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Individual Income Tax Outline

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					Income Tax Outline Chapter 1: Introduction Progressive rates – taxes the same dollar of income at different rates to different people. Capital gains – taxes different dollars of income at different rates to the same person. Deductions – amount subtracted from income before tax rate is applied. Credits – amounts subtracted from tax bill after tax rate is applied. Standard deduction – the sum of the basic standard deduction ($3,000) and the additional standard deduction. Deductions and Brackets How much a deduction is worth depends on the tax bracket a person is in. The lower the tax bracket, the less a deduction is worth. The higher the tax bracket, the more a deduction is worth. For example, to a 25% bracket taxpayer, a $1 deduction is worth 25 cents. Central point: deductions are worth more to some taxpayers than to others. Credits vs. Deductions Credits are worth the same amount to all taxpayers while the worth of deductions varies depending on the taxpayer (the bracket of the taxpayer). Policy Points  If a tax break is to be distributed equally, then it should be in the form of a credit. o Why? Because credits are worth the same to all taxpayers.  If a tax break is to be given selectively, then it should be in the form of a deduction. o Why? Because deductions vary with a taxpayer’s bracket. Statutes & Regulations  Statutes are written by Congress.  Regulations are written by the Treasury Department; Congress delegated this authority. Statutes are the highest authority. Regulations go along with the statutes. When a statute is passed, it takes about 3 years for the corresponding regulations to be promulgated. Cases  Tax Court opinions are appealable to the circuit court in which the taxpayer resided at the time the Tax Court petition was filed.  If the taxpayer is a corporation, the circuit is determined by the corporation’s principal place of business. Rulings

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 If IRS answers a question via letter – the letter ruling is binding on the IRS but can’t be cited

as precedent.
 A public Revenue Ruling is given by the IRS if it receives many questions about the same

topic. Such a ruling tells you what the IRS would do and you can’t go wrong following it. Constitution  Article I, Section 8 – sets forth Congress’s power of direct taxation.  16th Amendment – Congress has the power to collect income tax without dividing it and sharing it with the states. Taxation must be done with 1) due process of law and 2) without discrimination (Equal Protection Clause). Tax Options Head tax – tax each person equally to meet the government’s budget needs. Benefits tax – tax each person based upon the benefit they receive from the government. 3 Ways to Measure the Ability to Pay Taxes 1. Income 2. Spending 3. Wealth Progressive rates vs. Flat Rates Flat tax – all taxpayers pay the same percentage of their income. Example: If there’s a flat income tax, those with higher incomes pay more but at the same percentage as those with lower incomes. Progressive tax – taxpayers with higher incomes pay more dollars and at a higher percentage. Marginal rate – the rate on the last dollar of income. Rises with income in a progressive tax. Effective rate – computed by dividing the tax bill by the income. Regressive tax – higher income taxpayers pay a lower rate of tax than lower income taxpayers. Horizontal Equity – people in similar circumstances should be taxed in similar ways. Vertical Equity – the impact of the tax provision on different income levels.

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Chapter 2: Income A. Definitions: Economic Income vs. Tax Law Income 1. Economic Income a. Haig-Simons Definition i. Simply put: Income is spending plus savings. ii. More complex: Personal income is the algebraic sum of: 1. the market value of rights exercised in consumption, and 2. the change in the value of the store of property rights between the beginning and end of the period in question. 2. Tax Law Income a. § 61: Gross Income Defined i. Gross income means all income from whatever source derived. b. § 102: Gifts and Inheritances i. Gross income doesn’t include the value of property acquired by gift, bequest, devise, or inheritance. ii. But gross income does include the income from any property acquired by gift, bequest, devise, or inheritance. c. § 1001: Determining Gain or Loss i. The gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the adjusted basis. ii. “Realized” means the property must be sold or disposed of in some way. iii. The amount realized is the sum of any money received plus the fair market value of the property (other than money) received. iv. Gain = Amount realized – Adjusted Basis d. § 1011: Adjusted basis i. The adjusted basis for determining gain or loss is to be calculated from § 1012. e. § 1012: Basis of property – cost i. The basis of property shall be the cost of such property. ii. Gain is calculated by subtracting the cost from the amount realized. 3. Case Law Defining Income a. Commission v. Glenshaw Glass Company i. Issue: Whether money received as fraud or punitive damages must be reported as gross income under § 61. ii. Facts: Glenshaw was awarded damages in a lawsuit and didn’t report the amount as income; it argues § 61 doesn’t include punitive damages as income. iii. Rule: § 61 has been interpreted as taxing all gains except those specifically exempted. iv. Reason: Recovery for actual damages are taxable so punitive damages should be taxed as well. v. Holding: Punitive damages are taxable income.

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vi. Definition of income: instances of undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion. vii. Class Notes: Compensatory damages were taxable gross income because they fall under 61(2) as income derived from business. 4. Imputed Income a. Two sources i. When a taxpayer performs services for herself ii. When a taxpayer enjoys the rentfree use of property which she owns b. Imputed income isn’t taxed in the U.S. c. There are inherent tax advantages to home ownership in the U.S. B. Basis and Debt 1. Basis a. Basis is the cost of the property, § 1012. b. Basis is subtracted from the amount realized to equal gain, § 1001. c. Adjustments to basis are discussed in § 1016. d. The higher the basis, the lower the taxable gain. 2. First Northwest Industries of America, Inc. v. Commissioner a. Issue: Whether the taxpayer who bought the Seattle Supersonics can subtract a basis from the amount realized by the NBA’s subsequent expansion. b. Facts: Taxpayer’s total cost was $1.75 million, with $1 million in rights unallocated. The NBA expanded by selling new teams and taxpayer received a portion of the proceeds. Commissioner argues that taxpayer incurred no cost by the sale of new teams and cannot subtract a basis from the amount realized. Taxpayer argues specific rights were transferred to the new owners at a cost to himself. c. Rule: Only costs that are ascertainable may be subtracted as basis. d. Rationale: Some rights were partially transferred to the new owners. The taxpayer may subtract as basis the cost of these rights from the amount realized. e. Holding: Reversed and remanded. Yes, for ascertainable costs of rights transferred due to the expansion. 3. Debt a. § 61(a)(12): Income from discharge of indebtedness is gross income. b. § 108(a): Exceptions to gross income in the form of discharge of indebtedness include: i. Discharge occurring in a title 11 case ii. Discharge occurring when taxpayer is insolvent iii. Discharge is qualified farm indebtedness, or iv. Other than that of a C corporation, the indebtedness discharged is qualified real property business indebtedness. c. § 108(d)(1): Indebtedness of taxpayer means any indebtedness: i. For which the taxpayer is liable, or ii. Subject to which the taxpayer holds property.

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4. Case Law on Debt a. Old Colony Trust Co. v. Commissioner i. Issue: Whether the income tax paid by the company on behalf of its employee constitutes additional taxable income for the employee. ii. Facts: American Woolen Co. paid the income taxes for its president for two years. The court looked at whether the president could avoid reporting this on his tax return. iii. Rule: The discharge by a third person of an obligation to him is equivalent to receipt by the person taxed. iv. Rationale: The taxes were imposed on the employee and paid by the employer as compensation for the employee’s services. v. Holding: The payment of taxes is income for the employee. b. U.S. v. Kirby Lumber Co. i. Issue: Whether the income gained is taxable. ii. Facts: Plaintiffs issued its own bonds, received equal value, and later purchased the same bonds at lower value and made a profit. iii. Rule: Gross income includes gains or profits and income derived from any source whatever. iv. Rationale: The taxpayer made a clear gain so the regulations and Code should be adhered to and the gain taxed. v. Holding: Taxable. vi. Class Notes: A bond is an IOU. It says “I will give you X on this future date, if you give me less than X now.” c. Zarin v. Commissioner i. Issue: Whether Zarin had income from the discharge of indebtedness. ii. Facts: Zarin settled a lawsuit with a gambling resort for $500,000 when he owed the resort $3,435,000. The IRS says he realized an income of the difference, $2,935,000 and owes tax on the amount. iii. Rule: § 61(a)(12) discharge of indebtedness is income; § 108(d)(1) indebtedness is that for which the taxpayer is liable or subject to which the taxpayer holds property. Contested liability doctrine: 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. iv. Rationale: Zarin’s debt to resort was unenforceable under NJ law, so he was not liable for it; Zarin held no property for the debt, only gaming chips. Under the contested liability doctrine, the settled amount is treated as the amount originally owed, so Zarin didn’t have any income from the discharge. v. Holding: No income. vi. Class Notes: Forman says this was wrongly decided. Zarin should have lost because § 108(d)(1)(a), the definition for indebtedness, only applies to that section and not to § 61(a)(12) that says gross

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income includes the discharge of indebtedness. Zarin’s amount realized was $3.4 million and basis is $500,000 leaving him with a gain of 2.9 million that is taxable. d. Collins v. Commissioner i. Issue: Whether the debt Collins incurred by illegally gambling his employer’s money constituted taxable income. ii. Facts: Collins worked at a betting parlor, made wagers on his own behalf without the funds to pay for them, and lost. As a result of his theft, the IRS determined an income tax deficiency, and Collins appeals. iii. Rule: Income Test: All earnings, whether lawful or unlawful, is income except for loans which must be repaid. A taxpayer may claim a tax deduction for payments made in restitution. iv. Rationale: Collins total theft was reduced by the restitution he made to his employer, and the remainder was considered taxable theft income. This was not a loan agreed to by the parties but a theft by Collins. v. Holding: Taxable income. vi. Class Notes: Different from Zarin because Collins stole whereas Zarin borrowed 5. Additional Code Sections and Regulations a. § 1011: Adjusted Basis for Determining Gain or Loss i. The adjusted basis for determining gain or loss is to be calculated from § 1012. b. § 1014: Basis of Property Acquired from a Decedent i. The basis of such property shall be 1. the fair market value of the property at the date of death, as determined by the applicable Code section, or the basis in the hands of the decedent. ii. Property is acquired if it is by bequest, devise, inheritance, estate transfer, or inter vivos trust. iii. Property is not acquired if it constitutes a right to receive an item of income in respect of a decedent under § 691. iv. This section won’t apply to decedents dying after 2009. c. § 7701(g): Clarification of fair market value in the case of nonrecourse indebtedness i. For purposes of subtitle A, in determining the amount of gain or loss with respect to any property, the fair market value of such property shall be treated as being not less than the amount of any nonrecourse indebtedness to which such property is subject. d. Regulation: § 1.1001-2: Discharge of Liabilities i. Except as listed in (ii) & (iii), the amount realized from a sale or other disposition of property includes the amount of liabilities from which the transferor is discharged as a result of the sale or disposition. ii. Doesn’t include discharge of indebtedness

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iii. Doesn’t include liability incurred on acquisition 6. Recourse & Nonrecourse Debt a. Nonrecourse debt i. The lender has no recourse against the borrower, only against the collateral. If the collateral is insufficient to cover the debt, the creditor is out of luck. b. Recourse debt i. The creditor can go after the collateral and the personal assets of the debtor. c. Commissioner v. Tufts i. Issue: Whether rule in Crane v. Commissioner, that property encumbered by a nonrecourse mortgage must include the unpaid balance of the mortgage in the computation of the realized amount, applies when the unpaid amount of the nonrecourse mortgage exceeds the FMV of the property sold. ii. Facts: The partnership’s cost in the complex was over $1.4 million and the FMV was $1.4 or less. Each partner sold his interest to Bayles, who reimbursed their sales expenses and assumed the nonrecourse mortgage. The partners claimed a partnership loss of $55K on their tax returns, and the Commissioner said their was a partnership capital gain of $400K. iii. Rule: The amount of the nonrecourse liability is to be included in calculating both the basis and the amount realized on disposition. iv. Rationale: A nonrecourse loan is to be treated as a true loan. The amount of the nonrecourse loan must be included in the amount realized by the mortgagor when a third party who assumes the mortgage because it’s like the third party is giving the mortgagor the money to pay off the mortgage, so the mortgagor must include that amount in his amount realized. The mortgage amount must be included in both the basis and the amount realized. v. Holding: Same rule applies. d. Revenue Ruling 90-16 i. Issue: Whether the transfer of property that had a FMV in excess of the taxpayer’s basis to his creditor result in the realization of gain under § 1001(c) and § 61(a)(3). ii. Facts: Taxpayer took out a recourse loan from a bank in the amount of $12K. The FMV of the property was $10K and the basis was $8K. Taxpayer defaulted and the bank agreed to accept the property as satisfaction of his debt. iii. Rule: § 1.1001-2(a)(1) provides that the amount realized from a sale or other disposition of property includes the amount of liabilities from which the transferor is discharged as a result. The amount realized doesn’t include amounts that are income from the discharge of indebtedness in respect to a recourse liability. 1. Gain = FMV – Basis (Gain is included in amount realized)

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2. Income = Recourse Debt – FMV = amount of recourse debt discharged iv. The transfer of the property in satisfaction of a debt the taxpayer was personally liable for is a sale or disposition upon gain is realized to the extent that the FMV of the property transferred exceeds the adjusted basis. To the extent the amount of debt exceeds the FMV of the property, income would also be realized from the discharge of indebtedness.

