FEDERAL INCOME TAX

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                               FEDERAL INCOME TAX
                                    Prof. Mildred Robinson
                                           Fall 2005

Important Concepts:
    Taxpayers want a system:
          o that is equitable
          o that is efficient
          o that is administrable
    Our tax system is a progressive system:
          o top 5% of Americans pay 30% of taxes and bottom 50% pay between 1% and 5%
             of taxes (but see discrepancy chart on 8/31)

Important Definitions (pg. 22):
    Budget Deficit: ≈ $314B; estimated to be $1.2T by 2010
    Tax Gap: Difference between what people owe and what they pay on a timely basis (≈
       $310B)
    Tax Base: the amount to which the appropriate tax rate is applied (rate found in § 1)
          o To determine the tax base:
                   Gross Income (§ 61): any income realized in any form
                           Income: (per the Supreme Court)
                                 o Eisner (old law): gain derived from capital, labor, or both
                                 o Glenshaw Glass (current law): any increase in wealth; no
                                    limitations or restrictive labels on taxable receipts
                   Adjusted Gross Income (AGI): gross income minus items found in § 62
                           § 62 include deductions for:
                                 o Trade/business deductions (reimbursed expenses,
                                    performing artists, officials, teachers)
                                 o Losses from sale or exchange of property
                                 o Retirement savings
                                 o Alimony
                                 o Moving expenses
                                 o Interest on educational loans
                                 o Health savings
                                 o Attorneys fees for discrimination suits
                   Taxable Income: the “bottom line”
                           AGI – (personal exemptions + standard or “itemized” deductions)
          o The final step is the amount of taxes owed minus tax credits
          o Alternative: minimum tax for individuals (§ 55)
                   Only paid if it is greater than the tax computed under normal rules
                           26% of first $175K and 28% of amounts > $175K
    Capital Gain/Loss (§ 1222): gain or loss from the sale or exchange of capital assets
          o Capital Assets: property held primarily for sale to customers in the ordinary
              course of business
          o Capital Gain: taxed at a lower rate than other income (maximum rate of 20%)
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       o Capital Loss: only used to offset capital gain; up to $3K can be used to offset
            ordinary income
   Tax Accounting:
       o Cash Method: mostly used by individuals
                 Amounts are treated as income when received in cash and deductible
                    when paid
                                o Capital Costs: can only be deducted when the asset is used
                                    or sold, not when the cash outlay is made
                                o Constructive Receipt: a right to a payment is treated as
                                    received when the taxpayer has a right to receive cash, even
                                    if the case is not taken
                                          i.e., a check is income, even if never cashed
                                o Cash Equivalent/Economic Benefit: people are treated as if
                                    they had received cash when they receive valuable property
                                    or rights
       o Accrual Method: mostly used by businesses
                 Amounts are treated as income when earned, regardless of when payment
                    is received, and expenses are deductible when the obligation to pay is
                    incurred, regardless of when payment is made
   Realization vs. Recognition
       o Realization: a gain/loss is realized when it might be taken into account for tax
            purposes
       o Recognized: a gain/loss is recognized when it is taken into account for tax
            purposes
                 i.e., if you buy a house for $100K and sell it for $300K; you realize a gain
                    of $200K but b/c of statutory exclusions you don’t recognize that gain.
   Depreciation (a.k.a. Accelerated Cost Recovery System): a deduction amount that can be
    applied to a long-term investment (i.e., a piece of machinery bought for a business)
   Entities:
       o Sole proprietor: a person who owns a business solely and directly
                 All business income/expenses are treated as his income/expenses
       o Partnership: two or more people who carry on a business
                 “It” files a tax return but pays no tax
                          Pass-through taxation: partners report their share of profits/losses
                            on their own individual returns
                                o Partnerships are also referred to as a “conduit”
                                o Some people use them as “tax shelters”
       o Trust: legal device where a trustee holds and invests property for the benefit of a
            beneficiary
                 The trust may be required to pay a tax
       o Corporation: legal devices for organizing economic activity
                 Treated as separate taxpaying entities
                 Special rate: 15% of first $50K, 25% of next $25K, 34% of amounts >
                    $75K and 35% of amounts > $1M
                 Dividends: income paid to shareholders, which they must report as income
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                              Unlike partners, shareholders can’t deduct their share of corporate
                               losses

A.       CHARACTERISTICS OF INCOME

A.1.     Non-Cash Benefits (pg. 38)

        Pros and Cons
             o Necessary to be taxed b/c if they weren’t the following would result:
                     Unfairness: some people would take advantage of bartering arrangements
                       more than others
                     Inefficiency: people would prefer to work at tax-favored jobs, so those
                       jobs could offer lower wages and do better financially than other jobs
                     Wasteful: people would be encouraged to take compensation in the form
                       of goods and services instead of taking cash
             o Problematic b/c they raise problems of administrative feasibility and practicality
                     Difficult to know whether a non-cash benefit is valuable to the employer
        Ways to value non-cash benefits:
             o Fair market value
             o Cost to the employer
             o Subjective value to the employee
             o Nothing at all
        § 262: Personal, living, and family expenses are not tax-deductible (they are “universal
         expenses”)
             o Even if an employer pays some of these expenses in lieu of a higher salary, an
                employee may still have to pay taxes on the non-cash benefits provided
                     Old Colony Trust (pg.41): employer’s payment of employee’s income
                       taxes is considered the employee’s income
                             Suggests that an employee’s income includes their paycheck and
                                all benefits the employer bestows
                     Exception: Meals and Lodging Provided by Employer (pg. 39)
                             Benaglia (pg. 42): meals/lodging provided by and for an
                                employer’s (hotel) need and convenience is not considered part of
                                the employee’s (manager) taxable income
                                     o Dissent says:
                                             Letter/contract suggests that meals/lodging were
                                                understood to be additional compensation
                                             B managed other hotels that he didn’t live in, so
                                                living on the premises doesn’t seem to be necessary
                             § 119 (codifies the decision in Benaglia and applies to spouse and
                                dependents):
                                     o Meals: hot plates; sometime grocery stores included
                                        (Jacob)
                                     o Furnished: employer must supply food, not money to buy
                                        food
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                               o Convenience of the employer: business reasons other than
                                   tax purposes (i.e., employee needs to be “on call” outside
                                   of business hours)
                               o Business premises of the employer: the property, house
                                   across the street (Linderman) but not house two blocks
                                   away (Anderson); every state and highway for state police
                                   (Barrett)
                               o Employee: self-employed persons not included, but a
                                   person can be an employee of a corporation if s/he owns all
                                   the shares
                                        Other sections of the code (i.e., §162) may apply in
                                           situations where §119 does not
   § 132: Fringe Benefits (pg. 50)
        o Problems of valuation, enforcements, and political acceptance
                Regs. § 1.61-21 and § 1.132-1 to -8: rules for valuation of certain fringe
                   benefits (usually fair market value)
                        Special formulas for:
                               o Cars
                                        annual lease rate—Regs. § 1.61-21
                                        $3/roundtrip if car is used for commuting—Regs. §
                                           1.61-21(f))
                               o Aircrafts
                                        Regs. § 1.61-21(g)
                Court may determine valuation:
                        in very arbitrary manner
                               o Turner, pg. 59—court averages the opposing “bids” of
                                   steamship tickets won on a radio show to determine value
                               o McCoy, pg. 61—court appeared to randomly assign a value
                                   to a car won in an employer’s sales contest
                        some courts have required valuation at market price
                               o Rooney, pg. 61
                        Game show prizes now codified in § 74
                Difficult to tax employees b/c the value to the employee is often small and
                   hard to determine
                        Possible solutions are to have the employer compensate for this by
                           denying them a deduction or imposing a special tax on the amount
                           of the subsidy
        o Different Types of Fringe Benefits
                “Work-Related” (§132 trumps §61(a) language, which specifies that gross
                   income includes compensation for services; pg. 50; 9/6)
                        No-additional Cost Services (i.e., free airline tix)
                        Qualified Employee Discounts
                               o Item must ordinarily be offered to customers
                                        can’t exceed employer’s normal mark-up (that is,
                                           sales price must cover employer’s costs)
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                              o Must not be discriminatory or favor highly compensated-
                                  employees
                                       NOTE: anti-discriminatory requirement only
                                          applies to (a)(1) (no additional cost services) and
                                          (a)(2) (qualified employee discounts) under (j), and
                                          (a)(7) (retirement planning services) under (m)(2)
                              o Can also be provided to spouse and dependents
                       Working Condition Fringes (i.e., free use of company car)
                       De Minimus Fringes (free use of something it would be
                          unreasonable and impractical to keep track of; i.e., free pens and
                          post-it notes)
                       Qualified Transportation Fringes (i.e., free parking, transit cards)
                              o “deadweight loss”: when an employer pays more for a
                                  benefit than it is worth to the employee because the tax rate
                                  makes it wasteful to take the taxable cash instead of the
                                  non-taxable benefit (see pg. 56)
                                       Note: this theory supports valuing certain non-
                                          taxing benefits (i.e., parking) as income subject to
                                          taxation (b/c the employee will only take it if they
                                          really want it if they have to pay taxes on it)
                       Qualified Moving Expense Reimbursement
                       Qualified Retirement Planning Services
                       On-Premises Gyms and Other Athletic Facilities
                “Not Really Work-Related”
                       Cafeteria Plans (§ 125, pg. 52): employee can select from a menu
                          of benefit choices or take taxable cash
                                       Use It or Lose It (§ 125(d)(2)(A); Regs. § 1.125-1)
                                                one exception: change in family status
                                       “constructive receipt” suggests that an employee
                                          should also pay taxes on the non-taxable benefit b/c
                                          it’s almost like he took the cash and used it to pay
                                          for the benefit, but the code makes provisions
                                                for parking  § 132(f)(4)
                                                for cafeteria plans  § 125(a)
                              o § 79: health insurance > $50K (no deduction for individual
                                  purchases)
                              o § 104-106: health care coverage
                              o Deferred compensation (?)
                              o § 120: qualified legal services
                              o § 129: dependent care expenses
                “Not Work-Related”
                       § 127: Educational Assistance
                       § 137: Adoption Assistance
   Things not considered taxable income:
       o frequent flyer credits (pg. 53)
       o home-run ball (only when caught, but is taxable when sold, pg. 62)
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                            problem of valuation: the more unique the property, the more
                             difficult it is to determine its value, so property will probably be
                             taxed when sold
                   Questions pondered:
                          Can someone claim $10K immediately and then, if they later sell
                             the ball for $110K, can they say that $100K is a capital gain?
                             (remember, you only have to pay taxes on a portion of capital gain)
                          If a business buys the ball, can they claim it is a business expense?
                          When the restaurant destroyed the Cubs ball, can they claim it as a
                             business deduction? A charitable contribution (arguing that it
                             made Cubs fans feel better)?
      Things considered taxable income:
          o Free items given to a charity will be taxable if the TP donated them to charity and
              claimed them as a deduction (Haverly, pg. 54)
                          i.e., free books donated to a school’s library are taxable if the
                             taxpayer claims them as a deduction b/c when the TP has to
                             account for the books as income and then claims a deduction
                             everything equals zero.
      Exchanges of Property or Services:
          o i.e., painting a lawyer’s house in exchange for legal advice (pg. 68)
                   fair market value of the property or services must be included as income
                     under § 61 (Revenue Ruling 79-24 (pg. 68); Regs. § 1.61-2(d)(1))

A.2.   Imputed Income (pg. 62)

      when people use their own property or services to benefit themselves
                  potential problems:
                          fairness (b/c some would be able to benefit and others would not)
                          economic rationality (b/c taxpayer’s time might be better spent
                             working than doing services for him/herself)
          o Property home-ownership; vacation homes; time-shares; washer/dryer sets
                  Imputed income is the rental value of the home, but taxing impractical b/c
                     of valuation problems
                  Homeowners rely on 2 tax rules:
                                o non-taxation of imputed income
                                o deductibility of the interest payment
                          critics say this discriminates against renters:
                                o but tax breaks given to landlords are presumably passed
                                    down to tenants
          o Services i.e., painting one’s own house; changing one’s own oil; sewing one’s
             own clothes (pg. 65); serving as a housewife (pg. 66; tax-breaks in §§ 21, 125,
             129); “human capital” (i.e., forgoing years of income that could have been earned
             to study medicine and become a doctor)
                  Taxing impractical b/c of practicality, privacy, public comprehension, and
                     enforcement
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                   Bartering (exchanging services) contributes to the tax gap (but casual
                    exchanges okay)
                         Fair market value of the services exchanged are includible as gross
                           income under § 61 (Revenue Ruling 79-24)
                         When one service is exchanged for another service, both recipients
                           are supposed to report the fair market value of the service as
                           taxable income (Regs. § 1.61-2(d)(1))
          o Psychic Income and Leisure costs associated with one’s “psychic income” (i.e.,
            the costs associated with enjoying life; a traveler will spend more to achieve
            happiness than one who enjoys reading, pg.67)

A.3.   Windfalls and Gifts

      Windfalls are taxable
           o Punitive damages are considered taxable income
                   Glenshaw Glass (9/12; pg. 69): TPs had “undeniable accessions to wealth,
                      clearly realized, over which [they] have complete dominion.”
                           BUT damages for personal injuries are not taxable
           o Found/discovered money is taxable
                   Cesarini (pg. 72): money found in an old piano was deemed taxable
      § 102: Gifts and inheritances are not taxable
                   NOTE: gifts in excess of $11K may be subject to gift tax liability
           o To qualify as a gift, the item must be given with “a detached and disinterested
              generosity” (trial court examines TOTC, appellate court follows “clearly
              erroneous” standard)
                   Duberstein (9/12; pg. 74): Cadillac given from one business owner to
                      another not a gift b/c it was given to recompense for past services; absence
                      of legal or moral duty is not sufficient to constitute a gift
                           The fact that Berman took a business deduction indicated that the
                              Cadillac was a business expense, not a “detached/disinterested”
                              gift
           o § 102(c): Transfers between employers and employees are not gifts
                   Exception: employee achievement awards (§ 74(c))
           o § 274(b): “business gifts” are only allowed up to $25
           o A person who willfully fails to make a tax return is guilty of a misdemeanor
                   Harris (9/13; pg. 82): mistresses who were paid more than $½M were not
                      subject to criminal liability b/c the current law did not provide them with
                      notice that their conduct was criminal
                           Also note that even though evidence showed that the mistresses
                              described their relationship as “just a job,” the money received was
                              still not necessarily precluded from being a gift b/c it was the
                              donor’s intent that was relevant, not the donee.
                           If the mistresses had been married to their sugar daddy, the money
                              transferred would have been tax-free (§ 1041)
           o Application:
                   Tips are considered taxable income (Regs. § 1.61-2(a)(1))
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                     Poyner (pg. 90): payments paid by businesses to the surviving spouses of
                      deceased executives were considered gifts, not income, due to five factors:
                      1) payments made to wife, not estate; 2) no obligation; 3) no benefit to
                      employer; 4) wife performed no services for business; and 5) services of
                      husband had been fully compensated
                           This has been reduced by § 274(b), which limits business
                              deductions for gifts to $25
                     § 74: prizes and awards are considered taxable income
                     § 117: scholarships are not considered taxable income as long as the
                      money is not conditional upon teaching, research or providing other
                      services (note: room and board not expressly included in exclusion)
                     Bequests are not considered taxable income as long as they are not belated
                      compensation for services rendered to the decedent during his lifetime
                           see Wolder (pg. 92): a bequest to a lawyer who rendered legal
                              services w/o charge was considered income
                           but see McDonald (pg. 92): a bequest to a nurse “in appreciation of
                              services” was not considered income
                                  o payments in settlement of a contested will is a bequest
                                      (Lyeth)
                     Welfare (and other government) payments are not taxable, not because
                      they are excluded under § 102, but because they are not considered
                      income within the meaning of § 61
                           Under TANF, recipients are required to work and, if they reach a
                              certain threshold, may be taxed on the income earned from the job
                     Social security may or may not be taxable depending on the TP’s AGI (see
                      § 86 and pg. 93)
                     Alimony and child support (pg. 93)
                           Alimony is deductible by the payor and taxable to the recipient
                                  o If the recipient remarries and the alimony obligation ends:
                                           If the he didn’t know about the remarriage, he no
                                              longer gets a deduction and recipient is still taxed
                                           If the he knew about the remarriage and pays
                                              anyway, it’s a gift (he gets no deduction but she
                                              pays no taxes)
                                                   perhaps this is to facilitate communication
                           Child support payments are not deductible by the payor and are not
                              taxable to the recipient

