Federal Income Tax
Professor Shuldiner – Spring 2005
COMPUTING TAX LIABILITY................................................................................................ 1
WHAT IS INCOME? ................................................................................................................... 2
COMPENSATION FOR SERVICES ..................................................................................................... 2
FRINGE BENEFITS ......................................................................................................................... 2
Work-related fringe benefits -- §132 – ..................................................................................... 3
Meals and Lodging -- §119 ...................................................................................................... 5
Section 83 – Property Transferred for Performance of Services ............................................. 6
INTEREST-FREE LOANS -- §7872 .................................................................................................. 8
IMPUTED INCOME ......................................................................................................................... 9
DO YOU HAVE TO WORK FOR YOUR INCOME? ........................................................................... 10
Gifts and Bequests .................................................................................................................. 10
Government Transfer Payments ............................................................................................. 12
Prizes, Awards Scholarships .................................................................................................. 12
CAPITAL APPRECIATION AND RECOVERY OF CAPITAL ............................................................... 12
Present Value Computations .................................................................................................. 13
Capital Recovery and Basis ................................................................................................... 13
ANNUITIES -- §72 ....................................................................................................................... 17
LIFE INSURANCE ......................................................................................................................... 18
TREATMENT OF DEBT ................................................................................................................. 19
Illegal Income ......................................................................................................................... 20
Discharge of Indebtedness ..................................................................................................... 20
Borrowing and Basis .............................................................................................................. 23
DAMAGES AND SICK PAY ........................................................................................................... 27
Damages to Business Interests ............................................................................................... 27
Damages for Personal Injury and Sick Pay ........................................................................... 28
TAX-EXEMPT INTEREST .............................................................................................................. 29
ARBITRAGE ................................................................................................................................ 30
DEDUCTIONS AND CREDITS ............................................................................................... 31
BUSINESS EXPENSES (ABOVE THE LINE DEDUCTIONS) ............................................................... 31
Ordinary and Necessary......................................................................................................... 31
PUBLIC POLICY LIMITATIONS ..................................................................................................... 32
LOBBYING EXPENSES ................................................................................................................. 33
REASONABLE ALLOWANCES FOR SALARY .................................................................................. 33
EMPLOYEE BUSINESS EXPENSES AND THE 2% FLOOR ................................................................ 34
The 2% Floor ......................................................................................................................... 35
DISTINGUISHING BUSINESS AND PERSONAL EXPENSES .............................................................. 35
Hobby Losses ...................................................................................................................... 36
Travel Away from Home ........................................................................................................ 36
Transportation ..................................................................................................................... 37
Food and Lodging ............................................................................................................... 37
Meredith Huston i Tax Fall 2001
Limitations .......................................................................................................................... 38
Meals and Entertainment ....................................................................................................... 38
Home Office Expenses ............................................................................................................ 40
CURRENT VERSUS CAPITAL EXPENSES ....................................................................................... 41
Why do we care? .................................................................................................................... 41
Two Ways to Skin a Cat: Old and New IRA‘s .................................................................. 42
Acquisition and disposition of assets ..................................................................................... 42
Nonrecurring expenditures and expenditures that provide benefits beyond the current year44
Corporate Reorganizations.................................................................................................. 45
Expenses of an Ongoing Business ...................................................................................... 47
Expenses with Respect to a New Business – Start up costs ............................................... 47
Deductible Repairs s. Nondeductible Rehabilitation or Improvements .............................. 48
Job Search and Education Expenses ...................................................................................... 48
Depreciation and Amortization: Recovery of Capital Expenditures .................................... 50
Depletion ................................................................................................................................ 52
INTEREST .................................................................................................................................... 52
In General and Arbitrage ....................................................................................................... 52
Sham Transaction and No Economic Purpose Doctrines ...................................................... 55
What is Interest?..................................................................................................................... 56
Problems of Inflation.............................................................................................................. 57
LOSSES ....................................................................................................................................... 57
Business vs. Non-business profit Seeking Losses ................................................................... 57
Personal versus Business or Profit-Seeking Losses ............................................................... 58
Casualty Losses ...................................................................................................................... 58
Loss Limitations ..................................................................................................................... 58
Property Losses ................................................................................................................... 58
Tax Shelters ........................................................................................................................ 60
PERSONAL DEDUCTIONS ............................................................................................................. 62
Standard Deduction................................................................................................................ 62
Personal Exemptions -- §151 ................................................................................................. 63
Phaseouts of Exemptions and Itemized Deductions ............................................................... 63
Credits vs. Deductions............................................................................................................ 64
WHOSE INCOME?.................................................................................................................... 67
TAXATION OF THE FAMILY.......................................................................................................... 68
Treatment of Couples ............................................................................................................. 68
Treatment of children (“kiddie tax”) ..................................................................................... 69
Treatment of Divorce ............................................................................................................. 69
ASSIGNMENT OF INCOME ............................................................................................................ 71
Income from Services ............................................................................................................. 71
Income from Property ............................................................................................................ 71
Income from Property or Services: Which is it? ................................................................... 72
CAPITAL GAINS AND LOSSES ............................................................................................. 72
HISTORIC TREATMENT OF CAPITAL GAINS ................................................................................. 73
MECHANICS OF CAPITAL GAINS – SEE TEXT P. 530 ..................................................................... 73
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POLICY OF PREFERENTIAL TREATMENT OF CAPITAL GAINS ....................................................... 75
DEFINITION OF A CAPITAL ASSET -- §1221 ................................................................................ 75
DEPRECIABLE PROPERTY AND RECAPTURE ................................................................................. 78
DERIVATIVES AND HEDGING ...................................................................................................... 80
NONRECOGNITION OF GAIN OR LOSS: LIKE-KIND TRANSACTIONS .................. 81
Meredith Huston iii Tax Fall 2001
Federal Income Tax – Key Provisions
§61 Gross Income Defined – all income from whatever source derived
§61, 71- Items Specifically Included in Gross Income (not a comprehensive list)
89 §71 – Alimony
§72 – Annuities
§74 – Prizes and Awards
§79 – Group term life insurance purchased for employees
§82 – reimbursement for moving expense
§83 – Property Transferred in Connection with Performance of Services
§85 – Unemployment Compensation
§86 – Social Security and Tier 1 railroad retirement benefits
§101-134 Items Specifically Excluded from Gross Income (not a comprehensive list)
§101 – Certain Death Benefits
§102 – Gifts and Inheritances
§103 – Interest on State and Local Bonds
§104 – Compensation for injuries or sickness
§104 – Amounts received under accident and health plans
§106 – Contributions by employer to accident and health plans
§108 – Income from discharge of indebtedness
§117 – Qualified Scholarships
§119 – Meals and Lodging furnished for the convenience of the employer
§121 – exclusion of gain from sale of principal residence
§125 – cafeteria plans
§127 – educational assistance programs
§129 – dependent care assistance programs
§132 – certain fringe benefits
§135 – Income from United States Savings Bonds used to pay higher
education tuition and fees
§62 Adjusted Gross Income Defined – look here for above the line deductions
62(a)(1) – Trade and business deductions
62(a)(2) (A) – Reimbursed Employee expenses
62(a)(3) – Losses from sale or exchange of property
62(a)(4) – Deductions attributable to rents and royalties
62(a)(6) – pension plans of self-employed
62(a)(7) – retirement savings
62(a)(10) – alimony
62(a)(15) – Moving expenses
62(a)(16) – medical savings accounts
62(a)(17) – interest on education loans
§63 Taxable Income defined – look here for below the line deductions
63(c) – Standard deduction – for non itemizers
63(d) –Itemized deductions
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63(e) – election to itemize
§151 Allowance of Deductions for Personal Exemptions
In 2001 – personal exemption is $2900, in 2000, was $2000
§151(d)3 – personal exemption gets phased out once reach certain income
level (about 200,000)
§151(d)4, companion provision, inflation adjustment -- in the case of any
taxable year, the dollar amount shall be increased based on the cost of living
§152 Dependent Defined – taxpayers also entitled to exemption for each dependent
(includes children, grandchildren, parents and other relatives, and unrelated members
of taxpayer‘s household, more than ½ of whose support for taxable yr provided by
§162 Trade or Business Expenses – there shall be allowed as a deduction all the ordinary
and necessary expenses paid or incurred during the taxable year in carrying on any
trade or business . . .
deduction may be above the line or below the line
§163 Interest – There shall be allowed as a deduction all interest paid or accrued within
the taxable year on indebtedness
deduction is limited
may be above the line or below the line
§212 Expenses for Production of Income – In the case of an individual, there shall be
allowed as a deduction all the ordinary and necessary expenses paid or incurred
during the taxable year
for the production or collection of income
for the management, conservation or maintenance of property held for the
production of income or
in connection with the determination collection or refund of any tax
deduction may be above the line or below the line
§67 2% Floor on Miscellaneous Itemized Deductions – In the case of an individual, the
miscellaneous itemized deductions for any taxable year shall be allowed only to the
extent that the aggregate of such deductions exceeds 2% of any adjusted gross
If your expense is not on the list in §67, by default it is a miscellaneous
itemized deduction and thus subject to the floor.
Deductions not subject to the floor include (not comprehensive):
o interest - § 163
o casualty losses -- §165(a)
o taxes - § 164 (state, local, and property)
o charitable contributions -- §170, §642(c)
o medical expenses - § 213
o moving expenses - § 217
o annuity mortality losses - § 72(b)(3)
§64 Ordinary income defined – any gain from the sale or exchange of property which is
neither a capital asset nor property used in a trade or business.
§65 Ordinary loss defined – any loss from the sale or exchange of property which is not
a capital asset.
Meredith Huston B Tax Fall 2001
Federal Income Tax
Professor Shuldiner – Fall 2001
COMPUTING TAX LIABILITY
Determine Gross Income (§61) – statute lists a non-inclusive list of sources of $ included in gross
income. Includes compensation, fringe benefits, dividends, royalties, annuities, income from
insurance, discharge of indebtedness income, pensions, income from an interest in an estate or
o If it is included in gross income, will be found in §61, 71-89 of the code.
o Does not include excluded categories which are found in §101-134 of the code
Next take above the line deductions (§62). Allowable expenses (ie. trade or business expenses)
from Gross Income in order to compute Adjusted Gross Income.
o The deductions include:
ordinary and necessary business expenses - § 162
reimbursed business expenses - § 62(a)
expenses of performing artists - § 62(b)
losses from sale or exchange of property - § 161 + § 62(a)(3)
alimony by payor - § 215.
o It‘s above the line if in § 62. With § 162, 212, and 163 it depends.
Next take below the line deductions (= the sum of personal exemptions and either (1) itemized
deductions OR (2) standard deduction in order to get Taxable Income (§ 63). )
Below the line deductions are:
o (1) Allowance of Deductions for Personal Exemptions (§ 151) – deductions for taxpayer
and spouse and for dependents (§152)
In 2001 – personal exemption is $2900, in 2000, was $2000
§151(d)3 – personal exemption gets phased out once reach certain income level
§151(d)4, companion provision, inflation adjustment -- in the case of any taxable
year, the dollar amount shall be increased based on the cost of living adjustment
o (2) AND either
Standard Deduction (§ 63(c)) -- $5000 for joint (see code for other categories) or
Itemized Deductions (§ 63(d)) -- subject to §67 -- 2% floor of adjusted gross
Non-Miscellaneous Itemized Deductions - § 67(b)
o interest - § 163
o casualty losses -- §165(a)
o taxes - § 164 (state, local, and property)
o charitable contributions -- §170, §642(c)
o medical expenses - § 213
o moving expenses - § 217
o annuity mortality losses - § 72(b)(3)
Finally, apply the taxable income to the tax tables in order to find tax - § 1.
At this point, you may subtract any allowed Tax Credits in order to figure Tax Liability.
o Credits include Hope and Lifetime Learning (§25A), child care credit (§21(a)), disability
and old age (§ 22), tax withheld (§ 31), and earned income in the case of low-income
taxpayers (§ 32).
Meredith Huston 1 Tax Fall 2001
WHAT IS INCOME?
Haig Simons definition – algebraic sume of (1) the market value of rights exercised in
consumption and (2) the change in value of store of property rights between beginning and end of
period in question. Would tax imputed income and unrealized appreciation.
A first try: In MACOMBER (1920) – the court said income was everything from capital or labor
(the question is…what about prizes, scholarships etc?)
GLENSHAW GLASS -- Supreme Court, 1955 – narrows definition of income – all accessions to
wealth clearly realized and over which taxpayers have complete dominion.
o Recognition of Congressional intent to tax all income broadly under §61 – all income from
whatever source derived
o The issue is now simple enrichment. All gains are taxable, whether traceable to labor,
capital or good fortune. If its accession to wealth, its in the tax base per GLENSHAW
GLASS. §61 is source-blind.
The code also specifically provides that certain items are to be included or excluded from gross income.
Included in gross income -- §61, 71-89
Excluded from gross income -- §§101-134
COMPENSATION FOR SERVICES
§61 says compensation for services is included in income. Wages, salaries, fees, commissions, fringe
benefits are income. Form of payment doesn‘t matter. (Includes property, amount of income would be
OLD COLONY TRUST –
o Company agreed to pay employee‘s taxes for 2 years. Court found payment of the tax by
the employer was compensation for labor and as such was includible in employee’s
Could not be excluded as a gift under §102 because §102(c) says that gifts from an employer are
includible income. The situation here is the same as where the company is paying the employee a
higher income and the employee uses the money to pay the tax himself.
Reg. 1.61-2(d): if extra compensation is in the form of property, it is still income.
o Fair market value of property will be included in income.
o If purchase property from employer at less than FMV, the difference between the price
paid and the fair market value is considered to be salary
o Compensation = difference between FMV and amount employee paid for property
o Basis = amount paid + any amount included in compensation.
o If you sell property, then get FMV of property when given as compensation, don‘t want to
double tax – once for compensation and a second time for income on sale.
o Same rules follow when services are provided as compensation.
DEFINITION: Non-cash, in-kind compensation from employer.
Any fringe benefit not qualifying for statutory exclusion (§132(a)) is expressly includible in gross
income (§61(a)(1) and subject to employment taxes.
Rationale for taxation:
o Taxes serve as a proxy for ability to pay. Fringe benefits are a part of one‘s ability to pay
because they free up money which would otherwise be spent on supplied benefit.
o Horizontal equity – similar jobs should be taxed similarly. If have radically different
fringe benefits, without taxation, there could be wide disparities.
o Vertical Equity – better jobs usually have more fringe benefits. Without taxation, the rich
would get richer while the poor would have a greater % of their income taxed.
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o Efficiency –- if didn‘t tax fringes, would lead employees to take compensation in forms
that they don‘t want because it would be cheaper than cash at higher tax rates. Don‘t want
to distort consumption decisions.
Rationale for exclusion
o Administrative burden of accounting is not worth the overall benefit to the system
o Want to encourage people to buy certain goods (health care)
o Political/Historical reasons – certain fringes were initially de minimis and voters take it for
granted that are excludable. Change would not be worth the potential political costs.
o Difficult to estimate the value of a fringe to an employee and FMV may not be fair
measure of income. Fringes are partly non-compensatory as employer derives a benefit
Beneficiaries of fringe benefits exclusion include employee‘s spouse, dependent child, or
retired/disabled former employee.
Employer can always deduct whole cost of fringe, regardless of whether employee uses it for
business or personal expense because either way it is a business expense to the employer.
The concept of tax expenditures: we can use the tax treatment of fringe benefits to incentivize certain
behavior. But when we do that, rich people in a higher tax bracket are getting more of a benefit.
EXCLUDING COST OF FRINGE: Purpose business or compensation?
Employee can exclude cost of fringe from income if the primary purpose of the fringe is business. If
employer‘s motive is to compensate, employee, then will be included in income. Court will look at the
level of control of the employee and the primary purpose of the expense. See Gotcher below.
GOTCHER (1968) (108)
o Gotcher and his wife went on a 12 day all expense paid trip to Germany to tour
Volkswagen factory. Volkswagen hoped Gotcher would open a U.S. dealership.
o The district court held the cost of the trip was not income to D husband; however, as to D
wife, it constituted income and was not deductible.
o 2 part test to determine if something was includible as income under §61
Gain must primarily benefit taxpayer.
o Critical inquiry was what was the dominant purpose of the trip? If the payment of
expenses serves no legitimate corporate purpose, the economic benefit will be taxable to
the recipient. Look to whether taxpayer had control over the expenses. Did he have to
take the trip?
o The personal benefits Gotcher received were incidental to the dominant purpose of
marketing and cultivating investors. As for his wife, the trip was primarily a vacation, and
thus not deductible from income taxes.
§274(c) – explicit rule for foreign travel, now required to allocate expenses between business and
personal when trip is outside the U.S.
Work-related fringe benefits -- This is found in §132 – These are fringe benefits not covered by other
specific exclusion sections.
Gross income shall not include any fringe benefit if it qualifies as one of the following: (Otherwise, fringe
benefits which don‘t qualify for exclusion are now includable in gross income under §61 unless excluded
by some other Code provision.) Under §132(h)(2)(A), the spouse/dependent children of employees and
retired/surviving spouses of employees are treated as employees for No Additional Cost Service and
Qualified Employee Discount.
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No Additional Cost Service -- §132(b) and 1.132-2 – zero-marginal cost service provided to
employee. Like an empty seat on an airplane or an empty hotel room if they are residual spaces.
If employees are allowed to reserve in place of paying customers, will not qualify as a no-
additional cost service because revenue will be foregone. Service offered must be offered for sale
to customers in the ordinary course of line of business for the employer.
o (Line of business requirement keeps employees of huge conglomerates for getting a wide
range of tax free services).
o Must meet nondiscrimination requirements §132(h), can‘t discriminate in favor of
employees who are officers, owners, or highly compensated employees.
o Includes free standby flights to airline employees…the seat would go empty, they just take
it…there‘s no additional cost to the airline. It has to be a service of the same type
ordinarily sold to the public.
o Reciprocal agreements among employers operating similar businesses: can qualify under
Qualified Employee Discount -- §132(c) – savings by employee is not taxable – Employees can
get up to 20% of retail price (services) or employer‘s wholesale cost (goods) tax free. (That‘s the
same as you can offer employees a % discount up to your gross profit percentage).
o Example: sales of merchandise to store employees at cost.
o §132(j)(1) – not excludable if only offered to highly compensated employees.
o Same line of business requirement as above.
o Discounts on property held for investments (as well as discounts on real property) are not
excludable from income under §132(c)(4).
Working Condition Fringe -- §132(d) – property or services provided to an employee which
would be deductible as trade or business expenses under §162 or as depreciation expenses under
§167 if he paid for them out of his own pocket.
o This does not include any amount that would be deductible under a trade or business other
than that of working for this employer.
o §274(d) If employer uses fringe for both personal and business use, then employee must
substantiate what % used for business and only exclude that portion of the cost.
o Note: no discrimination clause for working condition fringes
o Examples: parking facilities, security guard protection, trade journal provided by
De Minimis Fringe -- §132(e) – Exclude if value considering frequency is so small as to make
accounting unreasonable or administratively impractical (e.g. personal letter typed by secretary,
use of copy machine)
o Eating facilities: Employer provided eating facility is de minimus if located on or near
business premises and revenue exceeds or equals operating costs.
o 1.132-1, 1.132-6: Include things like meals required to allow employees to work overtime,
use of a vehicle to get home if outside of working hours, etc. Company picnics etc.
Qualified Transportation fringe -- §132(f) --
o Any qualified transportation benefit including a carpool (―commuter highway vehicle‖)
with at least 6 people.
o Up to S100/month – including transit pass, $175/month in the case of qualified parking.
Used to be that parking was excluded, but not mass transportation
Qualified Moving Expense Reimbursement -- §132(a)(6), §132(g)
Other excludable fringe benefits:
o Meals and lodging, §119
o Group-term health insurance, §79
o Legal services, §120
Meredith Huston 4 Tax Fall 2001
o Health services, §106- this excludes employer contributions to accident and health plans
from the gross income of employees.
o Qualified education expenses – tuition reimbursement as a fringe benefit, especially for
employees of universities, §117
o Transportation, §132(f)
o Day care, §129 (phaseouts)
Meals and Lodging -- §119 (To be excluded from income)
Main issue is that it is difficult to draw the line between business and personal benefit. When cash
reimbursements are used, it is much easier to see how much personal benefit goes to the employee
(and may be less likely to be excluded from income). May still be able to deduct expenses under
§162(a) business expense provisions (50% limitation under that rule).
Lodging – Counts if (1) it‘s furnished on the business premises by the employer and (2) its
provided for the convenience of the employer, and (3) employee is required to accept lodging as a
condition of employment.
Meals furnished to employee, dependent or spouse for convenience of employer and served on
business premises are excluded from income. If it:
o (1) employer furnishes meals, (2) the meals are provided for the convenience of the
employer, (3) the meals are provided on business premises of employer.
Convenience of employer met where there is a substantial noncompensatory
purpose (Reg 1.119) Even if there is a part compensatory purpose, the non-
compensatory purpose will trump it.
o If excluded from income under §119, will be excluded under §132(e)(2). §132(e)(2) meals
in a company cafeteria are de minimis fringe.
ALTERNATE ROUTE TO DEDUCTIBILITY: If not excluded under §119, consider deductibility under
§162 (trade or business expenses); if deductible, then will be a working condition fringe under §132(d)
§274(n) – deduction denied for ½ all meals to employer because is hard to determine whether purpose of
meal is business or personal (more on this later).
If employee must pay fixed charge for meal, under §119(b)(3), allowed to exclude from income an
amount equal to the fixed charge, applies only if the employee must pay whether or not meals are
consumed – SIBLA – firefighter case.
CASINO EXCEPTION - §119(b)(4) - Also known as the 50% rule, where if over half the employees are
getting meals for non-compensatory purposes, then they‘re all deductible. (Inconsistent with regulation,
but the statute wins)
COMMISSIONER V. KOWALSKI (1977) (113)
o Cash meal allowances for a NJ state trooper were found to be taxable. The meals were not
consumed on business premises. Court found that reimbursements were undeniably
accessions to wealth, clearly realized, and over which respondent had complete control.
o The issue was whether the payments were meals furnished for the convenience of the
employer. The court held that § 119 did not cover cash payments of any kind.
Cash reimbursements aren‘t excludable under §119.
o Troopers had to eat anyway and weren‘t forced to eat in a particular place and were given
$ whether or not they actually ate. Court didn‘t buy argument that for state trooper
business premises consisted of entire state.
Meredith Huston 5 Tax Fall 2001
o If troopers had been given vouchers for their meals, the outcome would likely have been
different. §119 was intended for situations where employees feel restrained in their choice
of eating places.
Lodging excluded from income if employee is required to accept as a condition of employment, it is on
the business premises, and for the convenience of the employer.
Must have a reasonable noncompensatory purpose to qualify as a fringe.
If the house is close to the business premises, it can qualify (across the street).
Rule of thumb is that if business benefit is large enough relative to cost, then will not be taxed. See
ADAMS where big house in Tokyo had become associated with company and was used for
business entertaining. Court rules it was part of the business premises.
BENAGLIA V. COMMISSIONER (1937)(Handout)
o Hawaiian hotel manager given luxury suite and meals in hotel. Had to live there –
suggests lack of control, which under GOTCHER is not income. Expense was excludable
because it was for the convenience of his employer. Manager was constantly on-call.
o Presence of compensatory element does not change the answer if it is outweighed by non-
compensatory factors like the convenience of the employer.
o §119 codifies the results of Benaglia. Lodging must be a condition of employment to be
o Is this decision wrong? Salaries are paid so someone can exploit an employees
services...why are these benefits any different?
Focus on compulsion element. The employees are compelled to use the stuff.
This reflects that Congress thought these benefits would be worth less to employees
than market value, so they solve the measurement problem by putting the benefit
received at 0.
Section 83 – Property Transferred for Performance of Services
Basic rule: if you get property in exchange for services, that‘s income. When a taxpayer is allowed to buy
something at below market value in exchange for services, they pay tax on the difference. BUT…
If a person receives property in return for performance of services and if property is non-
transferable and subject to substantial risk of forfeiture (§83(c)(1)) at time of transfer, then
property is treated as still owned by transferor and no income is realized by the transferee.
o When is it ―substantial risk of forfeiture‖? When full enjoyment of the property is
conditioned upon future performance of substantial services by an individual.
o If you still get the dividend from this stock, that‘s income (its like another form of salary).
Once the property vests (and forfeiture risk is removed) the taxpayer must include the basis of the
property in his income. Basis = FMV at time of vesting minus any amount paid for the property.
o All or nothing approach – assume value is zero until it vests
o Cannot value ―possibility‖ of earning $ later
§ 83(b) also contains an election. The taxpayer can elect to count the property as income upon
receipt. That way, any appreciation in value will be taxed as capital gain at realization rather than
as income when the property vests.
o If the property never vests because leave employer (like lose stock options) code does not
permit a loss (although would have thought it would). Strange result
o So the election is a bad deal if you are not sure property will vest or if you would prefer to
minimize the capital gains you pay later on.
o The election is a good deal if you are sure property will vest and you want to pay lower
o In order to make the election, §83 must apply (stock options must have a readily
ascertainable fair market value.)
Meredith Huston 6 Tax Fall 2001
Tax Expenditure Fringes
Preference in Code which provides a subsidy to certain types of expenditures or transactions. Way
for government to encourage private expenditures in these areas.
Employer Health Insurance -- §106 – excludes from employee‘s gross income employer
provided medical coverage and health benefits.
Compensation and Insurance for Injuries and Sickness – §104(a)(3) – excludes from gross
income workers compensation, damages received on account of personal injuries or sickness
(other than punitive damages), $ received from accident or health insurance if insurance paid for
by employee. If employer paid for some or all of insurance, employee must include in income
portion of compensation received that is attributable to employer‘s donation; although these
payments might be included in gross income, they may be deductible as §213 itemized medical
Amounts received under Accident and Health plans -- §105 – includes in gross income all
payments received from health insurance plans to reimburse taxpayer for expenses incurred for
medical care to the extent that insurance plan (not including §105(b) medical expenses) was paid
for by employer and was not included in gross income buy §106
Dependent Care - §129 -- payments made by employer for employee‘s dependent care
excludable from employee‘s income up to $5000/yr ($2500 for married individuals filing
Cafeteria Plans - §125 -- when employees can choose from a variety of benefits, they can still get
their exclusions (provided that written and include in the choices cash and qualified benefits and
that the benefits are non-discriminatory).
o Designed to allow the choice of cash or tax-free benefits
o Availability of cafeteria plans = greatly expanded utility of tax provisions
Life Insurance – §79 -- employer payments to group term life insurance excludable from income
so long as costs less than $50K; Employer received deduction for premiums, benefit must be
provided to all employees on nondiscriminatory basis.
Interest Free Loans
Used to be a type of income-shifting from high-income taxpayers to low-bracket family members.
§7872 applies to a loan if:
(1) the loan is a below-market loan. (Interest rate is below the Applicable Federal Rate, different
for different length loans). If the loan is a demand loan, the short-term rate applies. Term loans go
by the rates listed.
(2) the loan is one of the types of loans in the scope of §7872. These are listed in §7872(c). They
are gift loans, compensation loans, corp-shareholder loans, tax-avoidance loans.
(3) None of the exceptions to §7872 apply. Check and see if an exception applies. One important
exception is §7872(c)(2), which excludes from §7872 auspices loans between individuals less than
$10,000. (Exception doesn‘t apply to loans to buy income-producing assets).
Assuming a loan is covered by §7872, the statute applies 3 fictions:
Loan bears a market rate of interest
Lender gives borrower sufficient funds to enable borrower to pay lender market interest
Borrower pays lender a market rate of interest on loan.
Result: high bracket lender gets interest income, low bracket person gets interest deduction.
Meredith Huston 7 Tax Fall 2001
Amy gift loans Bob $200,000 at 0% interest. AFR = 10%, compounded semiannually. Annual interest on
loan is $20,500. At the end of the first year, $20,500 of foregone interest is deemed transferred as a gift
from Amy to Bob, then retransferred from Bob to Amy as a interest payment. Amy‘s $20,500 will be
taxed at normal rates as interest income. (That‘s what she would have made investing in treasury bonds).
Bob will get a $20,500 interest deduction, subject to ―investment interest‖ restrictions.
INTEREST-FREE LOANS -- §7872
Shift taxes from lender to borrower.
General rule is that loans at the market rate are not treated as income because liability to repay
offsets the receipt.
