Federal Income Tax Final Review

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					            Federal Income Tax Final Review

Framework – people who complain about the income tax complain about one of three
things (typically):
    1. Special interests = special interest benefits/loopholes have undermined the tax
        system in some ways
    2. Complexity = taxes are too complicated!
    3. Wrong tax base = we shouldn’t tax income, but should tax consumption, wealth,
        head tax - some other base

Rates
Marginal tax rate = rate at which the last dollar of income is taxed
    In tax slang, this is your ―tax bracket‖ = top rate at which income is taxed (and
       since we have a progressive system this is the last rate)
Progressive tax system = different rates based on level of income
Average tax rate = the total tax over your total income
    This is lower than your marginal tax rate in a progressive rate system

Current rates – see addendum to tax code; rates are changes by legislature; sunset
provision on the reduction – it is only there for a period of time and then the rates will go
back to what they were previously!

Tax and Public Policy
 - Intersection important b/c of
       o Distributional consequences of the policy
                Upside down subsidies
       o Incentives/behavioral effects
                Who changes their behavior and what they do in response
                Unintended and perverse effects


Major themes of the course
      - Comparative institutional analysis
      - Statutory interpretation
            o Very active Congress creates very complicated tax code. Very few
                 things Congress does NOT have the power to do. Judiciary weaker in
                 tax than in other areas
            o No common law per se, but interpretations of the code can make
                 things tricky – Substance over form and the variations.
      - Ethics and professional responsibility
            o Difficult to draw the line btwn socially productive law and crime
            o Tax shelters can be benign but line is murky
            o Problem with detection
                      Audit lottery, decrease in experience in IRS, competitive
                       pressures in the legal industry incentivize deception.
      - Conceptual Themes
             o Valuation
                      Realization
                      Business v. Personal
                      Tax categories not matching up to economic reality. Little
                       boxes.
             o Income Shifting
             o Managing Complexity in the Law
                      Transactional
                      Compliance
                      Rule Complexity
                            Different types, hard to read, hard to get head around,
                              hard b/c of math etc.
Sources of Authority
   Congress (Code)

   Executive: Treasury → IRS (run by presidential appointee). IRS is both
   administrator and delegated interpreter. Issues:
      - Regulations: power delegated by Congress, within Code. When power is
          delegated, then Regulation has same force as Code, except for invalid
          (conflicting with Code) Regulations. If there’s an interpretive controversy
          between Regulation and Code, courts will make final call.
      - Rulings: different from Regs in that they are not subject to statement and
          comment. Merely statements of IRS’ litigating position. No legal authority


WHAT IS INCOME?

Code Baseline Code: § 61. All income from whatever source derived. Non-exclusive
list follows.

Base
Income tax = Rate x Base (Defining base is the tricky part)
    Haig-Simons income definition: cleanest and most intuitive
          o Haig: income is the money value of the net accretion to economic power
              between two points in time
                   Talks about flow and NOT stock – this is an increment
                   Net is important – what left with after paying all costs of living
          o Simons: (v. close to Haig’s def.) algebraic sum of (1) the market value of
              rights exercised in consumption and (2) change in the value of the store of
              property rights between the beginning and the end of the period in
              question
                   This gets us: Y = C + ΔS
                   Income equals consumption plus the change in savings
      Posner definition: all pecuniary and non-pecuniary receipts, including not only
       leisure and other non-pecuniary income from household production but also gift,
       bequests and prizes

Criteria for Evaluating Tax Policy
   1. Horizontal equity = those with equal ability to pay should pay the same
   2. Vertical equity = those with more ability to pay should pay more than those with
       lower ability to pay
   3. Efficiency = tax should interfere minimally with rational choice/economic behave
   4. Administerability = how easy will this be to apply

        Old Colony - Taxes paid for you represent compensation and therefore, you
         are taxed. All that is needed to attract § 61 is enrichment and realization. So
         modern result is GROSS UP!
             o Figure out what to pay in order to ―net‖ a certain amount
             o x – 7x = $1m x = 3.33m. 30% of that 1M. Modern result of full gross
                 up if you want to pay employee net 1M.
                      Remember salary deductible to employer.

Fringe Benefits

      Benaglia – Benaglia was head manager of a hotel in Hawaii and was required to
       live in the hotel and eat there (part of his job). The IRS Commissioner wanted to
       charge him for back taxes on the value of this food and living accommodations
       because they thought it should be included as income. The Court disagreed, ruled
       for Benaglia because the arrangement was for the convenience of the
       employer, not for the benefit of the employee.
          o NOTE: At the time only §61 (not §119, §132) was in existence.
          o Valuation problem – mix of business and personal.
          o Ruling fails horizontal equity, vertical equity, efficiency, but alternative of
               getting in people’s heads and figuring out personal v. business fails
               administerability.
          o The distinctive feature of Benaglia is that the in-kind payments are non-
               compensatory in a significant way. Important to remember that if a
               benefit is excluded when received in kind, it will not also be deductible
               when acquired for cash.
      Benaglia is a misleading case = the baseline is that fringe benefits are includable
      Fringe benefit – one type of in-kind compensation, usually refers to wages
       transferred in-kind (jobs, employment, wages)
          o Classic types: health insurance (talk about inefficiencies!), travel, pension
               benefits, company cafeteria, etc.
          o Default rule here: §61 – include everything unless it is excluded. Fringe
               benefits which do not qualify for exclusion are includable in income
               unless specifically excluded from income by some other code provision
               (like § 119 and § 106 which excludes employer paid health insurance
               premiums)
      Presumption that unless you meet the special circumstances in §132 or the
       employer convenience requirement (§ 119) , you should pay taxes on any
       benefits you receive from an employer.
           o Employer/Employee relationship important in this area. Candidate’s
              clothing example and RNC. Candidate not an employee of RNC so not
              deductible.
    Fringe benefits in certain industries can create a tax wedge that allows salaries to
       be lower (e.g. airline industry, people taking advantage of ―no cost‖ flights as
       fringe benefits)
    NOTE: frequent flier miles currently don’t count as taxable income due to IRS
       discretion. Could go after them and things like Radisson frequent guest points.
       For example could say unless business has a policy that you can’t use free
       miles/nights for business event then going to tax as income.
    Gotcher - Dominant Business Purpose. Gotcher & wife traveled to Germany to
       look at the VW plant there; Gotcher spent his time touring factories and going to
       meetings (i.e. for business purposes); Court winds up interpreting §61 based on
       the fact that no other exclusion applies (§119, 132 don’t apply b/c trip not
       provided by employer – also didn’t exist); in testing whether the trip was
       ―compensation‖, they say that it was not for him but was for Mrs. Gotcher (e.g.
       should be taxed for her part, law is that it is his income and is a gift to her = it is
       compensatory to him so it is his income); same valuation problem as in Benaglia
    Kowalski - §119 case, state troopers had meal allowances but they did not have
       to use them; the question was whether this was excludable; Argument on the
       basis of the code: furnished for the convenience of the employer only if meals are
       furnished on the business premises; Court said cash reimbursement for meals is
       not excludable under §119; §119 doesn’t apply to cash reimbursement (element
       of choice – less choice when on business premises, although AA thinks this is
       kind of a shoddy distinction), Court stricter than in Gotcher
    Big themes: business v. personal; valuation problem
    APPLICABLE CODE SECTIONS: §61, §119, §132
Form of Receipt/Compensation for Services
    Old Colony Trust Co. - SUBSTANCE OVER FORM ALERT question was
       whether the company that employed Mr. Wood (American Woolen) could pay
       his taxes – the court decides that such payment would constitute additional
       income (i.e. payment of someone’s taxes for them constitutes compensation);
       alternately, your federal income tax is not deductible from income; NOTE:
       Old Colony is acting on behalf of deceased Mr. Wood
    Stacking = i.e. if someone is compensating you for taxes on a piece of income,
       you want them to pay the higher marginal rates, so stack it on top of your other
       income
    Tax inclusive v. tax exclusive base
           o We have a tax inclusive system – you can’t deduct your federal income
              tax liability… you have to apply this provision equally
           o When Mr. Wood tried to exclude $700,000, he was essentially trying to
              deduct that from his actual income (i.e. he was deducting his tax liability)
       NOTICE: Old Colony applies to any kind of debt (so if someone else pays off
        your student loan, technically you have income)

Tax Expenditures
    Stanley Surrey = one good idea; a dollar of tax forgiveness can be understood as
      a dollar of direct spending
    NOTE: a dollar of exclusion is worth the marginal tax rate (i.e. excluding $10 at
      a 35% marginal tax rate is worth {$10/(.65)}-$10 in tax savings)
    Joint Committee on Taxation Report
         o Housing/mortgage exclusion – very big at a personal level
         o Depreciation of equipment – corporate breaks
         o Tax credit for children – v. costly, shouldn’t overlook this when we are
             comparing our social policies with other countries
         o Health care = $80 billion per year in foregone revenue; this is the US
             health policy for working age people
         o Lots of expenditures on pension plans
         o TAKE HOME POINT: you can go through this and see a lot of programs
             that you would not otherwise see as parts of government social policy
    §105 = prime example; (a) says that employer contributions for health/accident
      insurance are includable in income BUT then (b) says that ―gross income does
      not include amounts referred to in subsection (a) if such amounts are paid,
      directly or indirectly, to the taxpayer to reimburse the taxpayer for expenses
      incurred by him for the medical care as defined in section 213(d)…‖
         o 213(d) is actually doing the work of defining what is excludable
                  Distinguished medical treatment for injury/illness from cosmetic
                      procedures
                  Limits exclusion to necessary medical treatment – i.e. does not
                      include elective procedures
         o This is essentially a subsidy to the purchase of employer provided health
             care, but who ends up with the surplus? The employer or employee?
                  Capitalization – who does the benefit actually go to?
                  Concept is that the employer can now reduce the employee wage
                      because the employee is getting that benefit and will be indifferent
                      between the two salaries
                  You can’t say just from theory who will be getting the benefit!
                      You’d have to look at this empirically!
         o Two main effects = (1) expand prevalence of employer provided health
             insurance & (2) entrench significant gaps in coverage in the US population
         o This works badly for self-employed, transient, unemployed, and low
             income people and also works worse for women
    Surrey hated tax expenditures because of the “upside-down” subsidy = when
      you figure in the marginal tax rate, higher income people always benefit more
      from exclusions than lower income people because they are excluding income at
      a higher marginal tax rate. AND more likely to benefit from things like pensions
      plans. Employers would RATHER contribute to pension plans for high income
      workers b/c not taxed at high marginal rates for plan.
          o NOTE: tax credits don’t have this property (i.e. subtract from the tax bill
             rather than from taxable income). But non-refundable tax credits are
             useless you have taxable income to offset.
          o EITC example of tax credit problem. Non-refundable tax credit. HUGE
             program in US. Less invasive than welfare.
       BIG THEMES: Policy Area, Comparative Institutional Analysis.

Gifts & Bequests
    Duberstein & Stanton – 2 cases. In Duberstein, he had gotten a Cadillac as a gift
       during an ongoing business relationship. In Stanton, a man had retired and the
       company voted to give him a payment; question is whether these payments were
       gifts; we care because gifts are excludable under §102(a); at this point in time,
       the business gift category was a whipsaw for the government – (employers
       could deduct and employees could exclude the amount – never got taxed); USSC
       basically says that you have to take these cases on consideration under a ―totality
       of the facts‖ approach, case-by-case basis for decision; adopts a motive test for
       gifts = proceeds from “detached and disinterested generosity.” Will not
       categorically include business gifts as income.
    ** Eventually, Congress adopted §102(c) which disallowed exclusion of
       employer gifts and §274(b) which disallows deduction for employer-employee
       gifts that exceed $25; settled the Duberstein matter once and for all
    However, the Duberstein holding lives on when you are trying to distinguish a
       gift from compensation
    Current law – gift is not consumption to recipient and is consumption to donor
       (b/c not deductible)
           o Alternatives would be to tax it as consumption to the recipient only OR
               tax it as consumption to both donor and recipient
           o Both of these, in H-S income terms, would be more logical
           o HOWEVER, current treatment is used in an effort to prevent income
               shifting
    Big Themes: Valuation, Business v. Personal, Income-Shifting
    IMPORTANT PROVISIONS: §102, §274(b) Effect on § 170 – Charitable
       Donation Deduction.

