: If Hort had gone to court to collect this amount, it would be
collected as unpaid rent (negotiated amount is the same)
Court looks at what the payment is a substitute for, at underlying
Says Hort chose to accept less than strict present value to avoid
Assuming lease was property, cancellation of the lease was not a return of
Payment was still rent, or income earned on the capital asset, and still
Court wantes to avoid taxation at the end: assigns basis immediately
Shuldiner prefers spreading the cost, or basis, over lifetime of asset
Hort applies to cases where you retain a residual, and sell a piece of time
(here, Hort carved out a right to future income (leasehold) from larger
Carved-out interests do not qualify as capital assets, do not absorb basis
Similar to stocks that pay cash dividends: dividends fully taxable with
no offsetting basis, and so are rents (stock, like land, has indefinite
amortization - the changing right over time in property; you can split an economic
property into its income flow and its residual; the income portion becomes less
valuable over time because there are fewer years left for it to pay out; the residual
becomes more valuable over time because you are closer to recovery; you are
taxed on the income side, but you are not taxed on the appreciation of the residual;
in the end, the gov’t loses out, because the individual whose residual depreciates
gets a deduction, but the individual whose residual appreciates is not taxed on
gain until realization. Shuldiner believes in a mark-to-market system, whereby
the taxpayer would be taxed on the part that realized eahc year, so that the
taxation at the end equals the present value of the property in the year it is bought.
apportionment - “When a part of a larger property is sold, the cost or other basis
of the entire property shall be equitably apportioned among the several parts, and
the gain realized or loss sustained on the part of the entire property sold is the
difference between the selling price and the cost or other basis allocated to such
point.” Reg. 1.61-6(a)
If you buy a house and later discover that a tree in the yard is very valuable, if you
go to sell the tree, you have to figure out what portion of the price you paid for the
house covered the tree, before you knew its value. Any gain on that amount will
be taxed as ordinary gain under § 61 “dealings in property.”
Gains and losses in the value of property are generally only reflected in taxable
income when “realized”: unrealized appreciation is not taxed.
Administrative burden of annual reporting
Difficulty/cost of determining asset values annually
Potential hardship of obtaining funds to pay taxes on accrued but unrealized
a) Eisner v. Macomber (U.S. 1920)
Taxpayer owned 2,200 shares of Standard Oil common stock. Standard Oil
declared 50% dividend, so taxpayer received 1,100 additional shares which
represented about $20,000 of earnings accumulated by the company.
Court held that Congress cannot tax stock dividends, under Constitution
16th Am. gives Congress power to tax income “from whatever source
derived”: court defines “income” as gain derived from capital, labor, or
both combined, including profit gained through sale or conversion of assets.
Income derived from property proceeds from the property, severed from the
capital (however it may be invested or employed
Court reasoned that stock dividend did not take anything from property of
corporation nor add anything to shareholder’s property: shareholder has not
realized or recognized any income in the transaction.
Court does not see any increase in the intrinsic value of the holding, but
only in the number of shares (thus, dilution of value of each share)
If shareholder turned around and sold the stocks, then he will have
Rejects argument that dividend reflects gains of shareholder as a result of
the gains of the corporation (depends on how long shares were held; also,
enrichment through increase in value of capital investment is not income
Holmes’ dissent: wants “incomes” to mean what it did at time of adoption
Shuldiner thinks Macomber may be wrong as a constitutional matter,
though right as a policy matter; also, Macomber seems to conflict with
Glenshaw Glass definition of “income”; Graetz says continuing validity of
Macomber is doubtful.
b) Cottage Savings Ass’n v. Commissioner (U.S. 1991)
Cottage Savings is an S & L that held numerous long-term, low-interest
mortgages that declined in value. Deterred from recording the losses on the
books because the FHLBB would shut them down. FHLBB then relaxed its
requirements, saying S & L’s did not have to report losses associated with
mortgages exchanged for “substantially identical” mortgages held by other
lenders. Cottage Savings exchanged mortgages, all of which were secured
by single-family homes in Cincinnati, with participation interests the same.
Cottage Savings took $2.5 million deduction, difference between interests it
traded and those it received.
Court determines that these were realization events
Finds that § 1001(a) realization principle incorporates a “material
difference” requirement; looks at Reg. § 1.1001-1 which says income
gained or lost from an exchange of property for property differing materially
either in kind or extent.
Rejects IRS’ “economic substance” test for material difference in favor of a
test that is more administratively convenient
“Material difference” exists where there is a change in legal entitlements
Notes that where companies reorganized in new states, their legal
entitlements changed due to variances in state corporate laws (but legal
entitlements did not change where reorganized in same state)
Proposed regulations indicate IRS view that Cottage Savings does not
prohibit examination of changes in economic factors
Cottage Savings rule is more administrable by judges but it does produce
more realizations; IRS approach requires identification of markets,
assessment of market participants, etc.
Example of problems with realization doctrine
Annuity: give money to a company, and they pay you back a stream of money over
Can be during a fixed number of years, or over a lifetime (start paying at a
Can have level payments, or payments that change over time
Can start immediately (immediate annuity), or defer payments (deferred annuity)
For tax purposes, annuitant has income to the extent that he receives more than he
paid for the annuity
Bullet or balloon loans:
EX: borrow $1000; pay interest payments over period of time; at the end of the
period, repay $1000 principal amount
End payment is return of principal
Make constant installment payments of principal over years; borrow money for
less time and pay less interest
If interest paid at same rate you’re discounting back, principal value = present
Typically car loans and home mortgages are installments
Same thing as an annuity, yet tax treatment is entirely different
a) Section 72: Basis Recovery Scheme for Annuities
Entire amount expected to be received is compared to amount paid; ratable
portion of each payment received is excluded from income in amount expected
to restore capital in full when final payment is received
Portion of each annuity payment is treated as recovery of investment; portion
treated as taxable return
§ 72 spreads basis over the years, allows for straightline recovery
§ 72(a): entire payment is income except
§ 72(b)(1): exclude amount from income which bears same ratio as
investment in contract over expected return (investment/return = exclusion
ratio = percentage of each payment excluded from income)
§ 72(c)(3): “expected return” is aggregate of amounts receivable under
Use life expectancy of the individual to calculate expected return (tables,
pp. 1039, 1040); different tables for men and women
§ 72(b)(2): if you live too long, you’re taxed on the excess payments
(exclusion is limited to amount of investment; once basis is recovered,
excess is income)
§ 72(c)(3): if you die too early, then “mortality loss” taken by executor in
last taxable year in amount of remainder (basis was not completely
§ 72(e): cash withdrawals before annuity starting date of deferred annuities are
treated as income to the extend the cash value of the contract exceeds owner’s
Shuldiner asks why not treat annuities as we do installment loans: income for
annuitant is higher in earlier years (just as interest is higher in earlier years on
home mortgage), but is less in later years (just as interest payments toward end
Shuldiner thinks we have these rules for annuities because of powerful insurance
companies lobby, or because of policy of encouraging retirement savings (e.g.
penalties for early withdrawals from annuities, borrowing against annuities)
H. LIFE INSURANCE
Two elements: “pure term insurance” (protection against the event of death
occurring during period of coverage, obtained by payment of premium in return for
sum to be paid to survivors) and “savings” component (building up cash value of
“Ordinary life insurance” policy:
Pay constant premium each year
Excess money is put into savings account, to accumulate reserve for later
As insurance premiums increase (as you age) and exceed the fixed premium
amount, the company draws down from the savings account to pay the requisite
Need to distinguish for tax purposes the two components (insurance vs. savings)
§ 101(a): life insurance proceeds paid by reason of death of the insured are not taxed
§ 262: life insurance premiums are not deductible (no deduction for personal
a) Whole life insurance
Includes term insurance and savings account
When savings accumulate through such an insurance policy, interest on savings
is not taxed (compare with taxation of interest if you saved money in an account
and bought insurance)
Borrowing against life insurance is not a taxable event (compare with borrowing
against or withdrawing from annuities, which is taxable)
If policy is surrendered, receive balance of savings account (premiums paid in +
interest earned - term insurance premiums paid out - administrative costs)
Amount realized is the balance paid back to you when you cash out
Basis was everything you paid total
If premiums exceed interest, income is zero (premiums are low when
Problems: stuck with life insurance interest rate; don’t like life insurance
But option of “variable life insurance,” you pay money to the insurance
companies, and they invest it in riskier ventures yielding higher rates of
b) “Modified endowment contracts” (in Graetz)
Policies that look like investments rather than true insurance because they are
funded more rapidly than would be needed to pay for the death benefits they
Looks to amount of premiums paid during first seven years; asks if that amount
is greater than what would have been paid had contract provided for paid-up
future benefits after seven level premiums. § 7702(A)(b)
Amounts received under such contracts are treated as income to extent of
difference between policy’s cash surrender value and taxpayer investment. §
Amounts received in excess of that difference are recovery of capital.
Treated like annuities with respect to amounts received before death: taxable
10% penalty on early withdrawals § 72(e)(4); loans under policy are income. §
I. DEBT AND DISCHARGE OF INDEBTEDNESS
Borrowing money increases assets; but also increases liabilities due to obligation to
So, borrower does not realize income upon receipt of loan (regardless of its use)
And, borrower has no deduction when he makes principal payments on loan
Recourse loan: borrower is personally liable for debt
Lender can look to other assets
Non-recourse loan: borrower is not personally liable for debt; the debt is usually
secured by the property purchased
Note: Most home mortgages are nominally recourse, but are better seen as non-recourse because
it’s hard to collect from home-owners (there’s more non-recourse lending in real estate because
it’s hard to hide or conceal real estate).
Lumber company issued $12 mil in bonds. The bonds declined in the market, so company
bought back bonds at $11 mil. The Court treated this as a forgiveness of indebtedness,
and taxed the company on the $1 mil as income.
Zarin v. Comm’r (USTC 1989) p. 184
Zarin had a gambling problem. He racked up $3.5 mil in gambling debts. He worked out
a settlement whereby he paid back $500,000. The IRS wanted to tax him on the
difference between what he owed and what he paid as income from the discharge of
The Tax Court held that the chips supplied to Zarin represented a true loan that the
taxpayer expected to have to repay and would have had to repay had he won rather than
lost. Therefore, settling for less than face value produced taxable income under §
61(a)(12). (Shuldiner thinks it odd that a guy can lose $500,000 gambling and end up
being taxed on $3 mil income).
(See also § 165(d), gambling losses can only be claimed insofar as they offset gambling
gains. Reasons suggested for disallowing gambling losses: seems like consumption and
there are issues of proof, i.e. it’s easy to get losing gambling receipts. However,
professional gamblers can probably deduct their losses as § 162 ordinary and necessary
Note on enforceability:
Why should non-enforceability affect tax treatment? If a debt is not enforceable, and
someone lets you out of it, then you are really no better off than you were before the
discharge, so maybe there should be no income. Then again, if you initially assume that
the reason money received in a loan was not income was because it was offset by an
obligation to pay and it later turns out that there was no obligation to pay, then perhaps
the recipient should have been considered to have received income at that time. Zarin
ended up winning in the Court of Appeals on the enforceability issue. New Jersey law
forbade extending so much credit, so the debt was unenforceable anyway.
