Federal Personal Income Tax
I. GROSS INCOME – § 61(a)
1. (a) Gross income means all income from whatever source derived, including (but not limited to)
the following items:
(1) Compensation for services, including fees, commissions, fringe benefits, and similar
(2) Gross income derived from business;
(3) Gain derived from dealings in property;
(8) Alimony and separate maintenance payments;
(10) Income from life insurance and endowment contracts;
(12) Income from discharge of indebtedness
(13) Distributive share of partnership gross income;
(14) Income in respect of a decedent; and
(15) Income from an interest in an estate or trust.
• Tips are included
• Any amount conferred as compensation –doesn’t have to be money.
• Rebates or deductions on sales price are not really income, just the seller had adjusted the
amount for sale more slowly
2. Cesarini v. U.S. – Family got piano in 1957. IRS claimed tax liability for 1964. Here, statute of
limitations would have expired if that were income in 1957, says 1964.
• Court decided that it was theirs in 1964 under Ohio Law. Don’t have absolute ownership
rights until you discover it’s there. In applying national law, court is looking at state property
• In this case-they probably had a non-reportable source of income that they did not want to
report, so they said that they found it in the piano.
• Most prevailing Supreme Court view:
1. undeniable accessions to wealth
2. clearly realized
3. which the taxpayer had complete dominion over.
B. General Definition
a. Centerpiece of the income tax because it defines what is subject to tax
b. Section does not impose a tax but rather defines what is subject to tax.
c. §§ 71-90 are concerned with additional items specifically included in gross income.
d. §§ 101-136 specifically exclude certain items.
2. Regulation § 1.61-1 (note: regulations have force of law)
a. Gross income includes income realized in any form, whether in money, property or services.
b. May be realized in form of services, meals, accommodations, stock, other property or cash.
c. Not limited to enumerated items (inclusive)
a. Commissioner v. Glenshaw Glass Corp.
• Punitive damages included in gross income
• “Congress applied no limitations as to the source of taxable receipts, nor restrictive labels
as to their nature.”
• “Instances of undeniable accessions to wealth, clearly realized, and over which the
taxpayers have complete dominion.”
• Income should be broadly construed.
C. Compensation for services – § 61(a)(1)
1. Regulation § 1.61-2
a. (c) The value of services is not includible in gross income when such services are rendered
directly and gratuitously to an organization described in § 170(c). [meaning value of services
not includible in the organization’s income).
b. (d) Compensation other than cash
1) Except for the provided in paragraph (d)(6)(i), if services are paid for in property, the fair
market value to the property taken must be included in income
• If services are paid for in property, fair-market value is used to determine value.
• If there is a stipulated price, then it can determine the amount of income.
2) If services are paid for in exchange for other services, the fair market value of the other
services taken in payment are included as compensation.
• When individuals barter, basic rule is that exchange has taken place-person who receives the
good has been paid compensation.
Old Colony Trust Co. v. Commissioner
• Company by vote agreed to pay taxes for all officers of the company out of the corporate
treasury. Issue- did this additional payment constitute additional income to the tax payer?
• A taxpayer/employee cannot avoid paying a corresponding tax by having a third party pay his
income tax in return for his obligations.
• Should pay your own taxes- obligations that somebody satisfied will be treated as payment
made to you.
• Discharge by a third person of an obligation to the first is equivalent to receipt by the person
• Tax is not a gift despite its voluntariness because the payment for services is compensation
within the statute.
• The tax is not taxing a tax. The services provided to the taxpayer qualifies as income, not as a
tax. Thus, the government actually taxing once. Government further conceded that no further
tax was owed other than what was sought in this case.
• People who had performed professional services for clients- they tried to collect the money
and clients did not pay. Instead of risking the possibility that they would not collect anything
at all, they agreed to accept goods and services from clients and its an exchange of services
• Was there a stipulated price? Yes, the retail price. Tax payers argued that the value of goods
they received was not of the value that they would have normally paid. Taxpayers argue that
this amounts to a lesser amount.
• Court says: use objective standard or fair-market value. Fair-market value means price at
which thing would change hands between willing buyer and willing seller. If parties have
reached an agreement, that is considered objective. Because real people in the world were
paying these goods and services, that’s what’s used to determine this value.
D. Tax-free Fringe Benefits
1. Work Related Fringe Benefits – § 132
Statute – Gross income shall not include any fringe benefit which qualifies as a:
(a) Exclusion from gross income-shall not include any fringe benefit which qualifies as a –
(1) No-additional cost service – §132(b) –means any service provided by an employer
to an employee for use by such employee.
1. Line of business in which the employee works
2. Service offered for sale to customers in ordinary course of business
3. Employer cannot incur substantial additional costs
4. Employer cannot discriminate – look to §132(j)(1), these must be satisfied
5. The employer must provide service to an employee
• Reciprocal agreements – US Air employee can ride on TWA if there is a written
agreement (§132(I)(1)) so long as there are no substantial additional costs
(§132(i)(2)) to the employer.
• Spouse and children – benefit extends to the employee’s spouse and dependent
(2) Qualified employee discount - §132(c) -less than customers normally pay.
a) Any employee discount with respect to qualified property or services to the
extent such discount does not exceed—
1) Property – the gross profit percentage of the price at which the property is
being offered by the employer to the customers (cannot be lower than pre-
markup price), or
2) Services – 20% of the price at which the services are being offered to
customers. So, only 20% is excluded from income, the rest will be
considered income under §61as a fringe benefit.
• Spouse and children – benefit extends to the employee’s spouse and
dependent children (132(h)(2))
• Definition of qualified property or services-any property (other than real
property and other than personal property of a kind held for investment) or
services which are offered for sale to customers in the ordinary course of
the line of business of the employer in which the employee is performing
(3) Working condition fringe - §132(d)
a) Definition – any property or services provided to an employee of the employer
to the extent that, if the employee paid for such property or services, such
payment would be allowable as a ordinary and necessary deduction under § 162
or §167 if paid directly by the employee.
2) Reimbursed business trip
3) Office; desk on which to work and other equipement
• A good or service should not be excluded unless it is substantially related to the
employee’s work and is something ordinarily useful to someone in the
(4) De minimis fringe - §132(e)
a) Property or service the value of which (after taking into account frequency with
which similar fringes are provided by the employer to the employer’s
employees) so small as to make accounting for it unreasonable or
b) Examples – Fax and Xeroxing copy benefits and local calls
c) Eating facilities – Operation by an employer of any eating facility for employees
is de minimis fringe if:
(i) Such facility is located on or near the business premises of the
(ii) Revenue derived from such facility normally equals or exceeds the
direct operating costs of such facility.
(5) Qualified transportation fringe - §132(f)
a) Any of the following provided by the employer:
1) Transportation in a commuter highway vehicle (bus; not a car) if between
residence and place of employment,
2) Any transit pass,
3) Qualified parking (132(f)(5)(C) – means parking provided to an employee
on or near the business premises of the employer or on or near a location
from which the employee commutes to work by transportation described in
sub-paragraph (A), in a commuter highway vehicle, or by carpool. Such
terms shall not include any parking on or near property used by the
employee for residential purposes.
b) Amount excluded must not exceed
1) $100 per month of the aggregate of the benefits for transportation and
transit pass; and
2) $175 per month in the case of qualified parking.
(6) Qualified moving expense reimbursement - §132(g)
a) Expenses which would be deductible as a moving expense under § 217 if
directly paid or incurred by the individual.
(7) 132(j)- Certain exclusions are not available unless benefits are provided to a fair
cross-section of the employees. Applies only to paragraphs one, or two or sub-section
(a). No requirement that this can be on equitable basis here,.
What questions must you answer before decide whether no-additional cost service?
1. Is service offered for sale to customers?
2. Is service in ordinary course of the line of business of the employer?
3. Is the line of the business of the employer in which the employee is
4. Does the employer incur a substantial additional cost in providing such
service to the employee?
5. Does it include foregone revenue?
• Special Rule J- applies to any fringe benefit described therein provided with respect
to any highly compensated employee only if such fringe benefit is available on
substantially the same terms to each member of a group of employees which is
defined under a reasonable classification set up by the employer which does not
discriminate in favor of highly compensated employees.
United States v. Gotcher (§132 was developed after this case)
• Mr. and Mrs. G took an expense paid trip to Germany to tour a Volkswagen facility.
Upon his return, Mr. G bought an interest in a VW dealership. The cost of the trip
was paid by VW and not reported as income.
• The primary purpose of the trip was to induce Mr. G to buy the VW dealership
interest. The dominant purpose of the trip is the critical inquiry and some
pleasurable features will not negate the finding of an overall business purpose.
• In analyzing the tax consequences of an expense-paid trip, one important factor is
whether the taxpayer had any choice but to go; here Mr. G did not.
• If an expense-paid trip primarily benefits the party paying for the trip (VW), as it
does here, the value of the trip should be excluded from the gross income of the
• However, the expenses of the accompanying spouse that are of no benefit to the
parties paying for the trip should be included in the taxpayer’s gross income.
• What if case arose today?
a) His income would qualify as working condition fringe excluded under
b) Wife’s income, however, would not be excludable because inclusion of
wife under § 132(h)(2) applies only to no additional cost and employee
2. Meals and Lodging - §119
Meals or Lodging Furnished for the Convenience of the Employer
• § 119(a) – Meals and Lodging furnished to employee, his spouse, and his
dependents, pursuant to employment- There shall be excluded from gross income of
an employee the value of any meals or lodging furnished to him, his spouse or any of
his dependents by or on behalf of his employer for the convenience of the employer,
but only if –
(1) meals – they are furnished on the business premises of the employer, or
(2) lodging – the employee is required to accept such lodging on the business
premises of his employer as a condition of his employment.
1. furnished to the employee, his spouse, or any dependants (dependant is
resides with the tax payer and who either receives a majority of his
support from the taxpayer or over half his support and is under 24)
2. providing meals and lodging (by or on behalf of his employer)
3. provided for the convenience of the employer
4. meals are furnished on the business premises of the employer.
5. Lodging- the employee is required to accept such lodging on the
business premises of his employer as a condition of his employment.
• § 119(b)(4) – All meals furnished on the business premises of an employer
furnished to employees (not spouse or dependent) shall be treated as furnished for
the convenience of the employer … if more than half of the employees to whom such
meals are furnished on the premises are furnished for the convenience of the
• Meal must be in-kind to qualify for exclusion; cash reimbursements do not qualify
for excludability (Commissioner v. Kowalski).
Regulation – § 1.119-1
• Meals furnished by an employer without charge to the employee are furnished for the
convenience of the employer if such meals are furnished for a substantial
noncompensatory business reason of the employer (intended as compensation).
• The mere declaration that meals are furnished for noncompensatory business reason
is not sufficient to prove that meals are furnished for the employer’s convenience,
but the determination will be based upon surrounding facts and circumstances.
• What is non-compensatory business reason? Employee doesn’t have to leave to
get food and take time away from work.
• If meals are provided on the business premises, chance employee will east
at her desk, even if take time in going to conference room, still a lot shorter
than going to a restaurant.
• Meals furnished before or after working hours will not be regarded as furnished for
the convenience of the employer (but see (ii)(d) and (f)).
• Non-working day meals do not qualify for the exclusion.
• Meals will be regarded as furnished for a substantial noncompensatory business
reason of the employer when the meals are furnished to the employee during his
working hours to have the employee available for emergency call during meal
period. § 1.119-1(a)(2)(ii)
• Proof shown by the fact that
(1) Emergency has actually occurred;
(2) Can reasonably be expected to occur; or
(3) Results in the employer calling on the employee to perform his job during
his meal period.
• In order to be excludable, lodging must be on the business premises-close doesn’t cut
it. If law school bought house for a professor, would not be excludable benefit
because not on business premises.
Commissioner v. Kowalski
• Police officers were given cash allowances for meals so that they would not have to
leave their patrol areas at mealtimes. Taxpayer does not eat his meals on the
• They did not meet the requirement that the meals be “furnished” by the employer.
• The meal must be provided in kind can’t be cash allowance.
Benaglia v. Commissioner
• The manager and his wife resided in one of hotel rooms and had their meals in the
hotel in Hawaii. This was not included in compensation. Question is whether the
value of the meals and lodging would be considered taxable to the manager.
• People will generally not take these types of jobs if they are not provided housing.
• Since it was provided by the employer and for the employer’s convenience, then
there is not income to the employee.
• If there are significant business reasons for the person to be on the premises, then it
is excluded as income.
3. Other Statutory Fringe Benefits
a. Group-term life insurance purchased for employees - §79
• There shall be included in the gross income of an employee for the taxable year an
amount equal to the cost of group-term life insurance on his life provided for part of
all of such year under a policy (or policies) carried directly or indirectly by his
employer . . .
• Included in the gross income for the cost of a group-term life insurance but only
to the extent that:
1. Costs exceed the sum of $50,000 worth of life insurance (first
$50,000 is tax-free, anything above is taxable): and
2. Amount (if any ) paid by employee to purchase such insurance
3. Applies only to premiums made on behalf of employee
b. Compensation for Injuries or Sickness - § 104
(a)(3)- amounts received through accident or health insurance for personal
injuries or sickness (other than amounts received by employee, to the extent
such amounts (A) are attributable to contributions . . . .
• This covers people who use one after tax dollars to pay insurance. Not a
form or disguised compensation. If payments originate from employer,
directly or indirectly, they are taxable.
c. Amounts received under accident and health plans - §105
• §105(a) says that all payments received by an employee through an accident or
health insurance for personal injuries or sickness shall be included as gross income to
the extent that such amounts (1) are attributable to contribution by the employer
which were not includible in the gross income of the employee, or (2) are paid by the
• § 105(b) Amount expended for medical care.
• Definition of medical expense –213(d)(1)(A)- diagnosis, cure, mitigation,
treatment, or prevention of disease. Does not cover cosmetic surgery
• § 105(c) only applies to permanent loss or loss of use of a member of function of the
body, or the permanent disfigurement.
d. Contributions by employer to accident and health plans - §106
• Gross income of an employee does not include employer provided accident or health
coverage (premiums paid by employer).
• This covers two things: if employer pays the premium, employer providing coverage.
• This is a huge loss of revenue to the government, but it is justified for general public
Is §105/106 a good thing/who benefits?
1. employees- have security of knowing that they are insured-get medical coverage
2. Employer benefits- knows that employees are well taken care –of.
3. Insurance companies and HMO’s benefit- sell more health insurance.
4. Health industry-gets paid.
5. Society as a whole
6. Government- more people who have health insurance, less likely to pay the bills.
No Employer provided insurance Employer provided Insurance
Cash Salary $30,000 Cash Salary $26,000
Income Tax @ 40% $12,000 Income tax @ 40% $10,400
After tax Income $18,000 After tax income $15,600
Cost of Health Insurance $4,000 Cost of health insurance $0
Amount left over $14,000 Amount left over $15,600
• In the second scenario, there is a windfall created by the tax system. Then the
employer and the employee can decide how the windfall can be used. The tax laws
allow for both parties to be in a better situation.
• Because cost was shifted from employee to employer- employer’s cost of
compensation is unchanged and employer’s income has gone up.
• The health insurance companies also benefits from this situation, because they get
big groups using them and that creates more business and the risks go down. Doctors
also benefit because they have an easier time getting paid and people will go if they
have coverage. Encourages health insurance, saves money for government.
E. Gifts, Inheritances, and Scholarships
1. Gift or Compensation? §102
• Gross income of the donee does not include the value of property acquired by gift, bequest,
devise or inheritance.
• Excludes amounts of income that results in shift in wealth, but where no wealth was created.
• Gifts are generally included in the donor’s tax base
• Subsection (a) shall not exclude from gross income –
(1) Income from any property received from that above
(2) Where the gift, bequest, devise, or inheritance is of income from property, the
amount of such income.
(3) In other words, cannot qualify income from a gift as a continuation of the gift.
Gifts from employer to employee
• 102(c) – virtually eliminates exclusion for gifts between an employer and an employee, unless
it could be considered de minimus or if the employee can show that the transfer was not made
in recognition of the employee’s employment (i.e., it was outside of the employment
relationship) Reg. 1.102-1(f)(2)
• Note: § 274(b) provides a general maximum deduction of $25 for business gifts that are
excludable under § 102.
Commissioner v. Duberstein
• The taxpayer received a Cadillac as a gift in return for referring some customers over the
years. In return for this, the other party said that he was going to give taxpayer the car.
