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I. Structural Overview
Penalties for tax fraud. Civil no statute of limitations. Criminal, 6 years.

Definition of Income:
-Haig-Simons – the sum of a tax payer‟s consumption plus change in net worth.
-emphasizes observable inflows and outflows of cash and other valuable assets.

Realization and Recognition: To recognize, must be realization but not vise versa. Realize then

Depreciation called Accelerated Cost Recovery System (ACRS)
Accelerated only for tangible property.
Straightline for intangible (i.e., patents), also called amortization.

Basis: a record of the cost of an investment.
Adjusted basis: Cost minus ACRS deduction.

Recently Congress has been increasing federal revenues, not by increasing tax rates but by
changing the definition of taxable income (i.e., by decreasing the possible deductions, deduction

Capital gain (or loss) – the gain or loss on the sale of a capital asset.

Method of accounting: Cash method (recognize only cash/payment when dispersed or received
actually. Accrual method (recognize when earned).

Marginal Tax Rate: the rate applicable to the last, and the next increment of income.
-why not just increase in increments from say 15% to 28% and when you reach a knew level,
your whole income is taxed at that level? Because it would remove incentive, the extra $100
might make you have less (after you crossed a threshold) than if you didn‟t earn the extra.

Annual accounting: you must compute tax liabilities on an annual as opposed to transactional
basis. Ex. F spends $50,000 in expenses in 2000 towards a project for sale. F sell the good in
2001 for $50,000. Expenses should be recognized in 2000, and sale in 2001. Even with accrual

§1: the tax rates

Calculation of the tax base:
Step 1: Calculate the amount of gross income (§61)
Step 2: Subtract above the line deductions (§62)
Arrive at: AGI
Step 3: Subtract the standard deduction (§63(c)) or Subtract the itemized deductions (§63)

-Note: to arrive at itemized deduction: First, calculate the amount of allowable itemized
deductions. Second, subtract from that gross the lesser of (a) 3% of the amount by which the
taxpayer‟s income exceeds the threshold amount ($100,000 in 1999) or (b) 80% of the gross
amount (§68)-thus, no taxpayer may loose more than 80% of their deduction).
Step 4: Subtract personal exemptions (§151)
-Note: to arrive at personal exemption multiply the personal exemption amount by the
appropriate number of persons (§151), next, reduce the amount by 2% for each $2500 by which
the taxpayer‟s AGI exceeds the threshold ($100,000 in 1999 for single individual).
Arrive at: Taxable income
Step 5: Apply tax rate schedule

A partial list of deduction phase out and the code sections are on handout #2

II. Fringe Benefits – Realization Problems

Old Colony v. Commissioner of IRS (1929)
President of company, Mr. Wood. The company agrees to pay him a salary and the tax on that
salary. Gov‟t balks, he has to include the taxes they pay for him as add‟l income. Court agrees.
The discharge of a debt by another party is the equivalent to receipt by the person taxed.

Receipt the operative concept in determining income.
-Receipt also is used to designate proper timing
-Constructive receipt: a right to a payment.

§ 61: Gross Income Defined
-Income from whatever source derived.
Treas. Regs §1.62-2(d)(1) – Compensation paid other than cash. If compensation is in property
or services, they are assigned a current fair market value.

U.S. v. Drescher (1950)
B&L pays salary to Drescher, in addition buys annuity in his name from insurance company.
¿Does this need to be included in income to Drescher? He argues he shouldn‟t include in income
because no receipt. He says he should pay for income when he actually receives payments from
the annuity. Why would he want this? His tax rate may be lower (marginal rate) when he gets to
the payment phase (he may have retired). Additionally, the time value of money. Drescher
argues that the annuity is worth nothing to him for the year given by the Company. The IRS
argues that it is worth $5,000. The Court said it is somewhere between that amount. The
Company retained the annuity and he would have to go through hoops to get it early (before
retirement). This alone makes it worth less to him than what the Company paid for it. The Court
indicates it is the taxpayer who has the burden of proving how much it is worth. He will
probably be taxed for income pretty close to the $5,000 value. Remanded.

Handout #3:
Note the possible abuses if employee gets untaxed fringe from employer. The worst scenario is
that the employer can reduce salary and cut the fringe in half so employee is better off and
company pays less in salary.

III. Fringe Benefits II: Valuation Problems

Benaglia v. Commissioner (1937) – Board of Tax Appeals (a predecessor to the tax court)
A hotel manager and his wife live in the hotel and get meals, but it is not included as income.
The Court says if these are provided as a convenience to the employer they should not be
included. “He would not consider taking a job and the owners of the hotel would not consider
employing a manager unless he lived there.” “The advantage to him was merely an incident of
the performance of his duty,…”

Unlike the cases above (Old Colony and Drescher) – this does not seem like a tax dodge for the
benefit of the employee and possibly the employer (see hand-out #3). To not permit this would
penalize employers who have business requirements that look like compensation.

IRC § 119 basically puts the Benaglia holding in statute form. Meals and lodging not income if:
(1) furnished by employer (2) for the convenience of the employer for meals, for condition of
employer for lodging (3) on the premises

IRC § 132 Certain Fringe Benefits: excluded from gross income
   (1) no add‟l cost service
   (2) qualified employee discount
   (3) working conditions fringe
   (4) de minimis fringe
   (5) qualified transportation fringe
   (6) qualified moving expenses reimbursement

But note: conglomerate exception. If conglomerate has airlines and hotels, only get no cost
services from the sector you work for.

Charley v. Commissioner (1996) – 9th Cir.
Charley would travel for business. He would charge the company for 1st class travel, but travel
coach and upgrade to 1st class with his Frequent Flyer Miles. The difference in cost would be
credited to his personal travel account. Tax court and federal court basically conclude he was
wealthier after the transaction, and thus it was gross income. No §132 exception allowed either.
Basically the court viewed this as a sale in property with no basis (i.e., he had no basis in the
frequent flyer miles and then sold them, all income).

IRS no longer enforces rule that frequent flyer miles part of income.

Need to do PS #2.

IV. Income v. Capital Recovery

Inaja Land v. Commissioner (1947) – Tax Court
Taxpayer buys land along river for fishing club. LA pollutes the river. LA settles with taxpayer
and pays $50,000 to avoid any further liability. Commissioner wants to treat this like he sold a

portion of land. However, taxpayer says, how can I determine how much I sold? Can‟t be
measured. Court agrees. The basis is decreased by $50,000, but no immediate tax
consequences. This was treated as though city purchased easement.

Courts haven‟t tended to follow the Inaja approach. Not really good law anymore.

Clark v. Commissioner (1939) – Tax Court
Taxpayer and his wife hire counsel to file their taxes. Counsel should have filled separately and
would have saved them $19 K, but he filed jointly. When brought to his attention, the preparer,
acknowledging negligence paid them back. Commissioner wants it included in income for new
year. Taxpayer objects. Court agrees, not income. Payments for personal injury is not income.

Good law in cases where taxpayer actually pays the extra tax and is recouped for loss. I don‟t
know if the personal injury portion is still good law.

Hort v. Commissioner (1941) – S. Ct.
Taxpayer owned property. He had a contract with a tenant for 15 years. The tenant wanted out
and they agreed to a payment (less than the present value of the otherwise cumulative rent). The
taxpayer did not report the sum as income. Further he reported a loss for the amount less the
present value of income stream. His argument was that this was basically a capital loss. He
classified the lease as separate property from the real property. Thus, his lease was worth X, but
he got only X-Y. Pretty ingenious, but court rejected. The rent if paid would have been taxable
as ordinary income, thus the lump sum is the same.

Is the holding of Hort that there was no sale or exchange or that what was sold was not a capital
asset (that is property not within one of the exceptions of §1221)?

Note: What if tenant secures an advantageous lease for a number of years and sells it to another
for a profit? The profit is a capital gain. Revenue Ruling indicates that tenant‟s leasehold
interest in land is “real property.”

Courts didn‟t want to allow folks to split up the conception of their property (i.e., splitting
ownership of a building into occupancy and remainder) and therefore put off tax payments for
many years. If so, everyone would make such classifications of their property. Thus, rent would
never be ordinary income, but capital gain.

Plus: isn‟t the theoretical value of a piece of property is the present value of the future income
stream (rent). Thus, if you separate the two (the property) and (the income stream), one would be
0 and the income stream X.

