Fed Tax Outline
What is income?
A. This is governed by §61 of the code.
Problem is that this section of the code is vague.
B. Income actually means gain.
Definition of gain: what did you get for what you gave in the beginning.
Or in tax jargon: what you got for your basis.
Remember there is no basis in your personal services, anything you get from your personal services is
Idea is that all income is taxed unless there is a specific exemption.
Income can come in many forms: cash, property etc.
C. Cash bargain purchases are exempted from income.
If you purchase something through an arm’s length transaction and you get a bargain you will not be taxed
on the market price less the bargain price.
Example: You buy 10 lbs. Of swordfish for $1.00/lb, usually swordfish is $2.00/lb. You won’t be taxed on
the $10 of “gain” you received from this bargain purchase.
Reasoning: to difficult, administratively, to deal with.
Facts: Lobue claimed deficiency and went to court to avoid having to pay taxes when he exercised the stock option.
Lobue argues that the stock is designed to provide Lobue with an incentive as opposed to compensation.
Holding: Supreme Court rejects Lobue and says that the argument fails under §61 (§39 Code).
Court says the incentive argument is irrelevant, question is not about what the company intended, but
rather it is about gain.
Lobue tries to argue that he hasn’t really gotten any gain, because he worked for the option to buy $5
option. If the market price of the stock is $15, I gave $10 in sweat and $5 in cash. This is a loser argument
because there would be no tax on any personal service income.
People have no basis in their personal income, everything they make is income.
Court mentioned the idea that a gift is not income, but this is not a gift, or anywhere close.
Lobue also tries to argue cash bargain purchase
Court said that although we don’t tax bargains, this is not an arm’s length transaction, rather this is
compensation. This is not a bargain—this is compensation. Boom.
Lobue tries to switch strategies and go back to year one. Now he says he wants to pay when the option was
granted because if he uses this year, he won’t have to pay anything in year 2 and ten in year 3. Although it
is better to pay tax later, when all things are equal, all thing arent’ equal here. He’s only paying tax on $5.
Better to pay tax on $5 in year one, and nothing in year 2.
The option is contingent on working and was non transferable—this meant the gain was not incurred at
the time the option was offered..
Can have income when you get the option when the option has a readily ascertainable fair market value.
Might have gain, but if you can’t tell how much you don’t have income. Goes back to the self assessment
idea. Have to know how much gain you had.
Transferabililty and contingency have to do with how much something is worth on the market.
Court held: Lobue is required to report income when he exercised the option. When he paid $5 for stock
worth $15, he had $10 in income. When he sells in year 3 for $20, he has $5 income for that year.
Breakdown of Lobue
If Lobue could have gotten into year 3 without paying any taxes, he’ll be in the driver’s seat for his life and
then his heirs will be in good shape at the end.
Even if Lobue wants to sell in year 3, still want to get by year 2, so you can delay paying taxes to invest the
money and get the compound interest.
Basically, LoBue wants to get by years 1 and 2.
If Lobue gets by year 1 and 2, purchases stock for $5, sells for $20, has $15 in income.
Basically, if Lobue had won, the idea would have been that Lobue would have had the government’s
money to make his own money.
Employer’s intent is totally irrelevant.
Want to defer.
Deferral is really a rate reduction—have the use of the government’s money to off set whatever you want.
Deferral is the name of the game, it is seriously consequential and don’t be fooled when people say,
“You’ll just pay it later.”
Longer you defer the better it is.
E. §1001(a): Definition of gain
Value of what you got compared to the basis of what you gave up.
If you buy stock for $5, that is worth $15. Basis is $5, amount realized is $10, gain is $5.
Comparision is amount realized to basis.
F. What do realization and recognition mean?
A gain or loss is said to be realized when there has been some change in circumstances such that the gain
or loss might be taken into account for tax purposes.
A gain or loss is said to be recognized when the change in circumstances is such that the gain or loss is
taken into account.
G. Non Statutorily Defined Exceptions to income.
We can have gain and no specific exemption and still no income.
Examples: cash bargain purchase and instances where you can’t ascertain to some reasonable degree of
specificity of reliability what the fair market value is, there is no income.
Facts: Kids are playing b-ball in Lyle Lovett country and a meteor falls from the sky. Do they have to report this as
When the kids first pick up the meteor, is this income?
o NO. Don’t really know the value
When the phone starts ringing off the hook for offers. At this point the city took the meteor. Right now the
meteor is non-transferable and contingent.
o Not income right now, because the meteor’s value to the kids is contingent on being returned
Now city gives up and says finder’s keepers.
o Still is inherently speculative about what the meteorite is worth. At this point you don’t really
want to report. Reasonable basis for the conclusion.
When they get the $23K
o Now this is a taxable transaction.
What is the basis?
Declaration of Independence Hypo
Person who bought the painting and found the declaration of independence behind the painting.
o Does this guy have a cash bargain purchase?
He wasn’t bargaining for the Declaration of independence. He was bargaining for a
o Does this item have an ascertainable value?
When the painting is sold at auction, it is clearly income. There are 2 years in between discovery and sale.
Person who bought the declaration for 2 mil and sold it for 7 mil
They were able to defer the tax for many years.
This guy and the first owner are both able to defer, but for completely different reasons.
Makes no difference that you know you are having gain when you buy something and it appreciates, but
you are considered not to have realized that gain until you sell the item
1. Promises will not have an ascertainable value.
Suppose an employer says I will give you the same promise an insurance company will give you, and instead of
paying money into a pension plan for you when you reach 70 I will pay you money.
Not income because the value of the promise by the employer is not going to be said to have
ascertainability, primarily because it isn’t supported by any security.
All that is given in this situation is a promise.
An unsecured promise by an individual or other entity will not have sufficient value within notions of
Lobue, sufficient so as to have income.
H. §119: Meals and Lodging for Convenience of Employer.
§119: Can exclude meals and lodging if it is for the convenience of the employer. The rule requires, in the
case of lodging, that the employee is required to accept such lodging on the business premises of his
employer as a condition of his employment.
Benaglia v. commissioner (55) (Pre-Lobue)
Facts: Guy is working in a hotel and they are giving him a place to live. Tax court finds in favor of Benaglia. Holds
the lodging is provided for the convenience of the employer.
Given, Lobue, the government would argue that intent makes no difference. The question is about the
benefit to the employee, not convenience to the employer.
Following Benaglia, Congress Preempted the field and passed §119.
Congress, in §119, codifies Benaglia and now the issue is: Is this convenience to the employer?
We’re out of Lobue and this is a whole new kettle of fish and what a mess! This is §119, not §61.
Congress says that in order to give the employee a break, we’ll put some restrictions on it.
o Example: Have to be lodging someone on premises. Then…what does premises mean?
I. §132 Working Condition Fringe
This is the wash principle in action
Examples: company car or magazine subscription.
Basically, an employee does not have income if the employer provides something which if the
employee paid for herself the employee could deduct.
Deductibility is the key
1. Working Condition Fringe Only applies to employer/employee transactions.
BUT Joyce and the casebook: Joyce could deduct the cost of the casebook if he bought it, even tho he
doesn’t work for Aspen.
2. Fringe Benefits and Troublesome areas—why congress likely jumped into this quagmire.
Fringe benefits can be difficult to value.
Tough to enforce
Problems of political acceptance.
Hypo: suppose that A works for B and builds B a bookcase. B, in return for the bookcase, and writes A a legal brief.
Bookcase is worth $500. Brief is worth $500.
Does A have income?
o A received a $500/brief.
o Bookcase has a basis of 0
o A has 500 of gain, Lobue says this is income.
Does B have income?
o B has 500 of income.
This is not reported because it is not asked
If this had been a business bookcase, this might have been a wash.
Hypo: A writes his own brief and B builds his own bookcase.
Does B have income? He has a bookcase, worth $500. Basis was 0
Gain of $500.
Lobue would say this is income.
This is not income because this is called “imputed income”
II. Imputed Income—Another Exception
A. The basics
When people expend energy for their own benefit and end up with gain, which they would have to report
with the baker and the brewer, then this is not considered to be income.
This is allowed because to hold otherwise would create an enforcement nightmare!
Revenue Ruling (88)(handout 2/05/02)
No Exchange bargain purchase exemption.
If you get a bargain on exchange—I get make a necklace worth $500 and Mariely Makes a hat worth $500
and we exchange we both should claim $500 of income, you have to pay the tax on the bargain’s value.
Key is that the basis you get from your personal services is 0.
No tax on services you perform for yourself.
Why it is better to buy then rent.
No tax on the imputed income on the use of your own property.
Increases in value based on improvements are not included, but you’ll see the gains when you sell the
No Exchange bargain purchase exemption…
But if it is an intrafamily transfer, it probably won’t be considered income (father is housepainter and
daughter is the lawyer), but Joyce says this is suspect.
Two neighbors are carpooling the kids go gymnastics.
Is this taxed? This is clearly gain…but given what we’ve learned, we don’t really know.
Regulation §1.6045-1(a)(1): the term barter exchange does not include arragments that provide solely for
the informal exchange of similar services on a non-commercial basis.
o Indicative of the fact that there is leniency.
E. What is imputed income ?
Household services performed by the people in the household: cooking, cleaning, and childcare.
Exchange gain, in the house hold, is not taxed, we call this imputed income, but it really isn’t.
The IRS does not get into the home, they don’t get after intra-family exchanges.
Suppose the father is the housepainter and the daughter is the lawyer, they exchange services. Is this taxed
or is this an intra-family exchange?
o Suspect, Joyce would say this is no income, this is an intrafamily exchange.
Hypo: A owns blackacre and purchased it for $80K. A finds broker B, and finds buyer C. A sells house
for $100K, and pays the broker 6%. A has $14K as profit, and the broker has $6K as income.
Hypo: Suppose instead of the above, after trying to find a buyer, the broker decides to purchase the house.
Broker says, I’ll pay $100K, but I want my $6K, so I will give you $94K. Does the broker have to report
the $6K? Joyce says this is imputed income, but the caselaw goes the other way. Same as paying yourself
for your own services.
Hypo: Full service gas station, pay 1.25/gal vs. self service 1.20/gal. No income here, you paid less
because you performed a service for yourself. You are being paid in gas .05 for your labor.
There are cases that say that if you are an insurance sales person or if you are a real estate person, you have
to pay the tax on the commission, but Joyce thinks these cases are wrong, these aren’t Supreme Court
cases. Therefore, it depends on what it’s worth to you…you can fight it, the argument is that the cases are
III. WINDFALLS AND GIFTS--§102(exemption from §61)
A. To qualify as a gift, what it given has to be given as gift, can’t be in exchange for services.
Gifts require the right type of motivation.
Must have a detached and disinterested transaction.
Can’t have return for services rendered.
Asking, does this fit into Duberstein.
With gifts, motive is determinative, not just relevant.
Opposite of Lobue.
Motivation is paramount.
B. §102 Basics
Usually done during the lifetime, if done in a will, it is not done during lifetime.
§102 applies to gifts made during life, and during death.
§102 is derived from lifetime gifts.
C. How is intent ascertained?
Okay, you need a detached and disinterested transaction…how do we know?
Look objectively at the intent of the payor.
D. What about gifts with mixed motives?
Look at the dominant motivation.
If it’s 51/49 gift, this is a gift!
Look at the intent of the transferor, objectively, to determine if this is a gift.
If this is 51% a detached gift, then it’s 100% exempted
E. 102(c)-Employee Gifts
1. How does §102(c) analysis work?
§102(c): any amount transferred from an employer to an employee is income.
Analysis: Money that is gain in §61, is it excluded by §102(a)? Is this exclusion removed by §102(c)?
Under this section, §102(c): employer to employee transfer cannot be excluded from income.
Employee is a pretty narrow distinction.
Employer and employee relationship does not run through to family gifts. If the gift is between Ali and
Sharon, the family gift won’t be considered income, but the money she earns from working at Savory Fare
F. §274(b)—the Gov’t getting its $$$$
No deduction shall be allowed under 162 or 212 for an expense for gifts made directly or indirectly to any
individual to the extent that such expense exceeds $25.
Wants to make sure that at least one person pays, don’t want to get whip sawed by the deduction and
If person who receives the gift excludes, then the person who gives the gift can only deduct up to $25.
The overlay on this is that the government doesn’t put both returns together to figure out how the gifts are
operating. This section is an anomaly…puts the returns together in a weird way.
If the receiver doesn’t claim the “gift” the giver can only deduct $25.
If the receiver deems this gain as per §61 and does not exclude as per §102, then the giver can deduct the
This means that the government gets the money on it one way or the other.
G. Gifts Made while Donor is still alive and Determining Basis §1015
If, at the time of the transfer the FMV of the property is equal to or greater than the basis in the hands of the
donor, the donee takes the donor’s basis.
Example: Mother has property that cost her $20. Under §1012 Mother’s basis is $20. She gives the
property to the daughter, the property is now worth $50. The daughter’s basis will be $20, and the property
will have built in gain of $30.
If the property’s value has declined in the donor’s hands we have a different situation. This is where you
are running two basis.
o For a loss situation, the basis of the donee is the FMV
o For a gain situation, the basis of the donee is the donor’s basis
Example: Suppose a mother gives property worth 10, with a basis of 20, to her daughter. If the daughter
sells the property at 10, she realizes no loss, because for the purposes of determining loss, she is running a
basis equal to the FMV which is 10. If she sells the property at 15, she reports no gain or loss because for
the purposes of gain she is running a basis of 20.
Steps to determine gain or loss and basis:
First, it at the time of the transfer the FMV of the property exceeds or is equal to the donor’s basis, the
donee takes the donor’s basis. On a subsequent disposition of the property by the donee, she has gain to the
extent that her amount realized exceeds her basis.
If the property as declined in value in the donor’s hands…
On a subsequent disposition by the donee, first apply the gain rule. Give the donee the same basis as the
donor, if that produces gain to the donee, stop.
If the calculation does not produce gain, apply the loss rule and give the donee a basis in the property equal
to the FMV at the time of the transfer. The donee realizes the amount of loss that results from that
Person Donor Basis Fair Market Value at time Donee’s Basis
I. A (lifetime) 1000 2000 1000 (gain and loss)
II. B (lifetime) 2000 1000 2000(gain)
Taft v. Bowers
Someone has to pay tax on the gain.
One investment, then the investment was cashed in and that’s $4000 gain, and you Mr. Donee have to pay
tax on that.
Donee actually had $5000 gain because the donee paid nothing for the stock, all we are doing is taxing you
on $4K, we are giving you the benefit of §102. You need to include all of the gain except the basis of the
§1015 + §102=donee can exclude the full value of the gift at the time of the gift.
§1015 + §102—don’t work like other exclusions. Your exclusion doesn’t get excluded forever. All that
gets excluded forever is the donor’s basis. Appreciation in the hands in the donor is deferred. These work
together as a deferral, but not an exclusion.
Remember! Deferral is good stuff.
Decision not to tax the donor on the appreciation and to tax the donee and tax the donee only once.
o Evidence of shifting tax payments, in the aggregate the government gets its money, it just might
come from a different source.
o If the donee is in a lower tax bracket then the donor, then the government takes a hit and vice
H. The loss rationale
Can shift gain but not loss.
Loss is either use it or lose it.
