INTRODUCTION
TAX LAW V. TAX POLICY
Tax policy
[2-4]
Tax policy topics
 Size and structure of government
 Who/what levies and collects taxes?
 How much to tax?
 What to tax?
o Tax base: what is being taxed (mostly income for our purposes)
 Behavioral responses to taxes
 Deficits/surpluses
Tax gap
 Amount of taxes that should be collected under the current law versus the amount of taxes actually collected
o The tax gap has a negative effect on taxpayer morale
Tax expenditures
 Congress uses the IRC to disguise spending as taxes
o Expenditures operate like subsidies
Efficiency
 What does efficiency actually mean?
Incidences
 Disguising a tax on one person as a tax on another
Tax law
[4-8]
 Most of tax law is civil rather than criminal because the mens rea in tax cases is even hard to prove than in regular
criminal cases
Sources of tax law
 The Code
 Treasury Regulations
o Not law, but very, very persuasive authority
 Revenue Ruling
o Similar to a judicial opinion with hypothetical facts
o Essentially advisory opinions
o Helpful and persuasive, but not as much as the Regs.
 Private Letter Rulings
o Involves real facts
o Helpful and persuasive, but not as much as the Regs.
 Common law
Tax litigation
 Tax payer has three forums to chose from in bringing his case:
o Tax Court (national)
 Appeal as of right is in Court of Appeal for Taxpayer’s residence
1

If IRS is reversed in say the 4th Circuit, the only consequence is that it cannot no longer employ that
argument which they were trying to advance in the 4th Circuit. The argument is still valid in other
Circuits where it has not been shot down.
 Precedent is only set for people coming from that specific Circuit.
o District Courts
 Appeal as of right is in Court of Appeal for Taxpayer’s residence
 Same as Tax Court
o Court of Claims
 Appeal as of right is in the Federal Circuit
o …everything goes to the US Supreme Court
LEGAL ETHICS AND TAX ETHICS
 Tax evasion v. tax avoidance
o Evasion…you are on the illegal side of aggressiveness
o Avoidance…you are on the legal side of aggressiveness
[8]
AVERAGE AND MARGINAL TAX RATES
[9-11]
Terminology
 Average tax rate = total tax/total income
 Marginal tax rate = percent of next dollar of income that is taxed
 Progressive tax = tax rate rises as income rises
 Regressive tax = tax rate falls as income rises
 Proportional tax = tax rate is constant as income rises
 Zero bracket = amount of money which the federal government does not tax
Ways to get progressivity
 Zero bracket/single rate income tax
 Tax brackets
o 1: brackets
 1(f): Brackets are updated for inflation
 In determining tax liability, refer to Rev. Proc. (p.636-638 (Bank))
Calculation
 Gross income =
 Taxable income = Gross income – (Deductions + Exemptions)
o Deductions
 Above-the-line
 Below-the-line
 63(c)(2): standard deduction (p.638 (Bank)) OR
o married individuals filing jointly and surviving spouses: 11,600
o heads of households: 8,500
o unmarried individuals (other than surviving spouses and heads of households): 5,800
o married individuals filing separate returns: 5,800
 63(d): itemized deductions
o Exemptions
 151(d): personal exemption (p.636 (Bank))
 $3,700
 Tax = (.1 x 17,000) + (.15 x [69,000 – 17,000]) + (.25 x [139,350 – 69,000]) + (.28 x [212,300 – 139,350]) + (.33 x
[379,150 – 212,300]) + (.35 x [? – 379,150])
o 1,700 + 7,800 + 17,587.50 + 20,426 + 55,060.50 + ?
2



o Example of someone with a TI beyond the last bracket
MTR = 35%
o percent of next dollar of income that is taxed
ATR =
o Total tax/total income
More hypos (p.9-10 (Notes))
IMPLICIT TAXES
 Taxable bonds v. municipal bonds
[11]
WHAT IS INCOME?
DEFINING INCOME
[12-13]
Important terminology
 Stock variable: value is defined meaningfully without the passage of time
 Full variable: value is defined meaningfully only with respect to the passage of time
o There has to be a unit of time attached
 Income is a full variable
o High wealth individuals often have high incomes
o When we are talking about income, we are not talking about wealth
 Income refers to the flow of money into someone’s account over a period of time, usually a year
Haig Simons (HS) income
 Y (income) = FMVc (fair market value of consumption) – ∆NW (change in net worth [wealth])
o Consumption is a full variable
o Net worth is a stock variable
 Y = C (consumption) + S (saving)
 In order to measure income in all of its forms, we have to measure everything spent plus change in your net
worth
 Real world problems with HS…they don’t create exceptions, but “holes in the cheese”
o (1) Realization v. Accrual
 Accrual…you have gotten wealthier
 Realization…you have turned that wealth into cash
 If we focus on the realization of income, we are not really taxing the person’s change in net
worth, but rather how much they cashed out
o (2) Imputed income
 Things that have fair market values that you have received or consumed, but do not consider taxable
o (3) Below-market sales
 Paying a different price for the same product
 This skews the FMVc variable
o (4) Leisure
 Leisure is often described as a consumption choice
 Its never in actually included though
o (5) Valuation
 Often difficult to determine fair market value
 How do you determine the FMV?
 1.61-2(d)(1): if the services are rendered at a stipulated price, such price will be presumed
to be the fair market value of the compensation received in the absence of evidence to the
contrary
Defining income
3



61: gross income is all income from whatever source derived
o The broadest measure of income that we can impose
 Assume it is income unless the Code says otherwise
Important considerations
o Substance dominates form
o Under policy concerns
 Vertical equity
 Consider whether the thing we are looking at enhances the person’s ability to pay taxes?
o If yes, then it is probably income
 Taxes paid should increase with the amount of income earned
 Horizontal equity
 Two people who are substantially equal should pay the same taxes
 Whether something is earned by windfall or labor, it should be taxed the same
Many things are excluded from TI as matters of custom
o Imputed income
 Almost never taxed
o Some, but not all, below market sales
 You have know the common law to know which below market sales are taxed
o Leisure
OLD COLONY AND GROSSING UP
[13-14]
Old Colony
 Held that an employer’s payment of federal income taxes on behalf of its employee constituted income to the
employee
Grossing up
o Due to withholding, it is now routine for an employer to make federal (along with state and local) tax payments on
the employee’s behalf, and yet for these payments to be included in the employee’s gross income
o Calculation (p., 117-118 (Notes))
 G = Gross Pay (employer controlled); N = Net Pay (target); t = marginal tax rate
 Here, G = ? ; N = 80k; t = 0.2
 N = G – t(G)
 N = (1-t)G
 G= N/(1-t) = 80,000/(.8) = 100,000
o Checking your answer
 G – (G x t) = N
o Caveat in calculation
 If the gross up will send you into the next tax bracket, using the higher tax rate for it will provide you with
maximum amount necessary for grossing up
NONCASH BENEFITS
Introduction


[14-15]
Includes fringe benefits
Why should we tax fringe benefits?
o (1) Horizontal equity
 However, in practice, some noncash benefits get taxed and other don’t
 It really quite arbitrary
o (2) It would be unfair for those whose bosses don’t play along
o (3) Behavior would change in perverse ways if we didn’t
4


Employers and employees would both have an incentive to reduce the cash portion of their salaries
for the sole reason of reducing tax liability
 You would not want to run a system in that way that taxes changed peoples’ behaviors
Concerns about a slippery slope with regards to fringe benefits
o Everyone is going to want their benefit to be and remain tax free
Meals and lodging provided to employee
[14-19]
Beneglia (BTA 1937)
 Room and board provided to an employee is excluded from their income, and therefore not taxable, if its provide
for the convenience of his employer
o Here, room and board were provided for the convenience of the employer
o NB finds the rule and holding wrong
 But, NB suggests that the majority correctly limited the opportunity for collusion between the
employer and the employee under the COE test by shifting the burden of proof away from the
Service and onto them
 Valuation
o If dissent prevailed and room and board was TI, valuation is done by calculating the FMV of what the
employee received
119: codification of a variation of the “convenience of employer” test
 Meals and lodging furnished to employee, his spouse, and his dependants, pursuant to employment
o (a)(1): Meals shall be excluded from income only if furnished on business premises (not the fanciest
restaurant in town)
 (b)(4): Meals must be furnished to at least half of the employees for the meals to meet the
convenience of the employer standard
 egalitarian provision
 geared at preventing special treatment
 “furnished”
 Kowalski (US SC 1977)
o Meal allowance payments to state highway patrol troopers were not excludable under
119 due to failure to satisfy the “furnished” requirement. Thus, in effect, to meet the
terms of the statute, the state would need to open its own version of McDonald’s and
Pizza Hut at various convenient points along the highway, rather than relying on the
private sector to supply its troopers with fast food.
 9th Circuit essentially disregarded this holding
 This discord is not unusual in tax law. Furthermore, it highlights
how tax law is aberrant in that
o (a)(2): Lodging shall be excluded from income only if it is a condition of employment that you must live on
the premises
 (b)(1): A trier of fact may consider evidence of a contract saying that lodging is for the convenience
of the employee; however, such contract will not be determinative
 this is to prevent collusion between he employer and employee
o RR 71-411: Employer’s convenience is most often established by proof that the employee is ‘on call’
outside of business hours
o “employee”
 Exclusion is only available to employees so not to self employed but would be available to the sole
employee of a corporation even if that employee owned all shares and therefore was self employed
in the practical if not legal sense (and the corp could also deduct the cost as a business expense)
 Lodging furnished to certain education institution employees
5
o (d)(1): in the case of an employee of an educational institution, gross income shall not include the value of
qualified campus lodging
o (d)(2): Exception – cases of inadequate rent (cases when the employer charges below “reality rent”
(regardless of whether it is charging FMV to others) to its employees
 Paragraph (1) shall not apply to the extent of the excess of
 (A): the lesser of:
o (i) 5% x appraised value of the qualified campus lodging, or
o (ii) the average yearly rent paid by those not favored by the university (nonemployees)
 non-favored yearly rent (per/month x 12)
 (B): Lesser of (i) and (ii) – employee’s yearly rent (per/month x 12)
o If this number is positive, this is TI
o Qualified campus lodging
 119(d) applies when it is a university, and the university is providing rental apartments. However, if
you are living somewhere for the convenience of the university (the employer) – such as a RA – then
119(a) applies instead.
o Policy behind 119(d)
 The policy behind 119(d) is that when a university wants to provide its employees with discounted
housing, then the university has to provide that benefit to all people. If it does not provide discounts
to everyone, then the employee will have to pay taxes on some level of income.
 Horizontal equity
 Also, remember the employee is not living at the convenience of the employer here
o Calculation (p.18 (Notes))
 Facts
 Reality rent = 7,200
 Analysis (119)
 (d)(2):
o reality rent = 7,200 per year
o rent charged = 200 per month (2,400 per year)
o below reality rent
 (d)(2)(A): lesser of:
o (i): 5% x appraised value of qualified campus lodging
 200k is the FMV if the unit went condo
 .05 x 200k = 10k
o (ii): for comparable units, what the university is charging to not favored people (nonemployees)
 Monthly rent = 800
 Annual rent = 9,600 (800 x 12)
 (d)(2)(B): employee’s rent
o monthly rent = 200
o annual rent = 2,400
 9,600 (lesser of (i) and (ii)) – 2,400 (employee’s annual rent) = 7,200
o $7,200 would be included in TI
Other fringe benefits statutes
[19-20]
 American approach to fringe benefits
o Fringes started to be provided, and the if IRS doesn’t notice or doesn’t care, then the fringes get more
popular
 This is a huge morale issue
 Loss aversion
6
o People are more bummed out when they thought they had something then lost it,
rather than knowing they never had it at all
132: fringe benefits
 Drew a line at the fringe benefits people have gotten used to received as non-taxable
o There is no commonality amongst the fringes treated as non-taxable
 fringe benefits apply to families – i.e., spouses and dependants
o however, the definition of family is relevant to the traditional definition of a family as required by DOMA
 thus, same-sex couples are excluded
 (b) no-additional-cost service
o e.g., empty seats on airplanes
 letting an employee fill an empty seat is of no additional cost service to the employer
 the employee receives something of value, but 132 allows the employee to exclude that
from the value of their income
o (1) “in the ordinary course of the line of business”
 intended for corporations with multifaceted businesses
 if you are a programmer for a corporation that happened to have an airline, you
CANNOT get the free airfare deal
o (j) “boys in the boardroom” provision applies
 (c) qualified employee discount
o as long as the employer sells something to an employee at cost
 in the case of services, the Code simply institutes 20%
 employee does not have to include the difference between cost and retail, even though
they are receiving a benefit
o (4) “in the ordinary course of the line of business”
 Same as 132(b)(1)
o (j) “boys in the boardroom” provision applies
 (j) special rules
o (1) exclusions under no-additional-cost service and qualified employee discount fringes apply to highly
compensated employees only if there is no discrimination
 goes against the boys in the boardroom problem
 for our purposes, highly compensated means highly compensated
 (d) working condition fringe
o It can be excluded when it is provided by the employer as fringe benefit if an employee could have
deducted it as a business expense itself
 (e) de minimis fringe
o most important fringe of all
 does not mean it is a small fringe, it means that it is an annoying fringe
 accounting for them would be unreasonable or impracticable
o not about “lines of business,” about annoyance
 (f) qualified transportation fringe
o (1) you can exclude from your income, the costs of a
 commuter highway vehicle
 essentially employee vans taking employees from satellite parking lots to their offices
 a transit pass
 qualified parking,
 bicycle commuting -- from your income
o (2) limitations on exclusion – an exclusion shall not exceed
 $230 per month for commuter highway vehicles and transit passes
 $230 per month in the case of qualified parking
 the applicable annual limitation in the case of any qualified bicycle commuting reimbursement
7

