Tax Outline
(Fall 2013 / Textbook: Bankman, Federal Income Taxation, 16 th ed. 2012)
Introduction: Setting the Table
Tax Policy
 Civilized society  laws  government(s)  taxes (through either government spending or tax breaks)
 Size and structure of government is center of policy debate
 Who gets taxed (people, corporations)
 7/8 of tax revenue comes from individuals
 1/8 of tax revenue comes from corporations
 How much we tax
 Consult table on p. 3 to see where federal revenue comes from
 Tax base: “thing” that is taxed (income, property, sales, estates, consumption, wealth)
 Tax Fraud
 “Tax gap” = difference between the amount of taxes we would collect if people complied perfectly with tax law
and the amount of tax revenue generated in reality
 Who is cheating on their taxes? Overall, US has high level of tax compliance.
 Average person doesn’t cheat. Employers have an incentive to accurately report how much money you are
getting paid because that’s a deductible expense to them. That means there is no much opportunity for
individual to cheat.
 Roughly half of the tax cheating comes from small businesses and self-employed people. Particularly
among cash businesses. It’s a problem that arises from norm and opportunity, not complexity of the tax
code.
 Large business don’t cheat that much. Large businesses, by definition, have lots of people. When you have
lots of people in a business you have to keep track of cheating among your employees. Largest businesses
are under permanent audit. So it turns out tax gap is not due to larger businesses.
 Tax Incidence
 Incidence of tax = who is really bearing the burden of the tax; who ends up with less money in the bank as a
result of it
 Corporate income tax is collected from corporations, but the incidence of the tax is on employees, shareholders,
and suppliers
 Tax expenditures vs. tax cuts
 The same goal can be accomplished whether through tax expenditures or tax cuts
 But politicians of course prefer to call something a tax cut than expenditure increase
 Table 1-2: Housing ownership subsidies, pension subsidies & healthcare subsidies are the largest tax
expenditures
Tax Law -- Sources
 Internal Revenue Code of 1986 (Title 26 of the US Code)
 Note that whenever the Code says “to the extent,” that can be read as “by the amount”
 Civil law
 Goal is to try to make taxpayer and the Treasury whole
 So tax evader will have to make up for underpayment as well as interest
 Penalties may also be imposed, but that depends on how severe the evasion was
 Criminal law
 Criminal penalties rarely applied
 Only apply where heightened mens rea is found (purposefulness w/o a reasonable belief that what you are
doing might be legal)
 Treasury Regulations
 Interpretive guidance
 Fill in gaps in the Code
 Not updated reliably
 Revenue Rulings
 Look and read like opinions, without the names of the taxpayers
 Treasury can issue advisory opinions (unlike courts)
 Deference to these as well
 Private Letter Rulings
 Not binding
 Essentially telling a taxpayer what to do in a certain situation, in response to taxpayer inquiry
1
 Revenue Procedure
 Where IRS has done the requisite calculations for you where they come up in the Code
 Congressional intent very important (found in Committee reports)
 Common law
 Comes from administrative agencies primarily but also from courts
 Most of the issues that arise are statutory interpretation issues
 “Substance dominates form” = most important canon of interpretation
 The rationale behind this canon is that it encourages taxpayer morale, which currently favors paying
taxes
Tax Law and Tax Policy Combined
 Who loses when people don’t pay their taxes or when a tax break is granted?
 If you still want to collect as much money as the tax law should have collected, then the losers are the people
whose taxes go up.
 If you instead reduce the government’s activities (i.e. decide not to go after tax evaders and simply accept a
lower budget), then the beneficiaries of those activities are the losers.
 If you do neither (neither collect taxes from other people nor reduce spending elsewhere in the government),
then the deficit rises.
 Who loses then?
 Future taxpayers if what this does is put higher tax liabilities on them.
 People who had a good argument to increase the deficit lose. People who have an argument as to what
level of deficit is desirable lose in the sense that their proposed deficit level is increased by whatever
amount is lost through tax evasion.
Complexity, Congress, and the Code
 Why is tax law so complicated?
 Life is complicated. For example, we want to have this notion that it would be simpler if everyone paid the same
amount. Then you say “well, they’re not all adults.” So you leave out the kids. Then you say “not everyone has a
job.” So then you take out elderly and unemployed. The list goes on. Congress looks at reality and reality is
complicated.
 People are highly motivated to reduce their tax burden. When you have several hundred million people every
year trying to figure out clever ways to reduce their tax burden, they discover loopholes. Congress is always
trying to play “catch up” to plug in those loopholes.
 Congress is trying to seek political favor. Every single person has a special pleading.
 Tax expenditures. Tax expenditures are ways to accomplish something such that we can label them “tax cuts.”
One of the reasons that tax expenditures became so popular is that, in addition to the fact that they look like tax
cuts, is that the Congressional committee system encourages it. Passing a tax expenditure is easier than getting
tax spending approved.
The IRS
 A lot of public distrust of the IRS
 RRA-98: Internal Revenue Restructuring and Reform Act of 1998
 Congress wanted to rein in the purportedly out of control agency
 Shifted burden of proof to IRS but kept burden of production on the tax payer
 This was not such a big victory for anti-IRS people; burden of proof only matters where there’s an exact tie, and
that pretty much never happens
 Tax liability is based on preponderance of the evidence standard (50% + 1)
 Two benefits from RRA-98:
 Created Office of the Taxpayer Advocate. Responds to taxpayer complaints of IRS agent abuse. Also
conducts studies on general administration of the IRS, e.g. study during George W. Bush’s administration
examining cost-benefit of outsourcing of tax collectors.
 Created Treasury Inspector General for Tax Administration (TIGTA). Investigates potentially over-the-line
behavior of IRS employees.
Tax Litigation
 Very few tax controversies get litigated
 Why? There are many opportunities to resolve the dispute before trial: letters, internal hearings, offer-andcompromise process (where taxpayer gets to make an offer and IRS will consider and maybe accept it)
 Litigation forums:
2
COFC
Federal Circuit
SCOTUS
Federal
district court
Circuit court of
appeals
Tax court
 When it comes to litigation, IRS may choose to “acquiesce”
 Means IRS is not going to appeal a particular ruling but reserves the right to re-litigate the issue when it comes
up again
Legal Ethics and Tax Ethics
 Evasion vs. Avoidance
 If you decide it’s illegal, it’s called evasion
 If you decide it’s legal, it’s called avoidance (it’s expected people will avoid paying taxes to the extent that is
legal)
 Lawyers often try to sell “strategies” to clients that they claim will help clients minimize tax liability
 This can often subject lawyer to discipline for professional responsibility violations or to more serious
consequences
 What can get lawyer disbarred: willful, reckless, or gross incompetence
 In 1985 ABA opinion, the ABA says that a lawyer may assert a position in litigation if there is “some
realistic possibility of success if the matter is litigated”
Tax Protestors
 Tax protestors argue that taxes are illegal for some reason or another and that they should not have to pay them
 Tax protests are completely baseless. They always lose.
 On the other hand, liability only attaches to tax violations where heightened mens rea requirement is met. If tax
evader had sincere belief that the people who told you that you had no income to report were telling the truth, then
you are off the hook.
Frivolous Tax Arguments
 “861 position” – if you read sections 861 and 911 together, taxable income is only income earned abroad
 Response: taxable income includes income earned abroad, but not only income earned abroad
 Thirteenth Amendment argument – income taxation is a form of slavery, which is forbidden by the Thirteenth
Amendment.
 Sixteenth Amendment argument – Sixteenth Amendment was never ratified
 IRS is not actually a federal agency. It’s a private collection agency for the twelve richest families in the world.
 Taxes are voluntary.
 Response: Because we have high taxpayer morale we have high level of voluntary compliance. It doesn’t mean
compliance is voluntary.
Average and Marginal Tax Rates
 Average (effective) tax rate = tax paid / total income
 Total income can be:
 Gross income
 Adjusted gross income
 Taxable income
 Marginal tax rate = tax percentage paid on the next/last dollar of income
 Next/last – not the same thing, but often turns out to be the same thing
 Zero bracket (ZB) = amount of income on which a taxpayer pays no income tax
 It is possible to have a positive income and yet pay no income tax at the federal level b/c of this zero bracket
 Progressive rate
 Rate rises as income rises
 Federal tax system is designed to be progressive on its marginal rate and average tax rate
 Regressive rate
 Rate falls as income rises
 Proportional rate
 Rate is constant as income rises
 Example: social security tax is proportional up to a certain threshold
3
 Code § 1 contains list of tax imposed depending on income
 How to determine taxable income:
 Taxable income = gross income – zero bracket
 Zero bracket = standard deduction + personal exemptions
 Standard deduction = amount everyone is allowed to deduct (p 646 in textbook)
 Personal exemptions = $3800
 In a graduated bracket system (progressive marginal rates), you get an average rate that is always lower than your
marginal rate (unless it’s zero)
 Example of calculating income tax:
 Family of four. $420k in income.
 Taxable income = $420k - $27,100 = $392,900
 Tax owed = $105,062 + 0.35($392,900 – $388,350) = $106,654.50
 Average tax rate = $106,654.50 / $420,000 = 25.4%
 Marginal tax rate = 35%
4
What is Income?
Some Characteristics of Income
 Income is a “flow variable”
 Flow variable – can only be defined relative to the passage of time (e.g. $/year)
 Wealth is a “stock variable”
 Stock variable – defined at a moment in time
Haig-Simons Definition
 Y = fmvC + ΔNW = consumption + savings
 fmvC = fair market value of consumption
 ΔNW = change in net worth = change in person’s property rights
 Note that savings can be negative
 The Code starts with the Haig-Simons definition of income, and then Congress whittles it down
 Problems with applying Haig-Simons definition in real life:
 Realization vs. accrual
 An asset can grow in value, which increases individual’s net wealth, but you don’t necessarily “realize” that
growth in value (by turning it into cash), so taxpayer doesn’t necessarily have a greater ability to pay the
tax.
 In the real world, we use realization system. Taxpayer only gets taxed when he turns asset into cash.
Taxpayer can grow really wealthy but not have to pay tax on any of it (e.g. if he holds stocks that grow
tremendously in value).
 Imputed income
 Income through non-market transactions, e.g. enjoyment, growing your own vegetables, cleaning your own
home, stuff you do by yourself or stuff that has only a value to you
 Example: You own your house fee simple. When you don’t have to rent, that means you don’t have to pay
rent money. So it’s rent-free living. Haig-Simons would say “fair market value of consumption” – how much
would it have cost to rent your house in a fair market transaction? So the proper definition of income
would include imputed income from owning a house.
 Below market sales
 People don’t pay fair market value for everything. So income would be overstated when taking into
consideration those goods/services for which people paid below market prices (e.g. in-state tuition).
 Taxing leisure
 Leisure time could be counted as income, and would be valued at its opportunity cost.
 Valuation problems.
 It can be hard to determine fair market value (what someone would pay in arms length transaction)
sometimes
 Treasury Reg. 1.61-1: tells you what Code 1.61 says
 Treasury Reg. 1.61-2(d): tells you how to value something in $ that was paid for not in $
 If services were paid for with property  use FMV of property
 If services were paid for by some other means  tax payer is allowed to estimate the value of the
services, and is given the benefit of the doubt with regard to that estimation
 Three sub silentio exceptions to income included under Haig-Simons/Code § 61 (other exclusions are explicitly
written into the Code):
 Imputed income doesn’t get taxed
 Some below market sales don’t get taxed (e.g. in-state tuition)
 Leisure
 Policy goals in defining income:
 Horizontal equity: Treat likes alike. If you have two people who are in other ways similar but they receive their
income in different forms, then we want to treat them the same.
 Vertical equity: Those who have greater ability to pay should be taxed more than those who have lesser ability
to pay.
 Old Colony Trust Co. v. Commissioner (US 1929)
 Things that don’t necessarily look like income are counted as income
 Income tax paid by employer directly to the IRS constitutes employee’s taxable income
 Facts: Employer paid the employee’s income taxes for the employee. IRS says that paying of the income tax
is itself income.