Chapter 3: Exclusions to Income A. Gifts, Bequests, and Life Insurance a. Cases i. Commissioner v. Duberstein 1. Issue: Whether the Cadillac Duberstein received was a gift or compensation for business services. 2. Facts: Duberstein’s company and Berman’s company conducted business with each other; Berman asked Duberstein if he knew of any customers that would be interested in Berman’s products; Duberstein provided the info, Berman was grateful for the business and gave Duberstein a Cadillac. The Cadillac was deducted as a business expense by Berman’s company. Duberstein didn’t report the car as income but as a gift on his return. The Commissioner contends it was remuneration for services rendered and therefore income. 3. Rule: The statutory definition of a “gift” is that which proceeds from a detached and disinterested generosity out of affection, respect, admiration, charity or like impulses. The test is objective and looks at the totality of facts in each case. Appellate review must be limited and the decision may be overturned only when reasonable men couldn’t find the same. 4. Rationale: The Cadillac was really a recompense for Duberstein’s past services or an inducement for him to be of further service in the future. 5. Holding: Reversed. Compensation for services. ii. Stanton v. U.S. 1. Issue: Whether the $20,000 given to Stanton after he resigned was a gift or compensation for his services to the company. 2. Facts: Stanton resigned after 10 years. He was well-liked, and was given a gratuity of $20K over 2 years, with no additional services required of him. Stanton didn’t include it as income, and the Commissioner contends it was. Stanton paid the tax

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deficiency, sued for a refund, and the trail court granted it. The Court of Appeals reversed. 3. Rule: The statutory definition of a “gift” is that which proceeds from a detached and disinterested generosity out of affection, respect, admiration, charity or like impulses. The test is objective and looks at the totality of facts in each case. Appellate review must be limited and the decision may be overturned only when reasonable men couldn’t find the same. 4. Rationale: The district court only gave their conclusion that it was gift, but with no reason, which doesn’t make appellate review possible because there’s nothing to go on. 5. Holding: Vacated and remanded. b. Statutes i. § 102(a): Gifts and Inheritances – General rule 1. Gross income does not include the value of property acquired by gift, bequest, devise or inheritance. ii. § 102(c): Gifts and Inheritances – Employee Gifts 1. Subsection (a) shall not exclude from gross income any amount transferred by or for an employer to, or for the benefit of an employee. iii. § 6053: Reporting of Tips c. Regulations i. § 1.102-1(a): Gifts and Inheritances 1. Property received as a gift, or received under a will or under statutes of descent and distribution, is not includible in gross income although the income from such property is includible in gross income. An amount of principal paid under a marriage settlement is a gift. See § 71 for rules regarding alimony or allowances paid upon divorce or separation. § 102 doesn’t apply to prizes and awards, scholarships, or fellowship grants. ii. § 1.102-1(f)(2): Gifts and Inheritances – Exclusions (proposed) 1. Employer/employee transfers a. For purposes of § 102(c), extraordinary transfers to the natural objects of an employer’s bounty will not be considered transfers to, or for the benefit of, an employee if the employee can show that the transfer was not made in recognition of the employee’s employment. Accordingly, § 102(c) shall not apply to amounts transferred between related parties (like father and son) if the purpose of the transfer can be substantially attributed to the familial relationship of the parties and not to the circumstances of their employment. d. Tips i. Tips are taxable income because they do not proceed out of detached and disinterested generosity, and therefore, aren’t gifts. ii. § 6053 instituted a tip rate to ensure that tips would be reported as income.

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e. Life Insurance i. Life insurance is an alternative form of making a bequest and is tax free. ii. Exception: Transactions that are more commercial than testamentary in nature are taxable. iii. § 101(a): Certain Death Benefits 1. Proceeds of life insurance contracts payable by reason of death a. Except as otherwise provided in (d), paragraph 2, and (f), gross income does not include amounts received under a life insurance contract, if such amounts are paid by reason of the death of the insured. f. Basis in Property Acquired by Gift or Bequest i. § 1015: Basis of property acquired by gifts and transfers in trust 1. If the basis was acquired by gift, the basis shall be the same as it would be in the hands of the donor or last preceding owner by whom it wasn’t acquired by gift, except if the basis is greater than the FMV of the property at the time of the gift, for the purpose of determining loss, the FMV will be used as the basis. ii. Taft v. Bowers 1. Issue: Whether B’s income from the stock was $3K or $4K. 2. Facts: A bought stocks for $1K and gifted them to B when valued at $2K. B sold them for $5K. B claims amount realized is what stocks appreciated while she had them, $3K but IRS says $4K. 3. Rule: §1015 - For the purposes of taxation, the donee should accept the position of the donor in respect of the thing received. 4. Rationale: The donee is treated like the donor in that the basis of $1K will be subtracted from the amount realized of $5K, leaving a gain of $4K which is taxable. 5. Holding: Income is $4K. iii. A donee will pay tax on the appreciation which occurs during her ownership of the gifted property, and on the appreciation which occurred during the donor’s ownership. The donor’s basis will be carried over to the donee. When the donor’s basis is less than the FMV at the time of the gift, the FMV will be the basis (not the donor’s), to calculate the donee’s loss. iv. Farid-Es-Sultaneh v. Commissioner 1. Issue: Whether petitioner’s acquisition of stock was by purchase or by gift. 2. Facts: Petitioner was given many shares of stock by Mr. Kresge as gift in case he should die before he married her. In the ante-nuptial agreement, the shares were given in consideration of the promise of Kresge to marry her, consummation of the marriage, and that petitioner wouldn’t seek her marital rights, like alimony. The couple then married and divorced four years later. She sold the stock and contended that because she purchased the shares, the adjusted basis should be the FMV when she acquired them. The

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Commissioner contends the shares were a gift and the adjusted basis is that of Kresge. 3. Rule: If the goods were a gift, then the donor’s basis would pass to the donee, but since the goods were purchased, the purchaser’s basis is the FMV of the goods when received. 4. Rationale: This wasn’t a gift because the petitioner agreed to marriage and forewent her marital rights in consideration for the shares. Since she purchased the stock, her basis is the FMV at the time of acquisition. 5. Holding: Petitioner’s acquisition was by purchase, not gift. g. Basis in Property Acquired from Decedents i. §1014 1. The basis of property acquired from decedents is the fair market value of the property on the date of decedent’s death. 2. In contrast to §1015 for property acquired from live people, the transferred basis provision applies in the same way whether the property has gone up in value or down, whether one is determining a loss or a gain. 3. This stepped up basis is a result of the fact that prices in the U.S. have been going up since 1913. B. Fringe Benefits a. Fringe benefits have always been a predominantly tax-free category of economic income. Why? i. Because they always have been. ii. It would be ridiculous to tax them in some cases. iii. Difficult to assess their value. b. Turner v. Commissioner i. Issue: What amount of Reginald’s winning of steamship tickets should be counted as income? ii. Facts: Reginald won two first class cruise tickets on a radio show. He and his wife reported $520 in income from the winnings on their return. The Commissioner said the income is $2,220, the retail price of the tickets. iii. Rule: Valuation of fringe benefits is difficult and possibly arbitrarily decided by the court. iv. Rationale: The value of the tickets to petitioners wasn’t equal to the retail cost because there were restrictions on their use and would’ve been difficult to sell. It’s difficult to put a number on what value the tickets were to the petitioners so the court picked one. v. Holding: Income is $1400. c. Haverly v. U.S. i. Issue: Whether the value of unsolicited sample textbooks sent by publishers to a principal of a public elementary school constitutes gross income to the principal under § 61. ii. Facts: Principal received books FMV of $400 to be kept by him. Publishers intended them as samples for his consideration. He donated the books to the library and claimed a charitable deduction of $400. Principal

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d. e.

f.

g.

said the books weren’t gifts. His tax return didn’t include the books as income. IRS said he should have. He paid the tax, filed a claim for a refund and this action is to recover that amount. iii. Rule: When a tax deduction is taken for the donation of unsolicited samples the value of the samples received must be included in the taxpayer’s gross income. iv. Rationale: Taxpayer’s receipt of textbooks was an accession to wealth, whether he solicited them or not. His claiming a deduction for them shows that he had an intent to accept the property as his own. v. Holding: Reversed finding for plaintiff. Yes, gross income. § 61(a) Gross income defined i. Gross income includes fringe benefits. § 132 Certain Fringe Benefits i. The following fringe benefits are excluded from gross income: 1. no additional cost service 2. qualified employee discount 3. working condition fringe 4. de minimis fringe 5. qualified transportation fringe 6. qualified moving expense reimbursement 7. qualified retirement planning services §107 Rental value of parsonages i. In the case of a minister of the gospel, gross income doesn’t include 1. the rental value of a home furnished to him as part of his compensation; or 2. the rental allowance paid to him as part of his compensation, to the extent used by him to rent or provide a home and to the extent such allowance doesn’t exceed the fair rental value of the home. §119 Meals or lodging furnished for the convenience of the employer i. Excluded from gross income if 1. the meals are furnished on the business premises of the employer, or 2. in the case of lodging, the employee is required to accept such lodging on the business premises of his employer as a condition of employment. ii. U.S. Junior Chamber of Commerce v. U.S. 1. Issue: Whether or not the fair rental value of the House is excludable from the gross income of plaintiff’s presidents. 2. Facts: Plaintiff is a nonprofit corporation that has a president/CEO each year who lives in the plaintiff’s house rent free during time of tenure. IRS claims fair rental value of $125 per month should be included in gross incomes of the presidents. 3. Rule: §119 Exclusion of fair rental value of lodging from employee’s income is allowed if: 1) the lodging is furnished for the convenience of the employer; 2) the employee is required to

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accept such lodging as condition of his employment; and 3) the lodging must be on the business premises of the employer. 4. Rationale: The president was required to live at the house to do his job and the house was a part of the plaintiff’s business premises. The first requirement is not important, but 2 and 3 are. 5. Holding: Fair rental value is excludable. C. Scholarships & Awards a. Code Sections i. §74: Prizes & Awards 1. General rule: gross income includes amounts received as prizes and awards. ii. §117: Qualified Scholarships 1. General rule: gross income doesn’t include any amount received as a qualified scholarship by an individual who is a candidate for a degree at an educational organization described in section 170(b)(1)(A)(ii). b. Regulations i. §1.74-1: Prizes & Awards 1. Gross income includes all amounts received as prizes and awards, unless such prizes or awards qualify as an exclusion from gross income under subsection 74(b) or unless such prize or award is a scholarship or fellowship grant excluded from gross income by §117. 2. If the prize or award is not made in money but is made in goods or services, the fair market value of the goods or services is the amount to be included in income. ii. §1.117-1: Exclusion of amounts received as a scholarship or fellowship grant 1. Exclusion from income is determined by §117. iii. §1.117-3: Definitions 1. Scholarship – an amount paid or allowed to, or for the benefit of a student, to aid such individual in pursuing his studies. 2. Fellowship grant – an amount paid or allowed to, or for the benefit of, an individual to aid him in the pursuit of study or research. iv. §1.117-4: Items not Considered as Scholarships or Fellowship Grants 1. Any amount paid or allowed to, or on behalf of, an individual to enable him to pursue studies or research, if such amount represents either compensation for past, present, or future employment services or represents payment for services which are subject to the direction or supervision of the grantor. 2. Any amount paid to enable him to pursue studies or research primarily for the benefit of the grantor. v. §1.117-6: Qualified Scholarships (proposed) D. Damages a. Code Sections i. §61: Gross Income