Note on COD: § 108 (a)(1)(B) says that g.i. does not include dispositions of debt when
the beneficiary is insolvent.
Another theory for figuring the benefit actually received by Zarin:
Zarin received a purchase price discount (he purchased $3.5 mil worth of gambling fun
J. Borrowing and Basis
A has $100,000 cash. He borrows another $50,000 in a recourse loan, so that he can buy
building for $150,000. His initial basis is the purchase price, $150,000. The building
depreciates in value by $30,000. His adjusted basis is $120,000. If he now sells the
building for $140,000, he has actually suffered a $10,000 economic loss. However, for
tax purposes, he has gain of $20,000.
(I = AR - B). Even if he does not take the depreciation deduction, he still reduces his
A is better off taking his depreciation deduction every year for two reasons. First, the
present value of the loss is greater than the future value of the loss he will take later.
Also, the capital gain is taxed at a lower rate than income.
It may be possible to arrange the transaction so that the depreciation deduction off-sets
the interest payment on the recourse loan.
Crane (1947) p. 197
Decedent’s wife inherited property encumbered by a mortgage equal to the property’s
FMV. She operated the property for a few years, taking deductions for depreciation, but
made no payments on the mortgage principal. She included the full amount of the
mortgage debt when she computed her basis in the property for depreciation deductions.
Eventually, she sold the building. The purchaser took over the mortgage liability, and
gave her $3000, $500 of which went for the expenses of the sale. She claimed a gain of
$2500 on the transaction, reasoning that her basis was zero (despite her earlier
depreciation deductions) and that the amount she received from the sale was simply the
cash she received. The Comm’r argued that her basis was the property’s FMV at the time
of her husband’s death, adjusted for depreciation, and that the amount realized was the
cash received plus the amount of the outstanding mortgage received by the buyer.
Court agreed with the comm’r, holding that the nonrecourse debt should be included in
the amount realized and that Crane obtained an economic benefit from the purchaser’s
assumption of the mortgage identical to the benefit conferred by the cancellation of
personal debt. In other words, Crane’s income is equal to the boot plus the amount she
After Crane, recourse and non-recourse debt is treated alike. Buyer gets basis for the part
of the purchase price secured through non-recourse loan. This results in a depreciation
deduction even though none of the buyer’s own money is at risk up front.
Comm’r v. Tufts (US 1983) p. 195
Partnership built apt. complex with $50,000 of their money and a $1.85 mil. mortgage
(non-recourse loan) guaranteed by the gov’t. In the beginning, the partnership’s basis =
$1.9 mil. In 1971 and 1972, the partners all took deductions for their allocable shares or
ordinary losses and depreciation. The partnreships deductions totalled $450,000. This
left them with a basis of $1.45mil. The partners became unable to make their mortgage
payments, so they decided to sell out. At that point, the FMV of the property was $1.4
mil. The purchaser assumed the mortgage and paid each of the partners $250. The
partnership claimed a loss of $50,000. (Basis $1.45 mil minus the FMV). However, the
comm’r claimed the partnership actually had a $400,000 gain. This was the liability
assumed by the purchaser minus the adjusted basis ($1.85 mil - $1.45 mil).
This case deals with the issue mentioned in Crane FN37, but left unresolved. In Crane,
the property’s FMV was higher than the mortgage debt. In Tufts, however, the mortgage
is substantially higher than the property’s FMV. The court reasons that when a mortgage
is assumed by a third party, it is as if the mortgagor has been paid cash borrowed by that
party from the mortgagee on nonrecourse basis. The mortgagor then uses that cash to pay
off the mortgage. The Court points out that to permit the taxpayer to limit his realization
to the FMV would be to recognize a tax loss for which he has suffered no corresponding
The Court holds that a taxpayer must account for the proceeds of obligations he has
received tax-free and included in basis (depreciation). It would be assymetrical to allow
the taxpayer to include the proceeds of the nonrecourse obligation in basis but not
accounting for the proceeds upon transfer of the encumbered property. When a taxpayer
sells or disposes of property encumbered by a nonrecourse obligation, the Comm’r
properly requires him to include among the assets realized the outstanding amount of the
obligation. The FMV of the property is irrelevant to this calculation.
In a concurrence, O’Connor proposes that the sale be broken into two separate
transactions. First, the amount realized is FMV, or $1.4 mil. The basis is $1.45 mil, so
there is a $50,000 loss on the sale. Second, the debt is $1.85 mil, but you only have to
pay $1.4 mil, so there is COD income of $450,000. Shuldiner says the partnership might
prefer the court’s method of accounting because COD income is counted as ordinary
income. However, they might prefer O’Connor’s method because §108 exempts COD
income for insolvent parties.
Estate of Franklin v. Comm’r (9th Cir. 1976) p. 205
Drs. formed a limited partnership to “buy” a hotel as a tax shelter. They paid $75,000 up
front, and set up a payment and leaseback plan so that no other money would change
hands until a balloon payment was made at the end of the term. However, the FMV value
of the motel was always significantly less than the principal on the finance, and because
this was a non-recourse agreement, there was never any equity to the partnership because
they could forfeit at any point with no loss except the initial $75,000 outlay.
Tax Consequence for Purchaser
Stage 1: In this deal, the initial basis (B) = purchase price (PP).
Stage 2: Rental Income (R)= Interest Deduction (I) so (R - I = 0)
Stage 3: Gain (G) = AR - B
G = PP - 0 (B = 0 because of D)
G = PP
Ignoring time value, there is no net change. (R - I) + (G - D) = 0.
When you include present value, it’s a good deal because you get a stream of deduction
during the life of the deal and you don’t get hit with gain until the end. The gain may be
equal to the deductions in absolute value, but figured over time, the benefits exceed the
cost. You can make this deal even sweeter by doubling the PP, thereby doubling D,
which is the benefit.
Assuming the purchaser is in a 70% bracket, PP $1 mil, straight-line D over 10 yrs, and
10% interest on the loan:
Gain = $1 mil PDV = $1mil/(1.1)10 = $385,000
Depreciation = $100,000/yr for 10 yrs PDV = $615,000
So Net Deduction = ($615,000 - $385,000) = $230,000
After tax this has a value of $161,000 for the 70% taxpayer.
If the gain is taxed at the capital gains rate, the deal becomes even sweeter.
If the purchaser makes principal payments during the life of the loan, you can change the
rent so that it’s equal to I + P. However, there are a few other consequences. The
principal portion of the payment is not deductible as is the interest, so the payment will
not totally offset the rental payment. Therefore, you will have a little bit of income each
year from the rent. However, because you pay principal, the balance on the non-recourse
debt shrinks so you won’t realize as much gain at the end. Keep in mind, though, that in
present value terms, the purchaser would rather have more income at the end than a little
Tax Consequence for the Seller
Seller has gain, in Estate of Franklin, $75,000 at t0 and recognizes a loss at the end. This
probably won’t kill the deal for two reasons. First, the seller probably has other losses
which they can use to offset the initial gain. Second, the seller is probably in a lower
bracket than the buyer, so the gain won’t be taxed as heavily.
The actual key to this deal was the installment sale rule. When you sell property on an
installment basis, you don’t get taxed until you have the cash in hand.
The economic function of the $75,000: it served as the premium or fee the Romneys
(sellers) charged to set up this tax shelter. The buyers get basis in the $75,000. The
sellers may or may not be taxable on it. They called it “prepaid interest” although that
term doesn’t make any sense. Today, the deduction for prepaid interest has been limited
by § 461(g), except for points on mortgages.
The Comm’r attacked the deal in Estate of Franklin by calling it a “sham” or an “option.”
The tax court bought the option argument, but the Circuit Court called this a transaction
which “lacked economic substance.” They did not find it to be a sham. It’s a lot easier to
prove a transaction lacks economic substance than that it’s a sham, because proving a
sham would require proof of belief that one would never be an equity owner in the
Shuldiner There are 3 ways the court could have constructed this transaction:
1. Merely an option
2. Bona fide sale - Bona fide debt
3. Some middle answer
If this is considered an option, the Romneys would get D because there would be no
transfer of ownership of the property. Shuldiner points to an example though, where a
buyer purchases and option to buy property currently worth $1 mil in one year at a strike
price of $1.25 mil. If he paid $1 mil for such an option, he would be the economic owner
of the property while the common law owner would still be the seller until he exercised
his option. In such a case, Shuldiner says perhaps the buyer should get the depreciation.
In the court’s analysis, it is hard to tell who should get D. In theory, no one gets D until
the purchaser has a substantial enough investment in the property to hav equity, or
perhaps the seller gets depreciation until such a time. Shuldiner thinks the court means to
say that in order to get depreciation, you must have both the investment and the
ownership of the property and until then, no one gets depreication. At this time, the
Romneys have the investment, and the partnership has ownership.
The court’s approach denies anyone depreciation, so it’s a very brash approach. The
court doesn’t want this to apply except in the most egregious cases. The Code now has
explicit penalties when people mis-estimate expenses and values. §§ 6662 and 6664 not
only take away the excessive deduction, but also penalize 20% of the underpayment or
75% in a case of fraud.
Other approaches might be to limit deductions for nonrecourse debt, but Congress has
never been willing to do that. Or, the Service could give full basis, but limit deductions
to the cash actually laid down. In fact, they did this in the § 465 “at risk” and § 469
“passive loss” attacks on tax shelters.
K. Illegal Income
The fact that gain arises out of illegal activity does not result in its exclusion from
Collins v. Comm’r (2nd Cir. 1993) p. 211
Collins worked at OTB. He used to make bets on his computer w/o paying for them. He
would pay his losings into his cash drawer with his winning. One day, he apparently
went crazy and decided to take $80,000 in betting tickets. At the end of the day, he had
lost $38,000. He put his $42,000 back in his drawer and turned himself in, w/o paying
back the $38,000. The Comm’r maintained that Collins had $38,000 in gambling
income. Collins disputed this saying that he was being taxed on his losings. He argued
that rather than income, he had received a loan and the accompanying obligation to repay.
The court says he has $80,000 in theft income, of which he returned $42,000 and kept
$38,000, leaving him with a net income of $38,000. This gives g.i. of $80,000, he gets a
§165(c) deduction for the $42,000 he paid back, leaving him with a $38,000 net.
Shuldiner says the court applies §165 (c) because of the notion of a “transaction entered
into for a profit.”
Note: In early embezzlement cases, the theory was that the thief had no income by
embezzlement because he had an obligation to repay what he stole, just as he would in the
case of a loan. James overturns that theory, saying that it depends not on the obligation to
repay, but a “consensual recognition” of the loan or the obligation to repay.
Franklin and Collins both involve a taxpayer’s attempt to characterize a transaction as a
loan, and in both cases the court refuses to buy it.
Final note: Justice Black was an early critic of the use of federal tax law to punish
criminal offenses traditionally falling under state law.
