a. The Importance of Income Taxes
i. Some Data
1. 2004 FY Receipts $1 trillion
2. 74% of budget receipts
3. 2003 returns 130 million
4. perhaps 40 million involve zero or negative liability
ii. Effects on the Law
iii. Economic Consequences
1. choosing the taxing of one thing over the other
2. intended and unintended consequences
a. Create Incentives for various acts that we believe is beneficial to society.
3. Transactional consequences
4. social policy
a. tax policies create incentives to push forward
5. delivery of government payments
i. Federal Income tax was enacted for revenue sharing purposes
c. Theory and Policy
i. Why Income?
1. Wealth – something you can freeze theoretically, and at any one moment.
a. Asset minus liability – begging huge questions
b. Wealth is instant
2. Income – Change in wealth – income is change between instants
a. Define income by reference to something else
b. It is dependent on wealth and consumption
i. Wealth – balance sheet
ii. Consumption – output
iii. Income – changes in wealth and the consumption over the time of
3. why do we tax income?
a. Wealth Tax – value of asset and taxed like property tax
b. Consumption tax – measure goods and services consumed in each year
and tax that value
c. Income tax – tax people who are net-savers by taxing them as if they are
1. Conventional Definition of Income
a. Consumption + changes in wealth over a fixed time period
iii. The Tax Expenditure Budget
1. Concept under which certain tax benefits are equated with direct subsidies, data
published by U.S. Government
2. Various exclusions, deductions, deferrals, and credits are first identified, then cost
of these special provisions are determined, and then they are attributed to various
3. Tax savings depend on marginal tax rates.
iv. Tax Incidence
1. individual tax is generally not shifted to from one person to another.
2. Incidence of tax on corporate income and on individual investment income is not
3. Who pays the tax and who writes the check may not be the same person
1. Affects income tax in two ways:
a. Rate Table
i. Rate of taxation goes up as rate of inflation goes up
b. Gross Income
i. We do not adjust the original cost of purchase by inflation in
vi. Income Versus Consumption
1. Consumption Tax Proposal
a. Saving lowers the cost of investment, investment in turn create greater
economic opportunity, society as a whole is better off.
b. We should reward the ants and punish the grasshoppers
2. Currently, income tax favors grasshoppers and punishes ants.
d. The Rate Structure, Progressive and Marginal Rates
i. Tax Brackets
1. 10, 15, 25, 28, 33, 35 – these rates have been moving since 2003
2. 2001 Act phased in a reduction of the tax rate that’s completed for this year, but
in 2011, we’ll be back to pre-2001 rates
3. Tax rate is progressive .
e. Rate Schedules, the Taxable Unit, and the Marriage Penalty
i. Taxable Unit – individual, group of individuals, upon which the aggregate income is used
for the purposes of calculating the tax payable
ii. Five different taxable units
1. nuclear family
2. head of household
3. single taxpayer
4. married filing separate
iii. Joint Return, personal exemption, unearned income of children under 14
1. Everything goes on one tax return, since it is one family, taxed at a higher rate
iv. Marriage Penalty v. income averaging
1. One-wage earner family benefits from the joint tax return, but two-income
families have to pay a much higher rate than if they were to be single.
v. Electing to be married and filed separately
1. It is not beneficial, and one would only elect to do it if:
a. One does not trust the other in order to avoid culpability
b. Elder care issues – certain deductions are only available if your outlay will
exceed your income, and filing separately would maximize deduction of
medical expenses by having a lower income
f. Compliance and Administration
i. Payor reports and conducts self-assessment
ii. Employer reports and withhold
iii. 1099 – report but does not withhold
iv. Assemble these reports and put it together and file a return – filing the return in order to
get money back
v. 2% of all returns filed result in an audit – one meeting or it can be prolonged agony.
vi. Three years for assessment of deficiency
vii. Penalties and Fraud
1. interest is automatic
2. penalties can attach
3. if mens rea is higher – criminal liabilities
1. Tax Court Judge = tax specialist
2. two reasons to go to the tax court
a. if the government looks like it has overreached; professionals that will
understand the case.
b. Difficult Case
3. Small Claims Court – judges sit as a single judge – if you want a hearing, but not
to lawyer up
4. claims court for refund
a. lawyer up – pay the deficiency and ask for a refund later.
5. District Court for Refund
a. Good facts but lousy law
b. Crazy results that will favor you as an individual
6. Federal Circuit versus geographic circuits
a. Regular cir. cout gets appeals from tax court and district court
b. Claims court appeals go to Federal Circuit
g. Some Tax Terminology and Concepts
i. The Tax Base and Calculation of the Tax Payable
a. Tax base is the amount to be taxed pursuant to the appropriate tax rates. For income,
it is amount of the taxable income.
b. Gross Income [sec. 61] – all income no matter the source where the income is derived
c. Adjusted Gross Income [sec. 62] – gross income after above the line deductions
d. Taxable Income [sec. 63] – derived at by substracting (a) the amount of personal
exemptions plus (b) either (i) the standard deduction or (ii) itemized deduction.
i. Itemized deductions are taken when amount of permissible deductions exceed
amount of standard deductions.
ii. Itemized deductions are taken for mortgage payments, state income and
property taxes, casualty losses and medical expenses that exceed a certain
percentage, charitable contributions and certain business expenses of
e. Credits – used to offset tax
f. Alternative Minimum Tax – a tax on individuals imposed on special base at certain
percentage rate. Special base is adjusted gross income plus various preferences and
exclusions, reduced by certain non-section 62 deductions. Tax is due only if it is
greater than tax computed under normal rules.
ii. Capital Gain
a. Gain or loss from sale or exchange of capital asset
b. Capital asset is property, but there are exceptions
c. Historically, capital gains have been taxed at a lower rate.
d. Short-term capital gain – capital asset held for one year or less
e. Long term capital asset – gain from sale of capital asset that is held for more than one
iii. Tax Accounting
a. Cash Method: Capital Cost
i. The costs of capital investments may not be deducted when the cash outlay is
made, but only as the asset is used or when it is sold, exchanged, or
1. annual deduction is called accelerated cost recovery system deduction
ii. Capital expenditures = amounts spent for assets that have a useful life of more
than a year
iii. Amounts are treated as income when rec’d in cash or its equivalent and are
deductible when paid
b. Cash Method: Constructive Receipt
i. A right to a payment is treated as if it rec’d when the taxpayer had an
unrestricted right to receive cash, even if the cash was not in fact taken.
c. Cash Method: Cash equivalence and Economic Benefit
i. People are treated as if they had rec’d cash when they receive valuable
property or rights
d. Annual Accounting
i. Tax liabilities are computed on an annual, as opposed to a transactional basis.
1. must deduct expenses in the year it is incurred and income in the year
it is actually rec’d.
iv. Realization and Recognition
a. A gain or loss is realized when there has been some change in circumstances such
that the loss or gain might be taken into account for tax purposes.
b. A gain or loss is recognized when the change in circumstances such that the gain or
loss is taken into account
v. Recovery of Cost Depreciation, and Basis
i. Depreciation (accelerated cost recovery system) is a method of recovering a
cost of an investment. It’s a process of spreading deductions over period of
ii. The effect of the formula is to bunch the deductions in the early years of the
use of the machine. It is accelerated in comparison with normal methods of
iii. Tax method of depreciation is accelerated as compared with normal
accounting methods, which spread the costs over expected life of the asset.
Tax method produces much larger deduction for shorter periods of time
iv. Cost Recovery method only applies to tangible property like buildings and
1. for intangible property like patents, the cost must be deducted over
expected life of the asset in straight-line method
2. Spreading deductions over time for intangible assets commonly called
i. Amount used to calculate deduction for depreciation or amortization, and to
determine any gain or loss upon disposition of property
ii. Adjusted Basis
1. cost to purchase business asset less depreciation deduction is adjusted
basis for tax purposes.
iii. Gain is not realized until the building has been disposed off
1. if property is destroyed, and insurance pays for FMV and if FMV is
greater than adjusted basis, then that is considered a gain that’s taxed
iv. Year-end Stock bonus – paid to employees, but not sold, need not be included
in gross income for tax purposes. Basis for share is zero. If stock is later sold,
entire amount from sale is gain that is subject to taxation.
v. Personal Asset, such as car used for personal purposes, may not be used as
write-off when sold for less than original purchase price.
1. However, if personal asset is destroyed (with no insurance coverage)
the casualty loss is deductible in part
vi. Special rules apply for basis of property acquired by gift or inheritance
a. Sole proprietor – a person who owns a business solely and directly – no partners or
other co-owners and no use of a corporation or other such legal device
i. All items of income and expense of the business are treated for tax purposes
as items of income and expense of the sole proprietor
b. Partnership – combination of two or more people who have agreed to carry on a
business for profit as co-owners
i. Income and expenses are netted out but the partnership pays no tax. Instead,
the partners report on their individual tax returns their pro rata share of
whatever net profit or loss was calculated by the partnership
c. Trust – a legal device by which one person, the trustee, holds and invests property for
the benefit of another person, the beneficiary.
i. The general effect is to achieve a pass-through or conduit result, but the trust
may be required to pay a tax; which is generally treated like a withholding tax.
d. Corporations – legal devices for organizing economic ativity, and they are treated as
separate taxpaying entities.
h. Deferral and Its Value
i. A tax liability deferred from the present ot the future gives the taxpayer the use in the
interim of the amount that would otherwise been paid presently in taxes.
ii. PV = FV(1+r)n. – table on p. 31
1. PV = present value
2. FV = future value
3. r = rate of return
4. n – time you will compound
iii. Annuity: PV(A) A/r as n infinity
1. annual amount/interest rate
iv. Capital doubles every tens years at 7%
i. The Sources of Federal Tax Law in a Nutshell
1. Current S. Ct. imposes any signficiant restraint on the development of federal
1. the source of our tax law – IRC of 1986 as amended
iii. Legislative History
1. Strong part of the institution – through the level of tax court, it is understood that
the legislative history is a reflection of the very structure of legislative structure.
2. Joint Committee – produce a lot of history after big bills – and put the stuff they
couldn’t put into the bills in the general legislation, and courts are responsive to
these types of legislative history
iv. Administrative Regulation
1. Chevron Doctrine – a lot of deference
2. IRS and Treasury
v. Rev. Rul. And Rev. Proc.
1. Rev. Rul. – like a court decision with the names changed – normally there is a real
party that provoked the ruling. IRS proposes how to deal with these problems in a
series of hypothetical.
vi. Private Letter Rulings
1. Customer service dimension, where one can seek a determination of tax treatment
before the conduct has been conducted. These are to be used only privately, and
only applicable to the private party, hwoever it is in the public domain.
II. Some Characteristics of Income
a. Noncash benefits
1. Gross income includes income realized in any form, whether in money or
property, or service. Regs. § 1.61-1(a)
2. If the services are paid for in property, FMV of property is taken as payment must
be included in income. Regs. § 1.61-2(d)(1)
3. Barter arrangements are subject to taxation. In-kind exchange are generally
likewise subject to taxation
4. Employer’s payment of federal income tax on behalf of its employee constituted
income to the employee
5. In general, rule concerning non-cash income is when one receives something
other than money for services rendered, FMV of thing taken as payment shall be
included as taxable income. Exception: common law rule regarding meals and
lodging provided by employer.
ii. Meals and Lodging Provided to Employees
1. Benaglia v. Commissioner
a. Value of lodging and meals provided to employee by employer for
convenience of employer does not constitute taxable income to employee
2. §119(a) – adopted the rationale of Benaglia. The value of meals and lodging
were excluded from income if (a) meals are furnished on business premises of
employer, or (b) employee is req’d to accept lodging on business premises as a
condition of employment
a. Terms of the statute
1. Groceries were not within the term of meals (9th Cir.)
2. Groceries were within the meals exclusion but nonfood
items were excluded (3rd Cir.)
1. meal allowance payments were not excludable
2. in kind and only in-kind under Kowalski
3. Lower courts ignore the S. Ct.’s ruling, and will allow
reimbursements to be included if the facts are better than
the ones presented in Kowalski (state trooper given money
to go buy food.
iii. Convenience to the Employer
1. presumably refers to business reasons other than tax
advantages for having the employee accet free or below-
cost meals and lodging
2. the proof must bet that the employee is on call outside of
business hours to show to be at the convenience of the
iv. Business Premises
1. Paying for something nearby isn’t enough, the more
choices the employee has, the more likely it is a benefit
appreciated than a burden borne as a part of the job
2. If an apartment or a house has been permanently used by a
company becomes identified with a company is enough to
qualify as a business premise.
1. includes spouses and dependents but not same sex partners.
i. capacity of legislatures to cut special deals for special clients,
ii. Valuation – (d)(2) – campus housing – it has to charge you rent,
we’ll think it is FMV, but guaranteed to underestimate retail
iii. Other Fringe Benefit Statutes
1. Other Fringes
a. Life insurance; medical insurance, payments, discounts on merchandise,
parking, company cars, airline travel, club memberships, and tuition
b. Some fringe benefits were excluded as a result of the service’s inaction;
others were excluded by express statutory provisions: $50k worth of group
term life insurance [§79]; medical insurance and payments[§§105(b),
106], and dependent care assistance[§129].
2. Section 132 Fringe Benefits
a. The strategy is to provide statutory exclusion for well-established taxpayer
practices in exchange for forestalling further expansion of such practices.
i. No additional cost services – airline seating for employees
ii. Qualified employee discounts (§132(c))
1. only in the industry where the employee works
iii. Working Conditions Fringe – such as the use of business car or
free subscription (§132(d))
iv. De minimis Fringe – sufficiently low value to make accounting for
them unreasonable or administratively impractical (§132(e)(1).
Special rule extends the reach of this provision to certain eating
v. Qualified Transportation Fringe (§132(f))
vi. Qualified Moving Expense Reimbursement (132(g))
vii. Qualified Retirement Planning Services (§132(m))
viii. Certain On-premises gym and other athletic facilities (§132(j)(4)).
3. Further Notes on Fringe Benefits
a. Valuation: The Regulation
i. Detailed regulations on fringe benefits. Regs. §1.61-21 and
§1.132-1 to -8.
ii. The basic valuation rule ist hat the amount to be included is FMV.
iii. Special Optional Safe-harbor valuation formulas are provided for
aircraft and automobiles
b. Cafeteria Plans.
i. A cafeteria plan is a plan under which an employee may choose
among a variety of noncash nontaxable benefits or may choose to
ii. Sec. 125 expressly authorizes cafeteria plans.
iii. It limits the fringe benefits that can be included in a cafeteria plan
and imposes nondiscrimination rule
1. §79 - group-term life insurance (up to $50k)
2. §129 – dependent care assistance
3. §137 Adoption Assistance
4. §105 and §106(a) – excludable accident and health benefits
5. §401(k) – elective contributions under a qualified cash or
iv. Use it or lose it rule (§125(d)(2)(A) – if the person does not use the
benefits, one can not later elect to get cash.
c. Frequent Flyer Credits
i. IRS will not assert that any taxpayer has understated his federal tax
liability by reason of the receipt or personal use of frequent flyer
d. Employer Deduction
i. Instead of taxing the employee, the IRS will deny the employer
deduction to simply things, such as the value of meals supplied to
employees at a company cafeteria.
e. Benefits from other than employer
i. Only taxable if donated for a deduction
iv. Health Insurance
1. §162(a) – employers aer allowed to deduct the cost of medical insurance that they
buy for their employees to pay or reimburse employee medical expenses. They
are also allowed to deduct amounts they pay directly, under their own plans, for
employee medical expenses.
2. The benefits rec’d by the employees are excluded from their gross income. And
this extends to employees’ spouse and dependents.
3. Comparable tax benefit is extended to self-employed taxpayers by allowing thema
d eduction for the cost of medical care - §162(l).
v. Economic Effects: An Example
1. The Economic Preferences for Parking
vi. Another Approach to Valuation
1. Turner v. Commissioner
a. Turner wins a cruise, and exchanges for another prize
b. The government came up with one figure, and the taxpayer came up with
another figure, the court added them and divided it into two.
c. This rule gives the parties an incentive to exaggerate in order to get a
higher or lower number.
2. The Kid Who Catches the Historic Home Run Ball
a. IRS has made it clear that if a fan returns a ball to the team there is no
taxable income. But what if a fan keeps ball for sale? What’s the player’s
tax liability if the fan gives it back to the player?
b. Imputed Income
1. Imputed income is the benefits that are derived from u sing one’s own property or
services directly to benefit themselves or their family. There is monetary value in
these goods and services
2. Imputed income is not taxable due to the problem of valuation
ii. Property Other than Cash
1. The most important example of imputed income from property is the owner-
2. imputed income is normally not taxed due to the difficulty in assessing the value
of the income.
3. time share
4. the person who borrow to invest in a personal residence relies on a combination of
two tax rules:
a. the nontaxation of imputed income and
b. the deductibility of the interest payment
1. There is unfairness to not tax imputed income generated by self-service
2. non-ommodified services like in families are not taxed, and imposes a penalty on
iv. Psychic Income and Leisure
1. you can’t tax the value of fun.
v. Two general arguments for not taxing imputed income:
1. Liquidity – given the government require cash payment – we tax people
something other than cash, how can they pay for it?