A.4.   Transfers of Unrealized Gain (i.e., stock)

      Statutory Basis:
           o § 61(a)(3): gross income includes “gains from dealing in property” (i.e., stock)
           o § 1001: gain = amount realized (AR) – adjusted basis (AB)
           o § 1012: adjusted basis = the cost (of the property/stock)
           o § 1015: exception for property acquired by gift  donee’s basis = donor’s basis
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                       Unless at the time of transfer the donor’s basis is greater than the FMV
                        (meaning the donor would have taken a loss if he sold the stock); in such a
                        case, to compute the donee’s loss (but not gain), the basis = FMV
      Gifts v. compensation (pg. 97)
           o Gift stock transfers are excluded from income under § 102(a) (so there will be a
                taxable event at the time the property is sold, but not at the time the property is
                transferred)
           o There are different basis rules for compensatory stock transfers (see pg. 97):
                     If a client owes a lawyer $2000 and gives him stock that he bought for
                        $1000 but is now valued at $2000, the lawyer has income of $2000 at the
                        time of transfer and the client has a gain of $1000.
                             Lawyer’s basis is $2000 (which creates the same result as if the
                                client had given the lawyer $2000 in cash which he then used to
                                purchase the stock), so if the lawyer later sells the stock for $5000,
                                she has a gain of $3000.
      Taft v. Bowers (pg. 95): TP received stock as a gift from her father which appreciated in
       value by the time she sold it. Service said the basis was what he paid for the stock, but
       TP said the basis was the stock’s FMV at the time she received it. Court held that the
       transferee must pay taxes on the difference between the amount realized and the original
       basis, not the difference between the amount realized and the FMV at the time of transfer
       (that is, the donor accepts the donee’s basis. § 1015)
      § 1014: when property is transferred after someone’s death via a will, the basis = FMV at
       the time of death or (if the executor elects) six months after the death
           o § 1014(e): if a person receives property within one year of his death from a donor,
                the basis of that property to that donor will be the adjusted basis, not the FMV
                     i.e., a person buys property for $1K, which appreciates to a value of
                        $100K, and then transfers it to a dying relative. If the relative then
                        transfers that property back to that person via a will who then sells it for
                        $105K, the basis will be $1K, not $100K
      NOTE: § 102 gift exclusion does not exclude income from the gifted property
           o Gavit (pg. 102): a CD was established for a grandchild. The principal amount to
                be paid to the grandchild was a tax-free gift, but the yearly interest paid out to the
                son-in-law was taxable income.
           o The basis allocation goes entirely to the remaindermen (present-holder can’t use
                the basis to off-set their taxable interest)
      NOTE: we also discussed § 1031 and § 1041 (see below)

A.5.   Recovery of Capital

      Income includes returns on one’s capital and gains from the sale of that capital, but it
       does not include returns or recoveries of one’s capital (so TP only pays taxes on money in
       excess of cost).
          o Example:
                   Joan owns 30 collectible cows.
                                  o 10 were a birthday gift (cost = $300; FMV = $1000)
                                  o 10 were given in a will (cost = $700; FMV = $1500)
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                                o 10 she purchased at the mall (cost = $700)
                         Her basis = $300 (§ 1015) + $1500 (§ 1014) + $700 = $2500
                         If she sells all 30 cows for $3600, her gain = $3600 - $2500 =
                            $1100
                         But what if she sells 15 cows for $2200?
                                o She can’t say that b/c she hasn’t reached her total basis of
                                     $2500 yet she has no gain; instead, she has to identify the
                                     specific cows she sold and calculate her gain.
                 Bob owns 40 acres of property (cost = $20K)
                         If he sells 20 acres for $15K can he make the “basis first”
                            argument?
                                o No, b/c an expert appraiser can determine the value of the
                                     sold and leftover property
        o BUT what if the nature of the transaction is such that the value of the interest sold
            can’t be determined? In that case, you can make the “basis first” argument…
                 Inaja Land (pg. 107): TP was compensated for city’s easements of his
                    water preserve and argued he couldn’t apportion the money to the
                    disposition of certain units. The court held that the TP was not responsible
                    for paying taxes on the money received b/c 1) the apportionment could not
                    be determined with reasonable accuracy, and 2) the amount received did
                    not exceed TP’s costs
                         so the TP did not have to start paying taxes on money received
                            until his entire basis was recouped
                                o think of the cow example above, so none of that $2200
                                     would be taxable
   Life Insurance (pg. 108)
        o Three elements of an insurance investment
                 Original investment (i.e., premiums)
                 Return investment
                 Mortality gains (or losses if the insured doesn’t die during the term of the
                    policy)
        o § 101(a): life insurance payouts are tax-free to the beneficiaries
                 BUT premiums are not deductible so it all balances out tax-wise
                 This exclusion is not available to someone who bought the policy for
                    valuable consideration, and deduction of premiums (if a basis existed
                    under § 162) is barred by § 264(a)(1)
        o § 101(g): money received when insurance policies are sold to viatical companies
            are not taxable if the insured is chronically or terminally ill
        o Life insurance policies serve as a “tax shelter” b/c policyholder pays small
            amounts of money in exchange for future payouts of large amounts of money
                 To earn enough to make the payments, insurance companies invest the
                    small amount of money, and the returns on the investments are not taxable
                    to the company or the policyholder
        o § 264(a)(1): a company that buys insurance on a key employee w/ itself as
            beneficiary can’t deduct the premiums
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                   BUT if the spouse was named as the beneficiary the premium or if the
                    company buys group-term insurance for all of its employees, § 264(a)(1)
                    doesn’t apply and the premiums are deductible as a form of compensation
       o § 264(a)(2): interest paid on a loan that was used to buy life insurance is not
           deductible
                 A reaction to the fact that people were taking out loans (the interest on
                    which is deductible) to pay for a single-premium life insurance policy
                        This barrier can be avoided by buying policies w/ a large savings
                           element that isn’t considered “single premium”
       o § 7702A: requires that if a person withdraws money out of their single-premium
           life insurance policy (in an amount equal to the increase in value of the policy) or
           takes out loans against the policy, they must treat such money as taxable income
       o § 72(e)(5): for endowment policies, loans against the policy are nontaxable and
           cash distributions are taxable only if they exceed the policyholder’s investment
   Annuities and Pensions (pg. 114)
       o Annuities are when you pay a company $100K in exchange for the promise to pay
           $9K/year for the rest of your life (assume a life expectance of 20 years, so $5K of
           that yearly payment is what she initially gave the company and $4K is what they
           earn by investing the $100K at a 6.4% interest rate)
       o Different ways to deal with taxation on that yearly $5K
                 Investment-first rule
                        Each payment is a tax-free recovery of capital until the entire
                           $100K is recovered, then all payments are treated as income
                               o i.e., what the TPs in Inaja Land Co. wanted to do
                               o only allowed for “private annuities” (unsecured promises
                                   by individuals)
                 § 72(b): Exclusion ratio
                        Investment/expected return X annual payout
                               o In the above example, the TP is expecting to get a return of
                                   $180K ($9K X 20 years), so her nontaxable amount is:
                                        100K/180K = 55.55% X $9K = .5555 X $9K = $5K
                                           (so she is taxed on $4000)
                                        If she dies before 20 years, she can deduct the
                                           portion of her investment that was not recovered
                                        If she lives longer than 20 years, she is taxed on the
                                           entire $9K (but if they payments began before
                                           12/31/86, the exclusion ration applies as long as
                                           payments last)
                        § 72(e): TP who takes out a loan against an annuity policy will pay
                           taxes on either:
                               o The amount of the loan, or
                               o The increase in the value of the policy (whichever is less)
                        § 72(q): amounts received by a loan and premature distributions
                           are subject to a 10% penalty tax if the TP is not 59½ at the time
       o Pensions are treated the same as pension, except the exclusion is determined by
           dividing the investment by the number of anticipated payments
                                                                                                  12


                     NOTE: if the money is contributed by the employer and is not treated as
                      income of the employee, it’s not considered part of the employee’s
                      investment for purposes of § 72(b)
                           i.e., if for ten years the employer contributes $5K that is not treated
                              as part of the employee’s income, but the employee contribution is
                              $3K which is treated as taxable to the employee, when the pension
                              payments begin the employee can use $30K in the exclusion ratio
                              as part of the investment, but is not entitled to collect the $50K tax-
                              free.
                   § 801(g) addresses variable annuities (where payments depend on the
                      investment experience and are not fixed at the time the K is issued)
      Gains/Losses from Gambling (pg. 119)
          o § 165(d): gambling gains are taxable, and losses are deductible only to the extent
              of gains from the same taxable year (“basketing”)
                   i.e., gambling losses are not deductible in and of themselves; they can only
                      be used to offset winnings
                           if TP loses $40K, they can’t claim a deduction, but if they win
                              $60K and then lose $40K, they only have to report $20K as
                              income
                   other “basketing” situations:
                           investment interests (§ 163(d)), capital losses (§ 1211), personal
                              casualty losses (§ 165(h)), hobby losses (§ 183), and passive losses
                              (§ 469)
      Recovery of Loss
          o Recovery of loss is not considered income
                   Clark (pg. 120): TP hired an attorney to prepare his taxes. Due to an error
                      on his part, the TP ended up owing the Service more money. When the
                      attorney reimbursed the TP, the Service tried to argue that the money was
                      income. Court held that the money was not payment for taxes (as was the
                      case in Old Colony Trust, where an employer paid its employee’s taxes),
                      but was compensation for bad tax advice that led to higher tax liability that
                      the TP would not have been exposed to w/o the attorney’s advice.
      The Marriage Penalty and Bonus (9/21)
          o The idea that couples where only one spouse earns income is better off tax-wise,
              but couples where both spouses earn income is worse off tax-wise
                   i.e., assume taxable income of $145K
                           single: income tax liability  $41K
                           couple w/ 1 earner: income tax liability  $38K
                           couple w/ 2 earners of $72.5K each: income tax liability  $34K
                   this seems to be a disincentive for higher-earning couples to marry

A.6.   Annual Accounting

      Tax system uses annual, not transactional, accounting
          o Burnet v. Sanford & Brooks (pg. 125): S&B (TP) was hired to dredge the DE
              River over a long period of time and their expenses exceed their payments. When
                                                                                          13


           they took their employer to court, they received a lump settlement payment. TP
           argued the money was compensation for expense incurred in prior years but the
           Service said the money was taxable income for that year. The court held that
           money is income in the year it is received, even if it is received for work
           performed in previous years.
                NOTE: for capital expenditures (i.e., purchase of a truck) the cost is
                   spread out over the years and recovered through ACRS, but the income in
                   S&B was not an expenditure; it was earned
   § 172: Net Operating Losses (above-the line; gross income  AGI)
                Exception to the annual accounting rule
        o When businesses expenses exceed business income, TP can save those losses and
           apply them 2 years back (using an amended return) and 20 years forward
                NOTE: TP can waive carryback period (§ 172(b)(3))
                NOTE: each loss in each year has its own 20-yr period
                Example (pg. 130):
                        In 1999, TP has 60K from firm, $4K in personal exemptions, and
                           $16K in non-business deductions
                               o Taxable income = $40K ($60K - $4K - $16K)
                        In 2000, TP has 60K from firm, $80K in losses from his own
                           business, $6K in personal exemptions, and $15K in non-business
                           deductions
                               o TP can only carry $20K ($60K - $80K) of his 2000 loss
                                   back to 1999’s income
                                       Additional $21K can’t be carried back b/c:
                                               NOL does not apply to $6K in personal
                                                 exemptions (§ 172(d)(3)) nor $15K in non-
                                                 business deductions (b/c if the TP is not a
                                                 corporation, they are only allowed non-
                                                 business deductions from non-business
                                                 income (i.e., capital gains or dividend
                                                 income), and in this example TP does not
                                                 have any non-business income b/c working
                                                 as an attorney is a trade or business)
        o § 1212: provision for carryover of capital losses
        o § 460: when TP perform long-term contracts for construction/manufacture of
           property they can account for profit under the percentage of completion method
                Portion of contract price is included as income as the work progresses
   Claim of Right
        o TP has income if he receives it under a claim of right without restrictions on its
           use even though he may have to later return or restore that money
                North American Oil Consolidated v. Burnet (pg. 130): a lawsuit was filed
                   against TP to oust them from oil property they owned. In 1917, a court
                   said that the property belonged to TP and awarded money for income
                   earned in 1916. The plaintiff appealed and the case was finally decided,
                   again in TP’s favor, in 1922. Service said the award should’ve been
                   reported in 1917 but TP said they should pay taxes in either 1916 (when
                                                                                                 14


                  the money was accrued) or in 1922 (when the litigation was finalized).
                  The court said the income should be reported in 1917 when the TP
                  received the money without restrictions (if the plaintiff had prevailed in
                  1922 and TP had to return the money it would have been entitled to a
                  deduction in 1922)
                       Illinois Power Co. (pg. 133): No claim of right when TP is just a
                          custodian of the money and is under a duty to repay it
               Lewis (pg. 133): TP was given a bonus in 1944 and paid taxes on it but
                  had to return half of it in 1946. TP wanted to recompute his 1944 taxes
                  but Service argued TP should deduct half the bonus as a loss on his 1946
                  return. Court agreed with the Service.
                                       NOTE: this case may have gone the other way if the
                                           TP had been compelled to pay rather than doing so
                                           voluntarily
                              o § 1341 (Congressional reaction to Lewis): if deduction in
                                  the year of repayment is more than $3K, the tax owed is
                                  either the ordinary deduction or a credit for the tax that
                                  would have been saved by excluding the item in the earlier
                                  year, whichever is less
                                       But “mere errors” such as arithmetic mistakes don’t
                                           count, and embezzlers who return embezzled funds
                                           don’t qualify (b/c they don’t have an “unrestricted
                                           right” to the money)
                       NOTE: TP can only file an amended return if he made a mistake at
                          the time of reporting (i.e., if, on the basis of the facts existing at the
                          time the return was filed, the return was in error). If the TP makes
                          a mistake that becomes evident only b/c of events that occurred
                          after the year ended, he has to make an adjustment in the year that
                          the true facts were discovered.
                              o § 6511: claims for refund of overpayments must be made
                                  within 3 years from the time the return was filed or 2 years
                                  from the time the tax was paid
   Tax Benefit Rule (pg. 137)
       o When a TP claims a deduction in an earlier year and then recovers the deducted
          amount in a later year
               § 111: Exclusions
                       If a deduction does not reduce a TP’s liability and loss carryovers
                          resulting from it have expired without being used, the recovery of
                          the amount deducted doesn’t have to be included as income
                              o i.e., TP need not report an income tax refund as income
               Inclusions
                       If TP has received a tax benefit and the amount of the subsequent
                          offsetting gain is not clear, the amount of the prior deduction must
                          be included as income
                              o Alice Phelan Sullivan Corp. (pg. 138): TP gave a gift of
                                  property and claimed a charity deduction. When the
                                                                                             15


