Taxation Outline

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					                                               Taxation Outline
                                            Professor Mark Gergen
                                                   Fall 2007

 Income
   Intro
      Goals of Tax: economic growth, distribution of burdens/benefits of government, raise revenues to
        fund government
      Computation (individuals): ((gross income (§61) – above the line deductions (§62)) – below the
        line deductions (§151, 63, 67) x tax rates (§1)) – credits
             Above the line: business expenses
             Below the line: standard or itemized deductions (some subject to 2% floor), personal and
                dependency exemptions
             Credits are worth the same to all taxpayers, deductions are worth more to higher-bracket Ts
      Computation (corporations): gross income – all allowable deductions
      Criteria for Evaluating Taxes
         Equity: those with greater ability to pay taxes should pay more tax (vertical); those with equal
            ability to pay taxes should pay equal taxes (horizontal)
         Efficiency: tax should draw as much wealth from the country as possible without harming
            people. It should interfere as little as possible with economic behavior (unless we want to
            interfere). Favors taxing inelastic things, e.g. head tax.
         Simplicity/administrability: the tax which each individual is bound to pay ought to be certain,
            and not arbitrary. System should be easy to use/apply.
      Compensation, defined
         IRC §61: “all income from whatever source derived,” including the enumerated items
         Haig-Simons: consumption plus change in wealth
         Eisner v. Macomber: gain derived from capital, labor, or both combined
         Glenshaw Glass: undeniable accessions to wealth, clearly realized, and over which the taxpayers
            have complete dominion. (windfalls, punitive damages are taxable as income)
      Old Colony Trust Co.: where employer pays employee’s taxes, the amount paid is taxable as income
        to the employee.
         Federal income taxes are imposed on tax-inclusive basis: amount of tax is included in the amount
            of taxable income to which rates are applied.
         re = ri/(1 – ri) and ri = re (1 + re)
      how tax disputes are litigated:
         tax court (not jury trial, specialist judges)
             no prepayment of deficiency (government is suing T)
         district court (factual question, jury trial, non-specialist judges) – taxpayer is better off in district
            court if he has a weak case
             cost: must pay deficiency in advance (T is suing for return of money)
         appeal from either goes to US Court of Appeals (non-specialist judges)
         no penalty (beyond back taxes and interest) unless argument was unreasonable
   Alternative Tax Bases
      Income: income from labor and capital; includes savings and consumption. More comprehensive
        measure of ability to pay. Inhibits saving. Fairness argument stressed. Tax both when $ is earned
        and on returns from savings.
      Wages SS tax up to $80k, Medicaid.
      Consumption: excise taxes, retail sales taxes, VATs. Exempts savings. Treats equally people who
        consume identical amounts over their lifetimes. Efficiency argument stressed.
      Wealth: imposed on capital accumulation. Estate and gift taxes, local property tax.
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          Wage tax               Cash flow consumption tax             Income tax
        w*(1-t)*(1+r)                   w*(1+r)*(1-t)               w*(1-t)*(1+r*(1-t))
T earns $100, pays $40 in      T earns $100, which she           T earns $100, pays $40
taxes, invests $60, and has    invests. This grows to $110,     in taxes, invests $60,
$66 in year two                on which T pays $44 in taxes,    earns $6 on which she
                               leaving T with $66 in year       pays $2.40 in taxes, and
                               two.                             has $63.60 in year two
w=wage ($100)
t=tax rate (40%)
r=rate of return on savings (10%)
     Tax Expenditures: revenue losses attributable to provisions of the federal tax laws which allow a
        special exclusion, exemption, or deduction from gross income or which provide a special credit, a
        preferential rate of tax, or a deferral of tax liability.
         Tax expenditure versus proper definition of income (“expenditure” requires knowing the “ideal” tax)
         Alternatives for tax expenditures:
             Deduction: value varies with marginal tax bracket
             Credit: same value to all Ts, but no value to those who do not pay taxes.
             Direct subsidy: same value to all recipients. Harder to hide than a tax rebate, and only good for
                 one year, so politicians prefer tax approach.
         Deadweight loss for those who would engage in the activity that Congress wants to encourage
            regardless of the tax expenditure. No increase in the beneficial activity, but loss of revenue. Also
            deadweight loss for taxpayer who gets the deduction at $2000 but the activity is otherwise worth
            only $1800 to him. Deadweight loss of the difference ($200) plus the deduction ($300).
         Largest: employer-provided health insurance, pensions
             Health insurance subsidies through deductions or exclusions gives the greatest break to the rich.
                 Unemployed, part-time, etc. have no insurance. Huge expenditure with bad results. (We would
                 not lose any tax revenue on health insurance for low-income Ts because they don’t pay taxes
                 anyway, but they still aren’t covered.)
     Fringe Benefits
         In-kind benefits transferred to an employee (additional compensation or essential to job). Many are
            not taxed.
         Employer-provided health insurance, payments for injury/sickness are not taxable to employee.
            Benefits paid for medical expenses, permanent disfigurement/disability are not taxed to employee.
            Sick pay or pay in lieu of lost wages is taxed. (§104, 105, 106)
         Retirement income: employer may deduct amounts contributed to plan, employees only taxed on
            distribution (§401-04, 410-16)
             401(k), Keogh, IRAs
         Life insurance: income to employee, unless beneficiary is employer or a charity
         Moving expenses: reimbursement is deductible to the extent it could have been deducted if paid
            directly (§132)
         Dependent care: excluded, $5k/yr limit (§129)
         Educational benefits: excluded, $5250/yr limit (§127)
         Cafeteria plans: employees choose from a group of taxable and non-taxable fringe benefits
         §132 benefits: no-additional-cost service, qualified employee discount, working condition fringe, de
            minimis fringe, qualified transportation fringe, qualified moving expense reimbursement, qualified
            retirement planning services
         Evaluation:


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       Equity: fringe benefits more available to higher-paid Ts; incentive to use nontaxable fringe
        benefits increases with marginal rate (but employer may provide fewer fringes, accounting for
        tax benefit)
     Efficiency: changes T behavior, may produce deadweight loss (employer gives $5k airfare
        benefit, employee at 35% rate will take it even if it’s worth $4k to him)
     Simplicity: difficult to distinguish additional compensation from benefit essential to job.
   Deadweight loss: people who would have more marginal benefit than marginal cost are not
    choosing the good/service, or people who would have more marginal cost than benefit are choosing
    it. Costs to society created by an inefficiency in the market. Loss in welfare with no concomitant
    rise in revenue.





   Work-Related Fringe Benefits (§132)
     Problem of how to treat these. Don’t want to avoid taxing because employers will offer more in-
       kind benefits and people will take them if they’re worth the value discounted for the employee’s
       marginal rate (e.g. $1000 gym membership taken if worth $601 for T in 40% bracket).
       Efficiency/deadweight loss problem. And inequitable because T with in-kind benefit now has
       more money to pay tax because he didn’t buy the benefit himself. But very difficult to tax in-
       kind benefits (administrability).
     Solution: don’t tax benefits whose primary/substantial benefit accrues to the employer.
     §132: certain fringe benefits not included in income: no-additional-cost service, qualified
       employee discount, working condition fringe, de minimis fringe, qualified transportation fringe,
       qualified moving expense reimbursement, qualified retirement planning services.
        Nondiscrimination (to avoid hiding income to wealthy employees), line-of-business (e.g.,
           hotel employee taxed on free plane ride) requirements for some of these. Nondiscrimination
           doesn’t apply to on-site athletic facilities so upper class don’t have to share gyms with lower
           class.
        Since these are subject to a floor, it’s better to get employer reimbursement than to use the
           exclusion
        Corruption: $175/month for private transportation, $100/month for public. Ts were used to
           this benefit and Congress couldn’t change the world so rapidly.
        Administrability: no reason to include working condition fringe if it would later be
           deductible (although subject to 2% floor); cost of accounting for de minimis fringe is greater
           than increase in tax revenue
     Subjective devalution: T values the benefit less than employer/payor, so shouldn’t be taxable on
       the amount employer/payor was willing to pay
   Benefits not from employers


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        Gotcher: where the trip primarily benefited VW, the airfare was excludable from Gotcher’s
         income
   Employer-provided meals & lodging (§119)
      Meals/lodging furnished to T, spouse, dependents excluded from income if
          provided for employer’s convenience AND [standard]
          provided on business premises [bright-line rule]
      Reg. 119-1: “furnished for a substantial noncompensatory business reason of the employer”
      If provided at work, there is subjective devaluation by employee. More likely to be for
         employer’s benefit than for employee’s.
      Kowalski: only meals provided in-kind are excluded, not reimbursements for meals
          Exception: §132(d)(2): money is only occasional, employee works overtime, and employee
             eats meal during overtime period
   Receipt of property as compensation (§83)
      Property included as income when it is no longer subject to substantial risk of forfeiture (e.g.
         employee stays on past a certain date)
      If no restrictions, T taxed on any value over what he paid for it (e.g. taxed on $60 if paid $40 for
         $100 of stock)
      Employer cannot deduct until employee includes property in income
          Indirect/substitute taxation: benefit to employee is offset by delay in employer’s deduction
      83(b) election: employee can choose to be taxed while the property is still subject to forfeiture
          T takes risk of forfeiture (no loss if forfeited) and gets lower capital gains rate on dividends
          Can’t be taken on an option unless options are publicly traded and have readily ascertainable
             fair market value (T will undervalue the property, take the election, and pay lower tax)
 Imputed income: benefits derived from labor on one’s own behalf or the benefits of property ownership
   Usually not treated as income (administrability: where to stop? If I paint my nails, do I have
     imputed income of manicure cost?)
   Largest source: domestic services. Also owner-occupied homes (if T rents it, he is taxed, but if he
     lives in it, he is not).
   Deadweight loss: if T is subject to 40% marginal rate, she must make 40% more than the value of
     her domestic services to justify going back to work. E.g. if services would cost $12k, she must make
     $20k. If she can only earn $18k, there is $6k deadweight loss.
   Exchange of services: §1.62(2)(d)(1) – taxable at FMV of services received. If FMV only known for
     one, assume exchange was equal.
   Gifts, bequests, prizes, scholarships (§102)
      Value of property acquired by gift, bequest, devise, inheritance is excludable
      Justifications: 1) family is taxable unit, so transfer among it should not be taxable; 2) we should
         create incentives to give gifts because they increase the utility of the gift (both donor and donee
         get some benefit from the gift); 3) unadministrable to tax because most would be unreported
      Duberstein: gift is a transfer made “from a detached and disinterested generosity” and not from a
         sense of moral or legal duty or from an anticipated benefit.
      §102(c): employer gifts to employees are not excludable
      §274(b): gifts >$25 are non-deductible by donor. If donee excludes, donor cannot deduct. If
         donee includes, donor can deduct (business expense). Although they could take inconsistent
         positions ($800 bottle of wine was a gift vs. business expense to build goodwill)
      Tips are taxable
      Oscar goodie bags are taxable
      political contributions are not taxable to candidate if used for political campaign, family member
         and government support payments are excludable