§61(a)(3) – income includes gains derived from the sale of property.

Property Transactions:
Amount realized minus basis for income.

If you sell the property in the different unit(s) than you purchased. Allocate portions according to
fair market value.

Treas Reg §1.61-6: when part of the property is sold, the cost or other basis of the entire property
shall be equitably apportioned among the several parts, and the gain realized or loss sustained is
blah blah blah.

Equitable apportioned: apportionment in accordance with the relative fair market values of the
pieces of property.

However, what if the property is divided in some weird way like in Inaja? Then you can do one
of two things:
    1) Value the subdivided pieces and proceed as normal. (i.e., in Inaja determine the present
        value of the income stream for rent of such a easement.) Can also be done with
        something like a bond (the present value of the 2nd year‟s interest for example)
    2) Or, artificially allocate all of the basis to one of the parts and none to the others. (choose
        between maximizing/minimizing realization or deferral).

V. Gifts
§ 102 – gifts aren‟t included in income.

Gifts greater than $10,000 per year may give rise to gift tax (an extension of the estate tax. The
justification being one could avoid paying estate taxes by giving away everything during their

Commissioner v. Duberstein (1960) – S. Ct.
Two cases consolidated. Duberstein: two companies dealt with each other over the years.
Duberstein, the pres. of one company used to give the pres of the other company the names of
potential customers. The pres unexpectedly decided to give Duberstein a Cadillac. The corp
expensed the Cadillac as a business expense. In the second case a guy worked for a church. He
left to start another company. The directors of the church gave him a large payment. It
purported to be a gift, but said the guy would release the church from any lingering liability
related to pension (there was none, the directors testified it this was simply caution). IRS wants
bright line rule saying if business deduction, no gift treatment. Court rejects, they decide to have
a state of mind (intent) ruling, whether it was intended to be a gift or not. Noting, if paid out of
moral or legal obligation, it‟s not a gift. A gift proceeds from a detached and disinterested

IRS didn‟t like the Duberstein holding, appealed to Congress. Thus,
§ 274 (b) – you can‟t claim more than $25 in deductions and have it be gift for employees.
§ 102 (c) – if the gift comes from employer, it is going to be taxed (a little exception for
employee achievement award).

These provisions don‟t close down the situation in Duberstein, they weren‟t employer/employee.

What if you acquire property by gift? How do you establish basis for §1001 purposes.

Remember: Gain=amount realized – basis
By default your gain would be Amount realized less (0, the basis in a gift). That would mean if
Aunt gave you $2000 its not part of income. But, if she gives to a car worth $2000 and you sell
it, you have to report $2000 as income.

Taft v. Bowers (1929) S. Ct.
A purchased stock for $1000. Gave to B at a time when value was $2000. B sold later for
$5000. Is basis $1000 or $2000? B claims, it‟s not my income (the $1000 appreciation). Court
notes she stepped into the shoes of the donor and knew that she would be required to pay tax on
the amount of appreciation at the time of gift.

§ 1014: When property is acquired for reason of death, the basis is the fair market value.
-economists say the effect of this is to hold up appreciated property until death, immobility of

§ 1015: when gift property is sold for more than the donor‟s basis, the guy selling it uses the
basis from the donor. Carryover basis or substituted basis.
-allows an upward adjustment to the donee‟s substituted basis if the donor paid any gift tax
(equal only to the amount of gift tax attributable to the net appreciation of the property.)
-however, if the good has gone down in price (FMV at gift time is lower than donor‟s basis) than
the donee‟s substituted basis is the FMV.

Gifts of divided interest:
EX: giving a life estate and a remainder to separate people.
Irwin v. Gavit: Guy dies and has $100K put in a trust. It was used to purchase CD‟s. The
interest was paid to his son-in-law and the $100K went to his granddaughter at age 21. Son-in-
law argues it was a gift divided (he got interest and daughter got principle) . S. Court disagreed.
This would mean anyone could provide in will for gift to be split in present estate and remainder
and keep the donee from paying for the interest derived from the estate.

VI. Cancellation of Indebtedness Income

You don‟t owe taxes on money you borrow. However, if a portion is forgiven, then you
recognize the amount forgiven in current income.

Generally, if taxpayer insolvent (i.e., bankrupt), the old debt does not become income.

U.S. v. Kirby Lumber (1931) – S. Ct.
Kirby issues bonds for $1 million each. Then they are able to purchase on open market for
$862,000. The savings becomes income for tax purposes.

Zarin v. Commissioner (1990) – 3d Cir.
Zarin accrues a $3 million gambling debt. The casino extended him credit, but by law should not
have. Therefore, the debt was un-collectable. IRS says this is cancellation of indebtedness
income. Court says according to §61(a)(12), indebtedness is (a) for which the tax payer is liable
or (b) subject to which taxpayer holds property. Because debt was un-collectable under N.J.

state law, not liable. Further, he got in debt for getting chips, and chips not property, thus (b)
fails as well. “gambling chips are merely an accounting mechanism to evidence debt.” Court
says the more proper way to analyze this is according to contested liability doctrine, which holds
that if a taxpayer in good faith disputed the amount of a debt, a subsequent settlement of the
dispute would be treated as the amount of debt cognizable for tax purposes.

§ 108 (a)(1) – discharge of indebtedness income excluded from gross income if: bankruptcy,
insolvency, certain farm indebtedness.

Regarding cancellation of indebtedness – the analysis should hinge on whether the debt was
forgiven or if the original debt/value was renegotiated.

VII. Transfer of Property Subject to Debt

Diedrich v. Commissioner (1982) – S. Ct.
Parents give children stock if the children will pay the gift tax. Court holds that the parents
receive a discharge of indebtedness gain in this transaction. This gain derived by the donor is the
amount of the gift tax liability less the donor‟s adjusted basis in the entire property (consistent
with §1001). Accordingly, income realized to the extend that a gift tax exceeds the donor‟s
adjusted basis in the property.

In case of transfer to a charitable organization when part is a sale and part is a gift: the basis of
the property is allocated between the portion deemed to have been sold and the portion deemed
to have been given. § 1011(b).

Adjusted Basis = basis – depreciation.

Nonrecourse: in the event of default the lender can foreclose on the mortgage, but has no
recourse against T personally.

Crane v. Commissioner (1947) – S. Ct.(Hand-out #7)
Lady inherits building and mortgage from husband. She takes depreciation on it for 7 yrs. When
it is about to be foreclosed on she transfers mortgage to a third party and receives $2500. She
wants to pay taxes on that. Gov‟t argues she should pay taxes on Adj. Basis (basis less
depreciation) minus the amount realized (which in this case was the remaining amount owed on
the mortgage). Court agrees.
 -The correct value of the basis is the amount paid, whether you receive a mortgage or not. The
tax payer in this case argues that it should be her equity in the property (not so).

Commissioner v. Tufts (1983) – S. Ct. (Hand-out #9)
Partners get a nonrecourse loan. They take depreciation and loss deductions each year on taxes.
The value of the property depreciates. A third party takes on the mortgage. The partners
indicate that they lost money equal to the depreciated amount. The commissioner argues that
they should pay the difference between the adjusted basis (their original amount less
depreciation) and their amount realized (which was the original mortgage amount).

Woodsam v. Commissioner (1952) – 2d Cir.
Taking add‟l mortgages out does not change basis. “She never disposed of the property to create
a taxable event which is a condition precedent to the taxation of a gain.
See hand-out #8

Treasury Reg. § 1001-1(e) Computation of a gain or loss when transfer is in part a sale and in
part a gift: The trasferor (the guy who transferred) has a gain to the extent that the amount
realized by him exceeds his adjusted basis in the property. However, no loss is sustained on such
a transfer if the amount realized is less than the adjusted basis. (ex. A sells to son property for
$30, with an adjusted basis to A of $20, but a FMV of $50. A has a gain of $10. Son has a gift
of $20.)

Joe transfers property to a creditor with a FMV a $6000. However, Joe was personally liable for
$7500. The amount realized is $6000 (unlike $7500 if it was a nonrecourse loan). However, Joe
has $1500 in discharge of indebtedness.