Interest free loans are treated as if borrower was required to pay back to the lender the market rate
of interest. The foregone interest is then treated as a gift, dividend, contribution to capital, or
compensation, depending on the circumstances. The court will look to the economic realities to
determine the principal purpose of the loan.
Loans of less than $10K are generally excluded if interest is a gift and if loan proceeds are not
used for business or investment purposes, unless one of the primary purposes of the loan is tax
avoidance, if this is the case, will not be excludable.
o A gives a 10K loan to B at market interest rate – 10%). B ―pays‖ interest to A of 1K. A
―gives‖ B gift/refund equal to interest paid by B (1K). No money changes hands.
Structured in this way, A has income of 1K. A also will incur $1000 of gift tax.
o Instead, to avoid tax consequences, A loans $10,000 to B at zero% interest. A will have no
income and no gift tax.
However, §7872 says can‘t get around tax consequences by dropping interest rate
to zero. Will treat the cash flows in second scenario in the same way as in the first
although they will not be characterized in the same way.
Foregone interest is a transfer from the lender to the borrower and interest
retransfer from the borrower to the lender.
§7872(b) – applies to all below-market rate loans, not just interest-free loans
§7872(c) – treat reimbursement from lender to borrower as:
o dividend – if corporation to shareholder loan
o compensation – if employer to employee
o income – if sole purpose is tax avoidance
o gift – if gift loan
§7872(d) – in case of gift loan, amount of interest imputed as repayment to lender
is limited to the borrower‘s net investment income, so if borrower has a net
investment income of $0, lender does not have to treat would-be interest payment
as income for taxation. There is a $100K limit (aggregate of loans cannot exceed
To determine applicable interest rates, must decide if loan is a term loan or a demand loan.
o Term loan – calculate amount of interest by going to applicable federal rate (AFR)
(§1274), must then decide if short, mid-, or long term rate applies.
o Demand loan – cannot necessarily know what counts as income because don‘t know when
loan will be called in. Use short term rate and recalculate that rate annually according to
Is loan a gift loan?
Yes Tax Fall 2001
Is it a demand loan?
Use 7872(a) Use 7872(b)
Purpose is to avoid high income taxpayers from shifting cash to low income taxpayers to invest
and then pay lower tax rate on investment returns.
Limitation – if gift loan is $100k or less see 7872(d)
Limits Deemed Income (B) above for tax purposes. Limits amount of ―income‖ it to amount of net
If a loan is more than $10k there‘s no diminimus exception but for purposes of income tax, we‘ll treat it.
No tax abuse going on, why bother to treat it as interest.
DEFINED: Income derived from the use of household durables such as a personal residence, car, or
television set, and income from the performance of services for one‘s own or one‘s family‘s benefit
(plumber fixes his own pipes) This includes the income from homemakers. (A woman who worked and
then had to pay for child care wouldn‘t get deductions for this.
Imputed income is excluded from income under §61. Exception in barter exchanges – income is
imputed and included in income so there is no incentive for people to engage in non-cash
exchanges in order to avoid taxes. Alleviates efficiency concerns which arise when move away
from non-cash economy.
Reasons for excluding imputed income:
o Conceptual difficulty with taxing imputed income. Line drawing problems.
o Allows for administrative efficiency.
o Valuation Problems.
o Privacy intrusion for IRS to determine value of your services/how much you value things.
Reasons why imputed income should be taxed:
o Equity – people with tax free imputed income (eg. Service providing spouses) are better
off because don‘t have to pay for their services, while other people have to earn more
wages (and be taxed on those wages) in order to pay for the same services.
Efficiency – if two people have the same ability to pay, we should not tax one who chooses more
leisure less than one who chose to apply their ability to do income-producing work (which benefits
the economy) (e.g. want to encourage home-ownership). How should imputed income be taxed:
o Property tax can be viewed as payment for local services OR as income tax on value of
o Deny deduction for mortgage interest paid out each year. That would bring renters and
owners much closer together.
Imputed Income is divided into
(1) imputed income from capital
Meredith Huston 9 Tax Fall 2001
You put money into a capital good that you use for personal purposes. You still get a flow of
value out of the use of that money, yet you‘re not taxed on it.
o Example: paying cash for a house and then living there tax free.
(2) imputed income from labor.
You write your own will. It is hard to imagine taxing this.
In some cases the taxes could encourage you to not do your own work (like fix your own sink).
DO YOU HAVE TO WORK FOR YOUR INCOME?
Gifts and Bequests
§102 – excludes value of property acquired by gift/bequest
Donor is taxed instead of donee. The selection of the donee as the taxable person favors wealthy
people who give from higher tax brackets.
Ways we could tax gift income:
Donor Donee Analysis
No deduction Exclude gift Law for most gifts. Our system because donor is
(taxed) from income more likely to be in a higher tax bracket.
No deduction Taxed on gift as Don‘t do this because would be 2 full levels of tax
(taxed) income (taxed)
Exclude from Taxed on gift as Law for Alimony. Gave the $, but someone else
income (no tax) income (taxed) should pay tax.
Exclude from Exclude gift This would be a huge implicit-subsidy for gift-
income (no tax) from income giving, no tax, could make reciprocal gifts and
(no tax) evade tax. This is the deal with charitable gifts.
Why tax gift giver? Consider gift giving to be a form of consumption. No deduction should be
allowed for consumption. If were to tax the donee, would give the donor a chance for a tax-dodge
by ensuring $ will be taxed at donee‘s (presumably) lower rate. Less fear of fraud in the alimony
circumstance, which is why tax on donee is allowed there.
Gifts (made during donor‘s lifetime)
§102 – donee excludes gifts from income.
Gifts of Appreciated/Depreciated Property – What is the Basis?
Two scenarios - §1015(a)
(1) If, at the time of transfer, the FMV of the property is equal to or greater than the basis of the
property in the hands of the donor, the donee takes the donor‘s basis.
So on gifts of appreciated property, §1015(a) carries over the donor‘s basis to the donee.
Therefore the donee is responsible for any appreciation in value that took place while the donee
owned the property, as well as the appreciation between the gift and the sale of the property.
(2) What if the property has declined in value in the hands of the donor so that FMV of the property at the
time of transfer is less than the donor’s basis in the property?
For purposes of determining gain on the sale of property acquired by gift, the donee‘s basis is the
same as the basis of the donor.
Meredith Huston 10 Tax Fall 2001
However, for determining loss on a subsequent sale of the property by the donee, the donee takes a
basis equal to the FMV of the property at time of transfer.
If it is not possible to establish donor‘s basis, basis will be FMV at date property acquired by donor. Reg.
1.1015-4 provides that initial basis of transferee is greater of amount paid by transferee for property or
transferor‘s basis under §1015(d)/ For determining loss, never greater than FMV at time of transfer.
Example: Donor gives stock worth $2000 that cost the donor $1000. If the stock is then sold for:
$5000 Then the gain is $4000
$1750 The gain is $750
$600 The loss is $400 (because the basis is just
$1000, the lower of the donee‘s
basis/FMV at time of gift.
Another example: A gives B property worth $10, with a basis of $20. If she sells the property for $15.
For the purposes of determining loss, B has a basis of $10 so he has no loss. For the purpose of gain the
basis is $20 so he has no gain. B has no loss or gain on the sale.
§102 – beneficiary excludes gift from gross income.
Basis is determined by §1014. Property acquired by reason of death takes a basis in the hands of the
beneficiary equal to its fair market value on the date of the decendent‘s death. (Stepped up or stepped
This means appreciation of property during the decedent‘s life will never be taxed
Encourages individuals to retain appreciated property until their death, but to sell before death
anything that‘s declined in value.
§691(a) – Bequests – Bequest is included in gross income of estate or beneficiary, whoever receives it.
When is something a gift?
§274(b) – Employers can‘t deduct more than $25 in any year for gifts to employees.
o You get a business deduction for the first $25 of untaxed gifts made to a client.
§ 102(c): gifts transferred by employer to or for benefit of employee cannot be excluded from
gross income (require context of employment relationship). See reg 1.102-1(f)(2) – if familial
relationship, 102(c) will not apply id transfer of money is ―substantially attributable‖ to family
relationship and not to employment relationship.
o The taxpayer‘s argument that something is a gift will be a lot stronger if the business
giving to them doesn‘t deduct them as a business expense.
Tips that constitute compensation for services are income. (Reg 1.61-2(a)(1))
COMMISSIONER V. DUBERSTEIN (1960)(138) – The Cadillac case.
o Duberstein suggested customers to car dealer, who gave him a Cadillac in return. Stanton
acted as church manager and comptroller; board voted him a gift of $25,000 when he
o Court defines ―gift‖ as something given from detached and disinterested generosity; out
of affection, respect, admiration, charity or like impulses. You look at the donor‘s intent.
o Court looks to the totality of the facts and disregards common law definition of a gift (as a
voluntary transfer--that‘s not enough here) – said too broad
Under common law def, Duberstein would clearly have been gift.
Meredith Huston 11 Tax Fall 2001
o Problem with DUBERSTEIN: allows some room for donee to exclude gift from income
and for donor to deduct gift from income (Congress passes § 274(b) and § 102(c) to try to
close this gap)
o Court says if payment proceeds from constraining force of moral duty or from the
expectation of future benefit, it is not a gift (Shuldiner says do not take this at face value;
probably wouldn‘t apply to a gift to your grandmother out of moral duty clearly there‘s
this core idea of familial gifts that is excluded from ―detached and disinterested‖)
o Govt. wants clear test – personal property distinguished from business reasons.
Other possible tests: intent of donor (detached and disinterested generosity, not
from legal/moral requirement), common law definition (voluntary transfer), look at
estate and gift tax (but say can‘t analogize to that – don‘t tell us why there would be
different definitions of gift for gift tax and income tax; govt. for gift tax want as
broad def. as possible so can tax it under income since it would be deductible want
definition to be as narrow as possible.
Government Transfer Payments
Support provided by family members, like intra-family gifts, not included in gross income.
Welfare payments aren‘t taxable.
Unemployment is generally taxable - §85. (This is because its supposed to take the place of
Social security benefits are taxable according to an income schedule. See §86.
Prizes, Awards Scholarships
§74 – prizes and awards are income,
o But certain prizes are excludable if they are not retained by recipient.
Has to be in recognition of merit (see list), recipient didn‘t enter contest, award
can‘t require future services, and award has to go to charity.
§74(c) – exception – employee achievement awards (like for length of service to safety), not
included in gross income if less than $400; in certain cases, can avoid certain taxes if you win
prize and give it to charity.
§117 – Scholarships are excludable only if the are ―qualified scholarships‖
o A scholarship is qualified only to the extent that it covers tuition and required
o Students must include in income scholarships that cover other expenses, like room and
o §117(c) – exclusion don‘t apply for scholarships that are compensation for services, like
teaching or researching.
Athletic scholarships are a gray area. §117(c) would seem to apply if scholarship is
conditioned on playing a sport.
o §117(d) allows universities to give free education to employees.
§127 – allows any employer to give education assistance tax free to employees up to $5250 (see
also §25A for Hope Scholarships and Lifetime Learning Credit.)
CAPITAL APPRECIATION AND RECOVERY OF CAPITAL
need to decide when to tax gain from capital
o realization doctrine—wait until realization of gain
how to figure out how much gain?
o Basis – device tax law uses to keep track of cost
Meredith Huston 12 Tax Fall 2001
Present Value Computations
(1 rate of return ) num berof y earsdeferral
Future value = x (1 + r) (where R is the interest rate/rate of return, and t is number of years)
Best to deduct now and pay tax later (defer income) because $ today is worth more than $
Capital Recovery and Basis
§ 1001 -- determination of amount and recognition of gain or loss
o (a) gain = excess of amount realized minus the adjusted basis. Loss = excess of adjusted
basis minus amount realized.
o Amount realized = sum of $ received plus value of property received. Code generally only
taxes realized gains.
Recovery of Capital/Ways to account for Cost:
o Immediately deductible expense – costs said to be expensed. If enough income to offset
deductions, tax-free recovery of such income-producing expense is immediate. Expensing
sets the basis at $0 so that at the time of sale of property, all income from sale taxed.
This generally does not make sense because all you have done is to exchange asset
forms. Had cash, now have car. No better, no worse off than you were the day
before. Allowing this would essentially turn income tax into a consumption tax.
However, there may be timing issues associated with taxes that make this
o Capitalized – Purchase price or cost taken into account only when asset is sold or
exchanged. In case of stock, cost or basis taken into account only when stock is sold or
exchanged. Dividend income received while stock held is taxed in full without any offset
of capital invested.
o Depreciated – periodic deductions are allowed for asset‘s cost (e.g. cab driver taking
depreciations for car). When asset must be capitalized, basis is adjusted by a set % each
year. Depreciation is amount of decreased basis. Since depreciation is treated like cost,
tax liability on other income is offset by amount of depreciation taken
o Example: Buy an asset for $10K that will produce $3K of income.
Immediately Year 1 Year 2 Year 3 Year 4 Year 5
Gross Income 3K 3K 3K 3K 3K
Deduction 10K 0 0 0 0
Net Income (7K) 3K 3K 3K 3K
Gross Income 3K 3K 3K 3K 3K
Deduction 2K 2K 2K 2K 2K
Net Income 1K 1K 1 1k 1K
Gross Income 3K 3K 3K 3K 3K
Deduction 0 0 0 0 0
Net Income 3K 3K 3K 3K (7K)
Taxpayers will always prefer the first option – delay of income recognition and
acceleration of deductions. IRS will always argue for the third.
Meredith Huston 13 Tax Fall 2001
Determination of Basis of Property
o §1012 -- The basis of property is its cost, except as otherwise provided.
Cost – depreciation + capital investments = Basis
o Simple rule: Where the taxpayer receives property in exchange for cash or services, the
basis is the fair market value of the property received. (Reg. §1.61-2(d)(2)(i). It is as if
the employee had received compensation in cash and had used the cash to purchase the
If property purchased at less than FMV, purchaser takes cost basis and is not taxed
on gain until disposes of property at FMV.
o Where taxpayer acquires property in exchange for property, the exchange is usually
viewed as a realization event and any gain/loss will be recognized. Cost is generally the
value of the property received.
o Where bargain purchase is in substance a substitute for salary, amount of price reduction
should be included in income and purchaser should be treated as acquiring asset for FMV.
Cost basis of asset would be recharacterized purchase price, amount paid, plus
amount included in income as salary (e.g. employee permitted to purchase $100
stock for $80, taxed on $20, income and basis would be $100).
§1016 – Adjusted Basis – reflects capitalized expenditures, untaxed receipts, and certain losses,
Allocation of Basis (when there is a part sale of property)
Could apply amount realized against basis for entire property and not report any gain until aggregate
amount realized exceeds entire basis. Could allocate basis of whole between part sold and part retained
in some reasonable manner and compare amount realized with portion of total basis allocated to part sold.
Reg. 1.61-6 requires basis allocation rather than upfront recognition of the basis with the first sale
or deferral until final sale. Allocation is in proportion to FMV of portions at time property
purchased. May also allocate basis to figure out depreciation.
Can only allocate basis if give up a portion of all that you have. So if you own only income
stream, then can allocate basis when give away some of that income stream. If own income
stream and underlying residual, can allocate basis if give up interest in residual and income stream
(e.g. buy 4 acres land for $1K and sell 1 acre for $500 minus $250 of basis. Allocate basis
according to FMV of each part and amount realized applies only to basis of part sold.).
Another random exception: A court let a taxpayer treat the entire proceeds of a partial sale as tax-free
recovery of capital when someone damaged his riverfront property. Court was influenced by (1) basis
allocation would have been difficult and (2) the sale was involuntary.
HORT V. COMMISSIONER (1941) (140) (compare with HORST, below)
Hort inherited building. Rented out to Bank. Bank canceled lease when became no longer
profitable. Hort received $ in consideration of canceling lease. Hort claimed canceled lease as a
loss (difference between present value of future rental payments and the lump sum settlement
received for letting out to bank) and did not claim $ in consideration for cancellation of income.
Court held $ received in consideration was a substitute for rent and was taxable income. Taxed
as ordinary income, not at favorable capital gains rate.
o Cannot claim loss for canceled lease because undoubtedly diminished amount of gross
income expected to realize. But to that extent, he was relieved of the duty to pay income
tax. Had to report entire amount received for lease without regard to claimed disparity
Meredith Huston 14 Tax Fall 2001
between that amount and difference between present value of unmatured rental payments
and fair rental value of property for unexpected period of lease.
o §22(a)—expressly defines gross income to include gains, profits, and income from rent, or
gains or profits and income derived from any source whatever. Reaches rent prior to
cancellation. Would have included prepayment of discounted value of unmatured rental
payments whether received at inception of lease or any time thereafter. Would have
extended to proceeds of suit to recover damages from breached lease.
o Rental stream not a separate capital asset with allocable basis, merely creates ordinary
o If have property that produces stream of income and sell that stream, basis in property
unchanged and income is taxable.
o §1221(4) and 167(c) – cannot have basis in lease payments or in any right of future stream
of income arising out of a larger estate (e.g. lease is carved out of ownership in land);
carver out interest not a capital asset and cannot have basis. Therefore $ received for
carved out interest or right to future payment included in income with no adjustment to
o Shuldiner says Hort should have been arguing that he had basis = value of the lease. Court
is implicitly saying that his basis = 0, but there could have been some plausible argument
that the expected value of the lease was embedded in the basis of the sasset he received
from his father. Note that if Hort‘s asset consisted solely of the lease, then he would have
basis and this decision would not apply. This, however, was somehow not a property
o Shuldiner proposes this case was really about whether Hort had a realization event. If
lease were an asset, would the cancellation be a realization event?
o Moral – cannot divide basis intertemporally. Basis remains with the principal.
Gains and losses in the value of property are generally only reflected in taxable income when
o Reg. 1.1000-1: Gain or loss is realized only when exchange of property for other property
that is materially different in kind or extent (e.g. land is exchanged for cash); don‘t account
for intermediary gains/losses, only gains/losses upon realization. Realization events
include sales, changes to terms/legal entitlements, etc.
The realization requirement provides taxpayers with flexibility in the timing of taxation of gains
o This supplies possibility of significant abuse and much of the tax code is concerned with
limiting the ability to ―cherry-pick‖ from assets in terms of realization timing.
Realization requirement is necessary because periodic taxation of accrued gains and losses would
cause three problems.
o Administrative burden of annual reporting
o Difficulty and cost of determining asset values annually
o Potential hardship of obtaining funds to pay taxes on accrued but unrealized gains.
§1091 – disallows realization of loss in a ―wash sale‖ – (e.g buy 100 shares of stock, sell at a loss,
and buy 100 shares at a lower price within 30 days).
CESARINI V. US (1970)(144) – Taxpayer bought a piano for $15 in 1957. In 1964, found $4467
inside the piano. Court held that taxpayer must point to a specific statute to show an exception to
gross income or the cash will be included in income under §61. Cash is income for the year
found, not the year of purchase.
o Reg. 1.61-14 : in addition to the terms enumerated in §61(a), there are many other kinds of
gross income. Includes ―treasure trove‖ to the extent of its value in U.S. Currency, will
Meredith Huston 15 Tax Fall 2001
constitute gross income for the taxable year in which it is reduced to undisputed
o Note: Contrast from treasure trove: If you buy property (like a painting) and find out
immediately that it has a greater value than expected, the increased value is not income, it
is unrealized gain.
o The underlying logic here is that since cash has no basis, there is no need to wait for a
realization event in order to include it in income. If the found asset had been something
less liquid, would have been taxed when sold or converted to cash.
o Statute of limitations regarding taxes, generally 3 years if overstate depreciations, 6 years
if understate income, no limit where there is fraud/misrepresentation.
HAVERLY V. US (1975)(146) – School principal received unsolicited textbooks from publishers,
then donated them to school library and claimed a deduction. Receipt of books was an accession
to wealth and must be included in income. Where there is an intent to exercise complete
dominion when received, then have income. Here principal exercised dominion over books by
donating them and trying to deduct and here, taking deduction shows exercise of dominion and
o Court is not saying that donations to charity are realization events, just saying that
Haverly‘s donation of books made it clear that he considered them to be income.
o Haverly was trying to get a double tax benefit – no tax and get charitable deduction.
o If employer had given books to him, then could have argued were a working condituion
fringe under §132.
With charitable donations, general rule is that don‘t have to realize/recognize gain where donate
property which has appreciated in value. The gain is considered to be built into the property.
Frequent flier miles – consensus seems to be that for business they are income (because have
deducted the cost of the frequent flier miles as a business expense), for personal use they are not
(purchase price reduction).
Coupon -- income? No is merely a purchase price reduction.
o If employer gave it to you might be income (although de minimis)
EISNER V. MACOMBER (1920)(149) – Corporation had a lot of $ gains. Issued stock
dividends. (Issued shares of stock as a dividend rather than cash).
o Cash dividends are taxable whereas stock dividends are not taxable until stocks are sold
and cash gain is realized (now codified in §305(a)). Realization is fundamentally arbitrary.
o No realization, no income. Income must be derived from capital and not just increase in
wealth to be taxable under 16th amendment. This is an old standard, no longer good law,
but good to understand.
Cases since have held the opposite – BRUUN (159)– farm leased, tenant made
improvements, when owner got farm back, improvements were charged as income.
But see §109 – improvements to farm are not income.
Eisner v. Macomber still applies to stock dividends. If taxpayer receives stock
dividend, and, crucially, has no option to choose cash, then not taxable. If cash
COTTAGE SAVINGS (1991)(154) – S&L sitting on huge losses, want to take them as a tax loss,
but cannot do so without a realization event and therefore want to sell mortgage loans. Selling
loans means putting losses on books which creates insolvency issues and might require that S&L
be shut down under other laws. So they created a clever device by which they swapped losses
with another S&L (actually, FHLBB). Loans were materially different because holders had
different legal entitlements in kind/extent. This was a realization event, so losses were allowable.
o Respective possessors of properties must enjoy legal entitlements in different kind/extent
to qualify for a realization event. (e.g. Exchanged mortgages would qualify as a change in
Meredith Huston 16 Tax Fall 2001
o IRS argued that exchanges of substantially similar pools of mortgage loans was not a
realization event. Court disagreed, loans were different enough.
o Reg. 1.001-1 – for there to be a realization event, must be an exchange of materially
different sorts of assets. Question then is whether different sets of loans are materially
Ex. if exchange stocks, materially different, but perhaps not if exchange wheat
Look at characteristics of things exchanged, not their value. Here, the banks
emerged with legally distinct entitlements.
o Reg. 1.001-3 – makes easier to renegotiate instrument, redefined materiality. New
standard permits change in debt instrument without triggering a sale/exchange.
ANNUITIES -- §72
Annuitant has income to the extent receives more than paid for annuity. Investment in annuity is
in effect the ―basis‖ recovered when payments are received. It is necessary to determine what
portion of each payment is treated as tax-free recovery of basis and what portion is taxable return
IRS probably gives preferential treatment to annuities (by using exclusion ratio calculus rather
than bank deposit treatment) because want to encourage retirement planning. Deferred annuities
have most preferential treatment.
Term Annuity – i.e. for 5 years want $1000/month. Several approaches.
o Basis recovery first – this was the old way to do it. Taxpayer prefers this deferred
taxation. Don‘t begin recognizing income until your basis in the annuity‘s purchase price
is paid off. Tremendously taxpayer friendly. Allows for significant deferral of income.
o 3% rule – this was prior statutory approach. Here you were assumed to have an annual
income of 3% of your purchase price. Once your basis has been recovered, all additional
payments count as income.
o Exclusion ratio – this is the law – what §72 says to do – Set an exclusion ratio where the
numerator is the investment in the contract and the denominator is the expected return.
(§72(b)). This ratio remains constant through the life of the loan, and for every payment,
payment * exclusion ratio is the recovery of capital, and payment * (1-exclusion ratio) is
For example: if you pay $100,000 for a life annuity that is expected to give you 28
$5000 payments (for a total of $140,000). This creates an exclusion factor of 5/7
(100000/1400000). So the annual payment would consist of $3570 (5/7) of capital
recovery and $1430 of taxable interest.
o Bank Account Treatment – this is what Shuldiner likes. You are treated as if you
deposited your investment in the contract in the bank account and withdraw the fixed
amount of the annuity from the bank each year. The bank is assumed to pay a certain rate
of interest (market rate?)
Basically have a self-amortizing loan which = the present value of all annuity
payments. Set an interest rate of return (IRR), then the portion of each payment =
AIP*IRR is income. Remainder is recovery of capital.
This accelerates the recognition of income, since the earlier balances are
Year Starting Interest New Withdrawal Ending Principal
Balance Balance Balance Withdrawn
1 267.30 16.04 283.34 100 183.94 83.96
2 183.34 11.00 194.34 100 94.34 89.00
Meredith Huston 17 Tax Fall 2001
3 94.34 5.66 100.00 100 0.00 94.34
Total 32.70 300 267.30
PDV 29.67 267.30 237.63
Life annuity = Classic annuity
o Give insurance company $, they say will give you $1000/month for life
o Opposite of life insurance. Insurance contract against living too long and outliving your
o Uncertain what the final calue will be.
o §1275(a)(1) & Reg. 1.72-9 (table ages), §72(c) – often look to tables on life expectancies
to calculate out life annuities.
Actuarial tables used to be gender bifurcated, but now are aggregated. Since
women live longer than men, their exclusion ratio used to be lower and had to pay a
LIFE ANNUITY - TWO SCENARIOS – HOW LONG WILL YOU LIVE?
If you live longer than expected, and therefore outlive these allocations, you cannot exclude from
income more than your basis in the annuity K and therefore you must take all $ coming in from
that time (the time you were supposed to die) forward as income and therefore taxable.
o Shuldiner‘s theory is that this is a way to take back from the women who are now getting
lower averaged life exclusion ratios.
If you die early, then you (actually, your estate) get a deduction at death for all of the basis that
you did not get to exclude.
Deferred annuity – put aside $ now, when turn a certain age, get the $. When taxpayer wants payments
to be in the future, interest accrues between time of initial purchase and time of first payment. Interest is
taxed to annuitant as receives payment -- §72(b). If annuitant lives to life expectancy, annuity payments
will exceed annuity cost. Difference represents interest, to get value, must use present value, pay no tax
until get payment.
§72(e) – treats cash withdrawals before starting date of annuity as income to extent cash value of
K exceeds owner‘s investment. Thus when cash is withdrawn, interest is taxed first. §72(q)
imposes penalty on amounts withdrawn before retirement.
Ex. 20 years from now, annuity will kick in and pay $100/year for 3 years. Now you will pay
$267 for future privilege. Need present value of $267 in 20 years. $83 now (if rate is 6%), expect
$83 to grow to $184 (if you put $ in bank at 6%), under annuity rule, calculate exclusion ratio
($83/300 = .28) (where does 300 come from? -- $100 for 3 years), therefore, when you get
income, then take $72 into income each year for three years in which you get $ and $28/year
counted as repayment of basis.
Rules do a bad job of recognizing the difference between a deferred annuity and a term annuity.
§101 – except as otherwise provided, gross income does not include amounts received under a life
insurance contract, if such amounts are paid by reason of the death (or terminal or chronic illness)
of the insured. Mortality gains are not taxed.
o Preferential tax treatment – when compared to other forms of savings.
o §7702(a) -- Note contract requires real life insurance component for tax-free policy to
apply. This defines what gets this favored treatment.
Term insurance – premium in return for which a specified sum will be paid to insured‘s survivors
in event of death. Involves gamble that insured will live through term/period covered by
insurance. Survivors do not get return if insured survives, policy expires.
Meredith Huston 18 Tax Fall 2001
o No deduction for premium, no income if your beneficiary collect or loss if it expires.
o Shuldiner argues that on average, this is more harmful to taxpayer than if transactions were
actually taxed, since if insurance companies are doing their job, significantly more policies
will expire (for which they can‘t collect a loss) than pay out (for which they are not taxed
on the gain). Basically nets out.
o Alternatively wouldn‘t make much difference. If benefits taxed and premiums deductible,
then taxing gains would have no effect. Just buy n/(1-tax rate) to put yourself in the same
position as a no-tax world.