o this fringe is here to allow people to exclude commuting costs from their taxable income
1.61-21(b)…taxation of fringe benefits
o Valuation
 FMV if you can determine it
 If you can’t determine FMV, then there may be a safe harbor rule to turn to
 Sometimes its difficult to determine FMV. So if you follow a safe harbor rule, you can avoid
an IRS challenge.
o (b)(5) chauffeur services: use what the limo company paid the chauffeur
Cafeteria plans
[20-21]
125: cafeteria plans
 Another kind of fringe benefit
 (a): the fact that you have a choice among benefits does not turn them into cash and make them taxable
o 132 (a bunch of isolated benefits that you may receive) v. 125 (an employer has to specify a cafeteria plan)
 (d): you can choose some fringe benefits from the cafeteria plan and you will not have to include in your taxable
income, but if you opt out of everything and take the cash you have to pay taxes on that income
 (f): inclusion by reference (anti-abused provision)
o other Sections of the Code tell you what can be included in a cafeteria plan
 Key examples of what can be included in a cafeteria plan
 Group-term life insurance
 Dependant care assistance
 Adoption assistance
 Excludable accident and health benefits
 Elective contributions under a qualified cash or deferred arrangements under 401(k)
 The idea of a cafeteria plan is to allow employees to pick and choose all, some, or none of the benefits provided by
the employer
 If you take all of the benefits, you will have a lower taxable income
o So, there is no horizontal equity
o But, there are psychological aspects to this
 You can personalize the fringes to your own situation
 Employee envy
 The fact that you can opt-out should allegedly reduce the element of employee envy
 Use-it-or-lose-it rule
o If you don’t use the whole benefit up, you just lose it
 This stems from an incorrect estimation of what you may need in a flexible spending account
 People go in for all kinds of unnecessary medical procedures on March 30 or 31
o To cure these problems, NB suggests that Congress simply set limits rather than attempting to prevent
people from overspending on the preferred items by raising the risk associated with overestimating
o If you don’t use it, the funds go back to the employer
 The employer may pocket the excess funds
 Or, the employer may redistribute the excess funds across all the employees
Another Approach to Valuation
[21-23]
Turner (TCM 1954)
 Suggests a subjective approach to valuation…incorrect
Rooney
 Any previous hints at taking into account subjective valuation should not be taken seriously
8
Rule
 You want to look for objective manifestations of value
o Important distinction
 Opinions and the like can affect fair market value if people put their money where there mouth is
 What we don’t want to do is take into account people’s unique situations
Windfalls and perks
[23]
Treasure trove
 1.61-4: treasure trove, to the extent of its value in US currency, constitutes gross income for the taxable year in
which it is reduced to undisputed possession
 If you gave back such a windfall immediately, as in the case of the record-breaking home-run balls, you are treated
as if you never possessed it at all.
 There is a realization requirement for found treasure.
o Only when you sell it and turn it into cash are you taxed on it.
 HS income but not taxable income.
IMPUTED INCOME
 Benefits that are not part of a commercial transaction and are therefore generally not thought of as income for
tax purposes are generally not included in a TP’s taxable income
o Though failure to include them results in problems of fairness and economic rationality
 Property (other than cash) – increase in value of a house is not taxed so long as it is unrealized and if passed at
death with a stepped up basis will never be taxed and so the investment will escape taxation  shows a
congressional preference for home ownership and that tax system will influence actions
 Services – the benefit of the services that one performs for oneself is not taxed
 Physic income and leisure – there is a tax on the earnings, but not the benefit of leisure that one “buys” by not
working – so there is a tax benefit to being underemployed, you can buy leisure time with pre-tax dollars
Bartering
[23-24]
Rev. Ruling 79-24
 Barter income is taxable
 Valuation
o FMV
 If the FMVs are different, you have to look at the FMV of what the person received in order to
decipher their taxable liability
 As an administrative choice, you almost always anchor the work of the thing easily valued to
the thing not so easily valued
o With a presumption for stipulated value
 This value can be challenged by the IRS with affirmative evidence of their own

 Hypos (p.23-24 (Outline))
o Situation 1
 Barter club
 Lawyer provides a house painter trade with legal work in exchange for the painter to paint his house
 Tax analysis
 Lawyer values his work at $1,000
o Lawyer is taxed on $500 (received)
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Painter values his work at $500
o Painter is taxed on $1000 (received)
Situation isn’t normal as this is an example of a crappy deal
…if the FMVs are different, you have to look at the FMV of what the person received in
order to decipher their taxable liability
o Situation 2
 A professional artist provides an owner of an apartment building with a painting in exchange for 4
months rent
 Tax analysis
 6 months worth of rent…FMV easy to find
 piece of unique art…FMV not easily found
 As an administrative choice, you almost always anchor the work of the thing easily
valued to the thing not so easily valued
o This becomes even more difficult when you have two things that are not easily
valued. Then, you just hire and appraiser.
6045
 Requires information reporting by any “barter exchange”
 1.6045-1(a)(4): the term barter exchange does not include arrangements that provide solely for the informal
exchange of similar services on a noncommercial basis
o The IRS does not want to get into trivial matters, even if they are HS income.
o This sometimes applies to trivial matter with commercial bases as well.
WINDFALLS AND GIFTS
Punitive damages
[24]
Glenshaw Glass (US SC 1955)
 The Court holds that punitive damages are includable in taxable income
o Nothing limits the definition of gross income under 61
 Punitive damages falls under “any source whatever”
 SC sets super precedent (super precedent…decisions that is entrenched and if changed
would be a big deal)
o Income has never been limited before
104(a)(2): personal injury recoveries
 Compensatory and punitive damages are excluded from taxable income when it is a personal injury case
o Even though they are HS income
o Theory…all you are doing is making someone whole
 But, this doesn’t really draw a distinction to the GG case
 Mental or psychological injuries are not covered, just physical injuries
Gifts
[25-28]
 Income is not limited, except for exclusions, etc.
 Gifts are another type of exclusions
102: gifts and inheritances
 (a): Gifts are excluded from taxable income
 (b): you can exclude the initial gift, but not any income you derive from that gift
o e.g., if you get stock dividends as a gift
 Example (p. 25 (Notes))
10
o Donna 100k  Edward 30k
 (a) 70k GI Donna; 30k GI Edward
 E provides non-personal services to D
o I.e., anything that looks like a business expense
 (b) 100k GI Donna; 30k GI Edward
 E provides personal services to D
o E.g., E cooks for D
 Personal expenses are not deductible from income
 (c) 100k GI Donna; 0 GI Edward…allowed by fed income tax
 Gift as long as transfer is a “gift”
o Precisely because E did not work for D
 E works, in some degree, in each of the other two situations
Defining “gift” (this is the hard part)
 Duberstein (US SC 1960)
o Factors
 (1) “Detached generosity”
 Detached and generosity seems to be an internally inconsistent phrase
 (2) “Affection, respect, admiration, charity or like impulses”
 At least the court is getting somewhere here
 The transferor has to feel “happy”
 (3) Transferor’s “intention”
 The stance of the recipient is irrelevant to determining whether it is a “gift” for income tax
purposes
 “Gift” determination does not rest on the donor’s conduct, but rather his intention
o Objective/subjective test
 We are reading their mind to get an objective determination of the donor’s subjective intent
 Court will not look to language expressing that a “gift” is a gift as outcome determinative
 Court will look at the totality of the circumstances
 Whether a gift is from employer to employee is relevant, but will not determine the court’s
outcome
 Whether a gift is given by a corporation is relevant, but will not determine the court’s outcome
 Whether a gift is deducted is relevant, but will not determine the court’s outcome
o Gifts defined as “gifts” are excludable in the recipient’s tax income
o Standard for gift cases in the future
 If there is an appeal, anything short of “clearly erroneous” we lead to an affirmation
 “Clearly erroneous” is highly deferential to triers of fact…wrong because legal finding
seems to be getting the standard of review afforded to factual findings
o Pertains to fact
o Trial courts can handle these kinds of situations better than appellate courts
o Reasonable minds could defer
Congressional action (post-Duberstein)
 102: gifts
o (a): Gross income does not include the value of property, acquired by gift bequest, devise, or inheritance
o (c): value of gifts from an employer to an employee is not excludable from taxable income
 this is about gifts to employees from companies
 In these situations, the employer may deduct the value of the gift and the employee must
include the value of the gift in his income.
o We just treat such a gift as compensation.
11

274(b): businesses are not allowed to deduct expenses for gifts to individuals to the extent they exceed $25
(defines ‘gift’ by reference back to 102)
o this is about gifts to individuals from companies
 This standard governs the Duberstein situation
 If business gift, the business can deduct no more than $25. The recipient, however, may
exclude the entire value of the gift from his income.
o This disincentives business gifts.
 If not gift, and is instead determined to be an ordinary and necessary business expense, it is
deductible to the gift giver under 162. For the receipt, however, the value of the gift is
includable in their income.
 The determination of a gift for one party would hold true for the other party as well.
Further defining “gift”
 Harris
o A person is entitled to treat items from lovers as gifts as long the relationship consists of something more
than specific payments for specific sessions of sex
 to treat it as a gift, you could arrange for sex on a non-transactional basis
 In the case of married couples, taxability of transfers of money does not hinge on the application of the
“detached and disinterested generosity” test of Duberstein
Tips and unusual gifts
[28-29]
 Tips
o 1.61-2(a)(1): a tip is included in taxable income because it is compensation for services
 With regards to Duberstein, the unusual nature or unique motives of a tip may cut in favor of counting it as a
“gift,” rather than if the tip was just generally provided as additional compensation for the given transaction
o But it also may not cut that way
 Tipping a minister for performing a wedding; minister must include in TI
 Gamblers who tip out of compulsion or superstitution: dealers/servers must include in TI
 Scholarships: excluded from TI
 Surviving spouses – payments from corporations to surviving spouses  [5 factors to determine if it’s a gift] (1)
payments made to wife and not to estate,; (2) no obligation of corporation to pay anything additional; (3)
corporation derived no benefit from payments; (4) wife performed no services for corporation; (5) services of
husband had been fully compensated
 RR 76-144 – Traditional welfare payments and other government payments are generally not excludable under
102 but rather not within the contemplation of income under 61
 Bonus -- starting with most likely to be included as income (1) regular bonus from employer, (2) irregular bonus
from employer, (3) regular bonus from 3rd party, (4) irregular bonus from 3rd party
Transfer of unrealized gain by gift while the donor is ALIVE
[30-32]
 Taft (US SC 1929)
o Donee has to pay tax on entire realization even though some of it was “earned” before she go the property
– both because the law is clear and because the receiver of a gift is still better off
 Donee assumes the place of his predecessor
 Carryover basis
o Threshold issue: Is the property you are receiving a gift?
o 1015(a): basis of property (not cash) acquired by gifts
 you go back to the last person who paid money for the property that you are getting as a gift
 future gain…carryover basis (you use what the original purchaser paid for that property)
 future loss…FMV at the time of the transfer
12

This rule somewhat clumsily limits carryover loses and accompanying strategic tax
moves
o Calculation example (p. 31-32 (Outline))
 Original owner paid = $1500
 FMV at transfer = $1000
 (1) Recipient sells for $800; income = 800 (sale) – 1000 (FMV at transfer) = - 200 ($200 loss can be
subtracted from his income)
 Loss calculation (negative value when you subtract FMV)…subtract money from taxable
income
 (2) Recipient sells for $1600; income = 1600 (sale) – 1500 (carryover basis) = + 100 ($100 can be
added to his income)
 Gain calculation (positive value when you subtract carryover basis)…include money in
taxable income
 (3) Recipient sells for $1200
 carryover…1200 (sale) -1500 (carryover basis) = -300
o no gain
 FMV…1200 (sale) -1000 (FMV) = +200
o No loss
 Neither loss nor gain calculation (negative value when you subtract carryover basis AND
positive value when you subtract FMV)…thus, no tax consequence
o Policy behind carryover basis rule
 Gain side…progressive rule
 You are giving away something of value, and also ridding yourself of a potentially large tax
liability
 Giving it away does lose you money, but some people make tax motivated citizens
 One of the things that this does encourage is downward distribution of wealth
 Prevention of losses side…regressive rule
 A poorer person may transfer gifts up to a wealthy person in order for the wealthier
person to avoid tax liability
o Not a policy generally espoused by Congress
 Hypothetical
o 100k loss in real estate
o May transfer this losing property to a wealthier person who would like to be able to
deduct the amount of the “gift” from his GI
 …1015 does not force transfers of wealth to just the poor
o incentive to move assets in the right direction is removed
 The hole…no gain or loss
o Remember: 1015 ONLY applies to gifts, so if there is an arm’s length transaction, the person receiving the
property will take basis based on FMV rather than donor’s basis – so if shares were transferred as
compensation, the basis would be FMV and payer would pay tax based on “sale or disposition” of property
Transfers of unrealized gain by gift at death
[32-35]
 Threshold issue: Is the property you are receiving a gift?
 1014 (a): basis of property acquired from a decedent
o (1): basis of property is stepped up (or stepped-down) to the FMV of the property at the date of the
decedent’s death (2032 provides an optional valuation date of six months after death)
 Way different from carryover basis
 Much more favorable
 Example
o 1m at decedent’s death
o 1m when you received it
13


o you sell at for 1m the next day, then taxable income is 0
Policy
o If you hold onto property long enough there will not be income tax liability on the gain
 1014 creates an incentive to hold on to property and not sell it
 probably not a good way to distribute wealth
Estate tax comes in to compensate for this lack of taxable income
o Estate tax
 When a person dies
 you tax the value of their property
o take out the expenses of dying
o take out charitable gifts directed by the estate
o take out $5m zero bracket
 When the first spouse dies, the estate can be transferred to the surviving
spouse tax free
 When the second spouse dies, the estate can be transferred to beneficiaries
with a $10m zero bracket
 Marginal tax rate = 35%
o Policy rationales for an estate tax
 (1) Highly progressive
 Only high-wealth people pay it
 Satisfies vertical equity in spades
o Only those capable to pay it do so
 (2) If you collect money from this tax, you don’t have to collect as much from other taxes
 The estate tax allows you have lower rates on income, allows you to have 1014, etc.
 (3) Estate tax serves as a back-up tax on capital gains
 estate tax indirectly taxes capital gains that 1014 would let go untaxed forever
 (4) Encourages gifts to charity
 charitable gifts taken out of an estate are not subject to estate taxes
ANNUAL ACCOUNTING AND ITS CONSEQUENCES

Rules created by Congress over the years to get you out of arbitrary situations
Sanford and NOLs
[35-38]
Sanford (US SC 1931)
 Income tax system uses annual accounting rather than transactional accounting
o Court gets the law right even though the result is unfair
 Big policy argument
o Any government is going to have to collect income on a regular basis in order to meet revenue requirements
NOL (net operating loss) carryovers
 Cured Sanford problem stemming from the unduly drastic consequences of taxing income strictly on an annual
basis
 Essentially a business provision
 Allows you to use extra losses to offset income in other years
o NOL can be carried 2 years back, 20 years forward
 You continue to offset your gains until you offset all of your losses
 We are talking about net operating losses
o Operating losses are different from capital losses
 Operating losses are net profit from the business
14