Father has property with
- FMV of $250,000
- Basis $100,000
-liability $200,000

If given to son for paying off $200,000 what has happened?
One way to look at this is 1) 4/5 sold and 1/5 gift. Amt. Realized =200K less basis (4/5 of 100k)
80k equals 120k

VIII. Realization

Principle reasons for not taxing unrealized gains:
-difficulties with valuation
-liquidity problems

§1001: Determination of amount of and recognition of gain or loss. Basis less amount realized is
gain or loss and should be recognized.

Eisner v. Macomber (1920) S. Ct.
Stockholder received benefits of stock split. Stock had $100 par value. Gov‟t wants to tax as
income the new stock at a par value of $100. In these days par value was more descriptive, but
not really the measure of stock value. Court concludes that income is divisible from capital.
Basically, this was an increase in capital and not income thus taxable.

The rule of Macomber and §305 are disregarded for some stockholders of foreign and S corps.

Helvering v. Bruun (1940) – S. Ct.

Whether property owner has taxable gain when renter improves land, in this case builds a
structure. Court rejects argument of taxpayer that this gain was not a cognizable gain in that it
did not involve liquidation and should not be taxed. Taxpayer in such a case should recognize
income. This holding is overturned by statute.

Cottage Savings Assoc. v. Commissioner (1991) – S. Ct.
S&L‟s have mortgages on their books worth much less than they paid for them. They‟d like to
sell them, but S&L regulations don‟t allow this. But, the S&L regulators issue a memo which
allows them to basically exchange the mortgages for equivalent mortgages with each other.
Therefore, they hope to be able to report tax losses. The commissioner balks. First, this cannot
be a sale. But is it a “disposition of property?” Commissioner says it has to be materially
different to qualify. What is materially different? “Properties are different in the sense that is
material to the IRS code so long as their respective possessors enjoy “legal entitlements” that are
different in kind or extent. Because the mortgages where for different property and involved
different payees, they were materially different. Hence, per court the S&L‟s sustained losses.

Dissent: We should deal with realities not superficial distinctions. These exchanges are not
materially different. We should be concerned with substance not mere form.

§165 there shall be allowed as a deduction any loss sustained during the taxable year and not
compensated by insurance or otherwise.

Specific non-recognition rules w/ accompanying basis preservation rules.
§305 (a)
§305 (b)(1): Generally when corp. gives add‟l stock to stockholders, no gross income.
However, this section notes an exception, which is when the corp. gives the shareholders the
option of receiving cash or property instead of the stock split. Then it is taxable gain.

Basis preservation rule
§ 307(a) – this prevents 305 from acting to allow stockholder to never pay tax on stock split
income. Old basis is the continuing basis. However, how is the basis allocated? REM: the
stockholder starts with x number of shares and has them increased. See below.

Treasury Reg: §1.307-1 (a): reallocate old value of stock into all the shares. (i.e., old basis $300
for 2000 shares. New basis is $200 for 3000 shares.)

§109: Improvements by leasee (the renter) of leasor‟s property.
No gross income to property owner when renter fixes up.

§1019: basis is preserved when improvements made by leasee.

Revenue Ruling 84-145 (1984)
Prior to deregulation airlines would go through a costly process to get a route of service. They
would capitalize this cost and it would serve as a basis for tax purposes. However, after
deregulation the quasi-property value in a route was seriously diminished. ¿Is this a loss for

taxable purposes? No. “the mere diminution of value does not constitute the elimination or
abandonment of a completely worthless asset.

The airlines above could go through some sort of formal sale and then take the loss.

IX. Nonrecognition Rules

Sometimes tax consequences promote economically illogical events such as selling to claim a
loss or keeping property that is not ideal to you for fear of having to recognize gain. In certain
situations, §1031 aids taxpayer in postponing recognition.

§1031: No gain or loss on exchange held for productive use in a trade or business or investment,
if the property is exchanged solely for property of like kind to be used in trade business or
investment as well.
-For 1031 to apply it must be used in trade, business or investment property on both ends of
-determined on a tax payer by tax payer basis. One tax payer may get it and the other might not.
-this trading can be three or four cornered trades.
-like kind trade, land for land, cars for cars: look at regulations but don‟t try and do it from a
common sense approach. Generally, all real estate can be exchanged.
-misc. exclusions: not stocks, bonds, or notes and others.

There is a basis preservation rule § 1031 (d): The basis shall be the same of the property
exchanged – meaning they keep their old basis.

§1031 (b): when the exchange includes money (or other non-like kind property) and the property
traded. See handout #10. Note: the tax payer who receives the money isn‟t covered by §1031
for the money or other property that they receive that is not like kind.

§1031 (f): this won‟t work among family members unless both pieces of property are held for 2

Revenue Ruling 82-166 (1982)
Does an exchange of gold bullion for silver bullion qualify under §1031? No, must recognize for
tax purposes. Silver is primarily an industrial commodity. Gold is primarily utilized as an
investment in itself. Underlying investment difference.

Jordan Marsh v. Commissioner (1959) – 2d Cir.
Taxpayer sells real estate with a retail store on it. He then gets a lease on the store for 30+ years.
He wants to claim loss on sale because he sold for less than his basis. Commissioner disallows,
per § 1031. Treas. Regs say a leasehold for more than 30 years is the equivalent of the fee
interest. He sold it to stranger and pays a regular market rate rent. Commissioner argues this is
essentially a change in the form of ownership. Court holds that selling to a stranger as such is
more than a change in the form of ownership. Taxpayer allowed to deduct loss.

Boot: the extra money or property of not like kind that accompanies the like-kind exchange.

X. Imputed Income
For example home ownership. Home owners receive the imputed income of not paying rent, and
that is not taxable. (ex. A and B have $100 K. A buy house and B rents house and invests at
8%. The both make $50K in wages. A saves rent, maybe about $5 K per year. B pays tax on
the $8k he receives from his investment.

Also imputed income for doing work yourself (i.e., painting your house, having wife stay home
and care for children).

Related issue: people who barter for services. The fair market value of the service must be
included in gross income under §61 (see Revenue Ruling 79-24)

§ 163 (a) – interest on indebtedness is deductible.
§ 163 (h) – but this doesn‟t apply to people, just corporations, except in the case of qualified

We do tax some imputed income in situations when valuation and liquidity problems are not a

XI. Tax Expenditures/ Tax Free Municipal Bonds
Tax expenditures means really the combination of deductions, tax credits and deferrals. If you
looked at income as under the Haig-Simmons definition (consumption plus change in net-worth)
these tax expenditures are all the income not taxed.

§ 103: exempts interest on certain state, municipal and other bonds. Not valid for 1) private
activity bond and 2) arbitrage bond 3) not registered bonds.

Holders of muni-bonds pay a putative tax (they get less interest than a non-muni-bond)

Muni bond issuers began to take advantage of the tax break. They offered bonds and then used
the proceeds to benefit industry (couched in a economic stimulus package argument).
Essentially, this was private industry getting the benefits with local gov‟t just serving as
intermediaries (private activity bonds). §103 tries to eliminate this sort of use of the muni-bond

Tax Arbitrage: doing something solely for tax reasons. EX: guy gets a $100,000 loan with 10%
interest so he can buy a tax exempt bond with 9% interest. The tax consequences, including a
hypothetical ability to deduct the 10% interest could make the scenario preferred by the taxpayer.
But the only incentive is created by tax consequences. Another EX: muni‟s issue bonds at lower
rates and buy treasury bonds with greater returns (tax arbitrage). This is prohibited by §265(2).

§ 265(2): otherwise nontaxable interest is taxable if it is for arbitrage reasons.

XII. Intro. To Deductions
§ 62 Adjusted gross income defined. Equals gross income less:

-trade and business deductions
-certain trade and business deductions of employees
-lots of others including moving and interest on educational loans.

§ 63 Taxable income defined. Equals AGI less following deductions:
-standard or itemized deductions

§ 67 2% floor on misc. itemized deductions – itemized deduction must be 2% of AGI except the
ones noted in (b) taxes, interest, etc.

§ 68 If married males over $100 K, (single $50K), w/ inflation, itemized deductions will be
limited by the lesser of 1) 3% of the excess over AGI or 2) 80% of the itemized deductions
otherwise allowable. Does not apply for deductions allowable for medical care, casualty losses,
and investment interest expense.

