Federal
Income
Taxation
Professor Wells
Fall 2018
Federal
Income
Taxation
Professor Wells
01
Introduction to
Income Tax, Time
Value of Money
02
What is Income?
03
Deductions
04
Whose income is
it?
05
Capital Gains and
Losses
07
When is it
income?
This course was taught in the Fall of 2018 by Professor Wells at the
University of Houston Law Center. The materials for the course
included the following:
1. Graetz & Schenk, “Federal Income Taxation — Principles and
Policy,” 8th Edition, Foundation Press (2018) (ISBN:
9781640206809).
2. Wolters Kluwer / CCH Publications, “Federal Income Tax —
Code & Regulations, Selected Sections,” 2018-2019 Edition
(ISBN: 9780808050117).
a. This volume contains:
i. provisions of the Internal Revenue Code of
1986 (the most recent complete “codification”
of the tax statutes), as subsequently amended
on numerous occasions, and
ii. selected important “regulations,” as
promulgated by the U.S. Department of the
Treasury.
3. Recommended: Chirelstein & Zelenak, “Federal Income
Taxation—A Law Student’s Guide to the Leading Cases and
Concepts,” 14th Edition, Foundation Press (2018).
Table of Contents
History of U.S. Taxation ......................................................................... 19
Constitution................................................................................................... 19
Before the 16th Amendment .......................................................................... 19
Pollock v. Farmers Loan & Trust p. 7 ..................................................................19
16th Amendment ........................................................................................... 19
Tax Terminology .................................................................................... 20
Tax Incidence Theory ..................................................................................... 20
Definitions ..................................................................................................... 20
Taxable Income ...................................................................................................20
Gross Income ......................................................................................................20
Gains ..................................................................................................................21
Basis ...................................................................................................................21
Adjusted Basis ....................................................................................................21
Realization...........................................................................................................21
Deductions ..........................................................................................................21
Capitalization ......................................................................................................22
Capital Gains and Dividends ...............................................................................22
Average v. Marginal Rates....................................................................................22
Present Discounted Value....................................................................................22
Credit ..................................................................................................................22
Tax Deduction v. Tax Credit ................................................................................23
Tax Expenditure ..................................................................................................23
Tax Subsidies ......................................................................................................23
Tax Policy Concerns ............................................................................... 24
Why Tax Income? ........................................................................................... 24
Distribution Effects ........................................................................................ 24
Overview of the Taxing Process .............................................................. 24
Constitutional Provisions ............................................................................... 24
Statutory Provisions ...................................................................................... 26
Delegation ...........................................................................................................26
Administrative Law .............................................................................................. 26
Retroactivity ........................................................................................................27
Freedom of Information Act .................................................................................27
Investigation ........................................................................................................27
Administrative Resolution of Tax Disputes .......................................................... 27
Taxpayer Bill of Rights......................................................................................... 29
Levy and Liens.....................................................................................................29
Penalties..............................................................................................................30
Opinion Practice ..................................................................................................31
Golsen Rule .........................................................................................................31
Commissioner’s Acquiescence .............................................................................31
What is Income? .................................................................................... 32
Definition ....................................................................................................... 32
Constitutional Definition ..................................................................................... 32
Commonly Used Definitions ................................................................................32
Haig – Simons Definition ..................................................................................... 32
IRC § 61 – Gross Income ..................................................................................... 32
Time Value of Money ...................................................................................... 33
The Concept ........................................................................................................33
Implications ........................................................................................................33
Interest................................................................................................................33
Present Discounted Value....................................................................................34
Future Value .......................................................................................................34
Net Present Value ................................................................................................ 34
After-Tax Returns. ............................................................................................... 34
Effective tax rates. ............................................................................................... 34
Tax deferral as a source of capital. ......................................................................34
The Equivalence of Tax Deferral and Yield Exemption. ........................................34
Cary Brown Thesis .............................................................................................. 35
Soft Money Investing ........................................................................................... 36
Marginal v. Average Tax Rates .............................................................................36
Income................................................................................................... 36
Compensation for Services ............................................................................. 36
Trading Services with Each Other........................................................................36
IRC § 61 – Gross Income ..................................................................................36
Reg. §1.61–1 – Gross Income ............................................................................36
Reg. § 1.61–2(d) – Payment by Property or Services ..........................................37
Discharge of an Obligation ............................................................................. 37
Deduction for Paying Income Taxes Not Allowed ..................................................37
IRC § 275 – Deduction for Federal Income Taxes ..............................................37
The Taxpayer Always Possesses the Obligation to Pay Taxes ............................... 37
Old Colony Trust Co. v. Comm’r – Discharge of Obligation Income ................... 37
Imputed Income ............................................................................................. 38
Bartering for Services .......................................................................................... 38
Rev. Rul. 79-24, 1979-1 C.B. 60 – Barter for Services ......................................38
Imputed Income Inefficiencies .............................................................................38
Self-Provided Services ...................................................................................... 38
Horizontal Inequity ........................................................................................... 38
Vertical Inequity ............................................................................................... 39
Alternatives to the Failure to Tax Imputed Income ...........................................39
Differences in Court Holdings on Imputed Income ...............................................39
Morris v. Comm’r – Growing Food for Consumption Not Income ....................... 39
Dicenso v. Comm’r – Taking Food from Company Grocery Store Income ..........40
Comm’r v. Minzer – Receives Insurance Policy on Self Income .......................... 40
Benjamin v. Hoey – Brokerage Partner Commissions Not Income ..................... 40
Worden v. Comm’r – Ins. Agent Waived Commissions Not Income ....................40
Fringe Benefits ............................................................................................... 40
Economic Neutrality Thesis .................................................................................40
Health Insurance Benefits to Employees .............................................................. 40
IRC § 104 – Compensation for Injuries or Sickness ..........................................40
IRC § 105 – Benefits Paid under Employer’s Health Plan ..................................41
IRC § 106 – Exclusion for Employer Contribution to Health Care Plan .............41
Cadillac Tax .....................................................................................................41
Retirement Income Plans (§ 401(k))......................................................................41
Employer Paid Life Insurance ..............................................................................41
IRC § 79 – Group Term Life Insurance .............................................................. 41
Other Employer Provided Benefits Excluded ........................................................ 42
Macroeconomic Effects of Fringe Benefits ............................................................ 42
Meals and Lodging Provided by Employer ............................................................ 42
IRC § 119(a) – Meals and Lodging .....................................................................42
IRC § 119(b) – Meals and Lodging .....................................................................43
Convenience of the Employer Standard ............................................................ 43
Benaglia v. Comm’r – Hawaii Resort Convenience of the Employer .................. 43
In-Kind Compensation Issues...........................................................................44
Comm’r v. Kowalski – State Trooper Cash for Meals Income ............................ 44
On Business Premises Concerns ......................................................................44
Adams v. US – Housing designed for business overseas, Rev. Rul. 75-540 ...... 44
Negotiating a contract considering §119 ........................................................... 44
IRC § 119 Problems .......................................................................................... 45
Compare §119 Tax Treatments .........................................................................45
Other Work-Related Excluded Fringe Benefits ..................................................... 46
IRC § 132 – Work Related Fringe Benefits ........................................................ 46
IRC §132(h) – Who is an Employee? .................................................................46
Townsend Industries, Inc. v. U.S. – Fishing Trip Working Condition Fringe ...... 46
Reg. §1.162-1 – Business Expenses..................................................................46
IRC §274 – Entertainment Expenses ................................................................ 47
Ann. 2002-18, 2002-10 IRB 10 - Frequent Flyer Miles .....................................47
Distinguishing Excludable Fringes from Taxable Compensation ....................... 47
Reg § 1.61–2(d) - Valuating In-Kind Compensation...........................................47
Reg §1.132-6 – What is De Minimus and Occasional ........................................47
IRC § 132(c) – Employee Discounts ..................................................................48
Fringe Benefit Nondiscrimination .....................................................................49
Turner v. Comm’r – Contest Winner Actual Realization ..................................... 49
Non-Employer Benefits ................................................................................... 50
Companies Compensating People who are not Employees ...................................50
IRC §132(d) – Working Condition Fringe ........................................................... 50
Reg. 1.132-5(t) – Working Condition Fringes Application ..................................50
IRC §274(m)(3) – Travel Expenses of Spouse, Dependent. .................................50
US v. Gotcher – VW Plant Visit Wife Income ...................................................... 51
Alternatives to Ordinary Income Treatment ......................................................... 51
IRC §162(a) – Trade or Business Expenses ....................................................... 51
IRC §167(a) – Depreciation ...............................................................................51
Property Transferred in Connection with Performance of Services ................. 51
The Substantial Risk of Forfeiture Standard ........................................................ 51
IRC §83(a) – Property worth more than the service provided. ............................ 51
IRC §83(b) – Election to Include in Gross Income .............................................52
IRC §83(c) – Definitions ....................................................................................52
IRC §83(h) – Employer Deduction .....................................................................52
Gifts and Bequests ......................................................................................... 52
Gifts ....................................................................................................................52
IRC §102 – Gifts and Inheritances ....................................................................52
Detached and Disinterested Generosity ............................................................... 52
Comm’r v. Duberstein – Business Income ......................................................... 52
Stanton v. U.S. – After Retirement Gift .............................................................. 53
Goodwin v. U.S. – Congregation Income............................................................ 53
Yang v. Comm’r – Housewife Gift ..................................................................... 54
The Flu Shoes – Michael Jordan’s Gift to Ball Boy Income ................................ 54
Business Gifts .....................................................................................................54
IRC §102(c) – Employee Gifts ............................................................................54
Choices for Deciding Business Gift Cases ........................................................ 54
IRC §274 (b) – Disallowance of Gift Expenses as Deductions ............................ 55
Tip and Toke Income ........................................................................................... 55
Olk v. U.S. – Craps Toke is Income ................................................................... 55
Aaron’s Last Wish – Bequest to Leave Large Tips to Servers Income ................ 55
Unemployment and Social Security .....................................................................56
IRC §85 – Unemployment Compensation .......................................................... 56
IRC §86 – Social Security .................................................................................57
Political Contributions ......................................................................................... 57
Rev. Rul. 68–512, 1968–2 C.B. 41 – Political Contributions .............................. 57
Government Transfer Payments...........................................................................57
Notice 99-3 – Welfare Payments .......................................................................57
Rev. Rul. 2005-46 – Business Welfare Payments ..............................................57
IRC § 139 – Disaster Relief Payments ............................................................... 57
Rev. Rul. 2003–12 – Disaster Relief Payments ..................................................58
Bequests .............................................................................................................58
Excluding a Bequest from Income of the Recipient ...........................................58
Wolder v. Comm’r – Bequest in Exchange for Services ...................................... 58
Estate of Sydney Carter v. Comm’r – Payment to widow of former employee ... 59
Miller v. Comm’r – Caring for Incapacitated Person .......................................... 59
Prizes and Awards .......................................................................................... 59
Prizes are Considered Income to the Recipient ..................................................... 59
§ 74(a) – Prizes and Awards Generally .............................................................. 59
Oprah Winfrey – Cars and Trips are Income to the Recipient ............................ 59
Boston Furniture Store – Mattress Mack Deal is not Income ............................. 59
Exceptions to Prizes Being Income.......................................................................59
IRC § 74(b) - Nobel and Pulitzer Prizes.............................................................. 59
IRC § 74(c) – Employee Achievement Awards ....................................................60
IRC § 74(d) – Olympic Prizes .............................................................................60
Other Athletes................................................................................................... 60
Scholarships as Income ....................................................................................... 60
IRC § 117 – Scholarships Exclusion – No Quid Pro Quo ...................................60
Capital Appreciation and Recovery of Basis ............................................ 61
Tax Basis Recovery ........................................................................................ 61
Determination of the Basis of Property ................................................................ 61
IRC § 61(a)(3) – Dealings in Property ................................................................ 61
IRC § 1001 – Determining Gain or Loss ............................................................ 61
IRC § 1011 – Adjusted Basis for Determining Gain or Loss ............................... 61
IRC § 1012 – Cost Basis ...................................................................................62
IRC § 1012 General Conditions ........................................................................ 62
IRC § 1.1012–1(c) – Basis for Stock Transactions .............................................62
IRC § 1016 – Adjustments to Basis...................................................................62
Reg. § 1.61-3(a) – Gross Income Derived from Business ...................................62
Reg. § 1.61-6 – Gains Derived from Dealings in Property ..................................63
Allocation of Basis.......................................................................................... 63
Inter Vivos Gifts – Stand in the Shoes..................................................................63
IRC § 1015 – Basis of Property Acquired by Gift (Transferee) ............................ 63
Reg. § 1.1015–1 – Basis of Property Acquired by Gift (Transferee) ..................... 63
Reg. § 1.1015–4 – Transfer of Part Gift and Part Sale (Transferee) ....................63
Reg. § 1.1011–2 – Part Sale and Part Gift to Charity (Transferee)...................... 64
Problems ........................................................................................................... 64
IRC § 1041 – Transfers of Property between Spouses or Incident to Divorce. ....64
Taft v. Bowers – Transfer of Stock by Bequest ................................................. 64
Tax Basis for Gratuitous Transfers at Death – Step up Basis............................... 64
IRC § 1014 – Basis of Property Acquired from a Decedent (Transferee) .............64
IRC § 1014 Discussion ..................................................................................... 65
IRC § 1014 Problems ........................................................................................ 65
Gifts of Encumbered Property ..............................................................................66
Reg. § 1.1001-1(e) – Gain or Loss on Transfer of Part Sale and Part Gift
(Transferor) ......................................................................................................66
Diedrich v. Comm’r – Gifting Stock with Condition to Pay the Taxes ................. 66
Questions on Net Gift Transactions .................................................................. 66
Review Questions ............................................................................................. 66
Realization Requirement ................................................................................ 67
Miscellaneous Income.......................................................................................... 67
Reg. § 1.61–14 – Miscellaneous Items of Gross Income .....................................67
Treasure Trove – Gross Income when Reduced to Undisputed Possession ...........67
Cesarini v. U.S. – Cash Found in Piano is Income ............................................. 67
Non-Employer Benefits – Inclusion in Gross Income Under Symmetry Concerns .68
Haverly v. U.S. – Textbooks are Income Because Deduction Taken .................. 68
Windfall Gains – Determination of an Actual Gain is Necessary ........................... 69
Eisner v. Macomber – Fruit of the Tree Analogy with Stock Dividend (Split) ...... 69
IRC § 305 – Distributions of Stock and Stock Rights ........................................70
Capital Recovery and Timing ...............................................................................70
Reg. § 1.61-6(a) – Gains from Dealings in Property ...........................................70
Fairfield Plaza v. Comm’r – Selling a Portion of a Larger Parcel of Land ........... 70
Reg. § 1.1001-1(a) – Computation of Gain or Loss ............................................71
Hort v. Comm’r – Payment for Cancelling Lease is Ordinary Income ................ 71
IRC § 109 – Improvements by Lessee on Lessor’s Property ............................... 72
Helvering v. Bruun – Real Property Improvements by Tenant – Changed by IRC
§ 109 ................................................................................................................ 72
Cottage Savings Ass’n v. Comm’r – “Materially Different” Requirement ........... 74
Reg. § 1.1001–1 – Material Difference Requirement for Disposition of Property.75
Post-Cottage Savings – Significant Debt Modifications ...................................... 75
IRC § 1259 – Constructive Sales Treatment for Appreciated Financial Positions
........................................................................................................................ 75
Estee Lauder – Constructive Sale of Stock is Taxable ....................................... 75
Annuities and Life Insurance .......................................................................... 76
Annuities – Included in Gross Income .................................................................76
Level Payment Contracts ..................................................................................76
Allocation of the Cost and Timing Options ........................................................ 76
Distributions Made Before the Annuity Starting Date ....................................... 76
IRC § 72 – Annuities; Proceeds of Life Insurance Contracts .............................. 76
Annuity Income Calculation for Term Contract.................................................. 77
IRC § 72(b)(2) – Exclusion is Limited to the Investment ....................................77
IRC § 72(b)(3) – Deduction where Annuity Payments Stop (Early Death) ...........77
Tax Implications of Early Death ........................................................................ 77
Zedaker v. Comm’r – Must use the Annuity Formula ........................................ 77
Life Insurance – Excluded from Gross Income ..................................................... 78
IRC § 101 – Certain Death Benefits Excluded from Income............................... 78
IRC § 264(a) – No Insurance Premium Deduction .............................................78
Implications of the Exclusion ............................................................................ 78
Borrowed Funds ............................................................................................. 79
Illegal Income is Gross Income ............................................................................79
Collins v. Comm’r – Embezzled Funds are Gross Income ..................................79
Discharge of Indebtedness – Cancellation of Debt is Income ................................ 79
IRC § 108 – Income from Discharge of Indebtedness ........................................79
United States v. Kirby Lumber – Buying Back Bonds for Less Than the Sale
Price is Income .................................................................................................. 80
Gambling Winnings is Income .............................................................................80
Zarin v. Comm’r – Gambling losses and Loan Payments ...................................81
Effect of Debt on Basis and Amount Realized ...................................................... 81
Types of Debt ...................................................................................................81
Crane v. Comm’r – Recourse and Non-Recourse are Treated the Same ............ 81
Estate of Levine v. Comm’r – Donation Subj. to Assumption of Mortgage Income
to Donor ............................................................................................................ 83
Comm’r v. Tufts – Integrated Transaction or Two Transactions? ...................... 83
Tax Planning Concerns Related to the Effect on Basis ......................................84
Rev. Rul. 91-31 – Debt Reduction Without Transfer – Non-Recourse ................. 85
Rev. Rul. 90-16 – Bifurcation Recourse Debt..................................................... 85
Treasury Regulations & Non-recourse Debt ...................................................... 86
Disposition Examples ....................................................................................... 86
Estate of Franklin v. Comm’r – There must be Investment to have Depreciation86
Rev. Rul. 77–110 – Inadequately Secured Loans ...............................................87
Pleasant Summit Land, v. Comm’r – Deduction Allowed to Extent that Debt <
FMV .................................................................................................................. 87
Woodsam v. Comm’r – Borrowing in Excess of FMV not Realization Event ....... 88
Borrowing Summary............................................................................................ 88
Damages......................................................................................................... 89
Business Injuries – Lost Profits ...........................................................................89
IRC § 1033 – Involuntary Conversions .............................................................. 89
Raytheon v. Comm’r – Damages for Loss of Goodwill – Return of Capital......... 89
Recovery of Windfall Gains – Punitive Damages ...................................................89
IRC § 104(a)(2) – Personal Injury Damages Received .........................................89
Glenshaw Glass v. Comm’r – Punitive Damages are Gross Income .................. 89
Recovery of Nondeductible Items .........................................................................90
Overpayment of Taxes ...................................................................................... 90
Clark v. Comm’r – Recovery for Tax Preparer Error Not Gross Income .............. 90
Recovery for Personal Injury Damages .................................................................91
Tort Concerns ..................................................................................................91
Structured Settlements ....................................................................................91
Medical Expense Recoveries ................................................................................91
IRC § 104(a)(3) – Compensation for Injury or Sickness – Not Gross Income ......91
IRC § 105 – Accident and Health Plans – Not Included in Gross Income ...........91
IRC § 106 – Employer Contributions – Deductible for Employer ....................... 92
IRC § 162(a) – Trade or Business Expenses – Premiums Paid Deductible for
Employer ..........................................................................................................92
IRC § 213 – Itemized Deductions for Medical Expenses – Possibly Deductible for
Individual .........................................................................................................92
Miscellaneous Exemptions ............................................................................. 92
Tax Exempt Interest – Municipal Bonds .............................................................. 92
IRC § 103 – State and Local Bond Interest – Excluded from Income .................92
Economic Effects ............................................................................................... 92
Constitutional Effects ....................................................................................... 93
Sale of Home .......................................................................................................93
IRC § 121 – Exclusion of Gain from Sale of Principal Residence ....................... 93
Dividend Income and Capital Gains.....................................................................93
IRC § 61(a)(7) – Dividends are Gross Income ....................................................93
IRC § 1(h)(11) – Preferential Tax Rate for Dividends and Capital Gains .............93
Tax Expenditures ................................................................................................ 93
Deductions and Credits .......................................................................... 94
Basic Tax Structure ........................................................................................ 94
Calculations ........................................................................................................94
Business Expenses ......................................................................................... 95
Ordinary and Necessary ...................................................................................... 95
IRC § 162 – Trade or Business Expenses .......................................................... 95
IRC § 212 – Expenses for Production of Income – Note 2018 Disallowance .......95
IRC § 263 – Capital Expenditures – Not Deductible Business Expense .............96
Welch v. Helvering – Payments to Increase Goodwill Not Ordinary ................... 96
Jenkins v. Comm’r – Goodwill was Ordinary and Necessary ........................... 96
Deputy v. du Pont – Ordinary Has No Particular Frequency ............................. 96
Payment of Another’s Expenses ....................................................................... 96
Business v. Personal ........................................................................................... 96
IRC § 163(d) – Limitation on Investment Interest – Individual ........................... 96
IRC § 166(d) – Bad Debts – Nonbusiness Debts Not Allowed for Individual
Deduction ........................................................................................................97
IRC § 172(d) – NOL Deduction – Nonbusiness Deduction Not Allowed for
Individuals .......................................................................................................97
IRC § 469 – Passive Activity Losses and Credits – TP Doesn’t Materially
Participate ........................................................................................................97
IRC § 1221 – Capital Assets – Not for Trade or Business ..................................97
IRC § 1231 – Property Used in Trade or Business and Involuntary Conversion.97
IRC § 165 – Losses – Related to both Individuals and Businesses ..................... 97
Gilliam v. Comm’r – Criminal Defense Costs Not Deductible ............................. 98
Groetzinger – Pro Gambler – Must be involved in Activity with Continuity and
Regularity ......................................................................................................... 98
Levin – Passive Investors – Must Show an Intent to go into Business ............... 98
Origin of Claim Doctrine ...................................................................................... 98
Sports Fines .....................................................................................................98
New England Patriots – Deductible under Gilliam ............................................ 98
Attorney’s Fees .................................................................................................98
U.S. v. Gilmore – Legal Fees Not Deductible for Divorce .................................... 98
Hylton v. Comm’r – Legal Fees Not Deductible for Criminal Defense................. 99
Reasonable Allowance for Salaries .......................................................................99
IRC § 162(a)(1) – Trade or Business Expenses ..................................................99
Exacto Spring v. Comm’r – Test for Determining what is a Reasonable Salary . 99
Additional Issues from Exacto Spring ............................................................. 100
IRC § 162(m) – Excessive Salary for Top 5 Employees..................................... 100
IRC § 199A – Qualified Business Income – TP other than Corp. Can Deduct .. 100
Expenses Contrary to Public Policy.................................................................... 101
IRC § 162 – Trade or Business Expense – Public Policy Concerns................... 101
Tellier v. Comm’r – Legal Fees ARE DEDUCTIBLE for Defense Related to ProfitSeeking........................................................................................................... 101
Mazzei v. Comm’r – Deduction for Loss Related to Illegal Activity Not Allowed
....................................................................................................................... 101
IRC § 280E – Illegal Sale of Drugs .................................................................. 102
Olive v. Comm’r – Regardless of State Law .................................................... 102
Employee Business Expenses Reimbursed by Employer – Employer Deduction . 102
Careful Reading Required ............................................................................... 102
Rev. Rul. 2012–25 – Arrangements for Reimbursement of Business Expenses103
Planning Implications of Nondeductibility of Unreimbursed Employee Expenses
....................................................................................................................... 103
Business or Personal? .................................................................................. 103
Business or Investment v. Personal Expenses – Related to Business Deductions
.......................................................................................................................... 103
Fundamental Issue ........................................................................................ 103
Clothing Expenses.......................................................................................... 104
Pevsner v. Comm’r – Clothing Must Satisfy 3-Part Test .................................. 104
Items for the Office ......................................................................................... 105
Henderson v. Comm’r – Required to do Job? .................................................. 105
Other Items Expensed .................................................................................... 105
Childcare Expenses ........................................................................................ 106
Transportation Expenses ................................................................................... 106
From Home .................................................................................................... 106
Comm’r v. Flowers – Long Commute Not Deductible ....................................... 106
Away .............................................................................................................. 107
U.S. v. Correll – Sleep or Rest Overnight ......................................................... 107
Commuting Expenses..................................................................................... 107
Rev. Rul. 99–7 – Commuting Expenses .......................................................... 107
Summer Law Clerks ....................................................................................... 109
Hantzis Case – No Deduction Because Home is the New Job Location ........... 109
Entertainment and Business Meals ................................................................... 109
Business Meals .............................................................................................. 109
Moss v. Comm’r – Must be Different from or in Excess of Normal Personal
Expense .......................................................................................................... 109
IRC § 274 – Disallowance of Entertainment and Other Expenses ................... 110
Rev. Rul. 63–144 – No Deduction for TP Meals Eaten while Accompanying Client
...................................................................................................................... 110
Home Office Expenses ....................................................................................... 110
IRC § 280A – Disallowance of Expenses from Home Office and Vacation Home
Rental ............................................................................................................ 110
Rev. Rul. 94–24 – “Relative Importance” & “Time” Tests for Principal Place of
Business ........................................................................................................ 111
Popov v. Comm’r – Principal Place of Business Issue ...................................... 112
Comm’r v. Soliman – Relative Importance to the Business Issue .................... 112
Rental Losses for Vacation Home ....................................................................... 113
IRC § 163(h)(4)(A)(i)(II) – Personal Interest Deductions – Vacation Home ......... 113
IRC § 280A(d) – Disallowance of Expenses – Rental of Vacation Home ............ 113
Deductible Business & Invest. v. Nondeductible Capital ............................... 113
Introduction ...................................................................................................... 113
Capital Expenditures...................................................................................... 113
IRC § 263 – Capital Expenditures ................................................................... 115
Choices for Recovery of Capital and Benefits of Deferral ................................ 115
Capitalization Doctrine ................................................................................ 115
Introductory Concepts and Concerns ............................................................. 115
One-Time Costs ................................................................................................. 115
Nonrecurring Capital Outlays ......................................................................... 115
Encyclopedia Britannica – Creating a Book is Capital Outlay ......................... 115
Woodward v. Comm’r – Shareholder Litigation Costs are Capital Outlays ..... 115
Mt. Morris Drive-In v. Comm’r – Drainage System Capital Improvement and Not
Repair ............................................................................................................. 116
Expansion of a Business ................................................................................ 116
Repair and Maintenance Expenses ................................................................. 116
Midland Empire v. Comm’r – Repair to Return Capital to Original Condition
Deductible ...................................................................................................... 116
Environmental Cleanup ................................................................................. 117
Aircraft Maintenance ...................................................................................... 117
Rev. Rul. 2001–4 – Aircraft Maintenance Costs .............................................. 117
Production......................................................................................................... 118
Production of Tangible Assets & Inventory ..................................................... 118
Comm’r v. Idaho Power – Asset to Create Another Asset Must be Incl. in
Capitalization ................................................................................................. 118
IRC § 263A – Capitalization and Inclusion in Inventory Costs of Certain
Expenses ........................................................................................................ 118
Intangible Assets ............................................................................................... 119
Acquisition of Intangible Assets or Substantial Future Benefits ...................... 119
Indopco v. Comm’r – Future Benefit Derived from Valuation in Takeover ........ 119
Other Concerns with Intangible Assets ........................................................... 119
Job Seeking Expenses .................................................................................... 120
Rev. Rul. 75 – 120 – Job Seeking.................................................................... 120
Education Expenses ....................................................................................... 120
Wassenaar v. Comm’r – Self-Improvement and Not Deductible....................... 120
Other Educational Expenses........................................................................... 120
Before, During, or After Trade or Business ..................................................... 121
Rockefeller v. Comm’r – Must be Existing Trade or Business .......................... 121
Option to Deduct or Capitalize ....................................................................... 121
Recovery of Capital Expenditures................................................................. 121
Depreciation ...................................................................................................... 121
Introduction and Objective ............................................................................. 121
Economic Depreciation ................................................................................... 121
Methods of Depreciating an Asset................................................................... 122
What Assets are Depreciable?......................................................................... 122
IRC § 167(a) – Depreciation ............................................................................ 122
Effect of the Depreciation Deduction on Tax Basis ......................................... 122
Amortization of Intangibles ............................................................................. 124
Newark Morning Ledger v. Comm’r – Allowing Amortization of Subscriber List
....................................................................................................................... 124
IRC § 197 – Amortization of Goodwill and Other Intangibles ........................... 124
Depletion ........................................................................................................... 124
Types ............................................................................................................. 124
Cost Depletion ................................................................................................ 124
Percentage Depletion ...................................................................................... 125
Intangible Drilling Costs (IDC’s) and Exploration ............................................ 125
Interest Expense .......................................................................................... 125
General Structure.............................................................................................. 125
IRC § 163 – Interest........................................................................................ 125
IRC § 163(j) – Earning Stripping Limitations (Business Interest) ..................... 126
Investment Interest ........................................................................................... 126
IRC § 163(d) – Limitations on Investment Interest .......................................... 126
Estate of Yaegar v. Comm’r – Investor Interest has Limits .............................. 126
Rev. Proc. 72–18 – Interest Expense for Tax Exempt Bonds ............................ 127
Personal Interest Expense for Home ............................................................... 127
Personal Interest Education Loans ................................................................. 128
Economic Substance Doctrine ........................................................................... 128
IRC § 7701(o) – Economic Substance.............................................................. 128
Knetsch v. U.S. – Transaction Must Have Economic Substance ...................... 128
Goldstein v. U.S. – The Economic Substance Can Include Tax Planning ......... 129
IRC § 7872 – Below Market Rate Loans .......................................................... 130
Losses .......................................................................................................... 130
Existence and Amount ...................................................................................... 130
IRC § 165 – Losses ......................................................................................... 130
Business/Investment v. Personal Losses ........................................................... 131
Personal ......................................................................................................... 131
Business ........................................................................................................ 131
Gambling Losses ............................................................................................ 131
IRC § 165(d) – Gambling Losses ..................................................................... 131
Hobby Losses .................................................................................................... 132
Storey v. Comm’r – Hobby Loss Must not be for Profit .................................... 132
Reg. § 1.183 – 2(b) – Relevant Factors for Activity Not Engaged in for Profit .... 132
IRC § 183(a) – Activities Not Engaged in for Profit ........................................... 133
Nickerson v. Comm’r – Must Show Adequate Profit Motive Exists ................... 133
Plunkett v. Comm’r – Business v. Personal ..................................................... 134
Casualty Losses................................................................................................. 134
Amount of Casualty Loss................................................................................ 134
Reg. § 1.165 – 7(b) – Casualty Losses ............................................................. 134
Rev. Rul. 2009-9 – Bernie Madoff ................................................................... 135
U.S. White Dental – When Can You Claim a Loss? ......................................... 136
Limitations to Prevent Abuse ............................................................................. 137
Fender v. U.S. – Anti-Abuse Limits on Losses – Substance over Form ............ 137
Related Taxpayers .......................................................................................... 138
Capital Losses – Combine with At Risk and Passive Loss ................................ 138
Tax Shelter Losses ............................................................................................. 138
Tax Shelters ................................................................................................... 138
Tax Shelter Objectives and Techniques .......................................................... 138
Frank Lyon v. U.S. – Ownership Required ...................................................... 138
IRC § 465 – At Risk Limitation Rule ............................................................... 138
IRC § 469 – Passive Loss Limitation ............................................................... 139
Bad Debts ..................................................................................................... 139
Generally ........................................................................................................... 139
IRC § 166(a) – Bad Debt – Ordinary Loss – Short Term Capital Loss ............... 139
To Be a Business Bad Debt ............................................................................ 139
Loans to Friends and Family .......................................................................... 140
Existence of Loan and Basis ........................................................................... 140
Loan Guarantees ............................................................................................ 140
Voluntary Cancellation of Debt ....................................................................... 140
Timing ............................................................................................................ 140
Personal Deductions ..................................................................................... 140
Standard Deduction .......................................................................................... 140
Personal Exemption and Qualifying Child Credit ............................................... 140
IRC § 151 – Personal Exemptions ................................................................... 140
Earned Income Tax Credit ................................................................................. 141
IRC § 32 – Earned Income Tax Credit ............................................................. 141
Baker v. Comm’r – Must have Principal Place of Abode with Child ................. 141
Elderly and Disabled Credit ............................................................................... 141
IRC § 22 – Elderly and Disabled Credit ........................................................... 141
Education Credit ............................................................................................... 141
IRC § 25 – Education Credit ........................................................................... 141
Personal Itemized Deductions ...................................................................... 142
Taxes ................................................................................................................. 142
IRC § 164 – State and Local Tax Deduction .................................................... 142
Who Has the Deduction? ................................................................................ 142
Reg. § 1.164 – 1(a) – Deductions ..................................................................... 142
Charitable Contributions ................................................................................... 142
IRC § 170 – Charitable Contributions ............................................................. 142
Timing and Intent – Quid Pro Quo Analysis .................................................... 143
Hernandez v. Comm’r – Detached and Disinterested Generosity? .................. 143
Ottawa Silica v. U.S. – Indirect Benefit Still Quid Pro Quo .............................. 144
Other Holdings ............................................................................................... 144
§170(l) – Athletic Event Tickets – May Be Disallowed Currently ...................... 145
Lombardo v. Comm’r – Must Have Donative Intent ......................................... 145
Services Contributions ................................................................................... 145
Contribution of Appreciated Property ............................................................. 145
IRC § 170(e) – Contributions of Ordinary Income and Capital Gain Property .. 145
Questions – Contribution of Appreciated Property ........................................... 146
Limitations on Contributions.......................................................................... 146
Charitable Gift of Partial Interests .................................................................. 147
Self-Created Asset Donated to Charity............................................................ 147
Medical Expenses .............................................................................................. 147
IRC § 213 – Medical Expense.......................................................................... 147
What is a Medical Expense? ........................................................................... 147
Taylor v. Comm’r – Lawn Care Not Medical Expense ...................................... 148
History of U.S. Taxation
Constitution
Art. I, § 2, cl. 3
a. Representatives and direct Taxes shall be apportioned among the several
States which may be included within this Union, according to their respective
Numbers, which shall be determined by adding to the whole Number of free
Persons, including those bound to Service for a Term of Years, and excluding
Indians not taxed, three fifths of all other persons.