172: net operating loss deduction
o (b)
 (2): the loss must be carried back to the earliest year possible… start as far back as possible and
work your way forward
 (3): allows choice to only go forward and not carryback (but then you can’t carryback for any
year)
o (d)
 (3): when computing NOL deduction you cannot include deductions from personal exemptions
 (4): non-corporation…when computing NOL deduction, then you cannot include non-business
deductions
 “trade or business” never defined by the Code
Calculation
o 2009: 40k taxable income
o 2010: -41k TI
 60k salary
 -80k business loss
 -6k personal exemptions
o (d)(3) knocks out the 6k
 -15k nonbusiness itemized deductions
o (d)(4) knocks out the 15k
 No tax liability
 The business loss takes him into the negative (and thus the zero bracket) for taxable income
 He would like to carryback or carryover
 He can only carry the 20k of the 41k because 172 disallows carrying the 6k or 15k
o However, he can use the 6k and 15k in 2010
 However, they do him no good cause he is already in the negative (way in the
zero bracket)
 The 21k in deductions is essentially gone
 So, only 20k is his NOL for 2010
o What is his strategy?
 Allowed strategy
 (1) You can go back to year -2 then follow suit, OR
o -2…-1…+1…+2…+20
 special circumstances allow for a three year carryback
 (2) You can opt not to carryback to year -1 or -2, and start at year +1
o +1…+2…+20
 Cannot just carry to year -1, unless you have nothing to offset in year -2
 Here,
 Assume in 2008, he had nothing to offset
o He can go to 2009 and subtract 20k from the 40k and create only 20k in TI for 2009,
OR
o He can apply it to 2011, etc.
Claim of right
[38-40]
NAO (US SC 1932)
 You must include funds as income when you have:
o (1) legal right to the funds
o (2) received the funds without restriction
Illinois Power (7th Cir. 1986)
15

Custodian has no COR and thus does not have to pay taxes on the money they are holding
o However, what about the interest earned on that money?
Lewis (US SC 1951)
 No exception to the claim of right doctrine just because the taxpayer is mistaken about the validity of his claim to
the money (taxes paid on mistakenly large bonus which he gave back but which he had used completely as his
own)
 Income in earlier years, loss in later years, court says tough luck [don’t let perfection be the enemy of the good]
 Amended returns  used to claim a refund of overpayments but only about facts that were or should have been
known before end of earlier year AND amendment is within 3 year SOL period
1341: computation of tax where TP restores substantial amount held under claim of right
 income in early years that is later lost
 Congressional overgenerous response to inequity in Lewis…situations involving people who find themselves in
different marginal rate tax brackets in different table years
 Start with a deduction in the year of repayment (rather than reopening the earlier year)
o But, if deduction exceeds 3K, then the tax is the lesser of
 The amount determined by claiming a deduction in the ordinary manner, OR
 By forgoing the deduction and claiming a credit in the year of repayment for the tax that would have
been saved by excluding the item in the earlier year
 Essentially allows the taxpayer to reopen the earlier year except for the interest on the
overpayment
o In essence, the TP may strategically decide what outcome is better for him, rather then forcing
amendment in the year where funds were included in the income
 Depends on what year’s rates are higher
 1341 applies ONLY to those items to which it appeared that the taxpayer had an unrestricted right in one year and
to which a repayment is made in a later year because it was established after the close of the earlier year that the
taxpayer did not have unrestricted right to the funds
 1341 does NOT apply to restorations based on mere errors or on subsequent events (refunds pursuant to K rights),
or to repayment by an embezzler of stolen funds
Tax benefit rule

[40-41]
Situation: wrongly taken deduction that you may have to later include
o Took a deduction for a perfectly legitimate reason under your understanding of the facts at the time
o Later, you discovered the facts were not as you thought and you were not eligible for the deduction
111: recovery of tax benefit items
 If (or to the extent that) a deduction did not reduce the TP’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. (i.e., if you are already in the zero bracket, the deduction you wrongly took did you no good…really if it
didn’t shift your brackets in any way it did you no good)
o But, if you got any benefit, then you have to include it as income
 If valuation is difficult you can include it to the extent you deducted it, even though this ignores
inflation
 Safe harbor: the exact dollar amount you wrongly deducted in the first place is what you
later include
Summary of ruled created by Congress over the years to get you out of arbitrary situations
[41]
Claim of right
 The way you choose the year in which you have to include income is on the basis of the two prong test
16
NOLs
 You have losses in one year that aren’t helpful in one year and you want to carry them over to other years
o Fixing Sanford problem
 Even with NOLs, there is no transactional accounting
Tax benefit rule
 How to deal with a situation in which you had deduction first and income later
1341
 How to deal with a situation in which you had income first and lost it later
 1341 is an overgenerous response to Lewis
Recap
 We have considered timing issues and Congress’s as hoc responses
LOANS AND DISCHARGE OF INDEBTEDNESS



Equity v. debt
Bond
o Generic term for debt in the financial world is bonds
 Buying a bond = lending money
 Selling a bond = borrowing money
Secured v. Unsecured; Recourse v. Nonrecourse
Loans
[42-44]
 Rule
o When you take out a loan, even though you have money coming in, because it has an offsetting liability, you
do not need to include that money in your income.
o When you pay back the loan, you do not deduct the payments that you make
 Interest payments are taxable income to the lender
o In this way, a loan operates as a savings account
o Principal is not income
 Are interest payments deductible for borrowers?
o Interest payments on loans are deductible to business but not individuals
 Policy
 Congress decided Americans were spending too much money and getting into too much debt
Discharge of indebtedness
[44-50]
 “cancellation of debt” = “discharge of indebtedness”
 Discharge of indebtedness income (DOI income) becomes relevant when loans are not paid back
o We trust that you are going to pay back the loan until we decide that we cannot trust you
 KEY…The driving factor in determining DOI Income is whether the principal loan is paid in
full
 61(a)(12)
o “income from discharge of indebtedness”
 if a debt is discharged, then the borrower essentially has received income equal to the amount of the
indebtedness
Kirby Lumber (US SC 1931)
17


D did not have to pay tax when they sold bonds because it was a loan, but when bought back bonds at lower price
it was DOI income and thus taxable income
Discharge of indebtedness income really is income
o Income is included in the year of the discharge, not the year of the loan
108: income from discharge of indebtedness
 Congressional cure to KL
 (a)(1):
o (B): if you net worth is negative then you are insolvent, and if you are insolvent you do not have to
include discharge of indebtedness income in your taxable income
o (C): you can be a farmer who is not in bankruptcy and who is not insolvent, and you do not have to include
discharge of indebtedness in your income, so long as the farm indebtedness qualifies
 Congress loves farmers
 (d)(1): for the purposes of 108, “indebtedness of taxpayer” means any indebtedness:
o (A) for which the TP is liable, OR
o (B) subject to which the TP holds property
 (e)(5): purchase price adjustment
o after the fact, we act as if the price was different
o in the very limited situation in which the person you bought the good from also financed the loan, the
amount which you settle the loan for in not considered DOI Income
 (f)(2): excludes cancellation or repayment of student loan that is made contingent to work on charitable or
educational institution
Zarin (3rd Cir. 1990)
 Law is clear that D should have had to pay taxes on DOI, but that is too inequitable for court and so they find ways
around it
o 61 includes DOI is income, but 61 does not define indebtedness and so court looks to 108(d)(1) which refers
to a charge on which the taxpayer is liable or subject to which the taxpayer holds property and finds D
satisfies neither of these
o Court finds the gambling chips were a method of accounting rather than property
o The debt was so large as to be unenforceable under NJ law, so court finds that the taxpayer is only liable to
the extent of the court settlement and therefore the settlement can’t represent DIO
 Since D was not be held liable on larger amount, reducing amount was not DOI
 Chips were medium of exchange, and evidence of indebtedness since they don’t have any
economic value outside the casino (since any other reading would give casinos a right to print money
privately)
o Contested liability doctrine
 If a taxpayer, in good faith, disputed the amount of a debt, a subsequent settlement of the dispute
would be treated as the amount of debt cognizable for tax purposes and any excess over amount
determined to have been due is disregarded for both loss and debt accounting purposes
(judicially created). This particularly involves situations concerning illiquid damages.
 This serves as a washout tool because when you pay the debt on which is settled and looked
to, there is no DOI income because you paid the exact amount now considered to be the debt.
o This is no proper here because it would essentially read DOI income out of the
Code.
o
 165(d): wagering losses…GAMBLING
o 1.165-10: You pay taxes on net winnings, but you cannot deduct net losses
 You can only use losses to offset winnings, however you cannot make deductions for additional
losses
18

The IRS has ruled on comps and the Tax Court has said the taxpayer can offset the
comps as if they are winnings from gambling.
o Comps are considered gambling income.
 Gambling income can be offset by gambling losses.
GAIN ON HOME SALES
[50-55]
Old rule
 1034 – If income on sale of home, taxpayer can exclude that income if she buys a home of greater or equal value
within 2 years
 121 – At age 55, one one-time 125k exclusion, even if not used to buy home of greater or equal value within 2
years
 Policy for this rule
o Government was creating this new ethos of home ownership
o The path cut by Congress
 Continue to buy nicer houses until you want to cash out
 If you continue to follow this path of owning a house – then considered the ultimate middle
class asset – then you will receive a nice exclusion
121: exclusion from a gain from sale of principal residence
 (b)(1): Singles
o Requirements for singles to get 250k exclusion:
 (1) Used home as principle residence for 2 (in the aggregate, not consecutively) of the last 5 years
o Any GAIN over 250k is taxed at 15%
 (b)(2): Couples filing jointly
o Requirements for couples filing jointly to get 500k exclusion:
 (1) either of them have owned the home for 2 (in the aggregate, not consecutively) of the last 5
years, AND
 (2) both of them have used it as a principal residence for 2 (in the aggregate, not consecutively) of
the last 5 years, AND
 (3) they are not subject to any other exceptions
o Any GAIN over 500k is taxed at 15%
 Reg. 1.121-1: “principal residence”
o Totality of the evidence test
 What you need to do is look at all of the circumstances that indicate whether it is this TP’s personal
residence
 Does the TP have other residences? If no, then…
 Where are they registered to vote?
 Where is the car registered?
 Where are the kids in school?
o You can only have 1 principal residence
 (c)(2)(B): “unforeseen circumstances”
o You can get a proportional exclusion if you don’t meet the above requirements, but you moved you
changed your place of work, for health reasons, or unforeseen circumstances.
o What does “unforeseen circumstances” mean?
 “such sale or exchange is by reason of a change in place of employment, health, or, to the
extent provided in regulations, unforeseen circumstances.”
 Congress is trying to limit people who simply want to move prior to their two years being up
 Reg. 1.121-3
 Facts and circumstances test
o Safe harbors (these instances are considered unforeseen circumstances):
19

Occupants of the house have a multiple births or single births bunched in
a two year period
 This would be a situation where you would want to move out more
quickly than normally
 Divorce
 Change in economic circumstances
o However, you do not fall under “unforeseen circumstances” when you simply
want to move to another house out of preference
 Private letter rulings (PLR) (not quite a powerful of authority as Regs.)
 Not safe harbors, but things that have met “unforeseen circumstances in private letter
rulings…
o A blended family moves to some of the children’s school district
o When adult child moves back in with his parents
o If you need a bigger house because you have adopted kids
o If a disabled parent moves back into house
o Problems with airport noise
o A child was assaulted on a school bus
o Narcotics officer received death threat from someone who found out where they lived
 In short, we are trying to weed out people who are simply moving because they felt like moving
o (c)(1)(B): “unforeseen circumstances” calculation
 For a single:
 The shorter of:
o (1): the length of time you were in the house you are selling
o (2): The last time that you used the 121 exclusion
 “bears to”
o (x/250k) = (n from above/24)
o exclusion =
 15% tax on all income over exclusion granted
o (f): election to not have 121 apply
 Sometimes you are better off refraining from applying 121
Hypo 1(a)
 NB lives in Newark; wants to move after 19 months
o Can’t get tax break.
 Can he get a proportional break due to unforeseen circumstances?
o Instead of getting a 250k exclusion, he is trying to get a proportional exclusion based on 121((c)(1)(B):
 The shorter of…
 (1)
o NB moved out of his house in Newark after 19 months.
o 19 months
 (2)
o When was the last time NB used 121? How long has it been since you used the 121
exclusion?
 He used 121 to exclude a gain on sale while in law school when he sold his
house there. This also was 19 months prior.
 You might own a house when you move into your new house, then
you might sell the old house after you moved into your new house.
o 19 months
 “bears to”
 (x/250k) = (19/24)
o 250k because NB is a single
 exclusion = 180k
20


o 15% tax on all income over 180k
But does unforeseen circumstances apply?
o Employment? No, he didn’t change schools.
o Health? No.
o “Unforeseen circumstances” in Regs? No.
He moved because he was bored, so he does not even get the 180k
Hypo 1(b)
 NB keeps his Ann Arbor house for 12 months while he’s living in Newark
o Only 3k gain on this
 NB still sells his Newark house still after 19 months
o Gain will be greater on Newark
 “Shorter of” is now 7 months
o However, if you refrain from applying the 121 exclusion to the sale of the Ann Arbor home, you still get the
19 months to apply in formulating your exclusion from selling the Newark house
Hypo 2 (re: 121(b)(2)(B))
 Wilma (W) -- wife
o Lived in and owned A in 2008-2009
 Harry (H) -- husband
o Lived in and owned B in 2008-2011
 W lived in B in 2010 and 2011
 W sells A on 1/1/11
o Gain = 350k
o W excludes 250k
 Pays 15% taxes on 100k remaining
 H sells B on 1/1/12 due to change in health
o Gain = 400k
 121(b)(2)(A)
o Either spouse meets the ownership requirements? Yes.
o Both spouses meet the use requirements? Yes.
o Is either spouse ineligible due to the recent use of the 121 exclusion? No.
 If no 121(b)(2)(A), then 121(b)(2)(B) applies:
o Her use of 121 a year ago means they don’t get the whole 500k, so you run H through the three prong mill
(right above) as a single.
 H meets all three, so you get the full 250k
o W will only get the proportionality rule (the change in H’s health still applies because it his change in
health that prompts them to sell the house)
 Shorter of…
 Owned and used…24 months
 Last use of 121…12 months
 …calculation
o (x/250k) = (12/24)
 exclusion = 125k
o together, H and W can exclude 250k +125k = 375k
 400k (gain) – 375k (exclusion) = 25k taxable income
 15% tax on 25k
Policy effects
 Old rule
21


o If you bought a house for more than the previous house you get the exclusions, then you get the once a
lifetime exclusion at age 55
 Congress didn’t want to tax gains on home so long as gains add up to post-WWII ideal of suburban
life
New rule
o Employs a transaction basis
o Congress recognized that an across the board exclusion would inappropriately, from a policy standpoint,
give house-flippers an inappropriate tax break
 Congress still wants to reward middle-class homeownership, albeit not to the degree promoted by
the old rule
o Congress is limiting the benefit to deserving people… “less than 250k for a single and 500k for married”
Policy – old rule v. new rule
o Old rule
 Incentive effects
 Caused people to buy more expensive houses each time
o The idea is that baby boomers would be growing families and were upwardly mobile
o If you want to keep your tax liability at zero, go and buy more tax then you need
 This would be odd if you moved from a DC apartment to Nebraska and thus
had to buy a mansion to get the tax break.
 You get the one time lifetime exclusion at age 55
o People would wait past the time they became empty nesters and waited to move until
they were 55.
 …these two perverse incentives led to Congress’s production of 121
o New rule
 Incentive effects
 Problem stemming from universal application of numbers no matter where the house
o People were engaging in tax motivated sales as their houses would hit the 250k or
500k marks
 This occurred in the more expensive, hot markets
o 121 was never amended for regional variation because there is no longer really big
gains, let alone big regional disparities in gains due to the decline of any hot markets.
WHEN IS INCOME TAXED?
REALIZATION AND RECOGNITION