Major Legal Control Systems in Tax Policy
Major Sources of Regulation:
   1. Constitution
   2. Statute
   3. IRS Regulations
Governing Bodies:
   1. Congress  Statute
   2. Executive: President  Cabinet level department (Treasury)  IRS
          o The IRS is therefore directly beneath the President
          o IRS is the administrator – principle function is to collect taxes
          o BUT, IRS also has a delegated interpretive function
          o Issues certain legal authorities:
                   Regulations – interpretation of the statute, issued by virtue of the
                    power delegated to the IRS by Congress
                          When the IRS is validly exercising this power, the
                            regulations have the force of law
                          BUT, the IRS cannot adopt an interpretation of the statute
                            that is contrary to what the statute says – this would be an
                            invalid exercise of the delegated power
                          i.e. IRS cannot contradict the will of the superior authority
                            (Congress in this case)
                  Rulings – issued by the IRS, statement of the opinion of the IRS
                          Not the same as a regulation – doesn’t have the same legal
                            force of a regulation
                          Regulations are subject to a notice and comment procedure
                            to which rulings are not subject
                          Rulings just let you know what the IRS’s position on an
                            issue is (i.e. how the IRS will litigate an issue)… citing a
                            ruling is like citing the IRS’s legal brief
                  Acquiescence/Non-Acquiescence = essentially this is when the
                    IRS loses a case and they either say, ok, we agree with the ruling &
                    we are going to back off from the issue (acquiescence) or they say,
                    don’t try this in another circuit because we’ll get you there (i.e. we
                    don’t agree with the ruling – non-acquiescence)
         o Also, office of tax policy in treasury department that has some oversight
            here
   3. Courts – judicial oversight of the actions of the IRS & Congress
         o 2 kinds of cases:
                  Controversy over what the statutory language says
                    (language/interpretation controversy)
                  Adjudicate whether or not an IRS regulation is valid (i.e. whether
                    or not IRS has exceeded its delegated power)
         o When the court interprets a statute, that is typically the final word unless
            Congress changes the statute (i.e. IRS can’t change it with a regulation
            unless they have some broader delegated power)

Intro to Basis Recovery
    Basis = accounting term, measure of what the taxpayer has invested in an asset.
        Reflects things like depreciation deductions and improvements made.
    Gain = difference between amount realized and basis (G=A/R-B)
    Loss = difference between amount realized and basis when such amount is
        negative (L=B-A/R)
    Why do we have this system? It is administratively costly to have a mark-to-
        market system, so this is one way to approximate; only tax gain when realized
    ―Substance over form‖ doctrine – IRS can ―recharacterize‖ a transaction to
        make sure that all income gets accounted for (e.g. if you buy an asset for a
        bargain price, IRS could adjust the basis)
    §1015 – the ins and outs
           o NOTE: § 1015 permits income shifting by allowing the basis in the
               hands of the donor to pass down to the recipient (e.g. say the donor is in a
               higher tax bracket, the gain accrued during the time that person held it
               now gets taxed at a lower rate upon realization by the recipient); further,
               income shifting abilities here are asymmetrical and favor the taxpayer
               – taxpayer can choose how/when to transfer (e.g. sale versus gift
               depending on bracket differences)
           o Loss-basis rule = if the property has depreciated in the hands of the
               donor, and the donee ultimately sells at a loss, then the basis is stepped
               down to fair market value (see §1015)
                    THUS, §1015 does not allow loss shifting!
           o Asymmetry between gifting of money and gifting of property – if money
               were gifted it would all be taxed
           o THIS IS ONE OF THE LARGEST TAX PLANNING TECHNIQUES
               THAT WELL-OFF PEOPLE USE!!! (I.E. GIFTING TO CHILDREN)
           o NOTE: with these rules, there is a possibility that there will be neither a
               gain nor a loss!!! This is a statutory impossibility!!! In this case your
               answer is simply that the statute is ambiguous…
       §1014 step-up in basis at death: basic difference here is that the basis is the
        FMV when it is transferred (i.e. at the decedents death) – it doesn’t matter what
        the decedent’s basis was (that is irrelevant)
           o NOTICE: there is a $40 billion tax expenditure on this! IRS is losing a
               significant chunk of cash by not taxing the step-up in basis at death
           o Potential problems – disproportionately benefits the wealthy, property
               owners, creates lock-in (in other words, violates vertical, horizontal equity
               and efficiency criteria). Concern is about liquidity and valuation.
       MAJOR distortions with these policies…
       Big Themes: Income Shifting, Valuation (problems with administerability of
        mark to market, liquidity)
       IMPORTANT TAX CODE PROVISIONS: §1001, §1012, §1014, §1015

Basis and Realization Cases
    The depreciation assumption is an imperfect, rough-cut way to deal with a
        valuation problem; ultimately an arbitrary rule; RULE is that you can depreciate
        buildings over a long period of time; further it is straight line depreciation
        (there are other kinds of depreciation – i.e. depreciate by a percentage of the
        existing each year); capital improvements to buildings = you add the value to the
        basis…
    Hort – Hort inherits a building, subsequently Irving Trust leases part of the
        building, they want out of the lease before it ends and pay $140K to terminate it;
        Hort doesn’t want to count the $140K in income – instead he wants to count as a
        loss the difference between the $140K and the amount he would have gotten if
        the lease had been carried through (IRS wants the $140K counted as income);
        real controversy is whether Hort has basis in the lease; Court says that Hort
        cannot re-allocate some of the basis to the lease (draws line between stream of
        income and sales of assets – rent has no basis offset whereas a sale does… AA
        says this is kind of incoherent. Creating categorical distinctions (little boxes) that
        don’t map onto real world.); Court holds no realization, but this is a troubled area
        of law b/c Hort really was sitting on a big loss (Great Depression, value of his
        building went way down, this is why he reported as he did)
       This all shows how timing matters – in general you want deduction early and
        income late
       Farid-Es-Sultaneh – FES signed prenuptial agreement which said that the stock
        she had already been given by her soon-to-be husband was consideration for her
        to release the marriage rights she would otherwise hold under NY law; marriage
        ended, later she sold her stock; she wanted a stepped-up basis (higher) from
        when she received the stock whereas IRS wanted the carryover basis (much
        lower); question is whether the stock was a gift or exchange (i.e. given as
        consideration for relinquishing marriage rights or given as a gift?); Court holds
        that it was an exchange
       Some history:
            o Davis Rule: Wife takes FMV, step-up basis, Husband realizes gain from
                transferring the asset to his wife… in practice resulted in step-up with no
                taxation of realization b/c wife wouldn’t sell for a while & statute of
                limitations would toll
            o §1041 overturns the Davis rule but not Farid-Es-Sultaneh
                     Dissolution of marriage – in any divorce of a recognized marriage,
                        there is a carryover basis and the Davis rule no longer applies
                     When there is no formal marriage relationship (i.e. prenuptial
                        agreement or unmarried couple), however, the Farid-Es-Sultaneh
                        rule still applies and there is a step-up FMV basis for the wife

The Realization Requirement
    Ideal timing of taxes (―mark-to-market‖ tax system)
          o Valuation Problem – hard to price the change in value
          o Liquidity Problem – unfair to make people pay cash when all they have
              is an asset. Force sales of the asset in order to pay taxes.
    “Realization requirement” = helps draw the line between where you have
      liquidity and valuation problems and where you do not, this is ugly and
      complicated and has many consequences throughout the tax code.
    The standard realization event is a sale, but beyond that there is a lot of grey
      area…
    Cesarini – Cesarini buys a cheap piano for his kid for $15 in 1957. Later in 1964
      they found $4500 in the piano. They paid taxes on it and sued to recover the
      taxes. At issue is whether the money found in the piano should be included in the
      definition of income; Claim was that, because gifts were excluded and then
      prizes were specifically included but found treasure was not, found treasure thus
      remained in the definition of gifts (tried to draw a negative inference from the
      enactment of §74 which included prizes in income); Ultimately Court says that
      unless there is a specific exclusion for an item, then it cannot be excluded (i.e.
      §61 so broad that you can’t draw negative inferences)
   Haverly – Haverly gets textbook samples valued at $400. Doesn’t report as
    income. He donates the books to the school library and claims a charitable
    deduction of $400; issue is whether the $400 should be taxed as income to
    Haverly; IRS has bizarre dominion theory that he should report the $400 as
    income when he donates; symmetry issue – you can’t “double-dip” (i.e. he
    should not be able to both exclude and deduct the books… in essence that would
    make this an artificial loss tax shelter)
       o Problem is that §170 doesn’t limit deductions to basis. In certain cases you
           can deduct FMV. Here he has a basis in zero and can deduct 400. Court
           chooses not to punish IRS for slippage in the code.
   Eisner v. Macomber – important to note that the legality of the holding here is
    currently ambiguous – this is both good & bad law; based on what companies
    can do with earnings (retain and reinvest which is not taxable or distribute cash
    dividends which are taxable… intermediate option is stock dividends…); this
    case holds stock dividends to be similar to retained earnings and thus says that
    they are not taxable… the odd part is that the case draws on the 16th amendment
    (this would probably not be good law today), but the narrow result is still true
    (see §305(a))
   Alternative to the realization requirement = mark to market system
       o Problem is that this would be impossible to administer for all assets, so
           you’d still have to distinguish between which assets get MTM and which
           get realization
       o This line drawing would result in a lot of incentives to classify certain
           assets one way or another based on tax rules
   Problems with realization requirement:
       o Lock-in: incentive for people to keep their assets locked in where they are
           (i.e. don’t want to sell because they don’t want to pay taxes); skews
           incentives (efficiency)
       o Horizontal equity problem: people who get cash dividends from an asset
           in which they have invested get taxed differently from people who hold
           another asset that appreciates in a less obvious way (e.g. a house)
       o Inter-asset distortion: the skewing of investment incentives that results
           from the realization requirement; eg. people might invest in riskier assets
           (e.g. stocks); could also lead to a change in relative stock and bond prices
           (i.e. could distort the market)
       o Vertical equity problem: wealthier people will tend to hold more assets
           that will fall under the realization requirement – wealth is distributed very
           unequally in the US; ALSO, the people at the upper income echelons have
           higher tax rates, so the tax deferral is more advantageous to them
   Realization problems
       o Depreciation/Deductability – Anything dealing with mark to market
       o Lock in/ Basis
       o Basis – MTM would always be your basis.
                 Step-basis on death.
       o Capital Gains - Preferential Preferences
   Independent of Realization
            o Capitalization
            o Debt is included in your ownership. Amount you have at risk. Debt and
               ownership still an issue.
       Cottage Savings – (Substance over form doctrine implicated but this time court
        is respecting form over substance) In the 1980s, period of very high interest rates
        (double digits) was a boon to savers and a bane to lenders. Cottage Savings was a
        Savings & Loan (S&L) – losing out on current loans because they could have
        been loaning that money out at a higher rate; Cottage S&L put together a
        mortgage pool (ownership of loans) and swapped this with another S&L in the
        same position (FMV was $4.5M, CS’s basis was $7M – loss); no sale b/c S&Ls
        want a realization event for tax purposes that will not show up as a realization for
        the regulatory agency; at issue was whether the swap was a realization event;
        USSC standard = exchange of assets that are materially different constitutes a
        realization; regulations under §1001: ―exchange of property for other property
        different materially either in kind or in extent‖; USSC holds that the mortgage
        pools are legally distinct because they are different mortgages – legally distinct
        entitlements
       Post-Cottage Realization:
            o Exchange for cash
            o Opportunity to reinvest
            o Exchange of legally distinct entitlements (material difference)
       Big Themes: Valuation – realization req., Administerability, Managing
        Complexity in the Law.