 Held: This is equivalent to the taxpayer having received the money directly from the employer and then
using that money to pay the taxes. Simply because it came in a different form doesn’t change the substance.
5
 Grossing up
 Employer can pay employee more to compensate the employee for the income taxes that he will ultimately
have to pay
 To determine how much gross income an employer will have to give an employee to make sure that employee
receives the agreed upon amount, use the following calculation:
 G = N/(1-t)
 Gross income = income before taxes
 N = net pay = desired amount negotiated between employer/employee
 t = tax rate
 Example
 Employee/employer agree that employee should ultimately get $80k/year. Tax rate is 20%. How much
should employer pay employee?
 G = N/(1-t) = 80k/(1-0.2) = 80k/0.8 = $100k
 Grossing up in the instance where grossing up would put employee in a new tax bracket
 Example:
 Let’s say the boundary b/w the 20% and 25% tax bracket is $50,000.
 Employee wants his net pay to be $48,000. G = 48k/(1-0.2) = $60k.
 But once you gross up to $60k you are in the 25% bracket.
 So then you do G = 48k/(1-0.25) = $64k.
 Gross income should be somewhere in the range b/w $60k and $64k. You would need Excel to get the
precise answer.
Noncash Benefits
 Code § 161 – specifically mentions fringe benefits that are to be included in income
 Why do we tax noncash benefits?
 Noncash benefits are included in income to promote horizontal equity. If employer pays one employee $100k
in cash and another employee in benefits worth $100k, then employees should be treated the same.
 Employers would be incentivized to pay their employees through noncash means
 When noncash benefits are NOT included as income
 Common law
 When lodging and meals are provided for the convenience of the employer, they are not considered
income. The convenience of the employer test is not just for camps provided by employers. Benaglia.
 Burden of proof is on the taxpayer to prove that the meals/lodging were for the convenience of the
employer
 Court in Benaglia turns positive, statutory law in a Reg into common law
 Benaglia v. Commissioner (BTA 1937)
 Facts: Husband and wife filed joint tax returns in 1933 and 1934. The husband works as manager of
two hotels and a golf club in Hawaii. Husband and wife are provided lodging and meals at one of the
hotels at which the husband is the manager. Husband reported salary he received on his tax return but
did not include the value of the lodging and the meals. The Tax Commissioner served deficiency notice.
 Held: Because the lodging and meals were provided for the convenience of the employer, they need not
be included as taxable income. It’s convenient for his employer to have Benaglia live and eat at the
hotel because Benaglia needs to be constantly available to respond to client requests.
 Dissent:
 Dissent argues that “convenience of the employer” test is faulty. It creates horizontal inequity, by
not treating likes alike.
 Even if we do apply the convenience of the employer test, meals/lodging here were not provided
for the convenience of the employer. Benaglia didn’t live at all the hotels he was managing and he
took extended vacations away from the hotels/golf club.
 Valuation under Benaglia
 If Benaglias had lost and were required to report the lodging/meals as income, how should they value
the lodging/meals?
 It should be the fair market value of what they received (would require further factual findings)
 To calculate fmv, you would ask: how much would a horizontally equivalent person have to pay in
the same situation? The difficult thing is that there might not be any such people.
 Code § 119 (p 119)
 Meals and lodging can be excluded from gross income but only if . . .
 In the case of meals, meals are furnished on the business premises
6


In the case of lodging, the employee is required to accept such lodging as a condition of his
employment
 To determine if employee was required to accept lodging, court can look to employment contract
but doesn’t necessarily have to believe what it says
 119(b)(4) non-discrimination requirement
 If you have a group of employees, and they get free meals on the business premises of the employer,
and you have determined that half of them or more are getting them for the convenience of the
employer, then the others get a free ride
 119(d) exception (meaning value of the lodging DOES have to be included as income) for those cases where
lodging is furnished by an educational institution and the rent is “inadequate”
 Numerical example.
 Appraised value of lodging = $300,000
 Rent paid by the employee = $250/month = $3000/year
 Rent paid by non-employees = $1000/month = $12,000/year
 Section 119(d)(2): exclusion does not apply . . .
 119(d)(2)(A): to the lesser of . . .
 119(d)(2)(A)(i): 0.05*300000 = $15,000
 119(d)(2)(A)(ii): $12,000
OVER
 119(d)(2)(B): $3000
 So you do have to include as income $12,000 - $3,000 = $9,000
Code § 132 -- Fringe benefits that should not be included in gross income (even though they technically fit
under the Haig-Simons income definition)
 Rules of general applicability to fringe benefits:
 § 132(h) – retired and disabled employees and surviving spouse of employee who died while
employed by employer is treated as employee
 Non-discrimination rule (§ 132(j)) – Company can provide non-taxable fringe benefits but only so long
as it does so for pretty much every employee in the company and doesn’t just aim it at highly
compensated executives
 (1) No additional cost service
 Situation where the employer is providing a service and providing it to the employees doesn’t cost the
employer anything
 Line of business requirement – if employee doesn’t work in the line of business from which he is
getting the benefit, then value of that benefit must be counted as income
 Examples:
 Usher at movie theater watches a movie that is already being shown for customers
 Airline employees given empty seats on a flight
 (2) Qualified employee discount, § 132(c)
 Employer can sell the employees goods at cost, but not for an actual loss
 Line of business requirement – if employee doesn’t work in the line of business from which he is
getting the benefit, then value of that benefit must be counted as income
 Example: employee works for Proctor and Gamble. If P&G charges customers $5/quart for Tide, but
makes a $1 on each sale, then employee needs to only pay $4 and doesn’t have to include that extra $1
as income. However, if P&G only made 25 cents for each $5 quart sold, and sold it to employee for $4,
then employee would have to include 75 cents as taxable income.
 (3) Working condition fringe
 Anything the employer could deduct from their taxes, the employee could deduct also by not paying
tax on that
 Example:
 Employer buys book that is relevant to the company’s line of work. If employee bought the book,
that should not be included as income.
 Employer gives employee money to buy something that, if the employer had bought it himself,
would have been able to be deducted from taxable income
 (4) De minimis fringe, § 132(e)
 Something really small in value
 No line of business requirement
 Example:
 If employee is provided with coffee and donuts at a work meeting, he need not count it as income
7


If employer puts out a bowl of candy for employees to share, employee need not count a piece of
candy as income
 NOT meals provided to airline employees on flights (though those qualify under convenience of
the employer exclusion)
 (5) Qualified transportation fringe, § 132(f)
 Transportation stuff
 There is a limit however to the amount of service that can be excluded
 Example:
 IRS Commissioner gets driven around in limousine. Does he have to include the value? Yes.
Limousine is not a “commuter highway vehicle.” Those are really only shuttle vans running
between remote employee parking lot and office building.
 How much should the Commissioner include? Reg. 1.61-21 says to include the fair market value.
Reg. provides a safe harbor provision; fair market value can be estimated as the amount paid by
the employer to the employee. Even if that’s wrong, you won’t get in trouble.
 (6) Qualified moving expense reimbursement
 If employer gives you money to help you move for job purposes, then it doesn’t count as income
 Section 217 defines “moving expenses”
 (7) Qualified retirement planning services
 If employer plans 401(k) planning service fees to manage retirement fund, then you don’t have to
count what employer has paid as employee’s income
 Example:
 If employer hosts a JP Morgan representative to talk about retirement planning services, employee
doesn’t have to count that as income
Cafeteria Plans (Code § 125)
 Benefits that employer can make available to employees that are deductible from taxable income
 But if other employees don’t want those benefits, they can take cash instead (which is taxable)
 Cafeteria plan benefits include things like group term life insurance, adoption assistance, excludable
accident insurance
 So if the IRS determines that something is taxable, how should it be valued??
 Do not determination valuation on subjective basis!!
 Subjective valuation like this creates two problems:
 Tax outcomes will differ on the basis of whim
 People will create self-serving testimony as to what something is worth to them
 Turner v. Commissioner (TCM 1954)
 Facts: Turners won on a radio show two round trip first class cruise tickets between NYC and Buenos
Aires. They paid $12.50 and traded the tickets in for four round trip tourist class cruise tickets to
Brazil. Turners reported $520 on their tax return as the value they got from the tickets. IRS says they
should have reported $2,220 because that’s the retail value of the tickets to Buenos Aires.
 Held: Turners should have reported $1400. Court probably averaged Turners’ estimation and IRS’
estimation of the value. Tickets weren’t worth full retail value because this is not something Turners
would have bought in the first place and tickets were not salable.
 McCoy v. Commissioner (1962)
 Facts: taxpayer won a new Lincoln car in a sales contest. The car’s cost to the employer was more than
half of the taxpayer’s income for the year, and he did not own another car. He droves the Lincoln for
ten days and then traded it in for a Ford station wagon plus $1000 cash.
 Held: the amount includible in income was $3900 (dealer’s price of station wagon $2600 + $1000 cash
taxpayer received + $300).
 Better approach is objective!!
 Rooney v. Commissioner (1988)
 Facts: court required members of an accounting firm who had accepted payment in the form of goods
and services in payment of fees to include these items at their market prices
Regulations and safe harbor provision relevant to chauffeur services, Reg. 1.61-21(b)(5)
 The FMV of chauffeur services provided to the employee by the employer is the amount that an individual would
have to pay in an arm’s-length transaction to obtain comparable chauffeur services
 Safe harbor = FMV of the chauffeur services may be determined by reference to the compensation received by the
chauffeur from the employer
8
Unusual forms of income
 Imputed income – doing things for yourself, this stuff is not taxed
 Property other than cash
 Services
 Psychic income and leisure
 Other unusual forms of income where you get something from someone else – this is taxed
 Realization rule = don’t have to worry about being taxed on imputed income until you sell it for cash.
 If you win prizes or have found items, must pay tax on them
 Examples:
 Professors get free books. Under Haig Simons, that would be income. But it’s not treated as income unless
it’s sold for cash.
 Barry Bonds hit career home run. Mets fan catches it. Ends up being worth lots of money. He sells it for
hundreds of thousands. Must pay tax because value was realized.
 When Oprah gave her audience guests a new car, she grossed up. She gave audience members a car, cash to
pay taxes on the car, and cash to pay taxes on the cash.
Revenue Ruling 79-24: bartered services are taxable as income. What should be counted as income is fmv of the service.
 Situation 1: painter paints lawyer’s house in exchange for legal services. Both must include the value of the service
received as income.
 Situation 2: artist pays rent in the form of a painting. Artist must include value of rent in income and landlord must
include value of painting.
 Presumption is that services being exchanged are of equal value
Commissioner v. Glenshaw Glass (US 1955) Income = undeniable accessions to wealth and over which the
taxpayers have complete dominion (must have full right). Income becomes taxable when the accession to
wealth is “clearly realized.”
 Facts:
 Glenshaw Glass.
 What is the money at stake in the Glenshaw Glass case? Punitive damages for fraud and antitrust. $325k for
punitive damages and $475k was compensatory.
 What does GG do on their taxes? They reported the compensatory but not the punitive.
 IRS says GG should have reported whole $800k.
 William Goldman.
 WG got $125k in compensatory damages and $250k in punitive damages as the result of an antitrust suit.
 They reported the compensatory damages but not the punitive.
 Held: Punitive damages must be included as income to awardee. Definition of income is very broad. Punitive
damages are included in that broad definition.
Gifts
 Section 102(a): “gross income does not include the value of property acquired by gift, bequest, devise, or
inheritance”
 So recipient doesn’t have to pay tax on the gift, but giver can’t deduct from income
 Section 102(b): there are some things that might look like they would be excluded under 102(a) but they’re not . . .
 (1) Income from any property referred to in subsection (a)
 Let’s say that you receive as a gift 1000 shares of stock in Apple. 102(a) says that you don’t have to include
the value of the 1000 shares as income. 102(b) says that when you start receiving dividends on those
shares, the dividends are taxable.