L. Damages and Sick Pay
What are the damages a substitute for? See Hort. Recoveries which represent a
reimbursement for lost profits are income. The reasoning is that since the profits would
be taxable income, the proceeds of litigation which are their substitute are taxable in like
Building with initial basis of $1 mil, fully depreciated to zero. FMV $1 mil. Arson burns
building. Liable to owner in tort for $1 mil. What is the owner’s basis? § 1033 says if
you replace the property with similar property, there is no gain, and the basis is still zero.
If you pocket the money you have income.
What if damages are for loss of “good will”? How does a company get good will?
-Advertising, which is deductible.
-Making a good product, which is also deductible.
§ 104 excludes:
-Amount of any damages received on account of personal injuries or sickness.
-Interest earned when the payment of damages is periodic rather than a lump sum.
Although the supplement says that interest is not received “on account of personal
injuries or sickness.”
What coordination between § 104 and § 213?
-You can’t exclude the payment and deduct the income. Also, § 213 allows deduction for
loss “not compensated by insurance or otherwise.” This prevents double recovery.
Distinguishing between personal and business injuries:
In Roemer, the court took the position that injury resulting from defamatory statements
predominantly injured business representation and therefore recovery was not on account
of personal injury. In Threlkeld, the court realizing the futility of this position, reversed
its position, stating that “if compensatory damages are recived on account of any invasion
of the rights that an individual is granted by virtue of being a person in the sight of the
law,” exclusion under § 104 is proper.
Kurowski v. Comm’r (7th Cir. 1990) supp p. 18
Court held that settlement proceeds were taxable when received by a discharged teacher
because she never brought a tort action.
US v. Burke (US 1992) p. 222
Female employees received $5 mil settlement under Title VII. Court found that this
payment, designated as back-wages did not come from a tort or tort-type lawsuit, and
therefore could not be excluded as received “on account of personal injuries or sickness.”
If the employees had received these payments as wages, they would have been taxable.
O’Connor in her dissent maintains that the damages are intended to compensate not for
work, but for a harm suffered.
Comm’r v. Schleier (US 1995) supp. p. 5
ADEA case extends the “tort or tort-type” test from Burke and says that in order to
exclude from income, damages must be from (1)a tort or tort type loss, and (2) the
damages must be received on account of personal injuries or sickness. The Court’s
reasoning admits that in some cases, discrimination itself may cause personal injury, but
in this case, the discrimination simply caused the firing. The firing caused the injury.
The gov’t is constantly kicking around the issue of whether or not punitive damages are
taxable.. The current changes to § 104 state that all damages are taxable if not on account
of personal, physical injury. Punitive damages are taken out of the exclusion for
personal, physical injuries. However, it is not clear that punitive damages are
automatically taxable because they must still meet the inclusion requirements of § 61.
M. Tax-Exempt Interest
Interest on state and municipal bonds is tax-free.
Historically, the justification for this exemption was probably Constitutional (i.e.
restriction on inter-governmental interference). However, today it is questionable
whether or not state and municipal interest free bonds are protected by the Constitution.
South Carolina v. Baker (US 1988) p. 230
The Court upheld a Congressional provision taxing interest on state and local bearer
bonds. Registered bonds are still tax-exempt.
§ 103 provides a subsidy to state and local governments. Because buyers are not taxed on
the interest earned, state or municipal issuers can pay a lower return.
Assume a 40% tax bracket and 10% market interest rate. The buyer will be neutral if the
state pays 6% interest, because that is his effective return on the 10% market bond taxed
at 40%. A buyer in the 50% bracket will earn an extra 1% on the 6% gov’t bond.
Therefore, people in higher brackets get an added benefit, besides the state subsidy.
“Break-even” rate = IR(1 - TR) where TR = taxpayer’s bracket and IR = rate paid by
corporate bond). example: TR = 40%, IR = 10%; break-even is 10%(60%) or 6%.
There seems to be a vertical equity problem in this scenario. However, this may be offset
by the larger “progressive tax-rate” scheme. That is, people in lower brackets enjoy other
benefits not available to those in the higher brackets.
Rather than providing this exclusion, the Service could provide the subsidy to the states
in two other ways.
-Make state bonds taxable, but have the federal gov’t pay back direct subsidies on
the higher interest rates the states would have to pay.
-Give a tax “credit” rather than an exemption. In other words, count any interest
as income, but allow the taxpayer to count a credit for that amount against his tax
liability. This would be a pretty big incentive for taxpayers to buy state and local
bonds, even if they only charged a very low interest rate. This is very beneficial
for the state or municipality because it can pay extremely low interest rates.
-arbitrage by the issuer; a municipality issues bonds which are in turn secured by
market rate bonds. In the absence of a controlling code provision, the
municipality would pay no tax on the high interest their corporate bonds earn. In
turn, they issue lower rate bonds to the public on which the public pays no
-arbitrage by the holder; a purchaser borrows money at one rate to buy tax-exempt
bonds at a lower rate. The purchaser takes a business expense deduction for the
loan interest, but is not taxed on the interest earned on the tax-exempt bond. This
can result in an untaxed profit to the purchaser, if considered over time.
§ 103 (b)(2) makes explicit arbitrage bonds ineligible for interest exemption, but
according to Shuldiner, cities can still weasel their way into arbitrage.
§ 265(a)(2) denies deduction for interest or indebtedness incurred or continued to
purchase or carry obligations the interest on which is wholly exempt from taxes.
Shuldiner says there is an equity argument against § 265 because one person who has
suficient assets to purchase tax exempt bonds can get the benefit of arbitrage by
borrowing money to tie up in some activity which will allow the deduction and then using
available assets to purchase the tax-exempt bonds. Another individual who has no choice
but to borrow the money to buy the bonds cannot enjoy the benefit of arbitrage.
§ 103 (b)(1) denies municipalities the exemption for “private activity bonds” as defined
in § 141. There are further limits on exclusions in § 146 in the form of volume caps.
Interest from “private activity bonds” counts as income for purposes of the Alternative
Minimum Tax (AMT) even if such income is excludable under regular tax. The AMT
has lower tax rates, but generally reflects a broader base of income. It doesn’t apply to
too many people.
III. Deductions and Credits
One of the important underlying purposes of the tax code is to tax “net income.” The code,
therefore, attempts to match income with expense, so that it will only tax on actual profit or
Equity argument - “ability to pay” is a good basis for taxation, so someone who operates a
business which is very expensive to run, but grosses the same amount as a buisness which is less
expensive to run has less ability to pay tax.
Efficiency argument - if the tax was on gross income, a profitable activity might turn into an
unprofitable activity. This would discourage certain businesses or industries and encourage
others to develop in a way they would not in a tax-free world.
timing - when do you get to deduct an expense?
personal expenses - not deductible; rather, personal expenses are a form of consumption
A. Business Expenses
Allows as a deduction all the ordinary and necessary expenses paid or incurred during
the taxable year in carrying on any trade or business, including --
(1)a reasonable allowance for salaries or other compensation for personal services
(2)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; and
(3)rentals or other payments required to be made as a condition to the continued
use or possession, for purposes of the trade or business, of property to which the
taxpayer has not taken or is not taking title or in which he has no equity.
Higgins (US 1941) simply managing your own investment portfolio is not a “trade or
business,” although § 212 allows a deduction for expenses paid for production or
collection of income, or in the determining collection or refund of tax.
1. Ordinary and Necessary
Welch v. Helvering (US 1933) p. 236
Taxpayer had been secretary of a corporation. When the corporation went
bankrupt, the taxpayer paid its creditors with his own money even though through
bankruptcy, the corporation was absolved from debt. He did this in order to
protect his own personal good-will and business reputation. He attempted to
deduct the expense as an “ordinary and necessary” business expense.
Court defines “necessary” as helpful, useful, or appropriate. This test is very
subjective, and provides a fairly low hurdle to deductibility.
Court defines “ordinary” as within a known type in the community (not
necessarily a known type to the taxpayer). This test is much more objective.
The court says that Welch’s good-will is either a personal asset or capital, and as
such not deductible. § 263 disallows deduction for expenditures that should be
Note: Why should this be capitalized? He is trying to build up business over
time, so the benefit to be properly matched with this outlay will be returned over
Gilliam v. Comm’r (USTC 1986) p. 239
Gilliam was an artist. On his way to an exhibition, he went crazy on an airplane
and beat some people up. Criminal charges were brought against him. Gilliam
wanted to deduct his legal fees as an “ordinary and necessary” business expense.
The court holds that ordinary means “normal, usual, or customary.” The
“transaction which gives rise to it must be of common or frequent occurrence in
the type of business involved.” They believe that, while the travel itself might be
ordinary, the altercation was not. They reinforce this with an assertion that the
altercation was not undertaken to further Gilliam’s trade or businesses.
2. Reasonable Allowances for Salary
Salaries would probably be deductible even without § 162 (a)(1) as “ordinary and
necessary” business expenses. However, this section assures that unreasonable
allowances for salaries will not be deducted by businesses.
However, corporations cannot deduct amounts paid as dividends.
Note: There may be some situations where a salary may have to be capitalized,
for example, if you pay your own employees to build a new building for your
business, it may be a capital outlay to be recovered over the useful life of the
Thomas A. Curtis, MD, Inc. v. Comm’r (USTC 1994) p. 243
This case asks whether a salary paid to an employee who was also a 1/3
shareholder was reasonable. The court states that the test is whether the amount is
reasonable in relation to the service rendered. The five factors examined by the
court are (1)employee’s role in the company, (2)external comparison to
employee’s paid by similar companies for similar services, (3)character and
condition of the company, (4)conflict of interest in relationship of the employee to
the corporation, and (5)the internal consistency in the company’s treatment of
payments to employees.
The court focuses on the reasonableness of compensation paid to a shareholder-
employee and whether an independent shareholder would be happy with the
dividends paid. If an independent shareholder would be unhappy, it is evidence
that the profits are being siphoned out of the company disguised as salary.
The court found her salary to be unreasonably high.
Note: § 162 (m) allows publicly held corporations to deduct no more than $1 mil
for their 5 highest compensated employees, unless those employees are being
compensated for performance as well as service.
B. Public policy limitations
C. Lobbying expenses
D. Employee business expenses and the 2% floor
Direct (unreimbursed) employee business expenses are only deductible if itemized. If
reimbursed, then the employee may deduct them even if he takes the standard deduction.
However, he must provide substantiation to the person providing reimbursement, and he
cannot be reimbursed for more than the deductible expense. See § 62 (c). A self-
employed “independent contractor” can deduct all business expenses above the line. § 62
Under § 67 a taxpayer can deduct “miscellaneous itemized deductions” only to the extent
that, in the aggregate, they exceed 2 percent of the taxpayer’s a.g.i. for the year. The list
of “miscellaneous itemized deductions” is very short and is exclusive. It tells what is not
a m.i.d. Unreimbursed employee business expenses are not on the list, and are therefore
subject to the 2% floor, unless they are moving expenses which are not treated as m.i.d.
Note that § 132 (d) defines a working-condition fringe benefit as any “property or
services provided to an employee of the employer to the extent that, if the employee paid
for such property or services, such services would be allowable as a deduction under §
162 or § 167.” The regulations indicate that the 2% limitation can be ignored for
purposes of § 132.