2. Valuation – how can we assign value to this?
vi. Drawing the Line
1. Revenue Ruling 79-24
a. Barter Club – the FMV of the services rec’d b the lawyer and the painter
are includible in their gross income under sec. 61 of the code.
b. Paint for rent – the FMV of rent and painting are includible in the gross
incomes of the apartment owner and the painter under sec. 61 o8f the
c. Windfall and Gifts
i. Punitive Damages
1. Commissioner v. Glenshaw Glass Co.
a. Punitive damage awards are taxable as gross income.
i. Courts construed meaning of income and language of code broadly
ii. The fact it is punitive to the wrongdoer does not detract from the
fact that it is taxable income.
iii. There is no valuation or liquidity problems
b. Compare to treasure trove – income when found
c. Compare to gambling winnings and losses – gambling losses can be used
to offset gambling wins – basketing
d. Compare to insurance - If you win, money gets paid out
e. Compare to Personal injury Recoveries - §102(a)(1)
i. Punitive component is taxable, compensation for physical personal
injuries are tax free.
ii. Gifts: The Basic Concept
a. Gifts have always been excluded from taxable income under §102. This
exclusion extends to gifts that involve no valuation difficulty, and is not
simply a de minimis rule of administrative convenience.
b. However, gifts in excess of $10K (now $11K) a year may give rise to gift
c. §102: Gifts excluded from income
i. this contradicts the basic sense of what income is, makes no sense
why it isn’t included.
ii. It is a special carve-out
d. Three Strategies we might take toward gifts:
i. No deduction and income
1. Since there has been accession to wealth, it is taxable, but
since the donor has chosen to give the money away, it is
considered consumption, and has revealed his preference.
2. this would expand tax base
ii. Donor Deduction, Donee Inclusion
1. It is a consumption tax. The consumer is the donee, and the
right approach si to give the donor a deduction
iii. No Deduction to Donor, no income to donee
1. Implicit – neither the donor nor the donee has to deal with
the income taxation implication – donor gets no deduction,
donee gets no income. No one has to report anything and it
keeps it simple.
2. The donor technically bares the tax burden, so we tax by
e. Role of Gift Tax
i. Gifts and Estate tax affects only about .5 to 1% of the population
ii. Separate tax on the transfer of wealth
iii. Roughly speaking, it is a wealth tax
iv. Modest gifts are excluded
v. Lifetime credits are available
2. Commissioner v. Duberstein
a. The Court is operating under the presumption that businesses do not give
away gifts, and instead, they are in the business of making money.
b. Court declined to adopt a bright-line rule with regard to defining gifts. It
had held instead that appellate courts should only overturn trial courts if
lower court’s holding was clearly erroneous in applying the general
principles of gifts.
c. The Supreme Court adopted the donor motivation test
d. Compare Sections 102(c) and 74(c)
i. There is no gifts between an employer and an employee except
limited set of employee awards. Modest, standard-based awards
are considered gifts, but everything else are considered income
e. Compare §274(b)
i. The rule allows a business ―donor‖ to deduct as an ordinary and
necessary business expense the first $25 of any business gift.
ii. However if the business motivation is strong enough, then the
transfer will nto be trated as a gift, and the transferee will be req’d
to treat the value of the item rec’d as an addition to adjusted gross
income, and §274(b)’s limitation will not operate to deny a
deduction to the transferor.
iii. Since 102(c) - donor will always say it is not a gift, because then it
is deductible as a business expense
f. Role of §83
i. If you receive property in connection with performance of service,
then it is income, even if that connection isn’t really tight.
ii. Sec. 83 is a background rule that had stock bonuses in mind. If it
is broad enough to include more than stocks, then it is done right,
and it is considered a qualified option, and §83 doesn’t apply. But
if you flunk it,t hen it is taxable income.
g. Rule 62 (m)/(n)
i. For employees who are CEOs, for the corporation to get deduction
for their compensation in excess of $1 million – must have
plausible reason for doing it.
3. United States v. Harris
a. A recipient’s good faith belief that money rec’d was a gift, rather than
income, precludes a finding of willfulness for purposes of criminal
liability for willful tax evasion
i. IRS has to prove knowledge and intent beyond reasonable doubt in
order to convict mistresses who did nto report money rec’d from
ii. Double intent requirement – Donee must know what Donor
Intended, and IRS must prove the intent of Donee
b. Compare to marriage which is a tax free zone
iii. Gifts: Some Applications
1. Ordinary Tips
a. Includable in income on the theory that they are payment for services
rendered. [regs. §1.61-2(a)(1)].
2. Surviving Spouse
a. 274(b) – the firm that pays a death benefit gives up the deductibility of
that payment if they characterize it as a gift. Normally, the corporate
payor is in a higher marginal rate.
3. Prizes, Awards, Scholarships, and Fellowships
a. §74 – allowed a limited exclusion.
b. §117 – leaving only a limited exclusion for scholarships provided to
i. Portion of a scholarship that is req’d to be used for tuition, fees,
books and supplies and for equipment required for courses.
ii. The exclusion does not apply to any portion of a scholarship that
represents payment for teaching, research, or other services.
a. Under §102, bequests are excluded from income along with gifts.
b. A payment rec’d in settlement of a will contest will be considered a
bequest within the contemplation of §102.
a. Traditional welfare payments and various other government payments,
such as those for relief of disaster and for victims of crime, have long been
treated by the service as excludable not under §102 but rather as not
within the contemplation of §61.
6. Social Security - §86.
a. Before 1983, the entire amount of social security retirement benfits were
excluded from income.
b. Under current law, the treatment of social security benefits depend sont he
taxpayer’s adjusted gross income, augmented by one-half the benefits
rec’d. Tax-exempt interest and other items.
7. Alimony Versus Gift
a. Generally, alimony payments are deductible by the payor and taxable to
the recipient, while child support and property settlement payments are not
deductible by the payor and are not income to the payee.
iv. Transfer of Unrealized Gain by Gift While the Donor is Alive
1. Introduction to Basis
a. Basis is a tax concept and not an accounting concept
i. We look at the receipts to determine if anything is excludable, and
any expenditure deductible, and the net is income.
ii. We build the concept of gain into the definition of income
iii. Sec. 1001(a) – gain is amount realized minus basis.
iv. Basis is not adjusted for inflation
c. Cost Basis – sec.1011-1012
i. Sec.1011 – indemnify adjustments
ii. Sec. 1012 – presumptive basis of any asset is the acquisition cost
iii. Wasting Asset – violate the realization concept by allowing you to
recover the investment in advance of the disposition. Every time
you recover some of the acquisition cost, you have to adjust your
basis to show that.
1. Sec. 168 – appreciation deduction of tangible property in a
place of business or trade
d. Not All realization events are taxable events – gifts = an example
i. 1012 – the code says that the cost of acquisition is basis and so in
donee’s hand it is zero, and therefore all amount realized is gain.
ii. Donee’s basis = FMV of property – substituted basis
2. §1015: If property was acquired by the gift, the basis shall be the same as it would
be in the hands of the donor or the last preceding owner by whom it was not
acquired by gift, the basis shall be the same as it would be in the hands of the
donor or the last preceding owner by whom it was not acquired by gift, except
that if such basis is greater than fair market value of the property at the time of the
gift, then the purpose of determining loss, the basis shall be such fair market
value. Requires carryover basis to donee, but prohibits transfer of losses.
3. Taft v. Bower
a. Does the 16th Amendment Permit Substituted Basis?
i. Yes, donor’s basis was transferred to the taxpayer, who was liable
for tax on the gain. The donee voluntarily assumed the position of
ii. Any appreciation that occurs on the property in the hand of the
donor dos not affect he basis of the property. The basis is still the
cost of acquiring the property by the donor.
iii. If donor transfers depreciated property, then donee takes basis
equal to FMV of the property at the time of the exchange.
4. §83: Donation of appreciated property to an organization is considered a
realization event, unless the organization is charitable under §170(e).
v. Transfers at Death
1. Inherited Property
a. §1014 – the basis of property acquired by reason fo death is the fair
market value on the date of death or, at the election of the executor or
administrator under §2032, under the optional valuation date (six months
b. The Basis has been stepped up or stepped down from the decedent’s basis
to the date of death value.
c. The Effect of §1014 is to encourage people to hold on to appreciated
property until death, which results in some degree of immobility of
capital, which economists find troubling.
d. A modified carryover basis regime will be in effect for 2010 only.
Recipients under §1022 will generally take a basis that is the lesser of the
decedent’s adjusted basis or the fair market value of the assets.
2. Income in respect of a decedent
a. Under §691, income or gain that had been earned, in an accrual accounting
sense, before death is subject to a different set of rules. If the decedent
earned income that the estate or a beneficiary receives after death, the
estate of the beneficiary must include that as income. §691
b. It is subject to different rules concerning taxation. Generally, income tax
return of estate is filed reporting this post-death income. This return is in
addition to the final income tax return for the period up till death, and the
estate tax return.
vi. Gifts of Divided Interests
1. This is where the donor divide the interest in the property over time.
2. Brandy and Gavit – The Court made clear that only the principal of a gift or
bequest is excludable from the income of the donee or heir Sec. 102(b)(2) The
income beneficiary is taxed.
3. Exclusion of gifts from income does not extend to income from property that is
the subject matter of such transfers, including a life income in a trust
a. Situation: A places $100K in trust for B and his daughter C. B is to take
interest from the trust, $5K per year for 15 years to provide for C. After
15 years, C is to take principal as a gift.
b. Tax treatment: B is liable for $5K per year, C is not liable at all, since this
is a gift.
d. Recovery of Capital
1. Income includes interest, rents, dividends, and other returns on one’s capital or
cost or investment. It also include gains from the sale, but it does not include
returns or recoveries of one’s capital.
2. When Recovering Basis
a. Distinguish between wasting and nonwasting assets
i. Corporate stock is not a wasting asset
ii. Any tangible property is wasting asset
iii. All kinds of IP can be treated as wasting asset
b. Whether the basis recover, quick, slow or in between?
i. Quick – any cash that’s within the acquisition cost = not taxable,
only after beyond the acquisition cost = gain.
ii. Slow/Late: Assume no capital recovery until entire asset is sold or
liquidated. All gain until the end.
iii. Intermediate: use an allocation mechanism
1. Straight line
2. Sinking Line
ii. Sale of Easements
1. Inaja Land Co. v. Commissioner
a. Settlement about Government’s tortious act was considered a sale of land
and allowed taxpayer to recover basis.
b. Where it would be impracticable and impossible to apportion a definite
basis to an easement, no portion of settlement money received for the
conveyance of an easement should be considered as income, but full
amount must be treated as return of capital and applied in reduction of the
c. When the land was later sold, part of the price was considered cost
recovery, and part of it was considered gain. (61-49+25 = 13K gain)
iii. Life Insurance
1. §101(a) – blanket exclusion for insurance proceeds from life insurance paid by
reason o the death of the insured.
2. No deduction allowed from premiums paid.
3. The government is happy with this system as long as mortality gains are
4. §72 govern payouts from insurance policies that do not occur on account of death
of policyholder – not tax free if taxpayer receives proceeds from inside build-up
either before maturity or after maturity without death.
a. §72(e)(1) requires that the proceeds of a matured policy be included in
income, but only to the extent that such proceeds exceed the total of the
premiums paid by the insured.
b. §72(e)(2)(B) and (5) allows tax-free recovery of investment in the
c. §72(e)(6) defines investment in contract as premiums minus dividends.
5. Structural Reforms
a. Interest deduction - §264(a)(2) plus 163(h) – you can get your inside build
up but you can’t offset that with an interest deduction from the loan you
had taken out in order to pay for the insurance premiums.
b. Technical definition of life insurance under §7702
6. Employee Coverage - §264(a)(1) expressly denies the deduction of the business
buying term insurance on its key executives.
7. Transferees – The exclusion is generally not available to a person who acquired
the policy for valuable consideration.
8. Accelerated benefits fro the terminally ill and chronically ill – if sold to a viatical
settlement provider by a personw ho is chronically ill or terminally ill, the
payments received are treated as having been received by reason of the death of
the insured and are excluded from gross income under §101(a).
iv. Annuities and Pension
1. Basic Analysis
a. Traditionally, an annuity was a K requiring the payment of a specified
amount at specified regular intervals often for the lifetime of the person
entitled to the payments.
b. In the current era – the term annuity is widely used to refer to a K with an
insurance company under which the annuitant makes a current payment in
return for the promise of a single larger payment by the insurance
company in the future.
c. Three different tax treatments for the lump sum paid and the annual
i. Fast – no income until the year when you receive all your
ii. Back End – All payments could be treated as income to the extent
any income set aside for the policyholder by the insurance
company in its policyholder reserves.
iii. In Between – straight line analysis of the 20 year pay-out, either
fixed by K or life expectancy. Each year you recover a fraction of
the basis and pay taxes on the gain.
d. §72: exclusion ratio permits certain portion of each annuity payment to be
excluded from annuitant’s income and impose tax on rest.
i. Straight line, each year recover a set % of cost.
ii. If one dies before investment is used up, one would get a deduction
in the final year for uncovered investment loss.
iii. §72(e) – a taxpayer who receives a loan against an annuity policy
will recognize income equal to the lesser of the amount of the loan
or the increase in the value of the policy
iv. §72(q) – taxpayers who are under the age of 59.5 generally must
pay a penalty tax equal to 10% of the amount of the income
otherwise recognized. Applies to any premature distribution.
a. The tax treatment of pensions is essentially the same as the tax treatment
of annuities, except that the exclusion for one’s investment is determined
by a simplified method under which the investment in the K is divided by
the number of anticipated payments, specified in the Code according to the
annuitant’s age at the starting date. [§72(d)]
b. If qualified under the Section 400 provisions, then the investment is
deductible, earnings are tax exempt, and payout is fully included
c. Input is not taxed, and can elect to put in more money from your earnings
are not taxed. All payments are taxed.
3. Deferred Annuity – occurs when one pays sum of money to insurance company
before retirement and before any payments are called for under the K. Result is
longer period of time for investment by insurance company resulting in larger
payments to annuitant.
a. Favorable to taxpayers because the value of their investment increases
each year, but tax on the increase is deferred until the payments are rec’d..
v. Gains and Losses from Gambling
1. The basic Rule
a. §165(d) – all gains are taxable and all gambling losses are only eligible to
offset gambling gain in a particular tax year. (basketing)
b. By basketing, we differentiate based on the source different tax bracket
from anything else you do.
c. Reporting applies to legalized gambling.
vi. Recovery of Loss
1. Clark v. Commissioner
a. Payment received by taxpayer from his tax counsel for compensation for
damages or loss caused by tax counsel’s error is not considered income.
b. Court held it was not taxable income on the grounds that this was
compensation from damages.
c. The nontaxable holding from this case does not apply to reimbursement
from tax adviser unless it compensates one for having paid more than
minimum amount of tax that was actually due.
d. You can’t deduct tax payment had the Clarks figured out that they paid too
2. Current Legal Status of Clark
a. The Service will now treat the case as good on its facts – applies only
e. Annual Accounting and Its Consequences
1. The tax year is annual, but not all transactions fit neatly into a year.
2. Doing anything other than annual accounting would be transactional and it is too
confusing and not too beneficial.
ii. The Use of Hindsight
1. Burnet v. Sandford & Brooks Co.
a. One cannot average out losses and gains from numerous years, even if
they are from the same project.
b. This was modified by §172
2. Loss Carryover exception
a. Net Operating Loss (NOL) carryovers reduce harshness of annual
accounting by permitting losses incurred in a trade or business to be
carried over to other years
b. §172 currently allow such carryover to take place 2 years back and 20
a. if you produce something, you have to add the cost of making that thing,
and no recovery for making it until you sell it.
4. §186 – Certain Damage Recoveries
a. Special rule for compensation for certain business injuries which may take
longer than 20 years to recover, such as antitrust and fraud. Even NOL
can be used to offset recovery by those expired losses.
5. §460 – long term K
a. use the K to set the term of the transaction – you do use transactional
accounting, so you determine total- only fraction of outlay can be
recovered. IF K were deferred until completion, outlay is deferred until
b. As long as you have a profit on the K, deferral division does insure that
they are not used up in the early years wastefully.
iii. Claim of Right – Exception to Annual Accounting
a. §172 provides a considerable measure of averaging to offset the harsh
effect of the annual accounting system.
b. If there is a legal dispute over payment of money, that money becomes
―income‖ for tax purposes when someone has a claim of right to the
c. If the taxpayer receives income under claim of right without any
restriction as to how he may dispose of it, he has received income on
which he must pay taxes, even though it may still be claimed that he is not
entitled to retain the money, and even though he may still be adjudged
liable to restore its equivalent
2. North American Oil Consolidated v. Burnet
a. The claim of right doctrine requires inclusion of income in the year the
claim accrues and not necessarily the year the income is earned.
b. Current inclusion was required where the taxpayer
i. Received the funds in question,
ii. Treated them as its own, and
iii. Conceded no offsetting obligation.