1. The basics
The beneficiary’s property, acquired by someone else’s death, takes a basis in the hands of the beneficiary
equal to its FMV on the date of the decedent’s death.
Gain that has occurred in the hands of the donor escapes tax. This is the biggest give away in the tax
Policy reason: we have an estate tax, and this property is included in the estate of the donor, if the donee is
taxed this would be a double tax. This is not a plausible rationale, the estate tax has a high threshold.
Doesn’t wash, on the other hand Congress still seems to think in this way.
This is called the basis step-up.
Example: Testator’s basis is $1000, at death the fair market value is $2000.
Under §1014 the basis of the donee is the fair market value at death--$2000.
When property is sold at $5000, the gain is $3000.
Example: Now say the testator’s basis is $2000, but at time of death the property is worth $1000
Basis for the donee is the Fair Market Value at the time of death.
You have one basis, regardless of whether there is a loss or gain. Doesn’t matter if the value of the
property has gone down, the donee is not running 2 basis like she was in §1015.
Same policy, can’t shift the loss, the donor can’t shift the loss to the donee.
This is the step-down.
IV. Recovery of Capital—Determining Basis
You get your basis back before you start calculating gain.
2. Steps of Analysis
Example: Back to Lobue
Year 1: Gets option to buy at $5, stock is worth $10
Year 2: Purchases at $5, stock is worth $15. Pays tax on $10.
Year 3: Guy sells the stock at $20, in year 3 pays the tax on $5.
o Basis in year 3 is $15
Basis: Start with Basis being in §1012, cost, unless otherwise provided (1014 and 1015)
How can he have cost of $15, when he only paid $5 for the stock.
Basis: Market value of the time of the stock at the time he got it and paid tax on it.
o This is the FMV when he got the stock and paid the tax.
o He gets credit for the $5 he paid, and the $10 of income he included. $10 is treated the same as
the $5 he actually paid for it because it is the same as if the employer said I’ll sell you stock at
$15, but I’ll give you an extra $10 in your paycheck.
o When he has to pay the tax in year 2 it is the same as if he got extra cash in his paycheck and used
it to pay for the stock.
3. Bedrock rule: The basis of the property that you receive is the fair market value of the property you
receive at the time you receive it—most of the time this is going to be what you paid.
Philadelphia Park Case
Rule 1: The basis of the property that you receive is the fair market value of the property you receive at the
time you receive it.
Rule 2:If you don’t know the basis of what you received, you can look at the FMV of what you gave up…if
Rule 3: If you don’t know the value of either, continue basis in old as basis in new property.
Steps of Analysis:
1. X has a cost basis of 4 and a value of 6 to A, Y has a cost basis of 4 and a value of 5 to B.
2. A and B swap.
Calculating gain on the swap
A: A’s basis in X was 4, A’s basis in Y will be 5, therefore, A’s gain will be 1.
A sells Y for 6: A’s gain here will be 1.
Basis used is the value of the property received.
Rule: Fair market value of the property received will always be the same as the basis of the property given
plus the gain. This gives the property owner credit for the gain.
A will pay tax at the time of the swap and at the time of the sale, but it will be 1 each time, he gets credit
for pay tax at the time of the swap.
Determining basis after a swap is: Basis of what you gave up plus any gain or loss.
V. Recovery of Capital-continued
A. The Basics
Basically this is recovery of your basis,
Joyce calls this basis offset.
Example: If a buys X for 5 and sells for 10. Taxpayer can recover capital of 5, before recognizing the gain.
Therefore, there is no gain, until you recover the capital.
B. Basis Allocation
1. The easy stuff
X buys 2 shares of stock for 10, and later on sells one share for 10.
o Basis allocation: allocate 5, therefore the gain is 5.
o You are required to allocate basis and you are allowed to allocate basis, therefore your gain is 5.
o What did I pay for what I am selling? What did I pay when I bought it?
o Look to see what was paid for what was being sold, this will allow you to allocate the basis.
2. The trickier stuff
Suppose taxpayer buys blackacre for 100 and then sells West Blackacre for 100. What are the results there.
Say Westblackacre is one half in terms of area, how do you apply the allocation of basis principal?
o Taxpayer can’t allocate the entire 100 and therefore have no gain, the government can’t say you
have to keep your 100 in East blackacre.
o What did I pay for west blackacre when I bought west blackacre?
o What does the taxpayer do?
Remember, the taxpayer must allocate in this situation.
You are going to get your hands on a real estate appraiser, and she is going to give you a
strong estimate of how you should do your required and allowed allocation.
3. Basis offsets and renting your property
The basis stays in the fee simple, and you are not allowed to allocate any of it and therefore you pay tax on
the entire rent. This is bedrock in the system. Take this as a given and live with it.
NO basis offset for interest, dividends, and rent.
Think of blackacre as the tree and the rent is the fruit, and therefore you have to pay tax on all the fruit.
Joyce says this is all bullshit, because you are giving away a slice of time and you should get some a basis
offset for the slice of time you have away.
Inaja Land—Recovery of Basis, without immediate taxation.
Facts: Man owns land that he paid 61 for. The city of los angeles begins to divert water over his property. The man
gets paid 50.
Taxpayer got paid 50 to discharge City of Liability Forever. The first question that arises is what is the 50
for? If the 50 is for lost profits then it is all taxable, if it is for an easement the taxpayer can start working
with a basis offset.
To prevent the question of whether this was lost profits the lawyer should have put in the settlement
documents that this is a sale of an easement, rather than anything else.
If you can move things into the sale category that is good stuff. Move it out of lost profits and into sale if
Lost profits v. easement
o Example: Blackacre is a hotel and you have bought it for 50 and now it is worth 100 and it rents
for 10. Someone tortiously destroys the hotel. One year later, property is still worth 100, but you
have lost 10 in rent. If you are going for everything you’ll ask for 110, and if that is what you get,
you’ll get 100 with a basis offset of 50, and the 10 will be lost profit, and there is no basis offset,
therefore there is 10 of income on that. However, Joyce says that when you look at the 100 it
really is about future profit, therefore it really is lost future profit, and the lost rent is a lost past
o Therefore, according to Joyce, when the court talks about profit, it is about lost past profit, the
easement is about lost future profit.
o Therefore, you get basis offset for collecting the value of future profit.
When you give away part of your land, you have to pay tax on that, unless it is impossible to determine what
you have given away.
Taxpayer was able to convince the court that there was no way to determine what he had actually given
The water had the potential to invade the whole property, therefore the tax payer could have sold the entire
property and therefore, to apportion the property would be ridiculous.
Be careful: say the taxpayer sold an easement for just two years. Easement for 2 years would be no basis
Basis stays in the reversion.
Suppose that in a later year Inaja land is sold for $25,000?
What is the basis?
He paid 61 originally, 50 was recovered from the city non taxable, and then the land was sold for 25.
The basis is then 11, when you sell it for 25, you have tax on 14.
What this means is that when the taxpayer gets the money tax free, it reduces the basis of the property from
61 to 11.
Want to know the basis immediately after the court decision and you are able to tell.
Suppose the city paid the tax payer by issuing a bond that had a value of 50K, same result as the tax court,
that is a non taxable recovery of basis. If the taxpayer gets the bond, and is considered have no basis in the
bond when the taxpayer got it, then you can let the taxpayer keep the basis of 61 in the land, because
eventually the taxpayer is going to pay tax on the full 50.
Problem: your basis is in different assets, and because of this you may choose to sell one and keep one.
Problem: Cash. Cash can never have a basis other than its face value, this cash had to suck out 50 of basis
from the property. IF they had to include the 50 in income, that would be okay.
Keep in mind, when you receive property tax free, the basis needs to be adjusted downwards if the property
was received as cash, have to draw out the basis.
Suppose that the city of los angeles paid 65, when the taxpayer paid 61 when the land was originally
Taxpayer has to pay tax on 4 because in this instance there is no problem of allocation.
You will still pay tax on the 4.
Suppose now, after the above, he’s sells the property for 25?
He pays tax on all 25, because when he got the 65, he recovered the entire 61 and therefore his basis is
Hypo: Buy blackacre for a term of 3 years. You say I’ll pay 24, 9 first year, 8 second, 7, the third. When you
turn around and try to rent to a subtenant, you’ll get the basis offset on the rent you paid the first year. In
this situation the landlord will be taxed on the 24 right off the bat. When you still have the reversion, you’ll
be taxed on all rent.
Term of years purchaser gets the basis offset.
This yields two different results with the same fact scenario.
Difference: when you bought the term of years you bought a wasting asset.
Joyce says: when you buy the whole thing , you are really just buying the front end.
VI. CLAIM OF RIGHT DOCTRINE AND THE TAX BENEFIT RULE
1. The needed basics
Cash Basis Accounting: the taxpayer includes an item of income in the year in which the item is actually
or constructively received. A taxpayer deducts an expense in the year in which it is paid.
Accrual Method of Accounting: more complex than cash.
o A taxpayer includes an item of income in the year in which: (1) all of the events have occurred
that fix the right to receive the income and (2) the amount of the income can be determined with
o A taxpayer deducts an expense when: (1) all the events have occurred that establish the fact of the
liability, and (2) the amount of the liability can be determined with reasonable accuracy.
2. Legislative/Judicial Variations on the basic accounting methods-Net Operating Loss Provision §172
Net Operating Loss Reduction (§172): Congress stepped in and tried to make it better for the person who
has suffered losses. If you have a loss then what you can do is to take that loss and carry it forward or
back. Need to have a net operating loss for this to happen.
3. Claim of Right Doctrine
1. The Basics
You paid tax on something you actually didn’t have to (ie money you held under a claim of right , and so
paid taxes on, but found out later that you really were entitled to a deduction because you had to disgorge
whatever was mistakenly held under a claim of right).
Facts: Guy gets paid a 11K bonus in year one, and it comes to light in year 2 that he should not have been paid the
bonus and had to repay the bonus. The government said that only thing you can do is to deduct the repayment of the
bonus in year 2. Taxpayer wants to go back and amend his return for year one.
Taxpayer would want to file an amended return for year one because he was paying more tax in year one
by including the bonus, then he will be saving in year two.
The bonus was properly included under this notion of claim of right, therefore when it’s determined you
have to pay it back we could say that we wouldn’t even have to give you a deduction, you should be happy
with getting to take the loss when you have to repay it—even if the deduction is less than what it would be
if you filed an amended return for year one.
Holding: pay the previous tax, but take that amount that you were earlier entitled to deduct and deduct it
4. Congressional Response to Lewis-Current State of the Claim of Right Doctrine-§1341
We think he got screwed, therefore, we passed §1341.
Now under §1341:
o This gives the taxpayer an election—taxpayer can do either:
Option one: The taxpayer can deduct the repayment in the year of repayment (year 2).
Lewis. If the item is less than $3K this is the only option.
Option two: no deduction in year 2, go back to year one and say how much tax did I pay
in year one on that bonus, then can take tax owed on the bonus, and can subtract that in
year 2. Figure out how much tax you paid on the bonus, and then deduct that from year
2. Item in question must be over $3K.
o How to figure out how much tax you paid in year 1 on the bonus?
Calculate the tax with the bonus, then figure out the tax w/o the bonus: this tells you what
o However, if you pay too much in year one you don’t get the interest for the excess you paid.
5. Tax Benefit Rule—Judge Made Rule
A. The Basics
If you deduct something you shouldn’t have deducted you will have underreported, and therefore need to
claim the excess as income.
No elections like in §1341.
Rule: include the item in the year it comes back, regardless of what type of bracket you’re in.
No interest owed for wrongfully having taken the deduction.
Basic idea behind the tax benefit rule: if we knew then what we know now we wouldn’t have given you the
Hillsboro is the case we use on this.
Hypo: state income taxes on your income are deductible on your income for federal tax purposes. Say, you
pay 5K in state tax in year one and you’ve deducted it against your income. When you come to year two,
you find you have a check from NY returning 3K of that 5K.
o Tax benefit rule requires you report this as income for federal purposes.
o This is considered income because when you take the deduction in year one, you have a certain
amount of income hanging out there that you have never paid tax on.
o Example: You have 10 income in year one, state tax of 5, deduction of 5 in year one. Refund of 5
in year 2. Have to pay tax on the refund.
C. Even though the Claim of Right Doctrine says we don’t look back to year one, tax benefit rule implies that
The receipt of an item that was previously deducted is income under §61, BUT in order to find out that
something would have been underreporting your income, we had to look at what happened in year one!
Looking back to year one is a no no, but we end up doing it anyway to see what the deduction was.
Tax benefit rule is saying: there has to be room for movement and suggestion and that the annual
accounting system at times pushes towards doing transactional accounting.
Therefore, the tax benefit rule shows us that we are not bound by the annual accounting system.
You don’t have to have a receipt, what you need is something in a later year that is fundamentally
inconsistent with a deduction you took in an earlier year.
D. Exclusionary (§111) and Inclusionary Aspects of the Tax Benefit Rule
Inclusionary: include the money or whatever in the year it came back to you.
Exclusionary: you don’t have to report the item if you don’t receive a benefit from it.
Hypo: say in year one where the person paid 5K in state income tax, they used the standard deduction, and
in year 2 3K comes back, no income to report because they took the standard deduction that they would
have taken anyway—regardless of the 5K.
The deduction in year one, has to give you some benefit, to need to be reported as income in year 2.
INCLUDE TO THE EXTENT IT GAVE YOU BENEFIT
E. Summary of Tax Benefit Rule
No election like the claim of right doctrine, pay it back when you fit the profile.
Canceling of liability must also increase net worth in order for this to make sense. Kind of depends on how
you value the liability (example: canceling of tort liability doesn’t increase, while debt discharge does, but
VII. RECOVERIES FOR INJURIES
1. Property Injuries
Property injuries: taxable to the extent the money exceeds the basis.
Hypo: X purchased Blackacre for 100, it’s now worth 200, it’s being rented for 20. Y torches it. You get
200, but it takes a year, so really you have lost 220. So you sue Y for 220. You get the basis offset of 100,
so you pay tax on 120, 100 is gain from the property and 20 is income for lost profits.
2. Personal Injuries
§104: allows (unless you’re taking the medical deduction) you to exclude the entire $ received forlost
wages, pain and suffering, and medical expenses.
Policy behind §104: don’t hit a person when they’re down.
Recoveries for punitive damages are taxed and are not excluded by 104(a).
If a person has medical expenses and deducts, these won’t be excluded because they have already been
3. Physical vs. Non-Physical injury
Congress has distinguished between physical injury and nonphysical injury. Physical excludable,
Emotional Distress: 104(a)(5): emotional distress not considered a physical injury, but doesn’t say that if
you suffer emotional distress it is therefore includable. BUT the legislature has said that damages from a
physical injury that are emotional distress damages are excludable from income.
Defamation/Age discrimination/sex discrimination: damages that are incurred from these actions are not
excludable. These are considered nonphysical injuries. But medical costs for emotional distress are
excludable (unless you already deducted them)
4. Lump Sum Payments vs. Periodic Payments/Annuities (Ask Joyce how much we need to know about this)
Statute excludes the items it does exclude regardless of whether the payment is made in lump sum or in
Example: Taxpayer gets judgment at 24. He gets to exclude the 24. Say the taxpayer, with this 24 goes and
buys an annuity and which says you’ll pay me 10 a year for 3 years. Therefore the ratio is 4/5 and so he
only includes 2 in his income, and can exclude 8. therefore, he gets to continually exclude the 8, even
though it’s been excluded once.