Ordinary Life Insurance – Whole life, uniform annual payments. Pays out at death, whenever
that occurs. Smoothes out the effect of increasing premiums as you get older and more actuarially
risky. Overcharged when you‘re young, undercharged when you‘re old. Essentially are building
up a savings reserve in your insurance account with the too-high payments early on. Insurance
company invests this reserve and the interest or gain earned helps to pay out later.
o Two elements: ―pure term insurance‖ and ―savings‖ component (building up cash value
o Can borrow against this $ and can withdraw (surrender) $, if withdraw, are taxed.
o Interest build-up in savings portion is not taxed, this is clearly tax-preferential treatment.
o Even if you cash out via surrender, you are taxed on the savings component only to the
extent that it exceeds the value of the policy. This is a tax favored form of investment.
Basis is what you put in/spent on plan. Amount realized (what have in account) =
everything you put in (whole life premium) + interest – term premiums. Since gain =
amount realized – basis, then gain = interest – term premium. Result is to let you deduct
Under normal tax rules, would not be allowed to deduct term payments from your
Total policy costs consist of the cost of the pure insurance protection enjoyed up to
surrender date, the loading fee, and the savings portion. But its made interest,
which would be taxed. Except you can, in effect, offset that interest against the
costs associated with the policy.
Universal Life Insurance – huge lump sum payment up front. Company invests the sum, account
bears some interest, and every month they subtract your ―premium‖ from the account. Twist is
that insured can deduct money from his account at any time (after some minimum number of
years), or his beneficiaries receive balance in account on his death.
Variable Life Insurance – savings: paid premiums invested in equity market. Returns will vary
and insured bears the risk, not the company. Reflects investor‘s decide to increase savings
element of insurance component.
§101(g) – lets those who are terminally ill cash in policy and treat it as life insurance or can sell
policy and treat it as if life insurance and thereby get tax benefits. Idea is that terminally ill need $
at end of lives, not after death. Presumably buyer of plan is taxed on gain from $ paid out v. $
paid out by plan at death. Allows you to exclude income life insurance payments before death.
§101(c) – have to include interest payments made on insurance proceeds that have not been fully
distributed to beneficiary; in other words, if policy is paid out and beneficiary does not get all $
and instead someone else holds $ in exchange for interest, that interest must be included in
income. If amounts excluded are held under agreement to pay interest, those payments are taxed.
Essentially treats non-term life insurance like an annuity.
TREATMENT OF DEBT
A borrower doesn‘t realize income upon receipt of a loan, regardless of how loan proceeds are used.
There is also no deduction when he makes principal payments on the loan.
Makes sense because nobody‘s net worth is changing.
Meredith Huston 19 Tax Fall 2001
General rule – illegal income is included in income/taxable under §61, even if the
taxpayer/criminal is required to return the money.
Not fair to tax people who make legal $ but not those who make illegal $.
Distinguished from loans: with loans there is an understanding that the borrower will repay. With
illegal income (e.g. embezzlement) there is no repayment expectation (i.e. no simultaneously
occurring liability giving rise to a net increase in wealth.
o JAMES – Court requires a consensual recognition of an obligation to repay.
COLLINS V. COMMISSIONER – (1993) (167) – taxpayer made illegal bets by embezzling $
from off-track betting by punching up $80K in betting tickets for himself. Lost $38K. Cannot
deduct gambling loss because can only deduct against winnings §165(d). Collins derived a
benefit from illegal income, so it is taxable.
o Court rejects argument that in Zarin (3rd cir.) tickets have no economic value and should be
excluded under §108(d).
o When taxpayer makes restitution for illegal gains, he can deduct the amount of those
payments from his gross income.
Gain measured based on FMV at time of receipt.
Avoid purchase price redux theory that court in Zarin could have done.
HOW LOANS ARE TAXED
Principal of loan – Borrower does not realize income upon receipt of loan, regardless of how loan
proceeds are used because is offsetting obligation to repay. There is no deduction when makes
principal payments on loan. Lender does not have deductible loss upon making loan and does not
realize income on repayment of loan principal. Repayment is recovery of capital. Results are
appropriate because there is no change in the net worth of either party.
Interest on loan – Debtor may deduct interest payments. Creditor must include interest payments
Recourse debt – Borrower is personally liable for repayment of debt. Upon default, lender can
look not only to any asset securing the debt, but also to borrower‘s other assets for repayment.
Clear that recourse debt is not income when issued. Entered into legally-enforceable
promise to repay. Merely exchanging your future repayment for cash today. Not a taxable
Non-Recourse debt – Borrower is not personally liable for repayment of debt, lender can obtain
satisfaction of obligation only from property securing debt.
Less clear. Not obliged to repay, so could argue that this should be recognized as income.
Courts have held though that people act as if they have to repay and so treat non-recourse
debt in the same way as recourse.
Discharge of Indebtedness
§61(a)(12) – Gross income includes income from discharge of indebtedness (where debt is
cancelled for less than face value).
Rationale: 1) Net gain in wealth and therefore should be taxed, and 2) Original loan was
not taxed as income on assumption that it was later to be paid back. Once repayment is
discharged, must account for original loan in income.
HOWEVER, Congress passed §108 to provide some relief for this provision.
KIRBY LUMBER (1931)(see p. 175) – corporation sold bond (borrowed) for $12.15 M, bought back for
12M, ―found‖ $.15M in income. Court treated this as forgiveness of indebtedness and therefore taxable
Meredith Huston 20 Tax Fall 2001
Court saw issuing bonds at one date and then repurchasing them at another day as a good
investment, and the resulting gain was taxable like any other profit from speculative activity.
What‘s a better approach to base the decision on?
Typically businesses make deductible outlays with borrowed funds (pay employee
salaries, buy inventory - §162 ordinary business expenses). So people are allowed
to (1) exclude the borrowed money from income, (2) get deductions for outlays of
funds, ASSUMING (3) the company will subsequently repay the amount borrowed
out of after-tax income. That‘s how the Treasury makes it back.
If you get a discharge of indebtedness, you‘re not doing (3), and you‘re screwing
the Treasury unless they tax that muthafucka. Having reduced his repayment, he
now has to give back either (1) or (2).
Really, the Court should have made him reduce (1) or (2), but they didn‘t have a
statute for that, so they did the next best thing and include it in gross income.
o Why could they buy back bonds at less than face value?
Interest rates go up, so prices go down (if go down, prices go up). If the interest rate on
debt is lower than current market interest rate, lender may make $ by letting borrower pay
back less than full amount owed (i.e. selling at low rate) and then re-lending $ at higher
interest rate. Result to lender is income.
Alternative: Kirby Lumber looks like a worse credit risk now than when loan made. Can
buy back bond at a cheaper rate now than before.
ZARIN V. COMMISIONER (1989)(175) – Debtor gambled on credit and defaulted to casino for $3.5M.
Settled for $500K. Is amount forgiven taxable?
IRS‘ theory – there is a discharge of indebtedness so he has income under §61(a)(12) of $3M.
Economics perspective – had 3.5M gambling loss, 3M cancellation of indebtedness income, SO
net has .5M loss.
Tax perspective – we don‘t allowed gambling loss for taxable purposes so has 0 income, 3 COI income,
and so has loss of 3M.
Lawyer argues that loan was non-recourse so he is no better off legally than he was before the
loan was forgiven, his net worth did not increase. [Consumption + Δwealth = -500k argue he
didn‘t consume anything; but didn‘t he – e.g. happiness at the table]
o If yes, why should we just tax losers and not winners?
Consumption Argument – there is some consumption in gambling and so shouldn‘t be able to deduct it.
Counterargument – but why should we only go after net losers and not net winners?
Imputed income argument – should person who chooses work they like be charged for it?
Tax court said no, taxpayer received value of opportunity to gamble from casino. Also, there is no
purchase price reduction because chips had specific face value and statute didn‘t intend
adjustments for that. Didn‘t arise from a purchase of property.
Circuit court overruled tax court and found since the loan was unenforceable under New Jersey
law (adopt Jacobs argument), could not have income from discharge of indebtedness.
o Alternatively, it was a contested liability and income doesn‘t arise under settlement of a
contested liability. Under NJ law, taxpayer not liable for debt because chips are not
property, but rather are a medium of exchange.
Jacobs, J. argues that he didn‘t see chip income as debt because he didn‘t think he
was going to have to pay it back.
o Does the court say that exception 108e5 can‘t apply to intangible property? No, said it
may apply to some types of intangibles; but this case doesn‘t fall under what Congress
intended to be included. Property isn‘t chips themselves but opportunity to gamble the
Meredith Huston 21 Tax Fall 2001
§165(d) – can only deduct gambling losses against gambling gains (attempt to discourage
Rue’s theory in dissent (maj. rejects):
Exceptions to principle of indebtedness – 108(e)(5) – reductions in purchase price shouldn‘t be counted as
income (it‘s new amount not orig. amount that‘s important).
Freeing of assets theory
Counterargument – but if debt was never enforceable, then canceling of debt didn‘t free up any assets.
Looks at moment before debt was forgiven to moment after debt was forgiven and sees – you are better
o No, even if we can see ―chip income,‖ it happens only in the next year when he settles.
See debt as much more real, see debt as outstanding until it was settled in 1981. Have to
respect 165, and annual accounting system – was no gain until 1981.
Ultimately, all the theories revolve around the question of value.
Why is Zarin better under 3rd Cir. theory than under insolvency argument?
Under insolvency it‘s not a free ride – would have to reduce ―tax attributes‖ (other deductions).
He‘s developer, would lose bases in those properties – if sold, would have to pay more tax on the
sale; if didn‘t sell would bear higher cost of depreciation (couldn‘t deduct).
Qualified real property exception:
Building worth 2M; debt of 1.8M.
Fair market value is 1.5M; lender agrees to mark down debt to 1.5M.
Could I use purchase price redux theory – NO because money is from bank NOT seller.
Can‘t use insolvency exception – though within scope of the deal, might not be insolvent overall.
Has to be debt that was incurred to buy the building (not for other purposes).
HYPO – parents lend you money for tuition for law school and then say forget it.
it‘s a gift, not income
108f – loan forgiveness for students doesn‘t count as income.
Exceptions to Cancellation of Indebtedness rule - §108
o §108(a): A cancellation of debt is not taxable where the taxpayer bankrupt (108(a)(1)(a)) or is
insolvent (108(a)(1)(b)). Use the amount of debt forgiven in insolvency to reduce the basis in other
E.g. Assets are $40, liability is $100. So he‘s at -$60. $70 forgiven. Taxpayer has income of
$10 because insolvency exception only covers amount to extent of insolvency.
o §108(e)(2) – Lost deductions – excludes from income discharge of debt if its payment would have
given rise to a deduction (e.g. if bank forgives interest on mortgage. As if took deduction [for
business expense] and gave it back.) (Might have to itemize for this provision to apply)
o In other words, discharge of a liability doesn‘t result in discharge of indebtedness income
to the extent that liability would have been deductible had it been paid.
o §108(e)(5) – Purchase price Reduction – reduction in price owed to seller for purchase of property
(not services) not treated as a discharge of indebtedness (which is includible in income). Reduction
does not affect income. For reduction in amount of debt to be treated as a purchase price reduction,
Meredith Huston 22 Tax Fall 2001
debt is of purchaser of property (not a 3rd party) to seller which arose out of purchase of that
property (does not apply if debt transferred to 3rd party)
taxpayer must be solvent and not in bankruptcy when debt reduction occurs.
Except for §108(e)(5), debt reduction would otherwise have resulted in discharge of
(Why should 108(e)(5) only apply to property? Why not to services?)
Example: Like house painted, but poorly, so renegotiate the price – not covered by
108(e)(5), so would count as income. Seems to be comparable so should be covered
but isn‘t b/c 108e5 JUST talks about property.
o NOTE: whatever they settle on as the adjustment, that‘s the borrower‘s new basis in the
SMALL EXCEPTION – Reduction of principal of an undersecured nonrecourse debt by the
holder of the debt (not the seller) results in discharge income. Example: Borrow $200,000 to buy
building. When building is worth $150,000, the lender reduces principal to $150,000. That‘s
$50,000 in discharge income.
o §108(e)(6) – Corporate debt to stockholder – if stockholder forgives debt owed by corporation, the
Code treats it as if corporation satisfied debt with amount of $ equal to stockholder‘s basis in debt, so
the corporation has no discharge of indebtedness income.
o §108(f)(1)—Student loan – where school forgives part of a loan because go into a certain line of work,
not included in income (e.g. public service forgiveness programs)
If a debtor does not pay back a loan and someone else pays it back, it may be income under OLD
COLONY TRUST, or it may be a nontaxable gift.
o Treatment as a gift may only apply to loans extended in noncommercial setting -- e.g. parent
forgives loan – or may be treated as compensation.
§108(b)(3)(b) – reductions in B C and G shall be 33 1/3 cents for each dollar
o Why? All credits – if a credit rather than a reduction is 33 1/3 cents. If tax rate is 1/3 and have
a $1 deduction, will save 33 cents. If have a $1 credit, will save a $1. So since credits are
worth 3x more, should be reduced by a third if we are going to take them away.
§1017 – Rules for adjusting basis where there is a discharge of indebtedness
Other discharge exceptions: If a lender cancels the debt at a discount as a gift to the borrower, it doesn‘t
have to include the discount in income per §102.
Discharge of indebtedness in a commercial setting cannot be considered a gift.
Borrowing and Basis
Basis is not difficult to determine when asset is purchased with cash. When asset is acquired for
debt, it is more complicated.
§1012 – The basis of property is its cost, except as otherwise provided.
§1011 – allows for adjustments to basis
§1016 – allows for adjustments to basis including depreciation -- §1016(a)(2) and improvements
o You need to adjust your basis for depreciation even if you declined to take depreciation
deduction. If could decide to defer depreciation, could decide when to take deduction and
code does not generally allow you to elect when deductions are taken.
S1001 – determination of amount and recognition of gain or loss
o (a) gain = excess of amount realized over the adjusted basis. Loss = excess of adjusted
basis over amount realized.
Generally allowed to include amount of a loan in basis and then to take deductions on that basis.
Loan amount is initially included in basis under the assumption that you will later pay it back.
When no longer have to pay it back (e.g. buyer buys property and assumes loan), need to account
Meredith Huston 23 Tax Fall 2001
for discharge of loan. Need to know basis to calculate gains/losses when property sold and to
calculate depreciation over the life of the property (§1016).
Ex.: 100,000 recourse debt, 50,000 cash, buy building for $150,000, basis = 150,000
o Depreciate 30,000 – adjusted basis (§1016) = $120,000
o Sell property 140,000
100,000 cash to pay debt, 40,000 in pocket gain of 20,000 (even though net loss
= 10,000 cash – this is because of the deduction for depreciation)
20,000 Gain – 30,000 Depreciation = - 10,000 net
Ex. 2: 100,000 recourse debt secured by a mortgage, 50,000 cash, buy building for $150,000,
basis = 150,000
o Does not change the facts
Ex. 3: 100,000 secured non - recourse debt, 50,000 cash, buy building for $150,000 , basis =
o Does not change the facts – get this result from Crane
o Crane tells us non-recourse debt is the same as a recourse debt
Reg. 1.001-2: Discharge of liabilities – amount realized from sale of property includes amounts of
liabilities from which transferor discharged as a result.
o Reg. 1.001-2(4)(ii) – if property subject to recourse debt is sold and buyer agrees to pay
debt, seller discharged of debt and must include it in gains regardless of whether or not
bank holds seller personally liable for debt.
o Reg. 1.001-2(4)(i) – sale of property that secures non-recourse debt discharges transferor
from liability. Have to include amount discharged in amount realized.
Crane v. Commissioner (in Tufts -- 187) –Taxpayer received property through bequest, FMV =
$260K, debt = $260K, equity = $0. She operated the property for a few years, taking deductions
for depreciation, but made no payments on the mortgage principal. She included the full amount
of the mortgage debt when she computed her basis in the property for depreciation deductions.
o Sold property encumbered by non-recourse mortgage. The purchaser took over the
mortgage liability. In claiming her amount realized, she reasoned that her basis was zero
(despite her earlier depreciation deductions) and that the amount she received from the sale
was simply the cash she received.
o Commissioner argued that her basis was the property‘s FMV at the time of her husband‘s
death, adjusted for depreciation, and that the amount realized was the cash received plus
the amount of the outstanding mortgage received by the buyer.
o Court agreed with the commissioner, holding that the nonrecourse debt should be included
in the amount realized and that Crane obtained an economic benefit from the purchaser‘s
assumption of the mortgage identical to the benefit conferred by the cancellation of
personal debt. Basis was the FMV at time of husband‘s death (§1014 – inherited property)
adjusted for depreciation in the interim, undiminished by mortgages. (260 – depreciation).
So amount realized = net cash received + amount of outstanding mortgage.
o She is confusing her basis in the building with her equity in the building. "Amount
realized" from "the sale of property" is "the sum of any money received plus the fair
market value of the property," not its equity.
FMV Equity = Has a call option = not owner of property, so cannot depreciate
property. She has no downside risk. Only lender who suffers from decrease in
value of property.
Equity not zero because has the right to hold on to property until price
increases – and does not have to risk capital to do so. If building goes down
in value, can walk away without a loss because non-recourse
Meredith Huston 24 Tax Fall 2001
Contrast with put option – right to sell to the lender at a 260,000. In this
view: she owns building, plus owns put option, owes money – own
building and owe money cancel each other – leaves with put option.
Court says is neither.
o Case establishes principle that recourse and non-recourse loans are treated equally.
Either type of loan is included in the basis of the asset it finances and relief from a non-
recourse loan is used in determining the amount realized on disposition.
o Economic benefit theory?
o Consistency theory? Count on one, count on the other.
Commissioner v. Tufts (1983) (187) – taxpayers (partnership) borrowed $1.85M non-recourse
for apartments. Took out $450K in depreciation deductions, which reduced basis to $1.4M.
Unable to operate building profitably, and having repaid none of loan principal, sold property to
another investor who paid them $0, but took the building subject to the mortgage. At the time,
FMV not greater than $1.4M adjusted basis. Taxpayers argued no more than $1.4M should be
included in their amount realized and so had no recognizable gain. Court found taxpayers had
realized full unpaid balance of mortgage debt and must recognize $450K gain because
understanding of obligation to pay the full amount. When obligation relieved, realized value
o The Crane rule applies when the non-recourse mortgage exceeds the FMV of the property.
Sale price must include the amount of debt forgiven or assumed for less than face value.
Cannot use mortgage value in assessing basis and then leave it out of assessing amount
o To permit taxpayer to limit realization to FMV would be to recognize tax loss without
o Symmetry here, but no economic benefit. Incentive is to walk away, not to sell. Liability
would be the same if left mortgage out of basis and amount realized, but by including it,
can take advantage of the time value of depreciation deductions.
o O‘Connor concurrence – suggests that transfer of excessively mortgaged property might be
viewed as twofold event of (1) sale of asset itself (apartment building) for $1.4 FMV and
(2) use of constructive proceeds ($1.4M) to satisfy taxpayers debt of $1.85M, so sale
would generate no taxable gain, but debt repayment would be cancellation of indebtedness
(this would be ordinary gain, majority view would be capital gain (lower rate)). Shuldiner
says O‘Connor fails because different transaction.
Note this is how recourse loans are treated. Difference between outstanding value
on property and the FMV is considered discharge of indebtedness or ordinary
o Nonrecourse and recourse debt are not treated completely the same because lead to the
same total income, but recourse may be cancellation of indebtedness taxed as ordinary
income and subject to §108 restrictions.
Estate of Franklin v. Commissioner (1976)(196) – Doctors formed a partnership to by inn for
$1.2M nonrecourse debt. Paid $75K in prepaid interest and leased back to sellers who paid all
expenses for upkeep/ownership and paid rent to doctors equal to interest payments doctors made.
Option for Doctors to walk away in 10 years, forfeiting their interest payment. Doctors took
interest deductions on debt and depreciation deductions on $1.2M under Crane. Losses used to
offset gains made as doctors. No cash flow in this transaction rent (income) = Interest (deduction)
in every year so no net +/- effect,
Buyer -- Me Seller -- You
Buy Property Using Property
Lease property Using Property
Meredith Huston 25 Tax Fall 2001
Get property back at end of 10
o Could have been a valid sale allowing depreciation, but taxpayers failed to demonstrate
that purchase price was = to FMV of property. Transaction was really the purchase of an
option. Sellers lose depreciation deductions by selling, is possible that building was
already fully depreciated so this could have been a way to get fresh depreciation.
o Prepaid interest – cannot deduct for prepaid interest (§461(g)) – no real difference
between borrowing $1000 and prepaying $100 and borrowing $900, so can only deduct
interest over period for which it was allocated. If you prepay interest, must allocate for
time where interest would have accrued. Exception -- §461(g)(2) does allow for deduction
on mortgage points (form of prepaid interest).
Situation 1 Situation 2
$1000 loan $900 loan
10% - $100 prepay 11%
What’s the liability you owe? Same as if borrowed $900 and owe $1000. $900 princ. +
Have to pay $900 one year from now – BUT you have $900 in pocket. $900 one year from now is worth
less than what you would pay now (future value) so no deduction allowed.
Tax rule changes: get rid of tax rule for prepaid interest…
Change limited installment sales treatment (so that Romney would have declare $ upfront)
Charge penalties [this actually happened]
o Taxpayers could have artificially inflated basis (i.e. tack on another zero) to claim larger
depreciation deductions. This is not allowed. Basis in property cannot include debt. In
effect, a tax shelter was created here – this is now illegal – see At Risk Rules (§465 – can
get basis for nonrecourse debt, but will not be able to take out debt in excess of what you
invest in deal – either b/c you put money in or because you took out actual debt), Passive
Loss rules (§469) below. Where there is no equity, will not treat as real debt (opposed to
Crane and Tufts, where act as if investment will pay back). Nonrecourse like Tufts, so
there is no cancellation of indebtedness.
o Reg. 1.1001-2(a)(3) – Taxpayer‘s amount received reflects debt relief only to extent that
basis is included in debt.
o Test – look at objective reality at beginning of transaction and see if buyer really intends to
buy. If value of property drops so that is less than mortgage, apply Tufts reasoning.
Where it is not close, will ignore subjective test, where it is close, and there may
reasonably have been a bad bargain, will still use a subjective test.
o Shuldiner thinks better result would be no sale, taxpayers get depreciation
o Reconciling Tufts and Franklin: Tufts should be understood as holding only that taxpayer
must treat nonrecourse mortgage consistently when accts for basis and amt realized; thus in
Franklin situation, where amt of mortgage exceeds FMV of property securing it when debt
first incurred, mortgage not included in basis and not included in amt realized upon
disposition, generally foreclosure; in Tufts, where value of security exceeded debt initially,
debt will be included in basis and amt realized upon foreclosure, even if amt of debt then
Meredith Huston 26 Tax Fall 2001
DAMAGES AND SICK PAY
Personal Injury Awards (Generally)
Damage awards for personal injury (from individuals and workman‘s comp) are excluded from gross
income under §104(a).
Analogy to term insurance (though this is to replace lost wages in part, which would be taxable).
This applies only to physical injuries or sickness. (Defamation, civil rights awards don‘t count).
Punitive damages are taxed. §104(a)(2)
Commercial Damage Awards (Generally)
Damage recoveries arise out of involuntary transactions. (A forced realization). If a taxpayer‘s recovery
exceeds property‘s basis, the excess is taxable just as it would be through sale.
Though its unfair to tax someone on appreciation on an asset they didn‘t intend to dispose of.
o So §1033 says if a taxpayer reinvests the proceeds of an involuntary conversion in business
property of a similar character, this section lets him exclude the gain that would otherwise
Unavailable for things like business goodwill, which is established through
expensed items and has no basis. RAYTHEON.
Damages to Business Interests
If building burn down – can be paid damages for:
value of factory taxed in same manner as if sold factory (AR – basis)
o Doesn’t matter if AR is different than FMV – even if would have made more if
sold; still only get AR b/c would’ve been taxed on that additional amount
lost profits taxed as ordinary income
Substitution theory: What are the damages a substitute for?
Basic rule comes from HORT. Payment resulting from negotiated settlement of a canceled lease
was taxable because payment was a substitute for rent reserved in the lease.
RAYTHEON V. COMMISSIONER (204) – Antitrust suit damages are taxable income. Damages were
recovery for loss of goodwill because unable to show basis in goodwill. Fully taxable. Where taxpayer
receives amount to compensate for loss of property that has adjusted basis, amount of income is extent to
which amount received exceeds adjusted basis. Where taxpayer receives amount to compensate for lost
profits, no basis/fully taxable. Lost profits are a substitute for profits which are ordinarily taxed. (Also,
it could be thought of as no basis in lost profits).
o When settlement is for loss of capital, amount is recovery of basis, yet taxpayer cannot
attribute to capital amount in excess of adjusted basis of asset involved. (E.g. goodwill is
loss of capital, but no basis in goodwill)
GLENSHAW GLASS (205) – Court held that $ received as exemplary damages for fraud or as
punitive 2/3 of treble damage recovery must be included in gross income under §61 – accession to
wealth with complete dominion.
o Punitive damages are not a substitute for anything – they are therefore not excluded from
§1033 – Involuntary conversion -- allows you to replace stolen or converted property and elect to have
income = damages received – cost of replacement. Also applies to insurance proceeds received as result
of destruction. Otherwise even if got value of building back, would still have to pay taxes on gain and
Meredith Huston 27 Tax Fall 2001
then have less money to reinvest. In settlement for damages, need to allocate $ to recovery for lost profits
and recovery for property damage. Only works where basis = $0, because then if you sold, you realize
value of gain at sale.
o Assume Building is destroyed –Value of Building – 1,000,000 (Basis = 400,000).
Originally would be treated as if sold the building – 600,000 income. But if were forced to
sell building and then had to rebuild, should not have to pay taxes to replace property –
resolved by §1033.
If property destroyed is converted into money then get a gain
If property destroyed is converted into a new building, then no gain.
Damages for Personal Injury and Sick Pay
§ 104 excludes:
o Amount of any damages received on account of personal injuries or sickness.
o Interest earned when the payment of damages is periodic rather than a lump sum
(§104(a)(2)). Although the supplement says that interest is not received ―on account of
personal injuries or sickness.‖ With lump sum, principal is not taxed, but interest is
Assume car accident – in the absence of §104, how should these be treated?
No §104 With §104
Lost Taxable for personal injury excluded --
Punitive Taxable taxable – under current law (any
Damages damages (other than punitive
damages), used to not be specifically
excluded. IRS originally (casebook is
wrong . . . ) found that punitive
damages were not income because
were ―on account of‖ . . . then they
changed their position.
Medical Maybe we should exclude. Normally Excluded -- Congress feels bad for
Expenses (§213 – itemize) deduction limited to the injured.
7.5% of AGI (adjusted gross
income), odd disparity if we treat
people more favorably if they
recover from their accident.
Pain Maybe exclude, maybe include. ―on account of personal physical
And Made worse off by pain and injuries‖ are excluded under
Suffering suffering, now being made whole, so 104(a)(2). Extensive litigation on this
should not have income from these issue.
damages. But normally subjective
feelings are ignored (still are taxed if
hate the job which pays you income).
Here is non-voluntary.
Property Treat as if sold property. If had basis
Damages in property before, becomes zero
when damaged. Become whole
again with damages, so no income.
Meredith Huston 28 Tax Fall 2001
Emotional distress – only exclude recovery for emotional distress if the distress is the byproduct of other
physical injury or sickness.
Damages paid out over time – entire recovery is excluded from income, even if the payments in the
future implicate interest as compensation for the delay. (Incentive to use structured settlements).
What Injury constitutes a personal injury?
o Personal injury means Tort-like damages
o Sex discrimination case (206) -- Under BURKE could only get lost wages. Congress then
amended §104 provision to allow for full range of damages
o Age discrimination cases (p. 206) – workers took position that would have had an age
discrimination claim, and that severance pay in settlement of that claim and should be
excluded. Courts have been unsympathetic to that position
SCHLIER– clear age discrimination case – court said damages were not on
account of personal injuries. In a normal case, have a personal injury, because of
that have lost wages.
Back pay received on account of age discrimination was not on account of
personal injury (although injury may have been suffered)
104(a)(5) – Amounts received to victims of violent attacks determined to be terrorist attacks by
Secretary of State not included in income
o only helps U.S. Government employees and while working abroad
o does not apply to victims of domestic terrorism
Employer Payments -- Treatment?
o §105 – Amounts received Under Accident and Health Plans
Lost wages while sick (sick leave) – Taxable -- §105(a)
Medical expenses – excluded under 105(b) (would be included under 105(a))
10,000 per arm – excluded under 105(c)
o §106 – Contributions by employer to accident and health plans
Employer buys insurance – excluded under §106
You buy disability insurance – not excluded under §105, excluded under
§104(a)(3) (amounts received through accident or health insurance)
§103 – interest from state and local government bonds is not taxable. (Excludes§ 141 private activity
bond and arbitrage bond (where buy in one market and sell in another), and when not registered form.)