§ 162 Trade of business expenses. In general, the ordinary and necessary expenses paid or
incurred in carry on a trade of business. (i.e., salaries, traveling expenses, rental and property

Self employed person not subject to §67 for §162 expenses. But employee is.

§ 165: Losses. Claim losses unless compensated by insurance or otherwise.

§ 212: For individual taxpayers, they can deduct all the ordinary and necessary expenses paid in
pursuit of income, management of income property.

§ 262: except as otherwise indicated, no deduction for personal living and family expenses.

§ 274 (n): disallowance of certain entertainment expenses: 50% is deductible if employer did not

The problem with deductions is that they run counter to our general sense of gov‟t spending.
Giving a deduction is really a hand-out or gov‟t spending. However, the progressive tax
structure makes it so deductions are worth more to someone making more money. Therefore, we
are giving gov‟t money to a wealthy person and we‟d expect to only be giving it to poor folks. Is
it a subsidy or a definition of income?

§ 62: Above the line deduction : those taken between gross income to adjusted gross income.

§ 63: Below the line deductions: those taken between adjusted gross income and taxable income.
Itemized or standard deduction.

       Gross income
-      Above the line deductions
       Adjusted Gross Income
-      Below the line deductions or standard deduction

-       Personal Exemption
        Taxable Income

The reimbursement rule is designed with the assumption that an employer will police the
reasonableness of food and entertainment expenses if they reimburse the employee for them.

Moller v. U.S. (1983) – Fed. Cir.
A couple spends tremendous time each week managing their investments. Therefore, they seek
to deduct a portion of their home expenses under § 212. IRS balked. They are classified as
investors not traders. Only traders can thus deduct. See Court language below:
“In the instant case, taxpayers were not engaged in a trade or business. They were active
investors in that their investment activities were continuous, regular, and extensive. However,
this is not determinative of the issue and it is not the correct test. What is determinative is the fact
that the taxpayers' return was that of an investor: they derived the vast majority of their income
in the form of dividends and interest; their income was derived from the long-term holding of
securities, not from short-term trading; and they were interested in the capital appreciation of
their stocks, not short-term profits. Merely because taxpayers spent much time managing their
own sizeable investments does not mean that they were engaged in a trade or business.”

§280A stringent rule generally disallowing the deduction of a home for business purposes.
(c) exceptions: when a portion used as the principal place of business. And others.

XIII. Business/Personal Borderline

§ 183: Activities not engaged in for profit: If your engaged in an activity not-for-profit, you
can‟t deduct related expenses. (hobbies)
(b), income from hobbies can be offset by expenses for hobbies to the extent that it exceeds 2%
AGI (if the 2% floor applies to this taxpayer)
-certain provision requiring the taxpayer show profit for X amount of previous years, otherwise
there are a list of factors to consider (not in our statute book).

-Although § 183 allows taxpayers with hobbies to zero-out the income generated from the
hobby, once the effects of §§ 67 & 68 are factoring in, a taxpayer can show a taxable profit from
engaging in an unprofitable activity.

Nickerson v. Commissioner (1983) 7th Cir
Fellow anticipates getting out of advertising business. He purchases a farm and goes there
almost every weekend to work on it, in anticipation of it turning a profit in later years. It‟s
loosing money in the meantime. He tried to deduct losses. § 162 deduction of "all the ordinary
and necessary expenses paid or incurred during the taxable year in carrying on any trade or
business." § 183, however, limits the availability of these deductions if the activity "is not
engaged in for profit" to deductions that are allowed regardless of the existence of a profit
motive and deductions for ordinary and necessary expenses "only to the extent that the gross
income derived from such activity for the taxable year exceeds [otherwise allowable
deductions]." The deductions claimed by petitioners are only allowable if their motivation in
investing in the farm was to make a profit. Court lists several factors (see list below)

Ultimately, court concludes he is not doing this as a hobby or trying to avoid taxes by having a
loosing farm, but indeed planning to make an income from the farm. Taxpayer had to prove he
had a bona fide hope of getting profit, not a reasonable expectation. The court notes the tax court
erroneously knocked the tax payer out by arguing he probably would never make a profit.
Factors to consider whether a hobby or a business:
(1) Manner in which the taxpayer carries on the activity.
(2) The expertise of the taxpayer or his advisors.
(3) The time and effort expended by the taxpayer in carrying on the activity.
(4) Expectation that assets used in activity may appreciate in value. . . .
(5) The success of the taxpayer in carrying on other similar or dissimilar activities.
(6) The taxpayer's history of income or losses with respect to the activity . . . .
(7) The amount of occasional profits, if any, which are earned . . . .
(8) The financial status of the taxpayer . . . .
(9) Elements of personal pleasure or recreation.

-Note normally these outlays would be considered capital expenditures and not expenses,
however as a cash-method taxpayer these are considered expenses (especially for farmers).

-If the farm was considered a passive activity the loss could only be applied against the current
or future income of the farm or at the time the farm was sold.

Henderson v. Commissioner (1983) – Tax Court
Asst. states attorney buys a plant and art for her office. She also pays for parking. She deducts
under §162(a). Section 162(a) allows a deduction for all the ordinary and necessary expenses
paid or incurred during the taxable year in carrying on any trade or business. However, even
assuming an expense meets the requirements of section 162(a), it still may be disallowed if the
amount was expended for a personal, living, or family expense. Sec. 262. The essential inquiry
here is whether a sufficient nexus existed between petitioner's expenses and the "carrying on" of
petitioner's trade or business to qualify the expenses for the deduction under section 162(a), or
whether they were in essence personal or living expenses and nondeductible by virtue of section
262. Where both sections apply 262 takes priority over 162(a). Court concludes these
expenditures were personal. Her employer provided her with everything she needed to work.

§ 274: Disallowance of certain entertainment expenses. Only deductible when “directly related”
to business, not just for goodwill. Allows deduction if associated with business preceded by or
follow a bona fide business discussion.
(n) 50% limitation on meal and entertainment deduction.
-spouse or person along for trip is not deductible, unless otherwise deductible.
-foreign travel part business, part pleasure is only partly deductible.
-no cruise/business trips
-limits skyboxes
-substantiation, also need to keep receipts to show charges and prove business nexus.

Taxpayer needs to meet §162 before you get to § 274. §274 is to further screen out (disallow)

What §274 did: Beefed up business nexus test. Requires that the expense is directly related to
or associated with a bona fide business discussions. Gets rid of good will entertainment. Still
kind of easy to overcome this test.

Ex. Weekend trip with entertainment throughout and a two hour meeting. The service has not
attached these very much. Time on business does not have to be equal to entertainment.
Probably would not be taxed and the firm could deduct at 50%.

Ex. Season tickets used by a combination of clients and firm attorneys. Should firm be able to
deduct and employees pay taxes? She said good test question. Firm could say good for morale.
The firm argues the reason these tickets are available is because no client to see game. Little
value, otherwise the clients would want them. These tickets have tended to be deductible at 50%
and employee not taxed.

Moss v. Commissioner (1985) 7th Cir.
Chicago lawyers from common firm meet everyday at Café Angelo to eat lunch. The lawyers
meet and eat and discuss the cases. A partner deducts the cost. Posner says, it was not served on
employees premises, not an employee, but a partner, and not away from home (i.e., traveling).
However, the IRS concedes that it is deductible under 162(a) if an ordinary and necessary
business expense. This is not. If it was with clients or if it was occasional to become acquainted
with the co-workers, it could be justified, but not so in this case because they were a firm of 8
and familiar with each other. Interesting argument by Posner: Meeting in office is not the same
as at a restaurant. It eases the tension and lessons the frictions and failure of communication,
thus it is justifiable if with clients or as otherwise stated above.

Note regarding above and below the line deductions. Roin was really interested in showing that
without vanishing deductions and floors, these would really favor rich tax payers. While these
may solve some of this inequality – it leaves some holes. For example, the sole proprietor can
still get all of the deductions. And, these folks are the most likely to arrange there business to
benefit them personally (i.e., collusion between owner and employee who are one and the same).

XIV. Capital Recovery
§263 : Cannot get deduction for items purchased as capital expenditures in property, permanent
improvements or betterments made to increase the property value. This applies to accrual and
cash taxpayers.

Ex. What if person used money to buy ten shares of stock. Taxpayer cannot claim a current
deduction for the purchase of the stock. No. The taxpayer isn‟t out the money, he has $X worth
of stock.