II. Art. 1, § 8, cl. 1
a. The Congress shall have Power To lay and collect Taxes, Duties, Imposts and
Excises, to pay the Debts and provide for the common Defence and general
Welfare of the United States; but all Duties, Imposts and Excises shall be
uniform throughout the United States;
III. Art. 1, § 9, cl. 4 & 5
a. No Capitation, or other direct, Tax shall be laid, unless in Proportion to the
Census or enumeration herein before directed to be taken. No Tax or Duty
shall be laid on Articles exported from any state.
I.
Before the 16th Amendment
It was decided that the Carriage tax was not a “direct tax.”
Civil War
a. Income tax Act of 1862
b. Amendments to Act in 1864
III. Personal Income Tax – 1894
I.
II.
Pollock v. Farmers Loan & Trust p. 7
I. Facts
II.
a. The Constitution gave the states the power to impose direct taxation. The
federal government could impose direct taxes as well, but only if those taxes
were apportioned among the states in proportion to their representation in
Congress. In this case, the Court examined the Income Tax Act of 1894.
Holding
a. The Court held that the Act violated the Constitution since it imposed taxes on
personal income derived from real estate investments and personal property
such as stocks and bonds; this was a direct taxation scheme, not apportioned
properly among the states.
b. The decision was negated by the adoption of the Sixteenth Amendment
in 1913.
16th Amendment
I.
Congress shall have power to lay and collect taxes on incomes, from whatever
source derived, without apportionment among the several states, and without
regard to any census or enumeration.
Tax Terminology
Tax Incidence Theory
The theory describes the person that bears the ultimate burden of a tax.
Assumption – Income taxes (particularly on wages, salaries, and service income)
is typically not shifted but stays with the individual.
III. Hypotheticals
a. Are retail sales taxes borne economically by the customer or by the retailer?
i. Depends on whether prices can be increased.
b. Exemption for state and local interest. Municipal bond rates are lower to
reflect in part the tax preference given to the investor.
i. So, the investor tax savings is “shared” with states and municipalities via
lower interest rates.
I.
II.
Definitions
Taxable Income
I. Taxable income is the base on which we calculate the tax due.
II. Calculation:
a. Gross Income (§61)
i. Subtract
b. Deductions (§62)
i. Equals
c. Adjusted Gross Income
i. Subtract
d. Deductions (personal exemptions + either standard or itemized deductions)
i. Equals
e. Taxable Income (§63)
i. Compute tax (§1)
ii. Equals
f. Tentative Tax Due
i. Subtract
g. Credits (§21-§54)
i. Subtract
h. Minimum Tax Computations
i. Equals
i. Tax payable
Gross Income
I. Income from whatever source derived.
a. Includes gains derived from the sale of securities, real property, works of art,
and other tangible and intangible property.
b. Includes:
i. Wages, commissions and other compensation for services
ii. Dividends
iii. Lottery winnings
iv. Discharges of indebtedness
c. May exclude fringe benefits from employer and other types of income as
described by Congress.
Gains
I. The excess of the price at which the taxpayer sold the property over the price at
which she purchased the property.
a. Bought share of stock for $50 and sold for $70.
i. $70-$50= $20 gain.
ii. The gain is taxable
iii. The $50 is returned as invested capital without taxation.
Basis
I. The portion of the sales proceeds that the taxpayer may recover without incurring
tax liability.
a. Bought share of stock for $50 and sold for $70.
i. The $50 is the basis.
Adjusted Basis
I. The purchase price adjusted upward or downward to reflect subsequent
expenditures or tax benefits attributable to the asset.
a. If the adjusted basis exceeds the sales price, there is a loss.
b. Gains and losses are only taken into account when they are realized.
Realization
I. The gains or losses when the property is sold or otherwise disposed.
Deductions
I. Reduction in the computation of taxable income based upon certain expenditures
set forth by Congress.
a. Business expenses are often deductible
b. Personal expenses are typically not deductible.
i. Exceptions include home mortgage interest, state taxes, medical expenses,
and charitable deductions.
ii. Called Itemized deductions
c. Standard deduction
i. A flat amount of deduction that is set by the Tax Code and varies with
marital status.
ii. Can be deducted without regard to actual expenses.
II. Business expenses are deducted from gross income
a. Whereas personal expenses are deducted from adjusted gross income.
b. If personal expenses are less than the standardized deduction, then use the
standardized deduction.
III. The distinction is for individual taxpayers, and individuals who operate as sole
proprietors.
a. Corporations make all deductions before adjustment.
Capitalization
I. The cost of an investment that cannot be expensed in the year that the
investment was purchased.
a. The cost is recovered over a period of years called depreciation or amortization.
b. A car is purchased for $10,000. The car is expected to last (produce income)
for 10 years.
i. The depreciation of the car would be $1,000 per year.
c. Depreciation is a deduction from gross income.
d. Taxpayers prefer to deduct as much as possible, as soon as possible to
reinvest the tax savings and overcome the time value of money.
Capital Gains and Dividends
I. A tax rate preference for much of our history has existed for certain capital gains.
II.
§1(h).
a. Must categorize whether income is from a sale or exchange of a capital asset
or if ordinary income.
b. Individual capital losses can only offset $3,000 from ordinary income.
Capital or Ordinary gains
a. Depending on whether its disposition produces a profit or a loss.
i. Complicated.
Average v. Marginal Rates
I. Average Tax Rate
a. The percentage tax rate the taxpayer pays on their entire income.
Marginal Rate
a. The incremental tax rate the taxpayer pays on the next incremental amount of
income.
b. Marginal rates are what influence tax planning and investment decisions.
c. The marginal rate is the rate at which is charged on the last dollar of income.
III. Deductions
a. Deductions reduce the average tax rate but not always the marginal tax rate.
b. p. 25 for example.
IV. Types of income taxes
a. Progressive
i. Rates increase as income increases
b. Regressive
i. Tax rate decreases as income increases
c. Proportional
i. Tax rate remains constant.
II.
Present Discounted Value
I. The value of money now that will be received or paid at some time in the future.
Credit
I. A direct reduction in tax in the amount of the allowable credit.
a. Whereas as deduction is the reduction in the taxable income.
b. The deduction is more valuable to those with higher incomes, where a credit is
the same for everyone.
c. Most credits are non-refundable
i. Child tax credit and earned income credit are not.
Tax Deduction v. Tax Credit
I. Deductions
II.
a. Reduce income
b. The tax benefit of a deduction is the reduced income X tax rate.
Credits
a. Reduce the amount of the tax liability dollar-for-dollar.
b. The tax benefit of a credit is the amount of the tax credit if available.
Tax Expenditure
I. Taxation that is based upon the budgetary needs of the government and not
based upon the income or consumption of the individual.
a. Income tax is based upon the total amount of income of the individual.
b. Sales tax and other consumption taxes are based upon how much a person
consumes
c. Tax Expenditure models use the budgetary needs of the government to derive
a per person basis for taxation.
i. For example, if the budget was $1000 and there is a total of ten people:
1. The tax on each person would be $100 where:
 Budget / total taxpayers = tax per person
II. Can be eliminated in two ways:
a. By repeal of the expenditure
b. By repeal of the tax
c. Direct expenditures can only be eliminated by outright repeal.
III. Features of expenditures.
a. Encourage transactions that would not have otherwise been considered.
i. Environmental improvement transactions.
ii. These are economically inefficient transactions but necessary.
b. Reduce barriers to economically efficient transactions.
i. Promote housing and construction
Tax Subsidies
I. Involve using the tax system to redistribute money.
II.
a. Transfers
i. Refundable credits, energy credits, first time homebuyer credits.
b. Social Spending
i. Charitable deductions
Upside down subsidies
a. Subsidies that produce a greater benefit to wealthier people.
i. Mortgage interest deduction would be greater for the higher priced homes
and zero for those who don’t own a home.
Tax Policy Concerns
Why Tax Income?
I.
II.
III.
IV.
V.
VI.
Financing gov’t expenditures
Equity (fairness) / Ability to pay
Efficiency (minimize economic distortions and preserve neutrality)
Redistributing Income or Wealth
Create special incentives or disincentives for certain activities
Complexity / Administrability
Distribution Effects
I.
II.
The Ability to Pay
a. The reason why there is progressivity in taxation.
b. The wealthier people find less utility in each dollar.
i. Poor people find more utility in $100 than a billionaire
c. Which begs the question, should the wealthy pay more proportionately?
Income Utility Distribution
Overview of the Taxing Process
Constitutional Provisions
I.
Article I, § 2, cl. 3
a. Representatives and direct Taxes shall be apportioned among the several
states which may be included within this union, according to their respective
numbers, which shall be determined by adding to the whole number of free
persons, including those bound to service for a term of years, and excluding
Indians not taxed, three-fifths of all other persons.
i. Intended to prevent the more heavily populated manufacturing states from
financing the federal government’s spending by imposing land taxes that
would disproportionately burden farming states
ii. Other than land or head tax, what is direct tax?
1. Capitation
2. Real property
3. Personal property
4. Inference that no others. NFIB v. Sebelius, p. 52.
iii. Congress can impose penalties in aid of the exercise of any of its
enumerated powers.
1. Tax on coal producers not designed merely for revenue purposes.
Sunshine Anthracite Coal Co. v, Adkins, p. 52.
2. Tax on not buying health insurance. NFIB v. Sebelius, p. 53.
II. Article I, § 7, cl.1
a. All bills for raising revenue shall originate in the house of representatives; but
the senate may propose or concur with amendments as on other bills.
i. Rendered null by 1982 maneuver by Senate.
1. House passed bill to reduce tax
2. Senate rewrote bill to increase tax
3. House voted to accept the amendment.
4. Appeals courts upheld legislation
5. SCOTUS denied certiorari.
ii. House can prevent Senate from taking any action on taxation by refraining
from originating any tax legislation.
III. Article I, § 8, cl.1
a. The congress shall have power to lay and collect taxes, duties, imposts and
excises, to pay the debts and provide for the common defense and general
welfare of the United States; but all duties, imposts and excises shall be
uniform throughout the United States.
i. SCOTUS granted an exemption for Alaskan oil.
ii. Claimed that the exemption was not an undue preference but rather was
supported by geographic differences that could be taken into account by
Congress in creating the legislation. U.S. v. Ptasynski, p. 54.
iii. Damages awarded for emotional distress was originally decided as not
income under the Sixteenth Amendment.
1. Rehearing en banc changed it to gross income. Murphy v. IRS, p. 54.
IV. Article I, § 9, cl. 4-5
a. No capitations, or other direct tax shall be laid, unless in proportion to the
census or enumeration herein before directed to be taken.
b. No tax or duty shall be laid on Articles exported from any state.
V. Article I, § 10, cl. 2-3
a. No state shall, without consent of Congress, lay any duty of tonnage...
VI. Fifth Amendment
a. …nor be deprived of life, liberty, or property, without due process of law.
VII. Tenth Amendment
a. The powers not delegated to the United States by the Constitution, nor
prohibited by it to the states, are reserved to the states respectively, or to the
people.
VIII. Sixteenth Amendment
a. The congress shall have power to lay and collect taxes on incomes, from
whatever source derived, without apportionment among the several states,
and without regard to any census or enumeration.
b. The line item veto is considered unconstitutional.
i. Line item veto is essentially giving the President the ability to draft and
sign legislation into effect without consideration from the Houses. Clinton
v. City of New York, p. 56.
Statutory Provisions
Internal Revenue Code – Title 26 of the United States Code.
a. Assumes authority under the Constitution.
II. Administrative Guidance
a. Treasury Regulations, Revenue Rulings, Revenue Procedures, Private Letter
Rulings.
III. Judicial Decisions
IV. Legislative History
a. Committee Reports
i. Senate Finance, House Ways and means, Conference report, staff of the
Joint Committee on Taxation.
I.
Delegation
a. Delegation from Congress is to the Secretary of the Treasury or his delegate.
i. The Secretary shall prescribe all needful rules and regulation for the
enforcement. § 7805(a).
1. Treasury regulations get Chevron deference. Mayo Foundation for
Medical Education & Research v. U.S., p. 60.
ii. Who then delegates to the Commissioner of the IRS.
iii. Who then delegates to the various officers of the IRS. §§7802-7809.
Administrative Law
a. is pronounced by the Internal Revenue Service (part of the U.S. Treasury
Dept.) through regulations and other pronouncements.
i. Acquiescence by IRS to Tax Court decisions
ii. IRS Revenue Rulings (Rev. Rul.)
iii. IRS Revenue Procedures (Rev. Proc.)
iv. IRS Notices
v. IRS Private Letter Rulings (PLRs)
vi. Technical Advice Memoranda (TAM)
vii. Closing Agreements
viii. IRS Determination Letters
b. IRS is responsible for the enforcement of tax laws, including tax reporting,
collection and litigation.
c. Administrative Procedures Act
i. The APA applies to the IRS. Cohen v. U.S., p.63.
ii. Interpretative regulations are exempt from notice-and-comment rules.
1. Regulations must follow notice-and-comment.
2.
Temporary regulations unclear. Intermountain Insurance Service of Vail
v. Commissioner, p. 63.
iii. Treasury’s explanation of decision must meet the “reasoned decisionmaking standard.” Altera v. Commissioner, p. 63.
Retroactivity
a. The Treasury has the authority to make rulings and regulations retroactive. §
7805(b).
b. The IRS cannot apply an unfavorable ruling retroactively when it had
previously given a favorable ruling to the taxpayer’s competitor. International
Business Machines Corp. v. U.S., p. 62.
Freedom of Information Act
a. FOIA requires that all IRS information be released to the public.
b. Some information must be deleted.
i. Taxpayer name and identity
ii. Privileged or confidential business information
iii. Trade secrets
iv. Classified matter
v. Information exempted by statute
vi. Personal privacy matters
vii. Geological and geophysical information.
c. Tax Returns are not allowed to be released to the public. §6103.
i. May be released to Congress, President, Justice Department, etc.
Investigation
a. IRS has broad investigative authority. §§7601-7612.
b. IRS can prepare taxpayer’s return if one was not filed. § 6020(b).
i. And assert tax deficiencies. §§ 6201-6204.
c. IRS has broad authority to collect taxes that are assessed. §§ 6303, 6321,
6331, 6335.
Administrative Resolution of Tax Disputes
a. When to File
i. Every individual who has gross income in excess of a certain level must
file a tax return.
1. Taxpayer’s Exemption Amount + Standard Deduction. § 6012(a)(1).
 Exemption amount is 0 for 2018-2025.
 Standard Deduction:
i. $12,000 for individuals
ii. $18,000 for head of household
iii. $24,000 for married filing jointly and surviving spouses
iv. $1,300 additional for aged or blind.
ii. Every corporation subject to income taxation must file a return.
iii. Every trust and estate with gross income of $600 or more must file a
return.
b. Responsibility for Filing
i.
c.
d.
e.
f.
g.
h.
Each taxpayer is responsible for her/his own filing, regardless of who
prepares the tax return. Vaughn v. U.S., p. 65.
1. Reasonable cause arguments are invalid.
Uncertain Tax Positions
i. Those positions for which the taxpayer has recorded a reserve in an
audited financial statement
1. Must record for any position that is not “more likely than not to be
sustained.”
2. Any position the taxpayer expects to lose if the IRS finds out about it.
Payment of Tax Liabilities
i. Withholding or estimated tax payments
ii. Gambling winnings and dividend income must be withheld. §§3401-3406.
iii. Business income, interest or dividends not subject to withholding must
pay estimated tax payments quarterly. § 6654
Audit
i. Taxpayer who prevails in tax case can be awarded reasonable litigation
costs if the position of the government is not substantially justified
ii. Taxpayer may recover reasonable administrative costs incurred after the
date on which the first letter of proposed deficiency that allows the
taxpayer an opportunity for administrative review is sent. § 7430(a)(1).
Appeals Process
i. If TP does not agree with determination, TP receives 30-day letter
1. Explains options for further review
ii. If no settlement or TP forgoes review, then receives 90-day letter
1. TP has only 90 days to petition tax court.
2. Failure to respond to 30-day letter gets a 90-day letter
Where to File an Appeal
i. District Courts
1. On receipt of Notice of Deficiency, TP may pay the deficiency, file claim
for refund, and bring suit in District Court. 28 U.S.C. § 1346.
2. If TP loses, may appeal to Court of Appeals, then to SCOTUS.
ii. Claims Court
1. The TP may pay the deficiency, file claim for refund, and bring suit in
the Court of Federal Claims. 28 U.S.C. § 1491.
2. If TP loses, may appeal to the DC Circuit.
3. Suit must be filed within two years after the IRS denied the claim for
refund. § 6532.
iii. Tax Court
1. TP may refuse to pay the deficiency.
2. Within 90 days of receipt of the Notice of Deficiency, petition Tax
Court for review. §§ 7441-7478.
3. Tax Court decision may be review by either petitioner or the IRS in
court of appeals. §§ 7481-7487.
iv. Small Tax Court
1. Cases that involve $50,000 or less.
Statute of Limitations
i.
3 years from filing of tax return to send a 90-day letter. §6501(a).
1. Refund
 3 years from date return filed (or 2 years from day tax paid,
whichever later) to claim a refund. §6511.
 Must wait 6 months from date of filing to bring suit.
 Refund litigation must occur in the District Court or Court of
Federal Claims.
 Jurisdiction gives way to forum shopping.
ii. 6 years if the TP omits an amount from gross income that exceeds 25% of
the gross income on the return unless there is disclosure. §6501(e).
iii. Unlimited if no return was filed or the return was false or fraudulent with
an intent to evade tax. § 6501(c).
iv. Taxpayer can agree to extend the SOL
1. Failure to agree will result in a deficiency notice that is probably
erroneous.
Taxpayer Bill of Rights
a. Must conduct interviews at reasonable times and places. § 7605.
i. Can’t require a business owner to close shop for interview.
b. TP may record interview.
i. IRS may record with informed consent.
ii. IRS must give transcript of interview to TP upon request. §7521(a).
c. TP may stop interview to consult with authorized representative. § 7521(b)(2).
i. Attorney, CPA or any other person allowed to represent the TP before the
IRS.
d. IRS must abate any portion of a penalty that is attributable to a mistake in
written advice. § 6404(f).
i. Does not apply to advice given over the phone.
Levy and Liens
a. IRS may levy upon TP property. §6331.
i. If tax remains unpaid 10 days after notice and demand for payment.
b. Unless property is in jeopardy, must give notice of levy and wait 30 days
before levy. §6331(d)(2).
i. Must be in simple non-technical language and give information on how to
avoid or challenge levy. § 6331(d)(4).
ii. If causing economic hardship, then IRS must release levy
1. Also, in case of installment plan agreement.
c. Exemptions
i. Exemption from levy on personal property is $9,380. § 6334(a)(2).
1. $4,690 for business books and tools. § 6334 (a)(3).
ii. Weekly wages equal to the TP standard deduction and personal
exemptions are exempt. § 6334(d).
iii. Public assistance payments are exempt.
1. Unemployment, supplemental security income, worker’s
compensation. § 6334(a)(4), (7), (11).
Penalties
a. Underpayment of Tax
i. 20% on any portion of an underpayment attributable to:
1. Negligence or disregard of rules or regulations.
 Reckless or intentional
2. Substantial understatement of income tax liability.
 When underpayment exceeds 10% of correct tax liability or
$5,000, whichever is greater. § 6662(d)(1)(A).
 $10,000 for corporations.
3. Valuation misstatement. § 6662(b) & (e).
4. Overstatement of pension liabilities. § 6662(f).
5. Substantial gift or estate tax valuation understatements. § 6662(g).
b. Failure to File
i. Penalty is 5% per month up to 25% of deficiency.
c. Evasion of Tax Obligation with Criminal Intent. §§ 7201 et. Seq.
i. Any portion that is attributable to fraud
1. Civil penalty of 75% of the portion of the underpayment that is due to
fraud. §6663.
d. Revocation
i. IRS can request that the State Department revoke the passport of anyone
with a seriously delinquent tax debt (greater than $50,000).
e. Interest
i. Determined twice per year and is normally the Short-term Fed. Rate plus
3%, compounded daily. §§ 6621, 6662.
1. Interest begins form the date the tax was owed, usually the return
filing date.
2. Interest is not suspended while litigation is pending in the Tax Court.
f. No Penalty
i. No penalty imposed if reasonable cause for that portion of the
underpayment and the taxpayer acted in good faith. § 6664(c).
ii. No penalty to the extent that it is attributable to a position with respect to
which:
1. “Substantial authority” exists
 Less stringent than more likely than not (greater than 50%
chance).
 More stringent than reasonable basis. Reg. § 1.6662-4(d)(2).
 Substantial Authority includes:
i. IRC, other statutes,
ii. Proposed, temporary, and final regulations.
iii. Tax treaties and explanations,
iv. Court cases, committee reports and other legislative history
v. Private letter rulings, technical advice memoranda IRS
information and press releases,
vi. IRS notices and other announcements published in IR
Bulletin.
 Does not include:
i.
Treatises, legal periodicals, legal opinions, or opinions
rendered by tax professionals. Reg. § 1.6662-4(d)(3)(iii).
 Authority is substantial if the weight of authorities supporting the
proposition is substantial in relation to the weight of the contrary
treatment. Reg. 1.6662-4(d)(3)(i).
i. The position must be supported only by well-reasoned
construction of the applicable statutory provision. Reg. §
1.6662-4(d)(3)(ii).
iii. The relevant facts concerning tax treatment are adequately disclosed on
the return or an attached statement and there is a reasonable basis for
the opinion.
Opinion Practice
a. Set forth in IRS Cir. 230.
b. Reasonable Basis
i. 15% to 30% chance of success
c. Substantial Authority
i. 30% to 50% chance of success
d. More likely than not
i. More than 50% chance of success
e. Should prevail
i. More than 70% chance of success
Golsen Rule
I. Controlling Precedence
a. When tax court decision is reversed by court of appeals, that decision is
controlling on the particular case.
b. Other Courts of Appeal
i. The Tax Court defers to the decision of an appeals court whenever the
taxpayer’s appeal would be reviewed by that circuit.
c. Another taxpayer whose appeal is in a different jurisdiction
i. The different jurisdiction would be controlling. Kast v. Comm’r, p. 75.
Commissioner’s Acquiescence
I. Appeals
a. If comm’r loses case, he can acquiesce or not acquiesce
b. Comm’r publishes in the IRB
i. Acquiescence tells all treasury employees that the decision must be
followed
ii. Non-Acquiescence shows that the comm’r does not agree with the decision
but decided to not pursue an appeal.
1. Likely because the Solicitor general did not want to appeal
2. Or the Comm’r believes that the appeal would not be worth the time
due to weak evidence and is willing to wait for a stronger case to
appeal.
3. Means that the Treasury employees will not follow the court’s decision
in future cases.
What is Income?
Definition
Constitutional Definition
I. The concept of income is given a tautological definition in the 16th Amendment of
II.
the Constitution.
Is Income form whatever source derived. 16th Amendment to the U.S. Constitution.
a. Payments in settlement of cases
b. Compensation-type arrangements
c. Transactional issues
d. Encumbered real estate
e. Debt discharge issues
f. Family wealth planning
g. Marital settlements
Commonly Used Definitions
I. Income is the money value of the net accretion to one’s economic power between
two points of time. Robert Haig
Net individual income is the flow of commodities and services accruing to an
individual through a period of time and available for disposition after deducting
the necessary costs of acquisition. William Hewett
III. Personal income may be defined as the algebraic sum of (1) the market value of
rights exercised in consumption and (2) the change in the value of the store of
property rights between the beginning and end of the period in question. Henry
Simons
IV. The broadest definition of income would be all pecuniary and nonpecuniary
receipts, including not only leisure and other nonpecuniary income from
household production but also gifts, bequests and prizes. Richard Posner
II.
Haig – Simons Definition
I. This is a combination of the two definitions described above.
II. The “accession to wealth” consists of Y=C+∆W, where:
a. Y is the total income
b. C is the consumption during the measurement period, and
c. ∆W is the change in the value of the property rights during the measurement
period.
IRC § 61 – Gross Income
I. Gross income means all income from whatever source derived, including (but not
limited to) the following:
a. Compensation for services
i. Including fees, commissions, fringe benefits, and similar items
b. Gross income derived from business
c. Interest
d. Rents
e. Royalties
f.
g.
h.
i.
j.
k.
l.
m.
n.
Dividends
Alimony and Separate Maintenance (until Dec. 31, 2018)
Annuities
Income from life insurance and endowment contracts
Pensions
Discharge of indebtedness
Distributive share of partnership gross income
Income in respect of a decedent
Income from an interest in an estate or trust
Time Value of Money
The Concept
a. The concept of time-value of money is that a dollar today is worth more than a
dollar in the future. A dollar invested will increase in value over time.
b. Whereas, a dollar that is not invested until later will not increase in value until
it is invested.
c. Thus, a dollar invested today will always be worth more than a dollar invested
next week.
d. It follows logically then, that dollars received at different times will always have
different real meaning, (even if there were no inflation), so dollars received or
paid at different times cannot be netted or compared as if they were the same.
Implications
a. The taxpayer will want to defer the tax.
i. The benefit of deferring a tax or accelerating a deduction greatly impacts
the effective tax rate.
b. The IRS will want the tax now.
c. Can be viewed as an interest free loan
i. Or reduction in tax rate or tax forgiveness
ii. Or immediate deduction-yield exemption equivalence – See Cary Brown
Thesis below.
Interest.
a. The value of deferral is a matter of interest.
b. A taxpayer who can defer $1,000 of tax for one year and invest the retained
funds at 6% interest will earn or save $60.
c. Interest varies with time and rate, and the value of deferral depends on how
soon the tax will have to be paid and how the taxpayer employs the funds.
d. Example:
i. $100 dollars at Year Zero with a
10% interest market rate has the
following equivalent values
depending on the date (assuming
no taxes for the moment).
ii. Conclusion: If I can defer paying
a $100 tax until Year 3, I will
pay the $100 and have an extra
$32 to keep. In real terms, I have used the government’s money to earn
$32 to apply against my tax bill.
Present Discounted Value.
a. The present value is the amount of money that will grow to equal a particular
future value amount at given compound growth rates.
i. The present value answers the question of how much must I put into an
account if I need to have the future value by the end of n periods.
ii. Discount is just another way of describing interest, but in reverse.
𝐹𝑣
iii. 𝑝𝑉 = (1+𝑟) 𝑛 , r=interest rate, n=number of years
Future Value
a. The method of evaluating future implications of deferral or immediate payment
of money.
b. 𝐹𝑣 = 𝜌𝑣 (1 + 𝑟)𝑛 , r=interest rate, n=number of years.
Net Present Value
a. The present value of a series of investments over a given number of periods.
b. Takes into account differing future investments year over year
c. NPV = (C for Period 1 / (1 + R)1) + (C for Period 2 / (1 + R)2) ... (C for
Period x / (1 + R)x) - Initial Investment.
i. where C is the expected cash flow per period, R is the required rate of
return, and T is the number of periods over which the project is expected
to generate income.
After-Tax Returns.
a. Another way to measure the value of deferral is to compare after-tax returns if
the tax is paid currently or later.
Effective tax rates.
a. Measures the difference between the after-tax rate of return on income tax and
the rate of return if there were no income tax.
b. Analysis of after-tax returns can be carried further by computing the effective
rate of tax, which is the difference between the after-tax rate of return on an
investment and the rate of return if there were no income tax.
i. Ex.: A1 has an effective tax rate of 33% since her after-tax rate of return
(6%) is two-thirds of the tax-free rate of return (9%).
ii. This effective rate just equals her nominal tax rate.
Tax deferral as a source of capital.
a. Another way to look at tax deferral is as a source of equity capital.
b. Accumulated earnings are commonly viewed as such a source, effectively
contributed by the investors to whom they would otherwise be distributed.
c. Deferral of taxes, in this view, similarly represents a source of capital that has
been contributed by the government, to which they would be paid if taxation
were not deferred.
The Equivalence of Tax Deferral and Yield Exemption.
a. Deferring taxes has an equal effect as exempting tax yields.
i. Note that the equivalence between deferral and yield exemption is not
unconditional:
1. it depends primarily on constancy of rates.
2. The equivalence also depends on equality of rates on the item itself
and on its yield.
Cary Brown Thesis
a. An immediate deduction for the cost of a capital asset (expensing) can produce
the same results as exempting the income produced by the asset under
certain conditions.
i. The tax rate must remain the same.
b. PROBLEM: Prove the Carey Brown Thesis.
c. Proof #1: Assume you can make a $300 investment with funds that have not
been taxed. Assume that this investment will create a 100% return. The
investment along with the profit will be taxed in its entirety at the end of the
investment at a tax rate of 40%. Show the after-tax cash that the investor
would be entitled to keep under this scenario after paying the posited taxes.
i. Beginning with a $300 investment and assuming a 100% return, the
return on the investment would equal $300. Because there is no tax until
the end of the investment, the entire amount taxable totals $600. The
entirety of the investment is to be taxed at a rate of 40%. In this instance,
the total tax assessed on the investment and return on investment would
equal $240. The total investment and ROI will then be deducted by the
amount of tax due. Therefore, the after-tax cash that the investor would
be able to keep equals $360.
ii. $300 Investment x 100% ROI = $300 ROI
iii. $300 Investment + $300 ROI = $600 Total Taxable
iv. $600 Total Taxable x 40% Tax Rate = $240 Taxes Owed
v. $600 Total Taxable - $240 Taxes Owed = $360 After-Tax Cash
d. Proof #2: Assume that the $300 is immediately taxed as wages at a 40% tax
rate and that you invest your after-tax proceeds for your retirement. You have
a 100% return on your investment and all profits are exempt from taxation.
Show the after-tax cash that the investor would be entitled to keep under this
scenario after paying the posited taxes.
i. Assuming that a $300 income is immediately taxed at a 40% rate, the tax
owed would be $120. The remaining amount of income after-tax equals
the original income minus the tax owed, or $180. Assuming a 100% ROI
for the after-tax income, the ROI would equal $180. The entire amount of
the after-tax income and its ROI are not being taxed further, allowing the
investor to keep a total of $360.
ii. $300 Income x 40% Tax Rate = $120
iii. $300 Income - $120 Tax Owed = $180 After-Tax Income
iv. $180 After-Tax Income x 100% ROI = $180 ROI
v. $180 After-Tax Income + $180 ROI = $360 After-Tax Cash
e. NOTE: Did the after-tax cash that the investor keeps in your Proof #1 equal
the after-tax cash that the investor gets to keep in Proof #2? If so, you have
proved the equivalency of tax deferral investing as being equivalent to tax
exempt investing.
i. Both Proofs show that the investor would receive $360 After-Tax Cash,
showing that tax deferral investing is equivalent to tax exempt investing,
given certain parameters.