                                   property was returned 20 years later, TP had to pay income
                                   in the amount of the earlier deduction (instead of on the
                                   value of the property in the year it was returned)
                                 o Bliss Dairy (pg. 139): tax benefit rule only applies when
                                   the later event is “fundamentally inconsistent” with the
                                   premise on which the deduction was initially based

A.7.   Recovery for Personal and Business Injuries (pg. 140)

      For companies:
          o Damages for lost profits and punitive damages are taxable in the year received
          o If a company recovers damages to compensate for destroyed or damaged
              property, it must pay taxes if the amount received is more than the basis
                    § 1033: exception that allows a TP to defer taxation if they reinvest the
                       money in a similar or related use
      For individuals:
          o § 104: Damages for personal injuries are not taxable
                    But punitive damages for personal injuries are still taxable
          o § 104(a)(2): TP doesn’t have to pay taxes on damages for personal injuries even if
              they defer current payment and elect to take periodic payments (even though
              deferred payments usually contain some interest)
      Medical Expenses
          o § 213: Deductible only if they exceed 7.5% of the TP’s AGI
          o § 104(a)(3): recoveries under an insurance policy is excluded from taxation even
              if the recoveries exceed the cost of medical care
                    Exception for payments received in reimbursement of expenses previously
                       deducted (b/c of the tax benefit rule)
          o §§ 106, 162: if employer pays employee’s insurance premiums, it’s deductible by
              the employer but not included in employee’s income
          o § 105(b): if employer doesn’t provide insurance but pays or reimburses the
              employee’s medical expenses directly, the payments are not taxable to the
              employee
                    These exclusions extend to the employee’s spouse and dependents
          o Other exclusions:
                    § 104(a)(1): workers’ compensation
                    § 105(c): permanent physical injuries
                    § 104(a)(3): recoveries under disability insurance policies financed by the
                       TP (but premiums are not deductible)
      Legal Expenses
          o § 120: if employer pays for employee’s enrollment in any “group legal services
              plan,” it is not considered part of the employee’s income (limit is $70 worth of
              insurance per year)

A.8.   Transactions Involving Loans and Discharge of Indebtedness
                                                                                             16


   Loan proceeds are not considered taxable income (no distinction between recourse and
    nonrecourse loans)
        o b/c loans don’t increase the TP’s net worth b/c it must be paid back
   Loan repayments are not tax deductible
        o These rules apply to recourse loans (where TP is personally liable) and
           nonrecourse loans (where lender has to collect the property offered as security for
           the loan)
   § 61(a)(12): income from “discharge of indebtedness” is taxable
        o Kirby Lumber Co. (pg. 146): TP issued bonds valued at $1M and later
           repurchased the same bonds for $862K, which means they purchased the bonds
           for $138K less than they issued them for. The court held that TP realized an
           accession to income and had to pay taxes on the $138K
                 § 108: if TP is insolvent or a debtor in a Bankruptcy Court at the time of
                     discharge, the income from the discharge of indebtedness is excluded, but
                     certain tax attributes must be reduced
                          i.e., if company has NOL of $135K and $100K is discharged, only
                             $35K can be used to apply to past or future income
                 § 108(e)(5): when a TP has purchased property, if the seller discharges
                     some of the money owed on the property the discharge is treated as a
                     reduction in the sale price instead of income
                 § 108(f)(2): cancellation or repayment of student loans is not considered
                     income as long as the cancellation is contingent upon working for a
                     charitable or educational institution
        o If there is a discharge of indebtedness where the debt is paid in full by a third
           party (i.e., an employer), tax is imposed under § 61(a)(1) instead of under §
           61(a)(12)
                 Exception: if someone pays the debt as a gift (i.e., a parent), no taxation
                     under § 102(a)
   Contested Liability: doctrine that the amount of a disputed debt is the amount for which
    the debt is settled
        o Zarin (pg. 149): TP incurred $3.4M in gambling debts, which was discharged for
           $500K. The Service argued that TP had realized income of $2.9M. The court
           held that the TP’s situation did not classify as indebtedness b/c (1) he was not
           liable for the debt, § 108(d)(1)(A) (b/c it was illegal to extend credit to gamblers
           in NJ so his debt was unenforceable), and (2) he did not hold property subject to
           that debt, § 108(d)(1)(B) (b/c the gambling chips were not property; they didn’t
           have an economic value outside the casino). Because the amount of debt was
           disputed, the settlement indicated that the total amount owed $500K and since
           that’s what he received there were no additional tax consequences
   Conditional Gifts
        o Diedrich (pg. 158): TP gave gift of stock to children on the condition that the
           children had to pay the gift tax. Court held that if the gift tax exceeded the basis
           in the property, the TP had taxable income under the discharge of indebtedness
           doctrine (b/c legally the TP owed the gift tax, so when the children paid it they
           were discharging him of the debt he owed the Service).
                                                                                            17


                  TP bought 100,000 shares of stock for $50K. At the time of transfer, the
                   stock had a FMV of $300K. The gift tax amount on the stock was $60K
                        TP’s amount realized = $60K - $50K = $10K
                               o So if the child later sold the stock, he could not use a §
                                   1015 basis (the TP’s basis of $50K) b/c he needs to account
                                   for all the appreciation in the stock, so he would have a §
                                   1012 basis of $60K ($50K (original basis) + $10K (amount
                                   realized))
   Different types of deductions for property used for income purposes
        o § 162: immediate deductions (for salaries, traveling expenses, and property rental)
        o § 263: no deduction, capitalization only
        o Recover the outlay gradually
                 Various methods:
                        Useful life of the property (for a “wasting asset”)
                               o § 168 lists categories of property
                        Straight-line depreciation
                               o Amount of outlay/assumed useful life
                        Accelerated rate of depreciation
                               o This allows TP to shelter more income in the early years
                                   b/c it’s assumed the machine will be less productive as time
                                   goes on
                 Example: TP buys a machine for $5K with a useful life of 5 years. He
                   uses straight-line depreciation and deducts $1K per year. After 5 years,
                   the salvage value is $0. What happens if he sells the machine for $3K?
                        Gain = amt realized – adjusted basis
                               o = $3000 - $0 (basis is $0 b/c TP already accounted for the
                                   $5K over the 5 years of depreciation)
                               o Gain = $3000
                                         But the $3K is ordinary income, not capital gain!
        o § 1221: defines a “capital asset” by saying what a capital asset is not
                 NOTE: “quasi-capital assets” are items barred by § 1221(a)(2) but allowed
                   as tax benefits under § 1231
                        § 1231 allows businesses to basket certain transactions for gains
                           and losses from depreciable property used in a trade or business
                               o Gain = capital gain
                               o Loss = ordinary loss
                 § 1245: any gain from the disposition of depreciable property (up to the
                   original basis) is treated as ordinary income
                        That’s why the $3K in the example above is ordinary income
                               o So if the machine was sold for $6K, $5K would be ordinary
                                   income (under § 1245) and $1K would be capital gain
                                   (under § 1231)
   Transfer of Property Subject to Debt
        o When property is purchased using a recourse loan, TP is treated pretty much the
           same
                 Example: TP gets a loan for $5K and uses that money to buy the machine.
                                                                                                18


                             Income = $0 (b/c a loan is not income)
                             Basis = $5K
                                   o After these initial differences, the TP is treated exactly the
                                       same way
          o When property is purchased using a non-recourse loan, the amount of debt is also
              considered part of the basis
                   Crane (pg. 164): TP inherited a building that had a $262K mortgage
                      (which was the exact estimated value of the building). TP claimed
                      depreciation deductions of $25.5K and later sold the property (with the
                      attached mortgage) for $2.5K. TP only wanted to pay taxes on the $2.5K
                      but Service argued that her basis was $234 (the original value of the land
                      minus depreciation) and her amount realized included the principal
                      amount of the outstanding mortgage, meaning she had a gain of $23.5K.
                      The court held that the TP had to include the unpaid balance of the
                      mortgage in the computation of the amount realized on the sale and held
                      that the TP had realized $257.5K on the sale (see § 113(a)(5) which states
                      that the basis of property received by inheritance is the FMV at the time of
                      acquisition)
                   Tufts (pg. 171): similar fact pattern to Crane but in this case the value of
                      the property was less than the mortgage. Loan amount was $1.85M and
                      the basis was $1.85M - $444K (the total amount of deductions), or
                      $1.455M, but the FMV was $1.4M. TP argued that they had a loss of
                      $55K ($1.455M - $1.4M), but the Service argued there was a gain of
                      $395K ($1.85M - $1.455M). Court held that assuming a non-recourse
                      mortgage constitutes a taxable gain to the mortgagor even if the mortgage
                      exceeds the FMV of the property. The mortgage amount is included, tax
                      free (b/c it has to be repaid), in the basis. When a mortgage is transferred,
                      it’s almost like the seller was paid in cash which he then used to pay off
                      the mortgage, so that is clearly taxable income.
                            NOTE: § 465 would not apply here, but § 469 might (?)
      Passive Gains/Losses
          o § 469: allows deductions for activities which involve a trade or business in which
              the TP does not materially participate (which means it’s not regular, continuous,
              or substantial—i.e., being a limited partner is a passive activity)
                   but those deductions must be basketed
                            Passive losses can be deducted only to the extent of passive gains
                              (so TP can’t use excess losses against other sources of income
                              without limitation)
                                   o If the basket yields a negative amount, that amount is rolled
                                       over to the next year and will count as a passive loss then
                                   o If the basket yields a positive amount, it is considered
                                       income

A.9.   Illegal Income

      Illegal income is taxable if the money is received:
                                                                                                 19


            o Without consensual recognition of an obligation to repay
            o Without restriction as to its disposition
                  Gilbert (pg. 179): TP embezzled funds from his company to pay for stock
                    losses but intended to repay them. Upon the advice of an attorney, TP
                    executed promissory notes to the company, secured by assignment of his
                    property, for the value of the unauthorized withdrawals. Service argued
                    that the embezzled funds were taxable income, but the court said that the
                    TP was more of a borrower b/c he understood his obligation to repay the
                    money and used the money to better the corporation rather than himself.

A.10. Gain from the Sale of a Home

        § 121: deductions are allowed for the sale of a home if TP used the home as a personal
         residence for 2 of the 5 years preceding the sale
             o Limitations:
                     There is a $250K limit for a single TP and a $500K limit for a married
                        couple
                              i.e., if someone buys a home for $50K and later sells $750K, they
                                 have a gain of $700K, but $250K is not taxable (per § 121) and
                                 $450K is taxable (per § 61 and § 1221)
                     Only applies once every two years (§ 121(b)(3)(A))
                              Exception if the sale was because of a change in place of
                                 employment, health, or other unforeseen circumstances
                                    o This exception also applies to the 2 year requirement
                                         ($125K allowed after 1 year)

B.       PROBLEMS OF TIMING

B.1.     Gains and Losses

        Taxpayer is not liable for gains, nor can he claim deductions for losses, until there is a
         “taxable event”
             o Unrealized appreciation is NOT taxable
                     Eisner v. Macomber (pg. 192): requires that a gain be “realized” as a
                        condition for taxation
                             TP had not realized gain when she was issued stock dividends b/c
                                there was no effect on the underlying value of the stock so no
                                income was produced
                     § 305(a): does not include a business’s distribution of stock to
                        shareholders as income unless
                             The stockholder has the option to take case or some other property
                                instead of the stock
                             Some of the stockholders get property or there is an increase in the
                                assets or earnings of some stockholders
                             Common shareholders get preferred or common stock
             o Helvering v. Bruun (pg. 204)
                                                                                                 20


                     TP leased property to a tenant, who erected a building that was worth
                      $50K more than the old building. Court held that this is different from
                      stock splits where everyone’s proportionate interests remain the same b/c
                      the value of the owner’s land had been improved.
                           Realization does not have to be in cash or result from a sale (in this
                              case, the taxable event occurred when the TP reentered and
                              reclaimed his land when his tenant defaulted)
                     Congressional reaction to harsh decision in Helvering
                           § 109: gross income does not include improvements
                                  o NOTE: rent money does not get preferential treatment.
                                      Rent is still treated as earned income.
                           § 1019: lessor must account for improvements when property is
                              sold
                                  o This is a deferral, not a forgiveness, which allows the TP to
                                      pay the tax when they have the cash from the sale
                           Example: TP’s lessee erects a building worth $50K that has a 10-
                              year life and can be rented for $7K per year
                                  o Under Helvering:
                                           Income from bldg: $50K
                                                    It’s almost as if TP was given $50K and
                                                       then used it to erect the bldg, so he will be
                                                       entitled to a depreciation deduction
                                           Income from rental: $20K
                                                    $70K ($7K/year X 10 years) – $50K
                                                       (depreciation of $5K/year X 10 years)
                                           Total income: $70K
                                  o Under § 109 and § 1019:
                                           Income from bldg: $0K
                                                    So no depreciation deduction
                                           Income from rental: $70K
                                                    $7K/year X 10 years
                                           Total income: $70K

B.2.   Nonrecourse Borrowing in Excess of Basis

      Woodsam Associates (pg. 209): TP owned a building that had a basis of $270K and took
       out a mortgage of $400K. Service tried to argue that TP had received income and her
       basis should be increased. Court held that when the TP refinanced her mortgage from a
       recourse loan to a nonrecourse loan, there was no taxable event. Since there was no
       taxable event, there could be no taxation of gain until there was a final disposition of
       property. The new mortgage did not increase the TP’s basis.
           o Mere appreciation of property is not taxes in absence of a taxable event (i.e., sale
               or exchange) for three reasons:
                    Hard to measure
                    TP may not have the cash to pay the taxes
                    TP faces a risk of loss if it later declines in value
                                                                                                     21