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1. Gross income means all income from whatever source derived. ii. §104: Compensation for Injuries or Sickness 1. Gross income doesn’t include worker’s comp, damages received (except punitive), accident or health insurance amounts, pension or annuity amounts, or disability income. b. Regulations i. §1.104-1: Compensation for Injuries or Sickness c. Note i. In regards to damages, the law tries to put the plaintiff back where she would have been had the bad thing not happened. ii. Tax law requires the plaintiff to pay taxes on damages if plaintiff is put back in a position where she would’ve had to pay taxes anyway. 1. Examples: a. Employer breach’s employment contract i. Had breach not occurred, P would’ve been working and paying taxes on earnings so P must pay taxes on the damages received as substitute wages. b. P sues D for breaking vase i. Had vase not been broken, P would have an unbroken vase. By awarding P damages, P has cash instead. The conversion of a vase into cash looks like a sale and tax law treats it like one. P must pay tax on damages. c. P sues D for negligently running over him i. P loses his legs and is awarded damages for them. Had D not run over P, P would still have his legs. Having legs isn’t taxable, so P won’t pay taxes on his damages. ii. The rule is that any damages resulting from personal injury, except punitive damages, are tax free. 1. All damages for age discrimination, sex and racial discrimination, and libel are taxable. d. Case i. Amos v. Commissioner 1. Issue: Whether the $200,000 settlement that petitioner received in a settlement is excludable from gross income under §104(a)(2). 2. Facts: Petitioner was kicked by Dennis Rodman during a game in which Rodman fell into a group of photographers. They settled for $200K, which petitioner didn’t report on his tax return. Petitioner contends none should be reported because the entire amount was for the physical injuries he sustained. Commissioner contends that most of the settlement is income because petitioner failed to show how severe his injuries were and how much was for injuries. 3. Rule: The nature of the claim, physical injury or not, controls whether such damages are excludable under § 104(a)(2).

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4. Rationale: Rodman’s main reason for settling was petitioner’s physical injury claim, but he also paid petitioner not to defame Rodamn, disclose the terms of the agreement, publicize the incident, or pursue criminal prosecution of Rodman. These noninjury provisions amounted to $80K. 5. Holding: $120K is excludable and $80K is not. E. Tax Exempt Bonds a. Code i. §103(a): Interest on State and Local Bonds 1. Gross income doesn’t include interest on any state or local bond. 2. Exceptions: private activity non-qualified bonds, arbitrage bonds, and bonds not in registered form. b. The interest paid on most bonds issued by state and local governments is not taxable by the federal government.

Chapter 4: Business Deductions – Basic Principles A. General Notes a. Trade or business expenses get the best tax treatment. b. Code

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i. §162(a): Trade or Business Expenses 1. Allows a deduction for all he ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including salaries, personal compensation for services rendered, traveling expenses, and payments for rent. ii. §263: Capital Expenditures 1. A capital expense is an expense which is likely to generate income for more than one year. Such an expense should not be deductible in full in one year, but it should be spread out and matched with the income it generates. 2. No deduction shall be allowed for any amount paid out for new buildings or for permanent improvement or betterments made to increase the value of any property or estate. iii. §167: Depreciation 1. There shall be allowed as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear of property used in the trade or business, or of property held for the production of income. 2. Basis for calculating depreciation is that in §1011. iv. §168: Accelerated Cost Recovery System 1. The depreciation deduction provided by §167(a) shall be determined by using the applicable depreciation method, recovery period, and convention. c. Matching i. Expenses must be matched up with the income which they generate to allow for a fair net income tax. ii. Example: $500 machine generates $200 profits per year for 5 years and then dies. 1. Matching Method Year 1 2 3 4 5 $200 $200 $200 $200 $200 Income Expenses - $100 - $100 - $100 - $100 - $100 $100 $100 $100 $100 $100 Profits 2. Other Methods a. Flow of Cash Method Year 1 2 $200 $200 Income Expenses - $500 - $0 ($300) $200 Profits

3 $200 - $0 $200

4 $200 - $0 $200

5 $200 - $0 $200

b. Basis Method i. Basis is subtracted only at the end, when the asset is exchanged or discarded. Year 1 2 3 4 5 $200 $200 $200 $200 $200 Income - $0 - $0 - $0 - $500 Expenses - $0

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Profits

$200

$200

$200

$200

($300)

B. Welch and Its Progeny a. Code i. §162(a): Trade or business expenses (see above) ii. §262: Personal, living, and family expenses 1. No deduction shall be allowed for personal, living or family expenses. 2. Any charge for basic local phone service is a personal expense. b. Cases i. Welch v. Helvering 1. Issue: Whether payments by a taxpayer are allowable deduction in the computation of his income if made to the creditors of a bankrupt corporation in an endeavor to strengthen his own standing and credit. 2. Facts: Petitioner used to work for Welch but it went bankrupt. He got a new job with Kellogg, and to re-establish his relations with customers whom he had known when working for Welch, he paid some of Welch’s debts to those customers. The Commissioner contends these payments weren’t deductible from income as ordinary and necessary expenses, but were capital expenditures. 3. Rule: Ordinary and necessary expenses in the operation of a business are deductible from gross income. 4. Rationale: Petitioner’s payments may be necessary for his business with Kellogg, but they are not ordinary. It’s not ordinary for one to pay the debts of another without being required to. Here, his paying off debts amounted to capital – an investment in his future – but not an ordinary expense. 5. Holding: Affirmed. Not allowed as a deduction. ii. Fred W. Amend Co. v. Commissioner of Internal Revenue 1. Issue: Whether taxpayer’s payments to a Christian Science practitioner qualifies as business expenses and may be deducted from his income. 2. Facts: Amend hired a Christian Science practitioner to help with the company’s business problems and for employees to use when having personal problems that affected their work. Only Amend used the practitioner who gave no concrete business advice, but encouraged Amend to solve his problems through prayer and detaching himself from the problem. The Tax Court found the practitioner’s services to be personal and not business in nature, so it couldn’t be deducted as a business expense. 3. Rule: §162 provides for a deduction for ordinary and necessary business expenses. §262 prohibits deductions for personal expenses. 4. Rationale: The nature of the expense must not be personal for the expense to be considered a business expense under §162. Amend’s benefit was primarily personal, not business related.

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5. Holding: No, not a business expense. iii. Trebilcock v. Commissioner 1. Issue: Whether petitioner may deduct under §162(a) the amount he paid to a minister who provided spiritual advice to petitioner and his employee and performed business related-tasks. 2. Facts: Petitioner hired Wardrop, a minister, primarily to minister spiritually to petitioner and his employees, and perform some errands. Petitioner deduced the amount paid to Wardrop, $7020, as ordinary and necessary business expense. 3. Rule: Amend, Code §§162 & 262 4. Rationale: Amend says the prayer meetings are not a deductible expense because they are personal in nature. §262 says counseling for personal problems isn’t deductible. §162 says God given business solutions aren’t an “ordinary” expense. However, performance of business related tasks are deductible, and were valued at $1000. 5. Holding: Only $1,000 of $7020 paid is deductible as business expense. iv. Jenkins v. Commissioner 1. Issue: Whether payment made by petitioner to Twitty Burger’s investors is deductible as an ordinary and necessary business expense. 2. Facts: Conway Twitty is a country music entertainer who helped start a chain called Twitty Burger. The venture failed, and Conway decided to repay the investors their investment. The Commissioner contends this isn’t deductible because there was no business purpose for the payments because it has nothing to do with his being a country music entertainer. Petitioner contends that he wanted to protect his reputation and earning capacity as an entertainer. 3. Rule: §162 ordinary and necessary business expenses are deductible. 4. Rationale: In order to determine whether it’s deductible, the court looked at 1) the purpose of the taxpayer in making the payments and 2) whether there is a sufficient connection between the expenditures and the taxpayer’s business. The court found that the chain’s name and petitioner’s name affected petitioner’s business as a singer. 5. Holding: Yes, deductible as a business expense. 6. The IRS nonacquiesced to the decision; that means the IRS isn’t happy with the outcome, but it won’t appeal the court’s decision. C. Causation a. Proof i. It’s not enough to show that the taxpayer’s activities were ordinary and necessary business activities. One must also show that the expenses which

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the taxpayer seeks to deduct have the right kind of causal nexus to that business. b. Cases i. U.S. v. Gilmore 1. Issue: Whether husband-petitioner may deduct the costs of his divorce as business expense. 2. Facts: Husband owned controlling stock interests in GM. His wife filed for divorce, claiming that the interests were community property and she was entitled to ½ under CA law. Husband said the interests were his means of livelihood and if he were found guilty of infidelity, GM might cancel his franchises. Husband won divorce and deducted costs as a business expense. Government contends that the nature of the claims should determine whether they are business or personal expenses, not their consequences. 3. Rule: The origin and character of the claim with respect to which an expense was incurred, rather than its potential consequences upon the fortunes of the taxpayer, is the controlling basic test of whether the expense was business or personal. a. §212 allows for the deduction of ordinary and necessary expenses for the production of income or the maintenance of property held for the production of income. 4. Rationale: Husband’s expenditures were made in connection with a marital litigation and are not expenses incurred in carrying on trade or business under §162. 5. Holding: No, divorce costs may not be deducted as a business expense. ii. Kopp’s Company, Inc. v. U.S. 1. Issue: Whether payments made to settle a tort action are deductible as a business expense under §162(a). 2. Facts: Earl and Jean are Kopp Co.’s shareholders. Wayne is their son and employee. Wayne was involved in a car accident in which the victim filed suit against the company, parents, and Wayne. They settled with the Kopps paying $50K pus legal fees, which they deducted from their income tax return as a business expense. 3. Rule: §162(a); Origin of the Claim Doctrine determines whether expense was personal or business. 4. Rationale: Expense was business because Kopp Co. was named in the lawsuit and was potentially liable for negligent entrustment with the company car by letting Wayne drive. Kopp Co. paid the settlement amount to protect its assets. 5. Holding: Reversed. Yes, payments made to settle tort action are deductible because company’s involvement was substantial. 6. Dissent: Father loaned son company car for son’s personal use so the nature of the claim is personal, not business and the expenses shouldn’t be deductible under §162(a). D. Salary

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a. Code: i. §162(a)(1): Trade or Business Expense (see above) b. Regulation i. §1.162-7: Compensation for Personal Services 1. Provides for deductions for ordinary and necessary expenses paid for salaries or other compensation for personal services actually rendered. The test of deductibility in the case of compensation payments is whether they are reasonable and are in fact payments purely for services. c. Section Note i. A corporation may be tempted to disguise dividends as salary because a corporation is taxed on the income it earns and then the shareholder is taxed on the dividend it receives. However, if a corporation earns money and then pays it out as salary, the corporation will be taxed on the income but it can take a deduction for the salary as a business expense; the salary paid to the employee will be taxed to the employee as income. ii. Dividends = twice taxed, no deduction; salary = twice taxed, one deduction. d. Cases i. Exacto Spring Corp. v. Commissioner 1. Issue: Whether the salary Exacto paid its CEO Heitz was reasonable and purely for services as required under §162(a)(1) to be deductible as a business expense. 2. Facts: Heitz was paid $1.3 and $1 million in two years. Exacto had deducted the salary as a business expense. The IRS though this was excessive, that the corp. was paying dividends to Heitz in the form of salary. The Tax Court applied a 7 factor test that found for the IRS because it considered Heitz’s salary excessive compensation. 3. Rule: §162(a)(1); Market Test – goose that laid the golden egg; if the employee is producing such profits for the corp. as to deserve a high salary, it is reasonable to pay him one. 4. Rationale: Heitz’s performance resulted in an increase of expected profits to investors of Exacto of more than 50%. The expected return was 13% and he produced 20%. When the investors in a company are obtaining a far higher return than they had any reason to expect, the CEO’s salary is presumptively reasonable. The presumption of reasonableness is rebuttable, such as if the CEO was merely a figurehead and the company was actually being run and made profitable by someone else. 5. Holding: Yes, CEO’s salary is deductible as a reasonable business expense. ii. International Freighting Corp., Inc. v. Commissioner 1. Issue: Whether taxpayer realized a taxable gain when it transferred stock to its employees as a bonus after the stock’s value had increased.