Soft Money Investing
a. The ability to deduct an investment immediately or do the equivalent by the
taxation on income in order to make an investment with the pre-tax amount.
i. Taxpayers are given tax-free treatment on the return related to their aftertax equivalent amount
ii. § 401(k)
Marginal v. Average Tax Rates
I. Marginal
II.
a. Marginal tax rate is the rate at which the next dollar of income will be taxed.
b. For example, if there is a progressive tax scale, then the first $20,000 may be
taxed at 25%.
c. The next dollar may be taxed at 30%, up to a certain level.
Average Tax Rate
a. The average tax rate is the rate of tax that is imposed upon the entire amount
of income.
b. Calculated by taking the entire amount of tax and dividing by the entire
amount of income and then multiplying by 100.
c. For example, if the first $20,000 is taxed at 25%
d. And the next $20,000 is taxed at 40%, then
e. The total tax due is $13,000 on $40,000 of income.
f. And the average tax rate would be 32.5%
i. $13,000/$40,000 = 0.325 x 100 = 32.5
Income
Compensation for Services
Trading Services with Each Other
IRC § 61 – Gross Income
I. IRC § 61 requires that compensation for services be included in gross income.
a. Wages, salaries, fees, commissions, fringe benefits, and similar items.
b. Royalties, percentage of profits, etc.
c. Tips, legal and medical fees and jury fees
d. There does NOT need to be an employer-employee relationship.
e. Compensation would also include:
i. Stocks, notes, or other property transferred for services.
f. The amount of income is the fair market value of the property, if property is
given.
i. Normally at the time of the transfer of the property.
Reg. §1.61–1 – Gross Income
I. Gross income is all income from whatever source derived. It includes income
realized in any form, whether property, cash or services.
a. Gross income is not limited to the enumerated items in the Internal Revenue
Code
Reg. § 1.61–2(d) – Payment by Property or Services
I. Payment by Property
a. If services are paid for in property, then the fair market value of the property
taken in payment must be included in income as compensation.
II. Payment by Services
a. If services are paid for in exchange for other services, the fair market value of
such other services taken in payment must be included in income as
compensation.
b. If the services are rendered at a stipulated price, such price will be presumed
to be the fair market value of the compensation received in the absence of
evidence to the contrary.
Discharge of an Obligation
Deduction for Paying Income Taxes Not Allowed
IRC § 275 – Deduction for Federal Income Taxes
I. Denies any deduction for federal income taxes.
a. If federal income taxes were deductible, the system would always be a taxexclusive system.
II. The current system takes into account the differences between tax-inclusive and
tax-exclusive bases.
𝑟
a. 𝑟𝑒 = 1−𝑟𝑖
𝑖
b. 𝑟𝑖 =
𝑟𝑒
1+𝑟𝑒
c. Where re is the tax-exclusive rate
d. And ri is the tax-inclusive rate
The Taxpayer Always Possesses the Obligation to Pay Taxes
Old Colony Trust Co. v. Comm’r – Discharge of Obligation Income
I. Facts
a. American Woolen Company adopted resolution stating that the income tax of
all the executives would be paid by the company.
b. IRS says that the payment by the company is considered income to the
employee.
II. Holding
a. The payment of the tax by the employer
was in consideration of the services
rendered by the employee and was a gain
derived by the employee from his labor.
b. The discharge by a third person of an
obligation is a receipt by the person
taxed.
c. The payment cannot be considered a gift
because the payment was made in
consideration for the labor provided by
the employee.
III. Tax on Tax
a. The argument is that if the company pays a tax for the employee, then the
holding of the case would create a tax on a tax. This is not necessarily true.
i. First, the payment to the IRS by the company is not a tax, it is income.
ii. Second, the pyramiding of the income tax prevents the tax on tax issue.
IV. Pyramid
a. Tax-inclusive basis causes a pyramid situation where there must be an
algebraic calculation based upon geometric sequencing.
b. Net income = Gross Income (1-tax rate)
c. Gross income = Net income/ (1-tax rate)
Imputed Income
Bartering for Services
Rev. Rul. 79-24, 1979-1 C.B. 60 – Barter for Services
I. Situation 1
a. Lawyer and house painter trade services as members of a barter club
i. Barter club is organization where members can barter for services from
each other.
b. Holding
i. The fair market value of the services received by both parties are
includible in their gross incomes under § 61.
II. Situation 2
a. Landlord received works of art created by tenant in return for the rent-free use
of the apartment for 6 months by the tenant.
b. Holding
i. The fair market value of the works of art and the 6 months fair rental
value of the apartment are includible in the gross incomes of the landlord
and the tenant under § 61.
III. Barter exchanges are required to be reported to the IRS. See IRC § 6045(c)(1)(B).
Imputed Income Inefficiencies
Self-Provided Services
I. The income derived from self-provided services are not taxed as imputed income.
a. Walking one’s own dog v. paying someone else to walk the dog
b. There are too many difficulties in administering that type of regulation.
Horizontal Inequity
I. Taxpayers that are in the similar situations will be treated differently.
a. Walking one’s own dog v. paying someone else to walk the dog.
b. Suppose one person works regular hours, goes home and walks their dog.
Another person stays at work late to make $10 extra and pays someone else to
walk her dog.
i. The person that worked late will be taxed on the extra $10, whereas the
first person will not be taxed for the self-provided service.
Vertical Inequity
I. The concept behind self-provided services causes some taxpayers to make choices
regarding whether to perform the task themselves over performing a more
productive task.
a. The lawyer and the housepainter
i. Assume now that the lawyer gets paid $500 per hour.
ii. The cost of painting the house is $400 and it will take one hour.
iii. If the lawyer pays the painter, she will make $315 after taxes (@ 37%) and
will have to pay $400 for the service.
1. The lawyer would lose $85 versus taking the hour off to paint the
house herself.
II. The choice to be less productive causes some taxpayers to state less income than
their actual earnings potential.
a. Other taxpayers would be able to afford the services without having to perform
the service for themselves.
b. The vertical inequity is that those who can afford to pay for services will
continue to be wealthier (by focusing on their own income streams) and those
who cannot afford to pay for the services will have to stop being productive (on
their own income streams) to take care of tasks that do not provide a
monetary return on their labor but are necessary.
c. Assume now that the lawyer makes $500 per hour and the service costs $300
for one hour.
i. The lawyer would make $315 after taxes and would pay someone else
$300 for the house painting. The lawyer just made $15 performing two
tasks.
Alternatives to the Failure to Tax Imputed Income
I. None of the alternatives are good, just postulated as alternatives
II. Provide a deduction to those who pay others to perform the services.
a. Would allow many taxpayers to virtually eliminate their taxable income and
would seriously erode the tax base.
III. Allow a tax credit to families in which both spouses work.
a. Congress tried this approach
b. There is a disparity with single people who are paying for services.
Differences in Court Holdings on Imputed Income
Morris v. Comm’r – Growing Food for Consumption Not Income
I. Facts
a. Farmer grows crops on farm for personal consumption.
II. Holding
a. The court held that the crops that were grown on the farm for personal
consumption are not to be regarded as taxable income.
i. If so, then the services of the wife and children, the power generated by
the farm draft animals, and the value of the home should be considered
income because all of it creates an economic benefit to the farmer.
Dicenso v. Comm’r – Taking Food from Company Grocery Store Income
I. Facts
a. The owner of a grocery store takes home some of the groceries for personal
consumption.
II. Holding
a. The groceries are considered income to the owner of the store.
Comm’r v. Minzer – Receives Insurance Policy on Self Income
I. Facts
a. Insurance agent gets commission for selling insurance to himself.
b. The agent sent the premiums for the insurance policy minus the commissions.
II. Holding
a. The commissions are considered income to the agent despite not actually
receiving the commissions from the company.
b. Court found that he performed the same services for himself that he would
have performed for others
Benjamin v. Hoey – Brokerage Partner Commissions Not Income
I. Facts
a. Partner in a brokerage firm received commissions on transactions for his own
account, as part of his partnership profits.
II. Holding
a. The court held there was no income from this transaction.
Worden v. Comm’r – Ins. Agent Waived Commissions Not Income
I. Facts
a. Insurance agent waived commissions and sold insurance policies at cost
II. Holding
a. The court held that there was no income from these transactions.
Fringe Benefits
Economic Neutrality Thesis
I. Base Case: Alice is paid $5,000 per month. Alice pays rent and living expenses.
II. Variation #1: Alice paid $4,000 per month. Unitek pays $1,000 to Alice’s
landlord.
III. Variation #2: Alice is paid $1,500 per month. Unitek pays $1,000 per month to
Alice’s landlord and pays $2,500 to shops/restaurants/grocery stores as Alice
directs.
IV. Horizontal Equity Question: Is Alice more like the Base Case or more like the
person who earns only $4,000 (Variation #1) or the person who only earns $1,500
(Variation #2)? They are all the same.
Health Insurance Benefits to Employees
IRC § 104 – Compensation for Injuries or Sickness
I. Compensation for injuries or sickness is generally excluded from gross income.
a. Workman’s Compensation
b. Damages received in lawsuit or settlement on account of personal injuries or
physical sickness.
i. Except punitive damages
c. Accident or health insurance paid for by the employee.
d. Pension, annuity or similar allowance for personal injuries resulting from
active service in the military
e. Amounts received as disability income as a direct result of terroristic or
military action
IRC § 105 – Benefits Paid under Employer’s Health Plan
I. Benefits paid under employer’s health plan for employees or family members is
excluded from income.
II. Sick pay is taxable.
IRC § 106 – Exclusion for Employer Contribution to Health Care Plan
I. Provides an exclusion for the employer’s contribution to health care plans.
a. Health Savings Accounts are included
b. Reimbursement for prescription drugs and insulin is included
c. If employee purchases health insurance, no deduction is provided.
i. But proceeds not included as income when used. See IRC § 104(a)(3).
Cadillac Tax
I. A Cadillac plan is one whose total value including premiums paid by workers and
by employers exceeds a certain threshold
a. $10,200 for single person
b. $27,500 for family
II. The tax is 40% of the excess of the plan over the threshold. See IRC § 4980I.
Retirement Income Plans (§ 401(k))
I. Employee
II.
a. The employee gets the benefit of income exclusion for
i. The employer’s contribution to the plan, and
ii. The employee’s contribution to the plan.
b. There is no gross income for income build-up during the accumulation and
investment phase.
c. The proceeds are taxed when withdrawn.
Employer
a. The employer gets an immediate deduction for contributing to the plan.
Employer Paid Life Insurance
I. The employer’s payment of premiums on an employee’s life insurance policy IS
included in gross income.
IRC § 79 – Group Term Life Insurance
I. The first $50,000 of group term insurance that is provided by the employer is
excluded from income.
a. Term Life Insurance – Life insurance that only pays out to beneficiaries if the
insured dies during the term of the policy. Typically, does not accrue cash
value.
Other Employer Provided Benefits Excluded
I. Non-work Related
a.
b.
c.
d.
e.
f.
g.
Moving Expenses - § 132(a)(6)
Dependent care - §129 - $5,000 per year ($2,500 married filing separate)
Educational benefits - §127 - $5,250
Adoption assistance - §137 (subject to phase-out) - $10,000
Group Term Life Insurance – §79 – First $50,000
Medical Insurance payments - §105(b) – 100% up to employer contribution.
Cafeteria plans - §125 – Not food. Employee selects from a group of
nontaxable fringe benefits. Amounts not used in tax year are lost.
Macroeconomic Effects of Fringe Benefits
I. Deadweight Loss
a. A deadweight loss, also known as
excess burden or allocative inefficiency,
is a loss of economic efficiency that can
occur when equilibrium for a good or a
service is not achieved.
II. Violation of Horizontal Equity Principles
a. Two people with the same amount of
income are treated differently because
of the source of their income.
b. A person that pays their own medical
insurance with after-tax funds versus a
person who has employer provided
insurance.
c. There is less tax paid by the employer
and employee when there is an employer provided insurance plan.
d. Doesn’t seem fair to the person who has self-funded plan.
III. Violation of Economic Efficiency Principles
a. Distorts pre-tax versus after-tax preference for Fringe Benefits.
b. For example, if an employer was offering $5,000 cash or $5,000 in airfare,
then the person who doesn’t like to fly would be incentivized to take the airfare
because it isn’t taxed at the same rate and that person would net more value
from the airfare over the cash.
c. There is an incentive to work for companies that have employer provided plans
to save on the taxes.
Meals and Lodging Provided by Employer
IRC § 119(a) – Meals and Lodging
I. The value of any meals or lodging furnished to an employee, the spouse, or the
dependents is NOT considered income if:
a. The meals or lodging was for the convenience of the employer;
II.
b. The meals are furnished on the business premises of the employer;
c. The employee is required to accept such lodging on the business premises of the
employer as a condition of the employment.
Ann. 99-77, 1999-32 I.R.B. 243
a. Meals satisfy the convenience for the employer standard if employees are
precluded from going out to eat during reasonable meal hours.
IRC § 119(b) – Meals and Lodging
I. Provisions in an employment contract or a state law fixing the terms of
employment do not determine whether the meals or lodging were intended to be
compensation.
II. If the employee is charged for the meal or the employee may decline the meal are
not determinative of whether the meals were intended to be compensation.
III. Fixed Charge for meals – If the employee is charged a fixed charge periodically for
meals and the meals are furnished by the employer for the convenience of the
employer, then the charge must be excluded from the employee’s gross income.
IV. All meals furnished on the business premises of an employer to the employees
shall be treated as furnished for the convenience of the employer if more than half
of the employees to whom the meals are furnished are given for the convenience
of the employer.
Convenience of the Employer Standard
I. Conditions
a. There must be a substantial noncompensatory purpose for the benefit to be for
the convenience of the employer.
b. Lodging MUST be a condition of the employment
c. There must be a requirement that the employee be “on-call” after business
hours for the lodging and meals to be for the convenience of the employer.
d. Meals must be furnished on the business premises.
e. If more than one-half of the employees are furnished meals for the convenience
of the employer, then all of the employees enjoy the exclusion.
Benaglia v. Comm’r – Hawaii Resort Convenience of the Employer
I. Facts
a. Husband and wife live on the resort where the husband is the manager.
i. Live in one of the suites
ii. Have their meals at the hotel
iii. Neither employer nor employee regarded the meals and lodging as part of
the compensation for being the manager.
b. IRS added $7,845 for each year as compensation received from employer as
the fair market value of the rooms and meals that were furnished by the
employer.
II. Holding
a. If the meals and the lodging are primarily for the convenience of the employer,
then the meals and lodging are not considered income.
b. Comparison to the soldier living in the barracks, felon in prison, ship’s captain
while at sea, soldiers at war, etc.
III. Distinction from Old Colony Trust
a. This is a situation where there is forced consumption of the meals and lodging
for the convenience of the employer.
b. Care to having dominion and control over the economic benefit expended.
c. If not controlled, there would be horizontal equity considerations where some
employees are allowed a benefit and others are not.
i. There are still some HE problems with those who do not have employer
paid benefits.
d. See IRC § 119(a).
In-Kind Compensation Issues
Comm’r v. Kowalski – State Trooper Cash for Meals Income
I. Facts
a. NJ State Troopers exclude cash reimbursements that they receive for meals
eaten while on duty.
II. Holding
a. The cost of the meals cannot be excluded.
b. The meals were not furnished “in-kind”, meaning that cash was given instead of
the actual meals.
c. The meals were not eaten on the business premises
i. Even though the argument was that the business premises was the duty
location of each trooper.
d. The troopers had dominion, or control, over the money from the reimbursement
and there were no restrictions on how the money was to be used.
e. Further, this is not a forced consumption issue, even if there were meal stations
set up around the state to provide meals.
On Business Premises Concerns
Adams v. US – Housing designed for business overseas, Rev. Rul. 75-540
I. Facts
a. President of Japanese subsidiary of US company lived in company owned house
in Tokyo.
b. Living in house was mandatory, house had substantial office and business
accommodations.
II. Holding
a. The court used a functional rather than a spatial test to determine whether the
property was on the business premises.
b. There was sufficient evidence to show that the President did a sizeable portion
of the business at the house.
c. Normally, the lodging must be on the business premises. This was rare
exception.
Negotiating a contract considering §119
I. There are some things that do not count
a. Required clothing
b. Certain equipment (tools)
c. Vehicle
d. Travel
e. Substitute taxation of the meals
i. § 274(n) – allows 50% deduction if paid by the employee but required by the
employer.
IRC § 119 Problems
I. Anderson was a motel manager who lived in the motel until his family outgrew
their quarters. The motel had a high occupancy rate, and so instead of giving him
more space in the motel, the owner purchased a house in a tract two short blocks
from the motel and required him to live there.
a. This is not on the business premises under § 119(a). There needs to be
business activity at the location for it to be considered premises.
II. Dole was hired as assistant superintendent of Packard Mills, and he was told he
would be on call 24 hours a day and that he would have to live in a companyowned house approximately one mile from the mill so that he would be readily
available for emergencies and conferences. Other supervisory personnel were also
required to live in company houses at the same location. The company houses were
nearer to the mill than any other available housing, and Packard’s supervisory
personnel were frequently called on outside regular hours.
a. Again, this is not on the business premises.
III. A Veteran’s Administration doctor lives in a home on hospital grounds about a mile
from the hospital itself where he works. A so-called housing allowance is deducted
from his regular salary grade and would be deducted as long as government
housing were available, whether or not he occupied it.
a. He lives on the business premises, despite the size of the premises. Not only is
the housing on the premises, but the doctor’s income is being reduced by the
fair market value of the housing, meaning that he is paying for the housing and
it is not given to him.
IV. Taxpayers, husband and wife, accept jobs as domestic cook and gardener for a
wealthy couple who provide them a room in their house and meals in their kitchen.
a. Both the meals and the lodging would be excluded under § 119(a).
V. Must a university president report as gross income the rental value of an official
residence located adjacent to campus that is furnished free of charge?
a. If the residence is adjacent to, and not on, the premises, then yes, he has to
report the income.
Compare §119 Tax Treatments
I. A is paid $30,000 in stated wages, but $1,000 is withheld as payment for meals
furnished by the employer on business premises for the convenience of the
employer. §119(b)(3).
a. A’s gross income should be $29,000 under §119(b)(3)(A)(ii).
II. B is paid $29,000 in stated wages and is furnished free meal worth $1,000 by the
employer on business premises for the convenience of the employer. §119(a)(1).
a. B’s gross income should be $29,000 under §119(a)(1).
Other Work-Related Excluded Fringe Benefits
IRC § 132 – Work Related Fringe Benefits
I. Work-related
a. No additional Cost Service - §132(b)
b. Qualified employee discount - §132(c)
c. Working Conditions Fringe - §132(d)
d. De Minimus Fringe – 132(e)
e. Qualified Transportation Fringe - §132(f)
i. Bicycle commuting exclusion suspended through 2025.
f. Qualified Moving Expense Fringe - §132(g)
i. Suspended through 2025 except for active military
g. Qualified Retirement Planning Services - §132(m)
h. Certain on-premises gyms and other athletic facilities - §132(j)(1)
II. 2017 Tax Act
a. §217(k) suspends employer deduction for moving expenses through 2025 except
for bicycle commuting.
IRC §132(h) – Who is an Employee?
I. Retired and disabled employee and surviving spouse
II. Spouse and dependent children
III. Parents – in the case of air travel.
Townsend Industries, Inc. v. U.S. – Fishing Trip Working Condition Fringe
I. Facts
a. Company paid annual Canadian fishing trip. IRS determined the trip
represented taxable wages and assessed taxes against the company for wages.
II. Holding
a. 8th Circuit reverses the District Court
b. Holds that the fishing trip is a working condition fringe benefit under §132(d).
i. Any property or services provided to an employee of the employer to the
extent that, if the employee paid for such property or services, such payment
would be allowable as a deduction under §162 or §167.
c. The voluntary nature of the trip was not a bar to be a business trip.
i. Business discussions and team building aspects of the trip were business
benefits and necessary for the success of a small business.
Reg. §1.162-1 – Business Expenses
I. The petitioner must show that the Fringe benefit was a reasonable and necessary
business expense that was directly related to, or associated with, the active conduct
of the petitioner’s business purpose by showing:
a. It had more than a general expectation of deriving some income or other trade
or business benefit from the trip;
b. That the employees actively engaged in business meetings, negotiations,
discussions, or other bona fide business transactions; and
c. That the principal character of the combined business and entertainment was
the active conduct of the petitioner’s trade or business.
IRC §274 – Entertainment Expenses
I. Entertainment Expenses are no longer deductible - §274(a)(1)
a. Must separate the entertainment portion of the trip from the business portion.
b. May cause issues regarding expenses that are continuous, such as lodging.
c. The meals must create further business opportunities.
Ann. 2002-18, 2002-10 IRB 10 - Frequent Flyer Miles
I. If a business trip is paid for by the company, and the employee receives frequent
flyer miles, the miles are not considered income.
II. When frequent flyer miles are awarded as a premium for opening a financial
account, then the miles are considered income.
III. When frequent flyer miles are given as a prize, then the miles are considered
income.
IV. The valuation of the miles is based on the fair market value of the miles at the time
that they are given to the person. However, valuation is different for institutional
accounts versus individual accounts
Distinguishing Excludable Fringes from Taxable Compensation
I. Working Condition Benefits v. In-Kind Compensation
a. Working condition benefits are regarded as primarily for the benefit of the
employer.
i. There should be a noncompensatory business purpose for the benefit in
question.
ii. The good or service should not be excluded unless it is related to the
employee’s work; and is
iii. something ordinarily useful to someone in the employee’s position.
Reg § 1.61–2(d) - Valuating In-Kind Compensation
I. The amount of income includible in the employee’s gross income is the fair market
value.
a. Fair market value – the amount that an individual would have to pay for the
particular fringe benefit in an arm’s length transaction. Reg. § 1.61–21(b)(2)
II. Questions – Fringe or In-Kind Compensation?
a. Ford executive gets free car for both business and personal use.
i. Is the personal use of the car income to employee?
1. Yes.
ii. On audit, the revenue agent adds $6,000 to Derek’s gross income,
representing the value of the personal use of the Ford cars and asserts that
only the exclusions from gross income set forth in the Code and regulations
are allowable. Is this correct? See §61(a)(1).
1. Yes.
iii. If some amount is includible in Derek’s gross income, how is it determined?
1. The amount includible is the fair market value of the use of the car
during the periods of time considered personal use.
Reg §1.132-6 – What is De Minimus and Occasional
I. Employee measured frequency – If one employee receives more benefit than the
others, that employee’s benefit is not de minimus.
II. Employer measured frequency – If an employer makes sufficient controls for the
use of a benefit, then the use by a particular employee does not matter.
a. If the company is able to restrict the copy machine to 85% work-related
copying, then a particular employee’s usage is not taken into account in
determining de minimus fringe benefit.
III. Occasional meal money or transportation fare.
a. Occasional – depends on the frequency, the availability of the benefit and the
regularity with which the employee uses the fringe.
b. Overtime – if overtime work necessitates the employee work beyond the normal
working hours.
c. Meal Money – the meal or money is provided so that the employee is able to
work overtime.
IV. Associate supper money. See §132(e)(1); §132(e)(2) & (f).
a. De Minimus Fringe – any property or service the value of which is so small as to
make accounting for it unreasonable or administratively impracticable.
IRC § 132(c) – Employee Discounts
I. The discount must not be more than:
a. Property – the gross profit percentage from the price offered to customers.
Customer price – Employee price = Cost of Goods Sold or greater. In other
words, the company must make at least a penny profit.
b. Services – 20% of the price at which the services are being offered to customers
II. Employer provided cell phones and cell service, so the employee can speak with
clients at times when the employee is away from the office, or if the employee’s job
demands that she speak with clients located in other time zones at times outside of
her normal work day.
a. Employees are not prohibited from using employer-provided phones for
personal purposes. Is any amount taxable? §132(d), (e); IRS Notice 2011-72,
2011-2 C.B. 407.
III. Questions
a. A law firm at which Jane is a summer associate gives her tickets to a Broadway
show, which she attends with two other summer associates. What if the firm,
instead, gives Jane $125, and she uses the money to buy a ticket and attend
the show on her own?
i. The tickets should be valued equally as income amongst the three
associates.
ii. If given $125, Jane should report the entire amount to the IRS as income.
b. JetBlue allows its employees to ride for free on any of its routes by reserving a
seat at least 30 days prior to the departure date. Is the value of a free trip taken
by Employee A included in her income?
i. No Additional Cost Service – If there is no additional cost for the employee to
use the service, then it is a work-related fringe benefit that is excluded from
income.
ii. This may not be the case, however. If the employee is reserving a seat that
is pushing out paying customers, then that seat is considered income.
c. Suppose that Apple gives its employees a 50 percent discount. Employee C buys
a $4000 MacBook (which cost Apple $2800) for $2000. How much income does
C have as a result of this purchase? What if the discount is available only to
executives?
i. C would have an income of $800. The discount cannot be lower than the
Cost of Goods Sold. Anything lower must be considered income to the
employee.
ii. If the discount was only available to executives, then the IRS would consider
the benefit income due to discrimination.
Fringe Benefit Nondiscrimination
I. The House Ways and Means Committee Report, p. 103
a. There is a great amount of emphasis that Fringe benefits must not be only given
to executives.
b. There is not vertical equity in allowing the same dollar amount of benefits.
c. However, in proportion of total compensation, there is vertical equity.
Turner v. Comm’r – Contest Winner Actual Realization
I. Facts
a. Won a contest, got two first-class cruise tickets to Bueno Aires
b. Retail first-class ticket price: $2,220
c. Exchange first-class tickets plus $12.50 for 4 round trip tourist tickets to Rio
de Janeiro.
II. Holding
a. The court holds that there was $1,400 in income.
b. The value of a noncash benefit is the value actually realized by the
taxpayer and not the retail price.
i. The tickets could not be sold.
ii. But the Turners worked with the cruise company to exchange for 4 coach
tickets that were worth $1,400.
c. The winning of the tickets did not provide them with something which they
needed in the ordinary course of their lives and for which they would have made
an expenditure in any event…the value to the petitioners was not equal to their
retail cost.
d. The court was saying that the value of the ticket was less to the Turners than it
would be at the fair market value.
e. This holding is rather strange. Anyone could say that the subjective value of
the in-kind compensation is lower than the fair market value.
III. Notes
a. Does this case provide a viable solution for the valuation problem in Benaglia?
i. No. there will always be an unusually low subjective value of the benefit just
to subvert the income tax system.
b. Suppose Benaglia could show that living in a hotel was for him no boon but a
burden. Would that justify excluding or assigning a low value to the lodging
provided him?
i. No. The value of the room is the same. There is someone who has the
desire and ability to pay the fair market value of the property. Simply
because Benaglia is living in the room, the hotel is not receiving the fair
market value for the property as they should.
c. Suppose it could be shown that Benaglia had a passion for hotels and that
living in a hotel was worth much more to him (“consumer surplus”) than the
price of a room. Would it then be justifiable to tax Benaglia on more than the
established room rent?
i. No. Because again, the fair market value of the room is the value at which a
majority of people would pay for that room. Just because Benaglia is in the
room, doesn’t mean that the Hotel would be able to get that much money for
the room from others.
d. Is difficulty of valuation a reason for omitting a noncash benefit from income
entirely? Conversely, is ease of valuation a reason for taxation?
i. Not necessarily. Depending on the size of the transaction, the cost/benefit
analysis of valuing a benefit may be sufficient (for the IRS) to pursue an
income inclusion.
ii. Also, the size of the transaction may prevent taxation despite the ease of
valuation. For example, let’s assume that every staple that is used equals
$0.01. It would be very easy to value the staple, but there are so many
being used that taxing such a de Minimus transaction would overwhelm the
IRS.
e. Does the fact that an item is supplied for the convenience of an employer, or
other payor, bear significantly on the question of valuation or any other relevant
question?
i. It should not weigh on the valuation. The purchaser of the good or service
should not matter in the determination of a fair market value. In fact, there
are instances where the outlier transactions are disregarded for the
purposes of valuation due to exigent circumstances.
f. Does identity of payor impact the analysis?
i. It should not for the same reason as (e) above.
Non-Employer Benefits
Companies Compensating People who are not Employees
IRC §132(d) – Working Condition Fringe
I. Any property or services provided to an employee so that if the employee paid it,
the payment would be a deduction under §162 or §167.
Reg. 1.132-5(t) – Working Condition Fringes Application
I. If employer pays for spouse, dependent or another person not allowed under
§274(m)(3), then:
a. The total amount of the payment is included in employee’s income.
b. Any amounts that can be deducted by employee, will then be deducted or
excluded, placing the burden of proof on the taxpayer.
i. Spouse’s trip must have had a bona fide business purpose
ii. And be substantiated by employer.
II. Exclusion of spouse and family in §132(h) only applies to §132(a)(1) & (2).
IRC §274(m)(3) – Travel Expenses of Spouse, Dependent.
I. No deduction with respect to a spouse, dependent, or other individual, unless:
a. That person is an employee of the taxpayer,
b. The travel of that person is for a bona fide business purpose, and
c. The expenses would normally be deductible by that person.
US v. Gotcher – VW Plant Visit Wife Income
I. Facts
a. Employee and spouse had 12-day expense-paid trip to Germany to tour
Volkswagen facilities. Employer reimbursed $348.73. Volkswagen reimbursed
$1,023.53.
b. IRS: Entire reimbursement of $1,372.30 was income.
c. D. Ct. Entirely excluded.
II. Holding
a. 8th Cir.: ½ of reimbursement attributable to employee was excluded. ½ of
reimbursement for spousal travel was income.
b. The wife was not in Germany for the business or for the VW tours. Wife was in
Germany solely to vacation. Therefore, no business deduction and no
exclusion.
Alternatives to Ordinary Income Treatment
IRC §162(a) – Trade or Business Expenses
I. There is a deduction for all the ordinary and necessary expenses paid or incurred
during the taxable year.
IRC §167(a) – Depreciation
I. There is a depreciation deduction for the exhaustion, wear and tear of:
a. Property used in the trade or business, or
b. The property held for the production of income.
Property Transferred in Connection with Performance
of Services
The Substantial Risk of Forfeiture Standard
IRC §83(a) – Property worth more than the service provided.
I. Determine the fair market value of the property at the first time the rights of the
beneficiary are transferable or are not subject to a substantial risk of forfeiture
(SRF) (whichever occurs earlier).
a. Determined without restrictions except perpetual restrictions.
II. The amount paid for the property is subtracted from (I) above.
a. The amount paid for the property can be the services that were performed for
the property exchange.
III. The remainder is considered income to the person that provided the services in the
first year that the interest is transferable or not subject to SRF.
a. The person providing the services does not need to be the person that received
the property in consideration for the services.
IRC §83(b) – Election to Include in Gross Income
I. The service provider may elect to include the gross income of the property at the
time of the transfer, rather than wait for the property to be transferable or not
subject to SRF.
IRC §83(c) – Definitions
I. Substantial Risk of Forfeiture – The rights in the property are subject to SRF if
person’s rights to full enjoyment of the property are conditioned upon the future
performance of substantial services by any individual
II. Transferability – The rights in the property are transferable only if the rights in
the property of any transferee are not subject to a SRF.
III. Subject to Suit under Securities Exchange Act of 1934 – if the sale of the
property at a profit could subject the person to suit under §16(b) of the SEA, that
person’s rights are subject to SRF and are not transferable.
IRC §83(h) – Employer Deduction
I. The recipient of the services (employer) is allowed a deduction under §162.
a. Only in the year in which the employee (service provider) includes the property
into income.
Gifts and Bequests
Gifts
IRC §102 – Gifts and Inheritances
a. Gross income does not include the value of property acquired by gift, bequest,
device or inheritance.
i. No deduction is available to the donor upon transfer to the donee
ii. Must be an after-tax transfer
b. Income from the property in (I) is taxable.
i. When the gift is of income from a property, then that income is taxable.