3. United States v. Lewis
a. If the taxpayer receives and claims money as income in certain year and
paid taxes on it, but later discovers that he had received the money under a
mistake of fact, he can then deduct what he has to give back in the year it
is given back. He can’t reopen his file to recalculate his taxes, even
though the marginal rate has changed.
b. §1341: if an item was included in income in a taxable year because of the
claim of right doctrine, and if in a later year it is established that the
taxpayer did not have an unrestricted right to the item, so that a deduction
exceeding $3000 is allowable, the tax for the later year will be whichever
of the following is lesser:
i. the tax in the later year computed with the deduction, or
ii. the tax in the later year without the deduction, but reduced by the
amount by which the tax in the earlier year would have been
decreased if the item in question had been excluded from the
earlier year’s income.
iv. The Tax Benefit Rule
1. Symmetrical to Claim of Right – the situation is normally where deduction
(outlay) is followed by income (recovery)
2. The subsequent recovery is included in the taxpayer’s income, provided that the
earlier deduction produced a tax saving in the prior period
3. Exclusionary Aspect of the Tax Benefit Rule
a. §111 – if (or to the extent that) a deduction did not reduce the taxpayer’s
tax liability for any year and any loss carryovers resulting from it have
expired without being used, the recovery of the amount deducted need not
be included in income.
b. This section protects taxpayers against adverse marginal tax rate swings
that result from in effect, claiming the deduction at a zero percent rate and
then including the recovery at a positive rate.
c. It does not protect the taxpayer against adverse marginal rate changes
a. It arises when the taxpayer has indeed received a tax benefit from a
deduction, and the includibility or amount of the subsequent offsetting
gain is not otherwise clearcut. The rule requires that income in the amount
of the prior deduction be included, thus moving toward transaction rather
than strict annual accounting
b. The basic rule ist hat prior deduction must be included as income in the
eyar the deduction is returned. Repayment of a loan does not normally
produce income, but it will if the debtor had taken a bad debt deduction
c. Alice Phelan Sullivan Corp. v. United States
i. The court required the taxpayer to include the properties (which
she had donated in years earlier contingent on its use, and she had
deducted it) in its income in the year that they were returned at a
value equal to the amounts deducted as charitable contributions in
the earlier years.
f. Recoveries for Personal and Business Injuries
i. The Basic Rules
1. Damage awards for lost profits are taxed in the year received.
2. Punitive damages are also taxed in the year received
3. The recovery is taxable in the year received to the extent it exceeds the basis of
4. §1033 allows a taxpayer to defer taxation provided the amounts are reinvested in
similar or related use.
5. Personal Injury
a. Awards for individual taxpayers are generally tax free if the payment is
attributable to a personal injury. (§104) This does not apply to punitive
damages arising out of the personal injury
b. §104(a)(2) excludes only amounts arising from personal physical injuries
ii. Deferred Payments and Structured Settlements
1. 104(a)(2) – tort victim who is able to defer current payments can exclude the
entire amount of the later payments as recovery for personal injury
2. When the payment is in structured payments instead of a lump sum
a. Interest component is excluded, like life insurance
b. If tortfeasor gives money to insurance company, and pays out the $ over
time, everything the victim gets, including an element that’s return on
money market account is tax free
iii. Medical Expenses and Other Recoveries and Benefits
1. Employer provided Medical Insurance
a. Employers can deduct premiums paid for employee’s medical insurance,
but it is not includable in the employees’ income. §§106 & 162
b. If the employer reimburses employee medical expense itself, it is not
taxable to the employee. §105(b)
c. If the employee uses his/her income to purchase insurance, it is not
deductible to the employee.
d. Exclusions to employer extend to employees’ spouses and dependents.
2. Other expenses
a. §104(a)(1) excludes workers’ compensation
b. §105(c) excludes certain payments from employer insurance (or plans) for
permanent physical injuries
g. Transactions Involving Loans and Income from Discharge of Indebtedness
i. Loan Proceeds Are not Income
1. The Rule
a. Loan proceeds are not included in gross income and loan repayments are
2. The Rationale
a. Loan proceeds do not improve one’s economic condition because they are
offset by a corresponding liability.
3. Relation to Accounting Method
a. The rule applies to both cash-method and to accrual-method taxpayers.
ii. True Discharge of Indebtedness
1. General Rule
a. If the debt is discharged, there has been a change in net worth, and the
amount of the discharged indebtedness is taxable income. §612(a)(2)
b. §612(a)(2): gross income includes income from discharge of indebtedness
2. United States v. Kirby Lumber Co.
a. If a corporation purchases and retires any bonds at a price less than the
issuing price or face value, the excess of the issuing price or face value
over the purchase price is gain or income for the taxable year.
b. The difference between the bond issue price and the repurchase price is
iii. Relief Provision
1. §108(b) – If, at the time of discharge, taxpayer was insolvent or was the debtor in
a proceeding under the Bankruptcy Act, the income from discharge of
indebtedness is excluded, but certain tax attributes must be reduced so that in
effect the income will show up later if all goes well and the taxpayer has profits
that would otherwise escape taxation.
a. Rule allocates the amount affected by insolvency – you have a gain to the
extent you are able to pay for the loan back and you are discharged. So if
you have a debt of $2 mil, and asset of $1.5 mil, and $1 mil discharge, you
have a gain of $.5 mil.
2. The relief is available to solvent farmers for qualified farm indbtedness, which is
a debt incurred in the operation of a farm by a person who, during the three
preceding taxable years, derived more than 60 percent of his or her annual gross
receipts from farming. §108(g)
3. §108(e)(5) – the reduction of debt incurred to purchase property and owed to the
seller is treated as a reduction in sale price, rather than income to the purchaser.
4. §108(f)(2) excludes from income any cancellation or repayment of a student loan,
provided the cancellation or repayment is contingent upon work for a charitable or
5. §108(e)(2) – lost deduction
a. if you borrow money for business, when you dispose of the goods, when
you simultaneously get a discharge in the debt for the good, all you have
really done is lower the cost of the goods so no real income.
b. Whenever you borrow money to obtain goods that’s deductible when sold,
the reduction of the loan doesn’t create income
c. You just deduct les, instead of counting it as income.
a. If you borrow the money from your vendor, and he forgives part of the
purchase price, we’ll treat that as a retroactive reduction in the purchase
b. Only applies to purchases of property and only when the loan is from the
iv. Independence Doctrine in Tax
1. Default norm – treatment of the loan as independent from what is done with the
2. the general presumption is that loan proceeds are received tax free, the freedom
from the obligation to return the loan proceeds is a corresponding benefit beause
you got the money tax free.
v. Misconceived Discharge Theory
1. Unlikely the court will consider the discharge of illegal debt as income.
2. Zarin v. Commissioner
a. Settling for less than face value a debt that is disputed in good faith and
legally unenforceable is not gross income to the obligor.
b. The real issue in the case was whether there was a contested liability
doctrine embedded in 108.
i. As long as there is a valid legal defense to the debt, any settlement
is not covered by 108, because we don’t know what the debt is
until there is settlement. The settlement determines the amount of
c. Dissent argues that Zarin isn’t buying a piece of property, instead he is
buying service, and that’s not covered by (e)(5). He says that we’re back
in the master rulefo 108(a) – where reduced debt is considered income.
d. Alternative analysis
i. In order for gambling losses to have any value we have to offset it
with gambling wins under 165(d)
ii. Does 108(e)(2) override the limitations of 165?
3. Diedrich v. Commissioner
a. Donor who makes gift of property on the condition that donee pay
resulting gift tax receives taxable income to the extent that the gift tax paid
by the donee exceeds the donor’s adjusted basis in the property
b. Even though a donor is trying to relieve himself of the gift tax liability, the
donor realizes an economic benefit, which is treated as a discharge of
c. Gov’t waived the independence doctrine
d. IRS is treating the transaction as part gift, part sale, thereby linking the
discharge to transfer
e. §1015(d)(6): the basis of a gift increased by the same proportion of gift
taxpaid that the asset’s value has increased.
i. 170(e) approach- charitable contribution deduction. If you give
property, the deduction is the amount of the value of the charity.
ii. Rule – part-sale/part-gift to a charity, rather than recovering all of
the sale proceeds against basis, we disaggregate the transaction
conceptually into gift and sale part, and when you do that, you are
selling less, less basis recovery, and more gain to the parents.
iii. 170 – violations of symmetry – deduct built in gain and no income.
NO outlay involved in donation of property within built in gain
except basis, but allow you to deduct the full FMV. We’ll take
more away when it is a mixed transaction instead of a pure
iv. Bifurcation only works if you know the FMV of the property that’s
part-sold and part-given. In many incidences it is hard.
vi. Transfer of Property Subject to Debt
a. Borrowed funds are included under acquisition basis and it includes
b. For Parishble goods, like buildings, basis issued to calculate depreciation.
c. The useful life is determined categorically by statute in 168 and
depreciation deduction also decreases basis. No basis recovery until the
property is sold.
d. Discharge of nonrecourse debt = income
2. Crane v. Commissioner
a. Where taxpayer sells property encumbered by a nonrecourse mortgage and
the value of the property is equal to amount of nonrecourse mortgage – the
taxpayer must include the amount of the mortgage when computing the
amount realized on sale. The taxpayer realizes taxable income gain on the
sale in the amount of the mortgage plus any equity.
b. Under Crane, Amount realized by a seller of mortgaged property included
both the cash received from the buyer and the face amount of the
mortgage to which the property was subject.
c. Tax treatment
i. Calculate adjusted basis under §1014 (property received from
decedent): FMV at the date of his death.
ii. Under §1001, gain is amount realized minus adjusted basis.
d. Nonrecourse loan is treated as a true loan even if the remaining principal
is greater than the FMV of the property encumbered by the loan.
3. Commissioner v. Tufts
a. Where taxpayer transfers property encumbered by nonrecourse mortgage –
with an unpaid balance that exceeds the FMV of the property – the
taxpayer has realized, for tax liability purposes, an amount equal to the
unpaid mortgage balance. – Discharge of nonrecourse loan is property
even if the amount of debt exceeds the value of the security.
i. Problem resolved in FN 37 in Crane
1. whether the amount realized on the disposition of property
encumbered with a nonrecourse loan would still reflect the
remaining principle on the loan even if that amount was
greater than the actual market value of the property. Yes,
the court held that discharge of nonrecourse loan is treated
like the discharge of any other loan.
ii. Rationale: unless the outstanding amount of the mortgage is
deemed to be realized, the mortgagor effectively will have rec’d
untaxed income at the time the loan was extended and will have
rec’d an unwarranted increase in the basis of his property.
b. §7701(g) – statutory presumption that the value of the collateral is equal to
the face amount of the loan.
i. Creates irrebuttable presumption for nonrecourse debt only
ii. Leaves open bifurcation for recourse debt under treasury Reg.
4. §469 – if you are a passive investor (found under elaborate rules), the depreciation
deductions of passive investments can only be used to offset passive income.
5. Alternatives to nonrecourse debt
a. Sale lease back device – a formal device to change labels without
changing economic reality.
b. Option K – lender can give a put to the borrower – give the option to sell
the property back at a fixed price.
c. Lender can give customers lease and call right
i. Tenant- right to purchase the price at the set price, one would want
to increase in value, and tenant gives up the right to the increased
d. Lend money to a straw, and then conveys to customer via mortgage.
6. Rule of Symmetry: A taxpayer must account for the proceeds of obligations he
has received tax-free and had included in basis. Nothing in either §1001(b) or in
the court’s prior decisions requires the commissioner to permit a taxpayer to treat
a sale of encumbered property asymmetrically, by including the proceeds of the
nonrecouse obligation in basis but not accounting for the proceeds upon transfer
of the property
a. If a nonrecourse mortgage included in the property ―owner’s basis for
purposes of computing annual depreciation, then the unpaid balance of
that mortgage must be included as well in determining the amount
h. Illegal Income
i. Gilbert v. Commissioner
1. It is income when you gain the cash, and it is deductible when you pay the victim
2. Under Gilbert, however, the court held that where a taxpayer withdraws funds
from a corporation which he fully intends to repay and which he expects with
reasonable certainty that he will be able to repay, where he believes that his
withdrawals will be approved by the corporation, and where he makes a prompt
assignment of assets sufficient to secure the amount owed, he does not realize
income on the withdrawals under the James test.
3. When he withdrew the funds, he recognized his obligation to repay, and therefore
it was more of a nature of a loan than embezzlement.
i. Interests on State and Municipal Bonds
i. Basic Concepts
1. §103 – Interest on state and local bonds is tax exempt
a. You cannot take a deduction for interest on loans that generate tax-exempt
b. income. Under §256(2), but the government often cannot track this flow
ii. Limitations on Exempt Status
1. exemptions are available for bonds whose proceeds are used for traditional
governmental purposes such as financing schools, roads, and sewers.
2. Private-activity bonds and are not exempt unless it falls under an exception
a. Exempt-facility bonds – include bonds used to finance airports, docks, and
wharves, mass commuting facilities, water and sewage disposal facilities,
qualified hazardous waste facilities, and certain electric and gas facilities.
b. Mortgage bonds – qualified
c. Qualified veterans’ mortgage bonds, qualified small-issue bonds
d. bonds used for certain charitable purposes.
3. Rules against arbitrage – prevent a state or local government from borrowing at
tax-exempt rates and investing taxable obligations with the expectation of
profiting on the spread in interest rates. §148.
iii. Constitutional Barrier?
1. The requirement (§149(a)) that interest on otherwise qualifying bonds is not tax
exempt unless the bonds are registered and subject to certain reporting
2. no constitutional barrier to the imposition of a federal income tax on the interest
earned on obligations issued by a state or one of its instrumentalities.
iv. Tax Arbitrage
1. Tax-exempt bonds offer a good vehicle for describing a general tax strategy called
arbitrage and to examine its effects.
2. You lose interest deduction if you borrow at a high rate to buy tax exempt bonds.
3. the result of the rule is decreased demand, and suppression of price.
v. U.S. Treasury Bonds
1. §135 – exempts from taxation the interest on certain U.S. treasury savings bonds
if the proceeds of the redemption of the bonds do not exceed tuition and fees for
higher education for taxpayer and her or his spouse or dependents.
j. Gain on the Sale of a Home
i. §121 excludes from income certain gain on the sale or exchange of a home. The taxpayer
must have owned the home and used it as a principal residence for periods aggregating at
least 2 years over the five-year period ending on the date the taxpayer sold it. Allowed
every 2 years.
1. cap on exclusion of $250,000 for singles, and $500,000 for joint return filers.
ii. Rule 1034
1. allowed you to roll over the gain from the sell to new personal residence – you
would defer taxation, carry over old basis.
2. untaxed gain that’s a liability waiting to produce tax consequences when you sell
the home and do not convert it into a personal home.
3. exclusion for people over the age of 55 that allowed them to step down in
iii. §163(h)(3) – allows interest deduction on loans up to $1mil for qualified residences (up
to 2) – tax arbitrage is allowed.
1. As long as the two houses are both residences, you can deduct the interest even
when the income and appreciation is all tax free.
III. Problems of Timing
a. Two of the most important issues in tax timing are (1) realization and (2) recognition
1. Issue of Timing – taxpayers always want to defer tax liability due to the time
value of money, while the IRS generally wants to realize it.