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        Prizes/awards are taxable unless transferred to charity (and given in recognition of achievement,
         no future services required, and no action taken to enter contest) (§74)
      Bequests are excludable (§102) if it meets the Duberstein standard.
      Scholarship/fellowship excludable if used for qualified tuition and related expenses (§117).
         Cannot be quid pro quo for services rendered.
 Basis (§1001)
   §1001: gain or loss on disposition of property = amount realized - basis. Basis is already-taxed
     wealth.
   §1012: basis is cost that has not been recovered or deducted
      Cost to T
      Fair market value of property received by T
   Basis is recovered as an asset is used up by depreciation and amortization.
      Exception: debt-financed investment. T gets basis despite not already being taxed, on the
         assumption that the debt will be repaid with after-tax income.
   Where two parties exchange assets, they both realize gain or loss; they only trade basis if it is a gift
     (non-recognition)
   Gift (inter vivos): basis is transferred if there is a gain; donee gets donor’s basis. Basis is value at
     time of gift if there is a loss (to avoid loss shifting). If donee doesn’t know donor’s basis, basis is
     FMV. (§1015)
   Gift (heirs): heir’s basis is FMV at donor’s death. (§1014). Step-up in basis. Step-down if there is a
     loss. Incentive to keep appreciated assets until death and sell depreciated ones.
   Allocation of basis
      If part of an asset is sold, can’t treat the price as all recovery of basis (too much incentive to
         carve up assets) and can’t treat as all gain (too much incentive not to carve up).
      When a portion of property is sold, the basis must be divided among the parts. If the part sold is
         more valuable than the part retained, the basis should be divided equitably (§1.61-6).
      FIFO for assets of the same kind (if T cannot distinguish them)
      Part-gift, part-sale (gain): transferee’s basis is the greater of the amount paid or the transferor’s
         basis (§1015(d)).
          If loss, transferee’s basis is the FMV on transfer.
          If to charity: basis allocated in proportion to respective values
      Asset with periodic yield: yield is all income for nonwasting asset (bank account, land, stock,
         bond); basis is apportioned for wasting asset (loan repayment, depreciating assets [vehicles,
         buildings], premium paid for above-market lease/interest)
   Realization requirement
      Justification: administrability. Hard to value assets every year, and Ts may not have liquidity to
         pay an accretion tax.
      Distortions: incentive to keep gain assets and sell loss assets. And assets that don’t deliver gains
         until realization get the time advantage of money.
      Equity problem: A gets $1k in salary and is taxed, B’s property increases in value $1k and is not
         taxed. B gets time value of money.
      If T gets money he must later return, he is taxed on receipt and the return is deductible when
         paid.
      Eisner v. Macomber: Revenue Act of 1916 held unconstitutional. T’s stock dividends are not
         income because they are not “derived from capital.” T has same value invested and no liquidity
         to pay taxes because nothing was sold.
          If T has option to take cash or stock dividend, he will be taxed on the stock dividend.
      Bruun: when lessee makes leasehold improvements, landowner has income equal to the
         remaining value of the improvements when the lease terminates. Reversed by §109.

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         Distortion for accepting leasehold improvements in lieu of rent, but real estate owners have a
            very strong lobby
     Cottage Savings: realization event when mortgage loans are exchanged. Properties are
        “different” if their possessors have different legal entitlements. So S&Ls could realize a loss
        without sustaining book loss.
   Windfalls
     Income
     Cesarini: $4k found in piano was all taxable. No basis is allocable to the $4k because the money
        is not associated with a decline in value of the piano.
     No liquidity problem where money is discovered. If asset with estimated value is discovered, no
        income until sale. No basis in the asset.
     Haverly: when T donates books to charity, he must report their value as income
 Annuities & life insurance (§72, §101)
   Annuity: payment in return for a promise to pay certain sums at intervals (esp. if payment period
    measured by lifetimes)
     Amount received – amount paid = income to annuitant
         If T bought the annuity with pre-tax account (IRA), then annuity payments are all income.
            Only middle-income Ts buy annuities, and they fund with IRAs, so there is no real world
            application.
     §72: portion of each payment is treated as recovery of investment and a portion treated as taxable
        return
         Another approach: Burnet v. Logan – all payments are recovery until that amount is reached,
            then everything is income
     Equity concern: Delay in taxation of interest gives annuitants the time value of money, and
        usually only high-income Ts can use them. Annuities are better than savings accounts because
        economic accrual of interest (plus withdrawal of some portion of the investment) causes there to
        be more interest (and more tax) at the outset.
   Insurance: amounts paid by reason of the death of the insured are not taxed (§101)
     Premiums paid are not deductible
     Proceeds received upon termination of cash value policy (not death) are taxable if they exceed
        the cost of the policy
     Types of insurance
         Term insurance: pay premium in return for specified sum paid to beneficiaries upon death
         Ordinary life insurance: pay uniform annual premium through life; policy matures at death
         Universal life insurance: purchase contract for life insurance and deposit sum with insurance
            company
         Variable life insurance: premiums are invested by insurance company and proceeds are
            payable on the death of the insured; value depends on the success of the investments.
             Inside interest buildup: the interest that the company makes on the difference between the
                premium paid and the amount that covers the risk. E.g. $300 premium with $60 to cover
                risk leaves $240 invested, which makes $14.40 inside interest buildup (6% rate)
                 Inside interest escapes tax
             Once cash balance, including inside interest, reaches the policy amount, insured should
                get higher policy or distributions
             Advantage of whole: after awhile, premiums are paid from inside interest, not after-tax
                dollars; if surrendered before death, interest income was still deferred and T gets basis in
                the full cost of the insurance, including the portion that covers the company’s risk
     La Gierse: can’t combine annuity and life insurance to avoid tax (e.g. pay $100k for $100k death
        benefit and $6k yearly annuity payments). Some of the $6k will be treated as a recovery of basis

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         but it’s really interest on a loan. Substance over form. Some risk is required for insurance
         proceeds to be excluded.
          Can be done legally by purchasing separately
      Tax benefit may not make whole/universal life a better tax investment because companies charge
         high fees
 Loans & discharge of debt
   Borrower: No income on receipt of loan, no deduction on payments of principal. Lender: No
     deduction on making loan and income on recovered payments of principal
      No income because cash is offset by liability to lender
   When paid by another, either taxable under Old Colony (as compensation) or nontaxable gift
   When loan is cancelled for less than face value, borrower has income (§61(a)(2) discharge of
     indebtedness)
      Income is no longer offset by liability
   Contested liability doctrine: if T disputes the amount of a debt, the settlement is treated as the actual
     loan amount. No income to T on discharge of debt. This reflects the true value of the debt to the
     parties.
   Exception to rule that relief from debt may not be “cancellation of debt” income:
      E.g. employer loans employee for house, forgives part each year that employee works. This is
         regular compensation, so it is not subject to the COD exceptions (insolvency, etc.)
   Exceptions to rule that cancellation of debt results in income: (§108)
      Debtor insolvency: debt cancellation is excluded to the extent of insolvency (§108(a)).
          T must reduce other tax benefits (e.g. net operating loss carryovers) or the basis of his
              property by the amount of the debt cancellation.
      Lost deductions: no income if discharge of debt would result in a deduction (§108(e)(2))
          E.g. employer owes employee compensation, employee agrees to take less than what is owed
      Purchase money debt reduction/purchase price adjustment (§108(e)(5))
          Debt must arise out of the purchase of property and debt must still be held by seller/lender
              (n/a if sold debt to another). Debtor takes reduced basis in the property.
      Discharge treated as gift: only in noncommercial setting (§102)
      Student loan forgiveness: student must be required to work in certain professions for a time
   Zarin: Tax Court held gambler had income on cancellation of his gambling debt; Third Cir. reversed
     because the loan was unenforceable under the applicable state law.
      Gambling losses only deductible to the extent of gambling income.
 Real estate tax shelters
   Recourse debt: borrower is personally liable; nonrecourse debt: lender can only be repaid from the
     assets securing the debt
      T gets basis in an asset if it is financed by debt, regardless of whether the debt is recourse or not
          Argument that T should not get deductions funded by nonrecourse debt because he does not
              bear the economic risk of loss.
      Where the debt is recourse, debt forgiveness is ordinary income (unless a §108 exception
         applies)
          if basis is greater than FMV of property, T takes a capital loss in that amount
          if basis is greater than FMV of property, T has capital gain on that amount
      Where the debt is nonrecourse, debt forgiveness is part of the amount realized upon disposition
         of the property, which results in capital gains. Capital gain = debt – basis in property exchanged
   COD income is ordinary. Gain/loss on disposition of real property is capital.
   Tufts: T who exchanges property for relief of nonrecourse debt has capital gains on the difference
     between the debt and his basis in the property. T must treat nonrecourse mortgage consistently when
     he accounts for basis and amount realized.

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    Tax shelter: A, which cannot take advantage of a deduction, sells property to B, which can. B takes
     deduction and rents the property back to A. The rental payment is equal to the amount of principal
     and interest due on the note. B gets the time value of money by getting early deduction offset by
     later income (“phantom gain”/ “Tufts gain”). A usually gets some payment as incentive to engage in
     the shelter. B also gets conversion of ordinary income into capital gain where the tax shelter
     involves lender taking property to resolve debt.
   Estate of Franklin: buyers have no basis in the property when they could not show the nonrecourse
     debt-financed purchase price was at least approximately equivalent to the FMV of the property. Ts
     had no investment in the property because they had inflated the purchase price and it was mostly due
     at the end of the leaseback. Depreciation can only be taken where T has invested in the property; no
     investment where there is no real obligation to purchase (debt is nonrecourse and T could just
     default). A loan should not increase basis where it is unclear whether the borrower will ever actually
     make principal payments.
      Contingent liabilities excluded from basis until payment is made
   Pleasant Summit (3d Cir.): where nonrecourse debt greatly exceeds property’s FMV, T may deduct
     depreciation and interest attributable to the portion of the nonrecourse debt that did not exceed the
     property’s FMV.
 Damages
   Business damages
      recovery for lost profits are income (T had no basis in them, usually because costs were
          deducted)
      recovery for harm to an asset is recovery of basis (taxable to the extent it exceeds basis; capital
          gains if the asset is capital, ordinary income otherwise)
           e.g. lost goodwill is return of capital
      punitive, exemplary damages are income (T had no basis in them)
      no income if T can show that actual damages exceeded the settlement amount
      for prior undeducted losses (e.g. not enough income at the time), T can deduct lesser of
          compensation received (minus legal expenses) or unrecovered losses sustained (§186)
   personal damages
      physical injury/illness/emotional distress resulting from physical injury: excludable (§104(a)(2))
      emotional distress/physical injury resulting from emotional distress: income
      loss of consortium: excludable
      lost wages: excludable
      punitive damages: income
      compensation for previously deducted medical expenses: taxable (tax benefit rule)
      damage to asset: excludable if payment is less than basis in asset (probably true because most are
          not depreciable)
   interest portion of award: taxable
 Tax-Exempt Interest
   Interest on state/local bonds is excluded (§103)
   Implicit tax: difference between the amount a municipality would have to charge if the interest were
     taxable and the amount it does charge (e.g. for 35% taxpayer, 6.5% bond = 10% other investment,
     implicit tax is 35%)
      (rate of return on taxable investment – rate of return on tax-exempt bond)/rate of return on
          taxable investment = implicit tax
      Inefficient: municipalities save 2/3 of what federal government loses (if municipality offers bond
          at 8.5%, federal government loses $.35/dollar for 35% taxpayer and municipality makes only
          $.015/dollar)
           Where implicit tax = actual tax rate, municipality captures the value of the exemption

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               Municipality must offer higher rate of return for a lower bracket, and then the highest bracket
                  gets a windfall and municipality only captures a portion of the benefit of the exemption
            Tax-preferred investments and transactions may bear implicit taxes (e.g. municipal bonds,
              insurance contracts)
          §103(b)(2): income on municipal arbitrage bonds is taxable (before this, municipalities issued bonds
           and used the proceeds to invest elsewhere [tax arbitrage])
            Tax arbitrage: taking two offsetting financial positions that yield a positive after-tax return
              because the tax code treats them differently