Borrowing
    Collins - Collins was a compulsive gambler who worked at OTB. On a slow day,
      he ―sold himself‖ $80K worth of tickets. By the end of the day, he was left with a
      FMV of $42K and a loss of $38K; Tax issue: should Collins be taxed on $80K
      worth of income?; law draws a line between consensual and non-consensual
      bargaining – legal borrowing would not get taxed as income, but here the
      borrowing was illegal, so there can be no exemption from tax; no deduction of
      gambling losses (sees gambling as consumption)
    In general the law recognizes an offsetting obligation to repay when someone
      takes out a loan – so a person who takes out the loan does not really increase his
      income
    Concept of cancellation of indebtedness income = you get income when you
      repay a loan at less than dollar for dollar
         o Tax accounting theory = when you borrow a dollar, it is not included in
             income because of offsetting liability, but if it later turns out that the
             offsetting liability was less than the amount borrowed, then this calculus is
             later adjusted to account for that (i.e. there will be income)
         o Economic/Net Worth Theory = in the year of the bond buyback, the
             corporation is better off because it’s liabilities go down by more than its
             cash account, therefore there is income
    NOTE: the rules are different in Title 11 (bankruptcy) proceedings
          o §108 essentially bargains with these insolvent companies = they can have
              less taxable income now in exchange for more taxable income in the future
              when they are making money again – timing question
          o For example, say an insolvent company didn’t want to include $700K in
              discharge of indebtedness income… then they will not be able to use net
              operating losses (NOL) to reduce tax liability
          o This essentially provides for tax deferral
      Have to be careful with the terms of the discharge of debt… §108(e)(5) allows
       for purchase money debt reduction (e.g. if you sell a building to someone for X
       price and they are in debt to you for that amount, you later agree to discharge
       some of that debt because something comes up that makes both parties realize
       building is less valuable… this is NOT discharge of indebtedness income but
       merely a purchase price adjustment)
      Zarin – Zarin was a real estate mogul who was a heavy gambler; 1978-79, lost
       $2.5M and paid the debt in full. In 1980 he gambled and lost $3.5M and
       defaulted. In 1981 they settle for $500,000 (resorts skirting regulatory laws about
       credit extensions to gamblers – contracts dispute); Tax question: whether the
       discharge of $3M debt should count as income… Tax Court finds for IRS, Third
       Circuit overrules in favor of Zarin; valuation problem – do you see this as
       consumption? Did he get all that value out of gambling? Also, did he really
       expect to pay it back? (e.g. maybe the casino often forgives such debt); an
       important feature here is that the debt is seller financed – the person that lends
       the thing is the person that is financing it
      Doctrinal theories discussed in Zarin:
          o Disputed debt theory = he wins on the dispute over value piece in the 3rd
              circuit (even though it doesn’t fit)
                   Unenforceable debt theory: says that the debt is unenforceable by
                       resort malfeasance… however this doesn’t really work doctrinally
                       because it doesn’t say anything about the values. If not debt then
                       shouldn’t Zarin have reported income when he received the chips.
                   Dispute over value: someone sells a used car for some amount,
                       seller financed, there was a miscommunication over what the price
                       was and later the buyer comes back disputing the price… no
                       meeting of the minds… BUT DOESN’T FIT THE ZARIN FACTS
          o Purchase price adjustment = ex post adjustment to the price, but the
              hard part about this theory is that if you read §108(e)(5), this only applies
              to property… normally you don’t adjust the ―price‖ of money
              transactions… this is about real estate, not cash
          o There are other theories discussed, none really allows the Third
              Circuit’s result
      Thus, the decision in Zarin leads to some mayhem in the doctrine… no clear
       doctrinal theory for holding in favor of Zarin even though it seems to be the
       correct result
      Big Themes: Valuation

Borrowing and Basis
   Recourse debt = you are personally liable, the lender can confiscate whatever
    assets the borrower has to collect the debt
   Nonrecourse debt = e.g. mortgage, in this case, the only recourse if the debt is
    not paid is the collection of a security interest (i.e. if the security interest is the
    house, the lender can claim the house only, but can’t come after the borrower’s
    other assets; kind of like an option)
        o Isn’t this risky? YES, this allows lenders to charge higher interest rates
           for these loans and to be more demanding about down-payments (i.e.
           equity cushion – borrower will lose their own equity in the building,
           $200K here, before the lender starts to lose)
        o This is like a put option with the bank – right, but not the obligation, to
           force someone else to buy an asset (i.e. buy the building)… at any time the
           borrower can force the lender to buy the building and thus eliminate the
           buyer’s liability
        o Essentially it is a risk sharing device
   Depreciation is a conventional value system that assumes that the value of the
    building deteriorates over time (divide value of a depreciable asset over a time
    period and then write off equal amounts of value each year)
   Crane - Mrs. Crane inherited a building with FMV of $250K and a nonrecourse
    debt of $250K (i.e. this means there was a net value of $0). She kept the building
    for 7 years, took depreciation deductions of $25K according to the depreciation
    schedule. After 7 years, Mrs. Crane sells the building for $3K (buyer assumed
    the debt – took subject to the debt – as well as ownership of the building);
    Crane wants to report $3K gain (saying basis is $0); IRS wants original basis to
    be the FMV of the building ($250K) and basis at sale to be original basis less
    depreciation, further she should report $3K plus discharge of debt as gain… this
    would have been the clear way to do this with recourse debt; The Court
    acknowledges the option that Mrs. Crane has – but in this case they are in the
    range where nonrecourse debt is treated like recourse debt (i.e. FMV of building
    is greater than the nonrecourse debt) so the recourse debt rule governs (IRS wins)
   Recourse debt rule: when you have recourse financing, the amount of the
    recourse debt goes into basis and amount realized
   Basis is the amount of money you put into a transaction; §1012 = cost basis
        o In the simplest example, you have already paid taxes on the money that
           you put into a transaction – i.e. you buy a house for $100K, that is after-
           tax money you use because you earned it at some time
        o Say you borrow $250K to buy a building, the $250K is your basis, but it is
           not after-tax money – it is not taxed because it comes along with an
           obligation to repay and it gets repaid with after-tax funds (at the time of
           repayment you do not get a deduction)
        o This is all very simple with recourse debt because you will have the
           obligation to repay no matter what (short of bankruptcy)
        o The big leap in Crane is to extend this same logic to nonrecourse debt
           (there may never be obligation to repay); the IRS in Crane equates
           recourse and nonrecourse debt for tax purposes
   An alternative to this tax treatment would be to have an equity only basis rule
    (e.g. you only get basis equal to your amount of equity in the building)
       o Objection: there is not enough depreciation/cost recovery in the system if
           you limit a person to a small basis at the outset… there should be a greater
           recognition of the depreciation as it happens
       o BUT, the person who makes the loan could take those deductions… they
           would have the basis in the building. Doesn’t line up with our conceptions
           about property ownership though.
   Tufts - Mr. Tufts (& partners) bought a building using $1.85M nonrecourse loan
    Over time, Tufts put $50K of equity into building… initial basis: $1.9M,
    depreciation deductions: $450K, adjusted basis: $1.45M; value of the property
    meanwhile declined to $1.4M, at which point they sold the building to Bales for
    $250 (basically nothing) and the fact that he took subject to the nonrecourse debt
    (which remained at $1.85M); Tufts wanted to claim a loss of $50K (difference
    between their basis of $1.45M and FMV of $1.4M); IRS wanted to include
    discharge of indebtedness in A/R ($400K gain); Court concludes nonrecourse
    debt must be included in both Basis and A/R (IRS position, Tufts only
    including it in B- and then taking deductions against the basis. ); thus,
    nonrecourse debt is always treated like recourse debt. NOT a discharge of
    indebtedness ruling.
   Barnett thought that we should view transactions like that in Crane as
    bifurcated transactions:
       o (1) Property transfer = loss of $50K (i.e. basis of $1.45M and amount
           realized of $1.4M) So in this case basis doesn’t include NRD.
       o (2) Debt transfer = gain of $450K in cancellation of indebtedness income
           (i.e. previous obligation to pay $1.85 million, settled for $1.4 million… no
           longer have an obligation to pay the full debt)
       o Then, putting this together, you would get a gain of $400K overall
       o Why bother with this separate way to look at the transaction?
                 Analytically clearer and more intuitive…
                 ALSO, government would collect more money under the
                    bifurcated transaction because the cancellation of indebtedness
                    would be taxed as regular income whereas the loss on property
                    transfer would be taxed as a capital gains loss
       o In TUFTS, the whole $400K gets taxed as capital gains – there is no
           traditional cancellation of indebtedness income b/c the property transfer
           and the debt transfer are smashed together. Probably why IRS argues
           cancelation of indebtedness.
   NOTE: the nonrecourse debt deduction rules open the door for tax shelters… the
    typical scheme is to use nonrecourse debt to buy an overvalued asset, take the
    deductions – defers tax; also because the court does not use the bifurcated
    model, it allows for conversion (e.g. can be taxed at the CG rate on debt
    discharge that otherwise should be taxed at ordinary income rate)
   NOTE: Tufts buyer of the property doesn’t get a basis of 1.85 M, even though
    Tufts had to include that in A/R. Property KNOWN to be worth less than that.
    Basis is 1.4M.
       Result is consequence of treating NRD = to Recourse debt even though know
        that actors aren’t going to have same incentives in tax free world.
       Estate of Franklin – SUBSTANCE OVER FORM ALERT Romneys owned
        the Thunderbird Inn, associates came in and bought the inn, then leased it back to
        the Romneys; seller financed sale for $1.2M = Associates paid the Romneys
        $75K up front and then $9K per month but this was offset by Romneys rent
        payments of $9K per month; Romneys were responsible for upkeep and could
        mortgage the property; associates took deductions for interest and depreciation;
        Court disallowed deductions based on the fact that there is no real debt because
        of (1) over-valuation of the purchase price of the property and (2) seller-financed
        non-recourse debt; thus the fiction that the debt would ever be repaid is totally
        untenable (i.e. Court steps back from Crane-Tufts somewhat, acknowledges
        different of nonrecourse debt based on risk associated with it)
       Things that are suspicious = seller financing, non-recourse debt, over-valuation
        of an asset, lack of adversity of interests among dealing parties
       A bigger problem in Estate of Franklin is the lying about the value – could have
        been punished for fraud… problematic when the law encourages this kind of lie