General Obligation Bond – bond secured by full faith and credit of municipality or state. The
more general obligation bonds a municipality issues, the greater risk they will default, so will have
to pay out a higher interest rate to bondholder.
Revenue Bond – bonds paid out of proceeds of underlying project (e.g. bond for turnpike will be
paid out of tolls collected), municipality would use this to avoid the problem of compiling risks
which is endemic to general obligation bonds. With revenue bonds, the only risk involved is the
risk associated with the revenue of the underlying projects. These bonds are capped by §146(B).
Constitutional implications: SOUTH CAROLINA V. BAKER (212), court upheld provision that taxes
interest on state and local bonds unless bonds issued in registered form. Rejected argument that statute
interfered with state‘s right to borrow, made borrowing more expensive, and therefore impaired exercise
of sovereign powers.
Original constitutional justifications for tax-exemption having been eliminated, exemption
remains as a federal subsidy to the states for their activities. Allows state and local governments
to pay lower rates of interest on their debt then that paid on taxable corporate bonds.
Meredith Huston 29 Tax Fall 2001
o Tax yield (for taxable bonds) x (1-tax rate) = tax-exempt yield
o Problem is that exemption has different value to different taxpayer at different rates.
o If tax rate is 50%, tax-exempt yield at 5%, if bonds sell at 7% ―leakage‖ goes to high
Who is the break even taxpayer?
o Rate exempt = Rate tax x (1-tax rate).
o Ex. If MM mutual = 5.71%, tax exempt = 3.63%. Break even taxpayer = 1- (R exempt/R tax)
= 36.6%, so here, any taxpayer in a higher bracket is being subsidized.
These bonds are especially attractive to higher bracket taxpayers because may not need to borrow
to take advantage of these.
o Assume corporate bonds paying 10% interest and there are three classes of people – A:
50% bracket, B: 30% bracket, C: 10% bracket
To get highest bracket (A) to prefer state bonds to corporate bonds, municipal
bonds would have to pay 5.1% interest since they are paying 50% tax on interest
received for corporate bonds, effective after-tax interest rate they receive is 5%
To get B to prefer state bonds, would have to pay 7.1%, because bondholders only
get 7% after tax rate on corporate bonds
If all bonds could be bought by A, state could offer 5.1% bond and all of subsidy
would go to state. As an empirical matter, not enough people in A group to sell all
of tax exempt bonds, so to sell the entire issue, state has to attract B group of
investors by giving them a 7.1% interest rate. Thus the rich get a 2% subsidy and
state only gets a 3% subsidy.
So let’s say 7% is what the municipality has to pay. Let’s say they issue bonds to 50% and 30% taxpayers.
The federal government loses 8% here (from the 10% bonds they would have gotten on one 50% and 30%
taxpayer). The municipality gains only 6% however, because city have had to offer 10% if not for the tax-free
status, so they’re saving 3% on each of two bonds, which equals 6%.
Problems when have a piece of the market taxed differently from the rest.
Private activity bonds -- §141 exception, are taxable under alternative minimum tax. Only
government municipal bonds are exempt.
o Assume C wants to borrow at 6%, not 10%. Get government to borrow $ and lend it to
me. $ funneled to private and not government purpose. Don‘t want to allow this because
municipality uses $ for roads, schools, etc. cannot shift its gain to private business, this is
o §103(b)(1) – allows exemptions for certain qualified private activity bonds (§141(e) --
§146(a) puts a volume cap on these bonds.
Arbitrage bonds – not tax exempt (§103(b)(2)). Arbitrage bonds are basically where
municipality borrows at preferential rates to buy assets at retail.
o Ex. Philadelphia issues 7% bonds to invest in fed bonds at 10%. Like Private Activity
Bonds, completely subvert taxable bond market if allowed too often.
Arbitrage by holders of municipal bonds.
o Taxpayers may not deduct interest from borrowing to purchase tax exempt bonds --
§265(a)(2). If borrowed at 10% to by 7% bonds, and in 50% bracket, locks in a 2% gain.
Meredith Huston 30 Tax Fall 2001
DEDUCTIONS AND CREDITS
Theory, we only want to tax net income, so allow deductions for costs tied to producing income.
Roughly trying to tax profits, not revenues.
BUSINESS EXPENSES (ABOVE THE LINE DEDUCTIONS)
Often people try to say personal expenses are business deductions.
Courts use an objective standard to distinguish between the two.
Ordinary and Necessary
§162 – deductions allowed for all ordinary and necessary expenses in carrying out trade or business
paid in cash or incurred during taxable year (includes reasonable allowances for salaries, traveling
expenses, and rentals -- §162(a)).
What is trade/business? Trade/business has to be an activity entered into for the purpose of
making a profit, regular and continuous, and actively engaged in. This distinguishes provision
from nondeductible personal expenses (under §212)
o GROETZINGER – professional gambler engages in a trade or business if involved in
activity with continuity and regularity and with primary purpose of earning income or a
profit, even if no sale of good or services involved. Could deduct under §162. HIGGINS
provides no readily helpful standard [just says that you aren‘t in trade/business if managing
your own investment]
§212 – (for contrast) permits individuals to deduct ordinary and necessary expenses stemming from
income producing activities that do not qualify as trade or business (e.g. managing portfolio, investment
activity). §212 deductions are below the line, miscellaneous itemized deductions, subject to the 2% floor.
Taxpayer need not be actively engaged. [If take standardized deduction, obviously don‘t deduct for this]
This is a response for HIGGINS
o No the case that all 162 deductions are above and all 212 are below the line; have to
examine §62 and see if the item is on that list.
o Why is above the line deduction better?
B/c if not itemized you‘d lose it.
B/c of phase outs in the code – where say ―we said you could get this but you‘re
too rich‖ – these benefits are based on adjusted gross income, so if you take
deduction above the lie will have lower AGI and so can qualify for these things; if
take below the line will have to wait and apply to qualify.
Paid/incurred – included to allow for both cash-basis (individual) and accrual (corporations)
§62(a)(4) – includes rents and royalties – clearly above the line.
Investment income is below the line, not implicitly mentioned.
WELCH V. HELVERING (217) – taxpayer worked for company that went bankrupt. To reestablish
relationship with customers in industry, taxpayer decided to pay off as many creditors as could even
though not legally obligated to do so. Tried to claim a deduction for paying off debts. Court said expense
was not ordinary and necessary, not deductible under §162.
o Necessary – if taxpayer thought were appropriate and helpful. [That‘s a subjective std.,
easy to meet]
o Ordinary – common and accepted means. Not unusual. Not necessarily requirement of
regularity. Lawsuit is deductible (capital asset, but habitual); reputation and goodwill not
deductible (capital asset not ordinary)
Shuldiner asks – what if you come up with an original idea for your business.
Meredith Huston 31 Tax Fall 2001
Shuldiner argues ―ordinary‖ means non-capital expenditure. [clearly here was
capital expenditure]. That‘s what this case is about, whether this should be
immediately expensed or capitalized.
Examine – could he depreciate, amortize, etc.
o Good will in the past was not depreciable; now good will you
purchase is, good will you get yourself may not be.
o Rationale: amounts paid by taxpayer had to be capitalized rather than expensed under
§162 because repayment of discharged debts produced benefits (in form of goodwill) to
taxpayer that extended beyond year in which payments were made.
Could also argue that the repayments of debts were to protect something he already
possessed, a reputation in the grain trade. They were to shore up his goodwill, so
these could be called deductible repairs to an existing capital asset.
Legal Expenses as ordinary and necessary
GILLIAM V. COMMISSIONER (220) – taxpayer was artist flying to Memphis on a business trip.
While on plane, he flipped out and caused damage. Taxpayer tries to deduct cost of legal defense.
Court held defense of lawsuit was not ordinary and necessary, travel may be ordinary and
necessary to business, but altercation/lawsuit were not in furtherance of business. Not deductible
Looked at plane, meals, hotel – all could be looked at as paid in furtherance of
o Court here looks at the origin of the claim to determine whether expense is ordinary. If
the origin of the claim was a business activity, then the litigation costs are deductible.
Does not have to be a legal business cost – like securities fraud.
o US V. GILMORE (222) – taxpayer sought to deduct legal expenses incurred in contesting
divorce property settlement. ―Origin of the claim‖ test used to distinguish deductible from
nondeductible litigation expenses. Stemmed from personal marital relationship, so were
o DANCER V. COMMISH – where lawsuit arose out of car accident on a business trip,
litigation expenses were deductible because travel was ordinary and necessary to business
of traveling salesman. Contrast with Gilliam – where flying not ordinary part of being
PUBLIC POLICY LIMITATIONS
COMMISSIONER V. TELLIER – question of whether expenses incurred by taxpayer in
unsuccessful defense of criminal prosecution may qualify for deduction under §162(a) – ordinary
and necessary expenses.
o According to Shuldiner, can deduct expenses incurred in carrying on illegal activities
(bookies can deduct rent), apply normal ordinary and necessary test to see if expense was
incurred in carrying on trade/business.
Court should hesitate to read in public policy exception to allow for a deduction unless Congress
has specifically declared such exception. (E.g. congress specifically stated that deduction not
allowed for pursuit of certain kind of business.) See below for specific exceptions.
Reg. 1-162-1(a): deduction for expense which would otherwise be allowable under §162 shall not
be denied on grounds that allowance of such deduction would frustrate sharply defined public
§162(f) – can‘t deduct fines paid to government in violation of law
§162(c) – can‘t deduct bribes to public officials
§162(g) – can‘t deduct 2/3 treble damages paid when convicted of antitrust violations
§280(e) – can‘t deduct any expenses related to drug activity
Meredith Huston 32 Tax Fall 2001
§165 – limit on deductibility of losses that would frustrate sharply defined national or state
policies proscribing particular types of conduct, payments that would not pass muster under §162
should not be deductible under §165
PA bookie case.
Max Sobel case – can‘t deduct kickbacks but can include in costs of goods sold.
TANK TRUCK (234) -- Allowance of deduction for fines incurred by overweight trucks driving
through PA would undermine PA weight limit policy, no deduction allowed. One argument: Not
really a fine, just a way for PA to collect $, like a license fee or a toll. If a toll, why not deduct?
But the court wouldn‘t look at this in this way.
o What about deduction of legal fees for challenging the fines? Under Tellier, would be
permissible to deduct them.
§162(e) – Lobbying is generally not deductible, certain exceptions: at state or local level
o De Minimis -- <$2000 also deductible
o Lobbying for public initiatives and referenda is not deductible.
In order for expense to be deductible, need to have a trade or business and legislation must be of
direct interest to that business.
No constitutional problems with limiting deductions. Deductions are a matter of grace, not of
right. Also ensures complete hands-off policy on part of government – protects first amendment
o Limits on lobbying by non profit orgs. Does not result in an Equal protection violation.
Are not allowed to penalize organizations in exercising free speech, but do not have to
Difficult to draw the line between deductible institutional or goodwill advertising and
nondeductible efforts to influence the public on legislative issues of significance.
Attempts to influence executive and judicial branch do not constitute influencing legislation for
REASONABLE ALLOWANCES FOR SALARY
Note: some salaries are non deductible – where there is a salaried employee for personal use.
§162(a)(1) – reasonable allowances for salaries and other compensation for personal services are
deductible as ordinary and necessary.
o §1.162-7 – unreasonable compensation paid to an employee is not deductible.
o This is read as a limitation on the amount allowable (salaries would already be deductible
under ordinary/necessary business expenses).
o Limit to reasonable allowances because of 2 concerns:
Nomenclature: Don‘t want to be able to deduct things that are not what they say
they are (i.e. say salary (because deductible for corporation) even though something
else/really dividends (not deductible for corporation))
Does it matter to the employee whether income is a dividend or salary?
o There will be a tax cost to the individual if paid in salary because of
social security and Medicare taxes. The savings to the corporation
overwhelms this cost.
Overcompensation of employees: Don‘t want to pay more than deserve/more
than the work justifies/cannot pay unreasonable salary to siphon off dividends
Don‘t want people overpaying family members to shift income.
§162(m) – another limitation on salaries. Denies deduction for executive compensation over $1M
in publicly traded corporations. Worried about paying too much – non-tax concern of protecting
stockholder from rapacious CEOs?
Meredith Huston 33 Tax Fall 2001
EXACTO SPRINGS V. COMMISH (223) – Independent Investor Test – How to tell if a salary
o Tax court cited 7 factors: 1) type/extent of services rendered, 2) scarcity of qualified
employees, 3) goals/prior earning capacity of employee, 4) contributions of employee to
business venture, 5) net earnings of employer, 6) prevailing contribution paid to employees
with comparable jobs, 7) peculiar character of employer‘s business.
o Posner says even using these factors should be in favor of taxpayer or neutral. Feels
judges are not qualified to determine reasonableness, that factors are vague and not
properly weighted against each other. Uses indirect market test: see corporation as
having K with manager for services, higher rate of return for company = more salary
manager can demand. Independent investor test – reasonable rate of return to be gotten
by investor, then no reason to think siphoned off salary. Rebuttable presumption that
salary is reasonable.
Ultimately allows deduction – not a problem with publicly traded corporations,
because by definition independent investors.
Golden parachutes : §280(g) – limit to deduction taken for payments to key employees when
ownership of corporation changes. Parachute is excessive if present value of payment is greater
than three times employee‘s average salary for past five years. Excess over 3x of average is not
EMPLOYEE BUSINESS EXPENSES AND THE 2% FLOOR
§162 -- Expenses incurred by employee in connection with trade or business are deductible.
o Raises frequent question of whether expenses are personal and whether identical employee
expenses are subject to disparate treatment.
Generally, whether business expenses are taken above or below the line depends on whether are
reimbursed. Prefer above the line because
o if are not an itemizer, cannot take advantage of below the line deductions,
o taxpayers want a low adjusted gross income, which is decreased by above the line
deductions because many below the line deductions shave floor set by % AGI (e.g.
medical expenses are only deductible if rise to 7% AGI).
o Miscellaneous deductions are subject to a 2% floor and it is easier for total expenses to
exceed 2% AGI if lowered by above the line deductions which are not subject to the 2%
o Child care credit greater if AGI lower
o Some below the line deductions are phased out at a rate of 3% of excess of AGI over
particular threshold. Higher AGI greater phaseout.
Why a special treatment for reimbursed expenses? May be that employer is a gatekeeper in the
system. IRS figures that if your employer is parting with money, it is more likely to be a
legitimate business expense. Essentially using corporations to substantiate legitimacy of expenses.
Re-imbursement versus not-reimbursed
§62(a)(2)(A): If employee is reimbursed, employee can deduct above the line even if take a standard
All unreimbursed expenses are below the line and deductible only if employee itemizes
deductions. (These fall under miscellaneous deductions, subject to 2% floor see below)
o Rule inapplicable to artists whose employee business expenses are deductible in
§62(a)(2)(B), §62(a)(2): can only deduct expense if normally deductible under §§ 161-193
Meredith Huston 34 Tax Fall 2001
Reg. 1.162-2(c)—requires that reimbursement plans be accountable or won‘t be sufficient for
deduction, even if employee cannot deduct, business can deduct as a business expense. Can only
deduct above the line if reimbursed.
When firm pays expense directly working condition fringe, not included in income
When not reimbursed employee claims deduction §63(d), no above-the-line deduction, must
itemize to get. Since only 30% of taxpayers itemize, this is somewhat limited.
The 2% Floor
§67(a) – taxpayer can deduct miscellanueous itemized deductions only to extent that on aggregage
exceed 2% of taxpayer‘s AGI for the year. (So only deduct on amounts over 2%, that 2% is lost
o Why have the floor? To raise revenue, also provides some simplification. Would be very
tedious for taxpayer and for IRS to audit without the floor because of tons of insignificant
§67(b)– tells you what is not a miscellaneous itemized deduction. If your expense is not on this
list, by default, it is a miscellaneous itemized deduction and subject to the 2% floor (unless a
moving expense, explicitly excluded). List includes:
o (1) §163 interest; (2) §164 taxes; (3) §165 losses; (4) §170 charitable contributions; (5)
§213 medical expenses; (6) §1341 computation of taxes where tax returns $ held under
claim of right; (7) §72 annuity pmts; (8) §171 amortizable bond premium
The two big categories of miscellaneous deductions are employee business expenses (§162) and §212
DISTINGUISHING BUSINESS AND PERSONAL EXPENSES
need to distinguish between personal and business expenses because if allowed business deduction
for personal consumption would create horizontal inequity – taxpayers with similar income have
different abilities to obtain deductions depending on occupations, and vertical inequity – because
taxpayers with higher incomes often have more opportunities to obtain these deductions than
lower, would induce misallocation of resources.
A mixed motive (personal and business) must be treated as either personal or business, not both.
Congress has recently responded to abuses by imposing restrictions on or disallowing certain
deductions – e.g. travel and entertainment. Has attempted to limit ―mixed motive‖ expenses to
Tests applied by IRS:
o Appropriate and helpful to taxpayer‘s business or income producing activity.
o Primary purpose in incurring expense was profit-seeking (in some cases, but for
o Expenditures are reasonable even if clearly profit oriented
o Sometimes only for additional expenses due to need of taxpayer‘s business or income
o Sometimes allocated between business and personal
o Inherently personal – nondeductible even if shown to enhance profit-making activity (e.g.
§262 – no deduction for personal expenses
o §262(b) – for individual, any charge for basic phone service, for first phone line, personal,
regardless of business use. Second line, deductible.
TREBILCOCK—employed minister to give business advice with strong spiritual slant. TP wants
to deduct, but not deductible despite business benefit because not ordinary for business.
Meredith Huston 35 Tax Fall 2001
PEVSNER – Woman expected to wear designer clothing for boutique. Court used objective test:
1) is the clothing specifically required for employment? 2) Is the clothing adaptable for general
usage as ordinary clothing? 3) Does taxpayer wear the fashion as ordinary clothing? Taxpayer
o If employer provides free clothing, is probably income and not a working condition fringe
(§132), because if employer had purchased clothing would not be deductible under §162
o Suit not deductible even if have business need for one.
o Rev. Rul. 70-474: Uniforms are usually deductible.
Why the distinction? No personal value from McD‘s uniform, but you could wear
Armani suit to other events.
Distinguishes between activities that are engaged in ―not for profit‖ and those that are engaged in for
Activity must be engaged in for profit in order to claim loss deductions.
§183: test whether activity engaged in for profit;
o Shuldiner claims it is an allowance provision; allows to take deductions otherwise would
not be able to take;
§183(b)(1): doesn‘t prevent you from taking deduction from some other aspect of code;
§183(b)(2): if hobby not for profit, can still get deduction for things that would have been deductible if
were doing for profit, as long as gross income derived is greater than deductions allowed under this
section; can basically take deduction up to amt earned on activity, even if not engaged in for profit; can‘t
use losses from here to offset other gains. (Best you can do is break even – you‘re not going to produce
losses for these activities) Can‘t shield other income with hobby losses.
§183(d): rebuttable presumption that enterprise is a profit-making venture if is profitable 3 years
out of 5
Reg. 1.183-2(b): Factors in considering a for-profit operation... consider 1) manner activitiy
carried out, 2) expertise of taxpayer/advisors, 3) time and effort expended by taxpayer, 4)
expectation that assets used may appreciate, 5) success of taxpayer in carrying on
similar/dissimilar activities, 6) taxpayer‘s history of income/loss with regard to activity, 7) amount
of occasional profits earned, 8) financial status of taxpayer, 9) whether elements of personal
pleasure or recreation involved.
o NICKERSON - This turns on whether the taxpayer meant to make a profit (sincerity), not
whether it was likely to make a profit (reality).
Despite §1.183-2(a) that says greater weight is given to objective facts than to the
taxpayer‘s statement of intention.
If there is a demonstrable profit motive, then start looking to 162, 212 for deductions.
PLUNKETT V. COMMISH (1984) (371) – taxpayer not allowed to deduct for mud racing hobby
because profit potential was too slim. Was allowed a deduction for truck pulling expenses.
Standard is completely subjective – did taxpayer engage in the activity with the actual and honest
objective of making a profit? That someone derives pleasure from an activity does not, on its face,
Travel Away from Home
Travel/entertainment expenses associated with a business have an inherent element of personal
consumption and have been subject to substantial taxpayer abuse…§162(a)(2) and 274 put restrictions on
deductibility of such expenses.
Meredith Huston 36 Tax Fall 2001
§162(a)(2): allows deduction for (ordinary and necessary) travel expenses incurred (1) while
away from home (overnight, see CORRELL) (2) in pursuit of trade or business (motivated by
exigencies of taxpayer‘s business) and (3) reasonable/appropriate.
Commuting – costs of commuting from home to work are nondeductible personal expenses
(unless qualified transportation fringe under §132(f), Reg. 1.162-2(e). Where you live is a
COMMISH V. FLOWERS (255) – commuting expenses not deductible because it is a personal
choice to live away from work.
McCABE V. COMMISH (1982)(254) – Taxpayer is a NY police officer who must travel around
NJ to commute to work because cannot carry his weapon there legally (and must carry it in NY for
job). Commute is made much more expensive. Court held he couldn‘t deduct excess expenses
because he chose where to live (personal consumption).
o Shuldiner says should be deducted as a trade/business expense.
o Maybe would be a different decision if he had only tried to deduct the additional costs of
his commute – he tried to deduct them all.
o Small exception - FAUSNER – additional expenses may at times be incurred for
transporting required tools and materials to and from work, allocation of personal and
business costs may be feasible. (You may be able to deduct her extra commuting costs
that are attributable to transporting the tools).
o POLLEI – court ruled that police officers who began active patrol when they left their
homes were engaged in their jobs while driving to and from station, therefore commuting
expenses allocable to that time were deductible.
Transportation costs while on the job are generally deductible. §1.162-2
Revenue ruling 90-23 – transportation expenses in going between residence and regular place of
business are nondeductible, but if going between residence and temporary place of business, then
o If you go from your house to Philadelphia Construction site A, B, or C, cannot deduct costs
o If you go from your house to NY construction site D, can deduct costs.
o If you go from house in Philadelphia to work at Liberty Place and then to Courthouse – can
deduct cost from liberty place to courthouse – because is a business expense.
o If you go from house in Philadelphia to work at courthouse (skip the office) -- Will be a
deductible expense – temporary workplace -- as long as in the same trade or business as
normal employment – See. Rev Rul 99-7
Justification: Why would we want a rule that requires people to go to the office
when they don‘t need to?
How is this distinguishable from construction example? In construction, every
worksite is a temporary workplace, so is always a commute. Is this a reasonable
outcome? Not necessarily.
Food and Lodging
§162(a) – temporary employment doctrine: taxpayers can deduct transportation, meals, and
lodging expenses when assigned to work in a place away from home for less than one year.
Taxpayer must still have business reason for maintaining old home (i.e. plan to return to work
§162(a)(2): allows deduction for (ordinary and necessary) travel expenses incurred (1) while
away from home (overnight, see CORRELL) (2) in pursuit of trade or business (motivated by
exigencies of taxpayer‘s business) and (3) reasonable/appropriate.
Meredith Huston 37 Tax Fall 2001
o unreimbursed travel expenses are deductible as miscellaneous itemized deduction and are
subject to 2% AGI floor of §67.
o Reimbursed travel expenses are deductible from gross income under §62(a)(2)(A) and are
not subject to 2% floor
o In the case of food or beverages, only 50% of their cost is deductible. See §274(n) and
o Is §162(a)(2) necessary? Shuldiner seems to think not really.
Meals would be inherently personal and not deductible. Argument is that there is a
duplicative expense incurred, meals away = more expensive. Argument not as
strong here as for lodging.
Lodging = inherently personal. But lodging = duplicative expense incurred only
because traveling for business
Certain transportation expenses are deductible even without this provision.
CORRELL (259) – Requirement of sleep and rest – Taxpayer is traveling salesman and wants to
deduct meals eaten on the road. Court found that in order to get a deduction for expenses incurred
while ―away from home‖ must have an overnight stay/sleep and rest.
HANTZIS (1981)(260) – Harvard law student spent summer in NYC, claims Boston is home and
that stay in NYC was business related, temporary, and away from home. She deducts her
expenses for the summer. Court says she cannot deduct because Boston was not her home for tax
purposes as she had no place of business there. Business did not require her to maintain the
residence there (her spouse did). Need a business reason for both homes in order to deduct the
o Three part test – 1) reasonable and necessary, 2) incurred while away from home, 3)
motivated by exigencies of business.
Taxpayer‘s home for purposes of §162(a)(2) is the taxpayer‘s regular or principal
place of business.
o So if you do maintain two residences for personal reasons, generally not deductible.
o Shuldiner thinks that the important factor is the temporariness of the work, not that you be
performing the same work in temporary site or that the temporary business necessarily be
constant and ongoing. IRS is trying to make sure you‘re not double-counting for home in
one area, business in another.
§280F: limits deductions for luxury car expenses
§274(c): certain foreign travel; (d): substantiation requirement; (e): misc.; (h): attendance at
conventions nondeductible if out of continent; (k): extravagant meals nondeductible; (m):
additional travel limitations; (n) only 50% of business meals and business entertainment are
Meals and Entertainment
Business meals and entertainment expenses are reimbursed by an individual‘s employer are fully
excludable by employee, but employer is subject to 50/50 restriction.
Costs of business entertainment and meals may be deducted only if (§274(a)(1))
(1) item was directly related to the active conduct of taxpayer‘s trade (as opposed to creation of goodwill)
OR (2) the item preceded or followed a substantial and bona fide business discussion and was associated
with the taxpayer‘s trade or business.
And then if its meal/entertainment, it‘s a 50% deduction (see below).
Meredith Huston 38 Tax Fall 2001
Even if it slips through §274, 162 might get it - MOSS (269) – partners from law firm meet in restaurant
for working lunch every day. Lawyers argue that are compelled to eat there. Court says nondeductible.
Under §162 may be ordinary and necessary because of business benefit, might have had different outcome
if meal was not every day. §162 is the bar to deduction here, daily nature of meal makes it inherently
o Posner argues:
Bad Meal – exclude – don‘t get full value. Sibla is here – how posner
distinguishes from Moss. Anti-discrimination – trying to integrate firehouses,
forced mess = to force them to eat together, create social lubrication
Normal Meal – Moss is here. No exclusion.
Great Meal – Posner says if is really expensive meal, wouldn‘t be what you
usually eat. Don‘t get full value out of this meal. Can exclude.
o The firm ended up hiring their favorite waiter and opening a small dining room in the firm.
Excludable from income under §119
o If Moss were an associate rather than a partner, the issue would be whether or not the
lunches constituted compensation (274(e)(2), or whether they could be excluded under §
132 (fringe benefits) or § 119 (meals and lodging for the convenience of the employer).
SUTTER (Tax Ct. 1953)(pg. 270, see fn.): if personal living expense is to qualify under §162,
taxpayer must demonstrate it was different or in excess of that which would have been made for
taxpayer‘s personal purposes
§274(n) – 50% limitation on employer‘s deduction for employee meals. This is intended to
approximate the personal component of meals.
§274(n)(A) – if employer reimburses employee, then §274 (n) doesn‘t apply. 100% deductible for
employee. Employer may still only deduct 50%
§274(n)(B) – when employer pays, disallowance applies to employer because not reimbursed
o expenses subject not only to 50% exclusion but also to the 2% floor under §67.
Country clubs etc – can‘t deduct unless the club is used primarily for business purposes. (Need to
establish more than 50% of the days were for business use.)
no deduction is permitted for membership dues in any club organized for business or pleasure or
Cafeterias, generally Fifty-percent exclusion under 274(n) does not apply to cafeterias because
o §119(a) – Employee may exclude the value of meals provided for the convenience of the
employer on the business premises. Cafeteria, executive dining room.
o Under §132, §119 cases are deemed to be §132(e) cases, and 132(e) is exempted from 274
o Consider §132(e)(2) as alternative means of providing employer-subsidized meals – de
minimis fringe defined – treatment of certain eating facilities
o §274(e) – food and drinks served on the premises are an exception
§274(a): If take client out to lunch, cost of client‘s meal deductible under §274(a) if directly related or
associated w/active conduct of trade or business:
if (1) taxpayer has more than general expectation of deriving income or specific business benefit;
(2) taxpayer engaged in business discussions during or directly before/after meal or entertainment;
(3) principal reason for expense was active conduct of taxpayer‘s trade or business
Rev Ruling 63-144 argues that should only be able to deduct in excess of what would have had
Meredith Huston 39 Tax Fall 2001
§274(d): imposes substantiation rules, requiring taxpayer to retain adequate documentation
o Rule overruled COHAN rule, which had allowed approximations of the amount of
expenditures when there was evidence of a deductible expenditure in some amount.