Periodic payment: gives rise to the structured settlement industry. Liability company will offer periodic
payments, rather than lump sum, this way you don’t have to worry about investing that lump sum and
getting periodic payments and therefore you would get hit with the tax. Liability companies say, we’ll pay
you periodically, rather than you investing in an annuity and then getting taxed payments out of the
§104(a)(2): is a complete exclusion section. You are always excluding this income. Therefore, if the
taxpayer gets a settlement for 24, and buys stock. The taxpayer’s basis is 24.
§72: gives you the ratio for you to figure out how much to include for each payment
VIII. BORROWING AND DEBT
1. The Basics
Presumption of payback therefore money borrowed is not includable in income.
Borrowed money is given exceptional economic treatment in comparison to like items: ie borrowed
You want to buy a computer and take a deduction. Best idea is to borrow the money and then to buy the
computer. You are manufacturing the deduction, but this necessarily flows from the rule.
Suppose you want to buy a building and take depreciation deductions to offset your income. You borrow
the money to do this and then take the depreciation deductions.
One of the best things to do is to borrow money and take and invest it in a depreciable asset because this
way you get the borrowed money exclusion and a deduction and you haven’t spent a fucking penny.
2. Debt Discharge
61(a) 12—discharge of indebtedness income.
When a debt is discharged at an amount that is lower than the original amount the difference is considered
Example: In year one you borrow 100. In year one there is no income because this is borrowed money. In
year 2 joyce gets his creditor to take 75 in repayment of that 100. This results in income of 25 in year two.
3. Freed Assets vs. Tax Benefit
Always apply the freed assets rationale to the insolvent taxpayer.
Income from a discharge of debt is realized when there is a “freeing of assets previously encumbered.”
Hypo: suppose in year one the taxpayer has 100 saved, and then in year 2 taxpayer borrows another 100,
now taxpayer owes 100, but has 200. Taxpayer spends 125 in year 3 and now has 75. In year 3 has 75 and
still owes 100. In year 4 taxpayer goes to person he owes 100 to and says would you take 50? The creditor
says, I’ll take it. In year 4 there is no liability and he has 25. Key here is that in year 3 taxpayer is
insolvent, and in year 4 taxpayer is solvent.
o If you applied the freed assets approach: in year 4 you have freed up 25, so you should pay 25.
You have moved from the red to the black.
o If you apply the tax-benefit approach: there should be 50 of income.
o Two different results in the insolvency, but in the bankruptcy act of 1960 says you apply the freed
asset rationale to the insolvent taxpayer.
o Therefore, the rule now is that the insolvent taxpayer is only taxed to the extent they are in the
o Therefore, the insolvent taxpayer gets a double benefit.
o Focus on how much assets were encumbered and then how much are unencumbered.
Hypo: Taxpayer has 100 in the bank and then she does a favor for her husband and her husband owes 100
to the bank. Banks says to her, we’re going to let you take over your husbands debt. Now she owes 100,
and she gets the bank to take 75.
o If you look at Kirby assests this would be 25 of income
o But if you look at the tax benefit type of rule, you would come up with 0 of income.
o When the wife incurred the debt, she didn’t get anything. There is no inconsistent event, nothing
is inconsistent with anything she has been allowed to do previously.
o There is nothing in year one.
o Getting her husband off the hook: she gave her husband a gift, and therefore an economist would
say she got the benefit of giving a gift.
o Congress has not spoken on this issue, viable argument that the woman did get something.
4. Debt Discharges that are not considered income
Gifts: Debt discharges that are gifts are not taxed as per 102.
Wash Principle §108(e)(2): if debt is discharged, that would be income, it is not considered income if it
would be deductible. The wash principle in action.
o Working condition fringe: 132(d)—payment of business expenses are deductible, therefore the
payment to the secretary would be deductible.
Renegotiated Purchase Price-- §108(e)(5)
o Renegotiated Purchase Prices: if you owe a debt on purchased goods, and debt is discharged in full
or in part, treat it as a reduction in purchase price, not a discharge in full or in part, this is not a
discharge of indebtedness and is therefore not to be included in your gross income.
o Must be goods, can’t be services
5. Before you can have debt discharge income you need to have a debt, someone saying you have a liability
doesn’t necessarily mean you have one. Further discussion of 108(e)(5)
Facts: Guy runs up a serious gambling debt. Commissioner says you have 2.9 million dollars in income.
Taxpayer prevails because the taxpayer successfully argues that there isn’t any debt. because the New
Jersey law said that casinos couldn’t enforce their debt.
No income because court holds this to be disputed debt.
B. What is disputed debt? 108(e)(5)
Disputed debt: someone sends you a bill and you say, I don’t owe you that much, and there is a dispute and
then they settle, the amount settled can be determined in a couple of ways. Commissioner has a choice: can
say I think the taxpayer is lying and I’m going to out and prove this was a bonafide debt OR the
commissioner can say, the hell with it, we’re just going to settle here.
Was this a bonafide debt dispute? This became a heavily litigated area: so what Congress said was that
when this was a buyer and seller debt, the rule is no income. We’ll treat the amount negotiated as the
original debt and then we’ll move on from there.
When dealing with a situation of debt and the transaction is between buyer and seller, what you do is take
the settled on price—and say that there is no income (even if it looks like there was a debt discharge), and
then adjust the basis—the basis of the property becomes the settled on amount.
108(e)(5): only applied between the two original parties. If a third party enters the picture, you’re back to
the bona fide dispute business again.
C. Some courts don’t believe in disputed debt and reject Zarin
There are a series of cases that say Zarin is crazy. These decisions say that 108(e)(5) only applies where
the amount is in contention, not the fact that the debt exists.
Zarin is disputing whether or not the debt exists, not the amount. Zarin says 108(e)(5) applies if the
question of whether or not the debt exists.
Joyce says: the real problem in Zarin is whether there is income under §61, the thrust of §61 is gain under
Lobue. Joyce says these types of debts—are income.
Zarin as the cash bargain purchase: could argue that for a discounted price Zarin got the thrill of gambling.
Could argue that he got this entertainment at a discounted price because he would return.
o Counterargument: there was am implicit deal, this was services
Joyce: best argument for Zarin—suppose you have an alcoholic and you put her in a brewery and say drink
away. This is not income because this is taxing a disease.
Joyce says: Zarin received the value of gambling for nothing, and there is no exception that covers this (this
isn’t what the court in the case says).
D. Misc Gambling Info
§165(a): losses from wagering shall be allowed only to the extent of gain.
VIII. Liability (Theft vs. Borrowed money)
1. The basics
When you steal, without the consensual obligation to repay, the money you take will be considered income.
Embezzler gets the deduction in the year he pays the money back, but can’t get a §1341 benefit.
If you steal and repay in the same year, you pay be able to not include!
2. When you steal the money is considered income and is therefore taxed.
When you steal without the consensual obligation to repay there is income.
What you need is consensual obligation to repay rather than intention to repay—the other party from whom
you took the money from recognizes your obligation to repay.
Joyce: behind this is the notion that most people who steal and embezzle don’t pay the money back.
3. Repayment of Embezzled Funds
Hypo: What happen when the embezzler pays the money back?
If you repay in a subsequent year, no deduction because no claim of right doctrine! No unrestricted right to
the money in the first place.
Hypo: Suppose the embezzler pays off the debt in year one?
Give a deduction in year one.
Name of the game is if you steal money, pay it back in the same year—for your income tax liability.
BUT if the embezzler can’t pay the money back in this year, have the taxpayer borrow the money and pay
back the person whom he embezzled the money.
4. Using borrowed money to pay back the embezzled funds.
If the embezzler can get the borrowed money, this is okay and you are following the law, but who the hell
is going to give the embezzler money?
Person who you stole the money from would want to lend it to the embezzler because the person you stole
it from does not want to be second in line in terms of getting money back from you because the IRS would
Problem with the above is that the tax commissioner is going to be pissed—commissioner is going to say,
this is all smoke and mirrors and there is no real loan.
Facts: Guy who takes money for the betterment of the company.
Principle: Consensual recognition
Principle: if you pay it back in the same year, it’s a deduction.
Paying it back means paying it back, you have to pay the money back!
Was there consensual recognition?
o Corporation knew about it—this is as close to consensual recognition as you’re gonna get.
Was this repaid?
o Yes, it was secured by assets greater than the amount of the lien.
IX. REALIZATION & RECOGNITION—TIMING PROBLEMS
1. The basics
Trying to determine when a tax liability arises.
Most of the time it is pretty easy to determine when something is income, but when it’s not it’s a really big
Unrealized appreciation is the biggest gimmee in the entire income tax system, it’s the big sister of the
BUTs. Remember the little sisters: cash bargain purchases, transfers between family members and imputed
2. Dueling Hypos:
Hypo1: Joyce puts 100 in his own savings account, it’s earning 4%. At the end of the year the bank credits him for
$4 in interest, sends statement, and a 1099. Let’s the money sit
Hypo 2: Taxpayer 2 takes 100 and buys a share of Exxon. At the end of the year, he does nothing, and Exxon
doesn’t send a 1099, at the end of the year it is worth 104.
Joyce says: why do I have to pay tax and taxpayer 2 doesn’t have to, what is happening to me?
Explanation: in the stock situation the 5 of gain is not realized and until it’s realized it won’t be considered
Both of the scenarios are income under Lobue—this is gain, this is a BUT under Lobue.
o Other Buts: Cash bargain purchase, imputed income, transfers between family members
Unrealized appreciation is not in the code, therefore we are left at sea to try to explain the difference
between the 2 different hypos.
Why taxpayer 2 enjoys unrealized appreciation: Overriding Reason: problem is that person would have
to pay tax on the increase on everything that increased in value, this creates administrative hell
because you would have to value everything every year.
This is deferral of income with the possibility of complete exclusion by the angel of death.
3. Unrealized Gain
Eisner v. MacComber
Facts: See handout on page 3 for fact summary.
Tax the fruit from trees, not the growth of the tree,
Court held the stock income was not taxable income.
Her stock went from 100 to 366, she had gain, when the stock split happened—she got 2x as many shares
but the shares are worth half as much, she just had more shares, but not more gain.
What if Mrs. Macomber had received a bond instead?
o Yes, this would be income.
o This is not fruit from the corporate tree—but it is still decided to be income
Realization does not depend on output from the corporation.
The purpose of the case is: unrealized appreciation in capital is not income.
The above is a crazy statement! Think about the contradiction with Lobue! This is not a constitutional
Admission that the reason unrealized gain is not taxed is out of admininstrative convenience.
A material difference (realization) occurs whenever the legal entitlements change, no matter how minimal
the difference is from the volatility of your investment perspective.
4. Realization v. Recognition
Realization: Occurs when you enter into an exchange or sale which effectively ends your stake in the risk
of the old investment—whatever your gain or loss is is locked at this moment and therefore you must
account for it! And no matter how difficult it may be to value the gain/loss, we shall require you to do it as
this point. You may have had the chance to defer, but it’s over! Ending the old, and coming into the new.
Recognition: As long as you have realized gain or loss, it will be recognized (taxed now), unless there’s a
specific provision to save you. Realization is the inquiry whether something of tax significance happened
in the first place, recognition asks whether now is the time to actually account for it. Non recognition
extends deferral and remember deferral is a good thing!
A. Example of Realization and Recongition
Hypo: Suppose A buys stock X at 100 and it goes to 105. Suppose B buys stock Y at 100 and it goes to 105. A and
When A and B swap there is income for each of 5. (so much for the problem of each one having to sell the
property and so much for valuation problems)
When we are taxing A we are taxing the A on X stock.
At the moment of the swap the gain is fixed—it’s like taking a snapshot.
After A no longer owns X—he’s out, he’s out of the risk of the X’s gain or loss.
What this comes down to is you can’t require people to value assets every year, but we can require people
to value select assets at select times because it is not as administratively burdensome.
B. Why is there realization with the cash/bond dividend?
When a shareholder gets a dividend there is a sale—in a sense.
In a sense the dividend is like a partial cash out—partial ending of the risk.
Now his investment is stock in the corporation and cash in the cash.
Look to see if the form or extent of the investment has changed.
Bond v. Stock: when you hold a bond you have a right to be paid by the corporation, but as a stock holder
all you have is the right to persist.
Facts: The federal agency said that because the mortgages that were being swapped were similar there was no need
to report the loss. Commissioner said, then you don’t get the losss—this is nothing.
This involved a loss and not a gain.
A has X that went from 100-105.
A has Z that went from 100-99.
Realization requirement applies to both gain and loss.
A will want to hold onto the X stock and will want to sell Y stock.
It is completely in the control of A, to cherry pick—sell your loss assets and keep your gain assets.
In Cottage Savings the taxpayer wasn’t in A’s position, in cottage Savings the taxpayer wanted to take the
loss, but couldn’t take the easy loss of selling.
Court says: there was realization because there was a change in the form or the extent of the investment
Court says: the mortgages each bank now owns is different—it is different people. What the bank is really
swapping is liens on different properties. Swapping risk
BUT: Joyce says that in the real financial world, the swap is bullshit.
Joyce says, despite the fact that this is bullshit all we are really looking for is something different because
you aren’t in the same investment.
C. Remember with bonds/cash payouts the basis will stay in the fee, because this is not the realization of
Suppose that Mrs. MacComber had bought the stock at 366 and the next day she got a dividend of cash of
Her basis in the stock is 366, and because of the dividend her stock goes down to 346 (this may not be what
happens, just assume that this is the case).
She has the 20 in cash in her pocket—this is considered income. She will pay tax on the dividend even if
she just purchased the stock.
This is not the realization of appreciation—this is a cash payout.
Basis is kept in the fee—the basis, after the dividend is still 366. If the taxpayer sold, there would be an
offset and there would be zero.
There is really no gain or loss, just a redistribution of the corporation assets.
All gain has to be realized before it is included in gross income, but only if the gain is unrealized before the
gain is included is “realization” meaningful.
5. §1001-Deterimination of amount and Recognition of Gain/Loss:
Requires the “sale or other disposition of property”—a realization event—and then says that such gain or
loss calculated as per §1001(a) is to be fully recognized unless otherwise provided.
Then new cost basis, §1016, is present, and the whole process happens all over again.
6. §109 & §1019: (Non-Recognition)—Property on Which Lessee has made Improvements:
A. The basics
Don’t include in income gain or loss for improvements made on land by lessee, but don’t adjust the basis
Rents will be taxed as we go along, rather than allowing depreciation.
When you will be taxed: when you sell the property.
All the non-recognition provisions are designed to relax the realization principle: Even though a minimal
difference may be a material difference, and thus realized, we’re going to cut you a break in some instances
and say, really the basic sameness of your investment (and thus their volatility) is enough for us to defer
taxation a little longer.
Why is it that in Inaja Land the basis is adjusted downward, but with Lessee improvements there is no basis
adjustment? Inaja Land the settlement was in cash, and you can’t avoid assuming the cash’s basis.
B. A little bit o’history
Facts: A person built some buildings in a landowners property and the property increased in value, lessee defaults.