[55-57]
Timing issue
o A taxpayer has income, can they delay paying taxes on that income?
 Even if you lost on the merits, you may be able to argue that its not taxable yet.
Why do people care so much about timing?
There are several reasons for wanting to defer payment of your taxes
o (1) Taxpayer is hoping for a change in rate
 In this way, it is a gamble that Congress will lower the tax rates
 So this is a good reason to use doctrines like realization and non-recognition
o (2) Procrastination
 a real, albeit not highly defensible, reason
o (3) They do not have the money right now
 They are either illiquid or waiting on the cash to come in
o (4) As a financial matter, it is valuable to put off paying taxes as long as possible (p.40-42 (Klein))
 even if you don’t think rates will change, you’re not a procrastinator, or you’re liquid…
 Time value of money
22






If you owe a certain amount in the future, planning to pay that debt through the application of
interest rates from putting it in a CD, etc., will allow you
Example
o Tax bill = $105
 How valuable is it for me to pay that tax bill a year from now rather than right
now?
o Interest rate = 5%
o $100 today (present value) in a bank at a 5%  $105 (future value)
 by not waiting the year, you are costing yourself $5
You can generalize this concept to any number of rates and any number of interest
rates
Rule of 72
o Present value doubles in 72/r years
 r = 4%, then 72/4 = 18 years
 Your present value will double with the interest rate at 4% in 18 years
Because the federal government does not charge interest on legal deferrals
o So, every year you defer could earn some money
o However, interest is charged on illegal deferrals
So, how and why do we allow deferral? Because if its beneficial to the taxpayer, it is
harmful to the government…
Realization doctrine
 You do not have to pay taxes on HS income until you have realized the gain
o Realization usually means the sale or disposition of an asset, roughly speaking
 With a ton of exceptions
 Why do we have a realization doctrine a part of our tax Code? (p.225, n.9)
o (1) Valuation issues
 A lot of property that would be subject to taxation under HS income would be very hard to value
o (2) Liquidity problems
 You might have the money, but it is not in a form that you can easily cash out
o (3) Divisibility of assets
 You can’t just sell the fraction of a house to foot your tax bill
o (4) Variability
 If we had a really rigid HS system, then every year you would have people doing this valuation, and
frankly we have better things to do with our lives
 Unrealized gains in one year may turn into unrealized losses in another year
Recognition doctrine
 Some situations in which you have income, and have even realized income, Congress gives you the
opportunity to opt not to recognize income and not pay taxes
 Why do we have a recognition doctrine a part of our tax Code? (p.247)
o (1) Liquidity problems
o (2) Valuation issues
o (3) Nature of the investment has not changed
 gain may be realized but you took the gain and plowed it right back into something that looks
identical
o (4) This is a way for Congress to give people money
 Congress can pass recognition rules that amount to tax breaks, but which don’t look enough like tax
breaks to get on the news
REALIZATION
23
Legal origins of the realization doctrine
[57-60]
Macomber (US SC 1920)
 US SC held that stock dividends are not to be treated as realization events
o “Income may be defined as the gain derived from labor, from capital, or from both combined.”
o Creates realization requirement
o Constitutional analysis (that stock dividends don’t count as income taxable w/o apportionment) has
been abandoned
o Majority stated that it is not income unless the company gives him something separate that he can take
away from the company and use on her own (in essence, realization = liquidation)
 Even if the shareholder is the richer, its still not income
 This is 180 degrees wrong according to NB
 Court is trying to say that it’s not realized and therefore there is no income, which is wrong, because
on these facts FMV didn’t change and so there was no income and therefore nothing to realize.
 Brandeis’ dissent points out loophole where form was elevated over substance and the tax outcome is based on
whether it’s called a pure dividend (not taxed) or if SH is given option to buy (dividend is taxed)
o Would have been realization if corporation paid M to extinguish shares on the condition that she used the
money to buy new shares
305: modern rules on taxing stock dividends
 (a): except as otherwise provided, gross income does not include the amount of any distribution of the stock of
a corporation made by such corporation to its shareholders with respect to its stock
 (b)(1): stock dividend is taxable IF the shareholder has the option to take cash or other property in lieu of that
dividend
 1.307-1(a): taxpayer’s total basis of the old shares is allocated between old and new shares based on FMV after
distribution of stock dividend
The decline of realization as a constitutional requirement
[60-64]
Bruun (US SC 1940)
 narrowed Macomber
 SC held that there is indeed a realization requirement
o SC held that the cancellation of a lease because of the default of the renter is one of those non-sale
realization events
 Realization does NOT = liquidation (non-sales can be realization events)
 Realization is not limited to cash exchanges
 Bruun had to pay taxes on the increase in value of the property from the new building that the leaseholder built on
his land before he defaulted on the lease
109/1019: Bruun statutory aftermath
 Nonrecognition provisions
o You have income, but you don’t have to call it income this year
 109: gross income does not include income (other than rent) derived by a lessor of real property on the
termination of a lease, representing the value of such property attributable to building erected or other
improvements made by the lessee
o You can temporarily exclude the value of a building at the end of a lease
o But, to prevent abuse, you can NOT exclude value of property if building is in place of rent
 1019: Neither basis nor adjusted basis will be changed based on income generated for lessor that was not taxed due
to 109
 109/1019: when the lease gets cancelled, technically its still a realization event, but you don’t have to recognize it.
24

o Its still income, but you just get to put it off, until you choose to sell the land, if you ever choose to sell it.
 You will pay tax on the same amount of money at some point
 But clearly you’d rather be in the tax-friendly realm of 109/1019
o While this isn’t the kind of giveaway we’ve seen before, the taxpayer can surely earn
interest by delaying paying taxes
1.61-8(c)
o No safe harbors; no specificity
o But, makes the rule clear
 A building intended as rent has to be treated as a perfect substitute for the FMV of the annual
rent, thus the realization even cannot be delayed as in the 109/1019 situation above
 Applying this in real life situations will be really difficult
o This is the better way to handle it, but this isn’t how we handle it. We use
109/1019.
 We act as if the building is not yet in the possession of the lessor and thus he
pays no income taxes on it, but also gets no deductions
Hypo 1 (p.62-63 (Notes))
 Facts
o Building = 50k
 10 years of life
o Annual rent = 7k per year
 Bruun treatment
o 1933: 50k income
 Gives Bruun 50k in basis (important if he goes to sell it)
 If Bruun sold it a minute later for 50k, he would have no income on which to pay taxes
o 1933-1943: 7k per year in rent
 Building is losing 5k in value per year – depreciation
 Theoretically, a 1/10th of the building crumbles each year
 So, he has 2k per year in income that is taxable
 20k over ten years
o A total of 70k (50k + 20k) is included in his income from 1933-1943
 109/1019 treatment
o 1933: 0 income
 gives Bruun 0 in basis in the new building (important if he goes to sell it)
o 1933-1943: 7k per year in rent
 Because Bruun didn’t pay taxes on the 50k when he received it, he doesn’t get deductions on
the building’s decay
 Bruun did not buy the building up front
 So, he has 7k per year in income that is taxable
 70k over ten years
o A total of 70k is included in his income from 1933-1943
 Bruun will pay tax on $70k at some point
 But clearly you’d rather be in the tax-friendly realm of 109/1019
o While this isn’t the kind of giveaway we’ve seen before, the taxpayer can surely earn
interest by delaying paying taxes
Hypo 2 (p.63-64 (Notes))
 You are the owner of the land
 Person renting the land puts a 400k building on it
o HS income…400k increase in net worth
o Other possibilities…
25

Wait until year 10
 The building is half used up and worth only 200k
o Include 200k in income and take your depreciation deductions for every year after
that
 Acting as if the building is not in your possession for the first 10 years
 Here, we are pro-taxpayer
o A la 109/1019
The limits of realization: nonrecourse borrowing in excess of basis
 Recourse v. non-recourse loans
o Recourse
 Borrower is personally liable
o Non-recourse
 Lender can only get whatever is secured
 Lender has no access to borrower’s personal assets
[64-65]
Woodsam (2nd Cir. 1952)
 Example of a non-realization event
 Foreclosure is a disposition event and gain/loss would have to be realized then, however the change in the type of
loan (from recourse to nonrecourse) is not a disposition of the property
o Despite change in loan terms, taxpayer has control of building therefore it has not been not disposed
of, therefore not realized
o Foreclosure may result in DOI income, but 108(b) has exemption if D insolvent
Contemporary understandings of the realization doctrine
[65-76]
SL crisis
 The response of regulators to the SL crisis was to allow SLs to go ahead and gamble in the hopes that they would
get through the crisis until the interest rates come back down and the SLs become solvent again
Cottage Savings
 NB thinks the majority decision is awful in every respect; the dissent gets it right
o Inexplicable activism, the consequence of which is bad law, and therefore bad tax practice, which ends up
resulting in people being allowed to cheat
o Aside:
 Duberstein
 Because it provided no guidance
 Also bad because it said a legal finding would get the standard of review of a factual finding
 The consequences of bad law are bad outcomes
 Zarin
 Bad legal reasoning
 Macomber
 Subsequently, essentially defanged
o However, misunderstood again in CS
 SC
o Acknowledge that there was no sale…but was there a realization
o Whether there is a realized loss depends on a two-prong analysis
 (1) There is “material difference” requirement built into the realization doctrine. 1001.
 1.1001-1: “differing materially in kind or in extent”
 (2) “Material difference”
 Distinct legal entitlements make an exchange of properties materially different
26
o

Essentially the Court adopts the taxpayer’s argument that any difference is a material
difference
 properties may very well be substantially identical, but materially different
Dissent
o Majority applied form over substance
Standard going forward
 Establishment of a “hair-trigger” standard… any difference = realization event
o Any difference at all, under CS, is going to lead to a disposition and therefore a realization event
 Ever since CS, the regulators have been trying to establish a “materiality” requirement
 The Regs have tried to reduce the hair-trigger standard produced by CS
o Any refinancing would be a realization event
Applying CS (p.74-75 (Notes) and p.245 (Klein)))
(1)
 J and B
o Cotton dealers
o Business acquaintances
 Both have cotton in a warehouse
 Price of cotton has fallen
o So both have substantial unrealized losses on the cotton they have in storage
 Both would like to avoid selling, but both have large gains and would like to avoid losses
 2 ways of running the transaction
o Leaving your bale of cotton in a warehouse for storage and getting a bail back
 This is the non-tax, most sensible way to store cotton
o Leaving your exact bail of high-grade cotton in a warehouse for storage and getting an equally high-grade
bail, albeit not the exact same one, back
 Could report losses here under CS
 Under CS, whether there is a loss depends on how the warehouse works
 Question 1 suggests that there is no material difference between my cotton bail and a bail of the exact same
cotton, but its even worse as a practical matter because it will encourage people to engage in wasteful
activities for tax purposes that
(2)
 S and J
 S, in NYC, has the legal entitlement to Streaker 13 and J, in Miami, has the entitlement to Streaker 14
 Cars are sent to the wrong city
 Each dealer has the docs establishing ownership
 Both cars have 750k FMVs
 Both have a 100k basis from the down-payment
 Upon delivery, they now both have a 500k basis
 Modifications take several months
 J owns 13 but 14 is in his lot; S owns 14 but 13 is in his lot
 The sensible thing to do would be to send the papers through the mail
o But, the papers are distinct legal entitlements
 And because they are distinct legal entitlements, the exchange of them is a realization event
 The trade of papers is a 250k realized gain for both S and J
o If they did the sensible thing, it would weirdly trip to CS rule and provide both taxpayers with a gain that
they don’t want
 S and J may very well go through the ridiculously wasteful process of shipping the cars rather than the paper
 We apply notions of symmetry here
o CS triggers a realization event in situations that aren’t beneficial for the taxpayers
27
NONRECOGNITION
Introduction to nonrecognition rules