COHAN still applies to expenses outside of §274(d).
§274(l)—limits entertainment deduction.
§274(k) – extravagant meals non deductible
Home Office Expenses
§280A—Deduction for ―qualified‖ home office expenses. Space must be exclusively used for
business on a regular basis.
§280A(c) -- Space must be principal place of business (SOLIMAN) or used to meet clients
(telephone meetings not included – GREEN) or a separate structure
o Qualify as home office under §280A(c) only where the taxpayer uses the home office
exclusively on a regular basis (1) as the principal place of business for any trade/business
of taxpayer, OR (2) as a place of business that is used by clients, patients or customer is
meeting or dealing with taxpayer in his business, OR (3) in connection with the taxpayer‘s
business if the office in a separate structure not attached to taxpayer‘s home.
o If it‘s an employee, can only use home office deduction if use of home office is for
convenience of employer.
Convenience of employer = if employer doesn‘t provide employee with office or
employer has not provided adequate office space in which employee can effectively
carry out duties.
If employer has provided adequate office space, even if home office is only
used for business, that‘s for the convenience of the employee.
Note stricter requirement where taxpayer is an employee. Trying to make sure guy
who reads office papers in his la-z-boy doesn‘t take deduction for his den.
Principal Place of Business – SOLIMAN (277) –Taxpayer is a doctor who doesn‘t have office at
hospital. Wants to deduct room in home where works on paperwork although he sees patients at
the hospital. Court holds not deductible, principal place of business was hospital.
o Primary considerations: 1) relative importance of activities performed at each business
location, 2) time spent at each place. First part of test is more important. Look at second if
first is not definitive. Court found that these were not met.
o Focal point test, which principally considers point where services are rendered or goods
o Rev. Ruling 94-24 – principal place of business is location at which greatest number of
hours are spent.
o Flush language in §280A(c)(1) -- Resolution of SOLIMAN problem:
a home office can be the principal place of business if the taxpayer uses to office
to conduct administrative or management activities and there is no other fixed
location of the business where the taxpayer conducts substantial administrative or
SOLIMAN still applies if taxpayer is arguing that home office is principal
place of business and office isn‘t used for substantial
even if does these activities in his truck during the day, still gets deduction.
New rule very generous for home offices at least in non-employee context.
Exclusive use -- SENGPIEL (270) – lawyer used 51 percent of home for business. Court gave
him the living room, would not give him dining room which he exclusively used during business
day, but was used to eat some meals in (―time slice‖ case)
Meredith Huston 40 Tax Fall 2001
§280A(b) – Section does not take away deductions that are already entitled to (e.g. mortgage
interest, real property taxes, casualty losses). Office furniture and salary of assistant are business
expenses which would be deductible above the line under §62.
Home office expenses are limited to gross income from the use of home office less deductions
associated with residence that are allowable regardless of use and other deductible expenses
attributable to rental by employee of all or part of home to employer if employee uses rented
portion to perform services of employee. In effect, home office expenses cannot exceed net
income from that activity.
§280A(c)(5) –Disallowed deductions may be carried forward, subject to continuing application of
gross income limit. Must take expenses that exist apart from the business first – mortgage, taxes,
etc. (§280A(c)(5)(B)(i)), only then apply expenses that exist solely because of the business
(furniture, office assistant). So if any expenses cannot be matched, will not be mortgage interest
Home office need not be used for principal business. May be used for any business so long as
CURRENT VERSUS CAPITAL EXPENSES
§263 capital assets – disallows deductions for the cost of acquiring property whose useful life extends
substantially beyond the close of the taxable year.
Current expenses – immediately deductible
Capital expenses – not immediately deductible
Why do we care?
If all expenditures made for business or investment were immediately deductible, tax would be
imposed on consumption, rather than income.
o Capitalization requirement results from wanting to accurately reflect the taxpayer‘s true
income for each year by matching an expense with the income it creates. Capital assets
produce income for a while.
Equivalence, under certain conditions, of immediate deduction of capital investment to exemption
from tax of income from investment.
Tax deferral – don‘t want people to immediately deduct capital expenses because it delays their
actual payment of tax for a few years. Understanding that, in the end, the same nominal amount of
tax will be paid, the ability to front-load deductions and back load income is very helpful to
taxpayers. Equivalent to:
o Interest free loan—accelerated deductions allow $ now and pay it back later in reduced
o Consumption tax – Haig-Simons definition, income = consumption + savings. Pay for
machinery out of savings and allowed deduction for savings. All have left is increase in
consumption, so if permit people to expense purchase of capital assets, converts income
tax into consumption tax.
o Tax free return on amount invested – immediate deduction yields exemption
equivalence. Cost savings that occurs when cost of investment is deducted but income
taxed equals tax savings. Deduction is disallowed initially (must capitalize) but income on
investment is exempt. Assumes tax, interest, and investment yields are constant.
Permitting immediate deduction, not taxing yield.
o Allowing immediate expensing of capital expenditures basically eliminates all taxes on
Ex. assume 33% tax rate, asset with 10% annual return, asset is $1K, return on asset is $110,
taxes on income are $33 – net yield is $67 (6.7% after-tax return).
Meredith Huston 41 Tax Fall 2001
o If allowed to fully expense in year purchased, cost $1K, tax savings from expense = $333,
savings arise because income from other sources offset by immediately deductible $1K
expense. Out of pocket cost of asset $667, annual income = $100, taxes on income = $33,
net yield = $67/667 = 10% yield – eliminates all tax on capital.
Two Ways to Skin a Cat: Old and New IRA’s
If tax rates are consistent, the two IRA forms are generally economically equivalent.
Conventional IRA -- §219 Roth IRA -- §408A
-Expense (deduct) investment -No deduction
-No tax during life -No tax during life
-Full taxation when you withdraw -No tax at end
-Cap = $2,000 3,000 next year, then -Cap = $2,000 3,000 next year, then $5000,
$5000, people over 50 get extra 500 then people over 50 get extra 500 then extra 1,000
extra 1,000 -Can withdraw at age 59 ½ if remove
-Can withdraw at age 59 ½ if remove prematurely, 10% penalty, lose tax free status
prematurely, 10% penalty if withdraw (may have worse consequences,
-Covers people not in employer retirement but are exceptions – like if withdraw for first
account or those who are in employer time home purchase)
retirement accounts but with lower -Covers people with income up to $150K
income (50-80K range) income
If going to be in 35% tax bracket now and If going to be in a 15% bracket now and a 35%
a 28% bracket later, will prefer this. (high bracket later, will prefer this. (low high)
Decision will also depend on income tax Higher income tax rates later (increase in
rates. If predict lower rates later rates) = Roth IRA preferred
(decrease in rates), Conventional
Want to invest maximum in account.
o To invest 2,000 in Roth, assuming are in a 50% tax bracket, need to invest $4,000 in
Conventional, but can‘t there is a cap.
o In conventional are sharing the cap with the government – they get 50% of the deal
o Structurally the Roth is a better deal if can predict tax rates.
Revenue perspective (5 year window used by gov‘t to estimate revenue)
o Conventional IRA loses a lot of up front revenue for government because people will
deduct right away
Revenue window of only 5 years tends to overstate cost to federal government
Doesn‘t include benefit of getting that $ later
o Roth IRA – loses no up-front revenue for government, immediate revenue raiser (why
the income limit is higher – want to encourage more people to use this)
Loses the money later
If believe equivalencies, nothing actually happens to value of investment when choose Roth
over conventional IRA, but from revenue perspective gov‘t wins lots of money when people
choose Roth IRA or convert their IRAs
o In actuality, Roth may cost government $ because of shifting tax brackets, incentives,
Acquisition and disposition of assets
Meredith Huston 42 Tax Fall 2001
Whether an outlay should be treated as an expense under §162 or capital expenditure under §263 boils down
to a question of timing. If the outlay in question has a useful life over 1 year, then you have to capitalize it.
§263—disallows deduction for capital expenditures, specifically new buildings and improvements
to real estate.
Reg. 1.263(a) –2(a): Costs incurred in acquisition of asset must be capitalized.
What is tricky is the identification of the cost of purchasing an asset and determining whether an
asset has actually been purchased.
General rule: Want to match time period during which get benefit from an asset with its cost, even
if it is a one time cost. If benefit received from asset exceeds one year, will likely have to
capitalize the expense and depreciate over time.
o Broker‘s commission – not immediately deductible. Added to basis in stock. Expenditure
capitalized, recover cost when sell or receive future dividends. If borrow $ to buy stock
and have to pay interest under §163(d) (limitation on investment interest), can only deduct
interest on loan to extent paid out in dividends, remaining interest expense carried forward
and get to deduct any leftover expenses when sell asset.
o Depreciation – recognized each period as capital asset earns income. Recover asset‘s cost
over the term of its useful life. Recover purchase price of a tractor through depreciation.
Buy a cab – good for 5 years, depreciate and recover rest upon sale.
§167 – Depreciation – transfer basis from one asset to another
WOODWARD (290) – taxpayer claimed deductions for attorney‘s accountant‘s and appraiser‘s
fees for services rendered in connection with appraisal litigation which occurred to resolve price of
stock taxpayer purchased. No deduction was allowed. Court said expenditure was capital
expenditure connected with acquisition of stock.
o Cost incurred in acquisition or disposition of capital assets treated as capital expenditures –
falls under §212 and §162
o Court looked to origin of the claim (GILMORE)– in connection with what type of
transaction did these expenses arise?
o Which result is preferable?
Historically taxpayers would have preferred not to capitalize, less tax cost
Shuldiner thinks that for most taxpayers today, actually prefer capitalization
because don‘t get the ordinary deduction (this has something to do with the 2%
floor and above the line vs. below the line deductions (note everything is below the
line unless there is a specific provision making it above the line)
o Expenses incurred in defense of or perfection of title or property cannot be deducted as
current expenses, but must be capitalized and added to property‘s basis – follows Reg.
§263(a)(1): disallows deduction for any amount paid out of new buildings or for permanent
improvements or betterments made to increase value of property/estate.
o Construction costs – costs of constructing capital asset (Wages, supplies, etc.) must be
Why? Parity argument. Need to treat people who buy equipment to build and
people who hire people with equipment to build in the same way. Simpler
argument, just part of cost of acquiring the asset.
IDAHO POWER (293)(294) – Big crane spends ½ time working on building and other ½ in
garage. Capitalize ½ normal depreciation into project‘s basis and recognize depreciation as usual
for other ½ corresponding to time spent idle. Court upheld commissioner‘s position that under
§263, insofar as equipment was used for construction of capital facilities, depreciation deduction
should be disallowed and disallowed amounts added to taxpayer‘s adjusted basis in capital
facilities to be depreciated over useful life.
Meredith Huston 43 Tax Fall 2001
§263A – Uniform capitalization rule -- capitalization and inclusion in inventory costs of certain
expenses, must capitalize all direct and indirect costs incurred in acquisition of capital assets.
Taxpayers that produce property (real/tangible) are subject to the §263(A) UNICAP rules.
§263A(f) – Special rules for allocation of interest to property produced by the taxpayer. Must
capitalize interest incurred during production period. Indirectly taxes imputed income.
o §263A(f)(2)(A)(ii)—assigns interest on other debts to be included in basis of property to
extent that those interest payments could have been reduced if taxpayer didn‘t build
o ONLY Applies to property with a long useful life (real property) or property for which the
production period is long (jet aircraft, etc.)
o Provision is limited in scope, more limited than rest of 263A
Ex. Dog pays $5K to build milkbone machine. $ paid in wages and supplies. What is capitalized
-- $5K cost of machine. If dog owns bulldozer as part of construction, entitled to depreciation to
extent not using as part of construction. Capitalize cost of construction.
Ex. if dog spent $4.5 on wages and supplies and new machine must be aged before can produce,
then worth $5K. Depreciation deduction won‘t be allowed until machine placed in service. Any
appreciation will be taxed even though imputed income (§263A(f)), so if borrow for construction,
can‘t take interest deductions and must capitalize interest into cost.
§280B—disallows deduction of any expenses for demolition of structures and requires that such
expenses be added to the basis of the land on which demolished structures are located (not into the
o part of cost of acquiring land suitable for building is to get rid of old structure.
§263A(h) – exception for writers, artists, and photographers, do not have to capitalize costs of
§174 – research and development can usually be expensed. Want to encourage this activity.
Nonrecurring expenditures and expenditures that provide benefits beyond the current year
If §263(A) applies, it requires the taxpayer to recover the expenses of producing/selling goods when the
goods are sold. The UNICAP rules apply to the direct costs of producing and selling goods, and the
portion of indirect costs allocable to goods sold.
Direct costs – cost of materials, wages to employees who produce/sell goods §1.263A-1(e)(2)(i),
Indirect costs include costs of repair of repair/maintenance of equipment/facilities, utility costs,
rent on equipment, facilities or land, indirect labor costs, indirect material costs, costs of
tools/equipment, certain taxes, depreciation on equipment or facilities, costs of certain admin or
o Marketing, advertising and general business/financial planning don‘t have to be
o R&D can be expensed.
EXCEPTION – UNICAP rules (§263A) don‘t apply to businesses that are in the business of
buying/making property that have under $10 million in gross receipts.
o Ordinary(Recurring)/Nonrecurring Expenses?
Meredith Huston 44 Tax Fall 2001
Must capitalize all expenditures that produce or acquire assets or produce value to taxpayer for
period beyond one year. Creating or enhancing distinct asset sufficient but not necessary
condition to force expenditure to be capitalized.
Note that §263 Capitalization requirement trumps §162 -- if something appears to be ordinary and
necessary expense, and thus deductible under §162, but it is included under §263, then the expense
must be capitalized.
o See §161 for statutory support for this.
o Default assumption is that expenses should be capitalized. Have to look to §263 (see if
expense is explicitly included) and then 162 (to see if ordinary and necessary) before
deciding whether to deduct.
One year rule – where an expenditure is expected to produce income over a period of time rather
than only in the current year, capitalization, accompanied by a recovery of capital as the income
earned, is thought to reflect each year‘s income more accurately than immediate deduction of the
o FALL RIVER GAS (1965): Court required taxpayer to capitalize cost of installing gas
appliances that leased to customers b/c expenditure made in anticipation of continuing
economic benefit over period of years– indicative of a capital expense.
Arguably there is no asset here – cost of installation, not the furnace. Even though
no asset, still can recover cost over time through amortization
If equipment was pulled out of customer‘s home early, Fall River was required to
continue to amortize the installation charge over the period of time the equipment
would have remained under the lease. Seems odd, but court reasoned that
equipment remaining longer than expected provided a windfall to company that
cwould not be matched by a corresponding drawback unless they were forced to
recognize installation charges for all units over expected life. Ignores reality but
Recurring/Non-recurring -- Ordinariness of costs. If expenses are extraordinary and non
recurring, there will be a greater chance that they will be considered capital expenses.
o ENCYCLOPEDIA BRITTANICA (310) Company sent work out instead of doing it in
house; court says capital expense; if own employee wrote book, would not have to
capitalize it; §263A, had it existed then, would have required they capitalize it; arguably
buying book here and therefore must capitalize that cost just as would have to capitalize
cost of consulting services bought as cost of building asset; Posner suggests that
nonrecurring nature of expense is significant
Purpose – to match up expenditures with income
If really take seriously concept of capital expenditure as anything that yields
income, result will be to force capitalization of virtually every business expense
o LINCOLN SAVINGS (in case, 297):
Asset non-transferable and earned no return; no future benefit (court seems to
accept this), so did not want to capitalize it. Court says future benefit is not
controlling. What is controlling is that it enhances a separate or distinct additional
asset. Taxpayers argued that this means you only have to capitalize if separate
asset, Shuldiner not certain this is what Court meant;
Case stands for proposition that expenditures that serve to create or enhance
separate asset should be capitalized under §263; does not mean only
expenditures that create/enhance separate assets capitalized under §263
Corporate Reorganizations/BUSINESS INTANGIBLES
Requirement that long-lived assets must be capitalized applies to intangible assets from which the
taxpayer expects to realize economic benefits in future years.
Meredith Huston 45 Tax Fall 2001
INDOPCO (296) – taxpayer wanted to deduct legal and consulting fees spent engaged in friendly
takeover bid where they were target, on ground that they were ordinary and necessary. Taxpayer
said had no future benefit and no separate asset (since they were target). Court held taxpayer‘s
realization of benefit beyond year in which expenditure is incurred is undeniably important in
determining whether appropriate tax treatment is immediate deduction or capitalization. Said
deductions are exception and burden is on taxpayer to show entitlement to deduction. Here
taxpayer spent $ because of perceived benefit of being acquired. Match expense with benefit and
must capitalize expense.
o Case basically stands for the idea that tax law is trying to match current expenses with
current benefits. Through §162 and §263, code endeavors to match expenses with the
revenues of the taxable period to which they are properly attributable, thereby resulting in
a more accurate calculation of net income.
o Norm is to capitalize expenses – burden on taxpayer to show why their costs should be
o NOTE: Merger transaction (which was capitalized) benefits continue as long as merged
entity continues in being (no useful life)…so they can‘t take depreciation/amortization, so
capitalized expenditure only recovered if corp is sold/dissolved.
Implications of INDOPCO
o Hostile takeovers – probably would have been able to expense if hostile takeover because
neither creates new asset nor adds future value (although success might help to scare off
future takeovers (but administratively, would be impossible to argue this expense should
A.E. STANLEY (298) -- Permitted taxpayer to deduct fees in unsuccessfully
fighting a hostile takeover. Fees to protect existing structure. Court applied rule
saying costs incurred to defend a business are deductible.
o Advertising -- has always been deductible (§162). Service issued Revenue ruling 92-80
after INDOPCO – clarified that case does not change basic rule of deductibility for
o Employee training costs – treatment not changed by INDOPCO, Rev. Rul. 96-62. Still
WELLS FARGO (2000) (299) -- D attempted to deduct salaries paid to officers of a subsidiary for
services performed in merging companies. D also sought to deduct legal/investigatory expenses.
Commissioner disallowed deductions, salaries and legal expenses were not ordinary and had to be
capitalized. On appeal, the court reversed in part and affirmed in part. The court determined that
the officers' salaries were fully deductible because there was only an indirect relation between
the salaries and the acquisition, which provided the long-term benefit.
o The court determined that the legal and investigatory expenses that were incurred prior
to the subsidiary's "final decision" regarding the acquisition were fully deductible, but
the remaining legal and investigatory expenses were incurred after the "final decision"
and therefore had to be capitalized.
o Costs at issue here are internal, indirect. Case makes extreme distinction between
external and internal costs. Does not add much clarity to the direct/indirect relation
o Argument that salary costs did not have to be capitalized -- what could be more ordinary
than deducting employees‘ salaries? But does this ignore INDOPCO question of whether
there should be some matching going on?
Meredith Huston 46 Tax Fall 2001
o When paid outside lawyers to do work, cost had to be capitalized. If had paid inside
lawyers, costs would not have had to be capitalized. Do we want this outcome?
o Court quotes INDOPCO standard, but Shuldiner thinks they misuse the standard.
o Investigatory costs v. acquisition costs. Argument for not capitalizing investigatory costs:
Here the benefit is really in the future. No current benefit, but consummation should be
capitalized because of new asset.
Expenses of an Ongoing Business
IRS is more willing to allow deduction of costs of expanding an existing business.
Loan origination fees
PNC BANKCORP (2000)(302) –Loan origination charges (external 3rd party payments and
internal salaries of loan officers) should be expensed immediately as ordinary business expenses
(§162), not capitalized over the life of the loan (§263).
o IRS apparently viewed INDOPCO (green light to seek/presumption of capitalization) as a
reason to pursue capitalization of the costs that SFAS 91 requires to be deferred (loan fee
income and costs deferred and recognized over the life of the loan (amortized))
o Case stands for the proposition that routine costs do not have to be capitalized even if they
go into creating long-lived assets. Contrast with FALL RIVER.
o Matching -- IRS: upfront; TP should argue the cost is related to the fee income, but
didn‘t, not clear why not
o Creation of asset (LINCOLN SAVINGS)– relevant asset here is the loan, these are the
costs of creating the loan. Tax court accepted this argument. Circuit court disagreed – said
tax court reading of what could create assets was overbroad. ―Separate and distinct‖ asset
does not mean any identifiable asset.
o Future benefits -- Future benefit analysis in INDOPCO is not meant as a bright line test.
Because there is no separate and distinct asset, cannot support tax court analysis that there
is a future benefit. But future benefits do not depend on the creation of an asset. Shuldiner
thinks court‘s view is too narrow.
Eg. Burger seller current income and future income (good will) (incidental,
ignored) all considered current.
But here, origination of loan doesn‘t really have a future benefit, it‘s all future
INDOPCO, incidental future income is important, the court did not faithfully
follow the rule of the case but an extraordinarily narrow reading of INDOPCO.
o Accounting and tax accounting standards are different, not bound by the rules of financial
accounting. Have different purposes, financial accounting conservative view of what is
income; tax accounting goal to collect income.
o LYCHUCK (308) Here clearly don‘t follow PNC. Required company in business of
acquiring automobile installment loans from automobile dealers to capitalize the costs of
acquisition of the loans, including employee‘s salaries, which mostly paid for checks of the
creditworthiness of the borrowers.
Expenses with Respect to a New Business – Start up costs
Question of whether expense was incurred to maintain existing business or change/expand new
business. If the former, deductible, if the latter, must be capitalized (cannot deduct expenses of a
trade or business before you are in the trade or business).
o This applies to §212, even though with §212 you‘re not in a trade or business.
Costs of a new business Creation of new asset, Clear future benefit, Right thing is to match
current expense to future income
Meredith Huston 47 Tax Fall 2001
§195 – recognition of startup costs over a 180 month period
o Includes investigatory expenses.
Problematic – bank opens new branch – expansion of existing business or new business? Courts
have not required capitalization of existing business expansion. Cases are mixed. Unsettled area
of the law.
RICHMOND – Court required capitalization of job training and related expenses incurred before
co. obtained operating license from FCC; ct held not carrying on trade or business until licensed
Deductible Repairs s. Nondeductible Rehabilitation or Improvements
Repairs expensed under §162(a). Improvements, rehabilitation capitalized.
o Regs say that subsequent expenditures that alter the property‘s capacity or function or
extend useful life, should be capitalized.
o Rebuilding old building would be making good on previously taken depreciation.
Test is whether the improvements prolong the asset‘s life beyond its initial assessed life, and
whether they add to the asset‘s basis. 1.162-4. Also see 1.263(a)-2—improvements are example
of capital expenditure.
o Incidental repairs are of small and recurring nature.
Expenditures that substantially increase the useful life of an asset, which are large in comparison to the
asset, or are part of an overall plan of remodeling/rehabilitation are probably capital outlays.
But expenses made to restore property damage are generally deductible.
RR 94-12, repairs still deductible following INDOPCO. Had been fear that INDOPCO might
affect this, b/c repair has future benefit
Rev Rule 2001-4, (323) -- looks to depreciable life schedule to gauge whether you are prolonging
or maintaining. Aircraft have to redo/heavy maintenance, if don‘t then probably can‘t fly, every 8
yrs- expense this. Looks at 4 cases
Environmental clean-up costs -- My land, polluted, is clearly a future benefit if I clean it up. But
what are the tax consequences of cleanup?
o Matching argument – For past 20 years have been overstating profits because were not
calculating costs of cleaning up production. Part of costs of past goods produced (not of
future goods). Right answer should be that can expense clean up costs.
o Basis = zero because property is worth nothing cleaned up. If have to capitalize, basis = 2
million, FMV = 1 million. If can expense, basis = 1, million, FMV = 1 million
o Parallel to demolition cases – have to take into account cost of demolition.
o Note that this approach only right for original owner—subsequent purchaser who comes
in to clean up should capitalize. Seller gets their loss when they sell property for reduced
cost, take into account/recognize costs of polluting when go to sell. Buyers perspective is
purely future benefit.
o Government wants to encourage clean-up, but government‘s basic provision is really not a
subsidy for cleanup.
Job Search and Education Expenses
o Revenue Ruling 75-120 (320) – job seeking expenses in same trade or business are
deductible under §162 if directly connected with such trade or business as determined by
all objective facts and circumstances below the line deduction).
If unemployed, trade or business consists of services performed for past employer
unless there is a substantial lack of continuity since time of past employment
Meredith Huston 48 Tax Fall 2001
Not allowed if seeking employment in new trade/business . Not deductible for
individual seeking employment for the first time.
These are also not deductible under §212(1) – below the line deduction,
only applies to expenses incurred with respect to an existing profit seeking
endeavor not qualifying as a trade or business.
o MCDONALD (321): Court held state judge could not deduct assessments that had to be
paid to political party organization for election campaign; seeking office expenses
o What happens to the expense of a bar review course when employer pays for it?
Not within the trade or business until pass the bar
Why for lawyers, teachers, etc. changing states may be considered new
Is it a working condition fringe under §132? No because could not be deducted
o REUHMANN (322) – Law Student passed GA bar after his 2nd year. Wants to deduct
costs of 3L year as additional education. Also wants to deduct costs of LLM degree. IRS
argues that 3L year is disqualified under §1.162-5(b)(2) – minimum educational
requirements. Basically says that cannot deduct expenses for a base level of education.
Question is fact specific – what determines base level depends on occupation. LLM
degree was deductible under 1.162-5(c) but only because he had worked as a lawyer prior
to the LLM degree. Had he not worked, he would not have been able to deduct the LLM
(even though it was not a minimum educational requirement) because he would not have
been in the trade or business yet.
1.162-5: education expenses deductible as ordinary/necessary if: 1) maintain or improve skill in present
trade/business or 2) meet express requirements of employer.
Education that qualifies taxpayer for a new trade/business not deductible even if taxpayer never
intended/never entered new business. Because are not yet in the trade or business for which
education is a cost. This means most standard degree programs like JD, MBA etc are not
Cost of acquiring new skills is usually denied unless taxpayer can show intent is merely to
enhance the skills already possessed.
o BUT an accountant couldn‘t go to law school to be better at accounting
1.162-5(d): travel as education is not deductible unless you take classes or something. Don‘t want the
taking in culture along the Seine excuse. See also §274(m)(2)
§530(a) – education IRA account shall be exempt from taxation, but subject to taxes imposed by §511
(relating to imposition of tax on unrelated business income of charitable organizations).
§135 – savings bonds for education
§529 – qualified state tuition programs, just modified to include state and private tuition plans, like
Roth IRA, excluded from income when take out $ for education.
§25A – Hope and lifetime learning credits
Hope Credit allows credit for first 2 yrs of college; 100% for first $1K, 50% for
second $2K; like $1.5K scholarship designed more for middle class. Wealthy
phased out of Hope; increases marginal rate; §25A(d)
Meredith Huston 49 Tax Fall 2001
Lifetime Learning Credit is 20% of $5K ($1K)
Scholarships and Employer Provided Assistance
o §117: gross income does not include qualified scholarship by individual who is candidate
for degree at educational organization in §170(b)
o §127: gross income does not include amts paid or expenses incurred by employer for
educational assistance to employee if assistance is furnished pursuant to (b); $5250 max
Student Loan Interest
o §221: in case of individual, deduction allowed for taxable year amt equal to interest paid
by taxpayer during taxable year on any qualified education loan
o §62(a)(17): deduction on interest on education loans
Depreciation and Amortization: Recovery of Capital Expenditures
Steps to solve a depreciation problem: (under §168)
(1) the applicable depreciation method - §168
(2) the applicable recovery period - §168(c) and (e)
(3) the applicable convention - §168(d)
this is the date on which the depreciable property is deemed to be placed into service.
§167 – permits as depreciation deduction a reasonable allowance for exhaustion, wear and tear
(including reasonable allowance for obsolescence) of assets used in trade/business and held for the
production of income.
o Deduction designed to allow taxpayers to treat as expense in determining taxable income
in allocable part of cost of business or investment assets that have limited life. No
depreciation allowance is provided for assets acquired for personal use.
o §167 applies to property if its useful life is definite and predictable, and not if its perpetual
or indefinite, like land.
o Depreciation allowance is limited to cost.