• Under contract law, this was not a contract, but a gift. However, for tax purposes it is viewed
differently. Court will decide whether it was a gift or not by the intention of the parties
• Court’s definition of a gift a gift proceeds from a detached and disinterested generosity,
or out of affection, respect, admiration, charity, or like impulses.
• The most critical consideration in determining what constitutes a gift is the transferor’s
intent. This is a question of fact, and provides no real guidance on the issue.
• Decision must ultimately be based on the application of the fact-finding tribunal’s experience
with the mainsprings of human conduct to the totality of the facts of each case.
Regulations- in most cases-employer’s gifts will be taxable. If unrelated to employee, if
relationship does not exist, then not a problem. In a situation involving related employer and
employee, this is harsh.
2. Treatment of Inherited Property - §102(b)
Wolder v. Commissioner
• Attorney prepared the will and then got money in the will. Was this compensation for services
rendered or inherited property? Again, this is very fact specific.
• If gift because you performed certain lawyerly functions, then there are elements of
compensation as well as a gift.
3. Scholarships - §117
• Gross income does not include any amount received as a qualified scholarship by person who
is a candidate for a degree at an educational organization that has faculty, curriculum, and a
regularly enrolled student body.
• Qualified scholarship means any amount received by an individual to the extent the individual
establishes that the amount was used for qualified tuition (which includes tuition and fees
required for enrollment) and related expenses (fees, books, supplies, and equipment required
for courses of instruction).
• 117(b)(2)- qualified tuition and related expenses means – tuition and fees required for the
enrollment or attendance of student at an educational organization described in section
• Exclusion does not apply to portion of scholarship received as payment for teaching, research,
or other services by the student required as condition for receiving the qualified scholarship or
• Tuition reduction – Income does not include reduction in tuition provided to an employee of
an organization for the education (below the graduate level) for the employee or any person
treated as an employee (retired and disabled employees, surviving spouse, dependent
• Tuition reduction includes graduate student who is engaged in teaching or research activities
who also receives tuition reduction since parent is an employee at the institution.
• General issues:
(a) Statute does not exclude non-degree income (still income).
(b) Statute does not exclude room and board (still income)
(c) Statute does not exclude scholarships by employers except as provided in § 127 (still
(d) Does not apply to graduate students (except in tuition reduction circumstances).
Section 127 – Educational Assistance Programs
• Allows $5,200 to be excluded in educational assistance
• This is a separate written plan of an employer for the exclusive benefit of an employee
E. Gains Derived From Dealings in Property
1. Introduction to the Replacement of Capital Principle – § 61(a)(3)
• Gross income includes gains derived from dealings in property.
§ 1001 – Determination of amount of gain or loss
(a) Gain from a sale or other disposition of property shall be the excess of the amount
realized minus the adjusted basis in § 1011 for determining gain. Loss is the adjusted
basis in § 1011 for determining loss minus the amount realized.
(b) Amount realized from the sale or other disposition of property shall be the sum of any
money received plus the fair market value of the property (other than money) received.
(1) Amount realized does not include money reimbursed for real property taxes imposed
upon the purchaser.
(2) Amount realized does include real property taxes if they are to be paid by the
(3) Hypothetical: Angela buys property for $10,000 on January 1. She pays $2,000
property taxes additional for the year. On July 1, Kevin buys property from Angela.
a) Sell property for $11,000 claiming that $1,000 is for reimbursement for taxes.
Her amount realized is only $10,000. § 1001(b)(1).
b) Sell property for $11,000 claiming that the price includes her investment in the
property. Her amount realized in $11,000. § 1001(b)(2).
(4) Regulation § 1.1001-1(a) – Except as otherwise provided, the gain or loss realized
from the conversion of property to cash, or from the exchange of property for
another property differing materially either in kind or in extent is treated as income
or a loss sustained.
(1) Except as otherwise provided in this subtitle, the entire amount of gain or loss, on
the sale or exchange of property shall be recognized.
(2) Accounting for the realization into account for tax purposes.
(3) Everything realized is recognized unless the statute has a non-recognition rule,
§ 1011 – Adjusted basis for determining gain or loss
(a) The adjusted basis for determining gain or loss from the sale or other disposition of
property shall be the basis (determined under § 1012) plus adjustments (additions,
improvements, etc.) as provided in § 1016.
• Capital improvements increase basis
• Depreciation deductions decrease basis
§ 1012 – Basis of property
(a) The basis of property shall be the cost of property.
(b) When purchased with cash, basis is amount of cash paid.
(c) When taxpayer received property in exchange for exchange of services, the basis is the
fair market value of the property.
(d) The cost of real property shall not include any amount in respect of real property taxes.
• § 1012 – says that the basis of the property is the cost of the property (cost basis).
• § 1014 – says that the basis of property acquired from inheritance or will is the fair
market value of the property for estate tax purposes at the time of the decedent’s
death (stepped up basis)
• § 1015 – says that the basis of the property received as a gift is equal to the donor’s
basis (carry-over basis)
• § 1001(a) – defines gain as the excess of the amount relaized over the basis; the
loss is the basis (-) amount realized.
i.e., taxpayer buys property for $5 and sells it for $15, the gain is the AR
($15) minus the basis ($5) = $10
§1014 – Basis of property acquired from a decedent (stepped-up basis)
(a) The basis of property acquired from a decedent is the fair market value of the property at
the date of the decedent’s death.
• By stepping-up basis, Section 1014 forgives, for income tax purposes, pre-debt
appreciation in the value of property.
(b) 3 ways the system permits cost recovery
(1) Recovery on disposition – subtracting the basis from the amount realized
(2) Immediate Expensing – At the time of acquisition, the taxpayer is allowed an
immediate deduction (frequently described as up-front expensing).
(3) Depreciation – Periodic deductions spread over the entire holding of the property
(accelerated and straight).
§ 1015 – Basis of property acquired by gifts and transfers in trust
(a) Gain – The basis of property for computing gain in the hands of a donee shall be the
same as the basis in the hands of the donor or the last preceding owner by whom it was
not acquired by gift. Known as “carry-over basis” or “transferred basis”.
(b) Loss – The basis of property for computing loss is the donor’s basis, unless, at the time of
transfer, the donor’s basis is higher than the FMV at time of transfer; in that case, the
basis of property for computing loss is the FMV at the time of transfer.
Therefore, you should first determine if you have a gain or loss at time of sale. If donee
sells the property for lower than the donor’s basis, look at FMV at time of transfer to
determine what basis to use. If the FMV at time of transfer was lower than the donor’s
basis, use the transfer FMV as basis. If FMV at time of transfer is higher than the
donor’s basis, you will use the donor’s basis.
(c) Ultimate value dictates. If ultimate value is a gain, then the basis is the donor’s basis; if
ultimate value is a loss, then the basis should be the FMV.
(d) Hypo: Donor’s basis is $50. At time of gift, fair market value is $75.
1) At time of sale, value of property is $100. The amount realized is $100, the basis is
$50 and the gain is $50.
2) At time of sale, value of property is $40. The amount realized is $40, the basis is
$75 and the loss is $35.
3) At time of sale, value of property is $60. The amount realized is $60, the basis is
$50 and the gain is $10. (the fair market value of $75 is never actually realized).
F. Treatment of the Owner of Annuity and Life Insurance Contracts
Life insurance Contracts:
1) Term insurance – Short term life insurance. The insured pays a premium in return for
which a specified sum will be paid to his survivors in the event of his death.
(a) Involves a gamble: if the insured survives the period his beneficiaries do not
collect on the policy. If he dies, then the beneficiaries to collect. Most term life
insurance covers one year
(b) Represents a bet against the mortality tables
(c) The beneficiaries of the life insurance policy are not taxed because they don’t
receive income because §101(a)(1) excludes life insurance received through the
death of the insured from income, if such amounts are paid by reason of death of
2) Ordinary life insurance – payment of a uniform annual premium throughout the life of
the insured, which matures at death.
(a) The annual premium increases over time because of the likelihood of death.
3) Cash Value life insurance – whereby a person simultaneously purchases a K for life
insurance and deposits a sum with the insurance company; life insurance company
deducts from the amount deposited for that month’s premium insurance (plus loading and
administrative fees) and then credits the insured’s account with investment income on the
• Cash surrender value is amount that insurance policy owner would get back if
wanted to withdraw and get money back.
When a person transfers money or other property and receives from the transferee a promise to
pay certain sums at intervals (transferor receives a stream of payments usually at a delayed time)
the amount paid is likely an annuity. It is definitely an annuity if the payment is measured by a life
or lives, but if it is for a fixed period of years it may or may not be an annuity.
2. § 101 – Certain Death Benefits (Life Insurance)
(a) Proceeds of life insurance contracts payable by reason of death –
(1) General rule – gross income does not include amounts received under a life insurance
K, if paid by reason of the death of the insured. In other words, proceeds of a life
insurance K are not taxed.
(e) Treatment of certain accelerated death benefits –
(1) the following amounts shall be treated as an amount paid by reason of death of an
insured (thus is not taxed as gross income):
(a) Any amount received under a life insurance K on a life of the insured that is
(b) Any amount received under a life insurance K on the life of an insured that is a
chronically ill individual.
• Policy Q: annuities and life insurance received tax preference, but why don’t other forms of
savings, such as CDs and bonds are taxed currently. All sorts of savings plans – bonds, CDs,
stock, mortgages, etc.- which receive differential tax treatment. Should we have a bright-line
rule? Which are more fair? This begs the question whether the tax system really encourages
3. Annuities – §72
(a) Except as otherwise provided in this chapter, gross income includes any amount received
as an annuity (whether for a period certain or during one or more lives) under an annuity,
endowment, or life insurance contract.
(b) Exclusion ratio §72(b)
(1) In general – gross income does not include that part of any amount received as an
annuity, endowment, or life insurance contract which bears the same ratio to such
amount as the investment in the contract (as of the annuity starting date) bears to the
expected return under the contract (as of such date).
(i) Interpretation – every dollar you receive back up to the amount you originally
put in is not taxable income.
(2) Exclusion limited to investment (mortality gain) – the portion of any amount
received as an annuity, which is excluded from gross income under paragraph (b)(1)
shall not exceed the unrecovered investment in the K immediately before the receipt
of such amount.
(i) The money you receive beyond the expected term of the K is fully taxed as plain
income without any exclusion ratio calculation.
(3) Deduction where annuity payments cease before entire investment recovered
(mortality loss) -
(i) when you die before your entire investment is recovered, you get
to deduct the unrecovered investment.
(4) Unrecovered investment – for determining mortality losses and gains under (b)(2) and
(b)(3); it is the difference between the initial investment and the aggregate of
received annuity payments. This is used by IRS to determine how much money you
received back on the investment (irrespective that you are taxed on a ratio basis).
(c) Amounts not received as annuities – modified endowment contracts; Congress added this
section which treats cash withdrawals before the annuity starting date as income to the
extent the cash value of the contract exceeds the owner’s investment. Thus, when cash is
withdrawn, interest is taxed first. (paraphrase).
• This was to eliminate investments, which were made to look like life insurance Ks in
order to avoid tax, but weren’t.
(q) Imposes a penalty on amounts withdrawn before retirement.
• Year 1: taxpayer pays $5,000 into annuity K
• Provisions of K states that at year 15 taxpayer will begin to receive annual payments of
• Taxpayer is expected to live to year 30 and therefore expects a $15,000 return (including his
original $5,000 investment).
• Under (b)(1) his exclusion ratio is $5,000/$15,000 (investment /investment return) = 1/3rd.
• Under (b)(2) – mortality gain: taxpayer lives to year 35 (five years beyond expectation) so
each annuity stream payment for those additional 5 years are taxable income (additional
$5,000 is all taxed).
• Under (b)(3) – mortality loss – taxpayer dies after only 4 years of annual payments (before
receiving entire original investment back–his basis), so taxpayer deducts $1,000.
• Under (b)(4) – taxpayer dies at year 19 (after four annual payments) unrecovered investment
equals $1,000 ($5,000 - $4,000).
4. Individual Retirement Accounts
• Enacted by Congress to encourage people to save for their retirement.
• The tax treatment of an IRA – until the money is withdrawn there are no taxes. When it is
withdrawn, then every dollar is subject to tax. Still, the end result is more favorable than if the
taxpayer put it in a regular bank account.
• An IRA takes your employment income and defers the taxes until retirement age when you
decided to take the money out. There are of course technical rules to IRA:
1. The amount you invest can not exceed your income for the year.
2. Also, the amount is limited to $2000 per year.
3. Third, only certain people are eligible to make these investments. Upper
middle or high-income people that are already cover by pension plans, are
not eligible. Basically, the idea is to encourage middle to lower income
people to save for their retirement.
• Someone who is eligible for a deductible IRA is also eligible for a Roth IRA. With a Roth,
when you make the contribution, you do not get any tax deductions. However, when you
withdraw it, nothing is included in income. In the end, it is the same end result between the
• If you think that tax rates are going to go down, then the deductible IRA is better for you.
Because you are deferring the tax payments until a time when you think that the tax rates will
• Just the opposite is true for a Roth account. You need to decide what your income and tax
bracket you may be in the future.
• Roth is better for people whose income is relatively low, but think that income will rise.
Right now, not subject to a high tax rate, but will start to be subject to a high tax rate-and
economic benefit will be much greater.
• The economics of these plans are similar to IRA accounts.
G. Transactions Involving Indebtedness
Loans and discharge of indebtedness income
§ 61(a)(12): income from discharge of indebtedness
• If employer cancels the debt you owe; that is considered a form of income and is taxed.
• A taxpayer can have an increase in wealth both from an increase in assets and a decrease in liabilities.
§ 108 – exceptions to 61(a)(12):
(a) – Bankruptcy settlement
• Taxpayer who is insolvent or subject to bankruptcy proceedings settles with his creditors at a
discount; permits him to exclude the debt cancellation from income to the extent to which his
liabilities exceed his assets.
• The amount excluded is limited to the extent to which his liabilities exceed his assets.
(1) gross income does not include any amount which would be includible in gross income by
reason of discharge of indebtedness of the taxpayer if
(b) – Reduction of tax attributes
• The quid pro quo for non-recognition is that the taxpayer must reduce certain tax benefits or
the basis in his property by the amount of the debt cancellation.
(e)(2) – Lost deductions
• This excludes from income the discharge of a debt if its payment would have given rise to a
• This puts the taxpayer in the same position he would have been in had he paid the liability and
• Taxpayer may elect to either exclude from gross income or include, but have it deducted.
(e)(4) – Discharge of indebtedness treated as a gift
• in commercial settings discharge of indebtedness is not a gift
• in a non-commercial, family setting it is a gift; e.g. loan between family members which falls
under § 102.
(e)(5) – Purchase price reduction
• If the seller of specific property reduces the debt of the buyer arising out of the purchase, the
reduction is to be treated by both parties as an adjustment of the purchase price.
• Must result from an agreement and not result, for example, from a bar of enforcement of the
• This only applies to property, not cash (Zarin)
• Ex) you draw will for client charged at $5,000. He doesn’t pay, but later agrees to pay
$1,000. This is not income, but rather a price adjustment.
• This provision does not apply if:
1. the purchaser is insolvent; or
2. the purchaser is subject of bankruptcy proceedings; or
3. the seller has transferred the debt to a third party or purchaser has transferred the
debt to a third party
(e)(6) – Corporate debt to shareholder
• If a shareholder forgives a debt owned him by the corporation, this treats it as if the
corporation had satisfied the debt with an amount of money equal to the shareholder’s basis in
(e)(8) – Corporate stock issued in exchange for debt
• Provides that a corporation that is not insolvent or in bankruptcy proceedings realizes
discharge of indebtedness income when it issues stock in cancellation of its debt (to extent
that the value of the stock is less than the debt).
(f) – Student loans forgiveness
• When your student loan indebtedness is discharged for committing to working a for certain
period of time in a certain profession for a broad class of employers its not included in
• Usually tax-exempt charities (universities or government entity)
(a)(1) and (g) – farm indebtedness
• Under certain circumstances, gross income does not include the discharge of “qualified farm
(a)(1)(D) – Real estate business debt
• Permits individual taxpayers to elect to exclude from gross income the discharge of real
property business indebtedness in exchange for reducing the basis of property.
• The mortgage must have been incurred or assumed before 1993.
• Corporation issues bonds whose value dropped because of shift in interest rates.
• Corporation buys back bonds at less than par value and pays off the debt for less than its actually
• Court finds transaction a discharged of indebtedness and includes it in income because they are freeing
up assets previous encumbered by debt.