Or, what if Farmer bought a tractor for $150. He is not out the $150 and could conceivable
exchange it for the $150. In the future he can deduct for depreciation.

Encyclopedia Britannica v. Commissioner (1982), 7th Cir.

Brit used consultant to write encyclopedia and wanted to expense that amount under § 162. IRS
wanted taxpayer to capitalize. Brit argues that they could have paid for it to be written in-house
and then expense it. Court determines that the cost must be capitalized. Court uses good
analogy. If you hire a carpenter to build a rental property, the cost of the carpenter is capitalized
into the cost of the rental unit. There is a lot of hairsplitting in this opinion, but just think of it as
a common sense approach whether the cost seems to be in the regular (ordinary and necessary)
course of business (expense) or towards something that would make income for more than just
the immediate tax period (capital).

Depreciation and amortization: When an outlay is treated as the cost of acquiring a capital asset,
traditional accounting principle require that he cost be recover over the useful life of the asset –
that is the time it is expected to contribute to income. For intangible assets like a copyright on an
encyclopedia, its called amortized. For a tangible asset like a factory building or trucks

Exceptions to having to capitalize: 1) not for R&D 2) not for farmers when they invest in
developing farms, orchards and ranches (the cost of the property is capitalized, but the amount
sunk into it is expensed, see Nickerson.

§ 263 (a): The cost of producing self-created assets must be capitalized. This takes away the
inequality between the taxpayer in Britannica and those who used inside writers. More than just
salary of writers, allocated cost for supervisors and admin people would be included as well. A
complicated distinction between production and general business planning is used to determine if
expensed or capitalized. Doesn‟t apply to taxpayers with annual gross receipts of less than $10

Revenue Ruling 85-82 (1985)
Farmer buys field with crops already growing. He can‟t expense part of the price because it
included the price of the growing crops. If he had purchased it earlier and planted the crops
himself, the seeds and fertilizer would have been expensed.

S. Court holds that the legal and investment fees paid during a merger had to be capitalized, not
expensed. So, not just an identifiable asset.

-Should add‟l expenditures be expensed or capitalized. Two general categories (expected and
unexpected add‟l expenditures).

Midland Empire Packing v. Commissioner (1950) – Tax Court
Can cost of lining basement with concrete to improve packing plant be expensed or capitalized?
Taxpayer had to do this because oil was leaking into packing plant from refinery. Court holds
that taxpayer can expense. Seems motivated by the fact that taxpayer was just getting back to the
position he was in before – rather than really improving business. It‟s a timing question. Do you
value the plant the day before the seepage vs. now or the day after the seepage and now. An
evaluation of “necessary and ordinary.” Service contends it was necessary, but not ordinary.

Court states ordinary means not unique to the group or community of which taxpayer is a part.
Of course, this event was not ordinary to him. Court also makes some mention that he did not
enlarge room or make it more desirable than before – just made it whole.

-ok go with her a little on her little taxpayer vile rant: The court is sympathetic of taxpayer
because of a loss (the lowering of property value because oil leaking from refinery). However,
this would not be a realization event because the property has not been sold.

-one court didn‟t allow hotel to expense the installation of fire protection/sprinkler system.

Hotel Sulgrave
Tax court required hotel to capitalize the expenditures of installing sprinklers to become
compliant with fire code. It was a permanent addition, an improvement for extending the life.

Revenue Ruling 94-38 (1994)
Corp contaminated area around plant. He spends money to clean it up and builds groundwater
treatment plants to comply with regulation. He can expense those expenditures for cleaning up,
but not the treatment plants. Distinction turns on whether these expenditures “produce
significant future benefits.”

Depreciation (the counter part of capitalization).
Allows you to capture loss even without a realization event.

Taxpayer buys building for $100 which will last for 5 years.
Rent for $25 a year. Without depreciation.

                 Yr. 1          Yr. 2              Yr. 3             Yr. 4            Yr. 5
W/O dep.         $25 revenue    $25                $25               $25              <$75>
W/               $5 ($25 - $20) $5                 $5                $5               $5

§ 168: Accelerated cost recovery system: Defines what method to use in depreciating assets.
-recovery period stated for the different categories
-cost recovery starts not when purchased, but when placed in service.
-personal property has three, five, seven, ten, fifteen, twenty-year property.
-use 200 percent declining balance for three – ten-year property. And 150 % for the rest.
Ex. Asset costs $10K and is 10 year. Start with 200% which is $2k, then subtract that from
original asset value, the next year is 200% of remainder (see hand-out #15).
-for both 150 and 200% shift to straight-line when that produces larger deduction.
-real property: 27.5 for residential and 39 for other real property. Use straight-line. And prorate
according to month. Same method for all components (i.e., buildings, etc.)
-if your purchase more than one asset in a single transaction, must allocate for each component.

§ 197: 15-year amortization of intangibles (i.e., goodwill).

Ideally depreciation would be the amount something reduced in value over the tax period.
However, too hard to measure. Thus, we depreciate according to table /provisions which are
inflated – the amount deducted for depreciation is more than the asset really reduced in value.
This is to induce business investment.

Depreciation System involves:
   1) determining useful life
   2) taking into account salvage value
   3) application of a method of allocating cost over useful life

Tangible assets are depreciated pursuant to Modified Accelerated Cost Recovery System
(MACRS), which disregards salvage value (assumes it is zero).

For personal property like tractor that have been depreciated, the taxpayer must treat the gain in a
sale as a ordinary income rather than a capital gain to the extent of prior deductions for

Consumption Tax
Harvard Article – easy to measure. Just income taxed with a deduction for savings or a inclusion
of amounts withdrawn from savings.

Under a consumption tax system loans would be taxed and everyone‟s basis would be zero, no
X earns $100 k in salary. He borrows $50K. He buys a building for $85K. His would be taxed
on $65 K ($50K + $100K - $85K). He would not depreciate the building and his basis will be
zero because he expensed it at the time he purchased it.

Read Hand-out #16, sec. B; if you accelerate depreciation schedules so much that they
essentially allow for expensing everything, then you create a consumption tax.

XV. Anatomy of a Tax Shelter

Tax shelters created so result in (a) deferral (b) conversion and (c) tax arbitrage.

Knetsch v. U.S. (1960) S. Ct.
The taxpayer bought an annuity that would be paid years hence (2 ½ % return). He borrowed a
significant amount to pay for the annuity, and paid 3 ½%. However, he essentially borrowed
against every bit of interest payment that would be due to him upon maturity. Consequently, he
deducted the interest payments on both the original purchase and each time he borrowed the
future earnings portion. The Court balks, he can‟t do this just for tax avoidance. They say the
transaction was a fiction, a “sham.” Note: this was a deferral, he would have to pay taxes on the
annuity when it matured.

Why the outcome? We assume Congress made the exceptions for annuities so people would
save for old age. This guy wasn‟t saving for his old age – he was trying to offset income for
strictly tax avoidance purposes.

Goldstein v. Commissioner (1966) 2d Cir.
Another complicated tax shelter scheme to delay taxation on lottery winnings. Court does not
call it sham. However, court notes that the taxpayer‟s sole motive was tax avoidance. The
remedy: don‟t allow her to deduct interest. No interest deductions on arrangements like this one
that have no purpose, substance or utility apart from anticipated tax consequences.

§ 101(a): payments from life insurance contract not taxable.

§§ 264 and 265: both are attempts by congress to forestall arbitrage by tax payers borrowing to
invest in tax-favored assets and deduct the interest. It does this by not permitting the interest to
be deducted. So after these codes it doesn‟t prevent you from benefiting from tax exempt things,
it‟s just you can‟t borrow to accomplish this.

§ 265: no deduction for interest on loan to purchase tax free investments.

§ 163(d) Taxpayer cannot take any interest deductions for interest paid with respect to the loan
incurred to purchase stock unless and until the taxpayer has “net investment income.” Does a
similar thing (forestall arbitrage), but it does it by postponing the interest deduction until the
related income has been generated. (For example, a tax payer buys annuity by borrowing.) The
interest deductions are postponed until the annuity matures. Otherwise, this tax scheme would
permit the taxpayer to delay tax.