                              A nonrecourse loan is NOT a sale or exchange
           o Examples
                 TP acquires stock for $15K. Property appreciates in value to $80K. TP
                   gets a nonrecourse loan for $60K. TP sells the stock for $80K.
                              o Sale price accounts for $20K in cash and $60K in “other
                                   property” (in this case, loan indebtedness)
                        Gain = $65K ($80-$15)
                 TP acquires Blackacre for $15K. TP takes out a nonrecourse loan for
                   $60K and uses $40K to build a gazebo on the property and $20K to take a
                   trip. TP sells Blackacre for $80K.
                        Amount realized = $80K
                        Basis = $15K + $40K = $55K
                              o The use of borrowed money is important. If you have
                                   borrowing and reinvesting you can get an adjustment in
                                   basis.
                        Gain = $25K ($80K-$55K)

B.3.   Losses

      At one time, mortgage rates were extremely low, but when the market changed and the
       rates increase, customers exchanged their mortgages so that they could have a taxable
       loss.
           o Cottage Savings Association (pg. 213): TP sold mortgages worth $4.5M for
               mortgages worth $6.9M and tried to claim a deduction of $2.4M in losses.
               Service did not want to recognize the loss because the TP basically had the same
               property and there had not been a transaction to make a taxable event. Court
               allowed the deduction and held that an exchange in property gives rise to a
               realization event as long as the exchanged properties are “materially different”
               (i.e., if the properties exchanged embody legally distinct entitlements), which was
               the case in this situation.
                     Realization Test  § 1001(a) defines disposition as an exchange of
                         property that is materially different
                     Material Different Test 
                              Regs. § 1.1001-3 define when modifications to a debt instrument is
                                 treated as a “sale or other disposition”
                                     o When a significant modification has occurred in yield (i.e.,
                                         change of more than ¼ of 1% change in interest rate),
                                         timing or amounts of payments (i.e., extension of the final
                                         maturity date of more than 5 years or 50% of the original
                                         term), the obligor, or the nature of the instrument (i.e., if a
                                         substantial portion of the collateral is released or replaced
                                         with other property)
                              Phellis, Marr, and Weiss: old cases that hold that properties are
                                 materially different if their possessors enjoy legal entitlements that
                                 are different in kind or extent b/c the Service and the TP can
                                 calculate the appreciated or depreciated values of the property
                                                                                                 22


      Example: TP has a building with a basis of $60K and a FMV of $100K and wants to
       move his business down the street. If the property is sold, TP will realize a gain of $40K.
          o Before Cottage Savings, TP would think that his situation was a continued
             investment and that there hadn’t been any real changes (same business in a new
             place)
          o After Cottage Savings, the threshold is much lower and the TP has realization and
             recognition that triggers gain

B.4.   Non-recognition Provisions

      Exceptions that allows a TP to engage in exchanges in property without having to
       account for gain, but they also can’t deduct for losses (i.e., § 1031, § 1033)
          o § 1031: TP not required to recognize gain/loss even if that gain/loss is realized if
              property is exchanged for other “like-kind” property
                   Only applies for exchanges, not sales, of property for business
                           Sometimes allowed for personal/residential within limits (see §
                              1031(a)(2) and Regs. § 1.1031(b))
                   Does not apply to:
                           Stock, bonds, securities or evidence of indebtedness, interests in
                              partnerships, certificates of trust or beneficial interests, choses in
                              action
                   Time constraints (§ 1031(a)(3))
                           Property to be received must be identified within 45 days after TP
                              transfers property
                           Property is received after the earlier of either 180 days or the TP’s
                              tax return due date
                   Definition of “like-kind”  Regs. § 1.1031(a)-1(b)
                           Revenue Ruling 82-166: Exchange of gold bullion held for
                              investment for silver bullion held for investment not considered
                              “like-kind”
                   Example: A transfers a farm (Basis = $10K, FMV = $60K) for B’s farm
                      (FMV = $60K)
                           Realized Gain = $50K ($60K – $10K)
                           Recognized Gain = $0 (§ 1031)
                                  o BUT this is a deferral, not a forgiveness!
                                           So if A later sells B’s farm for $60K, the recognized
                                              gain will be $50K ($60K - $10K)
                   Example: A exchanges a farm (Basis = $ 70K, FMV = ?) for B’s farm
                      (FMV - $60K)
                           Realized Loss = $10K ($60K - $70K)
                                  o Assume properties are equal, so A’s farm has a FMV equal
                                      to B’s farm
                           Recognized Loss = $0K (§ 1031)
                           If A later sells B’s farm for $50K, the recognized loss will be $20K
                              ($50K - $70K)
                                                                              23


   Jordan Marsh (pg.225): TP conveyed land that had a basis of $4.8M. In
    return, TP received $2.3M in cash (the FMV) and was allowed to lease the
    property. TP deducted a loss and the Service disallowed the deduction b/c
    it said the sale and immediate lease was not really a sale, but a “like-kind”
    exchange. Court held that a sale had occurred b/c the TP liquidated his
    investment for cash equal to the property’s FMV (i.e., the TP cashed in his
    investment and then entered into a lease) so the deduction was allowed
   Boot (pg. 229): money and property that is transferred as part of the “like-
    kind” exchange but is not “like-kind” property
          Transfer of boot affects the basis
                 o § 1031(d) Basis = Basis in property exchanged – cash
                     received + gain recognized – loss recognized
                          Example: A exchanges a farm (Basis = $10K, FMV
                            = ?) for B’s farm (FMV = $100K), $15K in cash,
                            and a tractor (FMV = $8K)
                                 Gain realized = $100K + $15K + $8K =
                                    $123K - $10K = $113K
                                 Gain recognized = the lesser of either the
                                    gain realized or the amount of this boot
                                        o Here, the boot amount = $23K, so
                                            since that’s less than $113K that’s
                                            the gain recognized
                                                 $15K (cash) + $8K (tractor)
                                 § 1031(d) Basis = prop basis – cash received
                                    + gain recognized – loss recognized = $10K
                                    - $15K + $23K - $0K = $18K
                                 This amount, $18K, is then allocated to
                                    determine the basis of the non-cash property
                                        o $8K is the tractor’s basis (b/c that’s
                                            the FMV)
                                        o $10K is B’s farm’s basis (b/c that’s
                                            the leftover amount)
                          Example: A exchanges a farm (Basis = $110K) for
                            B’s farm (FMV = $100K), $15K in cash, and a
                            tractor (FMV = $8K)
                                 Gain realized = $100K + $15K + $8K =
                                    $123K - $110K = $13K
                                 Gain recognized = either $13K (gain
                                    realized) or $23K (boot), so $13K b/c it’s
                                    the lesser amount
                                 § 1031(d) Basis = prop basis – cash received
                                    + gain recognized – loss recognized =
                                    $110K - $15K + $13K - $0 = $108K
                                 This amount, $108K, is allocated to
                                    determine the basis of the non-cash property
                                                            24


                     o $8K is the tractor’s basis (b/c that’s
                         the FMV)
                     o $100K is B’s farm’s basis (b/c that’s
                         the leftover amount)
      Example: A exchanges a farm (Basis = $130K) for
         B’s farm (FMV = $100K), $15K in cash, and a
         tractor (FMV = $8K)
              Gain realized = $100K + $15K + $8K =
                 $123K - $130K = $-7K (so this is a LOSS)
              Loss recognized = $0K (No loss is
                 recognized per § 1031(c))
                     o NOTE: if the farm is later sold for
                         $100K, TP can deduct a loss of $7K
              § 1031(d) Basis = prop basis – cash received
                 + gain recognized – loss recognized =
                 $130K - $15K + $0K -$0K = $115K
              This amount, $115K, is allocated to
                 determine the basis of the non-cash property
                     o $8K is the tractor’s basis (b/c that’s
                         the FMV)
                     o $107K is B’s farm’s basis (b/c that’s
                         the leftover amount)
o For TP who GIVES appreciated boot:
              Gain/loss of non-qualifying property is
                 realized and recognized (§ 1031 doesn’t
                 come into effect at all)
              Receipt of qualifying property is controlled
                 by § 1031(a) (so no recognition of gain (or
                 loss))
      Example: A exchanges a farm (Basis = $25K, FMV
         = $100K), $15K in cash, and a tractor (Basis = $1K,
         FMV = $8K) for B’s farm (FMV = $123K)
              Taxable event for tractor: $8K - $1K = $7K
                 (realized and recognized gain)
              Nothing to account for with the cash
              Taxable event for farm:
                     o Gain realized = $123K – ($25K +
                         $15K + $8K) = $123K – $48K =
                         $75K
                              Note: Use the basis for the
                                 qualifying property (i.e., the
                                 farm) and the FMV for the
                                 non-qualifying property (i.e.,
                                 the tractor)
                     o Gain recognized = $0 (§ 1031(a))
                                                                                                 25


                                                    § 1031(d) Basis = prop basis – cash received
                                                     + gain recognized – loss recognized = ($25K
                                                     + $15K + $1K) – $0 + $7K – $0 = $41K +
                                                     $7K = $48K
                                                         o So if B’s farm is later sold, its basis
                                                             will be $48K
                                o For the TP who GIVES depreciated boot:
                                          Example: A exchanges a farm (Basis = $25K, FMV
                                             = $100K), $15K in cash, and a tractor (Basis =
                                             $14K, FMV = $8K) for B’s farm (FMV = $123K)
                                                  Taxable event for the tractor: $8K – $14K =
                                                     $-6K (realized and recognized loss)
                                                  Nothing to account for with the cash
                                                  Taxable event for farm:
                                                         o Gain realized = $123K – ($25K +
                                                             $15K + $8K) = $123K – $48K =
                                                             $75K
                                                         o Gain recognized = $0
                                                  § 1031(d) Basis = prop basis – cash received
                                                     + gain recognized – loss recognized = ($25K
                                                     + $15K + $14K) – $0 + $0 – $6K = $54K –
                                                     $6K = $48K
          o § 1033: TP not required to recognize gain if the property is involuntarily
            converted (i.e., theft, destruction, seizure, requisition or condemnation) and
            replaced with similar property
                        NOTE: under § 1033, unlike § 1031, gains are not recognized but
                            losses ARE recognized.
                 When the conversion is direct, nonrecognition is mandatory
                 When the conversion is indirect (i.e., TP gets cash and then buys the
                   replacement property), nonrecognition is optional
                        Generally, replacement must take place within 2 years and can’t be
                            purchased from a related person

B.5.   Recognition of Losses

      In order for losses to be recognized, a taxable event must occur, meaning there must be a
       defining moment (i.e., a point where the loss has a definitive value)
           o Revenue Ruling 84-135 (pg. 236): air craft carrier suffered a devaluation of its
              route authorities because of the enactment of the Airline Deregulation Act. Court
              held that the carrier did not sustain a deductible loss under § 165(a) b/c it did not
              sell or abandon its operating rights. Even though the value of the routes was
              reduced, that was not to constitute a taxable event (no closed and completed
              transaction fixed by identifiable events had occurred)

B.6.   Open Transactions
                                                                                               26


   If the amount a TP receives in consideration is uncertain (i.e., if there is no way to
    determine the FMV), the TP is not required to recognize gain until the payments received
    exceeds the TP’s basis
         o Burnet v. Logan (pg. 244): TP traded stock (and received less than the FMV for
            it) in exchange for the promise to pay a percentage of money received from
            mining ore in years to come. Service tried to estimate what that amount would be
            and make her account for it in that taxable year. Court held that a promise to pay
            indeterminate sums of money is not necessarily taxable income.
   Possible approaches to recognizing gain or loss and recovery of basis where property has
    been sold in return for the promise to pay a series of payments in the future:
         o Open transaction approach (Basis First): recover basis first and then all payments
            are treated as gain
                  Advantages for TP:
                          Maximum deferral
                          Maximum capital gain treatment
         o Closed transaction approach: determine the present value of the expected
            payments and treat it as if it was cash received on the date of sale (gain or loss is
            determined by comparing this amount to the basis)
         o Installment method: use the open transaction approach but allocate a portion of
            the basis to each expected payment received so that a portion of the gain or loss is
            recognized with each payment (§ 453, § 453A, § 453B)
                  First, § 483 applies to the unstated interest (§ 483) (a.k.a. the OID, original
                     issue discount), which ensures that the interest element in any deferred
                     payment is treated as ordinary income, not capital gain
                  For the remaining amount, the TP computes a ratio of gain to total
                     expected payments and applies this ratio to each payment
                          i.e., TP sells property with a basis of $100K in return for a total
                             amount of $300K which will be received over a term of five years
                                  o ratio = $100K/$300K = 1/3, so 1/3 of each payment is a
                                      recovery of basis and 2/3 of each payment is treated as gain
                          if the TP chooses not to use the installment method, the transaction
                             is treated as closed and gain is recognized at the outset (amount
                             recognized as gain is the FMV of the installment payments minus
                             the basis)
                  Installment method does not apply for sales of personal property under a
                     revolving credit plan, sales for publicly traded property, or sale of
                     inventory items by dealers in real or personal property
                          Exception available for sellers of time-share units and residential
                             lots
                  If TP uses the installment obligation to obtain a loan, the loan is treated as
                     a payment of the installment obligation
                  Installment method is not available where the consideration the TP
                     receives can easily be converted into cash (i.e., demand notes and publicly
                     traded debt obligations are treated the same as cash payments)
                                                                                                27


                             BUT just b/c a promise to pay is guaranteed does not mean it will
                              be treated as cash (i.e., guarantees from the bank in the form of a
                              standby letter of credit)
                     For sales where the payments are contingent (as in Burnet), there are three
                      solutions (Regs. § 15a.453-1(c))
                           If it’s possible to determine the maximum amount that may be
                              paid, the basis is allocated by treating that maximum amount as the
                              sale price
                           If it’s not possible to determine the maximum amount that may be
                              paid, but it is possible to determine a maximum period of time over
                              which the payments will be made, the basis is allocated in equal
                              annual amounts over that time period
                           If it’s not possible to determine the maximum price or the
                              maximum time period (as was the case in Burnet), the basis is
                              allocated in equal amounts over 15 years