2. Gain or loss in the value of property is not taken into account until a realization
event occurs, and even then only when a specific nonrecognition statute does not
b. Gains and Loses from Investment in Property
1. Eisner v. Macomber
a. Gains from dealings in property must be realized before they can be taxed.
b. Facts: taxpayer received dividends, but her net wealth was not
significantly altered because the market value of the shares dropped
substantially although she has more shares now which equals to her wealth
c. Court held that the concept of income implies a separation from the
underlying asset. A stock dividend is a capitalization of profits, as
opposed to a monetary dividend where cash is paid to stockholders. The
value of the stock is still tied to the company, so that the beneficiary can
not use it as she pleases. §305
d. The constitutional aspect of the case is no longer good law, but the
architectural aspect is still in play today.
e. Realization event means that gain or loss is taken into account only when
one’s ownership in that asset has changed in some way.
f. Possible alternative treatments:
i. Tax 10% of appreciation in stock of each taxpayer and adjust basis
upward by amount of gain recognized. How much gain has been
enjoyed since the ownership of stock.
ii. Treat each shareholder as receiving a dividend worth $910, and
adjust basis upward by this amount
1. gain inside the firm – doesn’t affect shareholders – events
in the company affect the P of the stock, but not the
shareholders – no tax impact on the shareholder until
something comes out of the stock or the shareholder sell the
iii. Ignore the stocks until it is sold, divided basis among old and new
2. Exceptions to realization requirement
a. Foreign Personal Holding company income
i. If a company is foreign dedicated to holding investment assets
instead of active trade or business and held by a relatively small
number of shareholders, you immediately impute corporate level
income to the shareholders. Ignore the foreignness of the
corporation and separate identity of the corporation. You treat
that’s as immediately paid to the shareholders even though in fact
they are getting nothing.
b. Subpart F
i. We treat all of its activity as belonging immediately to
ii. Typically trading company that a domestic mfr. Set up, will sell it
to wholly owned subsidiary offshore at economic value to
customer – the form of the transaction is respected, all of the gain
from sale is offshore, and won’t be taxed to the parent company
until it is repatriated as a dividend
c. S Corporations
i. Closely held companies, limit on how many there can be, only 1
class of stocks – can elect to be treated for tax purposes as if they
ii. What make S Corp. than
iii. F and foreign personal holding company is that it is elective, and it
is the shareholders’ choice.
d. Market-to market gains under §1256
i. They involve exploiting certain aspects of the commodities of
future market – Congress solved the problem in ’81 – if you have
positions on these markets, you’ll be taxed on their end value
whether you pulled your investment of the market or not
e. Inventory accounting
i. Allow you to take tax loss even if not sold yet.
f. Cost Recovery such as depreciation
i. Allow you to get an offset even though you may not have put in
any money in the investment
ii. Development: Tenant Improvements
1. Helvering v. Bruun
a. Mere increase in the value of the capital asset may be taxed without any
sale or exchange involved (no longer the rule under the Code)
b. Tenant improvements produced taxable gain and that gain had been
realized as soon as the lease is terminated.
c. The conversion of a remainder interest into a fee simple is a disposition.
d. They had three choices:
i. No gain until land is sold – strong realization requirement
ii. Amortize gain over lease – no realization requirement
iii. Gain upon termination of lease – weak realization requirement
2. §§109, 1019: tenant improvements to property are not realized until the sale of the
property ( and even then only indirectly)
a. Rent Substitution
i. Tenant agrees to put up the building and the useful life of the
building is longer than the length of the lease, and as a result the
landlord gives tenant a break on the rent
ii. While §109 seems to give blanket exemption even to rent
substitution, Treas. Reg. 1.61-8(c) permits improvement to
substitute for rent: something that is in form a transfer of
improvements but is in substance a payment of rent and will be
treated as the payment of rent.
iii. Payment is taxable when received even though the services are
received in later years.
iv. Depreciation Deduction
1. the tenant would have a depreciable interest in the building
because the useful life is less than the tenant’s property
2. The tenant would still be able to depreciate the building
using the ACRS schedule – ought to acquire all that is
a. If the building’s useful life is shorter than the term
of the lease – then get all depreciation;
b. if not, then problem with rent substitution
3. When lease ends, you get amount realized (0) – basis = loss
v. Landlord has no income and no basis.
b. If the property owner has not realized taxable income, neither can he take
a deduction for depreciation.
3. Realization After Bruun
a. Macomber is limited to stock dividends, where the shareholder’s inerest
was the same and inseverable
b. The S. Ct. – New Deal Court – not going to overrule Macomber, but
limiting it to its facts.
4. Legislative reversal in §§109 and 1019
iii. Nonrecourse Borrowing in Excess of Basis
1. Woodsam Associates, Inc. v. Commissioner
a. The receipt of a nonrecourse loan does not create a realization event, even
if the amount of the loan is greater than the basis of the property
encumbered by the loan
b. Tax treatment of nonrecourse and recourse loans is the same.
c. The execution of a nonrecourse mortgage is not a realization event.
i. Receipt of nonrecourse loan was not taxable event, and realization
is postponed until final disposition of property.
2. §357(c) – if you convert land into a corporation stock – and if you as contributor
of property to your wholly owned corporation to the extent it exceeds the basis,
you have gain, even though you are not getting cash, you are only changing forms
of ownership – that’s a good time to collect a tax.
1. Introductory Note
a. An exchange of property is a realization event only if the two properties
exchanged are materially different. Tres. Reg. §1.1001-1.
2. Cottage Savigns Association v. Commissioner
a. Swap of mortgage is realization event because the mortgages were legally
b. Realization – disposition within the meaning of §1001
c. Recognition – comes after realization, and we say that if we do have a
realization, is there a specific provision of the code that points for or
d. §165 – loss deduction - §165(a) allows deduction for losses be sustained.
The issue becomes whether sustained add or subtract from the disposition
v. Express Nonrecognition Provisions
a. Nonrecognition provisions provide that certain gains and losses, although
realized, will not be recognized – they will be taxed upon the final
b. §1013: like-kind exchanges
i. The most significant nonrecognition provision provides that gains
or losses will not be recognized on the exchange of property held
for productive use in trade or business or for investment if such
property is exchanged solely for property of like kind which is to
be held either for productive use in trade or business or for
ii. The provision is inapplicable to exchange of certain securities,
commercial paper, certificates of trust or beneficial interests, or
chooses in action. §1031(a)(2)
c. Reg. 1.1031(a)-1(2)(b), -2(b): definition of the same kind or class
2. Revenue Ruling 82-166
a. IRS has held the provision inapplicable to the exchanges of gold and silver
because ―like kind‖ refer to the nature or character of the property, not
grade or quality.
b. Principal value of gold is financial and not industrial; silver does have
industrial uses, and less the investment purposes of gold. Industrial metal
is not equivalent to financial metal.
3. Jordan Marsh Co. v. Commissioner
a. Sale of property for cash does not become an exchange of property simply
because the seller simultaneously executes a long-term fair market value
lease of the same property. An arm’s length, bona fide sale and leaseback
transaction is not an exchange subject to nonrecognition under §1031.
b. The simple fact that there is a formal transaction isn’t enough.
c. The idea behind §1031 – taxpayer owns the fee, and ends up owning a
property interest that is less than the fee, but not a lot less – it doesn’t
matter whether it is the same property or not, and has the same character
as capital asset that the taxpayer unlike the taxpayer envisioned by
assuming an obligation to pay 30-year leasehold described in the
regulation doesn’t include an offsetting regulation to pay rent.
vi. Boot and Basis
1. Boot is any additional money or property transferred as part of an exchange of
property. The transaction qualifies for nonrecognition despite the boot, but if
there is gain, it is recognized to the extent of the boot. §1031(b). Thus, amount
of gain recognized is lesser of amount of gain realized or the amount of boot. If
there is no gain to be realized, the boot is not taxable; it is the gain that is
recognized (and taxable) to the extent of the boot, not the boot itself.
a. First variation: farm with basis of $10K swapped for farm worth $100K,
cash of $15K, and tractor worth $8K (total of $123K in property and
cash). New basis in farm of $10K (same as old); $23K taxable gain; $90K
appreciation of farm, but this is not recognized (will be upon sale of farm).
b. Second variation: farm with basis of $110K, same facts-- $13K in taxable
gain ($23K minus $10K ―loss.‖ i.e., $110K minus $100K value of new
farm), and new basis in farm $100K.
c. Third variation: farm with basis of $130K, same facts—figuring in loss.
There is a loss ($7K), but it is not recognized since §1031 deals only with
i. For losses, you do not want §1031 to apply.
ii. To reflect the fact that there is a built-in loss, you raise the new
basis of the farm to $107K. This $7K loss is not yet recognized,
but is embedded in basis and will thus be accounted for upon
disposition of property.
2. §1031(d) sets forth rules of recomputing basis in an exchange that includes boot:
generally, there will be a substituted basis. i.e., the basis for the property rec’d
will be the same as the basis for the property relinquished. §7701(a)(42).
a. When gain is recognized because of boot, basis must be increased int eh
amount recognized. Of the total basis, a portion equal to the fair market
value of the boot must be allocated to that boot with the remainder
allocated to the like-kind property received.
vii. Three-Party Transactions and Substance Versus Form in Tax Matter
1. One area where courts have not used the substance-over-form rule to invalidate
artificial transactions structured merely to avoid taxes in the nonrecognition of
gains or losses realized from three-party exchanges
2. So the party with the property but does not want to recognize gain would make
the buyer buy a different property and swap that property with the party with the
property. The seller of the property for cash will recognize gain.
c. Recognition of Losses
i. Revenue Ruling 84-145
1. If costs are capitalized, and a loss is subsequently suffered, that loss is not
recognized until the sale or disposition of the property.
2. Treas. Reg. §1.165-1(d) – a loss must be evidenced by closed and completed
transactions, fixed by identifiable events, and actually sustained during the taxable
3. Substantial reduction in valuable right as a result in the change of law is not the
type of event hat leads to the recognition of loss unless those rights are sold or
abandoned as worthless.
4. Loss of monopoly value is not recognizable – it is not equivalent to loss of rights.
5. Compare to Cottage Savings – realization rule was over-inclusive because it
allowed a loss without corresponding economic change.
ii. Constructive Sales
1. §1259 treats shorting a stock as a sale (for purposes of gain or loss).
a. Example: A taxpayer who borrows stock and then sells the borrowed stock
is said to ―short the stock.‖ If he holds stock and then borrows and sells
the identical stock, that is going ―short against the box.‖
b. In the past, the sale of borrowed stock was not a realization event because
taxpayer did not own the stock sold and the appreciated stock the taxpayer
owned was not sold. But see §1259
2. §1259(a)(1): limited to gain – the underlying idea here is that when you achieve
the economic effect of a sale of an asset – that you ought to be taxed as if you sold
3. §1259(b)(1): Stock, debt instrument or partnership Interest
5. Why Constructive Sale/
a. The code presumes that these transactions only occur if the property can
be quickly liquidated.
d. Original Issue Discount and Related Rules
i. The concept of original issue discount imputes interest to debt instruments – notes,
bonds, loans, etc. – that do not state an adequate amount of interest
1. the interest imputed is then chargeable to the creditor as gross income and
deductible by the debtor
2. What constitutes an adequate amount of interest is determined according to the
interest rates published by the treasury.
ii. §§1272-1275 – to the extent that a debt instrument does not provide for current payment
of an adequate amount of interest, interest must be accrued.
1. When the bond is sold for cash, the OID is the difference between the issue price
and the redemption price. This amount is treated as interest earned ratably over
the term of the loan with semi-annual compounding.
2. Treatment is as if the investor put money paid for bond into an account that
accrues interest annually.
iii. The OID on a debt instrument equals to: (1) the stated redemption price at maturity of the
debt instrument less (2) the issue price of the debt instrument, which is generally the
amount of cash the bondholder paid for the debt.
iv. The OID is then allocated over the 10 year period during which time the bond is
1. One approach is to divide the OID equally over the 10 years or
2. Constant-yield to maturity or the economic accrual method – tax Mary in the
same way that someone with a savings account would be and require Mary to
include amounts of interest that increase each year – because the interest inclusion
is calculated by applying a constant rate of interest to a balance,that keeps
increasing to reflect prior accured by unpaid interest.
a. To calculate this – her OID inclusion for each semiannual period is the
product of multiplying (1) the yield-to-maturity by (2) the adjusted issue
price of the bond.
b. The adjusted issue price of the bond is (1) the issue price of the bond
plus(2) any unstated interest that has already accrued on the bond but not
been paid to the bondholder.
e. Open Transactions, Installment Sales, and Deferred Sales
i. When promises are of value – something other than receipt of cash – how the system deal
with problems of timing, generally three strategies
1. Wait and see - until the transaction is completed and all the obligations have been
honored, no immediate consequence
2. Best Guess now – guess what’s going on the best we can – immediate tax result
a. Assign a value of future contingent payment, and apply a tax between
basis and future contingent payment
3. Spread it out – guess what’s going on and spread out the tax consequences.
ii. Open Transaction
1. Burnet v. Logan
a. Where the total value of the consideration to be rec’d by taxpayer is
sufficiently uncertain, gain is not recognized until the payments actually
rec’d exceed basis.
b. Classic wait and see case – the transaction was not limited by time nor
amount – payments were to continue as long as the property, a mine went
on producing revenues for the buyer.
c. Open transaction results in basis-first rule – regard the payment as
recovery of basis and no gain on the property until the remainder of the
rights has been solved.
d. A promise to pay an indeterminate amount of money is not necessarily
taxable income. The income tax law is concerned only with realized
losses, as with realized gain
e. Three Possible Approaches
i. Open Transaction approach – all payments rec’d were treated as
recovery of basis until the full amount of the basis was recovered
and then all payments are treated as gain.
ii. Closed Transaction Approach – determine the present value of the
expected payments and treat this sum as if it were cash rec’d on the
date of sale. Gain or loss is then determined by comparing this
amount with basis.
iii. Installment Method – use an open transaction approach but to
allocate some portion of basis to each expected payment rec’d, so
that some portion of the gain or loss is recognized as each payment
iii. The Installment Method
1. §§453, 453A, and 453B – a set of accounting rules that permit nonrecognition of
gain in transactions involving the sale of property.
2. Principal congressional objective is to provide relief from the harshness of an
obligation to pay taxes when the taxpayer has not received dash with which to pay
tose taxes, but the benefits are enjoyed by many taxpayers who have no problem
of cash availability but who prefer as do most taxpayers to defer tax liability
3. Basic Approach
a. Rule relating to OID are applied (§483). The installment payment then
applies to what remains.
b. May opt to not use the installment basis under §453(d) – the transaction is
then treated as closed and gain is recognized at the outset in an amount
equal to the difference between the fair market value of the installment
payments and the basis.
4. Limitations – not available for sales of personal property under a revolving credit
plan, for sale of publicly traded property, or for sale of inventory items by dealers
in real or personal property. §453(b092), (k)(1).
a. Exception for sellers of time-share units and residential lots. §453(l)
i. Permitted to use the installment method, but when payment is
rec’d they must pay the government interest on the amount of tax
5. Not available if the consideration rec’d is readily convertible into cash.
a. The fact that a promise to pay is guaranteed does not transform that
promise into a payment that must be treated like cash. §453(f)(3).
6. Sales with contingent payments
a. If it si possible to etermine the max amount that may be paid, basis is
allocated by treating that maximum as the selling price
b. Where a max price cannot be determined, but it is possible to determine a
maximum period of time over which payments will be made, basis is
allocated in equal annual amounts over that time period.
c. If it is not possible to determine either a max price or a max time period,
basis is recovered in equal annual amounts over a period fifteen years.
f. Constructive Receipt and Related Doctrines
i. Basic Principles
1. Constructive receipts results in taxation of amounts that are set aside or available
– amounts to which the taxpayer has a legal claim – not amounts that would have
been available if the taxpayer had made some other deal.
2. Amend v. Commissioner
a. A cash basis taxpayer cannot be deemed to have realized income at the
time a promise to pay in the future is made.
b. Once he made the K, he has no right to demand immediate payment, must
receive payment at a later date.
c. He would now use the installment method. If elected out of installment
method he would be req’d to report in 1944 the FMV of the obligation of
3. Pulsifer v. Commissioner
a. The payment is normally pretty automatic once the representative of the
minors comes forward to demand the money, so the court held that the
claim to the money occurred as soon as money was placed on the trust,
and were income of the kids.
b. Relation with Economic Benefit Doctrine
i. If tangible economic rights have been realized by the taxpayer, that
event can be treated independently taxable even if the rights are
not immediately cash.
ii. Involve situations where there isn’t a K, and where taxpayer hasn’t
tried to control the timing. You don’t negotiate, normally, with the
c. An individual on the cash receipt and disbursement method of accounting
is currently taxable on the economic and financial benefit derived from the
absolute right to income in the form of a fund which has been irrevocably
set aside for him in trust and is beyond the reach of the payor’s creditors.
d. Note §451(h)
i. Code will honor the choice you made with respect to lottery pay
out of either a long term pay out or a lesser, immediate payout.
ii. Call off the constructive receipt doctrine.
e. If it is an Option K then constructive receipt applies.
f. Cash isn’t the only way to gain income, accession to a right can also be
ii. Qualified Employee Plans
1. Retirement Savings
a. Income tax imposes a tax when income is generated, even though it is
saved, and taxed again on the earnings of those savings.
i. The fact that you set aside surplus for retirement doesn’t affect
your income tax liability
ii. But when you draw down on your retirement savings, no tax.
b. Consumption tax leaves savings and earnings on savings out of the base
and delay tax until withdrawal
2. Qualified Retirement Savings
a. Unless you can qualify some way the double tax early rule does apply.
b. Generous rules for qualified retirement savings.
i. Employer deducts contribution
ii. No income to employee
iii. Earnings are tax free
iv. Taxed upon withdrawal
c. In order to get this treatment – must get the employer to do it for you
i. Dollar ceiling on how much money can be treated this way
ii. Nondiscrimination – can’t save more for high level employees than
low level, but can use a percentage
iii. ERISA protection – Mandated the pension rules to have certain
e. Penalty for Early Withdrawal – 10% surtax and treat it as income for
withdrawing it early with few exceptions
f. Mandatory withdrawal after 70
iii. Stock Options Restricted Property and Other Employee
1. Statutory Rules for Determining the Tax Treatment of Employee Stock Options
a. Three timing choices
i. Income on receipt
1. income even though option is never exercised, but if it is
unexercised upon expiration – make deduction previously
brought in under income
ii. Income on exercise of option
1. we know the value when exercised
iii. Income when underlying stock is sold.
1. ignore receipt of the option and wait until the stock
acquired with the option is sold and the gain would be the
value of the stock when sold minus the option price
b. Compensation is ordinary income, but gain is eligible for capital gain
i. Writer - the person who creates the option – employee –
cooperation is the writer
ii. Holder - The person who has right under the option – that’s the
iii. Strike Price- The price at which you can buy
iv. Term - Not indefinite, but it last up to some period of time.
v. In the Money v. Out of the Money
1. In the money – strike price is less than the current value of
the current commodity.