Alternative depreciation strategies:
o Economic depreciation – this is the ideal, neutral as to asset choice. Simply measures
true decline in the value of an asset over the course of a year. However, because it is too
difficult to figure out the true decline in value each year, the code does not use economic
depreciation. Would be administratively infeasible.
o Straight line method – cost of an asset is allocated in equal amounts over its useful life.
Estimate useful life of asset, determine cost of asset, subtract salvage value which will
receive at the end and divide that amount by the useful life.
o Double Declining balance method (Accelerated depreciation)– allocates a larger portion
of the cost to the earlier years and a lesser portion to the later years. A constant percentage
is used, but it is applied each year to the amount remaining after the depreciation of
previous years has been charged off
Inflation problems can justify using accelerated depreciation because if inflation
after year of purchase, value of depreciation deduction will decline over time.
To actually compute depreciation: Easy way: Refer to depreciation tables (page xv of code
book). Once figure out what kind of property it is, should be easy to apply depreciation table
Current System: Modified Accelerated Cost Recovery System (MACRS)
o Depreciable assets are assigned to one of eight recovery classes with lives of 3-39 years.
See §168 (e) for classification. Prescribes one of three depreciation methods for each
3,5,7,10 year classes: depreciated using 200% Declining Balance method with
appropriate switch to straight line method to maximize deductions (§168(b)(1))
Meredith Huston 50 Tax Fall 2001
15, 20 year classes: depreciated using 150% declining balance method, with
appropriate switch to straight line to maximize deductions (§168(b)(2))
o May elect to use straight line for any class (§168(b)(3)(c), §168(b)(5))
o Real estate—straight line may be used (§168(b)(3))
o Salvage value is not taken into account in any of these (§168(b)(4))
o Applicable Convention – Because property is seldom purchased on the first day of the
year and disposed of on the last day, adopt rules to determine depreciation allowance when
property is not used for entire year.
In theory, if bought car three months into year, get three months of depreciation,
But, default convention is ½ year convention -- §168(d)
Administrative convenience leads to ½ default. Creates an incentive to
―place property in service (§168(a))‖ in the second half of the year
In certain situations, will go to a mid-month or mid-quarter convention
Land -- Don‘t depreciate it – not expected to decline in value, won‘t wear out . . . not depreciable
under Reg 1.167(a)-2; when land and bldg bought together, purchase price must be allocated b/w
land and bldg in proportion to respective FMV
Intangibles - §168 only applies to tangible property. Big issue with intangibles in takeovers of
businesses. Huge effort to carve off intangibles (e.g. customer list, trained workforce in place)
which were distinct from goodwill
o HOUSTON CHRONICLE (1973) was able to demonstrate that old subscriber list had
value apart from goodwill, and that value decayed over time.
Because newspaper was defunct, was an argument that customer list had become
less valuable. Taxpayers won the case.
o NEWARK MORNING LEDGER (1993)-- Supreme Court said could depreciate these
types of assets as long as could be valued and had a limited useful life.
o §197 -- Amortization of intangibles: most intangibles, including goodwill, amortized on
straight line basis over 15 yr period; does not apply to any intangible created by taxpayer
unless created in connection w/acquisition of trade/business.
passed after NEWARK, put issue to rest
o §1.167(a)-3 – If an intangible asset is known from experience to be of use for a limited
period that can be estimated w/reasonable accuracy, you can get a depreciation allowance.
EX, patents, copyrights.
§179 – Election to expense certain depreciable business assets – generally applies to small
businesses. Permits taxpayer to elect to deduct immediately up to $17.5K of cost of tangible
business property where annual total investment in qualified property $200K or less. Any
additional property subject to usual depreciation rules; effect is to permit many small businesses to
deduct cost of business assets rather than capitalize
Recapture – Happens when depreciation is too rapid and go to sell depreciated property. §1245
and §1250 provide that certain amounts previously deducted as depreciation will be recaptured as
ordinary income rather than capital gain when depreciable property sold. More on this below.
Safe harbor leasing—Transfer depreciation deductions to higher bracket taxpayer or to taxpayer
who can use it against their gains. A sells to B, B leases to A, B gets depreciation deduction. Tax
code responds by saying that if there are insufficient attributes of ownership, the property will be
considered to be owned by the person leasing it back (Safe harbor leasing lasts about 1 year).
This was ESTATE OF FRANKLIN.
September 11 Exception -§168(k) – Property acquired after September 10, 2001 and before January 1,
You get an additional allowance of 30% of the adjusted basis of the property for the taxable year the
property is put into service. The adjusted basis of the property is reduced by the amount of the deduction
Meredith Huston 51 Tax Fall 2001
before computing the amount otherwise allowable as depreciation deduction under this chapter for such
taxable year and any subsequent taxable year.
§611 provides for a ―reasonable allowance for depletion according to the peculiar conditions in
Depletion allowances are used in situations where it is difficult to determine what portion of
property has been removed from the ground and sold and what has been retained – generally
applies to mineral or oil and gas exploration and development.
Cost depletion – estimates the total amount of natural resource in the property and allows
deduction of its cost in proportion to each year‘s extractions
o Has been allowed for water
Percentage depletion – allows the deduction of a specified percentage of the gross income from
the property year after year without regard to the recovery of cost. It remains deductible even after
the basis (capital actually invested) has been recovered.
o Limited to 50% of the taxable income from the property for minerals other than oil and gas
o Because Percentage depletion permits a taxpayer to deduct more than actual cost, it
provides a subsidy for the activities to which it applies and a stimulus to natural resource
exploration and development.
Is not necessarily better than cost depletion, but historically has been the case.
1975 – percentage depletion was repealed for oil and gas wells of major oil
Independent domestic oil and gas producers may use percentage depletion for
1,000 barrels of average daily production at a 15% rate
o Calculated with respect to gross income from the property, not the amount attributable
processing or manufacturing minerals, but only amount received from extraction
o Must have a ―economic interest‖ in the minerals to get a depletion deduction (includes
owners, lessees, but not licensees)
In General and Arbitrage
In a broad sense, interest should be deductible, as it represents a reduction in your net worth
without corresponding consumption. Shuldiner thinks we should look at indebtedness like a
However, there are practical reasons why we want to know whether money paid is actually
o For example, it might be difficult to distinguish between interest and principal components
in an installment loan payment plan.
o Also, the tax code does not always tax assets correctly and if liabilities (interest) are taxed
correctly, while assets are not, the door is left open for tax arbitrage.
§ 163 (a) -- generally, interest is deductible.
o However, the rest of § 163 whittles down the scope of deductible interest (i.e. investment
interest, business interest, and home mortgage interest are deductible; personal interest is
not deductible; passive interest may or may not be deductible or deductible to the extent
that it offsets passive gains).
Business Interest: interest on indebtedness used to operate trade/business is cost to taxpayer of
doing business and thus is deductible like any other business expense except when the interest is
required to be capitalized (e.g. when allocable to asset that taxpayer is constructing). §163(a)
Meredith Huston 52 Tax Fall 2001
o SEE §263A(f) – special rules in for capitalizing interest in making of long-production
Investment interest: deduction of interest on debt incurred by individuals to purchase or carry
investment property is limited to net investment income (with indefinite carry-forward of interest
disallowed under this provision. §163(d)
o So if you borrowed to finance investments but your portfolio did poorly, you cannot
generate a loss using interest. The best you can do is have no tax on your investment
o Interest incurred in connection with passive activity is not treated as investment interest,
but is instead subject to the rules of §469 which limit deductibility of passive losses.
o RENT ISN‘T INVESTMENT INCOME
o §163(d)(3)(A): links debt with activity so properly allocable to property held for
o §163(d)(4): Net investment income is total investment income less investment expenses.
o §163(d)(4)(B)(ii): gives you the option to recharacterize capital gains as ordinary
Pro: allows you to increase the amount of investment income against which you
can match investment interest.
Con: cannot then claim preferential capital gains tax rate on the amount elected. If
only short-term capital gains, you don‘t really care because the rate is not that much
better. Only a difficult question if dealing with long-term capital gains.
o Ex. $3K Investment expense, $1.2 investment income, $4K capital gains, look at all
investment activities and can carry forward. So take $1.2K and carry forward $1.8K
o Ex. If buy a bond for $1K and hold for one year in which earn $90 Interest, got $20
dividend and had to pay $100 interest for $ borrowed to buy bond. Could treat all as
ordinary income with $10 gain at ordinary rate or get capital gains on $10 or try to claim
$90 in capital gains and $80 in ordinary losses.
3rd Option is the most attractive because more gains are taxed as capital gains/lower
rate and creates ordinary losses that can be used to offset salary and other ordinary
Another option is to claim $90 in capital gains and no loss -- §163(d)(4)(B)(ii): net
investment income here is excess of net gain on disposition – capital gain +
(dividend – deduction)
Capital gains are not generally included in net investment income.
If you make no election, end up with $90 capital gains, $0 loss, and $80
carried forward on interest.
Could elect to include $80 in capital gain as an offset to investment income
expense (90-90+80=80), have 100 in net investment income –80 from
capital gains and 20 from dividend --> $100 interest deduction.
Downside is that you lose favorable capital gains treatment on the 80
included in net investment income (becomes ordinary). §10 in capital gains
(left from 90-80), $0 in ordinary income and $0 in carry-forward, therefore
you can take advantage of all this in one year if you are willing to give up
some capital gains benefit.
§265(a)(2) – can‘t deduct interest used to buy tax-exempt municipal bonds.
Personal Interest -- §163(h)—personal non-business interest is not deductible. Defined by
omission to include any interest otherwise deductible under §163 that is not a) interest paid or
incurred in connection with trade or business (not including for this purpose trade/business of
Meredith Huston 53 Tax Fall 2001
performing services as employee), b) investment interest, c) interest that would be deductible in
connection with §469 passive activity, d) qualified residence interest (as defined in §163(h)(3)), e)
interest on certain deferred estate tax payments
o Historically personal interest was fully deductible, deduction eliminated in 1986 (see home
o Things like interest on a personal auto loan, credit card interest, now all considered an
additional cost of the items purchased.
o §163(h)(1) interest on income tax deficiency is personal interest.
o §221 allows deduction for interest on student loans. (§221 does not use tracing rules,
presumption loan used for educational expenses – pro-taxpayer rule)
o How do I know whether interest is personal interest? How can I see if it is business,
passive or investment interest? Need to trace funds to their source. Variety of interest
provisions limit interest deductions based on purpose of loan; since $ is fungible, no
correct way to determine w/certainty purpose for which funds borrowed
Temp.Reg 1.163-8T: tracing principles for allocation of loan proceeds to specific
Temp.Reg 1.163-10T(n): definition of qualified residence interest
Are tracing rules good? Tracing rules are manipulable (such as through
Are there alternatives? Alternative = security rules (don‘t know what these are)
Refinancing rule – new loan has the same character as the original loan
o Ex. I‘m a traveling salesman and borrow money to buy a car that I use only for business
purposes. I then pay interest, gas, and tolls for the car.
Gas – deductible? Yes, trade or business expense under §162. Above or below the
line? Below the line, because an employee. If gas reimbursed, will be above the
Tolls – deductible, like gasoline.
Interest – no -- §163(h)(2)(3) – interest paid not deductible if in the trade or
business of performing services as an employee. Can‘t deduct if reimbursed either
What if employer buys the car – provides as an interest free loan – not deductible
Employer buys car and lets me use it – is payment of interest by employer imputed
income to me? No, use of car would be income (imputed rental income)– but
protected under §132 – Working condition fringe. Interest would not be seen as my
interest, would be seen as employer‘s income.
Home Mortgage Interest – Major exception to disallowance of personal interest. Congress
allowed this deduction to encourage homeownership (preference over renters). Allows for two
types of deduction:
o Acquisition indebtedness: interest deductible on up to $1M of debt used to acquire,
construct or substantially improve either principal residence (sale of principal residence =
no tax on gain under §121) or second home (sale = tax on gain under §121), debt must be
secured by the home (can‘t take out loan on 1st home to buy 2nd – 2nd home must secure 2nd
loan); limit reduced as principal is repaid on loan and refinancing does not increase.
o Home equity indebtedness: interest may be deductible on home mortgage equity
indebtedness up to $100K, regardless of purpose or use of loan, as long as debt does not
exceed FMV of home, must be secured by residence. §163(h)(3)(C). Loan may be taken
out to pay down personal credit cards and would still be deductible.
Meredith Huston 54 Tax Fall 2001
Refinancing is OK – still home mortgage interest after refinance. Cannot deduct
points on refinancing though.
Qualified residence may be vacation home, but must choose one home to get the
Only up to $1M of acquisition debt, plus another $100K in home equity
indebtedness --> max $1.1M -- §163(h)(3)(B)(ii)
o Arises when assets eligible for favored tax treatment are acquired w/debt; negative rate of
tax achieved when taxpayer can obtain both interest deduction and equivalent of 0% tax
rate on income from asset purchased w/debt
o Interest disallowance provisions permit wealthy taxpayers to obtain relatively greater
benefits from tax-favored assets b/c can acquire tax-favored assets by liquidating existing
o Deduction of interest expended to earn tax-exempt or tax-preferred investment income has
long been controversial; limited deductions in several contexts:
§264: forbids deduction of interest on borrowing with regards to certain life
insurance or annuity Ks
§265(a)(2): prohibits deduction of interest on indebtedness to purchase or hold
bonds that yield tax-exempt interest
§§1277 and 1282 defer deduction of interest on indebtedness to purchase or hold
certain bonds purchased at discount until interest income from bond taxed at
maturity or upon disposition
§163(d): limits deduction of investment interest to investment income
§461(g): deductions of prepayments of interest restricted
§263A(f): interest incurred in connection w/construction of certain types of real
property and tangible personal property must be capitalized and amortized
Sham Transaction and No Economic Purpose Doctrines
KNETSCH (1960)(352) – Created tax shelter with annuities. Bought single premium deferred
annuity, funded by loan from company that sold to him. Prepays interest on loan and takes
deductions. Taxpayer does not get deduction because there was nothing of substance to be
realized by Knetsch beyond a tax deduction (no tax on a deferred annuity until it is paid out.) (like
FRANKLIN). Never built up any equity in annuity. Was a flaw in the tax system, because defer
income on annuities and keep loan interest current because is deductible when paid. Problem of
matching income and interest.
o District court looked to motive (subjective test), but the Supreme Court focused on whether
what was done was what the statute intended (more objective than subjective). Not a clear
motive test, although it remains a factor.
o If the only purpose is to get tax deductions, transaction will not be upheld.
§264 – says cannot deduct interest used to purchase single premium annuity contract. Kills
loophole Knetsch tried to exploit.
o §264(a) – if borrow to buy annuities, don‘t get benefit of claiming interest deductions, out
of pocket is ok.
GOLDSTEIN (Note, 356) – Taxpayer prepaid interest in year where won sweepstakes and tried
to deduct prepayment. Court found there was no sham, but disallowed the interest deduction on
the grounds that there was no purposive reason for the prepayment other than to secure a
Meredith Huston 55 Tax Fall 2001
o How do we tell there is no purposive reason other than a deduction? – rejected idea that
she had a profit motive. Read into language of §163 a business purpose requirement. So
under §163, motive of tax avoidance is not permissible.
o Should you be able to deduct prepaid interest as interest? – Historically tax law respected
form of deduction and allowed you to deduct it. Does the transaction really represent a
loss of income? No. (e.g no real difference b/w borrowing $1000 and prepaying $100 and
borrowing $900, so can only deduct interest over period for which allocated); if you
prepay, must allocate for time that interest would have accrued.
o §461(g) – now makes prepaid interest non-deductible. The only exception to this rule is
the deductibility of mortgage points (§461(g)(2).
What is Interest?
Money is fungible – can‘t look at a dollar and tell what it is. Sometimes it is difficult to see
whether or not we have interest .
Is there equity or is there debt – use substance over form analysis to decide.
o Distinguishing Debt from Equity: §385 authorizes Treasury to prescribe by regulation
how to ascertain whether interest in corporation is stock or debt; but Treasury has never
issued final regulations under §385; making this distinction became increasingly important
in ‗80s b/c cos. converted large amts of equity capital into debt through financial
transactions/ leveraged buyouts and leveraged recapitalizations
Assuming there is debt, what part of debt is interest? What is principal?
o Distinguishing Interest from Principal: important because interest deductible but
principal is not; §163(b) allows interest deduction under certain circumstances where
carrying charges are imposed even though actual amount of interest cannot be determined.
§216 allows tenant-s/h in coop bldg to deduct pro rata share of interest;
§7872 recharacterizes as interest amounts designated otherwise on variety of no-
interest/below-market interest transaction;
o Ex. Mortgage – bank lends 1,000,000, I pay back 800 per month for 30 years.
Interest or principal? If in 1st month $780 interest has accrued, generally assume
780 is interest and rest is principal. In mortgages pay mostly interest in beginning.
o Ex. I lend you 100, you pay me back 110 in 1 year.
100 principal, 10 interest
105 principal, 5 interest
80 principal, 30 interest
indefinite number of characterizations. Labyrinth of rules which tell us correct
characterization: Original Issue Discount Rules.
o Ex. Zero Coupon Bond – 100,000 paid back over 30 years
Someone pays 32,000 back – value accrues each year with interest rate, taxed each
year as if were accruing interest at equal rate.
o Ex. Property transaction – instead of paying me now, I‘ll pay you 133,000 in 3 years
Bought property for 100,000, 10% interest rate, 3 years = 100,000 plus 33,000
If left up to parties, could structure many ways.
123,00 principal, 10,000 interest
80,000 principal, 53,000 interest
would be able to manipulate tax result.
Meredith Huston 56 Tax Fall 2001
Problems of Inflation
Inflation: causes problems for income tax; Congress has enacted provisions to take inflation into
account but none deals directly w/assets and liabilities; lender can suffer real loss later when time
for payback and $ not worth same as it was
We overstate interest income and we overstate interest deductions to deal with this problem.
Better solution would be to index basis or index interest to inflation. Government not in a hurry to
change because might be politically unpopular, people make out from overstatement of deductions
Does the government lose out on this? Usual assumption is that this is what happens, people tend
to hold debt in tax-preferred forms. May no longer be the case – inflation is not as high as it was.
§165(a) authorizes a deduction for any loss realized during a taxable year which isn’t compensated by
insurance or otherwise.
Individual taxpayers - §165(c) limits deduction to losses incurred in a trade or business or in
connection with any transaction entered into for profit, and casualty losses.
§165 permits deductions for certain losses not compensated for by insurance, generally, consistent
with §162 and §212, allows deductions for losses incurred in connection with trade or business
transaction entered into for profit. Other losses are personal and non deductible (exceptions for
casualty and theft losses).
§165(b) -- Amount of loss deduction: – loss is adjusted basis of property. Actual loss sustained is
a rule laid down by the courts and not replacement value.
When do losses occur?
o Tax consequences only when realized. Time of realization is clear when property is sold,
exchanged, or otherwise disposed of. However, taxpayer may dispose of property without
actually suffering economic loss where sells to related party or under obligation to
repurchase. Also not clear when property becomes worthless. Casualty is a realization
o Courts tend to fix the time of a loss by looking to definitive or identifiable event or to
conduct indicating a closed transaction or no reasonable prospect of recovery. Look to
realism and practicality.
Two types of losses:
o Operating losses – run a business and lose money
Have already dealt with these in several areas: §183 – hobby losses, §280A –
home office, can‘t take a loss
o Property Loss – When you buy an asset at one price and then sell it at a lower price.
Business vs. Non-business profit Seeking Losses
Trade or business losses are deductible from gross income rather than from AGI, and therefore can be taken
even if the TP doesn’t itemize. §62(a)(2).
Then there’s §162(c)(2) losses, which can only be deducted above the line (computing AGI) if they
result from a sale/exchange of property or are attributable to property that produces rent or royalties.
OTHERWISE, §162(c)(2) losses must be itemized below the line.
o Many non-business losses are capital losses, with limited deductibility.
Business losses under §165(c)(1) generally receive more favorable tax treatment over time, in
form of net operating loss carry-forwards (20 years) or carry-backs (2 years) as provided by §172
than do investment or transaction for-profit losses under §165(c)(2)
Meredith Huston 57 Tax Fall 2001
o Have a car used in business activity, accident. -- Above the line loss – 62(a)(1)
deductible from gross income rather than adjusted gross income (below the line) and
therefore can be taken even if the taxpayer does not itemize (§62(a)(2))
Have a car used in a for-profit activity, not a trade or business, is stolen. No sale or exchange of
property 62(a)(3) – so this is not an above the line loss
o Sale or exchange language is key. §165(c)(2) losses deducted in computing adjusted gross
income only if result from a sale/exchange of property or are attributable to property that
produces rent/royalties §62(a)(3) &(4), otherwise are itemized.
Personal versus Business or Profit-Seeking Losses
§165 denies deduction for personal losses other than theft/casualty. Corresponds to §262 denying
deductions for personal expenses.
Deduction allowed where inherited property sold at loss without ever having been used as a
residence by taxpayer.
When part of property is used for one purpose and part for another, or the same property is used at
different times for different purposes, losses from sale of property can be allocated between
different uses. Deduction allowed in proportion to business or income producing use in the same
way basis in property is allocated between personal and business uses when calculate depreciation.
See information on §183 and Hobby losses (Plunkett) above.
Casualty loss: attributable to fire, storm, shipwreck or theft (not sale/exchange). Personal
casualty loss where property not used for business/investment.
Casualty gain: recognized gain from any involuntary conversion of property, usually come from
insurance payments that exceed basis of property damaged
Argument for casualty loss provision is that does not recognize personal consumption. Lose
ability to pay taxes when lose value of property.
§165(h) -- Casualty losses are subject to a 10% floor. Get the first $100 of loss, and then can
only take losses to the extent that the uninsured losses exceed 10% AGI.
o This is a big limitation – must have a very big loss. Empirically this provision is of little
o Casualty loss is an itemized deduction, and thus taken below the line. It is not subject to
the 2% floor § 67 (b)(3)
Reg. 1.165-7 – amount of deduction on personal property is limited to lesser of FMV prior to the
casualty minus the FMV after casualty or the property‘s adjusted basis.
Ex. Taxpayer‘s car completely destroyed. Paid $20K for car. At time of accident, car worth $8K.
Deductible loss = $8K, $12K considered to be already consumed.
Ex. Painting destroyed was purchased at $30K, appreciated in value to $75K. Deductible loss is
$30K, $45K was untaxed appreciation.
o Disallow loss deduction for unrealized gains to prevent double benefit because gain never
taken into income.
FENDER (381) – Taxpayer sets up trusts for kids. Had large capital gains from sale of stock. To
offset gains, co-trustee attempted to sell bonds that had substantially declined in value. Owned by
trusts. Trust then sold bonds to bank over which he had significant control (owned 40%, single
largest block). Recognized tax loss. 42 days later, trusts repurchased bonds for value plus accrued
interest. Court held that because of the structure of the transaction, the taxpayer retained
Meredith Huston 58 Tax Fall 2001
sufficient domain over bonds to ensure that he could recapture them and not suffer economic
loss. Circumstances suggest there was no realization event, even though consistent with wash
sale rules. Found taxpayers motivated by tax avoidance. Insufficient for allowing deduction.
Found neither §267 (transfer to related party) nor §1091 (wash sale) applied.
§267: disallows deductions for losses from sales or exchanges of property, whether direct or indirect,
between certain related people, such as family members or corporations and majority (>50%)
shareholders; seller‘s loss generally lost permanently under this provision b/c purchaser‘s basis for
computing loss when sells property is his cost; if ultimately sells property for gain, purchaser‘s cost basis
is increased by seller‘s disallowed loss
§1091 -- disallows loss from sale preceded or followed by purchase of substantially identical securities
(including options) within 30 day period (look up/back 30 days); basis of stock purchased is that of
stock sold, plus any additional amount paid on repurchase, so losses are deferred, not lost; similar
rules apply to short sales; does not apply to gains nor if securities are not substantially identical
In other words, §1091 requires that the security repurchases take the basis of the security sold, so that the
loss deduction is postponed until a bona fide disposition is made.
o covers a 61 day period (day of sale, 30 days before, 30 days after)
o really requires that securities be identical to be caught in the wash sale provision. Could
switch for an identical yield, credit rating, duration, etc. but still be o.k. if a different issuer.
o Does not apply to gains, only to losses
o Defers loss rather than eliminating in by adding loss to basis of stock purchased. So when
that stock is sold, will have very high basis, generate smaller gains.
o Only covers securities, not all assets.
o If there is an explicit agreement to sell back, then clearly are disallowing loss realization.
Even worse if agree on a set price.
§165(f) – only allows you to take losses as permitted by §1211 and §1212
§1211: capital losses deductible by corporations up to capital gains; by individuals only to extent of
capital gains plus $3K ordinary income
§1212: any capital losses not allowed in current year may be carried forward indefinitely by
Straddles: where taxpayer retains related assets w/unrealized gains, can use tax losses to obtain optimum
tax treatment, regardless of effect on overall economic position or economic substance of transaction- ie.
Typical straddle, taxpayer acquires offsetting positions in commodity futures Ks (ie. to buy and
sell wheat); any changes will offset each other; can obtain deferral and conversion
To obtain deferral, sell loss leg in current tax year, while retaining gain until next year (accelerate
loss and defer gain)
One form of tax shelter
§1092: enacted to address this problem; limits deduction of losses from straddles to amt by which
losses exceed unrecognized gains on offsetting positions; applies to certain commodity future Ks
and stock and stock option transactions where offsetting positions are held in similar/related
o how to determine if two positions are offsetting? 1092(c)(2)
o before this was enacted, service would litigate these as not-for-profit transactions where
no loss is allowed (but this was messy)
o presumptions when something has a substantial diminution in risk – 1092(c)(3)
Meredith Huston 59 Tax Fall 2001
§1256: requires certain stock and commodities be marked to market at end of year, whether or not
taxpayer holds offsetting positions; each such K taxpayer holds treated as if sold at year end; gain/loss
fully recognized. Provision has been expanded over time.
Aim to generate losses that can offset or shelter other income, such as wages, interest, or dividends
that were neither produced by nor related to income produced by investment.
Often passive investments, and often structured as limited partnerships to provide investors both
the benefits of limited liability and conduit taxation (whereby income and losses of partnership are
passed through to partners).
May either be legitimate – sometimes intentional on the part of congress (accelerated deductions
for real estate to encourage real estate investment) -- or abusive.
What produces shelters? Bad tax rules – mismeasurement of income. If allow deduction for
prepaid interest (mismeasure income), accelerated depreciation (mismeasure income), don‘t take
inflation into account (mismeasure income).
How to attack shelters:
o Fix stupid rules like prepaid interest.
o Fix depreciation rules (didn‘t want to)
o Index debt for inflation (didn‘t want to)
o Abandon realization requirement (didn‘t want to)
o Use ―common law-like‖ doctrines like fact that need a profit motive. Problem because was
difficult to prove there was no profit motive.
BRANNEN (406): paid $1.5M for movie; $ came from nonrecourse loan from
seller; Brannen never at risk of having to pay back $; ct did not find honest profit
Problem w/using §183 to attack tax shelters is that highly fact sensitive analysis;
use §183 to determine profit motive
o Fix procedural rules
―Tax matters‖ partner – can sue one partner and decision will apply to all partners.
o Penalty rules
o All of these helped some, but did not really work.
§465 – At-Risk Rule -- somewhat successful – RESTRICTS THE AMOUNT OF DEDUCTIBLE
LOSS FROM OWNERSHIP OF DEPRECIABLE PROPERTY TO TOTAL AMOUNT THAT
TP HAS AT RISK. get basis, but not going to let you take deductions beyond where they exceed
how much you are at risk (i.e. own $ on the line). Nonrecourse debt is not considered $ that puts
you at risk unless is for real estate and then puts you at risk so long as borrow from someone other
than the seller of the property.
o §465 limits the deductions from a trade or business activity to the amount of taxpayer‘s at
risk investment as well. §465(b)
o Restricts the amount of deductible loss from the ownership of depreciable property (other
than real estate) to the TOTAL AMOUNT OF TP‘S INVESTMENT, THE AMOUNT AT
The at risk is only with respect to the cash/property he has actually drawn from his
o With real estate, nonrecourse loans from outside lenders continue to be free of at risk, so
investors are still entitled to include such third-party debt for the purposes of calculating
deductible losses. §465(b)
But if it‘s inside financing (loans made by promoter of property), the debt only
counts as at risk if the investors are personally liable for it.