 Deductions & Credits
      Above the line deductions: §62 (compute AGI)
         Trade & business, trade/business for employees (reimbursed expenses, must be in connection
            with performance of services as employee), losses from sale/exchange of property (§161),
            expenses incurred for producing rents & royalties, retirement savings (§219), alimony (§215),
            moving expenses (§217), interest on education loans (§221), higher education expenses (§222),
            health savings accounts
      Below the line deductions (itemized or standard): §63(c) (compute taxable income)
         Standard deduction OR
         Itemized deductions
             Some limited to deductions from certain types of income, some subject to floor
             §67(a): miscellaneous itemized deductions can only be deducted to the extent they exceed
                2% of AGI
                 Anything other than interest (§163), taxes (§164), casualty/theft (§165), charitable
                    contributions and gifts (§170), medical expenses (§213), annuity payments cease before
                    investment recovered (§72(b)(3)), amortizable bond premiums (§171), some others
             Some disallowed for computing AMT
      Some deductions lost, some carry over
      Some credits are refundable, some carry over, some are lost
      §262: no deduction for personal expenses
      §263: no deduction for expenses to increase an estate (i.e. personal investment; but paying an
        investment advisor is deductible under §212)
      Is expense deductible?: personal or to produce taxable income? If latter, is income current (income
        this year and no income later) or capital (income in future years)? (if capital, expense is added to
        basis, not deducted) Trade/business or income-producing activity? (§162 vs. §212)
   Ordinary & necessary expenses incurred in carrying on a trade or business (§162)
      Wages, insurance premiums on business assets, office rent, utilities, etc. (§162)
      §212: deduction for expenses from income-producing activities. Must produce taxable income, so
        can’t deduct investment advisor fees for tax-exempt bonds (only applies to individuals, is below-the-
        line, and subject to 2% floor) (e.g. investing on the side)
         Definition of trade or business: T is involved in activity with continuity and regularity and has
            primary purpose of earning income or profit
         Welch: paying creditors of bankrupt corporation to help develop T’s business is not ordinary.
            Reputation is a capital asset. No deduction.
             §162 allows advertising cost deductions. This is between advertising and goodwill, which is
                capital expense.
         §162: “all the ordinary and necessary expenses paid or incurred . . . in carrying on any trade or
            business”
             ordinary in the type of business involved, even if it only happens once/lifetime
             necessary means helpful to T’s business, not essential

                                                      9
         Gillam: T’s legal fees after psychotic episode on plane on his way to a job were not normal,
            usual, customary. The altercation and the legal fees did not further his trade as an artist.
             Legal expenses: look at origin of the claim (divorce settlement is personal, not business)
   Trade/business/profit-seeking losses (§165)
   Reasonable compensation
      Exacto Spring Corp.: CEO’s $1M salary was presumptively reasonable (salary approved by
        other owners and CEO’s work led to very high returns). “Independent investor” test: if an
        investor would be pleased with his returns and the returns are attributable to the officer, a higher
        salary is presumptively reasonable.
         BUT we also need to know risk to know if rate of return was reasonable
      §162: “reasonable allowance for salaries or other compensation”
         Failure to pay dividends suggests salaries are unreasonable (not conclusive)
         Tax Court, 5th, 10th Cir.: multi-factor test (type/extent of services rendered, scarcity of
            qualified employees, qualifications/prior earning capacity, contributions to the business,
            employer’s net earnings, prevailing compensation for employees with comparable jobs)
         Employer must also intend to compensate (can’t intend to avoid dividends)
         §162(m): CEO or four highest paid employees of publicly held corp. cannot deduct >$1M
            unless compensation is performance-based
      Disguised salary: cannot move salary to lower-bracket person if he didn’t do the work. Will be
        recharacterized as dividend to employee and income to other person (probably not gift because
        no donative intent)
   Employee business expenses – when deductible to the employee, can be excluded as working
     condition fringe (wash)
      Amount of deduction:
         1) ordinary & necessary in carrying on trade/business?
         2) above the line or itemized?
         3) if itemized, subject to 2% floor/2% haircut?
      Deductible employee expenses: supplies, professional dues, journal subscriptions, cars for
        business calls
         Above the line: reimbursed expenses & some expenses of performing artists and Nat’l Guard,
            expenses of self-employed independent contractors. Also employer trade/business expenses,
            losses from sale/exchange of property, contributions to qualified plans, alimony, moving
            expenses, interest on education loans
         Below the line: unreimbursed expenses
             2% floor: miscellaneous itemized deductions (§67) – unreimbursed employee expenses,
                investment expenses (§212)
                 Doesn’t apply to: interest, state/local taxes, charity, casualty/theft losses (has own
                    floor), medical expenses (has own floor)
             2% haircut (§68) for high-income Ts (over $100k AGI adjusted for inflation, now
                ~$150k): all itemized deductions other than medical expenses, investment interest,
                gambling, casualty losses (haircut is being phased out)
                 Reduction cannot be greater than 80% of the deductions.
                 Same effect as raising top marginal tax rate
                 Increases simplicity for Ts who cannot exceed floor
                 §132(d) working condition fringe is payment to employee that would be deductible if
                    paid for by employee. Not subject to 2% floor.
                 Haircut phased out: 1% in 2008-09, 0% in 2010
 Personal business expenses
   Fine line between personal and business – most consumption contributes to income production
   Congress restricted certain deductions (e.g. home office, vacation homes, travel/entertainment)
                                                 10
   Various tests for deductibility (depends on the expense type):
     Allowed when expense is appropriate and helpful to T’s business/income-producing activity
     Disallowed unless primary purpose was profit-seeking
         Relaxed for public employees
     Expenditure must be “reasonable”
     Allowed to the extent of “additional expenses” due to business/income-producing needs
     Allocate expense between business and personal use
     Disallowed because “inherently personal”
   Pevsner: YSL clothing not deductible because it was adaptable to general use as ordinary clothing
    (court rejected subjective test of what T would wear outside work; objective test more administrable)
     Test: deductible if 1) clothing is required for work, 2) it is not adaptable to general usage as
        ordinary clothing, and 3) it is not so worn
   Courts suspicious of unreimbursed expenses because if employer found it helpful, he would
    reimburse. If employee doesn’t pursue reimbursement to which he is entitled, he may lose the
    deduction.
   Tax credit for qualifying child care expenses (§21): 35% of expenses, phased to 20%. Credit limited
    to lower-income spouse’s income and expenses only qualify up to $3k for 1 kid/$6k for ≥2. Not
    refundable. Very few low-income Ts can take it and even fewer can take maximum credit ($2100).
   Travel expenses
     Deductible when T traveling on business (§162(a)(2))
     Commuting costs are nondeductible (personal)
     Meals/lodging while away from home in pursuit of trade/business
         Must stay overnight (for business reasons)
         Even if overnight is for personal reasons, can still deduct airfare
         If companion flies free (and comes for personal reasons), T must prorate his fare deduction
     Hantzis: law student who worked for summer in NYC while husband lived at home in Boston
        could not deduct the expenses of the transportation between NYC and Boston, the NYC
        apartment, and meals in NYC. If T maintains two homes for primarily personal reasons, no
        deduction allowed. Hantzis’s home was NYC. No business reason to maintain home in Boston.
     Consumption element of business travel is ignored (if trip is primarily for business purposes)
         Limitations: meetings outside N. America unless location is reasonable in context
     Temporary employment doctrine: temp job ≤ 1 yr, regular residence is “home” and food/lodging
        at temp job is deductible
   Entertainment & business meals
     Moss: law firm partners who met every business day for lunch (firm paid, but firm is a
        partnership) cannot deduct cost because daily meals are inherently personal. (Sutter: disallowed
        deductions for regular business meals). The firm did not need a daily lunch to derive income.
         Rationale for deduction: little consumption value to T. Moss partners enjoyed their lunch
             and chose to do it, Sibla firemen were required to contribute to the meal fund so it’s
             deductible, Christey state troopers were required to eat at public rest stops on highways, so
             it’s deductible.
     Client meal/entertainment is deductible if it is directly related or associated with active conduct
        of trade/business. T must have more than general expectation of deriving income, must discuss
        business before/during/after, and principal reason for expense must be trade/business. T’s meal
        is also deductible because he would not pay for it but for the business benefit, but must be
        reasonable amount.
     §274(n): deduction limited to 50% of cost. If reimbursed, the 50% applies to reimbursing party,
        not T. T is not taxed on the amount.
         Reduction is because some portion of food/entertainment is definitely consumption

                                                11
        §274(d): substantiation with contemporaneous records required (business travel, meals,
         entertainment). Or T can take the regulation rate (varies by city).
 Capitalized expenses
   §263: disallows deduction of capital expenditures (new buildings, permanent improvements to
     increase value of any property or estate). Instead, added to T’s basis, and recovered on sale or
     through depreciation/amortization.
   Some capital losses may be carried forward or back, but if not used in statutory period, they are lost.
      Purchasing/acquiring asset (stocks, land, contracts), constructing asset (building), raising capital
         (issue debt), entering new trade/business: capitalized
      Expenditures producing income in later years, recurring expenses. Usually increases value of
         identifiable asset (so it can be added to that asset’s basis).
          Exception: advertising costs, employee compensation
          Also, repairs produce future income but are deducted (vs. improvements)
      Expenditures that produce capital gain/loss should be capitalized; those that produce ordinary
         income should be deducted (matching character).
   Woodward: must capitalize litigation expenses where origin of claim is in the process of acquiring
     an asset. Attorney, accountant, appraisal fees for Ts to purchase minority stock in a corporation
     were capital expenses.
      Also includes costs of equipment to build, taxes, salaries of construction workers
   Intangibles
      INDOPCO: i-banking and legal fees incurred in friendly takeover are not ordinary, necessary
         business expenses, so they must be capitalized (despite not being associated with a tangible
         asset)
      Cost of purchasing/acquiring most intangibles (stock, leases, IP rights, licenses): capitalized.
      Amounts to create intangibles (obtain/modify contract rights, defend title): capitalized.
          Exceptions:
              Employee salaries (but not independent contractor)
              Cost of borrowing to finance the acquisition
              overhead costs under $5k (e.g. employee flying to TX to buy asset)
              Maintaining existing asset: deductible (Staley: deduction of fees to fight hostile takeover)
              Contracts terminable at-will (e.g. signing bonus, franchises): deductible
              Wooing seller (payment in hopes of creating/acquiring asset): deductible
              Internal investigation of contract: deductible
      Must involve “separate and distinct asset”: “a property interest of ascertainable and measurable
         value in money’s worth that is subject to protection under applicable State, Federal or foreign
         law and the possession and control of which is intrinsically capable of being sold, transferred, or
         pledged . . . separate and apart from a trade or business.”
          Exceptions: package design, computer software developer fees, goodwill, consulting fees
      Business expansion/reorganization: deductible (startup of new business: capitalized (§195))
      Capitalized cost of intangible asset is amortized over useful life
          T proves useful life for amortization, or use 15 yrs
   Repairs and improvements
      Repairs (preserving asset, keeping in efficient operating condition): deductible (§§162, 212)
      Improvements (replacing property, permanent increase in value or prolonged life over original
         expected life): capital (§263)
          Like buying a new asset
          Rev. Rul. 2001-4: doing routine maintenance on Aircraft 1 which did not prolong life or
             increase value can be deducted; Aircraft 3 involved general plan of modernization/upgrade,
             so maintenance was part of that and all must be capitalized; Aircraft 2’s improvements must