Ex. If tax payer has $20 K investment expense and $25 K in investment income he has no
problem deducting his whole $20K of expense. However, if he has $20K investment expense
and only $15K investment income, he can only deduct $15k in expense. The extra $5k can be
deducted later when he realizes income.

163(d)(4)(B)(iii): after selling stock the taxpayer can choose to count the gain on the sale of
stock as investment income or capital gains income. Therefore, he can deduct all the investment
expenses (i.e., the interest if he got a loan to buy stock) against the investment income. Or, he
can take it as capital gains.

Interest is not a miscellaneous itemized deduction, thus the 2% floor nor the §68 phase out are
applicable. Therefore, if it survives § 163(d) it‟s as good as an above the line deduction.

§ 163 (d) relates only to investment interest.

XVI. Responses to Tax Shelters

Estate of Franklin v. Commissioner (1976) 9th Cir.
Group of doctors as partners, “associates” so-called buy a motel in Williams Az. They
simultaneously lease back to owners for the amount they owe in payment. The debt is non-

recourse and it is indicated that after ten years the associates will make large balloon payments to
pay off debt. Only $75,000 is originally paid to previous motel owners; this is a prepaid interest
payment. Other than that, no money changes hands. However, the associates get significant tax
deductions in the meantime for interest payments and depreciation of assets. It would appear
they could walk away after 10 years. The tax court‟s analysis turned on whether it was really a
sale or not – they determined it was not. The appeals court‟s analysis turned on whether the
purported sale was for a fair market value. It was not. The pointed out that this analysis seems
to root out the illegitimate schemes because if it was really for the market value the associate‟s
would have built up too much equity to walk away from the transaction, even with the tax
benefits. Therefore, the depreciation and interest deductions were disallowed. No depreciation
because depreciation is permitted by one who invests in property. Because, they never will have
equity, no depreciation. Similar rationale for interest deduction. To justify the deduction the
debt must exist; potential existence will not do. For debt to exist, the purchaser, in the absence
of personal liability, must confront a situation in which it is presently reasonable from an
economic point of view for him to make a capital investment in the amount of the unpaid
purchase price.

A brilliantly reasoned case. The court goes further to state this does not mean an above market
sale is not valid. Obviously, the Court needed to get around this without making such sales void.
Otherwise burned buyers could get out of sales.

Congress is interested in giving subsidies to people who make real investments – in the form of
depreciation. However, not interested in giving subsidies to pretend investors.

Tax shelter promoters try and get lawyers to write a tax opinion that the shelter is more likely
than not to be upheld. This is a marketing tool and more. Taxpayers who rely on tax opinions,
even ones solicited and paid for by the promoters are protected against penalties. I‟m thinking
this might just mean penalties beyond paying the tax in question post facto.

To fight tax shelters congress passed many measures in the 80‟s. Penalizing the folks who aided
and those who participated. They also started basketing, whereby deductions as losses in many
cases had to relate to the gains. Ex. gambling losses only against gambling gains.

§ 469 eliminates deductions for losses from passive activities. (i.e., lawyers who invest in
loosing cattle farms to offset high salary). Passive activity loss: a loss on an investment (a) that
constitutes a trade or business (b) in which the taxpayer does not “materially participate.”
Rentals always passive.

Material participation one of three tests:
  1) spend more than 500 hours on the activity
  2) spend at least 100 hours and as much time as anyone else would
  3) if facts and circumstances show participation.

RE: 469, the loss or credit not permitted to deduct is: The aggregate losses for the activity exceed
the aggregate gain.

§ 465 disallows deductions for “losses” of an investment in excess of the amount that the
taxpayer has at risk in that investment. (i.e., A buys motion picture for $2 million, but only pays
$200,000 and has non-recourse loan for the rest. He can‟t loose more than the $200,000.)
-every trade or business activity covered by §465, per (c)(3).
-amount at risk: the amount of money and the adjusted basis of other property invested in the
activity, plus the amount borrowed for which the taxpayer is personally liable, or any amount for
the FMV of other unrelated property pledged as collateral. Equity is included as part of amount
of money invested in activity. The tax payer can deduct for the loss up to the amount they
gained in gross income and the amount they were at risk. However, the at risk deduction can be
taken only once – not the second year and so on.

These sections do not apply to large corporations (469, 465)

Provision                          Investment Affected           Deductions Affected
§ 469                              Passive Trade of Business     All Deductions
§ 465                              Trade or Business Investments Deductions in excess of “at
                                                                 risk” amount
§ 265                              Tax-Exempt Bonds              Interest
§ 264                              Insurance                     Interest
§ 163(d)                           Portfolio Investments (stock) Interest

§§465 & 469 Losses:
These are losses for a specific activity (as differentiated from a loss on the sale of an asset or net
operating loss). The cost of the activity exceeds the gross income generated.
-The tax payer can deduct losses up to the extent of their income generated from that activity.
-The loss either evaporate permanently or is held in “suspense” until it can be taken according to
statutory conditions.

§163(d): doesn‟t allow a taxpayer to take any interest deduction for interest paid with respect to
the loan incurred to purchase stock unless and until the taxpayer has “net investment income.”
-thus, taking the tax advantages of purchasing growth stock is reserved for those who don‟t have
to borrow.

A compilation of IRS revenue rulings regarding sale/leaseback arrangements:
-must have at least 20% unconditional at-risk investment in property.
-option to purchase after lease (only if at fair market value)
-leasee can‟t provide money for the investment.
-leasee can‟t loan money to leasor
-lessor must expect to profit from arrangement and have positive cash flow (independent to
-the leasor has not retained a significant possessory interest.

Treasury rules and the ABA indicate lawyer cannot accept as true facts that he should doubt
when writing opinion letters.

The Alternative Minimum Tax (AMT):

To ensure folks could not take advantage of certain preferences (deductions, etc) to avoid all tax

Prosman v. Commissioner (1999) – Tax Court
Fellow works as a consultant for company. The company pays him an hourly wage and travel
expenses. He asked to have them separated and only report the wages for the W2; the company
refused. Accordingly, he deducted the travel expenses when paying taxes. However, the AMT
was higher because the W2 included the travel expenses. He asks for equitable relief. Court
rejects his argument and he must pay.

XVII. Personal Deductions

Personal deductions are subtracted from AGI to arrive at taxable income.
Includes: casualty losses, charitable donations, medical expenses, interest, state and local taxes
and alimony.

Taxpayers can take standard deduction instead of personal deductions
They also take a personal exemption for each person in the household, but it decreases by 2% for
each $2500 increment above $189,950 (married filling jointly in 1999).

The benefits of itemized deductions also decreases at certain threshold amounts. (§68)

§165: General Rule: You can deduct any loss not compensated by insurance or otherwise.
However, the deduction is limited to the basis of the asset.
-exempted from §§67 & 68, because it already has internal caps, set by the section.
-threshold of 10% AGI less $100.
-one has a casualty gain if insurance gives them more than the basis price.

Hypo for casualty loss:
Max buys boat for $10 K, pleasure craft, can‟t depreciate. Basis is $10 K. Shortly after he buys
it the designer of boat becomes famous, and the boat becomes worth $50K. It‟s sitting at dock
and struck by lightning, and burns. 165(b) says only deduction for basis of asset, despite his
$50K loss. Thus, his loss is only $10 K. However, per 165(h)(1) loss must exceed $100. Thus,
his deduction goes to $9900. Further, per 165(h)(2) his deduction is contingent upon his
adjusted gross income (net casualty only to the extent it exceeds 10% of adjusted gross income).

What is a casualty loss?
§165(c)(3): personal (not business) arises from fire, storm, shipwreck or other casualty or from

Revenue ruling (a suddenness test):
Floods a casualty.
Droughts, no, it‟s not a casualty, because not sudden enough.
Termites, no
Dry rot, no
Lost wedding rings (it depends)

Dyer v. Commissioner (1961) – Tax Court
Taxpayer claims $100 casualty loss for vase broken by cat. They claim the cat was having the
first of a series of neurotic fits. Court says casualty loss does not occur when the family is
negligent or by pets. Court asks if this occurrence is analogous to a fire, storm or shipwreck. No

-this deduction in a way discourages tax payers to get insurance.