Meredith Huston 60 Tax Fall 2001
o Ex. 50K down, 200K recourse debt, 1,000,000 non recourse. Assume 100,000 interest
year 1. Assume 100,000 income year 1
Year 1, 125,000 net deduction -- Could I take entire deduction? Yes, because is
lower than at risk amount of 250K (down payment + recourse debt)
Year 2, 125,000 deduction, Can I take it? Yes
Year 3, can‘t take deduction because no longer have anything at risk
o When rules originally enacted, had a very limited scope. Certainly did not apply to real
estate. (see 465(c)). In 1986, expanded to include real estate, but were still allowed most
non-recourse debt. Effective in shutting down real estate rules? Don‘t know because this
was the same year as passive loss rules were enacted.
You can carry over the losses to offset any income from the depreciable asset the next year.
§469 – Passive Loss rule -- very successful -- basically shut down the tax shelter industry. –
o When people engage in tax shelter activities, their involvement is basically passive.
o Congress said we‘ll divide the trade/business world into passive and active (and
Loss from passive business cannot offset active business
Loss from active business can offset passive business
Allow only $3000 capital losses a year from investment. But allow active losses to
offset investment income.
o §469 -- If engaged in a passive activity can only deduct losses from those activities to the
extent that there is a gain from those activities (i.e. can‘t use losses from passive activities
to offset gains from business or investment income)
o What is a passive activity? –
469(c)(1) conducted in trade/business that taxpayer does not materially participate
§469(h)(1) -- material participation = regular, continuous and substantial basis. 6
factors to show material participation (p. 408):
o > 500 hours/taxable year
o performs substantially all of activities involved with activity
o > 100 hours /year where that equals or exceeds participation of any
o ―significant participation‖ with respect to this activity (more than
100 hours, but less than that required for material participation) and
her combined participation in all such activities exceeds 500 hours
o she materially participated in the activity for any 5 of the last 10
prior taxable years
o she materially participated in a ―personal service‖ activity in any one
of the three prior taxable years (a trade or business in which capital
is not an income producing factor)
Alternatively, may show material participation by ―Facts and
circumstances‖ that demonstrate that she participates in the activity on a
regular, continuous and substantial basis.
Is this determined on an activity-by-activity basis? No, pool activities
together. Uses basket approach – divides income into certain categories or
baskets and limits deductions against that income to expenses related in
some manner to the production or receipt of that income. (p. 411)
Meredith Huston 61 Tax Fall 2001
o 469(g) – dispositions of entire interest in passive activity – A lot of tax shelter activities
are timing gains, if fully dispose of activity, there is no timing gain, loss is allowed, there is
no tax shelter anymore –not a taxable gain, would not trigger suspended losses. Less fear
of fraud when are getting out of an investment.
o 469(c) (2) rental activities – no matter what are included in the passive loss world.
§469(i) -- Rental real estate – exception in the code when enacted. If were
an active participant in rental real estate, up to $25,000 losses can be used
against nonpassive income. Has phaseout provision. For individuals for
small scale rental activities who actively manage them.
§469(c)(7) – Real estate professionals –must perform 750 hours of work in
area and this must constitute more than ½ of his services. Applies to any
real property (not just rental).
o Note there is an exception for home mortgage interest -- $100,000
Debts which become worthless during the taxable year are deductible from gross income under §166.
Business debts – deducted when it becomes wholly worthless, or when partially worthless.
Non-business debts – profit-seeking activity or in personal setting – must be wholly worthless.
o §166(d) – loss sustained on the worthlessness of a nonbusiness debt is treated as a short-
term capital loss, only available to offset capital gains plus $3000 of ordinary income.
GENERES – The proper measure to determine if a bad debt has a proximate relation to the taxpayer‘s
trade or business is dominant motivation. Guy loaned $300,000 to a corporation he was president of and
owed 44%. Corp fails. He said he loaned it to protect his job, not his investment.
These are largely unrelated to the costs of earning income. They reflect differences in ability to pay.
Standard deduction taken below the line in lieu of itemizing; effectively acts as floor for itemized
deductions (get regardless of expenditures)
Itemized deductions other than those listed in §67(b) are allowed only to the extent they exceed 2
percent of the taxpayer‘s AGI. Says 67(a).
o All major itemized deductions are listed in §67(b) and not subject to 2% floor.
§63(c) – defines standard deduction, different rates depending on filing status (determined by
§7703). For 2001 –
o Single = 4550
o Married filing separately – 3,800 (1/2 joint filing)
o Married filing jointly – 7,600
Married filing jointly is less than 2x Single
Creates both marriage penalty and marriage bonus.
o No income, married income marriage bonus
o Two incomes, married marriage penalty
§167 – will eliminate marriage penalty, increase marriage bonus
o phases in beginning in 2004, but only until 2010
Note that certain taxpayers are required to itemize even if their deductions are less than the
standard deduction – not available to married taxpayers filing separate returns where either spouse
itemizes, to nonresident aliens, to U.S. citizens with income from U.S. possessions, and to estates,
trusts, common trust funds or partnerships.
Meredith Huston 62 Tax Fall 2001
Why have a standard deduction? (two arguments)
o Zero bracket amount -- viewed as adjustment of tax rate schedules; reflects view that no
tax should be paid for incomes below certain amt since std deduction + personal exemption
nullifies such income (creates $0 tax bracket) – floor under which people don‘t pay tax or
file returns, adds to progressivity
o Administrative simplification -- viewed as substitute for itemized deductions for those
taxpayers whose itemized deductions would be relatively small amts
o Choice of argument will effect position on other issues
Like is it fair that non-itemizers (generally poorer) cannot deduct charitable
More than fair – have included amount in standardized deduction (if chose
Efficiency problem – not encouraging standard deduction people to give to
Dependents -- Used to be that children were treated as separate deductions. Now, there is a cap –
standard deduction is maximum greater of $750 or earned income+$250 (didn‘t used to add this
unearned income – meant if kid had $1 interest, had to file a return. Now don‘t have to.) if you
can be claimed as a dependant on someone else‘s return. §63(c)(5)
Personal Exemptions -- §151
§151 – for tax years beginning in 2001, the personal exemption amount under §151(d) is $2,900
(indexed for inflation). Taxpayers are allowed to exempt this for themselves.
§152 – Taxpayers entitled to exemptions for dependents, if pass support test – need to provide
greater than 50% support. Then,
o If child 18 or under or 23 and under and a student, you get it
o If a member of family (great grandparent, uncle, nephew, etc.) and very low income
(income under exemption amount), you can get it.
o Anyone else, if they are a member of your household and they are very low income.
o Used to be that everyone got them (now don‘t unless pass the support test).
§151(d)(2) -- After 1986, you can no longer take the personal exemption for yourself if someone
else can claim you as a dependent on their return. Person who actually pays support should claim
§152(e) – dependency exception in the event of divorce/separation allocated to parent with
custody unless they waive that right.
SEE NEW §152 IN PACKET
Child credit - §24 – get a tax credit for each child. Subject to phaseouts.
Phaseouts of Exemptions and Itemized Deductions
PERSONAL EXEMPTION PHASEOUT – Applies to personal and dependent exemptions
§151(d) – personal exemption phased out for income above a threshold amount. (PEP)
o Phaseout based on AGI
o Threshold -- $150,000 indexed $199,450
Phase out: Lose 2% per $2500 increment in income over the threshold amt.
So on a joint return, deduction for exemption is reduced when income reaches
$199,450 and completely eliminated when income reaches $321,950
Looks like it would take about 50 * $2500 to be phased out, but lose it on
the 1st dollar, so really is 49 * $2500
Meredith Huston 63 Tax Fall 2001
o Example: $10K income above the threshold amount, $2.5K/$10K is 4 *2% = 8, so lose
8% of exemption (assuming $2.5K threshold); if $10,001, then 5 increments above 2%, so
that have a 10% reduction in personal exemptions.
o Phaseout effectively raises the marginal rates on high income taxpayers because the
phaseout applies progressively to higher incomes.
o Note: phaseout is not properly indexed. Threshold element is indexed for inflation, but
$2.5K not indexed. (Phaseout faster and faster every year because of inflation).
Why didn‘t they index? Carelessness, too complicated, or a desire to increase tax
revenues over time.
ITEMIZED DEDUCTION PHASEOUT
§68 – claims to tell you your itemized deduction has been phased out (PEAS)
o §68—Threshold is 100,000 (married filing jointly or single) indexed 132,950. Lose the
3% of AGI over the threshold ((AGI minus threshold)* 3%) or
80% of itemized deductions. (certain protected deductions not phased out, e.g.
investment interest, medical expenses, casualty losses)
o Example: assuming threshold $100K, if have AGI of $120K, take excess $20K, multiply
by 3% = $600, so itemized deductions would be reduced by $600.
o Phaseout cannot reduce itemized deduction below level of standard deduction because
would always elect standard deduction rather than itemize.
o Marriage penalty is more severe for §68 than for other sections because married filing
jointly has the same income level phaseout as single taxpayers and married filing
separately gets only ½ of what single filer would get.
o Reduction of itemized deductions? If we want to look at influence of this on people‘s
behavior, need to look at rule which applies.
For most people (96% over the threshold), the 3% rule is the operative rule.
For most people §68 imposes a 1% surcharge on income over the threshold
– did this rather than raise tax rates (sub rosa way to raise taxes, avoided
unpopular politics). (§151 was about ½% surcharge)
Would only use 80% rule if high income and few itemized deductions (rare). Why
some high income people now take standard deduction (5% high income
Marginal tax rate effectively goes up as a result of phaseouts. (And if he asks us to do this . . . !)
Why phase out?
o In 1986, decided to go with top income tax rate of 28%, but this didn‘t raise enough
revenue. Really would have a 33% rate, but would pretend was 28%. How did they do
this? With a ―bubble‖ (???? no idea what this means)
o In 1991, decided to get rid of bubble, decided would add phaseouts instead to get the $
o 2001 Act phases out phaseouts
in 2006 and 2007, 1/3 phaseout disappears
in 2008, 2009, 2/3
in 2010, effectively repealed
Shuldiner argues repeal is a hidden way to cut taxes for high income taxpayers.
Credits vs. Deductions
Credits = $1 credit is equal to $1 tax. Same value to higher income people as lower income
Deductions = higher value to higher income people?
Meredith Huston 64 Tax Fall 2001
Personal credits include
o Education credit -- §25A – Hope and lifetime learning credits
o Credit for the Elderly and Disabled -- §22(a)
o Child care credit -- §21
o Child credit – §24 -- phased out– taxpayer gets credit of $700 in 2005 for each qualifying
child (not indexed for inflation). Qualifying child must be under 17 and dependent under
§151. Phaseout based on AGI. Range starts at $100K for married/joint, $75K single.
Equivalent to increase in marginal rate by 5% for people w/kids in phaseout range.
Phaseout = $50 for each $1K of modified AGI exceeding threshold amount.
o Earned Income Tax Credit – §32 – refundable credit
Provides credit to low income individuals who have earnings (really seen as a
subsidy for low income wage earners, way to assure minimum standard of living
for working poor). Originally built in to offset cost of social security tax for low-
income wage earners. Over time has expanded:
For people with no qualifying children – 7.65% = burden of social security
34% with one child
40% with two or more children
in many ways congress has backed off.
Serious marriage penalty issues with this. Alleviated to some extent in 2001 act.
Is it a refundable credit or a non-refundable credit?
o Refundable = even people with no tax liabilities can receive credit, file tax return simply
for cash payment. Reduces tax liability to negative numbers, rather than just to zero.
o Very important where credit is aimed at low income people
Taxes – SEE NEW §154 IN PACKET
§164 -- permits a deduction for state and local income and property taxes. Only available to
itemizers (not subject to 2% floor -- §67(b)(2))
o Why? Two theories:
If pay tax, have no ability to pay.
Consumption expenditure, but permitted because want to subsidize state and local
Foreign income taxes treated differently under §164
o Can take deduction if you want, but can also take a credit.
Sales taxes – no longer deductible for non-business activities. Were deductible prior to 1986.
Taxes incurred in business activity or in connection with the production of income are deductible
under §162 or §212 in the calculation of AGI.
Business taxes – sales tax on business activity is deductible.
o If were buying tractor for farm and there was a sales tax, can‘t deduct, is part of cost of
acquisition. Would capitalize and depreciate along with rest of cost.
§275 – federal income tax, Social Security Taxes, estate, inheritance, gift taxes imposed at federal,
state, and local levels are not deductible regardless of whether are personal or profit-seeking.
State sales tax/income tax election – you can deduct the state and local sales taxes instead of state/local
income taxes (useful for residents of states without income taxes).
Foreign income taxes subject to some limitations, may be allowed as a credit against domestic income tax
liability instead of a deduction.
Meredith Huston 65 Tax Fall 2001
§170(a)– get a deduction for cash or FMV of property you donate to a charity (must itemize)
§170(b) -- limitation on deduction – for most is a limit of 50% of AGI (congress does not want
elimination of tax liability)
§170(b)(2) – corporation‘s charitable deduction limited to 10% of taxable income.
Public Charity – gets support from public, like red cross, art museum
Private Foundations – get support from smaller group of individuals. Huston Foundation.
o 30% AGI restriction on deductible giving for private foundations – we don‘t trust them as
much, lack public monitoring function of public charities.
§74—prizes and awards, if all given to charity, will not be income. Gets around §178.
Is it a real donation?
o Requirement of detached and disinterested generosity (Duberstein) – the quid pro quo
o $100 to public radio and get a $15 umbrella, should only get an $85 deduction.
o Substantiation requirement -- to prevent people from understating quid pro quo and
overstating a deduction.
Why have deduction?
o If I gave it away, I can‘t consume it
o Subsidy to giving
o Why deduction rather than credit? Why only available to itemizers?
One answer -- More cost effective to give to rich.
Matching program perspective – if you‘re poor, we don‘t trust the way you give, so
we won‘t match it. Couldn‘t say this outright . . .
Gifts of Property
o §170(e): taxpayer who gives appreciated property to charity doesn‘t realize gain; but
can deduct full FMV of appreciated property; thus untaxed gain (effectively subsidy for
donations of appreciated property);
applies to all contributions of property that would produce ordinary income or
short-term capital gain if sold and to contributions of property that would produce
long-term capital gain if sold where donee is private foundation or where
contributed property is tangible personal property unrelated to exempt function of
charitable contributions to public charities of appreciated securities or real estate
therefore are deductible in full if would produce long-term capital gain if sold
Contribution of any property other than marketable securities to private foundation
gives rise to deduction generally limited to basis
o To determine amount of deduction:
Questions to ask here (VIA §170(e):
(1) Is it going to be long term capital gain?
YES (jump to Q2)
NO – (short term capital gain or ordinary income property) You get to deduct basis.
(2) Is it private?
YES – we’re a little more suspicious. (jump to Q3)
NO – Public charity – (charity where you have to go to the public for your funds. (Like a museum)). (jump to Q4)
(3) Is it marketable securities (Corporate stock)? (look at 170(e)(5))
YES – you get the FMV
NO – You get basis as a deduction.
Why? Because if there could be a valuation problem
Meredith Huston 66 Tax Fall 2001
(4) Is it tangible personal property? (You can feel it…that’s tangible.)
YES – jump to Q5
NO – (Intangibles or real property) – you get FMV.
(5) Is it using it for related use?
YES – (This means that art is being displayed at a museum), book used for a library. You get FMV.
NO – basis.
170(e)(2) and 1011(b) if you do a part sell part gift, you have to allocate the basis to the part sold and part given.
o Contribution of property to public charity generally FMV- amt of gain that would not have
been long-term capital gain; but if tangible property that will not be used by donee in
charitable function, FMV reduced by full appreciation (e.g. deduction for painting donated
to museum, don‘t get deduction of painting donated to Greenpeace)
o Limitation: to extent would have been ordinary income, do not get deduction (e.g. $10K
rental pmts and 50% tax rate; if donate, can only take deduction of $5K and not full rental
amt since would have been ordinary income)
o §170(b)(1)(d): amt of deduction for appreciated property w/long-term capital gain limited
to 30% of donor‘s AGI
o If property had loss, would probably sell it to get deduction and then donate the $
Gifts of Services
o Taxpayer cannot deduct the value of services rendered to charitable institutions. Person
may deduct unreimbursed out-of pocket expenses incurred in connection with donating
services to a charitable organization.
HERNANDEZ – Fixed payments to churches and synagogues for pew rents or to attend certain services
are deductible, even though you get a benefit. Court here says fees paid to Scientology for training and
auditing are a quid pro quo and he doesn‘t get the benefit. IRS wins, then says later that it will allow
deductions to Scientology.
Tax Exempt Organizations
Skipped by me.
Medical benefits provided by an employer are fully excludable from an employee‘s income - §105(b) and
§213 – a taxpayer can deduct amounts spent on medical care (not compensated by insurance or otherwise)
for the taxpayer and taxpayer‘s spouse and dependents to the extent that the medical expenses exceed
7.5% of AGI.
If you‘re installing a swimming pool, which the Service has held is an expenditure incurred for the
primary purpose of medical care, to the extent the expenditure exceeds the increase in value of the
taxpayer‘s property, it‘s deductible.
If you make a capital expenditure that would otherwise qualify as being for medical care, any additional
expenditure that is attributable to personal motivation does not have medical care as its primary purpose
and is not related to the medical care for purposes of §213. So if you make your pool pretty, for instance,
you can‘t deduct those additional costs as being for medical care.
Meredith Huston 67 Tax Fall 2001
TAXATION OF THE FAMILY
Treatment of Couples
Should we treat a married couple differently than two individuals?
Pre 1948 – separate taxpayers. Began to break down.
o Common law states v. community property states (allowed spouses to split income – Poe
v. Seaborn 1930)
Matters because we have a progressive tax.
Common law – 100, 0, much greater tax liability
Community property – 50, 50, lower tax liability
States began to adopt community property laws to avoid tax problems. States also
allowed people to elect into community property regime (courts said had to be
mandatory community property regime)
o Community property = in effect joint filing, so in 1948, congress implemented joint
filing. Did away with geographic and cross-couple differences.
Joint filing. Add incomes, divide by 2, compute tax and multiply by 2.
o If both earning 50K, no change in tax when marry.
o If one earns 100K and one none, there was a huge bonus when got married.
Singles began to get upset. Huge single penalty relative to marriage bonus
In 1969, Congress adopted special rate for singles – not as good as joint filing, but penalty not as
steep – maximum 20% more takes rather than 40%.
o Creates a marriage penalty for spouses who earn similar incomes.
If allow for marrieds to both file as single – creates inequality across couples. But can argue that
don‘t care about this.
Joint filing has administrative arguments in favor. Eliminates many questions or extra steps.
Mandatory separate filing would eliminate marriage penalty, single bonus. But brings in lots of
complications: Who gets deductions for kids, investment interest, etc.?
It is impossible to simultaneously address all these problems and retain a progressive income tax.
o The tax on a single person earning 200,000 must be greater than the total tax on two single
people each earning 100,000 if we are to have a progressive tax structure. See table:
Single 100, 100 < 200,0
Married 100+100 = 200+0
2nd earner deduction – allowed deductions of 10% income of lower earning spouse up to $3K,
gives couple equality, but justified with imputed income argument, had effect of reducing
maximum marriage penalty to about $3K.
o 1986, repealed, but rates were flattened, so penalty decreased.
What happens when both earners individually fall in highest bracket?
o Marriage penalty remains from the standard deduction??
o 1986 – bubble – for mid-high income earners – 33%, people above and below = 33%
what does this do????
§68 – threshold = same for married and single – huge marriage penalty.
§151 – less of a marriage penalty, but still there.
o Standard deduction – 2 times single
Meredith Huston 68 Tax Fall 2001
o 15% bracket – 2 times single.
DRUCKER (2ndCir.1982) (pg.467): taxpayers are married couple each w/earned income;
challenged marriage penalty by filing married w/separate return applying rate of unmarried
individuals under §1(c) instead of §1(d); court held rules do not significantly interfere w/decisions
to marry/did not deprive constitutional right; taxes place little obstacle on getting married
Treatment of children (“kiddie tax”)
Children used to be treated as separate. Got one standard deduction, personal exemption.
Concern that the rich would hide their income with their lower bracket kids, so in 1986, integrated
children more into family.
Parent takes exemption (§151), child cannot -- even if parent is phased out or chooses not to take
Parent takes standard deduction, dependant has lower standard deduction
o §63(c)(5)(a) – standard deduction shall not exceed greater of $500 or the sum of $250 and
such individual‘s earned income.
§1(g) -- Kiddie tax. Earned income is taxed like that of an adult. LOOK AT 433 E&E FOR
THIS IF HE ASKS.
o Unearned income of children under 14 = taxed at parents top marginal rate regardless of
source Unearned income includes dividend and interest income.
o net unearned income= unearned income minus ($750 (standard deduction for dependent
under §63(c)(5)(A), indexed for inflation) plus the greater of $750 (indexed amt.) or if kid
itemizes, the amount of itemized deductions directly connected to production of unearned
income --> so basically $1500)
o unearned income above 2X standard deduction- unearned income above $1.4K; covers
interest, dividends, and unearned gains
o Child‘s income actually added to the parents‘ taxable income, not AGI, which is important
b/c it won‘t affect the phase-outs.
1500-2000? 15% ????
2001+ parents‘ marginal
Example: if kid has $3K unearned income, then first $1-$750 taxed at 0% b/c
covered by standard deduction; next amt $751-$1500, is taxed at 10% (§1(i) and
then 1500 –2000 is taxed at ???. Final amt $2001-$3000 taxed at parents‘ rate;
therefore, kid does not get to ride up tax brackets b/c not independent from parents
o Now have option to elect to report child‘s full income on parents‘ return if child‘s income
if less than 10X standard deduction (less than $7500K) but not attractive option most of
time b/c lose capital gains treatment on kid‘s income b/c added to parents‘ AGI
Earned income is taxed
Treatment of Divorce
§71: permits payments (whether in discharge of alimony or support obligations or property rights)
to be treated as deductible alimony so long as: (1) payments are in cash rather than property or
services; (2) parties do not earmark payments as nondeductible to payor and nontaxable to payee;
Meredith Huston 69 Tax Fall 2001
(3) parties do not live in same household if already legally divorced or separated; (4) no liability
for any payment after death of payee; and (5) payments do not constitute child support
§215: alimony deductible by donor; but must be under written agreement of divorce/separation
(above the line deduction under §62(a)(10))
Tax treatment is actually more favorable for divorced couples
A and B get divorced. A pays:
o $100/month to B as alimony, -- Income to payee under §71, deduction to payor under
parties may elect to treat alimony payments as nondeductible to the payor and
nontaxable to the payee so that two parties will pay lowest total tax §71(b)(1)(B) –
allows lower bracket TP to make payments to higher bracket recipient. Rare.
Note: §71(f) – cannot front load alimony (make larger payments in early years).
There may be excess alimony in 1st and 2nd post-separation year, but will be
included in income for third year.
Excess 2nd year = excess of 2nd year payments minus 3rd year plus 15K
Excess 1st year = excess year 1 minus average 2nd and 3rd year plus 15K.
ex. W pays H 40K in Year 1, 25K in year 2 and zero in year 3. Excess
alimony in year 2 is 10K (25K-(0+15K)). Average alimony for 2 and 3 is
7.5K ((25K-10K + 0)/2). Excess for year one is therefore 37.5K (50K-
(7.5K +15K)) which she reports as gross income. H has a deduction of
37.5K that year too.
―Recapture‖ does not apply if annual alimony is less then $15K
o $800/month to B as child support – Not income (not taxable) to payee, Not deductible to
Incentive from payor‘s point of view to recharacterize alimony as child support.
Can‘t do this.
o Property settlements -- §1041 provides that no gain or loss is to be recognized on any
transfer of property between spouses or on transfer incident to divorce between former
spouses. Applies regardless of whether transfer was of community property of separately
owned property or whether was for consideration (divorce is not a realization event).
Recipient takes carryover basis in property equal to adjusted basis of transferor (effectively
treated as a gift). Transferee‘s basis is carryover basis regardless of value of transferred
property (can transfer loss – unlike with a gift).
Ex. A Transfers $40,000 in stock to B -- Not income, Not deduction, carryover
basis, no gain/loss, see §1041 – not quite same basis rule as for gifts (§1015)
because can transfer a loss with gifts.
Is §1041 pro or anti-taxpayer as opposed to realization regime (which existed
A pro-taxpayer rule – suspect that on average taxpayers substantially win
Under divorce, if there is a loss, you can sell it and take loss.
Also, property generally held for a while, so IRS loses time value of $ and
then again when an asset is ultimately taxed because then taxed at
transferee‘s rate and transferee rate is generally lower.
Can you get around 1041 by gifting to spouse? No. Any transfer between spouses
is a non-recognition event.
Men (traditional transferor) vs. women (transferee) (on average) –
Transferor rather no gain under 1041 than gain before 1041.
Transferee would prefer it to be pre §1041 because there their ex-spouse
would have had to pay the tax under the old regime and now they do
Meredith Huston 70 Tax Fall 2001
Of course couple could take the implicit tax liability into account into their
bargaining – but this could be hard to do, lots of uncertainties – when will
sell, what tax rate will be.
Primary residences not taxed for the most part.
ASSIGNMENT OF INCOME
(1) earned income is taxable to the person who earns it.
(2) income from property is taxable to the owner of the property.
Income from Services
Earned income is taxed to the person who earned it. Principle helps preserve the progressive tax
In general, income from services cannot be assigned to another entity. Sticks with you.
LUCAS V. EARL (1930)(479) -- taxpayer entered into agreement prior to marriage to split
income w/wife; results were that she was taxed at lower rate; occurred in 1901, before tax code in
1918; so not for tax avoidance purposes; taxpayer prevented from assigning earned income to
those whose services did not produce the income; fruits must be attributed to tree from which
grew (don‘t want people just assigning income to lower bracket)
ARMANATROUT (1978)(481) -- corporation set up Educo trust fund which paid for employers‘
children for education purposes; siphoning wages of employers; IRS wanted to call this
compensation, though employees said was not; can‘t do anticipatory arrangements to avoid
taxation; income to parents when paid from trust to children; not taxable immediately b/c until
paid out to kids, substantial risk of forfeiture; employer gets benefit of deferral.
o So basically the company is paying a third-party (the kids) for the employees services.
o Court rules amounts paid by employer to trust for education of kids was additional income
to the employees.
o Why not a tax-free scholarship? Because $ goes to parent, not to student. Scholarship
cannot be a quid pro quo, and here seems $ is exchange for services.
o Could this be set up in a tax-free way under current law? §127 – educational assistance
program – up to §5,250 of compensation. – But only works for employee?? Not clear
(Shuldiner doesn‘t know.)
§83: No realization of income where there is a substantial risk of forfeiture, get deferral until
o In ARMANTROUT, there is a risk of forfeiture if kids don‘t go to college, leaves job, etc.
so cannot be income right away to employees.
o Contrast with BASYE: when partnerships shift their income into trust held until retirement
that trust is taxable, as partners are considered to own income; ct says income is taxable
immediately to partners when paid to trust
in BASYE no substantial risk of forfeiture (to the partnership); relevant entity in
ARMANTROUT is employer, relevant entity here is trust
Income from Property
BLAIR (1937)(487): Blair has life interest in trust created by father; assigned $9K in interest
(entire property interest) during his life to his children; Court concludes valid; considered income
to kids; so long as assignable and has been assigned w/o reservation, assignee becomes beneficiary
entitled to all rights, and is taxpayer on that income; essentially here gave up corpus (tree)
o Key is that he is assigning fractions of what he owns, he has transferred a share of all that
he has -- not just streams of income. Is a good transfer because has nothing else.
Meredith Huston 71 Tax Fall 2001
o The assignment in this case was in a permanent interest in the donor‘s property—once
given away the donees‘ fractional interests could never revest in the donor.
HELVERING V. HORST (1940)(489): Horst has coupon bond and gives to child; kept principal;
only gave away interest income (fruit, not tree); taxable to Horst
o The court taxed Horst on the income from the property, and then viewed the son (who
actually collected the income) as the receiver of the gift.
o Corpus = bond, he retains corpus, he is owner of corpus, so he is taxed
He could have distributed the later year coupons to himself or anybody else.