Bruun is no longer applicable because of §109 and 1019.
C. §109 &1019 Further Explored—These 2 sections work together
109: Gross income does not include income (other than rent) derived by a lessor of real property on the
termination of a lease, representing the value of such property attributable to buildings erected or other
improvements made by the lessee.
1019: Basis will not be increased or diminished as a result of buildings erected or other improvements
made by the lessee.
109 and 1019: says we are going to exclude income now, but not forever.
1019 (these two work together like the gift stuff): the landlord gets no increase in basis from improvements
made by tenants, therefore, when the landlord sells the property all gain (including gain from tenant
improvements) are considered income.
1019 is really Philadelphia Park—fair market value receive in a taxable exchange. Don’t get credit for
stuff you haven’t included…you need to pay on the gain.
These are deferral sections.
Hypo: Landlord comes to you and says I have this property, I bought it for 100 and now because of this building my
tenant put up it is worth 150. Basis will still be 100, and the 50 will be reported when it is sold. You say, what are
you going to do with the building? You say you will still get taxed on the rent and there will be no basis offset on
the building and you get depreciation on the building, but you won’t get depreciation because you didn’t include it
o Is there any way I can get out from under this? Yes, go live in the building, and this will be
imputed income and this is not taxed.
o If you sell or rent you are still going to have to pay.
Hypo: suppose that in 1915 the landlord put a 50 year lease on, and in 1939 the tenant build a 99 year building?
Now the building will be there substantially beyond the term of the lease.
Shouldn’t the landlord have income at the time the building was erected?
o What is being given is an increase in the value of the reversion.
o Tenant who builds a 99 year lease is probably going to ask for a decrease in the rent of the
o What the tenant has really done is paid some rent.
Landlord would not have to pay tax.
The landlord gets no basis on the building and when you get the property back you won’t be able to
depreciate this building—therefore any rent paid is total income.
Hypo: Suppose that a taxpayer owns some property and allows someone to use the property for several months, and
in return for use of the property the user paints the house on the property and increases the value of the property
This is not unrealized appreciation, this is the sale of services. Therefore this is gain that is taxable right
As soon as the renter paints the house is when the gain should be calculated.
Only talk about realization when talking about something previously done.
X. LIKE KIND EXCHANGES-- BOOT AND BASIS--1031
1. The baby steps
This is about delaying the tax, allowing people mobility, by delaying tax payments.
Think of this as a way of getting around Philly Park—it’s so fucking brilliant!
This is a realization event that is unrecognized—realization w/o recognition!
Way 1031 works: 1001 says all gain is recognized, unless you can find a section that says otherwise.
Hypo: Taxpayer has a farm X. Farm X has a basis of 10 and the FMV of the farm is 100. Taxpayer wants to get out
of the farm, and doesn’t want to pay tax.
If this taxpayer is able to find Y farm in a place where she wants to be, and this farm is worth 100. X can
exchange Y farm without having to pay the tax.
If you stay in the same type of situation, and use like for like, then we are willing to say that we will
continue the deferral into Y farm and you will carry your basis from X farm.
1031: first thing it says is no gain is recognized—not included in income, but there is a basis ramification,
your basis has to stay in the new property such that if you pay the new property for cash, we get the tax. In
the above, the basis will stay at 10.
Philadelphia Park: The basis of property received is the basis of the old, plus the gain that is REQUIRED
to be included in income. The key is to look for some reason that the gain will not be REQUIRED TO BE
INCLUDED and 1031 is such a reason.
3. What does 1031 apply to?
First, remember that 1031 is mandatory!
Only applies to investment property—won’t apply to the vacation home or the personal residence.
Not included: financial instruments such as stocks, bonds, notes, K rights, etc.
Land for land is okay, tractor for tractor is okay, land for tractor NOT okay.
Revenue rulings will tell you lots.
Something to boot! Something a little extra!
If there’s a like-kind exchange, it only gets recognized to the extent of the boot!
You recognize (pay taxes on) the lesser of the gain or the boot!
Your basis in the like-kind property you acquire is the same as the basis in the property you gave up, unless
there is boot!
If you pay boot, you can add that to your basis; if you receive boot…
The basis will be equal to: (1) the basis of the property given up, (2) less the fair market value of the boot
received (3) plus any gain recognized. (See Joyce handout)
o If X exchanges his farm , in which his basis is 50K, for a farm worth 100K, plus a tractor worth
15K, there’s recognition of only 15K of gain ( the portion of the 65K of gain realized, which is
represented by the boot). Therefore the farm will have a basis of 50K and the tractor will have a
basis of 15K.
o If the farm X received in return was only worth 40K, X would now have stuff worth a total of 55K
and only 5K is recognized (remember it’s the lesser of the gain or the boot is what’s recognized).
The farm will have a basis of 40K, and the tractor would have a basis of 5K
Just remember to follow the formula!
5. Miscellaneous Like for Like X-change stuff
o Say, you sell the X farm for Cash and the next day you buy the Y farm. 1031 won’t apply here.
o 1031 talks in terms of an exchange, you can’t cash out and put yourself back in the position.
o Given rise to 3 cornered Xchanges, have someone go out and buy Y farm for you, and then you do
o Many 3 party exchanges, be on the lookout for these in practice, by Joyce doesn’t care.
1033: this deals with involuntary conversions, property is condemned or burned, if this property is held for
investment, if the owner gets 123 for the burnt farm (farm had a basis of 10), then you will be given the
1031 break if you take the money in a few years and buy Y farm. If you buy Y farm for 100, the 23
becomes the boot.
1033: is elective, where 1031 is not.
7. Losses under 1031
Person bought farm at 130, farm is now worth 123. This taxpayer wants to stay and take the loss. If the
taxpayer does nothing, she never gets to claim the loss. Taxpayer wants to create a situation in which there
is an event so that the loss can be recognized.
Person xchanged X farm for cash and a tractor. See the sheet for the numbers.
If you xchange loss property for like property, then no loss is recognized.
If there is a loss, to determine the basis of the new farm, just subtract the boot from the basis of what was
Facts: Sale+ Leaseback. Commish wanted to cast this as an exchange to force non-recognition of the loss—
remember that under 1031 losses aren’t recognized. Commish argued that lease is a fee (of sorts), so this was just an
exchange of a fee for a fee. Jordan Marsh wanted to characterize this as a sale and a repurchase so there would be a
loss recognized. Jordan Marsh wins!
In Joyce terms: Jordan Marsh transferred a fee simple, which was broken up into a 30 year term plus a
remainder and the promise to pay rent
Buyer transferred 2.3 million dollars and a 30 year term. Joyce says that this can be broken up too.
o 760K plus 1.54 Million plus a 30 year term, this is what was transferred from the buyer to Jordan
Say, I have a farm I purchased for 130, it’s worth 123. I sell it to a straw man for 123, and then I buy is
back for 123.
o Not good, transfer of the farm, with an agreed upon transfer back is no transfer at all.
Joyce says that the same court that would turn down the above, was hoodwinked by Jordan Marsh.
What this court did was to treat this agreement as two separate transactions, on day one you had the
retransfer agreement, but then on day two you had sale, and then a leaseback.
Really, what the buyer was buying was the remainder, and the promise to pay rent.
Jordan Marsh got a total loss, but Joyce says that the taxpayer should only have been able to get a partial
loss. All that has actually been sold is a remainder.
Taxpayer was able to stay on the property and declare the entire loss by running papers back and forth.
This type of transaction may not be recognized in circuits other than the 2 nd.
X. Section 121: PERSONAL RESIDENCES
1. The Basics
121: people can sell the residence and escape the gain on $250,000/person, if it is a personal residence and
it is lived in for 2 years. You get this every 2 years.
121: doesn’t apply to vacation home unless it becomes a personal residence.
121: is a nonrecognition provision.
2. Requirements of 121
Have to have owned a home and lived in it for an aggregate of 2 years over a 5 year period ending on the
date of the sale.
Amount of gain excluded is limited to 250K, up to 500K for married taxpayers so long as they both meet
the 2:5 requirement.
Exclusion is only available once every 2 years.
If more than one sale occurs in the 2 years, or you don’t meet the 2:5 requirement, then you can get a
reduced exclusion if the sale or exchange was made because of a change in employment, health, unforeseen
3. 121 and Divorced Couples
If former spouse (H) occupies the home pursuant to a separation instrument, then W can be treated as
having lived there as principal residence during that time, even though she’s not! This means that W can
still exclude $250K on his/her gain on sale.
If H lives in the 400K house (basis 100K), and the house is sold, the entire 300K can be excluded, even if
both are remarried, provided the proceeds are divided in such a way to stay under the 250K cap.
XI. CONSTRUCTIVE SALES-Trying to be sneaky
Example: A taxpayer owned stock at 10, but it is now worth 100. Taxpayer wants to lock in the gain.
What taxpayer does, is finds someone with the same stock, and you say I want to borrow your stock, and
I’ll give it back to you in a few years. Joyce sells the stock that he borrowed. When the stock is borrowed,
the basis in the promise to repay the stock is FMV, when the stock is sold, it is sold at FMV, and there is
therefore, no gain.
When you borrow, you get advance credit for repayment, the basis of what is borrowed is FMV.
Now, whatever happens to the stock, has happened to the person you borrowed it from, not you. You’re
out after having purchased the stock. Risk of loss and opportunity for gain has been ended.
1259: when you sell the friend’s stock, and have no more interest, this is the same as if you have sold your
own stock. This is an example of taxpayer’s attempting to realize, but not recognize. 1259 is an example
of the reaction by the treasury.
XI1. 1041—NON RECOGNITION OF GAIN/LOSS FOR TRANSFER BETWEEN SPOUSES OR
INCIDENT TO DIVORCE.
1. The basics
Whether property transferred has appreciated or depreciated, if transferred from one spouse to another or to
a former spouse (so long as incident to a divorce), gain/loss won’t be recognized on the exchange.
Tranferor gets no deduction, and transferee has no income and takes a substituted basis.
1041(b)(1): says treat this like a gift, don’t tax it! But don’t treat it like a normal gift because the transferee
takes a substituted basis even if there’s a loss!
Problem: when the transfer is treated as a gift, 1041(b)(2): the basis of the property is the property’s
original basis, there is no basis step-up.
2. Divorce Negotiations
It’s likely that each party is going to try to screw the other by offering up the property with the lowest basis
so the other party will have to pay the most taxes—lower the basis bigger the gain.
However, once you have control of the property, you are in the driver’s seat, you make the choice of when
the gain will be recognized.
When people argue that a divorce swap isn’t equal—this is pure speculation, who knows what the market
All negotiation is done in the shadow of the law.
3. 1041 Permits Loss Shifting
In this situation you aren’t running two basis the way you are in 1014.
United States v. Davis: Overruled by 1041
Facts: Taxpayer had appreciated property, stock, and in connection with the divorce the taxpayer made a transfer to
wife of appreciated stock and in terms to this the wife waived all of her marital rights in connection with the divorce.
Basically, how is this transaction to be treated? Sale? OR is this to be considered by co-owners of the property.
If this had been treated by a division of co-owners, there would not be a taxable event—therefore, treasury
says sale, and Davis says division.
If you have a division between co-owners, these types of transactions are non-realization events, even
though after cottage savings, the treasury could now say that even a division between co-owners is a
taxable event because the form has changed.
1041 completely overrules this decision because after Davis, states were saying that DE law was different.
Legislators were being dragged in to pass laws to say that this was really co-ownership.
Lesson of Davis: when you have appreciated property and you make a change, you have to be susceptible
to the argument that you are discharging debt.
Heart of Davis: if I owe someone something, the gain in the property has benefited me, not the person I
owe something to. The person who gets the property, I owe this regardless.
4. Using Appreciated Property to Pay Off Debts
This is usually a realization and a recognition event!
Usually you will be treated as though you made a sale and then gave cash.
Example: This can get hairy. Suppose that a person is a lawyer’s secretary. Lawyer gets 500 from a client
and pays the secretary 100. All other things being equal, this will be taxable for 400. Suppose the lawyer
pays the secretary with stock worth 100 which the lawyer paid 20 for. Now we have income of 500 from
the client, and then 80 from the stock, but then we have a deduction of 100 to pay the secretary—480 of
5. Pre-Nuptial Transfers
Pre-nup transfers are non-taxable exchanges under income tax, since the surrender of marital rights is
adequate consideration for tax purposes.
Problem: the transferred property still needs a basis, despite the fact that the basis is never included in the
Basis for the transferee will be fair market value.
Assumes that what you paid (which was the surrender of marital rights) is equal to whatever that surrender
would be on the market.
Legal Fiction: spouses entered into a market exchange.
Facts: this case involved the Wife. This case is not overruled by 1041 because this transaction took place before the
marriage. Issue that arises: was this a gift or was this a sale? Was this a realization event.
Question here is what are the ramifications for the recipient.
Court said this was a sale, what the wife to be gave up were her contingent support rights (even though they
were unenforceable), this was like she was relinquishing the husband from a debt. This was not a gift, the
husband was buying off the wife, and the value was in the nature of a debt.
Therefore, this would have given rise to gain on the husband’s side, in light of this,
Prior to section 1041, basis would be the FMV of the property received, we are back to Philly Park.
For the wives, we know that there is an exclusion, for interfamily support types of payments. What the
wives are getting, in exchange for what they would have been getting tax free when they were married,
when the husbands bargain themselves out, you have to treat the wives as paying cash for the property—
need to get the basis. Don’t want to tax the wives on support.
Treat the wife as if she paid for the settlement—want her to never have to pay tax on what she received.
Wife holds the stock as a purchaser, legal fiction is that she purchased the stock for the FMV.
How do you make the Farid Situation into a 1041 situation?
o Have to do the arrangement so the transfer doesn’t take place until the wedding takes place.
o Transfer is contingent on the marriage.
I. THE BASICS
No real difference between exclusions and deductions. The tax is only on taxable income anyway when it
is all said and done.
The idea is to take the figure that equals what you received (gross income) and deduct what it cost you to
receive that much.
Deductions are essentially your cost-basis for gross income, so you wind up with a figure that is closer to
what you actually earned.
A. What’s deductible?
Losses, but just as with gain, this really depends on whether the loss is recognized or not.
B. Two types of categories of deductions:
Personal vs. Business (Personal generally not deductible) (Example of personal expense: haircut, shoe
shine) §262 is the provision that rules out personal deductions
Capital vs. Expense (Capital not deductible, but is depreciable). §263 says no deduction for a capital
What is deductible is a business expense.
II. §162: ITEMIZED DEDUCTIONS FOR TRADE OR BUSINESS
1. The Basics
These are “ordinary and necessary expenses incurred or paid in carrying on any trade or business.”
This is the light bulb Posner was talking about, this is salaries etc.
Travel is what we spent the most time on.
2. Travel deductions
A. The basics of what can be deducted
Daily expenses incurred going between your home and a temporary work location outside your metro area.
If you have got one or more regular work locations away from your personal residence, you can deduct
expenses traveling from there to any temporary work location.
If your residence is your principal place of business you can deduct your expenses traveling to any other
work location in the same trade or business—doesn’t matter if it’s regular or temporary.
o Principal place of business is determined under 280Ac1A—your business activity at home is so
central that it overwhelms the personal nature of the residence.