All of this has led to pressure on employers to reimburse expenses.
E. Distinguishing business and personal expenses
Assume a meal costing $100. If the meal is eaten as part of business, then you might get
a $50 personal benefit out of the meal, along with the $50 business benefit. Economist
Halpern would tax individuals on personal satisfaction as income. In this scenario, the
result would be $50 income minus a full deduction of $100 for the cost. This would net a
§ 274 only allows deduction of 50% of meal and entertainment expenses. In the hypo
above, you would have the same result.
Amend (USTC 1970) p. 265
Amend sought the assistance of Preacher Halverstadt in both business and personal
matters. Halverstadt did not offer specific solutions, but tried to raise Amend’s
awareness so that he could solve his problems himself. The company paid Halverstadt
directly. After that point, Halverstadt was available to other employees, but only Amend
consulted him. Even though these services raised Amend’s business performance, the
benefits of Halverstadt’s services were found to be inherently personal, and therefore fell
within § 262 prescription against deductibility for personal expenses under § 162.
Trebilcock v. Comm’r (USTC 1975) p. 265
In Trebilcock, Preacher Wardrop was retained both to perform spiritual services for
employees and to perform clerical duties. The court allowed the deduction for the
payments allocable to the clerical duties, but not for the spiritual duties, because those
were not found to be “ordinary” expenditures in this field, but were rather inherently
personal, as in Amend.
Pevsner v. Comm’r (5th Cir. 1980) p. 267
Lady was a mgr of an YSL store in Dallas. Was required to wear YSL clothing while at
work.. While taxpayer maintained that she did not wear the clothing during her personal
time, they were items which she could have worn off the job and in which she would
have looked nice.
Court applies the Donnelly Test. Cost of clothing is deductible iff:
(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, and
(3)it is not so worn.
The Court rejects a subjective test of the taxpayer’s lifestyle in favor of an objective test.
Almost no clothing is deductible, except for maybe uniforms.
(a)No deduction shall be allowed for personal, living, or family expenses.
(b)For purposes of subsection (a), in the case of an individual, any charge (including tax
thereon) for basic local telephone service with respect to the 1st telephone line provided
to any residence of the taxpayer shall be teated as a personal expense.
See also § 280F for treatment of certain personal property used in business.
§ 274 is a gold-mine of restrictions on deductions.
§ 21 provides a credit of 30%, decreased by 1% for each $2000 over $10,000 a.g.i. (not to
go below 20%) for child care. If this were truly a business expense, it would be a
deduction rather than a credit. § 129 provides an exclusion for employer provided child
care. § 125 would allow the employer to include child-care as part of a cafeteria plan.
The credit is good in terms of equity, because it is not affected by the taxpayer’s bracket.
The exclusion would be worth more to people in higher brackets. Another problem is
that the credit is capped at $4800 for 2 or more kids. The exclusion is capped at $5000.
Another point is that the credit is available to anyone, but you can only get the exclusion
if your employer has some kind of plan.
F. Travel away from home
Generally, commuting expenses are nondeductible. However, § 162 (a)(2) allows a
deduction for travel expenses incurred “while away from home in the pursuit of a trade or
business.” An employee’s unreimbursed travel expenses are deductible as a
miscellaneous itemized deduction and are subject to the 2% a.g.i. floor of § 67. Travel
expenses reimbursed by the employer as well as those incurred by self-employed
individuals are deductible from gross income under §62(a)(2)(A). Deductions for travel
apply whether the employee is travelling from city to city, or within one metropolitan
Comm’r v. Flowers (US 1946) p. 273
Flowers lived in Jackson, MS but worked in Mobile, AL. He tried to deduct
travel expenses incurred in his excursions between the two cities and for meals
and hotel accommodations while in Mobile. The IRS argued that your home is
where your desk is, but the Court rejected that. Rather, the Court used a tree part
test. Deductible expenses must be (1)reasonable and necessary travel expenses,
(2)incurred while away from home, (3)in pursuit of business. The exceptions to
this are “qualified transportation” fringes.
Fausner (US 1973) p. 274, says that incremental expenses for the transportation of
job required tools and material to and from work.
McCabe v. Comm’r (2nd Cir. 1982) p. 272
NYC cop lives in NY state, but has to drive through NJ in order to get to work via
fastest route. He is required to carry his gun any time he is in NYC. He claims
that he would be unable to get a license to carry his gun on buses in NJ en route to
work. He wants to deduct the cost of the extra distance he has to drive in order to
get to work w/o going through NJ.
Court found that McCabe’s case did not fall under Fausner because of the
ordinary and necessary business expense requirement. Rather, they found that his
decision to live in a remote suburb was personal, and was the source of his
problem following the NYC rule that he had to carry his gun.
2. Food and Lodging
US v. Correll (US 1967) p. 277
Travelling salesman in TN. Typically left home early in the morning, ate lunch on
the road, and returned home in time for dinner.
Court uses the comm’r’s sleep or rest rule: travel away from home excludes all
trips requiring neither sleep nor rest regardless of how many cities a given trip
may have touched, how many miles it may have covered or how many hours it
may have consumed.
Hantzis v. Comm’r (1st Cir. 1981) p. 279
Law student at Harvard worked for the summer in NYC while her husband stayed
in Boston. She had transportation costs travelling between Boston and NYC, and
she rented a small apartment in NYC. She claimed these as business expenses
incurred while away from home
The court held that she had no business reason for maintaining her home in
Boston, but rather only personal reasons for doing so. The court rejected her
argument that the temporary nature of her employment eliminated the requirement
that her continued maintenance of a first home have a business justification. The
traveling expense deduction is not intended to exclude from taxation every
expense incurred by a taxpayer, who, in the course of business maintains two
homes. § 162 (a)(2) seeks rather to “mitigate the burden of the taxpayer who
because of the exigencies of his trade or business must maintain two places of
abode and thereby incur additional and duplicate living expenses.” Only a
taxpayer who lives one place, works another and has business ties to both is in the
ambiguous situation that the temporary employment doctrine is designed to
Note: There is a one-year cap on temporary lodging. If you are away from home
for more than a year, it is considered indefinite rather than temporary, and
expenses are not deductible.
G. Meals and entertainment
What if you go out to a business lunch?
-deduction - § 162 ordinary and necessary (appropriate and helpful)
-no deduction - § 262 personal benefit (you were going to eat anyway)
Putting aside administrative considerations, you should deduct whatever goes beyond you
regular lunch expense minus the amount you enjoyed personally. However, this is
impossible to figure as a practical matter.
The law says that as long as you aren’t abusing the system, you can deduct both.
Sutter v. Comm’r (TC 1953) p. 289
If a personal living expense is to qulaify under § 162, the taxpayer must demonstrate that
it is different from or in excess of that which would have been made for the taxpayer’s
Wells v. Comm’r (9th Cir. 1980) p. 290
Denied deduction by a public defender for the cost of occasional lunch meetings w/his
Moss v. Comm’r (TC 1983) p. 288
Moss was a partner in a small law firm that met every day for lunch at a cafe. The firm
paid for the lunches. Moss wants to deduct his share of those expenses.
The court analogizes this situation to commuting. They admit that these lunches have a
real ordinary and necessary business function, but so does commuting and that is barred
by § 262 because there is something inherently personal in it (The court might also think
it excessive that these meals happen every day . . . ).
If Moss were an associate rather than a partner, the issue would be whether or not the
lunches constituted compensation, or whether they could be excluded under § 132 or §
§ 274 is a disallowance of certain entertainment expenses. Generally, the taxpayer has to
show that he performed a business function or discussion either before, during, or
immediately after a meal to get the deduction unless he is out of town. There must be an
expectation that the taxpayer will derive a business reward.
However, § 274 (e)(2) excludes entertainment treated as compensation, so in that case,
entertainment is treated as income to the employee.
Outside of § 274 (d), there is no general requirement for substantiation. § 274 (d)
requires substantiation on the W2 for meals and entertainment.
H. Home office expenses
-How do you get to be a “qualified home office”?
-How do you complete the expenses and deductions?
§ 280A (a)
The general rule is to disallow any deduction for a home office.
§ 280A (c)
Provides exceptions to the general rule if the item is allocable to the portion of the
dwelling unit exclusively used on a regular basis
-as the principal place of business for any trade or business
-as a place of business which is used by patients, clients, or customers in meeting
or dealing with the taxpayer in the normal course of his trade or business, or
-in the case of a separate structure which is not attached to the dwelling unit, in
connection with the taxpayer’s trade or business.
Further exceptions in this subsection if you use your home for a day-care center for
children, old people, or mental cases.
Comm’r v. Soliman (US 1992) p. 296
Soliman was an anesthesiologist who moved from hospital to hospital where he
anesthetized people and ran his business out of a spare bedroom in his house.
In denying Soliman the deduction, the Court applies a subjective test:
-importance of activity in each location
-amount of time spent in each location
The Court disallows his deductions, as the home office was not his principal place of
Compare this approach to the “focal point” approach:
Weismann v. Comm’r (2d Cir. 1984) p. 300
If the taxpayer is an employee, the home office is supposed to be provided for the
employer’s convenience. However, a university professor was permitted to
deduct home office where he was required to share employer-provided office with
several others. Would probably lose now.
Baie v. Comm’r (TC 1980) p. 300
Denied deduction for use of home kitchen where she spent twice as much time
cooking and bookkeeping as selling, when hot dog stand was principal place of
business. Would probably lose too.
Drucker v. Comm’r (2d Cir. 1983) p. 300
Allowed deduction for musician in Met Opera who performed 12 hrs/wk at
Lincoln Center and practiced 32 hrs/wk in music study at home. The home study
was the principal place of business.
The plumber who has his office and staff at home, but who spends most of his
time in other people’s homes was not allowed the deduction because although the
activities performed at home were essential, they were minor.
I. Current versus capital expenses
No deduction shall be allowed for any amount paid out for new buildings or for
permanent improvements or betterments made to increase the value of any property or
estate (except for most mine or mineral excavations, soil or water conservation
Requires the capitalization and inclusion in inventory costs of certain expenses.
1. Why do we care?
There are significant advantages to accelerating losses while deferring gains.
There is a huge potential for abuse. If a certain expenditure will produce a gain
that will be realized or recognized later, then that expenditure should be matched
against the gain at that time.
2. Acquisition and disposition of assets
If I buy an asset, I clearly have to capitalize it. What if I make some expenditures
which will give me a long-term benefit but which will not result in an acquisition?
What about expenses related to the start-up of a new business? What about
The rule seems to be that if you see all of the return w/in the taxable year, you can
The object is to match the income to the expense. If you get the income this year
for an expenditure this year, then you deduct it this year. If the benefit comes over
a period of time, then you capitalize it.
§ 163 (d)
If you borrow money to buy stock, you can deduct the interest on the loan up to
the amount of income on the investment asset. The rest you can carry over.
Woodward v. Comm’r (US 1970) p. 308
The taxpayer wanted to deduct $25,000 spent in appraisal litigation.