This practice would make the progressive rates hard to enforce.
o Must look at whether coupon was mature or unmature.
o Bond payable semi-annually on June 30 and Dec. 31.
June 1, transfers entire bond. Valid assigment of income? Not quite. What
happens to interest already earned between Jan 1 and June 1? – where there is
interest already earned, cannot transfer. So no transfer of this interest, but the rest
o Particular holding obviated by §1286.
To the extent you have accrued income in some sense, transfer of property will not be respected.
Is this a sensible scheme? Yes and no.
o If I transfer principal to daughter and interest to son? Tax on son‘s income to daughter?
Problem is similar to problem in Hort (lease cancellation). – Value of
residual will increase over time. How are we going to tax increase in
Income from Property or Services: Which is it?
If transferor retains power and control over assigned income, he will be taxed on that income.
Problem in distinguishing the two arises often in copyright and patent cases.
Heim (495) – assignment of royalties is income from property when assignor retains ownership
interest in income producing property.
CAPITAL GAINS AND LOSSES
§1001 – taxes you on gain and loss from sale or disposition of an asset (both capital and ordinary)
For capital gain, need a sale or exchange of a capital asset.
o §1(h) – net capital gain requirement
o §1222(11) – defines net capital gain
o §1222 provisions require sale or exchange
o So to get preferential rate under §1h, must have a sale or exchange under §1222
Ex. If I have stock and get a dividend, stock may be a capital asset, but no sale or
exchange, so is not a capital gain
§1211 and §1212 penalize capital losses
o §1211 – losses from sale or exchange of a capital asset.
o §1212 – capital loss carrybacks and carryovers
Holding period – important
o §1h requires net capital gain
o §1222 – net capital gain defined in essence as net long term capital gain
long term -- gain from sale or exchange of assets held for longer than one year.
Holding period requirement fluctuates. Was recently 6 months
o §1223 – holding period of property – provides a set of tacking rules whereby can add
holding periods across assets or people
Meredith Huston 72 Tax Fall 2001
give property to my son after 9 months, he holds for three months, but can count
my 9 months in his total – he has 1 year.
Basically happens in carryover type provisions – where basis is carried over
§1221–capital asset defined – see below
HISTORIC TREATMENT OF CAPITAL GAINS
Historically there has been a preference for capital gains (with brief hiatuses). Means of giving
preference has fluctuated.
o Was percentage exclusion until 86—got ordinary rate on 40% of your capital gains.
capital gains exclusion was good for everyone (contrast with rate cap).
o 1986—took off preferential treatment as trade to get marginal rates low. However, capped
capital gains rate at 28% (effective rate was 33%). At the time that was the top marginal
rate, so no preference, but as marginal rates crept up it remained there, and preference
Note that this rate cap is of no use to low-bracket TP (contrast with exclusion)
1997 – decision to reintroduce capital gains rate current §1(h) – extraordinarily complex
MECHANICS OF CAPITAL GAINS – SEE TEXT P. 530
20% -- Basic preferential capital gains rate =
o 28%, 31%, 36%, 39.6% brackets
o but look to §1(i)(2) for actual tax rates
Year 28%, 31%, 36% 39.6% Bracket
2001 Subtract ½% Subtract 1%
2002-3 Subtract 1% Subtract 1%
2004-5 Subtract 2% Subtract 2%
2006 and Subtract 3% Subtract 4.6%
10% capital gains rate = Low income TP
o §1(i)(1) -- low income defined –income to be taxed at a rate of less than 25%, 15% or 10%
o No special rates for these guys
o 7.5% -- §1202 (small business) stock – subject to a 50% exclusion if otherwise taxable at
15% (not significant category, Shuldiner thinks it is actually 5%)
o 8% -- Assets held for more than 5 years if otherwise taxable at 15%
o 14% -- §1202 (small business) stock – old preference of 28% on ½ gain, so is effectively
o 15% -- Shuldiner doesn‘t get this one
o 18% -- Greater than 5 years held
Holding period beginning after 12/31/00 (Will really become a long time before
this really becomes effective – why???)
o 25% -- gain to the extent of depreciation on real estate held for more than one year
(unrecaptured §1250 gain)
o 28% -- Gain on collectibles held for more than one year.
Congress does not want to provide same incentive for collectibles
Collectible defined in §408(m)
Implicit in this are all sorts of netting rules which we will not focus on.
Meredith Huston 73 Tax Fall 2001
How to compute capital gains – Jeff example
(1) §1222 divides capital gains and losses into two classes…long term and short term.
Long term is gain/loss from sale/exchange of capital assets held for over 1 year.
o Net long-term gains taxed at preferential rates.
Short term gain/loss is sale of capital assets held for 1 year or less.
o Net short term gains are taxed at normal rates.
In general capital losses can be offset only against capital gains. Unused capital losses can be
carried over indefinitely.
§1211 permits individual taxpayers to offset capital losses (long or short term) against ordinary
income up to $3000 annually.
(2) §1222 netting procedure. Taxpayer nets the gains and losses in each category (long term and short
term) separately. If one category shows a net loss and the other a net gain, then the net loss and net gain
are netted against each other. (Long term loss can offset short term gain, and vice versa).
If both categories have net gains, then short term is taxed at ordinary rates, while net long term is
treated preferentially in §1(h).
Net losses in both categories, so then the net losses are combined and can offset up to $3000 of
ordinary income with unlimited carryforward.
Having combined the two categories,
o There‘s an excess of short term gain over long term loss, the excess is a short term gain
taxed at ordinary rates.
o There‘s an excess of long term gain over short term loss, the excess is long term gain taxed
o In either case, the excess loss is offset against $3000 of ordinary income, with unlimited
(3) Apply the tax rates.
Any excess not allowed in one year is carried forward indefinitely. §1212(b)(2), Losses carried
forward keep their character
Short term losses are deemed to offset ordinary income before long term losses.
Basic netting rules -- §1222 – 4 categories; see p. 533 to work through this.
o Short-term gains must be netted against short-term losses. If short-term gains exceed
short-term losses, there is a net short-term gain. If short-term losses are greater, there is a
net short-term loss.
o Netting of long-term gains and losses produces either a net long-term gain or net long-term
o Short-term gain or loss is then netted against long-term gain or loss.
o If net short-term capital gains exceed net long-term capital losses, the excess short-term
gain is taxable in full as ordinary income.
o If the net long-term capital gain exceeds the net short-term capital loss, the excess (―net
capital gain) is taxed at the preferential capital gains rate.
o When taxpayer has both net short-term gain and net long-term gain, the former is taxed in
full as ordinary income, and the latter is subject to the favorable rate.
o Where losses exceed gains, excess capital loss offsets up to $3,000 ordinary income each
taxable year. Any excess not allowed in one year is carried forward indefinitely.
§1212(b)(2), Losses carried forward keep their character
Meredith Huston 74 Tax Fall 2001
POLICY OF PREFERENTIAL TREATMENT OF CAPITAL GAINS (SEE PAGES 546-551 FOR THIS)
Bunching—progressive rate structure. Person normally in 25% bracket, but in one year have a
big gain. If we look at you only in this year you look like a fat cat. But you‘re not. Problem with
annual accounting. To make up for this
o Overbroad: What if you are a fat cat and you always were one. For you there is no
bunching problem because you recognize capital gains every year. You get a great
o Incorrect solution where there really is bunching. If really wanted to solve problem, would
use an averaging scheme, to average income over period of time (say 5 years) and level out
the gain. Used to have one. Repealed in 1986 when rates became flatter – in interest of
simplicity and revenue.
Lock in—if you hold an asset on which you have already had substantial gain. Can sell asset now
and pay tax on gain, or hold on to it an defer gain forever. Even if expect a less than optimal gain,
may be in your interest not to buy a more productive asset and to hold on to this asset. When
reduced tax on gain, lessen lock in.
o Biggest lock in provision is step up at death – way to avoid tax altogether.
2001 act eliminates this – will this change lock in effect?? Unknown.
o Alternative approach – tax without regard to realization (mark to market system).
Inflation – if you bought an asset for 1000 and there is now 20% inflation and you sell for 1500,
will be taxed on $500 gain, but this is not correct. Cost of asset should be adjusted for inflation.
Asset really cost 1200, so proper gain is 300. But we don‘t do this, so preferential tax rate should
o Right solution is to index basis for inflation (don‘t do this)
Can argue don‘t need indexing because have given people benefit of deferral.
o Problem – solution we use doesn‘t get it right. Also need to take into account benefits of
deferral when calculating what preferential rate should be.
Incentive – want incentive for capital formation. Don‘t give preference to interest, dividends, so
argument is a bit odd. Also, why give incentive to old investments, not new ones. Very crude
DEFINITION OF A CAPITAL ASSET -- §1221
§1221: defines capital asset broadly to include all property held by taxpayers (whether or not
connected with his trade or business w/certain exceptions: (THESE ARE NOT CAPITAL
o §1221(a)(1): inventory, or property held primarily for sale to customers in ordinary
course of trade or business
Ex. CVS – Sell Toothpaste. Ordinary gain.
Ex. Own home. Capital Gain.
Ex. Hold stock.
Dealer in Stock – in it for dealer markup, not long term gain. Ordinary
gain. Trade/business. Taxed under §475 (marked to market – taxed
without regard to realization)
o Investment portfolio, held for investment, can I get capital gains for
this? Yes. Causes problems, dealer can say will bought stock for
investment where have a gain and bought for business where have a
loss. How do we solve this? Must identify asset at purchase in
order to get capital gain. Once identified as investment, can‘t
change your mind. §475 has this rule.
o See also §1236
Meredith Huston 75 Tax Fall 2001
Investor – not in trade/business because they have no customers. Capital
Active traders – may be so active that rise to level of trade or business.
Looking for short term swings. Courts say are in a trade or business, but
have no customers. Capital Gain, capital loss. For all but a few taxpayers,
securities are capital assets.
MALAT (1966)(554): Mixed motive case – in mixed motive case must look at
primary motivation to determine whether is held for sale to customers. Taxpayer
bought land and was going to build apt bldg to rent; would have been capital under
§1221(a), but plans changed and sold off some parcels, so ordinary income; later
sold rest of it and claimed capital b/c claimed primary purpose was to hold for
investment in apt bldg; selling remainder of land terminates joint venture so not in
ordinary course of business; turns on meaning of primary taxpayer‘s primary
motivation is key in determining whether should get preferential rate; IRS wants it
to mean substantial purpose; Court disagrees, it says ―primary‖ means principally
or ―of first importance - found not enough- have to show #1 purpose; look to see
whether investment or personal consumption
If a taxpayer‘s real estate or other property is not regarded as stock in trade, its classification then depends
on whether it is used in the taxpayer‘s business…as a warehouse or factory for instance…or is merely
held for investment. The latter is capital, the former, it is excluded from capital asset status by §1221(2).
This means the gain/loss will be treated by the favorable rules of §1231.
INTERNATIONAL SHOE (1974)(545): co. rents out shoe-making equipment;
forced to sell some of machines; selling machines is ordinary course of business;
IRS says primary purpose to sell machines and co. says sales are secondary purpose
and rental is still primary purpose; ct holds machinery was inventory; taxed at
ordinary rate; ct says that these sales were ordinary and predictable end; not
Construes Malat to say that primary purpose pivots on ordinary course of
business motivation, or liquidation motivation; ct uses semantic trick and
makes primary modify ordinary business purpose and not purpose
Import limited greatly- playing fast and loose w/language of statute; and
look at time of sale to see what purpose was at that time
CONTINENTAL CAN (545) -- made can processing machinery. Had been rented
out for 20 years and now had to sell something. Court said because are selling
today, is held for sale to customers – ordinary, not capital. Even though yesterday
was not held for sale.
Ways courts get around Malat
Bifurcation of business
Ordinary course? Or exceptional or liquidation sale?
o Real estate – holding for investment or for sale?
BRAMBLETT (546) – Partnership and corporation have same members.
Partnership bought land –> sell land to corporation. Corporation develops the land.
Issue is whether partnership held land as a capital or ordinary asset. Taxpayers
position is that should have ordinary income for development by corporation and
capital gain for sale of land by partnership.
Meredith Huston 76 Tax Fall 2001
Was the taxpayer engaged in a trade or business, and if so, what business?
Was the taxpayer holding the property primarily for sale in that business?
Were the sales ordinary in the course of that business?
o In order to be ordinary, must answer yes to all three of these
Nature and purposes of the acquisition, duration of the ownership
Extent and nature of the taxpayer‘s efforts to sell the property (depends on
nature of the market)
Number, extent, continuity and substantiality of the sales
o Most important factor.
Extent of subdividing, developing, and advertising to increase sales
Use of a business office for sale of property
Character and degree of supervision or control exercised by the taxpayer
over any representative selling the property
Time and effort the taxpayer habitually devoted to the sales.
Also considered – relative income (not in case) (p. 554)
Partnership made only one substantial sale and four insubstantial sales over three
years; court says not enough to make partnership directly in the business of selling
Second question is what happens when you integrate partnership with corporation.
Corporation merely acting as agent of partnership? Court says will not assume
agency simply because there is control. According to court, corporation must be
acting like an agent – get agent‘s fee, have legal authority to bind the partnership.
Third question is what about form over substance? When does form control over
substance? Frank Lyon – when the structure has genuine economic substance, is
compelled or encouraged by business or regulatory reality, and is not shaped by
solely tax avoidance motives. Justification here is desire for limited liability for
development activities. Court won‘t say this is a sham.
Could look at the question in the other way to ask why the partnership
makes sense here. Shuldiner says there is no reason.
Partnership wins – so have capital gains.
THE REST OF THE THINGS THAT AREN’T CAPITAL ASSETS
§1221(a)(2): property, used in trade or business, which is entitled to depreciation under §167 or is
§1221(a)(3): copyright, literary, musical, artistic composition, letter or memo held by taxpayer
who created it, taxpayer for whom created if letter or memo, or taxpayer in whose hands basis is
§1221(a)(4): accts or notes receivable from ordinary course of trade or business
§1221(a)(5): U.S. gov‘t publication
§1221(a)(6): any commodities derivative financial instrument
§1221(a)(7): any hedging transaction which is clearly identified as such on date on which
§1221(a)(8): supplies of type regularly used or consumed by taxpayer in ordinary course of trade
Meredith Huston 77 Tax Fall 2001
DEPRECIABLE PROPERTY AND RECAPTURE
Under §1221(a)(2) real or depreciable property used in a trade or business is excluded from the category of
§1231 -- allows real and depreciable property used in trade/business to yield capital gain when
disposed of at gain (held at least one yr) and ordinary loss when disposed of at loss (best of both
What property qualifies? – property used in a trade or business, of a character that can be
depreciated according to §167, held for one year or more. - §1231(b)
o §1231 basically—Each year, gain or loss on any item of §1231 property is netted against
gain or loss on other items of §1231 property.
If, in a given year, a taxpayer has a net gain on §1231 sales or exchanges, the §1231
gains and losses are capital. (Subject to §1245 recapture rules)
If in the year, the taxpayer has a net loss on §1231 sales/exchanges, the §1231 gains
and losses are ordinary.
EXCEPTION §1231(c) - If, in a given year, a taxpayer recognizes a net §1231
gain, but has taken an ordinary deduction for a net §1231 loss in the last five years,
the prior ordinary loss deduction is recaptured by recharacterizing that portion of
the net §1231 gain in the current year as ordinary.
Example – In one year, guy recognizes a $10k gain on a truck, and a loss of
$50k on a building. This results in a net $40k §1231 loss, so the gain and
loss will both be ordinary.
o Now say he sells the truck in year one, the building in year two.
Can he take a 10k capital gain year one, and a 50k ordinary loss in
year two? Oh HELL no. §1231(c) says that the 10k as ordinary, so
the guy would recognize net 40k ordinary loss, the same result as if
he sold them in the same year.
o3 types of dispositions may give rise to §1231 treatment:
(1) gain/loss from sales and exchanges of property used in trade or business;
(2) gain or loss arising from condemnations and involuntary conversions (ie.
casualty or theft losses) of property used in trade or business; and
(3) gain or loss from condemnations or involuntary conversions of capital assets
held in connection w/trade or business or in profit seeking activity that falls short of
trade or business
o §1231 requires 2-stage netting process:
(1) taxpayer nets gains from casualty and theft losses (e.g. insurance) against losses
from such involuntary conversions; if losses exceed gains, §1231 does not apply
either to losses or gains (deemed no sale or exchange); if gains exceed losses, both
gains and losses carried over to second stage of netting process;
(2) taxpayer compares total gains w/total losses from involuntary conversions
carried over from first stage ―firepot,‖ and condemnations and sales/exchanges of
business property; if losses exceed gains, gains includible in ordinary income and
losses deductible from ordinary income; if gains exceed losses, gains treated as
long-term capital gains and losses treated as long-term capital losses; carried over
to tax return combined w/long-term capital gains and long-term capital losses from
If net gain for all §1231 property, gains and losses are capital
If net loss for all §1232 property, gains and losses are ordinary
o Favorable regime for casualty losses.
Meredith Huston 78 Tax Fall 2001
§1245 recharacterizes capital gain from the sale of a depreciable asset (other than real property) as
ordinary income equal to the lesser of
(1) the gain recognized on the sale of the asset OR
(2) prior depreciation taken on the asset sold.
Property is §1245 property if (1) depreciation is allowed on the property under §167, and (2) the property
is one of the types of property specified in §1245(a)(3), including personal and tangible property. (also
includes amortized property like patents).
EXAMPLE – Guy buys truck for $10,000. Under §167/§168, he can depreciate it over 5 years. This is a
business expense. After the truck is fully depreciated, he sells it for $2000. Thus the depreciation
allowance was too generous by $2000.
If there was no recapture provisions, Max would have a $2000 capital gain (assuming he didn‘t
sell other §1231 property that year).
Under §1245, gain to the extent of the prior depreciation (here he took $10,000 in depreciation) is
characterized as ordinary income. So here Max includes the $2000 as ordinary income.
If he sold the car for $13,000, $10,000 of the gain would be ordinary to make up for the
depreciation, and the remaining $3000 would be capital under §1231.
§1250 – real property depreciation recapture – says that any depreciation over straight line has to be
recaptured, but you can‘t use anything but straightline on real property since 1986, so generally there‘s no
depreciation in excess of straightline and no portion of the gain is subject to §1250 recapture.
o §1245 – enacted to prohibit conversion of ordinary income into capital gain on sale of
depreciable property by requiring recapture of previously deducted depreciation as
ordinary income; ordinary gain reported pays back excess depreciation, although taxpayer
has enjoyed time value of earlier depreciation deductions; if any depreciable property is
sold for more than adjusted basis, any gain not exceeding total depreciation allowed is
taxed as ordinary income
Example: Truck bought for 100K for use in business for more than 1 year, took
$15K depreciation, new basis is $85K. Truck is depreciable property used in
trade/business, so excluded under §1221(a)(2)
Case 1 Case 2 Case 3
FMV $75K $90K $105K
Gain/Loss ($10K) $5K $20K
Ordinary Loss-- Ordinary Gain-- $15K ordinary, $5K
§1231 §1245 capital -- §1245
Example: S has 2 trucks, each purchased for $10K and each depreciated $2K.
Truck 1 sold for $9K (gain of $1K) and 2 for $7.5K (Loss of $500). Under
§1221(a)(2), $1K ordinary gain and $500 ordinary loss.
§1231 – 1 is capital gain and 2 is ordinary loss, would be great, but not how
it works, under §1231, must net, here there is a gain of $500
§1245 – 1 capital gain and 2 capital loss, but wrong, apply §1245 before
§1231, then §1245 would take 1 out and only apply §1231 to 2. 2 would
get ordinary loss because 1 is one with the recapture. Takes recapture gain
out of the situation. Shuldiner says the regulations imply that you
should do §1245 first and then §1231 (first take out any gains from netting
which are made ordinary by §1245)
Meredith Huston 79 Tax Fall 2001
If 1 sold for $11K, then $3K gain, $2K gain is ordinary, $1K subject to
§1231 as gain , 2 still $500 of §1231 loss, net $1K against $500, $500 gain
under §1231, net gain is capital, net loss is ordinary.
o §1250 – only recapture extent to which have taken accelerated depreciation. kind of
circular—only recapture gain over straight-line, but have to depreciate real property
straight-line, so rarely any overage for 1250. More common under 1245 b/c of accelerated
depreciation. Ordinary (unrecaptured gain) taxed at 25% for 1250.
In the code because we used to allow accelerated depreciation. Has now been
effectively written out of the code.
However – still a Partial recapture scheme. Gain up to the amount of depreciation
allowed on real property held for more than 12 months is taxed at a special capital
gains rate of 25%. This is more advantageous than taxing gain at ordinary rates,
which can be as high as 39.1%, but is not as beneficial as usual capital gains rate of
DERIVATIVES AND HEDGING
Businesses use hedges to reduce risk of price fluctuation or selling right to buy fixed amts of
underlying product at fixed price on certain date; hedging legitimate form of business insurance
Example: farmer buys 10K bushels corn @ $2/bushel; price could change by time K becomes
o could be $1.8/bushel or $2.35/bushel; enter into forward K now to sell 10K bushels for
$2.35/bushel; then when K due, can either perform or sell corn and close out K for value; if
corn then is $1.8/bushel, would have loss of $.2 on books; but K has value of $2.35-
$1.8=$.55 gain; if net gain and loss- $.55-$.35=$.2;
o on other hand, if at time K due, corn is at $2.5, then sell for $2.5; profit of $.5 and loss of
$.15 on K (for canceling K); Successfully locked in profit of $.35 either way
1936 – IRS said true hedges are common trade practices generally regarded as insurance. As such
the costs thereof are an ordinary and necessary expense. Proceeds thereof should be reflected in
net income. Why does this become an issue in Corn Products 20 years later
o taxpayer has gains, not losses and is hoping to get out of hedging treatment
o What is excuse for saying GCM does not apply – (what is GCM??? I have no idea)
GCM referred to true hedges – caselaw regarding what true hedges are.
Also had to really lock in profit for hedge. Was Corn Products really doing this?
No, look at facts of case, if prices dropped, corn products would lose money. This
is not a perfect hedge.
Corn Products v. Commissioner (562) – Company wanted to assure themselves a supply of corn
at a given price. Issue was what should character of hedges be? Company argued were capital
o 2 arguments: Narrow hedge, not a true hedge, or were just legitimate capitalists – if were
speculators, hedging doctrine would not apply.
o Court says gain is ordinary. To hold otherwise, would permit those engaged in hedging
transactions to transmute ordinary income into capital gain at will. If a sale of the future
created a capital transaction while delivery of the commodity under the same future did
not, a loophole in the statute would be created and purpose of Congress is frustrated.
o Gains and losses from the sales of the futures contracts were an integral part of the
taxpayer‘s business. Test is what company‘s motive was when bought/sold asset. Here,
was to maintain operations of company (e.g. to ensure they could buy corn to make corn
syrup). Where an integral part of business will not get capital treatment
o Broadens inventory exception because future is just substitute for actual corn (inventory).
o Unclear what grounds and scope of holding were – Arkansas Best resolves this.
Meredith Huston 80 Tax Fall 2001
Arkansas Best (565)—buys stock in a bank, bank starts to go bad, buy more stock in bank to try
to preserve its reputation. Original purchases of stock had been for investment purposes; claim is
that later purchases were business necessity; therefore wanted original purchases to be capital and
later ones ordinary. Courts look at statute and determine ―integral part of the business test‖ of
Corn Products is wrong/misinterpretation; said business purpose/motive irrelevant.
o If there was a general exception for things integral to business, why would there be the
exceptions in §1221(a)? Exceptions would be redundant, so this couldn‘t be what congress
o Court did not overrule Corn Products; still good law; expansive reading of inventory
exception, expanded to include surrogates to inventory and therefore motive is only
relevant when bears on something surrogate for inventory. Corn Products does not extend
to assets other than futures purchased for inventory hedging purposes.
o Here did not narrowly apply definition, instead broadly applied exclusion
o Simple application of the substitution doctrine (See Hort)
o FN 3 (667): in Hort narrowly construe property. Does not apply here?
o Income right is ordinary gain
o Long hedge? Ok, capital
o Short position? Position to sell, not buy, so doesn‘t fit, so is ordinary?
o Debt hedge? Debt is ordinary. Are debt hedges ordinary or capital?
o If you are hedging an item that is ordinary, it will generate ordinary gain, not capital gain.
o How are you going to account for the hedge?
When will I realize gain or loss under hedge – normally when I would go out and
sell. But they said no, we‘re abolishing realization requirement for hedges. IRS
regulations said have to match income – gain/loss on hedge with income gain/loss
on item being hedged and must do so up front, not after the fact.
Congress then codified regulations. Now have 1221(a)(7)
o What if you are an airline and you have jet fuel? Want to hedge jet fuel costs. Are they
Under corn products they were because were part of trade or business
Problem is if sold fuel, would not be ordinary, because not depreciable property or
held for sale to customers – would get capital gain.
SO put in 1221(a)(8) do deal with things like jet fuel.
o Hedging is alive and well. If designed to manage risk on assets or debt (present or future)
and you identify it, it will be an ordinary transaction.
o Business purpose test is gone.
Stock – can stock be ordinary?
o Circle K --Ct. ruled that, yes, purchase of interest in a gas company was inventory. IRS
settled rather than let this ruling muck things up any more.
NONRECOGNITION OF GAIN OR LOSS: LIKE-KIND TRANSACTIONS
§1001 – determination of amount and recognition of gain or loss
General Rule: §1001(c) and §1002: gains and losses must be realized and recognized (taxed);
realization of gain/loss is taxed when recognized
§1031-§1042 = nonrecognition events.
§1031 -- when taxpayer exchanges property of like kind held for investment, trade/business, no
gain or loss recognized; property must be held for productive uses
o Applies primarily to land. All real estate considered like kind
Meredith Huston 81 Tax Fall 2001
o Limitations: §1031(a)(2): like-kind exchanges disallowed for: (1) stocks/bonds; (2)
certificates of trust; (3) other securities; (4) partnership interests; (5) inventory; (6) other
property held primarily for sale
o If you have a loss, and have a like kind exchange, cannot recognize loss. If you have a
loss, won‘t swap, will exchange for cash and get the loss.
§1031(b): Boot -- if in exchange, in addition to like-kind property, get property which is not
similar- boot- realized gain is recognized to extent boot (transferred basis in new property
decreased by any $ received and increased by any gain recognized)
o boot = cash or nonqualifying property
§1031(d): Basis of property disposed of becomes property acquired and is decreased by any $
received and increased by any gain recognized
o Old basis –Cash+Gain-Loss = new basis
Is it merely a deferral provision? Both a deferral and nonexclusion provision?
o Meant to be a deferral and not an exclusion provision
Why particularly generous here? For valuation issues? Not clear. Continuity of business
activity? But would only apply to business.
FMV = 100,000 Swap FMV = 100,000 Like – kind exchange
Basis = 10,000 Basis = 60,000
Gain = 90,000
Basis after swap =
Used for Blackacre still gets like-kind
pleasure exchange, only care about what B
would use land for. Whiteacre does
not get like-kind exchange
FMV = 100,000 FMV = 80,000 Like kind exchange? Not car or cash
Basis = 10,000 Throw in for property.
10,000 cash and §1031(a) says exchange solely for
Here will recognize a car worth property of like kind, but look at
20,000 of gain (gain 10,000 §1031(b).
recognized up to amount
of cash and nonqualified
What is basis?
Ex. 3 FMV Basis Gain
Cash 10 10K 0
Car 10 10K 0
Property 80 10K 70
o Old basis –Cash+Gain-Loss
o 10-10+20-0 = 20K basis . . .
10 basis to car, rest to property, preserve gain in property
FMV = 100,000 Swap Basis = 70,000 o What is amount realized? Debt
Meredith Huston 82 Tax Fall 2001
Basis = 10,000 assumer counts as amount
Debt = 30,000 realized (Tufts and Crane)
Equity = 70,000 So amount realized =
Basis = 10,000
Gain = 90,000
o There are some exceptions to this rule in the regulations
What if swap where FMV = 100,000 and also has 30,000 debt – can offset debt
with your debt. Do not recognize a gain.
One of the issues you get here is that most of the time people do not want to swap property – so
have deferred exchanges and third party exchanges. Complicated situations. In Carlton, taxpayers
didn‘t make the arrangement carefully and got caught.
Meredith Huston 83 Tax Fall 2001