Debt and Tax Shelters
    The factors that led to the Estate of Franklin styled tax shelters were:
           o (1) Crane rule that gave basis for nonrecourse debt
           o (2) availability of nonrecourse debt
           o (3) availability of seller financing
           o (4) availability of fast depreciation allowances
           o (5) installment sale rules – Romneys did not have to report gain on the
              sale until they got the money
           o (6) losses in excess of income – can write loss off against your income…
           o (7) high marginal tax rates – bigger incentive to cheat
           o (8) passive/non-economic investment – at the time you could invest this
              way without a change in tax consequences
           o (9) Audit Lottery – Low risk of detection. Especially if didn’t overvalue
              as much.
           o (10) Fraud – noticeable overvaluation of the property.
    Valuation problem in Estate of Franklin - Ordinarily the law accepts the value
       that the parties put on good in a transaction, but here the law cannot do that;
       nevertheless getting courts involved in valuation opens a dangerous can of
       worms
    Conversion/Deferral: these are the main ways that people gain from tax
       shelters… either being allowed to defer taxation, or being allowed to convert a
       normal gain into a capital gain or some other sort of tax entity that will be taxed
       at a lower rate OR both!
    Rate arbitrage: people like the Romneys will be willing to sell their deductions
       to people like the associates from NYC because of differences in tax brackets –
       e.g. deductions are worth more to someone in a higher bracket
    Problems associated with tax shelters:
          o Seen as abusive tools for the rich – public perception was that the
               income tax pretended to tax the rich but really only taxed the working
               people
          o Huge deadweight loss, skewed incentives, bad investments, lost revenue,
               unnecessary transactions costs
    Legitimate v. abusive tax shelters – Estate of Franklin is abusive because of
       overvaluation, but there was also a possibility of obeying all the rules and still
       benefiting legitimately
    Legal solution began with Tufts and Estate of Franklin, but there were still
       problems:
          o (1) audit lottery – they have to catch you first, many people could get
               away with it by not getting caught
          o (2) vagaries of valuation litigation – one of the hardest things to litigate
               is the value of something, burn up resources fighting over values
          o (3) uncertainties of the court doctrine – judges made decisions under the
               law as it was, could not change the problematic laws… ultimate point of
               the case was only moderately important (just induced people to ―paper up‖
               their deals to make them look legitimate)
    The ultimate statutory solution was the following:
          o (1) at risk rules §465 (basketing) – you cannot take deductions in excess
               of investment income from nonrecourse debt and/or seller financing this
               was effective at getting rid of shelters, but downside is that it is a step back
               from H-S income, will overtax some. Only allowed to take deductions to
               the amount you have put at risk.
                     EXCEPTION § 465(6) For QUALIFIED NRD. Limited to activity
                       of holding real property and borrowed funds from qualified 3rd
                       party lender. Not convertible debt.
                            Congress still wants to incentivize construction, real estate
                               etc. § 465 meant to cover things like box-cars, river-
                               barges and movie rights.
          o (2) passive loss rules §469 – if there is a transaction in which you do not
               materially participate, you cannot deduct losses from that investment.
               Basketing – Losses limited to gains from that passive investment.
    NOTE: these rules did not alter fast depreciation (sacred cow of American tax
       policy), the Crane doctrine, availability of seller-financing, or availability of
       nonrecourse debt
    ALSO NOTE: the rules draw a line between portfolio investment (i.e. shares in
       non-tangible assets like stocks) and non-portfolio investment (like assets)…
       e.g. stock not subject to passive low rule
    Take home lesson: judges are not well-placed to counter these problems &
       despite the social benefit of shutting down shelters, there are costs (overtaxing
       some, raising the cost of capital, adding a layer of complexity)
    Big Themes: Valuation - Realization, Complexity – Compliance Complexity
Deductions – Business Expenses
    Deduction = subtraction from income, we have them to try to better calculate
       accretion to net worth. We tax your NET income, not gross.
   Concept is that you should be able to deduct the costs of earning income
   §162 is the doctrinal starting point, allows deductions for costs of doing
    business…
       o Important to note that we don’t worry about the upside down subsidy
            for deductions because they are aimed at calculating income accurately, so
            you need deductions to accurately say which bracket you are in
   Welch - Welch was an executive in a grain business that went bankrupt, then he
    gets a job in a different business but he had a bad business reputation … so he
    decided to pay off the debt from the previous business... then he wanted to deduct
    these payments as a business expense; The court decides that he cannot deduct
    the payments because the payments, though they may be necessary, are not
    ordinary business expenses under the meaning of the code; valuation problems
    here – is goodwill (what he is buying) a capital expenditure or a regular business
    expense? Further, is this a personal or business expenditure? Ordinary –
    presumption for repetitive payments, but unique payment doesn’t automatically
    mean not ordinary. Could be ordinary in the industry even if specific company
    typically only pays out once – something like insurance.
   Capital expenditure – theory about the timing of deduction…
       o Capital expenditure means that an asset has a basis… it should be
            deducted as it depreciates
       o One difficulty is deciding what should count as a capital expenditure
            (deducted over time) and what should not (deducted immediately)
       o In drawing the line between a deduction and a capital expenditure,
            you have to make a valuation judgment about how long something will
            generate value, how much it will generate, etc. – this is another effect of
            the realization requirement
   Typically understand §162 as being very permissive except for the red flags
    of personal expenditure and capital expenditure
   The important point is that not everything business related is deductible… you
    have to ask 2 questions:
       o Is this business or personal? (personal = non-deductible)
       o Even if it is business, is it deductible now or is it a capital expenditure that
            must be capitalized and deducted over time?
   Gilliam - Gilliam was an emotionally unstable/psychologically unsound artist
    who accepted a lecturing gig; ultimately he freaks on the plane and gets arrested;
    Tax problem = he wanted to deduct the legal fees as a business expense, IRS
    thought that those weren’t business expenses because ordinarily artists who are
    traveling do not get into psychotic episodes on airplanes; IRS wins, fees said to
    originate in personal conduct, not business
   Dancer (referenced in Gilliam) - Dancer was a horse trainer on his way home for
    lunch, hits a child on a bicycle and hurts him badly; deduction of legal fees is
    allowed; Court distinguishes this by saying that an incident like this is more
    likely than Gilliam. Driving to and from feels ordinary -- very loose doctrine
    that doesn’t provide for a lot of certainty
   Doctrine on deductability of legal fees:
           o You can deduct fees that originated in business-related incidents.
               Deduction of legal business feels of company for fraud or something.
           o HOWEVER, you cannot deduct fees that originate in personal conduct
       This line of doctrine is plagues by the inherent difficulty of distinguishing
        between business and personal consumption
       Tellier – Tellier was a securities underwriter who was convicted of fraud, paid $20K in legal fees,
        paid criminal fines and went to jail; at issue was whether the fines were deductible; §162(f) says
        that you cannot deduct fines resembling penalties paid to the government for violation of a law so
        they are not deductible; also at issue was whether he could deduct the legal fees; Court holds that
        he can (look to origin of the claim – business or personal… although that is debatable here, could
        say it came out of his personal defect); also case repudiates public policy doctrine (i.e. you can
        deduct unless it would be against public policy)
       The law in this area is all over the place – there is a line between business crime
        and personal crime and judges have to draw the line all the time, very blurry
            o Securities fraud, lying about Medicaid = business crime
            o Killing someone for profit, burning down competing restaurant = personal
                crime
       IMPORTANT CODE SECTIONS: §162, §212 (NOTE: the way they fit
        together is that §162 is a subset of §212; further, §162 deductions are privileged
        in that they are always allowed whereas §212 are limited by §67 to only those
        above a 2% of income floor)
       Big Themes: Valuation – Business v. Personal. Complexity – Compliance

Salaries
    Exacto Spring - Heitz owns 55% of stock in Exacto Spring. 2 other investors
        have 20% each. Thus there is a dual relationship – he is both owner and
        employee. Capitalist and worker. Heitz got $1M in salary for his role as CEO of
        Exacto Spring. The IRS thought that this was excessive and that some of this was
        actually accounting for a dividend; controversy is whether Exacto Spring is
        paying Heitz his ―dividend‖ in the form of salary (matters because of ―double-
        tax‖ on corporate income); Posner in this case rejects a vague 7-factor test in
        favor of the Independent Investor test = judge should put himself in the
        position of a third party investor and see if the salary seems reasonable from that
        point of view, the higher a rate of return a manager can generate, the greater the
        salary he can command; Posner holds the salary to be reasonable under this
        standard
    Underlying problem is very difficult – how do you value labor when you may
        have reason to believe that the market value is inaccurate?
    Problems with the independent investor test
           o Doesn’t tell you the actual market clearing rate
           o Treats all of the returns about the market return as returns to labor (could
               be returns to labor AND capital or even all returns to capital)
           o Look at objective data, but doesn’t take account of things like goodwill
               etc.
           o Difficult to value with closely held companies etc.
    Alternative test would be to find a similar worker and compare salaries, the
        excess salary would be treated as a dividend
    In response to this, there is a statutory limitation on deductibility of large salaries
           o §162(m) says no deduction beyond $1M of compensation.
                   BIG Loophole however for performance based compensation.
                       Goals set by outside directors and measures like that but clearly
                       162(m) didn’t really reign in salaries that much.
           o Came about because of populist dislike of large salaries and a concern that
              investors do not have enough voice in corporate dealings (i.e. management
              is milking the corporation, paying itself inflated salary)
       Big Themes: Valuation – deference to business valuation at times.

Business versus Personal Deductions
    Pevsner - Pevsner worked in an Yves Saint Laurent boutique and had to buy and
       wear their clothes for business purposes. She wanted to deduct the expense as a
       business expense; the Court concluded she couldn’t deduct under a 3-factor test
       saying clothing is deductible when: (1) clothing is of a type specifically required
       as a condition of employment; (2) clothing not adaptable to general usage as
       ordinary clothes; (3) clothing not worn for daily usage; Issue was whether #2
       should be interpreted objectively or subjectively (i.e. the clothes were objectively
       fit for use, but subjectively not); Court goes with objective test (fairer and
       administratively easier)
    NOTE: although Pevsner has the same flavor as Benaglia, they are from two
       different lines of doctrine (Benaglia deals with exemption from income of
       certain fringe benefits; this deals with a deduction from income of business
       expenses). No real reason why Benaglia wins and Pevsner loses.
    The Pevsner outcome probably overtaxes some people like her; one way to get
       around it would be to require that the clothes stay in the store.
    McCabe - McCabe was a police officer who was required to carry a revolver on-
       duty. His most direct route to work was via NJ, but he could not get a NJ gun
       permit… thus he was forced to drive to work and take a much longer route to
       work – cost him extra; question in the case is whether the extra costs of the
       longer route can be deducted. The court holds that he cannot take the deduction;
       generally you cannot deduct commuting costs; further, McCabe doesn’t fall
       under the work implements exception because the extra costs were not for his
       employer’s convenience but instead were because of where he chose to live
    Flowers (invoked in McCabe) – he incurred substantial commuting costs, not
       allowed to deduct the costs because it was a personal decision for him to live so
       far away
    Exception to non-deductibility of commuting costs = can deduct additional
       costs incurred because of the necessity of transporting work implements to
       and from work (IRS revenue ruling)
    Hanzis - Hanzis was a law student in Boston, took a temporary summer job in
       NYC after being unsuccessful at finding a job in Boston. She sought to deduct
       the costs of her housing/meals (living expenses) in NYC as business expenses
       while she was ―away from home‖; Court decides that it was a personal decision
       for her to maintain the second place of residence – i.e. there was not a
       business reason to maintain the two homes; court uses but for test for the
        motive of keeping the Boston house (i.e. was it ―but for‖ a business reason or a
        personal reason? They say personal reason).
       Big Themes: Valuation: personal v. business.