Blackman v. Commissioner (1987) – Tax Court
Husband and wife were fighting. Husband placed wife‟s cloths on the stove and started them on
fire. The house burned. Insurance wouldn‟t pay, so the taxpayer deducted as a casualty loss.
Unlike the previous case (with regard to negligence), this court says negligence is ok, but gross
negligence not ok. This was gross negligence or worse – maybe intentional. Also against public
policy (he was convicted of lots of arson-type offences in this matter).

Medical Expense:
-deductible to the extent they exceed 7.5% of AGI.
§213(d) defined- amounts paid for the diagnosis, cure, mitigation, treatment or prevention of

Reasons for allowing medical deductions:
   1) these amounts spend are not really on consumption, thus shouldn‟t be taxed for the
      income used towards them.
   2) These folks are relieving gov‟t from paying med expenses
   3) Encourages folks to take care of themselves (I think the opposite)
   4) Oftentimes either was caused at work, or prevents one from working, thus a cost of
      producing income.

Taylor v. Commissioner (1987) – Tax Court
Whether taxpayer can deduct for having lawn mowed by someone else, because he had allergies.
Dr. told him not to mow anymore. Service says not deductible under §213, but payable under
§262 (personal living expenses not deductible). Court says many Dr. recommended activities do
not become deductible. No showing that other family members could not do it, and no indication
he did mow before Dr. told him not to. “Dr. recommended activities have been held in a number
of cases not to constitute deductible medical expenses where they did not fall within the
parameters of „medical care.‟”

Ochs v. Commissioner (1952) – 2d Cir.
Wife is sick and can‟t home teach children. Therefore, they sent kids to boarding school and
deducted as medical expenses. Court rejects. Using examples court shows that these were
household expenses. What if wife died? They would have to pay for the school with no

Statutory language may help:

Covers expenditures for “cure, mitigation, treatment, or prevention of disease or for the purpose
of affecting any structure or function of the body.”

Ochs case seems to dealing with the consequences of the disease

-permits Braille books (the price above regular books)
-someone guiding blind child at school
-cosmetic surgery limited (generally not allowed)
-elevators and swimming pools and ramps in house if they don‟t increase value of house.

Congress offers self-employed a deduction for paying for own insurance. Not also offered to
employees who‟s employers don‟t provide insurance. Didn‟t want to encourage employers to
not provide insurance.

§105: If you get money for an accident or health insurance for an injury is taxable except to the
extent it is used to pay for medical expenses.

XVIII. Charitable Contributions
Maybe the justification is to benefit the good organizations and not to benefit the taxpayers. This
is not a complete explanation.

Why have charitable deductions vs. having the gov‟t just funding the charities (pros):
  1) people like giving to charities vs. the gov‟t
  2) people have different preferences
  3) allows folks to give to religious institutions that the gov‟t can‟t fund
  4) limits the gov‟t intervention of charities

   1)   We need to pay for glamorous and non-glamorous orgs/causes
   2)   Some of the preferred groups who get tax free funds are not desirable.
   3)   Supporting religion via gov‟t should be prohibited, even if one-step removed
   4)   It really is gov‟t intervention

This previous pro/con discussion relates to a principle of using the tax code to permit direct

Sec. 170: Allows charitable deductions for individuals and corps.
-(b)(1): 50% of AGI cap for churches, educational orgs, medical institutions, publicly supported
-30% of AGI cap for donations to private foundations or for the use of charity org.
-if gift exceeds these thresholds, it can carryover to next year.
-the applicable group may likely have tax exempt status, but not necessarily (see other code
-if the group uses funds to lobby it looses charitable deduction candidate status.
-Capital gain property:

1) if the asset will produce a long term capital gain then the deduction is for the FMV. (but the
   deduction is capped at 30% agi, or 20% if to a private foundation or gifts for the use of the
   charity org)
2) if the asset will produce a short term capital gain then the deduction is for the donor‟s basis.

In order to give appreciated property to charitable organization and get FMV deduction it needs
to be related to the function of the organization. (i.e., you can‟t do it if you give art to red cross,
but can if you give art to art museums). Stocks and bonds are intangible personal property, thus
doesn‟t need to be related.

This rule created tax shelters whereby folks would donate things with arbitrary value (like art,
not stock and bonds). Then they would attach very high values to the goods donated.
-congress enacted special punitive rules for people that inflated charitable deductions.
-congress also added some extra substantiation requirements. The evaluation had to be
independent (gems going to Smithsonian can‟t be valued by Smithsonian employees.)

§ 68 phases out itemized deduction for taxpayers with income above a threshold. This operates
to reduce charitable deductions and other deductions.

In the end, charitable contribution deduction might favor middle class vs. the rich. Those who
make between $50,000 and $125,000 make out like bandits.

What is a donation? See Ottawa case. Can‟t get substantial benefit for the donation. Seems to
boil down to a test of the “intent of the donor.” The Service doesn‟t push this too hard.

Ottawa Silica v. US (1983) Fed. Cir.
Company was in the mining business and thus owned much land. Some of the land did not have
mineral deposits and it was anticipated that it would be developed. State of California asked the
company to donate 50 acres of land for high school. The company donated it and deducted
accordingly. Court rejects deduction. The company would ultimately benefit from the high
school. Court says contribution is not exclusively for public purposes if tax payer receives or
anticipates receiving benefits in return.

Can‟t “anticipate receiving a substantial benefit in return” – Substantial benefit defined as
“greater than those that inure to the general public from transfers charitable purposes.”

Another court indicated the intent of the taxpayer should control.

A court could conceivably give the deduction at the FMV less the benefit received by taxpayer.

If more than $75, A charity must release an estimate to the taxpayer of how much is a donation
and how much is the fair value received. (ex. PBS gives Cats video for contributing, only the
amount over the fair price of video is deductible.)

No quid pro return for psychic value (naming building after you), you get the whole deduction.

Gifts over $5 K must be appraised.

Gifts over $250 must have written verification from donee, noting estimated FMV. Canceled
checks not good enough.

Bob Jones University v. US (1983) – S. Ct.
The univ had a policy prohibiting inter-racial dating and did not accept students who did it. The
IRS issued a rev ruling that said charitable orgs must conform to public policy to receive tax
exempt status. Therefore, univ was deemed not tax exempt. The IRS relies on a common law
understanding that a charitable org must not violate public policy. Court agrees. IRS did not go
too far in exercising discretion. To rebut argument that only congress can make this decision,
Court indicates that they have let the ruling stand for 10+ years and there was lots of debate in
the meantime.

Dissent: The court can‟t step in and legislate just because congress hasn‟t spoke.
This is not necessarily a good example of an org being rejected from tax exempt status. A more
common example is one where the org is a private foundation and serves a more private than
public purpose.

XIX. Introduction to Capital Gains
Short or long term capital gain: Whether it was property held for more than a year.

Capital assets are not the same as capitalized assets (i.e, one that has basis). Capital assets is a
subset of capitalized assets.

Rationales for favorable capital gains treatment:
-Bunching: its arbitrary to have the gain taxed at x rate because of the timing of the sale where
the tax payer could have been taxed at different rate had he sold earlier/later
-Lock-in: without it the sale of assets is prohibitive. Frees up assets and capital.
-Inflation: otherwise, taxpayer is hurt by inflation which isn‟t a real gain.
-incentives to new companies
-double tax on corporate earnings: reduces this effect by making the gains from the sale of stock
taxed at a lower rate.

Individuals: If long term the gain is taxed at the favorable capital gains rate. Losses can offset
$3000 ordinary income and be carried forward (for individuals). (Ex. for individual: $6K cap
gain and $13K cap loss. He can claim a $9K loss. Leaving $4K for subsequent years. If
nothing else occurs he can take $3k the next year and the remaining $1K the next year.)

Corporations: only offset capital losses with capital gains. The carryover is limited to 3 previous
years or 8 years hence (for corps).

Net capital gains treated favorably in that they are taxed at lower rate than ordinary income.
Ordinary income taxed up to 39.6% - capital gains is 20%; but if you are taxed at 15% or less,
then cap gain is 10%. This is set out in §1(h). The lower rate can range from 10% to 28%.

   Small business stock, bought directly from business and held for 5 year – 14%

   Sale of collectible (art and baseball cards, etc) – 28%

   Real Property – 25%

Not all capital gains qualifies for the rate advantage – it‟s net capital gain.