[76]
Underlying incentives stemming from the realization doctrine
o If people have lost money on assets, the realization doctrine gives people with losses the ability to realize
those losses
o On the other hand, if you have gains, you want to hold off paying gains as long as you can by avoiding
realizing them
 If you can hold off on realizing gains until you die, then you have completely avoided paying
taxes on those gains
Congress doesn’t like some the incentives in some of the situations created by having a realization regime…
o So, they created a nonrecognition rule
Realization v. Recognition
 Realization event…did something happen that looks like it is the right moment to tax
 Nonrecognition…you can have a realization event, but Congress allows you to delay paying taxes
 How to look at a given situation.
o Is there income?
 Income, unless you can find a special exclusionary provision inserted by Congress
o Has this income been realized?
o Even if realized, is there a special rule that allows the taxpayers to defer tax for the time being?
 Realizations are going to be tax events, unless you can find a special nonrecognition provision
inserted by Congress
 Nonrecognition rules are “giveaways”
o Defers when a person has to pay taxes
 This is valuable…think about the time-value of money
 Potential rationales for nonrecognition rules (p. 247)
o Gain should not be recognized if the transaction does not generate cash with which to pay the tax and
the party is in pretty much the same business situation
 Congress is deliberately creating an asymmetry, but Congress is the right organ to do so
Like-kind exchanges
[77-81]
1031: exchange of property held for productive use or investment
 Like kind exchanges are granted non-recognition status (even when substantially different)… it is income,
and it is realized, but congress has provided for it as a non-recognition
 (a): no gain or loss is recognized upon exchange of property held for productive use in trade or business or for
investment solely for property of a like kind to be held either for productive use in trade or business.
o Excludes inventory held for sale
o Excludes financial assets easy to value and liquidate
 E.g., stock, bonds
 Policy
o This is supposed to be a business-enhancing rule
 1.1031(a)-1
o LK means two things that are darn close to the same thing
 LK is much broader than “substantially identical”
o Focus is on the nature and character of the property and not on its grade or quality (from Private Letting
Ruling)
 1.1031(a)-2
28

o Creation of classes (p. 624 (Bank))
 If you are in a like class, means you are LK
 If you are not in a like class, you might be LK
o General Asset Classes (GAC)
 Fairly arbitrary distinctions created by Regs. Writers
 Even though arbitrary, they act to provide guidance to those seeking it
Basic rule
o When defining LK, you get a vibe
Boot and basis
 1031(a): pure LK exchange
o You are exchanging only LK things…nonrecognition rule
 1031(b): mixed LK exchange
o If you give up a piece of LK property and receive back LK property and non-LK property and that is a gain
to you, then you will have to pay tax on some of the gain, but not necessarily all of it depending on how
much you got back was boot
 Mixed LK exchange…some of the gain is recognized
o Shorthand
 You will have to recognize the lesser of the gain or boot
 1031(c): mixed LK exchange
o Mixed LK exchange…none of the loss is recognized
 Asymmetry between (b) and (c)
o Shorthand
 Losses are not recognized
 But losses are easy to take advantage of because you can sell the thing rather than engaging
in a LK exchange
 Mixed LK exchange summary
o Recognize the lesser of the gain or boot
 However, losses are not recognized
o Formula (Calculations on p.78-79 (Notes))
 Proceeds of the disposition
 Proceeds – Basis you had in property disposed = gain realized
 Recognized gain
 Lesser of
o boot received in proceeds, OR
o gain realized
 If gain realized is negative, do not recognize losses
 1031(d): what you do with the basis after applying (b), and (c)…mixed LK exchange
o Formula (Calculations on p.79-82)
 A (original basis) + B (gain recognized) = C (total basis) – D (FMV of the boot) = E (new basis of
the like-kind property received)…useful equation
 Total basis (C)
o If you’ve recognized the gain, then you paid taxes on it, and you are done paying
taxes on that income. So, we insert the gain into the basis so that you can later deduct
that amount when you sell
 You want to figure out the new basis because you won’t hold onto the new property forever and
you’re going to want to know what basis you have in that property
 How the equation comes out depends upon whether you are the payor or the payee of the boot
 Whether an exchange is pure or mixed depends on whether you are the payor or the payee of the boot
Sample complete calculations: mixed LK exchange problems
29



(1) S owns Farm X and has a 10k basis in it; T owns Farm Y
o Exchange: T owns Farm X; S owns Farm Y
 S also gets 15k in cash and an 8k tractor
 So, there is a 23k boot
o FMVs
 Farm Y FMV = 100k, so
 Farm X FMV = 123k
 This is deciphered from the 23k boot (and also assuming that this is an arm’s length
transaction
o Boot/Basis
 Proceeds from the disposition of X
 100k + 15K +8k = 123k
 Amount realized = Proceeds – Basis
 123k – 10k = 113k
 S has a 113k realized gain
 Recognized gain is the lesser of the realized gain or boot = 23k boot (rather than 113k realized gain)
o New Basis
 10k (original basis) + 23 (gain recognized) = 33k (total basis)
 33k (total basis) – 23k (FMV of boot) = 10k (new basis of the LK property received)
 B = D…E remains the same (substituted basis)
 Basis when you sell property = 10k
(2) S owns Farm X and has a 110k basis in it; T owns Farm Y
o Exchange: T owns Farm X; S owns Farm Y
 S also gets 15k in cash and an 8k tractor
 So, there is a 23k boot
o FMVs
 Farm Y FMV = 100k, so
 Farm X FMV = 123k
 This is deciphered from the 23k boot (and also assuming that this is an arm’s length
transaction
o Boot/Basis
 Proceeds from the disposition of X
 100k + 15K +8k = 123k
 Amount realized = Proceeds – Basis
 123k – 110k = 13k
 S has a 13k realized gain
 Recognized gain is the lesser of the realized gain or boot = 13k realized gain (rather than 23k boot)
o New Basis
 110k (original basis) + 13 (gain recognized) = 123k (total basis)
 123k (total basis) – 23k (FMV of boot) = 100k (new basis of the LK property received)
 Basis when you sell property = 100k
 The basis you had in the original property was 110
o The 10 in boot that you didn’t pay taxes on is made up for by knocking off 10 of
your basis
(3) S owns Farm X and has a 130k basis in it; T owns Farm Y
o Exchange: T owns Farm X; S owns Farm Y
 S also gets 15k in cash and an 8k tractor
 So, there is a 23k boot
o FMVs
 Farm Y FMV = 100k, so
 Farm X FMV = 123k
30


This is deciphered from the 23k boot (and also assuming that this is an arm’s length
transaction
o Boot/Basis
 Proceeds from the disposition of X
 100k + 15K +8k = 123k
 Amount realized = Proceeds – Basis
 123k – 130k = -7k
 S has a -7k realized gain…no recognized gain because it is a loss
o New Basis
 130k (original basis) + 0 (gain recognized) = 130k (total basis)
 130k (total basis) – 23k (FMV of boot) = 107k (new basis of the LK property received)
 Basis when you sell property = 107k
 The rule says you have 7k loss that 1031 prohibits you from reaping a tax advantage
o When you sell your property later you subtract 107k instead of 100k…there is your
7k loss
(4) Example of when you are giving up boot, rather than receiving boot
o T owns Farm Y (100k FMV)
 T has 10k basis in Farm Y
o T exchanges Farm Y + 15k cash for Farm X
o Boot/Basis
 Pure LK exchange for the person giving up boot…so no recognized gain
o Basis
 10k (original basis) + 0 (gain recognized) = 10k (total basis)
 10k (total basis) – (-15k) (FMV of boot) = 25k (new basis of the LK property received)
 Basis when you sell property = 25 k
(5) Exam review hypo
 Formula
o A (original basis) + B (gain recognized) = C (total basis)
o C (total basis) – D (FMV of boot received) = E (new basis of the LK property received)
 Facts
o Y owns Greenacre
 Basis in GA is 50k
 FMV of GA is 130k
o Z owns Redacrre
 Basis in RA is 10k
 FMV of RA is 200k
 So, Z will require boot
o Exchange
 Z gets GA + 70k in boot
 Y gets RA
o Z’s basis in GA
 200k (130k + 70k) (proceeds) – 10k (basis) = 190k
 Z has a realized gain of 190k
 Recognized gain is 70k (lesser of boot or gain)
 Thus 70k TI here, and it is paid up front
 10k + 70k = 80k – 70k = 10k
 Basis = 10k
o If she sells GA tomorrow (or in some time where FMV doesn’t change)…
 130k – 10k = 120k TI
o Y’s basis in RA
31

(200k – (50k basis in GA + 70k boot)) = 80k
 Pure LK exchange for the person giving up boot…so no recognized gain
o Thus no TI here
 50k + 0 = 50k – (-70k) = 120k
 Basis = 120k
o If she sells RA tomorrow (or in some time where FMV doesn’t change)…
 200k – 120k = 80k TI
o Coming full circle
 Z is ultimately paying tax on her 190k gain
 Y is ultimately paying tax on his 80k gain
Timing Review


[82]
Realization
o Macomber
 Creates realization requirement
 Stock dividend is not only not realized, it is not even income
o Bruun
 Non-sales can be realization events
 Bruun is partially overridden by 109 and 1019
 Particular situation involving lease ending and property coming back to the owner
o Woodsam
 Gives you an example of a non-realization event
o (Cottage Savings)
 Distinct legal entitlements, blah, blah
 In brackets because it has been appropriately (very) narrowed
Nonrecognition
o Like-kind
 Non-recognized except to extent of boot
o PLR
 Nature or character defines what is LK
o Regs.
 Give you rules and examples to determine LK
o Basis equation
 Tells you how to adjust basis after a LK exchange
TRANSFERS INCIDENT TO MARRIAGE AND DIVORCE
Introduction
[82]
 Current law re transfers incident to divorce
o Property v. Alimony
 Property (on-going financial obligations)
 Treated like a gift
o Property is not treated as income to the recipient and is not treated as a deduction
to the payor
o Payee takes basis of payor
 Alimony
 Not treated like a gift
o Alimony is income to the recipient and is a deduction to the payor
o Payee does not take basis of payor
 Child support
32

Child support is not treated as income to the recipient and is not treated as a deduction to
the payor since money is same as would be paid as a personal expense if living with child
and not deductible
Property settlements
Transfers incident to a divorce or separation agreement
[83-86]
Davis (US SC 1952)
 In return for the shares of stock, ex-wife entered into a divorce with D and waived all legal rights
 SC’s analysis
o This was a taxable event
 Mr. Davis’s Gain
 Taxable gain = Proceeds (Inchoate marital rights = FMV of shares) – Basis in shares
held by Mr. Davis
o Inchoate marital rights are equal in value FMV of the shares (re: Proceeds)
 You have to treat it as if she bought the shares with something of equal value
o Otherwise, it becomes problematic
 Mrs. Davis’s basis in the shares bargained for:
 Her basis is the FMV of the shares on the day of divorce
o Exchange was not a gift, so basis does not transfer…1041 cures this…
1041: transfer of property between spouses or incident to divorce
 Congress’s response to Davis
o It is not a gift, but by legislative fiat, it is given gift treatment
 Basis is transferred to recipient of property (it is no longer the FMV of the shares on the day of
divorce/transfer)
 (a) No gain/loss shall be recognized on a transfer of property from an individual to a spouse or former spouse (if
the transfer is incident to the divorce [defined in 1041(c) to mean occurring within 1 year after marriage ceases
OR related to the cessation of the marriage]
o 1.1041-1T, A-7: a transfer of property is treated as related to the cessation of the marriage IF the transfer
is pursuant to a divorce or separate instrument AND the transfer occurs not more than 6 years after the
fate on which such marriage ceases
 (b) In this case the transfer is treated as acquired by gift and the basis of the transferee will be the adjusted basis
of the transferor
 Statute makes the difference between community and separate property irrelevant
 Recipient of property will have to pay tax on original basis
Hypo (Calculations (p.85-86 (Notes))
 H wholly buys W out of jointly owned house for 200k note
o H and W have basis of 100k in the house
 1041 treatment
o H buys W out
 For W
 200k (proceeds) – 150k (basis) = 50k (gain)
o Under 1041(a)(2), the transfer is not a taxable event and she does not pay tax on
her gain
o H sells house for 400k
 For H
 Basis is transferred: H now has entirety of 100k basis
33
o 400k (proceeds) – 100k (basis) = 300k (gain) [IF 121 was found applicable here, H
would only have to 15% taxes on the 50k]
o tax rate = 20%
o tax = .2 x 300k = 60k
 H’s net gain
 300k-60k = 240k
 H still has to pay note
 240k – 200k = 40k
o 140 Cash out (40k + 100k basis)
Remember: W’s tax is 0




 For W
 200k note
 no tax
o 200k cash out (no basis)
 Because of 1041, the person who keeps the property and does not cash out first ends up with
the tax bill (he cashes out 140k, while W cashes out 200k)
Davis treatment
o For W
 50k basis
 Selling her interest to H for 200k note
 HS income/gain is 150k
o 200k (proceeds) – 50k basis = 150k (taxable gain when she leaves the house) [IF 121
was found applicable here, W would not have to pay any taxes]
 tax rate = 20%
 tax = .2 x 150k = 30k
 170k cash on hand (200k – 30k)
o made 200k on note
o For H
 50k basis
 Paid 200k for her half of the house
 H’s basis goes up by 200k to 250k
 H then sells the house for 400k
 400k (proceeds) – 250k (basis) = 150 (taxable gain when he leaves the house) [IF 121 was
found applicable here, W would not have to pay any taxes}
o tax rate = 20%
o tax = .2 x 150 = 30k
 170k cash on hand (200k – 30k)
 had 200k in cash (400k in proceeds - 200k note (cash))
IF house is sold some time after divorce w/ proceeds to be split evenly, 121(d)(3)(B) allows a spouse who has
not lived in the house for some time to use ex-spouse’s use of the property to establish use/ownership
requirements
Davis treatment is equal tax treatment, 1041 is not equal tax treatment
Prenuptial settlements
[86-88]
Mercer (2nd Cir. 1947)
 Mr. Mercer’s Gain
o Taxable gain = Proceeds (Inchoate marital rights = FMV of shares) – Basis in shares held by Mr.
Mercer
 Mrs. Mercer’s basis in the shares bargained for:
34

o Her basis is the FMV of the shares on the day of transfer
 Exchange was not a gift, so basis does not transfer
Congress overruled Davis with 1041, but Congress did not overrule Mercer because the transaction occurred
before marriage
o However, you can elect yourself into 1041 by specifying for the transfer of property in the pre-nup to
occur after the marriage
 Remember: Davis treatment is equal tax treatment, 1041 is not equal tax treatment
Basis in Davis and Mercer
[88-89]
 Timeline
o 0…1…2….3
 0 – husband buys shares
 this gives husband his basis
 1 – husband marries wife
 2 – transfers shares to W; also, divorced
 3 (not necessarily one year later) – W sells shares
o Tax-relevant transactions
 (1) In Y2, H realizes gain on sale of shares
 We are looking at it as H sold the shares on the open market and W bought them back
 TI (Y2) = value of the inchoate marital rights in Y2 – basis of shares in Y0
o Value of inchoate marital rights is presumptively equal to the values of the
shares themselves
 This is less compelling in the Mercer case because divorce is more of an
adversarial situation
 Pre-nups are not as adversarial and it may very well be that this
equivalence is really off
 When do inchoate marital rights come into existence?
 Davis…year 1, when they took the vowels
 Mercer…not as clear as Davis
o Inchoate marital rights occur even before marriage
o W signed away marital rights contractually
 So, inchoate marital rights may come into existence before year
one, but when exactly?
o If we can’t point to the exact moment, should her basis in
transaction (2) be 0?
 …TI (Y2) = FMV of the shares in Y2 – basis in Y0
 (2) In Y2, W realizes income from selling her inchoate marital rights
 TI (Y2) = FMV of shares in Y2 – FMV of shares in Y2
o Under 1041, H’s Y0 basis is in the shares that transfer to W
 But isn’t this problematic? Shouldn’t the basis be 0 as suggested above?
 (3) In Y3, W realizes income from stock sale
 TI (Y3) = FMV of shares in Y3 – basis in Y2
o Under 1041, W gets transferred H’s basis in the share from Y0
 (4) … Hypothetically… In Y4, H disposes of inchoate marital rights for 0
 TI (Y4) = 0 (Proceeds) – Basis (Y2)
o So is there a tax loss that H never realizes
o In summation…this discussion…
 Highlights tax logic
 Congress did a smart thing by saying that inchoate marital rights should not be viewed as
property
 So, considering that they are not property, we treat inchoate martial rights as gifts
35