Capital Expenditures
   Once you have determined that an expense is business related, it does not follow
        that you get a §162 deduction – you have to look to §263 and see if it is a capital
        expenditure in which case you must capitalize rather than getting an immediate
        deduction
   A capital expenditure is any improvement/investment in an asset that yields value
        over time
   Some examples of capital expenditures = building lease that extends beyond a
        year & is paid in advance, cost of employee labor used to produce a product
        valuable past the end of the year – like construction worker.
   This matters because of the concept of tax deferral (time element of income)
   Woodward - Woodward is majority stockholder in a corporation. Iowa statute
        requires them to buy out the minority stockholder at a fair value, they had to go
        to court to appraise the stock and they wanted to deduct the expenses of the
        appraisal litigation. The deduction was disallowed – classified as a capital
        expenditure, so it gets capitalized into the minority stock that was acquired –
        resulted in a very large basis in that stock. Court said related to asset acquisition.
        Woodward said just related to valuation and not acquisition. Court doesn’t buy.
   NOTE: §67 = sets a floor for “miscellaneous itemized deductions” (i.e.
        disallows relatively small deductions – those below 2% of income)… thus this
        limits deductions under §212 but not under §162 (except §162 employee
        deductions are subject to the 2% floor in §67 if unreimbursed)– makes it harder
        to deduct small §212 expenses, helps prevent cheating
   INDOPCO - Unilever wanted to acquire National Starch (INDOPCO), which
        incurred substantial investment banking and legal fees as well as other
        acquisition expenses in the course of the acquisition; issue was whether they
        could deduct banking legal fees under §162(a); Holding is that these expenditures
        are capital expenditures because they produced benefits that lasted more than a
        year (i.e. benefits of being acquired, like investment, market synergies, cost
        cutting); this case was a way for the Court to point out that a creation or
        enhancement of a separate asset was not necessary for expenditures to be
        capital – the essential characteristic is whether the expense will generate
        value over time. Gets around Lincoln Savings ruling to that affect by saying that
        was sufficient but not necessary. Non-exclusive test.
   PNC Bancorp, Inc. – IRS got greedy after INDOPCO challenging lots of
        deductions; this case was a slapdown, shows limits of INDOPCO doctrine; the
        question was whether the costs incurred by banks for marketing, researching, and
        originating loans were deductible… IRS said that they weren’t and that they
        should instead be capitalized… the Court rejected this theory and allowed the
        deductions (to hold otherwise would basically mean that lending institutions
        could make virtually no business deductions); this opinion is very muddled
       Wassenaar – LLM wants to deduct cost of getting JD. Higher education CAN
        be deductible only if 1) Already in trade or business, 2) Doesn’t qualify you for
        new trade or business 3) Necessary – maintain or improve your skills 4) Doesn’t
        meet minimum job qualifications. W fails on the first 2 prongs. Court rejects
        argument that already in trade or business of rendering services to employer for
        compensation but have to be specific about what kind of employee you are in
        this body of doctrine
       Alternate regimes:
           o Make the following assumptions:
                     (1) Assume that there is a constant interest rate – it doesn’t change
                        over time and it doesn’t change based on the amount you invest
                     (2) Assume that there is a constant tax rate – flat rate that does not
                        change over time or over different incomes
                     (3) Assume no chance of default on investments
           o Suppose you have $100 pre-tax, tax rate of 30%, investment rate of return
               of 10%. In this static case, this is how the regimes will come out:
                     (1) Income tax = ~7% return (i.e. taxed on the $100, invest what is
                        left, taxed on gain on the investment)
                     (2) Immediate deduction (e.g. ―the‖ flat tax, savings deduction) =
                        10% return (only get taxed when you cash out with $110)
                     (3) Yield exemption = 10% return (taxed immediately, gain
                        exempted)
       These alternatives show why people sometimes say that the income tax is a
        ―double tax on savings‖
       **NOTE the equivalence between regimes #2 and #3 – allowing an
        immediate deduction for investment is the same as exempting the interest
        income on that investment from tax
           o This is what is at stake in INDOPCO and PNC - whether you want to
               exempt the yield from a particular investment from income tax… you
               would essentially exempt the yield if you allow an immediate deduction
               for something that really should be a capital expenditure
           o Because of this equivalence, that would move us closer to a consumption
               tax! Consumption tax can be understood as an immediate deduction. It's
               the same thing as an income tax WITH a deduction for savings.
               Consumption tax is a wage tax. Y = w + r
       ** The real world income tax occupies a grey area between regime #1 and
        #2!! It is not a pure income tax… Even have some regime #3 examples – tax
        exempt bonds.
       Big Themes: Valuation – result of realization requirement, Complexity –
        Compliance.

Depreciation
    Depreciation is essentially just cost (basis) recovery over time
    E.g. buy a building for $1M, basis in the building is $1M, building declines in
       value over time…
          o You have to capitalize the purchase price & then depreciate the capitalized
              amount over time (~40 years useful life under present law, rate of
              ~$25,000 per year – straight line deduction for real property )
          o Adjusted basis = basis changes over time based on subtractions for
              depreciation until eventually being 0 in 40 years (e.g. $975,000 adjusted
              basis in year 2)
   Depreciation is necessary in a realization based income tax system
   Assets with a predictable decline in value over time get depreciated (e.g.
       buildings, machinery, cars, tools – contrast this with things that do not
       predictably decline in value like art, land, diamonds, stock)
The law doesn’t even attempt to mimic economic depreciation anymore… it used to
 (dudes went out and did useful life studies of different things) but lately we have
moved towards more accelerated depreciation. Lots of Congressional action in this
 area. Way to affect policy that doesn’t set off the radar of many lay people – yet.
   Depreciation deductions are meant to encourage business investment, not
       personal consumption! This is why a taxi service could depreciate cars but an
       individual could not… Presumably the individual consumes the enjoyment he
       gets out of the car - so not depreciable.
   Simon - 2 expert violinists bought expensive antique bows & then tried to
       depreciate the cost of the bows. The IRS contended that the bows could not
       decline in value because they were antiques, violinists said that the bows would
       only be playable for so long, so they should be depreciable; §167(a) allows a
       deduction for ―exhaustion, wear, and tear‖… this language becomes critical in
       the opinion; Court finds in favor of the violinists and allows them to depreciate
       the full value
   Alternate Depreciation Regimes:
          o ―Wear & Tear‖ theory allows them to depreciate the full cost over time
          o Mark-to-market would take into account how the value actually fluctuates
              over time – this is seen as the baseline/‖best‖ or most economic solution
          o IRS theory is that these things hold their value over time, so the IRS
              doesn’t think that they should depreciate the bows over time
          o Bifurcation theory = very clever, but not as good on the numbers (i.e.
              doesn’t as closely approximate MTM); would separate out the ―play‖
              value from the ―antique‖ value and allow depreciation of only the playing
              value
   NOTE: IRS has announced that it will not follow Simon!!! So this ruling is
       only followed in the 2nd Circuit!!
   Big Themes: Valuation – Realization Req. Consequence - depreciation
       schedules don’t match up at all with economic reality Complexity –
       Compliance, unclear what qualifies as depreciable. Huge policy area.

Interest Deductions
    Interest can be conceptualized as the cost of renting capital
    Annuity – worry that you will live too long (life annuity), i.e. you want to make
        sure that you will have enough income as you get older (social security is a
        mandatory life annuity), will pay you a certain amount for all the years you live
       beyond a point (kind of the flip of life insurance), under tax rules you don’t have
       income from an annuity until you actually get the cash. Congressional policy to
       encourage savings.
      Knetsch – SUBSTANCE OVER FORM ALERT Transaction at issue: (1)
       Knetsch buys bonds (30 year annuities) for $4,004,000 ($4K cash, $4M non-
       recourse seller financing; bond pays 2.5% interest, debt 3.5%), (2) Knetsch pre-
       pays the first year’s interest on the transaction, (bond value $4.1M, pays $140K
       interest using $41K cash and further $99K nonrecourse debt he can borrow back,
       also prepays interest on that of $3,465), (3) Tax deduction for $140K plus
       $3,465 for a total tax deduction of $143,465; this was essentially a scheme of tax
       arbitrage = deductible interest expense against an income stream that is
       itself tax free or tax deferred; e.g. for the first 30 years Knetsch reports no
       income but gets $140K deductions; Knetsch basically bought a tax shelter for
       ~$40K (see 4/2 – 4/3 for details); Court holds that Knetsch cannot take the
       interest deductions because the transaction was a sham
      Ways to fight tax shelters & tax arbitrage:
           o One way to fight shelters is to look to see if the deal would be profitable in
               the absence of taxes – if not it is probably a shelter! (e.g. sham doctrine).
               Although people do make stupid deals
           o Basketing as in §163(d) – disallow deductions beyond the income you get
               from that investment… but some problems:
                    Money is fungible so people could ―re-basket‖ to get around rule…
                       especially rich people with lots of investment income
                    Will overtax some
      One argument in favor of taxpayers like Knetsch is that they are not violating any
       law – Congress should change the law if they do not like the consequences
      NOTE: §163(h) mortgage interest is a legal form of tax arbitrage!! Not only
       privileges borrowing for a house over borrowing for other assets, also allows you
       to deduct interest even though imputed income from house occupancy is not
       cashed out in the tax system (e.g. you deduct the interest, but you don’t have to
       report the income you get later!); biggest middle class tax shelter - ~$40-60
       billion per year
      Big Themes: Complexity – compliance – sham doctrine, transactional. Ethical,
Losses
    2 types of loss:
       1. Loss = Basis-Amount Realized
       2. The excess of deductions over income from an activity. Like Net Operating
           Loss
    You have to determine from context what the speaker means when he/she says
        ―loss
    Generally, losses are only allowed for the following:
           o Losses incurred in trade or business
           o Losses incurred in a transaction entered into for profit
           o Casualty losses (e.g. theft, natural disaster)
      The basis for loss is your adjusted basis under §1011 even if the FMV is higher
       than that at the time – the rationale is that you already got a deduction for the
       excess of FMV over adjusted basis
    NOTE: if you get overcompensated by insurance, you get taxed on gain!
       (involuntary conversion – a disaster is a realization event!)
    For individuals there is a 10% floor on casualty losses (must exceed 10% AGI)
       - this developed because of controversy over what casualty is
    Also, in the case of personal use property destroyed by fire, you can only deduct
       a loss of FMV – the excess of purchase price over FMV is conceptualized as
       consumption
    Plunkett - Plunkett is an engineer, gets interested and involved in mud racing and
       truck pulling. Eventually he switches fully to truck pulling with the aim of
       making a profit, modifies his cars, spends lots of time on it, etc.; has losses in
       both areas, quandary is what he can deduct and what he cannot; depends on
       whether the activities were engaged in for profit or not (§183); Court’s decision
       here = the mud racing was merely a hobby whereas the truck pulling was
       engaged in for profit; thus only truck pulling deductions allowed to offset regular
       income
    NOTE: If an activity is not for profit, only certain deductions are allowed:
           o Deductions allowable without regard to whether the activity is profit
               related (e.g. a casualty loss under §165, §162 deductions, §163 interest
               deductions, §167-168 depreciation deductions)
           o Deductions allowable if the activity were for profit, but they are allowed
               only to the extent that they offset income from that activity and only to the
               extent that such income exceeds the other allowable deductions – this is
               the taxpayer favorable part of §183… allows you to deduct hobby loss
               up to the income from the hobby
    Fender - SUBSTANCE OVER FORM ALERT 2 trusts, Dad and a bank – Dad
       owns 41-50+% of the bank; Trusts had a high gain, looked for assets they could
       sell at a loss – they had bonds that had depreciated & they sold them to the bank
       at a loss, basis had been $450K and they were sold for FMV of $225K,
       repurchased 32 days later, Trust claimed a deduction of $225K; Court holds that
       this sale has no economic substance (i.e. there is no substantive loss) and the
       court disallows the deduction (disregards the sale); tricky problem
       determining what a true sale is (risk as an important factor)
    Real sale must expose you to market risk, you don’t own the asset anymore
           o Couldn’t get them under § 1091(wash sales) or 276(related parties) so got
               on economic substance. Shows the consequences of BLRs. People
               follow letter rather than spirit – that comes with sense of certainty though.
    Big Themes: Valuation – business v. personal, realization. Complexity –
       Compliance. Income-shifting with losses generally.
Tax Shelter Losses
    Frank Lyon – Complicated sale-leaseback arrangement between Lyon and
       Worthen composed of: (1) Ground Lease = W owns the ground where the
       building sits, leased the ground to L, L pays W ground rents, (2) Building Sale =
       L buys the existing building from W for $7.6M, (3) Leaseback = W agrees to
       pay L building rents for use of the building, (4) Third Party Lending
       Agreement = New York Life lends L the money ($7.1M) and L has to pay
       interest and principal on the debt, (5) Purchase Option = W has the right during
       the first 20 years to purchase the building at a set price that changes over time;
       the oddity is how it plays out (low ground rent, building rent mirrors loan
       payments in T1, T2 the ground rent rises and building rent is fixed, T3 ground
       rent falls again and W has no lease rights, T4 the land reverts to W); essentially
       pre-tax, Lyon has a lot of downside risk (W folds, rental markets fall and W
       decides not to renew, etc.), not much upside gain; this flips when you take taxes
       into account… Lyon is essentially buying depreciation deductions on the
       building; (NOTE: W, as a bank, already had a tax shelter in that it could borrow
       to buy tax exempt bonds, so that is why it was willing to pass this off to L); tax
       question is whether to allow deductions; IRS thought this was a sham (W is
       really the building owner/borrower, L is just a ―lender‖); big question = what is
       ownership for tax purposes? USSC finds L to be owner b/c he bore burden of risk
      Owner for tax purposes is the person who has meaningful upside and downside
       risk (i.e. they have some potential for gain and some potential for loss)
          o Typical upside and downside risks:
                     OWNER: full upside, full downside
                     LENDER: zero upside, fixed return, credit risk
          o Problem in Lyon is that nobody has exactly these bundles
      Frank Lyon Facts handout and 4/9 for more details
      Different types of Substance over form doctrine: Sham Transaction, No
       Economic Substance, Step Transaction. Litigators need to know precise
       differences.
          o Economic Substances takes 2 forms. 1. Business purpose 2. Would have
               entered transaction pre-tax motives. Profit making potential – but unclear
               how much profit sufficient.
      Big Themes: Valuation – little boxes problem, Income Shifting, Complexity –
       Compliance and Transactional, Professional