James v. United States
• Whether embezzled funds are to be included in gross income.
• All unlawful gains are taxable creates a broad rule that courts won’t look at the type of crime.
• James was taking money from insurance company and got caught for embezzlement.
• Issuer-whether the money he embezzled is taxable-whether he had it in his possession.
• When he embezzled money-he has obligation to repay it-so is it a loan?
• Court concluded that a plausible distinction could be drawn between the theft and legitimate borrowing
and held that stolen money was fully taxable within the year obtained.
• Have no right to report your income, but you have a right to no self-incrimination. So, if you have
income from illegal activities, you can report it under “other” income, and if IRS asks where you got it,
you can plead the fifth. Based on the tax forms, you don’t need to indicate specifically where you get
Commissioner v. Indianapolis Power Company
• It is not income for a landlord when he is merely holding the security deposit. Because if certain
things, such as damage, do not occur, then the landlord has to give the money back.
• If taxpayer receives money and has contingent obligation to repay, presence of that contingency will
not effect conclusion that there was a loan. As long as obligated, then will be treated as a loan, and not
Effect of Debt on Basis and Amount Realized
• Lori buys house for $75,000; she puts $25,000 down and receives $50,000 debt financed mortgage.
• The basis = $75,000 – purchase price
• Lori later pays back mortgager $5,000; so her equity is now $30,000 (up from $25,000) and her debt is
$45,000 (down from $50,000).
• Lori sells house for $100,000.
• Lori’s gain = $25,000; $100,000 is AR - $45,000 (debt pay back) and - $30,000 (original equity). OR
$100,000 (AR) - $75,000 (basis) = $25,000 (gain)
1. Recourse debt – borrower is personally liable for the debt; lender can look not only to any
assets securing the debt, but also to the borrower’s other assets for repayment. If secured
property is not adequate to satisfy the debt, the lender suffers the loss.
2. Non-recourse debt – borrower is not personally liable for debt; upon default lender can obtain
satisfaction of the obligation only from the security.
• Lender’s choose non-recourse debt b/c the loan to value ratio. If there is enough security, it doesn’t
matter how whether it is non-recourse or not.
• This is why the lender never lends out 100% of the value so that they have a cushion to lean on since it
The seller’s AR is calculated the same way as the buyer’s original basis. So then when this buyer later
sells the same property, his AR is calculated the same as the new buyer’s original basis.
1. Damages to property or to business interest
• 2 different situations: damages in a business context or damages in context of personal
Raytheon v. Commissioner
• Taxpayer was the victim of an unfair business practice. Taxpayer received money as a
compromise settlement. Taxpayer claims that this is a return of capital.
• The award is taxable because it is a substitute for lost earnings and since earnings would have
been taxed, the money is now taxable. Rule: Recoveries which represent a reimbursement for
lost profits are income b/c since the profits would be taxable income, the proceeds of
litigation which are their substitute are taxable in a like manner.
• Where the suit is for injury to goodwill, the recovery represents a return of capital and is not
taxable. Goodwill – the excess of the value of the company over the value of its assets.
2. § 104(a) – Compensation for Injuries or sickness
In general – except in the case of amounts attributable to (and not in excess of) deductions allowed
under section 213 (relating to medical, etc., expenses) for any prior taxable year, gross income
does not include –
• 104(a)(2) - The amount of any damages (other than punitive damages) received (whether by
suit to agreement and whether as lump sums or as periodic payments) on account of personal
physical injuries or physical sickness.
• Payments for pain and suffering are excluded from income.
• Lost wages will be excluded as income.
• Punitive damages-included in gross income- this is not really compensation, but is done to
punish the wrongdoer.
I. Tax-Exempt Interest
1. § 103 – Interest on state and local bonds
(a) Exclusion - except as otherwise provided in subsection (b), gross income does not include
interest on any state or local bond.
(b) Exceptions – subsection (a) shall not apply to –
1. Private activity bond which is not a qualified bond – any private activity bond which is
not a qualified (within the meaning of § 141)
2. Arbitrage bond – any arbitrage bond within the meaning of § 148
3. Bond not in registered form, etc. – any bond unless such bond meets the applicable
requirements of § 149
(c) Definitions – For purposes of the section and part IV –
(1) State or local bond – The term “state or local bond” means any obligation of a state or
political subdivision thereof.
(2) State – The term State includes the District of Columbia and possession of the United
• Interest from state and local bonds are exempted from income
• This allows state and local governments to pay lower rates of interest on their debt than that
paid on taxable corporate bonds and encourages taxpayer's to invest in state and local bonds.
• Market interest rate – 10%
• US government issues bond for $10,000. So the yearly interest will be $1,000. The interest is
taxable. So the after tax return would be $600. (Assuming 40% tax)
• If Virginia issues the bond at the same price. None of the interest will be including in gross
income. The interest rate should be 6% or greater. If not, then it is the same as a US
government bond. Interest rate of 7.5%, then you are paid $750.
• Your tax brackets determines which type of bond you want to invest in.
Bonds that are includable in gross income 103(b)
1) Private activity Bonds – States are supposed to use money for public uses. When
the money that comes in is diverted to the private benefit of certain taxpayers,
they are called private activity bonds and are excluded.
2) Arbitrage Bonds – Used by state or local government to acquire other securities
with a higher rate of return. A state government borrowing money to invest in
higher yield corporate bonds isn’t appropriate.
3) Bonds not in registered form – this is to ensure who owns the bonds.
• Some say we should get rid of §103
• Benefit high tax bracket taxpayers most – “official estimates that ignore the interest savings to
state and local governments show that 83% of the benefits from the tax exemption accrue to
individuals with adjusted gross income of $50,000 and only 4.5% of the benefits go to
individuals with adjusted gross income of $20,000 or less"
• Result in excessive subsidy (i.e., too much to the more wealthy)
• Limited market (pensions are tax exempt so they always use federal bonds to receive the
higher interest rate and don’t need state or local ones; and college endowments don't either for
the same reason; both are big players in the bond market)
• This is a huge revenue drain on the federal government. This costs the federal govt. a lot.
Can't get rid of it b/c states depend on it too much.
• Could get rid of it and compensate the states with another subsidy, but that involves more
bureaucracy; undermines state sovereignty.
• Alternative to § 103 – revenue sharing; you eliminate § 103 and have federal govt. send
money to states.
I. Social Security Proceeds
Except for a little portion, social security is not an income tax question. However, in terms of total revenue
the tax from social security accounts for about 40%. For a lot of the adult population, the social security tax
is greater than income tax.
Social security pays for disability, retirement, death benefit, medical expenses, and health insurance. In
addition, if one individual dies, the survivor gets a benefit. Most people think of the social security system
in terms of the old age retirement plan. FICA is the tax that is collected out of your paycheck that goes to
social security. Each year employees must make payments of 7.5% of salary up to $76,200. In addition, the
employer must also pay an equal amount. Combined 15% pays for social security benefits.
1. disability-if someone is disabled-government will make monthly payments to them.
2. Survivor benefits-if wage earner dies before retirement and leaves either a surviving
spouse or a minor child-surviving spouse will get benefits from social security system.
This is not means-tested benefit, used traditionally in welfare programs.
3. Old-age benefit-public retirement benefit-when individuals reach a certain age, they are
entitled to get money from federal government- begins at age 62, but traditionally began
at age 65.
This money goes into a pool, goes into a trust fund that is paid out when you reach eligibility. However,
this is a lie. Probably a trillion dollars a year comes in and it is immediately paid out to people who need it.
It is really a pay as you go system. There is no assurance that there will be enough money there when we
reach retirement age.
1. medical and nutritional advances-people live longer.
2. Throughout the developed world, number of children being born is much fewer-as
percentage of young population is going down, percentage of old people going up.
So the question is, how are you taxed on this? Problem 1 on Assignment 3
• At most, half will be included.
• 30,000 – 4000 half the social security benefit – look to see if that exceeds the base amount.
• Amount in Income :
• § 86 – if income is exceedingly modest, then no portion is included as gross income.
• Only subject to section if in § 86(b)(1)- modified adjusted gross income of the taxpayer for the taxable
year (30,000), plus half of social security benefits for that year (1/2 of 8000= 4000) exceeds base
• § 86(c)(1) – base amount is 25,000 or 32,000 in the case of a joint return. For single senior citizens,
25,000 would apply, but if married, 32,000 would apply. If fall below these numbers, then not taxed at
• Calculating taxable income under 86.
(1) 1/2 of benefits (50% of $8000 = $4,000)
or (2) 1/2 of excess of Modified adjusted gross income : 30,000
plus 1/2 of social security benefits: 4000
Over base amount: $25,000
Excess is 9000 and half of that is 4,500. Here, the lesser is (A)- 4000.
• Certain taxpayers have to include 85% of their income, but this is very complicated.
II. PROPERTY TRANSACTIONS
I. Realization when property transferred as compensation
1. The Realization Requirement
• The non-taxation of unrealized appreciation is one of the most fundamental aspects of the
federal tax system fluctuations in value are not taken into account until there is a sale
• This provides taxpayers with considerable flexibility in the timing of taxation of gains and
losses, this is the essence of tax planning.
Eisner v. Macomber
• Standard Oil was an oil company that was a monopoly in the early 19th century. Mrs.
Macomber owned stock in Standard oil. She owned about 10% of the shares. Standard oil
decided to transfer a 50% stock dividend to the shareholders. The question is whether the
distribution of the shares should be considered income.
• The Court said no for two reasons. One does not matter any more. The second reason is the
basis for the realization requirement. Her economic situation did not really change as a result
of the dividend. She did not really gain anything.
• Before, she had 10% ownership in Standard. Now, she still owns 10%. What matters is the
percentage that you own, not the total number of shares. No material change in the taxpayer
economic position, thus there is no realization.
• The question then is – what is material change in your economic position? In most cases, it is
fairly easy to figure out.
2. §83 – Property Transferred in Connection with performance of Services
Four questions to consider:
1. Does section 83 apply to the transaction in question?
2. Who has income? Certain amount shall be included in the gross income of person who
performed such services.
3. When is it included in income? Income will be included in the first taxable year in which
the rights of a person having a beneficial interest in such property are transferable or are
not subject to a substantial risk of forfeiture.
• Not income until the rights of person receiving are transferable. Until person has
right to transfer rights, and cannot be forfeited- at that time, person has income.
• 839(c)(1) - When property is transferred, subject to a risk of being taken away and a
substantial risk of forfeiture, there is no income
4. How much income? Excess of fair market value of such property over the amount paid
for such property-shall be included in gross income of the person who performed such
services in the first taxable year.
(1) If a person receives property in return for the performance of services and if the
property is 1) non-transferable or 2) subject to a substantial risk of forfeiture then
the property is treated as still owned by the transferor and no income is realized by
• A person’s property is subject to a substantial risk of forfeiture if the
person’s right to full enjoyment of the property is conditioned upon the
future performance of substantial services. (§83(c))
(2) When risk of forfeiture is removed (property vests in employee), any amount in
excess of the fair market value (at time property vests) of the property minus any
amount paid for the property (if any) is taxable income.
(3) E.g., Small Company gives property (stock) as part of compensation but requires 5
years of employment before stock vests in employee.
(a) Election Provision – Employee has two choices:
(1) Person may elect to include in his gross income the fair market value of the property
at the time of transfer minus the amount paid (if any).
(2) If the property is subsequently forfeited, no deduction shall be allowed in respect to
• Not a true “exclusionary” statute.
• Includes excess as gross income once risk of forfeiture is removed.
• Dual-benefit: this restriction on property keeps the employee in the corporation for a certain
period of time and benefits the employee that they do not have to pay tax on.
Reasons to elect early
• All about timing. Choosing when to elect determines the basis of the property for purposes of
a later sale for measuring capital gains.
• Deductions, which are non-carryover, for one year may drop below income. Thus, electing
early would increase the amount of taxable income that year for those deductions to offset the
gain or else they are lost.
Benefit to Employer
• The employer can take a §162 deduction for the property transferred to the employee equal to
the amount included in the gross income of the employee in the year when the employee
included the property in his gross income. (§83(h))
B. Non-recognition of Gain or Loss in Certain Property Dispositions:
• When taxpayer exchanges property and gets back property that’s materially different in some way-then
there’s realization-hair-trigger realization requirement.
• Realization-taxpayer had given up asset that had before.
• Recognition- gain that has been realized will not yet be taxed.
1. Property Settlements in the Context of a Marital Dissolution
United States v. Davis
• Transfer of stock from husband to wife. In return, the husband got back the relinquishment of marital
• The stock had a basis of $75,000 and the fair marker value was $82,000. There is $7000 increase in
wealth that has been built up over a period. That $7000 is taxable.
• The wife is treated as a purchaser – basis of 82,000. Husband has a gain of $7000. He has to pay the
tax when he transfers the stock; the wife gets the fair market value as her basis.
• Court said-when parties operate at arms-length, the presume that husband got back equal value for
what was surrendered.
§ 1041 – Transfers of property between spouses or incident to divorce
• Effectively overrules Davis. Gain is not recognized on a transfer of property from an individual to a
spouse or a former spouse (if in incident to a divorce)
• (a) - no gain or loss shall be recognized (it is realized) on a transfer of property from an individual to
1) a spouse or;
2) a former spouse, but only if the transfer is incident to a divorce
• (b) - transfer is treated as a gift (look to 102(a)); regardless of the value of the transferred property,
transferee’s basis is the carryover basis of the transferor
Note consequences: because of § 1015 (carryover basis for gifts) the transferee, when selling the
property, realizes a greater gain (she took on her husband’s basis) and suffers negative tax
consequences as a result
• (c) – the transfer must occur within 1 year of the date of the divorce or is related to the cessation of
- § 1041 is based upon the theory that a married couple is a single economic unit, and it is
inappropriate to tax transfers between spouses
- § 1041 generally hurts women
2. Like-kind Exchanges - §1031
(1) No gain or loss is recognized on the exchange of property held for productive use in business or for
investment if exchanged solely for property of a like kind also for use in business or investment.
• Note that there is no “sale”, only exchanges
• Includes also a loss
• Leaves out personal property
(2) This section does not apply to any exchange of:
a. stock in trade held primarily for sale - § 1221(1)
b. stock, bonds or notes
c. other securities or evidence of indebtedness
d. interest in partnership
e. certificate of trust or beneficial interest
f. chases in action.
• Most of these exchanges involve real estate
(3) You have to identify the property within 45 days and exchange it in within 180 days or the due date for
the tax imposed by that tax year.
(b) Boot - gain from exchanges not solely in like-kind shall be recognized in an amount not in excess
of the sum of the money and the FMV of the property.
• Boot is taxed upon exchange
(d) Basis – basis shall be the same as that of the property exchanged, decreased in the amount of any
money received by the t/p and increased in the amount of gain or decreased in the amount of loss to
the t/p that was recognized on such exchange.
• Always look for boot provision and basis provision (b/c basis carryover is the mechanism to
preserve taxation for later).
1. exchange of property
2. property given must be in trade, business, or investment
3. property exchanged must be like in kind
4. property received must be used in trade, business, or for investment
Reg. § 1.1031(a)-1(b) – definition of like kind
• Refers to the nature or character of property and not its greater quality
• If both properties are business or investment properties they are like-kind even though they may seem
to be different, e.g. farm exchanged for office building – if for business purposes it would constitute §
1031 like kind exchange.
• Business property can be exchanged for investment property
• Exchanges of livestock of different sexes are not property of like-kind
• See list of like-assets classes on p. 1378 – can exchange within these classes, but not among them.
• Mortgage properties (often carried with real property) – a mortgage is part of the seller’s AR; so if
property is transferred debt relief is treated as boot to the extent it exceeds the net value of the
property. See §§ 661-666.
Question to ask during a property transaction:
1) How much gain is realized?: Value of property, plus cash and liabilities (subject to which old property
was transferred, less adjusted basis of the property transferred.
§1001 amount realized
- Adjusted basis
2) Was it a Like-Kind exchange? For real-estate, this is pretty broad.
3) Amount realized that is not like kind? Cash and liabilities?
4) §1031 gain recognized? Cash?
• If not exchanged solely for property of like kind, Section 1031(b) deals with exchanges that are in part-
like in kind, or not like in kind. Gain, if any, shall be recognized, but in an amount not in excess of the
sum of the money or fair market value of the property. Phrase “boot” – simply means non-like kind
5) Basis in property acquired? Basis of property exchanged minus money received, plus gain recognized.