The Court held that costs incurred in the acquisition or disposition of a capital
asset are to be treated as capital expenditures. The test is not based upon the
taxpayer’s purpose in undertaking or defending litigation, but rather the simpler
inquiry whether the origin of the claim litigated is in the process of acquistion
There seems to be a trend toward reducing formalism and looking at the
underlying economic reality of the transaction, however, some formalism and
some need for formalism remains.
David R. Webb v. Comm’r (7th Cir. 1983) p. 311
When taxpayer bought business, he agreed to continuing making pension
payments made by the previous owner. He did not include those payments in his
basis, but deducted them as ordinary and necessary business expenses the first
couple of years. The court held that he could not have assigned a definite value to
the payments up front, but that they were capital expenditures to be added to his
basis each year when he made them. Shuldiner notes that if Webb wanted to
capitalize the whole thing immediately, he could just buy the pensioner a lifetime
annuity which would pay the amount of the pension annually. Then he could
capitalize the cost of the annuity and add it to basis immediately.
What about construction or production of a capital asset, as opposed to
§ 263A (f)
Impute income created by the difference between the cost of making something
yourself and paying the FMV to someone else. You might be able to get around
this by borrowing money for some other purpose in order to free up capital to
spend in producing the asset.
Comm’r v. Idaho Power (US 1974) p. 312
Public utility used its own equipment to construct its own capital facilities.
Wanted to deduct depreciation.
Court held that the taxpayer was required to capitalize all the indirect costs as well
as the direct costs allocable to construction or production of real property or
tangible personal property.
Gains and losses on the sale of property are treated differently than ordinary gains
3. Nonrecurring expenditures and expenditures that provide benefits beyond the
Capitalization accompanied by a recovery of capital is required if the expenditure
is expected to produce income over a period of time rather than only in the current
Fall River Gas v. Comm’r (1st Cir 1965) p. 317
Gas co. was leasing out equipment and paying for the installation. The leases
were terminable at will, but the gas co. expected a continuing economic benefit
over a number of years.
Encyclopedia Britannica v. Comm’r (7th Cir. 1982) p. 317-18
Encyclopedia Britannica was too busy to write a book itself, so it sub-contracted
another group to do so, paying the group up front. EB expected to receive
royalties on the book over a number of years. The court required them to
capitalize the book because it was a non-recurring expense and therefore not
Under § 263A (a), tangible property is deducted, and intangible property is
Note: § 263A (h) provides an exemption for free-lance authors, artists,
photographers, etc. However, this would not apply to the writers in the
Encyclopedia Britannica case, because they wrote in their capacity as employees.
“Indirect expenses” - GM has to capitalize the parts that go into its cars, the
salaries of assembly line workers, the salaries of front office workers, new wings
on their buildings, etc.; they would deduct the salaries of custodial staff
Comm’r v. Lincoln Savings (US 1971) p. 315
Taxpayer’s expediture that serves to create or enhance a sparate and distinct asset
should be capitalized under § 263. This was read by some as requiring the
creation of a new asset in order to demand capitalization.
Indopco v. Comm’r (US 1992) p. 314
This case either overruled or at least clarified Lincoln Savings. Indopco was the
target of a friendly takeover, which cost a lot of money to effectuate. The Court
reread Lincoln Savings. The rule in Lincoln Savings was not exclusive. It did not
say what was not a capital expenditure, it only pointed to something that was a
capital expenditure. The Court held that Lincoln Savings did not eliminate the
future benefit test. Even though no new asset was created, capitalization was
Repairs and improvements
In general, expenses associated with preserving assets and keeping them in
efficient operating condition are deductible under §§ 162 or 212, and expenditures
for replacement of property or “permanent improvements” made to increase the
value or prolong the life of property are capital expenditures, similar to the
purchase of a new asset.
If you put a new roof on your house, you might want to capitalize the expense
rather than deduct. If you deduct, then it is a personal expense and is
nondeductible. If you capitalize it, it will go into basis and might decrease your
capital gain when you sell the house.
Environmental clean-up hypothetical (p. 316):
IRS says that the proper test is to compare the status of the asset after the
expenditure to the status before the condition arose that created the need for the
expenditure. Shuldiner thinks the IRS should not be making policies like this.
A plain example where you should have to capitalize the expense is when you buy
land you know is contaminated so that you pay a discounted price, and you clean
up the property raising the value.
If you pay full price because you don’t know the land is contaminated, and it’s
really worth much less than you paid, you then pay to clean it up, and it’s now
worth what you paid for it, you should deduct the expense of the clean-up.
However, the law is unclear.
If you buy property for $15 mil to use as a toxic waste dump, dump there for 30
yrs, and then pay $10 mil to clean it up, you should probably get to deduct the
expense because you’ve enjoyed the benefit already.
4. Start up expenses
As a general rule, no deduction is allowed for start-up expenses. However, the
expenditures may be treated as deferred expenses prorated equally over at least 60
Start-up expenses include amounts paid or incurred in investigating the creation or
acquistion of a trade or business, creating an active trade or business, or any
activity engaged in for profit and for the production of income before the day the
business begins, in anticipation of such activity becoming a trade or business
which if paid in connection with an operating business would be counted as a
deduction that year. It doesn’t include any amount allowed as a deduction under
§§ 163(a), 164 or 174.
Richmond Television Corp. v. United States (4th Cir. 1965) p. 321
Court required capitalization of job training and related expenses incurred before
the company obtained its operating license from the FCC and began broadcasting.
The Court held that Richmond was not carrying on a trade or business until the
license was obtained.
If you simply expand a currently operating business, you must capitalize
expenditures. For example, the Court denied a new business expense to a bank
that spent money getting into the credit card business.
5. Job search and education expenses
Rev. Ruling 75-120
In general, you can only deduct the cost if its a new job directly connected to the
old trade or business, you can deduct it. If it’s a brand new field, you cannot
Shuldiner says that the “all the facts and circumstances” test established by the
IRS is a tougher standard than “ordinary and necessary” because the IRS is
worried about people setting up sham interviews and then deducting them.
If it’s a new trade or business but you don’t get the job, it seems that you should
be able to write it off because you get no lasting benefit, however, the revenue
ruling says you do not. Shuldiner points out, though that this is just an IRS
position, not established law.
Expenditures made by an individual for education (including research undertaken
as part of his educational program) whch are not expenditures of a type described
in paragraph (b)(2) or (3) of this section are deuctible as ordinary and necessary
business expenses (even though the education may lead to a degree) if the
-Maintains or improves skills required by the individual in his employment
or other trade or business, or
-Meets the express requirements of the individual’s employer, or the
requirements of applicable law or regulations, imposed as a condition to
the retention by the individual of an established employment relationship,
status or rate of compensation.
An individual cannot deduct expenses incurred in meeting the minimal
educational requirements established by law or the employer, for a field.
Ruehmann v. Comm’r (TCM 1971) p. 324
Taxpayer went to U.Ga law school. Passed the bar before his third year, and did
some work for a Hotlanta firm. Then he went to Harvard to get an LLM. While
in Boston, he did some work for firms up there.
Court found that the cost of the third year of law school was not deductible, even
though Ruehmann was able to take the bar after the second year. It was still
common, and part of the standard educational requirement that lawyers would go
to three years of law school. The cost of the LLM was deductible, because
Ruehmann was doing work of the type before he went to Harvard. (Contrast this
with some cases where lawyers have gone straight from JD programs to LLM
programs w/o working and have been denied deduction).
6. Depreciation and Amortization
See § 167
The taxation scheme allows depreciation deductions because it attempts to
measure actual net income. Therefore, it is important to account for economic
decline in assets.
There are a few potential depreciation schemes:
-straight line - depreciate 1/10 the value over 10 yrs
-economic depreciation (actual economic decline) - this scheme is neutral
as to whether you buy a cheap, short living asset or an expensive, long
-accelerated depreciation - this makes it attractive to buy assets by
lowering the effective rate on investments. This can be done by shortening
the straight line or graduating the depreciation.
There is no depreciation for personal assets because that would be allowing a
deduction for consumption. Only §§ 162 and 212 type activities get depreciation.
Depreciation is not mentioned in § 62 but sometimes the deduction is above the
line. For example, rents and royalties are typically above the line.
Depreciation makes the sale-leasback deal look pretty good. You could
effectively sell your depreciation rights to someone in a higher bracket by selling
the property, and then having the purchaser lease it back to you. These types of
transactions have been limited a great deal by §§ 465 and 469.
MACRS (Modified Accelerated Cost Recovery System)
Currently, depreciation is figured using MACRS. Property falls into either a 3, 5,
7, 10, 15, or 20 year category.
In order to figure depreciation, you must use the applicable depreciation method,
the applicable recovery period, and the applicable convention. See dep. tables on
Typically, the depreciation method is 200% declining balance, switching to
straight line when that would yield a higher allowance. To compute declining
balance depreciation, first compute the straight line rate. Then increase that rate
by the appropriate factor (usually 200%). Apply that factor to the adjusted basis
each year. Eventually, the basis will be reduced to the point that straight line
decpreciation would provide a larger allowance. At that point, the taxpayer
switches to straight line.
Usually, the taxpayer uses the half-year convention, so that in the first year and
last year of depreciation, he will only take half the depreciation. Keep in mind
though, that this extends the period during which the property is depreciated by
Note: § 168 (g) provides an alternative depreciation system for classes of property
which Congress feels the over-all system treats too generously. They discourage
investment in such property by reducing the subsidy. In order to effectuate this,
ADS sometimes forces straight line depreciation over longer property lives.
This section provides a subsidy for small businesses. It gives an immeditate
deduction for assets placed into service by a business who places less than
$200,000 worth of property into service.
Note: Generally, any change to the depreciation scheme is prospective so that
taxpayers do not have to go back and recompute depreciation rates.
Historically, there was no special provision for dealing with intangibles. Now,
there is. The traditional problem was that you could not depreciate good will
because there was no reasonable ascertainable life over which to depreciate. In
order to get depreciation for intangibles, you had to be able to separate from good
Now, there is a 15 year life for intangibles across the board. See § 197. § 197
(f)(1) prevents the taxpayer from taking a loss for disposition of an asset peeled
off from an intangible that, as a whole, is doing quite well.
You can take a “depletion” deduction for mineral assets which will disappear over
Cost depletion - deduction from cost or depletion of the whole basis (i.e. estimate
your field has I million barrels of oil and you extracted 100,000 this year, you
have depleted 10% of basis).
Percentage depletion - simple deduction in lieu of depletion of a set percentage of
your gross income. Basis is irrelevant.
Graetz p. 344
“Although cost depletion can be analogized to depreciation, percentage depletion
serves an additional purpose. Because it permits a taxpayer to deduct more than
the actual cost, it provides a subsidy for the activities to which it applies.”
Shuldiner says this is not necessarily true. It isn’t always more attractive to be
able to deplete more than the cost because if you get a heavier deduction now, and
don’t get to deplete the whole thing, it may still be worth more than if you get a
heavier deduction later and deplete more than your basis. Present value
determines which is worth more . . .