1. Father has a rental house and gives the rent from the house to his son
as a gift
2. The gift of income from a property, such as above, is taxable.
c. Employee gifts are always taxable.
i. If an employer gives a gift to an employee, then that gift is taxable
1. “Close personal friends” does not matter.
ii. Except:
1. achievement awards §74(c)
2. de minimus fringes §132(e)
Detached and Disinterested Generosity
Comm’r v. Duberstein – Business Income
I. Facts
a. Duberstein was given a Cadillac by Berman because Duberstein was
suggesting customers to Berman.
b. Berman listed the Cadillac as a business expense under § 162(a)
i.
II.
Essentially, Berman is stating that the Cadillac was necessary to make a
profit under § 162(a).
Holding
a. The gift must be out of detached and disinterested generosity
i. Measured by the:
1. Maxims of experience
2. The mainsprings of human conduct to the totality of the facts of
each case
ii. The transferor’s intention is critical.
1. Affection
2. Respect
3. Charity
4. Admiration
5. Other like impulses
b. Because the Cadillac was given as a result of Duberstein’s work at suggesting
customers, the Cadillac was not given under a detached and disinterested
generosity.
Stanton v. U.S. – After Retirement Gift
I. Facts
a. Taxpayer was comptroller of the Church and real estate manager.
b. Resigned in 1942
c. Directors voted him a gratuity of $20,000 after his retirement.
II. Holding
a. The court notes that there was no enforceable right or claim for the payment.
b. The decision was vacated and remanded back for more proceedings on
whether the payment was made with detached and disinterested generosity.
c. On remand, the court found that the gift was made with detached and
disinterested generosity and therefore, a gift.
d. The common law meaning of gift would undermine the purpose of the statute.
i. Everyone would then claim that the transaction is merely a gift.
e. There is a presumption that a transfer from employer to employee is not a gift.
III. Dissent
a. The dissent shows that there are presumptions made when the gift is from a
family member versus a gift from a business or employer to employee.
b. Says that the burden of proof should shift to the taxpayer if the gift is from a
business.
i. Whereas the burden should be on the IRS to show that a transfer from
family members was not a gift.
Goodwin v. U.S. – Congregation Income
I. Facts
a. Goodwin was a minster at a church
b. Received small salary
c. Received gifts from the congregation.
II. Holding
a. The gifts were considered income.
b. It is the rare donor who is completely detached and disinterested. To decide
close cases using this phrase requires careful analysis of what detached and
disinterested means in different contexts. Thus, the phrase is more sound bite
than talisman.
Yang v. Comm’r – Housewife Gift
I. Facts
a. Boyfriend gives $10,500 to girlfriend.
b. GF does some cooking and cleaning for the BF, but not an employee.
c. Douche BF gives GF an income statement and deducted the $10,500 as a
business expense.
II. Holding
a. This is not income to the GF.
b. Made with detached and disinterested generosity out of his affection for her at
the time.
c. Appears as if the court was sparing the GF and going after the BF for the
deduction (almost looks like he was trying to protect the money by giving it to
her).
The Flu Shoes – Michael Jordan’s Gift to Ball Boy Income
I. Facts
a. Michael Jordan was sick with the flu but still played game 5 of the 1997 finals
b. Finished with game high 38 points, 7 rebounds, 5 assists and 3 steals
c. Won the game and eventually the NBA Championship.
d. Gave shoes to ball boy who brought Jordan Applesauce and Graham Crackers
during the game.
e. The shoes were eventually sold for $104,000 in 2013.
II. Issue
a. Are the shoes a gift or income?
b. It appears that the shoes were given as a payment for giving Jordan the
applesauce and graham crackers.
c. Also, the ball boy was an employee at the time.
i. But, it can be argued that the ball boy was not an employee of Jordan,
rather the Chicago Bulls.
ii. In that case, it appears that the shoes would be tip income for services.
Business Gifts
IRC §102(c) – Employee Gifts
I. Employee gifts are always taxable.
a. If an employer gives a gift to an employee, then that gift is taxable
i. “Close personal friends” does not matter.
b. Except:
i. achievement awards §74(c)
ii. de minimus fringes §132(e)
Choices for Deciding Business Gift Cases
I. Factual analysis for each situation
Rebuttable presumption that not gifts but rather income derived in a business
transaction exchange
III. Non-rebuttable presumption that compensation received
a. Cf. §102(c)
II.
IRC §274 (b) – Disallowance of Gift Expenses as Deductions
I. No deduction for any expense made for gifts made to the same person and in the
same tax year over $25.
II. Does not include:
a. an item having a cost less than $4.00 and has the taxpayer’s name on it.
SWAG
b. a sign, display rack or other promotional material to be used on the business
premises of the recipient.
III. Special
a. Partners and the partnership are both considered employees of each other
b. Husband and wife are treated as one taxpayer
Tip and Toke Income
I. Tips are considered income. Reg. §1.61–2(a).
II.
a. Difficult to collect, especially cash tips.
b. Recent rules and technologies have made tip income easier to collect.
i. Credit card receipts
ii. Cash out procedures at end of shift.
c. Policy concerns may add layers of difficulty.
i. Low income persons – Taking money from the poor.
Tokes are considered income
a. A toke is a chip received from the gambling table—given by the players to the
employee.
b. Don’t confuse with a rake – A take from the gambling table by the employee as
business income to the casino.
Olk v. U.S. – Craps Toke is Income
I. Facts
a. The Craps table operators were receiving chips from the patrons.
II. Holding
a. The court held that the chips were not given out of a detached and
disinterested generosity but were actually given as consideration for good luck.
b. SUPERSTITION
c. “Tribute to the gods of fortune which it is hoped will be returned bounteously
soon can only be described as an involved and intensely interested act.”
III. The better rationale for this case is that the employee was receiving income for
services.
Aaron’s Last Wish – Bequest to Leave Large Tips to Servers Income
I. Facts
a. Not in text or supplement. In slides.
b. www.aaroncollins.org
II.
c. Aaron’s last wish in will is “leave an awesome tip (and I don’t mean 25%). I
mean $500 on a…pizza for a waiter or waitress.”
d. Brother, Seth, goes around the country giving $500 tips to servers
e. Family didn’t have enough money, so sets up donation website
f. Posts videos of all the interactions with the servers online.
Question
a. Is this income to the servers?
i. It could be argued either way.
ii. The bequest is not taxable under §102(a), if there is money to be
bequeathed to someone.
iii. But the money acquired by website to carry out the bequest is considered
income under 102(b)(2).
1. Presumably, money was used from the bequest to set up the website
(property).
2. Income from website (property) is then used to carry out the bequest.
3. But it can also be argued that the gift is not being paid out in intervals
to the servers and therefore not a gift from §102(b)(2).
iv. The donation money is for detached and disinterested generosity by the
people who donate to the website. Comm’r v. Duberstein
1. The money could be considered a gift to the current owner of the
website (Seth) rather than an income from property acquired to carry
out a bequest.
2. Which would mean that the money from the website is a gift to Seth.
3. But the donators of the money on the website are donating under the
precept that the money will be given to a server in completion of
Aaron’s last wish.
4. Which then turns the gift away from the detached and disinterested
generosity and no longer is a gift to Seth.
v. If Seth orders food, just as the last wish suggests, then the server would
receive the $500 as tip income under Reg. §1.61–2(a).
1. The argument can be made that the money was not meant as
compensation for services and is a separate transaction from the food
service.
2. Rather, Seth is merely a vessel, or medium by which the donator’s
money is given to the server.
3. Then there is the question of whether the recipient of the gift needs to
be identified before the transaction occurs.
vi. If Seth does not order food, then the money may be considered a gift
under IRC §102(a).
Unemployment and Social Security
IRC §85 – Unemployment Compensation
I. For individuals, gross income includes unemployment compensation.
II. Unemployment Compensation means any amount received under a law of the US
or of a State which is in the nature of unemployment compensation.
IRC §86 – Social Security
I. Gross income for Social Security benefits that are the lesser of
a. 1/2 of social security benefits received during the taxable year, or
b. 1/2 of the excess in (b)(1).
II. If taxpayer has more income than the adjusted base, then gross income is lesser
of
a. The sum of:
i. 85% of the excess, plus
ii. Lesser of (I) or 1/2 the difference between adjusted base and the base
amount, or
iii. 85% of the social security benefits received for the tax year.
III. Why would we include in gross income if there is a basis in the contributions?
Political Contributions
Rev. Rul. 68–512, 1968–2 C.B. 41 – Political Contributions
I. Political contributions are not taxable to a political candidate to the extent used
for expenses of a political campaign.
a. Any diverted for personal use is taxable
b. Even a diversion to pay federal income taxes is personal use.
II. The funds appear to be exempt under §102, however that means the funds could
be used for anything.
a. Not so with campaign contributions.
b. Maybe the court is saying that these are not gifts (donations for political gain)
and are being exempted otherwise.
Government Transfer Payments
Notice 99-3 – Welfare Payments
I. TANF and General Welfare payments
a. Excluded from Gross Income
b. General Welfare Exemption
i. If the person is so poor that they qualify for these programs, then there is
little use in taxing the income from the program.
ii. The taxes would undermine the effectivity of the payment in raising that
person out of poverty.
Rev. Rul. 2005-46 – Business Welfare Payments
I. Disaster relief to businesses is taxable
II. The payments made to a business do not qualify for the general welfare exception.
a. Likely that nonrecognition provisions would apply, such as § 1033 –
Involuntary Conversion.
IRC § 139 – Disaster Relief Payments
I. § 139(a) – Gross income shall not include any amount received by an individual as
a qualified disaster relief payment.
II. § 139(b) – Qualified Disaster Relief Payment Defined
a. Any amount paid to or for the benefit of an individual for:
i. reasonable and necessary personal, family, living, or funeral expenses,
ii. repair or rehabilitation of a personal residence or repair or replacement of its
contents to the extent that the need for such repair, rehabilitation, or
replacement is attributable to a qualified disaster,
iii. by a person engaged in the furnishing or sale of transportation as a common
carrier by reason of the death or personal physical injuries incurred as a
result of a qualified disaster, or
iv. if such amount is paid by a Federal, State, or local government, or agency or
instrumentality thereof, in connection with a qualified disaster in order to
promote the general welfare,
v. but only to the extent any expense compensated by such payment is not
otherwise compensated for by insurance or otherwise
III. § 139(c) – Qualified Disaster Defined
a. Results from terroristic or military action - §692(c)(2)
b. Federally declared disaster - §165(h)(3)(C)(i)
c. Results from accident involving a common carrier or determined by Secretary to
be of catastrophic nature
d. For amounts under (b)(4), as determined by federal, state or local authority to
warrant assistance from that authority.
Rev. Rul. 2003–12 – Disaster Relief Payments
I. State grants to individuals as a result of flood.
a. Not gifts but fall under the general welfare exception and IRC § 139.
b. Must be for certain reasonable and necessary medical, temporary housing, or
transportation expenses incurred – IRC § 139
c. Must be presidentially declared disaster in IRC § 1033(h)(3).
d. The expenses must not be compensated by insurance or otherwise
e. Not to:
i. indemnify all flood-related losses
ii. reimburse nonessential,
iii. luxury,
iv. or decorative items and services.
II. Charitable Organization grants to individuals as a result of flood.
a. Are considered gifts under § 102 because the organization does not have any
duty or moral obligation to make the payment.
III. Employer grants to an employee as a result of flood.
a. Are considered excluded under §139
i. Not gift and not general welfare
Bequests
Excluding a Bequest from Income of the Recipient
Wolder v. Comm’r – Bequest in Exchange for Services
I. Facts
a. Attorney worked for the lady throughout her life in exchange for a bequest of
stock or its equivalent.
b. IRS claims that the FMV of the stock is compensation for services and not a
bequest.
II. Holding
a. The 2nd Circuit affirmed the lower decisions that the transfer was in exchange
for services throughout the life of the client and not a gift under § 102.
Estate of Sydney Carter v. Comm’r – Payment to widow of former employee
I. Facts
a. Company paid the salary of the former employee to the widow
b. IRS claims it is income
II. Holding
a. The court held that this was a gift from the company to a nonemployee.
Miller v. Comm’r – Caring for Incapacitated Person
I. Facts
a. A and B agreed to take care of C for the rest of his life.
b. C agreed to leave all of his personal property to A and B in will.
c. IRS claims that this is payment for services.
II. Holding
a. The Tax court held that this is income to A and B.
Prizes and Awards
Prizes are Considered Income to the Recipient
§ 74(a) – Prizes and Awards Generally
I. Except as otherwise provided in this section or in section 117 (relating to qualified
scholarships), gross income includes amounts received as prizes and awards.
Oprah Winfrey – Cars and Trips are Income to the Recipient
I. Facts
a. Oprah gave away a trip to Australia and several cars.
b. IRS claimed that they were income to the recipients.
II. Holding
a. The court held that the items were not gifts and are considered income to the
recipients.
Boston Furniture Store – Mattress Mack Deal is not Income
I. Facts
a. Furniture store made deal that if the Red Sox won the World Series, then their
furniture was free.
b. Store urged the IRS to declare that the furniture was not to be considered
income.
c. The IRS agreed stating that the customers owed no income tax on the furniture
because the store claimed that the refunds were a purchase price reduction and
not a prize.
Exceptions to Prizes Being Income
IRC § 74(b) - Nobel and Pulitzer Prizes
I. No income for prizes and awards made primarily in recognition of:
a. Religious,
b. Charitable,
c. Scientific,
d. Educational,
e. Artistic,
f. Literary, or
g. Civic Achievement.
II. Only if—
a. Recipient selected without any act on the recipient’s part
b. The recipient is not required to render future services
c. The Prize is transferred to charity or university.
IRC § 74(c) – Employee Achievement Awards
I. Not income to the employee if the award is less than the allowed deduction to the
employer under § 274(j) ($400, or $1600).
II. Excess is income
a. The greater of either:
i. the cost to the employer, or
ii. the value of the award.
IRC § 74(d) – Olympic Prizes
I. Facts
a. IRS claimed that the medals and the prize money from participating in the
Olympics was to be considered income.
b. Congress quickly passed §74(d).
II. Limits the exclusion to prizes from the US Olympic Committee.
a. Prizes awarded by other countries not covered.
III. Inclusion into income for those who have more than $1 million in income from
other sources.
a. NBA players have to report the Olympic income.
Other Athletes
I. Anything given to the athlete is considered income to the athlete.
a. World Series Rings
b. NCAA National Championship gear and rings
Scholarships as Income
IRC § 117 – Scholarships Exclusion – No Quid Pro Quo
I. Must be candidate for degree (below graduate level) at educational institution
under § 170(b)(1)(A)(ii)
II. Must be used for qualified tuition and expenses
a. Tuition and Fees
b. Fees, books, supplies, and equipment required
c. Room and Board is taxable
III. Teaching payments are not Scholarship – Income
a. Or any other instance where the student must provide a service as condition
for receiving “scholarship”
b. Sports scholarships do not fit here – Rev. Rul. 77-263
i.
Court has said that the student is doing it for the fun of the game
ii. Also, the student is not an employee, as the others are under (c)(1).
IV. Qualified Tuition Reduction
a. Employee of the university exempt from gross income for reduction.
b. The reduction must not discriminate in favor of highly compensated persons.
c. Can apply to graduate level research and teaching assistants.
Capital Appreciation and Recovery of Basis
Tax Basis Recovery
Determination of the Basis of Property
IRC § 61(a)(3) – Dealings in Property
I. Income is from whatever source derived and includes income derived from dealings
in property.
IRC § 1001 – Determining Gain or Loss
I. The gain from sale or other disposition is the excess of the amount realized over
the adjusted basis from § 1011
a. Loss is the adjusted basis – amount realized.
II. Amount realized is the sum of all money and FMV of property received in
exchange for the property being sold.
a. Disregard reimbursement for real property taxes if imposed on the purchaser.
i.
If seller pays the buyer’s prorated property taxes, reimbursement is not
taxed.
b. Include real property tax payments imposed on the seller, if the tax is going to
be paid by the purchaser.
i.
If the buyer pays the seller’s prorated property taxes, then the seller must
claim as gain.
III. The entire amount of the gain or loss must be realized unless otherwise stated.
IV. Installment payments are to be taxed in the year that the payment is received.
V. Term Interests
a. The portions determined under §§ 1014, 1015, or 1041 are disregarded
b. Term interest is:
i.
A life interest,
ii. Term of years interest, or
iii. Income interest in trust
c. Disregard (a) does not apply if the entire interest in the property is transferred
to any person.
IRC § 1011 – Adjusted Basis for Determining Gain or Loss
I. The adjusted basis is the Basis (§1012) changed by Adjustments (§1016).
II. Bargain Sale to Charity
a. If allowed by §170, then the adjusted basis is:
i. (Amount Realized / FMV) x Adjusted Basis (§1016) = Adjusted basis for
determining the gain of the sale to charity.
ii. For Example:
1. A person sells their car to charity for $1000. The FMV of the car is
$5000.
2. The person purchased the car for $2500 and made adjustments to the
basis (§1016), increasing the basis to $3000.
3. The amount realized is $1000 / the FMV $5000 = .2
4. .2 x the adjusted basis $3000 = $600
5. The adjusted basis for the purposes of §170 charity is $600 and the sale
was for $1000, leaving the person with a $400 gain.
IRC § 1012 – Cost Basis
I. The basis of the property is the cost of the property unless otherwise stated.
II. The cost of real property does not include the amount of real property taxes paid
that were imposed on the taxpayer.
IRC § 1012 General Conditions
I. Tax basis is “cost” – even if the purchase was a “good deal” or a “bad deal.”
a. This assumes there’s not a “bargain purchase,”
i. i.e., a price differential attributable to another relationship, e.g., as an
employee or a child.
II. Basis determined in a taxable property swap:
a. general rule is that the fair market value of the property received is the amount
realized and is the measurement of the §1012 basis per Philadelphia Park
Amusement (p.141).
III. Basis when property received for services:
a. FMV at time of receipt. Reg. § 1.61–2(d)(2)(i).
IRC § 1.1012–1(c) – Basis for Stock Transactions
I. First-in, First-out Rule
a. Sale of stock is charged against the basis for the earliest lot of purchases unless
the TP can adequately identify the particular lot from which the shares of stock
were purchased.
IRC § 1016 – Adjustments to Basis
I. Adjustments are to be made for:
a. Expenditures, receipts, losses or other items properly chargeable to the capital
account.
i. But not for:
1. Taxes or other carrying charges in §266; or Expenditures relating to
circulation in §173
 For which deductions have been taken in the current or prior years
2. For mortality, expense, or other charges under an annuity or life
insurance
b. For depreciation as allowed.
Reg. § 1.61-3(a) – Gross Income Derived from Business
I. In manufacturing, merchandising, or mining, gross income means:
a. Total sales (Rev.) – Cost of Goods Sold (COGS) = Net Sales
b. Net Sales + Investment Income + Incidental Income (including any outside
income) = Gross Income.
Reg. § 1.61-6 – Gains Derived from Dealings in Property
I. Property includes tangible items such as the building and intangible items such
as goodwill.
II. Amount realized – Unrecovered cost = Gain
Allocation of Basis
Inter Vivos Gifts – Stand in the Shoes
IRC § 1015 – Basis of Property Acquired by Gift (Transferee)
I. Carryover Basis
a. The basis for the donee is the basis that was established by the previous owner.
i. This does not have to be the donor, it could be a previous person.
ii. If the basis is greater than the FMV at time of gift, then:
1. The basis is the FMV for determining a loss.
II. Transfer in Trust
a. Other than by gift, bequest or devise
b. The grantor’s original basis +/- the amount recognized by grantor at transfer.
i. If gain, then +
ii. If loss, then –
III. If transfer is before January 1, 1921
a. Then the gift or transfer in trust basis is the FMV at the time of the transfer.
IV. Increase in the Basis
a. Increase in basis up to the amount of gift tax paid on the property at the time of
the transfer. After 1976. Proportional, see § 1015.
Reg. § 1.1015–1 – Basis of Property Acquired by Gift (Transferee)
I. If the basis for determining a loss (FMV) is lower than the sale price of the property,
and the basis for determining a gain (original basis) is higher than the sale price of
the property, then there is no gain and no loss.
a. Basis of $100, FMV of $90 at time of gift.
b. Sold for $95 = No gain and no loss.
Reg. § 1.1015–4 – Transfer of Part Gift and Part Sale (Transferee)
I. The initial basis to the transferee is the greater of the amount paid or the
transferor’s basis under § 1015(d).
a. Sale of property with adjusted basis of $80 and value of $100
b. Sale price is $75
c. The transferee’s basis will be $80.
II. For the purposes of determining a loss:
a. The basis is never greater than the FMV of the property at the time of the
transfer.
b. Sale of property with AB of $80 and FMV of $60
c. Sale price is $50
d. Transferee resells for $40
e. Transferee’s basis is no higher than $60 FMV, where it should have been $80
Reg. § 1.1011–2 – Part Sale and Part Gift to Charity (Transferee)
I. Basis allocation is in proportion to their respective values.
a. Sale of $100 property for 3/4 of value ($75) to charity:
i. Adjusted basis is $80
ii. 3/4 of adjusted basis = $60
iii. $75 sale - $60 allocated adjusted basis = $15 gain
iv. Charitable contribution would be $25.
Problems
I. “A” purchased shares of stock for $10,000. In 2002, when they were worth $16,000
he gave them to B, who sold the shares in 2014 for $15,000. How much gain (or
loss) did B realize?
a. B would have a gain of $5000
II. “C” purchased shares for $1,000. In 2011, when the shares were worth $600, she
gave them to D. How much gain or loss will D realize if he subsequently sells for
$500? For $900? For $1,400
a. $500 = $100 loss with FMV basis.
b. $1400 = $400 gain with original basis of $1000.
c. $900 = No gain and no loss.
d. Cf., §1041 (p.143)– carryover basis; not loss limiting.
IRC § 1041 – Transfers of Property between Spouses or Incident to Divorce.
I. No gain or loss recognized on transfer of property from an individual (or in trust) to
a. Spouse
b. Former spouse, but only if incident to divorce.
II. Treated as a gift and the transferee basis is the adjusted basis of the transferor.
Taft v. Bowers – Transfer of Stock by Bequest
I. Facts
a. 1916: A purchased 100 shares for $1,000
b. 1923: A gifted shares to B at a time when worth $2,000
c. 1923: B sold shares for $5,000
II. Arguments
a. Taxpayer Position: B’s gain for the period B held stock was $3,000
b. IRS Position: B has gain of $4,000
III. Holding
a. The original basis for the shares of stock is the basis for which the donee must
use for determining a gain on the sale of the stock.
i. There is a gain of $4000 because the donee adopted the original basis under
§ 1015.
Tax Basis for Gratuitous Transfers at Death – Step up Basis
IRC § 1014 – Basis of Property Acquired from a Decedent (Transferee)
I. The basis of property transferred upon death is the FMV of the property at the date
of death.
II. Applicable Property
a. Bequest, devise, or inheritance
i. Or by decedent’s estate from the decedent
b. Property transferred in trust during life to pay income for life
i. Must be revocable
c. Property passing without full and adequate consideration under a general
power of appointment exercised by the decedent by will
d. Property that is 1/2 half the surviving spouse’s property under community law
IRC § 1014 Discussion
I. Tax basis step-up occurs as of death - §1014(a).
a. What happens to the accrued appreciation? Poof!
II. Could be a step-down in tax basis if the property is depreciated as of the time of
death.
III. Tax basis step-up at death is not applicable to IRD - “income in respect of a
decedent”. See §691.
a. Relevance of estate tax alternative valuation date?
b. Tax policy option: gain realization at death.
IV. What cost of §1014(a) to the US Treasury? See Tax Expenditure list p. 537 estimate
of $179.3 billion for 2015-2019.
IRC § 1014 Problems
I. TP owns blocks of stock in three large publicly traded corporations, General
Electric (FMV=$100,000;B=$60,000), General Foods (FMV=$100,000; B=
$100,000), and General Motors (FMV=$100,000; B=$150,000). TP plans to sell one
block of stock, make an inter vivos gift of another block, and bequeath the third
block. From a tax standpoint, How should TP make proceed?
a. Sell GM, Gift General Foods, Bequeath General Motors
II. A purchased shares of stock for $10,000. In 2003, when they were worth $16,000,
he gave them to B subject to a reserved life income interest. A later transferred the
life estate to B in 2005, when the stock was worth $17,000. A died in 2007 and the
property, which was then worth $19,000, was includible in his gross estate
pursuant to §§2035(a) and 2036(a). B sold the shares in 2014 for $24,000. How
much gain or loss did B realize?
a. $5000 gain
III. C purchased shares for $1,000. In 2014, when the shares were worth $600, C died,
leaving the shares to D. How much gain or loss will D realize if he subsequently
sells for $500? For $900? For $1,400?
a. $100 Loss
b. $300 gain
c. $800 gain
IV. E died, and her estate assets were $10,000 worth of accounts receivable for
services performed for patients. These were valued in her estate at $9,800, and the
executor subsequently sold them all to a collection agency for $9,500. How much
gain or loss is realized on the sale?
a. $300 loss
Gifts of Encumbered Property
Reg. § 1.1001-1(e) – Gain or Loss on Transfer of Part Sale and Part Gift (Transferor)
I. Transferor has gain when the amount realized is greater than the adjusted basis of
the property.
a. There is no loss if the amount realized is less than the adjusted basis.
Diedrich v. Comm’r – Gifting Stock with Condition to Pay the Taxes
I. Facts
a. Gifted 85,000 shares of stock to three children
b. Used both direct transfer and trust arrangements
c. Conditioned the gifts on the donee paying the gift tax
II. Holding
a. Gift of property subject to an obligation on the donee to pay gift tax arising from
the transfer. A satisfaction of a TP liability by a 3rd party.
III. Reasoning
a. Income is any gain direct or indirect.
b. A tax liability is a burden upon the taxpayer that cannot be transferred.
c. Because the gift was conditioned upon payment of the gift tax, it constitutes an
indirect benefit (gain) to the donor.
d. The donor is obligated to report the benefit as ordinary income.
Questions on Net Gift Transactions
I. Gift to non-charity
a. Basis is $15, FMV is $100.
b. Conditioned on donee paying $20 of gift tax
c. Gain of $5 ($20 amount realized - $15 basis)
d. Gain = Amount Realized by Donor – Donor’s Basis
e. Donee’s basis is the greater of the donor basis or the amount paid.
i. Donee’s basis is $20
ii. See Reg. § 1.1015-4
II. Gift to Charity
a. Basis is $20 and the FMV is $100
b. Sold to charity for $20
c. Gain of $16
i. $20Sale – [$20Basis * ($20Sale/$100FMV)] = $16 Gain
ii. Gain = Sale – [Basis * (Sale/FMV)]
Review Questions
I. Parent, P, transfers to child, C, shares of stock with a value of $10,000 and a basis
of $1,000. No gift tax is payable. P tells C that C is free to do what she wants with
the property. C sells the shares.
a. The basis for C is $1000, making the gain on the sale $9000 (if sold at
$10,000).
b. There is no income tax implication for P.
II. P transfers the shares to C and tells C to sell the shares for her and use the
proceeds to pay P’s $10,000 bill at the country club.
a. The basis is $1000, making the gain on the sale $9000 (if sold at $10,000).
b. However, C’s gain would be taxed as capital gain.
c. Any payment to the Country Club would incur an ordinary income inclusion for
P.
i. Because it was a conditional gift, the portion sent to the Country Club would
be considered an “amount realized” on the part gift, part sale.
III. P transfers the shares to C and tells C that she can do as she wishes with them
provided that she pays P’s $10,000 bill at the country club.
a. Same as II
IV. Same as #3 except that C must pay P’s $10,000 debt to the United States Treasury
for income taxes.
a. Same as II
V. Would the result have been different if the gift tax liability were imposed on the
donee and not the donor?
a. No, the gift tax implications were not contemplated in these scenarios.
VI. Would it matter whether the donee had funds with which to pay the tax without
selling any of the shares?
a. Yes.
i. Instead of using the part sale, part gift calculations, all of the funds used to
pay off the condition on the gift would be included in ordinary income to the
donor.
ii. Additionally, the donee would not incur the capital gains from the sale of the
property.
iii. And the donee’s basis would still be the greater of the amount paid or the
original adjusted basis.
Realization Requirement
Miscellaneous Income
Reg. § 1.61–14 – Miscellaneous Items of Gross Income
I. In addition to the items in § 61(a) there are many other kinds of gross income.
a. Punitive Damages
i. such as treble damages and exemplary damages
b. 3rd party payment
i. of TP income taxes (unless excluded by law)
c. Illegal Gains
d. Treasure Trove
i. to the extent of its value in United States currency, constitutes gross income
ii. for the taxable year in which it is reduced to undisputed possession.
Treasure Trove – Gross Income when Reduced to Undisputed Possession
Cesarini v. U.S. – Cash Found in Piano is Income
I. Facts
a. Couple purchased an old piano for $15.
b. Inside the piano, there was a wad of cash - $4,467.
c. Couple paid the tax on the money and sued for a refund.
II. Holding
a. The cash is considered treasure trove and is taxable as income when reduced to
undisputed possession.
b. The cash is not a prize or award.
c. The cash is not a gift.
III. Notes
a. Capital Investments (other treasures)
i. An object that is purchased is not considered treasure trove.
1. Therefore, the object would likely be considered a capital investment
2. The realization of the capital gain would occur at the time of the sale.
ii. An object that is found, while may be treasure trove, is not realized until
sold.
1. It may be possible to have the object appraised and pay the tax on the
object at the onset of possession.
b. Undisputed Possession
i. An object that is found or received inadvertently (like a baseball at a
stadium) can be returned immediately and that will not be considered
undisputed possession.
ii. Retention of the object that is subsequently the subject of a legal dispute is
not considered undisputed possession.
iii. Considerations:
1. Are the legal fees and costs incurred by both litigants deductible,
presumably under Section 212 (rather than Section 162)?
2. Are they instead capitalized, and ultimately offset against the sales
proceeds received by Popov and Hayashi, when the ball is ultimately
sold? (Compare Prop. Reg. 1.263(a)-4;
3. If the receipt of the ball and the court's ruling are not a taxable event, do
Popov and Hayashi retain a zero basis in the ball until the sale occurs?
4. Could the ball qualify for capital gains treatment? If so, is it to Popov and
Hayashi's advantage to have the sale occur at least 12 months and one
day from the time they are deemed to become the respective owners of
the ball (or the proceeds thereof)?
5. When does their holding period start: on 10/7/01 (the date of Bonds's
epic homer), the date of the court's initial opinion (12/18/02), the date
the court's order becomes final and nonappealable, or some other date?
Non-Employer Benefits – Inclusion in Gross Income Under Symmetry Concerns
Haverly v. U.S. – Textbooks are Income Because Deduction Taken
I. Facts
a. Principal received free sample textbooks from publishers
b. Principal donated the textbooks to Library
c. Principal claimed a charitable deduction for the donation of the textbooks to the
library.
II. Holding
a. The transfer of the books from the publisher to the principal was not under a
detached and disinterested generosity – Not a gift.
b. The receipt of the textbooks is an accession to wealth
c. There is a complete dominion and control over the textbooks evidenced by the
taking of a charitable deduction.
d. Claiming a deduction is manifesting an intent to accept the property as one’s
own.
e. Not taking a deduction would have prevented the inclusion into gross income.
i. This maintains the tax system symmetry.
ii. Also, there is a valuation issue with respect to taxing the income at the
onset of possession.
iii. Lastly, the time dilation is not as important a factor in determining whether
a person has exhibited dominion and control over an object that would
constitute gross income.
1. The principal could have stored the books until he figured out how to
return or dispose of them properly as to prevent him from being assessed
gross income.
2. The key in that regard is the unsoliciation of the object
Windfall Gains – Determination of an Actual Gain is Necessary
Eisner v. Macomber – Fruit of the Tree Analogy with Stock Dividend (Split)
I. Facts
a. Petitioner owned 2200 shares of Standard Oil.
b. Standard Oil gave pro rata dividend of 50% of outstanding shares
c. Petitioner increased her shares to 3300 without increasing the proportionate
ownership interest.
i. NOTE: This is a stock split and not an actual cash dividend. This is
crucial to understanding the case.