 Note that where the donor gives the donee a gift of more than $14,000/year, the donor must pay a gift tax
 Section 102(c) – per se rule – employer to employee can’t be a gift
 Section 274(b) -- doesn’t say that there’s no business gift, but deduction of business gift is limited to $25. So
Berman can deduct the first $25 but has to pay tax on the rest of the gift. Note that Berman would also have a
$14000 gift tax liability.
 Business gifts are something like gifts between partners at a law firm
Commissioner v. Duberstein (US 1960)
 For a transfer to constitute a gift, it must proceed from a “detached and disinterested generosity” and “out
of affection, respect, admiration, charity or like impulses”. It’s an objective, totality of the circumstances test.
 This was the only case that’s ever dealt with the definition of a gift
 Facts:
 Commissioner v. Duberstein
9



Facts: Duberstein is president of Duberstein Iron & Metal Company located in Dayton, Ohio. The
company buys metals and forms them into products for sale. Duberstein does business with Mohawk.
Berman is president of Mohawk, located in New York. They do regular business with each other.
Duberstein refers Berman to some people who might buy his products. Turns out to be lucrative.
Berman gives Duberstein a Cadillac. Duberstein says it’s a gift.
 Held: Cadillac wasn’t a gift; it was compensation for the referral. Berman deducted the car as a
business expense and claims it to be past consideration for the help Duberstein gave him.
 Stanton
 Facts: Stanton was Comptroller of Trinity Church and was president of their subsidiary corporation – a
real estate corporation. He worked at Trinity for 10 years but he resigns. He resigns because the Board
got rid of the Treasurer and Stanton disagreed with that. So Board gave him $22,000 upon the
resignation. They call it a “gratuity” but they also call it “for services rendered.” So it’s kind of unclear
whether it’s out of gratitude or whether it’s delayed compensation. Stanton says it’s a gift.
 Held: remanded because trial court didn’t sufficiently explain why it reached the conclusion that the
$22k was a gift. On remand, court concludes again it was a gift.
Key points
 SCOTUS rejects per se rule that no business related transfers could be a gift.
 They reject Frankfurter’s rebuttable presumption that business related transfers are not gifts
 They reject common law definition of gift
 Instead they give “donors intent drives the result” test
Standard on review of appeal of determination of whether something is a gift
 Going to be slightly different depending on whether it’s jury trial or bench trial
 Bench trial – “clearly erroneous”
 Jury trial – “reasonable men could not reach differing conclusions on the issue”
 Court is basically making sure nothing gets to the appellate level
 Plus, intent is really subjective, it’s the type of call that’s better for a trial court to make
United States v. Harris (7th Cir. 1991)
 Facts: Conley and Harris are Kritzik’s companions. He gives them each over half a million dollars over the course of
several years. They’re both charged and convicted of tax evasion.
 Elements of criminal tax evasion: (1) the money was income, (2) D knew she had the duty to pay taxes, and (3)
she willfully failed to file.
 Held: criminal convictions are reversed. Government failed to prove mens rea element of the crime.
 Dicta about gifts: it’s income only if each act of sex is paid for on an a la carte basis
 If this had been a civil case . . .
 And the government had lost, Conley and Harris wouldn’t have had to report income but no deduction for
Kritzik because no deduction for personal services
 And the government had won, Conley and Harris would have had to report income & Kritzik would have gotten
a deduction
 If Kritzik was a business . . .
 And the government had lost, Conley and Harris wouldn’t have had to pay income tax and Kritzik would have
been able to deduct from his income $25 but any more than that would have been taxable against Kritzik
 And the government had won, Conley and Harris would have had to report payments as taxable income but
Kritzik could have deducted the full amount
Tips and Unusual Gifts
 Tips
 Reg. 1.61-2: Tips are income
 The problem is enforcement. It’s often done in cash.
 Employer reports gross receipts to IRS. Then in addition they report the tips that were paid for with credit
cards. Employees are told to report at least 12% of gross receipts as income.
 Unusual payments
 United States v. McCormick: contributions received by a city clerk after marriage ceremonies from bridegrooms
who were fearful of being accused of stinginess were taxable
 Olk v. United States: money given to craps dealer out of superstition in a casino by gamblers is income. People
are buying luck, not giving gift.
 Welfare payments. Ruling says it’s not income at all. That’s not true, but it resolves the question.
 Social security – treatment of social security benefits depends on taxpayer’s adjusted gross income. As income
rises, exclusion phases out.
10

Alimony vs. gift – Alimony payments are deductible by the payor and taxable to the recipient. Child support and
property settlement payments are not deductible by the payor and are not income to the payee.
Taft v. Bowers (US 1929) Recipient of non-cash gift should be taxed on realization of increase in value even
though part of that increase in value accrued before recipient received the gift
 Introduces idea of basis = price it was bought at – only applies to property of some sort
 Gift not in the form of cash
 Facts: T’s father bought 100 shares of stock for $1,000 in 1916. In 1923, he transfers the shares to Taft when FMV is
$2,000. Later in 1923, she sells the shares for $5,000. Taft reported income of $3,000, which is the amount that her
net worth has gone up. IRS says Taft should have reported $4,000 in income.
 Issue: does she have to pay tax on $4000 or $3000?
 Answer: she has to pay the tax on $4000.
 Reasoning:
 If you look at Sixteenth Amendment, there’s no restriction as to whom the IRS can tax
 Plus, this isn’t such a horrible outcome for Taft.
 She could have just turned down the gift.
 She didn’t have to pay tax on the $2000 gift when she received it in the first place, so be happy.
 Introduction to “surrogate taxation”
Carryover Basis / Substituted Basis (Code § 1015)
 Congressional response to the Taft case
 Deals with the question of: what do you count as income when you get a non-cash gift and then sell it? ONLY
APPLIES TO GIFTS!!
 To calculate how much you should tax, do the calculation: gain = proceeds – adjusted basis
 Proceeds – FMV at transfer = gain 
 If this number is positive, then use the original purchase price instead of FMV at transfer.
 If this number is negative, then count it as your loss.
 If selling price is in between fmv at time of transfer and original purchase price, taxpayer reports $0.
 Examples
 FMV at transfer = $1000. Original owner paid $1500. No other adjustments to basis.
 Example 1. Recipient later sells for $800.
 Gain = $800 -- $1000 = - $200
 This loss is deducted from taxable income of the recipient
 Example 2. Recipient later sells for $1600.
 Gain = $1600 - $1000 = $600  because this number is positive, we must use original purchase price
 Gain = $1600 - $1500 = $100 gain
 Example 3. Recipient sells for $1200.
 Gain = $1200 -- $1000 = $200  because this number is positive, we must use original purchase price
 Gain = $1200 - $1500 = - $300  this is not right either because we end up with a loss.
 So in this scenario, taxpayer declares no gain or loss. Taxpayer just reports $0.
Transfers at Death
 Section 1014(a) – taxing sale of property by heir that was passed to him/her by will or intestacy
 When property is transferred at death, and then relative turns around and sells the property, the basis is the
value of the property on the date of death
 Creates a “lock in” effect -- The older you are, and the more the property has appreciated, the less likely it is
that you will want to sell the property. You have a very good incentive to take advantage of 1014(a)(1) for your
heirs.
 What an old person would prefer to do instead is to borrow against the shares  loans are not countable as
income
 Estate tax
 You can give a total of $5.25m throughout life and at death without getting taxed
 Only when the transfers amount to more than $5.25m does the estate have to pay a tax
11
Loans
Income to borrower
Loans do not count as income
Discharge of indebtedness does count as income
Borrower cannot deduct interest payments when
borrower is a corporation
Borrow can deduct interest payments when borrower is
an individual (only applies to specific types of loans)
Income to lender
Repayment of principal does not count as income to
lender
Interest payments do count as income
 Debt-equity distinction
 Equity: ownership interest, where Party A gives money to be invested in a business enterprise, in return for
some of the profits; owning stock is a form of equity
 Debt: loan from Party B to Party C where Party C agrees to pay specific amounts at specific times
 Company has to pay back loans before it pays shareholders
 Bond is a type of loan, buyer of bond is lender and seller of bond is borrower
 Structuring loans to make them less risky to lender:
 Secured v. unsecured loans
 Recourse v. non-recourse loans
 Recourse loan: borrower is personally on the hook for what borrower said he would pay
Kirby Lumber – plain vanilla DOI case
 Discharge of indebtedness income is counted as taxable income.
 Facts: Kirby Lumber decides that they need to raise money. They issue their own bonds worth $12m in July 1923.
Then Kirby Lumber re-purchases $1m in bonds for $862,000. So they increased their net worth by $138,000.
 Held: the $138,000 is taxable. There was a clearly realized accession to wealth. Accession was realized in the year
the debt was discharged.
 Kerbaugh-Empire reference – Court uses KE case to distinguish. But the problem is that KE isn’t a DOI income case
at all. They borrowed 1 million reichsmarks and paid back 1 million reichsmarks.
 Application of Kirby Lumber
 When custodial parent gives up on trying to recover child support payments from non-custodial parent who
refuses to pay, the deadbeat parent has DOI income.
 The rationale is that we’d at least rather have tax on DOI income than no child support payments at all.
Code s 108
 Exceptions – categories of people who don’t have to recognize DOI income as taxable income:
 108(a)(1)A). When a taxpayer is declared bankrupt, any DOI income he has is not taxable.
 108(a)(1)(B). When a taxpayer is insolvent, any DOI income he has is not taxable.
 Definition of insolvent. 108(d).
 When liabilities > assets. When net worth is negative.
 Rationale = “don’t hit a person when he’s down”
 108(a)(1)(C). Discharge occurs when indebtedness is qualified farm indebtedness.
 Qualified farm indebtedness is defined in 108(g).
 Qualified farm indebtedness = debt incurred in the operation of a farm by a person who, during the
three preceding taxable years, derived more than 50% of his or her annual gross receipts from farming
 Farmers don’t have to be insolvent to get the exception. Congress loves farmers.
 108(a)(1)(E). Discharge occurs when qualified principal residence indebtedness is discharged before January
1, 2013.
 So basically this helps people who were kicked out of their home during the recession.
 It’s not that helpful because people who’s principal residence indebtedness is discharged are also highly
likely to be insolvent, so they wouldn’t have to count DOI income under 108(a)(1)(B).
 108(h) defines principal residence indebtedness.
 108(e)(5). Purchase-money debt treated as price reduction.
 Describes situation in which a person buys something from a company and the company itself loans buyer
money to buy the piece of property.
 If that company later says “you can stop paying us back now,” for any reason, then rather than treating that
as DOI, we’ll treat that as a purchase price adjustment. Both parties can just treat it as if the purchase price
adjustment was the original price the seller sold the good for.
 Example: Seller sells buyer couch for $1000 and gives buyer loan to buy the couch. Later, seller agrees to
accept only $732. We won’t treat the balance as DOI income.
12

108(f). Student loans.
 Excludes from income any cancellation or repayment of a student loan, provided the cancellation or
repayment is contingent upon work for a charitable or educational institution
Zarin v. Commissioner (3d Cir. 1990)
 Buchanan thinks the court came out wrong on this one. Professor thinks this is a DOI case, and Zarin should be
taxed. This case is mostly not good law anymore.
 Facts: Zarin is a huge gambler. Resorts casino was extending him credit in violation of New Jersey regulations.
Eventually Zarin racks up $3.435m in debt. He promises to pay Resorts back. He doesn’t, so Resorts sues. They
settle for $500k. Tax Commissioner goes after Zarin seeking tax on the $2.935m balance as DOI income.
 Held: Zarin doesn’t have to pay tax.
 This isn’t DOI income because Zarin wasn’t indebted to Resorts.
 Definition of “indebtedness” requires that (1) the debt be enforceable against Zarin, or that (2) Zarin hold
property subject to the loan. Buchanan thinks using this definition of indebtedness is wrong because
indebtedness was only meant to apply to the section in which it was defined, not to § 61.