§ 163 (a) says that, generally, interest is deductible. However, the rest of § 163 whittles
down the scope of deductible interes (i.e. investment interest, business interest, and home
mortgage interest are deductible; personal interest is not deductible; passive interest may
or may not be deductible or deductible to the extent that it offsets passive gains).
Shuldiner says that perhaps interest should be deductible, because in a broad sense, it
represents a reduction in your worth without a corresponding consumption. If everything
else were taxed properly, all interest should be deductible. However, there are practical
problems in knowing whether or not the money paid is actually interest. For example, it
might be hard to distinguish between interest and principal components in an installment
loan payment plan. There are futher problems with questionable debt and arbitrage.
In general, in order to determine whether or not interest on indebtedness is deductible,
you have to look at what you purchased with the money borrowed.
Possible ways to determine whether interest is personal or business-related:
-What secures the loan?
-Trace the use of the loan.
-Facts and circumstances rule
The IRS uses the “tracing” method, which seems simple conceptually, but is not really.
Home Mortgage Interest
§ 163 (h)
This section disallows personal interest, but excepts “qualified residence interest.”
Qualified residence interest is further subdivided into acquision and home equity
indebtedness. The deduction for acquisition indebtedness is limited to two homes and
has a $1 mil cap. The debt is traced to the residence. The deduction for home equity
indebtedness is limited to $100,000 but is not traced, so you can use that loan to purchase
anything, and the interest is deductible.
The home mortgage interest deduction trumps some other code provisions (i.e. §§ 469,
263A) but not others (i.e. §§ 265, 264).
Cases on Interest
West v. Comm’r (USTC 1991) p. 360
Home-owners were charged late fee for delinquent mortgage payments. They wanted to
deduct the surcharge as part of their home mortgage interest.
Court found that the purpose of the fee was to cover administrative costs to the bank of
processing the late mortgage payment. Therefore, it was a personal charge to the Wests
and not a part of the deductible interest.
Shuldiner says that if this were a business loan, the late fee would be deductible as an
ordinary and necessary expense, so why deny the home-owner the same deduction?
Knetsch v. US (US 1960) p. 355
Knetsch set up a very complicated transaction, whereby he bought for $400,000 apiece,
ten thirty-year annuities, which had a purchase price of $4,004,000 and bore 2 1/2%
interest. He bought the annuities by paying $4000 cash and signing non-recourse notes
secured by the annuities for the other $4 mil. He had to pay 3 1/2% interest on the $4 mil
indebtedness, but the interest was pre-payable annually. He was able to borrow against
the annuities the amount by which their value exceeded his debt. The first year, the value
on the annuities totalled $4,100,000. His indebtedness was $4 mil. Knetsch borrowed
$99,000 and used it towards pre-paying the $140,000 interest he owed on his non-
recourse loan. He also pre-paid the $3,465 interest he owed on taking out the loan against
the annuity. He deducted both interest payments ($143,465). The next year, he owed
$143,465 interest on his aggregate indebtedness of $4,099,000 (initial $4 mil + $99,000
he borrowed in year one to pay his first year’s interest). He pre-paid this amount,
borrowing another $104,000, which was $1000 less than the difference between the value
of the annuities ($4,204,000) and his aggregate indebtedness. Again, he claimed the
deduction for both interest payments.
The result of this transaction was that Knetsch was able to deduct about $150,000/yr for
interest payments even though he only laid out about $30,000-$50,000/yr of his own
money. After a few years, the amount he had to pay himself got so high that it wasn’t
really worth it anymore, and Knetsch let the non-recourse debt on which he had never
paid any principal revert back to the lender, the initial seller of the annuities. In effect,
Knetsch had purchased deductions for about 1/3 their face value.
The court found that this transaction “lacked economic substance” and that it was
therefore a sham transaction. The court stated that it did not appreciably affect his
beneficial interest except to reduce his tax. If he had continued to perform the way he
performed every year so far, he would have never had more than $1000 in the annuities,
which would not really pay him any annuity. The court found that the $91,570 paid by
Knetsch to the insurance company was the fee charged for setting up this deal.
Shuldiner notes that in order for the court to reach its position, it has to integrate or
combine the two transactions (the purchase of the annuities and the loan). However, he
suggests that the court might not be able to do so as easily if the taxpayer obtains the loan
from a different source.
Goldstein v. Comm’r (2d Cir. 1966) p. 359
Taxpayer who won $140,000 in Irish Sweepstakes paid 4% to borrow money which she
used to purchase T-notes yielding 1.5% over a number of years. She pre-paid the interest
on the 4% loan with money she won, and then tried to deduct the pre-payment. This
would have allowed her to offset much of her winnings.
The court found no economic purpose for the transaction other than tax avoidance and
thus disallowed the deduction.
Note: The transaction in Goldstein would now be disallowed by § 461 (g)(1). There has
been no statutory response to Knetsch. According to Shuldiner, this might be because the
insurance lobby is so strong.
Property losses - i.e. when you buy an asset at one price and then sell it at a lower price
Operating losses - i.e. when it costs $15,000 to run your business, but your income is
Casualty losses - i.e. you buy a car and it is immediately stolen or crashed.
1. In general
(a)There shall be allowed as a deduciton any loss sustained during the taxable year
and not compensated by insurance or otherwise.
(b)The basis for determining the deduction for any loss shall be the adjusted basis
provided in § 1011 for determining the loss from the sale or other disposition of
property (i.e. lower of adjusted basis or FMV)
(c)In the case of an individual, the deduction shall be limited to
(1)losses incurred in a trade or business
(2)losses incurred in any transaction entered into for profit, though not
connected with a trade or business; and
(3)except as provided in subsection (h), losses of property not connected
with a trade or business or a transaction entered into for profit, if such
losses arise from fire, storm, shipwreck, or other casualty or from theft.
2. Personal versus business or profit seeking losses
You do not generally get a deduction for personal losses. However, you can
deduct business losses.
In the case of property which has mixed business and personal use, you divide the
property proportionately into its business and personal parts. Then you depreciate
the business basis but not the personal basis. When you sell, you divide the sale
price by the same proportions and use that to measure whether you have a
business gain or loss. It is possible to have a business gain which is taxed and a
personal loss which is not deductible even if you sell the property for much less
than you paid for it.
3. Casualty losses
Casualty losses are extremely limited by § 165. There is a deductible of the
higher of $100 or 10% of AGI. In other words, if your AGI is $100,000, and the
casualty damage is $12,000, you only get to take a $2000 loss. In fact, the $100 is
practically obsolete, and is only still there because they hardly ever take anything
out of the code.
Congress probably limits the casualty loss deduction because they want to
encourage people to buy insurance to cover such calamities.
The case law suggests that in order to get the deduction, the loss must be “sudden,
The loss is the adjusted basis or the FMV of the property, whichever is lower. So,
if I have a car for a few years, and it gets smashed, the loss will most likely be the
FMV. If the car is used for business purposes, the loss will be the adjusted basis
(PP - D).
Casualty loss is an itemized deduction, and thus taken below the line. It is not
subject to the 2% floor § 67 (b)(3).
4. Loss limitations
a. Property losses
Fender v. US (5th Cir. 1978) p. 387
Investment banker had a couple of trust funds set up for his children. The trusts
held some bonds. As trustee, Fender sold the depreciated bonds for a loss to a
third party bank, over which he had substantial control. He deducted the loss,
which offset gains on other properties held by the trusts. 42 days later# , he
bought the bonds back at the same price for which he had sold them.*
The court denied the loss because the parties maintained sufficient control over
the purchaser to ensure that they could repurchase the property w/o suffering a
real economic loss.+ There is a further suggestion that where, as here, the loss is
due to a change in the interest rate, and if you held the property until maturity
there would be no loss, then there was never any real economic loss.
Shuldiner says there are two important questions. First, was there a realization?
Second, if there was a realization, was there a loss? In the Fender case, the court
says there might have been no realization because of the close relationship of the
parties. However, even if there was a realization, it does not look as if there was a
real loss associated with it. Shuldiner says that there was a loss because the
interest rates rose making the bonds worth less than they used to be, however
Fender has not realized that loss.
Tax Straddles p. 391
A tax straddle occurs when an individual buys options on two identical assets, one
betting that the price of the asset will go up, the other that the price will go down.
If one goes up in value, you hold on to it, deferring the gain. If the other goes
down, you sell at a loss, taking the deduction. The price has to either go up or
down. In this way, the individual can assure that he always receives the tax
Fender waited 42 days because of the wash sale rules in § 1091. If you enter a transaction, you are required to wait
at least 30 days before an offsetting transaction in order to take a loss. Otherwise, the sale is treated as a wash.
§ 165 (f) allows deductions for loss on sale of assets only so far as allowed by §§ 1211 and 1212; §1211 (b) allows
the deduction for capital losses to the extent of capital gains + $3000, with a carry-over for anything beyond that
amount. The purpose of § 1211 is to correct partially the timing problem that the realization doctrine creates.
Realization is not fair to the IRS because the taxpayer gets to choose whether to be taxed on the gain now or to wait
until later. People could immediately deduct all capital losses if not for § 1211 and its off-setting gains requirement.
Under § 267, the loss would have been disallowed because the transaction would have been considered to be
between related parties if Fender had owned 50% or more of the bank at the time the sale was made.
benefit of the loss without ever suffering any risk of economic harm. This is
made possible by the realization doctrine.
§ 1092 Deals with straddles. It says that any loss with respect to a position shall
be taken into account for any taxable year, only to the extent that the amount of
such loss exceeds the unrecognized gain (if any) with respect to offsetting
positions. Any loss not takeninto account shall be carried over.
§ 1256 says some assets are “marked to market.” This means that the asset is
considered to be sold for its FMV on the last day of the year. The basis is then
adjusted according to the losses and the presumed gains on the FMV sale. This
provision applies to regulated futures whether or not they are straddles.
b. Tax Shelters
A “tax shelter” is an activity that you expect to throw off losses for tax purposes
so that you can shelter other income. See Estate of Franklin.
Shelters are often created by non-economic rules:
-pre-paid interest (Goldstein)
-investment for tax credits
-installment sales rules
-capital gains rates
-leverage (interest on indebtedness) rules make tax shelters sweeter
Tax shelters are dependent on the ability to shift losses from a party in a low
bracket to one in a high bracket (i.e. sale-leaseback, partnership rules).
(1)In general and judicial response
The judicial response to the rampant pre-1986 abuse of tax-shelters, was largely
Frank Lyon Co. v. United States (US 1978) p. 396
AR bank wanted to build a new office building, but they could not issue bonds
because to do so would have required them to issue the bonds at a rate exceeding
the AR usery limitations. They could not borrow against the building because
they were undercapitalized. So they set up an elaborate plan with a board member
(Lyon), whereby his company would buy the building from the bank as each floor
went up and then lease it back to them. Lyon bought the building with a $500,000
initial outlay, and he borrowed the rest from NYL. Lyon’s loan payments equalled
the rent the bank paid Lyon. The bank had the option to buy the building at any
time at a fixed price. Regardless of when the bank buys back the building, Lyon
will always get back his $500,000 + 6%. In effect, the bank borrows the money
from NYL using Lyon as a conduit. In exchange for his $500,000 investment and
his agreement to serve as a conduit, Lyon gets to take the substantial deduction for
depreciation of the building.