II. Holding
a. There was no accession to wealth and therefore no income.
b. The tree merely grew another branch.
III. Notes
a. If there was an actual dividend of shares, then the value of each share would
not change inversely proportion to the number of shares.
i. For example:
1. A has 1000 shares of stock and each is worth $10 for a total value of
$10,000.
2. Company declares stock dividend of 10% (or 10 new shares for each 100
owned)
3. The value of A’s holdings would be 1100 shares for a value of $11,000.
 Because of market inefficiencies, there may be some derivation of
these numbers.
b. However, a true stock split, such as Macomber, would not result in a change in
the value of the holdings.
i. For example:
1. A has 1000 shares of stock worth $10 each.
2. Stock split is declared. For ease of math, 1 for 1 split (double the number
of shares).
3. A now has 2000 shares worth $5 each.
IRC § 305 – Distributions of Stock and Stock Rights
I. Gross income does not include the amount of any distribution of the stock of a
corporation made by that corporation to its shareholders.
II. Exceptions:
a. If the shareholder can elect to have the distribution made in stock or property.
b. If the distribution is disproportionate with respect to the shareholders
i. Some shareholders receive stock and their proportionate interest in the
company is increased
c. If the distribution is made in part by preferred and in part by common stock
d. If the distribution is of preferred stock and any convertible stock ratios are not
changed as a result.
e. If the distribution is of convertible stock and the Secretary is satisfied that the
distribution will not fall under (b).
Capital Recovery and Timing
Reg. § 1.61-6(a) – Gains from Dealings in Property
I. When a part of a larger property is sold:
a. the cost or other basis of the entire property shall be equitably apportioned
among the several parts.
b. the gain or loss realized on the part of the entire property sold is the difference
between selling price and the cost or other basis allocated to such part.
c. For example:
i. if a property is purchased for $100,000 and divided
1. each piece of the division is an equitable portion of the purchase price
2. This is not necessarily based upon size.
3. There could be a fantastic portion of road frontage property that is worth
90% of the entire purchase price, but only 10% of the overall size of the
original parcel.
 The remaining portions could be swamp or other nonmarketable
quality.
Fairfield Plaza v. Comm’r – Selling a Portion of a Larger Parcel of Land
I. Facts
a. Land purchased in 1955 of the whole tract was $110,941.12. In addition,
petitioner spent a net of $29,584.64 for engineering, grading, and other
miscellaneous items which are to be capitalized.
b. In 1957 Taxpayer sold eastern tract for $100,000 to Big Bear.
c. In 1958, Taxpayer sold 30% of western tract for $150,000 to Paisley.
II. Holding
a. 40% of basis allocated to Paisley parcel due to the facts indicating that its
frontage on main through street added value to that portion of the tract.
b. The parcels of land were treated both as one and as individual tracts.
i. For the apportionment of capital spent on the property as a whole, divided
by size.
1. Grading the entire property
ii. For capital spent on an individual parcel, remains only for that parcel
1. Building slab on a single parcel.
iii. For capital spent on the purchase of the property originally, basis is the
FMV of each divided portion based on appraisal and valuated at time of
purchase.
Inaja Land Co. v. Comm’r – Easement and Damages to Property are Return of Capital
I. Facts
a. Consideration received for an easement in land. The amount received was less
than the tax basis for the property.
II. Issue
a. How allocate tax basis to the amount received?
b. Exclude entire proceeds received and reduce basis by that amount received?
III. Holding
a. The amount received for the easement and destruction of the land is not
ordinary income because it is a sale of a portion of the bundle of sticks.
b. Because the money does not exceed the original basis of the property, there is
no gain, and therefore no tax.
c. But, the money received must go to adjusting the basis in the property.
d. Also, because it is impossible to allocate the payment to a portion of the land, it
may be allocated to the entire property as a whole.
IV. Note
a. Burnet v. Logan case says that there must be basis recovery first before any
gain recognition.
b. see Reg. §1.1001-1(a).
Reg. § 1.1001-1(a) – Computation of Gain or Loss
I. In property transactions
a. Realized gain is money in excess of the adjusted basis
b. Realized loss is money that does not fully compensate the adjusted basis.
Hort v. Comm’r – Payment for Cancelling Lease is Ordinary Income
I. Facts
a. In 1928, Hort (plaintiff) acquired an office building from his father.
b. At the time, Irving Trust Co. (Irving) was renting the first floor of the building.
c. However, in 1927, Irving entered into a new lease with Hort’s father for a
fifteen-year term set to begin upon expiration of the original lease, at an annual
rental fee of $25,000.
d. In 1933, Irving decided to close its branch in Hort’s building.
e. Hort agreed to cancel the lease in return for a payment of $140,000.
f. Hort did not include the payment as income in 1933.
i. Instead, he reported a loss of $21,494.75, the amount he relinquished by
releasing Irving for less than the full value of the lease.
g. The Commissioner (defendant) included the $140,000 in Hort’s gross income for
that year and disallowed Hort’s claimed loss.
II. Holding
a. The payment for cancellation of the lease is considered ordinary income. In
addition, all payments on the lease would have been considered ordinary
income and not capital gain.
III. Reasoning
a. Under § 22(a) of the Tax Code, income derived from a leased rental is taxable as
ordinary income.
b. If the taxpayer agrees to cancel a lease in exchange for a lump sum, that lump
sum is a substitute for rent that is also taxable as ordinary income.
c. Here, had Irving honored the lease through its full term, any payments would
have been includable in income.
i. Similarly, had Hort sought a court judgment against Irving for full
satisfaction of the lease’s value, any proceeds from that judgment would also
have been taxable as ordinary income because the proceeds would be paid
as a substitute for rent.
d. It follows that the $140,000 payment, which was meant to substitute for the
rent that Hort would have received had the lease been honored, is taxable to
Hort in 1933.
e. Hort argues that the money received in exchange for cancellation of the lease
was a return of money invested in a capital asset, which is non-taxable.
i. While true that courts have characterized leaseholds as capital assets, they
also hold that income derived from such property is includable in gross
income.
ii. Here, the payment was not intended as a return of money invested in the
leasehold. It was intended to substitute for rental payments, which have
always been includable in gross income. The payment must therefore be
treated as ordinary income.
IV. Follow-up
a. What if the lessee built a building worth $140,000 and walks away from the
lease?
i. §109 – would not be income to the person and they would have a 0 basis in
it
b. Court says this is not property, but rather a substitute for ordinary income
IRC § 109 – Improvements by Lessee on Lessor’s Property
I. Gross income does not include income (other than rent) derived by a lessor of real
property on the termination of a lease, representing the value of such property
attributable to buildings erected or other improvements made by the lessee.
Helvering v. Bruun – Real Property Improvements by Tenant – Changed by IRC § 109
I. Facts
a. WARNING – CHANGED BY IRC § 109.
b. Landowner leased his land which was supposed to last for 99 years
c. The lessee was given permission to remove buildings on the land so long as he
put down a bond
i. Lessee constructed a new building that was expected to last not more than
50 years
ii. The expected value to the lessor on day 1 of the construction of the building
was 0
d. Lessee thinks the construction will only benefit him while he has control of the
leasehold estate
e. 4 years after the new building was built – the tenant defaulted (it was in the
middle of the Great Depression)
f. Landowner receives back their land – and ultimately the building – which had a
FMV of $64,000
i. The building torn down, the lessor had a basis in $12,000
ii. Difference in $52,000
g. IRS trying to get the owner to pay taxes on the realized gain of the building that
is now his
i. Taxpayers argument as to why he has no income (per Eisner)
ii. He hadn’t disposed of the building; no seller exchange – he wanted to wait
until there was a disposition of the asset
II. Holding
a. Eisner
i. court says the explanation of the difference between a stock and cash
dividend: “while it is true that economic gain is not always taxable as
income, it is well settled that the realization of gain need not be in cash
derived from the sale of an asset.”
ii. The severance of the asset from the gain pertains to only the stock – court
says this severance is not controlling here
iii. So that decision is not necessarily as controlling on any other facts
b. Under federal tax law, a taxpayer realizes a taxable gain from land
improvements at the end of a lease agreement.
III. Reasoning
a. Federal taxpayers realize taxable gains from improvements to land when their
lease agreements end.
b. Realization does not have to occur as a cash gain from the sale of an asset.
c. Realization can also occur from profit obtained at the end of a transaction.
d. Here, Bruun engaged in a business transaction in which his property value was
increased by more than $50,000.
i. The mere fact that part of Bruun’s gain was in the form of property does not
exclude it from taxable income.
ii. Otherwise, the longstanding taxable gain that occurs in the exchange of
property would not be recognized.
iii. Therefore, Bruun must include the increased value of the property as gross
income. The judgment of the court of appeals is reversed.
IV. 4 Different Ways the Taxpayers Could Have Had Income: (Bruun)
a. Could tax addition on your property – this is a clear accession to wealth
(regardless of whether it under the provision of the lessee)
i. Income on day 1 as the building is completed
ii. Depreciation deduction
b. Tax on the expected value of the improvement at the end of the lease
c. Income when the lease terminates (What the court decides) –accession to wealth
as to the building (but he gets a basis on the building improvements; given
basis as to the amount of the inclusion of income)
i. Clear accession to wealth when he gets complete dominion and control over
the asset
ii. Does he have an economic gain?
1. This tax payer probably has a loss on the land due to the Great
Depression
 Will get to recognize the loss whenever he sells the land (which is
probably substantial)
2. But as to the building they will have a gain of $50,000 (As to the court)
 Building likely to be un-leasable for several years
3. Court side steps the issue as to whether they have an economic loss
4. Likely would have been considered as a loss to the lessee
d. Spread the income over the period of the years for the term of the lease
Cottage Savings Ass’n v. Comm’r – “Materially Different” Requirement
I. Facts
a. Financial institution exchanges one group of residential mortgage loans with
another financial institution for another package of residential mortgage loans.
i. A swap of “participation interests” occurs.
b. Long-term low interest mortgages had declined in value because of the
significant increase in market interest rates.
c. Seller did not want to record the losses on its “books” (i.e., reporting for
regulatory and financial accounting purposes).
i. Because they would have been shut down by the FHLBB.
II. Issue
a. Does tax disposition event occur only if properties are "materially different"?
III. Holding
a. There is a requirement for the disposition of properties in question to have been
materially different. The exchange of the mortgage interests was sufficient to be
considered materially different.
b. This exchange does cause realized losses for federal income tax purposes.
i. Cf., inclusion of income based merely on appreciation, i.e., an accretion to
wealth.
IV. Cited Cases
a. Phellis and Marr cases – Both companies changed from New Jersey to Delaware
companies. Courts held that there was a material change in the rights and
responsibilities of the shareholders.
b. Weiss – The shareholders of the old corporation were given the same shares in
the new corporation, with the same values. Also, the new corporation was
incorporated in the same state. Therefore, there was no realization event.
Reg. § 1.1001–1 – Material Difference Requirement for Disposition of Property
I. The gain or loss realized from the conversion of property into cash, or from the
exchange of property for other property differing materially either in kind or in
extent, is treated as income or as loss sustained.
a. Legally Distinct Entitlements
Post-Cottage Savings – Significant Debt Modifications
I. Tax community became concerned that Cottage Savings created a “hair-trigger”
realization event analysis. The Treasury Department responded with regulations
under §1.1001-3.
II. Is the modification of a debt a realization event? Reg. §1.1001-3(b) states a
“significant modification” of a debt instrument is an exchange.
III. Consider change in (1) term, (2) interest rate, (3) other (e.g., priority)? Exception for
a “unilateral option.”
IRC § 1259 – Constructive Sales Treatment for Appreciated Financial Positions
I. If there is a constructive sale of an appreciated financial position
a. The TP shall recognize a gain as if the position were sold, assigned or otherwise
terminated
b. Application
i. An adjustment must be made in the amount of gain or loss
ii. The holding period of the position shall be determined as if such position
were originally acquired on the date of the constructive sale
II. Appreciated financial position means any position with respect to any stock, debt
instrument, or partnership interest if there would be gain were the position
terminated at FMV
III. The TP shall be treated as having made a constructive sale of appreciated financial
position if the TP:
a. Enters into a short sale for the same or substantially identical property
b. Enters into an offsetting notional principal contract with respect to the same or
substantially identical property
c. Enters into a futures or forward contract to deliver the same or substantially
identical property
IV. The property must be a marketable security (publicly traded - § 453(f))
Estee Lauder – Constructive Sale of Stock is Taxable
I. Facts
a. Lauder had enormous value in her company, but didn’t want to sell the stock
(to avoid to massive gain)
i. But wanted the liquidity of the assets
b. So, she borrowed stock in the market equivalent to her wealth – and sold her
owned stock
i. She would pay back her stock loan with her shares when she dies – because
the people will have a basis in the FMV
1. And they have no gain at that point
c. Estee Lauder tried to use this method to postpone sale/gain recognition, but
§1259 states that you must recognize a gain on this transaction.
II. Holding
a. An end run around paying taxes is frowned upon.
b. The constructive sale above is taxable
Annuities and Life Insurance
Annuities – Included in Gross Income
I. What is an “annuity”?
a. A payment for living – often paid periodically.
b. How is an annuity purchased? From whom?
Level Payment Contracts
I. Annuitant can have a contract providing for the receipt of level payments for:
a. A specified term (e.g., ten years)
b. One life or several lives
c. One life plus a specified term.
II. An annuity recipient is in a similar position to the lender in a level payment
mortgage loan.
a. Amounts “realized” periodically, i.e., in pieces.
Allocation of the Cost and Timing Options
I. Tax policy choices for determining the timing for the inclusion of annuity income:
a. As the value accrues with the contract?
i. Cf., amounts credited to bank account or mutual fund account or OID
concepts. Tax shelter benefit with an annuity?
b. Only as amounts are paid under the annuity contract either:
i. before or
ii. after the annuity starting date.
II. How are annuities to be treated?
a. Depends
Distributions Made Before the Annuity Starting Date
I. Pre-starting date annuity contract withdrawals are sourced first from accumulated
income. Code §72(e)(2)(B)
II. Loans are also treated as withdrawals (& sourced from income?). Code §72(e)(4)(A).
III. A penalty tax of 10% (of the distribution) is applicable for pre-age 59 ½
distributions. Code §72(q).
IRC § 72 – Annuities; Proceeds of Life Insurance Contracts
I. Gross income includes any amount received as an annuity
a. Except below
II. Each portion of an annuity that is 10 years or more, or spans two or more
lifetimes, each portion is considered a separate contract.
a. Allocated pro rata
b. Separate starting dates are calculated for each portion of the contract from
which amounts are received
III. The Exclusion Ratio
a. GI does not include any amount received as an annuity under a K, which bears
the same amount to the investment
i. If there is no investment in the annuity – the full amount received each year
is taxable
1. Determine the total income tax basis
2. Determine the expected term
3. This ratio is applied to each payment when received.
 The formula is:
i. (Total basis/expected payment) X Each payment =
1. Amount excluded from gross income.
Annuity Income Calculation for Term Contract
I. $100,000 payment today; annuity makes 15 payments of $12,000 (total $180,000)
a. Exclusion computation = $100,000 (investment in contract)/$180,000 (12K per
yr x 15 yrs) = 55.55% times $12,000 (=$6,667).
i. $6,667 to be excluded and $5,333 to be included in gross income (12K
minus exclusion amount).
IRC § 72(b)(2) – Exclusion is Limited to the Investment
I. The exclusion ratio applies only when there is unrecovered investment in the
contract.
IRC § 72(b)(3) – Deduction where Annuity Payments Stop (Early Death)
I. After the annuity starting date, payments under the annuity contract stop because
of death of the annuitant, and;
II. On the date the payments stop, there is unrecovered investment in the contract,
a. The amount of unrecovered investment is allowed as a deduction to the
annuitant for the last taxable year.
Tax Implications of Early Death
I. Termination of the annuity contract – if based on life expectancy.
a. If tax basis not recovered?
i. Deduction on annuitant’s last return for unrecovered basis. § 72(b)(3)
II. If tax basis is recovered prior to death?
a. All subsequent proceeds are includible in gross income. § 72(b)(2).
III. Example continued:
a. Death occurs before reaching life expectancy (e.g., after only 9 payments).
i. The tax basis recovered was $60,003 – ($6,667 times the 9 payments made).
The unrecovered basis in the contract is $39,997 of the $100,000.
ii. Deduction of this amount on final income tax return is permitted (if
expiration of contract at death). §72(b)(3).
Zedaker v. Comm’r – Must use the Annuity Formula
I. Facts
a. 1991: Deposited $149,553.01
b. As of August 1, 2006, monthly annuity benefit was $1,524.46.
c. In 1998, taxpayer received $19,100.
d. IRS asserts that $13,311 was taxable on theory that 310 payments were
expected and basis recovery was $149,553.01/310 x 12 months= $5,789.16.
e. Taxpayer Position: None was taxable as unlikely to live past 90 and should get
basis recover first. First-in, first-out
II. Holding
a. Court held that §72 schedule is prescriptive.
b. Tax Court is court of limited jurisdiction and cannot make decisions based
solely in equity.
i. Absent a constitutional defect, the court is constrained by the law as
written.
Life Insurance – Excluded from Gross Income
I. What is “life insurance”?
a. A payment for dying – ordinarily paid in a lump sum.
b. If paid at death, why not call it “death insurance,” rather than “life insurance”?
c. Cf., mutual fund investments.
II. If not treated as “life insurance,” then taxed as if a “savings account”:
a. i.e., inclusion in current income of:
i. increase in cash surrender value of the account, and
ii. value of current insurance coverage.
IRC § 101 – Certain Death Benefits Excluded from Income
I. Gross income does not include payments from a life insurance contract if the
amounts are paid by reason of the death of the insured.
II. Except
a. If the contract is transferred for valuable consideration
i. Then, the exclusion must not exceed the amount of the consideration plus
any other payments made by the new owner
1. The exception does not apply when:
 If the transferee’s basis is determined by the transferor’s basis, or
 If the transfer is made to the insured, a partner of the insured, a
partnership in which the insured is a partner, or corporation in which
the insured is a shareholder or officer.
IRC § 264(a) – No Insurance Premium Deduction
I. No deduction for:
a. Premiums on any life insurance contract if the TP is directly or indirectly a
beneficiary under the policy
b. Any amount paid or accrued on indebtedness incurred (loan borrowing on the
policy)
Implications of the Exclusion
I. Gross income exclusion (§101) is available when proceeds are paid at death for
both:
a. the pre-death interest buildup, and
b. the mortality gain (i.e., the “windfall” because of an early death).
II. The “transfer for consideration” limitations may apply. §101(a)(2).
a. Purpose of limits?
i. Prevention of the over-monetization of the death contract.
III. The gross income exclusion is not applicable to any post-death interest
accumulation.
IV. No income tax deduction is available for policy premiums paid. §264(a)(1).
V. Policy loans are not treated as distributions. Code §72(e)(5)(A).
VI. Policy settlement options after maturity at death:
a. a deferred receipt produces taxable interest income; see Code §101(c) & (d)
(concerning the annuity option).
Borrowed Funds
Illegal Income is Gross Income
Collins v. Comm’r – Embezzled Funds are Gross Income
I. Facts
a. Employee of the race track was betting on the horses by printing tickets for
himself without paying for them.
II. Holding
a. Despite the obligation to repay the funds, the embezzlement is considered
income to the TP
b. The TP realized an economic benefit from the embezzlement. James v. U.S.
i. If he didn’t get caught, there would be income
ii. Cf. the intent to create a loan with a lender.
1. The borrower and the lender both have the intention to create the loan
2. Whereas the embezzler intended to have income
III. Notes
a. There is no constitutional self-incrimination issue forcing a person to disclose
illegal income.
b. Controversially, the tax laws can be used to bring criminals to justice
i. Al Capone
Discharge of Indebtedness – Cancellation of Debt is Income
IRC § 108 – Income from Discharge of Indebtedness
I. The following is not included in Discharge of Indebtedness income:
a. Bankruptcy proceeding (CH. 11). See §108(a)(1)(A)
b. Taxpayer insolvency. §108(a)(1)(B).
c. Discharge of Deductible Amount. §108(e)(2).
i. If the discharge amount is deductible under normal conditions, then the
amount is not considered income.
ii. Makes sense that if it was deductible, then forcing it to be income and then
turn around and deduct the income would be a waste of time and resources.
d. Purchase Price Adjustments. §108(e)(5).
i. What effect on tax basis of the acquired asset?
e. Corporate Debt to Shareholder. §108(e)(6).
f. Corporate Stock Issued to Retire Debt. §108(e)(8).
g. Discharge of Debt is in reality a gift.
i. Use gift analysis
h. Qualified farm indebtedness. §108(a)(1)(C).
i. Certain real estate business debt. §108(a)(1(D).
j. Certain Student Loan Forgiveness. §108(f).
United States v. Kirby Lumber – Buying Back Bonds for Less Than the Sale Price is Income
I. Facts
a. Kirby lumber issued bonds for cash ($12,126,800), and then bought them back
for a little less (difference of $137,521) (they received cash and then gave it back
but kept some)
i. So they receive cash in the first year, and spend money in the later years
b. When does Kirby receive income?
i. When the bonds are repurchased – why?
1. Why not when they issued the bonds and received the money?
 Assumption of repayment of the same amount
 Kirby Lumber did not pay back the total amount they were obligated
to do so. Why?
i. Interest Rates changed, so they could buy the bonds at a discount
to their face
II. Holding
a. A corporation that buys back a bond at less than its issuing price realizes
taxable income.
b. Court says Kirby has income because they have made a clear gain
i. They had part of their indebtedness to bond holders “cancelled” – they had
an accession to wealth for the difference in the purchase price
III. Two theories of why income exists:
a. Transactional Approach – putting the transactions together to find an
inconsistency
i. Then creating a fictional receipt of income in year 2 in the later year
1. This inconsistency crystallizes in this year
b. The taxpayer has freed up more assets than they had before
i. Then cancellation of indebtedness income
IV. What if the company was bankrupt (e.g. they were $12 million in bankruptcy,
negative net worth) – would they have income as to the cancellation of
indebtedness?
a. YES – when the two transactions fit together, and there is an inconsistency –
the taxpayer is $135,000 richer
Gambling Winnings is Income
I. Gambling gains are income
II. Gambling losses are deductible only to the extent of the gambling gains – IRC §
165(d)
III. Withholding requirement of 20% on gambling winnings – IRC § 3402(q)
Zarin v. Comm’r – Gambling losses and Loan Payments
I. Facts
a. Big-time gambler racked up large tab at Atlantic City casinos.
b. Couldn’t pay the tab and negotiated a settlement
c. IRS says difference is Discharge of Indebtedness (DOI)
II. Holding
a. Normally, because this is a loan from the resort to the borrower, there would be
discharge of indebtedness.
b. This is not gambling winnings and losses because the loan transaction came
first
i. It doesn’t matter what the borrower does with the loan proceeds
c. Not a purchase money debt reduction because the chips were not property
i. They’re a medium for exchange with no intrinsic value
d. The petitioner did not have an obligation to pay under NJ law
Effect of Debt on Basis and Amount Realized
Types of Debt
I. There are two types of debt
a. Recourse
i. There is a personal liability for the repayment of the obligation
b. Non-Recourse
i. The debt is secured only by the pledged asset
ii. Typically equipment purchases and such
II. What is the effect of debt on the income tax basis of an acquired property?
a. Acquisition of debt is to be included in the buyer’s tax basis for acquired
property. This can include “seller financing” debt.
b. Also, property can be acquired with debt attached, i.e., either :
i. assumed debt, or
ii. non-recourse debt, with property subject to debt (but no personal liability).
c. Cf., post-acquisition debt (i.e., borrowing with existing property as collateral).
Crane v. Comm’r – Recourse and Non-Recourse are Treated the Same
I. Facts
a. 1932: Property worth $262,042.50 inherited subject to non-recourse debt of
$262,042.50
b. 1932-1938: Property depreciated by $28,000 (25,500).
c. 1938: Property sold subject to mortgage ($255,000) + $2,500 cash
d. Taxpayer Position: Amount Realized of $2,500 less Zero Basis.
e. IRS Position: A/R of $257,500 – Basis $233,997.40 = Gain $23,502.60
i. ($178,997.40 + $55,000)
II. Holding
a. Taxpayer gain is $23,502.60. Relief of mortgage is as real a benefit as the
receipt of cash.
b. This is a NON-RECOURSE DEBT AND SHE IS NOT PERSONALLY LIABLE
FOR THE PAYMENT.
i.
However, the court treats this transaction as a recourse transaction for tax
purposes
c. Footnote 37
III. Analysis
a. Crane inherits a building from her husband – and she has a basis in the FMV
i. RECALL -- §1014, she gets a FMV basis in the property
b. The property was encumbered by a mortgage – could have constructed that she
got a basis in the mortgage
i. Because she is paying for the mortgage – she was obligated to pay $262,000;
would be just like her taking out the loan herself
1. She assumed her husband’s debt equal to the value of the property
2. She has in effect purchased the property
c. Crane argues that she does not have the purchase basis – she says her
investment is only her equity
d. This was a non-recourse loan that Crane inherited
e. Why is she saying the non-recourse debt is the type of debt assumption that is
a true obligation to her?
i. Because she isn’t really obligated – she has no liability to pay off the debt
(only thing is the property)
ii. Could have viewed it as an option – if property goes down in value, don’t pay
off the loan and let bank take the property; if it goes up, sell it and make
money
f. Property had depreciated by $28,000 and she had claimed the depreciation
g. Court sides with IRS – holding that her basis on day 1 was $262,000 (she had
in effect purchased the property)
i. Court treated the debt as a true purchase price
1. Here the obligation was real so it was true debt – because the debt was
the real value as the property
2. And the court gives her credit basis assuming she will pay off the debt
(and was able to claim a tax benefit for it – e.g. depreciation)
ii. If Crane’s argument is right, she never really had true debt on day 1 – so she
should have never depreciated anything
1. If she never had an investment, her basis would be 0
h. Crane never received anything – she was relieved of an obligation – how do you
measure this?
i. Amount received less basis
1. $257,500 - $233,997.40 = Gain of $23,502.60
i. If you give her basis on day 1 – you assume she will pay off the debt
i. Selling property with the debt; it is the same as she sold the property for
cash; and kept the debt and paid off the loan
1. This is a symmetry point = making both transactions identical
j. The relief of the liability is part of the amount realized
i. Does she have cancellation of indebtedness income?
ii. NO – She paid it
Estate of Levine v. Comm’r – Donation Subj. to Assumption of Mortgage Income to Donor
I. Facts
a. Gift (FMV = $925,000; B = $485,429.55)
b. Encumbrances: $910,481.34
c. IRS position: Gain = $910,481.34 - $485,429.55 = $425,051.79
d. TP Position: Crane inapplicable bc gift, not sale.
II. Holding
a. If the donee assumes the debt of the donor, then that is an amount realized as
to the donor
b. Taxpayer had an accession to wealth because he was relieved of encumbrances
(expenses assumed by donee, mortgages, interest payments assumed by donee)
subtract basis that would be a loss, and realized a gain of $425,051.79
c. Everyday meanings are not necessarily what gets the answer in federal income
tax
d. Courts look behind the plain meaning of the statute – so that it creates rational
outcomes
Comm’r v. Tufts – Integrated Transaction or Two Transactions?
I. Facts
a. Partnership created to purchase an apartment complex subject to a
nonrecourse debt for $1.85 million dollars.
i. $400,000 depreciation claimed.
1. Tax basis reduced to $1.45 million dollars under §1016
b. Property FMV at disposition was $1.4 million
i. $1.850 million debt exceeds tax basis and the FMV of the property.
c. Taxpayer disposes of the property by having another party assume the
mortgage
i. the FMV was $1.4 (property declined in value).
II. Issues
a. Gain or other income? Loss? Tax character? How much?
b. So TP argues that there was a $50,000 loss (since their adjusted basis was
$1.45M).
c. IRS disagreed – argued that the full amount of the unpaid mortgage ($1.85
million) was realized; so compared to the $1.45 million it looks like the taxpayer
has a $400,000 gain
III. Holding
a. The amount realized in the disposition of property subject to a nonrecourse
mortgage includes the entire amount of the mortgage regardless of whether the
mortgage exceeds the fair market value of the property.
IV. Reasoning
a. Though a taxpayer could technically only be relieved of liability equal in value to
the fair market value of the property, the mortgagor must include the entire
amount of the unpaid mortgage in the amount realized.
i.
This is because the taxpayer receives certain benefits based on the
assumption that the taxpayer is obligated to repay the entire nonrecourse
mortgage.
ii. For instance, the taxpayer receives a nonrecourse mortgage tax-free, since it
is money the taxpayer must eventually pay back.
iii. If, after receiving the mortgage tax-free, the taxpayer does not include the
entire unpaid loan in the amount realized upon disposition of the property,
he receives the amount in excess of the fair market value of the property
tax-free.
iv. Furthermore, a taxpayer is allowed to include the entire amount of a
nonrecourse loan in his cost basis of the property because he is expected to
repay the entire loan.
b. If he is not correspondingly required to include the entire unpaid loan in the
amount realized, the taxpayer would receive an untaxed increase in basis.
c. To prevent such incongruities, a taxpayer must include the entire unpaid
amount of a nonrecourse mortgage in his amount realized, regardless of
whether the mortgage exceeds the fair market value of the property.
i. The defendants received the $1,851,500 mortgage tax-free and included the
entire amount in their basis.
ii. When they were unable to pay their mortgage, they were only liable up to
the fair market value of the apartment complex, which was about
$1,400,000.
iii. But because they received tax benefits on the assumption that they would
repay the entire $1,851,500, the inclusion of the entire unpaid mortgage in
their amount realized is warranted.
iv. To allow the defendants to count only the property’s fair market value in the
amount realized would allow them to claim a capital loss of $55,740 when
they did not actually sustain an economic loss.
V. Justice O’Connor Concurrence
a. Split the transaction into two – and consider the debt relief separate from the
$50,000 loss
b. Two Transactions:
i. $1.85M (debt) – $1.4M (value) = $450K COD income {as they would not have
to pay back the .45 differential); or
ii. $1.45M (basis) – $1.4M (value) = $50K capital loss
c. Court used Integrated transaction to calculate gain or loss on the amount
realized: (1.85) less the basis (1.45)
i. Also equals 400 gain.
Tax Planning Concerns Related to the Effect on Basis
I. What practical difference does it make to your client that the court went with the
integrated approach (first transaction) versus O’Connor’s two transaction?
a. Under O’Connor’s you could look to §108 for exceptions to exclude the gain
from tax
i. You could potentially qualify 450 of COD Income under a § 108 exclusion
b. Under the SCOTUS integrated transaction; it is a gain, and thus taxable – can’t
use §108 AT ALL
i. This would be really important in a bankruptcy proceeding
c. What to do under the SCOTUS approach and are going to have a $400K gain?
i. Cite Rev Ruling 91-31 – DEBT REDUCTION; NO TRANSFER
(NONRECOURSE DEBT)
ii. Get the creditors to agree to cancel the excess nonrecourse debt and it
would be a realization of COD income
iii. If there is an upside-down property (loan more than value)
1. work with the creditor to lower the debt (without taking the property) to
the FMV
d. If the bank won’t do it – and you give the property back to the bank – you are
back in the situation in Tufts
i. Not treated as a seller disposition, as you haven’t gotten rid of the property
Rev. Rul. 91-31 – Debt Reduction Without Transfer – Non-Recourse
I. Lender agreed to reduce the nonrecourse debt when the value of the bldg. ($800K)
was less than the outstanding mortgage debt ($1M). No insolvency.
II. Reduction of the principal amount of the undersecured nonrecourse debt was
made by the holder of debt who was not the seller.
III. This debt reduction constitutes realization of COD income (even in the nonrecourse
debt context) since no disposition of the collateral has occurred. $200K COD
income.
a. Or, should a tax basis reduction result?
i. No, transaction is complete and the person has the option of taking
deductions.
Rev. Rul. 90-16 – Bifurcation Recourse Debt
I. Similar fact pattern to Tufts in that it is an acquisition of property, but big
difference is that it is recourse debt
II. Property was transferred to lender and borrower was released from liability.
a. Debt: 45x
b. FMV: 30x (15x COD income?)
c. Basis: 10x (20x property gain?)