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2. Facts: Corp’s basis was $16,153.35 and FMV was $24,858.75. Corp took a deduction for the latter, but the Commissioner reduced the deduction to the former. Commissioner alternatively contends that if the latter, the corp also realized a profit of $8,705.39 on the disposition of the shares and its taxable income should increase accordingly. 3. Rule: §1001 gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the adjusted basis. 4. Rationale: The corp’s basis is what the stock was initially bought for. The court found that the stocks were paid to the employees for consideration of their past services rendered, which were equivalent to the FMV of the stocks; if not equal, the bonuses would be invalid because the employees would be compensated more than their services were worth. The corp had a basis of $16,153.35 and an amount realized of $24,858.75, so it had a gain of $8,705.39 which is taxable. 5. Holding: Yes, taxpayer realized a taxable gain.

Chapter 5: Business Deductions – Capital Recovery and Depreciation A. Capital Expenses a. Business expenses may either be deducted or capitalized. Those that are deductible may be deducted from income immediately. Those that are capitalized are added to the basis of property and are only deducted when sold. b. Regulations

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i. §§1.263(a)-1 & 1.263(a)-2: Capital Expenditures and Examples 1. No deduction is allowed for a capital expenditure. Capital expenditures generally add to the value or substantially prolong the useful life of property or adapt the property to a new or different use. Capital expenditures are recovered through depreciation, amortization, cost of goods sold, as an adjustment to basis, or otherwise, at such time as the property to which the amount relates is used, sold or otherwise disposed of. 2. Examples include the cost of acquisition, construction or erection of buildings, machinery and equipment, furniture and fixtures, and similar property having a useful life substantially beyond the taxable year. c. Revenue Ruling i. 2001-4 1. Issue: Whether the costs incurred by a taxpayer to perform work on its aircraft airframe are deductible as ordinary and necessary business expenses under §162 or must be capitalized under §§263 and 263A. 2. Facts: FAA requires taxpayer to perform maintenance on its planes to if he wants to keep flying them. Plane 1 underwent routine maintenance. Plane 2 had a lot replaced. 3. Rule: Repair and maintenance expenses are incurred for the purpose of keeping the property in an ordinarily efficient operating condition over its probable useful life for the uses for which the property was acquired. Capital expenditures are for replacements, alterations, improvements, or additions that appreciably prolong the life of the property, materially increase its value, or make it adaptable to a different use. The characterization of any cost as deductible repair or capital improvement depends on the context in which the cost occurred. Where an expenditure is made as part of a general plan of rehabilitation, modernization, and improvement of the property, the expenditure must be capitalized. 4. Rationale: Plane 1’s repairs were only for keeping it in working condition whereas Plane 2’s repairs was a major overhaul, adding to the value and life of the plane. 5. Holding: Plane 1 may be treated as §162 expense and Plane 1 is treated as §263 expense. d. Cases i. Fall River Gas Appliance Company v. Commissioner 1. Issue: Whether the gas company’s expenditures in installing gas appliances was an ordinary business expense or capital expenditure. 2. Facts: Gas company installed gas heaters and burners in customers’ homes for lease; customers had the option of ending the lease or not using the appliance at all. Gas company argues

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that the nature of the installations and their lack of permanency dictate the existence of an ordinary business expense. 3. Rule: A capital expenditure is one that secures an advantage to the taxpayer which has a life of more than one year, and that the taxpayer must acquire something of permanent use or value in his business. 4. Rationale: The totality of the gas company’s expenditures was made in anticipation of a continuing economic benefit over a period of years and such is indicative of a capital expense. 5. Holding: Capital expenditure. ii. Norwest Corporation v. Commissioner 1. Issue: Whether taxpayer’s costs of removing the asbestos containing materials are currently deductible pursuant to §162 or must be capitalized pursuant to §263 or as a part of a general plan of rehabilitation. 2. Facts: Taxpayer planned on remodeling its bank building to accommodate additional personnel. Since it was already remodeling, it decided to remove the asbestos from the building as well. Taxpayer argues that the expenditures constitute §162 ordinary and necessary expenses. Commissioner contends the expenditures must be capitalized. 3. Rule: §263 requires taxpayers to capitalize costs incurred for permanent improvements, betterments, or restorations to property; these costs include expenditures that add to the value or substantially prolong the life of the property or adapt such property to a new or different use. §162 permits taxpayers to currently deduct the costs of ordinary and necessary expenses that neither materially add to the value of property nor appreciably prolong its life but keep the property in an ordinarily efficient operating condition. General Plan of Rehabilitation Doctrine – expenses incurred as part of a plan of rehabilitation or improvement must be capitalized even though the same expenses if incurred separately would be deductible as ordinary and necessary. 4. Rationale: The taxpayer’s removal of asbestos containing materials was required prior to remodeling because the remodeling would’ve disturbed the asbestos fibers. The projects weren’t separate; the cost must be capitalized because they were part of a general plan of rehabilitation. 5. Holding: Capitalized because part of a general plan of rehabilitation. iii. Indopco, Inc. v. Commissioner 1. Issue: Whether certain professional expenses incurred by a target corporation in the course of a friendly takeover are deductible by that corporation as ordinary and necessary business expenses under §162(a).

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2. Facts: National Starch incurred professional expenses of over $2 million paid to Morgan Stanley and National’s legal team during Unilever’s takeover of National Starch. National claimed a deduction for the $2 million bill, but not $500K legal expenses as an ordinary business expense. Commissioner disallowed the deduction. The tax court and court of appeals agreed with Commissioner because the transaction resulted in the long term benefit to National. 3. Rule: §162(a) allows the deduction of all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. §263 allows no deduction for a capital expenditure. 4. Rationale: Unilever’s acquisition of National Starch provided a long term benefit to National Starch that qualifies as a capital expenditure and not a business expense. National Starch changed its corporate structure for the benefit of its future operations. The expenses incurred were a part of that betterment. 5. Holding: No, not ordinary business expenses but capital expenditures. B. Depreciation a. Code i. §167(a), (c): Depreciation 1. There shall be allowed as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear of property used in the trade or business or of property held for the production of income. 2. The basis shall be the adjusted basis provided in §1011 for the purpose of determining gain on the sale or other disposition of such property. If any property is acquired subject to a lease, no portion of the adjusted basis shall be allocated to the leasehold interest and the entire adjusted basis shall be taken into account in determining the depreciation deduction. ii. §168(a)-(c): Accelerated Cost Recovery System 1. The depreciation deduction provided by §167(a) for any tangible property shall be determined by using the applicable depreciation method, the applicable recovery period, and the applicable convention. 2. See (b) for depreciation methods. 3. See (c) for applicable recovery periods. iii. §197: Amortization of goodwill and certain other intangibles iv. §263(a): Capital Expenditures 1. No deduction shall be allowed for any amount paid out for new buildings or for permanent improvement or betterments made to increase the value of any property or estate. b. Regulations

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i. §1.167(a)-1: Depreciation in General 1. A reasonable allowance shall be allowed as a depreciation deduction. ii. §1.167 (a)(2): Tangible Property 1. Depreciation allowance applies to that part of property which is subject to wear and tear and only to property used exclusively in a business. iii. §1.167 (a)-3: Intangibles 1. Patents and copyrights; the length of such as asset which can be estimated with reasonable accuracy may be subject to a depreciation allowance. iv. §1.167 (b)-1: Straight Line Method 1. The cost or other basis of the property less its estimated salvage value is deductible in equal annual amounts over the period of the estimated useful life of the property. 2. The allowance for depreciation for the taxable year is determined by dividing the adjusted basis of the property at the beginning of the taxable year, less salvage value, by the remaining useful life of the property at such time. v. §1.167 (g)-1: Basis for Depreciation 1. Basis upon which the allowance for depreciation is to be computed is the adjusted basis in §1011. 2. In the case of property which hasn’t been used in business and which thereafter is converted to such use, the FMV on the date of such conversion, if less than the adjusted basis of the property at that time, is the basis for computing depreciation. c. Depreciation Basics: Formulas i. Allowable Depreciation = Basis – Salvage Value ii. Straight Line Depreciation = Allowable Depreciation/Useful Life iii. §1016: For every $1 of depreciation taken, reduce the basis by $1. d. Cases i. Fribourg Navigation Co. v. Commissioner 1. Issue: Whether the sale of a depreciable asset for an amount in excess of its adjusted basis at the beginning of the year of sale bars deduction of depreciation for that year. 2. Facts: Taxpayer bought a ship for $469K. The adjusted basis for the ship after two years of deductions was $326,627.73. Taxpayer sold the ship for $695K. Taxpayer reported a capital gain of $504,239.51 after taking a depreciation allowance of $135,367.24. Commissioner contends that the deduction for depreciation in the year of sale of a depreciable asset is limited to the amount by which the adjusted basis of the asset at the beginning of the year exceeds the amount realized from the sale. 3. Rule: A decline in the market value of an asset is not necessary for a taxpayer to take a deduction on the wear and tear or decreased useful life of the asset.

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4. Rationale: Depreciation of an asset through wear and tear and fluctuations in the value of an asset through changes in market values are different concepts of tax accounting. 5. Holding: Depreciation deduction is allowed. ii. Harrah’s Club v. United States 1. Issue: Whether it is proper to deduct from gross income, as a current expense or as an allowance for depreciation, of the taxpayer’s costs of restoring antique cars. 2. Facts: Taxpayer’s business is an antique car museum. Taxpayer restores antique cars, and contends that the excess costs of restoring a vehicle over its market value should be either deductible as a business expense or depreciable over 5 or 10 years. 3. Rule: Once the useful life of an asset used in taxpayer’s business is determined to be indefinite, the asset can’t be given a salvage value as of the end of an estimated period of usefulness. Salvage is the amount realizable at the end of the useful life in the taxpayer’s business. Without a salvage value, there can be no allowance for depreciation 4. Rationale: The useful life of the restored vehicles is indefinite because no limit can be put on the use of vehicles as museum objects. 5. Holding: Depreciation deduction is not allowed. iii. Frontier Chevrolet Co. v. Commissioner 1. Issue: Whether Frontier must amortize the covenant not to compete under §197. 2. Facts: Roundtree owned a majority of Frontier’s stock. Frontier redeemed its stock from Roundtree, and paid Roundtree consideration for the non-compete covenant it entered into with Frontier. Frontier amortized the covenant payments under §197 but later filed a claim for refund asserting that the covenant should be amortized over the life of agreement and not pursuant to §197. 3. Rule: Any covenant not to compete entered into in connection with an acquisition in a trade or business is a §197 intangible and must be amortized over 15 years. 4. Rationale: By acquiring its own stock, Frontier acquired an interest in trade or business. The legislative history indicates that Congress intended to simply the treatment of intangibles by providing one period of amortization. 5. Holding: Yes, Frontier must amortize the covenant. C. Annuities, and Payment of Life Insurance Proceeds at a Date Later Than Death a. Code i. §72(a)-(c): Annuities; certain proceeds of endowment and life insurance contracts

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1. Gross income includes any amount received as an annuity, endowment, or life insurance contract. ii. §101(d): Certain Death Benefits 1. The amounts held by an insurer with respect to any beneficiary shall be prorated over the period with respect to which such payments are to be made. There shall be excluded from the gross income of such beneficiary in the taxable year received any amount determined by such proration. b. Regulations i. §1.72-1: Introduction 1. §72 provides that amounts received under a life insurance, endowment or annuity contract are includible in the gross income of the recipient except to the extent that they are considered to represent a reduction or return of premiums or other consideration paid. ii. §1.72-4: Exclusion Ratio 1. Ratio is determined by dividing the investment in the contract by the expected return under such contract. Any excess of the total amount received as an annuity during the taxable year over the amount determined by the application of the exclusion ration to such total amount shall be included in the gross income of the recipient for the taxable year of receipt. iii. §1.72-5: Expected Return 1. Expected return is determined by multiplying the total of the annuity payments to be received annually by the multiple shown in Table I or V of §1.72-9 under the age and sex of the measuring life. iv. §1.72-6: Investment in the Contract 1. The aggregate amount of premiums or other consideration paid for the contract reduced by the sum of the total amount of any return of premiums and the total of any other amounts received with respect to the contract which were excludable from the gross income of the recipient. v. §1.101-4(a): Payment of life insurance proceeds at a date later than death vi. §1.101-4(b): Amount held by insurer vii. §1.101-4(c): Treatment of payments for life to a sole beneficiary c. Annuities i. §72(a) provides that all annuity payments are included in gross income. ii. §72(b) sets up the exclusion ratio: 1. That part of any amount received = investment in the contract Such amount expected return Excluded from gross income is the number that is “that part of any amount received. The difference between that number and “such amount” is included in gross income.