                                                   12
           be capitalized, but the routine maintenance can be deducted because the main purpose of the
           work was maintenance (improvements were not part of original plan or impetus behind
           taking plane out of service)
   Job-seeking and educational expenses
     Rev. Rul. 75-120: expenses of seeking employment in new trade/business not deductible;
       expenses of seeking employment in existing trade/business deductible
     Test: separate trade/business if there are substantial differences between tasks and activities of
       the occupations/employments
        Estate of Rockefeller: “holding public offices” is not a single trade/business
     Educational expenses deductible if they bear a direct and proximate relation to T’s trade/business
        Wassenaar: T’s Tax LLM costs not deductible because he was not an attorney before getting
           LLM (only on law review and summer employment, but not member of bar)
        Where self-improvement aspect is predominant over other goals, no deduction
        Travel as education: no deduction
        $5250 of employer-reimbursed undergrad/grad expenses are excludible (§127)
        General education deduction: $4000 for T/spouse/dependent’s college tuition/related
           expenses. Used to be “cliffed” out by income level.
            Must be coordinated with other education benefits (Hope, Lifetime Learning, etc.)
   Option to expense
     T has option to deduct expenses for: periodical circulation (§173), research/experiment (§174),
       farmer soil/water conservation (§175), environmental remediation (§198), qualified clean fuel
       vehicles (§179A), farmer fertilizer (§180), removing barriers to handicapped (§190)
        If no income that year, T would prefer capitalization
     T has option to capitalize, e.g.: deductible interest, taxes, carrying charges (§266)
   Depreciation
     Non-wasting assets: cost is part of basis, no depreciation, offset by reduction in sale price
     Wasting assets: Reasonable allowance for exhaustion, wear and tear (including a reasonable
       allowance for obsolescence) of assets used in a trade or business or held for the production of
       income (§167)
     allowance for allocable part of costs of business/investment assets
     depreciation allowance applied to basis (cost, capital expenditures added, etc., reduced by prior
       depreciation deductions)
     ideal rate is economic depreciation (reflect actual loss in value). worse for T than straight-line.
       E.g. bank account with declining balance earns more interest initially, so there is less
       depreciation initially.
     rate of depreciation depends on depreciation method and recovery period
        straight line method: cost allocated equally over useful life
        declining balance method: constant percentage applied over useful life (so more depreciation
           at the beginning, “accelerated depreciation”)
            double/200% declining balance method: percentage used is twice the percentage of
                straight line method ($100 five-year asset would have 20% straight line, so 40% in first
                year = $40, 40% in second year = $24, etc.)
     current rule: asset assigned to recovery class which determines recovery period (§168)
        3, 5, 7, 10 yrs: 200% declining balance (switching to straight line when that gives larger
           deduction)
        15, 20 yrs: 150% declining balance (switching to straight line)
        Real estate: straight line
        Salvage value always excluded (since T will recover upon final disposition)
        Half-year depreciation in first and last years of ownership; half-month for real estate
                                               13
          Intangibles (incl. goodwill) amortized on straight line basis over 15 years (§197)
          Commercial building: straight line over 39 years (§168)
          Small business preference: current deduction up to $100k of acquisition costs ≤$400k, with
             dollar-for-dollar decrease after that. (§179)
          Annuity: straight line over life of annuity
      T may elect to deduct some start-up ($5k for expenses up to $50k)/organizational expenses and
         amortize remainder over 15 yrs (§§195, 248)
          So starting new business for oneself allows some immediate deduction and shorter
             amortization period than entering new profession as employee (amortization over lifetime,
             plus 2% floor/haircut)
      Depreciation subject to later recapture if asset yields capital gain (recharacterized as income)
      No depreciation for personal property. If both personal and business, basis allocated.
      Land not depreciable; buildings are. If bought together, basis allocated.
      Antiques not depreciable (no determinable useful life)
 Interest Deduction
   deductible if used for trade/business. Deductible without limit other than passive loss
      exceptions:
          expensive long-lived asset T is constructing (§163).
          purchase/carry tax-exempt bond (§265(a)(2))
          expenses of producing tax-exempt income generally
      passive loss (trade/business in which the individual does not actively participate) only deductible
         against passive income or when investment ends in loss (§469)
   if used for investment, deductible up to investment income (gross income – expenses), with
     unlimited carryforward. (§163(d))
      Investment income does not include net capital gains/dividends unless T forgoes preferential
         rate.
      163(d) prevents borrowing to buy investments and pay capital gains rate while deducting the
         interest on the loan at the higher ordinary rate
   Generally nondeductible for personal uses (incl. life insurance, annuities)
      Exceptions
          qualified residence interest. $1M to acquire, construct, substantially improve principal
             residence or second home. $100K home equity. Debt must be secured by the residence.
             Below the line. (§264(h)(3))
          Education loans: up to $2500 of interest paid. Above the line. Decreases with AGI. Must be
             T’s debt but can be for dependent’s education. (§221)
   Accounts with mingled funds: withdrawal first of borrowed funds, then unborrowed. If more than
     one loan in account, FIFO.
   Tax arbitrage: assets eligible for favored tax treatment are acquired with debt.
      Negative tax rate results when T gets interest deduction and zero rate of tax on income from the
         asset purchased with the debt.
      Knetsch: T must pay interest on arbitrage scheme in which he bought ten 30-year annuities
         ($400k each, 2.5% interest) for $4,004,000; paid $4k and $4M nonrecourse notes with 3.5%
         interest; prepaid $140k interest. Kept borrowing on the annuity cash value, so payments limited
         to $1k. Deducted interest on the loans and deferred the income on the annuities and used the
         deduction to offset other income. Transaction did not appreciable affect his beneficial interest
         except to reduce his tax.
      Economic substance doctrine: financial transactions will be recognized by court and give
         deductible interest only if there is a tax-independent purpose


                                                 14
        Subjective rule: financial transaction not recognized unless it was done for a substantial business
         purpose
      Sham transaction: one that never occurred
   Distinguishing interest from other payments
      Interest is amount paid for the use or forbearance of money
          Halle: contract price for option to buy reset each day based on interest rate is an increase in
             interest.
      On sales with deferred payments: if buyer is tax-indifferent and seller has high marginal rate,
         they will prefer to characterize as much as possible as principal, on which seller pays capital
         gains rate and ordinary income on interest. If buyer has high rate and seller is tax-indifferent,
         they prefer to characterize more as interest because buyer can deduct it immediately against
         income.
      Parties generally cannot recharacterize a transaction. Sometimes, but only if both parties agree.
 Losses
   §165: deductions for losses incurred in trade/business or investment, not compensated by insurance
      Trade/business: net operating loss carryforward/back and above the line. Ordinary loss.
      Investment: above the line only if from sale/exchange of property or attributable to property that
         produces rents/royalties. Otherwise below the line. Capital loss.
   Deductions for some personal casualty, theft losses. Otherwise no personal loss deductions.
      Ordinary, and only above 10% of AGI
      Carryforward/back
      Gambling losses deductible to the extent of gambling gains.
   If used for different purposes, allocate losses.
   Limitations on deductions:
      Losses that might be personal
      Losses related to unrealized gains
      Tax shelter losses
   Objective test of loss (actually lost value, not T thought it did). Timing: identifiable event indicating
     no reasonable prospect of recovery.
   Amount: adjusted basis of the property – any insurance payment
   Hobby losses: not-for-profit activities (§183)
      Plunkett: T’s mud racing was not-for-profit so he couldn’t deduct losses. His truck pulling was
         for-profit, so he could deduct losses up to the amount of related income.
          Test: did the individual engage in the activity with the actual and honest objective of making
             a profit? Look at: manner activity is carried on, T’s expertise, time/effort spent, expectation
             that assets involved will appreciate, T’s success in other similar or dissimilar activities, T’s
             history of income/loss on the activity, amount of occasional profits earned, T’s financial
             status, personal pleasure/recreation involved
      Rebuttable presumption: requisite profit motive if profits produced in 3 of the past 5 years. If
         this isn’t met, T can use Plunkett factors.
      Hobby losses are miscellaneous deductible (2%/2%)
   Losses incurred in a trade or business always are deductible above the line. Losses incurred in other
     profit seeking activity sometimes are deducted below the line and if so are subject to the floor and
     the haircut.
   Loss road map - A loss may result from a disposition of property at a loss (i.e., for an amount less
     than basis), a casualty to property, or when expenses of an activity exceed income from the activity.
      Personal losses (i.e., losses not incurred in a profit-seeking activity) are deductible only if they
         are casualty/theft losses and only to the extent they exceed 10% of AGI. § 165(c)(3). Casualty
         losses are ordinary, not capital. They may be carried forward or back under § 172. [See

                                                   15
       172(d)(4)(C).] They are not treated as miscellaneous itemized deductions subject to the 2%
       floor, § 67(b)(3), or the “haircut” in § 68.
     Losses in a profit-seeking activity that is not a trade or business.
        If the loss is on sale or exchange of property, it probably is a capital loss subject to the capital
           loss limitation. The loss is above the line. See § 62(a)(3).
        If it is a deduction attributable to rents and royalties it is above the line (§ 62(a)(4)) but
           cannot be carried forward or back under § 172.
        If it is a casualty loss, then it is fully deductible under § 165(d), it is not subject to the 2%
           floor or the haircut in § 68, and it may be carried forward and back.
        Other losses are below the line and subject to the 2% floor and the “haircut” in § 68, cannot
           be carried forward or back under § 172, and are not deductible in determining the alternative
           minimum tax, § 56(b)(1)(A)(i).
     Losses in a profit-seeking activity that is a trade or business.
        If the loss is on sale of exchange of property, it may well be ordinary under § 1031.
        Deductions are above the line and losses may be carried forward and back.
        Casualty loss: deduction is basis (not FMV, because no attribution to consumption)
     Non-casualty loss must be realized, so damage to asset does not result in loss until
       sale/disposition of the asset.
     Trade/business: T must be actively engaged, must be continuous and regular activity.
   Casualty losses: 165(c)(3)
     Deduction for personal loss from “fire, storm, shipwreck, or other casualty, or from theft”
        Must exceed $100 and 10% of AGI. No deduction if received insurance payments or any
           prospect of recovery, and must filed timely insurance claim.
        Itemized
        Rationale: no ability to pay tax when T has these losses and not result of personal
           consumption choice
        Critique: deduction decreases incentive to get insurance
     Casualty: Sudden, unexpected, violent, not due to deliberate or willful actions. Advance warning
       precludes deduction. Can result from T’s negligence, but not gross negligence or more.
     Theft: must prove defrauding or stealing. Cannot be T’s accident.
     Loss = lesser of adjusted basis or (FMV before casualty – FMV after casualty)
     §123: reimbursement for living expenses when home destroyed are excluded from income
   Limitations on losses
     Fender: T could not deduct losses from selling and repurchasing bonds to a bank in which he
       was a majority shareholder because there was no reason to sell the bonds other than to avoid tax.
       T was not exposed to any risk that he wouldn’t be able to repurchase the bonds, and it would be
       difficult to find buyer other than the bank.
     No deduction for sale/exchange of property between related people (§267). Loss is lost unless
       buyer sells at a gain, then he can include the disallowed loss in his basis.
     Wash sales: no deduction for losses from sale and purchase of same securities within 30 days
       (but the loss is added to his basis, so it is deferred until a real sale) (§1091)
     Capital losses: deductible only to the extent of capital gains plus $3k ordinary income (§1211).
       Indefinite carryforward (§1212)
     Straddles: T retains related assets with unrealized gains and uses tax losses to get optimum tax
       treatment regardless of overall economic position. E.g. offsetting positions in commodity futures
       contracts. Sell loss portion and retain gain portion so loss is accelerated and offsetting gain is
       deferred.
        §1092: deduction of straddle losses limited to amount by which losses exceed unrecognized
           gains on the offsetting position
                                                 16
          Some stock and options get mark-to-market treatment (as if all are sold at year end, so only
             losses that exceed matching gains can be taken)
   Real estate tax shelters
      Often structured as limited partnerships, include investment/transaction that produces tax savings
         greater than that which would be appropriate given its economic income or loss.
      Legitimate tax shelters: tax-favored investments sanctioned by tax laws to create incentives for
         certain activities
      Abusive tax shelters: transactions that would not stand in court
      Techniques:
          Income shifting: move income/deductions/credits among taxpayers (e.g. Estate of Franklin
             sale-leaseback)
          Exemption: economic income not subject to tax (e.g. IRAs, municipal bonds)
          Deferral: accelerate deductions/credits, postpone income. Early deduction usually offsets
             unrelated income.
          Conversion: investment generates deductions against ordinary income and income taxed at
             favorable rates (usually capital rate)
          Leverage: use borrowed funds to increase deductible expenditures. Greatest advantage in
             nonrecourse debt.
      Frank Lyon Co.: tax shelter of sale-leaseback of building being constructed by company (T took
         out loan and company’s rent equaled it) was legitimate because regulations required company to
         have third-party owner, T bore risks of company defaulting, because the loan was recourse, and
         company exercising repurchase option or not renewing if interest rate changed enough, there was
         competitive bidding for the contract, there was no net tax benefit, and more than two parties
         were involved (more likely to be arm’s length, not like Franklin)
      §465: losses financed by nonrecourse borrowing can only be deducted against income from the
         same activity
 Bad Debts
   Bad business debt: ordinary loss, and can deduct only a worthless portion
   Nonbusiness bad debt: short-term capital loss, and must be completely worthless
   Generes: T could not take bad deduction for unrepaid $300k loan to a corporation in which he had
     invested $39k and received annual salary of $12k because his dominant motivation was to protect
     his investment, not his salary.
      If lending activities are extensive and continuous, may be considered T’s business
   No deduction if debt was worthless when acquired
   Loss from guaranteeing loan = as if loan were made directly (same loss)
   No deduction for bad debts owed by political party
   No deduction if debt was voluntarily canceled by T, unless cancellation was for business purpose.
 Personal deductions & credits
   Standard deduction: taken instead of itemizing ($6k joint, $3k single, $4400 HH; 2007: $10,700,
     $5350, $7850). Marriage bonus for couple with one wage earner.
      For individual who can be claimed as a dependent: lesser of $3k or greater of $500 or T’s
         earnings + $250
      Some Ts must itemize: married filing separately if other spouse itemizes, nonresident aliens,
         citizens with income from U.S. possessions, estates, trusts, common trust funds, partnerships
      Rationale: simplification, or adjust tax rate schedules so very low-income Ts not taxed
      Problem: no incentive power of itemized deductions for nonitemizers
      Head of household: unmarried and maintains household which is principal residence >1/2 year
         for qualifying child/dependent or maintains separate household for dependent parent
   Personal exemption