B.7.   Constructive Receipt, Economic Benefit, and Deferred Compensation

      Constructive Receipt: TP is taxed on amounts that are set aside or available if he has a
       legal claim over them
           o Amend (pg. 251): TP sold wheat in 1944 and buyer promised to pay (in 1944) for
               the wheat in Jan of 1945. Service tried to tax TP in TP’s 1944 income under the
               theory of constructive receipt. Court held that CR could not be applied in this
               case b/c the TP had no legal right to demand and receive his money until Jan
               1945, as stated in their contract
                    NOTE: Under the current installment method, TP would report his entire
                       gain in 1945 b/c that’s when he received the payment, but if he opted out
                       of installment method he would be required to report the FMV of the
                       buyer’s obligation to pay in 1944
                             BUT if the TP had the option to take the money in 1944, the TP
                                would have had to report the money in 1944 and could not have
                                deferred recognition under the installment method
      Economic Benefit: TP must report income when they have the absolute right to the
       income in the form of a fund which has been set aside and is beyond reach of creditors
           o Pulsifer (pg. 256): TPs were minors when they won a sweepstakes. Their father
               had the winnings deposited into an account until the TPs were 21. Service argued
               the money should be included as income in the year it was set aside in the
               account, and TPs argued it should be included in the year they gained access to it.
               Court held that the economic benefit rule applied b/c if the TPs wanted access to
               the money all they needed was for their legal representative to apply for the funds
           o Drescher (pg. 257): TP’s employer bought him annuity policies (to pay him
               income when he retired) and TP did not report any increase in income. Service
               argued the employer gave the TP additional compensation, but TP argued that he
               hadn’t received additional compensation b/c he wasn’t receiving any income until
               after he retired. Court held that the annuities were a form of present
               compensation and represented an economic benefit to TP
                                                                                                 28


                      NOTE: when the TP purchases an annuity with his own money, there is no
                       tax liability until the payments are received
      Deferred compensation: a TP is not taxable by an employer’s mere promise to pay, but
       when money is set aside in a trust for the benefit of the employee, out of control of the
       employer, the employee is taxed at the time the money is paid to the trustee (but the
       employer will not receive a deduction for the amount to be paid in the future until the
       year the employee recognizes income)
          o Minor (pg. 266): TP, doctor, entered into an agreement where he could utilize
               deferred compensation (he took only 10% of his fees). All the money not
               received by the doctor at that time was put into a trust, of which the physician’s
               group was the beneficiary of the trust. Service argued the amount paid into the
               trust was taxable. Court held that the TP did not have taxable income b/c his
               rights to receive benefits under the plan were subject to a number of conditions
               and subject to a risk of forfeiture (i.e., his receipt of benefits under the plan was
               contingent upon his agreement to limit his practice after he retired and refrain
               from competition)
          o Al-Hakim (pg. 272): TP, sports agent, negotiated a contract for a client and agreed
               to be paid $112.5K over the next 10 years. Client then “loaned” $112.5K to TP to
               be repaid over the next 10 years. Service argued that the $112.5K the TP’s client
               gave him was not really a loan, but a disguised payment in full. Court held that
               the documentation supported the TP’s contention that the money, so the money
               was a loan, not a fee
                    § 7872 will no longer allow this result b/c it imputes interest on below-
                       market (or no) interest rates
          o Olmsted (pg. 274): Insurance company pays TP $500/month for 15 years in
               exchange for TP’s assignment of all rights to renewal commissions to the
               company. TP wants to pay taxes on $5500 (the amount received that year) but the
               Service wants the TP to pay taxes on $67,924 (FMV of the entire contract) under
               the economic benefit doctrine. Court held that the periodic payments were
               taxable only upon receipt b/c the TP had only exchanged one contract for
               another—the new contract just provided for a different rate or manner of
               payment. This case was different from Drescher b/c in that case a 3rd party issued
               the annuity, but in this case the original parties to the contract were involved in
               the transaction. Here, there was no taxable exchange, only a novation (i.e.,
               change in the contract terms; modification ≠ disposition) and TP derived no
               economic benefit from the new contract.

B.8.   Qualified Employee Plans (i.e., benefit plans, contribution plans such as 401(k))

      Three characteristics
          o Amounts paid into the plan by employer is not taxable for the employee when
              benefits are earned, only when received on retirement
          o Employer can deduct contributions into the plan immediately (so employer
              doesn’t care whether it pays employee is salary or contributions)
          o Inside build-up is protected as interest accrues (deferral, not forgiveness)
      Downside/safeguards
                                                                                               29


          o Necessity of including rank-and-file employees means a range is established that
            is less beneficial for highly compensated employees
          o Vesting requirements must be met (§ 411), which ensures that after a specified
            period of service an employee’s retirement benefit become nonforfeitable
          o Part-time employees not covered at all
          o Penalties of 10% for early withdrawal before the age 59½ unless the employee
            retired after age 55, died, or became disabled, or withdraws the money for
            qualified higher education expenses or first-time home purchases
          o Mandatory minimum distributions before at age 70½
          o Maximum benefit under any plan can’t exceed $160K

B.9.   Stock Options (NOTE: This section will not be on the exam)

      For certain corporate employees, a portion of their compensation is in the form of
       “compensatory” or “employee” stock options entitling the employee to buy a specified
       number of shares of the employer’s common stock
           o Reasons to issue employee stock options:
                     To compensate the employee to work for the company
                     To improve the employee’s incentive to do good work b/c he will benefit
                       if the stock price goes up
           o Stock options are taxable (LoBue), but there are three approaches on how and
               when to tax the options
                     Income upon receipt of the option
                     Income upon exercise of the option (this was the Court’s choice in LoBue)
                     Gain recognized upon sale of the stock
           o § 422: addresses incentive stock options (ISOs) (applies to the third approach)
                     Potential downfall: $100K limit, so may not be beneficial for highly-
                       compensated employees
      Cramer (pg. 290): TP receives stock options and claimed them as income with a value of
       zero even though the stock was not publicly traded so that they could receive capital gain
       treatment if they were exercised in the future. However, an IRS regulation held that a
       stock option could not be treated that way unless it had an ascertainable FMV. When the
       employer was bought out and the value of the TP’s stock options increased, TP reported
       the increase as capital gain. The Service argued that the option sales produced income,
       not capital gain. Court held that a stock option that is not transferable or immediately
       exercisable and subject to restrictions can’t be considered income at the time of issuance,
       but at the time it is transferable, exercisable, and not subject to restrictions (§ 83).

B.10. Transfers incident to marriage and divorce

      Three issues usually arise when dealing with divorce:
          o 1) Property settlement (dividing the wealth)
                           Not deductible by the payor and not income for receiver
                   Davis (pg. 298): TP transferred stock to his ex-wife in a divorce
                      settlement. TP argues there was no taxable event b/c the transfer was just
                      a division of property between co-owners. The Service argued that was a
                                                                               30


    taxable event b/c the transfer was not a gift (obviously not motivated by
    love, affection or charity) and said the consideration was the release of all
    claims to his property. Court held that the transfer was a taxable event and
    TP had to report the FMV at the time of transfer less the basis as a capital
    gain.
         Davis has only been overruled in the marriage context, so if
            appreciated property is being transferred between non-married
            persons to settle a claim, the Davis rule still applies
                o Example: A transfers property to B (but they are/were not
                    spouses). Basis in property = $40K and value of B’s claim
                    = $95K
                         A’s amount realized = $95K (b/c the parties are
                            dealing at arm’s length, so you can assume the
                            FMV of the stock = the value of the claim)
                         A’s income = $95K - $40K = $55K
                         B’s basis = $95K
   § 1041: Congressional reaction to the harsh results in Davis (only applies
    to MARRIED couples)
         No gain or loss will be recognized on transfers of property between
            spouses or incident to divorce
                o Example: If Husband transfers stock to Wife (Basis = $20K
                    and FMV at time of transfer = $45K)
                         After Davis, H would have $25K in taxable income
                            and W’s basis = $45K
                         After § 1041, H would have no income and W’s
                            basis = $20K
         NOTE: only transfers from a sole title holder to a non-title holder
            applies Davis or § 1041. In any situation where the law is
            community property or if both H and W were co-owners, there is
            no taxable event and the property is divided
                o Example: if property’s basis = $100K and FMV = $400K, a
                    division for joint owners means both husband and wife
                    have a basis = $50K and FMV = $200K
   NOTE: § 121 allows the exclusion of gain from the sale of a home if the
    owner has lived in the house for 2 of the 5 years prior to the sale. What if
    a divorce settlement allows the H to remain in a home for 6 years until the
    kids turn 18 while the W lives in an apartment. When the house is sold,
    can the W exclude half of the sale proceeds from income under § 121?
         On it’s face, it doesn’t look like it b/c the W hasn’t lived there for 2
            of the 5 year period before the house is sold
         BUT § 121(d)(3)(b) allows up to a $250K deduction where a
            spouse is granted use of the property under a divorce
   Farid-Es-Sultaneh (pg. 303): TP received stock from her fiancé in an
    antenuptial agreement. TP wanted her basis to be the stock’s FMV at the
    time of transfer, not her husband’s basis (as would be the case if the
    transfer was treated as a gift). The court held that the transfer was not a
                                                                                    31


          gift b/c consideration was present (stock was in return for relinquishing
          rights in her husband’s property) and the parties were not married at the
          time of transfer so there was no shelter under § 1041.
               NOTE: this case illustrates that what constitutes a gift for estate tax
                   purposes may not be considered a gift for income tax purposes
o 2) Alimony (support issues; transferring income form more affluent to less
  affluent spouses)
       Payments received are taxable to the receiver (§ 71(a)) and deductible to
          the payor (§ 215) as an above-the-line deduction (gross income  AGI) as
          long as certain conditions (outlined in § 71) are met:
               Payment must be in cash (i.e., transfer of appreciated property
                   doesn’t count)
               Payment must be received under an “instrument” of divorce or
                   separation maintenance (i.e., unmarried couple and oral
                   agreements don’t work)
               Parties can’t agree that the payments will be nontaxable to the
                   receiver and nondeductible to the payor
               Parties can’t live in the same house
               Payments can’t continue after the death of the paying spouse
               Payments can’t be made for child support
                       o i.e., a payment that is called alimony but terminates when a
                           child dies or reaches 18 is treated as child support
                                rationale is that it the payor had custody of the
                                   child, he wouldn’t be able to deduct those child-
                                   rearing costs, so he shouldn’t be allowed to claim
                                   deductions just b/c the child doesn’t live with them
               Payments can’t be “front-loaded”
                       o Only payments that are “substantially equal” for the first
                           three years are considered alimony
                       o This requirement distinguishes between regular support
                           payments (alimony) and once-and-for-all settlements
                           (property settlements)
                       o If the 1st year payments exceed 2nd and 3rd year payments
                           by more than $15K, payments are initially treated like
                           alimony but the excess amounts are “recaptured” in the 3rd
                           year (meaning the payor mist include the excess in income
                           to make up for the amount previously deducted)
                                Example: TP pays $50K in alimony is year 1 and
                                   nothing in year 2 and 3. The amount recaptured in
                                   the 3rd year is $35K ($50K - $15K threshold) which
                                   must be included in the TP’s income
                                        And the receiver, who included $50K as
                                           income in the 1st year, must deduct $35K in
                                           year 3.
o 3) Child Support
       Not deductible by the payor and not income for receiver
                                                                                                32


                       Even if the paying parent defaults on payments, the receiving parent can
                        not claim a deduction
                             Diez-Arguelles (pg. 311): TP was supposed to receive $300/month
                                in child support and when the ex-husband defaulted she claimed a
                                “bad nonbusiness debt” deduction (§ 166). The Court held that
                                amounts due to a TP for child support can’t be deducted with the
                                bad nonbusiness deduction b/c those bad debts are deductible only
                                to the extent of the TP’s basis in debts and here, the TP had no
                                basis (TP’s “out-of-pocket” argument denied).

C.       PERSONAL DEDUCTIONS, EXEMPTIONS AND CREDITS

C.1.     Personal deductions

        Personal deductions are subtracted from AGI to arrive at taxable income and includes
            o Itemized deductions (i.e., listed below and alimony) OR standard deduction (§
                63(c)(2))
                            NOTE: § 68: overall limitations on itemized deductions
                     Casualty losses
                            § 165(c)(3): Deductions allowed for losses from fire, storm,
                               shipwreck, or other casualty, or from theft IF the loss exceeds in
                               the aggregate 10% of AGI after reduction by a $100 “floor”
                            Dyer (pg. 339): TP claimed a casualty loss deduction of $100 for
                               damages to a vase broken by a cat. TP argued that b/c the cat was
                               having a neurotic fit caused by an incurable disease, the vase was
                               not damaged by the cat’s normal behavior and fell under the “other
                               casualty” category. Court held that a vase broken by a cat was not
                               analogous to a fire or other catastrophic occurrence.
                                   o NOTE: the 10% threshold now prevents small claims like
                                       this from being litigated
                                   o NOTE: suddenness requirement per Revenue Rule 63-232
                                            No deduction b/c not sudden: Termite damage (rev
                                               ruling), ring lost in pond, ring flushed down toilet
                                            Deduction b/c sudden: ring rinsed down disposal,
                                               ring destroyed when car slammed on hand
                            Chamales (pg. 341): OJ Simpson’s neighbor tried to claim a
                               casualty loss deduction for the decline in property value after
                               Nicole’s murder. Court held that no such deduction would be
                               allowed b/c a loss must be “evidenced by closed and completed
                               transactions” and “fixed by identifiable events.” Although the
                               murder was sudden and unexpected, there was no actual physical
                               damage to the TP’s home and the court would not allow a
                               deduction for a temporary decline in FMV.
                            Blackman (pg. 348): TP, angry at his cheating wife, set fire to her
                               clothes and left the house. The house burned down, and TP
                               claimed the lost value of his house as a casualty deduction. Court
                                                                            33


           held that even though a TP can claim a deduction on a loss caused
           by his negligence, he cannot claim a deduction where the loss was
           caused by his gross negligence or intent.
   Medical expenses
        § 213(a): deductions allowed for medical expenses that exceed
           7.5% of AGI
        § 162(l): self-employed persons allowed a deduction for the cost of
           health insurance premiums
               o 30% at time this section was enacted (1995)
               o 60% in 1999 thru 2001
               o 70% in 2002
               o 100% in 2003 and thereafter
        Cost of dental care is completely deductible
   Charitable deductions
        § 170: deductions allowed for gifts made to churches, educational
           organizations, medical institutions, and certain publicly supported
           organizations (listed in § 170(b)(1)) UP TO 50% of the TP’s
           “contribution base” (generally the AGI)
        § 170(b)(1)(B): deductions to other organizations (i.e., private
           foundations) are deductible UP TO 30% of AGI
        If TP’s contributions exceed these limits, the excess can be carried
           over to for the next five years
        For Capital Gain property:
               o If the property’s sale would produce long-term capital gain,
                   the amount allowed as deduction is the FMV of the
                   property (Limit is 30% of AGI, or 20% if the fist is to a
                   private foundation)
               o If the property’s sale would produce short-term capital gain
                   or ordinary income, the deduction is limited to the TP’s
                   basis in the property
        If a contribution has a private objective or benefit, no deduction
               o Ottawa Silica (pg. 363): TP, company, bought land for
                   mining. When a school district asked them to donate a
                   portion of the land, TP did so b/c it knew that in order to
                   build the school, the district would have to build access
                   roads. The court held that TP was not allowed a deduction
                   b/c the only reason the TP donated it was b/c when the
                   district built the roads the TP would benefit from the
                   increased value in the land for residential development.
        A charitable contribution deduction is limited to the excess of the
           payment to the charity over the value of the benefit to the donor
               o i.e., if a radio station offers a CD worth $15 in return for a
                   contribution of $50, the deductible amount is $35
                        value to the donor = FMV of what is being received
        § 170(f)(8): TPs who claim a deduction of more than $250 must be
           able to substantiate the deduction with a written acknowledgement
                                                                               34