However, you still need to be aware of Mercer
 If the nexus of the transfer is not tied so closely to marriage, you have to make sure to define
the transfer of the gift
…Key to this discussion: as a matter of understanding divorce transactions, this is what 1041
avoids (or gift transactions if not in marriage)
Alimony and child support


Aside from transfers of property, the only other transfers incident to divorce are alimony and child support
Again, only applies to marriage, so DOMA is relevant
Alimony
[89-90]
215/71/62: the recipient includes alimony in their income and the payor deducts it
 The requirements (71) to receive alimony treatment (p. 320-321(Klein))
o (1) Payment must be in cash
 In cannot be stocks, land, a car
 It can be a check
 Cash means not property
o (2) It has to be a written instrument
 If there is a written instrument of divorce, you can presumptively get 215/71 treatment
o (3) You can opt-out of 215/71 treatment
 However, you can opt out of 215/71 treatment in such an agreement
o (4) Parties cannot be living in the same household
 Anti-fraud part of the Code
o (5) Payments have to end at the death of the recipient
 If they don’t, then apparently they weren’t alimony
o (6) Cannot be payments for child support
 62: alimony is an above the line deduction
Child support
[90]
71(c): the recipient DOES NOT include alimony in their income and the payor DOES NOT deduct
 Alimony does not apply
 The custodial spouse is going to be receiving money and the divorce instrument has to say how much is for alimony
and how much is for child support
 Child support, unlike alimony, is not included in the income of the custodial spouse
o Child support payments are not taxable to the recipient because the recipient essentially has basis in
that money
 The recipient is really a pass-through that spends the money on the children
o Not taxable to the recipient because this is not a gain
 Not deductible to the payor
o The tax logic is that if they had not divorced he would be paying this money to support his children and that
would not be deductible
 These kinds of expenses are personal expenses
 71(c) maintains a structure that is consistent with the rest of the Code
Excess front-loading
[90-92]
71(f)
 Tough tax provision
36



Essentially, this is a very clumsy way for Congress to make sure that substance dominates form
o Remember:
 There is a tax advantage to be had here (p.323 (Klein))
 Most times…wealthier spouse gets the deduction and poorer spouse has to include the sum in
income
 Poorer spouse is a lower bracket, if not the zero bracket…so, there is a revenue loss to the
Treasury
Formula (Calculations p.90- (Notes))
o Payments (numbers in ks)
 Y1 = ?; Y2 = ?; Y3 = ?
o Analysis (71) (13 steps)
 (f)(4)(B)(i): (Y3 payment)
 (f)(4)(B)(ii): 15k
 (f)(4)(B): (Y3 payment) + 15k = (f)(4)(B)
 (f)(4)(A): (Y2 payment)
 (f)(4): (Y2 payment) – (f)(4)(B) = (excess payment for Y2)
 negative number = no excess payment for Y2
 (f)(3)(B)(i)(I): (Y2 payment) –(excess payment for Y2) = (f)(3)(B)(i)(I)
 (f)(3)(B)(i)(II): (Y3 payment)
 (f)(3)(B)(i): [(f)(3)(B)(i)(I) + (Y3 payment)]/2 = AVERAGE
 (f)(3)(B)(ii): (average from above) + 15 = (f)(3)(B)
 (f)(3)(A): (Y1 payment)
 (f)(3): (Y1 payment) – (f)(3)(B) = (excess payment for Y1)
 negative number = no excess payment for Y1
 (f)(2): (excess payment for Y1) + (excess payment for Y2) = (f)(2)
 (f)(1): In Y3, payor includes (f)(2), recipient deducts (f)(2)
The point of all of this is curing the one-time payment termed alimony, but which in effect wasn’t alimony
because alimony is to be received over time
o Recapture
Exam review hypo
 Facts
o Y1 = 75; Y2 = 35; Y3 = 10
 Analysis
o (f)(4)(B)(i): 10 (Y3 payment)
o (f)(4)(B)(ii): 15
o (f)(4)(B): 10 (Y3 payment) + 15 = 25 (f)(4)(B)
o (f)(4)(A): 35 (Y2 payment)
o (f)(4): 35 (Y2 payment) – 25 (f)(4)(B) = 10 (excess payment for Y2)
o (f)(3)(B)(i)(I): 35 (Y2 payment) –10 (excess payment for Y2) = 25 (f)(3)(B)(i)(I)
o (f)(3)(B)(i)(II): 10 (Y3 payment)
o (f)(3)(B)(i): [25 (f)(3)(B)(i)(I) + 10 (Y3 payment)]/2 = 17.5 AVERAGE
o (f)(3)(B)(ii): 17.5 (average from above) + 15 = 32.5 (f)(3)(B)
o (f)(3)(A): 75 (Y1 payment)
o (f)(3): 75 (Y1 payment) – 32.5 (f)(3)(B) = 42.5 (excess payment for Y1)
o (f)(2): 42.5 (excess payment for Y1) + 10 (excess payment for Y2) = 52.5 (f)(2)
o (f)(1): In Y3, payor includes 52.5 (f)(2), recipient deducts 52.5 (f)(2)
 Excess payment questions on the exam may ask for component pieces of this equation
Child support obligations in default
[92-93]
37
Diez-Arguelles (Tax Court 1984)
 166(d): non-corporate taxpayer can deduct non-business bad debts as a short-term capital loss in the year such
debts become completely worthless.
 166(b): bad debts are deductible only to the extent of the tax-payer’s basis
 Here, court continues to deny the deduction since there is no basis due to the fact that she had not “out of pocket”
expense
o NB thinks this is just wrong and that it has been established that she (1) has basis and (2) the debt is
hopelessly lost and unrecoverable



Perry
o deduction for bad debt again not allowable, court tells taxpayer to go to congress and get it fixed there
1.166-1(c): to claim a deduction for a bad debt there has to be a valid an enforceable obligation to pay a fixed or
determinable sum of money
o But, in Diez, the debt was valid, enforceable, and clearly could not be collected
When the law is bad like this, you should use persuasive commentary or get professors to write a note or amicus
brief on the issue [especially in tax where you can go for a split in the law between tax court, court of claims,
circuits]
HOW CAN TAXABLE INCOME AND TAXES BE REDUCED?
DEDUCTIONS (Itemized), EXEMPTIONS, AND CREDITS
[93-95]
 When considering income, after you determine how much and when, you want to see if you can whittle down
your taxes due to the lowest amount possible
 Our rules on deductions, exemptions, and credits (DEC) work in such a way that people may have very
different zero brackets even if they have the same family size
o It all depends on how they take advantage of the various DEC
 Exclusion v. Deduction
o Some deductions aren’t fully usable in ways that you might imagine
 Phaseouts
o Phaseouts…Personalized exemptions and itemized deductions are reduced as adjusted gross income
rises above certain threshold amounts
 As income rises, the tax benefit of something incrementally declines
o Phase-outs amount to little more than back-door increases in the marginal tax rates.
 But, these hidden taxes are in no way large
o The Tax Code is being changed so as that phase-outs may no longer exist in the near future
 Personal deduction
o In addition to itemizing or claiming the standard deduction, all taxpayers are entitled to a personal
exemption deduction for themselves and for each of their dependants.
 Standard deduction v. itemized deduction
o You can take either the SD or the ID, but not both
o From here forward, we will be considering itemized deductions…
 Deductions operate like public subsidies
o We have to consider under what circumstances people in this country would be willing to take on a high tax
burden…KEY RATIONALE
 Topsy-turvy benefit of itemized deductions
o Generally, Higher income  higher marginal rates  deduction is more valuable per $  regressive effect
 Could change this, as WI has, by making deductions into credits so that they are the same dollar
amount for everyone
 Flow chart (p.353)
o Gross income (61)
 This is NOT an exhaustive list
38


Includes
 Explicit exclusions
 Implicit inclusions
o Minus Above the Line Deductions (62)
 Above the line v. below the line
 If it is above the line, then you don’t lose it if you decide to take the standard deduction
below the line
o If you are a lobbyist and you can move a deduction from below to above, you have
made you clients a lot of money
 Above the line deductions work the same way as exclusions from income
 This is an exhaustive list
 These are the 20 things, that’s it…no other deduction is an above the line deduction
 Examples mentioned by NB (62)
 (a)(2)(D): certain expenses of elementary and secondary school teachers
 (a)(3): losses from sale or exchange from
 (a)(7): retirement savings
 (a)(10): alimony
 (a)(15): moving expenses
 (a)(17): interest on education loans
 (a)(18): higher education expenses
o tuition and fees
 (a)(19): health savings account
o Equals ---------------------------Adjusted Gross Income (62) --------------------------------------------------------o Minus Below the Line Deduction (either the standard deduction [63(c)] OR itemized deductions
[63(d)])
 Must choose between SD and ID
 SD Amounts (p.638 (Bank))
o married individuals filing jointly and surviving spouses: 11,600
o heads of households: 8,500
o unmarried individuals (other than surviving spouses and heads of households): 5,800
o married individuals filing separate returns: 5,800
 NOT an exhaustive list
 Consists of all the deductions that are not above the line deductions
 In essence, every other deduction
 Notice that for some itemized deductions that there are thresholds
 Choosing SD or ID?
 Being below the line means two things
o Dealing with thresholds
o Dealing with an amount of itemized deductions would that exceed the standard
deduction
 …always consider whether the SD would be greater than the total
amount you could deduct for itemizing
o And Deduction for Personal Exemptions (151)
 PE Amount = $3,700 per person in 2011 (p.638 (Bank))
o Equals Taxable Income (63)
SIMPLE EQUATION
o Gross income – ATL = AGI – [(greater of BTL OR standard deduction) + personal exemption] =
Taxable Income
Exam Review Hypo
 Single person with 2 kids
39
o Personal exemption = 3,700 x 3
 11,100 total
o Standard deduction
 Head of household
 So, SD = 8,500
o Itemized deductions
 Charitable contributions = 2,000
 2,000 deduction
o you can take up to 50% of your adjusted GI
 Unreimbursed employee expenses = 8,000
 7,000 deduction
o 2% threshold
 Mortgage interest = 1,500
 1,500
o in full
 State and local taxes = 1,200
 1,500
o in full
 Medical expenses = 3,000
 None
o 7.5% threshold
o AGI = 50,000
 Possibilities
 (1) AGI – SD – PE = TI
o No itemizing (SD)
 50,000 – (11,100 + 8,500) = 30, 400 TI
o Itemize if you can do better than 30,400
 (2) AGI – ID (itemized deductions) – PE = TI
o Itemizing
 50,000 – (11,100 + 12,000) = 26,900 TI
 We go with Possibility (2)
DEDUCTIONS
 Below, we are dealing with all itemized, below-the-line deductions
o Aside from Section (1) Health Insurance, which is not even income
Health Insurance
[95]
 162: deductible for employer
 106: excludable from gross income for employees
 Health insurance is a completely nontaxable event
o The purest subsidy you can get through the Code
 Examples (p.95 (Notes))
o (1)
 E (employee) receives
 70k in salary
 5k in health insurance
 HS income: 75k
 Because of 106…
 5k is excluded and 70k is her gross income
o (2)
 S (self-employed):
40



75k in receipts
5k in health care expenses
o deductible under 162
GI: 70k
o (3)