III. Bank forgives debt for the car; relieves debt of 45x and takes the car worth 30x.
How is this treated?
a. IRS says this is a bifurcated transaction – like Justice O’Connor
i. Property gain of 20x = FMV – Adjusted Basis
b. What explains the difference between the 45x of the loan and the 30x
value?
i. If it is recourse debt – the bank can go after your other assets
ii. If they choose to not come after you, that means the bank made a
secondary determination that they can’t get anything else out of you
c. The difference is COD Income = 15x
IV. Foreclosure proceeding = same result.
Treasury Regulations & Non-recourse Debt
I. Reg. §1.1001-2(a)(1) – the amount realized includes the amount of liabilities from
which the transferor is discharged.
II. Reg. §1.1001-2(a)(4)(i) – the sale of property that secures a nonrecourse liability
discharges the transferor from the liability
III. Reg. §1.1001-2(b) – the FMV of the security is not relevant for determining the
amount of liabilities being discharged.
Disposition Examples
I. Example 1:
a. FMV = 100x; R. Debt = 90x; Cash = 10x; Basis = 50x
b. See Reg. §1.1001-2(a)(1)
c. Gain of 50
II. Example 2:
a. FMV: 100x; NR Debt = 90x; Cash = 10x; Basis = 50x
b. Gain of 50x
c. See Reg. §1.1001-2(a)(1)
III. Example 3:
a. FMV: 100x; NR. Debt = 120x; Basis = 50x
b. Gain of 70x
c. Tufts
IV. Example 4:
a. FMV: 100x; R. Debt = 120x; Basis = 50x
b. COD Income = 20x
c. Gain = 50x (may be entitled to capital gain/loss treatment)
d. Rev. Rul. 90-16
Estate of Franklin v. Comm’r – There must be Investment to have Depreciation
I. Facts
a. Purchase of motel for only prepaid interest and a non-recourse debt (with
balloon payment). Warranty deed in escrow.
b. Leaseback to sellers & lease payment equal to P&I amount.
c. Value of property not shown, but presumably far less than the promissory note.
II. Holding
a. No investment in the property and no depreciation deduction and no interest
expense deduction.
b. When the amount of the mortgage exceeds the fair market value of the
property securing it when the debt was first incurred, the mortgage is not
included in the basis and will not be included in the amount realized on
disposition.
c. Estate of Franklin does not apply in situations where there is a third-party
lender
d. Buyer has the option to buy property (buyer hasn’t really bought it) – this is
when the FMV is less than the non-recourse debt
i. Expect the buyer to ask the bank to mark the debt down; and if not they will
just give the property back to the bank
e. This case would treat the buyer in Tufts as not having finished the transaction
– so no basis credit yet; once the debt is reduced – the buyer will get cost basis
on that date (this would NOT result in COD – as it was not treated as true debt
on day 1)
i. Although the seller has – Tufts has a seller event
f. Tax shelter case – when you have debt that is “phony debt” (when non-recourse
debt is way more than the actual property)
i. Court doesn’t treat this as true debt
1. What if the bank never gets paid – does the buyer have COD?
2. NO – because it was never true debt
g. Held true because no rational person is going to take a property which is worth
$1.4 and obligate themselves to $1.85 of debt
i. But WE STILL TREAT THE SELLER AS HAVING A $1.85 gain less the basis
(1.45) – so $400,000 gain
Rev. Rul. 77–110 – Inadequately Secured Loans
I. Inadequately secured non-recourse loans are too contingent to merit
characterization as indebtedness and will not allow any portion of the loan to be
considered an acquisition cost includible in basis
Pleasant Summit Land, v. Comm’r – Deduction Allowed to Extent that Debt < FMV
I. Facts
a. PSLC entered into an agreement to purchase the Summit House, a property.
b. Purchase closed and consideration was paid of $250K in cash, by delivery of a
$1.35M note secured by a purchase money mortgage, and by PLC taking
subject to a previously existing $2.6M nonrecourse mortgage.
II. Holding
a. Depreciation deduction allowed to the extent that nonrecourse debt not
exceeding FMV of the property - that amount effectively recognized as tax basis
on the acquisition.
b. Court says “the consequence of these transactions was to leave PSA with large
debts with interest charges and a substantial depreciable asset, a situation
setting up the possibility for it to claim large tax deductions…”
c. Different approach than Franklin case. “While we regard Odend’hal and Estate
of Franklin as the appropriate precedents, we do not consider them as authority
to eliminate all deductions for interest and depreciation.”
III. Reasoning
a. “Thus, it is appropriate to disregard only the portion of nonrecourse debt in
excess of FMV of the property when it was acquired for purposes of getting
interest and depreciation deductions and to regard the nonrecourse debt as
genuine indebtedness to the extent that it is not disregarded.”
b. We will assume it is genuine indebtedness and allow the deductions so long as
debt does not exceed FMV, because we know that a TP holding a property with
debt > FMV has no incentive to pay anything at all, while at the same time, the
creditor holding the debt has no incentive to take back the property if the TP
offers to pay the FMV.
c. The court determines that the transaction makes sense up to the point where
the debt begins to exceed the FMV
i. when debt exceeds FMV, it is no longer logical and thus it’s obvious that TP
obtained the property solely for the purpose of claiming interest and
depreciation deductions.
d. Consider the tax basis to Bayse – the purchaser in the Tufts case.
i. Basis limited as in the Franklin or Pleasant Summit cases?
ii. Only $1.4 million is real debt in the buyer’s hands – and they can claim
basis in that amount in the property
iii. What if the debt over the $1.4 was cancelled – is that COD Income?
1. NO – treated as non-event; UNLESS part of the debt used to recognize
basis is cancelled.
Woodsam v. Comm’r – Borrowing in Excess of FMV not Realization Event
I. Facts
a. Purchase real property for $50k
b. When FMV is $100k, takes out nonrecourse loan for $80k secured only by the
property
II. Holding
a. Borrowing is not a realization event and therefore not taxable
Borrowing Summary
Damages
Business Injuries – Lost Profits
IRC § 1033 – Involuntary Conversions
I. If property is involuntarily converted (theft, seizure, requisition, condemnation or
threat of condemnation) into:
a. Similar property or service – no gain
b. Money – gain recognized; Except
i. if TP uses funds to buy similar property or service within 2 years of the
conversion; or
ii. uses the money to purchase a controlling amount of stock in a company
that possesses the substitute property.
c. If the subsequent replacement property or service costs less than the money
received for involuntary conversion,
i. Then the remaining funds are taxable as income.
Raytheon v. Comm’r – Damages for Loss of Goodwill – Return of Capital
I. Facts
a. Raytheon won lawsuit for antitrust actions
b. Claimed that a portion of damages were for the loss of goodwill
II. Holding
a. Damages for any type of income are taxable
i. Lost profits claims
ii. Antitrust claims for loss of income
b. Damages for any type of capital investment are return of capital first, then
income.
i. Raytheon did not show the court the amount of capital expended for the
investment in goodwill
ii. Therefore, the court could only show that the basis was zero.
1. Unfortunately, all proceeds had to be deemed income due to an inability
to show that there was a basis in the goodwill investment.
Recovery of Windfall Gains – Punitive Damages
IRC § 104(a)(2) – Personal Injury Damages Received
I. Gross income does not include:
a. The amount of any damages (other than punitive damages) received (whether by
suit or agreement and whether as lump sums or as periodic payments) on
account of personal physical injuries or physical sickness.
Glenshaw Glass v. Comm’r – Punitive Damages are Gross Income
I. Facts
a. Glenshaw Glass sued a company that made sold the machinery that Glenshaw
used in their business
b. The court found violations of antitrust law and Glenshaw was awarded
$324,529.94 in punitive damages
c. Glenshaw did not report this settlement amount as income in the taxable year
to which it applied
d. Commissioner found a deficiency for that amount
II. Issue
a. Is the amount realized from punitive damages considered income and as a
result, taxable?
III. Holding
a. Money received as punitive damages is Gross Income
b. The punitive two-thirds portion of treble damages are taxable as Gross Income.
c. Income is to be determined based on “accession to wealth, clearly realized.”
d. The money realized from the settlement was income and is taxable as it was an
undeniable accession to wealth, clearly realized, in which the recipient had
complete dominion and control.
e. There is no requirement of “source-based” taxation (i.e. Eisner v. Macomber)
f. the fact the payments were from wrongdoers for punishment cannot detract
from the character as taxable income to the recipients
g. Court looked at a movie theatre case where the settlement was clearly split up
between lost profits (which was taxable) and punitive damages – in which they
held it was not taxable
i. However, the court reasoned differently here, as they saw Congress’
definition of income was to yield the full measure of its taxing power
1. Income defined in §22(a) as gains derived from personal salary or service
h. Court does not think that Congress intended to carve out and exception for this
type of income here – as such it is taxable
i. This is clearly not a deductible gift or are exempt under any other provision of
the code
Recovery of Nondeductible Items
Overpayment of Taxes
Clark v. Comm’r – Recovery for Tax Preparer Error Not Gross Income
I. Facts
a. Clark was married and asked professional to do taxes
b. Professional made error in filing joint or single and made unallowable deduction
II. Holding
a. The amount received from the professional is not considered income.
i. It is compensation for a loss incurred due to negligence
b. The notion that this was an Old Colony Trust payment of taxes is clearly
erroneous.
i. Clark OVERPAID taxes to the gov’t.
ii. Clark received his reimbursement from the professional instead of the IRS.
III. Other Recoveries that are not Taxable
a. Breach for a promise to marry
b. Settlement in an action for damages against a bank
c. Compensation for libel or slander
d. Damages for Personal Injury
Recovery for Personal Injury Damages
Tort Concerns
I. Code §104(a)(2) – exclusion for damages received for personal physical injuries. The
“physical injury requirement” cuts back the holdings of cases that involved
discrimination claims, loss of familial rights (Rev. Rul. 74-77), and scope of
Solicitor Opinion 132.
a. The omitted Murphy case upheld the constitutionality of taxing nonphysical
injury personal awards.
b. Exclusion whether received as a lump sum payment or in periodic payments.
i. Not including sex/race/age discrimination lawsuit proceeds.
ii. Not including payments for emotional distress (unless distress attributable
to physical injury).
II. Punitive damages are includible in Gross Income.
III. Business deduction for payment of Sexual Abuse or Harassment claims are not
allowed – IRC § 162(q)
Structured Settlements
I. What is a “structured settlement”?
a. Code §104(a)(2) provides for exclusion whether amount received “as lump sums
or as periodic payments” for amounts received for personal physical injuries.
b. What about the “interest” income component inherent in the delayed payments?
i. Interest is taxable
II. Examples
a. Assume court petition/complaint specifies $1 million for pain and suffering and
$9 million punitive.
i. Parties then settle for $2 million:
1. How allocate this amount to excluded and included amounts?
 Amend the petition prior to effective date of the settlement
agreement?
 No, ensure that the settlement agreement specifies the particular
amounts of taxable and nontaxable payments before signing.
b. What is the result of the NFL’s $765 million concussion settlement with former
players reached on 8/29/2013?
Medical Expense Recoveries
IRC § 104(a)(3) – Compensation for Injury or Sickness – Not Gross Income
I. An amount received by the TP from an accident or health insurance plan for
personal injuries or sickness are not gross income.
a. Provided the payments are part of the plan – See IRC § 105(I) below.
IRC § 105 – Accident and Health Plans – Not Included in Gross Income
I. Payments made by the employer for accident or health insurance are included in
gross income if:
a. Not includible in employee gross income
II. Exception
a. Employment medical plan payments by the employer are exempt from gross
income
IRC § 106 – Employer Contributions – Deductible for Employer
I. Health Savings Account Contributions are deductible for employer
IRC § 162(a) – Trade or Business Expenses – Premiums Paid Deductible for Employer
I. Deduction allowed for ordinary and necessary expenses paid or incurred during the
taxable year in carrying on a trade or business.
IRC § 213 – Itemized Deductions for Medical Expenses – Possibly Deductible for Individual
I. Deduction allowed for medical expenses paid during the taxable year, not
compensated by insurance or otherwise
a. To the extent that the expenses exceed 10% of adjusted gross income.
II. Insurance Premiums are not deductible for individuals
a. except for long-term care situations
Miscellaneous Exemptions
Tax Exempt Interest – Municipal Bonds
IRC § 103 – State and Local Bond Interest – Excluded from Income
I. The exclusion is not allowed for the following types of bonds:
a. Private Activity Bond
i. Use of muni-bonds:
1. for government functions and
2. to assist private industry (by acting as intermediary).
ii. The bond must not have more than 10% Private Activity. IRC § 141(b)
b. Arbitrage Bond
i. Bond used to acquire higher yielding investments. IRC § 148
c. Bond not in Registered Form. IRC § 149
II. The entity issuing the bond must be a State or political subdivision of a State.
Economic Effects
I. Reduce the amount of interest payable by the state/local govt. obligor.
II. Note the leakage for this gross income exclusion between:
a. benefit to local govt and
b. cost to U.S. Treasury.
c. Tax Expenditure cost is $194.6 billion
III. Distributional impact results in benefits going to upper income taxpayers
Constitutional Effects
I. Would taxation of muni-bond interest by U.S. Government be constitutional?
a. Consider the rights of states as being impaired if federal taxation occurs.
II. Cf., South Carolina v. Baker that muni-bond interest is taxed if bonds are not in
“registered” form. Code §§103(b)(3) & 149.
a. Registration ensures that the bond doesn’t become a monetized object
b. If the bond was not registered, then the holder would not be identified, and
anyone could claim that they possess a bond interest
i. The amount of administrative resources needed to verify possession of a
bearer bond for every TP would be astronomical.
Sale of Home
IRC § 121 – Exclusion of Gain from Sale of Principal Residence
I. During 5-year period:
a. Must live in the home for two of the years
i. In aggregate
b. Period ends on date of sale
i. Calculate backwards
II. Exclusion amount is:
a. $250,000 of gain for individuals
b. $500,000 of gain for MFJ
III. Possible to use exclusion for vacation home, as well.
a. Married TP take one each
IV. Surviving spouse gets 2 years to sell for $500,000, after is only $250,000.
Dividend Income and Capital Gains
IRC § 61(a)(7) – Dividends are Gross Income
IRC § 1(h)(11) – Preferential Tax Rate for Dividends and Capital Gains
Tax Expenditures
I. What is Tax Expenditure?
a. deviations from the norm for the measurement of economic income (both
positive and negative amounts)
II. Tax Expenditure Budget
a. Budget used to determine the future impact of Expenditure
Deductions and Credits
Basic Tax Structure
Calculations
Gross Income (§61)
minus
Above the Line Deductions (§62(a))
- In case of Entity other than Individual
o Everything
- In case of Individual
o Trade and business deductions
o Trade and business deductions of employees
 Reimbursed expenses
 Performing Artists
 Officials
 Elementary and Secondary School Teachers
 Reserve Component Military
o Losses from Sale or Exchange of Property
o Rents and Royalties
o Life Tenants and Income Beneficiaries
o Pension, Profit-Sharing and Annuity Plans of Self-Employed
o Retirement Savings
o Penalties from Premature Withdrawal from Savings Accounts or
Deposits
o Alimony
o Supplemental Unemployment
o Jury Duty
o Interest on Education Loans
o Higher Education Expenses
o Health Savings Accounts
o Costs Involving Discrimination Suits
Equals
Adjusted Gross Income (§62)
minus
Below the Line Deductions
- Either standard deduction (§63(c)) or itemized deductions (§63(d).
- Itemized Deductions are any deduction other than:
o ATL Deductions
o Personal Exemptions in § 151
o Any § 199A Deductions
and
Deduction for Personal Exemptions (§151)
Equals
Taxable Income (§63)
Business Expenses
Ordinary and Necessary
IRC § 162 – Trade or Business Expenses
I. There shall be allowed as a deduction all the ordinary and necessary expense paid
or incurred during the taxable year in carrying on any trade or business,
including:
a. Reasonable allowance for salaries or other compensation for personal services
actually rendered
b. Traveling expenses while away on business
i. Includes meals and lodging other than lavish or extravagant under the
circumstances
ii. Cannot be away for more than a year
1. Except for Federal employees investigating Federal crimes
c. Rentals or other payments required to be made as a condition to the
continued use or possession of property
i. Property must be used for trade or business
II. Items that cannot be deducted under this Section:
a. Can’t deduct charitable contributions over the § 170 limit.
b. Illegal payments cannot be deducted
i. Kickbacks and such
c. Lobbying and Political Expenditures cannot be deducted
d. Dues paid to tax exempt organizations cannot be deducted
e. Influencing Legislation cannot be deducted
i. Similar to lobbying
f. Exception to political expenditures
i. If TP is engaged in the trade or business of lobbying
1. Must act for someone else
2. “campaign manager”
ii. De Minimis
1. Up to $2000 per TP per tax year
2. Don’t take into account overhead costs – allowed elsewhere.
3. Must be in-house
 TP or employee
IRC § 212 – Expenses for Production of Income – Note 2018 Disallowance
I. For individuals, deductions allowed for ordinary and necessary expenses paid or
incurred during the taxable year:
a. For the production or collection of income
b. For the management, conservation, or maintenance of property held for the
production of income; or
c. In connection with the determination, collection, or refund of any tax.
II. Tax Act disallows this until 2026, except:
a. Rents and Royalties are deductible
b. See IRC § 62(a)(4)
IRC § 263 – Capital Expenditures – Not Deductible Business Expense
I. Any amount paid out for the new buildings or for permanent improvements or
betterments made to increase the value of any property or estates.
II. Also, for any amount in restoring property or in making good the exhaustion
thereof for which an allowance is or has been made.
III. Does not include:
a. Development of mines or deposits – §616
b. Research and experimental – §174
c. Soil and water conservation – §175
d. Farmers and fertilizer – §180
e. Removal of architectural and transportation barriers to handicapped – §190
f. Tertiary injectants – §193
g. §§ 179, 179B, 179C, 179D, 179E
Welch v. Helvering – Payments to Increase Goodwill Not Ordinary
I. Facts
a. Welch was a salesperson for the Welch co.
b. Welch co. was involuntary declared bankrupt
c. Welch then worked for another company
d. Welch paid debts of the former E.L. Welch Company to improve his personal
relationships with creditors of old co.
II. Holding
a. Payments by the taxpayer were not ordinary business expenses (§162);
i. Likely were necessary, though
b. Court held that the expenditures were capital expenditures (extraordinary) for
the development of “goodwill” (and not “personal” expenses).
c. Necessary is not essential; it means “appropriate and helpful for the
development of the TP business”
Jenkins v. Comm’r – Goodwill was Ordinary and Necessary
I. Allowed Conway Twitty to deduct expenditures to defend his brand name.
II. Analysis
a. There appears to be a difference in that personal services (celebrity & athlete)
TP expenditures on goodwill overcome the ordinary prong of the doctrine.
Deputy v. du Pont – Ordinary Has No Particular Frequency
I. An expense can be ordinary even if it only happens once in a person’s life.
Payment of Another’s Expenses
I. If the payment is made to protect the payor’s own business, then deductible.
II. Moral obligation to pay is not deductible.
Business v. Personal
IRC § 163(d) – Limitation on Investment Interest – Individual
I. Amount allowed as deduction for investment interest shall not exceed the net
investment income of the TP for the tax year.
a. Investment Income = income that exceeds expenses for the investment
II. TP must not be corporation.
IRC § 166(d) – Bad Debts – Nonbusiness Debts Not Allowed for Individual Deduction
I. If TP is other than corporation:
a. No deduction for nonbusiness debts
b. If nonbusiness debt becomes worthless, the loss shall be considered a loss
from the sale or exchange of a capital asset held for not more than 1 year.
IRC § 172(d) – NOL Deduction – Nonbusiness Deduction Not Allowed for Individuals
I. For TP other than corporation – for expenses not attributable to trade or business:
a. Net Operating Loss deduction NOT ALLOWED;
b. § 1202 Capital Gain or Loss NOT ALLOWED;
c. Personal Exemption deduction NOT ALLOWED; for
i. Any gain or loss from the sale of
1. Property, used in trade or business, subject to depreciation; or
2. Real property used in the trade or business
ii. Any deduction for casualty or theft losses attributable to trade or business
iii. Any § 404 deductions
IRC § 469 – Passive Activity Losses and Credits – TP Doesn’t Materially Participate
I. No loss or credit for TP that is:
a. Individual, estate, or trust
b. Any closely held C corporation
c. Any personal service corporation
II. Passive Activity is any activity where:
a. Conduct of trade or business occurs, and
b. The TP does not materially participate in the activity
i. Stockholder, etc.
IRC § 1221 – Capital Assets – Not for Trade or Business
I. Capital asset is property held by the TP that is not:
a. Used in the TP’s trade or business.
IRC § 1231 – Property Used in Trade or Business and Involuntary Conversion
I. Gains and losses from property used in the trade or business of the TP
a. If gain > loss, then treated as long-term capital gain or loss
b. If gain < loss, then shall not be treated as gains or losses from sale or
exchange of capital asset
II. Involuntary Conversion
a. Total amount of losses from destruction, theft or seizure, or requisition or
condemnation of;
i. Property subject to depreciation, or
ii. Capital assets held for more than a year
iii. Both used in trade or business
b. This subsection will not apply if losses exceed gains from the conversions.
IRC § 165 – Losses – Related to both Individuals and Businesses
I. Deduction allowed for loss sustained during the tax year and not compensated for
by insurance or otherwise.
II. Individuals limited to:
a.
b.
c.
d.
e.
Losses incurred in a trade or business;
Losses incurred in any transaction entered into for profit, though not
connected with a trade or business; and
Losses of property not connected with trade or business or a transaction
entered into for profit, if loss arises from:
i. Fire, storm, shipwreck, or other casualty, or from theft
Deduction allowed only to the extent that the loss exceeds 10% of the AGI.
If casualty gain > loss, then gains and losses are treated as sale of capital
asset.
Gilliam v. Comm’r – Criminal Defense Costs Not Deductible
I. Facts
a. Dude lost his mind while on flight for business
b. Tried to deduct his criminal defense costs as business expense
II. Holding
a. The criminal defense expenses were not activities directly in the conduct of his
trade or business.
b. Dude’s actions were not ordinary
Groetzinger – Pro Gambler – Must be involved in Activity with Continuity and Regularity
I. Dude is pro poker player.
II. Must be involved in that activity with continuity and regularity
a. The primary purpose of the activity must be to earn a profit
i. Even if there is no sale of good or services
Levin – Passive Investors – Must Show an Intent to go into Business
I. Can’t take deduction for research and experimental costs because the investors
had no intention of going into the business.
Origin of Claim Doctrine
Sports Fines
New England Patriots – Deductible under Gilliam
I. Bill Belichick and Patriots fined for spying and for deflategate
II. Because cheating is an ordinary (morally wrong, but ordinary) part of playing
sports, it would meet the ordinary prong
a. Because the cheating would likely be seen as necessary to carry on the trade
or business, it would also meet the necessary prong.
Attorney’s Fees
U.S. v. Gilmore – Legal Fees Not Deductible for Divorce
I. Facts
a. The husband’s property consisted of interests in three corps. holding auto
dealerships.
b. Husband claimed expenses for attorney’s fees for his successful resistance to
wife’s community property claims in their divorce proceeding
c. Husband claims that the deduction falls under § 212(2) – conservation of
property held for the production of income.
II. Holding
a.
“Origin of the claim” doctrine (here a personal item) applies to deny tax
deduction.
b. The divorce is the driving force behind the dispute, which is personal and not
business related.
III. Analysis
a. This holding runs a fine line between the origin of the claim and the
separation of marital property v. business property.
b. The properties in question were several auto dealerships that the wife wanted,
not the house or vacation home or anything like that
c. § 212 is not written from the perspective of the origin of the claim, but from
the perspective of a business person protecting the business.
d. Surely, the legislature would have made a distinction between which types of
attacks could be successfully defended using money from the business.
Hylton v. Comm’r – Legal Fees Not Deductible for Criminal Defense
I. Facts
a. Taxpayer quarreled and shot and killed brother-in-law and sister in-law but
was ultimately acquitted.
b. Taxpayer incurred $4,500 in legal fees to defend the murder trial.
c. IRS disallowed the deduction as a personal expenditure under §262.
d. Taxpayer claimed that the legal fees were deductible “were necessary to the
continuation of his business, and that had he been unable to successfully
defend himself against said charges his business would have been entirely
destroyed.”
II. Holding
a. Citing Gilmore, the court held that these expenses had their origin in a
personal matter and were not business related.
b. TP can only deduct the cost of defending against prosecutions that stem
from profit-seeking activities
Reasonable Allowance for Salaries
IRC § 162(a)(1) – Trade or Business Expenses
I. There shall be a deduction for a reasonable allowance for salaries or other
compensation for personal services actually rendered.
Exacto Spring v. Comm’r – Test for Determining what is a Reasonable Salary
I. Facts
a. Business took deduction for CEO pay.
b. $1.3 mil. And $1.0 mil respectively over 2 years.
c. IRS says salary is too high
II. Holding
a. The factors test is bunk.
b. Indirect market test is better
i. Corporation is a contract where the owner of assets hires a person to
manage them
ii. The owner pays the manager a salary
iii. Manager works to increase the investment rate of return
iv. The higher the rate of return, the greater the salary that can be
commanded.
1. Too high and the owner would easily replace the manager without
killing the goose that laid the golden egg
v. There is a rebuttable presumption that the salary is reasonable
1. Due to market forces
2. Rebutted by evidence showing that increase in internal rate of return
not attributed to the manager’s actions.
 Dying company sits on giant oil field
Additional Issues from Exacto Spring
I. Legal
a. Independent Investor test is tossed by some circuits
b. Gift or Dividend could be masked as salary
II. Factors
a. Education, Position, and title may be factors (Nurse and Doctor shouldn’t
make same salary)
b. Absence of dividends being paid by the company is a factor in determining
reasonable salary
i. Can disguise dividends in the salary
c. The analysis should be done from the perspective of the independent investor
d. Salaries of competing positions is a factor
e. Consulting fees that reduce the net income of the company to almost zero is
presumptively not reasonable
f. Employer’s intent must be compensatory
g. An agreement between company and employee to repay salary that is deemed
unreasonable—is, in itself, evidence that the salary is unreasonable.
III. Undercompensation
a. Corp. tax rate is less than income tax rate.
b. Dividend tax rate is less than income tax rate
c. Pass-through entities undercompensate one partner to create tax savings from
lower bracket partner
i. §§ 706, 1366(e) prevent that shift
d. Compensation is converted into dividend or partnership draw to prevent
Medicare and Social Security Tax
e. Also some cases there is 20% reduction in dividends from pass-through.
IRC § 162(m) – Excessive Salary for Top 5 Employees
I. Publicly held corporations cannot deduct more than $1 mil per employee for the
top five employees of the company.
a. CEO, CFO and three other top paid employees
IRC § 199A – Qualified Business Income – TP other than Corp. Can Deduct
I. Deduction allowed equal to the lesser of:
a. Combined Qualified Business Income (QBI) of the TP, or
b. 20% of excess of:
i.
ii.
Taxable income of the TP for the tax year, over
The net capital gain of the TP for that year
1. Taxable Income – Net Capital Gain = Amount
2. Amount * .20 = Value to be compared to QBI above.
II. QBI means:
a. A+B
b. A = Lesser of:
i. 20% of QBI for each business, or
ii. Greater of
1. 50% of W-2 wages, or
2. Sum of 25% of W-2 wages + 2.5% of unadjusted basis immediately
after acquisition of all qualified property
c. B = 20% of the aggregate amount of the qualified RIET dividends and publicly
traded partnership income.
Expenses Contrary to Public Policy
IRC § 162 – Trade or Business Expense – Public Policy Concerns
I. The following are not allowed to be expensed
a. Code §162(c) – Illegal bribes.
b. Code §162(e) – Lobbying expenditures
c. Code §162(f) – Payments to government for violations of law except:
i. if the payment provides restitution or paid to come into legal compliance.
d. Code §162(g) – 2/3rds of an antitrust treble damage award.
e. Code §162(q) – no deduction for sexual harassments payments.
f. Code §280E – no deduction for activities in illegal drug trafficking.
II. Why enable a deduction for inventory costs (but not other expenses)?
a. Note that marijuana is legalized in some states, then does this impact broad
non-deductibility rule for illegal drugs?
i. Yes.
Tellier v. Comm’r – Legal Fees ARE DEDUCTIBLE for Defense Related to Profit-Seeking
I. Facts
a. Prosecuted for Securities Act violations by Underwriter
II. Holding
a. Court allowed deduction for defense against the charges.
b. Note that the violation is a direct relation to and consequence of the trade or
business.
c. SCOTUS says there is no omnibus public policy exception to deductibility.
Mazzei v. Comm’r – Deduction for Loss Related to Illegal Activity Not Allowed
I. Facts
a. Taxpayer claimed $20,000 loss deduction under §165(c) for theft of money he
intended to use in counterfeiting scheme.
II. Holding
a. Tax Court Majority: disallows loss deduction on public policy grounds and
distinguishes Tellier.
b. Concurring Opinion (better): says the origin is personal, not business.
c.
Dissent points out two problems. First, legislative public policy exceptions only
deny §162(a) business expense deductions, not loss deductions claimed under
§165.
i. If Congress really intended those rules to serve as the exclusive grounds
for public policy disallowance, then Tellier standard no longer governs.
ii. Second, even if Tellier standard continues to apply outside of §162 and
granting that there is an important public policy against counterfeiting,
still the allowance of a deduction cannot frustrate that policy where whole
scheme was impossible!
IRC § 280E – Illegal Sale of Drugs
I. No deduction or credit is allowed for any amount paid or incurred by trade or
business if:
a. The activities consist of trafficking controlled substances
i. Sched. I & II of CSA
b. Which are prohibited by Federal law or law of any state in which the trade or
business is conducted.
Olive v. Comm’r – Regardless of State Law
I. Facts
a. Olive ran a vapor room and medical marijuana dispensary
II. Holding
a. TC says the business expense deduction not allowed under § 280E
b. 9th says that the denial is not conditioned on the legality of the practice under
state law.
Employee Business Expenses Reimbursed by Employer – Employer Deduction
Careful Reading Required
I. §162: Is an expense directly related and ordinary and necessary to conduct of the
employee’s business activity? If yes, then preliminarily deductible.
a. Careful if the activity is personal in nature.
b. Careful if the reimbursement is a working condition fringe benefit
II. §62(a)(2)(A): reimbursed employee expenses are “above the line” deductions. Thus,
deductible and analysis ends for these expenses.
a. Employee must substantiate the expense.
b. Employee cannot be reimbursed more than the deductible expense
c. Employer that takes ATL deduction also allowed Standard Deduction BTL
III. §67(a) defines miscellaneous itemized deductions by exclusion (while Reg. §1.671T(a)(1) defines miscellaneous itemized deductions positively).
a. §67(a) appears to reduce miscellaneous itemized deductions by 2% of an AGI
limit, but §67(g) outright disallows all miscellaneous itemized deductions
through 2025.
i. In theory, unreimbursed business expenses incurred by the employee
would be deductible in itemized.
IV. Workaround
a. Workers will have to persuade employers to reimburse expenses or
recharacterized the employee as an independent contractor
Rev. Rul. 2012–25 – Arrangements for Reimbursement of Business Expenses
I. Section 62(c)
a. an arrangement will not be treated as a reimbursement if:
i. it does not require the employee to substantiate the expenses covered by
the arrangement, or
ii. such arrangement provides the employee the right to retain any amount in
excess of the substantiated expenses covered under the arrangement.
II. Situation 1
a. Hourly tool charge to mechanic employee.
b. Holding
i. Because employer pays wages determined without regard to reimbursable
expenses, the designation of part of those wages as reimbursements (e.g.,
reimbursement for costs of tools) does not satisfy the business connection
requirement because same gross amount is paid regardless.
III. Situation 2
a. Hospital provides per diem for deductible travel expenses.
b. Holding
i. Same as Holding #1 because amount is not dependent on reimbursable
expenses.
IV. Situation 3
a. Employer pays per diem mileage reimbursement.
b. Holding
i. Same as above because amount does not vary with actual expense.