           of the organization that states the FMV of the goods provided in
           exchange for the donation
          § 170(l): If a TP’s contribution to a college receives the right to
           purchase tickets to sports games, only a deduction for 80% of the
           amount contributed is allowed
          Contributions must be voluntary for deductions to be allowed
               o Lombardo (pg. 370): no deduction for contributions made
                   to a county fund when the contribution was required as a
                   condition of the TP’s probation
          For an institution to qualify as a charitable organization, its
           policies can not be in contrary to public policy
               o Bob Jones University (pg. 371): TP, a university, had
                   racially discriminatory policies and protested when the IRS
                   revoked their tax exempt status. Court held that racial
                   discrimination was contrary to public policy and affirmed
                   the revocation of the TP’s tax exempt status.
   Interest
         § 163(a) and (d): Business and investment interest (incurred in a
             trade or business) has always been allowed as a deduction
         Before 1987, all personal interest was deductible too
         Now, only deductible personal interest is the interest on a home
             mortgage IF it is a “qualified residence” interest (§ 163(h)(3))
                 o Qualified residence interest can be either:
                         Acquisition indebtedness (§ 163(h)(3)(B))
                                  Debt incurred to buy, build or improve a
                                    personal residence (limit = $1M)
                         Home Equity indebtedness (§ 163(h)(3)(C))
                                  debt secured by a personal residence that is
                                    NOT in excess of the home’s FMV (limit =
                                    $100K)
                         Example: TP buys a house worth $1.5M. TP
                            makes a down payment of $300K and takes out a
                            loan of $1.2M.
                                  Acquisition indebtedness = $1M
                                  Home equity indebtedness = $100K
                                         o TP can deduct $1.1M of $1.2M loan
                         Example: TP buys a house worth $300K. TP makes
                            a down payment of $185K and takes out a loan for
                            $115K. A month later, TP takes out another $125K
                            secured by the house
                                  Acquisition indebtedness = $115K
                                  Home equity indebtedness = $100K
                                         o NOTE: If TP had borrowed the
                                             entire $240 ($115 + $125) at the time
                                             of purchase, the entire amount would
                                                                                    35


                                               have been deductible as acquisition
                                               indebtedness
                                 Example: TP buys a house for $50K. It is now
                                  worth $300K. TP takes out a loan against the house
                                  of $140K
                                       Acquisition indebtedness = n/a
                                       Home equity indebtedness = $100K
                                            o NOTE: home equity indebtedness
                                               can exceed basis, but not FMV
                                            o NOTE: if TP sold the house for
                                               $300K and bought another house for
                                               $300K, but used $140K from a loan,
                                               she would have $140K in cash but
                                               would still be able to deduct the
                                               whole loan of $140K as acquisition
                                               indebtedness
               Tracing:
                    o Interest is allocated according to the use of the loans
                        proceeds
                             Interest on a loan that is used for personal purposes
                                is characterized as personal interest, even if the loan
                                is secured by business property
              § 221: Student loan interest
                    o Deduction for interest on indebtedness used to pay higher
                        expenses is deductible up to $2500
                             Deduction is phased out for TPs with modified AGI
                                in excess of $50K
o Personal and Dependency Exemptions
      § 151: Each TP allowed a personal exemption
              Amount was $2900 in 2001, currently is $2000
      § 151(e): exemption allowed for each dependent if the dependent
              Is related by blood, marriage or adoption
              Gets more than ½ of his support from the TP
              Had a gross income of less than the exemption amount
                    o This restriction not applicable if the dependent is the TP’s
                        child, under the age of 19 or a student under the age of 24,
                        and, if married, doesn’t file a joint return with his spouse
                    o If parents divorced, custodial parent takes the exemption
                        (but can waive that deduction in favor of the noncustodial
                        parent)
o Credits
      § 32: Earned Income Tax Credit
              Only available to the working poor
              Gives a credit of a percentage of earned income up to a specified
                level
                                                                                               36


                                  o Credit rises as earned income rises up to a certain amount,
                                      then it phases out
                      § 22: Credit for Elderly and Permanently and Totally Disabled
                            Gives a credit for income from any source, including earnings for
                              services currently performed, for persons age 65 and older
                            Credit amount reduces as income rises above $7.5K (for single
                              persons), $10K (for joint returns) or $5K (separate returns filed by
                              married person)
                      § 23: Adoption expenses credit
                            Gives a credit of up to $10K/child for adoption expenses
                            Credit amount is phased out as income rises above $150K
                      § 24: Child Tax Credit
                            Gives a credit of $500 for each dependent child under age 17 ($600
                              in 2001, $700 in 2005, $800 in 2009 and $1K in 2010, and may
                              revert back to $500)
                            Credit is reduced by $50 for every $1K that income rises over the
                              threshold amounts of $75K for single, $110K for joint returns, and
                              $55L for married person filing separately

D.       ALLOWANCES FOR MIXED BUSINESS AND PERSONAL OUTLAYS

D.1.     The continuum for business and personal expenses

Transformation: when a TP wants to make a nondeductible expense into a deductible one

        At one end of the spectrum
             o § 162(a): allows deductions for “ordinary and necessary expenses paid or incurred
                … in carrying on any trade or business”
                     i.e., office expenses, salaries, auto expenses, travel, entertainment
                        expenses
                     these are above-the-line deductions (gross income  AGI)
                             a salaried associate would rely on this section to deduct
                                unreimbursed expenses such as legal periodicals, bar dues, CLEs
                                   o BUT when the employee uses § 162 instead of the
                                       employer:
                                           He is subject to the 2% threshold (§ 67)
                                                    BUT employee can ease this by establishing
                                                       a reimbursement allowance arrangement (§
                                                       62(a)(2)(A))
                                           His deductions they are below-the-line deductions
                                              (AGI  taxable income)
             o § 212: allows deductions for expenses of generating income from sources other
                than a trade or business
                     i.e., stocks and bonds, so TP could deduct fees paid to investment
                        advisors, expenses incurred in attending investment seminars, etc.
                     these are below-the-line deductions (AGI  taxable income)
                                                                                                   37


                    § 212 is subject to the 2% threshold (§ 67)
      At the other end of the spectrum
           o § 262: no deductions allowed for personal, living or family expenses
      § 67: limits the amount of deductions allowed
           o certain deductions are allowed only if they, in the aggregate, exceed 2% of AGI
                    i.e., deductions under § 212 and deductions under § 162 if claimed by
                       employees
                    Example: TP earns $40K and spends $5K continuing his education. He
                       tries to deduct the $5K under § 162
                            2% of $40K is $800, so TP can only deduct $4.2K ($5K - $800)

D.2.   Controlling the abuse of business deductions

      § 183: limits the availability of § 162 deductions if the activity is not engaged in for profit
           o Basketing: income generated by hobbies can offset the expenses of that hobby,
               but only if those expenses and other miscellaneous expenses exceed 2% of the
               AGI
           o Nickerson (pg. 391): TP bought a farm, which was in great despair, and leased it
               to a tenant farmer for $20/acre. TP visited the farm infrequently, and when he did
               he only worked on renovating the farmhouse. TP did not expect a profit for 10
               years and claimed deductions for losses occurred in renovating the farm. The
               Service denied the deduction b/c it said TP could not have believed the farm
               would be profitable b/c he emphasized remodeling instead of crops. Court held
               that to claim a deduction, the TP doesn’t have to show a reasonable expectation of
               immediate profit; he need only show an expectation of future profit. Court said
               the farm was a business, not a hobby, so TP’s losses were deductible and could be
               used to offset TP’s salary and other income.
                    Factors the court looked at to determine the TP’s motivation:
                            Manner in which TP carries on the activity
                                   o i.e., if TP carried on the activity in a businesslike manner
                                       and kept accurate books/records
                            Expertise of TP or his advisors
                                   o i.e., preparing for the activity by studying the practice or
                                       consulting with experts
                            Time and effort expended by TP
                                   o i.e., if TP devotes personal time and effort to carrying on
                                       the activity, esp. if the activity does not have substantial
                                       personal or recreational aspects; OR if TP devotes a limited
                                       amount of time but employs qualified persons to carry on
                                       the activity
                            Expectation that assets used in the activity will appreciate in value
                            Success of TP in carrying on similar or dissimilar activities
                            TP’s history of income or losses w/ respect to the activity
                            Amount of occasional profit, if any
                                   o NOTE: inability to make a profit in the particular taxable
                                       year is not dispositive
                                                                                               38


                            Financial status of the TP
                            Elements of personal pleasure or recreation
                                o i.e., personal motives may indicate that an activity is a
                                     hobby, but a profit motivation may be indicated where an
                                     activity lacks any appeal other than profit
                     Primary Purpose test: court seeks to determine TP’s primary purpose when
                      determining if an activity is a business or a hobby
                           TP need only prove their sincerity rather than their realism,
                             meaning a person might establish a sincere intent to make a profit
                             even though the hope or expectation of profit is unrealistic

D.3.   Home office and Vacation homes

      Home office
          o When a part of the home is used exclusively as the principal place of business, the
              costs of that part of the home (including a pro rata share of utility bills and
              depreciation) might be deducted as a business expense
          o § 280A: (a) gives a general rule denying deductions for any use of a home for
              business purposes but (c) lists specific, concrete exception
          o Popov (pg. 401): TP, professional violinist, claimed a deduction for her living
              room, which is where she practiced. The Service denied the deduction, but Court
              allowed it. Court looked at the relative importance of the activities performed at
              the business location (here, practicing was undeniably important) and the time
              spent at the home office (4-5 hours per day sufficient) vs. the time spent at other
              places where business occurred (TP spent more time at home practicing than she
              did at the studio recording). Court also noted that no one used the area except the
              TP, but what was important was not how many people used the living room and
              for what purpose but rather that the living room was the only place that the TP
              had to practice.
      Vacation homes
          o § 280A: lists rules dealing with vacation homes
                   No personal use of the vacation home
                            All deductions allowed under § 162 (i.e., utilities, repairs, condo
                              fees, etc.) subject to limitation on deduction of passive activity
                              losses
                   Personal use for less than specified amount of time (which is 14 days or
                      10% of the number of days the unit is rented)
                            § 280A does not apply (which means itemized deductions allowed)
                              but § 162 deductions are allowed on a pro rata basis (i.e., TP must
                              tease out the part of the expenses allocated to the personal time
                              usage) subject to limitation on deduction of passive activity losses
                   Personal use for more than specified time and incidental rental use (<15
                      days)
                            TP can exclude rental income but can’t claim § 162 deductions
                              (other than for interest and taxes)
                   Personal use for more than specified time
                                                                                               39


                              Expenses must be pro rated, but § 162 deductions for the expenses
                               cannot exceed rent received (that is, income absorbs all
                               deductions)

D.4.   Income Unconnected to a trade or business

      § 67 imposes a 2% threshold on income generated under § 212, but not under § 162 as a
       trade or business expense, so there is a lot of litigation on what constitutes a trade or
       business
           o Moller (pg. 406): TPs were investors and tried to deduct their home office as a
               business expense under § 162. The Service decided that their investments were
               not a trade or business and refused the deduction. Court agreed with the service
               b/c it said that managing one’s own investments was not a trade or business
               (production of income ≠ business).
                    NOTE: a stockbroker or investment fund manager is a “trader” which is
                        different from an “investor”
                    NOTE: even if these TPs had one or two clients, it still may not have
                        classified as a trade or business unless a “substantial amount” of their
                        activity was done for people other than themselves
                    NOTE: these TPs could still claim deductions under § 212 if they reached
                        the 2% threshold.
      § 165 allows deductions for losses incurred that are not compensated by insurance or
       otherwise
      § 165(d), which is also an above-the-line deduction, allows deductions for wagering
       losses only to the extent of the gains
           o Whitten (pg. 413): TP game show contestant argued that he should be able to
               deduct the expenses of appearing on the game show (i.e., transportation, food,
               hotel) against his game show winnings. The Service and the Court disagreed b/c
               it held that the TP was not in the trade or business of gambling (§ 165(d) is only
               applicable to professional gamblers) and did not incur losses or expenses in
               excess of his winnings.
                    NOTE: wagering losses must be reported separately from expenses
                        incurred in the engagement of gambling activity
                    TP’s expenses were better characterized as miscellaneous itemized
                        deductions under § 67

D.5.   Office Decoration

      § 162 deductions may be denied if the amount was expended for a personal, living or
       family expense
           o Henderson (pg. 416): TP was an attorney general who bought a plant and a
              framed picture to decorate her office and tried to deduct the expense under § 162.
              Court held that the deduction was rightly denied b/c the purchases were personal,
              not business expenses.
                   Test: Is there a sufficient nexus between TP’s expenses and the carrying
                     on of TP’s trade or business to qualify the expense for a § 162 deduction?
                                                                                               40


                             A remote or incidental connection is not enough
                             Where both sections apply, § 262 (personal expenses) may
                              override § 162 (business expenses)
                                 o NOTE: § 212 is also subject to § 262 limitations

D.6.   Travel and entertainment expenses

      Engaging in travel and entertainment in an business setting transfers what would be a
       nondeductible expense into a deductible business expense
            o § 162: allows deductions for business travel
            o § 162A(2): allows deductions for business travel away from home (i.e., overnight
               travel)
      § 132(d): an employer-provided benefit is not included in employee’s income if the
       benefit would have been deductible as a business expense if the employee had paid for it
       out of his own pocket
      If the purpose of the travel is not primarily business, some or all of the trip may be
       imputed into TP’s income
            o Rudolph (pg. 420): TP insurance agent sold a certain amount of insurance and
               qualified for a trip to NY to attend a convention. The trip was week long and
               included one business meeting (the rest of the time TP and his wife did whatever
               they wanted). The employer paid for the trip and the Service included the amount
               of the trip as part of TP’s income. Court agreed with the inclusion b/c it said the
               trip was “primarily a pleasure trip” in the nature of a bonus/reward for a job well
               done.
      § 274: travel and entertainment expenses are only deductible if “directly related” to
       business
                    Congressional reaction to uncertainty of decisions like Randolph
            o Even if the entertainment directly precedes or follows a “substantial or bona fide
               business discussion” a deduction is allowed (i.e., a football game after a business
               dinner)
            o 50% limitation: only half of the cost of meals and entertainment is deductible and
               the remaining half is a nondeductible personal expense
            o No deduction for attending spouse unless there’s a bona fide business reason for
               the spouse’s presence
            o Substantiation requirement: TP must provide the Service with written
               documentation listing
                    The amount
                    The time and place of the travel or entertainment
                    The business purpose of the expense
                    The business relationship to the person entertained
            o If a TP combines business and pleasure on a trip to a foreign country, the airfare
               is partially disallowed
            o No deductions for conventions held outside North America unless it is reasonable
               for the meeting to be held there