N (employed, but not provided with health insurance by employer):
 75k in salary
o both E and N cost employer 75k a year
 doesn’t matter for the business tax-wise because salary and health are both
deductible for the employer
 5k in health care expenses
o This 5k is a huge assumption because if you are a non-covered employee looking for
health insurance, you will get nowhere near as close to the same deal
 GI: 75k
Medical expenses
Introduction
[95-96]
 What about medical expenses that are NOT REIMBURSED BY ANY MEDICAL COVERAGE you may have?
262
 Deductions cannot be personal, living, or family expenses except as otherwise permitted in the Code
213
 (a) allowance of deduction
o You can deduct medical expenses, not covered by insurance or otherwise, for yourself, spouse, or
dependents to the extent that such expenses exceed 7.5 percent of adjusted gross income.
 Policy-wise, 213 is only there for extraordinary misfortune
 213 is for people who have something very big go wrong that is not covered by insurance
 Keep in mind, when we give someone a break on their taxes, everyone else pays
 So, we have to consider under what circumstances people in this country would be willing to
take on a high tax burden.
o This 213 logic applies to deductions in general…KEY RATIONALE
 My aside: 213 kind of works like insurance…however, the funds after the “deductible” threshold are
not covered, just merely not included in income
 213 creates a disincentive to purchase health insurance
 (b) limitation with respect to medicine and drugs
o We are talking about prescription medicine, not Advil
 (d) definitions
o (1) “medical care”
 medical care is deductible
 a bit of broad definition
 fleshed out below
 (1)(A): for the disagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of
affecting any structure or function of the body
 (1)(B): for transportation primarily for and essential to medical care
 (1)(C): for qualified long-term care services, when provided by licensed health care practitioner
o (2) amounts paid for lodging
 lodging away from home, that is part of the medical care, is deductible
 you are not there for pleasure or spending money lavishly because you know it is deductible
 amount taken into account for each individual shall not exceed $50 per night
41




o (9) cosmetic surgery
 “medical care” does not include cosmetic surgery unless it is performed to cure a birth defect,
an injury stemming from an accident or trauma, or a disfiguring disease
RR 75-318 – the cost of Braille books was deductible over the cost of regular books
RR 64-173 – deduction allowed for cost of person to walk with a blind child through the halls
Regs §1.213-1(e)(1)(iii): Outlays to make a house handicap accessible, or as necessitated by illness are only
deductible to the extent they do not increase the FMV of the house
o E.g., Constructing entrance/exit ramps; Widening doorways; Modifying hallways ; Installing railing,
support bars, or other modifications to the bathroom; Lowering or making adjustments to kitchen cabinets;
Installing porch lifts or other forms of lifts; Modifying fire alarms, smoke detectors; Modifying stairs;
Adding handrails or grab bars; Modifying hardware on doors; Modifying areas in front of entrance and exit
doors; AND Grading of ground to provide access to residence.
The rules on what constitute “medical care” are very much socially contingent
o While falls under “cosmetic” and therefore a little too weird to constitute a deduction for “medical care”
will change over time as different procedures become more mainstream
Health Savings Accounts
 Allow you to saving money for health care
 223(c)(2) – deductible must be at least $1K and not more than $5K
 An employee that has a health care plan within this can claim tax deductible contributions to the LESSER of (1)
the amount of the deductible or (b) $2250 (self coverage)/$4500 (family coverage)
o Contribution to HSAs by employers are deductible to employers and nontaxable to employee recipients
 These contributions are considered an adjustment to gross income under §62(a)(19) and t/f can be claimed by
those who do NOT itemize
o Deduction is also not subject AMT
 §233(e) – Amount earned in the accounts are not taxable
 §223(f)(1) – Amounts paid from the account to reimburse employees for medical expenses are nontaxable to the
employee
 §223(f)(2) – Amounts paid out that are not for medical expenses are taxable as ordinary income
 In effect this serves as a retirement account as the deduction is allowed even though amounts were left over from
prior years coupled with the broad allowable use of this money (213 term is generally broader than insurance
definition) gives people an incentive to careful in incurring medical expenses because they will be spending their
own money
Further defining “medical care”
[96-99]
 Taylor (Tax Court 1987)
o Court held that TP could not deduct lawn mowing fees as a medical expense (it was a personal expense)
 Some factors to consider
 (1) The expense is not necessarily directly tied to healthcare providers, etc.
o Someone in the family could have helped
 However, some things are medical expenses that don’t have anything to
do with healthcare providers (consider lodging provisions)
 (2) Causation
o It is not clear whether “but for” his allergy he would have otherwise mowed his own
lawn
 Important to look to the past here
 (3) Doctor recommended activities do not always constitute deductible medical expenses
o TP has the burden in these situations
 Henderson I (Tax Court Memo 2000-231)
42

o Depreciation of the van used from disable kid will not be deductible as a medical expense because
deprecation does not constitute “amounts/expenses paid”
 The lift installed was deductible in itself
 “Amounts/expenses paid”
o When you pay an expense, money must change hands
 Court is saying that “amounts paid” means dollars changing hands, but this
isn’t really the case in an accounting sense (consider the change in HS income
that the parents experience here)
o However, it reasonable to say that the depreciation constitutes an amount paid in that it lowers their
HS income (NB thinks this case came out wrong)
OCHS
o Majority dismisses this as 262 personal expenses since someone would have needed to take care of kids
even if there was no sick mother – but this ignores the fact that there IS a sick mother
 Majority is worried about permitting a deduction for what they view as a personal expense that also
happened to result in a medical benefit to the wife
o Dissent acknowledges that the majority is worried about a slippery slope and so proposes his own test
 Would taxpayer normally spend their money in this way?
 Did the taxpayer buy such luxuries in the past?
 Did a doctor prescribe this?
 Did taxpayer act in most economically efficient way?
 Was this over and above normal living expenses?
 Was this closely geared to a particular condition rather than general health?
o Dissent is willing to limit the deduction to the expense to the deductible expenses to the care of the
children at the time when they would otherwise be around the mother
 NB agrees with the dissent
Charitable Contributions
Introduction
[99-100]
 One of the safest bets in the world that big time tax reform efforts will never get rid of this
 Charitable contributions account for large sum of money, but it is not going anyway because it is considered
absolutely fundamental to American values
 Also, charitable contributions are highly abused
Two sides of the story for charitable contributions
 170: governs deductibility of charitable contributions
o If you make a contribution to a charity, and you are itemizing, you can take the amount you give as a
deduction
 Charitable contributions are allowed as itemized deductions…above the line
o Any given year the maximum you can take is 50% of your adjusted gross income
 But, 5 year carrover allowed
 Thus, another place, in addition to the medical expenses context (think the 7.5% threshold),
where adjusted gross income is important
o (b)(1)(B): if donation is principally for a private foundation it is limited to 30% of AGI
o (b)(2): corporations are limited to donations of 10% of taxable income
o (c): categories of charities
 (1): governments
 (2): non-governmental charities
o (e)/(f): compliance provisions
 (f)(8): TPs who claim a deduction for any form of contribution in excess of $250 must be able to
substantiate the reduction with a written acknowledge of the donation by the donee.
 (f)(8)(D): the donee organization can alternatively file information with the IRS directly
43





(f)(11): for contributions which are not readily valued and for which the deduction is more than
$500, the TP must include with the return a description of the property
 (f)(12): when vehicles are donated the deduction is limited to the proceeds of the sale
501: governs the recipients of charitable contributions
o (c)(3): if you organized properly as a charity, the charitable contributions that you receive are not
taxable.
170 charities = 501 charities
o Requirements for “charity” status
 (1) Charitable institutions cannot privately benefit individuals from the tax-exempt status.
 The private benefit is interpreted to mean “extraordinary benefit”
o There is a reasonable element to this
 (2) You cannot engage in electioneering
 You cannot engage in candidate advocacy
o But this doesn’t seem to be enforced so strictly.
Contributions of Property
o The difference between long-term and short-term
 This is really important because the tax treatment on short-term is not very generous
 Short-term: If you have held the property for less than a year, the only thing you can
deduct is the basis
 Long-term: If you have held the property for more than a year, you can deduct the FMV of
the property.
 Deductions for gifts of property that would be long term capital gains are limited to 30% of AGI
(20% to a private foundation)
Policy
o Way for the government to help subsidize charities
 But, where do we draw the line when deciding what TPs are going to be subsidize?
Gifts with private objective or benefits: BUSINESSES
[100-102]
 Ottawa Silica (Fed. Cir. 1983)
o OS loses deduction for charitable contribution because of the roads they expected to be built in return
o Substantial benefit test
 You will not be allowed to deduct if you receive a substantial benefit in return for your
charitable contribution, regardless of whether the predominant purpose of the contribution
was charitable abd not business-related
 “substantial benefit”
o Something beyond what everyone else from the supposed act of charity
 It is okay for a donor to get a benefit from a nominally charitable deduction so
long as long as the benefit is not uniquely beneficial to the donor
 Contra e.g., you can get a deduction for donating to an anti-gang
organization
o If this is really a business transaction in disguise than a deduction is not allowed
o Very TP unfriendly
o What happens when OS loses its charitable donation?
 Although OS loses the charitable donation, they get to take advantage of the basis
 The basis in the land that they gave away can now be added to their basis.
o Had the taxpayer won, it would have recognized a current deduction equal to the
FMV of the contributed property. Instead, the TP received no current deduction and
could only add to the basis of the contributed property to its other land. The TP
would, in effect, be able to deduct that basis when and if it sold its other land.
 The effect of the government victory was twofold. First, the taxpayer was
forced to defer any tax benefit for what might turn out to be many year.
44
Second, the eventual tax benefit would be limited to the basis of the
contributed property, rather than the fair market value of the contributed
property. (p. 386-387 (Klein))

Duval (Tax Court)
o Tax Court went other direction from OS
o Predominant purpose test (predominant purpose of the donation must be for a public purpose)
 (1) Intent-based
 (2) More than incidental
o Very TP friendly
 For the IRS to win a case under this test, they have to prove that the TP knew they were going
to get a benefit AND that’s the biggest reason why they engaged in the transaction.
 “biggest” v. “substantial”

Law from OS and Duval
o There are at least two different standards out there
 (1) substantial benefit
 (2) predominant purpose
o There is a possibility that a business may lose its charitable deduction for engaging in a quid pro quo
 The two different standards explore how much self-dealing is allowed
o Businesses who take charitable deductions need to be able to prove that they did not intend to receive
a substantial benefit in exchange
o All or nothing test
 If you fail the standard, then you lose the entire value of the charitable deduction
 All you get to do is take advantage of the basis of the property given away
 This rule seems very harsh… (next section)
o Important aside: The deduction itself cannot be the economic benefit that disallows the charitable
deduction …you need to get something beyond the tax benefit
Gifts with private objective or benefits: NON-BUSINESSES
[103]
 The same two contrasting standard may apply:
o (1) substantial benefit
o (2) predominant purpose
 Important distinction between business and non-business
o If a business makes a charitable contribution and gets too much benefit, then they lose the whole
thing
o RR 67-246: For non-businesses, there can be a quid pro quo
 The existence of the quid pro quo means you lose only the value of the thing you receive as a part of
that deal
 This does not exist for businesses because, as a policy matter we strongly suspect businesses
as seeks profits…so we need a relatively severe regime
 An OS-like rule would kill much of charitable giving, so instead we have a partial reduction
rule
 Non-businesses
o Charity gets full advantage
o Donor gets partial deduction
 The deduction you get comes from the amount of your donation minus the value of the goods you
received in exchange
 The deduction is offset by the substantial benefit you receive in return
o De minimis exception
45



You don’t have to offset your charitable deduction when the only thing you
receive is very minimal (e.g., swag).
One of the problems is substantiating values
o 6115 polices this by requiring that for any quid pro quo contribution over $75 the charity must provide the
donor with a written statement that the entire amount is not deductible and must provide a “good faith
estimate of the value of the goods or services” received.
 Items below the $75 threshold are still not entirely deductible, there is simply no rule requiring
charities to provide documentation
Although there are huge psychic benefits to charitable donations, the IRS does not offset the psychic benefit you
get from the amount of the charitable deduction
Private charitable contributions in short
 Business…all or nothing rule
 Non-business…quid pro quo reduction rule
The special case of collegiate athletics
[103]
 170(I): allows for a deduction of 80% when contribution would be deductible but for the direct/indirect option to
buy tickets
o NB says this is an example of law taking a backseat to politics
What is charitable?
[104Bob Jones
 To qualify for tax exempt status an organization must (1) fall into one of the enumerated (8) categories AND (2)
promote a general public policy of charity
 Revocation of charity status on public policy grounds
o Really heavy burden
 There has to be “no doubt” that the charity violates a “fundamental public policy”
 In short, there is a public policy exception, but the reading of “public policy” is so narrow that the exception
is essentially limited to the fact of BJU (race-based discrimination).
o We have to consider what the average TP would be willing to “subsidize”

501(i): disallows charitable deductions for racially discriminatory social clubs, let alone educational institutions
o does not disallow charitable deductions for gender-biased social clubs
 fraternal organizations wouldn’t have it
TAX CREDITS

[105-106]
Deductions v. credits
o The basic difference is that the value of a deduction to a TP varies depending on what tax bracket they are in
 A deduction only reduces your tax income by your marginal tax rate
 Tax deduction is never worth more than 35 cents on the dollar
 A credit is always worth a dollar
 You get to reduce your tax owed by that amount
 Difference is further complicated by refundable and non-refundable credits
 Also, deductions are non-refundable
 Deductions are used to reduce your taxable income; however, credits are actually used to
reduce the tax itself.
o Order that you would lobby Congress:
 Refundable credit
 Most taxpayer friendly thing we have
 Non-refundable credit
46

 Above-the-line deduction
 Below-the-line deduction subject to no threshold
 Below-the-line deduction subject to some threshold
 Timing rule
Two types of credits
o Refundable
 You get the surplus of the credit minus the tax liability that you have if that number is positive.
o Non-refundable
 You tax liability goes down to zero, but you do not get the surplus if there is one.
Why do people have zero federal tax liability?
o You are poor
o You have attained the amount of credits that has completely offset your tax liability.

32: Earned income tax credit (EITC)
 Refundable tax credit, does not just offset liability but also results in payments
 (k):
o if you do anything wrong, you will lose the ability to attain future benefits
 this provision is to stop cheating
 The EITC is the worst of all worlds because it is the most complicated enforcement regime directed at the
population least capable of dealing with this regime
 The EITC is there for the working poor with kids
 Phase-out
o At a certain threshold, you begin to lose benefits as your income increases
 You can go through an income range where you are worse off for earning more
 This creates a tax disincentive to work and earn more
 The EITC is biggest tax credit regime that we have

Tax credits, for the TP are…
o Better than a deduction
o Better when refundable
MIXED BUSINESS/PERSONAL DEDUCTIONS
Introduction
[106-107]
-
162
 Allows deduction for “ordinary and necessary business expenses” paid or incurred during the taxable year in
carrying on any business or trade
 For individuals, limited by 67
o 67: 2% of AGI threshold
 For this 2% threshold you can aggregate all of your miscellaneous “ordinary and necessary business
expenses”…..KEY: AGGREGATE 2% THRESHOLD FOR “ORGINARY AND
NECESSARY BUSINESS EXPENSES”
 Purpose of the threshold is to avoid dealing with de minimis expenses
 For businesses, there is no limiting threshold
o If self-employed, no threshold
 It’s not really “income” if paid out of pocket for production
 Below-the-line deductions
o Dealing with AGI threshold
212
47