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Chapter 6: Timing A. General Accounting Principles a. Code i. §446(a)-(c): General rule for methods of accounting 1. Taxable income may be computed by the following methods: a. Cash receipts and disbursements b. Accrual

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c. Any other method in this chapter or any combo of the above. ii. §451: General rule for taxable year of inclusion 1. The amount of any item of gross income shall be included in the gross income for the taxable year in which received by the taxpayer unless such amount is to be properly accounted for as of a different period. b. Regulations i. §1.446-1(c)(1)(i): Cash method 1. All items which constitute gross income are to be included for the taxable year in which actually or constructively received. Expenditures are to be deducted for the taxable year in which actually made. ii. §1.446-1(c)(1)(ii): Accrual method 1. Income is to be included for the taxable year when all the events have occurred that fix the right to receive the income and the amount of income can be determined with reasonable accuracy. iii. §1.451-2: Constructive Receipt 1. Income although not actually reduced to a taxpayer’s possession is constructively received by him in the taxable year during which it is credited to his account, set apart for hi, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given. c. Cases i. Hornung v. Commissioner 1. Issue: Whether taxpayer constructively received a car in 1961 or 1962. 2. Facts: Taxpayer was assessed a deficiency in income tax for 1962. Taxpayer was selected MVP and recipient of a Corvette in 1961 but didn’t receive the car until January 1962. Taxpayer contends that the car was constructively received in 1961, and that it isn’t involved in deficiency claim which is for 1962. 3. Rule: §451 provides the basis of constructive receipt is essentially unfettered control by the recipient over the date of actual receipt. 4. Rationale: Taxpayer didn’t have control over receipt of the car in 1961 because it was a Sunday, the car dealership was closed, and the car was in a different city. 5. Holding: Taxpayer received the car for income tax purposes in 1962 as reported in his 1962 return. ii. Ames v. Commissioner 1. Issue: When petitioner should have reported the income from his illegal espionage activities. 2. Facts: Petitioner sold secrets to the KGB in exchange for money. He contends he received most of the money in 1985,

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but the Commissioner contends the income was reportable in 1989-1992 when the deposits were made to his bank account. 3. Rule: Constructive receipt is the unfettered control over the date of actual receipt. There is no constructive receipt of income where delivery of the cash is not dependent solely upon the volition of the taxpayer. 4. Rationale: Even if the Russians had set aside an amount for petitioner to withdraw from in 1985, the Russians had control over it and would’ve had to gone to great lengths to get him the money. If the Russians were unhappy with petitioner’s work, they could’ve stopped paying him. Petitioner didn’t have control over the money in 1985. 5. Holding: Petitioner should’ve reported income from 1989-1992. d. Basis and Deferral i. Code 1. §109: Improvements by lessee on lessor’s property a. Gross income doesn’t include income other than rent derived by a lessor of real property on the termination of a lease, representing the value of such property attributable to buildings erected or other improvements made by the lessee. 2. §1019: Property on which lessee had made improvements a. Neither the basis nor the adjusted basis of any portion of real property shall, in the case of the lessor of such property, be increased or diminished on account of income derived by the lessor in respect of such property and excludable from gross income under §109. If an amount representing any part of the value of real property attributable to buildings erected or other improvements made by a lessee in respect of such property was included in gross income of the lessor for any taxable year, the basis of each portion of such property shall be properly adjusted for the amount so included in gross income. 3. §166(b): Bad Debts a. Amount of deduction: for purposes of subsection (a), the basis for determining the amount of the deduction for any bad debt shall be the adjusted basis provided in §1011 for determining the loss from the sale or other disposition of property.

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Chapter 7: Capital Gains A. Definition a. A capital gain occurs when you realize a gain on the sale or exchange of a capital asset. b. Long-term capital gains i. Occur when you have held your capital asset for more than one year before you sold it. B. Policy, Mechanics

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a. Gains i. Merchant’s Loan & Trust Co. v. Smietanka 1. Made it clear that capital gains are taxable income. ii. Gray v. Darlington (bad law but good background) 1. Issue: Whether the advance in the value of the bonds, during this period of four years, over their cost, realized by their sale, was subject to taxation as gains, profits, or income of the plaintiff for the year in which the bonds were sold. 2. Facts: Taxpayer owned U.S. treasury notes and exchanged them for U.S. five-twenty bonds. 3 years later, he sold them at an advance of $20,000 over the cost of the treasury notes. Assessor assessed a tax of 5% alleging it to be gains, profits, and income of the plaintiff for that year. Taxpayer paid the tax and seeks to recover the tax paid. 3. Rule: The general rule is that there shall be a tax collected annually upon the gains, profits and income of every person which is to be assessed, collected and paid for the year ending the 31st of December next, preceding the time for collecting and paying such tax. Exception: regarding profits upon sales of real property, requiring in the estimation of gains, the profits of such sales to be included where the property has been purchased not only within the preceding year but within the two previous years. 4. Rationale: In the estimation of gain of any one year the trader and merchant will often be compelled to include the amount received upon goods sold over their cost, which were purchased in a previous year. 5. Holding: Affirmed. Yes, subject to taxation as gains. iii. Note: 1. Reasons why capital gains are treated differently from ordinary income: a. Bunching i. The appreciation of an asset happens gradually. Bunching describes the total appreciation at the time the asset was sold (realized appreciation). Bunching causes appreciation to be allotted to the year in which the asset was sold as opposed to allotting it gradually each year. ii. Bunching causes a taxpayer to be pushed into a higher bracket that he normally is in. b. Inflation i. Decrease in the value of the dollar. ii. The price of an asset may increase not because of any increase in its real value but because the price of everything has gone up due to the decrease in the value of the dollar.

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c. Investment Incentive i. The lower the tax on the gain from investment, the less deterred investors will be from investing. ii. Lock-in Effect 1. Hinders the liquidity of investment by making investors less willing to shift their money out of unproductive investments into more productive ones because they will have to pay tax on the capital gain when they sell. b. Losses i. Congress placed restrictions on the ability of taxpayers to bunch too many losses into any one year. Otherwise, a taxpayer could wait to sell an asset that has decreased in value when she has a lot of income and few deductions, then she will realize the loss and wipe out some of that income. C. Mechanics a. Code i. §1(h): Maximum capital gains rate 1. If a taxpayer has a net capital gain for any taxable year, the tax imposed by this section for such taxable year shall not exceed the sum of a tax computed at the rates and in the same manner as if this subsection had not been enacted on the greater of: a. Taxable income reduced by the net capital gain; or b. The lesser of: i. The amount of taxable income taxed at a rate below 25%; or ii. Taxable income reduced by the adjusted net capital gain. ii. §1211: Limitation on capital losses 1. Corporations a. Losses from sales or exchanges of capital assets shall be allowed on to the extent of gains from such sales or exchanges. 2. Other Taxpayers a. Losses from sales or exchanges of capital assets shall be allowed only to the extent of the gains from such sales or exchanges, plus (if such losses exceed such gains) the lower of : i. $3,000 ($1500 in the case of a married individual filing a separate return), or ii. The excess of such losses over such gains. iii. §1212(b): Capital loss carrybacks and carryovers – Other taxpayers 1. If a taxpayer has a net capital loss for any taxable year, the excess of the net short term capital loss over the net long term capital gain for such year shall be a short term capital loss in the

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succeeding taxable year, and the excess of the net long term capital loss over the net short term capital gain for such year shall be a long term capital loss in the succeeding taxable year. iv. §1221: Capital asset defined 1. Property held by the taxpayer but does not include: a. Stock in the trade or inventory of the taxpayer or property held for sale to customers in the ordinary course of his business. b. Property subject to a depreciation allowance, a copyright, accounts or notes receivable, a publication of the U.S. government, any commodities derivative financial instrument, hedging transaction, and supplies used in the taxpayer’s business. v. §1222: Other terms relating to capital gains and losses 1. Provides a list of definitions for different gains and losses. D. What is a Capital Asset? a. See §1221. b. Byram v. U.S. i. Issue: Whether taxpayer held his properties for investment (and therefore are capital assets) and not for sale in the ordinary course of his trade or business. ii. Facts: Taxpayer wasn’t a real estate broker. He sold seven pieces of real property resulting in a profit of $2.5 million. Taxpayer argues the profit should be treated as a capital gain because the properties were capital assets. The government argues that taxpayer intended to hold the properties for sale in the ordinary course of business, therefore not capital assets. iii. Rule: Capital assets are entitled to favorable tax treatment. A capital asset is property held by the taxpayer not including property held primarily for sale to customers in the ordinary course of the taxpayer’s trade or business. iv. Rationale: To determine the purpose of taxpayer’s reason for holding the properties, the court looked at the seven pillars of capital gains treatment aka Winthrop Factors: 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 exercised by the taxpayer over any representative selling the property; and 7. The time and effort the taxpayer habitually devoted to the sales.

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v. Holding: Held for investment so treated as capital assets and subject to favorable capital gains tax treatment. Affirmed. c. Hollis v. U.S. i. Issue: Whether oriental art objects sold by the partnership of Hollis were capital assets or property held primarily for sale to customers in the ordinary course of business within the meaning of §1221. ii. Facts: Plaintiff was an art curator who formed two syndicates with his friends for buying and selling Japanese art objects. Plaintiff contends that the art objects are capital assets while the government contends that they are property held primarily for sale in the ordinary course of business. iii. Rule: §1221 iv. Rationale: Hollis No. 1 was a business venture whose stated purpose was acquiring an investment, but objects acquired were sold immediately. Hollis No. 2 not only acquired and sold objects, but continuously replenished its inventory upon sales. The market is so small for such sales that advertising wasn’t necessary. v. Holding: Oriental art objects were held for sale. Found for government. E. Corn Products Doctrine a. Corn Products Refining Company v. Commissioner i. Issue: Whether Corn Products’corn commodity futures are capital asset transactions under §1221. ii. Facts: Corn Products manufactures corn products, and to prevent paying high prices during possible future corn shortages, it bought corn futures. Corn Products contends that these futures were capital assets distinct from its manufacturing business and that the gains and losses therefrom should be treated as from the sale of a capital asset. iii. Rule: §1221’s preferential treatment applies to transactions in property which are not the normal source of business income. iv. Rationale: Corn Products’ futures activity wasn’t separate from its manufacturing operation but was insurance against increases in the price of raw corn. v. Holding: Corn commodity futures are not capital assets when bought as insurance in the corn business. b. Arkansas Best Corporation v. Commissioner i. Issue: Whether capital stock held by petitioner Arkansas Best is a capital asset as defined in §1221 regardless of whether the stock was purchased and held for a business purpose or for an investment purpose. ii. Facts: Arkansas Best held bank stock which it sold for a loss of nearly $10 million which it deducted as an ordinary loss on its tax return. Commissioner disallowed the deduction, finding the loss to be a capital loss and subject to capital loss limitations. Tax Court found the loss to be an ordinary loss and the Court of Appeals reversed. iii. Rule: §1221 doesn’t exclude stock from being a capital asset.

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iv. Rationale: A taxpayer’s motivation in purchasing an asset is irrelevant to the question whether the asset is property held by a taxpayer and is thus within §1221’s general definition of capital asset. v. Holding: Stock was a capital asset so loss was a capital loss. Affirmed.