V. Situation 4
a. Employer reimburses employees for their equipment expenses
b. Holding
i. Reimbursement based on actual expenses so qualifies
Planning Implications of Nondeductibility of Unreimbursed Employee Expenses
I. Have employer increase reimbursements even if corresponding decrease in salary.
II. Characterize individual as “independent contractor” and not an “employee.”
a. Rev. Rul. 87-41 that lists 20 factors to consider in determining Independent
Contractor status.
b. Independent contractors can also benefit from §199A.
Business or Personal?
Business or Investment v. Personal Expenses – Related to Business Deductions
Fundamental Issue
I. How distinguish between business and personal when expenses are for
consumption purposes?
a. Include in gross income the value of the personal satisfaction element?
b. Allow corporate officers to fund large personal expenses disguised as business
expenses? Equitable to workers?
II. Compare Bittker & Chirelstein view that “a sharp division between pleasureseeking and profit-seeking is alien to human psychology and essentially
unrealistic” to Halperin’s view that a deduction should be allowed only to the
extent it exceeds the personal benefits derived regardless of the context.
III. Irwin case
a. deduct “life experiences” because they help your writing career?
b. Is this fair to the rest of us that must spend after-tax earnings on
consumption items?
Clothing Expenses
Pevsner v. Comm’r – Clothing Must Satisfy 3-Part Test
I. Facts
a. Manager of a high-end clothing store; spent $1,400 in buying the clothes –
which was required by the employer (had to wear the clothes while she was on
the job
b. Never wore the clothing outside of work – it was too nice for her outside of her
work
c. Tried to claim a deduction for the clothes
II. Issue
a. Was it a business expense (§162) or a personal expense (§262)?
III. Holding
a. The cost of clothing is deductible as a business expense for federal tax
purposes if it is:
i. of a type specifically required as a condition of employment,
ii. not adaptable to general usage as ordinary clothing, and
iii. not worn as ordinary clothing.
b.
Objective Three Part Test Created:
i. Clothing is required for business use
ii. Cannot be adaptable to general use
iii. Cannot be worn outside of the workplace (is not so adapted)
c. There is no deduction if #2 applies
i. EVEN IF YOUR EMPLOYER REQUIRES IT
d. Court determined that the clothes are adaptable to general uses
i. She works at a retail store that sells to the general public.
IV. Analysis
a. Don’t want the tax deduction to depend on the person themselves – don’t want
it to be a subjective test (based on the person’s attitude towards the clothes –
e.g. whether they wear them or not)
V. Lady Gaga Clothes
a. #1 & #2 would be satisfied – and #3 could be brought into question
b. But we know that Lady Gaga always wears that stuff out in public – so it
would not be deductible
VI. Line of cases involving employee apparel – is that deductible?
a. Ski patrol – Yes
b. Disney world – Yes
c. McDonalds – Yes
d. Business suits for law firm?
i. No – general apparel
Items for the Office
Henderson v. Comm’r – Required to do Job?
I. Facts
a. Karen Henderson was an assistant attorney general for the State of South
Carolina. She had an office with essential furnishings.
b. She bought a plant for $35 and a framed print for $35. She also had parking
expenses of $180. She claimed deductions for all these items.
II. Holding
a. No deductions. They’re all personal. As to the plant and picture, if they had
been necessary for Henderson’s job, the state would have bought them for her.
b. Note: through 2026, these unreimbursed employee expenditures would be
nondeductible even if business related. See §67(g).
Other Items Expensed
I. Not allowed
a. Welder – Work Boots. Wore them to court.
b. News Anchor – Conservative Business Clothing. Court found that it included
bikinis and thongs
c. Tennis Pro – Tennis shoes. Can be worn outside work.
d. Model – Styling hair is done outside work.
e. Business Person – Ministerial advice is “inherently personal”.
f. CPA – Athletic equipment to stay sharp at work. Not allowed, inherently
personal.
g. Drama Professor – Theatre tickets, video rentals. Personal expenditure
h. Communications Professor – Internet, books under lifelong burden for
knowledge. Books turned out to be personal in genre.
II. Allowed
a. Concert Pianist – Tuxedos for Concerts
b. Soldier – Military clothing
c. Lawyer – Legal Pad
d. Public Employees – if not dodging tax obligation, food, lodging travel can be
expensed.
III. Reconcile with Working Condition Fringe § 132(d)
a. The decision to make the purchase or investment lies with the company and
not the individual.
b. All of the examples above are individuals making the purchases themselves
c. If it were sufficiently appropriate, then the company would have helped pay
the cost of the item
Childcare Expenses
Smith v. Comm’r – Legislature Changed to Allow Deductions and Credits
Facts
a. Mr. and Mrs. Smith were both employed and hired a nursemaid to care for
their young child while they worked. They claimed a deduction for the childcare expense, as a business expense.
II. Holding
a. No deduction. The expenses are personal and not ordinary (in the sense that
they are not incurred by all people who work).
III. Legislative Changes
a. §21 – qualifying child care credit (up to $1,050/$600 for one child)
b. §24 – child tax credit ($1,000 per child but phased out)
c. §32 – earned income credit (# of children, but phased out)
d. §129 –exclusion from GI for dependent care cost covered by employer
e. §45F –employer credit for child care facilities
I.
Transportation Expenses
From Home
Comm’r v. Flowers – Long Commute Not Deductible
I. Facts
a. Flowers was a lawyer who took a job with a railroad with its offices in Mobile,
Alabama.
b. At the time he took the job, Flowers had settled in Jackson, Mississippi and
was unwilling to move away from there.
c. So he traveled between Jackson, where he kept both his home (in the nontax
sense) and an office where he worked some of the time, and Mobile, where he
needed to work some of the time.
d. He had a railroad pass, so all that was at stake was his living costs in Mobile,
for which he claimed a deduction.
II. Holding
a.
b.
c.
No deduction. The Court avoids the question of the location of Flowers’ tax
home. It concludes simply that the expense was not attributable to the
exigencies of the business.
He just had a long commute.
3-Part test
i. Expense must be reasonable and necessary
ii. Must be incurred while away from home
1. Home is the Principal Place of Business for the Employee
iii. Must be incurred in pursuit of business
1. Direct connection between the expenditure and the trade or business
2. Must be necessary or appropriate to the development and pursuit of
the business or trade.
Away
U.S. v. Correll – Sleep or Rest Overnight
I. Facts
a. Man travelled around during the day out of town – so he tried to deduct his
meal expenses while travelling around out of town
b. He actually left the city everyday – which made it difficult to have a
consumption choice
II. Holding
a. Under federal tax law, business-travel expenses are tax deductible only if
the taxpayer’s travel requires him to sleep or rest or stay overnight.
b. Sleep or rest OR overnight rule – travel expenses not deductible if he did not
stay out of town overnight
i. Administratively easy to assert this rule
ii. Court giving deference to the IRS – it is reasonable for the Treasury
Department to draw lines
1. While this may not be the best rule for overnight – but deference
granted
iii. Old rule required you to calculate how much your normal food costs were
1. Deduct the overage
2. Allows a deduction of the forced consumption benefit
 IRS rejected this rule
i. practical nightmare to administer
c. Sleep or rest rule is OVERLY beneficial: (this is a good example of the all or
nothing general rule for business expenses)
i. If you stay overnight somewhere – it is ALL deductible (when at home, you
still would have had to eat)
d. Rule is also UNDER beneficial:
i. Because if you are in Correll’s position – you don’t get any benefit
Commuting Expenses
Rev. Rul. 99–7 – Commuting Expenses
I. In general, daily transportation expenses incurred in going between a taxpayer's
residence and a work location are nondeductible commuting expenses. However,
such expenses are deductible under the circumstances described in paragraph (1),
(2), or (3) below.
a. A taxpayer may deduct daily transportation expenses incurred in going
between the taxpayer's residence and a TEMPORARY work location OUTSIDE
the metropolitan area where the taxpayer lives and normally works. However,
unless paragraph (2) or (3) below applies, daily transportation expenses
incurred in going between the taxpayer's residence and a TEMPORARY work
location WITHIN that metropolitan area are nondeductible commuting
expenses.
b. If a taxpayer has one or more regular work locations away from the taxpayer's
residence, the taxpayer may deduct daily transportation expenses incurred in
going between the taxpayer's residence and a TEMPORARY work location in
the same trade or business, regardless of the distance.
c. If a taxpayer's residence is the taxpayer's principal place of business within
the meaning of section 280A(c)(1)(A), the taxpayer may deduct daily
transportation expenses incurred in going between the residence and another
work location in the same trade or business, regardless of whether the other
work location is REGULAR or TEMPORARY and regardless of the distance.
II. Temporary is 1 year or less
a. No realistic expectation that it will be 1 year or less, then not temporary
i. Regardless if it lasted less than a year.
III. A business trip occurs when you go to a temporary worksite (but you have to go to
PPB FIRST)
a. E.g. going to the courthouse
IV. You can go to temporary worksite directly, so long as you have a PPB in the
metropolitan area
a. If you go outside the area – that is a business trip as well
V. What if your PPB is your home?
a. Any trip from PPB to any other business site, you would have a deduction for
a business trip
VI. No deductions for the traveling salesman – they are at home on the road (so they
can never travel away from home); need a principle place of business as a base
a. Tax turtle
VII. Other Holdings
a. Transportation of Tools and Equipment can be deducted
i. Only the excess from normal commuting.
b. Police Officers can deduct commuting
c.
Daily travel between the residence and a temporary work location is deductible
Summer Law Clerks
Hantzis Case – No Deduction Because Home is the New Job Location
I. Facts
a. Home in Boston but worked during summer in NYC as summer clerk in a law
firm.
b. Apartment cost in NYC for during the week and Boston-NYC transportation
cost.
c. Tax Court says deduction is available.
II. Holding
a. §262 disallows a personal cost deduction.
b. The temporary employment rule necessitates business location as the primary
home.
c. One-year rule of Rev. Rul. 93-86
Entertainment and Business Meals
Business Meals
Moss v. Comm’r – Must be Different from or in Excess of Normal Personal Expense
I. Facts
a. Moss is a partner in a defense litigation law firm. Partners met for lunch daily
at Café Angelo and discussed their cases at lunch.
b. Firm paid for the meals every day
II. Holding
a. Meals are inherently personal.
b. Heavy burden to show otherwise.`
c. Code §262 (no deduction for personal expenses);
d. Code §119 (exclusion for meal provided in kind on the premises); and,
e. Code §162(a) (ordinary and necessary business expenses are deductible)
f. LA firemen that were required to participate in food fund allowed the
deduction.
i. Primarily because the expense was a requirement of the Fire Department
and the meals were required to be eaten on the business premises, like §
262.
g.
Note – because the meals were paid for by the partnership, they should have
been considered income to the partners.
IRC § 274 – Disallowance of Entertainment and Other Expenses
I. No deduction for:
a. An activity that is generally considered to be entertainment, amusement, or
recreation
b. A facility that is used in connection with those activities
II. Factors
a. Time, place, business purpose, amount of the expense, and the relationship to
any recipients of the entertainment.
b. Must have adequate contemporaneous records. No estimates permitted.
i. Cf., Cohan doctrine.
c. Certain per diem allowances OK in lieu of specific expense recordkeeping.
d. Foreign Travel: §274(c) partially disallows deduction for foreign travel for
mixed business and pleasure.
e. Cruises; §274(h) disallows deduction for cruises and conventions held outside
N.A. unless business connection test met.
III. Only 50 percent deductibility for meals.
a. There is an element of personal consumption in every meal.
b. Roughly accommodates the argument that the gov’t is subsidizing “expense
account living.”
c. Applies to meals that are eaten while on travel
d. Does not apply to holiday party or summer outing
e. Does not apply to meals sold to customers – Restaurant COGS
IV. Spousal Travel is deductible if:
a. spouse is an employee,
b. spouse had a bona fide business purpose for trip, and
c. the expense is otherwise deductible.
Rev. Rul. 63–144 – No Deduction for TP Meals Eaten while Accompanying Client
I. There is no deduction for meals eaten by the TP unless the meal exceeds the
amount he would normally spend on himself.
Home Office Expenses
IRC § 280A – Disallowance of Expenses from Home Office and Vacation Home Rental
I. Individuals and S corps. cannot deduct residence expenses.
II. Except:
a. Any deduction that is not connected with trade or business.
i. Home sale, interest deduction, taxes, etc.
b. The portion of the home that is exclusively used on a regular basis
i. As the principal place of business for the trade or business of the TP
ii. Place of business for patients, clients or customers in meeting or dealing
with the TP in the normal course of trade or business, or
iii. A separate structure that is not attached to the dwelling unit of the TP
c. If employee:
i. Only if the exclusive space above is for the convenience of the employer.
d.
Portion of dwelling that is regularly and exclusively used for storage of
inventory.
e. Rental Properties.
i. Duplex, tri-plex, etc.
f. Day Care Services
i. Used on regular basis for care of children, 65 and over, and physically or
mentally ill.
III. Limit
a. Deduction cannot exceed excess of
i. Gross income, over
ii. Sum of
1. Deductions from this Chapter
2. All other trade or business deductions in relation to the use of this
location.
b. In other words:
i. Gross Income – All Deductions Related to the Home Office = Max
Deduction under § 280A.
Rev. Rul. 94–24 – “Relative Importance” & “Time” Tests for Principal Place of Business
I. Law
a. Section 162(a) provides a deduction for all the ordinary and necessary
expenses paid or incurred during the taxable year in carrying on any trade or
business.
b. Section 262 provides that no deduction is allowed for personal, living, or
family expenses.
c. Section 280A(a) generally prohibits otherwise allowable deductions with
respect to the use of a dwelling unit which is used by a taxpayer as a
residence.
i. This deduction prohibition does not apply to any deduction, such as
interest or taxes, that is allowable without regard to its connection with
the taxpayer's trade or business. Section 280A(b).
d. Under section 280A(c)(1), the section 280A deduction prohibition does not
apply to the portion of a dwelling unit which is exclusively used on a regular
basis i. as the principal place of business for any trade or business of the
taxpayer,
ii. as a place of business which is used by patients, clients, or customers in
meeting or dealing with the taxpayer in the normal course of the
taxpayer's trade or business, or
iii. in the case of a separate structure which is not attached to the dwelling
unit, in connection with the taxpayer's trade or business.
e. In the case of an employee, the preceding sentence applies only if the exclusive
use is for the convenience of the employer.
f. In Commissioner v. Soliman, 113 S. Ct. 701 (1993), the Supreme Court
identified two primary factors in determining whether a home office is the
taxpayer's principal place of business for purposes of section 280A(c)(1)(A):
i.
the relative importance of the activities performed at each business
location; and
ii. the amount of time spent at each location.
II. Outcome
a. Teacher who grades tests at home (with a small office at the school to grade as
well)
i. NO deduction because there is an office in which the grading could be
done at the school
b. Self-employed writer; spends 10-15 hours doing research elsewhere
i. Home is PPB – so deduction
c. Self-employed jewelry seller and goes to craft shows and whole sellers; does
admin work at home
i. This is what Congress wanted to reverse from Soliman – home can be PPB
if the only place to do clerical work is the home
ii. Deduction allowed
Popov v. Comm’r – Principal Place of Business Issue
I. Facts
a. Musicians claimed deduction for 40% of rent and 20% of electricity costs for
one-bedroom apartment.
b. Tax Court disallowed deduction, claiming that principle place of business was
the Lincoln Center where they provided services for their employer.
II. Holding
a. Ninth Circuit: Reversed.
b. Principle Place of Business:
i. relative importance, and
ii. time.
c. What do you think of this statement: “They are accordingly entitled to a home
office deduction for Katia Popov’s practice space, because it was exclusively
used as her principal place of business”?
i. Do you think the four-year-old child and the rest of the family did not use
this common space in a one-bedroom apartment?
Comm’r v. Soliman – Relative Importance to the Business Issue
I. Facts
a. Soliman was an anesthesiologist that worked at various hospitals but used a
home office to do his paperwork. Only work at this office was administrative
matters and not providing anesthesiology services.
b. Tax Court: Held Soliman’s home office was his principal place of business,
thus abandoning its “focal point” test after Drucker.
c. Fourth Circuit. Affirmed.
II. Holding
a. Supreme Court reversed. Administrative chores were far less important in
comparison of anesthesiology activities.
b. How did the court determine the PPB?
c.
Court aggregated all of the times in the hospital – which would not allow an
office deduction
i. Court also conceived that there may not be a principal place
d. Court held home office needed to be most important place – and admin work
was not most important
III. Subsequent Change
a. Congress changed the outcome.
b. Code §280A(c) disallows all §§162, 165, 167, 168 and 212 deductions for a
home office or work area in a personal residence.
c. But, Congress provided a new Code §280A(c)(1) that permits a home office
deduction if exclusively used on a regular basis, such as for meeting
customers or it is the principle place of business for a trade or business, or if a
separate building, unattached to dwelling residence, used in connection with
trade or business.
d. The flush language to §280A(c) that Congress added in 1997 post-Soliman
allows for home office to be used for admin work
i. ONLY IF hospital did not provide a place for him to do so
ii. Has to be for convenience of employer – meaning they are not providing a
space for you.
Rental Losses for Vacation Home
IRC § 163(h)(4)(A)(i)(II) – Personal Interest Deductions – Vacation Home
I. Allows interest expense for one non-principal residence.
a. Must qualify under § 280A(d)(1).
IRC § 280A(d) – Disallowance of Expenses – Rental of Vacation Home
I. provides rules limiting deductions for costs of vacation homes:
a. Under 15 days rental use - income and deductions both ignored; §280A(g).
b. Over 14 days personal use - limit on % of deductions for rental use;
§280A(d)(1)& (4).
c. Rented more than 14 days, but personal use is less than the greater of 14
days or 10% of period rented, then get full deductions.
Deductible Business & Invest. v. Nondeductible Capital
Introduction
Capital Expenditures
I. Purchasing an asset
a. Financial asset
i. Stocks or bonds
ii. Real property
iii. Tangible personal property
1. Machinery and equipment
iv. Intangible Assets
1. Contracts and Patents
II. Constructing an Asset
a. Buildings
III.
IV.
V.
VI.
b. Infrastructure
c. Utilities
d. Even the labor that was paid for the construction. Reg. § 1.263(a)–2T
Company Raising Capital
a. Issuing debt or stock
b. Reorganizing company’s capital structure
Entering into a new Trade or Business
a. Legal Structure
b. Capital requirements
c. Initial Inventory
d. Equipment
Acquiring a new Business
a. Stock or assets
Issues
a. Is expenditure for entering a new trade or business OR expanding a current
trade or business?
b. Is the expenditure allocated to capital or business expense?
IRC § 263 – Capital Expenditures
I. Any amount paid out for the new buildings or for permanent improvements or
betterments made to increase the value of any property or estates.
II. Also, for any amount in restoring property or in making good the exhaustion
thereof for which an allowance is or has been made.
III. Does not include:
a. Development of mines or deposits – §616
b. Research and experimental – §174
c. Soil and water conservation – §175
d. Farmers and fertilizer – §180
e. Removal of architectural and transportation barriers to handicapped – §190
f. Tertiary injectants – §193
g. §§ 179, 179B, 179C, 179D, 179E
Choices for Recovery of Capital and Benefits of Deferral
I. Choices
a. Immediate Deduction
b. Spread cost over life of asset
c. Cost recovery upon disposition
II. Benefits of Deferral
a. Equivalent to interest free loan
b. Equivalent to tax rate reduction (or forgiveness)
c. Exemption from income from investment
i. Present value charts
ii. Discount factors
iii. Future value
Capitalization Doctrine
Introductory Concepts and Concerns
I. What is the function of the “doctrine of capitalization”? See IRC §263.
II. How identify the dividing line between:
a. current expenses, and
b. capital expenditures (requiring capitalization)?
III. Consider the non-relevance of the capitalization doctrine in the consumption tax
context.
One-Time Costs
Nonrecurring Capital Outlays
Encyclopedia Britannica – Creating a Book is Capital Outlay
I. “Turnkey” deal made for the preparation of an entire book for Britannica.
II. Holding
a. Expenditures to create a book must be capitalized.
b. Rejection of the argument that this was part of a number of continuing
projects and, therefore, that a “period cost” concept was not necessary.
Woodward v. Comm’r – Shareholder Litigation Costs are Capital Outlays
I. Facts
a.
b.
Minority shareholders voted against extension of the corporate charter.
Dissenters' rights cash-out valuation proceeding. Appraisal to determine the
fair value of the minority owned shares.
II. Holding
a. Yes, the costs incurred in negotiating the purchase of the minority’s stock are
capital costs.
b. Capitalized costs included purchase price of minority shares plus attorney
fees, accounting fees, appraiser fees, and broker’s fees.
c. Basis adjustment to the purchase price of the stock.
Mt. Morris Drive-In v. Comm’r – Drainage System Capital Improvement and Not Repair
I. Facts
a. Purchased land to create drive-in theatre.
b. Land drained sharply to other property.
c. Developer had constructive knowledge of the issue and did not fix during
initial construction
d. Other property owners sued the theatre and won.
e. Theatre claimed deduction for installation of the drainage system
II. Issue: Repair (§162) versus improvement (§263) distinction.
a. Tax Court Majority: Drainage system is a capital expenditure either because:
i. it was an integral part of the original costs of building the drive-in; or
ii. the drainage system itself was a separate long-lived asset.
b. Tax Court Dissenters: Ordinary repair currently deductible under §162(a)
because the drainage system did not prolong the useful life of the drive-in or
increase its value or income-producing potential—it’s the same drive-in with
the same seating capacity.
III. Holding
a. Sixth Circuit Majority: Affirmed capital improvement. The drainage system did
not extend the physical useful life, but it did substantially prolong the
economic useful life because, absent this expenditure, the neighbors would
have shut it down.
Expansion of a Business
I. Central Texas S&L – 5th Cir. held that expenditures to investigate and establish
new branches treated as capital expenses.
II. NCNB Corp.– 4th Circuit held that expenditures to investigate and establish new
branches were deductible because were not incurred to enter a new business.
III. These cases diverge in part on the question of whether a separate and distinct
asset was acquired or simply expenditure for existing business assets.
Repair and Maintenance Expenses
Midland Empire v. Comm’r – Repair to Return Capital to Original Condition Deductible
I. Facts
a. The taxpayer operated a meat packing plant in a building it owned. The
building had a basement in which meats were cured and stored.
b.
Oil (apparently from a nearby refinery) seeped into the basement and made it
unusable. The taxpayer was required to, and did, oil-proof the basement by
adding a concrete lining to the walls.
c. It claimed a deduction for the cost, as a repair. The government denied the
deduction on the ground that the new lining was a capital expenditure.
II. Holding
a. Deduction allowed.
b. The new concrete lining did not enlarge the basement, make it more desirable
(than it was before the seepage), or prolong the life of the building or increase
its value (compared with the value before the seepage).
Environmental Cleanup
I. Rev. Rul. 94-38 – Deduction for cleanup of hazardous waste.
II. Rev. Rul. 98-25 – Cost of disposing of underground storage tanks as currently
deductible.
III. But
a. Rev. Rul. 2004-18 & Rev. Rul. 2005-42 – Capitalization into the inventory cost
for environmental remediation expenses.
Aircraft Maintenance
Rev. Rul. 2001–4 – Aircraft Maintenance Costs
I. Law
a. Section 162 and § 1.162-1(a) allows a deduction for all the ordinary and
necessary expenses including “incidental repairs.”
b. Section 1.162-4 allows a deduction for incidental repairs that neither
materially add to the value of the property nor appreciably prolong its useful
life but keep it in an ordinarily efficient operating condition.
i. However, § 1.162-4 – Cost of repairs in the nature of replacements that
arrest deterioration and appreciably prolong the life of the property must
be capitalized and depreciated in accordance with § 167.
c. Section 263(a) provides that no deduction is allowed for:
i. any amount paid out for new buildings or permanent improvements made
to increase the value of any property or estate or
ii. any amount expended in restoring property or in making good the
exhaustion thereof for which an allowance has been made. See also§
1.263(a)-1(a).
d. Section 1.263(a)-1(b) provides that capital expenditures include amounts paid
or incurred to
i. add to the value, or substantially prolong the useful life, of property owned
by the taxpayer, or
ii. adapt property to a new or different use.
iii. However, that regulation also provides that amounts paid or incurred for
incidental repairs and maintenance of property within the meaning of §
162 and §1.162-4 are not capital expenditures under §1.263(a)-1.
e. Section 263A – direct and indirect costs properly allocable to real or tangible
personal property produced by the taxpayer must be capitalized.
i.
Section 263A(g)(1) provides that, for purposes of § 263A, the term
“produce” includes construct, build, install, manufacture, develop, or
improve.
II. Outcomes
a. Situation 1
i. Heavy maintenance on airframe. No material upgrade or addition to its
airframe.
ii. Holding: deductible.
b. Situation 2
i. Heavy maintenance plus replacement of significant portions of skin
panels.
ii. Holding: deduction for heavy maintenance but capitalize skin panels.
c. Situation 3
i. Heavy maintenance plus substantial modifications that increased the
plane’s useful life.
ii. Holding: Capitalization of all work.
Production
Production of Tangible Assets & Inventory
Comm’r v. Idaho Power – Asset to Create Another Asset Must be Incl. in Capitalization
I. Facts
a. Self-created assets: Automotive equipment was used for the construction of
capital facilities. 10-year depreciation life?
II. Holding
a. The assets used to create another capital asset must be included in the
original outlay for the new asset.
i. That includes trucks, tractors, backhoe, etc.
IRC § 263A – Capitalization and Inclusion in Inventory Costs of Certain Expenses
I. The costs with respect to any property (other than inventory) are:
a. The direct costs of such property, and
b. The property’s proper share of those indirect costs (including taxes) allocable
to the property
c. Whether produced or acquired
d. Except
i. Personal use property
ii. Research and development
iii. Development of oil and gas and other minerals
iv. Log-term contract rules
v. Timber
vi. § 59(e)
vii. § 168(k)(5).
e. Example:
i. Machinery has $10,000 of depreciation and was used to create an office
building. Labor costs were $100,000 and cost of materials were $200,000.
ii.
The basis of the office building is $310,000 and it gets depreciated over 39
years. If put in service on January 1, then approximately $7,618 of
depreciation in the first year for all of the costs.
Intangible Assets
Acquisition of Intangible Assets or Substantial Future Benefits
Indopco v. Comm’r – Future Benefit Derived from Valuation in Takeover
I. Facts
a. Expenses incurred by a target corporation (seller) in a friendly takeover.
b. Investment banker charged the seller a valuation opinion fee of $2.2 million &
also attorney’s fees.
c. The Tax Court and Third Circuit treated these intangible expenditures as
capital.
d. National Starch (Indopco) paid the fee.
II. Holding
a. Expenses are to be capitalized, even though no specific asset was created,
since a “future benefit” would be realized.
b. The future benefit is the use of the valuation for the next few years until a new
valuation must be created.
c. Changing the corporate structure for the benefit of future operations are not
ordinary and necessary business expenses.
i. I believe ordinary, but not necessary
III. Subsequent Rulings
a. Numerous IRS published rulings (p.820-821) distinguishing the Indopco
decision, including with respect to:
i. Employee training costs,
ii. Employment severance benefits, and
iii. Advertising costs.
b. Subsequent Regs. § 1.263(a)-4 & 5 providing various exceptions from strict
adherence to the Indopco “future benefits” test for certain intangibles.
c. IRS authority to issue these rulings & regulations?
i. Lesson: administrative practicalities.
Other Concerns with Intangible Assets
I. Separate and Distinct Asset
a. There needs to be a separate and distinct asset for capitalization.
i. A property interest of ascertainable and measurable value in money’s
worth that is subject to protection under applicable law and the
possession an control of which is intrinsically capable of being sold,
transferred or pledged…separate and apart from the trade or
business.
II. Advertising and Promotion
a. Future benefit that does not need to be capitalized. Reg. 1.263(a)–4(b)(3).
III. Transaction Costs that Must be Capitalized
a. Anything that facilitates the acquisition, creation, or enhancement of an
intangible
i.
ii.
Investigate possible transaction
Pursue transaction
1. Attorney, accountant, appraiser
b. Except
i. De minimis – transaction less than $5000
ii. Employee compensation and overhead costs.
IV. Reorganization
a. Capitalize
i. Arraisals, tax advice, structuring the transaction, regulatory and
shareholder approvals, and costs of conveying the property
b. Don’t capitalize
i. Other costs before the BRIGHT-LINE DATE
1. Date which is the earlier of agreement or board authorization
Job Seeking Expenses
Rev. Rul. 75 – 120 – Job Seeking
I. Expenses to seek new employment in same trade or business are deductible.
II. Expenses not deductible if seeking employment in a new trade or business.
a. What about cost for seeking one’s first job (e.g., after law school)?
i. At least permit amortization of any cost?
1. Blah
Education Expenses
Wassenaar v. Comm’r – Self-Improvement and Not Deductible
I. Facts
a. Obtained LL.M. degree in taxation. Taxpayer deducted expense for tuition,
etc., as an employee business expense? IRS – never began the practice of law –
which is essential for the deduction.
b. Not admitted to practice law before LLM.
II. Holding
a. Reg. §1.162-5(b)(3) – re new trade or business. Held for IRS.
b. Ruehmann– master’s degree program deductible because Ruehman had
already commenced practice of law before going to graduate school.
III. In general, college courses are general self-improvement and not deductible as
they are inherently personal expenses. Reg. 1.162-5(b).
Other Educational Expenses
I. Continuing Legal Education deductible under §162. Reg. 1.162-5(c).
II. Travel in and of itself cannot be treated as a deductible educational cost. Code
§274(m)(2).
III. No gross income from educational assistance program. Code §127.
IV. To the individual, a deduction for up to $4,000 for college tuition. Code §222. But,
AGI cap on deduction, with a “cliff” effect, rather than a phase-down.
V. Lifetime learning credit under §25A(b) for a maximum credit of $2,500.
Before, During, or After Trade or Business
Rockefeller v. Comm’r – Must be Existing Trade or Business
I. Facts
a. Nelson Rockefeller deducted costs associated with confirmation hearings. IRS
disallowed expenses as being incurred before Nelson Rockefeller was in the
trade or business as a public official.
II. Holding
a. Court agrees that he is not in trade or business yet, so not an expense related
to an existing trade or business.
Option to Deduct or Capitalize
I. §174 – deduction for research and experimental expenditures.
a. Alternatives: capitalize or deduct over 5 years.
II. §175– soil and water conservation
III. §190 costs of removing architectural and transportation barriers
IV. §198 – certain environmental clean-up costs
Recovery of Capital Expenditures
Depreciation
Introduction and Objective
I. Depreciation – Code §§167 & 168.
II. Adjusted Tax Basis = Original Tax Basis - Depreciation
III. Objective
a. allocate the cost of a depreciating item over its period of productivity. Concept
of matching income with the expenses associated with that income over the
asset’s “useful life” (as prescribed in the Code). This assumes “useful life” is
determinable.
IV. For federal income tax purposes how should the cost (i.e., tax basis) for
equipment, buildings, and intangibles (other than financial instruments) be
recovered (prior to disposition)?
Economic Depreciation
I. Value of property is equal to the present value of the remaining cash flows
expected over the assets remaining useful life.
a. This is called “economic depreciation.”
b. Economic depreciation is administratively impracticable because the valuation
of each asset must be done annually.
c. Theoretically correct
depreciation would be
to allow depreciation
equal to amount
asset declines in
value.
Methods of Depreciating an Asset
I. Straight Line
a. Equal amounts over the life of the asset
II. Declining Balance
a. Larger portion of the cost in the early years
b. Constant percentage is used, creating the reduction over time
III. Double Declining
a. Twice the percentage rate
b. Double the straight-line rate
IV. Salvage Value
a. The amount that the TP would expect to recover when he stops using the asset
for the production of income
b. Requires an estimate of salvage value at the time the asset is acquired or
created. § 168(b)(4)
What Assets are Depreciable?
IRC § 167(a) – Depreciation
I. Deduction allowed. Reasonable allowance for exhaustion, wear and tear (including
obsolescence). Must be:
a. Property used in the trade or business, or
b. Property held for the production of income
II. Raw land and Corporate Stock are not depreciable assets
Effect of the Depreciation Deduction on Tax Basis
I. Depreciation reduces tax basis, but not if disallowed as a deduction. See §1011.
II. Personal use property does not cause a reduction in tax basis.
a. Similar if a Code §280F(a) disallowance.