                                                 17
      $2,000 (§151) indexed for inflation ($3,400 for 2007)
      Exemption for both spouses, each dependent (§152)
        Qualifying child: lineal descendant/sibling/lineal descendant of sibling, same principal place
            of abode >1/2 yr, under 19/24 if student, did not provide >1/2 own support
        Custodial parent gets exemption unless they agree otherwise
        Qualifying relative: relative of anyone in T’s principal place of abode; gross income <$3050,
            T provides >1/2 support, not qualifying child, relationship doesn’t violate state law
     T cannot claim if another can claim T as dependent
     Phased out by income (over ~$200k)
   Dependent child credit (§24)
     $1,000 for each qualifying child under 17, phased out by income. Refundable up to a portion of
       T’s earned income. ([15% x earned income] - $10k adjusted for inflation)
     Rationale: set some amount that should not be taxed (then there should be no phaseout) or
       exempt subsistence level of income from taxation
   Earned income credit (§32)
     Eligible Ts: Ts with qualifying child, individuals 25-65 who are not another’s dependent
     Marriage penalty (lower percentage refunded for married couples than two individuals)
     Refundable
   Elderly/disabled: credit of 15% of income, with specified maximum (§22(a)), reduced by SS and RR
    benefits and other tax-exempt retirement income
   Education credits
     Nonrefundable
     Phased out by income (except §529), aimed at middle-income Ts
     Hope Credit: up to $1500 for first 2 yrs of college for T/spouse/dependent (§25A(b))
     Lifetime Learning Credit: undergrad/grad education, 20% of tuition/fees up to $10k, (§25A(c))
     If T takes Hope/Lifetime for student, no one else can take deduction for that student
     Coverdell Education Savings Account: up to $2k/yr, distributions for
       elementary/secondary/higher education for T/spouse/dependent. Phased out at ~$200k AGI.
     §529 Plans run by states, some colleges: no phaseout, so good for high-income Ts.
   Personal itemized deductions
     State, local, foreign taxes (§164).
        Property taxes must be based on property’s value and imposed on annual basis Must be
            personal property
        Income: largest deduction for most itemizers (Ts in states w/o income tax may deduct state or
            local sales tax instead)
        Foreign income taxes: credit against income
   Charitable contributions
     Cash, FMV of property, but not services (§170)
        Expenses incurred in donating are deductible (e.g. food, lodging, paying someone to help)
     Limited to 50% of AGI (corporations: 10% of taxable income); appreciated property limited to
       30% AGI
     Haircut, not floor
     Hernandez: contributions to Church of Scientology were not deductible because they were
       payments for church services (audits and training).
        Charitable contribution must not involve quid pro quo
        Dissent: IRS allows deductions for quid pro quos in other religions (e.g. pew fees, dues)
        1993: donations allowed for “intangible religious benefits” without commercial value outside
            the donative context

                                              18
           
           Substantiation requirement: charity must give receipt noting if anything was provided that has a
           non-donative market value (e.g. book for radio donation), and gift of property over $5k requires
           qualified appraisal. Car/boat/plane: deduction limited to resale price if charity resells.
        Courts increasingly follow Duberstein test (detached, disinterested generosity)
            But many charitable gifts are made with sense of moral obligation
        Transamerica: no deduction where there is direct economic benefit, but deduction where there is
           indirect business benefit like public recognition of charitable giving
        If donation makes donor eligible for athletic tickets, donation limited to 80%
        No deduction if payment is in lieu of a service (e.g. tuition)
        Property: T can deduct FMV of property regardless of embedded appreciation (no gain realized)
            Exception: property that would produce ordinary income or short-term capital gain if sold, or
                any property donated to private foundation (except qualified stock), or any tangible personal
                property unrelated to charity’s function - deduction is reduced by amount of unrealized gain.
                (§170(e))
        Depreciated property: should sell first, realize the loss, then donate.
        Charity: public activities, religious, scientific, literary, educational, preventing cruelty to animals
           or children. Cannot be involved in propaganda/political campaigns/activities against public
           policy.
   Alternative Minimum Tax (AMT) (§55(a))
     Rationale: Ts shouldn’t be able to get out of paying all tax when they are able to pay; broadens tax
       base
     AMT applies if it produces greater tax than regular tax would.
     Growing number of Ts will be subject because AMT exemption is not indexed for inflation and it
       includes middle-class-oriented deductions and credits (state income taxes, personal credits, etc.)
     26% of first $175k of AMT base, 28% on the rest
        AMT base: AMT income – allowable exemption ($45k married/$33,750 single, reduced 25
           cents/dollar over ~$150k married/$112,500 single)
        Base up to $62,550 (0%), up to $237,550 (26%), higher (28%) (a little higher because of $.25/$1
           phaseout after $150k)
        AMT income: slower depreciation rates, disallowing some itemized deductions (p. 774-76)
        No standard deduction, personal exemptions, no deduction for state/local taxes, only interest on 1
           home mortgage, ISOs, etc.
     Not simple, may restore tax equity and increase compliance because people will perceive the system
       as fair, can recapture windfalls (like tax-exempt bonds for high-income Ts)
     Congress must extend $62,500 base amount in 2008 or the AMT will apply after $45k. Standard,
       personal deductions are indexed for inflation and AMT is not. More people subject to AMT.
     Financial planning is difficult if T doesn’t know if he’ll be subject to AMT
 Whose Income Is It?
   Taxation of the Family and on divorce
     Poe: income split between spouses in community property states. Huge benefit for couples in those
       states, especially when rates were very progressive. 1948: Congress created joint return. 1969:
       reduced rates for singles.
     Druker: marriage penalty is not unconstitutional. It is impossible to design a progressive tax rate
       schedule that involves no marriage penalty, no singles penalty, and horizontal equity.
        Second earner’s salary taxed at higher marginal rate after marriage. Standard deduction for
           married is < twice single. Also penalty in EIC (p. 420), haircut (because phaseout begins at the
           same income level regardless of status), phaseout of dependent exemption.
        Marriage bonus: if one spouse earns >> other spouse, their combined taxes decrease due to lower
           rate on larger earner’s income.

                                                      19
        Imputed income problem: since income from domestic services not imputed, this creates
         incentive not to work unless T can earn more than a certain amount after taxes.
   Kiddie tax (§1(g)) restrict intrafamily income shifting
      Children under 19 and students under 24
      $1k indexed for inflation ($1400) of child’s unearned income is not subject to kiddie tax (uses
         child’s, not parent’s rate)
      Up to $700, no tax; $700-1400 gets kid’s rate (10%), above $1400 gets parent’s marginal rate
   Spouses jointly, severally liable for tax liability on joint return. But if tax understated, if one spouse
     didn’t know the mistakes, he is not liable for penalty/assessment.
   Civil unions/domestic partners must file separately.
   Head of household: one spouse living apart/ex can use this, other must file as single (§7703(b)); T
     married to nonresident alien uses this also
   Divorce
      Rev. Rul. 76-255
          Determination of marriage status as of close of taxable year
          IRS doesn’t question validity of divorce decree until court w/jurisdiction declares it invalid
          If no valid marriage ever existed, couple could not file jointly
          Divorce has no effect for tax purposes if it is only to avoid taxes (couple intends to remarry at
              time of divorce)
   Alimony/support
      Taxable to one of the spouses
          Alimony: recipient taxed, payor gets deduction (§71). Parties can elect not to do this.
               Above the line
               Cannot have any obligation to pay after spouse’s death, cannot be reduced upon child-
                  related events, e.g. graduation (this is child support)
               Cannot be front-end loaded (this is property settlement) (§71(f)). Declining payment is
                  okay as long as decline is <$15k/yr.
                   Excess payments recaptured in year 3
                   Yr 2 excess = yr3 + $15k – yr2
                   Yr 1 excess = yr1 - [([yr2 – yr2excess] + yr3)/2] + $15k
          Child support/property settlements: recipient excludes, payor cannot deduct (§152)
               Rationale: payor gets consumption value of paying for his child
          Property settlements: no gain/loss recognized on transfer incident to divorce. Recipient takes
              adjusted basis of transferor (so transferee is eventually taxed). (Treated like gift.) (§1041)
               Must be related to the divorce (in divorce document and within 6 yrs) or within one year
               Davis: H recognizes gain when he gives W stock to satisfy marital obligations (marital
                  obligation cannot be valued, but assumed it is equal to what is given up). W takes FMV
                  basis. §1041 reversed this.
               Theory: family is taxable unit, so tax should only be imposed once; or transfer is in lieu
                  of support that would have been untaxed
      Requires divorce/separation agreement (cannot just be offer to pay)
      Delinquent payments applied against child support first, then alimony
   Antenuptial agreements
      Farid-Es-Sultaneh: wife gave up valuable legal right (marital rights) upon receipt of husband’s
         stock, so it was not a gift. She takes basis on day of transfer, not husband’s (much lower) basis.
          Dissent: the pre-marriage gift of 700 shares could not have been a sale because she didn’t
              have marital rights at that point.
   No double taxation within family unit. So if there is an exchange/transfer, no realization, only one
     side is taxed.
 Assignment of Income
                                                    20
          Earned income taxable to earner; income from property taxable to owner
          Earl: H must pay tax on income he earned even if he assigned it in advance to his wife and therefore
           never had legal ownership of it.
            Today this result can be achieved through joint returns
            Same applies to, e.g., employer putting some of employee’s salary in trust for kid’s education
          Hundley: T had to pay income on salary assigned to father as his baseball agent, but could take
           business deduction for the salary paid.
          Rev. Rul. 74-581: where amounts received by law professors for pro bono work were endorsed to
           their law school, the income was excludible to them because the pro bono work was part of their
           duties as professors.
            If they had been included, professors would get business expense deduction when turning over to
               the law school, but employee business deductions are subject to 2% floor. Less favorable.
          Agency theory of assignment: Employee performs services, paid directly, gives funds to employer,
           employee is not taxed because he is employer’s agent.
            Priest not taxed on income turned over to church if the church itself performs those services.
               Otherwise, priest gets charity deduction (e.g. ascetics who give their outside income to the
               church).
            Giannini: employee who refused income and the corporation created a university foundation
               named for him did not have to include it as income.
          Income from property:
            If property gifted, any income from it is taxable to donee
            If income from property gifted, donor is responsible for tax
            Blair: T’s children responsible for tax on income from trust he had assigned to them.
            Horst: T owed tax on interest earned on bonds when he had detached the interest coupons just
               before maturity and given them as a gift to his son. He got the benefit of giving his son a gift.
                Overruled by §1286: basis of bond is allocated between portion retained and portion
                   transferred. Both parties subject to OID rules (each party reports increase in value of his part
                   each year). Total amount of income is the same.
                But generally, deferred compensation is taxable to the earner, not the donee.
            Heim: where T assigned 25% of an agreement to receive royalties from patents (that included
               reversionary interest and ability to negotiate other royalties on new products), the assignees
               (wife, kids) were taxable, not T.
            Short-term temporal carve-outs are ineffective to assign income.
            To avoid problems, people should make property gifts, not contract gifts (e.g. copyright itself,
               not right to royalties).