2. Out of the money – strike price is higher than the current
trading value of the firm’s stock.
a. More Likely, because You don’t want your
employees to be able to take money away now.
vi. Call v. Put
1. Call – right to buy
2. Put – theoretically – valuable to the extent the strike price
is greater than market price – you are allowed to sell back
to the company, and incentive is to drive the trade price
2. Incentive Stock Options
i. Give you the best tax treatment when all else are held equal
1. option cannot be out of the money
a. strike price must be at least the current value if not
2. Restriction on resale of stock
a. At least a year after the exercise of the option must
remain at the company.
b. Not a 10% stockholder
c. $100K cap.
i. You can have a rolling plan, and when the
option is exercised they are no longer
counted against this cap
i. Written with the assumption that property acquired is stock option
ii. Option is taxed as ordinary income at the time it vests
iii. Option is valued without any consideration for the restrictions like
it can be expired or a limitation on resale.
iv. §1259 – constructive sale – transaction that limits the risk.
3. Nonstatutory Stock Options
a. Purposefully failing §422 –
i. These claims to a zero inclusion upon option exercise could be
based either on the difficulty of valuing the stock itself or on
valuation difficulties created by the restrictions that the option at
least initially placed on the employee’s ownership
b. In response, congress enacted §83
i. If property is transferred to a person as compensation for services,
the tax consequences
1. If when the stock option is transferred to employee –
person can then transfer it without restriction or does nto
face a substantial risk of forfeiture – the difference between
the value of the property and the amount paid for is income
at the time. §83(a) and (h)
2. even if the restrictions on transferability or a substantial
risk of forfeiture call off the mandatory application of this
approach, the employee an elect it. And if so elected, FMV
of property is determined without regard to any restrictions
other than those that will never lapse. §83(b)
3. Neither of the above two rule applies, and the receipt of an
option therefore is not immediately taxable after all, if,
when granted the option lacks a readily ascertainable fair
market value. §83(e)(3)
a. Cramer issue is embedded. §83 doesn’t apply if the
option can’t be valued.
4. If election could have been made but did not the option is
included in income when it either ceases to be non-
transferable or ceases to be subject to a substantial risk of
4. Cramer v. Commissioner
a. Enforces Treas. Reg. §1.83-7(b)(2)
i. If the option is not publicly traded – automatically disqualifying
with respect to whether it has ascertainable value.
ii. Taxable event is when the option is exercised, and you are out of
iii. They held onto the option until it became extremely valuable, and
therefore should be taxed when the option is e
iv. They held onto the option until it became extremely valuable, and
therefore should be taxed when the option is exercised.
g. Transfer Incident to Marriage and Divorce
1. Alimony is includible and deducible but property settlements and child support
ii. Property Settlements
1. Transfers Incident to a Divorce or Separation Agreement
a. United States v. Davis
i. The transfer of stocks is deemed to be a taxable event, and the
marital rights are judged to be equal to the value of the property
that they had exchanged
ii. She had given up her marital rights in considerations of the stocks
transferred to her
i. Divorce is not a time for taxation and indeed more broadly
transfers between spouses, including spouses that are becoming
ii. Nonrecognition rule – still a realization rule, but with a
nonrecognition override. No immediate tax when property is
transfered. There is tax liability built into the property that the
receiving spouse now has because the basis is preserved.
iii. Note – exception for transfers in trust when liabilities exceed basis.
1. when you appreciate property with debt in excess ot basis
into a corporation, there is no tax but doesn’t apply under
2. Antenuptiqal Settlements
a. Farid-Es-Sultaneh v. Commissioner
i. In exchange of marital rights, she signed an agreement that she will
receive these stocks instead. It is a contingent transfer that vests
only if they get married.
ii. Since the agreement was signed before they were married, he has
to pay taxes when the transfer is made to her from him.
1. you have to write the agreements so that nothing actually
happens until after marriage, or there are tax liabilities.
3. Alimony, Child Support, and Property Settlements
a. The Basic Scheme
i. Following divorce, certain payments rec’d by the payee spouse are
taxable to him or her under §71(a) and those payments become
deductible by the payor spouse under §215.
ii. Other payments are not taxable to the payee spouse and are not
deductible by the payor spouse.
iii. Alimony deduction is an adjustment in arriving at AGI, so it is
available to payors who do not itemize deductions. §62(a)(10).
b. The Rules
i. Must meet the conditions set out in §71
1. the payment must be in cash. §71(b)()
2. rec’d under a written instrument of divorce or separate
maintenance §71(b)(1)(A), 71(b)(2).
3. Parties must not have agreed that the payment will be
nontaxable and nondeductible
4. The parties must not be members of the same household.
5. The payment cannot continue after the death of the payee
6. The payment must not be for child support §71(c)
7. Rules that deals with the problem of distinguishing between
alimony and cash property settlements
a. §71(f) provides that only payments that are
substantially equal for the first three years will be
treated as alimony.
i. The difference cannot be greater than $15K
between year to year, otherwise recapture
rule would apply.
4. Child Support Obligations in Default
a. Diez-Arguelles v. Commissioner
i. The amounts due to ex-wife by former husband for child support
are not deductible under §166 as nonbusiness and bad debts
ii. No basis in the loan
iii. Had she been able to negotiate a negotiable note for the debt, then
she could’ve written it off it is not paid. That way the claim is
liquidated instead of unliquidated. The note would then have the
basis of its value, and if she sells the note and no gain, then the
basis = value of the note, and would be able to write it off.
IV. Personal Deductions, Exemptions, and Credits
i. The Mechanics of Personal Deductions
1. Personal deductions are subtracted from adjusted gross income to arrive at taxable
2. The Code contains a number of different personal deductions that qualify
taxpayers may take. The lit of personal deductions include both itemized
deductions and standard deductions.
a. Value of standard deduction, which depends on party’s filing status, is set
forth in §63(c)(2) and the exact value changes annually, depending on
b. A party cannot take both itemized deductions and the standard deduction,
but must choose between the two, i.e. a party who chooses to take the
standard deduction cannot take deductions for casualty losses, medical
expenses, and other itemized deductions.
c. Itemized versus standard deduction – subject to phase out.
ii. The Role of Personal Deduction
1. Personal deductions are those that have nothing to do with the production of
2. Personal exemptions are scaled to family size and it is subject to phase-out
i. Relative, living with you, or someone who is not a relative, but
receives 50% of support
ii. §152(b)(5) – a person can’t be a dependant if the relationship
violates local law.
b. Casualty Losses
1. §165(c)(3) – deduction for losses from fire, storm, shipwreck, or other casualty or
from theft. Limited to losses that exceed in the aggregate, for the year, 10% of
adjusted gross income, after reduction by $100 floor for each individual loss.
2. §165(h)(4)(e) – deductions for losses covered by insurance are allowed only if a
timely claim was filed.
ii. Dyer v. Commissioner
1. Destruction of ordinary household equipment such as china or glassware through
negligence of handling or by a family pet is not a casualty loss under §165(c)(3).
iii. Chamales v. Commissioner
1. Rule: Court has traditionally held that only physical damage or destruction of
property will be recognized as deductible under §165. In contrast, court has
refused to permit deductions based upon temporary decline in market value.
2. Held: Chamales have not established their entitlement to a casualty loss deduction
because it does not constitute the type of damage contemplated under §165(c)(3).
But since they acted in good faith, no additional liability (i.e. §6662(a) accuracy-
related penalty) will be imposed on them.
3. Whether casualty imply a physical casualty, or is a shocking economic event
a. 9th cir. – there has to be a physical event – realization event
b. 11th cir. – rare case where taxpayer is going to identify a non-physical
injury that is none-the-less casualty.
c. The difference is that in 9th cir. – we don’t listen to your story, 11th cir. –
we’ll listen to your story, but we won’t accept it.
4. penalties and role of explanatory statements
a. when a taxpayer is so wrong, he owes the IRS penalties over and above
underpayment and interest.
b. Civil fraud instead of criminal
i. 50% + interest
c. If not fraud, then negligence or substantial underpayment.
d. They included an explanation, and so it is not fraud and instead it is
negligence. This will allow them to insulate penalties.
5. Role of gatekeepers in the tax law
a. Lawyers and accountants can provide a service over and above good tax
guidance, which is protection against penalties, reliance on opinion letter
from a lawyer, usually insulate the taxpayer from penalties, and only
underpayment and interest.
iv. Blackman v. Commissioners
1. Gross negligence on the part of a taxpayer that results in the destruction of
property will bar any casualty loss deduction for the destroyed property.
2. Public Policy Limitation
a. General Doctrine
i. Even if a taxpayer qualifies under the letter of the tax law, no
deduction due to non-tax policy.
ii. The deduction was not allowed in this case because allowing it
would be against (a) common law tax rule that gross negligence or
willful behavior on part of taxpayer cannot create deductible loss,
and (b) common law tax rule that courts will not frustrate the
public policies of states—here would have frustrated state policies
against arson and domestic violence.
c. Extraordinary Medical Expenses
1. Medical expenses are deductible to the extent that they exceed 5.5% of adjusted
gross income. §213(a).
a. Includes insurance premiums covering specified medical care under
d. Charitable Contributions
1. The Code allows individuals and corporations to claim as itemized deductions of
any charitable contribution payment which is made within the taxable year.
2. The good feeling of donating to a charity is rewarded by a tax deduction. All that
matters is the deductibility of the contribution to the donor and not the donee.
3. §170(b)(1) – certain public org. – max deductible is 50% of AGI, and private for
the use of organization – 30% of AGI.
4. If the taxpayer makes gifts that exceed any of these limits, the excess may be
carried over to the succeeding five years.
5. §170(c) – specifies the organizations that qualify as recipients of deductible
contributions. But the organizations own immunity is determined by §§501.
a. Many orgs meet the standard of 501 but not 170.
b. §527 provides separate and detailed rules for the tax treatment of political
organizations, making them taxable on their income, but excluding from
their income such items as political contributions income from fund-
6. below the line deduction, but no floor.
ii. Contributions of Capital Gain Property
1. when a taxpayer makes a gift of property whose sale would produce long-term
capital gain, the amount allowed as a deduction is the full fair market value of the
2. 30%/20% instead of 50%/30% for donation of property.
3. §1011(b) – requires that basis be allocated in a bargain sale to charity – must
bifurcate the transaction. The adjusted basis for determining the gain from such
sale shall be that portion of the adjusted basis which bears the same ratio to the
adjusted basis as the amount realized bears to the FMV of the property.
4. Short-run capital gain property – amount of deduction is the taxpayer’s basis in
5. §1221(a)(3), (5)
a. one of the statutes – two provisions that are actually about the charitable
contribution instead of the preferences
b. took away the preferences
i. (a)(3) – wide category of transactions involving executive branch
1. Property you either created yourself, or something that’s
created for you. – not eligible for deduction
c. (5) – took away deduction of legislators forgetting the congressional
record as a business expense.
iv. Gifts with Private Objectives or Benefits
1. Ottawa Silicon Co. v. United States
a. When charitable contribution provides benefit to the donor, as well as the
donee (quid pro quo), the Code limits the amount of deduction that can be
b. If the benefit received by the donor is greater than that which inures to the
general public, then no deductions can be taken.
c. If, on the other hand, the value that inures to the public exceeds the value
received by the donor, then the amount of the available deduction is the
difference between that which the donor receives and the value of the
v. More on Private Benefits
1. quid pro quo contributions – the amount of any non-business-related deduction
for a charitable contribution is limited to the excess of the payment to the charity
over the value of any benefit rec’d by the donor.
2. The complicatous role of some charitable organizations – individuals deduct
amounts that might be more accurately described as nondeductible fees for
services because charities blur the fee structure.
vi. Overvaluation of Contributed Property
1. §170(f)(11) – amended in 2004 – valuation of property that may or may not be
sold by donee needs a professional to put his or her reputation on the line. Must
get an independent appraiser to validate the valuation you are using for your
2. §170(f)(12) – by pattern and sociology and affect lower-end charities. After Jan.
’05 – your donation is limited to what the charity actually realizes when it sells it
3. Strong Preference for in-kind donations in spite of attendant valuation difficulties.
4. Effect of 107(e)(2) – recover only 10% of your basis – undermines some of the
charitable contribution deductions
vii. The Special Case of Collegiate Athletics
1. Rev. rul. 86-63, 86-1 C.B. 88 – IRS held that where reasonably comparable
seating would not have been available in the absence of contribution, there is a
presumption that the contribution was the price of a substantial benefit to the
taxpayer and no deduction is allowable unless the taxpayer can establish that the
amount of the contribution exceeded the value of the benefit rec’d.
2. §170(l) – adopted in 1988 – allows a deduction for 80% of any amount paid to an
institution of higher learning if the deduction would be allowable but for the fact
that the taxpayer receives as a result of paying such amount the right to purchase
tickets for seating at an athletic event in an athletic stadium of such institution.
viii. Religious Benefits and Services
1. Rev. Rul. 70-47, 1970-1 C.B. 49, states that pew rents, building fund assessments,
and periodic dues paid to a church are all methods of making contribution to the
church, and such payments re deductible as charitable contributions within the
limitations set out in section 170 of the code.
2. fees for attendance at parochial schools providing mostly secular education are
1. denial of charitable contribution deduction when the contribution as made in
accordance with a court order.
x. What is Charitable
1. Bob Jones University v. United States
a. In order to achieve tax exempt status under §501(c)(3), an organization
must not only comply with the statutory requirements, but also with
common law standards of charity. A charitable organization must ―serve a
public purpose and not be contrary to established public policy.‖
i. The Rules
1. Business investment interest – interest incurred in a trade or business or for the
production of income – is a proper adjustment in arriving at net income and has
always been allowed as a deduction, though in recent years subject to certain
limitations designed to curb tax avoidance. §163(a)
2. Personal interest on a home mortgage loan is deductible if it is qualified residence
a. Interest on loans falling within either of 2 categories
i. There is acquisition indebtedness, which is debt incurred to buy,
build or improve a personal residence. Limit of $1 million dollars
on the debt. §163(h)(3).
ii. Home equity indebtedness, which is any debts secured by a
personal residence, with a limit of $100K, but not in excess of the
FMV of the residence. §163(h)(3)(C).
3. All other interest not incurred for business or investment purposes is
nondeductible personal interest. §163(h)(2)
ii. Policy Issues
1. whether deduction encourages people to spend more than they should. Policy
goal is to increase homeownership
1. Treasury Regulation – interest generally is allocated according to the use of the
2. Although the equity loan is supposed to be used on the home, there is no way to
be able to trace where the money goes, so it’s just whatever interest you happen to
be paying at the time.
iv. What is Interest?
1. Contingent on other variables, including depreciation of property.
2. Under Rev. Rul. 69-188, codified in §461(g)(2), if paid out for the use of money,
points on home loans are deductible as interest, but not other ―loan costs‖ such as
cost of credit reports, escrow and other fees.
v. Interest and Inflation
1. no adjustment for interest income and expense according to inflation.
vi. Interest on Student Loan
1. §221 allows deduction for interest incurred in connection with loans taken to
finance higher education. The amount of the deduction caps out at $2500.
i. §164 provides a personal deduction for payment of state and local income taxes and taxes
on real property. Federal taxes are nondeductible, as are sale staxes.
ii. Taxes are involuntary and not a consumption.
iii. Option – deduct your state income taxes or sales tax
1. only available to itemizer – you may deduct your property taxes, real and personal
– if you have state income taxes – if you don’t , you can deduct your state sale
g. Personal and Dependency Exemptions
i. §151 – grants each taxpayer a deduction for personal exemption.
ii. §151(e) – provides an exemption for each qualified dependent of the taxpayer. See §152
for definition of dependent.
iii. §152 – two interest problems
1. who gets the child deduction credit when the family is not intact?
a. Alimony is deductible to the payor
b. Child support is not
c. Division of property is not
d. First agree on the amount of money, then decide who is going to take the
iv. §152(d)(2)(H), (f)(3)
1. bars same-sex deduction
v. §152(e) – after amendment
1. special rule for divorced parents – strong hint that divorced parents imply
someone who was once married to each other.
h. Credited Based on Personal Circumstances
i. The EITC
1. §32 – allows for EITC as welfare payment for the working poor ( percentage of
taxpayer’s earned income is returned in the form of a refundable credit, meaning
the credit not only offsets liability, but also results in a payment from the
government to the taxpayer if enough is due).
ii. Credit for the Elderly and the Permanently and Totally Disabled
1. §22 – provides tax credit to the elderly (over age 65) and the permanently and
totally disabled in the amount of 15% of the taxpayer’s ―section 22 amount‖
(calculated according to the rules set forth in §22).
iii. Credit for Adoption Expenses
1. §23 – provides tax credit for adoption-related expenses
iv. Child Tax Credit
1. §24 – provides $500 tax credit for each of taxpayer’s dependent children.
v. Credits, Phase-out, and Effective Tax Rates
1. Many credits are targeted to provide relief for low-income families and are phased
out as income rises above specified levels.
V. Allowances for Mixed Business and Personal Outlays
i. Two provisions under which individuals may claim deductions for expenses that may be
thought of as the cost of generating income
1. §162(a) – the deduction for the ordinary and necessary expenses paid or incurred
… in carrying on any trade or business.