Applies to individuals
For “cost of producing income”
212 was added specifically for income from sources other than a trade or business
o The expenses that go along with managing an investment portfolio
212 is probably unnecessary
o 162 is the go to section in terms of business deductions
Below-the-line deductions
262
 No deduction allowed for personal, living, or family expenses
o We will not subsidize people’s personal expenses
Controlling the abuse of business deductions
Hobby losses
[107-108]
Nickerson (7th Cir. 1983)
 Must be sincere, though not necessarily realistic expectation of profit
 183: activities not engaged in for profit
o Deduction allowed only when the activity is engaged in for profit (but only to the extent that it exceeds
2% AGI threshold)
 Determined by a facts-and-circumstances test
 All-or-nothing approach…you fail 183, you get no deduction
o (b)(2): expenses incurred in activities not engaged in for a profit can be deducted only to the extent that the
gross income derived from such activity exceeds otherwise allowable deductions (d): profit presumption
(rebuttable)
 If you made a profit in 3 of the last 5 taxable years, then you are presumed to have engaged in the
activity for profit
 If the TP does not meet the requirements for this rebuttable presumption, he has the
burden of proof, and must show a bonafide expectation that at some point you will be
making a profit
o 1.183-2(b): totality of the circumstances test
 Some factors considered:
 Manner in which taxpayer carries on activity
 Expertise of taxpayer or his advisors
 Time & Effort expended by taxpayer in carrying on the activity
 Expectation that assets used in activity may appreciate in value
 Success of the taxpayer in carrying on other similar or dissimilar activities
 Taxpayer’s history of income or losses with respect to the activity
 Amount of occasional profits, if any, which are earned
 Financial status of taxpayer
 Elements of personal pleasure or recreation
o Policy
 Again, we have to ask when we are willing to see the activity as business focused enough so as to
provide a “public subsidy” via a tax deduction?
 Holding
o TP’s activity on the farm was not for profit
 Court concludes that “[c]ommon sense indicates to us that rational people do not perform hard
manual labor for no reason, and if the possibility that petitioners performed these labors for
pleasure is eliminated the only remaining motivation is profit.” (p. 430)
 NB thinks that court comes out wrong in reversing the trial court on this rationale
48
Other hobby cases
 McCarthy: father was allowed to deduct managing costs of 13 year old son’s motorcross racing career even though
he had no likelihood of making a profit in any particular year
o Pre-opening expense doctrine under which expenses incurred before taxpayer begins business operations
must be capitalized [unless they are a farmer]
 Farish: Likelihood that taxpayer engaged in business to make a profit can be considered in light of geographical
and occupational factors – breeding horses was found deductible for Texans engaged in oil drilling
 Daily: Trips to Europe are not deductible as a business expense when antique dealers never advertised any items for
sale, never offered anything for sale, and never actually sold an item
Home offices
[108-110]
Popov (9th Cir. 2001)
 280A: disallowance of certain expenses in connection with business use of home, rental of vacation homes,
etc.
o (a) General rule is to deny deductions for any use of a home for business purposes
 technically unnecessary with 262 but serves as a reminder that personal expenses are non-deductible
o (c)(1): Subsection (a) shall not apply to any item to the extent such item is allocable to a portion of the
dwelling unit which is exclusively used on a regular basis
 (a) As the principle place of business for any trade or business of the taxpayer
 (b) As the place of business which is used by patients, clients, or customers in meeting or dealing
with the taxpayer in the normal course of his trade or business, OR
 (c) in the case of a separate structure which is not attached to the dwelling unit, in connection with
the taxpayer’s trade or business (if you set up a separate structure, the Code is more forgiving, and
does require that business be principle use)
 ...exceptions get gradually more lenient
 280A(c)(1) is at issue here (where professional musician is entitled to deduct expenses for the portion of her home
used exclusively for musical practice)
o Court addresses whether this deduction is allowed on the grounds that it is a home office that is exclusively
used as the principal place of business for any trade or business of the TP
 Solomon test
 (1) Relative importance of the activities performed at each business location
o Point of performance should not determine the principal place of business
o This prong is not too important to the court here
 (2) Time spent at each place
o Court knows this is the money factor
 Does the person spend significantly more time here than anywhere else?
 Take away
o Advise your client to engage in exclusive use
 There may be not that much left of (c)(1)(a) once your satisfy the exclusive use case
Office decoration
[110-
Henderson II (Tax Court)
 Where 162 and 262 may apply, 262 takes priority
 Court finds that plants and prints in Henderson’s office were not deductible
 Rule
o There essential inquiry is whether there is a “sufficient nexus” between the expense and the “carrying on”
of the individual’s trade or business to qualify the expenses for the deduction under 162(a), or whether they
were in essence personal or living expense and non-deductible by virtue of 262.
49


To receive the deduction, the expense cannot be too “tangential,” “remote,” or “incidental” in
aiding in the performance of the taxpayer’s business or duties
Aside: commuting expenses are nondeductible (somewhat addressing the parking issue that the court seems
to ignore)
o Commuting expenses are personal
Travel and entertainment expenses
[111-114]
132
 Employees are not taxed on whatever personal benefit they receive out of employer-provided business travel
o If the trip is characterized as non-business then it is treated as a form of salary and taxable income
o The cost of employee business travel is deductible for employers
o Non-business-related trip that an employer pays for is deductible to employer (along the same lines of
salary IF it meets ordinary and necessary business expense test) but is taxable to the employee
Rudolph
 No holding. US SC realizes that they should not have granted cert.
o Found that the trip was just a different form of compensation/income (61) and the employee cannot
deduct it because it is not a business expense (162) as there was no compulsion to attend the trip
 Even though the employee couldn’t deduct here, the employer can deduct the expense as if he were
deducting salary
 Test
o Dominant motive and purpose test
 Is it related primarily to business or is it personal/for-pleasure in nature?
 If for pleasure, the expense cannot be for business, and thus is not deductible.
o Basically 162 v. 262
 1.162-2(c): Where a taxpayer’s wide accompanies him on a business trip, expenses attributable to her travel
are not deductible unless it can be shows that the wife’s presence on the trip has a bona fide business
purpose. Incidental service does not qualify as a deductible business expense.
 Take away
o When can you make a deduction in situations involving some degree of compulsion, but also entailing
something that an objective observer may find to be enjoyable?
 Very fact-specific inquiry
Danville Plywood
 Mirror image issue to Rudolph
o In R, we are looking at the employee
o In D, we are looking at the employer
 To be deductible, an entertainment expenses must meet the requirements of BOTH 162 and 274
 Statutory analysis
o 162
 “Ordinary and necessary business expenses”
 What does “ordinary and necessary” do in terms of modifying what a “business expense” is?
o “ordinary and necessary” is read conjunctively
o “ordinary and necessary” can be rare
 e.g., if there is a storm and you need to rebuild the business
o overall, it is a pretty forgiving test
o 274: disallowance of certain entertainment expenses, etc.
 Serves to limit “ordinary and necessary”
 Closes a loophole to business trying to write-off entertainment expenses
50
 If its not business, then its not a business expense
(a)(1)(A)
 Entertainment, amusement, or recreation cannot be deducted as a business expense unless it
was “directly related” to the active conduct of the taxpayer’s business or “directly
preceding or following a substantial and bona fide business discussion (including a
business meeting at a convention or otherwise) that the entertainment was associated
with”
o This was created to prevent situations in which there was a nominal business aspect to
an vacation or entertainment excursion
 E.g., Rudolph
 (n)
 Even if you can pass muster, you can only deduct 50 percent of meal and entertainment
expenses
 1.274-2(c): deduction is not allowed when entertainment is intended merely to establish good will
o Congress went out of their way to write 274 so as to disable expanding the legitimate part of the
business trip to cover all of the expenses related to the pleasure of the trip-goers



Note
o Buchanan could have easily deducted this if he paid the employees a bonus and afforded the opportunity to
come to New Orleans (with that money in hand)
 This creates a R-like inquiry
 In this sense, it seems as though we are predicating form over substance
o Keep in mind the compulsion faced by the “organization” man
Planning guidance
o If you’re going on a trip, make sure that there is more business than pleasure going on
 Make sure you have a written-down plan
1.162-2: Traveling expenses
 The traveling expenses have an all-or-nothing rule
 Even if we determine that the overall purpose of the trip was personal, you can still take deductions for particular
items on the trip that were business-related
o However, you do not get to deduct a portion of your travel expenses
 You can only deduct the travel expenses when you can deduct all of them because the trip was
found to be business-related
 Thus, the all-or-nothing nature of traveling expenses rule
Lesson from Rudolph and Danville
 Does the pleasure element or the business element dominate?
Clothing expenses
[114-115]
Pevsner (5th Cir. 1980)
 P tries to deduct clothing as an “ordinary and necessary expenses”
 The generally accepted rule governing the deductibility of clothing expenses is that the cost of clothing is
deductible as a business expense only if:
o (1) the clothing is of a type specifically required as a condition of employment;
o (2) it is not adaptable to general usage as ordinary clothing; AND
 Objective test
 The clothing cannot be considered generally accepted for ordinary streetwear
o While this analysis isn’t completely clear, it is more clear than a subjective analysis
o Also, this analysis is more horizontally equitable than a subjective analysis
51

Tough argument to make here because horizontal and vertical equity analyses
seem both cut against on another and also collapse on themselves.
 Horizontal equity -- could be argued either way, that two managers
who both buy clothes should either both be allowed deduction or
neither should be allowed, BUT in other direction this doesn’t work
because if managers are of different socio-economic classes then it’s
not horizontal
 Vertical equity -- lower classes will be less likely to take advantage of
deduction because less likely to have specialized uniforms [seems
violative of vertical equity]
o (3) it is not so worn
Nelson
 They focus on situation specificness
o Which the Pevsner court seems to try to avoid
 The deduction was allowed because the clothing worn by the cast members was support to exemplify Middle
America, even though the show was filmed in Southern California
o i.e., cast members were not going to wear cardigans in Southern California
ALTERNATIVE MINIMUM TAX
[115-117]

Income tax is only one of two parallel tax systems in the US
o The other being the AMT
 AMT is defined as the amount over what taxpayer would otherwise owe, so it is not one or the
other, but rather both, since AMT is defined as the excess
 We are only looking at Sections 55 and 56 and the individual (non-corporate) AMT
 The basic idea for the AMT is kind of like a flat tax
o The AMT is really close to a single rate tax
 Two rates
o 26% and 28%
 The purpose of this system is to broaden the base by taking out a bunch of things people ordinarily use to
lower their tax liabilities
o Congress realized that people with high incomes had zero tax liabilities due to preferences
 To the extent the AMT is imposed based on timing, the payment is treated as a credit and can be used in
later years to reduce regular tax
 The AMT is set-up to take out deductions, exclusions, and accounting methods that enabled high-income
people to get the incomes down to zero
 Structure of the tax
o Really big zero bracket
 Stands in for preferences eliminated by AMT
55: AMT
 (a)
o AMT = TMT (tentative minimum tax) – Regular tax
 This is your AMT only if you get a positive AMT
 You have no AMT liability if you get a negative AMT
o Total Tax = Regular Tax + AMT
 (b)
o TMT

Big picture
o The difference between the two tax systems
52



The AMT eliminates a bunch of deductions, credits, and special accounting methods
 The question is which one’s get eliminated? … p.612
o (6) Itemized deductions
 Note that you still get your deduction for your home mortgage interest
 This is the biggest area where the AMT cuts back on things that normal
people take as deductions
 You lose the state and local taxes deduction
 You lose the deduction for interest on home equity loans
 You lost the deduction for certain job related outlays
 The deduction for medical expenses is limited to the excess over 10%
(rather than 7.5%) of AGI
 You also lose the standard deduction and personal exemptions
The AMT has become problematic
o There are rich people still getting their incomes low by using non-AMT preferences
o There are poor people suffering due to ATM-preferences
o Roots of problems
 AMT is not indexed to inflation
 So Congress has to engage in ATM fixes
 Administrative problems
 Hard for people to know whether they have to pay the AMT
NB sometimes calls the AMT the “enough is enough tax”
o The government (and thus the citizenry) will stop subsidizing you at some point
Klaassen
 Ks are a family with a lot of kids because they are religious
 AMT Calculation
o Normal/regular tax (1994) determination
 AGI = 83,056
 Minus Itemized deductions = 19,564
 Medical expenses = 4,767
 State and local taxes = 3263.56
 Minus Personal exemptions = 29,400
 12 personal exemptions: one for each of themselves and their 10 kids
 Equals TI = 34,092
 Regular tax = 5,111
o AMT determination
 (1) State and local taxes = 3263.56  0
 56(b)(1)(A)(ii): All state and local taxes have to be added back under AMT
 (2) Medical expense deduction = 4,767  2076.41
 56(b)(1): AMT reduces deduction for medical expenses from 7.5% AGI to 10% AGI
threshold
o so, they lose 2.5% AGI
 (3) Personal exemptions = 29, 400  0
 55(b)(1)(E): in computing the AMT, 151 personal exemptions are not allowed
o 55(d)(1): instead of 151 personal exemption, the AMT provides s substituted fixed
exemption for purposes of AMT computation
 AMTI = 68,832
 Then, you get to take out the AMT exemption amount
 Taxable Excess = 68, 832 (AMTI) – 45,000 (AMT exemption amount) = 23, 832
o 55(d): default and 2010/2011 AMT exemption amounts
 (A): joint return/surviving spouse = 74,450 for 2011
53
 (B): single (not a surviving spouse) = 48,450 for 2011
TMT = (26% and/or 28%) x 23,832 (Taxable Excess) = 6196
 55(b)(i): determines whether to use 26% or 28% for individual TPs
o 26% of so much of the taxable excess as does not exceed 175k
o 28% of so much of the taxable excess as exceeds 175k
 AMT = 6196 (TMT) – 5111 (Regular Tax) = 1085
 Positive AMT, so you have to pay it
o If negative, you don’t have to pay it
Majority’s legal analysis in K
o Congressional intent
 Even if the TP can show legislative history pointing to the fact that this is a millionaires’ tax, what
Congress ended up doing is not at all what it intended to do
 The Code sections are very unambiguous and need to be taken at face value
o Constitutional arguments
 TP suggests that the tax infringes on their freedom to exercise their religion because it makes
additional children more expensive than they would otherwise be
 Court says that this statute is facially neutral, so tough luck
o For the TP to win, Congress would almost have to explicitly target the group being
harmed
 Court knocks this out of the park and says no constitutional problem at all
Concurrence
o Pleads with Congress to solve the problems embedded in the AMT



Prosman (TC Memo 1999-87)
 56(b)(1): in calculating AMTI, no deduction is allowed for miscellaneous itemized deductions and State and local
taxes, unless such amounts are deductible in determining AGI (i.e., above-the-line deductions)
 56(b)(1)(E): there is no deduction for personal exemptions under 151
 Also, even though the court sympathized with the lower income TPs at bar, the plain meaning of the AMT suggests
that they too are subject to it.
o The AMT is not just for high income earners
Exam review Hypo
 H and W filed join return in 2009
 TI = 100k
o Regular tax = 17,375
 AMTI = 150,000
o Taxable excess = 150,000 – 45,000 = 105,000
 TMT = 26% of 105,000 (Taxable Excess) = 27,300
 AMT = 27,300 (TMT) – 17,375 (Regular Tax) = 9,925
o Positive AMT, so you have to pay it
 Total tax = 27,300 (9,925 + 17,375)
54