 Capital Gains & Losses
   Rates:
      5% for long-term if T in 10/15% bracket
      10% for T in 10% bracket, on short-term gains, gain to the extent of depreciation on long-term real
        estate, collectibles
      15% for T in 15% bracket, on short-term, gain to extent of depreciation on long-term real estate,
        collectibles
      15% normal long-term rate
      25% for 25% or over T, gain to extent of depreciation on long-term real estate
      25% for 25% T, gain on collectibles
      28% for 28% or over T, gain on collectibles
   Mechanics
      Realization requirement
      Capital losses only deductible against capital gains (plus $3k income for individuals)
                                                        21
    Holding period: 12 months. Long-term > 1 year. For carryover and substituted basis (gifts, like-
     kind exchange?), donor’s time is tacked onto donee’s.
   Calculating capital gains:
      [Short-term gains – short-term losses] - [long-term gains – long-term losses].
      Net short-term gain = ordinary income
      Net long-term gain = capital gains
      If there is net gain on both, tax each on its own rate
      Net loss = offset $3k ordinary income (short-term is used up first), excess carried forward (and
         each type of loss retains its character)
          E.g. $4k long-term loss, $2k short-term loss. $3k offsets T’s ordinary income, $3k long-term
             loss is carried forward (first $3k was $2k short, $1k long).
      Corporations: no preferential capital gains rate. No offsetting ordinary income. Carry forward 5
         yrs, carry back 3 yrs.
 Policy
   Arguments for preferential treatment:
      Capital gains are not income (not recurring, sometimes just reflect changes in interest rates
          Dollar of capital gain gives just as much ability to pay as dollar of income. Equity demands
             no preference.
              Dollar of capital gain is different for all the reasons below (different savings pattern,
                 bunching, etc.)
      Bunching: realization forces tax all in the year of disposition, but gains accrued over years.
         Bunching may force T into higher marginal tax bracket.
          But T got benefit of tax deferral
      Capital gain may just be inflation
          May be offset by benefit of tax deferral. Capital gains rate bears no relation to inflation rate.
      Tax on stock is double taxation
          Problem is with corporate taxation, not capital gains. Appropriate solution would be to
             coordinate stockholder and corporation’s tax.
      Disincentive to risk-taking: tax reduces expected return.
          Complete tax offset for losses would help. Government bears some of the risk of loss.
      Disincentive to savings: the earnings would tend to be saved by individuals, not spent.
         Government spends immediately. When T is taxed, savings suffer before consumption.
          Solution is taxing consumption, not income.
      Lock-in: Ts don’t sell to avoid taxes
          Mark-to-market would solve this.
   Arguments against preferential treatment:
      Complexity.
          This is not solved by taxing at ordinary income rates. Complexity comes from measuring
             gain/loss, not from applying the favorable rate.
      Primarily benefits high-income Ts, produces too little additional risk taking and saving to
         compensate for the lost revenue
          If rate were higher, people would defer realization, leading to less revenue. Wealthy can
             always control timing of tax because they can borrow against appreciated assets instead of
             liquidating.
 Definition
   Capital transaction: 1) involves property that is a capital asset; 2) property is transferred in
     sale/exchange; 3) minimum holding period must be met



                                                   22
   Capital: investment, reward for taking risk, market fluctuation; ordinary: compensation for services,
    interest from passage of time, normal business profit (wages, interest, rent; payment for use of
    person’s services, money, property)
   Most property is a capital asset.
     §1221 exceptions:
         Stock in trade or inventory of a business, or property held primarily for sale to customers in
            the ordinary course of trade/business
         Depreciable or real property used in trade/business
         Literary/artistic property held by its creator
             Composers can elect for capital treatment
         Accounts or notes receivable acquired in the ordinary course of trade/business
         U.S. gov’t publications sold at below-public price
         Commodities derivative financial instruments held by commodities derivative dealers
         Identified hedging transactions
         Supplies regularly consumed in ordinary course of trade/business
   Statutory Framework
     Property held for sale to customers (§1221(a)(1))
         Malat: “primarily” means “of first importance” so district/tax court must determine this.
             Timing problem: at time of sale, T’s purpose is certainly to sell (tautology)
         Equipment sold after rent-producing potential ended can get capital treatment
         Bramblett: T can apply capital rate to gains from sale of property to related entity that then
            developed it and sold in several parcels. T did not sell frequently, held the property 3 years,
            did not advertise, did not have office. Town East was not Mesquite East’s agent.
             Court looked at: is T engaged in t/b, if so, what? Was property primarily held for sale in
                that t/b? were sales “ordinary” in the course of t/b? nature/purpose of acquisition,
                duration of ownership, T’s efforts to sell, substantiality of sales,
                subdivision/development/advertising, use of business office to sell property, control by T
                over representative seller, time and effort devoted to sales.
             If T subdivided to facilitate liquidation, that helps his case for capital treatment.
             Continental Can: antitrust law forced T to sell previously leased sealing equipment to can
                customers. Held: ordinary gain, there was no change in T’s intent (forced to sell).
         Stocks/securities
             Dealer: realizes profit through mark-up, not through rise in value of stock (ordinary
                income)
             Trader: in t/b (ordinary income) if trading is frequent, substantial (although profit is from
                rise in value)
             Investor: profit from rise in value, but usually disregards short-term profit. Always
                capital.
     Property used in business
         §1231: real/depreciable property used in t/b yields capital gains and ordinary loss.
             Includes gains/losses on insurance, casualty, involuntary conversion
             Calculation:
                 Firepot: (gains from casualty/theft loss (insurance) – casualty/theft loss)
                     net losses  §1231 does not apply, gains are added to income, losses are
                         deductible from ordinary income
                     net gains  use firepot in hodgepot comparison
                 hodgepot: compare gains from firepot (if applicable) – [gains from condemnation/sale
                    – losses from condemnation/sale)


                                                23
                    net losses  gains are ordinary income, losses are deductible from ordinary
                     income
                  net gains  gains are long-term capital, losses are long-term capital
         if T has §1231 loss followed by §1231 gain in the next five years, the loss is recaptured
            by treating that portion of the gain as ordinary income
     §1245 recapture of previously deducted depreciation (T still gets time value)
         Up to amount of depreciation, gain is taxed as ordinary. E.g. $100k property, T takes
            $40k depreciation deductions. T later sells for $150k. $10k capital gains, $40k ordinary.
         Similar provisions for soil/water conservation, drilling/mining costs, oil/gas depletion.
         Does not apply to real property (§1250 applies: accelerated depreciation is recaptured)
         Gain up to amount of depreciation on real property held >12 months taxed at 25%
   Self-created intangibles
     Copyrights, literary/musical/artistic compositions, letters/memos/similar property prepared
        for T are not capital asset in creator’s hands or when basis is determined by creator’s basis
        (§§1221(a)(3), 1231(b)(1)(C))
         If children inherit copyright, they get basis step-up and any gains are capital. If creator
            gifts copyright to children, their basis is his and their gains are ordinary.
     §1235: capital gains for sale of patent by inventor, but must transfer all substantial rights
     §1223(b)(3): music composer can opt for capital gain/loss treatment (can get the best of both
        worlds, like §1231: ordinary loss, capital gain)
     “similar property” – software creator has ordinary income on sale of program
         Exception: records that are part of going concern value (e.g. patient records). Capital.
     §1221(a)(3) does not cover trade secrets, trade names. Capital assets.
   Financial contracts used in business
     §1221(a)(4): accounts or notes receivable acquired in the ordinary course of trade or business
        for services rendered or from the sale of property held for sale to customers in the ordinary
        course of business
     §1221(a)(5): government publications received by Ts without charge or at reduced price
         Ts should not get deductions for FMV of the materials when they’re contributed to
            charity (library/university)
     §1221(a)(7) and (8): hedging transactions, derivatives, supplies used in business
         Corn Prods.: T realized ordinary income on sale of corn futures because it bought them
            to hedge against rising corn prices. Its business was corn, so the hedging was part of its
            t/b.
             IRS won the battle, lost the war because Ts will argue that losing investments were
                 held for t/b purposes.
         Arkansas Best: T’s loss on sale of stock in a failing bank was capital because §1221 at
            that time defined capital asset as “property held by a taxpayer (whether or not connected
            with his business)” and didn’t fall into any of the exceptions (T didn’t argue it was
            inventory).
             If it doesn’t fit into a 1221(a) category, it is capital. Seems like it overturns Corn
                 Prods., but basically that case was just an expansive reading of 1221(a)(1)
         Hedge must be on ordinary property. If hedge is to protect investment, gain/loss is
            capital.
         T must declare something a hedge immediately to prevent calling it not a hedge later if it
            is profitable.
     §1256: some financial contracts and options must be marked to market each year, including
        business hedges that are not considered ordinary. Gain/loss is 40% short-term, 60% long.