2. §212 – covers expenses of generating income from sources other than trade or
ii. §262 emphasize that, except as otherwise provided, no deduction is allowed for personal,
living, or family expenses.
iii. §67, adopted in 1986, provides that certain deductions are allowable only to the extent
that in the aggregate they exceed 2% of adjusted gross income.
1. Covers deductions under §212 and deductions claimed by employees under §162.
2. Has the effect of disallowing deductions for expenses with a significant personal
iv. §280A – severely limits deductions for vacation homes and home offices.
v. Self-employee deductions are above the line.
vi. Reimbursements by employer to employee for business related expenses are not taxable
b. Controlling and Abuse of Business Deductions
i. Six ways we can convert outlays into deductions
1. Strategy 1
a. Above the line deduction – outlay that reduces income to get to AGI –
classic incidence, such as trade or business expenses
b. Non-employee trade/business expenses
2. Strategy 2
a. Below the line deductions – charitable deductions – only good if you are
an itemizer, does not reduce AGI, but they are otherwise good dollar for
dollar, except the constraint of §68 that reduces deduction as income goes
3. Strategy 3
a. Misc. Itemized Deduction - §67
i. All the bad things associated with itemized deduction – and only
usable if in total it exceeds 2% of AGI.
4. Strategy 4
a. Basketed deduction – certain kind of activities are generally isolated for
tax purposes, and the income is subject to that tax regime – subject to
b. Big basket – deduction that can only be offset by some kind of income –
but broad definition of income – like passive activity losses – passive
activity deductions can only offset income generated by the passive
5. Strategy 5
a. Little basket - §183, 280(A)
i. Deduction from the activity can only offset income from that
particular activity, such as hobby and gambling losses.
ii. Hobby Losses
1. §183(a) – establishes default rule that taxpayer cannot take deduction for
expenses associated with activities not engaged in for profit.
2. §183(b) allows income for a hobby to be offset by expenses associated with the
3. §183(d) defines an activity engaged in for profit as one that makes a profit in 3/5
previous consecutive taxable years, unless the IRS otherwise determines that the
activity is a profit-making enterprise. Unless you show profit in the past 3 years,
the burden is on the taxpayer to show that it is a profit-seeking activity.
4. §469 – denies current deduction for certain losses from passive activities.
5. the test to determine between business expense and a hobby expense comes down
to the determination of the ―primary purpose‖ of the taxpayer.
6. Nickerson v. Commissioner
a. Taxpayer need not expect an immediate profit from a business, and the
existence of ―start up‖ losses does not preclude a bona fide profit motive.
b. Nine Point Test
i. Manner in which the taxpayer carries on the activity
ii. The expertise of the taxpayer or his advisor
iii. Time and effort expended by taxpayer in carrying on the activity
iv. Expectation that assets used in activity may appreciate in value
v. The success of the taxpayer in carrying on other similar or
vi. The amount of occasional profits, if any, which are earned
vii. The financial status of the taxpayer
viii. Elements of personal pleasure or recreation
c. Role of §183(d)
i. Flunking it only means the burden of proof is on the taxpayer to
demonstrate it is for a profit-seeking purpose.
7. Pre-Opening Expenses
i. cost of a project that’s absorbed before you produce any cash flow
ii. Once money starts to come in, you can take the deductions for up
to $5K/year as long as the statutory criteria are met.
iii. Home Office and Vacation Homes
a. §183 – ultimately a fact/circumstances/taxpayer intent standard
b. §280A – bright line rule that denies deductions for any use of a home for
business purposes and then to list specific concrete exceptions
i. Home Office
1. Congress used broad language to denying a deduction
(§280A(a)), followed by a set of specific, relatively
concrete exceptions (§280A(c)).
a. Deduction is allowed for use of portion of dwelling
used on a regular basis
i. As the principle place of business for any
trade or business of taxpayer;
ii. As place of business used by patients,
iii. Or in the case of separate structure not
attached to dwelling unit.
3. While it is possible to take deduction where you rent out a
portion of your home, §280A(c)(3), you cannot rent out a
portion of your home to a business where the ―employer‖ is
the actual owner of the home. §280A(c)(6)
ii. Vacation Home
1. §469 – disallows deductions for passive losses. Therefore,
the lack of personal use will result in it being treated as a
passive activity, and the gains and losses are basketed.
2. Statute covers any dwelling unit that is used by the
taxpayer for more than a specified amount of time during
the year for personal purposes.
a. Specified amount = greater of 14 days or 10% of
the number of days during the year for which the
unit is rented at fair rental - §280A(d)(1).
3. If the Unit is not used at all for personal purposes, the
taxpayer is allowed to deduct expenses, interest, and taxes,
subject to the limitation on deduction of passive activity
4. If the unit is used for personal purposes for more than the
specified amount of time, but is rented out for less than 15
days, then the owner excludes the rental income and may
not claim deductions other than for interest and taxes.
5. If the unit is used for personal purposes for less than the
specified amount of time, the disallowance rule of
§280A(a) does not apply, but the deduction other than for
taxes is allowed only on a pro rata basis, and again, is
subject to the limitation on the deduction of passive activity
6. If the unit is used for personal purposes for more than the
specified amount of time, then expenses other than interest
and taxes must still be prorated, but the deduction for such
prorated expenses cannot exceed the rent received, reduced
by an allocable share of the interest and taxes.
2. Popov v. Commissioner
a. On the facts of the case, that a professional musician is entitled to deduct
the expenses from the portion of her home used exclusively for musical
b. Principal Place of Business Test
i. Relative importance of the activities performed at each business
ii. Time spent at each place
iv. Income Unconnected to a Trade or Business
1. Moller v. United States
a. If you are not in a business, then your home office can’t be a principal
place of business. The mere management of investments even though it
takes a considerable amount of time is not a business.
b. What is determinative is the fact that the taxpayers’ return was that of an
investor: they derived the vast majority of their income in the form of
dividends and interest; their income was derived from the long-term
holding of securities, not from short-term trading; and they were interested
in the capital appreciation of their stocks, not short-term profits.
2. Feldman v. Commissoner
a. Substance over form, and not a legit transaction when you are on both
3. Whitten v. Commissioner
a. Mere profit-seeking is not enough.
v. Office Decoration
1. Henderson v. Commissioner
a. Priority of §262 – nondeductible because they constitute nondeductible
personal expenses under §262.
b. Employer as gatekeeper – the fact that your employer doesn’t think it’s
important is a good indication that it isn’t.
c. The purchase of the frame and plant are personal expenses and are not
aiding her in her work.
vi. Automobiles Computers and Other Listed Property
1. §280F(d)(4) – defines listed property
2. Where the listed property is used 50% or less for business purposes depreciation
is limited to straight line using the normal useful life. §280F(b).
3. Where an employee acquires and uses listed property, the business use
requirement of this provision is not met except that s for the convenience of the
employer and required as a condition of employment §280F(d)(3).
c. Travel and Entertainment Expenses
1. The cost of a trip, or other activities such as dinner with a customer at a
restaurant, is deductible if the ―primary purpose‖ is business.
a. The primary purpose test is based on unrealistic assumptions about how
people think and about the ability of the tax authorities to get at the true
facts. In all probability, in practice, the test is that if there is sufficient
business justification for the trip, the deduction will be allowed.
ii. Question Presented
1. Rudolph v. United States
a. When purpose of trip is primarily personal in nature, rather than related
primarily to business, expenses for transportation, meals, and lodging are
not deductible as ―ordinary and necessary‖ business expenses under §162.
iii. Section 274
1. (a)(1)(A): Must be ―direct relationship‖ rather than ―primary purpose,‖ qualified
by ―associated with‖ language – i.e., there must be a direct relationship between
the expense and a business endeavor.
2. (n) – 50% cap (80% as of 1986) – we know how much fun it was, so meals and
entertainment associated with business are non-deductible for half of the amount
for whoever is picking up the tab.
3. (m)(3) – spouses’ travel expenses are generally not deductible.
a. If both spouses qualify, then it’s ok
4. (d) – substantiation
a. Credit cards have created a paper trail.
5. (h) – on conventions
a. The convention must be held within the country, or if it is outside, must
provide some justification.
b. Much higher burden on travel and convention outside of the country
(Caribbean basin = America for tax purposes)
6. (c) – limitation on foreign travel deductibility
iv. Business Lunches
1. Provisions Related to Business Lunches
a. §262 – personal expenses are not deductible, and meals are personal, and
262 disallow deductions fro personal expenses.
b. §119 – allows exclusion for meals on business premises
c. §162(a)(2) – allows deduction for meals while you are away from home
d. §162 – allows deduction for ordinary and necessary business expenses
e. §274(k) requires taxpayer presence, no extravagance
f. §274(n) – allows only fifty percent deduction.
2. Moss v. Commissioner
a. If one were able to show some systematic relationship between business
and the space, the deduction might’ve worked.
b. Meals are not deductible under §162(a) when they are ordinary and
necessary business expenses.
c. The reason for the denial of deduction is because the cost of the meals is
not included as income to those who received it.
3. §274(2)(c)(3) – suggests that obtaining a client’s good will is never sufficient
v. More on Entertaining Customers
1. Danville Plywood Corporation v. United States
a. To qualify as an ―ordinary and necessary‖ business expense under
§162(a), an expenditure must be common and accepted in the taxpayer’s
community, as well as appropriate for the development of the taxpayer’s
b. Elements of deductibility: relationship between deductibility and
d. Commuting Expenses
i. Commissioner v. Flowers
1. Travel expenses in pursuit of business within the meaning of §162(a)(2) can arise
only when the business forces the taxpayer to travel and to live temporarily at
some place other than his home, thereby advancing the interests of the business.
2. If it is the personal choice of the taxpayer to live at a different location than the
location of work, then he shall bear the cost of commuting to and from work.
ii. Hantzis v. Commissioner
1. For a taxpayer to be ―away from home in the pursuit of trade or business,‖ she
must establish the existence of some sort of business relation both to the location
she claims as ―home‖ and to the location of her temporary employment sufficient
to support a finding that her duplicative expenses are necessitated by business
2. Deduction only applies of the business exigencies require two abodes, and
taxpayer has business ties to both.
3. Temporary v. Indefinite
a. Costs are deductible where one is away from her job temporarily, but be
careful to distinguish temporary from indefinite – temporary jobs can last
no longer than a year under §162(a).
4. Minor Post Rule
a. If taxpayer has two widely separated posts or duty, the Service considers
the home of the taxpayer to be her Principal Business Post, and her other
post as her minor post. Taxpayer can deduct living expenses while at
minor post. Rev. Ru. 94-432.
5. General Rule
a. Commuting is not deductible, but going among places of business is
deductible. Rev. Ru. 94-47.
6. Moving Expenses - §217
a. If you pay them out of your own pocket, they are not MID, and they are
deductible. If new employer compensates you, then no includible income.
e. Clothing Expenses
i. Pevsner v. Commissioner
1. General rule limits deductibility to clothing required as a condition of
employment that is not generally adaptable to general usage. As long as the
clothing can be worn outside of employment, we’ll treat your decision to purchase
that clothing personal, even if it is a condition of employment.
2. Objective test to determine adaptability for general use:
a. Uniforms are not adaptable
f. Legal Expenses
i. United States v. Gilmore
1. The deductibility of legal fees depends upon the origin of the litigated claim
rather than upon the potential consequence of success or failure to the taxpayer’s
g. Expenses of Education
i. Reg. §1.162-5 adopted objective standard for determining whether cost of education may
be deducted as a business expense: deduction allowed when education ―maintains or
improves skills required by the individual in his employment or other trade or business,
OR if it ―meets the express requirements of the individual’s employer, or the
requirements of applicable law or regulations…‖
ii. Compare treatment of job search costs—deductible within industry, not deductible if you
seek to move to another industry.
iii. §274(m)(2) deals with travel as education. Travel is not educational simply because it’s
travel (responding in part to schoolteacher cases, but also educational tours for
1. Compare §274(h) on convention expenses: There must be a substantive program
to allow for a deduction
iv. Carroll v. Commissioner
1. The cost of education may be deducted as a business expense if there is a
sufficient relationship between such an education and the particular job skills
a. The cost of college education is personal and not a business expense.
v. Other Rules for Education
1. §274(m)(2) - Teacher’s argument
2. Compare to 274(h) - Conventions – constrained to deduct
3. §222 – allows immediate deduction for educational expenses even if your income
is below certain level
4. §§529 and 530 – not deductible but to put into tax free savings accounts for future
VI. Deductions for the Costs of Earning Income
i. §162(a) allows deduction of all ―ordinary and necessary‖ expenses incurred while
carrying on any trade or business.
1. The term ―necessary‖ is usually taken to mean anything appropriate or helpful in
earning income or carrying on any trade or business, and thus is generally an easy
requirement to satisfy.
2. The term ―ordinary‖ has proven to be more challenging. In order to be an
―ordinary‖ expense, it is not necessary for an expense to be habitual or normal, in
the sense that the same taxpayer will have to make them often. Rather, an
expense has to be common or accepted in a taxpayer’s trade or business, even
though for a specific taxpayer, the expense needs only to be made once. Expenses
will be deductible if they are closely or causally related to attempts to produce
income, or if they are common or frequent in the taxpayer’s industry.
ii. But §162(a) is qualified by §263(a) which requires capitalization of expenses related to
acquiring or improving an asset, even if they are paid or incurred while carrying on any
trade or business. It forbids the immediate deduction of ―capital expenditures‖ even if
they are ordinary and necessary business expenses.
1. The expenditures made to improve or acquire the asset, must be capitalized, or in
other words, recovered over the time in which the asset is expected to contribute
to the production of income.
iii. Note: §263(a) disallows current deduction for ―amount paid out for new buildings or for
permanent improvements or betterments made to increase the value of any property or
estate,‖ except amounts paid out for:
1. Development of mines or deposits
2. R&D: research and development;
3. Soil and water conservation;
4. Expenditures by farmer for fertilizer, etc;
b. Current Expenses v. Capital Expenditures
1. expensing - allowed to take an immediate deduction
a. Allowing an immediate deduction of an investment and then taxing the
return, is equivalent with all things held equal, to not allowing the
deduction but not taxing the income on the investment at all.
b. It also does not affect IRR (Internal Rate of Return)
2. capitalizing – deferring in some way the deduction; determining the projected
useful life of the asset that is produced or purchased, and spreading the acquisition
cost over that useful life using some method. If no useful life can be determined,
no recovery until the entire asset is disposed of or written off.
a. Straight Line – Divide the cost by the number of years of useful life, and
equal that amount each year recovered.
3. Depreciation and amortization
a. Intangible assets subject to amortization based on useful life and §197.
i. Sports teams
1. Sports teams used to be treated when they are purchased as
the K right to use the players’ services.
2. Today, the real vale is in the profit anticipated in TV
revenues, and that’s an indefinite asset, and hard to write
a. Half the cost over 5 years.
ii. Catch-All rule
1. For intangible rights that can’t be captured by IP or player
K where you can look at the useful life and come up with a
number, the backstop rule is 15 years.
b. Tangible assets subject to depreciation using Modified Accelerated Cost
Recovery System of §168 (MACRS)
i. The idea was to encourage the industrial base to reinvent itself by
allowing them rapid write-off. It is much faster than real economic
useful life of the equipment
ii. When you recover a capitalized expenditure, if it is intangible –
amortization, if it is tangible it is depreciation.
4. Research and Development
a. R&D costs are usually expensed under §174
i. Drug companies benefit the most from this because it takes many
tries to develop a successful product that will produce income,
which will come much later when the drug is finally produced.
Congress decided that the cost of the labs should be expensed
1. It’s administratively efficient – difficult to tell the
difference between whether you are simply inventing
something new, or modestly increasing your knowledge.
b. Not applicable to land or its improvements, except amortization and
depreciation used in improvement
c. Still limited by §469
5. Prepaid expenses
a. When you pay for something that will have a pay-off as soon as the next
year, but not this year
b. §461(g) – prepaid interest and point exception
i. you pay all the interest up-front, even though you make your cash
transaction now, the actual pay-out is immediate, you have to
spread it out over the life of the loan.
c. §461(h) – economic performance test
d. §464 – farm syndicates
i. you can take an immediate deduction, but if you are not a farmer,
you must wait until income comes into take the deduction.
ii. Encyclopedia Britannica v. Commissioner
1. Expenditures that can be unambiguously identified with specific capital assets are
not immediately deductible.
2. The rationale was that hiring outside help for a project makes it a long-term
capital asset, whereas when it is done in-house, hard to distinguish how much has
been spent on a particular project when you are just paying salaries.
3. Faura has been limited to situations where taxpayer creates a series of assets, and
not one distinct asset. Relied on Idaho Power instead – that recovery over the life
of the book was required. Idaho Power – capitalize a tractor that was used to
create something that delivers power, the tractor itself was not the asset created.
a. Idaho Power - You take the cost measured by depreciation deduction and
pour that into a new account, which is the power line account. So in
figuring out how much the power line cost, one would take into
consideration the wear and tear of the tractor and spread that out over the
power line’s useful life.
b. Faura – Posner’s conceptually wrong – but not §263A(h)
i. Special rule for freelance artists, allowing them to take immediate
deductions instead of capitalizing.
4. §263A – capitalize whenever possible the cost of self-produced property.