Start by combining long term transactions and short term transactions and put in two columns.
    1) If both columns are gains then the net long term gain becomes net capital gain and the
        short term net becomes ordinary income.
    2) If long term is a gain and short term is loss, but the gain is greater, then combine to create
        net gain.
    3) If short term is gain and long term is a loss and the gain is greater than the overall gain is
        ordinary income.
    4) If both columns are losses. The losses add together and deduct according to rules (i.e.,
        only $3000 for individuals etc.)
    5) Both short term and long term gains are treated identically.

XX. Definition of a Capital Asset

Van Suetendael v. Commissioner (1945) Tax Court
Taxpayer was very involved in the buying and selling of stocks and bonds. He was not a
member of an exchange. However, he experienced some losses and wanted the losses to be non-
capital losses. Thus, he argued that this was his trade or business and these were his inventory
for the sale to customers. The court said that by default property is capital unless it falls within
one of the exceptions set forth in §1221. Court finds these securities were not held primarily for
sale to customers in the ordinary course of business. Rather, he held for speculation or for
investment. He is not a middleman, a wholesaler. He ends up selling them to regular schmoes
like himself. Court thus concludes they are capital assets.

Biedenharn Realty v. U.S. (1976) – 5th Cir.
A corp was formed to hold and manage family investments. The corp holds many assets in real
property, stock, etc. The buy a plantation and later subdivide it and sell it for significant profit.
Question: whether the lots constituted property held by the taxpayer primarily for sale to
customers in the ordinary course of its business or trade under §1221? Court considers: (1) the
nature and purpose of the acquisition of the property and the duration of the ownership; (2)
the extent and nature of the taxpayer's efforts to sell the property; (3) the number, extent,
continuity and substantiality of the sales; (4) the extent of subdividing, developing, and
advertising to increase sales; (5) the use of a business office for the sale of the property; (6)
the character and degree of supervision or control the taxpayer exercises over any
representative selling the property; and (7) the time and effort the taxpayer habitually devotes
to the sales. Applying the facts the court first notes the frequency and substantiality of the sales.
Also the improvements, adding streets, sewerage, etc. Taxpayer notes they did not advertise.
Court retorted, demand is so high, no need to advertise. Plus, just developing the land produces
advertising. Taxpayer argues they used broker and thus not a business; to this end they cite case

law. The Court distinguishes, in the other cases the taxpayer turned the whole land over to
broker. In this case, taxpayer developed land and used broker for individual sales. Further, in
some instances, they used no broker at all. Court said every instance in which a taxpayer divides
land and improves it will not result in ordinary income treatment. But it will be rare, maybe only
when something lie an act of God, or rezoning forces them to make that decision.

The book notes a few other cases where the court was less stringent in allowing an active change
to result in capital gain rather than ordinary income. Such as improving apartments and selling
as condos. The improvements were mainly painting, and the like and the situation (market, or
health of owner) had changed and made it more desirable.

§1221 Capital Asset Defined: Property held by taxpayer except whether held for trade or
business or otherwise:
   1) the inventory or stock of trade of a business (property to be sold to customers in the
       ordinary course of business)
   2) real property and depreciable property used in trade of business
   3) copyrights and the like held by the creator (not held by someone who bought from
   4) regular accounts receivables
   5) U.S. gov‟t publications held by someone who received them for free or at a reduced cost.

The default is that property is a capital asset unless in exceptions.

§1231: applies to property used for trade or business. The gains are treated as capital gains. The
losses are treated as ordinary losses. Tax payer gets the best of both worlds. –But, see §1245.
This still is helpful for real property.

§1245 Gains from the disposition of certain depreciable property. Depreciable business property.
If you‟ve got business property your gain will be treated as ordinary gain to the extent that it has
been depreciated. The rest gets treated as capital gains. This has basically read §1231 out of the
code. This does not include real property.

XXI. Judicial and Regulatory Gloss: Hedging Transactions

Corn Products Refining v. Commissioner (1955) – S. Ct.
Corn Products (“CP”), used corn to produce syrup. There was a drought and prices were rising.
The company bought long term futures (i.e., we‟ll pay $x for corn in three months). Then when
the time came the prices had generally risen. Thus, they could buy the corn and produce the
syrup and the profit would be ordinary income. However, they could sell their future‟s contract
and pay the market price for the corn. Then they would make less in profits from the syrup, but
they would have made a lot on the sale of the future. They wanted this to be capital gain. They
argued that it was a separate part of their business. The court said it was an integral part of their
manufacturing business and thus ordinary income. CP also argued that this was not true
hedging because they didn‟t protect themselves from falling profits (apparently hedging is
explicitly excluded from capital gains/losses). Court said they knew the market was heading up,
not down, thus the result was the same – ordinary income.

Court seems to go out of its way to say this isn‟t part of inventory exception, but a new

Arkansas Best v. Commissioner (1988) – S. Ct.
Ark is a large holding company. It bought lots of stock in a Texas bank. The bank started
having problems (Texas real estate market crash). The holding company sold stock and claimed
the loss as regular income. Ark argues that Corn Refining stands for the premise that assets
acquired and sold for ordinary business rather than investment purposes should be given ordinary
asset treatment (i.e., capital gains/losses). Thus, because this stock purchase is obviously the
ordinary business activity of a holding company, it should be ordinary income. The court
disagrees. It says Corn Refining did not create a new exception to the otherwise default rule
classifying property as capital property. Rather, by classifying what Corn Refining did as
hedging, they put it in the inventory exception. Hedging in this case kept the Corn from having
to build warehouses to hold corn inventories, thus an inventory measure. As such, what Ark did
was not within this inventory exception and is a capital gain. This case really re-writes Corn
Products and makes it an inventory exception.

§1221 (7): Subsequent regulation have permitted regular gain and loss provisions for hedging
transactions. However, the taxpayer must commit beforehand. He must keep records and
indicate whether hedging or not. Thus, he can‟t abuse by characterizing as hedging just when it
would benefit him.
 But, if they don‟t identify as a hedge and it‟s a gain then they take delivery and then they
    only pay capital gain. If it‟s a loss, they just take delivery and the loss will be ordinary
    income loss.

Merchants National Bank v. Commissioner (1952) 5th Cir.
Bank had bonds worth about $50 K. They determined they were un-collectible and wrote them
off and deducted as ordinary income. Subsequently, they sold the bonds for about $18K. They
recorded this as a capital gain. No, no, no, no, no! Consistency.

Arrowsmith v. Commissioner (1952) S. Ct.
Two taxpayers liquidate a corp they owned jointly. They show the gains for the sale as capital
gains. However, they are subsequently assigned liability as proxy for the corp. They claim as an
ordinary gain. The Service and the Court deny this. They need to treat these transactions

If the corp had paid the liability during its life it would have been a deduction to ordinary
income. Then the amount for distribution would simply have been reduced. Thus, the same
result would have been reached by allowing the taxpayers to deduct as ordinary income. Also,
this rationale used by majority my actually reduce money collected in taxes. If it was different
and corp had extra uncollected income, it would be treated subsequent to liquidation as capital

XXII. Substitutes for Ordinary Income

See Hort case again.

Commissioner v. Ferrer (1962) 2d Cir.
An actor contracts with a writer to manage and produce his play. The contracts includes terms
whereby the actor will have power to prevent the writer from contracting with a motion picture
company for a period of time. Furthermore, the actor will have a right to the proceeds of such a
deal. A motion picture company contracts actor to be in the film. They also negotiate with both
the actor and the writer to get rights to the film. Thus, the question is whether the compensation
received by the actor is capital gain or regular compensation (ordinary income). Court divides
the compensation into three parts. Part is the right to the play. This is a capital asset (however, it
would be different if he was the creator of the copyrighted material). Next, is the payment for
his right of refusal (the ability o prevent the contract between the writer and the motion picture
company). The analogizes this to the right of a tenant to prevent his landlord from allowing a
similar business to occupy an adjacent space. This has been treated as a capital asset and so the
court does likewise with this right. Last the portion is the percentage of proceeds the actor
received from the motion picture company in exchange for the proceeds he would have received
for producing the play. Because this would have been ordinary income, if he‟d produced the
play, it will consistently be characterized as ordinary income. The court remands to lower court
to sort out how much each of the above categories represents.

Note: a percentage of profits can be treated as a sale for a capital gain. Thus, sale of licenses or
copyrights can be similarly treated.


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