                                            24
       Small business stock gets preferential rate (§1202) (exclude 50% of stock acquired at original
         issuance and sold >5 yrs later, remainder taxed at preferential rates depending on T’s
         income)
          Small business = net worth <$50M, ≥80% assets used in conduct of active t/b during T’s
             holding period, primary asset is not reputation of its employees (law, accounting,
             athletics, etc.)
       Dividends will be treated as ordinary income in 2010.
   Common Law of Capital Gains
     No capital treatment where substitute for future ordinary income
     Carve-outs
       Vertical carve-out (interest coterminous with seller’s rights): capital (selling the tree)
       Horizontal carve-out (interest sold ends before seller’s rights): ordinary (selling fruit)
       Hort: prepayment of lease (to get out of contract) was ordinary income to landlord.
       P.G. Lake: president’s cancellation of debt in exchange for an assignment of oil payment
         rights was a lump sum substitute for what would be future ordinary income on the oil. It was
         not a sale producing capital assets.
          Sale of interest income (without sale of underlying asset) produces ordinary income
       Bell’s Estate: assignment of life trusts to the remainderman resulted in capital gains to T. T
         sold the asset itself, not just the right to future income.
       §1258: gain realized on conversion transaction is ordinary. E.g. T buys $62 gold, enters
         forward contract to sell it in 5 yrs for $100. Correct to call it ordinary because T is only
         getting the time value of his money (interest), but incorrect to tax all at the back end (gives
         preference over other investments yielding ordinary income, like OID).
       Usually no basis allocated to the carved out interest (Hort) but it must be allocated when the
         carveout is given as gift/devise/etc. because otherwise family could carve up interest, hold
         gain portion (carved out interest) and take a loss on the asset (since whole basis is allocated
         to asset, despite it losing value due to carveout).
          §1001(e): where basis is determined under §§1014 (gift), 1015 (bequest), 1041 (property
             transfer incident to divorce), basis is allocated to the carved out portion, but disregarded
          §1001(e)(3): unless the asset and interest are sold to the same person (because no risk of
             holding on to gain only)
       §167(e): holder of carved out interest cannot deduct depreciation/amortization when
         remainder is held by a related person (although the interest itself is wasting), but disallowed
         depreciation shifts to holder of the asset/remainder.
          This is because the reduction in the value of the interest is tied to an increase in value of
             the remainder.
     What is property
       Ferrer: T, actor, had a lease on the play Moulin Rouge, the right to block sale of movie rights
         if he produced the play and to 40% proceeds from the movie. He sells both rights to Moulin
         as part of deal to act in movie. Moulin paid him salary and some profits, contingent on his
         performance. Surrender of lease on play is like lessee’s surrender of lease (Hort) but Ferrer
         could get injunction to enforce lease, so it is like property. Same re: right to block movie.
         Capital gain for those two. But 40% proceeds is a right to future income, so selling that right
         now produces ordinary income.
          Property: injunction, enforceable against world - capital
          Contract: damages, enforceable against other contractors - ordinary
       Maginnis: proceeds from sale of lottery ticket were ordinary because T made no investment,
         sale did not represent an accretion of value over cost.
          Not true: payment for ticket is very small investment and winnings are huge accretion
       Lattera: Lottery winner who sold right to remaining future payments had ordinary income.
                                                 25
              1) family resemblance test: does it look more like stock/bond or interest/rent?
                  2) type of carve-out: horizontal (ordinary), vertical (capital)
                      3) character of the asset: right to earn income (capital), right to earned income
                         (ordinary)
          when T receives payment both for services rendered and an asset, the price must be allocated.
             Ferrer was remanded for tax court to determine this wrt the 40% proceeds.
          Property is a capital asset, unless one of the §1221 exceptions apply, or unless it is a
             claim/right to ordinary income
     Sale of a going business
          Williams: upon sale of going business, look at each part separately to determine
             characterization. In sale of hardware store, fixtures, inventory, goodwill, and receivables
             were all capital and everything else was ordinary.
              Typical problem: how much of business is goodwill (capital, 15-yr straight-line
                 depreciation)
     Prior transactions
          Cummings: since gains on illegal 16(b) sale/repurchase were capital, T’s repayment of the
             gains was a capital loss (despite being done for a business purpose, i.e. preserving business
             reputation).
              Dissent: T should have to add the repayment to MGM to his purchase price because the
                 disgorgement was caused by the repurchase, not the sale. (Worse for T, because his
                 capital loss is deferred to a later date, when he sells.)
                  §1212(b): T cannot carry the loss back to 1961 to offset the capital gains he reported
                     then.
              Arrowsmith doctrine: transactions that are sufficiently related to an earlier transaction that
                 produced capital gains must be treated as producing capital loss.
                  Sometimes applied to reverse: gain related to earlier loss reported as capital must be
                     reported as capital also.
                  Ordinary income linked to later deduction, deduction usually treated as ordinary
                  Where an ordinary deduction is linked to later gain, the gain is not always treated as
                     ordinary income
 What is a sale or exchange
   Short sale: contract for sale of shares which seller does not own, but will make available for delivery
    at the time when delivery must be made
   Prior law: no recognition on the short sale because cost of securities not known. Recognition
    postponed until T returned identical property to the lender.
   §1259: tax to holder on any gain where there is a constructive sale of an appreciated financial
    position.
     Constructive sale: T/related person enters short sale or offsetting notional principal contract with
         respect to substantially identical property. Also when T holds appreciated short position and
         acquires long position in same property.
     At time of sale, seller recognizes the difference between the FMV and his basis, then when the
         contract is closed, the remainder of the gain is recognized.
   Yarbro: T had capital loss when he abandoned property subject to a mortgage whose value exceeded
    the property value. The abandonment was a sale/exchange because T exchanged his property for a
    relief from his debt. The relief from debt caused T to abandon.
     Where T receives some benefit by abandoning (e.g. release of a legal obligation), the loss must
         be capital. Otherwise T with very low worth property will abandon rather than sell, to get
         ordinary loss instead of capital loss.



                                                   26
    Sale/extinguishment of contract rights (e.g. tenure, lease provision calling for return of property in
     same condition) is not a sale/exchange. The right cannot be transferred to or utilized by another. So
     T realizes ordinary income, not capital gains.
   Structure sale as lease to convert ordinary income into capital gains. E.g. Corp sells stock to
     Charity, which pays nothing. Charity liquidates stock, leases assets back to NewCorp, which pays
     its profits to Charity as rental payments. Charity pays it back to NewCorp as installment payments
     on the purchase price of the stock.
   §514: tax on income of tax-exempt organization from debt-financed property. Net income taxable in
     proportion to ratio of debt to adjusted basis of the property.
      Approach can still be used with a company that has net operating losses.
   §1231: how to characterize losses on involuntary conversions of business assets
      Stocks/bonds that become worthless: capital loss (§165(a), (c)(2))
           Or ordinary loss if it is qualifying small business stock
      Nonbusiness bad debt: short-term capital loss (§166(d))
           Bad business debt: ordinary, other than securities (§166(e))
      Casualty losses: business run through §1231; personal is capital loss (§165(h))
           Rationale: nonbusiness bad debt and personal casualty losses were not profit-seeking
              anyway, so shouldn’t get ordinary loss.
      Payment by company to retire stock: capital gain (§331)
      §1241: amount received by lessee/distributor (not supplier) for cancellation of lease/distributor
          agmt is capital gain/loss
   Net gifts
      Diedrich: where T makes gift of property on condition that the donee pay the gift tax, T has
          income of donor’s adjusted basis – gift tax paid. Donor has the debt to IRS, and he has been
          relieved of that.
           Estate of Weeden: donor realizes income in the year that donee pays the gift tax (if cash basis
              T)
           Tax liability < transferor’s basis  no gain, and transferee gets transferor’s basis
           Tax liability > transferor’s basis  transferor has gain on (liability – basis) and transferee
              gets basis in the tax liability paid
               For part-gift/part-sale to charity, transferor’s basis is apportioned and he can deduct (gift
                  portion – basis apportioned to part).
 Holding period
   Year + 1 day.
   Day of purchase is excluded, day of sale is included
   No holding period requirement for capital assets acquired through inheritance (§1223(11))
   Holding period of previous owner is tacked on for, e.g., gifts (§1223)
 Nonrecognition rules
   Recognition postponed until T’s investment is significantly altered
   Like-kind exchanges
      No recognition when certain property held for productive use in t/b or for investment is
          exchanged for property of a like kind (§1031)
      Basis of property given up becomes basis of property received (§1031(d))
      Gain realized is recognized up to the amount of any boot received
           T recognizes gain, but not loss, on any boot received (§1031(b), (c))
      BOOT: non-qualifying consideration (cash, stock, assumption of liability)
           Transferor (of boot) recognizes gain up to the amount of boot received (first taxed on the
              gain, then it reduces basis)
           Transferee (of boot) increases basis by the amount of boot paid

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       
        Basis = original basis – boot received (or + boot paid) + gain recognized
        Debt
            Assumption of debt by a transferee is treated as cash paid to transferor on relief of debt
            If both parties swap debt, the debt is netted and the one with more relieved debt is treated
               as having that amount of cash as boot
     Transaction in which T receives cash which he uses to buy like-kind property will be treated as a
       sale, not like-kind exchange
        To avoid, T must designate the property within 45 days and complete the exchange within
           180 days
     Both properties must be held for t/b or investment
     if T has intent to give the property received as a gift (not hold for investment), it is a sale
     §1031 is mandatory, not elective. If T wants to realize loss on property before exchanging, he
       should sell first, then buy the other property.
     Like-kind property: within the same class (10 classes)
        Intangibles, nondepreciable property not in the classes; regulations consider these
        “like kind” defined more narrowly for personal property than real property
     §1031 limited where exchange is between related parties:
        If either party disposes within 2 yrs, the gain on the original transfer is recognized on
           disposition
     Holding period of previously held property tacked on to holding period of acquired property
       (§1223(1)) if basis in the two properties is equal and property given up was capital asset or a
       §1231 asset at the time of exchange
     Rationale: avoid taxing when T has no liquidity to pay the tax; also difficult to value the
       property; T has changed only substance, not form of investment
   Involuntary conversions
     §1033: nonrecognition is permitted on gain resulting from involuntary conversions if T uses
       proceeds to acquire property of similar use (or, if real estate, like kind) within 2 yrs after
       involuntary conversion
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              Elective, not mandatory
              No nonrecognition treatment for stock in trade or property held primarily for sale (§1033(g)).
               Where disposition was a matter of business discretion, not practical necessity, there must be
               recognition.
          Sale/exchange of principal residence
            T may exclude $250k ($500 married) on gain from sale of principal residence if used for two of
               previous five years (§121)
            If gain is attributable to depreciation (i.e. place was used for business), the gain is not excludible
          Small business investment companies: nonrecognition of gain on sale of publicly traded securities if
           proceeds are invested in stock/partnership interest in “specialized small business investment” within
           60 days. (§1044)
          Qualified small business stock: T can defer recognition of gain on sale of qualified small business
           stock held for >6 months if T buys replacement stock in another qualified small business (§1045)

Bond risks: company doesn’t repay; market risk (interest rates go up); inflation risk; sometimes liquidity risk;
foreign exchange risk (if bond is not in dollars)