Chapter 8: Mixed Personal and Business, Investment Deductions A. Travel, Meals, & Entertainment a. Travel b. Code i. §162(a)(2): Trade or Business Expenses 1. There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including traveling expenses (including amounts expended for meals and lodging other than

36

amounts which are lavish or extravagant under the circumstances) while away from home in the pursuit of a trade or business. ii. §274(a), (c), (d), (e), (g), (h), (k), (l), (m), (n): Disallowance of certain entertainment, etc., expenses 1. (a) Entertainment, amusement or recreation 2. (c) Certain foreign travel 3. (d) Substantiation required for deduction or credit. 4. (e) Specific exceptions to (a) 5. (g) Treatment of entertainment, etc., type facility: as an asset which is used for personal, living, and family purposes (and not as an asset used in trade or business). 6. (h) Attendance at conventions 7. (k) Business meals 8. (l) Additional limitations on entertainment tickets 9. (m) Additional limitations on travel expenses 10. (n) Only 50% of meal and entertainment expenses allowed as deduction iii. §67(a): 2% floor on miscellaneous itemized deductions 1. In the case of an individual, the miscellaneous itemized deductions for any taxable year shall be allowed only to the extent that the aggregate of such deductions exceeds 2% of adjusted gross income. iv. §67(b) 1. Defines miscellaneous itemized deductions c. Regulations i. §1.162-2: Traveling Expenses ii. §1.274-1: Disallowance of certain entertainment, gift and travel expenses iii. §1.274-2: Disallowance of deductions for certain expenses for entertainment, amusement, recreation, or trust 1. An objective test is used to determine whether an activity is considered entertainment, but the taxpayer’s business will also be considered. iv. §1.274-4: Disallowance of certain foreign travel expenses v. §1.274-5T: Substantiation requirements d. Revenue Ruling 99-7: Commuting i. General rule: daily transportation expenses incurred in going between a taxpayer’s residence and a work location are nondeductible commuting expenses. ii. A deduction is allowed for daily transportation expenses incurred in going between the taxpayer’s residence and a temporary work location outside where the taxpayer lives and normally works if 1) the taxpayer has one or more regular work locations away from the taxpayer’s residence or 2) if the taxpayer’s residence is also the taxpayer’s principal place of business.

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e. Cases i. Green v. Commissioner 1. Issue: Whether taxpayer should be allowed a deduction for travel expenses associated with donating blood. 2. Facts: Taxpayer’s primary source of income was from her activity as a blood plasma donor. She was reimbursed $5 per trip, agreed that was income, but claimed that she should be allowed to deduct the same amount as a business expense. Commissioner contends it was a personal commuting expense and thus disallowed it. 3. Rule: Business expenses are deductible and personal expenses are not; commuting expenses are personal expenses and therefore not deductible. 4. Rationale: Petitioner didn’t commute to the blood lab but transported her blood in the container that was she. Had she been able to extract her blood and ship it, the shipping expense would be deductible as a business expense so her trips to the lab should be taken as business expenses. 5. Holding: Deduction allowed. ii. U.S. v. Correll 1. Issue: Whether taxpayer’s meals on his daily trips were traveling expenses incurred in the pursuit of his business while away from home under §162(a)(2). 2. Facts: Taxpayer was a traveling salesman who made daily trips during which he ate breakfast and lunch on the road and returned home by dinner. He tried to deduct the cost of his meals under §162(a)(2) but the Commissioner disallowed the deductions as personal living expenses under §262. 3. Rule: §162 allows for a deduction for the cost of meals and lodging away from home; §262 makes personal, living, or family expenses nondeductible. 4. Rationale: Commissioner has long maintained that a taxpayer traveling on business may deduct the cost of his meals only if his trip requires him to stop for sleep or rest. §162 speaks of “meals and lodging” as a unit, suggesting that a meal deduction is allowed only where the travel involves lodging. Congress may have intended that only taxpayers who incur higher living expenses as a direct result of his business travels should be permitted to deduct their living expenses (meals & lodging) while on the road. 5. Holding: Meals were personal living expenses, and not deductible as business expenses. iii. Hantzis v. Commissioner 1. Issue: Whether taxpayer should be allowed to deduct the traveling expense she incurred due to temporary summer employment.

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2. Facts: Taxpayer was a law student who lived in Boston and had summer employment in NYC. She deducted on her tax return her transportation, apartment, and meal expenses in NYC. Commissioner denied the deduction on the ground that the taxpayer’s home was her place of employment and therefore the traveling expenses weren’t incurred while away from home & that the expenses weren’t incurred in the pursuit of a trade or business. 3. Rule: Whether a deduction is allowed or not is the reason why a taxpayer maintains two homes. If the reason is personal, the taxpayer’s home will be held to be his place of employment and the deduction will be denied. If the reason is business, the person’s home will usually be held to be his residence and the deduction will be allowed. 4. Rationale: Taxpayer’s trade or business didn’t require that she maintain two homes. She maintained her Boston home because of her husband and maintained her NYC apartment for her summer job. Her decision to keep 2 homes was a personal choice not business. Therefore, her home under §162(a)(2) was NYC, and her expenses were not incurred while away from home. 5. Holding: Deduction for traveling expenses not allowed. iv. Andrews v. Commissioner 1. Issue: Whether Andrews may deduct his Florida house as a business lodging expense under §162(a)(2). 2. Facts: Andrews resided in Massachusetts with his wife where he ran a pool business. He established a horse racing stable which he eventually moved to Florida. He bought a house in FL where he lived during the racing season. He claimed all of his FL house as business usage on his tax return, and deducted furniture, tax, mortgage interest, utilities, and insurance as lodging expenses. Commissioner contends that Andrews’ FL home is his tax home and that the FL meals and lodging were personal and nondeductible living expenses. 3. Rule: a. §162(a)(2) provides that travel expenses are deductible only if 1) reasonable and necessary, 2) incurred while away from home and 3) incurred in pursuit of business. b. Whether it is held in a particular decision that a taxpayer’s home is his residence or his principal place of business, the ultimate allowance or disallowance of a deduction is the reason for a taxpayer’s maintenance of two homes. c. Living expenses duplicated as a result of business necessity are deductible, whereas those duplicated as a result of personal choice are not.

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4. Rationale: A taxpayer’s home is his major post of duty; his major post of duty is determined by where the greatest length of time spent engaged in business occurs. Andrews had two businesses, one in MA and one in FL, that required him to duplicate his living expenses. 5. Holding: Deductions for duplicate living expenses allowed. Remanded. f. Revenue Ruling 93-86 i. Issue: What effect does the 1-year limitation on temporary travel, as added by §1938 of the Energy Policy Act of 1992 have on the deductibility of away from home travel expenses under §162(a)(2). ii. Facts: Taxpayer A is regularly employed in City 1, accepted work in City 2 which A realistically expected to be completed in 6 months. Taxpayer B realistically expected the work in City 2 to be completed in 18 months but it was completed in 10 months. Taxpayer C realistically expected the work in City 2 to be completed in 9 months, but after 8 months, C was asked to stay for an additional 7 months for a total of 15 months. iii. Rule: §162(a)(2): a. If employment away from home in a single location is realistically expected to last (and does in fact last) for 1 year or less, the employment is temporary. b. If employment away from home in a single location is realistically expected to last for more than 1 year or there is not realistic expectation that the employment will last for 1 year or less, then employment is indefinite regardless of whether it actually exceeds 1 year. c. If employment is realistically expected to last for 1 year or less, but at some later date the employment is realistically expected to exceed 1 year, that employment is temporary until the date that the taxpayer’s realistic expectation changes. iv. Rationale: (a) A’s travel expenses paid or incurred in City 2 are deductible. (b) B’s travel expenses paid or incurred in City 2 are nondeductible. (c) C’s travel expenses paid or incurred in City 2 during the first 8 months are deductible, but the expenses thereafter are nondeductible. v. Holding: Effect of 1-year requirement is that if it’s expected to be less than 1 year, it’s deductible; if expected to be greater than 1 year, it’s not. b. Meals, Entertainment, Clothing i. Cases

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i.

ii.

iii.

Moss v. Commissioner a. Issue: Whether taxpayer could deduct the law firm’s lunch meetings as an ordinary business expense under §162. b. Facts: Taxpayer was partner in a law firm that held lunch meetings at a restaurant. The firm paid for the lunch and sought to deduct the expense under §162. Commissioner disallowed it, claiming the lunches were personal, not business, expenses. c. Rule: Daily meals are an inherently personal expense, and the taxpayer bears a heavy burden in proving they are routinely deductible. d. Rationale: While the meetings were ordinary and necessary to the law firm’s partnership, the lunches were personal expenses under §262. Although the lunch meeting was an extra hour of work, this is no different from an attorney spending the lunch hour reading up on a case on his own. e. Holding: No, lunches aren’t deductible under §162. Danville Plywood Corp. v. U.S. a. Issue: Whether the corporation’s Super Bowl Weekend expense was deductible under §162. b. Facts: Danville Corp. was run by Buchanan. He invited his employees, family, friends, and customers to Super Bowl Weekend and paid for the trip. He deducted the expenses on his tax return, but the Commissioner disallowed it. c. Rule: §274 disallows deductions for entertainment expenses otherwise deductible under §162 as ordinary and necessary business expenses unless taxpayer establishes the item was directly related to or associated with the active conduct of the taxpayer’s trade or business. d. Rationale: Danville failed to satisfy its burden of proof that the Super Bowl expenses were ordinary and necessary business expenses under §162. Danville failed to show they had a real sales pitch while entertaining customers at the Super Bowl so the event was entertainment rather than business. e. Holding: No, Super Bowl Weekend not deductible. Pevsner v. Commissioner a. Issue: Whether taxpayer’s clothing purchases for work are deductible as ordinary and necessary business expenses under §162. b. Facts: Taxpayer worked at YSL boutique and had to wear YSL clothes which were very expensive. She deducted $990 on her joint federal income tax return for her clothing purchases. In tax court, she claimed $1621.91, the total

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c.

d.

e. f.

cost of the clothing and upkeep, and was allowed the deduction. Commissioner appeals. Rule: Clothing expense is deductible as a business expense only if: 1) the clothing is of a type specifically required as a condition of employment; 2) it is not adaptable to general usage as ordinary clothing; and 3) is not so worn. Rationale: Tax court applied a subjective test and allowed deduction because YSL clothes weren’t appropriate for taxpayer’s plain lifestyle. However, Court of Appeals determined objective test, whether clothing is generally accepted for ordinary street wear, should be used instead. Holding: Reversed. Clothing expense not deductible. Class Notes  YSL should pay taxpayer a higher salary or give her a greater employee discount to make up for the fact that she doesn’t get to deduct her clothes under §162.

B. Deductions for Education a. Code i. §274(m)(2): Additional limitations on travel expenses i. No deduction shall be allowed under this chapter for expenses for travel as a form of education. b. Regulations i. §1.162-5: Expenses for Education i. Expenses for education are deductible as ordinary and necessary business expenses if the education a. Maintains or improves skills required by the individual in his employment or other trade or business, or b. Meets the express requirements of the individual’s employer, or the requirements of applicable law or regulations. ii. Nondeductible educational expenditures a. Expenditures made for education which is required in order to meet the minimum educational requirements for qualification in employment or other trade or business. b. Expenditures made for education which will lead to qualifying in a new trade or business. c. Cases i. Coughlin v. Commissioner i. Issue: Whether taxpayer could claim his expenses for attending a tax seminar as an ordinary and necessary business expense under §162. ii. Facts: Taxpayer was a tax attorney who attended the Institute on Federal Taxation to keep abreast of changes in tax law for his firm. He incurred $305 in expenses which he sought to deduct but the Commissioner denied the deduction saying it was personal. iii. Rule: Education expenses made for the purpose of maintaining or improving skills for business or trade are deductible.

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Rationale: Taxpayer was morally bound to keep informed of tax law and the seminar was a useful way to maintain his tax knowledge. v. Holding: Deduction is allowed. vi. Class Notes: IRS wanted to disallow deduction because the attorney traveled from Binghamton, NY to NYC for the seminar, stayed in a hotel, and undoubtedly engaged in personal entertainment activities while he was there. ii. Hudgens v. Commissioner i. Issue: Whether taxpayer is entitled to deduct as educational expenses costs incurred obtaining a L.L.M. in tax under §162. ii. Facts: Taxpayer was in the National Guard. He attended law school and received his J.D. and a masters in tax. He obtained his L.L.M. while unemployed. He claimed employee business expense deductions for the cost of obtaining his L.L.M. Commissioner disallowed the deduction. iii. Rule: “Hiatus Principle” – an unemployed taxpayer may be considered to be carrying on a trade or business if the taxpayer was previously involved in and intended to return to a particular trade or business. iv. Rationale: Taxpayer’s employment at Arthur Andersen, where he prepared tax returns, and at STC, where he managed client’s assets, were different trades or businesses. v. Holding: No, cost of L.L.M. may not be deducted. vi. Class Notes: Taxpayer’s LLM was not an ordinary or necessary business expense in carrying on a trade or business as a tax preparer/asset manager. iii. Sharon v. Commissioner i. Issue: Whether taxpayer may deduct as a business expense “dues and professional expenses” and the cost of admission to practice before the U.S. Supreme Court. ii. Facts: Taxpayer is a licensed NY attorney. He moved to CA for his new job and became licensed in CA, was admitted before the District Court of CA, and the U.S. Supreme Court. None of this was required by his new job. Commissioner denied deductions. iii. Rule: Capital expenditures are amortizable. iv. Rationale: Taxpayer’s NY license fee, CA bar exam fee, admission fee to practice before CA federal courts, and travel expenses incurred to practice before the U.S. Supreme Court are capital expenditures and therefore not deductible under §162 but are amortizable over petitioner’s life expectancy. v. Holding: No business deduction but may be amortized. vi. Class Notes: No deduction for getting admitted to another state to practice law. d. Tax Incentives for Education i. Code

iv.