Does Joyce get business expenses deducted from going from home to work?
Methodologically, you have to be told you have to fit w/in business, therefore you don’t really need 262.
This is personal, you chose to live where you live, you chose your residence, therefore this is considered a
Like the Flowers case, if you decide to live in Jackson, even if you are working in Mobile, this is your
choice, therefore commuting is non-deductible. It is always a personal choice, we won’t get into the
Now Joyce is at the law school, and now he is going to go downtown to do a CLE program for the bar
association. He goes downtown and then he comes back to the law school.
This will be deductible, but this hides the fact that these are two different businesses, you could say why
not treat the law school as the home for the purposes of the CLE class.
Treasury has treated this as one business, even if it is two. Going from one business from another is okay,
but what isn’t deductible is residence.
This is true even if this is for a different business than your primary business. If Joyce goes to speak to
alumni or if he goes to consult, it’s all deductible.
Now Joyce goes from home to Rochester to consult with a lawyer.
If you are traveling out your geographic area you get to deduct the entire trip and back.
Any travel outside your metro area, you will get the deduction.
Also get the deduction if you drive yourself to the airport and then fly to NYC.
Now Joyce goes from home right to Buffalo to deliver the CLE program, he never goes to the law school.
This is deductible. If Joyce has one or more work locations away from the law school away from the
residence, and expenses are incurred going to a temporary place, you can take the deduction.
Has to be in the same trade or business.
Revenue Rulings Say if you don’t have a regular place of business, you can’t get the deduction for going to
temporary work locations.
Walker says that you can get the deduction.
Therefore, if you are going to claim this, you are going to have a fight on your hands.
Now Joyce goes from home to NYC. He goes there for a bar association conference, which runs for 3 days,
but he’s only interested in programs that are being given on one day, but he’s going to stay for the whole
time, but the rest of the time he’s going to tourista around.
Unlikely Joyce will get this deduction.
Overriding principle, if you go on a trip, that would otherwise be deductible, but you go primarily for
pleasure vs. business, this won’t be deductible at all.
Much like the gift situation—if it is primarily for business, you get the whole thing, primarily for pleasure,
you won’t get any of the transportation costs.
This is called the primary purpose test.
Joyce goes from the law school to buffalo to give his talk, before he gets to the talk, he stops for lunch, can he
get this deduction?
162(a)(2): can get travel expenses for meals and lodging while away from home in pursuit of a trade or
Must be away from home.
Before 162(a)(2), what the treasury would say is that you have to eat anyway so this is personal, but they
would allow the excess of what you paid, but this would be a nightmare of record keeping.
Therefore, the treasury went to Congress and said, we’ll give the taxpayer everything, but she needs to be
away from home.
Therefore, Joyce can’t take this deduction because he’s not away from home, when he’s in Buffalo,
Orchard Park or at the law school.
Now Joyce is going from OP to Rochester, and while he’s in Rochester he eats lunch.
There would be no deduction for this because the regs, which have been blessed in a case called correll,
that says you are not away from home for the purposes of meals unless you are in a sleep situation.
If Joyce does a day trip, then there will be no meal deductions.
If Joyce goes to NYC and stays overnight, he gets all meals and lodging—can’t be excessive.
Now Joyce goes to Rochester, he meets with a lawyer and has a lunch meeting to discuss a case. Joyce picks
up the lunch tab.
Look at §274 (493-96).
If Joyce discusses the case, he can deduct the other lawyer’s portion of the meal.
Can Joyce deduct his meal? You can’t really find an answer, Joyce says deduct it, even though there is
really no authority, except for the treasury not saying much.
If the other lawyer purchases the meal, Joyce won’t have income because of the wash principle.
Location does not make a difference—could be in Buffalo, could be at home.
The most important aspect of this rule is to be reasonable.
Section 274, has a 50% rule for meals, you can only deduct half.
50% rule doesn’t apply if you are reimbursed, because you are reimbursed
If this is a private employer, the 50% is imposed upon them.
When you are reimbursed, it’s washed.
3. CHILD CARE DEDUCTIONS
No child care deduction.
What is given is a credit.
Credit: at the end, after you determine your taxable income, you get credits for things that you owe.
Child care credit is a limited credit.
4. CAPITAL EXPENDITURE VS. EXPENSE
1. Capital Expenditures Are Not Deductible
§263 says that no deduction is allowed for a capital expenditure.
BUT: If you decide that something is a capital expenditure rather than a (deductible) expense—so that you
won’t get the deduction all at once—your next step is to figure out what asset you can/could capitalize it
into, so that you have a chance of getting it back! And/or try to get a loss.
Expenses are deductible.
2. Why does something have to be an expense to be deductible?
Example: Lawyer makes 400 from a client, and pays the secretary 100. therefore, there is an income of
300. But now suppose, that the taxpayer makes 50K in business receipts, and pays 5k in salary, and pays
20K for a truck that is used in the business. Both the salary and the truck are for business only. If the
taxpayer is allowed to deduct the salary and the truck—taxpayer would have 25K of taxable income, but
this would be a false reflection of taxpayer’s gain, taxpayer starts with 0, pays salary of 5K, now has 45,
now buys a truck, and wants to say all he has is 25K, but the taxpayer also has this truck. Therefore,
taxpayer really has a gain of 45K, and part of the gain has been transformed into a truck.
To allow the taxpayer to deduct the full cost of the truck is to understate the gain.
Alternative is, that if that is a truck that will last for 5 years, you can take 4K a year in depreciation for 5
Taxpayer wants it all at once and this would give him deferral. We’re now right back to Lobue. This
person wants to deduct all in the first year, and in the end this is deferral of the payment of gain until later.
If you get a big deduction in year one, you are deferrering income.
The code allows this type of deferral as a stimulus in many areas—congressional policy making.
MACRS—modified accelerated cost recovery system, this is basically fast tracking depreciation.
Where Congress hasn’t specifically allowed it, the general rule is that you can’t deduct a capital
expenditure, because it is not reflecting your 61 income. The way the code does this is to classify the truck
as something other than an expense.
3. What is a capital expenditure and what is an expense is defined by case law.
Whether you get a business expense or just a capital expenditure really depends upon when you expect to
get a return on your outlay.
Remember, the object of 162 and 263 is to match up expenditures with the income they generate.
4. Repairs and Replacements
This is not the way to differentiate capital expenditures and expenses.
This does make it possible to get both a 165 loss deduction and a 162 expense deduction.
Example: tires blow on a truck: get a loss deduction from the basis of the truck, but basis will go back up
with the cost of the replacement tires, when replacement tires wear out quickly, you will get am expense
deduction for the tires.
This can be seen as two different realization events.
Facts: Issue as to whether expenditure for oil-proofing the basement is an expense or a capital expenditure.
Court basically decided this was an expense rather than a capital expenditure because the liner maintained
the SQA of the business, as far as the profits went.
Joyce says SQA my ass! Without this liner the property was useless to the owner.
Do you look at the useful life, before the oil refinery or after? Joyce says, this shouldn’t be the test.
Really, just look at the state of someone’s income, in this situation you look and see, you paid out the
money, but you’ve got a cement liner, and this liner is going to be with you for a long time, and what you
want to do is deduct the cost of the cement liner now. Want us to understate your income, understate your
BUT this can be deducted, the court uses this useful life or added value.
Joyce says, the real test is how long is it going to be there? If it is for beyond a year, then this is a capital
Repair and maintenance cases, courts are unwilling to apply the capital expenditure reasoning to its logical
conclusion, because it would be an impossible situation.
o Think about touch-up paint jobs, light bulbs—logically you would depreciate it, but you would
have to set up a depreciation schedule for everything. What a pain in the ass!
Problem from this case: Where do you draw the line? Where is the distinction between repair and replace?
Mt. Morris Case
Facts: Company had to put in an irrigation system. Is this an expense or a capital expenditure?
Court said it was a capital expenditure.
Court didn’t look at this before the neighbors complained.
Facts: Threat of closure if the hotel didn’t sprinklers into the hotel
Chronological approach not used, and the sprinkler installation was determined to be a capital expenditure.
5. When you put Midland Empire together with Mt. Morris and Hotel Sulgrave, what do you get?
Hopelessly inconsistent situation, no way to predict.
In NY have to run and see what the 2nd Cir says, and because this is the court that will hear your appeal.
Tax court has a rule that even if they think the law is X, if they are in a situation where an appeal will be to
a particular circuit, then the tax court will look at the circuit’s law and they will follow it.
On the other hand, section 162 might not be all you have. For example, in Midland Empire, the taxpayer
also sought relief as a 165 loss. Loss should be measured by what it costs me to fix the basement—same
cost as the liner. Court didn’t reach this, because they went with 162.
6. 165 Loss Deductions
For loss deductions the question is, whether the physical damage to the basement is more like the
roof blowing off or is it more like the stock going down.
Get the loss all at once, just like a 162 deduction-yummy!
If you can’t get the 162 deduction try to make it into a 165 loss—shove it in the best box possible!
165 Requires that the loss be related to business or a profit seeking activity.
If roof of house blows off, this is not a deductible loss, unless you can fit into 165(c)(3), which is casualty,
there is a limitation for this loss—10% of gross income.
When looking at this as a loss, still have to run the gamut to try to figure out if this is a loss that falls under
Suppose the court, in Midland Empire, says we won’t allow you to expense this, and you say I want this to
be a 165 loss. You bought the property for 100, there’s a 5 of loss, and you get your deduction. Joyce says
this is what the court in Midland might be really doing, what that is really saying is that the taxpayer
doesn’t really care.
Suppose you are in a jurisdiction that is really friendly to Midland Empire, can you get the 162 and
o Casebook says NO. Joyce says YES.
o When the roof blows off, you are deducting the basis in the roof, you are deducting what you
paid. When the roof goes on, you are paying for the roof. So essentially, there are two
o This is not a double deduction, but despite this fact you may not get double.
o If you get one deduction, what happens to the basis in your property?
If you don’t get a 162& 165, your basis will have to stay the same.
If you get a 162&165, your basis will go down by 5( the amount of loss you claimed
Suppose you have a truck, and you are doing heavy construction, and the tires are always wearing out.
You’ll get the 162 expense for the tires, and a loss deduction under 165 for the truck.
In a proper case, go after 2 different deductions for two different outlays.
If you have a hotel Salvey situation, you may lose both deductions. In hotel salvey, your basis will increase
by whatever you put into the hotel. Basically, you will get a basis offset for what you put into the property
when you sell the property.
7. Really considering Expenses vs. Capital expenditures
RR 94-38: Environmental clean-up ruling.
If you take money and buy an asset, the asset has value and for you to deduct the asset is to pretend the
asset is gone, and this is to understate your income.
Here, the taxpayer has property with groundwater contamination. Taxpayer excavated the dirt and
disposed of the dirt and then replaced the dirt. Revenue ruling says that the way this dirt was replaced was
by backfilling (new dirt). Tax court calls this a 162 deduction. With respect to the groundwater they
company builds a treatment facility—this is a capital expenditure.
o What the hell is going on here?????
o This court took the midland empire approach, said that the new dirt didn’t prolong the useful life
or add to the value. This is more of a repair. But what about the treatment facilities—isn’t this the
o You are left with the impression that the reason the treatment facility isn’t deducted is because the
treasury saw pipes, physical structure! BUT there is new dirt!
Facilities won’t be gone in one year—this is really the only logical test, what we said ultimately in midland
empire, is that the courts are unwilling to apply this logical test because the costs of administering this test
is too much—would require a depreciation schedule for absolutely everything.
Facts: Company hires this guy to write a specific book. This isn’t really a tangible asset, it is about the creation of
intellectual property. Issue is whether the acquisition of the book is an expense or is it a capital expenditure.
This was held to be a capital expenditure.
Money they paid went to the author, and now the money they have is in the copyright for the book, they
purchased an asset.
Why is this case a big deal?
o What Posner is saying is that what everyone knows is that if the encyclopedia was produced in-
house, it would be deductible because it would be salary.
o Posner is trying to reconcile the oddness of the fact that you would be able to deduct in house, but
not out-house. Posner basically said, I’m looking at the outhouse situation, and when the in house
comes up, I’ll deal with it then.
Idaho Power: the taxpayer bought a truck for 20K, and the taxpayer said I know I can’t deduct the truck all at
once, but everyone knows that the way you get your outlay back is to get a depreciation deduction. Taxpayer
took 4K depreciation each year for 5 years. Taxpayer was making 50/year. Therefore, taxpayer was being
taxed on 46 each year for 5 years.
Supreme court said, you get nothing!
In Idaho power, as part of their business they were conducting transmission facilities (electricity),
these were built in-house, and to that end they bought trucks. No deduction for the trucks or the salary
because at the end of the year, the truck and the salary had turned into transmission facility.
So what happens is that the truck and the salary are capitalized—which means that they become part
7. 263A-- If the item is going towards producing other income, then you can’t depreciate it.
Luckily, 263A was passed by Congress which said, that for in-house operations, you should follow Idaho
power. Therefore, that means you have to capitalize the direct and indirect costs of manufacturing items.
Costs are capitalized or added to basis.
This means that part of the salary of the janitor in an auto factor goes into the basis of the auto.
Additional notion that it is important to remember, the underlying principle of determining capital expense
from expenses is true not only with respect to repair and replace, but also it is true with respect to
depreciation deductions and other aspects.
Suppose you buy a truck, and then you rent the trucks out. No deduction for the cost of the truck, when
you rent the truck, you will deduct the cost of truck over the period in which it is wearing out.
If you don’t rent the truck, but rather use the truck to build something, then you can’t depreciate the truck
because the truck is not being turned into something that you have to account for gross income. If the item
is going towards producing other income, then you can’t depreciate it.
If a guy owns a pizza place and he has a delivery truck, but he is also going to use the truck to build an
addition, what does he do? He depreciates half the truck.
This does create some accounting issues, but you don’t have to account for every light bulb—that’s
Midland, that’s repair and replace.
This statute has exceptions and applies to business that are making lots of money.
108(f)—Student Loan Forgiveness
127—Educational assistance for employees
135-US Savings Bonds
25A-Life time learning and the Hope Credit
8. Lawyer’s fees
A. Basics: Business Legal Fees
An individual may deduct legal fees that are incurred in a trade or business or related to the production of
income under §162 or §212 (expenses for the production of income).
Legal fees incurred in a business context must be capitalized, however, if they are incurred in connection
with the acquisition of property that has a useful life extending beyond the close of the year in which the
legal expense is incurred.
Expenses that create long-term benefits are required to be capitalized (INDOPCO).
Facts: Corporation is merging with another and wants to deduct legal expenses associated with the merger.
Expenses that create long-term benefits are required to be capitalized.
B. Personal Legal Fees
Case law gives this weird test that says that some personal legal fees, if they have their origin in a 212 type
scenario, can be deducted—“origin” test.
According to KT: origin test if fucking useless.
Facts: Fees for a divorce case.
Since the court found that the expense was personal, the question of whether the expense was capital or not
was never reached.
If the court had taken up this question, then this would have been a deemed a capital expense—because it
involved the defense of income producing property that has a life longer than one year.
What the court should have done was to say that this expense had to be capitalized or added to basis.
The Supreme Court could have taken the easier question, which would have been what is capital?