Charitable Contributions
   §170(a) = allows deduction to those who give a contribution to certain (not all)
       tax-exempt organizations
   §170(c) = defines charitable contribution… 5 requirements:
      1. Only if the gift goes to an eligible donee (if individual is not eligible, no
          deduction even if your donative intent is charitable, e.g. giving bucks to a
          beggar), essentially eligible entities are §501(c)(3) organizations
      2. Payment must be a “contribution” – a lot of doctrinal freight is put on this
          definition, defined much the same way as gifts in §162 (detached and
          disinterested generosity as in Duberstein); see Hernandez
      3. Must take the form of cash or property – no deduction for services
              a. Why can’t you deduct services?
                       i. Economic efficiency?
                      ii. Double-deduction problem – you don’t report the value of the
                          services as income, yet you get the deduction
                  iii. Imputed value argument – the value of services you don’t get
                       income for… you aren’t getting taxed on the imputed income
                       you would have gotten for the rendering of services, so you
                       should not also get to deduct it
                  iv. Valuation problem? Especially if no market for service
           b. This should prevent the creation of tax shelters – but a big hole in the
               logic is §170(e) where in the case of some gifts of property, you can
               deduct more than the amount that you previously included in income;
               thus you CAN get a double-deduction for certain kinds of property, i.e.
               you can deduct FMV when it is higher than your basis in some cases
  4. Percentage limitations – amt. limited to a certain percent of your income,
      generally 50% but for some kinds of contributions it is lower, like 30%
           a. In principle this is a bizarre rule – hits extraordinarily charitable
               people and people who would otherwise engage in tax fraud
           b. Rationale is to prevent the fraud, but there is a side effect that you may
               actually discourage people who are incredibly generous (especially
               hits people who are in religious orders and give their income back to
               the order… e.g. a nun professor who gives all income back to the
               order)
  5. You have to itemize.
           a. Gross income-ATL(above the line) deductions = AGI
                    i. AGI-(itemized deductions OR standard deduction, whichever
                       is more) = taxable income
                   ii. The person taking the standard deduction gets no marginal
                       benefit from the charitable contribution – as far as social
                       policy, charitable contribution rules operate at the margin only
                       for itemizers, which turns out to me mostly well-off people
           b. The fact that it is itemized means that the incentive effects occur
               differently across itemizers as opposed to those who take the standard
               deduction
 Examples:
      o You would have to reduce the amount you donated by whatever bonus
           ―goodies‖ (e.g. free cd) you get for the donation
      o Donation to a school your kid goes to – does it stem from detached and
           disinterested generosity?
      o Donation for a ―chair‖ at a university – totally deductible (too hard to
           separate out which part is for personal benefit and which part is charitable)
      o College donation by corporation – deductible, kind of like advertising
 Hernandez - Members of the Church of Scientology claimed deductions for
   money they paid for individualized religious services & the IRS disallowed the
   deductions because it was a quid pro quo exchange, and therefore should be
   classified as consumption rather than a contribution (valuation problem – how do
   you value religious ―goods‖?)… NOTE: it is essentially agreed by secret
   settlement that the IRS will not enforce this holding
 Two main arguments for the charitable deduction:
           o (1) Income defining – if you give money to charity, it is not really
               personal consumption because the charity spends it; this is controversial –
               some people would say it IS personal consumption in the same way that a
               gift is personal consumption
           o (2) Tax expenditure – government wants to encourage charitable
               contributions, and does this by exempting such income from tax, social
               policy function
       Key features as instrument for subsidizing public sector:
           o Subsidy paid to individuals
           o Rebate for charitable contributions which is a function of your
               marginal tax rate (upside down subsidy effect – value of rebate per dollar
               rises with your income)
           o Elasticity of charitable contributions – do charities benefit on net? This
               will depend… imagine someone who gives $100 before §170, then §170
               enacted:
                    Still donate $100 – windfall to taxpayer who gets deduction
                    Gives an amount greater than $100 – benefits charity and taxpayer
                             $167 – break even rate (same cost after tax as the original
                               $100 benefit)
                             Any donation up to $167 higher than $100 = charity gets
                               more, but it all come from Uncle Sam (pure transfer from
                               government)
                             Any donation over $167 = individual is actually giving
                               even more! (actual increase in giving)
       Who decides? This program says that the money the government uses to
        subsidize charities will be given according to how much people give and what
        their marginal tax rates are, very decentralized way to distribute money
       What are alternative systems?
           o Centralized system of government grants
           o Tax credit for charitable contributions (gets rid of the upside down
               subsidy, esp. if refundable tax credit)
           o Block grants to the states, leave it to them to distribute the money
       Big Themes: Valuation – personal v. quid pro quo, categories that don’t exactly
        map on.

Corporate Tax Shelters
    ACM Partnership – Complicated transaction where: (1) ACM buys $180M
      Citicorp Notes, (2) ACM sells $180M Citicorp Notes (no profit, no loss
      economically, sold for $140M cash, $40M LIBOR notes, installment sale so you
      can defer gain, LIBOR has no minimum guarantee, so brought this into
      contingent installment sale rules), (3) Use the $140M to buy back Colgate debt –
      this allowed them to use the argument that the whole deal was legitimate because
      it was all about buying back debt (try to say there was economic substance); the
      key in this shelter is that the gain was allocated to a foreign party who would not
      get taxed, Colgate could write loss off against gains; Court applies economic
      substance doctrine, no economic substance, disallows the deductions…
       The ACM transaction was blatantly for tax purposes… but important question is
        whether they should be allowed to rely on rules (they DID follow the rules)
       Detailed facts at 4/10 and ACM hand out
       Are corporate tax shelters a bad thing?
           o Inefficient because you get a lot of smart people wasting their time on it
           o Distributional consequences – doesn’t really benefit the average
                American, helps fat cats get fatter
           o People also worry about cultural consequences – these things tend to
                breed disrespect of the tax system
                     Indicator of certain law defying culture in business.
       Bad things that were done in wave of corporate shelters:
           o Accounting firms sold products to their own clients (i.e. guaranteed that
                the auditing firm would not question these practices)
           o Tax return preparation by the same firm that marketed the shelter and
                audited the firms (shady hiding of transactions on returns)
           o Canned legal opinions used as ―insurance‖; got megabucks in return for
                the opinion and only had to do the legal work once (easy money)… also
                allowed the client to say they relied on it (in the end this didn’t work)
       Raised questions about whether lawyers were too adversarial (more cooperation
        to prevent shelters) and pointed out collective action problem = the bad actors
        get all the business! Deloitte & Touche though refused to do. Only big player.
       KPMG – brings out distinction between tax products and tax advice; Tax
        products/shelters = turn the lawyer into an entrepreneur marketing a deal to make
        money; Trend for corporations to have ―in-house‖ lawyers;

        Sources of Problems                                             Remedies
Uneconomic rules                                         Mark-to-market accounting

Realization req. Recourse debt treated same              Make tax reality closer to economic reality
as NRD, sale lease back not treated same as
loan
High fees/low risk                                       Increase the penalties on lawyers/increase,
                                                         impose penalties on the clients who buy
(i.e. if an opinion gets invalidated by the IRS, it is   into this
easy to prove that you wrote it in good faith and that
the opinion sufficiently warned the taxpayer of the      (NY State Bar supported raising penalties on clients
risks; few penalties… even under Circular 230 the        because they thought it would cause a race to the
penalty is that you can’t practice in front of the IRS   top;
– doesn’t matter if you don’t litigate)
Secrecy & the Audit Lottery                              Disclosure rules with penalties for
                                                         nondisclosure
(ex ante shelters are good business because you have
a low risk of being caught and punished)                 Public Returns for Corporations

                                                         Improve IRS resources

                                                         (not foolproof strategy, some people still make a
                                                         bus. decision not to disclose; also, not clear what
                                               the IRS can do with the disclosed info… IRS
                                               auditors are not as well paid, not as smart… the
                                               smarter people go to the Treasury… disclosure pits
                                               people with good training and resources against
                                               people with less training/resources /institutional
                                               knowledge)
 Legal Uncertainty/Complex Tax Code            Codify Economic Substance

 Unclear when court would ―go off script‖
 and do things like substance over form
 Structure of Legal Profession                 Change Professional and Corp.
                                               Accountability Structure
 Zealous Advocate Model
 Inadequate Ethical Rules                      Limited Liability Rules
 Lots of $$ at stake - For tax payers too if
 high marginal tax rate