 First of all, the debt against Zarin isn’t enforceable because he was extended the credit in violation of
the state regulations.
 Second of all, Zarin did not hold property subject to the indebtedness because the chips aren’t
property. They are owned by the casino and aren’t worth anything. Even if this definition were right
for the purposes of defining income, the chips should be considered property.
 DOI income is the wrong way to conceptualize this issue. This is CONTESTED LIABILITY or DISPUTED
DEBT.
 Under the doctrine of contested liability, 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.
 So the amount of debt that Zarin owed Resorts was $500k and he paid that all back.
 This is wrong because contested liability doctrine applied only where there is an unliquidated debt – a
debt for which the amount cannot be determined. Here, we know exactly how much Zarin borrowed
and how much he promised to pay back.
 CONTESTED LIABILITY only comes up where there is a dispute over how much is owed or if the
lender doesn’t have a clear right to getting the property back or if there is a dispute about liability.
Code s 165(d) – Gambling
 1.165-10: You pay taxes on net winnings (H-S income), but you cannot deduct net losses
 You can only use losses to offset winnings (if total gains exceed total losses, deduct losses to offset gain, report
rest as TI), however you cannot make deductions for additional losses (zero sum gain)
 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.
 Comps are considered gambling income.
 Gambling income can be offset by gambling losses.
 AND, winnings before New Year’s Eve cannot be offset by losses after New Year’s Eve
  losses can be offset, but only in the taxable year
Gain on Home Sales
 If you have loss on sale of home, you are not allowed to deduct that loss.
 § 121 excludes gain on sale of home from taxable income
 A single taxpayer gets to exclude $250k or less
 A married couple gets to exclude $500k or less
 Any amount of gain over and above the exclusion limit is taxed at a capital gains rate
Qualifications for single taxpayer
Single taxpayer gets $250k exclusion if, for at least two out
of the past five years, taxpayer:
 Owned the home
 Used the home as taxpayer’s principal residence
 Not gotten the exclusion during the two year period
prior to the sale of the home
Qualifications for married taxpayer
Married couple gets $500k exclusion if, for at least two of
past five years,:
 Either spouse has owned the home for at least two of
the past five years
 Both spouses have used the home as their principal
residence for two of the past five years
 Neither spouse must have gotten the exclusion within
the past two years
13
 If a taxpayer doesn’t qualify for the exclusion because of the use, ownership, or timing requirements, the taxpayer
can still exclude some of the gain if the reason he or she is selling the house is because of:
 Change in place of employment
 Health
 Unforeseen circumstances
 Examples:
 Blended family moves to children’s school district
 Adult child moves in with parents
 Taxpayer adopted kids and wants to get bigger house
 Disabled parent moves in with taxpayer and taxpayer must buy different house as a result
 Aircraft noise
 Child assault on school bus, so family moves to new school district
 DEA (narcotics) agent threatened by drug lord and has to move
 How much can taxpayer exclude if he doesn’t qualify for the full exclusion but falls into one of the special categories
(health, change in place of employment, unforeseen circumstances)?
 (no. of months since TP used exclusion/24 months)*(total amount of exclusion for which TP would normally be
eligible) = $ amount
Example:
Wife lived in House A from 2009 to 2010. Husband lived in House B from 2009 to 2012. Wife lived in House B
from 2010 to 2012. Wife sells House A on July 1, 2011 for $450k gain and uses the exclusion to exclude $250k
from taxable income. Husband gets sick and Husband and Wife sell House B on January 1, 2013 for $500k gain.
How much can they exclude?
Answer:
Husband gets $250k exclusion because he has not used the exclusion in the past two years, and he owned and
lived in the home for the past three years.
Wife used the exclusion 18 months ago when she sold House A, so she gets to exclude (250,000)*(18/24) =
$187,500.
Together they can exclude $250,000 + $187,500 = $437,500. The remainder of the gain ($62,500) is taxed at
capital gains rate.
14
When Is Income Taxable?
Depreciation
 Tangible/real property assets bought by a business depreciate over time and that depreciation can be deducted
from taxable income
 Two ways to calculate depreciation:
Straight-line method
(Initial cost – salvage value) / useful life = annual deduction or
“cost recovery”
Example: Original purchase price was $10,000. Useful life is 10
years.
(10,000 – 0) / 10 = $1000 → every year for 10 years the
business can reduce profits by $1000
Double declining balance method
A lot of depreciation in the beginning of the asset’s useful life and
then a switch to straight-line method when the point is reached
where the straight-line amount exceeds the declining balance
amount
Example: Original purchase price was $10,000. Useful life is 10
years. Declining balance factor is 200%.
First year deduction = $2000 (straight-line method deduction x
2)
That means asset is now valued at $8000.
Second year deduction = $1600 (20% of $8000)
That means asset is not valued at $6400.
Third year deduction = $1280 (20% of $6400)
That means asset is now valued at $5120
Fourth year deduction = $1024 (20% of $5120)
That means asset is now valued at $4096
Fifth year deduction = $819.20
That means asset is not valued at $3276.80
Etc. But revert to using straightline method when straightline
depreciation amount exceeds declining balance amount.
Salvage value default = $0
Useful life of an asset – found in Code § 168(e), p 193 of supplement
 Three year property
 Five year property
 Seven year property
 Ten year property
 Fifteen year property
 Twenty year property
 When you sell a piece of property that you’ve been depreciating, count as income the sale price – depreciated value
(not the entire sales price!!)


Summary of Annual Accounting Issues (material below)
 Big picture:
 We have annual accounting system
 No negative tax refundability
 Because of these things, Congress goes around trying to fix inequities that result
 Under the claim of right doctrine (date rule), we have two prong test:
 You pay taxes in the year in which the second of the two prongs: (1) taxpayer becomes entitled to the money
and (2) taxpayer actually receives the money.
 Inequities that flow from the claim of right doctrine
 Three possible situations:
 Loss in earlier year, income in later year (Sanford & Brooks situation)
 Congressional response = Section 172 – net operating losses
 Income in earlier year, loss in later year (Lewis)
 Congressional response = Section 1341, gives taxpayer a windfall
 Deduction in earlier year, restoration in later year
 Section 111 (the tax benefit rule), which is limited to situation where TP got literally no tax benefit in
the earlier year
15
NAO v. Burnet (US 1932)
Money should be counted as income in the year in which the taxpayer has a CLAIM OF RIGHT to the money.
Taxpayer has claim of right when (1) you have legal entitlement to money and (2) you actually receive the
money. Both prongs have to be met.
In this case, that was the year district court issued final decree.
 “If a taxpayer receives earnings under a claim of right and without restriction as to its disposition, he has received
income which he is required to return, even though it may still be claimed that he is not entitled to retain the
money, and even though he may still be adjudged liable to restore its equivalent”
 Background: 1916 corporate income tax rate – 2%, 1917 corporate income tax rate – 6% plus an excess profits tax
from 20 – 60%, 1922 corporate income tax rate – 12.5%
 Facts:
 NAO leases government property. Government sues for ouster. While that case is being settled, court sets up
receiver to manage the property. Receiver gets paid $172k in 1917 for the work done by NAO in 1916. In 1922,
ouster case gets dismissed. NAO wants to count money as income either in 1916 or in 1922 and IRS wants to
count the money as income in 1917 because that’s when it was paid.
 Held: Money should be counted as 1917 income. That is when the district court issued its final decree.
Repercussions from annual accounting system:
Loss in Earlier Year, Income in Later Year
Congressional response
Sanford & Brooks
Net operating losses (NOLs), § 172
 We use an annual accounting system, not a
 Congressional response to S&B – now you can use
transactional accounting system. So when TP has
some of the net operating losses incurred in one year to
loss in earlier year and income in later year, all
reduce net income in another year
stemming from the same transaction, TP still has  NOLS = “negative profits” = when expenses > revenue
to pay tax on the later income.
 Only applies to NOLs, not:
 Facts: S&B was subcontractor for a dredging project.
 Capital losses (e.g. depreciation, loss incurred
In years 1913, 1915, 1916 they declared net loss. In
from selling an asset for less than you bought it
1914 they declared net income. In 1915, S&B
for)
abandoned work on the project and sued for
 Personal exemptions. § 172(d)(3).
compensatory damages. In 1920, S&B gets damages
 Nonbusiness deductions. § 172(d)(4).
for doing the work they weren’t paid for. S&B says
 Under § 172(b)(2), you have a choice about how to
they shouldn’t be taxed on the compensatory
transfer your net operating losses to another year:
damages because overall the project was not
 Apply them to income return from two years ago
profitable. IRS says they recognized income in the
and then, if you still have NOLS, apply them to
year 1920.
return from last year, and then, if you still have
 Held: S&B must recognize the damages as income in
NOLS, apply them forward for the subsequent
the year 1920. So there were some years that S&B
twenty years, OR
didn’t have to pay income tax (the years with net
 Forget about the past and just go forward
loss) and in 1920 S&B does have to pay income tax,
 Example.
even though if we used a transactional accounting
 In 2012, Bob earns salary of $60k. He had
system, they wouldn’t have had to pay tax.
deduction for personal exemptions of $4000 and
itemized nonbusiness deductions of $16000, so
taxable income was $40k.
 In 2013, Bob earns salary of $60k. Suffers ordinary
loss of $80k from wholly owned business. His
deduction for personal exemptions was $6000 and
nonbusiness deductions were $15k.
 How come loss can Bob carry back to 2012?
 Bob can’t carry over personal exemptions and
nonbusiness deductions.
 So the only thing he can carry over is $60k -$80k = $20k.
 So 2012 income can be reduced by $20k.
Case law
16
Income in Earlier Year, Loss in Later Year
Congressional Response
Claim of right/Lewis
Congressional response to Lewis:
 Facts: Mr. Lewis receives $22,000 bonus in 1944. He
 § 1341(a) – income in earlier year, loss in later year
uses it as his own, in good faith though mistaken
 Taxpayer gets to deduct the amount of tax they
belief, that that was a bonus that he had earned. Then
paid in the prior year
two years later his employer says that they meant to
 However, if this year’s tax rate is higher than the
only have given him a $11,000 bonus. So they want
previous year, then you get to use this year’s tax
$11,000 back. So then he wants to deduct the money
rate when calculating how much to deduct from
by amending 1944. IRS says he should deduct the
this year’s income.
$11,000 from his 1946 return.
 Example.
 Held: Lewis should deduct from his 1946 return.
 Two years ago I earned $5000 of income and
Lewis had a claim of right to that money in 1944 so it
today I lost that because it wasn’t owed to me.
was properly counted as income in that year.
Two years ago, the tax rate was 10%, so I
owed $500 worth of tax. Today the tax rate is
15%. Because the tax rate today is higher than
it was at the time I counted the money as
income, I can deduct 15% of the original
amount ($750) rather than $500.
Case Law
 § 1341(b)
 If you embezzle money, you have to pay taxes on
that income.
 However, if it’s found out that you embezzled and
have to pay the money back, you can’t take
advantage of 1341 or 172 (NOLs)
Deduction in Earlier Year, Restoration in Later Year
Case Law
Congressional Response
 N/A – we didn’t read a case for this
Tax benefit rule, § 111
 Deduction in later year, restoration in earlier year
 Must include the value of the restoration in your current
income
 Exclusionary aspect
 If, in the year you took the deduction, you were
already in the zero bracket or it put you in the
zero bracket, then you don’t have to include it
as income in the year it is restored
 If the deduction created a NOL, then you have
to include the restoration in the later year
 Inclusionary aspect
 If it’s unclear, upon restoration, what the value
of the restored income is, then you can just
include the same value you used when you took
the deduction earlier
 Alice Phelan Sullivan Corp. v. United States
 Taxpayer made a charitable gift of property
and calimed a charitable deduction. Nearly
twenty years later, the charity decided not
to use the property and return it to the
taxpayer. The recovery was held to
generate taxable income in the amount of
the earlier deduction as opposed to the
value of the property in the year in which it
was returned.