§1031(d) basis in old property
- money received
+ gain recognized
6) Double-check for errors- this step is to double-check your calculations. The Gain realized on the sale of
property reduced by the amount of gain that was tax earlier (recognized) should equal the gain preserved.
- Gain recognized
= Gain preserved
• A transfers Whiteacre to B in exchange for Blackacre. A’s basis is Whiteacre was 60; the FMV of
Whiteacre is 100. How much gain does A recognize, and what basis will A have in Blackacre?
• Look to §1001. A sold or disposed of his property. The amount realized was 100 because it is the sum of
the money received plus the fair market value. He received no money and the fair market value was 100.
The basis was 60. So, the gain was 40.
• Under §1031 –Does this provision apply here? Yes, if you assume certain conditions, such that the property
was used in trade or business, etc. Also, assuming that they are like-kind. He did not receive any property
that was not like-kind. So, there is no gain recognized.
• Now, turn to the basis of property acquired. The rules are in §1031(d) – The basis shall be the same as the
property given up, which was 60. Decreased by the amount of money received, which is zero. Add the gain
recognized, which is zero. So it remains 60.
• A transfers Whiteacre to C. In exchange, C transfers Yellowacre and $15 in cash. A’s basis in Whiteacre
was 60; the FMV of Whiteacre is 100. How much gain does A recognize, and what basis will A have in
• First compute the amount of gain A realized on the disposition of Whiteacre. Under §1001 the amount
realized shall be the sum of any money received ($15) plus the fair market value of the property received
(this amount not given in the problem, but should be $85, assuming that they two properties are worth the
same) So the amount realized was $100. The adjusted basis was 60, so the gain realized was 40. Need to
take this preliminary step to figure out the gain realized under §1001 before you turn to §1031 to figure
out gain recognized.
• Assume that they are like kinds. Then the amount realized that is not like kind was $15. Now, turn to
§1031. §1031(a)(1) does not apply because he also got cash. However, §1031(b) does apply. Then the gain
realized if any should be recognized, but in amount not in excess of the sum of the money and the fair
market value of the property. This is basically saying that the gain recognized is the number which is
whatever is less, the gain realized or the amount of property or cash realized that is not in cash. In this case,
it was $15.
• §1031(b) means – the amount recognized would be either, (1) the total amount of gain realized or, (2)
the amount of non-like kind property that is received, WHICHEVER IS LESS.
• Finally, the gain realized = 40. The gain recognized = 15. So, the amount preserved is 25.
3. § 1033 – Involuntary Conversions
(a) If property (as a result of its destruction in whole or part, theft, seizure, requisition or condemnation,
or threat or imminence thereof) is compulsory or involuntarily converted; then:
(1) No gain is recognized if converted into property similar or related in service or use to the
(2) If, however, it is converted into money or into property not similar or related in service or
use to the property, then:
(A) Gain, if any, shall be recognized unless the taxpayer conforms to requirements
within this section. At election of taxpayer the gain should be recognized only to
extent that AR exceeds cost of other property or stock.
(B) Must be converted in 2-years after close of first taxable year
• The basic transaction that is covered by this provision involves a property that is compulsorily or
involuntarily converted. Usually it applies to property that is condemned and then sold, or the property
is stolen or destroyed.
• Much more common situation is 1033(a)(2)-property converted into money-basically, deals with 2-3
scenarios-insurance company and proceeds to compensate your loss. Under section 1033, if taxpayer
uses proceeds to buy replacement property, then no gain will be recognized.
• For example, if a business burns down and they get money from insurance company and they rebuild
directly, that that amount is not taxed. If they get a check, then need to look to rest of section.
• Definition of replacement property – focuses not on the two pieces of property themselves, but on the
uses to which they were put by taxpayer. Apartment building owned by taxpayer but managed by
contractor is similar in use to an office building, which taxpayer previously had owned but had paid
others to manage (Liant Record)
Differences between §1031 and §1033
• §1033 is elective – taxpayer does not have to meet its requirements and comply with its rules unless
the taxpayer affirmatively elects to do so.
• §1033 involves gain, not loss
• §1033 replacement property has to be property “similar or related in service or use” instead of “like-
kind” like-kind is a broader standard.
• Congress has liberalized the language in 1033(g) with respect for real property – treats property in a
• If you have a casualty loss under § 165(c) it will likely constitute an involuntary conversion under §
1033. § 1033 uses “threat or imminence” whereas § 165 does not have this language; therefore § 1033
4. § 121 – Transactions Involving Residential Property
Exclusion of gain from sale of principal residence - §121
1. The principal residence must be taxpayer's home for 2 of the last 5 years 121(a)
2. Taxpayer can only get one exclusion in a 2 year period, unless taxpayer has some
work related reason for moving 121(b)(3)(A)
3. A single taxpayer can only exclude up to $250,000 of gain recognized from the sale
of a personal residence 121(b)(1)
4. Married taxpayers, filing jointly, can excluded up to $500,000 if either spouse has
live in the house for 2 of the last 5 years
• If one spouse meets the residency requirement that is enough if they file jointly to get the
• Both spouses must meet the use requirement.
• If have to change principle residences by reason of change in place of employment, health or
unforeseen circumstances, you don't have to meet the two year requirement
• It is an exclusion provision and allows taxpayers to exclude from income $250,000 if single or
$500,000 if joint return –
• Inconsistency with § 1211(b) - $3,000 limit for single; § 3,000 married filing jointly;
and $1,500 each for married filing separately.
• Can be used repeatedly with certain time gaps
III. DEDUCTIONS AND CREDITS
Anything is income unless otherwise excluded; nothing is a deduction/credit unless explicitly stated.
Income deals with receipts and deduction deals with out of pocket expenditures.
Difference b/w Credits and Deductions:
• Credits – A dollar for dollar reduction after calculation of adjusted gross income; more valuable b/c it
is dollar for dollar reduction of tax you owe rather than a percent of a dollar reduction before taxes
• Deduction – reduction under gross income; take amount out of AGI before you multiple by your tax
bracket (figure out what your AGI is first and then find out what your tax bracket is).
B. § 162 – Trade or Business Expenses
1. General Rule – “ordinary and necessary requirement”
(a) Allows a deduction for all the ordinary and necessary expenses paid or incurred while
carrying on a trade or business including:
(1) – Reasonable salaries or other compensation for personal services actually rendered.
(2) – Traveling expenses (including meals and lodging that aren’t lavish or extravagant)
while away from home in the pursuit of a trade or business.
(3) -Rentals or other payments in which he has no right to possession.
Welch v. Helvering
• Taxpayer, a secretary of a business that went bankrupt paid the debts of the business to
solidify his credit standing.
• Issue was whether payments after bankruptcy made anyway (wanted customers to work with
him again) are allowable deductions in computation of income if made to creditors in an
endeavor to strengthen his own standing.
• Ordinary – norms of conduct: what is normal, customary, the standard within the industry
(another person or company in the business would have done the same thing). This does not
have to be a recurring expense. An expense made once in the lifetime of a business can be
considered normal. A capital expenditure is not an ordinary expense – a payment which
creates an asset or benefit with a useful life that “extends substantially beyond the year of
• Necessary – appropriate and helpful; very low bar.
• Court held that payment to establish goodwill is a capital expenditure. It is highly
extraordinary for an individual to pay the debts of others in the absence of some legal
obligation to do so.
• This court is developing a standard for ordinariness, but also the timing issue. Some
payments aren’t deductible (in full) b/c they are capital investments and relate to more than
one taxable period. With this payment here, the taxpayer is buying back his reputation that is
not something that will last in just one tax year, but is for future use over a lifetime.
Therefore, it is not deductible.
Examples of what would be ordinary and necessary:
1. floors/office space for attorneys
2. malpractice insurance
3. Laptops for every associate
Gilliam v. Commissioner
• Taxpayer, an artist, freaked out on plane while on his way to give a lecture (business trip)
• He faces criminal charges and attempts to deduct the legal fees under § 162
• It is not ordinary for people in the artistic trade or business to be involved in altercations on an
airplane in the course of any travel. It is ordinary for people in this trade or business to travel,
but not freak out on the airplane and then have their legal expenses deducted.
• Section 162(c)(1)- illegal bribes, kickbacks, and other payments-
(1) Illegal payments to government officials or employees-no deduction shall be allowed
under subsection (a) for any payment. . .
(2) directly or indirectly to any person
2. Reasonable allowance for salaries
162(a)(1) – Allows a deduction for a reasonable allowance for salaries or other compensation for
personal services actually rendered.
• Issue- whether salary of 10,000 plus 20% of net profits was reasonable compensation.
• Here, 2 facts that are unusual: (1) family relationship under which some of these people are
being employed; (2) Raymond is a domineering person.
Curtis v. Commissioner
• Medical Corporation which is very profitable. Nurse works very hard and almost as much as
doctor does. Doctor and nurse both get over ½ million dollars in high salary (plus extras) as a
way to get out of paying dividends (§ 61(a)(7) – no deduction for dividends)
• At issue was nurse’s salary and whether it was reasonable under § 162(a)(1)
• Court applies the “amount test” – test of deductibility in the case of compensation payments
is whether the amount of payment is reasonable is relation to the services performed.
• Four factors to determine reasonableness:
1. Employee’s role in the company – favors nurse
2. External comparison – this is a draw
• Elements to consider within this factor: work, responsibility, nature of
operations, years in which paid, local cost of living, industry standard (the
comparison of employee’s salary v. similar company’s salary; this is most
3. condition of company– favors nurse
• looks at revenue of corporation
• focus is on company’s size as indicated by its sales, net income, or capital value,
and complexities of the business
4. conflict of interest – favors commissioner
5. Internal Consistency – favors nurse
• Salaries paid to other employees.
• Primary issue is whether some relationship exists b/w the taxpaying company and its
employee which might permit company to disguise nondeductible dividends as salary
expenditures (in this case no dividends were being paid out), looked at from shareholder’s
• Nurse’s full deduction not allowed. Court determines what is reasonable compensation and
allows deduction only for that amount.
Absence of Dividends Scenario
• An ostensible salary paid by a corporation may be a distribution of a dividend on stock.
• This is likely to occur in the case of a corporation have few shareholders, practically all of
whom draw salaries. If the salaries are in excess of those ordinarily paid for similar services
and the excessive payments correspond or bear a close relationship to the stock holdings of
the officers, it would seem likely that the salaries are not paid wholly for services rendered,
but that the excessive payments are a distribution of earnings upon the stock. 1.162-7(b)(1)
• If excessive payments correspond or bear a close relationship to stockholdings, and are found
to be a distribution of earnings or profits, the excessive payments will be treated as a dividend
and included in gross income of the recipient. 1.162-8
§ 162(m) – Executive Compensation
• Denies deduction for compensation over $1 million paid to the CEO or for the most highly
compensated employees of a publicly held corporation unless the compensation is
• Key definitions are applicable employee relation and covered employee
• Covered employee-means at the close of the taxable year, such employee is the chief
executive officer of the taxpayer or an individual acting in such a capacity.
• Golden parachute – occurs in many m&a’s; compensation paid to executive members of the
corporation being acquired in anticipation of being “squeezed out” and terminated. Generally
defined as a payment whose aggregate present value exceeds 3 times the average annual
compensation includible in the recipient’s gross income over a preceding five year period;
(look at last five years and average it; if this payment is 3 times larger of preceding 5 years it
is a parachute).
• § 280(G)(a) – no deduction shall be allowed for any excess parachute payment; see § 4999 –
imposes a 20% excise tax for golden parachute. Thus, they are not outlawed, but made very
3. Expenses contrary to public policy
Commissioner v. Tellier
• Taxpayer indicted for violations of securities fraud and claims deduction of legal expenses
under § 162(a).
• There is no public policy offended here expenses incurred by taxpayer for his criminal
defense are reasonable and necessary.
• The deductibility of legal fees doesn’t turn of the taxpayer's guilt or innocence of the charges,
but rather on whether the charges stem from his trade or business.
Tank Truck Rental
• Company not able to deduct punitive fines for violating weight and size limitations. Based on
a cost/benefit analysis, they intentionally incurred these fines instead of traveling around the
• Allowing the deduction would have defeated the purpose of a penalty/fine and therefore
frustrated state policy. State shouldn’t subsidize fines.
Specific deductions denied by Congress:
1. § 162(f) - no deduction for fines and penalties
2. § 162(c)(1) – specifically disallows certain deductions from illegal brides ad kickbacks
3. § 162(c)(3) – no deduction for bribes or referral fees for Medicaid ad Medicare patients
4. § 162(c)(2) – any other illegal kickback or payment under any law if such law is generally
enforced and it subjects the payor to criminal penalty or the loss of license or privilege to
engage in trade or business.
5. 162(g) – no deduction for treble damages
6. 280E – no deduction expenses related to illegal drug activity
4. Lobbying Expenses
§ 162(e)(1) – no deduction for any amount incurred in connection with:
(a) influencing legislation
(b) participation in any political campaign for any candidate for public office
(c) attempt to influence the general public with respect to elections, legislative matters
or referendums; or
(d) direct communication with a covered executive branch (Pres., VP of any officer of
white house) official to influence official actions
(e)(2) – exempts from the prohibition of local governing bodies
(e)(5)(B) – de minimus – prohibition of deduction should not apply to in house
expenditures if they don’t exceed $2,000.
• Congress is trying to prevent corporations from influencing legislation in their favor while
also getting a deduction for it.
• You have a right to participate in lobbying, but the govt. does not have to subsidize it.
• A corporation can take real advantage of it and have more influence than average citizen.
• Lobbyists significantly assist congress in writing/amending laws/statutes. This is a true
business expense that should be deducted.
• Lobbyists better the law
1. In order for lobbying expenses to be deductible the taxpayer must have a trade or business and
the legislation must be of direct interest to that business.
2. Constitutional limitations – can’t deduct some indisputably business-related expenses solely
because they involve politics.
3. Advertising – Reg. 1.162-20 – institutional or goodwill advertising is deductible so long as if
you keep taxpayer's name before the public or the advertising presents a view on general
economic, financial or social matters (e.g. contributing to Red Cross or purchasing US
savings bonds). But efforts to influence the public on particular issues of legislative expenses
are not deductible.
4. Lobbying by charitable orgs. is regulated in that if it does too much or gets political, its
charitable status can be taken away – they are much more restricted. E.g. Christian Coalition.
No direct support for candidates allowed. See § 501(h) and §4911.
5. Grass Roots - § 162(e)(1)(C) – denies the deduction of grass roots lobbying (e.g. flyers, door-
5. Employee Business Expenses
1. § 162 covers both employees and employers, but § 67 is a limit on employee business
expenses – 2% floor limit only on miscellaneous itemized deductions. Statute defines what
is not a misc. itemized deduction (defines by exclusion) so that if the statute defines it, you
can deduct it in full.
2. Floor deduction (imposed in 1986) – anything above the floor amount is deductible; if you
make $100,000 in income and have $2,500 in expenses, you meet the floor b/c the expenses
are 2.5% of the income and can deduct $500 – the amount that is above the 2%
3. Why did Congress implement this floor for employees?
a. This has the effect of wiping out small expenses; IRS really likes this b/c people tend
to exaggerate and generally overestimate the amount of their small expenses.
b. Before the floor there was a lot of cheating since most employees were not audited.
c. Keeps IRS from auditing small amounts – administratively efficient.
Major rule to remember for all business expenses:
Rules regarding reimbursed expenditures v. non-reimbursed expenditures:
• If the expenditure is reimbursed by the employer a taxpayer has the option of:
1. ignoring it from your income (doesn’t step up your GI) and treating the reimbursement like a
working condition fringe which is excluded from income under § 132(d) (so long as this could
have been deductible under § 162); the 2% floor does not apply (see § 62(a)(2)(A) and Reg. 1.32-
2. you accept the reimbursement stepping up your GI and then claim the deduction under § 162(a); the
2% floor does not apply (see § 62(a)(2)(A) and Reg. 1.32-5);
• If expenditure is not reimbursed by the employer the taxpayer deducts it under § 162(a) and this
deduction is subject to the 2% floor under § 67(a).
IV. The Distinction between Deductible Business and Investment Expenses and
Nondeductible Capital Expenditures
1. § 263 – Capital Expenditures
(a) No deduction shall be allowed for
(1) Any amount paid out for new buildings or for permanent improvements to increase the
value of any property.