Instead the court took up the question of what is business vs. personal and screwed it up..
Lower court said that 80% of your legal fees were to protect your business interests, but the SC said that
these expenses arose out of your divorce. Therefore, sorry Charlie.
Court says that there are two personalities of taxpayers: profit seeker, and the family person. Problem, as
far as Joyce sees it, is that Gilmore was a profit seeker.
The case has been swept aside, and the only place you now see it is casebooks.
C. What does Gilmore mean in terms of advising a client?
Really, Gilmore doesn’t mean much, what you look at is whether the expenditure is capital.
Therefore, Joyce says that Gilmore was right for the wrong reasons.
Suppose Joyce loans his son some money (this is a real loan). Joyce charges interest and his son defaults
on the interest. Joyce sues for the interest, and pays the lawyer 50. Can Joyce deduct the 50? Yes.
Suppose that in connection with this divorce, Joyce negotiates an alimony agreement. If it’s alimony, by
the meaning of the statute, Joyce’s wife has to include it in her income. Now, Joyce doesn’t pay the $ in
the time he’s supposed to. Wife gets a lawyer, can she deduct this? Yes. The Regs say so, even though
8. The important steps of Analysis
First, ask was this a capital expenditure or an expense. If this is a expense deduct it all NOW, if this is an
What this says is that you can’t deduct it all at once.
The next question is, can I do anything with it?
The answer is usually that you add it to the basis of an item.
The next question is what can I do with my basis? This is a very crucial question.
o Offset gain
o Increases basis
o Take a depreciation
Suppose that T operates a business on Blackacre, and T has an employee X who drives a truck. In
connection with the business X runs someone over. The person who is run over sues in tort. Person who
sues in tort is looking for $ from the D. This $ will come from the business, and if there is not enough cash
in the business, the business will have to be sold. In a real sense, when a lawyer defends against someone
suing for damages, what is really being defended is title.
o Isn’t this to say that you are hiring the lawyer to keep your property, and the benefit of that is
going to be there for a very long time. If you follow this line of reasoning, even though this is
business related, it should be capitalized.
o Problem here is that if the expense is capitalized, then you should add the fees to the basis. But
the basis of what?????? It would be impossible to allocate.
As a practical matter, this will be an expense, even though logically it should be capitalized.
Courts said that in this situation the lawyer’s fee will be an expense, and we will allow the distortion.
Therefore, the rule will be: that for costs that are unambiguously associated with the defense of a
particular asset, then the expense will have to be capitalized.
A. The basics: When is education deductible?
If the education maintains or improves skills by the individual in his trade or business or
Meets express requirements of the individual’s employer or legal requirements imposed by applicable law
or regulations as a condition of doing work of the type performed by the taxpayer.
B. What is not deductible for education
Educational expenses incurred to meet the minimum education requirements of a new trade or business.
This means most of the time law school tuition and most college tuition will not be deductible.
C. Buzz words of education that will indicate a deduction:
maintain, sharpen, enhance skills, required.
D. Problem of Education and the Remedies Available in the Code.
Exclusions: student loan forgiveness, educational assistance, and US savings bonds
Deductions: interest on student loans, hope and lifetime learning credit.
Educational Savings Account
Facts: guy gets assigned to work in CA. He tries to deduct the cost of the bar review course in CA.
Court said this is a new trade or business.
This is the 9th Cir., so who knows what the 2nd would say.
What a new trade or business is, is a concept that Joyce says is a sometime thing.
Hypo: Person who graduates from law school, gets a job with a firm, and then the firm says you should get an
Joyce says go for it!
Hypo: Person passes the bar, has a job, quits the job and now pursues an LLM. Deductible?
There is an additional line of cases that requires that in order for a person to take an educational deduction
she needs to be in an established business.
Be on the lookout for the court to say that you are not already in a business.
10. Start up costs
Start-up costs: courts would say you can’t deduct your start up costs, but what you can do with start up
costs is capitalize them!
197: Congress overrides the above, and does allow some start-up costs to be amortized over five years.
11. Goodwill deductions
A. The Basics
Is always a capital expenditure.
197 lets you amortize good will over 15 years.
Welsh v. Helvering
Facts: Person is working for employer. Employer went out of business, person decides that he will pay off the debts
of the employer to protect his reputation.
Only SC case that has taken the word “ordinary” in 162 and tried to interpret it.
Focus in this case was on the word “ordinary”—Joyce says, don’t bother with this crap, the real question is
whether this is a capital expenditure.
Question the court focused on was whether it was common for the business to make this type of outlay.
Most people say that Cardozo was off his rocker, and that extraordinary means capital!!!!
Much like the educational expenses, the goodwill outlays that were present in Welch gave rise to the
problem of once you add the basis to yourself, how do you get the $ back. Response to this was very
unsatisfactory: when we come to this problem in connection with depreciation both education and goodwill
don’t wear out and therefore they can’t be depreciated. .
1. The Basics
Depreciation is a way to recover COST, not VALUE.
Once you have capitalized an expenditure into an asset (if you’ve managed to do so in the first place, and
remember that just cause it’s a capital expenditure doesn’t mean there is going to be a way to get it back; at
least not always be depreciation).
CRUCIAL POINT: to depreciate the asset MUST be a wasting asset.
Definition of wasting asset: one that’s used for the production of revenues, and has a useful life beyond a
single tax year, but the value of which is going to be wasted over the course of its useful life.
Why use depreciation: if you were allowed a deduction in the year of purchase you would be understating
your income, but if you waited and took the deduction in the year of the scrap, you’d wind up overstating
Depreciation on an intangible is called amortization.
Land is not considered a wasting asset, but the building on the land will be.
2. How the hell does depreciation work?
You allocate a portion of the cost to each year of use—or really under MACRS, for the recovery period
applicable to the category of asset you possess.
Under MACRS the salvage value is presumed to be zero, and the recovery period you’re given is usually
much shorter than the actual life of the asset.
Idea is that if you get a deduction in excess of anticipated decline, you will be more likely to invest.
MACRS gives huge depreciation deductions in the early years of ownership.
What you get for depreciation doesn’t have any correlation with what you make on the asset.
3. Effect of Depreciation on Basis
You adjust basis downward as you depreciate.
Because you are adjusting basis downward and depreciation rates are so favorable it is very likely you are
going to have some gain when you dispose of the asset (assuming it is done in a recognizable way)
Gain or loss will be reported when you sell the asset.
§167 says that for depreciable property used in a trade or business you reduce your basis as the asset
depreciates whether or not you actually take the depreciation deduction!
4. Section 179 of the Code
For tangible personal property, up to 24K, you can deduct the full cost of the item in the year you paid it.
179 is elective
This means that under 179 you can expense certain capital items.
If you elect and 179 is elective, when you take it, you get the deduction and then under the 5 year
depreciation it treats you as if you paid 11, for the 35K truck
In the first year you would get the 24K, plus the 11 depreciated.
This is a stimulating incentive, nothing to do with true economic gain.
I. The Basics
Really this is a §61 question
Attempts to escape the progressivity of the rates by getting as many starts at the bottom of the brackets as
Used really in intra-family stuff, since the function of the family as a single economic unit, in many
respects, invites taxpayers to try to avoid the principle in our system that our tax structure is based on:
namely that individuals are separate taxable units.
Basic Concept divides into two prongs:
o Splitting income from personal services
o Splitting income from property.
II. Splitting Income from personal Services
1. The basics
Attempts to do this are almost always unsuccessful, the opposite is true for property. With property you
can do it, unless you screw it up.
He who earns and could have received the money for his services cannot voluntarily and gratuitously
assign it! (Lucas v. Earl)
If you could have negotiated for receipt of the money due for your services, then you could have got it, and
so we are going to tax your ass on it. (armantrout)
Most likely it has to be legally impossible for you to receive the income from your services if the court is
going to allow you to shift income.
Lucas v. Earl—Moot because of advent of joint return
Facts: Husband earns money outside home, wife does not. H and W make an agreement that is enforceable under
CA law that the W will get half the H’s income. The wife reports half the income and the H reports half.
Commisioner says that all income should be reported by the H.
Court says that you can’t try to skirt the tax you are going to pay by using anticipatory arrangements.
Statute says nothing about anticipatory arrangements, but the court thinks that what the statute means.
Court says that salaries attach to those who earn them, he who earns pays the tax. This is the basic reason
why you can’t shift personal service income—bed rock!
But we know about Lobue—you tax the person who has gain!
If you look at this with Lobue eyes you come out the other way, what this case does is reject Lobue.
Lucas is still applicable to nonmarried persons arrangements: ie parents and children and same sex
Rule of Lucas: person who earned the income will be taxed!
The idea behind all this is the idea that Mr. Earl is being taxed on what he could have gotten.
Notion of earning: what you could have gotten.
Facts: Company has a college tuition payment plan that is generated by employees. The deal was you come to work
for us, and this is the plan that we have in place.
Court says that when tuition payments are made this is income.
The problem is that people could have gotten this. This is the ghost of Earl.
Could the employee say that she didn’t want to get this deal?
o Unclear from the opinion, but the court says that there is no evidence that the petitioners were
unable to bargain to be removed from this plan.
o Court basically says we are unwilling to get into the thicket of all this.
What this case seems to mean that when part of the money you generate ends up going to someone
in your family, that we will presume that you could have bargained to get the money yourself and
therefore you are within Lucas v. Earl.
Court had to cite §83. Section 83 seems to codify Lucas v. Earl.
Section 83: if in connection with the performance of services, property is transferred to any person other
than the person for whom such services are performed the excess of--…shall be included in the gross
income of the person who performed such services.
Section 83 assumes that you could have gotten the money yourself.
2. What about Mrs. Earl after Lucas v. Earl, what about the children in Armoutraud?
Mrs. Earl under Lobue has gain, as do the kids in Armoutraud, but Joyce says…
The fact that Mr. Earl and presumptively the parents could have gotten the money themselves means that
we will say that though the earner, who is taxed, in fact got it, and then turned around and gave it to the
Treat this as if there was never any agreement, and no plan.
So, he counts 100% and gives her half, and then because this is a duberstein gift, she excludes it under
3. Can you get away with shifting personal service income?
Do your work for nothing, gratuitous services.
When you do volunteer work, Joyce pouring beer, this really is shifting income.
Suppose you have a charity paid instead of you…this is really income splitting, the real problem is whether
you can deduct this when you have it paid to the charity. Issue is whether or not you are an agent for the
charity. This really is more about the charitable contributions requirement.
Suppose a professor is working for a law school and he handles cases for the clinic. Clients pay, but
professor turns over all money to law school. Revenue ruling says no because in some ways they are
saying he is working for nothing. Really this is the wash principle in action.
Lucas is the paradigm and NOT Lobue.
4. Family Partnerships
Child who just passed the bar. I am an established lawyer and child comes on. Deal with child is 50/50.
This is skirting with Lucas and Earl danger.
Same thing with Corporations. If you hire own kid and pay her, this could be seen as just trying to get
III. Splitting Income from Property
1. The basics
Property falls under the Lobue paradigm.
Income from property will be successfully shifted if the assignor assigns a chronologically conterminous
slice of her interest to the assignee. This is referred to as a horizontal interest. An interest is called a
horizontal interest because the donee’s interest in the property extends as far in time as the donor’s interest
in the property did or if this is a partial donation, as far in time as the owner’s interest does.
Said another way, you can successfully shift income by a transfer of part of the property so long as the
interest you transfer it chronologically coterminous with the interest you retain.
Basically, you make the transfer, the donee receives it as a gift, but once the donee receives it, whatever
income the donee gets is taxable to the donee!
Do a Blair, not a horst!
2. How to mess up splitting income from property.
Bottom line: if you are the donor, don’t be a jack ass and retain the reversion.
Giving away the right to income in advance of payment is not transferring “ownership.” Even if you give
away ownership in the sense that you give an interest outright, or a good horizontal slice, you still have to
be sure that income is not so close to payable at the time of the transfer that you have already effectively
Blair v. commish
Facts: Father was a beneficiary of a trust and at a certain point he assigned to his daughter an interest underwhich
she would get 6k for the remainder of the year, and then 9k every after as long as he was getting the income.
This case says that we accept Lobue, the person who is benefited by the income, because it is theirs to do
with as they wish, they are taxed.
Just because someone could have benefited this doesn’t mean they are taxed.
Court here said that Lucas v. Earl is confined to personal service income.
The court says in this case there is no question of evasion—Joyce says this is just not true!!!!!
Basic idea is that you can shift income with property, the problems come in when people fuck shit up.
3. What does it mean when you say you can shift income from property?
Easy one is Joyce shifting property to me as a rental.
4. What happens when Joyce says I don’t give you blackacre, but I give you the right to the rent.
You can’t do this, you haven’t done the right dance, haven’t shifted the right way.
The right to the rent..Joyce will be taxed, just as if this as personal service income.
Facts: Guy gives detachable interest income coupons to his daughter. He doesn’t give her the entire bond.
Court here says no, you will remain taxed on the interest.
Taxpayer argues Blair to no avail.
Court talks about this as being a gift of income, rather than a gift of income producing property, taxpayer
didn’t shift in the right way.
If you give the income, but not the income producing property then we will treat you the same as Lucas v.
Idea is that the basis stays in the fee simple, we are considered to own that.
5. Partial transfer of property-
Suppose Joyce has 100 shares of stock and each share of stock is worth 10. Joyce keeps all shares and says
I’ll give you the right to the dividend for a year.
o Joyce gets taxed on the dividend. Suppose Joyce transfers one share to me, who gets taxed on the
Suppose Joyce transfers 1/10 of blackacre, and you get 1/10 of the rent. You are taxed on the 1/10—double
check with Joyce.
6. Be careful about time.
Giving away the right to income in advance of payment is not transferring “ownership.” Even if you give
away ownership in the sense that you give an interest outright, or a good horizontal slice, you still have to
be sure that income is not so close to payable at the time of the transfer that you have already effectively
Suppose for example, with blackacre the rent is paid by the year. One December 30, Joyce comes to me and gives
me everything. He retains nothing.
Joyce will pay the tax, too late to do a Blair.
Have to do a Blair before the income is earned. Give away a slice before the income is earned.
Woman inherited a gas station from her husband. She wanted to give the proceeds of the sale to her kids.
She split the proceeds after the K was signed—too late to shift. If you have any idea you are going to sell,
split first, sell later.
7. Kiddie Tax
If you have done a Blair the right way, and it wasn’t too late, you are still not off the hook if the kid is
under 14. You get the kiddie tax, and that provides that for a certain amount of unearned income of a child
under 14 is taxed at the rate of the child’s parents. Says that there are no Blairs for kids under 14.
8. Is it income from property or is it income from personal services? (basically, can you shift or not?)
Services transformed into property: May be possible to do this, didn’t work in Eubank, worked in Heim v.
Helvering v. Eubank
Facts: Guy was an insurance salesman and by virtue of the sale of those policies, he received right to a commission
when people renewed the policy. He transferred right to the commission to family members.
court said that he was to be taxed, not the family members.
Could say this is a simple case, this is Lucas v. Earl.
The majority doesn’t rely on Lucas v. Earl, instead they rely on Horst. Horst is a property case.
Really the court should have used Lucas v. Earl.