17
Eisner v. Macomber (US 1920) for income to be taxable, the income must be “realized”. Stock dividends are not
realized gain to taxpayer.
 Buchanan says that the government’s arguments are right given the law at the time. The Supreme Court gets it
wrong here.
 Facts: Macomber is a stockholder. She owns 2200 shares of stock in Standard Oil. In 1916, company issues stock
dividends. So Macomber receives an additional 1100 shares. She now has a total of 3300 shares. Because par value
of the stock is $100/share, it looks like she has received income of $110,000, but the market value of the total
number of stocks she owns has remained the same. IRS argues the stock dividend was income and the issuance
constitutes a realization event.
 Held: the issuance of the stock dividend was not a realization event.
 Government’s arguments:
 (1) stock dividend is income. The law at the time explicitly said that a stock dividend is income. Court says
the statute is unconstitutional and that a stock dividend is not income. While it’s true that a stock dividend
is not income, the way the court got to that conclusion made a big mess.
 (2) issuance of stock dividends is a realization event. Buchanan thinks Brandeis dissent got it right:
substance dominates form. Giving Macomber the stock dividend would be the same as her selling her
shares back to Standard Oil, the company giving her money, and then she buys the shares herself. In that
scenario, the purchase of the stocks would be counted as income, so the equivalent should be counted as
income.
 (3) the time at which the stock dividends are issued is no worse a time than any other time to tax the
income. Macomber had been getting a free ride for years, so that should come to an end.
Aftermath of Macomber
 Congress put realization requirement into section 1001 of the Tax Code
 Exactly as Macomber is saying, when you have a “disposition of property,” any excess that is realized will be
counted as realized and any loss that is realized will be counted as a loss
Bruun v. Helvering (US 1940)
Realization events are not limited to cash exchanges.
Gain may occur as a result of (1) exchange of property, (2) payment of the taxpayer’s indebtedness, (3) relief
from a liability, or (4) other profit realized from the completion of a transaction
Court limits Macomber “severability” and “detachable” language so that it only applies to stock dividends.
Bruun narrows Macomber.
 Facts: Bruun leases building in 1959 with a 99 year lease. In 1929 lessor builds a new structure on the property
that increases the value of the property $50k. In 1933, lessor defaults on the lease payments and the property gets
return to Bruun. IRS says Bruun has realized income in the year 1933 in the amount of $50k because of the
improvements on his property.
 Held: this was a realization event, so Bruun recognized income in 1933.
 Court limits the Macomber opinion to its facts. In Macomber the court seemed to say that for realization event
to occur, the income must be “severable” or “detachable.” The court says that requirement only applies to stock
dividends.
Bruun Aftermath
 Section 109 = future Bruuns do not have realization events. Where a lessee makes improvements (some kind of
structure or something attached to the land) upon a property and then defaults on the payments with the result
that the more-valuable property goes back to the lessor, the lessor does NOT have to recognize income.
 Stock dividends are still not income.
 Section 1019 = if/when lessor sells the improved property, the basis is the value of the old land/building, not the
value of the land/building with improvements. The IRS wants to tax every dollar of gain that the lessor got.
 Whether you apply Bruun framework of 109/1019 framework, the ultimate amount subject to income tax is the
same:
In 1933, lessor gets property back with $50k in improvements. He’s able to rent the property out at $7k per year.
Bruun
$50k realization event in 1933
$7k income per year for 10 years but with depreciation
deduction each year of $5k (so $20k in income over the
course of ten years)
Total income of $70k
109/1019
No realization event in 1933
$7k income per year for 10 years ($70k total in rental
income)
Total income of $70k
18
Note 3, p 211
 Reg. 1.61-8(c) says that if building is basically a substitute for rent (determined by the facts and circumstances),
then the building will be counted as income
 If IRS thinks this is happening, then IRS would determine what the rental rate would be for a property like this, and
then charge it as income to the taxpayer.
Woodsam
There are some transactions that are not realization events. Change from recourse to nonrecourse mortgage is
one of them.
For a sale or disposition of property to count as a realization event, someone has to give up ownership of
something; there must be a “relinquishment”
The borrowings did not change the basis of the property for the computation of gain or loss
 Facts:
 In 1922, Mrs. Wood bought a piece of property for $296,400
 Mrs. Wood was personally liable for the mortgage she owed on that property (recourse mortgage liability)
 In 1931, she re-mortgaged and consolidated the mortgages into a $400k nonrecourse mortgage – meaning she
was not personally liable for the mortgage
 In 1933, she defaults on the loan. The mortgage lender takes possession of the property and cancels the
mortgage. The mortgage balance by that point was $381,000.
 IRS argues that Wood should have to recognize DOI income in the amount of the loan cancelled.
 Wood argues that she should have been taxed when the loan was converted from a recourse to a nonrecourse
mortgage because that was tantamount to a disposition of the property since legal entitlement to the property
was transferred to the bank should she default. So in 1931, she should have been taxed on more than $100k
gain, but SOL has run to tax that income. Because IRS didn’t tax at that point, basis became $400k and her
corporation suffered $19,000 loss when the property was sold for $381,000.
 Held: Change in the type of loan – from recourse to nonrecourse – is not a realization event. There was no
relinquishment of the property after the 1931 refinancing event.
Savings and Loans Crisis
 S&L companies were depository institutions for the personal side of banking
 Individuals would deposit their money into S&Ls and take mortgages out of S&Ls
 The way the S&Ls would make money would be to charge a higher percentage rate on the mortgages they
loaned out than the percentage rate that the S&L paid out on deposits
 The S&L balance sheet looked like this:
Assets
Cash
Mortgages issued (issued at 7% interest rate)
Liabilities
Deposits (generating 5% interest/yr)
Net worth = assets – liabilities
 In the 1970s, there was huge inflation; inflation was higher than the amount an individual could get from depositing
money in an S&L
 Regulators did not allow the S&L companies to raise the deposit interest rates, so depositers started to take
their deposits out either b/c they wanted to spend it before inflation devalued their money even more or b/c
they wanted to invest abroad and getting higher interest rates.
 Another effect of the inflation was that the mortgage portfolios held by the S&Ls went down in value
 The mortgages are set at a fixed interest rate
 But when interest rates in the rest of the economy go up, the mortgage portfolios are less valuable; their
net worth in fact was negative
 Regulators had to decide what to do to avoid shutting down all these insolvent S&Ls that were too big to fail
 So they allowed the S&Ls to invest in “junk bonds” (investments that were very risky but potentially high pay-offs)
 The junk bonds didn’t get the return the S&Ls hoped, so eventually the government had to do a bail out of the S&L
industry
 Cottage Savings case comes at the end of the S&L crisis
Cottage Savings, p 216
If there are distinct legal entitlements in the two pieces of property being exchanged, then the property is
materially different and a realization event has occurred.
 Distinct legal entitlements exist where the property is different in either kind or extent
19
Mortgage portfolios exchanged were materially different so S&Ls can deduct losses from income.
Dissent: material difference exists where it influences a decision.
 Buchanan thinks the majority got it wrong here and that the dissent (Blackmun and White) got it right. Majority
essentially approves form dominating substance 
 Facts:
 Federal Home Loan Bank Board is an agency that promulgates savings & loans regulations. In addition, it goes
to every S&L, asks for its balance sheet, and looks to see whether net worth is positive. If it’s not, it shuts the
S&L down.
 Because every S&L is insolvent due to the S&L crisis, the Board comes up with a solution – Memorandum R-49.
 Memorandum R-49 says that S&Ls do not have to report losses on their book for mortgages that are
exchanged for “substantially identical” mortgages held by other lenders. But it does allow the S&Ls to
report the difference b/w the market value and face value of the exchanged mortgages as a loss for income
tax purposes.
 Mortgages are substantially identical where they meet 10 criteria (FN 3, p 217). The point is to make
sure that no investor would notice the difference b/w one mortgage portfolio and another.
 To take advantage of Memorandum R-49, Cottage Savings sold 252 mortgages and then simultaneously bought
305 mortgages. The mortgages are for houses in the Cincinnati area.
 Issue: does a realization event occur when Cottage Savings exchanges its mortgage portfolio for one that is
“substantially identical” and therefore allow Cottage Savings to recognize tax-deductible losses?
 Answer: yes.
 To determine whether non-cash sale is a realization event, court asks two questions:
 (1) does the realization principle under s 1001(a) require that property disposed of be “materially
different”?
 (2) are the mortgage portfolios exchanged b/w the S&L companies materially different?
 Under first prong, Treas. Reg. 1.1001-1 clearly says that for a realization event to occur, the property
exchanged must be “materially different,” the answer is clear. It’s been around so long that Congress has
passively approved it.
 Under the second prong, court says there is a “material difference” in these mortgage portfolios. Buchanan
thinks there’s no difference.
 IRS’ test for material difference: look to the attitudes of the parties, how the market treats the property, the
views of the relevant regulatory agency. Court thinks this test is too subjective and un-workable. Buchanan
thinks the test is workable in these circumstsances.
 Court’s test is whether the respective possessors enjoy legal entitlements that are different in kind or
extent by virtue of the exchange.
 Court says that if you adopted IRS position – that there can only be a meaningful difference if they’re
different in a way that an investor would care about – then that would render the like-kind doctrine
unnecessary.
o Buchanan’s two responses:
 That’s wrong. If you think about what LKE doctrine encompasses, LKE would clearly
expand what the IRS is trying to get at here.
 It is an example of where the court is reading into the Tax Code a requirement that there
not be “surplusage.” We know that’s not true in the Tax Code; the Tax Code is very
repetitive.
o The court gives no reason as to why the word “material” doesn’t mean anything in the phrase
“material difference”
Applying Cottage Savings
Problem 1, page 226.
 Jim and Barbara are cotton dealers. They have each deposited 1000 bales of cotton into warehouse. Basis = $100k.
Current fmv = $60k. So they each have unrealized loss of $40k. They want to exchange cotton to realize their losses.
If cotton is just dumped into the warehouse without
segregation . . .
Exchanging pieces of paper indicating ownership of cotton
does nothing. No realization event. Jim and Barbara can’t
recognize losses.
If cotton is kept segregated in warehouse according to
who owns it . . .
Exchanging pieces of paper indicating ownership is a
realization event. Jim and Barbara can recognize losses.
 Cottage Savings makes the second scenario look different, and because of that we waste economic resources
(someone has to segregate the cotton).
20
Problem 2, page 226.
 Machorari cars. Get sent to dealers. Dealers customize the cars for their ultimate clients. Susan is in New York City
and she owns Streaker #13. Josh is in Miami and he owns Streaker #14. Upon delivery, Susan gets #14 and Josh gets
#13 by accident.
 Each have a basis of $500k because that’s who much they paid upon delivery. The FMV of the cars is $750k.
If they ship each other the cars
No realization event
If they exchange ownership papers
Realization event! They have exchanged property with
distinct legal entitlements. Susan and Josh have to
recognize gains.
 To avoid recognizing gains, Josh and Susan will have to do the more expensive thing! 
Non-recognition and like-kind exchanges
 Non-recognition rules are those where you have realized gains but Congress says you don’t have to recognize them
until later
 They’re transfers of property that should be income and should be realized, but Congress says they’re not
 Rationale behind non-recognition rules:
 Gain should not be recognized if the transaction does not generate cash with which to pay the tax
 Gain or loss should not be recognized if the transaction is one in which the gain or loss is or might be difficult to
measure – valuable problems
 Gain or loss should not be recognized if the nature of the taxpayer’s investment does not significantly change
(as long as TP is doing the same type of business as he was before the exchange, gain or loss shouldn’t be
recognized)
 Gain should not be recognized in order to avoid discouraging mobility of capital
 Like-kind exchanges are the most prominent kind of non-recognition events
 Like-kind exchanges
 Original purpose = allow farmers to trade farm lands
 Section 1013: if you have two businesses that have similar types of property (“held for productive use in a
trade or business or for investment”) and they want to exchange them, that’s a realization event but it doesn’t
have to be recognized for tax purposes in the year of the exchange
 Exceptions!! (times when similar property is exchanged and the gain/loss DOES have to be recognized;
excepting out property that’s not real property):
 Exchange of:
 Stock in trade or other property held primarily for sale (inventory)
 Stocks, bonds, or notes
 Other securities or evidences of indebtedness or interest
 Interests in a partnership
 Examples – are these exchanges taxable? Page 229
 Stock for stock  falls within exception, so exchange is taxable.