• § 162 deductions are subject to exceptions, most notably section 263 which covers capital
• Payments that add value or substantially prolong useful life of the property or adopt property
to a new and different use. If the expenditure is determined to be capital, amount that is
capitalized will be added to the basis. If not capitalized, probably added under § 162 of under
§ 212 for expenditures that are related to income producing activity.
• §263 deals with expenses that people incur that have a useful life that extends beyond a year
and contributes income over a period of years. Value is not consumed or dissipated within the
current tax year. It says that these expenses have to be matched up against the stream of
income that is generated by that expenditure.
• §263 deals with timing It is not deductible when the expenditure is made. It will, however,
be deductible at some future time.
• What can the taxpayer do after he capitalizes an expenditure?
1) Include the cost in the basis of the asset acquired and use that basis to offset future
gains realized on the sale of the asset
2) Include the cost in the basis of the asset and recover the cost over a fixed period of
time through depreciation or amortization.
• Tangible asset depreciation deduction
• Intangible asset amortization
§ 212 – Expenses for production of income
• In the case of an individual, there shall be allowed as a deduction for people engaging in
practices for the production of income, but it is not quite a trade or business.
2. Acquisition and Disposition of Assets
Woodward v. Commissioner
• Taxpayers, the majority shareholders of a corporation paid various attorney and accounting
fees to determine the value of dissenting stockholders shares, which they were required to
purchase. They then claimed deductions for these expenses as ordinary and necessary and for
the production of income.
• These types of fee are normally deductible under §162(a)(1), for services rendered. However,
the Court found that the expenses were incurred while in the acquisition of the minority stock
• Legal, brokerage, accounting, and similar expenses incurred in the acquisition or disposition
of a capital asset are capital expenditures and can’t be deducted as business expenses.
INDOPCO v. Commissioner
• National Starch (t/p) was the target of friendly takeover by Unilever and incurred significant
investment banking and legal fees as well as acquisition expenses which it sought to deduct
under § 162.
• Changing the corporate structure for the benefit of future operations are not ordinary and
necessary business expenses and must be capitalized.
• A taxpayer's realization of benefits beyond the year in which the expenditure is incurred is
undeniably important in determining whether the appropriate tax treatment is immediate
deduction or capitalization.
• Here the merger produced significant benefits that would be realized by taxpayer in future
years, so fees can’t be deducted and must be capitalized.
• The decisive distinctions between the current expenses and capital expenditures are those of
degree and not of kind. The notion that deductions are exceptions to the norm of
capitalization finds support in various aspects of the Code. Deductions are specifically
enumerated and are subject to disallowances in favor of capitalization.
• The separate and distinct asset test is not the only way of determining capital expenditure,
look at the realization of benefits beyond the taxable year.
• Hostile takeover – court’s reasoning in INDOPCO implies that the expenses of fighting a
successful takeover would be deductible b/c they neither create a new asset nor add future
value. This, however, seems inconsistent with the rule that expenses to defend the title to
property must be capitalized. This conflict is shown through Staley – which held that defense
of hostile takeovers are deductible b/c such response is ordinary and necessary while the tax
court has held it is not deductible.
• Advertisement produces current benefits and long term benefits but are currently deductible.
Traditionally, advertising costs have always been deductible, even though it is inconsistent
Northwest and DBTC Case
• Due diligence review when buying up stock is trying to be taken as a business deduction.
• Court says they can’t deduct the costs because they were not significantly related to an event
that produced long-term benefits- the costs were not directly related to the acquisition of the
benefit. Work was incidental to their overall responsibility.
• Defense of title – Reg. 1.263A-2(c); p. 992 also capitalized and amortized; this rule follows
from the general rule requiring the costs of asset acquisition or disposition to be capitalized.
• Rationale: the case matches expenditures to income; if an expenditure creates an entity that
generates income over a period of years that income has to be recovered over a period of
years through amortization not recovered through immediate deduction.
• Despite the future benefit, writer’s can deduct in the year paid or incurred expenses of
creating literary property – codified in § 263A(h) which exempts writers, photographers and
artists from capitalization requirements.
• Environmental cleanup is deductible b/c it doesn’t provide a permanent improvement, but
rather places the land to its original condition.
• Contingent Liabilities – when a buyer buys assets of a company they may be assuming the
liabilities of the purchased company as well. Sometimes these liabilities are contingent. So
when liabilities ripens the buyer/new owner is obligated to pay and cannot argue that it is an
ordinary expenses and therefore deductible under § 162. Rather it is simply a purchase price
adjustment and part of the acquisition cost, therefore a capital asset. The new owner cannot
deduct and must depreciate instead.
3. Repair v. Improvements
Reg. § 1.162-4 – the cost of incidental repairs, which don’t materially add to property or prolong
its life, but only keep it in ordinary operating condition may be deducted provided the cost of
acquisition or production or the gain or loss of the basis of the property is not increased by the
amount of such expenditures.
• Repairs are deductible if they are made to business property, improvements are not. A repair
is an expenditure that neither materially prolongs the life of an asset nor raises the value of it.
• If a repair merely keeps the status quo of the property and allows it to be continued to use for
its intended purposes, then it is treated as a deductible, even if it is substantial and may
provide long-term value. (Meat packing concrete lining case)
• What happens if there is expenditure that requires something to be done- change in building
code or environmental reg.?
• If purposely didn’t make repairs in compliance with code, then it is part of original
capital expenditures and should not be deducted immediately. If didn’t know that they
were building in violation of the code, then would be a repair under the Mount Morris
test because they intended to comply.
• Section 174 of the code says that research and experimental expenditures are deductible.
4. Expenses with respect to a new business
• Courts have held that the pre-entry or pre-opening expenditures are acquisition costs
and generally nondeductible capital expenditures. They are found not to be deductible
because of the “carrying on a trade or business” language and a new business is not carrying
on anything; it is starting fresh.
• Although § 212 does not require that the taxpayer be “carrying on a trade or business” as
does § 162, the courts have held that the pre-opening expenses doctrine applies to § 212 as
§ 195 – Start-up expenditures
• No deduction shall be allowed for start-up expenditures (so you have to amortize).
• Start-up expenditures may at the election of the taxpayer, be treated as deferred expenses;
such deferred expenses shall be allowed as a deduction prorated equally over such period of
not less than 5 years as may be selected by a taxpayer beginning with the month in which the
active business began (usually the date of incorporation is the date the business starts).
• Interpretation - This means that a taxpayer can elect to defer his costs and if he does this, he
must then amortize the start-up costs equally for no less than 5 years (straight-line
depreciation). A start-up business would want to do straight-line amortization rather than
acceleration because it has no income to offset the expenses its incurred right away. After 5
years or more, the business can then start to amortize it in an accelerated method.
• Start-up expenditure only applies to those expenses, which would be deductible if in the
• This does not apply to § 212 because § 195 applies only to an active trade or business, which
relates to § 162; and § 212 is expenditures for production of income for an individual (doesn’t
talk about active trade or business).
V. Recovery of Capital Expenditures
A. Depreciation and the Accelerated Cost Recovery System
The problem that deprecation deals with is the fact that an asset declines in value or gets used up
entirely during the life of that asset. While it is inappropriate for the taxpayer to deduct the cost of
the asset when it is bought, it is also unfair to not allow the taxpayer to take some deduction for
the loss of value.
Three things you must remember about depreciation:
1. Only business assets can be depreciated, not personal assets; it is a substitute for a §§ 162, 212
2. You are only depreciating the basis, not the fair market value. This is because depreciation is
an allowance for an investment in property and the investment is the cost/basis, not fair
3. Certain things are non-depreciable because they do not wear out – e.g. land, stock, art,
antiques; building on land – you must apportion it (determine what part depreciable and what
1. Depreciation is a matter of kind
2. Choice or assumption that is made concerning useful life of an asset can have a very
3. Particularly for capital intensive businesses- depreciation deduction can have an enormous
effect- tax rate goes down significantly.
4. Administrative concerns.
A) § 167 – Depreciation
(a) – one may depreciate a reasonable allowance for the exhaustion, wear or tear
(1) of property used in a trade or business (§ 162); or
(2) property held for the production of income (§ 212)
• Implicitly excludes personal property (b/c § 262 explicitly excludes
deductions which then excludes the application of a depreciation
Straight Line Method
• Value against time, the asset will decline in value by the same amount over period of
time. This is basically an incorrect assumption of reality, because some lose value
more quickly on the front or back end. Cars, for example, lose value very quickly at
first. Buildings, however, loss value on a more even level.
• For example, $1000 property with a 10-year life – $1000/10 = $100 depreciated
deduction from your gross income taken each year (basis knocked down by $100
B) § 168 - Accelerated Cost Recovery System (ACRS)
• Depreciation deduction for any tangible property shall be determined by using:
1. depreciation method
2. applicable recovery period –over how many years depreciation deductions are
• Residential property – 27.5 years
• Nonresidential property – 39 years
• If doesn’t say what life is, assume its 5 or 7 years
3. Applicable convention-assumed that property is used for half-year.
• Applies to property placed in service post-1981 far more reaching than §167
• What is meant by “accelerated” is that investments in depreciable property could be
claimed over lives that are substantially shorter than their useful life. By shortening
lives, deduction would be larger, and there is an incentive to invest because
investments could be written off over a shorter period.
• Recovery period (not call useful life as in §167) is what is important. The actual
useful life is irrelevant. The relevant factor is what category the particular property
falls (i.e., 3 yr property, 5 yr property) 168(c)
• 168(b)(4) – salvage value shall be treated as 0.
Double declining balance (accelerated)
• Permits taxpayer to claim higher deductions in the earlier years, and lower
deductions in later years. Used when taxpayer is not depreciating real property.
• A constant percentage is used, but it is applied each year to the amount remaining
after the depreciation of previous years has been charged off.
• LOOK TO HANDOUT FOR COMPUTATIONS
$1000 property with 10-year life:
1. Year 1: $1000 x 20% = $200 depreciation deduction ($1000 basis -$200 = $800).
2. Year 2: $800 x 20% = $160 depreciation deduction ($800 basis - $160 = $640).
3. Year 3: $640 x 20% = $128 depreciation deduction ($640 basis - $128 = $512).
4. Year 4: $512 x 20% = $ 102.40 deprec. deduction ($512 basis - $102.40 = $409.60).
5. Year 5: $409.60 x 20% = $81.92 deprec. deduc. ($ 409.60 basis - $81.92 = $327.68).
• By the year 5 you are depreciating less than you would be depreciating in year 5 if
straight-line method was used; this is b/c you front loaded your depreciation
deductions and depreciated more in the beginning than in the end.
• The advantage of the double declining balance (or any appreciated method) is that
you can depreciate more in the beginning and if you then sell it before the life of the
property is expired you can recover more than the cost of the property than you
would had you used straight-line.
• In straight-line you recover the full basis of the property at the end of the property’s
life whereas in double declining balance you never will recover the full value.
B. Other Depreciation Matters
A) § 179 – Election to expenses certain depreciable business assets
• Exception to everything covered above.
• Intended to help small businesses who have limited expenditures in assets to allow
them to deduct/expense it (rather than capitalize) in the taxable year rather than
setting up complicated accounting schedules.
• Permits a taxpayer to elect to deduct immediately some of the cost of certain tangible
business property where the annual total investment in qualified property is $200,000
• Property that qualifies for this treatment is found in 179(d) Must be tangible
property to which 168 applies, which is § 1245 property (not real property) which is
acquired by purchase for use in the active conduct of a trade or business.
• Limit on how much can be deducted-first year is 24,000.
• Congress justified this as a subsidy for small businesses – benefit is denied to GM’s
and IBM’s of the world.
B) § 197 – Amortization of goodwill and certain other intangibles
• Problem with intangibles is that they don’t have a definable useful life
• This section allows taxpayers to amortize over a 15 year period the cost of acquiring
certain intangible assets (see §197(d))
• Congress provided a statutory 15-year life – made this simple and eliminated lots of
disagreements over intangible property
• In the case of goodwill, going concern value, and customer and supplier based
intangibles, the amortization is allowed only if taxpayer purchased the asset rather
than created it.
§ 165 –
• (a) - Allows a deduction for any loss sustained during a taxable year and not compensated for
by insurance or otherwise.
• This section starts off very broad, but becomes more limiting with later provisions that narrow
its scope of 165 losses.
• (b) – The basis for determining the amount of the deduction for any loss shall be the adjusted
basis provided in § 1011 for determining loss from the sale or other disposition of property
(w/o insurance a business which has already depreciated down most of its assets has a
minimal § 165 loss to deduct compared to his actual loss).
• (c) – in the case of individuals, a deduction under subsection (a) shall be limited to:
1. loss incurred in a trade or business
2. losses incurred in transaction entered for profit, e.g. investment;
3. except as in (h), losses of property not connected with a trade or business or a
transaction for entered into for profit, if such losses arise from fire, storm,
shipwreck or other casualty or from theft.
Personal losses v. For-profit losses
• The deductibility of losses under §165(c)(2) may depend upon whether taxpayer's motive in
entering transaction was primarily for profit.
• Personal occupancy or use is inconsistent with the presence of a profit motive.
• If primary purpose for the underlying transaction was personal, then don’t get to declare a loss
under Section 165(c)(3).
• If property purchased or constructed by taxpayer for use as his personal residence is, prior to
its sale, rented or otherwise used for income-producing purposes and is used for such
purposes up to the time of sale, a loss sustained on the sale of the property shall be allowed as
a deduction. (1.165-9(b)(1)
• Disallows deductions for any loss that is from the sale of property to family members.
• Members of the same family-family shall include only brothers and sisters, spouses,
ancestors, lineal descendant.
D. Bad Debts
1) § 166 – Wholly worthless debts
• Deals with bad debts, which are not losses although in many ways they are very
• Two ways in which bad debts can arise:
1) Somebody formally acts in the capacity as lender, be it a bank or a person.
2) Arises in the normal operations of a business. As a business, you have
customers. In some cases, you extend credit to them. If they don’t pay, you have
what the tax law calls a bad debt.
• Taxpayer must have a basis in the debt (i.e., unpaid wages or rent) §166(b)
• Business bad debt
• A business bad debt is deductible in full as an ordinary loss when it
becomes wholly or partially worthless §166(a)
• Non-business debt
• An individual may deduct only a wholly worthless non-business bad debt.
• A non-business bad debt is deductible as a short term capital loss.
• Capital losses are not as valuable as an ordinary loss taxpayers prefer
business bas debt to non-business bad debts, which can be deducted only as
capital losses and only when entirely worthless.
• It is sometimes advantages for a taxpayer to attempt to achieve deductions
as a §165 loss, instead of a bad debt because a non-business profit seeking
transaction that produces a loss is deductible against ordinary income.
• § 162- if not in a trade or business, non business bad debt.
US v. Generes
• Taxpayer was president and shareholder of a company. Loans company $300,000 but
company goes bankrupt.
• Taxpayer claims business bad debt deduction under § 166(a), asserting that he made
the loan to protect his job and salary (a legitimate business reason).
• Whether a bad debt has proximate relation to the taxpayer's trade or business, and
thus qualifies as a business bad debt, the proper measure is that of dominant
motivation, and that only significant motivation is not sufficient.
• Court holds that this loan is protecting his personal investment in the company as a
shareholder. Court compares taxpayer's $12,000 salary to his $38,900 investment
and finds that the disproportional size of the personal investment takes away from
the taxpayer's argument that protecting his salary was dominant motivation of the
• Court treats $300k in debt as a non-business debt and as a short-term capital loss,
which is deductible at $3,000 a year. (assuming that taxpayer doesn’t have any
capital gains, 1211(b))
VI. Distinction between Deductible Business or Investment Expenses and Non-
deductible Personal, Living or Family Expenses
A. Travel Expenses
1. Local Travel and Commuting
• Section 262 – Commuting to and from work is a personal expense and not deductible. The
policy is that it is a personal decision as to where someone chooses to live.
• The black letter law is that commuting expenses are not deductible. However, §132(f) states
that there are transportation fringe benefits. The effect of this from inclusion of income is the
same as if the employee was paid more money. If the employer pays the commuting cost, it is
the same economically as the deduction.
• Can’t deduct cost of traveling from home to office-personal choice how far you live away
from home. Even if not really a choice, still not deductible.
• Can you deduct the cost of driving your own car while on business? As an employee, no. But
if you where a lawyer going from place of business to place of business, then yes.