Basically, what this case stands for is that you can’t transfer income received AFTER services are
When you put Lucas and Eubank together what you get is that the reason you can’t shift is because it’s
personal service, doesn’t matter if it’s before or after.
Eubank, only a right to get paid—too amorphous for the Supreme Court
Heim v. Fitzpatrick
Facts: Transfer of a patent from a man to his kids.
Court holds that the one who holds the patent is taxed, not the guy who originally took out the patent and
Now, you have transformed your personal services to property. Now you are outside of Lucas and Eubank.
If you have made your personal services into property, then you can transfer the property and the one who
receives the property will be taxed and the income will be shifted successfully.
Heim gets you out of Lucas because you have something you can see and touch.
Heim is flirting with Horst danger in this case because he at first keeps a reversion, but then he transfers all
his rights, including the reversion.
Still have to worry about the kiddie tax. Kiddie tax applies even if it is not the parent who gives the gift.
The kiddie tax cuts through the distinction between personal service income, and property income.
9. Bottom line of income shifting
You’ve got to do the right dance.
First, make sure you’re not shifting income from personal services, figure out a way to transform those
services into property.
Second, now worry about Horst, did you retain a reversion? If you did, you’re fucked, if you didn’t okay,
Third, make sure your timing is okay, make sure you aren’t doing stuff too late.
Joyce says that it’s crap that you if you create a right to be paid you can’t shift, but if create a right to a
house or a copyright you suddenly can shift.
This is crap to Joyce.
If you have a book/copyright/patent issue, now worry about Horst
Don’t keep the reversion, watch out for this, if you keep the reversion you’re screwed.
Some cases say that if you write a book, then get the rights under the K for the sale of the property and
transfer, then this is okay. Other cases hold the opposite, and say that it is too late.
Cleanest way, get rid of the copyright or the patent before you earn anything.
Trusts are arrangements by which people shift the equitable ownership and legal title. Trustee has to act to
the property for the benefit of the beneificaries. The beneficiaries don’t do anything.
Code says that there are true trusts and grantor trusts.
True trusts: if you give up all your rights, the person who sets up the trust, has given away sufficient
interest not to be taxed.
Grantor Trust: grantor has retained certain rights or interests then it is as if the trust has never existed, the
grantor is taxed. This is like Horst.
Congress: specific provisions are enacted to cover trusts, this is because people who practice trusts work
want to know exactly who is going to paying the tax on the trust.
III. The Joint Return
1. The Basics
H and W can split their income, regardless of where they live.
The real benefit to the joint return is enjoyed by people who have high incomes who marry people with low
or no income.
See the Joyce handout.
Facts: WA community property state. Income from personal services and property.
Court holds that since this is community property state, both H and W own half, and therefore, each should
only be taxed on half.
This court takes a Lobue approach, and asks who is entitled to the income? Not, how did they get the
This resulted in a disparity between how married couples were taxed in common law and community
This results in the 1948 Joint Return.
The real benefit to the joint return is enjoyed by people who have high incomes who marry people with low
or no income.
2. Marriage Penalty
People who are exactly even, get the marriage penalty.
People who are exactly disparate get the marriage bonus.
Because we have progressive system, there is a break point where no penalty or bonus. Whether the couple
is married or single, the will all pay the same rate.
More penalty than marriage bonus.
IV. Alimony Provisions
1. The Basics
§71 and §215 are complimentary provisions to let you continue the income splitting you’re allowed in
marriage after divorce.
Alimony is an above the line deduction. Deduction from gross to adjusted gross income.
§71 requires that alimony be included in the income of the person who gets it, and §215 says that if
alimony has to be included by the payee, then the payor has to deduct.
Therefore, the question of what is includable and what is deductible is all about what is includible.
Just because this is an income splitting arrangement, this doesn’t mean that the person who is paying has to
have income. Alimony is deductible even if it is wasted. This can then result in an inclusion and no
Code §71(b) allows the party to agree that something that would be alimony won’t be includable and
deductible. This won’t go the other way.
Child Support and property settlements are not taxable to the payee nor deductible by the payor.
2. §71 Alimony Requirements: These are bedrock! Doesn’t matter what the intention of the parties is.
Payment must be in cash
o Payment can be made to another party on behalf of the payee, remember the life insurance
Must be received pursuant to a written “instrument” of divorce or separate maintenance, oral agreements
are no good.
Parties must have agreed to the 71/215 scheme.
Parties must not be members of the same household.
Payments cannot continue after the death of the payee (the one receiving the cash) spouse.
o Watch out for stuff like life insurance, would just continue for the life of the payee, watch for stuff
that looks like a life estate.
Payments must not be for child support—any payments that end when a child dies or turns a certain age
will be characterized as child support.
Payments should be roughly equal for the first 3 years.
3. Problems on Page 375
A. Problem 1: Alimony agreements must be in writing.
Even if alimony agreement isn’t in writing, does the person have to include this in his or her income?
o Under 61 the SC has said that support payments in the context of family are not includable as
income. Therefore, he gets to exclude and she can’t deduct.
o Unless this is a payment that is valid under §71 the payor will not be able to deduct.
o Alimony payments will not be considered income under §61. Really this is a question of 71 or 61.
B. Problem 2: Problem of frontloading the payments-§71(f)
For the first year, the whole 60 is included and deducted. Same thing in the second, but in the third year it
all goes to shit because of 71(f)
71(f) says that we don’t want this alimony to be a property settlement, and if you are trying to disguise a
property settlement as alimony, we’ll get you in the third year.
Congress is concerned that people will front load and will allow people to disguise a property settlement.
Why does this matter? Alimony is really about people being allowed to continue to file a joint return.
Front loading provision of 71(f), prevents people from making property settlements into alimony payments.
71(f): will require the payor to include, as income, the amount of excess alimony that is really a property
settlement. Payee will then get a deduction, because he has been including this in his income the whole
time. Payee’s deduction will be an above the line deduction.
The hammer comes down in year 3 and 71(f) is designed to tell you how big the hammer is.
One of the problems of 71(f): the reason that the H paid, 60, 60, 5, might be that he only had that money.
The problem is that people generally don’t plan on getting screwed by 71(f). Also, the one who gets to
deduct the big deduction in year 3 may not have the income to make the deduction really valuable.
71(f): don’t front load, order the way you set this up.
Don’t want the alimony lookin’ like a property settlement.
C. Problem 3: Alimony payments cannot continue after the death of the payee spouse. 71(b)(1)(D)
This provision is like the front loading and is designed to prevent deductions and inclusions for what is
really a property settlement.
IF there is a requirement beyond the death of the payee, the Congress says that can’t be support.
Remember the problem says that if Wanda dies after 4 years, what about the first two years of the
If there is any liability for any period, then the payments that are made are not alimony. The fact that it was
paid during life to the payee is irrelevant, what is relevant is that there was liability to Fred.
None of these payments can be alimony.
What does it mean if this is not alimony?
o Neither Wanda includes, nor does Manuel deduct.
1041 not implicated, the decision that intrafamily payments that look like alimony are not included in
income comes from caselaw.
71(b)(1)(d): applies where you can find authority that says under state law that if the payee dies, the payor
is still required to make the payment.
D. Insurance Policy Payment Instead of Cash
Manuel is required to pay for an insurance policy on Wanda’s life, with Fred as the beneficiary.
o 71(d)(1)(b): doesn’t apply because it only is valid for Wanda’s life.
o But the alimony payment must be in cash. Alimony must be a cash payment.
o Is the insurance policy cash? statute also says that if the cash is paid on behalf of someone, so the
cash can be converted into other things such as a life insurance policy.
o Wanda could specify that someone else receive the payment.
Life insurance is weird, in order for the payments to be considered to be made to Wanda, she has to be the
owner of the policy: right to change the beneficiary, right to borrow on the policy, to get the cash surrender
value of the policy.
If Wanda is the owner of the policy this can be considered to be alimony.
BUT, if Wanda is living in Manuel’s house and this is mortage insurance, this would not be alimony
because the payments wouldn’t be made on Wanda’s behalf.
If this is a payment made on an insurance policy that is on the H’s life, but the W is the beneficiary this
will be considered a cash payment.
If the life insurance is considered a cash payment and it is alimony, it will be deductible by him, and it will
be includable by her.
What about Fred? Fred will have income under 61, unless he has an exclusion. Fred’s only shot is to
weave this gift through Wanda’s estate, get this as a §102 bequest.
D. Problem 4: Don’t want your alimony lookin’ like child support.
A payment called alimony, but that terminantes when a child dies or reaches 18 will be treated as child
In this problem there is no fixing by implication, under the prior law, this type of provision will be
considered alimony, but now with 71(c)(2): fixing is defined.
Fixing defined: if there is a reduction of an amount otherwise payable on the happening on a contingency
relating to the child, shall be treated as fixed for child support and therefore not alimony.
In this case there is a fixing and it will therefore the 40K/year will not be considered alimony—from the
outset, this is a tainting provision.
If the reduction says, that upon X’s death 10K will be reduced, then the 30K will be alimony.
D. Problem 5: Stock payment Instead of cash
Stock instead of cash payment.
The payment must be made in cash, if he takes this stock the payment is not cash.
Say that W says to H, give me 10K and then turn around and give me the 10K back, and I will give you the
stock—is this okay? This problem is similar to Jordan Marsh. Agreement where I transfer cash to Sheryl
and she transfers the cash back to me, then there is no transfer at all. Therefore, all that is transferred in this
instance is the stock and that is no good.
Assume that this stock is a cash payment that is alimony and therefore, is includable by him and deductible
Remember 1041 and the basis stuff.
If you respect the transaction under 71, then you have to also respect 1041.
1041: there would be no gain to her, the one who gave the property in this instance (gain for paying off the
debt to him). The transferee will take the basis of the tranferor.
She would have no recognized gain and he would have the stock with a basis of $1,000.
1. The Basics
Alimony deductions are not personal, rather they are income splitting deductions
Alimony is taken in addition to the standard deduction.
Business expenses are allowed in addition to the standard deduction.
Personal exemption is allowed in addition to the standard deduction.
Alimony is personal in the sense that it is not business—not profit making, but also not personal in the
sense of the way the other deductions are described.
2. Analysis Basics
Essentially our steps of analysis are: what is gross income, what’s recognized, what’s deducted.
Pattern of deduction: only get a deduction for producing income and no deduction for personal or living
Personal deductions: pattern says you can’t deduct these expenses now or later, but there are some
exceptions even tho these are strictly personal.
3. §63 A vs. §63B
This is figuring out whether a taxpayer is better of itemizing her personal deductions or taking the standard
To make this determination:
o First, Take the taxpayers gross income and subtract “business” expenses (these will be your §62
deductions, depreciation, and alimony)
o Now you have your adjusted gross income or AGI
o Now add up the personal deductions, if the personal exceed the standard deduction the taxpayer
will opt to go with §63A, if the deductions are less than or equal to the standard deduction, then
the taxpayer will select §63B.
o After the taxpayer has made the 63 A or B decision, the taxpayer will now take her personal
4. §67-2% Floor—Miscellaneous Itemized Deductions
This section states that the miscellaneous itemized deductions for any taxable year shall be allowed only to
the extent that the aggregate of such deductions exceeds 2% of adjusted gross income.
5. Specific Deductions
A. Medical Deductions
Amounts that are not insured.
To be deductible the amount of the expenses has to exceed 7.5% of AGI.
B. Casualty and Theft
Loss must be more than 10% of AGI.
C. Interest Paid on a Home Mortgage/Business Interest
This is the biggee and is what will make people decide to itemize.
Interest that we are talking about is personal interest—this is not business interest.
Business interest is deducted and is done so when you are calculating adjusted gross.
Personal interest is home mortage interest, etc. and unless congress singled it out this would not be
Suppose that a person has 20K in the bank, and wants to buy a business truck and a personal auto, each one
costs 20K. He can’t buy both with 20K he has in the bank. Suppose he buys the business truck and then he
borrows money and then buys the personal auto with the money?
o Auto can’t be deducted, unless it is transmuted by using a home equity.
o Auto can’t be deducted unless it is made into mortgage interest. 2 types of mortgage interest:
Acquisition and improvement mortgage, with a limitation of 1 million.
100K that is not acquisition, that you can use the borrowed money for anything and the
only thing you have to do to make this money home interest is to make the home security
o If you have house worth 1.5mill, that you bought for 1mill and financed the whole thing, the
interest will be fully deductible, now the property goes to 1.5 so there is 500K equity you can
borrow up to 100k and you can use the money for anything you want…including buying the
Now suppose he takes the 20K buys the car, and then borrows and buys the truck. Now, he gets the
deduction on the interest on the money he borrowed to get the truck because it is business interest.
Whether interest will be deductible depends on what you used the money you borrowed for…it is
D. Charitable Deduction
You can only deduct contributions of property, services are not considered property. Blood donation is
o Policy: if you donate your services, what you are really doing is splitting income and you are
getting a break cause we’re not making you include it in your income.
Stock worth 3000, with a basis of 500, this is a fully deductible deduction. You get a deduction of 3K even
though you report none of the gain in your income. This allows a benefit of 5500 because you never pay
tax on the gain and you get to deduct the entire 3K, this is a biggeee!
Must donate to an organization—can’t donate to the needy Jones family.
Property Donated: Distinguishing among types of property. In example, the donated property is stock,
purchased in 1995 for $500, now FMV is 3K. All other things being equal this would be long term capital
gain property, and under the Rules of §170 this is treated as if you gave cash. There is a 30% limitation,
here. Important thing here is that this is treated as cash. You get a 3K deduction, and you don’t pay tax on
any of the gain. If you had bought the stock, less than a year ago, then this is not long-term capital gain
property, would be short –term, and the only deduction you would have would be the basis in the stock, not
it’s FMV at the time of donation.
If Joyce gives a painting to the redcross, with a basis of 500 that he has owned for 1 year, this is long-term
capital gain tangible personal property, redcross won’t use this property in its operation. If you give the
painting to the redcross you just get the basis, don’t get the FMV.
Best thing to give: stock that has appreciated that you have held for more than a year.
Transfering stock to UB, but retain a life estate in the dividends. Can’t do this because what people were
doing was putting stock in trust and saying to the trustee, pay me the income, and then give the stock to
charity, and wink wink, invest in really risky stuff so I will get lots of income, and the charity may end up
with nothin’. Congress said this was an abuse. What you need to do is a charitable remainder trust—very
7. Tax Preparation Fee—Example of Unremibursed Employee Expenses which is a miscellaneous deduction.
Miscellaneous itemized deduction governed by §67.
Itemized deductions are deductions governed by something other than §63.
Miscellaenous deductions have the 2% floor.
8. Miscellaneous deductions: most important is unreimbursed employee expenses.
§62 excludes employee expenses,
To figure out if you can take the miscellaneous deductions add up all the miscelleanous deductions and if,
in total, the figure is not greater than 2% of your income, you can’t get it.
If you buy stuff as an independent contractor you go right from gross to adjusted gross under §62.
Other big category: §212 deductions. Distinction between business and profit seeking, even for non-
Facts: Guy’s payment of 98K to lawyers in connection to recover $$ for age discrimination. This will be considered
a miscellaneous itemized deduction under §67 and will be subject to the 2% floor. He gets less of a deduction. He
deducts only the extent to which the 98K exceeds his 2% income from that year
Commissioner says is that you received 230K in the settlement, and you can deduct the 98K, but you have
to be subject to the 2% floor.