 Farm held for investment for another farm  not taxable, so long as the second farm was also held for
productive use or for investment.
 TP sells farm, gets cash, uses cash to buy another farm  taxable, this is a normal purchase not a like kind
exchange.
 Farm for fleet of tractors  taxable, not a like-kind exchange.
Defining like-kind exchanges
 What makes something like kind is the nature or character of the property and not it’s grade or quality. Reg.
1.1031(a)-1(b).
 Examples: super high-end wool is the same as low-end wool to be used as pillow filler. Land exchanged with
skyscraper is same as land with nothing on it.
 Reg. 1.1031(a)-1(c) examples of like kind exchanges:
 Truck for a new truck
 Passenger automobile for a new passenger automobile to be used for a like purpose
 Taxpayer who is not a dealer in real estate exchanges city real estate for a ranch or farm
 Taxpayer who is not a dealer in real estate changes a leasehold of a fee with 30 years or more to run for real
estate
 Taxpayer who is not a dealer in real estate exchanges improved real estate for unimproved real estate
 Taxpayer exchanges investment property and cash for investment property of a like kind
21
 In general, assets are of like kind if they are in the same asset class. Reg. 1.1031(a)-2.
 Asset classes, supplement p 630:
 Office furniture, fixtures, and equipment
 Information systems (computers and peripheral equipment)
 Data handling equipment, except computers
 Airplanes, except those used in commercial or contracting carrying of passengers or freight, and all
helicopters
 Automobiles, taxis
 Buses
 Light general purposes trucks
 Heavy general purpose trucks
 Railroad cars and locomotives, except those owned by railroad transportation companies
 Tractor units for use over the road
 Trailers and trailer mounted containers
 Vessels, barges, tugs, and similar water-transportation equipment, except those used in marine
construction
 Industrial steam en electric generation and/or distribution systems
Boot
 Boot = cash and non-like-kind property
Recognizing gain/loss in the year of the transaction
 NO BOOT
 You don’t have to recognize a gain or loss in the year of the transaction, except under certain circumstances:
 Stock in trade or other property held primarily for sale (inventory)
 Stocks, bonds, or notes
 Other securities or evidences of indebtedness or interest
 Interests in a partnership
 THERE IS BOOT
 TP gains from the exchange (fmv of what TP got > basis in property TP gave away), then the amount of gain TP
must recognize is lesser of the amount of gain realized or the amount of the boot. 1031(b).
 TP loses from the exchange (fmv of what TP got < basis in property TP gave away), then TP reports $0.
 Since most of the time you want to recognize losses, you’d be better off selling the property for a loss than
exchanging the property for a loss.
 Example 1. Example of 1031(b) where gain > boot.
 TP gives up property with basis of $10k. In exchange, she gets property with fmv of $100k, cash of $15k, and
tractor worth $8k.
 Boot = $15k + $8k = $23k.
 Proceeds from sale are $123k.
 Her gain is $123k - $10k = $113k.
 She only has to recognize the lesser of the amount of the gain ($113k) or the amount of the boot ($23k). So her
recognized gain is going to be $23k.
 Example 2. Example of 1031(b) where gain < boot.
 TP gives up property with basis of $110k. In exchange, she gets property with fmv of $100k, cash of $15k, and
tractor worth $8k.
 Boot = $23k.
 Proceeds from sale = $123k.
 Gain = $123k - $110k = $13k.
 She has to recognize gain of $13k.
 Example 3. Example of 1031(c).
 TP gives up property with basis of $130k. In exchange, she gets property with fmv of $100k, cash of $15k, and
tractor worth $8k.
 Boot = $23k.
 Proceeds from sale = 100k + 15k +8k = $123k.
 Loss from sale = $7k.
 So she has $0 in gain/loss to report.
22
Basis
 So when you ultimately go to sell the property you just got in the exchange – what should you use as your basis?
 When there’s no boot at all  the basis for the property received will be the same as the basis of the property
relinquished
 When there is boot 
 (A + B) – D = E = substituted basis of the like-kind property received
 A = original basis of the property you just traded away
 B = amount of gain recognized = tax consequence today
 Gain realized = proceeds – basis in property traded away
 If positive  use that number for gain recognized
 If negative  use 0 for gain recognized
 D = fair market value of the boot (this is positive if you got boot or negative if you gave it away)
Example 1 (gain to TP from transaction):
TP has basis in farm X of $10,000. She trades for farm Y, which has fmv of $100k, and boot of $15k. Original
owner of Y farm has basis of $50k.
So that means farm X must have fmv of $115k.
How much should TP getting farm Y recognize in gain in the
year of the transaction?
How much should TP getting farm X recognize in gain in the
year of the transaction?
Gain recognized is the lesser of the amount of gain
realized or the amount of the boot you got. 1031(b).
$0. See 1031(a) (for the payor of the boot who receives no
boot, it is a pure like kind exchange).
Amount realized = proceeds – basis = ($100k + $15k) -$10k = $105k gain
Amount of boot = $15k
So TP must recognize a gain of $15k in the year of the
transaction.
Basis for recipient of the boot
(A + B) – D = E
($10k + $15k) -- $15k = $10k
Basis for giver of the boot
(A+B) – D = E
(50k + 0) – (-15k) = 50k + 15k = $65k
So if TP later sells farm Y for $100k, her gain realized and
recognized = proceeds – basis = $100k -- $10k = $90k
So if TP later sells farm, his basis will be $65k.
Example 2 (loss to TP from transaction):
TP gives up property with basis of $130k. In exchange, she gets property with fmv of $100k, cash of $15k, and tractor
worth $8k.
What is TP’s immediate tax consequence?
Gain = proceeds – basis = 123k – 130k = - $7k
Immediate tax consequence  TP recognizes gain/loss of $0
What is TP’s basis for the future?
(A + B) – D = E
(130k + 0) – 23k = $107k
So if TP sells the property for $100k, what is the tax consequence?
Gain/loss = proceeds – basis = $100k -- $107k = -$7k
So TP gets to recognize $7k loss.
23
Transfers Incident to Marriage and Divorce
 United States v. Davis
Exchange of property as part of divorce settlement is not a gift; it’s a bargained-for exchange. Husband has
realization event when he turns over stock, and wife will use fmv at time of transfer as her basis.
 Facts: In divorce settlement, Mr. Davis agreed to pay Mrs. Davis 1000 shares of stock in exchange for her
inchoate marital rights (her dower and intestacy rights). The title to the property is in his name because this is
a separate property state.
 Held: This was a bargained-for exchange. That means Mr. Davis has a realization event in the year of the
exchange and has to pay tax on the difference of the fmv of the stock and his basis in the stock. Mrs. Davis
adopts the fmv of the stock at the time of transfer as her basis for the future.
 Congress didn’t like this outcome, see § 1041 (transfers of property b/w spouses or incident to divorce)
 Transferor doesn’t have to recognize income pursuant to a divorce settlement where he turns over property
 Transferee will get transferor’s basis. Transferred basis (like a gift).
 Post-Davis problems
 Ask: what is person in dollar amounts? What is the person giving up (e.g. legal right in property)? What is the
basis that is going to apply to this new property?
 In other words, how does basis compare to amount of value transferred?
 If the person that is receiving the property had a basis in the property ($50k in example) that is different than
just the cash value of it at the time of transfer ($200k in example)  there is going to be some tax that the
recipient owes.
 If the person that is receiving the property had a basis in the property that is the same as the cash value of it at
the time of transfer, then there will be no gain for recipient or receiver under 1041 and Davis.
H and W are living in a house where they have basis of $100k. The house has fmv of $400k. They divorce. W moves out
and H buys her half of the house. So he gives her a promissory note of $200k for her half of the house.
What amount of gain does W
recognize?
Result under 1041
Realized gain = proceeds – basis
Realized gain = $200k -- $50k = $150k
But under 1041(a)(2), she has no
recognized gain.
What is W’s basis in the note?
$200k. The reason it is $200k is
because we are treating it like cash.
Later, she will receive $200k in cash
and she will give up the note.
Result for W?
She gets $200k and has a basis of
$50k, so she ends up with $150k gain.
What is H’s basis in the house?
Result for H?
This is NOT taxable b/c it was transfer
of property during divorce. The
promissory note is to be treated like a
gift, so when she “realizes” the
promissory note for $200k, she has $0
gain and no tax consequence.
His basis is now $100k. 1041(b)(2).
Let’s say he sells house for $400k.
Proceeds = 400k – 100k = 300k
If tax rate is 20%, he has to pay
20%(300k) = $60k in taxes.
So he has $340k in cash left, but he
24
Result under Davis
W’s realized gain = $200k - $50k =
$150k
Her recognized gain is also $150k.
Let’s assume tax rate is 20%. So she
has to pay taxes of 20%($150k) =
$30k
So she winds up with cash of $170k
Because her basis was $50k, she
really only netted $120k
$250k
So if he does sell for $400k, then his
realized gain is $400k – $250k =
$150k.
Again assuming a 20% tax rate, his
tax bill would be 20%*$150k = $30k.
So he nets $170k in cash.
has to pay off the note of $200k, so
ultimately he has $140k.
Punch line.
Person who moved out is better off
than person who stayed in the house.
But because his basis is $50k, he
really only makes $120k.
W and H end up the same.
What result if we consider § 121 (gain from sale of home is excluded)?
 Usually there is a two out of the last five years use requirement.
 But if one spouse moved out, and pursuant to the divorce agreement, one spouse stays living in the house until the
children reach 18, at which point the house is to be sold, then the two out of the last five years use requirement is
waived. § 121(d)(3)(B).
 Farid-es-Sultaneh (Mercer)
 Taxpayer can transfer inchoate marital rights in anticipation of marriage as consideration in a prenup.
1041 is not applicable because transfer was made before marriage.
 Transfer of stock was contractual agreement; not a gift.
 Facts: Kresge and Mercer sign a pre-nup. He gives her $800k worth of stock and in return she promises to
marry him and not claim her inchoate marital rights. Kresge and Mercer marry and divorce. She ultimately sells
the stocks. IRS says she should have to pay tax using Kresge’s basis as her basis. She said it was a bargained-for
exchange, and that her basis is the fmv at time of transfer.
 Held: This was a contractual agreement. Kresge had a realization event when stocks were transferred. Mercer’s
basis is the fmv of the stock at the time of transfer.
 Marvin v. Marvin
 Payment for personal services is not deductible but is income to the recipient.
 Common law marriage in a state that didn’t recognize common law marriages. She cooks, cleans, etc. for him
and he takes care of her financially. Upon the dissolution of their not legal marriage, does Michelle Marvin get
any fraction of his legally owned property as if she were a wife?
 Court says P stated a cause of action.
 What’s the tax treatment of whatever P ultimately receives?
 Income to her.
 No deductions for him (personal services are not deductible).
 1041 is irrelevant because they’re not actually married.
 Basis in Davis and Mercer
 Buchanan: As wrong as it seems, treating the transactions as gifts is better tax doctrine than treating them the
way the courts in Davis and Mercer treated them.
 In Davis and Mercer, there are realization events with respect to the husband/fiancé selling stocks to
wife/fiancée. Wife/fiancée is giving up her marital rights. This should be a realization event to the wife/fiancée,
but the courts are just ignoring that.
 Court disposes of the problem briefly – page 294, footnote 20 – “the release of marital rights in exchange for
property or other consideration is not considered a taxable event as to the wife”
 Note: 1041 applies only to couples that are married as recognized by federal law (so same-sex couples don’t get
1041 treatment).