D.7.   Business Lunches
                                                                                              41



      Business lunches are completely deductible if the expense is different from or in excess
       of that which would have been made for TP’s personal purposes
           o i.e., a TP who takes a client to an expensive restaurant and also orders something
               to eat  he would not have eaten there had it not been for his boogie clients and
               would get more value from using the same money to buy something else
      IRS requires that the meal be shown to be a real business necessity (a condition which is
       most easily satisfied when a client or customer or supplier or other outsider is a guest)
           o Moss (pg. 427): TP attempted to deduct the cost of his daily lunch with other
               attorneys, who met at the same Café every day to discuss their cases. The Court
               upheld the Service’s disallowance of the deduction b/c the meal were not a
               necessary part of the meeting (the co-workers knew each other well and didn’t
               need the “social lubrication” that a meal with an outsider provides). Court said
               the members of the firm had to eat somewhere and didn’t claim to have incurred a
               greater daily lunch expense than they would have had there been no lunch
               meetings.
                    NOTE: case might be different if location of the courts required the firm
                       to eat everyday in a disagreeable restaurant or in a restaurant too
                       expensive for their tastes (so that they derived less value from the meal
                       than it cost them to buy it)

D.8.   Entertaining clients

      To be deductible, an entertainment expense must satisfy two requirements:
           o § 162: ordinary and necessary business expense
           o § 274: directly related to or associated with the business
      Danville Plywood (pg. 430): TP invited potential customers to New Orleans to see the
       Super Bowl. TP met with the customers briefly to discuss his business products and
       displayed them. He later claimed the expenses as a business deduction, which the
       Service denied. The Court held that the deduction was properly denied because the
       expenses were not undertaken for a “bona fide business purpose” and was not an ordinary
       and/or necessary business expense as required under § 162.
           o NOTE: if TP had just given his employees the cost of the travel and entertainment
              he could have deducted it under § 162 as salary.
           o NOTE: the requirement that a deduction be “necessary” is rarely invoked b/c the
              TP (if he is in the 40% tax bracket) only saves 40 cents for every dollar spent, so
              it is assumed that he would not make unnecessary payments to an unrelated party

D.9.   Child Care Expenses

      Smith (pg. 437): TP husband and wife claimed a deduction for childcare expenses so that
       the wife could work. Service denied the deduction, and TP argued that “but for” the
       childcare the wife would not have been able to work. The Court held that, per § 262
       which denies deductions for personal living or family expenses, TP could not deduct an
       expense that applies to everyone regardless of their occupation. An indirect relationship
       with business pursuits does not mean the expense can be deducted as a business expense.
                                                                                                  42


          o NOTE: child care is now addressed in § 21, which allows a $3K credit for one
            child and a $6K for two or more children if the care is provided outside the home
            by a dependent care center (cares for more than 6 children) for a dependent child
            younger than 13
                 BUT child care expenses don’t include the cost of summer camp
          o NOTE: § 129 allows an employer to make up to $5K per year available to an
            employee for child care expenses through a dependent care assistance program as
            part of a cafeteria plan (TP can treat that amount as a nontaxable DCAP benefit),
            but this reduces the § 21 credit

D.10. Commuting Expenses

      Despite the fact that employees need to commute to and from their jobs, commuting
       expenses are considered a universal expense and are non-deductible unless the TP can
       show that his commute rises to the level of “travel,” which is deductible under § 162 as a
       business expense or § 162(a)(2) as a traveling expense while away from home
      Only travel required by the employer matters; if an employee chooses to travel those
       expenses are not deductible
           o Flowers (pg. 440): TP lawyer did some work for a railroad company located in
               Mobile, AL and agreed to be there general counsel as long as he could continue to
               live in Jackson, MS. TP attempted to deduct the expenses as travel expenses
               under § 162(a)(2) and the Service denied the deductions. Court noted three
               requirements for such a deduction: 1) it was a reasonable and necessary business
               expense, 2) it occurred “while away from home,” and 3) it was incurred in the
               pursuit of business. Here, the TP didn’t satisfy the last requirement b/c the
               expenses were not incurred in pursuit of the employer’s business but were
               incurred only b/c of the TP’s desire to maintain a home in MS while working in
               AL.
                    Here, Court seemed to imply that “tax home” = employer’s principal place
                        of business
      “tax home” can be the TP’s residence or the employer’s place of business depending on
       the reason behind the TP’s travel
           o Hantziz (pg. 447): TP lived with her husband in Boston where she attended law
               school. Over the summer, she moved to NY and rented an apartment there while
               working for a firm for 10 weeks, occasionally visiting Boston. TP deducted the
               travel expenses and cost of maintaining the NY apartment under § 162 and the
               Service denied the deduction. Court held that NY was the TP’s “home” for tax
               purposes of § 162. Boston was not her “home” b/c she had no business
               connection there and the mere fact that her husband lived there was not sufficient.
                             Being a student is NOT a trade or business
                    Location of a “home” is only an issue when a TP lives in one place and
                        works in another.
                             If a TP maintains two homes (i.e., a personal home and a principal
                                place of business), there is no deduction when the travel is personal
                                (“tax home” is employer’s place of business) but a deduction is
                                                                                              43


                             allowed when the travel is required by the employer (TP’s
                             residence is the “tax home”)
      Hypo: If a TP wants to live in Charlottesville and work at a law firm in Richmond, how
       can he deduct those commuting expenses as travel expenses?
          o Using the employer
                   Show that the employer has reasons for the TP to frequently travel to
                      Charlottesville (i.e., important client contact)
          o Using the TP only
                   Have the TP establish an independent business connection to
                      Charlottesville (i.e., doing private legal work in Charlottesville)
      NOTE: a “home” must exist in order to deduct under § 162(a)(2) b/c there must be
       something for the TP to “be away from”
          o i.e., a truck driver who lives out of his truck can’t deduct traveling expenses
      commuting expenses only tax deductible if:
          o work location is temporary and located outside the metropolitan area where the
              TP lives and normally works
          o work location is temporary and TP has one or more regular work locations in the
              same trade or business
          o TP’s residence is the principal place of business and the work location is in the
              same trade or business

D.11. Moving Expenses

      § 217: allows a deduction for un-reimbursed moving expenses of a TP who moves at
       least 50 miles to start a new job or to take a new job that would add at least 50 miles to
       his commute
           o TP must work at least 39 weeks at the new job over the next year
           o Deductible expenses include the cost of moving your belongings from the old
               residence to the new residence and the cost of traveling to the new residence
                     If moving to foreign location, the cost of storing belongings also included
      NOTE: § 162(a)(2) and § 217 are mutually exclusive
           o § 162(a)(2) only applies when a TP is temporarily assigned to another location
               (i.e., less than one year)
           o § 217 only applies when a TP is indeterminately assigned to another location (i.e.,
               requires an intent to stay more than one year)

D.12. Clothing expenses

      Clothing expenses are considered universal expenses and are not deductible
          o Exceptions for uniform employees (i.e., police officers, food service workers) b/c
              they have to purchase clothes that are not appropriate for street-wear
                   NOTE: when the cost of the clothes are deductible, so is the cost of
                      maintaining the clothes (i.e., dry cleaning)
          o NOTE: military uniforms wore by active duty officers are not deductible b/c they
              take the place of ordinary clothes, but uniforms for part-time reserve personnel
              are
                                                                                                 44


          o Pevsner (pg. 456): TP worked in a boutique and was required to wear the
            expensive clothing sold there while at work. TP bought the clothes and wore
            them exclusively at work and deducted the cost of the clothes as a business
            expense. The Service denied the deduction, but TP argued that she wouldn’t have
            bought them had she not been required to do so as a condition of her employment.
            Court held that the deduction was rightly denied b/c the TP chose not the wear the
            clothes away from work. If the clothes are adaptable to ordinary use (objective
            test), as was the case here, no deduction is allowed.

D.13. Legal Expenses

      Recall § 212 allows deductions for expenses of generating income from sources other
       than a trade or business if:
           o The activity is done to produce income or
           o The activity is related to the management or maintenance of property held to
               produce income
      Legal expenses may be deductible, depending if it satisfies one of four tests:
           o To protect something under § 212(1) (activity to produce income)
           o To protect something under § 212(2) (property held to produce income)
           o Proximate relationship of the profit-oriented activity
                    i.e., no deduction to defend a suit as a tortfeasor where TP was negligently
                       driving for pleasure, but deduction for suit to defend as a tortfeasor where
                       TP was negligently driving on the job
           o Origin of the claim
                    Gilmore (pg. 459): TP spent several thousands to defeat his wife’s suit for
                       divorce and alimony and attempted to deduct the legal expenses incurred
                       under § 212 b/c he argued that without his legal expenses his wife would
                       be able to cut his income-producing assets through alimony. The Service
                       disallowed the deductions and the Court agreed. Court stated that the test
                       to determine whether the legal expense is “business” or “personal”
                       depended on if the claim underlying the litigation arises in connection
                       with the TP’s profit-seeking activities. Here, the TP’s legal expenses were
                       incurred b/c of personal, not business, problems
           o NOTE: deductions for legal expenses made during the conduction of illegal
               business (i.e., prostitution, extortion, etc.) are allowed
                            NOTE: no § 162 deductions allowed if the TP is acquitted during
                                the criminal trial b/c then they are not considered in that trade or
                                business
                    BUT not if that illegal business was in connection with the sale of drugs
                       (explicitly stated in § 280E)

D.14. Expenses of education

      Education expenses are not deductible if the education is undertaken to :
          o Meet minimal educational requirements (i.e., college degree)
          o Qualify for a new trade or business (i.e., J.D.)
                                                                                                 45


                       Carroll (pg. 465): TP police officer enrolled in college (philosophy major)
                        to preparation for the study of law and deducted his education expenses.
                        Service and Court denied the deductions b/c there was an insufficient
                        relationship between the subjects he studied and the skills required to be a
                        policemen.
        Education expenses are deductible if the education is undertaken to:
             o Maintain or improve skills (i.e., CLE courses)
             o Meet the requirement of the employer AFTER the job has been obtained
        § 222: allows a deduction of $4K if TP’s AGI is less than $65K and $2K if TP’s AGI is
         less than $80K for 2004 and 2005 (in 2002 and 2003 only $3K allowed for TP’s with less
         than $65K AGI)
             o Not allowed if TP elects to take the credits allowed in § 25A
                      Hope Scholarship Credit
                             100% of tuition for the first $1K and then 50% of tuition up to $2K
                                for the first 2 years of college
                                    o Only applies if student is at least a half-time student
                                    o Does not apply if student is convicted of felony drug
                                        offense
                      Lifetime Learning Credit
                                    o Can be used in addition to the Hope Scholarship Credit
                             20% of tuition up to $10K (up to $5K in 2003)
                             Reduced by a ratio (TP’s modified AGI/$40K to $10K)
        § 221: deduction allowed for interest on student loans
             o Maximum deduction allowed is $1K in 1998, $1.5K in 1999, $2K in 2000 and
                 $2.5K in 2001 and thereafter
             o Reduced by a ratio (TP’s modified AGI/$50K to $15K)

E.       DEDUCTIONS FOR THE COSTS OF EARNING INCOME

E.1.     Current Expenses vs. Capital Expenditures

        Current expenses (i.e., salaries paid to employees) are seen as a cost of doing business
         and the total amount is immediately deductible
        Capital expenditures (i.e., the purchase price of a new building) are seen as an investment
         and may be recovered via
             o Capitalization via annual deduction for exhaustion or wear and tear (§ 167)
                      For property that has a useful life (i.e., a piece of machinery)
                             The deduction is referred to as a
                                     o “deduction” for tangible assets such as a truck or factory
                                              Now called the ACRS: accelerated cost recovery
                                                  system (§ 168)
                                     o “amortization” for intangible assets such as a copyright
             o Recovery of capital only when property sold
                      For property that doesn’t have a useful life so there’s no way to recover on
                        a pro rata basis (i.e., land)
        § 263 and § 263A limits the deductions available under § 162
                                                                                                  46


                       Similar to § 274 (which requires that travel and entertainment expenses be
                        directly related to business) except § 274 is a screen and § 263 is a bar
           o Bars deductions for
                     New buildings (acquiring, constructing or erecting)
                     Permanent machinery or equipment that increases the value of the
                        property
                             This bar is based on the premise that the TP is acquiring property
                                 with a useful life of more than one year
      Capital expenditures are defined as expenses that are expected to produce an income in
       the future
           o Encyclopedia Britannica (pg.): TP Encyclopedia Britannica hired a company to
                produce a manuscript that they planned to publish. TP deducted the advances
                they paid the company but the Service denied the deduction b/c it said the
                advances were capital expenditures. Court agreed with the Service b/c it said a
                capital expenditure is money expended with the intent to generate income over a
                period of years. TP expected to generate money from the manuscript beyond the
                year of the expenditures, which were not ordinarily made by the TP b/c they
                usually produce the manuscripts in-house but had to hire the company b/c of a
                shortage of employees.
                     i.e., if you hire a carpenter to build a tree house that you plan to rent out,
                        his wage is a capital expenditure
      NOTE: exceptions to the capitalization requirement exist for research and development
       expenditures (R&D expenditures are allowed as deductions per § 174) and development
       of farms, orchards, and ranches (per Regs. § 1.162-12)
                     So maintaining is deductible (§ 162) and researching/developing is
                        deductible (§ 174) but enhancing/improving is not deductible (§ 263)
           o High-income TP used to be able to take advantage of this by purchasing an
                undeveloped orange grove (capital expenditure), developing it (current
                deductions), and using the losses to offset TP’s income. TP could then sell it
                when the grove reached a productive state (favorable tax treatment b/c it was a
                capital gain)
                     This possibility is now foreclosed by § 469 (passive activity losses)
      Rev. Ruling 85-82 (pg. 478): TP farmer can deduct the portion of land’s purchase price
       that is allocable to the growing crops when the crops are sold but not when they are
       harvested
      When an expense does not create a long-lived identifiable asset but provides a long-term
       benefit for the organization’s entire business, that expense must also be capitalized
           o INDOPCO (pg. 481): legal and investment banking fees incident to merger was a
                capital expenditure because the merger produced long-term benefits to the
                company (made more resources available, provided operational synergy)
                     fact that an expense does not create or enhance a separate and distinct
                        asset is irrelevant
                     expenses must be “directly related” to an acquisition in order to be
                        capitalized (court looks at the “origin of the claim” as in Gilmore)