           Common Features of this wave of tax shelters
                  o Secrecy, Aggressively literal interpretations, individual tailoring,
                       questionable ethics, big names
Taxation of the Family
    Income shifting (rate arbitrage) can occur in different contexts, always involves
       a relationship of some kind:
       1. Within the family or otherwise by gift – this is dealt with below
       2. Relationships defined by arm’s length contract – similar to Frank Lyon,
           network of contracts allocates deductions & income in tax advantageous way
    Income shifting in family: two conditions must be met
          o (1) Members of the family have different marginal tax rates
          o (2) Parties within the family have some economic identity of interest,
              e.g. the nominal shifting of money effects no real change in consumption
              or saving opportunities (the family has one shared ―pot‖ of resources)
    Druker (marriage penalty case) - constitutional challenge to the marriage
       penalty, taxpayers lose; Drucker’s bring a constitutional claim, say that the right
       to marry is fundamental, this violates the 14th amendment, court says NO
    Marriage Penalty = 2 people filing jointly as married individuals might pay a
       higher total tax bill than they would have paid if they remained single… under
       the current rate structure only exists for double-earner families, and it is higher
       the closer the incomes are to each other (in fact, when one spouse does not work,
       there is a marriage bonus in that the marrieds pay less than equivalent singles)
    What are your options in dealing with marriage?
          o (1) Single filing – marriage neutral (had this until the 1940s)
                   Argument is that this will tax different couples with the same total
                      amount of income differently
                   Horizontal equity across married couples
          o (2) Joint filing
                   (A) Bonus only – so marriage always at least lowers your tax bill
                      (file the lower)
                   (B) Penalty only – marriage always makes your tax bill higher
                   (C)*** we currently have a mixed system, mixed A/B
           o (3) Flat tax rates
    Impossible to have horizontal equity, no bonus/penalty for marriage, and a
       progressive tax system all together
    Marriage penalty hits the hardest at the low end and the high end, but not as hard
       in the middle
           o At the low end – EITC progressivity makes marriage penalty hit harder
           o At the high end – higher marriage penalties because they are bumping up
              through more bracket break points (e.g. 2 single people making $80K
              each will bump up a lot more brackets together than will 2 single people
              making $40K each)
    Two potential inefficiencies:
           o (1) Tax law leads people to either get married or not get married –
              data suggest that this doesn’t really happen empirically
           o (2) Prevents women from entering the work force – secondary worker
              problem, primarily a problem for wives. Married women more sensitive
              to economic costs of working.
    NOTE: option for married filing separately is to separate the liability for the
       accuracy of the return… usually just increases amount owed
Assignments of Income
    Lucas v. Earl - Mr. Earl was a lawyer, Mrs. Earl was pretty well off; they enter
       into a contractual arrangement agreeing to split all income that comes in to either
       one of them (she got mostly investment income, he got income from clients);
       question was who the income gets taxed to (she legally owns it, but he earned it);
       Court agreed with the IRS theory (Mr. Earl should be taxed on all his income),
       said the contract was an invalid assignment of income
    Principle of beneficial ownership of income (e.g. in a relationship between an
       investor and a mutual fund, the mutual fund is the legal owner of the stocks in
       which the money is invested, but the beneficial owner of the income is the
       investor)
    Basic principle is that income from property is taxed to the owner (or
       beneficiary) of property
    Blair - Blair’s father dies and leaves him some property (property grows off
       income and leaves a remainder; Life interest: income interest for life, when the
       last remaining life interest recipient dies, you have the ―remainder‖); Mr. Blair
       assigned a piece of his life interest to his kids, wants them to be taxed on the
       income; Court holds that the kids should get taxed (allows income shift)
    Horst - Coupon bonds case, Horst gives some coupons (next to mature) to his
       son to assign income, says son ought to be taxed on the income, and not the
       father; (NOTE: with coupon bonds, there were actually pieces of the bond that
       you would clip-off, a legally, free-standing obligation, e.g. the holder of the
       coupon was the holder of the property); the Court held that the income still gets
       taxed to the father (sees coupon like a gift of cash from the income) because the
       father retains control of the income stream
           o Distinctions the Court offers don’t really hold up:
                       B transferred property and H didn’t – Just not true under any def.
                        of property
                     Realization - H realized the value of the coupons by giving to son.
                        Know that gifts are not realization events. Same thing could be
                        said for B
                     Control – Shaky, distinction seems to be temporal. B gave up
                        control for whole life and H gave up control of coupon for 1 year
       DISTINCTION: Blair gave up a proportional share of everything he had (the life
        interest) and the share was coextensive in time with the share he had. Horst
        carved out a coupon in the simple sense and retained the bond (reversion).
        Doctrine: if you give up less than everything you own, you have to give away a
        proportionate slice of everything you own. If you give less than that in a temporal
        sense, it is an invalid assignment of income.
           o Doesn’t really hold up – B – also reversionary interest – not B but still
               exists.
       Hypothetical: say you have a 20 year income stream
           o Assigning 10 years to son 1 = invalid under Horst
           o Assigning all 20 years to son 1 = still invalid under Horst because you still
               have a reversion interest (principal)
           o Assigning all 20 years to son 1, principal to son 2 = here you DO income
               shift and son 1 gets taxed
       ALSO, important distinction between earnings and property – you can never
        assign your earnings to someone else, but you can assign the income from a piece
        of property as long as you set it up the right way
       Johnson – basketball player who assigned all his income to a company, then it paid him his
        salary; idea was that he could pay less taxes because company earnings would get taxed at the
        corporate rate, also some advantages from foreign status of company; however the basketball
        team would not contract with the entity, only directly with Johnson; in this case there is kind of a
        “form over substance” approach and the Court says that b/c the contract was not with the entity
        that this was an invalid assignment of income under Earl (however if the contract had been with
        the entity then the income could have been filtered through)
       Problem with a substance over form doctrine in cases like Johnson is that you would end up
        impeding some legitimate deals
       Big Themes: Income Shifting, Valuation- little boxes

Capital Gains
   Capital gains are the gain on the sale or exchange of a capital asset; don’t
        think of it as a kind of income, but as something that arises from transactions in a
        particular kind of asset
   If an asset is capital as opposed to ordinary, two consequences:
           o Rate Preference if the asset is held for more than a year; this is mainly
               what people mean when they talk about capital gains
           o Capital loss limitations apply; you can’t write off so much loss
   You must have a capital asset and a sale or exchange in order to qualify for
        the capital gains treatment
           o NOTE: corporate stock (except such stock held by dealers in such stock)
               is typically a capital asset, but dividends paid out on that asset are not
               capital gains because there is no sale or exchange.
                       HOWEVER, another provision in the code treats then as capital
                        gains anyway (policy change in 2001)… see §111. Didn’t talk
                        about it this year. Example was interest on bonds not CG.
           o Another example of an exception would be interest payments on bonds –
                that would be ordinary income because no sale/exchange
       Currently the maximum capital gains rate is ~15%
       Suppose a well-off person has $300K of salary & they sell an asset at a gain of
        $10K (calculated as amount realized minus basis); marginal tax rate for this
        person is 35% (regular income tax)
           o If the gain is ordinary, then the gain is taxed at 35%
           o If the gain is capital and short term then it is subject to the 35% rate
           o If the gain is capital and long term then it is subject to the 15% maximum
                CG rate
       NOTE: there is a refinement based on short term versus long term capital gains –
        want to find out if you have a net long term capital gains, only those get
        preferential treatment
       Capital gains rules are essentially basketing rules – toss all capital short term
        gains/losses in a basket and see what nets out (i.e. do you have a net short term
        gain? Net long term loss? etc.)
           o Basic rule – capital loss of an individual can only be used against
                capital gains (basketing idea)
           o Except - §1211(b) – can deduct capital losses to the extent of capital
                gains, then up to $3K per year against ordinary income
       Intuitively basketing should seem wrong because it will disallow real losses
           o But… problem of cherry-picking – abuse realization requirement to seem
                poorer, report an artificial tax loss by selectively selling losing assets
           o Basketing rules help counter cherry-picking (helps prevent the selective
                realization of capital losses and writing them off against earned income)
           o This safeguard against selective realization will result in some over-
                taxation
       Standard planning mode = want capital gain (preferential rate) and ordinary loss
        (can deduct it fully)… e.g. Ordinary income bad (taxed at higher, ordinary rate),
        capital loss bad (limited)
       Overview of policy:

          Problems                        Causes                       Solutions
Bunching – get taxed            Realization requirements,     Capital gains rate
higher because you realize      progressive tax rates, annual preference, mark to market,
capital gain all at once (can   measurement of income         income averaging
bump you up brackets)
Inflation                       Basis in nominal year 1 $’s   Indexing basis for inflation,
                                                              capital gains rate preference
Lock-in                         Realization requirement,      Capital rate preference,
                                step-up in basis at death     MTM + repeal §1014
   Bunching – suppose you buy IBM stock in year 1 for $10K, sell in year 10 for
    $100K… you have a gain of $90K but all is realized in year 10, have to pay a ton
    of tax then… creates an unnatural income profile
       o Could spread income via MTM, income averaging (this could be too
            taxpayer friendly – esp. averaging over later years – b/c of possibility for
            tax deferral)
       o CG rate preference also helps mitigate bunching
   Inflation – key mismatch, basis measured in nominal dollars and amount
    realized in inflated dollars
       o Could index for inflation. Computers with the ability to do it now.
       o CG rate preference also helps mitigate this
   Lock-in – people don’t want to sell because they don’t want to realize gain
       o Could change policies that cause this – § 1014
       o CG rate preference does help!
   Basic point is that the CG rate does help mitigate some serious tax problems
   Arguments AGAINT CG preferential rate
       o Complexity - Rule, Transactional
                 Not clear how much of complexity would go away. Result of
                    realization req.
       o Deferral benefit already counters bunching and inflation
       o Fairness. Vertical and Horizontal inequities.
       o Unclear whether really helps to stimulate the economy. Yes in short run –
            but that’s b/c people think going to go away. Very volatile areas of the
            law.
   NOTE: capital gains treatment of capital assets held for “personal
    consumption” = loss disallowed, gain allowed
   Malat - taxpayer was part owner of some real estate, thought about developing
    the land or holding it to sell, when the market turned against them they sold it;
    Taxpayer wanted to report capital gains because their ―purpose‖ was to develop
    thus it was not a business sale; IRS thought main purpose was sale so it should
    not be capital gains; Court holds that the principal reason for holding the asset
    (this is how primary is interpreted) is what matters… finds in favor of Malat
   Malat holding is problematic because it is impossible to know what people are
    thinking, what the intent of holding an asset is – also, plans change all the time
   Court identifies two motives for holding property – business and investment
       o Law tries to conceptualize these as polar opposites
       o Active business (e.g. grocery store – business motives to sell inventory,
            stock things, etc.) versus a passive long term holding (e.g. grandpa
            buying stock and holding it forever)
       o The doctrinal problem is the grey area between these motives
   Bramblett – You have ME (a partnership) and TE (a corporation), both owned by
    the same four people; standard transaction: ME would buy the land, would hold
    the land, and would sell the land to TE. TE would develop it and sell it to the
    buyer. There would be a certain amount of gain isolated in ME and a certain
    amount of gain isolated in TE; ME gain was capital gain and TE gain was
    ordinary gain; IRS contends that ME gain should be ordinary; central question
       was whether ME was a dealer in land… court holds that they were not and
       therefore capital gains treatment is OK… NOTE: this was a very shammy
       transaction and frankly the only purpose of ME being separate was for taxes
      For cases like Bramblett, the multi-factor test is governing doctrine: Doctrine
       for determination: (1) number of sales, (2) did they advertise, (3) did they have
       management, (4) were they active, etc…. factors listed on p. 558.
      NOTE: important difference between real estate industry and securities… in real
       estate the number of transactions matters (indicates whether you are a dealer)
       whereas you could be busy dealing in securities and still not be a dealer… one
       key factor is whether activities are motivated primarily for selling to customers
      §1231 = Just know essentially what 1231 is, but don’t worry about the nuance.
       Allows certain assets to create both capital gain and ordinary loss. This is called
       ―whipsaw‖ and it is illegal. But businesses are allowed to do this by
       Congressional decree.
          o Imagine: As an individual, you run an auto factory. As assets you have (A)
               factory, (B) machines, (C) raw materials, and (D) finished cars.
                    (A) and (B) are not capital assets under 1221(a)(2).
                    (C) and (D) are not capital assets under ―inventory‖.
          o BUT… If the factory (A) and machines (B) are held for more than a year,
               then they are capital assets. (C) and (D) are still not—still inventory with
               ordinary gain and ordinary loss. (A) and (B) lead to capital gain and
               ordinary loss—the best of all possible worlds
      §1245 = Anti-conversion rule. Easiest way to convert asset is to depreciate the
       asset against ordinary income and then sell the asset at an artificial amount for
       capital gain. To the extent of past depreciation, we will apply a match in rates.
       When you have later gain, we will recapture that gain at the ordinary rate of past
       depreciation. This is carving out from 1231.
          o Hypo: If you have an asset purchased for 10K and it were depreciated to
               6K and then sold for 9K. The gain of 3K would be recaptured as ordinary
               income.
          o If same property were sold for 11K. First 4K would be recaptured.
               Remaining gain of 1K would be capital gains
          o § 1245 doing much more work as accelerated deprecation is increased.
               Result of tax and economic realities not lining up.
      Distinguish between personal property and personal use property. Personal
       property is everything that isn’t real property (e.g. Car and desk are personal
       property—house is real property because it is attached irrevocably to land)…
       §1250 refers to real property… you cannot depreciate personal use property at all
          o For personal use property: gain is includable in your income – that is an
               accretion to net worth; the asymmetry is that any loss on the asset is NOT
               deductible because that loss itself is conceptualized as a §262 living
               expense. Loss is seen as consumption of the personal item.