Alimony
 Alimony
 Alimony counts as income to the recipient. § 71.
 Payor gets deduction for the amount of the alimony payment. § 215.
 To be properly considered alimony, the payments must meet certain conditions:
 (1) Payment must be in cash. § 71(b)(1).
 (2) Payment must be received under an “instrument” of divorce or separate maintenance. Oral agreements will
not do.
 (3) The payments have to be taxable to the payee and deductible to the payor.
 Parties can opt out. Can elect not to include in income and not to deduct.
 (4) The parties must not be members of the same household.
 (5) The payments cannot continue after the death of the payee spouse.
25
 If payment made is less than the full alimony + child support payment the payor was supposed to make, then the
payment should be treated as child support first and then the balance is to be treated as alimony. § 71(c)(3).
 Example: Payment is supposed to be $2000. That’s $1200 in child support and $800 in alimony. Payor only
pays $1500. So $1200 is treated as child support and $300 is treated as alimony.
Child Support
 Child support does not count as income to the recipient
 Child support payments are not deductible to the payor spouse. It’s just a personal expense, which is not deductible.
§ 262.
Excess Front-Loading
 Scenario: Payor is paying a lot of money to payee incident to divorce. It’s being called alimony, but it should be
property settlement.
 Section 71 (p 73 supplement)
 Section 71(f)(4): Excess payments for second post-separation year
 71(f)(4) = A – B
 71(f)(4)(A) = alimony payments made in second year
 71(f)(4)(B) = alimony payments made in third year + $15,000

Section 71(f)(3): Excess payments for first post-separation year
 71(f)(3) = A – B
 71(f)(3)(A) = alimony payments made in first year
 71(f)(3)(B) = sum of . . .
 (i) average of (the second year alimony payments less what you got above) and third year alimony
payments, and
 (ii) $15,000

Section 71(f)(2): Excess alimony payments
 71(f)(2) = Add the main numbers you got above

Section 71(f)(1)
 The payor spouse includes the excess payments in his gross income in the third post-separation year
 The payee spouse deducts the excess payments from her income in the third post-separation year
Example: $50k in year 1; $0k in year 2; $0k in year 3
Excess payments for second post-separation year
71(f)(4) = $0, there is no excess.
 71(f)(4)(B) = $0 + $15k = $15k
o (i) $0
o (ii) $15k
 71(f)(4)(A) = $0
Excess payments for first post-separation year
71(f)(3) = $35k
 71(f)(3)(B) = $0 + $15k = $15k
o 71(f)(3)(B)(i) = 0
o 71(f)(3)(B)(ii) = $15k
 71(f)(3)(A) = $50k
Excess alimony payments
71(f)(2) = $35k
 71(f)(2)(A) = $35k
 71(f)(2)(A) = $0
26
Diez-Arguelles v. Commissioner (Tax Court 1984) Wife cannot deduct non-paid child support payments. Lack of
child support payments does not fall under section 166. In order to write off the money that you are owed, you
have to have some kind of basis/cost that you paid to get that in the first place (example = you incur costs in
producing iPhone. Customer never pays. You can deduct that as nonbusiness bad debt.)
 Facts: Deadbeat dad. Kevin doesn’t pay child support. Christina tries to deduct what she should have gotten as a
nonbusiness bad debt under section 166. IRS disallows this.
 Held: Christina can’t deduct what she didn’t get as a nonbusiness bad debt. Buchanan thinks Tax Court got it wrong.
 (1) Court looks to sections 166(a) – (b) to require that Christina have some basis in the debt for the debt to
qualify for deduction as a nonbusiness debt.
 Christina is relying on provision 166(d), which specifically says that 166(a) does not apply. Therefore the
requirement under 166(b) of basis does not apply either.
 (2) Court relies on Long v. Commissioner to argue that Christina has no basis in the debt because she is not “out
of pocket” anything as a result of Kevin’s failure to pay.
 Christina does have a basis in the debt. The amount she paid for her children are her “out of pocket”
expenses and thus her basis.
 How should a future Christina avoid the same result in the future?
 (1) Re-argue in the Tax Court for new law. Point out that payments to support children, mentioned in s
71(c), are not supposed to have tax consequences and what’s happening is that she is making payments out
of pocket that someone else was supposed to pay.
o A good faith argument that the law is wrong is not a frivolous argument. So don’t fear individual
sanction.
 (2) Go forum shopping. This is in Tax Court. You can still go to COFC or district court.
 (3) Appeal to scholarly commentary. Commentary on good ways to develop the law.
 Perry v. Commissioner (note case)
 Facts: Same scenario as Diez-Arguelles case. Tax Court didn’t budge and got nasty about it.
 Court’s points: (1) Courts don’t legislate. TP can go to Congress if they want a change. (2) Because TP doesn’t
get max benefit (she isn’t in highest tax bracket), she shouldn’t get any benefit.
 McClendon v. Commissioner
 Legal fees for litigating these types of deadbeat dad cases are non-deductible also
27
Personal Deductions, Exemptions, and Credits
Gross income (§ 61)
Minus
Above the Line Deductions (§ 62(a)(1) – (20))
Equals
Examples: alimony,
educators’ expenses,
retirement savings,
higher education
expenses
------------ Adjusted Gross income (§ 62) -----------Minus
Below the Line Deductions
(Either: the standard deduction, § 63(c) & supp. p. 646, or itemized deductions, § 63(d))
And
Zero
bracket
Deduction for personal exemptions (§ 151 & supp. p. 647)
Equals
Taxable income (§ 63)
Introduction
 A taxpayer’s zero bracket is at least as big as their standard deduction + personal exemption, but may be larger if
their itemized deduction > standard deduction
 Tax benefit from using itemized deduction rather than standard deduction = TP’s marginal tax rate * (itemized
deduction – standard deduction)
 It’s NOT the marginal tax rate * itemized deduction!
 The personal exemption and itemized deduction have been subject to “phase out” – amount of deduction gets
smaller as adjusted gross income rises
Health Insurance
 Employers are allowed to deduct the cost of medical insurance that they buy for their employees as a business
expense under § 162.
 At the same time, benefits received by employees are excluded from their gross income under § 106(a).
 Self-employed people can deduct premiums from their income.
 So it’s a total lost taxable opportunity for IRS.
Medical Expenses, § 213
 Medical expenses are deductible to the extent that they exceed 7.5% of gross income.
 Example: TP makes $100k. TP can deduct any medical expenses in excess of $7500.
 Amounts paid for medicine shall be counted as deductible medical expense ONLY IF the medicine is a prescribed
drug or insulin.
 Defining medical care. § 213(d).
 Amounts paid for the diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of
affecting any structure of function of the body.
Medical care does include . . .
Breast pumps and supplies that assist lactation
Amount paid for lodging, but it’s limited to $50 per night
for each individual
Medical care does not include . . .
A cosmetic surgery unless the surgery or procedure is
necessary to ameliorate a deformity arising from a
congenital abnormality, a personal injury, or disfiguring
disease
Health care provided by spouse or relative is not
deductible
Depreciation on property does not count
28
Taylor v. Commissioner (1987) Paying someone to mow your lawn b/c you have allergies is not a medical
expense.
 Facts: TP has severe allergies so doctor recommends he avoid mowing the lawn. TP pays someone else to do it for
$178 and then tries to deduct the money as medical expense.
 Held: the money was not spent as a medical expense.
 (1) TP has burden of proof. TP didn’t cite any legal authority that this is medical expense.
 (2) Altman case. Golf expenses are not medical expenses, even if golf helps TP’s emphysema. So if mitigation of
emphysema isn’t going to get a deduction, mitigation of allergies is not going to get a deduction.
Ochs v. Commissioner Boarding school expenses not deductible.
 Facts: TP’s wife gets cancer. Doctor recommends that wife avoid anything that could irritate her or create
nervousness. TP sends two children (4 and 6) to boarding school for two years until they are certain wife is cured.
Then they bring the kids home and send them to public school. TP wants to deduct boarding school expenses as
medical expenses.
 Held: boarding school expenses not deductible.
 The personal expenses benefited the whole family, not just the sick person.
 This is more like a personal expense b/c it’s the equivalent of hiring a nanny, which wouldn’t have been
deductible.
 Dissent: Buchanan sides with the dissent. Dissent’s rule is the one that has become reality.
 If mother had been sent to sanitarium, that would have been deductible expense. We should treat it the same.
 The doctor didn’t prescribe “less housework,” he specifically prescribed “peace and quiet,” and mothering is
incompatible with peace and quiet.
 This isn’t going to open the floodgates. Here are some factors to consider:
 Would the TP, considering his income and living standard, normally spend money in this way regardless of
illness? (no  deductible).
 Has he enjoyed such luxuries or services in the past? (no  deductible).
 Did a competent physician prescribe this specific expense as an indispensable part of the treatment? (yes
 deductible).
 Has the TP followed the physician’s advice in the most economical way possible? (yes  deductible).
 Are the so-called medical expenses over and above what the patient would have to pay anyway for his
living expenses, that is, room, board, etc.? (yes  deductible)
 Is the treatment closely geared to a particular condition and not just to the patient’s general good health or
well being? (yes  deductible).
Ochs is still the law, but IRS has loosened up over time and allowed more medical expense deductions
 Taxpayers can deduct the excess cost of Braille books for blind child over the cost of regular editions
 Taxpayers can deduct cost of hiring a person to accompany TP’s blind child for the purpose of guiding the child in
walking
Charitable Contributions
 Cash Donations
 Effect on Donor
 Taxpayer can deduct donations he gives to charity. § 170.
 Anti-abuse mechanisms:
 The max deduction you can take is 50% of your AGI. § 170(b). Example: if you have $100k in AGI and
donate $100k, you can only deduct $50k.
 But, five year carryover allowed.
 Donating used motor vehicles, boats, airplanes
 Charities typically sell these things for cash, so TP can deduct what the charity is able to sell the car for.
§ 170(f)(12).
 Effect on Recipient
 Charities don’t have to pay income tax. § 501.
 For our purposes, “charities” under § 501 are the same as “charities” under § 170.
 Property Donations
 Property held by donor for short-term (one year or less)
 Donor can only deduct the basis
 Property held by donor for long-term
 Donor can deduct FMV
 Donor does not have to pay tax on gain
 What’s a “charity”? § 170(c), § 501(c)(3).
29
Government, but only if contribution is made for exclusively public purposes
Organization operated for religious, charitable, scientific, literary, or education purposes, or to foster national
or international amateur sports competition, or for the prevention of cruelty to children or animals
 Fraternity of some sort
 Organization for war veterans
 The earnings of the corporation can’t inure to the benefit of any private individual or shareholder
When Private Business/Person Benefits in Exchange for Charitable Contributions


For businesses:
Rule
Case
COFC/Federal Circuit
If donor RECEIVES or EXPECTS TO
RECEIVE substantial benefit (benefit that
doesn’t inure to the public at large), then
donor gets no deduction
Tax Court
If primary or dominant INTENT of
the donor is to get a personal benefit
from the donation, then no
deduction
Ottawa Silica
Facts: Ottawa Silica is involved in mining
operation in southern California. Donates
70 acres to school district with
knowledge that county will have to build
access roads to access the donated
property. Claims a deduction for fmv of
property. Access roads will improve
access to Ottawa Silica’s mining
operations and increase the value of the
land for when OS sells the property for
residential development.
Held: Because OS received a substantial
private benefit (did not “inure to the
general public”), it can’t claim a
charitable deduction.
DuVal v. Commissioner
Facts: Developer contributed land as
site for a library. Developer needed
rezoning for a parcel of property he
intended to develop.
Held: DuVal can claim a charitable
deduction. DuVal wanted to “give
something back” to the community.
For individuals:
 Amount of deduction is limited to the excess of the payment to the charity over the value of any benefit received by
the donor
 Value of benefit = fmv of whatever is received by the donor
 Example:
 You bid $2000 for dinner with Buchanan at EJF auction. Normally the dinner would cost you $200. So you get a
charitable deduction of $2000 - $200 = $1800.