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i.

§25A: Hope and Lifetime Learning Credits a. For each eligible student, the credit is the sum of 100% of the qualified tuition and fees paid by the taxpayer during the taxable year which do not exceed $1000, and 50% of the next $1000 of such expenses (another $500). The threshold is modified adjusted gross income of $40,000 for single taxpayer and $80,000 for a joint return. The credit is reduced in the ratio of the MAGI in excess of the threshold. b. Formula: Amount of reduction = Excess of MAGI over threshold Otherwise allowance credit $10,000 [$20,000 joint return] c. Example: Single taxpayer incurs over $2000 in qualified tuition and related expenses. Her modified adjusted gross income is $45,000. Amount of reduction is $175. $175 = $45,000 - $40,000 $1500 $10,000

d. Lifetime Learning Credit Equal to 20% of so much of the qualified tuition and related expenses paid by the taxpayer during the taxable year which do not exceed $10,000. Student need not be enrolled half-time and the credit may be claimed for an unlimited number of years. ii. §529: Qualified Tuition Programs iii. §530: Coverdell education savings accounts ii. Regulations i. §1.221-1 a. Interest on qualified education loans is deductible up to $2500 per year. The threshold is MAGI of $50,000 or $100,000 for joint returns. b. Formula Amount of reduction = Excess of MAGI over threshold Otherwise allowable deduction $15,000 C. Expenses for the Production of Income a. Code i. §212: Expenses for Production of Income i. In the case of an individual, there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year – a. For the production or collection of income; b. For the management, conservation, or maintenance of property held for the production of income; or c. In connection with the determination, collection, or refund of any tax.

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ii. §165(c)(2): Losses – Limitation on losses of individuals In the case of an individual, the deduction under (a) shall be limited to losses incurred in any transaction entered into for profit, though not connected with trade or business; iii. §167(a)(2): Depreciation i. General rule – there shall be allowed as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear (including a reasonable allowance for obsolescence) – of property held for the production of income. b. Regulations i. §1.212-1: Nontrade or nonbusiness expenses i. An expense may be deducted under §212 only if it has been paid or incurred by the taxpayer during the taxable year for 1) the production or collection of income, 2) for the management, conservation, or maintenance of property held for the production of such income, or 3) in connection with the determination, collection, or refund of any tax , AND it is an ordinary and necessary expense for any of the purposes stated above. c. Cases i. Higgins v. Commissioner i. Issue: Whether expenses the taxpayer incurred as a result of managing his investments are deductible under §162 as ordinary and necessary business expenses. ii. Facts: Petitioner lived in France and his financial affairs were conducted in New York. Petitioner kept careful watch over his investments and tried to deduct the expenses in doing so on his 1932 and 1933 returns. Commissioner denied deductions saying taxpayer’s activities weren’t carrying on a trade or business. iii. Rule: Mere personal investment activities never constitute carrying on a trade or business, no matter how much of one’s time or one’s employee’ time they may occupy. iv. Rationale: Taxpayer merely kept records and collected interest and dividends from his securities through managerial attention for his investments. v. Holding: No, not deductible. vi. Case Note: Congress was unhappy with Higgins so it enacted §212 to ensure that such expenses were deductible. vii. Class Notes: This case is about whether Higgins could deduct expenses for running an office that managed his investments. However, expenses are deductible to the extent that they are attributable to a trade or business. The real estate operation was a trade or business. Expenses incurred by managing his stocks and bonds was not a trade or business. ii. Horrmann v. Commissioner i. Issues: Whether petitioner is entitled to a deduction for depreciation on the property; whether petitioner is entitled to a

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deduction for expenses incurred during the taxable years for the maintenance and conservation of the property under §167(a)(2); whether petitioner is entitled to a deduction for a long term capital loss arising from the sale under §165(c)(2). ii. Facts: Petitioner inherited house from mother, spent $9K fixing it up, lived in it then tried to rent it/sell it for two years before it was sold. iii. Rule: Petitioner is entitled to a deduction for depreciation provided the property was held for the production of income which is determined by looking at how the property was used and how it was intended to be used. Petitioner is entitled to a deduction for expenses if the property was held for the production of income. Petitioner is entitled to a deduction for a long term capital loss if the transaction was entered into for profit. iv. Rationale: Petitioner attempted to rent the property so it was found the property was held for the production of income, and therefore, petitioner is entitled to a deduction for depreciation and expenses. Petitioner instructed an agent to rent/sell the property which isn’t enough to show that he entered into a transaction for profit because it remained a personal residence. v. Holding: Entitled to depreciation and expenses deduction but not long term capital loss deduction. D. Business Use of Homes a. Code i. §280(A) i. No deduction shall be allowed for personal dwelling units used by the taxpayer as a residence. Exception: business use of the home, including the home office and the time-sharing rental possibilities. Limited to the extent that they wipe out the income attributable to one’s home. b. International Artists, Ltd. v. Commissioner; Liberace v. Commissioner i. Issue: Whether Liberace’s home may be deducted as a business expense. ii. Facts: Liberace is an entertainer signed on with International who provided him with a home. The home was lavish and used for business purposes but Liberace also lived there. iii. Rule: §280A wasn’t enacted yet but would probably allow deductions for those portions of the home used for business purposes. iv. Rationale: Liberace’s home was his residence and although business was done there, a lot of personal living was done there, too, so a court would not be likely to grant a complete deduction. v. Holding: I don’t know. c. Commissioner v. Soliman i. Issue: What is the appropriate standard for determining whether an office in the taxpayer’s home qualifies as his principal place of business under §280A(c)(1)(A).

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ii. Facts: Taxpayer was an anesthesiologist who practiced at hospitals and maintained a home office where he worked for a few hours per day. Taxpayer claimed deductions for the portion of his home, utilities, and depreciation attributable to his home office but Commissioner disallowed those deductions saying the home office was not his principal place of business. iii. Rule: Appellate Court’s Test – where management or administrative activities are essential to the taxpayer’s trade or business and the only available office space is in the taxpayer’s home, the home office can be his principal place of business with the weighing of the following factors: 1) the office in the home is essential to the taxpayer’s business; 2) he spends a substantial amount of time there; and 3) there is no other location available for performance of the office functions of the business. iv. Rationale: The Supreme Court rejected the lack of an alternative place to conduct management or admin activities but looked to the time spent by the taxpayer at the home office, and what important business activities took place there. Taxpayer was a doctor whose important activities and most of his time was spent at the hospital. v. Holding: Not principal place of business so no deduction. E. Activities Not Engaged in For Profit a. Code: i. §183: Activities Not Engaged in For Profit i. In the case of an activity engaged in by an individual, if such activity is not engaged in for profit, no deduction attributable to such activity shall be allowed under this chapter except as provided in this section. ii. In the case of an activity not engaged in for profit, there shall be allowed the deduction which would be allowable under this chapter for the taxable year without regard to whether or not such activity is engaged in for profit, and a deduction equal to the amount of the deductions which would be allowable under this chapter for the taxable year only if such activity were engaged in for profit, but only to the extent that the gross income derived from such activity for the taxable year exceeds the deductions allowable. b. Regulations: i. §1.183-1: Activities not engaged in for profit ii. §1.183-2: Activity not engaged in for profit defined i. Any activity other than one with respect to which deductions are allowable for the taxable year under 62 or under paragraphs (1) or (2) of §212. c. Cases i. Dreicer v. Commissioner i. Issue: Whether taxpayer should be allowed to deduct the losses from writing and lecturing activities under §183.

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ii.

iii.

iv.

v.

Facts: Tax Court disallowed deductions for losses from writing and lecturing as a multimedia personality because taxpayer had no bona fide expectation of realizing a profit. Rule: A taxpayer claiming a deduction under §§162 or 212 for an expense, or under §165 for a loss must show an associated profit motive in order to avoid the disallowance provision, §183, for activities not engaged in for profit. Rationale: Tax Court used the reasonable profit expectation test rather than the profit objective test to determine whether taxpayer was engaged in a business or a hobby. Deduction should be allowed if the taxpayer engaged in the activity with the objective of making a profit. Holding: Reversed and remanded. Taxpayer engaged in activity for profit and deduction for losses is allowed.

F. Child Care Expenses a. Code: i. §21: Expenses for household and dependent care services necessary for gainful employment i. There shall be allowed as a credit an amount equal to the applicable percentage of the employment-related expenses paid during the taxable year when the taxpayer has at least one qualifying individual. b. Regulations i. §1.44A-1: Expenses for household and dependent care services necessary for gainful employment i. Expenses are considered to be employment-related expenses only if they are incurred to enable the taxpayer to be gainfully employed and are paid for household services or for the care of one or more qualifying individuals. c. Cases i. Wright Smith v. Commissioner (1940) i. Issue: Whether childcare expenses are deductible. ii. Rationale: Children are a personal concern. iii. Holding: Childcare expenses are personal and not deductible. ii. Symes v. Canada (dissent) i. While the decision to have children is a choice, it is burden primarily on women. The legal profession discriminates against women for having children. A woman’s ability to work is dictated by her ability to find childcare. Childcare expenses should be deductible. iii. Zoltan v. Commissioner i. Issue: Whether petitioner’s summer camp expenses and Washington D.C. expenses qualified as childcare expenses and were deductible under §21.

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ii.

iii.

iv.

v.

Facts: Petitioner was away from home for 55 hours a week due to work. She incurred $1180 for her son’s summer camp expenses and $116 for his trip to D.C. Rule: §21 provides a credit to a taxpayer for child care expenses incurred when the taxpayer has a qualifying dependent; expenses must be incurred for the purpose of allowing the taxpayer to work and for the protection and well-being of the dependent. Rationale: If the disputed expense was incurred with the dominant purpose of permitting the taxpayer to be gainfully employed and to assure the child’s well-being and protection while the taxpayer is so employed, it qualifies as employment-related despite the existence of other incidental benefits. Holding: Yes; summer camp expense is deductible; only part of D.C. trip is deductible because trip was mostly educational.

G. Interest a. Code: i. §163(a): Interest – General Rule i. There shall be allowed as a deduction all interest paid or accrued within the taxable year on indebtedness. ii. §163(h): Disallowance of deduction for personal interest i. No deduction shall be allowed for personal interest paid or accrued during the taxable year. iii. §265: Expenses and interest relating to tax-exempt income i. No deduction shall be allowed for any amount other than interest that is wholly exempt from taxes imposed by this subtitle or any amount otherwise allowable under §212 which is allocable to interest wholly exempt from the taxes imposed under this subtitle. ii. No deduction shall be allowed for interest on indebtedness incurred or continued to purchase or carry obligations the interest on which is wholly exempt from the taxes imposed by this subtitle. iv. §221: Interest on Education Loans i. There shall be allowed as a deduction for the taxable year an amount equal to the interest paid by the taxpayer during the taxable year on any qualified education loan. v. §7872: Treatment of loans with below-market interest rates i. In the case of any below-market loan which is a gift loan or a demand loan, the forgone interest shall be treated as transferred from the lender to the borrower, and retransferred by the borrower to the lender as interest. b. Tracing – Business Interest, Personal Interest, and Home Mortgage Interest i. Pursuant to §265, if the bond interest received is tax exempt, then the interest paid will be nondeductible. ii. A deduction is allowed for home mortgage interest as long as the loan is secured by a qualified residence. c. Interest on New Car Loans: A Proposed Statute i. Proposes that interest on new car loans be deductible under §163(h).