The Court, in approving this deduction, places a lot of emphasis on the fact that
Lyon was a third party. In Lazarus, they denied the deduction because the loan,
sale and leaseback were all done between only two parties.
Basically, the Court holds in this case that if all formal requirements are followed,
one can buy tax benefits. The IRS is required to follow the form of the transaction
and not the substance. Compare with Estate of Franklin where the parties were
denied the benefit of the depreciation deduction. The difference is probably that
in that case, the loan was for an amount inflated ridiculously above the FMV.
(2)At-risk rules and § 183
Operating losses are suffered when the cost of operating a business exceeds the
income produced. Such business losses may be carried backwards and forwards,
although personal losses may not. See §172(d)(4).
If you have losses from one business and you want to use them to offset gains
from another business, you can usually do that. Investment losses are allowed if
capital to the extent that they offset capital gains. Any excess over that amount
may be carried forward. See § 1211.
§ 183 says that you can get a deduction for activities not engaged in for profit if
they would be deductible anyway. It also allows other expenses as if they were
entered into for profit to the extent that the g.i. from the activity exceeds the
deduction. If income exceeds deductions for 3 of 5 years, then it will be presumed
to be a “for profit” activity.
Brannen v. Comm’r (11th Cir. 1984) p. 411
M.D. using psychologist as his investment counselor enters a limited partnership
with purpose of buying a film worth $50,000 for $1.5 mil. This was a good deal,
because they planned to depreciate about 95% of the cost in the first two years.
The court points to five factors found in the regulations accompanying § 183 to be
considered in determining whether or not the activity is for profit. The court
found that this partnership was not operated for profit and disallowed the
The test of a “for profit” activity is subjective:
-The manner in which the activity is carried out
-The expertise of the taxpayer
-The time and effort of the taxpayer
-The financial position of the taxpayer
In general, cases like Brannen and Frank Lyon were ineffective in dealing with the
tax shelter problem, because they are too fact specific and because “profit motive”
is hard to define. Do you have to be motivated to get the best profit or is anything
over 0% return a “profit motive”? Furthermore, Congress subsidizes these
activities through accelerated depreciation, so how can the IRS turn around and
use the courts to take these subsidies away?
(3)Passive loss rules
In its 1986 revisions to the tax code, Congress finally took some action to solve
the tax-shelter problem.
§ 465 “At Risk” Limitation
This section limits the ability to leverage the purchase of income producing assets
by denying a deduction unless the taxpayer puts his own money at risk in such a
transaction. According to Shuldiner, this provision has been fairly ineffective at
dealing with the tax shelter problem because it is easy to structure around the
limitation and because the limitations were not very broad in scope.
§ 469 “Passive Loss” Limitation
This section creates baskets of loss and gain for business in which the taxpayer
does not materially participate. You can’t use loss in one basket to offset gain in
another basket. Also, you can only carry the losses forward to use against future
income from activity within the basket. This fixes the timing problem and tries to
match income from the business with loss rather than accelerating the loss and
postponing the income. However, § 469 (g) will allow you to recognize all losses
§ 469 (h) defines material participation as (1)regular, (2)substantial, and
(3)continuous. The regs say that regular participation must be more than 500
hrs/yr, or you have to perform all the services that are provided, or you must work
more than 100 hrs if that is equal to or greater than any other person’s
contribution. Finally, the determination will be made in light of the facts and
Note: Real estate was initially subject to tougher rules. For example, rental real
estate was automatically deemed to be passive. However, the r.e. lobby got busy
and the rules have been changed.
It is unclear whether the taxpayer would prefer to aggregate or disaggregate his
passive activities. There are various rules providing this determination, and the
taxpayer would want to consider them carefully.
Shuldiner says that § 469 has been much more successful than either § 465 or
jurisprudence at taking care of tax shelters.
L. Bad Debt
Analogous to COD provisions. I get a loss if I cancel someone else’s bad debt. § 166 is
an extension of § 165.
For debt, I can get a deduction for partial worthlessness. Also, in order to get the
deduction for tax purposes, you have to take the loss for book or accounting purposes.
M. Personal deductions
1. Standard deduction
-currently $4000 for single taxpayer
-currently $6400 for married couples filing jointly
Any taxpayer can take the standard deduction. However, taxpayers whose
allowable itemized deductions are greater should prefer to take itemized
deduction. Most taxpayers do, in fact, take the standard deduction. This provides
administrative simplicity for the IRS and the taxpayer.
2. Personal exemption
Taxpayers are allowed to exempt $x of income indexed annually for inflation
(currently $2550) for themselves, their spouses and certain dependents identified
in § 152 ((1)if the taxpayer provides more than 50% support, (2)there is a familial
relationship or the dependent is a member of taxpayer’s hh).
Eligible dependents are children 18 or younger, students under 24, low-income
After 1986, you can no longer take the personal exemption for yourself if
someone else can claim you as a dependent on their return.
3. Personal credits
Taxpayers can get credits for childcare (§ 21), for disability and old age (§ 22), for
tax withheld (§ 31), and for earned income in the case of low-income taxpayers (§
Credits are amounts subtracted from the tax liability after everything is computed.
The Earned Income Credit is a refundable credit available to taxpayers whose
income is below a certain level. The gov’t actually gives them a check. The
original justification of the EIC was to offset SS. Now, its a subsidy for poor
4. Phaseouts of exemptions and itemized deductions
§ 151 has a phaseout provision for personal exemptions.
This effectively raises the marginal rates on high income taxpayers because the
phaseout applies progressively to higher incomes (i.e. 2% for each $2500 over the
threshhold, which is currently $150,000 for married people).
For example, if a married couple has $160,000 income, they exceed the threshold
by $10,000. Divided by $2500, that is 4 x 2% = 8% of the personal exemptions
which are phased out. If a couple has 2 exemptions of $2000 each, then the
exemption will be lowered by $320 (8% x $4000). In a 31% bracket, this will
translate into $100 in extra tax, or 1% of the $10,000 income in excess of the
threshold. In other words, the marginal rate is raised by 1%. The raise in the
marginal rate will vary proportionally to the number of exemptions, so a single
taxpayer will pay an extra 1/2 %, and a family with four exemptions will pay an
A further reason why the phaseout effectively raises marginal rates is because it is
only partially indexed for inflation. The threshold and the exemptions are
indexed, but the $2500 is not. The result is that the phaseout becomes faster and
faster every year.
§ 68 phases out itemized deductions.
Reduces itemized deductions by 3% of the excess of AGI over the threshold
amount. However, it states that you can never lose more than 80% of your
itemized deductions. Shuldiner says that the 80% provision is meaningless
because most people come nowhere near losing 80% of their itemized deductions.
For example, it the threshold is $100,000 and I have $1.1 mil AGI, then I lose 3%
of $1 mil or $30,000. However, if I have $1.1 mil in AGI, I will probably have a
lot more than $30,000 in itemized deductions. According to Shuldiner, this
makes the phaseout an increase in the marginal rate rather than a decrease in
Note: There are some deductions that cannot be phased out.
§ 164 provides a deduction for certain taxes.
An argument for deductibility of taxes is that they are just another cost of doing
You don’t get a deduction for federal income taxes, although that doesn’t really
matter because if the gov’t decided to give such a deduction, they would just raise
the tax rate. This would be a “tax exclusive” rate rather than the “tax inclusive”
rate we currently use.
You can get a deduction for state and local income taxes. In effect, this is a
subsidy for state and local gov’ts.
There is no itemized deduction for state sales tax.
6. Charitable deductions
§ 170 allows a deduction (of up to 50% of income for public charities and 30% of
income for private foundations) for contributions to charitable organizations. This
encourages donations to charity plus there is no consumption connected to the
outlay, so it should be deductible. (A credit would favor those in high brackets;
also, a deduction is harder for Congress to limit)
Private foundations are set up by one or a few people.
Public charities collect their money more broadly.
If you spend time driving people around for charity, you can deduct gas and
depreciation, but not time. That would be like imputing income.
If you donate $50 to a local PBS station and they send you a $15 CD, you subtract
the FMV of the benefit. § 6115 requires charities to disclose the values of quid
If you donte $10,000 to a school and your child gets free tuition, you only get to
deduct the amount that exceeds what tuition would have cost.
Hernandez v. Comm’r (US 1989) p. 439
Scientologists had a set rate for religious services. Court found that taxpayer
could not deduct that amount as a charitable contribution when he received a
Gifts of Appreciated Property
§ 170 (e) limits your ability to take the full deduction. You can take the deduction
to the extent that the recognition would have been ordinary income. See also
7. Medical Expenses
§ 213 allows a deduction for medical expenses including home improvements
directly tied to a medical necessity.
IV. Whose Income?
A. Taxation of the family
1. Treatment of couples
Poe v. Seaborn (US 1930) p. 468
Court held that if there was a comm’ty property law in a state, couples were taxed
individually as if each earned 50% of the total income. States started passing
comm’ty property laws, so Congress changed the law.
Marriage penalty/Marriage bonus
If both people in the couple earn the same amount, the marriage provisions are a
penalty. If one earns a lot more, they are a bonus.
One reason for the problems in the tax treatment of marriage is the imputed
income from housekeeping services when one partner can stay at home.
The EIC punishes marriage. Two individual EICs are a much higher percentage
of two low incomes than the one figure for married couples.
2. Treatment of children
§ 1 (g)
Assignments for capital to children are ok.
However, the standard deduction for children is now limited to the lesser of $500
or the child’s earned income. § 63 (c)(5).
Also, the kiddie tax says that to the extent unearned income exceeds x, that
unearned income will be taxed at the parent’s marginal rate. (i.e. 0-500 no tax,
500-1000 child’s rate, 1000+ parent’s rate). This substantially reduces the
parent’s ability to shift income into a lower bracket. See also § 1 (g)(5) (if the
parents aren’t married, the child’s rate will be that of the higher parent).
Taxation of trusts
Congress did 2 things in 1986:
-squished down the brackets for trusts (§ 1 (e)); the top bracket kicks in at $7500,
so the maximum tax benefit is $845
-tax parents on grantor or revocable trusts
3. Treatment of divorce
Property transfers w/in marriage (§ 1041)
§ 1041 provides pure carry-over basis in inter-marriage transaction, so you can
transfer losses to your spouse.
§ 1041 (d) denies the allowance for people whose spouses are non-resident aliens.
This prevents the transfer of appreciated property out of the country to a spouse
who could sell it w/o paying a capital gains tax.
§1041 is really only a deferral of tax on gains. The recipient of the property will
be taxed on the gain when realization finally occurs. Often, in the case of divorce
the gain will be shifted to the spouse in the lower bracket.
Farid Es Sulteneh p. 486
No recognition of gain or loss; carry-over basis
Alimony § 71 (b)
The code extends income splitting to the post-marital situation. Alimony
payments are deductible above the line. They are fully includable to the recipient.