Bob Jones University
 To get 501(c)(3) tax exemption, the organization has to (1) fall within one of the specific categories of
501(c)(3) and (2) has to be harmonious with public policy.
 If tax exempt organization is racially discriminatory, it will lose tax exempt status.
 Facts: Bob Jones University is Christian school that forbids interracial relationships. In 1970, IRS denied it tax
exempt status on the basis that it is racially discriminatory and therefore not consistent with public policy. Bob
Jones University sued because it wants to retain tax exempt status.
 Held: Tax exempt status denied.
 Majority:
 Public policy requirement stems from common law and policy (if everyone has to pay more tax to make up
for the tax exemption, the recipient of the tax exemption should be something helping everyone).
 Congress has acquiesced in the IRS rulings b/c it hasn’t done anything to disallow them even though they
are more than a decade old.
 Indeed, Congress has enacted 501(i) denying tax exemption for organizations with written policy of
discrimination on the basis of race, color, or religion.
 No First Amendment violation because combating racism is more important.
 Powell concurrence:
 Wants to limit the holding of the majority.
 You should lose 501(c)(3) status if you are an openly racist organization.
30
Tax Credits
 Earned Income Tax Credit, § 32
 Several features:
 Amount of credit depends on number of children
 It’s a “refundable” credit – meaning it doesn’t offset tax liability but rather results in payment from the
government
 Credit rises as earned income rises and then at a certain point the credit decreases
 Marriage penalty – when two wage earners get married, their combined EITC is lower than the sum of their
EITCs had they stayed single
 “Phase in” & “phase out” graph, p 385
 Anti-abuse mechanism -- § 32(k)
 (1) if you fraudulently claim a deduction, you can’t get a EITC credit for the next ten years
 (2) if you improperly claimed a credit due to recklessness or intentional disregard of rules and regulations
(but not due to fraud), you can’t get EITC credit for the next two years
 Personal exemptions vs. standard deductions
 Personal exemptions – counts one per person on tax form
 Standard deduction – one per tax form
Mixed Business Deductions
 Mixed business/personal consumption deduction
 Scenario: operate business out of their home, operate a business on the side, buying pens/paper for your job
 Statutory scheme
 § 162(a) allows a deduction for “ordinary and necessary expenses paid or incurred in carrying on any trade
or business”
 The amount that you are trying to deduct has to be greater than 2% of AGI
 Example: you make $50k. Expenses would have to be at least $1000 before you get deduction.
 § 183 – business deduction is not allowed if activity “is not engaged in for profit”
 § 183(d) presumption – if TP made profit on the activity in 3 of past 5 years, there’s a presumption that the
activity is engaged in for profit
 § 212 covers expense of generating income from sources other than a trade or business
 A person with investments in stocks and bonds would claim deductions for fees paid to investment
advisors, subscription to WSJ, and expenses incurred in attending investment seminars
 § 262 – “no deduction shall be allowed for personal, living, or family expenses”
 Nickerson v. Commissioner
 Expenses for hobbies are non-deductible. If you are intending to make a profit from your activity, then
you get the deduction.
 Whether or not activity is engaged in for profit is a facts and circumstances test. Factors to consider:
 Manner in which TP carries on activity (is it businesslike with accurate recordkeeping?)
 The expertise of the TP or his advisors
 The time and effort expended by the TP in carrying on the activity
 Expectation that assets used in activity may appreciate in value
 The success of the TP in carrying on other similar or dissimilar activities
 The TP’s history of income or losses with respect to the activity
 The amount of occasional profits, if any, which are earned
 The financial status of the TP
 Elements of personal pleasure or recreation
 Facts: TP Nickerson buys a farm in Wisconsin. He wants to transition out of advertising career. He goes there
every weekend during growing season and twice per month during non-growing season. He mostly works on
the home while he’s there. Nickerson has experienced losses on the farm and wants to deduct them under §
162.
 Held: This is an activity engaged in for profit, so TP can get the deductions.
 Appellate court is supposed to apply clearly erroneous standard. Appellate court actually applies de novo.
 Court says people don’t do hard labor unless it’s for profit. What about Iron Man competitions??
 Buchanan thinks the farm is just a man cave so that TP can take a break from family/city life.
Business use of a home, § 280A
 Generally, business use of a home is not deductible
 Exceptions: When portion of the home is exclusively used on a regular basis –
 As the principal place of business for any trade or business of the taxpayer,
31
Solimon majority: what is the principal place of business? Consider:
 Relative importance of the activities performed at each business location
 The time spent at each place
 Solimon concurrence (Thomas and Scalia):
 To be a PPB, there has to be income earned in that location
 We should rule out any place where there’s no money earned at all
 If there is, then you would move onto majority test
 As a place of business which is used by patients, clients, or customers in meeting or dealing with the taxpayer,
or
 In the case of a separate structure which is not attached to the dwelling unit, in connection with the taxpayer’s
trade or business.
 Popov v. Commissioner
 Musician may deduct expenses from the portion of their home used exclusively for musical practice.
 Facts: Popov is a professional violinist. She practices 4-5 hours at home per day in her living room. Her
employers do not provide her practice space.
 Held: She can deduct 40% of her rent and 20% of her electricity bill b/c her home is her principal place of
business. Her living room space was used exclusively for her business.
 While the place of delivery is important, the four to five hours of daily practice she did at home “lay at the
very heart of her career as a professional violinist”
 She spent a lot of time in her practice space as compared to place of delivery

Henderson v. Commissioner
 Facts: Henderson buys plant and print for her office and tries to deduct as a business expense.
 Held: No deduction allowed.
 For § 162, there has to be sufficient nexus b/w the expense and the “carrying on” of the business. If the expense
is “in essence personal,” then no deduction is permitted.
 These expenses weren’t necessary for her to perform her job.
 § 262 trumps § 162.
 Cf. Judge (allowing deduction for pediatrician’s expenses spent on pictures specifically appealing to children
and displayed in patient rooms).
Travel & Entertainment Expenses
 Rudolph v. United States
 T&E expense of traveling to NYC as reward for meeting sales goal is income and not deductible as a
business expense under §162
 Facts: TP and wife went to NYC. He got to go on the trip because he met certain insurance sales goal.
 Held: This was income. No deduction allowed.
 Prong one: was this income? Yes. It was for pleasure.
 Test = “dominant motive and purpose”
 Prong two: is this personal expense or deductible business expense?
 Test = whether it’s related primarily to business or is primarily personal. Fact specific inquiry.
 This is personal. He wasn’t forced to go.
 Dissent:
 Prong one: this isn’t income.
 No evidence this was a sham. But that’s not the legal test.
 This isn’t compensation. No connection between the trip and services rendered. That’s exactly what
this is! A reward for selling insurance!
 Expense as to wife is a business deduction
 Wives contribute to productivity of the husbands
 Section 274
 Expenses of spouses, § 274(m)(3)
 When TP is on legit business trip, no deduction allowed for spouse who comes along unless:
 Spouse is employee of TP,
Primary purpose
 Spouse had bona fide business purpose for going on the trip, and
depends on the
 Additional expenses would otherwise be deductible
facts &
 Reg. 1.162-2: traveling expenses
circumstances in
 If trip is primarily related to TP’s business, traveling expenses to and from destination are
each case, but
amount of time
deductible
spent on
 If trip is primarily personal, traveling expenses to and from destination are not deductible even
personal/biz
though the TP engages in business activities while at the destination
activities is
important
32

Expenses at the destination that are related to business are deductible
Clothing as a Business Expenses
 The cost of clothing is deductible as a business expense only if:
 The clothing is of a type specifically required as a condition of employment
 It is not adaptable to general usage as ordinary clothing (objective test)
 General adaptability can’t have national meaning. See Nelson v. Commissioner (allowing a business
deduction for clothing expenses where clothing was heavy costumes worn on the set of a TV show filmed in
southern California).
 It is not so worn
 Pevsner
 Facts: TP is manager at YSL boutique. She has to wear YSL clothes at work and at work events. She does not
wear them when she’s “off duty” because she leads simply life. She wants to deduct the expense of the clothes
from income.
 Held: She can’t deduct. The clothing is adaptable to general usage as ordinary clothing.
 Types of clothing that would qualify: astronaut suit, deep sea diver’s suit, something that would look weird in
public
Educational Expenses, Reg. 1.162-5(b)
 Expenditures made by an individual for education are deductible as business expenses if the education:
 Maintains or improves skills required by the individual in his employment or other trade or business
 Meets the express requirements of individual’s employer or requirements of regulations (e.g. CLEs)
 The following are non-deductible education expenses:
 Expenses required of TP in order to meet minimum educational requirements for qualification in his job
 Expenses for education which is part of a program of study being pursued by him which will lead to qualifying
him in a new trade or business (this could be considered a capital expense rather than a current expense)
 Even if the employee does not ultimately switch jobs, but the education still qualified him for a new trade
or business, the expenses are still not deductible
 New trade or business ≠ new duties involving the same general type of work as is involved in individual’s
present employment (e.g. elementary to secondary school classroom teacher)
 Limitations on amount TP can deduct for educational expenses, § 222
 If AGI < $65,000  maximum deduction is $4,000
 If AGI is between $65,000 and $80,000  maximum deduction is $2,000
 If AGI > $80,000  no deduction is permitted
 When you are determining whether you are above the AGI threshold, ignore this particular deduction.
§222(b)(2)(C)(i).
 To figure out if you’re qualified for the deduction, take out all your other above-the-line deductions and
then use that as your AGI to determine for what level of deduction you qualify.
 Carroll v. Commissioner
 Facts: TP was police officer. He took liberal arts courses at DePaul University and tried to deduct them as a
business expense.
 Held: TP can’t deduct the expense of the classes. The classes did not maintain or improve skills required by him
in his employment. The classes were not connected to his work.
Hierarchy of Tax Reduction Techniques
 Tax Credits – you get your money back
 Expensing – TP can take deduction in full in a single year
 Depreciation – TP can deduct in allotments over several years
 Add to basis – then when TP sells the property, he has to pay less tax on the gain
 No deduction, e.g. personal expenditures
33
Alternative Minimum Tax
 If you are in a certain income range, you have to calculate your tax liability using both the 1040 method and AMT
method
 Whichever one is bigger is the one that you pay
 AMT = (taxable income + disallowed itemized deductions – alternative minimum standard deduction) * tax
 Disallowed itemized deductions:
 Standard deduction
 Deductions for personal exemptions
 Deduction for state and local taxes
 Deduction for interest on home equity loans
 Certain job-related outlays
 Deduction for medical expenses is limited to excess over 10% of AGI (as opposed to 7.5% for the normal tax)
 Alternative minimum standard deduction
 $50,600 for singles
 $78,750 for married couple filing jointly
 Tax
 26% tax rate for first $175k
 28% of so much of the taxable excess as exceeds $175k
 Klaassen v Commissioner
 Facts: Klaassens had ten kids and want TMT to apply to them rather than AMT. AGI = $83,056.
Tentative Minimum Tax
AGI – itemized deductions – personal exemptions =
taxable income = $34,092
Itemized deductions = $4,767 for medical expenses,
$3,264 for state and local taxes, $11,533 for charitable
donations)
12 personal exemptions = $29,400
Tax * taxable income = TMT = $5,111


Alternative Minimum Tax
$34092 + 3264 + 29400 + 2076 = $68,832
$68,832 – standard deduction at the time (which was
45000) = $23,832
0.26*23,832 = $6,196
Held: they have to pay AMT.
Concurrence (Kelly):
 Kelly is very sympathetic. You can look at congressional intent. He doesn’t want majority to say that
congressional intent doesn’t matter.
 Suggested alternatives:
 (1) Eliminating itemized deductions and personal exemptions as adjustment to regular taxable income
in arriving at AMT income
 (2) Exempting low and moderate income taxpayers from the AMT
 (3) Raise and index the AMT exemption amount (this one has actually come to be)
 (4) Some other measure.
34