Hedging
   Corn Products - buys corn products from corn suppliers and made corn syrup for
      customers. The only bad case could come if there is a shortage of corn and the
    price of corn inputs goes up. Its customers can enforce fixed price. They decide
    to hedge against one market outcome (corn shortages) by investing in forward
    contracts. Are these forward contracts ordinary or capital? In the end, the gains
    were bigger than the losses. They argued for capital gains treatment. Holding was
    that the gains were ordinary; problematic holding b/c this really looks a lot like a
    capital asset… Court was trying to prevent whipsaw, but ambiguous language
    (i.e. something ―integral to business‖) was too fuzzy, allowed almost anything to
    fall under this standard (mostly helped people trying to claim ordinary losses)
        o The feared abuse was this: Futures Contracts and Raw Corn are
            substitutes… If the Court called Fcs capital assets, tax payers like Corn
            products would just HOLD their Fcs so that is they rose they’d sell for
            capital gains then buy corn. If they didn’t go up in value they’d just use
            them. Get the corn and sell at a loss which would count as ordinary. TP
            could elect in.
   Arkansas Best - Stock-investment case. Bank does badly and AB sells the stock
    of the bank at a loss—wants to classify the loss as ordinary. SCt, at the behest of
    the IRS, says NO. Goes back to 1221 and gets aggressively literal. Finds that the
    stock was a capital asset and that it doesn’t matter whether the asset was integral
    to your business. Business purpose distinction too loose for court. Capital
    assets are defined broadly and the exceptions should be construed narrowly (see
    reverse language in Corn Products). If you’re not a dealer in stock, stock is a
    capital asset as to you. AB didn’t overrule Corn Products, but it did narrow the
    CP holding to ―substitutes for inventory‖.
   Court is trying to disable the post-Corn Products whipsaw
        o Quietly take CG on sales of plausible investment assets like stocks
        o When losses arise on investment - call law firm and search for any
            business purpose that could confer ordinary character.
                Like if person who owns newspaper company buys stock in paper
                    generally. Hold on past LTCG period. Sell at a gain with CG rate
                    preference or if loss – say about capturing supplier – ordinary loss.
   Hedging is when you invest in something to lessen your risk. AB says that there
    is no blanket exception from CG treatment for hedging
   § 1221(a)6-8: hedging transactions and supplies. Return ordinary character to
    hedging investments
   Exam Strategy for Capital Gains questions:
        o AA owns a piece of land. Is that a capital asset that gets preferential rate?
                Sale or exchange involved?
                How long as taxpayer held on to asset?
                Included in any of the exceptions in 1221?
                         Is she a real estate developer?
                         Land isn’t depreciable.
                Interplay with other code provisions
                         Is land personal use? No deductions allowed for personal
                            loss. § 262
                         If land was sold at a gain – no restrictions on counting
                            personal gain as income.
                         1(h) Exceptions or limitations to certain preferential rates.
    Big Themes: Valuation – little boxes, business v. investment, Complexity –
        Compliance and Transactional, Huge policy area, Income-shifting
When is NRD the bad guy?
Estate of Franklin

But NOT:
Knetsch (not so much -- asset was pretty safe, could have financed with recourse debt).
Frank Lyon (actually cuts against shelter aspect -- NRD character increases FL downside
risk, making him look more like owner)
ACM (definitely not -- no debt at all)


Substance over Form/ Sham Cases
-arguably, Old Colony
Estate of Franklin
Knetsch (sham)
Fender (no economic substance)
ACM Partnership (no substance)

Respecting Formality:
Bramblett
Frank Lyon
Cottage Savings

Taxpayer's Motivations:
-not Pevsner
-not Benaglia
-Duberstein
-Malat
-Plunkett
-Hernandez?
IMPORTANT CODE PROVISIONS

§1 – Overview, tax imposed
    (a) Rates for married individuals filing jointly
    (b) Rates for heads of households
    (c) Rates for unmarried individuals
    (d) Rates for unmarried individuals filing separately
    (e) Rates for estates and trusts
    (f) Marriage penalty phase-out
    (g) Certain unearned income of minors taxed as parents’ income
    (h) Maximum capital gains rate
    (i) Rate reductions after 2000

§2 – important definitions (cross referenced in §1)

§61 – Definition of gross income; ―all income from whatever source derived‖

§102 – Gifts and inheritance, generally excluded
   (a) General rule
   (b) Income as adjusted by rule
   (c) Employee gifts not excludable

§108 – Income from discharge of indebtedness
   (a) General exclusion from gross income (some DOI income excluded)
   (b) Order of tax reductions (e.g. how excluded DOI reduces tax liability)
   (c) Qualified real property business indebtedness
   (d) Meaning of terms/special provisions
   (e) General rule for discharge of indebtedness
   (f) Student loans (exception – don’t have to count as income in some cases)
   (g) Qualified farm indebtedness

§119 – Fringe benefits; meals/lodging furnished for the convenience of the employer
   (a) Meals/lodging on business property excluded
   (b) Special rules for (a)
   (c) ---
   (d) Lodging furnished by educational institution

§132 – Fringe benefits
   (a) Overview of which fringe benefits are excludable
   (b) No additional cost service
   (c) Qualified employee discount
   (d) Working condition fringe
   (e) De minimus fringe
   (f) Transportation fringe
   (g) Moving expense reimbursement
   (h) Individuals treated as employees for (b) and (c) – see §152 for dependent def.
   (i) Reciprocal agreements
   (j) Special rules (disallows if benefit offered discriminatorily, auto salesmen, on
       premises gyms, air cargo)
   (k) ―Customers‖ doesn’t include employees
   (l) Section doesn’t apply to fringe benefits provided for elsewhere
   (m) Qualified retirement planning services

§162 – Trade or business expenses
   (a) Generally ―ordinary and necessary‖ business expenses are deductible
   (b) No deduction for charitable contributions or gifts exceeding percentage
       limitations
   (c) Illegal bribes, kickbacks, payments – no deduction
   (d) ---
   (e) No deduction for certain lobbying/political expenditures
   (f) No deduction for fines/penalties paid to government or for violation of law
   (g) Antitrust treble damage payments only partially deductible
   (h) State legislator travel expenses away from home
   (i) ---
   (j) ---
   (k) Stock reacquisition expenses – generally not allowed with some exceptions
   (l) Rules for health insurance costs of self-employed
   (m) Certain excessive employee remuneration (no deduction beyond $1M salary)

§163 – Interest
   (a) Generally interest paid on indebtedness is deductible
   (b) Installment purchases – treated as if they included 6% interest
   (c) Redeemable ground rents – treated as interest on indebtedness
   (d) Deduction can’t exceed investment income, excess can be carried forward
   (e) Original issue discount
   (f) Denial of deduction for interest on certain obligations not registered
   (g) ---
   (h) Disallowance of deduction for personal interest (exception for mortgage)
   (i) High yield discount obligation
   (j) Limitation on deduction for interest on certain indebtedness
   (k) §6166 Interest
   (l) Disallowance of deduction on certain debt instruments of corporations

§165 – Losses
   (a) Generally you can deduct for any loss not compensated (e.g. by insurance)
   (b) Basis for determining the amount of deduction is generally §1011 basis
   (c) Limitations on losses (trade/business/profit activity/casualty)
   (d) Wagering losses only allowed to extent of gains from those activities
   (e) Theft losses treated as sustained in taxable year when discovered
   (f) Capital losses limited by §1211 and §1212
   (g) Worthless securities – when they become worthless, treated as sale loss
   (h) Casualty gains and losses – must exceed $100 per casualty, 10% of income total
   (i) Disaster losses – can be allocated to year preceding disaster year
   (j) Denial of deduction for losses on certain obligations not in registered form
   (k) If ordered to demolish/relocate because of disaster, treated as disaster loss

§167 – Depreciation
   (a) Allowed a reasonable depreciation deduction for exhaustion, wear, tear
   (b) Cross reference to §168
   (c) Basis for depreciation is adjusted basis from §1011 in general
   (d) Life tenants/beneficiaries of trusts/estates
   (e) Certain term interests not depreciable
   (f) Treatment of certain property excluded from §197 (computer software)
   (g) ---
   (h) Cross references to §611 (mines, timber, etc.), §197 (intangibles, goodwill)

§168 – Accelerated cost recovery (i.e. determining how to depreciate something)
   (a) General rule for determining §167(a) depreciation deductions
   (b) Applicable depreciation method (X% declining balance, then straight line)
   (c) Applicable recovery period
   (d) Applicable convention (base case: half year)
   (e) Classification of property
   (f) Property to which the section does not apply (elected, film, video)
   (g) Alternative depreciation schedule for certain property
   (h) ---
   (i) Definitions and special rules
   (j) ---
   (k) Special allowance for certain property acquired 10/10/01-1/1/05

§170 – Charitable contributions and gifts
   (a) Generally charitable contributions are deductible
   (b) Percentage limitations for deductions (most allowed below 50% income)
   (c) Charitable contribution defined
   (d) Carryovers of excess contribution (5 year carry-forward)
   (e) Certain ordinary income & capital gain property contributions (reductions)
   (f) Disallowance of deduction in certain cases
   (g) Amounts paid to maintain students generally not charitable contributions
   (h) Qualified conservation contribution
   (i) Mileage rate for passenger car (14 cents per mile)
   (j) Denial of deduction for travel expenses
   (l) Treatment of donations to institutions of higher education

§212 – Ordinary/necessary expenses for the production of income are deductible

§262 – Personal, living & family expenses generally not deductible (part (a))

§263(a) – No deduction allowed for capital expenditure with some exceptions
§274(b) - Disallows employer gift deductions for gifts over $25 in value
§1001 – Determination of amount/recognition of gain/loss
   (a) Computing gain or loss
   (b) Amount realized
   (c) Recognition of gain or loss (entire amount recognized unless otherwise stated)
   (d) Installment sales
   (e) Certain term interests

§1012 – Cost basis for property

§1014 – Basis of property acquired from decedent (step up in basis at death)
   (a) General rule – basis becomes FMV at date of death
   (b) Lists types of property considered acquired/passed from decedent
   (c) Property representing income (rights to receive income doesn’t count)
   (d) ---
   (e) Appreciated property acquired by decedent within 1 year of death
   (f) Termination of this provision (sunsets in 2009)

§1015 – Basis of property acquired by gift/transfer in trust
   (a) Recipient’s basis is generally the donor’s basis except for purposes of calculating
       a loss when FMV was less than donor’s basis at time of gift
   (b) Transfer in trusts – basis is adjusted by gain and loss in transfer year
   (c) Transfers before 1921…
   (d) Increased basis for gift tax paid
   (e) Gifts between spouses

§1211 – Limitations on capital losses
   (a) Corporations – losses only allowed to the extent of gains
   (b) Ordinary taxpayer – losses only allowed to extent of gains plus another amount

§1212 – Capital loss carry-backs and carry-overs
   (a) Generally corporate net capital loss can be carried back 3 yrs., forward 5
   (b) Generally for ordinary taxpayer – short/long term losses carried forward as such
   (c) Carryback of losses from §1256 contracts to offset gains from such contracts

§1221 – Definition of capital asset
   (a) In general, property held by taxpayer, not including:
           (1) Stock in trade/property in inventory, property held for sale to customers
           (2) Trade/business property with §167 depreciation allowance
           (3) Copyright, literary/musical composition, letter/memo held by the creator
               or person for whom it was produced/in whose hands basis was determined
           (4) Accounts/notes acquired in course of trade or business
           (5) US Government publication
           (6) Commodities derivative financial inst. held by dealer unless held as personal
           (7) Any hedging transaction which is clearly identified as such before the close
               of day on which hit was acquired
          (8) Supplies of a type regularly used or consumed by the taxpayer in the ordinary
               course of a trade or business of the taxpayer
   (b) Definitions and special rules (commodities derivatives, hedging)

§1222 – Other Capital Gains/Losses Terms (see code)

				
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