• 132(d)- any property provided to the employer to the extent that if employee paid for such
property or services, such payment would be allowable as a deduction under § 162 or 167.
• 132(f)- qualified fringe benefits- transit pass is excluded from employee’s income. If take
mass transit and paid for it out of pocket, it’s a non-deductible personal expense.
2. Food and Lodging: Away from Home?
• § 162(a)(2) – allows a deduction for traveling expenses (except what is lavish and
extravagant) while away from home in the pursuit of a trade or business.
• When are you away from home? Not away from home if not away over night.
• Can only be in a place for one year before it is considered your home. If somewhere for
less than a year and employer pays for your expenses, they are not considered income.
These expenses include day-to-day living expenses
• When traveling in one day-can deduct ordinary and necessary business expenses.
• Traveling expenses are broken up in 3 components:
• Reimbursed v. un-reimbursed:
1. When traveling expenses are reimbursed employee can deduct in full under
§ 62(a)(2)(A), and is not subject to the 2% floor under § 67.
2. When not reimbursed employee may deduct under § 162(a)(2) so long as ordinary
and necessary and subject to the 2% floor of § 67.
McCabe v. Commissioner (transportation expenses)
• Taxpayer police officer lives in NY and was required to carry his revolver at all times while in
NY. Didn’t have a permit to carry one in NJ. So taxpayer takes long route and attempts to
deduct travel expenses incurred as a result.
• Normally, expenses incurred as a result of commuting from home to work are personal and
not deductible under § 162 (Flowers).
• Three prong test for when travel expenses are deductible under Flowers:
1. expense must be a reasonable and necessary (appropriate and helpful) travel expense
2. expenses must be incurred while away from home.
3. expense must be incurred in pursuit in business (direct connection between the
expenditure and the trade or business of the taxpayer).
• McCabe says his gun is his working tool, but court disagrees b/c his it is choice to live where
he does. This policy is limited to NY only and doesn’t require carrying a gun outside of NY
so the extra tool of carrying the gun outside of NY limits did not further NY city police
dept’s. business of preventing crime within the city itself (therefore 3-prong not met).
• Rev. Ruling 75-380 – deductions are permitted only for the portion of the cost of
transporting work tools by a mode of transportation in excess of the cost of commuting by the
same mode of transportation without the tools.
1. Commuting to temporary employment is treated as deductible – Rev. Ruling 90-23.
Most common for construction workers
2. Safety exception – where reasonably unsafe conditions exist to walk or take public
transportation employer compensated commuting expenses generally are not
considered gross income beyond a $1.50/per one-way commute.
Business use of car
• 280(f) – employee deductions are limited to cases where the use of the car is for the
convenience of the employer and required as a condition of employment. The employer may
generally deduct “Company cars”.
• 274(d) – Requires the employee to substantiate through contemporaneous written records the
business use of the car. If self-employed person uses a car, she must use it at least 50% for
business purposes, or will face substantial limitations on deductibility.
United States v. Correll (meals)
• Taxpayer, a traveling salesman eats breakfast and lunch while on the road every day then goes
home for dinner and to sleep at night. Taxpayer tried to deduct the cost of breakfast and lunch
• A taxpayer traveling on business may deduct the cost of meals only if his trip requires him to
stop for sleep or rest (away from home). Food is only deductible to the extent it is coupled
with lodging – this is a bright-line rule
Hantzis v. Commissioner (lodging)
• Harvard law student who lived with husband in Boston tried to deduct living expenses for
summer associate job in NYC.
• For taxpayer to deduct the expenses of maintaining a second home, taxpayer's trade or
business must require that multiple homes be maintained. The cost of maintaining a second
home for temporary employment is only deductible if there is a compelling business reason t
continue maintaining the first home.
• A t/p in these circumstances to be away from home in pursuit of a trade or business must
establish the existence of some sort of business relation both to the location claimed as home
and to the location of temporary employment sufficient to support a finding that the
duplicative expenses are necessitated by business exigencies.
• Because taxpayer had no business reason to have a house in Boston, but it was simply for
family reasons, she was not away from home. Need a business reason in both locations.
• The IRS’s position is that you can only be away from home on business if you have a trade or
business that pre-dates the travel.
Andrews v. Commissioner (lodging)
• Taxpayer lived for half a year in Mass and half a year in Florida. In Florida he breed horses
and in Mass had another business. He sought to deduct the travel expenses to Florida. Also,
had meals and lodging expenses.
• He had a business reason to be in both locations for half the year. If he had been only in
Florida for a few weeks each year, then it would be ok because he was away from home on
trade or business.
• The Court found that Mass was his principle place of business and when in Florida he was
away from home on trade or business. The court said that for purposes of §162 if you are
constantly traveling then you may not have any tax zone at all.
• The policy reason was that the taxpayer was incurring duplicative living expenses.
B. Entertainment and Business Meals
1. Entertainment Expenses
§ 274 – Disallowance of certain entertainment, etc. expenses (whether deduction
allowed is from the perspective of employer)
• Additional set of requirements- § 162 must be satisfied as well – ordinary and
necessary business expense. This is the first threshold!!!
• (a)(1)(A) - No deductions allowed for entertainment, amusement or recreation unless
the taxpayer establishes that the item was directly related to, or directly preceding
or following a substantial or bona fide business discussion, that such item was
associated with the taxpayer's trade or business. E.g. cost of client’s meal would be
deductible if directly related with or associated with his trade or business.
• Under regs-directly related means that there must be more than general
expectation that business will be generated at some point in the future.
• Principle character based on all the facts and circumstances must be directly
related to the trade or business.
• Associated with test applies as well
• (a)(1)(B) – no deductions allowed for a entertainment facility (boat, hunting lodge)
• (b) – No deduction shall be allowed for gifts made directly or indirectly to an
individual when such expense exceeds $25 within the entire taxable year.
• (c) – foreign travel –
(1) The portion of time of travel outside of the US in pursuit in a trade or
business or in pursuit of a § 212 investment no deduction shall be allowed
for the portion of those expenses not allocable to such trade or business.
(2)(A) – if travel does not exceed one week, you may deduct it all
regardless of how much of it is personal
(2)(B) – if entire travel is more than one week, and less than 25% of the
time is personal or not attributable to the business, it is all deductible.
• (d) – substantiation required – no deduction or credit shall be allowed:
1. under §§ 162 or 212 for any traveling expense
2. any item generally considered to constitute entertainment, amusement or
3. any expense for gifts, or
4. with respect to any listed property
unless the t/p substantiates by adequate records or by sufficient evidence
corroborating the taxpayer's own statement. (taxpayer has to keep adequate
(A) the amount of such expense or other item
(B) the time and place of the travel, entertainment, amusement, recreation, use
of facility, or the date and description of the gift
(C) business purpose of the expense or other item; and
(D) business relationship of the t/p or persons entertained, while using facility,
or receiving gift.
• (h)(1) – Attendance at conventions – no deduction shall be allowed for an individual
who attends a convention or similar type meeting outside the north American area
unless the taxpayer establishes the meeting is directly related to the active conduct of
his trade or business and that it is as reasonable to have the meeting outside North
America as it is inside it.
• (h)(2) – Conventions on cruise ships – taxpayer must prove that meeting is directly
related to the active conduct of trade or business.
• (n) – only 50% of meal and entertainment expenses can be deducted
If the employer does not reimburse the employee, the expenses for meals and
entertainment are subject to not only the 50% limitation, but also the 2% floor.
When is a deduction for entertainment purposes appropriate?
• Taxpayer establishes that the cost was directly preceding or following a substantial
and bona fide business discussion (274(a)), OR:
1. Entertainment which occurs on the same day as a substantial and bona fide
business discussion will be considered to directly precede or follow such
2. If the entertainment and the business discussion do not occur on the same
day, the facts and circumstances of each case are to be considered. Such as
the place, date, and duration of the discussion and whether the taxpayer is
from out of town, and reason why there was a delay. 1.274-2(d)(3)(ii)
3. It is not necessary that more time be devoted to business than to
• Taxpayer establishes that the cost was associated with the taxpayer's trade or
• There are exceptions §274(e) allows deductions for:
1. Expenses for food and beverage for employees furnished on the business
premises of the employer.
2. Recreational expenses for employees.
• If the expense is considered lavish or extravagant, then you lose the entire
Walliser v. Commissioner
• This case illustrates that §274 is an additional requirement, it does not allow
deductions, only an additional requirement for §162. Also, §274 requires serious
connections to business, not enough that the activity is just good for business.
• The Court viewed the trips in question as recreation, look to the regulation. This was
a business motivated event, but the taxpayer got screwed.
2. Business Meals
• §274(k) – there is virtually no enforcement of this rule.
• Cannot be lavish or extravagant and taxpayer has to be present at the meal.
• The employer who reimburses his employee gets to deduct 50%.
• The employee may deduct the entire amount as a working condition fringe benefit
Moss v. Commissioner
• Moss had a small law firm and the only time that they could meet was during lunch
at a restaurant. They want to deduct their meals as business expenses under §162(a).
• Their business was furthered during these meetings because they were talking about
business. Ordinary and necessary means that it is somewhat normal and reasonable.
Needs to be appropriate and helpful to the business needs.
• So what was the problem here? The court talked about §262, which disallows
deductions for personal expenses. Meals may fall under this category. So there is
tension between the two statutes.
• The court focused on the relationship with the other people at the meal. This is where
to draw the line.
3. Policy arguments on entertainment expenses:
Arguments in favor of entertainment deductions:
1. We need social lubrication – more deals made over golf course rather than ones w/o
the wining and dining.
2. Restaurant/entertainment business thrives on these lunches, games, etc.; this
corporate use of these facilities greatly increases their business
3. This drives the economy and provides jobs for all levels of employees (e.g.
waitresses, vendors at games as well as the corporate big-wigs of entertainment
4. Fosters goodwill/communication.
Arguments opposing entertainment deductions:
1. Entertainment is more personal than even business expenses, so if business
expenditures are not deductible, than entertainment shouldn’t be either
2. Easy to abuse b/c so intertwined with personal expense
3. Legalized bribery
4. Administratively inefficient b/c allowing deductions for certain circumstances and
not others so you end up with litigation (no bright-line rule).
5. Unfair – favors bug business who can afford to take their clients out and comply with
substantiation requirements. Others can’t afford to do this nor can they follow these
C. Education Expenses
Non-deductible Educational Expenses
1. Expenditure on minimum educational requirements for qualification in his employment or
other trade or business. Reg 1.162-5(b)(2)
2. Expenditure made by an individual for education, which will lead to qualifying him for a new
trade or business. Reg 1.162-5(b)(3)
Deductible Educational Expenses
1. The education maintains or improves skills required by taxpayer in his employment. 1.162(a)
2. The education meets the expressed requirements of the employer or applicable laws. 1.162(a)
1. § 25A(b)- Hope scholarship credit- equals full cost of tuition up to 1,000 dollars a year.
• § 25A(b)(1)(B)- will allow credit to go up to 1,500 if tuition is 2,000 or more.
• Available for only two taxable years.
• Student must be at least half-time student.
• Only allowable for first two years of post-secondary education, first and second year
• Not eligible if convicted of felony relating to controlled substance
2. § 25A(c)(1)- lifetime learning credit
• maximum tuition you can take into account is $5,000. Can take 20% of tuition or
$1,000, whichever is greater
• Starting 2003- credit will go up to 20% of 10,000 or 2,000, whichever is greater.
• Available only for taxpayers who had fairly modest incomes. Under 25A(d)- if
taxpayer’s income become too high, then allowable. For unmarried individual, limit
• Your income cannot be too low- because this is used to offset tax liability and people
with low income don’t have any tax liability.
• No credit for dependents (Bill Gates’ children).
D. Child Care Expenses
• This is a personal expense that relates to the decision to have children and is not deductible
under §262. However, §21 provides a tax credit for qualifying childcare expenses.
• Qualifying individual – child must be under the age of 13.
• Amount received from childcare shall not exceed earned income. Parent needs to be working.
• Credit is allowed with respect to employment related expenses-expenses incurred that enable
taxpayer to be gainfully employed.
• What types of child care centers are covered? If it takes place within the taxpayer's residence,
there are no real requirements. If the child is in an independent place, the credit is available
only if the center follows all the applicable laws of the state. Must care for more than 6
• (a)(2)(A) - Permits an employee to deduct up to $5,000 in depended care assistance provided
to the employee. Employer cannot discriminate to benefit highly paid employees.
E. Legal Expenses
US v. Gilmore
• Taxpayer tried to deduct legal expenses incurred contesting a divorce property settlement.
• Taxpayer attempted to claim deductions arguing that it would negatively affect his business.
• Origin of claim test whether claim arises from profit-seeking activities- distinguishes
deductible from nondeductible litigation expenses. If origin from lawsuit is from business,
expenses are deducted. If from personal situation then expenses are not deductible.
• Court held that this suit stemmed from personal situation (marital problems) and court found
the expenses nondeductible.
• Note: in criminal cases t/p may deduct the cost of defending against prosecutions that stem
from profit seeking activities (white-collar crime).
F. Clothing Expenses
Pevsner v. Commissioner
• This was an upscale clothing store and the manager was required to wear the expensive
clothing while at work. The taxpayer sought to deduct the cost of the clothes and maintenance
of them as a necessary and ordinary business expense.
• She could have not gotten the job if she did not wear the clothing, because it is a requirement
of the employer. There is tension between this and §262 which bars deductions for personal
things, which clothing usually is.
• Court uses objective test: the general rule for deductibility for clothes is:
1) The clothing is a of a type specifically required as a condition of employment
2) It is not adaptable to general usage as ordinary clothing
3) It is not so worn
• In this case, the taxpayer did not meet requirement #2. The tax court used a subjective test and
found that in her case, she did not use the clothes outside of work. However, the appeals court
used an objective test and found that the clothes could be worn by others outside of work and
thus no deduction was allowed.
VII. Personal Deductions
• More and more taxpayers are getting deductions that have nothing to do with business. This is
designed to produce vertical equity and fairness. Currently, people who are poor are not required to
pay income taxes. This is achieved in three ways:
1. The standard deduction, which is allowed for everyone, irrespective of the expenses
that they incur. For unmarried individuals, standard deduction is $4,550. For
married people, standard deduction is $7,600.
2. The personal exemption deduction (itemized) –exemptions that have nothing to do
with income producing activities. They are personal in nature- personal taxes,
casualty or theft losses, medical expenses, and charitable contributions.
3. The earned income tax credit.
A. Standardized Deductions and the Personal Exemption- §63
• The idea behind the standard deduction is that we have to give everyone a subsistence
allowance and to allow low-income people a certain amount that is not subject to tax.
• When people claim these personal deductions, they claim them on a Schedule A deduction.
The standard deduction varies based on the taxpayer's filing status.
• A taxpayer who doesn’t itemize deductions, but instead takes the standard deduction, would
determine his taxable income through the following formula:
AGI – (Standard deduction + Personal exemption) = TI
• Section 1, which imposes the tax, is divided into four filing statuses:
(a) married filing joint returns 1(a)
• $5000 – Filed by two people who are married as of the last day of the
• Determination made at the close of the taxable year.
(b) heads of households 1(b)
• $4,400 – defined as a single, unmarried taxpayer who maintains a
household and has a resident child.
(c) unmarried individuals other than heads of households 1(c)
• $3,000 – the single rates are more favorable than the married filing
(d) married taxpayers filing separate returns 1(d)
• $2,500 – such as persons getting divorced who don’t want to show spouse
B. Personal itemized deductions - §151
• Taxpayer has a choice between itemizing deductions and claiming a standard deduction. A
taxpayer would add up the itemized deductions to see whether they are more than the standard
• Under §67(a), a taxpayer may only deduct miscellaneous itemized deductions to the extent
they exceed 2% of the taxpayer's AGI.
1. Taxpayer §151(d) specifies that the taxpayer is allowed a personal exemption of
$2,000 each for himself.
2. Spouse 151(b) allows an additional exemption for the spouse if:
i) a joint return is not made by taxpayer and his spouse
ii) the spouse has no gross income for the calendar year
iii) the spouse is not the dependant of another taxpayer
3. Qualified Dependents
• Dependents are persons who receive more than half their support from
taxpayer and must either be a relative or a member of taxpayer's household.
• The dependent exemption can only be taken if:
i) the dependent earned less than the exemption amount, 151(c)(1)(A),
ii) OR, the dependent was a child of taxpayer and was either under the
age of 19 or was a full-time student under age 24. 151(c)(1)(B)
• 151(e) – provides a support test to determine which parent gets the
exemption in the case of children with divorce parents.