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d. Low Interest and No Interest Loans i. For no interest or low interest loans, §7872 assumes the forgone interest is transferred by the lender to the borrower and that the borrower retransferred it back to the lender as interest. e. Original Issue Discount i. The difference between the stated redemption price for a debt instrument at maturity and the price paid for the debt instrument at the time it was issued. f. Interest and Inflation i. Under current law, the tax effect of interest paid or earned does not take inflation into account. g. Interest and the Economy: A Comparative Approach i. U.S. makes it easier to borrow money by providing generous treatment of interest deductions and has one of the lower savings rates among other countries. H. Bad Debts a. Code: i. §166: Bad debts i. There shall be allowed as a deduction any debt which becomes worthless within the taxable year. ii. A deduction is allowed for a partially worthless debt not to exceed the amount of debt charged off. iii. The basis for determining the amount of the deduction for any bad debt shall be the adjusted basis. iv. No deduction shall be allowed for any nonbusiness debts. b. Cases: i. U.S. v. Generes i. Issue: Whether for the shareholder-employee, a debt owed to him by a corporation was business or nonbusiness bad debt within §166. ii. Facts: Taxpayer was both an employee and shareholder of corporation. On his tax return, taxpayer took his loss on his direct loans to the corporation as a nonbusiness bad debt; he claimed the indemnification loss as a business bad debt and deducted it against ordinary income. iii. Rule: Whether a bad debt has a 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 signification motivation is insufficient. iv. Rationale: Dominant motivation test is easier to apply. Here, taxpayer’s dominant motivation was his (personal) interest as shareholder based on the amount he had invested in the corporation and not as (business interest) employee (to keep his $12,000 per year job). v. Holding: Nonbusiness bad debt. Reversed and remanded. ii. Perry v. Commissioner

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i.

ii.

iii.

iv.

v. vi.

Issue: Whether petitioner may take a bad debt deduction for her husband’s failure to pay child support and alimony under §166; whether she may deduct airfare as a dependent care expense under §21. Facts: Petitioner paid for husband’s schooling. Couple divorced and husband was ordered to make child support and alimony payments which he failed to pay. Petitioner sought deductions. Rule: Bad debt deduction requires a basis in the debt. Dependent care expense must be for household or the care of a qualifying individual. Rationale: Petitioner had no basis in the child support and alimony debts because it was an amount ordered by court so not deductible. Petitioner’s expense for airfare so children could be cared for by grandparents at grandparents’ home is not deductible because the travel was not for household nor did it constitute care. Holding: No deductions. Class Notes: Payor spouse’s child support payment are not deductible under §262. Payee spouse does not treat what she receives as gross income under §71(c).

I. Lobbying a. Code: i. §162(e): Denial of deduction for certain lobbying and political expenditures i. No deduction shall be allowed for any amount paid or incurred in connection with influencing legislation, participating in any political campaign for public office, any attempt to influence the general public, or any direct communication with a covered executive branch official in an attempt to influence the official.

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Chapter 9: Who is the Taxpayer? A. So Who is He? a. Case i. Richard H. Medina v. Commissioner 1. Issue: Whether the money seized in a drug raid belonged to petitioner. 2. Facts: Petitioner was arrested in a drug raid possessing $39,870. As a result, the Commissioner found petitioner’s return to have a tax deficiency. 3. Rule: §142(a): petitioner bears the burden of proving, by a preponderance of evidence, that Commissioner erred with regard to the tax deficiency and additions to tax. 4. Rationale: There is no evidence showing that the money belonged to petitioner. Petitioner alleges that the money was not his, he was just a runner delivering the money, and was supposed to be paid $5,000 for his work. 5. Holding: Money didn’t belong to petitioner; no tax deficiency. B. Assignment of Income a. Income from Services i. Case 1. Lucas v. Earl (cite for assignment of income rule) a. Issue: Whether the respondent, Earl, could be taxed for the whole of the salary and attorney’s fees earned by him in the years 1920-1921 or should be taxed for only a half of them in view of a contract with his wife. b. Facts: Earl and his wife agreed that any property that either of them received during their marriage would be held by both of them as joint tenants. Earl asserts he should only be taxed on half of his earnings. c. Rule: Revenue Act of 1918: imposes a tax upon the net income of every individual including income derived from salaries, wages or compensation for personal service of whatever kind and in whatever form paid. d. Rationale: Earl was the reason for earnings so even if he agreed to share them with his wife, he is the origination and he will be taxed. e. Holding: Earl should be taxed on his whole salary. f. Class Notes: Earl entered into this contract before the income tax even existed. b. Income from Property i. Case 1. Blair v. Commissioner a. Issue: Whether taxpayer’s assignments of income to his children via a trust was still taxable upon the income of the taxpayer.

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b. Facts: Trust created by William Blair. Taxpayer-Edward Blair received income from trust. E. Blair assigned to his children a portion of his future income from the trust. c. Rule: The one who is to receive the income as the owner of the beneficial interest is to pay the tax. d. Rationale: If under the law governing the trust the beneficial interest is assignable, and if it has been assigned without reservation, the assignee thus becomes the beneficiary and is entitled to rights and remedies accordingly. e. Holding: Assignees became the owners of the interests in the income and so they and not the taxpayer should have been taxed. f. Class Notes: A trust is money or property set aside for beneficiaries. 2. Helvering v. Horst a. Issue: Whether the gift, during the donor’s taxable year, of interest coupons detached from the bonds, delivered to the donee and later in the year paid at maturity, is the realization of income taxable to the donor. b. Facts: Taxpayer owned negotiable bonds. He detached the negotiable interest coupons before their due date, gifted them to his son, who then collected them at maturity. Commissioner contends the interest payments were taxable to taxpayer. c. Rule: The power to dispose of income is the equivalent of ownership of it. d. Rationale: Income is realized by the assignor because he, who owns or controls the source of income, also controls the disposition of that which he could have received himself and diverts the payment from himself to others as the means of procuring the satisfaction of his wants. e. Holding: Interest payments are taxable to donor. f. §1286: Tax treatment of person stripping bond – person shall include in gross income interest accrued on bond while held and before bond was disposed of in the accrued market discount on bond as of the time such bond was disposed of. 3. Meisner v. U.S. a. Issue: Whether Mr. Meisner exercised power or control over Mrs. Meisner’s share of the property division award. b. Facts: Mr. Meisner received royalties from Eagles singing group. When Meisners divorced, Mrs. Meisner received 40% of royalties earnings according to the property settlement agreement. The royalties were without conditions and checks were sent to her directly. She

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contends that she should be refunded for the tax she paid on these royalties in the past and that Mr. Meisner should pay them. c. Rule: Whether or not the assignor is to be taxed on an income producing asset depends on whether the assignor retains sufficient power and control over the assigned property or over receipt of the income. d. Rationale: When a taxpayer is firmly entitled to receive income but anticipatorily assigns this income to another, the donor will be taxed n it just as though he had actually received it. However, if the taxpayer instead assigns an income-producing asset, the result is different. All income that is thereafter produced by the asset is taxed to the assignee. Since Mr. Meisner retained no control over the royalties after assigning them to Mrs. Meisner, Mrs. Meisner is responsible for paying the tax. e. Holding: Mrs. Meisner is to pay the tax on the royalties. ii. Notes 1. §67(a): Miscellaneous Itemized Deductions a. Miscellaneous itemized deductions are allowed only to the extent that, in the aggregate, they exceed 2% of adjusted gross income. 2. Alternative Minimum Tax (AMT) a. Congress is concerned the some taxpayer take too many deductions, and thus pa taxes at too low a rate. To alleviate these concerns, some taxpayers are required to compute their taxes a second time, eliminating many of the deductions, to make sure that they are paying taxes equal to at least 26% of this higher income figure. iii. Cases 1. Commissioner v. Banks a. Issue: Whether the portion of a money judgment or settlement paid to a plaintiff’s attorney under a contingentfee agreement is income to the plaintiff. b. Facts: Respondents contend that they should only be taxed on their portion of their recovery because the attorney’s fees portion is that earned by the attorney. Commissioner maintains that a contingent agreement should be viewed as an anticipatory assignment to the attorney of a portion of the client’s income from any litigation recovery. c. Rule: Income should be taxed to the party who earns the income and enjoys the consequent benefits. In the context of anticipatory assignments, the question is whether the assignor retains dominion over the income-generating asset.

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d. Rationale: The income-generating asset in a litigation recovery is the cause of action that derives from the plaintiff’s legal injury. The plaintiff retains dominion over this asset throughout the litigation. e. Holding: When a litigant’s recovery constitutes income, the litigant’s income includes the portion of the recovery paid to the attorney as a contingent fee. C. Children a. Earned Income of Children i. Code 1. §73: Services of Child a. Amounts received in respect of the services of a child shall be included in his gross income and not in the gross income of the parent, even though such amounts are not received by the child. b. All expenditures by the parent or child attributable to amounts which are includible in the gross income of the child solely be reason of (a) shall be treated as paid or incurred by the child. ii. Case 1. Allen v. Commissioner a. Issue: Whether bonus payment received by petitioner’s mother represented amounts received in respect of a minor child and were taxable to petitioner. b. Facts: Petitioner, a minor, signed with the Philadelphia Phillies minor league team through the negotiations of his mother with a Phillies scout. She signed the contract, thereby giving parental permission for petitioner to play. The signing bonus was paid in part to mother and petitioner. Commissioner assigned a deficiency to petitioner and increased his taxable income to include portion of bonus paid to his mother. c. Rule: §73 d. Rationale: The payments made to petitioner’s mother were received solely in respect of petitioner’s services and that all such amounts were therefore includable in his income. e. Holding: Bonus paid to mom is taxable to petitioner. D. Income Producing Entities a. Partnerships i. Case 1. Commissioner v. Culbertson a. Issue: Whether the income from a family partnership entered into by respondent and his sons must be taxed to respondent. b. Facts: Taxpayer is a rancher and partner of Coon and Culbertson. He bought out Coon’s interest, and sold half

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the whole interest to his sons to form a new partnership. Commissioner disallowed the division of income from the ranch among the five partners. c. Rule: Trial court’s test for partnership for income-tax purposes: each partner contribute to the partnership either vital services or capital originating with him. Also, intent. d. Rationale: The question whether the family partnership is real for income-tax purposes depend on whether the partners really and truly intended to join together for the purpose of carrying on the business and sharing in the profits and losses or both. Their intention is a question of fact, to be determined by their agreement and conduct. Trial court was incorrect to use vital service and capital alone as deciding factors. e. Holding: Remanded to determine if sons were partners. b. Corporations i. Case 1. Johnson v. Commissioner a. Issue: Whether the amounts paid by the Warriors with respect to petitioner’s services as a basketball player are income to petitioner or to the corporation to which the amounts were remitted. b. Facts: Petitioner, basketball player, contracted with PMSA and gave PMSA the rights to his basketball services in exchange for being paid $1500 a month. PMSA licensed its rights under the contract to EST. The Warriors paid petitioner directly, who remitted payment to EST. Petitioner reported no wages or salary on his tax returns but reported the payments from EST as business income. Commissioner assigned a deficiency to petitioner in the amount with respect to the petitioner’s services over the amount paid petitioner by EST. c. Rule: Two necessary elements before the corporation, rather than its service-performer employee, may be considered the controller of income: 1) the serviceperformer employee must be an employee of the corporation whom the corporation has the right to direct or control in some meaningful sense; 2) there must exist between the corporation and the person or entity using the services a contract or similar indicium recognizing the corp’s controlling position. d. Rationale: The court assumed the first prong to be met since the contract gave PMSA the right of control over petitioner’s services. The second prong isn’t met because the Warriors didn’t recognize PMSA as in control but paid petitioner directly. Therefore, court found petitioner

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controlled his earnings, not PMSA, so those amounts were income to petitioner. e. Holding: Yes, income to petitioner. c. Trusts i. Three possible taxpayer groups in a trust 1. Settlors 2. Trusts 3. Trust beneficiaries ii. Types of Trusts 1. Grantor a. The trust entity is essentially ignored and income earned by trust assets is taxed to the grantor, as if the trust had never been created. 2. Nongrantor a. The grantor will not be taxed trust income. Income will be taxed either to the trust or its beneficiaries.

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