Requires capitalization of all costs directly and indirectly related to the production
of self-created assets.
a. Limited to real or personal property under §263A(b)(1)
i. Books, films and records are tangible property even though their
value is in the IP.
b. Treasury Reg. §1.263A-2(a)(2)(ii)
i. Even though in general IP is treated as distinct from the physical
embodiment. For this purpose, it is treated as tangible personal
property, as long as the IP is stored in a tangible medium.
iii. Revenue Ruling 85-82
1. Cost of seeds and seedlings can be expensed under Reg. 1.162-12. But this Rev.
Rul. deals with someone who purchases land after the crops have already been
planted, so that the person who planted the crops took this allowable deduction.
Held: Purchase price for land allocable to seeds and seedlings cannot be
expensed. General pattern of resisting a market in tax preferences. (Cabining
over conceptual coherence.)
a. Regs. 1.162-12 permits expensing of the costs of developing farms,
orchards, and ranches. Although this led to substantial amount of
investment by high-bracket people seeking tax shelters, many tax
avoidance possibilities have been foreclosed by the denial of deductions
for passive activity losses and by a requirement of capitalization of the
cost of property produced by a taxpayer. §§469 and 263A
iv. Note on Uniform Capitalization Rules (sec. 263A)
1. The cost of producing self-created assets, such as the in-house production of a
manuscript must be capitalized.
2. §263 – deals generally with the issue capitalization.
v. Note on the INDOPCO Decision
1. Legal and investment baking services associated with consummating merger must
be capitalized. Cannot measure benefits from merger directly. This decision
reflects the reality that merger benefit extends over time.
a. It is irrelevant that merger did not create a distinct separate asset. There is
a long term payoff, and the outlay has to be capitalized.
2. The test is to determine whether an outlay is to be capitalized is to see if it is
associated with a particular property, the more relation, the recovery ought to be
associated with whatever amortization scheme.
c. Repair and Maintenance Expenses
1. Repairs to assets are deductible as ordinary and necessary business expenses paid
or incurred during the taxable year, while improvements are not.
a. Generally – repairs are expenditures incurred for the purpose of keeping
an asset in an ordinary efficient operating condition. Improvements, on
the other hand, prong the life of the asset increases its value, or make it
adaptable to a different use.
2. How to treat ongoing maintaining expense associated with an asset?
a. Add to basis and then depreciate/amortize
i. Maintenance would go into the building basis and would be
recovered by the proper depreciation formula
b. Treat it as a current expense
i. Repair and Maintenance is not supposed to produce long-term
effects, just to keep things up to where they are suppose to be. If
there are no long term benefits, then should be no delay in the
accounting of the outlay.
ii. If we knew the effect of the outlay, then we can determine if it is
short-term or long-term.
3. Administrative problems in line drawing
a. Reg. 1.162-4 – incidental repairs neither materially add to the value nor
appreciably prolong its life. As compared to what? A world with no
4. Baseline Issue
a. Any repair and maintenance adds useful life compares to total neglect, and
the regulation presumes that total neglect is not the baseline, but the regs.
Do not tell us what the baseline is.
b. Maintenance – normal stuff you do, cleaning the floors, changing the oil in
c. Repair after an incident
i. If something bad happens, you fix it, in a sense you have improved
the value compared to when you didn’t fix it.
ii. Do we apply this test add value or prolong useful life – pre or post-
incident property. What’s implicit here is that when we ask
whether something is a deductible repair or capitalize
improvement, we ask is it responding to an incident, and if it’s
merely responding to an incident, then it’s repair
iii. What counts as incident?
1. physical changes only or changed perception of the
condition that already exists?
ii. Midland Empire Packing Co. v. Commissioner
1. Ordinary and Necessary
a. Ordinary – tax meaning – it needs to be capitalized.
i. Ordinary doesn’t mean everyday
ii. In this case, it only matters that the oil is kept out, although now
that the water is kept out too is an improvement, that’s not
2. Alternative of a loss deduction and the problem of realization
a. Until wealth is converted through realization, there is no taxable event.
b. Loss sustained in the current year and not loss realized in the current year.
c. To the extent that you have basis in the asset that’s damaged, you can
recover the basis at the time of the event, even though you don’t sell off
the underlying asset.
3. Regulatory Change
a. Different than physical intervention like the Midland case
i. Mt. Morris Drive-In Theatre Co. correct drainage in response to
1. Landscaping that doesn’t flood your neighbors as much as
before, it is seen as an improvement
2. From the point of the taxpayer, they are just trying to get
back to being legal again.
ii. Hotel Sulgrave v. Commissioner: add sprinkler to comply with fire
1. The argument is that they are trying to be in compliance
with the code, and that’s the baseline, so this is incidental
repair than improvement
2. The court treats this as an improvement even though it is
coerced by regulation
3. Not putting guests in so much danger as before
4. Changes made in property to comply with regulation are
seen as improvements and not repair
iii. Revenue Ruling 94-38
1. removing hazardous waste is a future benefit in the sense that you are improving
the property by getting rid of it.
a. If you created a separate asset, a new structure, the cost must be
b. Simply remediation, which is physical extensive, excavate contaminated
areas and replace with clean material there is an implicit assumption that
baseline isn’t hazardous, even though the taxpayer created the hazard.
2. Citation to Plainfield- Union Water Co. for use of pre-incident comparison
3. Policy Issue?
a. Private letter ruling on similar facts that came to a different outcome 2
i. Before remediation you had hazardous facility, you remove the
problem, that’s an improvement, being an improvement you must
iv. Rev. Rul. 2004-18
1. Nearly identical to the facts of 94-38 – creates a new wrinkle
a. Remediation costs doesn’t have to be capitalized under §263, but must be
added to product inventory under §263A.
2. Remediation associated with things that make inventory should be added to
inventory accounting – it should be treated the same as the cost of materials – and
recovery of the cost as soon as the product is sold. Not exactly capitalization, not
treating it as having a long-term useful life – it just may be on the shelf for a long
period of time when it is sold.
v. Norwest Corporation and Subsidiaries v. Commissioner
1. Removal of asbestos = remediation, whereas remodeling is an improvement.
a. The Court held that if you are doing it just as a repair then it is
remediation, and it is expensed, but since you are removing asbestos in the
context of a general overall improvement, then the cost of the repair is
absorbed in the cost of improvement.
2. Expense incurred as a plan of rehabilitation or improvement must be capitalized
even though the same expenses if incurred separate would be deductible.
d. Inventory Accounting
i. Inventory accounting – when business produce and sell stuff, there often is an interval
between production and sale, and we want to account for that somewhat. If you produce
everything in year zero, and sell everything in year 1, then production cost should be
deferred until year of sale, even if only 1 year difference.
ii. Strategy to take into account the fact that what you make today may not be sold until next
iii. The purpose of inventory accounting is to link the cost of producing merchandise to the
time of sale
1. Challenge – adapt to already established business practices and also limit choices
that taxpayers may otherwise have given the array of choices.
iv. Proper accounting is necessary step for determination of tax liability, especially if income
is produced, for instance, through the sale or production of assets. Therefore, inventory
accounting is required in every situation, except for farming, where the production,
purchase, or sale of merchandise is an income-producing factor.
v. §263A would have no impact on companies that sell out their inventory each year. Only
when you build up inventory, i.e., do not sell it within a year, will you be disallowed a
deduction for outlays, and instead required to capitalize expenses.
vi. Tied to accrual accounting
1. Cash method accounting – look at when the money leave and enter into your
hands. We book expenses and receipts when they come due and not when they
are actually paid.
2. Inventory accounting requires taxpayers to use exactly the same method for tax
purposes as for your financial accounting purposes.
vii. When a taxpayer builds up inventory, he must choose between the LIFO and FIFO
methods of recovering costs—cannot simply deduct costs of adding to inventory.
viii. The basic formula for tax liability is:
1. Gross profit (income) is Gross receipts MINUS cost of goods sold PLUS change
in inventory value (i.e. difference between starting value of inventory and ending
value—end of year).
ix. Inventory value is typically cost-based, and can be FIFO (first in first out) or LIFO (last
in first out).
1. FIFO is the default – assumes that you sell your oldest stuff first. FIFO will
minimize cost and maximize profit and maximize income tax liability
2. LIFO is friendlier to taxpayers in a world of steadily rising costs, because the
more recent inventory additions generally cost more than additions from an earlier
3. Some companies will not use LIFO because it gives the appearance of devaluing
inventories—which does not look good to investors. (Stephan thinks this is not
true, but it is an explanation for not using LIFO.)
e. Rent Payment versus Installment Purchase
i. Starr’s Estate v. Commissioner
1. Sale leasebacks –
a. This is where the owner of the building will sell it to the buyer, and the
buyer will lease the building back to the seller. The buyer pays off the
interest every year in the same amount as the rent is due from seller to
buyer, and at the end, the buyer will walk away from the transaction once
depreciation deductions have been used up.
b. The service will look at the substance rather than the form of transaction,
because too much transactional freedom will allow parties to game the
2. Sprinklers were leased for five years at $1240/year with an option to extend at a
a. The court viewed this not as a lease, but rather an install payment of the
cost of installing the sprinklers and the sprinkler system. Therefore the
court recharacterized the transaction as a sale.
b. Since there is deferred payment, there is interest – the taxpayer chose this
method because they got to deduct sooner as rent rather than deducting
interest over a period of time.
f. Goodwill and Other Assets
i. When you buy a business, the difference between the value of tangible property and what
you actually paid is goodwill
1. you can recover the outlay of the goodwill over 15 years – the process is
2. Advertising outlays can be expensed where as self-generated goodwill expenses
cannot be. Regs. §1.263A-1(e)(iii)(A).
3. §197 – distinguishes between acquired and self-created goodwill
a. You can only recover the cost of self-created goodwill after you sell the
ii. Welch v. Helvering
1. Although much of this opinion is framed in terms of the §162 ―ordinary and
necessary‖ requirement, the strongest rationale for the holding of in this case is
that amounts paid by the taxpayer had to be capitalized because repayment of the
discharged debts produced benefits to the taxpayer that extended beyond the year
in which the payments were made. The taxpayer’s expenditures were for
1. a lawyer could not amortize the cost of a legal education or for a bar preparation
course (§167) but could amortize registration, test and bar admission fees over his
iv. Job Search Costs
1. the costs are either immediately deductible, or never deductible
a. moving around within a given profession is just like repair and
maintenance, while leaping into a new field is a start-up cost
b. Search cost of 1st job is not deductible, but moving around in one field is
deductible – and defining what a field is simply arbitrary
g. Ordinary and Necessary
1. The U.S. and other modern capitalist societies generally construe ―necessary‖ in
subjective terms, i.e. the business judgment of businesspeople. Courts are often
reluctant to question the business judgment of a taxpayer, therefore, taxpayers are
permitted to deduct business expenditures even if they appear unusual and
2. But there are some public policy limitations on deductions:
a. ―Unreasonable salaries‖—really substance-over-form issues. §162
i. Salaries considered unreasonable (because ―salary‖ is really a
payment) may be denied deductions. Most common situation
which gives rise to a denial for ―unreasonable‖ salary deductions
happens in the context of closely held corporations, where salaries
are in fact a nondeductible dividend or ―disguised dividend.‖
ii. Corporations may not deduct more than $1M a year in pay to a
CEO or any of its four highest paid employees. §162(m)
b. §162 limitations: 1969 and 1982 amendments
i. §162(c)—denies deductions for illegal payments to government
officials, other illegal payments, Medicare and Medicaid kickbacks
(which are not criminal)
ii. §162(f)—fines and penalties are not deductible, even if there is a
clear business purpose.
iii. §162(g)—punitive portion of treble damages under antitrust laws
are not deductible.
ii. Extraordinary Behavior
1. Gilliam v. Commissioner
a. Cost of criminal defense and settlement of intentional tort is not
iii. Reasonable Compensation
1. §162(a)(1) – expressly provide for the deduction of a reasonable allowance for
salaries or other compensation for personal services actually rendered.
a. Originally enacted to allow business who were not paying salaries to take
an offset against their income when they are in a war-profit stance.
b. It was a pro-taxpayer rule to allow taxpayer to reduce their taxable
income, it reads as if it is a limit on the deduction rather than authorizing
the deduction that’s not allowed.
2. §162(m) – CEO compensation can’t exceed $1 million by public company in
performance, but very few restrictions on what counts as performance.
iv. Costs of Illegal or Unethical Activities
1. Pre-1970 judicial doctrine – before 1970 the courts, generally relying on the
ordinary and necessary language of §162(a) – disallowed deductions whose
allowance, it was thought or assumed would frustrate public policy.
a. Tank Truck Rentals
i. Fines paid by a trucking company for violations of state maximum-
weight laws are non-deductible
i. Permitted the deduction of the rent and wages paid in operating an
illegal bookmaking establishment, even though the payment of the
rent itself was an illegal act under state law.
i. Only where the allowance of a deduction would frustrate sharply
defined national or state policies proscribing particular types of
conduct have we upheld its disallowance.
2. The tax reform Act of 1969 amendments to §162
a. §162(c) – covers bribes and kickbacks
i. §162(c)(1) prohibits the deduction of any illegal bribe or kickback
to a government employee and bribes or kickbacks to employees of
foreign government if it is illegal under the Foreign Corrupt
Practices Act of 1977.
ii. §162(c)(2) covers illegal payments to people other than
government employees, but only if the law is generally enforced
iii. §162(c)(3) disallows deductions for kickbacks, rebates or bribes by
physicians, suppliers, and other providers of services or goods in
connection with Medicare or Meidcaid, regardless of whether the
payment is illegal.
i. Prohibits deduction of any fine or similar penalty paid to a
government for violation of any law.
i. disallows deductions for the punitive two-thirds portion of
damages paid for criminal violations of the antitrust provisions
found in the Clayton Act.
d. §280E – drug enterprises
i. overrules the tax court’s decision- allows the cost of running a
drug business to be deducted. Drug dealers can recover sales
income the cost of the drugs sold, but no other expenses.
3. Stephens v. Commissioner
a. Court ordered restitution as part of sentencing (involuntary repayment of
embezzled funds in lieu of jail time) was treated under §162(f) and thus
not deductible because it is considered a fine/penalty (sanction?).
b. This case deals with the relationship between §162 and §165
i. §162 – allows deduction of ordinary and necessary expenses
associated with a trade or business
ii. §165 – losses sustained in the tax year are deductible if it arises out
of trade or business.
c. If you make restitution before sentencing, you get a deduction, but if you
wait for the judge tot ell you, then you lose the deduction.
h. Depreciation and the Investment Credit
i. General Principles
1. The Basic Idea – the economic or accounting concept underlying the allowance
for depreciation is that there should be an offset against revenues for the cost of
wasting assets that are used for the production of those revenues, but have a life
extending beyond the current tax year.
a. The full cost should not be treated as a cost of earning income in the year
of purchase, since the tractor will have a substantial value at the end of
2. Economic depreciation and economic incentives - Economically accurate method
for allocating the cost of the tractor, or any other asset, would be to treat as a cost
of each year’s operations the difference between the value of the asset at the
beginning of the year and the value at the end of the year. The provisions are
designed to overstate the decline in value of business property, and, in so doing,
understate taxable income
3. The building blocks of depreciation rules
a. The determination of useful life
i. 10% of the upfront cost of equipment is paid by the government in
a form of a tax credit.
b. Taking account of salvage value
i. Salvage value is disregarded (presumed to be 0) under MACRS
c. The application of a method of allocating the cost, in excess of salvage
value, over the useful life.
i. Straightline – where equal portions of the total cost of the asset are
allocated each year
ii. Declining balance method – the straightline percentage is
determined and then this percentage is increased by a specified
factor. The resulting percentage is applied to the cost of the asset
reduced by the amounts previously deducted.
iii. Decelerated method or sinking fund method – deductions taken are
lower in the early life of an asset
iv. Income forecast method – the current year’s depreciation
deduction is derived from a projection of future income –
specifically that portion of basis equal to a fraction of which the
numerator is the current year’s income and the denominator is the
estimated total income to be derived from the asset for its entire
4. Rapid amortization and current deduction
a. Code allows rapid amortization for certain investments and current
deductions for various other investments.
5. The first year of service
a. Applicable convention
6. Basis and gain or loss on disposition – deduction for depreciation or cost
recovery, results, for tax purposes, in a reduction of basis. In fact, the basis is
reduced if depreciation is allowable, even if the deduction is not taken.
7. Recapture – when a business asset is disposed of, any gain is treated as capital
gain, but the depreciation deduction is an offset of ordinary income.