 When Is It Income or Deductible? (Accounting)
   Accounting method used on T’s books determines accounting method for tax purposes
     Cash method: income taxed on receipt, deductions taxed when paid
     Accrual method: income taxed when earned, deduction taxed when owed
   Exception: Secretary determines method if T’s does not clearly reflect income
   The taxable year
     Burnet: T got judgment because co-contracting party had underestimated the costs of dredging a
       river. So T earned the money when dredged (1913-1916) but was not paid until judgment (1920).
       Had reported losses in earlier years because it had spent more doing the work than it had in income.
       Held: T had income in 1920, could not use it to offset losses from earlier years. Can’t combine years
       because IRS must assess taxes at some reasonable interval.
     Taxable year is calendar year for most Ts. Can be fiscal year ending on last day of any other month.
        Short taxable year (T died, corporation dissolved/created) treated as full tax year
     Tax benefit doctrine
        Inclusionary component: where T deducts from income in yr 1 and recovers that amount in yr 2,
            the amount recovered must be in included in income in yr 2.
        Exclusionary component: where deduction in yr 1 produced no tax benefit, subsequent recovery
            does not produce taxable income
             E.g. credits: If T took tax credit in yr 1 and had recovery in yr 2 of the item giving rise to the
                credit, T must report income of the portion of the credit recovered in yr 2 (§111)
             Damage recoveries: if T earlier got no benefit from a contract/antitrust/patent infringement
                loss, he can deduct it from the recovery when reporting income later
        BUT current tax rate applies, so if T’s bracket goes up, he pays more in tax later than he would
            have paid earlier
        Hillsboro: where state refunded tax to shareholders (which corporation originally paid for them),
            they had no income. Where company deducted cost of feed and then distributed it to
            shareholders, they had income. Tax benefit rule requires reporting income later where the
            receipt of money is inconsistent with the earlier position (if they had occurred in the same year, T
            would not get a deduction). Need not be “recovery.”
             Test: the deduction and later event are fundamentally inconsistent
        Can also be used to give T income where it was excluded earlier (e.g. bank with unclaimed
            deposits)
        No statutory provision for recapture after conversion of business property to personal property
                                                     29
   Net operating loss deduction
     T may apply a business loss incurred in one year against income earned in another year. Carry
       back a net loss 2 years and carry forward 20 years. (§172)
        Business loss only. Expense must be related to t/b. (plus casualty/theft losses)
            Other capital losses carried forward only
        Married Ts on joint return can use NOL of one spouse’s business to offset income from other
           spouse’s business, but no carry back to spouse’s business after that spouse died.
        No carryover to decedent’s estate, but can be carried back 3 yrs on T’s personal returns.
     Mechanics for carry back: file refund claim to recover tax already paid for year past
 Methods of accounting
   Cash method
     Cash method is default method (§451)
     Deductions, credits follow same method as income (§461)
     Can be used by qualified personal service corporations (activities in certain field, 95% of stock
       owned by retired of current employees who perform the qualified activity)
     Constructive receipt doctrine
        T has income when he has the immediate power to receive the income
        Carter: income earned by T in 1974 but not paid until 1975 was taxable in 1975 because he
           did not have free, unrestricted control of the wages before receipt
        T not taxable on compensation he refuses to take
        No constructive receipt just because T could have arranged to receive payment earlier
        Escrow often shifts income to later years (unless escrow agent is payee’s agent only)
        Where funds embezzled and then returned, they were constructively received on return, not
           when earned.
     Economic benefit/cash equivalent
        Cash equivalent (actual receipt of property or right to receive property in the future) is
           taxable upon receipt
            Rev. Rul. 80-52: barter club members had income upon receipt of credits because they
               were immediately useable to purchase other items/services.
        checks = cash. Some debate where T couldn’t cash the check in yr 1, e.g. received it on
           Saturday Dec. 30 and bank closed until Jan. 2.
        Promissory note (if promisor is solvent and note is unconditional and assignable and of a
           type frequently transferred to lenders) = cash
        Accounts receivable, non-negotiable notes, other debt instruments ≠ cash (this would turn
           cash method into accrual method)
        The more liquid a note is, the more likely it will be treated as cash.
        no income on “unfunded, unsecured” promise to pay in the future
     Pre-payments
        Boylston Market: cash-method T who prepaid insurance premiums must deduct pro rata over
           the relevant years; deduction in the year of prepayment distorts income. Payment creates an
           asset with life beyond the current year.
            Pure cash method accounting rules give way to capitalization rules.
            Accrual method T who receives pre-payment must include it as income in the year
               received. So prepayment is bad because payor must delay deduction and payee must
               include income immediately.
                Solution: structure as loan or deposit.
        Exception: prepayment for intangibles whose benefit lasts 12 months or end of the year
           following year of payment can deduct upon payment. Accrual-method payor can defer some
           advanced payments to succeeding year.
                                                30
        Cash method T must allocate and deduct prepaid interest over the loan period (§461(g))
        IRS suffers where accrual method T makes deferred payment to cash method T. Payor takes
            immediately deduction, payee delays inclusion of income.
             Addressed by matching rules, e.g. payments among related parties (§267), deferred rental
                payments (§467), etc. Payor cannot take deduction until payee includes in income.
   Accrual method
     More accurate reflection of economic gain
        Problem: incomes, deductions taken at stated amount, no discount to present value; also
            liquidity problems for T if income earned now but not paid until later
        Payment accrues even if payment is unlikely (so no discount for risk or time)
     Required for businesses with inventories
     “All events” test: all events have occurred which determine the fact of liability and the amount
       of such liability can be determined with reasonable accuracy (§461(h)(4))
        Hughes Props.: casino could deduct amounts guaranteed but not paid as payoffs on
            progressive slot machines (casino will definitely be liable, and amount is at least what is
            guaranteed in the machine)
        General Dynamics: self-insurer employer could not accrue employees’ expected medical
            costs until claims were filed even though the medical services had already been provided
     Time value
        Ford Motor Co.: Ford could only deduct amounts of structured settlements that it paid in the
            taxable year. Its method of deducting all amounts paid in the year plus all amounts due under
            periodic payment schedule did not “clearly reflect income.” Ford could exclude income from
            annuities and take an immediate deduction for the cost of the annuities that paid the
            settlements, rather than recovering under §72 (benefits Ford).
             Secretary determines a computation method that clearly reflects income (§446(b))
        Problem is allowing a current deduction for a future expense. Mooney Aircraft (promise to
            pay $1k in 20 yrs; if deductible now, Mooney saves $350, investing at 6.5% yields more than
            $1k in 20 yrs, so Mooney makes a profit). If Ford could do it, they’d make a profit on killing
            people.
     Economic performance (since 1984): accrual basis T can only deduct a liability when the
       events that give rise to the liability have taken place. E.g. A will pay B $100 in year 3 for
       performance of service in year 3. No deduction until year 3, despite a liability on the books.
        Accrual method T cannot deduct a tort liability until the year in which payment is made
            (§461(h)(2)(c)). Same with awards, prizes, jackpots.
        Recurring items exception: T may deduct expenditures on recurring items as soon as “all
            events” test is met, if economic performance occurs within 8.5 months after close of taxable
            year.
   Installment method
     Where gain is uncertain (value or timing of satisfaction is uncertain), basis is recovered first (no
       allocation of basis). Open transaction. Gain reported on “cost recovery” basis: payments applied
       first to basis and gain recognized after that point.
        Applies only to gains, not losses
        Not used on sale of inventory/real estate held for sale in the ordinary course of t/b, publicly
            traded securities, or where the installment note itself can be publicly traded
     T can opt out of installment method (§453(d))
     Result: tax deferral until basis is used up
     Installment sales between related parties: where purchaser disposes of the transferred property
       within two years of the installment sale, the initial seller recognizes gain on resale of property to


                                                31
        the extent the amount realized on the second sale exceeds the actual payments made under the
        installment sale (§453(e))
      Calculation: apply ratio (gross profit/total contract price) to each payment and tax that amount.
        The rest of each payment is recovery of basis.
         Gross profit = any cash received + any mortgage assumed + note value – basis
             Do not include assumption of mortgage in contract price except to the extent it exceeds
                basis. (because T doesn’t have liquidity to pay when the consideration is only mortgage
                relief)
      Disposition of installment obligation (sale, transfer, gift, cancellation, unenforceability) triggers
        recognition of any remaining gain.
         Does not apply to bequest or transfer between spouses upon divorce
         No step-up in basis of the installment obligation at decedent’s death
         Gain/loss recognized = T’s basis in the installment obligation – amount realized on
            disposition
             T’s basis = face value of obligation – amount reported as income if obligation were
                satisfied in full
      Property will only be determined to have no FMV in rare cases
      Where there is no stated maximum sale price or no fixed period for payment, the term will be 15
        yrs
         If too speculative (open stream of percentage payments), treated as rents/royalties: then T
            pays ordinary income on present payments (least advantageous)
 Imputed interest
   Compound interest = economic = actuarial
   Original issue discount (OID): debt issue price is less than amount to be paid at maturity
      Bonds issued with zero or below-market interest payable currently
      Lender reports annually the OID that accrues economically. Interest income. (§1272)
      Adjusted issue price at the beginning of the period * yield to maturity
      Add OID for each accrual period to the adjusted issue price of the bond and to the holder’s
        adjusted basis
      Borrower deducts same amount as interest
      Puts both parties on accrual method for OID
      OID rules do not apply to tax-exempt debts, US savings bonds, or debts with term <1 yr; debts
        between people if total loan is <$10k, loan isn’t part of lender’s trade/business, and no tax
        avoidance purpose
      OID rules apply whenever there is unstated interest on a debt instrument (recharacterizes part of
        the sales price as interest). If debt instrument does not declare an interest rate, or states on less
        than the applicable federal rate (AFR), interest is imputed.
         Does not apply to sale of principal residence, debt instrument traded or issued for publicly
            traded property, sale of patent where part of price is contingent on use, or sale of farm by
            individual/small business for ≤$1M (§483 applies to these, other than patents)
             §483: imputed interest allocated among principal payments under the contract using
                economic accrual computation, but amounts are reported as interest by cash basis Ts at
                time of payment, not upon accrual
             Use 6% interest rate to determine whether there is unstated interest on sales <$500k of
                land between related people
      Market discount: bond’s stated redemption price > holder’s basis in the bond at the time of its
        acquisition
         value of debt declines after it is issued (usually because interest rates increase)
         Market discount treated as ordinary interest income on compound basis (§1276)

                                                   32
              Cash method Ts can report interest at bond disposition
          Below-market demand loan (gift loan/loan payable on demand) (§7872(f))
              Each year loan is outstanding, amount of interest that would have been payable if the interest
                 rate were the AFR is treated as if it were transferred by the lender to the borrower then
                 retransferred to the lender as interest.
                  E.g. employer-employee loan. Employee has income of the interest amount, employer
                     has deduction. Transfer back to employer is deductible to the employee only if the
                     interest is deductible under §163.
          Term loan: below-market if amount loaned > present value of all payments to be made under the
             loan, using the AFR on the date the loan is made. If the interest is too low, §7872 applies.
   Deferred compensation
      Qualified plan: employer may deduct deferred compensation now and employees are taxed when
         they receive the payment
          Qualified benefit plan: employee entitled to specified benefits; employer makes contributions
             required to provide those benefits. Max $160k/yr benefit.
          Defined contribution plan: employer makes specific contribution, employee receives whatever
             accumulates. Max $40 contribution.
          Nondiscrimination requirement: substantial number of lower-paid employees must participate
      Nonqualified plan: employer can only include deduction when employee includes in income
          §409A: employee must include in income currently if:
              he is protected against employer’s bankruptcy (e.g. money is in escrow)
              employee didn’t ask for deferral until the money was offered (must commit beforehand that
                 the money will remain in employer’s hands)
      Tax penalties for employees who withdraw pension funds before retirement
      IRAs: Roth paid with after-tax dollars, no tax on distribution; traditional paid with pre-tax dollars,
         tax on distribution. Economically equivalent if tax rates are constant, but Roth permits larger
         accumulations ($5k after-tax contribution instead of the after-tax equivalent of $5k pre-tax)
      401(k)/403(b) etc.: optional salary reduction plans (pre-tax saving)
      ISOs (§421(a)(1))
          Non-ISO treatment: income on exercise (stock price when option exercised - stock price when
             option granted); capital gains on subsequent sale; or if option is publicly traded, then income on
             receipt of option, no income on exercise, and capital gains on sale
          ISO: Not taxable when granted/exercised; basis is price at exercise; capital gains on sale. No
             deduction to employer.
          Option price cannot be less than FMV of the underlying stock when the option is granted.
             Employee may not dispose of stock within 2 yrs of receipt or one yr of exercise. Option term
             cannot be > 10 yrs. Option cannot be transferable.
          ISOs are treated as non-ISO for AMT. tax on (sales price – exercise price).
 Corporate Tax Shelters
   Criticism: short-term revenue loss, promotes disrespect for the system and others perceive unfairness,
     increases complexity in response to abuses, uneconomic use of resources (IRS time, money;
     accountant/lawyer time, money)
   Hard to define. Usually use lack of economic substance, inconsistent financial accounting and tax
     treatments, tax-indifferent parties involved, marketing activity of the scheme, confidentiality required,
     contingent promoter fees based on level of tax savings realized, high transaction costs
   ACM: 3d Cir. used two-pronged economic substance test: subjective (business purpose) and objective
     (practical economic effects other than creating tax losses). Abusive tax shelter present where ACM
     invested in Citicorp notes that would not have greater return than a bank account (loss on LIBOR notes
     is not “economic substance” because Colgate could have accomplished this without the Citicorp

                                                      33
  transaction), ACM planned the transaction with no regard to pre-tax economic benefit and there was no
  reasonably anticipated pre-tax profit especially given the high transaction costs.
   Cottage Savings allowed the loss because there was real loss, not artificial. Here, the loss was
      artificial and created during the transaction. There, the loss occurred in the market.
   Test looks for unnecessary transaction features that create artificial losses or boost basis artificially
      but have no reasonable potential for profit after transaction costs.
 Shelter users usually protected against penalty if they have a legal opinion letter stating that the shelter
  does not violate law.




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