C. Earned Income Tax Credit - § 32
• This is basically an anti-poverty provision.
• The structure of the provision is like the child-care provision. In the case of an eligible
individual, which is a defined term.
• To get the credit you multiply the credit percentage by the earned income. There are
mechanisms to make sure that this is applicable only to low-income people.
• Credit percentage is found in §32(b)(1). On page 554 the revenue procedure states the
numbers. The credit starts to be eliminated as the taxpayer starts to exceed certain income
amounts. For a couple, the credit is not eliminated until the combined income exceeds
• Eligible individual – any individual that has a qualifying child for the taxable year. Qualifying
child is then defined under §32(c)(3).
• You don’t have to have children to be eligible for this credit.
• Must have attained the age of 25, but can’t be 65.
• Maximum amount of credit is about 4,000-this applies when someone had about 10,000. This
provision actually encourages people to have more income!!!
• § 32 (b)(1)(A) - provides phase out qualification percentages rather than having a bright-line
rule in which people are in or out.
• The § 512 definition of dependant child and the § 32(c)(3) definition of qualifying child are
very different definitions b/c a qualifying child is based on residence while in determining
dependency support is the focus of the analysis.
D. Personalized Itemized Deductions
1. The Interest Deduction - §163
Congress limited interest deduction by dividing interest into 3 different categories:
1) Business – deductible without limit like any other business expense.
2) Investment – 163(d) limits investment interest deductions to the net investment income
for the year (total investment income less investment expenses)
3) Personal – Personal interest paid or accrued during the taxable year is not deductible.
163(h)(1) Except for mortgage interest, investment interest, qualified residence.
Mortgage Interest (Qualified Residence Interest) 163(h)(3)
• The only personal interest that is deductible is mortgage interest.
• Home Equity Indebtedness (163(h)(3)(B)) arises when taxpayer borrows against the home to
pay for something else unrelated to the home. Limit = $100,000
• Qualified residence- includes both principle residence and other residence-can have up to two.
• Acquisition Indebtedness (163(h)(3)(C)) is incurred in buying or improving a home. Limit =
• If you take the standard deduction, then this section is not applicable.
• Three questions to ask with this section:
1) Is there interest personal? 163(h)(2).
2) Is it qualified residence interest?
• Underlying debt: acquisition indebtedness? 163(h)(3)(B)
home equity indebtedness? 163(h)(3)(C)
3) Do any of the limitations apply?
• What is interest? Amount agreed to pay for the use of borrowed money.
• Assume that you borrow money from a relative. Should the interest paid to that person be
deductible? If the parties act at an arms length manner, then it will be treated as interest. If it
is more informal, then it is more difficult to assess.
• About a person who borrowed money to start a business. The loan was for 15 million. The
interest was for 1,587,000.
• It was due 1.1.81. On 12.30.80, he borrowed the amount of the interest due. Then on 12.31.80
he paid back the interest due.
• It was not deductible, however, because he was not initially able to pay back the interest. So,
he borrowed more money from the same person to pay back the interest.
• There was nothing ever really paid. A mere promise to pay the interest does not constitute
payment or giving someone a promissory note saying that you will pay.
• Need to actually pay in order to take a deduction. In this case, it was really just another IOU,
just another promissory note.
Knetsch v. US
• Taxpayer bought annuity at an interest of 2.5% and paid for it with a loan with interest rate of
3.5% which means he is losing money! There was no economic purpose in these transactions
other than tax avoidance.
• Issue is whether these are real interest deductions. While 163 allows an individual to deduct
interest paid on indebtedness, if that indebtedness is the result of a sham, a transaction which
has no appreciable benefit to taxpayer except to reduce his taxes, the deduction will not be
§ 265(a)(2) – disallows a deduction on interest on debt which is used to buy tax exempt bonds
• Closes a huge loophole where a taxpayer could borrow tons of money to purchase these tax
exempt bonds writing off the interest on the debt while never paying taxes on the return of the
2. Deductible Taxes
§ 164(a) – except as otherwise provided in this section, the following taxes shall be allowed as a
deduction for the taxable year when paid or accrued
1. state and local foreign real property taxes
2. state and local personal property taxes
• 3-prong test for personal property § 164(a)(2) or see Reg. § 1.164-3(c):
a) must be related to the value of the property;
b) must be imposed on annual basis;
c) tax must be on personal property, rather than business
3. State and local and foreign, income, war profits, and excess profits taxes
3. Casualty and Theft Losses
• If the loss is related to trade or business then it is deductible.
• It matters if there is insurance, because if you are reimbursed for it, under §165(a), then it is
not deductible, because you have not suffered any economic injury.
• Two questions:
1. is this the type of injury to property which tax law characterizes as casualty?
2. Are losses significant enough so that deduction should be allowed even though they are
§ 165 –
• (c) – in the case of individuals, a deduction under subsection (a) shall be limited to:
1. loss incurred in a trade or business
2. losses incurred in transaction entered for profit, e.g. investment;
3. except as in (h), losses of property not connected with a trade or business or
a transaction for entered into for profit, if such losses arise from fire, storm,
shipwreck or other casualty or from theft.
• Has to be sudden, unexpected, and unusual in nature
• If you are responsible, it’s considered willful and no deduction is allowed
• (h) – treatment of casualty gains and losses (limitations)
(1) - any loss of an individual described in subsection (c)(3) shall be allowed only to
the extent that the amount of the loss to such individual arising from each casualty,
or from theft, exceeds $100. Old and arbitrary; see below for real limitation.
(2)(A) – if personal losses for any taxable year exceed the personal casualty gains for
such taxable year (insurance coverage), such losses shall be allowed for the taxable
year only to the extent of the sum of
(i) the amount of the personal casualty gains for the taxable year, plus
(ii) so much such excess as exceeds 10% of the adjusted gross income of the
• Amount of loss is limited to basis – 165(b).
• Assuming that there is no insurance, the amount of deduction is found under § 165(b) – how
• Start with taxpayer’s basis, subtract any insurance reimbursement; subtract 10% of t/p’s
AGI, then subtract $100 and whatever is left is your casualty loss.
• Watch for compensation through insurance, or otherwise (litigation, settlement, etc.)
4. Medical Expenses
• Medical Expenses are deductible if:
1. Medical expenses are not reimbursed by insurance or other forms of compensation.
2. The amount of medical expenses exceed 7.5% of taxpayer's AGI is deductible.
• (d)(1) medical care means amount paid
(A) for diagnosis, cure, mitigation, treatment, or prevention of disease, or for purposes of
affecting any structure or function of the body
(B) transportation primarily for and essential to medical care
(C) qualified long-term care services
(D) insurance premiums covering medical care
• if medically prescribed procedure, have to decide whether it’s generally contributing to
• (d)(9) – does not include cosmetic surgery or other similar procedures unless necessary to
ameliorate a deformity, etc. Won’t be considered cosmetic surgery if promote the proper
function of the body.
Reg. § 1.213-1(e)(1)
• Medical care expenditure deductions will be confined strictly to expenses primarily incurred
for prevention or alleviation of a physical or mental defect. Expenditures merely beneficial to
general are nondeductible, i.e vacations, spa, heated pool (depends on reason).
• Capital expenditures are generally not deductible, but a capital expenditure may qualify as a
medical expense, if it has as its primary purpose the medical care of the t/p, spouse or
dependent; thus a capital expenditure which is related only to the sick person and is not
related to permanent improvement or betterment of property shall be deductible.
• A capital expenditure for permanent improvement or betterment of property may qualify as a
medical expense to the extent the expenditure exceeds the increase in the value of the related
value, if the particular expenditure is directly related to the medical care.
• You get to deduct the difference b/w the amount paid for the improvement and the value
added to the residence. E.g. you build an elevator to your house; it costs $1000 and adds $700
to the value of your house you only get a $300 deduction (and you would then add the $1000
to your basis when you sell your house).
• Ferris – t/p build a pool for medical reasons; he incurred additional costs for architectural and
aesthetic reasons which were not directly related to medical care purposes. Court allowed
deduction to the extent it was functional, but additionally costs for aesthetic reasons were not
5. Charitable contributions - §170
• Expenses that are purely personal in nature-decision by individual to support various
organizations, including universities and other non-profits.
• Not all non-profits are eligible. If giving to something other than governmental unit, must be
• Corporations organized for religious, charitable, educational purposes.
• Can’t inure to the benefit of any private individual.
• Substantial part of activity can’t be propaganda.
• Can’t be a lobbying organization.
• Allows deduction for contributions to organizations described in 170(c).
• 170(c)(1) says that if you want to give money to the US government other than taxes, that is a
• 170(c)(2) is the most important provision. Says that tax-exempt organization must be created
for a limited purpose. Every tax-exempt organization isn’t a qualified recipient.
• Substantiation requirement – if contribution is $250 or more, taxpayer must substantiate it.
• Two questions to ask:
1) Whether there really was a gift
2) Are there any rules that limit the deduction
• If incidental benefit, then deductible. If benefit or service constitutes a quid pro quo, then it’s
an exchange that is not considered deductible. If have a pattern of giving and not getting
anything back, the won’t be a quid pro quo.
Hernandez v. Commissioner
• Scientologists believed that one can awaken their immortal being by participating in
“auditing” and “training” sessions, for which there was a price to attend. Taxpayer sought to
deduct the expense on the ground that it was religious.
• Here- there is a quid pro quo- have to provide money in order to get services in order to
advance through the ranks.
• Where taxpayer pays for a particular service, no contribution exists, even if the services are
religious in nature.
• In general, application to faith-based organizations is very difficult.
Gifts of Appreciated Property
• §170(e)(1)(A) – The code allows taxpayer to deduct the full FMV of the appreciated property,
thus the gain remains untaxed.
• If taxpayer buys property for $10 (basis) and it appreciates to $50, and then taxpayer gives
property to charity The gift is of the value of the appreciated property ($50).
• Amount of charitable deduction for a donation of appreciated property depends on whether
the recipient is a private foundation or a public charity; whether the appreciation would be
taxed as a capital gain or ordinary income if the property were sold; and whether the gift
consists of tangible property or securities.
1. Private foundation
• Contribution to a private foundation (other than securities) gives rise to a deduction
equal to FMV of the property minus any CG or ordinary income.
• The deduction is generally limited to basis.
2. Public charity
• Deduction is generally the FMV minus the amount of gain that wouldn’t have been
long term CG.
• If the property is tangible personal property that will not be used by the donee in its
charitable function, the deduction is the FMV reduced by the full amount of
• Rule – to avoid being subject to the limitations you must meet all of the following:
1. It must be a long-term capital gain; AND
2. It must be intangible and unrelated OR tangible and related
§170(e) – Exemption of contributions of ordinary income and CG property
• 170(e)(1)(A) – In the case of a contribution of inventory (bought at $10, contributed at $50),
the amount that would not have been taxed at long-term CG is $40. $40 is subtracted from the
adjusted basis ($50), which gives you a $10 deduction. (it will always be basis)
• 170(e)(1)(B) – Says that the amount of any charitable contribution of property shall be
reduced by the amount of gain which would have been long-term CG. ($40) If the property
contributed had been sold by taxpayer at its FMV ($50). If to could deduct the full value of
the property without having taken appreciation into income, a kind of double benefit would
Reg. § 1.170a-1(c)(1) – if a charitable contribution is made in property other than money, the
amount of the contribution is the FMV of the property at the time of the contribution reduced as
provided in § 170(e)(1). FMV = the price at which the property would change hands b/w a willing
buyer and a willing seller.
Policy arguments behind § 170:
1. The idea behind the § 170 as a whole is to encourage people to give to charities and so the t/p
can avoid having to appraise the value of the property himself and get the benefit of the
appreciated property without having to realize the gain for tax purposes. T/p gets the benefit
of the fair market value deduction (unless it falls under (e)(1)(A) or (B)) w/o having to realize
2. Limitations of § 170 - § 170(e)(1)(A) and (B) - The IRS narrows a t/p’s ability to deduct a
property contribution to only gifts/contributions that are related to the charity itself. The
reasoning for this is that people would give things to charities simply to get the tax shelter and
be able to write it off (b/c they would rather have the money going to the charity rather than
the govt.); these transactions have no economic value; the t/p will often inflate the value of the
property contributions and this is very difficult to enforce. It is easier for the IRS to set these
strict guidelines. If the t/p really thinks the property should be values much more than the
deduction allows, sell it yourself and give the cash.
VIII. Limitations on Deductions, Losses, and Expenses
A. Requirement of a Profit-Seeking Activity - §183
General Rule – If any activity is not engaged in for profit and bad things happen to the taxpayer,
no deduction attributable to that activity will be allowed under this section. However, figuring out
whether a transaction is entered into for profit depends on the facts and circumstances.
183(a) in the case of an activity engaged in by an individual of an S corp., if such activity is not
engaged in for profit, no deduction attributable to such activity shall be allowed under this chapter
(b) deductions allowable.
• Interest on mortgage (163(h)) and real estate taxes (164) are two main deductions
allowable- otherwise known as category one deductions.
• If considered home or second home, interest will be deductible.
• Utilities, maintenance, salaries of employees - category two deductions.
• Depreciation 167(a) – category three deduction. But only deduction if used in trade
(b)(2) Can deduct additional amounts to the extent of gross income received. Saves tax
deductions from unlimited scope of 183.
Dreicer v. Commissioner
• Individual traveled all around the world and ate at the best restaurants. He tried to get a
deduction for these activities because he tried to base a book on these activities.
• Rejects bona fide expectation test and replaces it with bona fide objective test- whether
taxpayer had a bona fide objective of seeking profit.
Regs §1.183-2(b) – for the list of nine factors that are used to determine if activity was for profit:
1. Manner in which t/p carries on the activity
2. expertise of t/p
3. time and effort expended
4. expectations of asset appreciation
5. success of similar or dissimilar activities
6. t/p’s income history (continuous stream of losses – red flag for audit)
7. amount of occasional profits
8. financial status for t/p
9. personal pleasure or recreation from activity
• No one of these factors is controlling, but continuous stream of losses is very important.
• You have to show you made a profit for 3 out of 5 years to prove the activity is engaged in for
profit; (if it is for horse breeding activity only needs to be for profit for 2 out of 7 years).
Presumption is in favor of taxpayer. Once you qualify for profit for 3 out of the 5 years, you
qualify under § 165 and can deduct in full.
2. Home Office Expenditures and Vacation Homes - §280A
A) Home office Expenses
Commissioner v. Soliman
• Taxpayer was a doctor who spent many hours a week with patients at various
hospitals. He also spent time in a home office doing paperwork. He sought to deduct
the expenses of maintaining this home office.
• Two primary considerations for determining whether a home office is taxpayer's
principal place of business:
1) The relative importance of the activities performed at each business location.
The point at which goods and services are delivered is given great weight.
2) The time spent in each place
• Principle place of business includes a place of business which is used by the taxpayer
for the administrative or management activities of any trade of business of the
taxpayer or if there is no other fixed location of such trade or business where the
taxpayer conducts substantial administrative or management activities of such trade
• Taxpayer was not allowed to deduct his home office expenses because he delivered
his services at hospitals and spent more time there.
• This case was overruled by § 280A(c)(1)
§ 280A Disallowance of certain expenses in connection with business use of home,
rental of vacation homes, etc.:
• (a) – in the case of a t/p who is an individual, no deduction shall be allowed for the
use of a dwelling unit which is used by the t/p as a residence.
• (b) - subsection (a) shall not apply to any deduction allowable to the taxpayer
without regard to its connection with his trade or business.
• (c) - Exceptions for certain business use:
• (1) – subsection (a) shall not apply to a dwelling unit which is exclusively used
on a regular basis:
(A) – as a principal place of business for any trade or business of the
(B) – as the place of business which is used by patients, clients or
customers in meeting or dealing with the t/p in the normal course
of his trade or business
(C) – in the case of a separate structure not attached to a dwelling unit
in connection with the t/p’s trade or business.
(qualifying language added after Soliman) – in the case of an
employee the preceding applies only if its exclusive use is for
the convenience of the employer. Principal place of business
includes a place of business used by the t/p for administrative
or management activities of a trade or business if there is no
other fixed location where the t/p conducts substantial
administrative activities for his trade or business.