Posner agrees with the commissioner.
Lobue says that income is gain. Therefore, when Posner says that the taxpayer has $100 at a cost in
generating that income of 25, he has a gross income of 100 and a deduction of 25, yielding a taxable
income of 75. Really this is a fuck up because gross-income requires income, look at what the gain is, the
gain is 75, and that is the gross income. 75 is all the person ever got, that is all the gain the person
Remember income is not gross receipts—it’s gross receipts less what you paid to make that much.
Problem that exists: the statute talks in terms of moving from gross income to adjusted gross income in
§62, and moving from adjusted gross income to taxable income in §63. Still does this methodology of
what is my gross income and what are my deductions, this is okay as long as you don’t have more taxable
income than you have gain. When you have a 2% floor you are being taxed on more than your gain.
Alternative, because the constitutional problem is so tough, is to figure out a way around this problem.
Don’t want it to look like you are paying fees to get income, this puts you right into gross income minus
deductions and that gives you the 2% problem.
This fight is really Jordan Marsh: is the structure of the transaction going to be allowed to get around
what the result would be if the transaction was structured differently, even if the result is the same.
Posner says that a contingent fee is not an assignment , no ownership of the client’s claim.
Problem is that we are now right back to Lucas v. Earl—this is shifting income, person is trying to collect
what is salary if he hadn’t been discriminated against because of his age. Can’t assign a personal service
Blair, Horst, etc. is designed to prevent people from shifting income, attempt to shift income from higher
bracket taxpayers to lower. These are all about gratuitous shifts. Assignment of income in these cases
makes sense only as attempts by the judges to say we are going to shore up the progressive rate structure.
Blair, Horst, etc. has nothing to do with selling your income!!!!!! These splitting of income cases are not
about selling your income.
Kenseth has nothing to do with Lucas v. Earl, that case dealt with an assignment of income means
Here Kenseth is really selling 60% of the claim in return for the services (see Davis). This is the same as if
he had sold the claim on the market and then paid the attorney (but that raises other issues in §67, 68).
Kenseth has to do with whether you can get around 2% by structuring the transaction like this.
Joyce says this is Jordan Marsh, Posner fucked up.
Say Kenseth sells the $230k claim to the lawfirm for $140k.
- How does Kenseth treat the 140k that he gets? 140 will be gross income, his basis will be 0 because the
claim came from his services (lost wages fro age discrimination)
- 140 would be the lawfirms basis in the claim that they bought, if they sold it for $230, tax on 90k
- Will this get by Posner?
Alternative Minimum Tax
Alternative Min tax is: in addition to the basic minimum income tax
basically there are certain preferences in the code, and if big riches take advantage of all these preferences
they could end up paying nada and that’s uncool.
If we adjust the base of the tax, take away some of the preferences, if you are still over we will make you
pay some tax,even if you wouldn’t’ have to pay. One of the adjustments is that the misc. itemized
deductions is not present at all. Therefore, Kenseth lost 98K deduction.
If you have too much gross income, and therefore, too much adjusted gross income, you start to lose your
1. The Basics
Capital gains and losses is a direct consequence of Eisner v. Macomber—requirement of realization and
If, with stocks we didn’t have unrealized appreciation and all the gain was taken into account as we went
along, we wouldn’t have to deal with all this capital gain stuff—we would be realizing and recognizing the
gain as we went along.
We give capital gains breaks to remove deterent to sell (Corn Products)
Most capital gains will be in: real estate, stock, and bonds—this preference will usually be at 20%.
Gain has to be realized and recognized, if you have a realized gain that is not recognized, don’t worry about
Capital gain is not required to be a business interest.
2. Basics of Capital Gain
Whether this is short term or long term capital gain this is 100% part of your gross income, preference is
not given in terms of an exclusion for gross income. Capital gain is just as much gross income as anything
3. Basics and Methodology of Capital Losses
The capital losses are fully deductible under 165 and 1211 and are 62 deductions. Capital losses are fully
deductible as long as they are realized, recognized, deductible (profit seeking), and allowable (1211).
Deductions for losses is governed by 165. Therefore, only get deductions for capital losses that are in
connection with business or profit seeking (stock would be considered profit seeking).
o Example: Personal residence: Bought for 100, but sold for 95: no capital deduction for this
because it is not deductible because it is not profit seeking. To get a deduction have to get in the
profit seeking box. Opposite for gain on the residence, this will get capital gain treatment.
Allowability (1211): you can deduct all of your otherwise permissible capital losses up to the amount of
capital gains +3K of ordinary income. Restriction on the deduction of capital losses. Gain doesn’t matter
if it is long term or short term. This is section 1211.
4. Methodology of Capital Gain
Preference only to long term gain (property held for more than a year)
Short term gain is considered ordinary income.
Long term capital gain process: first net out all the net capital gain. Net long term gain is net long term
gain minus net short term loss.
Notice that the adjusted gross income doesn’t change by the amount that is the capital income.
You put all your capital gains in gross income, and then you deduct all your losses (don’t care if they are
short term or long term)—won’t see the preferential treatment until you figure out taxable income.
Capital gains preference is a rate preference.
5. What happens if you have more capital loss than gain?
You know there will be no preferential capital gain treatment.
Also look to see if there is enough capital gain to deduct from—if losses exceed gain and you reach the 3K
max of ordinary income you have a carryover.
When offsetting capital gain income you are losing the preference.
Losses can be really useful to deduct ordinary income—best scenario is to have a situation with no capital
gain and have a capital loss—then you take it out of ordinary income and you will get a carryover if the
loss exceeds 3K.
6. 1221: Defining a Capital Asset
For capital gain/loss to be an issue there has to be the sale or exchange of a capital asset.
1221(1): defines what a capital asset is. Says that a capital asset is property, starts of by basically saying a
capital asset means everything, doesn’t have to be connected with a trade or business—means home is a
capital asset, means that an asset can be (unless it’s excluded) can be a capital asset even if it is connected
with my trade of business.
1221: Exclusions: Reinforce the notion that we give preferential capital gain treatment because we have to.
o Inventory: Joyce who buys shirts wholesale and sells them retail: not a capital asset in the hands of
the buyer. This is inventory—inventory is out!. I buy the shirt and sell it to Sheryl, the gain will
be capital gain to me, but with respect to Joyce this is not capital gain. With inventory don’t need
to encourage people to sell, they buy the inventory with the intention of selling.
o Property subject to depreciation******
o Copyright, Literary, or Similar Property: Don’t give authors capital gain when the sell the book,
don’t need an incentive for authors to sell.
o Services Rendered:
o Charitable Contributions Deduction:
Patent: not an exclusion, congressional directive, greater encouragement for patents, but Joyce says this is
not a sensible omission.
Analysis: Is it property? Is it within the exclusion?
If no preferential treatment, then it is ordinary income.
7. Depreciable Property Exclusion.
A. The basics
The most common 1221 exclusion applied.
Applies to: Personal property or real property.
Policy: depreciation schedules are so rapid you get such a break, we’re going to kick you ass now. This is
the recapture of the excess.
B. Steps of Analysis
1221: depreciable property is not a capital asset, but congress doesn’t really know what do to about this. It
definitely is not a capital asset, but now you have to go to 1231.
1231: requires you to put all your business property sales into the calculation, and now look at all these
sales, and look at the total, do you have a net gain or loss? If this is a net gain then we will treat everyone
of those transactions, that are in that pot, as if they were all capital assets. If it is a loss they are all ordinary
1231 transforms what would be ordinary gain into capital gain, but you still have to wrestle with 1245.
1245: even though 1231 has taken what would otherwise be ordinary income into capital gain, treat all the
gain as ordinary to the extent of depreciation that you took.
Say the truck was 30K when purchased, depreciated by 6K, sold for 31K. 1221 exclusion will say that this
is not a capital asset, 1231 will say this is turned into capital gain, but 1245 will gain will be treated as
ordinary to the extent of depreciation, therefore 6K of ordinary income and 1K of capital gain.
Look at the property and see how much the item has depreciated, subtract from initial basis, get the basis,
see how much this was sold for, then see how much income you have, now figure if this income will be
ordinary income or capital gain.
C. Recapture and Real Property:
1221: exclusion applies to real property subject to depreciation—this will be the building, remember the
land is not a wasting asset.
Real Property: move into 1231, that this can transform ordinary gain into capital gain.
1245: doesn’t apply to real property.
1250: applies to real property, more lenient than 1245, 1250 only recapture as ordinary income, excess
depreciation. Since 1986, there is no excess depreciation. No accelerated depreciation for real property. In
1997, but, even though this is all going to end up as capital gain, this won’t the same rate as stock, to the
extent of depreciation, you will have a 25% rate. Only to the extent of depreciation. If there is 6K gain,
and 5K depreciation, first 5K will be at the 25% rate, but the other 1K since not depreciation recapture will
be eligible for the 20% rate.
D. Determining what is and what is not a capital gain/loss transaction.
This has been determined by caselaw
Facts: CP manufactured Corn Products, corn was the raw material and CP wanted to protect itself against the rise of
raw material. Say that the plan of CP is that they will pay 40 for the Corn, and will sell it for 100 and will have 60
of income. This 60 will be ordinary income—buying the shirts. CP doesn’t know that it will be able to buy at 40,
what it buys today is an option to buy, in the future, Corn at 40. Corn goes up to 60, but they have their security at
40. Now CP says instead of buying the Corn under the K, we’ll buy the Corn for 60, and now we have this future
that is worth 20. Then the Corn is sold for 20. They want to say that they had income of 60, 20 of which is capital
gain. Comish said this is all ordinary income because that is an asset that is strictly a business asset that is integrally
For a long time was read as saying that the 1221 exclusions were not exclusive.
SC says we agree with the Comish, but they also say that the Corn Futures are not literally listed in 1221(1)
because this is a right to buy corn, but not actual corn. SC said this isn’t really 1221(1), but this is not the
kind of stuff Congress wanted to give preferential treatment to.
Facts: Arkansas Best, buying stock in all types of Companies. One of the Companies is a bank, the bank isn’t doing
very well, AB wants to help business out by buying more stock. AB bought more stock to protect one of its
businesses, protect its own business. Unlike CP the stock it purchased, sold at a loss. Now, in AB the taxpayer says
we have a loss, and we don’t want a capital loss, we want ordinary loss. Have to say that this asset is not a capital
asset and this is what CP tells us.
Arkansas best says that the exclusions are exclusive, they are not merely illustrative. don’t look at
motivation(business vs. investment), what do we do with the statement that we made the Corn Future was
not in one of the exclusions—SC disavows w/o saying so.
Court says if you have something that is property and it is not w/in one of the exclusions it’s a capital asset,
therefore the Declaration of Independence is a capital asset.
SC says, whether this is gain or loss the question is whether CP is right, and it really isn’t right because
these exclusions should be exclusive, secondly, don’t look at motivation(business vs. investment), what do
we do with the statement that we made the Corn Future was not in one of the exclusios.
Basically, CP didn’t mean anything, except that a Corn Future is the same as corn.
Lesson: it’s property, unless you can fit it into an exclusion!
Hypo: Suppose a person owns and operates a grocery store on the west corner. There is a vacant lot across the
street, taxpayer who owns the grocery has gotten wind that the vacant lot will be bought by Tops. Our taxpayer
buys the vacant lot to protect being purchased by the chain, and then holds on to the property. Property appreciates
and then the chain decides to locate 5 miles away. Now our taxpayer wants to sell the Y property at a gain.
CP was looked at as saying that the exceptions are not exclusive and that if you have something that is
integrally related to your business, then Congress didn’t want to give it capital gain treatment.
When AB came around, the question arose if you could still not give capital gain treatment if integrally
related to the business. Fairest reading of AB is that this possibility of exclusion is gone as well.
Now this would be capital gain or capital loss.
E. Summing it up
If it’s property it is a capital gain or loss unless an exclusion applies. If you can find something that is so
close to being an inventory type of hedge we will say this is not a capital asset. This is an interpretation of
1221(1)—not a gloss on 1221.
True hedges will be non-capital assets: ordinary income/ordinary loss. When you buy you have to identify
as a hedge.
F. If you want Capital Gains Treatment, don’t keep a reversion!!!!
Example: Blackacre bought for 100, renting for 10. Property goes from 100 to 200, and rent goes from 10
to 20. Taxpayer A sells for 200. First, taxpayer has a basis offset, gain of 100. Also, resulting gain is long
term capital gain. Taxpayer B, instead of selling for 200, rents for 20 a year. Taxpayer B, no basis offset,
no capital gain, gain is ordinary income. Taxpayer C, rents for 2 years and gets the tenant to pay upfront
the present value of 2 years rent, 34. Taxpayer C gets no basis offset, and the income is ordinary income,
Taxpayer D rents for 100 years and gets the tenant to pay upfront 200 D gets treated like A and gets capital
gain treatment. D has a reversion after 100 years, and this is worth a neglible something, but really
The question is how do you treat C. There is a reversion, so there is no basis offset and the whole 34 is
Suppose Joyce takes B/A and sells West B/A for 100. Get a basis offset allocated, and the gain will be
For the taxpayers between C and D we litigate a lot.
E. Capital Gains sale vs. Rental
No matter that every lease is really a sale, where BA is n more than the present value of your future right to
receive rents. If you treated every lease like a sale, then every lease would give rise to some bit of capital
gain income, rather than ordinary income.
Hort Case and the PG Lake Case
PG lake is really like taxpayer C.
SC: have seen no conversion of a capital investment—we don’t see anything that Congress wanted capital
preferential treatment. Taxpayer C hasn’t really gotten out. NO way to determine the answer to who has
gotten out, except for the feudal notion of the reversionary interest.
Reversionary interest, when it becomes so small, say this is more like conversion than retention of a
IN Lake and Hort you have the fact that the person retained a reversion, therefore ordinary income and no
The reversion is poison for income shifting, capital gains, basis offset.
Hort: landlord was paid by the tenant, a sum as consideration for being released from the lease. SC said
this is all ordinary income. Reversion retained. SC said this was a substitute for rental payments (this
makes KJ mad), this is so frustrating because when A sells what she is getting is a substitute for what
would be ordinary income in the future—arghhhhh. This is logically inconsistent.
Good news is that we know the rules. If you want capital gain, don’t retain a reversion.
Hypo: Suppose taxpayer L rents to the tenant and the T gets a 10 year term. Then instead of the T wanting to get
out, the tenant is now paying to little cause rents have really gone up, T says pay me and I’ll surrender my lease. T
would have capital gain, no reversionary interest. This is the McCallister Case.
Not bonds or stocks, but plain old K, this is regular old Mensch stuff.
Pittson: sale of coal. Surrender of rights retains no reversion, but this is called ordinary income.
For Ks, what the courts have done is to say that when a tenant surrenders this is different from a lease
Why are K’s not given capital gain treatment?
o Substitute for ordinary income.
o This is not property, they are naked K rights.
o K right was not sold or exchanged but it was released and it vanished.
Joyce says this K stuff is all a bunch of horseshit. What this means is that you advise people to find cases
that are on point.
These K cases go both ways, there is no settled body of law. Just make good argument by analogy.