8. Investment Tax Credit – depreciation deduction has been supplemented from time
to time, by a series of investment tax credits. An investment tax credit gives a
taxpayer a one-time credit upon purchase of a qualifying asset.
iii. Basic rules
1. Recovery Period – stated directly in the statute
2. Personal Property: Basic Recovery Period – recovery periods for 6 different
classes of property
3. Personal property
a. 200% declining balance for three-, five-, seven-, and ten-year property and
150% for fifteen-and 20-year property, shifting to straightline when that
produces larger deductions
b. Taxpayer has the option of using certain recovery periods and methods
that tend to delay deductions
4. Real Property
a. Recovery period – 27.5 years for residential rental property and 39 years
for other real property
b. Basic method – strightline. First year applicable convention is that the
full-year deduction is prorated according to the number of months during
which the property is in service during the year.
c. Optional recover periods and methods – taxpayer must use optional longer
a. Generally, when a business asset is disposed of, any gain is treated as
capital gain. But since depreciation deductions offset ordinary income,
Code established different rules for situations in which a depreciation
deduction has been taken, so that upon sale, gain must be characterized as
either ordinary income or capital gain. The recapture rule transforms
capital gain, which can e offset by capital losses, into ordinary gain, which
cannot be offset by capital losses.
i. Recapture gain is not eligible for the installment method. §453(i)
ii. The amount of recapture gain reduces the amount of the deduction
in the area of a gift of property to a charity. §170(e).
iii. Deductions are subtracted from original basis. Note that since
depreciation deductions offset ordinary income, the taxpayer
benefits from capital gains preferences to the extent that the Code
allows for characterization as capital gains. See §§ 1245, 1250 on
iv. §1245, applying to personal property, allows for full recapture.
Provision establishes that any gain on disposition of personal
property is treated as ordinary income to the extent of prior
deductions for depreciation (symmetry, but still deferral
v. §1250, applying to real property, allows for recapture of amount of
depreciation in excess of straight-line to be recaptured. BUT, note
that for real property acquired since 1986, only straight-line
depreciation is allowed, making this provision moot. §168(b)(3)
iv. Goodwill and Other Intangibles
a. Applies to intangibles, whether purchased or self-created – fifteen year
b. Inapplicable to self-created intangibles that are not licenses covenants not
to compete, or trademarks.
i. Depletion and Intangible Drilling Costs
i. Cost and percentage depletion –
1. Originally, the deduction was based on the cost of the property being depleted,
and cost depletion is still authorized under §611.
2. Second method – percentage depletion – ignores both the taxpayer’s cost and the
number of recoverable units. Instead, the taxpayer is permitted to deduct a given
percentage of gross income as a depletion allowance. Avoids the problem in cost
depletion of estimating the number of recoverable units in the deposit.
ii. Percentage Depletion Rates – the percentage of annual gross income that may be
deducted as depletion ranges from 22% for certain minerals to 5% for other minerals.
iii. The concept of economic interest in the depletable mineral
1. to have an economic interest, the taxpayer must have acquired an interest in the
mineral in place and must look only to the mineral for return of his or her capital.
iv. Income subject to percentage depletion
1. The appropriate percentage depletion rate for a mineral is applied to the gross
income from mining to determine the taxpayer’s percentage depletion deduction.
v. Limits on percentage depletion - §613 limits the percentage depletion deduction to 50%
of the taxable income from the property.
vi. Intangible drilling costs
1. §263(c) allows taxpayers that develop an oil, gas, or geothermal deposit to deduct
as current expenses the intangible and development costs.
2. These costs include materials that are used up in the drilling or development
process and labor. Regs §1.612-4
3. dramatic exception to the general rule that the costs of acquiring a capital asset
must be treated as a capital expenditure; it is an important element in the
economics of the extractive industries and in tax-shelter planning.
4. Percentage depletion is particularly beneficial to taxpayers that take advantage of
vii. Foreign natural resources interest – while the tax benefits provided the natural resource
industries are often justified on the ground that they stimulate increased supplies of such
resources in the United States, the benefit in the past normally applied to foreign
j. Legitimate Tax Reduction, Tax Avoidance, and Tax Shelters
i. Definition of Tax Shelter
1. describes an investment that is unrelated to a taxpayer’s trade, business or normal
investments, that is certain to produce a tax loss though not expected to produce
an economic loss.
2. Many tax shelters were based on financial investments, that allowed an individual
to borrow money to buy a deferred annuity that provided a lower percent of return
than the interest on the loan. Although it would seem like a loss, the interest on
the loan would be currently deductible and the percentage on the return would not
be taxed until the payments on the annuity began.
ii. Tax Shelter Problem
1. Elements of a Tax Shelter
a. Deferral – take deduction now for income that will be taxed later
b. Conversion – take deduction against ordinary income, bring back income
in the form of capital gains.
2. The goal is to create a transaction that is economically a wash with no gain, but
produces income tax benefits
iii. The Judicial Response to Tax Shelters
1. Knetsch v. United States
a. Sham Transaction Doctrine
i. Sham means that a transaction is undertaken that is solely
motivated by its tax attributes.
ii. Congress had taken away deduction for interest on annuity Ks in
1953; the Court was simply applying this retroactively under the
sham transaction doctrine.
b. Retroactivity issue concerning §264(a)(2)
i. The transaction is a façade for tax law purposes and it was not a
profit seeking activity.
ii. Statutorily fixed by §264(a)(2)
c. Goldstein v. Commissioner
i. The court disallowed the interest deductions for 1958. It argued
that absent tax consequences, no taxpayer would borrow at 4% to
buy an investment that yields 1.5%. Scheme was devised to
reduce tax liability after winning Irish sweepstakes.
ii. In light of the strong tax avoidance motive and the lack of other
business motivation for the transaction, the court concluded that
the interest was not deductible under §163.
iii. Statutory Fix - §163(d)
1. limited investment interest deduction to income (big basket
d. The IRS will invoke the sham transactions doctrine when the sole purpose
of the transaction is naked – devoid of anything other than conversion,
deferral and deflection.
2. Estate of Franklin v. Commissioner
a. Sale leaseback scheme
i. 9th cir. rejects the Option analysis, and instead insist that the debt
must exist and not potentially exist.
ii. The amount at risk is insignificant because the debt is so much
greater than the underlying asset.
b. Statutorily Fixed by §§465 and 469
i. In order for a loan to count as your acquisition cost, you have to be
at risk – either putting up cash or collateral other than the property
you are buying.
ii. Must pass the time-sheet test. Otherwise it is a passive activity,
and you are basketed.
iv. The Congressional response to Tax Shelter
1. Special statutory rules
a. Penalties on promoters of tax shelters for gross overvaluation and false
b. New ―substantial understatement‖ (10%) penalty—thus it became riskier
to understate income. This penalty can be defeated if you prove that your
position was based on substantial authority, as in an opinion letter.
c. Registration requirement added in 1984—which includes a list of
customers for the tax shelter. This results in an almost automatic audit,
reducing incentives to tax great risks with these shelters.
d. Basketing rules: e.g., passive activity loss rules, etc.
2. Passive Activity Losses:
a. Added in 1986, the high water mark of efforts against artificial tax losses.
b. Trade or business in which taxpayer does not materially participate. Form
is business, but ―owner‖ is not an ―operator‖ (not involved in ―regular,
continuous, and substantial‖ activity with the business).
c. Portfolio investment is not passive activity.
d. Rentals and limited partnerships are per se passive activities, with
exceptions in §469.
e. Net effect of §469 is to limit PA deductions and losses to PA income.
3. Modifications of Interest Deduction:
a. Barring some minor exceptions, interest on anything was deductible. This
changed in 1986, allowing only deduction for interest on home.
b. §163(d) limits the deductibility of investment interest to net investment
c. There is unlimited carry forward.
d. Deductible against capital gains only if taxpayer foregoes capital gain
e. §§ 264 and 265 completely disallow certain interest expenses associated
with tax-free or deferred financial instruments.
f. Keep in mind tracing problems (administrative problems) in tracing the
uses for which loan proceeds are used.
4. At-risk Investments:
a. §465: enacted ’76, extended ’86.
b. ―Funny money doesn’t count‖: if the money invested in an activity is not
money for which you are personally liable (nonrecourse), that investment
doesn’t count. Thus, no depreciation allowance.
c. There is a per-investment limitation, with deductions subject to a ceiling
of at-risk investment. This is not ―basketed‖ with all at-risk investments,
but rather treated investment-by-investment (project-by-project).
d. Some exceptions for real estate (bank loan secured by real estate—if a
bank is willing to lend money, we’re willing to consider the loan ―real‖).
This may be applied to other loans secured with other property (stock,
etc.). The ultimate criterion is whether there is an economic risk to which
you are exposed.
v. Sale and Leaseback Transactions
1. Mixture of motives
a. One looks at – and if the two elements are met, then the form is accepted.:
i. Amount of risk exposure on the part of the nominal owner
ii. Triangular versus bilateral
vi. Rules Aimed at the Tax Lawyer
1. Lawyers provide certain amount of immunity to clients, and the new reg requires
specificity, a story as to why it is structure in such a way other than it’ll be a tax
vii. The Alternative Minimum tax
a. The AMT was enacted to make sure that the powerful or privileged pay
some significant tax on their economic incomes despite the continued
availability of tax-exempt income sources. The AMT was established as a
second tax system – one that defines income base more broadly than the
regular tax system, but then applies a lower rate of tax to that broadened
b. Taxpayer is required to calculate their regular tax liability and the AMT
liability and compare the two, and will have to pay whichever one is
greater. Taxpayers are still benefit from the use of such preferences for
regular tax purposes, but the benefit is limited because the minimum tax
that the taxpayer must pay.
c. §55(b) – applies 26% as the tax rate on the first $175K of alternative
minimum taxable income above a so-called exemption amount and 28%
on AMTI over $175K.
d. The minimum tax base equals the regular tax base increased by the add-
back of certain designated preference items. Where individuals are
concerned, the latter include: the excess of depreciation on real property
under normal ACRS rules over the amount that would result using a 40-
year life for such property; the excess of ACRS depreciation on business
equipment, which entails use of the double declining blanace method, over
the allowance determined uner 150% declining balance and longer useful
lives; the benefit of the installment and certain other long-term methods of
accounting; and incentive stock option gains.
e. Personal exemptions and certain itemized expenses, including misc.
expenses and state and local taxes are disallowed for AMT purposes.
f. AMT does not reflect the number of children in the family, and so has
been reaching middle class taxpayers.
2. Klaasen v. Commissioner
a. The reason the taxpayer fell into the AMT category is because they were
not allowed to deduct expenses for their children, and the court took a
literal reading instead of an interpretive reading of the statute.
3. Prosman v. Commissioner
a. Failure of employer to reimburse travel expenses, and refusing to label it
as reimbursement, and instead insisted on labeling it as salary.
viii. The New Market in Corporate Tax Shelter
1. Winn-Dixie Stores, Inc. v. Commissioner
a. Employees that are responsible for the value of the firm – firm has an
insurable interest on these people, and the code allows interest on loans to
pay the premiums to be deductible
VII. The Splitting of Income
a. Splitting income is spreading the income around to other people or entities so that the total
income may reap the tax benefits of more than one rate at the bottom of the income tax rate
b. Income from Services: Diversion by Private Agreement
i. Lucas v. Earl
1. Basic Principle – compensation is taxed to the earner even if it is someone other
than the earner that has a complete legal right to the compensation. No matter if
that legal right has been established by express private agreement of assignment.
2. Doctrine of constructive receipt – can’t make anticipatory arrangements to escape
3. The assignment of unearned wages is ineffective under the federal income tax to
shift income to the assignee, whatever its effect as a matter of ordinary K law.
The intent of the statute was to tax salaries to those who earned them.
c. Income from Services: Diversion by Operation of Law
i. Poe v. Seaborn
1. Instead of a K to assign income, they lived in a community property state which
gave husband the right of management but held him accountable to his wife.
ii. The Court held that local law was effective for federal tax purposes and sustained the
taxpayer in reporting only half the salary and property income in his return. The earnings
were never the property of the husband, but that of the community.
d. The Marriage Penalty (and bonus)
i. The legislative solution: Partial Income Splitting
1. Congress enacted legislation allowing joint returns and new rates to remove the
disparate tax treatment of married couples in community property and common
law states. They were all given the right to split their income. Single taxpayers
therefore paid higher taxes at equal income levels.
2. Bonus for single wage earners but penalty for 2 wage earners.
3. Years later, Congress changed the rate schedule for single persons and reduced
the rate for them, so it is no longer super beneficial for married couples
ii. Proposals to Eliminate the Marriage Penalty
1. Could be eliminated by going back to the system that allowed all married couples
to split their income, ro adopting a rate structure that had the same effect.
2. Or by going back to the system that existed in common-law property states before
1948, with each individual taxed his or her own income.
e. Transfers of Property and Income from Property
i. Income from property is generally taxed to the owner of the property. Taxpayer may not
avoid taxation by assigning income derived from property unless the taxpayer also
assigns the property
ii. For children under 14 – the income is thrown back to the parents
iii. If the former owner is also now the source of the income by renting the property – then if
the rent is FMV then it is ok. You can’t ignore the form of transaction, even though what
you are doing is to shift income to a child.
iv. Blair v. Commissioner
1. The assignment of his future income from the trust to his children was valid under
a. If there is a valid, unconditional assignment of beneficial interest, the
assignee becomes the beneficiary and is then taxable for the income the
she receives. He assigned the portion of the right that he had (the right to
receive income from trust). Because the assignments were valid, the
assignee became the owner of the specified beneficial interest in the
income. The assignees, not Blair, were taxable on the income rec’d from
b. Principle that property law dictates tax outcomes. The interest in the trust
becomes the underlying property.
v. Helvering v. Horst
1. Negotiable bonds are the property, while the bond coupons are the proceeds or
interest from the property. The interest coupons were not assignable for tax
2. Assigning the income from property is no different than assigning salary.
vi. Distinction between Blair and Horst
1. If you are going to divide the interest, you have to give the all of the income or
the same percentage of income for the entire life of the interest.
a. Bondholder has no control over the company
3. In Blair, the retained interest is declining over time, but Horst’s interest increases
in value as it gets closer to maturity date, because the coupons are gone, but he
now is whole again.
vii. Theory that Blair and Horst are Congruent with each other
1. Hedonistic Consumption Argument
a. We tax Horst because it feels good to give
2. Accured income argument
a. Horst, when he parts from the coupons retains a remainder interest.
b. Simply by the passage of time, the reversion increases in value, and
therefore tax the person with the retained interest instead of the person
whose interest’s coming to an end. To buy the income attribution between
the coupon holder and bond holder – we go with the person with
reversionary interest even though cash is going somewhere else
3. Control of the source of the income
a. Argument comes from Income taxation of trust.
VIII. Capital Gains and Losses
b. Statutory Framework
i. Capital Gain or loss arises from the sale or exchange of capital asset.
1. Capital Asset is defined in §1221 as all property with five listed exceptions:
a. Inventory §1221(a)(1)
i. The product that they sell is not investment, there fore the sale of
those products are not considered capital.
b. Creator’s Property §1221(a)(3)
i. Particularly IP – it is treated as if the author/artist was selling a
service instead of selling property, and therefore not considered
c. Account Receivables §1221(a)(4)
i. You can sell your account receivable, but we’re going to treat it
more as inventory and not as capital gains property
d. Congressional Records §1221(a)(5)
i. You can’t deduct something that you get for free
e. Section 1231 Property – coextensive of 1221(a)(2) property
i. §1231 applied to the gains from the sale of these preferred property
the capital gains preference
ii. §1221(a)(2) applied to the loss of things and treated them as
iii. §1250 - §1231 capital gain isn’t really capital gain if there are old
iv. The property must be tangible real property
2. Dividend is treated with the same capital gains preference but not interest.
3. Capital losses can only offset $3000 of ordinary income each year, and it can be
forwarded into future years. Otherwise it can be used to offset capital gains.
ii. Sale or Exchange
1. Unpaid Debts
a. If the debt arises in a trade or business it is considered ordinary loss,
otherwise it is a capital loss, even though you are writing off the debt
instead of selling it at a discount
2. Retired Assets
a. Usually covered under §1221(a)(2) – in a trade or business you don’t’ care
if you have sale/exchange. Industrial property is not a capital asset –
sometimes it is not covered by (a)(2) or if one’s holding the property as an
investment instead of trade/business
b. If the asset is seized by a collector, probably an exchange and a loss which
is a capital loss
3. Worthless Securities
4. Financial Instrument versus trade debt
a. Receivable that in fact don’t get received, if you hold the financial
instrument and you’re a trade or business, then loss is ordinary loss, if it is
investment then capital loss
5. §1241 – lease cancellation payments
6. Damages in Lawsuits
a. Business is injured and can treat the business tort analogous to a sale, and
you can argue that what you sold is an asset subject to goodwill
i. Rationale for Favorable Treatment of Capital Gain
a. Income appreciate overtime, but taxed in the year of realization, and that
can bump you up to a higher rate, and the preference will help to tax at a
lower rate if realized ratably during the entire period of ownership of an
a. A tax on capital gains tends to induce people to hold assets instead of
selling and reinvest the proceeds. Some supporters of the preference state
that the lock-in effect is so strong that a reduction in tax rates would
encourage more sales.
a. No longer a real big issue.
b. It’s only a concern for assets held for the shortest period of time.
4. Promote Investment
6. corporate Tax integration
a. 2-tier system
ii. Rationale for the Limitation on the Deduction of Capital Losses
1. Capital losses ought to be treated differently than regular losses because of the
realization requirement – an assumption that taxpayer has some control – buffered
by economic reality –but some control over the timing of when to take their loss
deduction – we want to counteract it.
2. §1211 – since people have control over the time to offset more than the capital
gain in that year, there is a limit on how much capital loss can be offset against