It truly is income shifting, although it must stop upon the death of the receiving
Child Support § 71 (c)
Child support is not deductible. Furthermore, the code makes it difficult to
disguise child support as alimony. If the amount of alimony is contingent upon
some significant event in the child’s life, it will be treated as child support.
B. Assignment of Income
1. Income from Services
Lucas v. Earl (US 1930) p. 487
Classic reassignment of income for services case. Earl and his wife made an
agreement that they would split any amount either earned 50/50.
You can’t do that. Lucas gets taxed on the income.
US v. Bayes (US 1973) p. 489
Under Lucas, income is taxed to the person earning it. A corporation cannot place
income earned by a partnership of doctors into a trust without paying income tax.
The payments into the trust constituted income earned by the doctors.
Note: In both Lucas and Bayes, the taxpayers lost, but they would be allowed to
do the things which led to the litigation today. These cases are still good law on
income shifting in general, though.
2. Income from Property
Blair (p. 500)
Taxpayer signed over a stream of income on a trust that he would have been able
to receive for his life, although he had no other control over the trust. He is no
longer taxed on the stream of income.
Lucas (p. 487)
The taxpayer signed over a stream of income from for services. He is taxed on the
Horst (p. 502)
The taxpayer signed over interest coupons for a bond, although he retained control
over the principal of the bond. He is taxed on the income.
In the income from property cases, the issue seems to be (1)how much did
someone own? and (2)how much did he sign over?
In Blair, the taxpayer really retained nothing, he transferred basically everything.
In Horst, the taxpayer retained a substantial portion of the asset for himself. It
seems that a test of substantial control is used.
Note: § 1286 income from stripped bonds is now allocated depending on who
owns which part of the bond. The holder of the income part is taxed on the
income, the holder of the principal will be taxed on any capital gain.
V. Capital Gains and Losses
A. Historic Treatment of Capital Gains
B. Mechanics of Capital Gains
§ 1 (h) provides a maximum rate for taxation of capital gains.
Net long term capital gain = excess of long term capital gains over long term capital
Net short term capital loss = excess of short term loss over short term gain
Net capital gain = excess of net long-term capital gain over short term capital loss
§ 1222 The holding period to get long term capital gains treatment is one-year in obvious
cases. §1223 provides a formula for figuring it out in unobvious cases.
C. Policy of preferential treatment of capital gains
“Incentive” argument - encourages capital investment and risky investment.
“Bunching” argument - because we don’t have a realization system, capital gains often
reflect income earned over a number of years, so we don’t want to tax them as if they
were earned all at once.
“Inflation” argument - if you taxed capital gains at the full rate it would be an
overtaxation because of inflation. (you could solve this problem by indexing for
D. Definition of a capital asset -- § 1221
Anything could be a capital asset, although inventory and property used in a trade or
business and subject to depreciation under § 167 are explicitly excluded (among 3 other
Difficulty - Unless you know the purpose of the statute, it’s hard to read. Here the
problem is circular because in order to know whether something falls within the statute,
you need to know whether or not it’s a capital asset.
“Mixed-motives” - is an asset intended to be held for business or investment?
Stocks and bonds - in order for stocks and bonds to fall within the inventory exclusion,
they must be held for sale to customers; stocks and bonds are usually an easy case,
because most people are not holding stocks and bonds for sale to customers. However,
some banks may have a problem because they do sell stocks and bonds to customers as
well as hang on to some for their own investment purposes. § 1236 requires purchasers
of this kind to designate a stock or bond upon purchase.
Real estate is a harder case because it’s not always clear whether someone is a dealer . . .
Malat v. Riddell (US 1966) p. 579
Joint venture bought 45 acres to develop into apartments. They ran into zoning
difficulties, so they sold off part of the acreage. Eventually, they sold it all off. They
wanted to get a capital gains rate on the sale.
No capital gains from sale of “property held by taxpayers primarily for sale to customers
in the ordinary course of business.” § 1221.
Primarily is defined as “of first importance” or “principally.”
The law wants to separate profits and losses arising from everyday operation of a business
and the realization of appreciation in value accrued over a substantial period of time.
Malat is clear that you should look to the number one purpose to see whether something
is ordinary or capital.
Byram v. US (5th Cir. 1983) p. 584
Taxpayer sold over 20 pieces of property over the course of a few years making several
million dollars. The Dist. Ct found that he was not engaged in a trade or business but that
he held the property for investment purposes. The questions are sometimes subdivided
into (1)was he engaged in trade or business? (2)was the asset held primarily for sale in
that business? (3)were sales ordinary in that course of business?
The elements suggesting capital treatment:
-not a licensed broker
-property not subdivided
-did not advertise or list
-transactions initiated by purchasers
-did not spend a lot of time on these properties
Elements suggesting ordinary treatement:
-property held for a short period of time
Byram is fairly near the edge of how active you can be and not be found to be engaged in
a trade or business or holding property primarily for sale to customers.
International Shoe Machine Corp. v. US (1st Cir. 1974) p. 580
Int’l Shoe rented out machines. They then decide to sell some of the machines.
Issue: Are these sales in the ordinary course of business?
It is clear that their main business is renting, not selling machines. However, the court
has no toruble finding that the machines were held primarily for sale. Even if sale only
represents a small percentage of the business, something for sale is considered to be
ordinarily for sale. The court also says that the primary purpose can change. The purpose
might have been leasing at first, but at the time of the sale, the primary purpose was sale.
E. Depreciable property and recapture
§§ 1245 & 1250
Recapture provisions say some of the capital gain reflects part of prior depreciation. To
the extent you took prior depreciation, your gains will be capitalized.
§ 1245 - personal
§ 1250 - recaptures to the extent that your depreciation was faster than straight
line on real property. This doesn’t mean much today since no depreciation is
faster than straight line on real property.
Note: In general, when someone has subdivided land, they are more likely to be deemed
in a trade or business and holding property for sale to customers. However, if they
decided to hold onto the land, but liquidated for some reason, they might get capital gains
F. Judicial Gloss
1. Corn Products Doctrine
Imagine an inductry where it would be cheaper for a purchaser of raw materials to
purchase futures rather than store the materials themselves until needed. He may
or may not exercise his option to purchase the commodity depending on
availability and market price when his need arises.
Hedging - purchasing futures in order to guarantee a steady supply at a favorable
price. i.e. Farmer agrees to deliver crop at a certain time at a certain price. He
doesn’t know whether or not he’ll be able to perform, so he buys futures to cover
the order. When the delivery date arrives, whether or not he exercises his option
depends on the market price. Hedging is arguably a form of business insurance,
and should therefore be treated as an ordinary gain or loss.
Corn Products Refining Co. v. Comm’r (US 1955) p. 599
Refining co. needed a steady supply of corn. When the corn crop failed, they
instituted a policy of buying futures so they would always have corn at a steady
price. Sometimes they would exercise the options, sometimes they would not,
depending on the market. Corn products wanted capital treatment for its gains.
They maintained that they were true capitalists, speculating in corn futures. They
argued that this was not a true hedge because they were only protected against a
rise in the market. If the market fell, they would be stuck with high price futures
options. The IRS said that Corn Products was simply operating a hedge and that
this was an indispensable part of their business.
The Court found this to be ordinary.
Note: Is this a narrow reading of “property” under § 1221 or a broad reading of
one of the exceptions?
Shuldiner says the Court is taking a different approach than the Malat court.
The doctrine coming out of Corn Products is that if something is an integral part
of your business, it is always ordinary gain or loss.
Arkansas Best Corp. v. Comm’r (US 1988) p. 602
Holding co. buys stock in a bank for investment purposes. The bank starts to go
belly-up, so in order to protect its business reputation, the holding co. pumps more
capital into the bank.
The Court says that since Malat, the statute has been misread. Under the statute,
this is property and does not fall into one of the five enumerated exclusive
exceptions, and therefore this is capital. The purpose is irrelevant.
What Corn Products means after Arkansas Best, which takes an extremely wide
reading of capital assets, is that if your hedging program is part of your inventory
system, it falls under § 1221 inventory exception and is ordinary for that reason.
Now there are regs under § 1221 (1.1221-2) that say that a hedge of an ordinary
item is generally ordinary, but it also institutes an identification requirement.
Timing problem - can I sell my corn future now and take the loss now? (1.446)
Timing of gain or loss on a hedge is the same as on the item being hedged. The
hedging problems have been solved by these regulations.
Circle K provides a way for someone other than a dealer to buy stock and claim it
as an ordinary asset. Circle K wanted a supply of gasoline, so they bought up all
the stock in a gas company. Later, they sold the company at a loss, and expensed
it because they counted the gas as inventory.
2. Sales of rights to future income
Hort, PG Lake, etc.
Things treated nominally as property won’t be treated as property.
Hort sold a stream of future income. This was found to be ordinary, not capital
PG Lake sold oil profits from one well for 5 years. This was also found not to be
However, if the only thing you own is the income, then a sale of the stream is a
capital transaction. You cannot strip off a portion of the income and call it a
capital asset when you retain the corpus.
G. Nonrecognition Transactions
In general, when you sell something, you recognize gain or loss. There are, however,
some notable exceptions to the rule:
-If an individual incorporates and transfers property to the corporation in exchange for
shares, it’s not recognized
-ditto on formation of a partnership
-like-kind exchange is non-recognition event
-involuntary conversion is non-recognition event
-sale of principal residence followed by reinvestment in new home
-wash sale (recognize gain, but not loss)
Chirelstein suggests 3 categories of non-recognition transaction:
-continuity of invetment - not enough has changed to constitute a realization event
-hardship cases - doesn’t seem appropriate here
Shuldiner suggests a fourth category: § 1044 small business roll over
1. Like-kind exchanges
-meaurement problem - either there’s no economic gain or it’s hard to tell how
Shuldiner suggests that it is no harder to figure gain for a like kind exchange than
for any other kind of exchange. He also suggest that the reason non-recognition
of like-kind exchange is limited to property held for production of income is
because gain is unlikely to occur w/personal use property except for residences
which are already subject to a more generous rather than a less generous rule.
The need for exchange rather than sale is not as restrictive as it seems, because
you can pick any property you want to exchange for, and have the other party to
the deal buy that property. As soon as he swaps with you, he can sell your
property and he will be no worse off.
You are not allowed to do like-kind exchanges of securities or inventory. The
main category of allowed property is real property.
“Boot” is cash or other property that accompanies the like-kind property
Gain is recognized to the extent of boot. However, you can never recognize more
gain than you realize. The presence of boot doesn’t change the basis.
The basis in the new property is the old basis + gain recognized - money received.
Note: You never recognize loss in a like-kind exchange. In a like-kind exchange
resulting in a realiztion of loss, you are better off selling the property for cash and
taking the loss.
2. Sales of principal residences
§§ 121, 1034
If you sell your principal residence, you do not recognize gain as long as you buy a
new house w/in two years that has a FMV equal to or greater than the price you
received for your house. Furthermore, § 121 allows people over 55 a one-time
non-recognition of up to $125,000 gain on the sale of a principal residence. Keep
in mind that if you hold your house until death, you get a stepped-up basis, so it is
possible to avoid ever being taxed on a gain from the sale of a house.