E.2.   Repair and Maintenance Expenses
                                                                                              47



   repairs and maintenance expenses (look at Regs. § 1.162-4)
        o are deducted under § 162 if they are incidental repairs that simply maintain what
            you have but doesn’t increase the value of the property or prolong its life
                 i.e., restore to a sound state; mend; return to an ordinary, efficient
                   operating condition
                        Midland Empire Packing Co. (pg. 483): TP company used its
                           basement for curing meat. A nearby refinery was leaking oil so TP
                           oil-proofed the basement and tried to deduct that expense as a
                           business expense. Service denied the deduction b/c it said that the
                           expense was a capital expenditure (the oil-proofing also stopped a
                           water leak that had been a problem), but Court allowed the
                           deduction. The deduction was obviously necessary, and ordinary
                           does not mean “habitual.” Rather “ordinary” just requires that the
                           expense would be a common and accepted means of combating a
                           given problem. The life or use of the basement had not changed
                           and TP dealt with the leak threat in a normal and acceptable
                           manner, so the expense was a repair, not a capital improvement
                               o NOTE: TP could not deduct under § 165 (losses) if there
                                    was no identifiable event unless he could show that the leak
                                    was a sudden, unexpected event
                                          But he could not make that argument if he knew
                                             about the leak and did nothing about it until the
                                             Feds showed up and threatened to close down his
                                             business
                        Rev. Ruling 94-38: costs incurred to clean up land and treat
                           groundwater that a TP contaminated with hazardous waste from its
                           business is not capitalized under § 263 (b/c they are not permanent
                           improvements or provide significant future benefits). Court said
                           the test is to compare the status of the asset after the expenditure
                           with the status of the asset before the condition arose that
                           necessitated the expenditure. Here, the expenses were deductible
                           under § 162 b/c they were appropriate in carrying on the business
                           and frequently required in that type of business
        o must be capitalized under § 263 if they are in the nature of replacements (which
            do increase the value of the property or prolong its life)
                        i.e., permanent improvement
                               o Hotel Sulgrave (pg. 486): TP hotel was required to install
                                    sprinklers b/c of a new state ordinance. Court held that
                                    even though the new sprinklers did not extend the use or
                                    life of the hotel, it make the property more valuable
                                    through its compliance with state requirements
                               o Norwest Corp. (pg. 489): TP hotel constructed a building
                                    that used fire-proofing materials that contained asbestos.
                                    As part of a remodeling project, TP removed the asbestos-
                                    containing materials and tried to deduct the costs associated
                                                                                                    48


                                       as a business expense. Service and Court disallowed the
                                       deduction b/c the expense was a capital expenditure (it
                                       increased the value of the property and prolonged its use).
                                       When a plan to rehabilitate (which is a capital
                                       improvement) coincides with an ordinary and necessary
                                       expense (normally deductible), it is all capitalized
                           i.e., an expense that is necessary to complete the investment
                                  o Mt. Morris (pg. 486): TP cleared an area to build a drive-in
                                       movie theater and caused an increase of water drainage
                                       onto a neighbor’s property. TP installed a drainage system
                                       when the neighbor threatened to sue, and Court said the
                                       cost of the system had to be capitalized b/c the need for it
                                       was foreseeable and was part of the process of completing
                                       the TP’s initial investment for its original intended use
                    the amount is added to the bases and recovered through ACRS deductions
      Repairs and maintenance expenses affect the basis in different ways depending on the
       section of the code under which relief is sought
           o § 162(a) (business expense) — no basis adjustment
           o § 165(a) (loss) — basis MINUS amount of outlay
           o § 263 (capital expenditure) — basis PLUS amount of outlay
      4 ways to distinguish repairs from replacements
           o Expenditure result in material increase in property value?
                    replacement (capitalization)
                           i.e., Encyclopedia Britannica
           o Expenditure result from a general plan of rehabilitation and upgrading?
                    replacement (capitalization)
                           i.e., Norwest
           o Expenditure necessitated by casualty or responding to building codes or lawsuits?
                    repair (deduction) IF it is unexpected in nature AND TP only repairs the
                       property to its prior level
           o Expenditure address more than what is required?
                    replacement (capitalization)
                           TP can NOT separate what was required from what was more than
                              required and capitalize part and deduct the other part (Norwest)

E.3.   Categories of Capital Expenditures (summary)

      Material increases in property’s life
      Repairs that rise to the nature of replacements
      Alterations that have the effect of modifying property to a new or different use
      Material increase in property’s value (i.e., rehabilitating and/or improving property)
           o NOTE: expenditures that are periodic and small in cost are most likely deductible
               (for administrative ease), but if is part of a program of overall rehabilitation, it is
               likely to be a capital expenditure

E.4.   Goodwill and Other Assets
                                                                                             49



   Goodwill expenses made out of “goodwill” deductible under § 162 only if it is necessary
    and ordinary; otherwise, it is a capital expenditure
        o Welch (pg. 503): TP businessman paid some of his bankrupt company’s creditors
            to re-establish his relationships and solidify his credit and standing with them. TP
            tried to deduct the expenses under § 162 but the Service and the Court disallowed
            the deduction. Court said that the payments were not ordinary or normal b/c the
            TP paid people he had no obligation to repay (the company had declared
            bankruptcy) and noted that the TP was not protecting what he had, but rather was
            building a business relationship (so the amounts should be capitalized)
   Charting deductions:
                     Capital vs. Current
                                        ↓
                            Business vs. Personal
                                 ↓                 ↓
                         (via goodwill)      i.e., education  § 262
                                 ↓
            § 162  Current vs. Capital  § 263 (but no amortization b/c no useful life)
   § 197: now permits amortization for goodwill expenses but only for “acquired”
    (purchased) goodwill
        o In Welch, the TP was not allowed amortization treatment under § 197 b/c he was
            not purchasing a business
   Calculating the sale of a business
        o Purchase Price = $165K
          Buyer                 Business Costs                     Seller
            ---                 Cash—$8K                           Not a capital asset
            ---                 Receivables—$7K                    Not a capital asset
                                                                   (§ 1221(4))
          Assets subject to Fixtures—$10K                          Not a capital asset
          depreciation                                             (§ 1221(2)) but
          (§ 167 & § 168)                                          runs thru § 1231
          Assets subject to Building—$50K                          Not a capital asset
          depreciation                                             (§ 1221(2)) but
          (§ 167 & § 168)                                          runs thru § 1231
          Assets subject to Land—$15K                              Not a capital asset
          depreciation                                             (§ 1221(2)) but
          (§ 167 & § 168)                                          runs thru § 1231
           ---                  Inventory—$40K                     Not a capital asset
                                                                   (§ 1221(1))
          NOTE: goodwill TOTAL—$130K                               NOTE: goodwill
          amortizable for       (NOTE: $35K attributable to        is a pure capital
          15 years (§ 197) goodwill)                               asset (not
                                                                   eliminated by any
                                                                   of the language in
                                                                   § 1221)
                                                                                                  50


E.5.   “Ordinary and Necessary”

      A deduction under § 162 is only allowed for “ordinary and necessary” expenses
          o Gilliam (pg. 508): TP artist had mental and emotional problems and was under
             continuous psychiatric and medical care. TP accepted an invitation to teach in TN
             and, b/c he felt nervous about the trip, got a prescription the night before. The
             medication made him extremely nervous and anxious and caused him to go crazy
             on the plane (he assaulted another passenger). TP sought to deduct the legal
             expenses incurred for defending his criminal and civil lawsuits as a business
             expense but the Service disallowed the deduction. Court agreed with the service
             b/c the events that occurred on the plane were not events in the ordinary course of
             the TP’s business (criminal charges as a result of a mental episode do not occur
             frequently or ordinarily in an artist’s career and TP did not take the medicine
             specifically b/c of his trade or business).

E.6.   Reasonable Compensation

      § 162(a)(1): employers can deduct a reasonable allowance for salaries and other
       compensation for services
           o Subject to limitations
                   “disguised dividends”: when a closely held corporation purports to pay a
                      salary when it is really paying a nondeductible dividend to an employee
                      who is a principal shareholder or an employee who is a child, parent or
                      other relation of a principal shareholder
                   $1M limit on salaries paid to chief executive officers or any other of the
                      company’s four highest paid employees (§ 162(m))
                   No deductions on golden parachute payments (bonuses paid to corporate
                      executives on termination of employment after a change in control of the
                      corporation (§ 280G and § 4999)
      Types of compensation and treatment
           o Salaries
                   Deductible to business; income to employee (taxed once)
           o Dividends (after-tax sharing of profits)
                   No deduction to business; income to employee (taxed twice)
           o Qualified Dividends (not-shared profits)
                   No deduction to business; capital gain to employee
           o Gifts
                   No deduction to business (“gifts” from employer to employee is not
                      considered a gift under § 102(c))
                           $25 business deduction allowed under § 274
           o Property purchase disguised as a lease
                   Lease = deduction to business (b/c it’s rent under § 162(a)(3)), but no
                      deduction to business for sale (if useful life is greater than one year, outlay
                      is capitalized and depreciated); employee has income regardless of if it is
                      characterized as a lease or a sale
      Questions to ask to determine if the amount to be deducted is a “reasonable” allowance:
                                                                                                  51


          o  What kind of services is an employee performing? Significant?
          o  How do those services compare with other employees in a comparable situation?
          o  How do salaries compare with other employees?
          o  What is the employer’s prosperity like?
          o  What is the pattern of employer performance?
                  i.e., is the employer coming out of a bad year and compensating
                    employees who were under-compensated during that time?
         o Do the employees own stock or are they related to the business owner?
                  If so, a denied deduction is more likely
         o Have here been improvements in the economic conditions of the employer?
         o Is the salary guaranteed compensation or contingent compensation?
                  Large amounts of money paid to a good-performing employee who is paid
                    on a contingent basis is usually okay
      When salary amounts are disallowed as a deduction:
         o Employee keeps the money as income
         o Employer is only allowed to deduct the reasonable amount (based on industry
             norms)

E.7.   Illegal or Unethical Activities

      Certain sections of the code specifically deny deductions for criminal activities
           o § 162(c): no deduction for bribes and kickbacks
           o § 162(f): no deduction for fines
           o § 162(g): no deduction for punitive damages
           o § 280E: no deductions for expenses involved in drug trafficking
      Otherwise, if the illegal activity amounts to “trade or business,” deductions are allowed
       the same as they would be with any other trade or business
           o Exception exists when allowing the deduction would frustrate public policy
                   Stephens (pg. 518): TP was convicted of embezzlement and was ordered
                       to pay restitution, which he did. TP tried to deduct the restitution amount
                       as a loss under § 165 b/c he had paid income on the embezzled funds in
                       the earlier year. Service denied the deduction b/c it argued the restitution
                       amount was made in lieu of punishment. The Court said that this would
                       not frustrate public policy (b/c TPs who repay embezzled funds are
                       ordinarily entitled to a deduction in the year that the funds are repaid), nor
                       is against the code (not a fine under § 162(f) b/c the money was paid to the
                       company, not to the government and doesn’t go against § 162(g) b/c the
                       money paid was compensatory, not punitive).

E.8.   Qualified Dividends

      Three conditions
          o Must be received between January 2003 and December 2008
          o Must be paid by a domestic corporation or a qualified foreign company
          o Shareholder must reach a specified holding period
                  NOTE: business must specify whether the dividends are qualified or not
                                                                                            52


      Tax rates
          o If shareholder is in the 25% tax bracket or higher
                  QD is taxed at 15%
          o If shareholder is in the 10-15% tax bracket
                  QD is taxed at 5% through 12/31/2007 then 0% through 12/31/2008

E.9.   Tax Shelters

      The type of TP that uses tax shelters are
          o High income
          o Risk-averse
          o Wants to use borrowed money (preferably non-recourse) to use legal venues to
              lower their tax liability
      Kinds of tax shelters (and Congressional responses)
          o Leveraging: using borrowed money to create the amount of available deductions
                           Knetsch (pg. 534): TP borrowed $4M from life insurance company
                              to purchase an annuity and deducted the interest paid under § 163
                              (which allows TPs to deduct interest paid on indebtedness). Court
                              denied the deduction b/c sham loan transactions that serve no
                              purpose other than to reduce the amount of their tax will not be
                              allowed.
                                  o Economic substance required; TP can’t take out a loan just
                                       to secure an interest deduction
                    Now limited by
                           § 465: deductions limited to amounts that is actually at risk
                           § 469: no deductions on passive losses (trade or business that the
                              TP does not materially participate in)
                                  o § 469(h): defines material participation
          o Arbitrage: incurring expenses that are deductible in order to generate income that
              is tax favored and creating a tax loss in excess of any economic loss
                    Now limited by
                           § 163: no deductions for interest on loans used for purely personal
                              purposes
                                  o But basketing is okay
                                            Interest on loans to make investments can be
                                               deductions against that investment income
                           § 264: no deductions for interest on loans used to buy insurance
                           § 265(a)(2): no deductions on loans used to buy tax-exempt
                              property (i.e., bonds)
          o Deferral: pushing income into the future by incurring costs that are currently
              deductible and receiving the return from the investment in some future year
                    Now limited by
                           § 465: deductions limited to amounts that is actually at risk
                           § 469: no deductions on passive losses (trade or business that the
                              TP does not materially participate in)
                                  o § 469(h): defines material participations
                                                                                             53


          o Conversion: converting ordinary income into tax-favored income (such as capital
            gain)
                       Estate of Franklin (pg. 542): Businessman sells hotel to TP, who
                          then leases the hotel back to him. Tax implications were such that
                          both parties benefited (i.e., man had a deduction (rent) and income
                          (interest from TP), and TP had a deduction (interest paid to man)
                          and income (rent)) but the government got nothing. Court denied
                          the deduction
                 Now limited by
                       § 1245: limits depreciation for personal property
                       § 1250: limits depreciation for realty

E.10. Alternative Minimum Tax

      Enacted to prevent high-income TPs from avoiding tax liability
           o In 2003-2005, AMT kicked in at about $100K
           o In 2006, AMT will kick in at about $75K
      Takes taxable income and re-calculates the income base by adding back items for which
       deductions had been permitted
           o Exemptions
           o Standard deductions
           o State and local taxes
           o Interest on a second mortgage
                   Deductions for the first mortgage is still preserved under the AMT
           o Equity lines
           o Medical expenses more limited
           o Miscellaneous itemized deductions (large numbers and large amounts)
           o Income from stock incentive options
           o Large capital gains
           o Tax-exempt interest
      § 55(d)(1)(a): re-determined amount is not taxable in its entirety (see FN 32, pg. 559)
           o Deduct $40K from AMT tax base for corporations
           o Deduct $45K from AMT tax base for married TPs
                   Extra relief from 2003 to 2005 only; deduct $58K
           o Deduct $33.75K form AMT tax base for single TPs
                   Extra relief from 2003 to 2005 only; deduct $40.25K
      Professor sees a problem with the AMT primarily b/c it adds tax liability for married
       people and people raising children
           o i.e., Klaassen (pg. 562): AMT calculations denied exemptions for TPs and their
              ten children, even though this was not what Congress had in mind when they
              enacted the AMT

				
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