B) Vacation Homes
§ 280A(d)(1) – a t/p uses a dwelling unit as a residence if he uses such unit for personal
purposes for a number of days which exceeds the greater of 14 days or 10% of the
number of days that the unit is rented at fair value. (it is going to be considered personal
and therefore not deductible if you stay there over 14 days or 10% of the useful days and
rent it out all of the other days – a response to abusive deductions).
• Must be a qualified residence- 163(h)(4)(a)(1)- one other residence of the taxpayer
which is selected by the taxpayer for purposes of this subsection for the taxable year
and which is used by the taxpayer as a residence.
• Vacation home mortgage interest would probably be deductible as long as used for
IX. When is it Income? Tax Accounting
A. The Cash Method of Accounting
• Used by most individuals and many services business. Potential to be abused.
• Basic Rules:
Income is taxable when it is received.
Expenditure is deductible when payment is made.
• Checks are like money under this system, when you receive a check you are deemed to have
the money. When you put a check in the mailbox, it is out of your hand. So that is deemed to
be payment is made.
• Basic tax-planning strategy is to pay expenses prior to year’s end.
The “Cash Equivalence” Doctrine
• Since income need not be received in cash to be taxable, the cash method entails reporting
cash or its equivalent, including the FMV of property.
• Requires the actual receipt of property or of a right to receive property in the future.
The “Constructive Receipt” Doctrine
• Cash, property and services constitute income for the cash method taxpayer when “actually or
constructively” received. Taxpayer may not postpone income that is available to him merely
by failing to exercise his power to collect it.
• Responsible for it when reduced to taxpayer's possession and control.
• Income is constructively received when it is made available so that the taxpayer may draw
upon it any time, but is not constructively received it taxpayer's control over the receipt is
subject to a substantial limitation or restriction. 1.451-2(a)
• Third party payments are constructive event – see Duberstein
• Taxpayer was paid in year 2 for work completed in year 1; he wanted to include it in year 1
because he earned it then; taxpayer argued it was constructively received in year 1
• Court held: taxable in year received even though earned in prior year.
Deferred Compensation – The cash method excuses taxpayer from currently reporting items,
which happen to be outstanding at the close of the taxable year. Deferred compensation
arrangements are allowed if the arrangement to defer compensation is entered into before the
services are performed.
Pre-payments – Pre-payments of insurance premiums, rents, compensation and the like are
currently deductible only to the extent that the “asset” or service so acquired is exhausted during
the taxable year.
B. The Accrual Method of Accounting
• Less potential for abuse. Required to be used for financial reporting for business. Creditors
want income measured this way. Required for inventories as well.
• Income in the first year that the taxpayer has the right to receive payment under whatever
agreement the parties are offering. It doesn’t matter if they have not yet been paid or may
never get paid. (Then they have a bad debt deduction)
• Deduction is allowed when a taxpayer’s obligation to make a payment becomes fixed and
absolute and the amount can be determined with reasonable accuracy.
• For accrual, people say that if all events have occurred that entitle payment then it kicks in.
• The accrual methods looks at rights, does not look at actual payments. If there is a loan for
$100,000 at 10%, then for that year the taxpayer has the right to deduct that 10% interest
US v. General Dynamics
• Company puts aside money for health insurance plan based upon their projected outlays.
Court held that deductions didn’t satisfy the all-events test; it was just an estimate, not a fixed
amount of liability based on events that had not occurred in the taxable year. They have to
wait until they are issued.
• The fact that taxpayer accurately could project these expenses doesn’t justify a deduction;
if all the events fixing the actual liability had not yet occurred.
US v. Hughes Properties
• Taxpayer ran casinos that had progressive slot machines. They had to pay out a minimum of
• Taxpayer could accrue these payouts as soon as the legal obligation to make the payments
X. Capital Gains and Loses
A. Statutory History and Policy
• We have had this preference since 1922
• 1986 – in part to finance overall rate reduction, Congress increased the capital gain rate to
28%. Then there was no rate preference until Bush’s “no new taxes” was broken in approx.
’91; at that time the rate increase of ordinary income went up to 31% and capital gains rate
remained the same. Now the maximum rate of ordinary income is 39% and capital gains rate
is still only 28%.
• Capital Gains are subject to a preferential rate of taxes, for a variety of rationale:
1) One rationale is “bunching” – because the taxpayer has to include all of the gain
realized on the capital asset in his GI in the year of the exchange. The taxpayer may
be thrown into a higher tax bracket the year the asset is sold than the taxpayer
otherwise would have been in had the gain been taxed over a number of years.
2) Capital gain should be taxed at a favorable rate to mitigate the “lock-in” effect. We
don’t want a taxpayer to hold on to an asset that they would otherwise sell simply to
3) We want to encourage people to invest in capital assets.
4) Prevent shareholders of a corporation from being taxed twice.
B. Tax Treatment of Capital Gains and Losses
1) Section 1(h)
• Tax rate will not exceed 28%, as opposed to 39% for ordinary income
• Capital gains provisions essentially create 2 tax systems – one for ordinary income
and the other for capital gain or loss.
• A lot of taxpayer's time is spent trying to recharacterize income into capital gains and
recharacterize loss as ordinary rather than capital loss.
• There is a huge revenue loss from treasury from this preferred tax rate.
• People who have ordinary income rate of 15% will have a capital gains rate of
10%. All others will have capital gains rate of 20%
2) § 1221 – capital asset defined – Are we dealing with the exchange of a capital asset?
• Defines what capital asset is; unless you have a capital asset none of the other rules
• §1221 defines a capital asset as any property held by the taxpayer. Examples include
corporate stock, a bond, one’s personal residence, car, etc.
• Capital asset does not include:
1. Inventory – stock in the taxpayer's trade that is held primarily for
sale to customers in the ordinary course of business.
2. Property, used in a trade or business, that may be depreciated
3. Real property used in a trade or business.
4. A copyright, a literary, musical, or artistic composition, created by
5. Government publication
3) Did the taxpayer realize gain from the sale of the asset?
• Gain realized from the sale of the asset is called a capital gain. §1222
4) Is the capital gain included in the taxpayer's GI?
• Capital gain is included in the taxpayer's GI, unless a provision calls for the non-
recognition of gain. §§ 1001(c), 1222(1),(3) (i.e., the exclusion for selling the
• §1202 – provides that a taxpayer can exclude from income 50% of the gain from the
sale or exchange of “qualified business stock”. Defined as stock issued by a
corporation with assets of $50 million or less, but stock of corporations engaged in
law, accounting, health, consulting, athletic brokerage services, mining, banking, and
farming does not qualify. §1202(d),(e).
5) § 1222 – Is the gain short-term or long- term gain
• LONG TERM: Results when the taxpayer sells or exchanges an asset held for more
than one year. 1222(3)
(a) When a taxpayer has long term capital gain for the year, assuming no losses,
that gain is called net capital gain, and is eligible for preferential tax treatment
• SHORT TERM: Results when the taxpayer sells or exchanges an asset held for one
year or less. 1222(1)
6) § 1211 – Limitation on losses
• Loss realized from the sale or exchange of a capital asset is called a capital loss and
may be deducted if §165(c)(1),(2) requirements are met, AND
1. Losses incurred in a trade or business.
2. Losses incurred in a transaction entered into for profit not
connected with a trade or business.
• However, loss deduction for the year is limited to amount of capital gain recognized
during the year, plus an additional $3,000 for individuals. §1211(b)
• There is an unlimited carryover. So that if you have hit your $3,000 in year 1, you
carry over the remaining loss to the next year and every year thereafter until your
losses are recouped entirely.
• Example X has $50k of ordinary income, $10k of capital loss, and $15k of
income that conceivably could be either ordinary income or CG. If the ambiguous
amount is ordinary income, X has a taxable income of $62k ($50k plus $15k minus
$3k). If then item is CG, X’s taxable income is $55k ($50k plus $15k minus $10k).
C. Quasi- Capital Assets - §1231
§ 1231 – property used in the trade or business and involuntary conversions
• Govt. forced sales upon taxpayer’s property and the huge gains from these appreciated
properties was taxed as ordinary gain. Therefore, Congress enacted § 1231 in order to give
taxpayers a benefit of a lower tax rate, treating the gains as capital gains.
• The exclusion provided by § 1221(2) for real and depreciable property used in the taxpayer’s
trade or business is affected by § 1231.
• The principle affect of § 1231 is to characterize net gain on sales of depreciable or real
property used in a business as capital gain and net losses on sales of such assets as ordinary
(a)(1) - If gains exceed losses, they are all treated as long-term capital assets
(a)(2) - If gains do not exceed losses (it is a loss), the gains and losses are treated as
• The net effect of these provisions is that §1231 overrides §1221(2) on the gain side, but not on
the loss side depreciable assets still produce ordinary loss, but if they are sold as a gain,
they produce CG.
• This is good because you avoid the $3,000 limitation on thee loss side.
D. Recapture of Prior Deprecation Deductions
• Recapture rules are intended to take gains that arise not by market appreciation, but because
the depreciation declined faster than the asset actually declined in reality.
• This is a way of accommodating for the fact that we do not use economic depreciation (actual
depreciation), but rather accelerated/straight depreciation.
• Recapture is the payback of depreciation and taxed as ordinary gain (up to the FMV).
• Recapture only comes into play when selling depreciated/non-real or real property.
• Steps to be taken are:
a. Only deals with § 1221(2) property
b. § 1231 – if there is a capital gain then recapture applies
c. Recapture rules - § 1245 (nonreal property) and § 1250 (real property)
d. See § 1(h)(1)(D) – whatever is left of capital gain after recapture is taxed at 25%
• § 1245 and 1250 recaptured depreciation overrides 1231.
E. Transactions Involving Liabilities and Property Subject to Liabilities
Crane v. Commissioner
• Taxpayer inherited an apartment building subject to a non-recourse mortgage equal to the
value of the property. She calculated her basis as equal to the total value of the property,
without reduction for the mortgage. Taxpayer sold the mortgaged property, receiving both
cash and a release of liability from the mortgage indebtedness.
1. Basis = value of mortgage balance + cash
2. Amount realized = cash received from buyer + outstanding value of mortgage
3. Recourse and non-recourse debts are treated alike
• Significance of Crane:
a. If the property is eligible for depreciation deductions, including the borrowed amount in
basis enables a taxpayer to recover costs that she has not yet paid or assumed directly.
(you are able to deduct what you have yet paid for).
b. If the money for buying the property is borrowed through a non-recourse mortgage it may
be possible for her to recover through depreciation acquisition costs for which she may
never have to put up her own money.
c. Although the amount of the outstanding debt will be included in the taxpayer’s amount
realized upon an eventual sale (offsetting the earlier deprecation deductions), the taxpayer
enjoys the time value of the depreciation deductions.
• Rule: a taxpayer who sells property encumbered by a non-recourse mortgage (the amount of
the mortgage being less than the property’s value), must include the unpaid balance of the
mortgage in the AR upon sale.
• Crane case with #s:
• FMV of property is $250,000
• Taxpayer $25,000 of depreciation deductions over 6-year period and then sells the
property for $255,000.
• Taxpayer argues that gain is only $5,000 ($255,000 - $25,000/AR - original basis)
• IRS argues that the gain is actually $30,000 ($255,000 - $225,000/AR-adjusted basis)
• In Crane she had no basis because it was all deducted via depreciation.
Commissioner v. Tufts
• Rule: a taxpayer who sells property encumbered by a non-recourse mortgage (whether the
amount of the mortgage is more or less than the property’s value), must include the unpaid
balance of the mortgage in the AR upon sale. Thus, the fact that the amount of the loan
exceeds the fair market value of the property becomes irrelevant. Non-recourse mortgage
(debt relief) is included as the AR for the seller and the basis for the buyer.
• General partnership (GP) secured non-recourse loan for $1.85 million for apt. building; GP
eventually contributed $44,000 in capital and took $440,000 in debt deductions, leaving an
AB of approx. $1.45 million. GP sold building. FMV did not exceed $1.4 million (building
lost value). GP took a $55,000 loss (AB/$1.45 million – FMV of property).
• IRS says partners had no loss, but rather a gain which should have been approx. $400,000
($1.85million/AR - $1.45 million/AB). IRS said AR includes the loan.
Reconciliation of Tufts and Estate of Franklin
• If the value of the security exceeds debt initially (Tufts – note: GP went into deal legitimately
despite the fact that later the value of the property decreased and the debt exceeded the FMV
of the property), the debt will be included in the basis and likewise included in the AR upon
foreclosure. On the other hand, where the amount of the mortgage exceeds the FMV of the
property securing it when the debt was first incurred (Estate of Franklin – sham from day 1),
the mortgage is not included in the basis and thus will not be included in the amount realized
upon disposition, generally foreclosure.
Tufts Type Scenario Estate of Franklin Type Scenario
Initial FMV $100,000 $100,000
Debt (mortgage) $90,000 $1,000,000
Equity $10,000 None (deductions taken on
depreciation of inflated debt erase
any equity paid in initially)
Basis Debt included Debt not included
Amt. Realized Debt included Debt not included
XI. Marriage Penalty and Alimony
A. Marriage Penalty
• Bonuses – usually arise when one income earner makes substantially less than the other is a
• Penalties – arise when there is roughly equivalent income.
Applicable Tax rate schedule (this is a flat tax)
Income level Tax
Up to $40,000 0
> $40,000 30% of income in excess of $40,000
Family #1 Family #2
Husband has income of $40,000 Husband and wife are lawyers and earn $60,000 each
Wife has income of $80,000 Tax will be $24,000
Tax will be $24,000 If this family gets divorced, then their tax liability
goes down. Then they each only pay $6,000. So, in
effect their tax liability is cut in half.
• As long as you have joint returns that allow you to combine income and be considered one
entity and have progressive rates it is impossible to have a system without a penalty.
• Marriage penalty also exists in the following:
1. Standard deduction as well. Two individuals filing separately get a standard deduction
of $3,000 each for a total of $6,000 in deductions. Whereas if these 2 individuals got
married there standard deduction would either be one $5,000 on a joint return or two
$2,500 deductions on a married, but filing separate return for a total of $5,000 in
2. Earned income tax credit.
• § 6013(e) – old rule, now moved to § 6015
• § 6015
(a) – The innocent spouse may seek relief from joint and several liability
(b) – if:
(A) a joint return has been made,
(B) there is an understatement of tax due to erroneous items (under inclusion or
(C) the innocent spouse, dispute signing the return, does not know or does not
have reason to know of the understatement (very hard to prove);
(D) taking into account all facts and circumstances it would be inequitable to
hold the innocent spouse liable for the deficiency; AND
(E) the innocent spouse makes use of this § within 2 years of IRS beginning the
- Then the innocent spouse should be relieved of liability to the extent attributable to such
• (c) – Allows taxpayers to separate their liability so the government can only go after the party
whose financial circumstances generated the liability. In the case of deductions which are
shared between spouses, it is extremely difficult to determine who’s deduction was whose.
Deductions are not separated on the return, but only if/when audited.
• (f) – if you can’t get relief under (b) or (c), (f) is a catchall provision for basic equitable relief
• These provisions are in reality very pro-women
Revenue Ruling 76-255
• Whether a couple is married for the purposes of taxation is determined at the close of the tax
• An individual shall be considered as married even though living apart from the individual’s
spouse unless legally separated under a decree of divorce or separate maintenance
• When a couple gets a legal divorce at the end of the tax year and then is remarried in the
beginning of the following tax year in an effort to file separately, the IRS shall construe the
divorce as a sham transaction, designed only to manipulate your federal income taxes. For tax
purposes they will still be considered married. The true nature of a transaction must be
considered in light of the plain intent and purpose of the statute. Such transaction should not
be given any effect if it merely serves the purpose of tax avoidance. This rule abandons the
state law and creates a federal definition of divorce for tax purposes.
B. § 71 – Alimony and separate maintenance payments
• Recipient must include the amount received in income.
• Payor permitted to deduct the cost of alimony under §215, so long as the payments (71(b),(c)
1. Are is cash
2. Received under a divorce or separation instrument (in writing)
3. The parities don’t live in the same household
4. There is no liability for any payment after death of the payee
5. The payments don’t constitute child support
• Payor can make a deduction for alimony paid during the taxable year as defined in § 71(b)
• Note: this would be subject to the 2% floor of § 67
Child Support – § 71
• Child support is not deductible
• (c) – amounts payable for the support of children of the payor spouse (child support) are not alimony
and are not included in the receiving spouse’s income
• (b)(1)(B) – to be child support, it must be designated in the divorce or separation instrument and is not
allowable as a deduction under § 215