III. Tangible property depreciation rules.
a. Property classification - §168(e).
i. What types of property are in each year-classification
b. Recovery period - §168(c).
i. Period of time each year-classification can be depreciated
c. Depreciation method - §168(b).
i. Each of the methods of depreciation noted above
d. Applicable convention - §168(d).
i. Note: no salvage value is required - §168(b)(4).
ii. The applicable convention affects how you figure your depreciation
deduction for the year you place your property in service and for the year
you dispose of it. It determines how much of the recovery period remains
at the beginning of each year, so it also affects the depreciation rate for
property you depreciate under the straight-line method.
iii. Half-Year
1. You deduct a half-year of depreciation for the first year and the last
year that you depreciate the property. You deduct a full year of
depreciation for any other year during the recovery period.
2.
Figure your depreciation deduction for the year you place the property
in service by dividing the depreciation for a full year by 2.
 If you dispose of the property before the end of the recovery period,
figure your depreciation deduction for the year of the disposition
the same way.
 If you hold the property for the entire recovery period, your
depreciation deduction for the year that includes the final 6
months of the recovery period is the amount of your unrecovered
basis in the property.
e. Bonus Depreciation - §168(k):
i. 2023:100%; 2024:80%; 2026: 60%; 2027:20%
ii. Special properties
iii. Example
1. Entire $150,000 cost is deductible. Seven-year class life; 5-year
property. No §179. Depreciated using 200 percent declining balance
method.
 General rule of §168(k)(1) $75,000 + [75,000*20%* 200%*50%) =
$90,000
 Special Rule of §168(k)(5): $150,000
f. §179: Immediate expensing of $1 million for small businesses.
i. Limitations
1. If the property exceeds $2.5 mil, then the excess reduces the $1 mil
expense limit by an equal amount
2. The deduction cannot exceed the aggregate amount of taxable income
from the trade or business
3. Expense can be increased by lesser of:
 Aggregate amount disallowed for prior years, or
 Excess of:
i. Adjusted limitations over
ii. The normal limitation without regard to the subparagraph.
4. Married filing separate can split costs 50-50
5. Limitation on Passenger Vehicles
 Not over $25,000
 Not too large
6. Adjustments made for inflation
IV. Recapture
a. If the depreciation exceeds the disposition price, then the overage will be
reflected in the gain from the sale.
b. The gain in the sale will be taxed at ordinary income rates. §§ 1245, 1250.
c. The seller’s recapture resulted in a time value of money situation where the
seller reported more depreciation than the actual decline in the value
i. Resulting in a reduction in tax in the preceding years.
V. Property for personal use
a. Dual use property must pro rata allocation of the basis for each business and
personal uses.
b.
Conversion of personal to business – depreciation is the lesser of the FMV or
the adjusted basis.
VI. Land and Buildings
a. Land is not depreciable because it does not have wear and tear
b. Buildings are depreciable and the adjusted basis in the property must be
properly allocated to the land and buildings.
i. In proportion to their respective market values
VII. Antiques
a. Not depreciable because impossible to determine useful life.
VIII. Vehicles
a. Limit on depreciation for luxury autos. § 280F
i. Size limit – 6000 lbs. or less (cars and not trucks)
ii. Intended to exempt farm trucks and such from being used for personal
trips.
1. Didn’t contemplate the monster SUV from hitting the roads
 Had to limit the depreciation due to the Hummer craze.
IX. Ownership
a. Capital investment owners only. No ownership, no depreciation.
Amortization of Intangibles
Newark Morning Ledger v. Comm’r – Allowing Amortization of Subscriber List
I. Facts
a. Newspaper company wanted to amortize the subscriber list, stating that it had
its own value.
II. Holding
a. Permitted because the TP could prove the value and useful life of the asset but
noted that the TP burden of proof often will prove too great to bear.
III. Notes
a. Amortization
i. When a company purchases an intangible asset, it is considered a capital
expenditure.
ii. Rather than expense the purchase cost all at once, a company must
amortize it over the life of the asset.
iii. Amortization is the method used to determine how much of the asset’s
acquisition cost can be written off annually.
iv. This amortized amount is used as a tax deduction to reduce the
company’s taxable income.
v. Called amortization because intangibles don’t have wear and tear.
IRC § 197 – Amortization of Goodwill and Other Intangibles
I. Permitting (or requiring) 15-year amortization for intangibles (subject to certain
exceptions).
Depletion
Types
Cost Depletion
I.
Estimates the total amount of natural resource in the property and allows
deduction of its cost in proportion to each year’s extractions.
a. Total number of units recoverable / Basis = Basis per unit
b. Basis per unit * number of units sold in tax year = deduction for depletion
Percentage Depletion
I. Allows the deduction of a specified percentage of the gross income from the
property year after year without regard to the recovery of the cost.
a. Remains deductible even after the basis has been recovered
b. Percentage determined by the type of resource. § 613(b)
c. Percentage depletion is limited to 50% of the taxable income from the property
for minerals other than oil and gas. § 613A
i. Not available for oil and gas
d. Percentage depletion provides a subsidy to those using the method.
Intangible Drilling Costs (IDC’s) and Exploration
I. IDCs for oil & gas wells are deductible. §263(c) & Reg. §1.612-4.
a. Cf., exploration.
II. §617 permits a current deduction of hard mineral exploration expenses.
a. Deducted expenses must be “recaptured” when production commences.
III. What is a development expense?
a. Answer: The cost of preparing the site for production or extraction. See §616.
Interest Expense
General Structure
IRC § 163 – Interest
I. Deduction allowed for all interest paid or accrued within a taxable year on
indebtedness
II. Installment Purchases where the interest is not readily ascertainable is calculated
to have 6% interest on the average unpaid balance for the year calculated
monthly.
a. For educational services or personal property.
III. Limitations
a. For TP other than a corporation, the deduction cannot exceed the net
investment income of the TP for that year.
i. Can be carried over to next year
b. Investment interest must be from:
i. Interest paid or accrued on indebtedness allocable to property held for
investment
ii. Not Include:
1. Qualified residence
2. Interest from passive activities under § 469
iii. Does include personal property short sale
IV. §163(h) Exception: Disallowance for interest for personal interest.
a. §163(h)(2)(D) Exception to Exception: Qualified Residence interest is not
“personal interest” within the meaning of §163(h)
IRC § 163(j) – Earning Stripping Limitations (Business Interest)
I. “Earnings-stripping” is business interest paid to related party.
a. Postpones deduction for “disqualified interest”.
II. 163(j) limit: business interest income + 30% ATI + floor plan financing interest
III. What is “business interest”?
a. Business interest includes debt from unrelated party loans.
i. Old law restricted this to only unrelated party debt guaranteed by the
parent company, but now it includes all debt.
b. Business interest does not include interest from trade or business as
employee, interest related to electing real property business, electing farm
business interest, interest related to furnishing electrical energy, water, or
sewage or gas or steam or transportation of gas or steam by pipeline.
IV. Small Business Exception
a. 3-year average gross receipts < $25 million.
V. §163(j) is applicable to all taxpayers regardless of form (special rules apply for
partnerships and S Corporations) and regardless of whether interest is paid to
related or unrelated parties.
VI. Explanation
a. Generally, interest expense is deductible just like any other expense
i. Except where interest is required to be capitalized, like construction
b. § 163(j) limits the interest deductible by businesses
i. Business interest income + 30% of ATI (EBITDA) + Floor Plan Financing
Interest = Maximum Business Interest Expense
1. Floor plan financing is a revolving line of credit that allows the
borrower to obtain loan for retail goods/inventory.
2. These loans are made against a specific piece of collateral (i.e. an auto,
RV, manufactured home, etc.).
3. The loan advance against that piece of collateral is repaid when each
piece of collateral is sold by the dealer.
ii. Disallowed interest can be carried forward indefinitely.
Investment Interest
IRC § 163(d) – Limitations on Investment Interest
I. Limited to net investment income
a. With indefinite carry forward
II. Net Investment Income
a. Total Investment Income – Total Investment Expenses
III. Passive Activity Income is not investment interest
IV. Net capital gains or dividends are not included
a. Unless TP elects to do so under § 163(d)(4)
Estate of Yaegar v. Comm’r – Investor Interest has Limits
I. Facts
a. Taxpayer traded stocks for his own account. He purchased undervalued stock
and held until stock traded at fair value. He often provided business advice to
companies he invested into. Margin debt ranged from ~$42 million in 1979,
~54 million in 1980, and he had margin debt of ~70 million at his death.
b.
1979 1980
c. LTCG
$13,839,658 $1,099,921
d. STCG
184,354
728,404
e. Dividends
2,339,080
3,648,441
f. Interest
57,958
91,717
g. Director Fees
10,660
II. Issue
a. Was the taxpayer’s interest expense subject to §163(d)’s limit?
III. Holding
a. Court said “yes” because Yaeger was an investor, not in trade or business of
buying and selling stock.
b. The two fundamental criteria distinguishing traders and investors of stocks
are:
i. The length of the holding period, and
ii. Source of the profit
1. Traders profits are derived from the direct management of purchasing
and selling
2. Investor profits are from interest, dividends, and capital appreciation
of securities
IV. Note
a. Deduction under §163 is not a miscellaneous itemized deduction. See
§67(b)(1).
Rev. Proc. 72–18 – Interest Expense for Tax Exempt Bonds
I. Rev. Proc. 72-18 states that Section 265(a)(2) denies an interest deduction for debt
incurred to purchase tax-exempt bonds. But, in applying this restriction, this
revenue procedure provides that there must be “direct evidence” that indebtedness
was incurred to purchase tax exempt bonds and absent direct evidence Section
265(a)(2) would not be applied.
II. Direct evidence exists in two instances:
a. Direct evidence of a purpose to purchase tax-exempt obligations exists where
the proceeds of indebtedness are used for, and are directly traceable to, the
purchase of tax-exempt obligations.
i. Section 265[(a)](2) does not apply, however, where proceeds of a bona fide
business indebtedness are temporarily invested in tax-exempt obligations.
b. Direct evidence of a purpose to carry tax-exempt obligations exists where taxexempt obligations are used as collateral for indebtedness.
Personal Interest Expense for Home
I. §163(a) Allows interest expense deduction generally.
II. §163(h)(1) Disallows interest expense deduction for personal interest
III. §163(h)(2) Exception: interest on a qualified residence is excepted from §163(h)(1)’s
prohibition up to a cap of $750,000 of acquisition indebtedness. See §163(h)(3)(F).
IV. Examples
a.
b.
EXAMPLE A: A buys a house for $1.5 million, with a down payment of
$300,000 and a loan of $1.2 million. Acquisition indebtedness accounts for $1
million (which is the limit) of the loan. Tax Court in Pau v. Commissioner, 73
T.C.M. 1819 (1997) said that $1 million is the overall cap that applies. But, in
Rev. Rul. 2010-25, 2010-2 C.B. 571, the IRS indicated it would allow $1.1
million via treatment of the extra $100,000 as a home equity loan. (Cap of
$750,000 through 2025).
EXAMPLE B: B buys a house for $300,000, with a loan of $115,000 and the
remaining $185,000 from her savings. A month later she borrows $125,000,
secured by the house. The entire amount of the first loan ($115,000) is
acquisition indebtedness. The second loan ($125,000) is a home equity loan.
Under the law through 2025, no deduction is allowed for home equity
indebtedness per §163(h)(3)(F).
Personal Interest Education Loans
I. §221(a) allows deduction for an individual for educational loans.
II. §221(b)(1) limits the deduction to $2,500.
III. §221(b)(2) subjects this deduction to phase-out as income rises (full phase-out for
individuals at $65,000 and for MFJ at $130,000).
a. If someone other than a college student makes the interest payment, then it is
treated as a gift. See Reg. §1.221-1(b)(4)(i).
Economic Substance Doctrine
IRC § 7701(o) – Economic Substance
I. The transaction must have economic substance or the business purpose that is
substantial in respect to the tax benefit
a. True indebtedness cannot just be for tax shelter purposes
II. Sham Transaction Doctrine – courts do not recognize sham transactions with no
economic substance and being used only as a tax shelter
III. When Congress was granting deductions for interest, was looking to do so for
transactions with real economic substance
a. Taking the plain language of the statute and imputing Congress’ intent on it
Knetsch v. U.S. – Transaction Must Have Economic Substance
I. Facts
a. Knetsch will pay an insurance company ~$140,000/year interest ($294,570
over two years) and will receive an increase in cash surrender value of his
annuity contracts of ~$100,000 a year ($203,000 over two years) that he
borrowed against to partially pay this annual interest. Why would anyone
enter into the deal?
II. Holding
a. Denied interest deduction on grounds that transaction lacked economic
substance. “Plainly, therefore, Knetsch’s transaction with the insurance
company did ‘‘not appreciably affect his beneficial interest except to reduce his
tax. . . .’’
III. Question: How did this transaction artificially reduce Knetsch’s taxes?
a.
Knetsch had a circular flow of cash, in which he was taking interest
deductions off of payments made from borrowed funds
b. He borrowed on a non-recourse basis; and never intended to pay it back –
which would have been a year 4 issue
c. Court said this was a sham transaction – and to just use it as a tax shelter
IV. Subsequent Events: See §72(e)(2); §7701(o).
Goldstein v. U.S. – The Economic Substance Can Include Tax Planning
I. Facts
a. Tillie Goldstein: Won Irish Sweepstakes ($140,218.75).
b. Tillie borrowed two loans (totaling $945,000 to purchase $1 million of US
Treasuries bonds that were pledged as collateral for the loans.
c. Tillie prepaid the first two years of interest of ~$81,000. The purpose of the
plan was to shield the sweepstakes winnings in the year of receipt by reducing
net income for that year, with the expectation that the profit when the
investments were subsequently closed could be reported as long-term capital
gain.
II. Holding
a. Not allowed.
b. There was no purpose to gain economic benefit other than doing an end-run
around the tax code.
c. Transactions were not shams as conducted by true independent parties with
independent significance.
i. However, “[o]n the other hand, and notwithstanding Section 163(a)’s broad
scope, this provision should not be construed to permit an interest
deduction when it objectively appears that a taxpayer has borrowed funds
in order to engage in a transaction that has no substance or purpose aside
from the taxpayer’s desire to obtain the tax benefit of an interest
deduction: and a good example of such purposeless activity is the
borrowing of funds at 4 percent in order to purchase property that returns
less than 2 percent and holds out no prospect of appreciation sufficient to
counter the unfavorable interest rate differential.”
d. §163(a) of the IRC does not permit a deduction for interest paid or accrued in
loan arrangements, like those now before us, that cannot with reason be said
to have purpose, substance, or utility apart from their anticipated tax
consequences.
i. But, deductibility of interest is permitted when a TP has borrowed funds
and incurred an obligation to pay interest if such action was done in order
to engage in what with reason can be termed purposive activity – even if
TP decided to borrow in order to gain an interest deduction rather than to
finance the activity in some other way.
ii. Doesn’t mean TP can’t borrow for the purpose of gaining, just means
ALSO has to be able to be seen “with reason” as some sort of “purposive
activity”.
e.
Expands Knetsch from just attacking sham transactions to transactions that
may be real, but have no non-tax business motivation (only motivation is the
tax benefit)
f. By frontloading her interest payments, and leaving the investment without any
expenses incurred in year 3 – she will have interest income with no deduction
in the later years
i. But it will be much less; so she will benefit from the lower bracket over
these years
ii. She will have income with no deductions in the later years
g. Ultimately a losing transaction; but it was more valuable to lose this money
than to have to pay a higher tax bracket over the next three years
h. Congress used plain language for all interest paid – but she still lost here
i. Not a sham, but the transaction did not have any economic substance
here
1. P. 592 – paragraph starting with “We hold…anticipated tax
consequences.”
2. “Mixed motives” on p. 592
ii. Judge gave a purposive meaning of the statute here – if they just used the
plain language here you think she would have won
i. How do you reconcile this with Cottage Savings?
i. It seems that Cottage Savings was trying to get the tax benefit to match
the economic reality
1. So here, the court came behind the transaction with no business
purpose – and doesn’t match economic reality; probably going to get
overturned as here
IRC § 7872 – Below Market Rate Loans
I. Treats forgone interest as transferred from lender to borrow and then retransferred
as interest payment from borrower back to lender.
II. The transfer from lender to borrower is treated, for tax purposes, as a sham
transaction. See §7872(c).
a. Exception for loans of less than $10,000. See §7872(c)(2).
III. If loan < $100,000, then forgone interest is limited to borrower’s investment
income. See §7872(d)(1)(A).
Losses
Existence and Amount
IRC § 165 – Losses
I. Deduction allowed for any loss sustained during the year and not compensated for
by insurance or otherwise
a. Amount is the adjusted basis – disposition compensation
i. No more than adjusted basis, regardless of FMV.
b. For individuals, limited to losses:
i. Incurred in trade or business
ii. Any transaction entered into for profit, not connected with trade or business
iii. Property losses from fire, storm, shipwreck, or other casualty, or from theft.
1. This one is limited by (h).
c. Loss occurs at time of realization
i. Courts look for a definitive or identifiable event identifying a closed
transaction or no reasonable prospect of recovery.
ii. Theft is at time of discovery.
II. Businesses
a. Loss of Goodwill cannot be deducted until entire company is sold.
b. Net operating losses (NOL) can be carried forward. § 172.
c. Deductible from gross and not AGI.
i. Taken even if itemized.
d. Considered ordinary losses and not capital losses (which are limited)
Business/Investment v. Personal Losses
Personal
I. No deduction for personal losses – other than casualty loss as part of a federal
declared disaster (see §165(h)(5)).
Business
I. What happens when a personal residence is converted into a “rent house”?
a. The residence was purchased primarily as home and not a profit-making
venture. Considered Personal Loss
b. The property must be appropriated to income-producing purposes. Reg. §
1.165–9(b)(1)
II. What happens when the rent house is converted into the personal residence and a
sales loss is incurred?
a. Same as II above.
III. What happens when portions are used for:
a. business and personal purposes?
b. The property losses must be allocated to each respectively.
Gambling Losses
IRC § 165(d) – Gambling Losses
I. No deduction allowed.
II. Limit on deduction to amount of gambling gains – during the tax year.
III. How prove the gambling losses?
a. Ticket stubs and such.
b. Need to make sure that the stub doesn’t have heel print on it (picked up off
ground at race track)
IV. What about the tax treatment of professional gamblers?
a. Expenses are deductible (and including an NOL deduction), but only to extent
of gambling income. See §165(d).
b. Note that it says gains and not winnings. There may be a gain from the
transaction that would not be a winning.
Hobby Losses
Storey v. Comm’r – Hobby Loss Must not be for Profit
I. Facts
a. Taxpayer was a law partner who engaged in film production.
II. Holding
a. Concluded that activity was engaged in for profit.
b. Court Analysis. Applies the Reg. §1.183-2(b) factors – at p. 380.
Reg. § 1.183 – 2(b) – Relevant Factors for Activity Not Engaged in for Profit
I. Any activity other than one with respect to which deductions are allowable for the
year under § 162 or 212.
a. “it is not intended that only the factors described in this paragraph are to be
taken into account in making the determination, or that a determination is to
be made on the basis that the number of factors indicating a lack of profit
exceeds the number of factors indicating a profit objective, or vice versa.”
(explains Nickerson decision)
b. Manner in which the TP carries on the activity
i. The fact that the taxpayer carries on the activity in a businesslike manner
and maintains complete and accurate books and records may indicate that
the activity is engaged in for profit....
c. Expertise of the TP or TP’s advisors
i.
d.
e.
f.
g.
h.
i.
j.
k.
Preparation for the activity by extensive study of its accepted business,
economic, and scientific practices, or consultation with those who are expert
therein, may indicate that the taxpayer has a profit motive where the
taxpayer carries on the activity in accordance with such practices....
Time and effort expended on the activity by the TP in carrying on the activity
i. The fact that the taxpayer devotes much of his personal time and effort to
carrying on the activity, particularly if the activity does not have substantial
personal or recreational aspects, may indicate an intention to derive a
profit....
ii. The fact that the taxpayer devotes a limited amount of time to an activity
does not necessarily indicate a lack of profit motive where the taxpayer
employs competent and qualified persons to carry on such activity.
Expectation that assets used in activity may appreciate in value
The success of the TP in carrying on other similar or dissimilar activities
TP’s history of income or losses wrt the activity
The amount of occasional profits, if any, which are earned
The functional status of the TP (the fact that the TP does not have substantial
income or capital from sources other than the activity may indicate that an
activity is engaged in for profit)
Elements of personal pleasure or recreation
i. The presence of personal motives in carrying on of an activity may indicate
that the activity is not engaged in for profit, especially where there are
recreational or personal elements involved.
ii. On the other hand, a profit motivation may be indicated where an activity
lacks any appeal other than profit.
iii. It is not, however, necessary that an activity be engaged in with the
exclusive intention of deriving a profit or with the intention of maximizing
profits....
Keeping of financial records is not dispositive, but Wells thinks it is REALLY
important and should be close to dispositive
IRC § 183(a) – Activities Not Engaged in for Profit
I. generally, if an activity is not engaged in for profit, no deduction attributable to
such activity shall be allowed except as provided
l. §183(b) allows deduction for hobby losses to extent of hobby income
i. The problem with hobbies is that you have more expenses than income
Nickerson v. Comm’r – Must Show Adequate Profit Motive Exists
I. Facts
a. Advertiser purchased farm and lost money on the farm for 10 years
b. Claimed deductions for the farm losses against his advertising salary
II. Holding
a. Found that Nickerson was in a trade or business.
b. Standard of review: clearly erroneous for Tax Court to have said anything other
than this person was in a “trade or business”.
c. Even though this is a fact question, the circuit court decides this was a for
profit motive
i. He only did it on the weekends
ii. But he was performing manual labor – so they only saw this guy doing this
to make money in the long run
iii. Judge says he is looking at “common sense” – looking to Posner’s “life
experiences”
1. Ironic – because it depends on whose common sense you are looking to!
2. Here they decide as a matter of law it isn’t reasonable for someone to
work outside without a profit motive
d. He was likely doing it for long term gains
Plunkett v. Comm’r – Business v. Personal
I. Facts
a. Plunkett engages in mud racing in the “super modified division.” Also, taxpayer
competes as a truck puller.
II. Holding
a. Truck pulling a business, but mud racing is just a hobby (not trade or
business)
i. It was easier to make money in the truck pulling competition
ii. Plunkett is nationally renowned in truck pulling the nation
b. IRS argues that this is something he does for fun on the weekend
i. Court resolves this by weighing the factors:
1. He had employees (his son helped him fix vehicles)
2. He didn’t keep formal business records
III. Framework of Truck pulling
a. For truck pulling he can deduct ATL because it is a trade or business expense
under §162 (which would reduce his AGI)
b. For mud racing he can deduct his hobby losses under §183(d) only as an offset
to the income of that activity
i. NOTE this is an itemized deduction subject to the limitations of §§67 (on
misc. item) & 68 (overall)
c. Other than farming – where is this a hotly contested issue?
i. Horseracing
ii. Buying the horse and deducting it against your salary
iii. If it is a hobby – it is only deductible against what you win in the Kentucky
Derby
Casualty Losses
Amount of Casualty Loss
Reg. § 1.165 – 7(b) – Casualty Losses
I. For individuals, currently only allowed for Presidentially declared disaster
II. The amount of the deduction is limited to the lesser of:
a. The FMV immediately before casualty – FMV immediately after casualty, or
b. tax basis from sale or disposition
c. If for business or income and totally destroyed, and FMV immediately before is
less than Adjusted Basis, then use Adjusted Basis.
III. Consider the appreciated property lost in casualty – deduction is limited to basis.
IV. No loss if an insurance recover?
a. Use difference between casualty and amount recovered
b. No possibilityPossible casualty gain (with insurance)?
V. Note: Personal casualty losses for individuals are allowed only if part of a federal
declared disaster through 2025. See §165(h)(5).
Rev. Rul. 2009-9 – Bernie Madoff
I. Is a loss from criminal fraud or embezzlement in a transaction entered into for
profit a theft loss or a capital loss under §165? Yes.
a. §165(a) allows deduction for losses sustained during the taxable year not
covered by insurance or otherwise
b. §165(c)(2) allows deduction for losses incurred in a transaction entered into for
profit
c. §165(c)(3) allows deductions for transactions not for profit; including theft
losses
d. “Theft” = general word – any criminal appropriation of property
e. Taxpayer need not show conviction of theft – just criminal intent
f. Disposition of worthless stock after criminal/fraudulent activities by a company
doesn’t qualify as this type of loss – this would be a capital loss (not a theft loss
allowable under §165)
g. This case different than that – B took A’s property by criminal acts
II. Is such a loss subject to either the personal loss limits in §165(h) or the limits on
itemized deductions in §§67 and 68? No.
a. §165(h) imposes two limitations on casualty loss deductions
b. (h)(1) & (h)(2)
c. However, this theft loss was entered into for profit – and thus was deductible
under §165(c)(2); and not just (c)(3)
d. (c)(3) is subject to the (h) limitations (c)(2) is not
e. A theft loss is not allowable under §62 and thus is an itemized deduction
f. And thus subject to §§67 & 68 limitations
g. §165(c) losses are specifically exempt from §§67 & 68 – so not subject to
limitations here
III. In what year is such a loss deductible? Year of discovery as long as no reasonable
prospect for recovery.
a. §165(e) allows a loss arising from theft is deductible in the year it is discovered
b. EXCEPTION: §1.165-8(a)(2) AND §1.165-1(d) – if in the year of recovery there is
a reasonable prospect of recovery; the deduction will be limited by the amount
thought to be recoverable
c. EXCEPTION: If the amount recovered is the same or less than what was
anticipated – it is not included in gross income
d. If it is greater – it is included in gross income
e. §111; §1.165-1(d)(2)(iii)
IV. How is the amount of such a loss determined? Basis less amount reasonably
expected for recovery.
a. §1.165-8(c) says theft loss is calculated just like a casualty loss in §1.165-7
b. Consider the value of the property to be immediately 0 after theft – taxpayer
gets deduction of their basis in the property
c. In stock investment cases you get:
d. Initial investment + any additional investments + and income included on tax
return (as a result of reported income) LESS (-) any disbursements, reasonably
anticipated recoveries, withdraws
V. Can such a loss create or increase a net operating loss under §172? Yes.
a. Theft loss deduction allows for a carryback of 3 years and a carry forward of 20
years
VI. Does such a loss qualify for the computation of tax provided by §1341 for the
restoration of an amount held under a claim of right? No.
a. The application of §1341 only applies when there is an obligation to restore
income
b. Here the deduction which A is entitled to did not arise out of the requirement to
restore income – so §1341 does not apply
VII. Does such a loss qualify for the application of §§1311-1314 to adjust tax
liability in years that are otherwise barred by the period of limitations on filing a
claim for refund under §6511? No.
a. §§1311-1314 allow for the mitigation of errors made in previous years barred by
the statute of limitations
b. Theft losses do not qualify under these provisions
U.S. White Dental – When Can You Claim a Loss?
I. Facts
a. German government seized business assets when in March 1918.
b. Taxpayer wrote off entire investment in 1918 but pursued remedies.
c. Assets returned in 1922 but were now worth only $6,000.
d. In 1924, taxpayer was awarded a $70,000 judgment but collectability of that
judgment was uncertain.
e. IRS asserted that the loss was not deductible in 1918 as the matter was not
part of a closed and completed transaction.
II. Holding
a. allowed deduction in 1918. Test is an “objective” worthless standard but is a
“flexible practical one.”
b. the loss taken by the company was within the meaning and was granted the
deduction on the loss / allowed in 1918
c. Losses claimed incurred in trade or business must usually be evidenced by a
closed and completed transaction
i. No closed transaction in this case as the assets were seized by a foreign
government – court held there were additional considerations to be had
d. Surrounding and attendant circumstances indicate debt is worthless and
uncollectable, and legal action to force payment in all probability would not
result in satisfaction – showing this would allow deduction §1.165-1(d)(2) p.
1136
i.
If there is a reasonable prospect of recovery exists, no claim for a deduction
exists (question of fact) – then until the loss can be defined; you do not have
a loss under §165
ii. Can’t claim a deduction just because of the loss of value of property
iii. Mere fluctuation in value is not enough
e. Germans seized property – no idea if they were ever to receive the property back
i. Company doesn’t have to show eventual recoupment of assets
f. Court not requiring the taxpayer to wait to see if there is recoupment – to be an
“incorrigible optimist”
g. What year should the company get the deduction?
i. IRS argues for the earlier year (Iran example) – because the statute of
limitations had run
ii. If it was your client you would claim a deduction in the later year and file a
protective return for the earlier year to prevent the barring by the statute of
limitation
Limitations to Prevent Abuse
Fender v. U.S. – Anti-Abuse Limits on Losses – Substance over Form
I. Facts
a. Taxpayer had a trust sell unrated bonds to a friendly bank and repurchased
those same bonds 42 days later.
b. Statutory limitation provisions were not applicable:
i. §267 (no related parties) &
ii. §1091 (wash sale loss rule of 30 days not applicable).
II. Holding
a. Taxpayer did not have an economic disposition that represented a cessation of
interest that was meaningful and thus the loss was disallowed.
i. Court relies on a tax “common law” rule – no real economic loss and,
therefore, no realized tax loss.
III. Statutory Restrictions:
a. §267 (p.399): Related Party Losses
b. §1091 (p.400): Wash Sale Rules
c. §1092 (p.400): Straddle Rules
d. §1211 (p.400): Capital Losses
Related Taxpayers
I. Transactions between related TP’s not allowed deductions. § 267
a. Courts also have found that the use of an intermediary is prohibited – Indirect
Sale
Capital Losses – Combine with At Risk and Passive Loss
I. Deduction restricted (by individuals) to capital gains, plus $3000 of ordinary
income. §1211
a. May be carried forward indefinitely. §1212
Tax Shelter Losses
Tax Shelters
I. Objective of tax shelter investment: generate tax losses (but not real economic
losses) which can offset other ordinary income.
a. (Remember the Tufts case).
II. Investment vehicle is an LP or an LLC - limitation of liability and conduit
treatment.
III. What is an “abusive tax shelter”? P.394
Tax Shelter Objectives and Techniques
I. Income shifting (to low taxed taxpayer)
II. Exemption of income
III. Deferral of income recognition or acceleration of deductions
IV. Conversion from ordinary income into capital gain (tax rate arbitrage).
V. Leverage – debt included in tax basis - remember the Tufts case.
Frank Lyon v. U.S. – Ownership Required
I. Facts
a. Lyon owned building leased to Worthen Bank. Sale and leaseback and a
purchase option by lessee at end of 15-year term at set price (not then FMV).
b. Option prices (at various intervals) equaled the then unpaid mortgage balance
plus 6% return on Lyons 500x investment.
c. Only the building (not land) owned by Lyon.
II. Holding
a. IRS says Lyon not the true owner, but Sup. Ct. says Lyon is the owner.
b. This was a sale and leaseback, rather than a loan transaction.
IRC § 465 – At Risk Limitation Rule
I. Loss deduction only to the extent of the amount at risk.
a. Sometimes TP are not personally liable for the debt that they incurred.
b. That TP is only allowed to deduct to the extent that the TP was personally at
risk.
II. “At risk” is only to the extent of:
a. cash investment,
b. basis of contributed property,
c. personal liability debt, and
d. assets securing nonrecourse borrowings.
III. Deduction limitation rules, not a basis rule (e.g., Crane doctrine is not impacted).
IRC § 469 – Passive Loss Limitation
I. Passive activity losses in excess of passive activity income are not deductible.
II. Passive activity:
a. taxpayer does not “materially participate” and rentals (regardless of material
participation).
i. Material participation
1. where 500+ hours spent on the activity.
2. Substantially all of the activities compared to all of other individuals
3. More than 100 hours which equals or exceeds participation of others
4. Significant participation (more than 100 and less than material) and
combined participation exceeds 500 hours
5. Materially participated in any five of last 10 years
6. Materially participated in personal service activity
7. Not a ltd. partner.
III. Special §469(i) $25,000 loss allowance rule.
IV. Passive activity income not including portfolio income.
Bad Debts
Generally
IRC § 166(a) – Bad Debt – Ordinary Loss – Short Term Capital Loss
I. business bad debt deduction treated in full as an ordinary loss; nonbusiness bad
debt is deductible as a short-term capital loss.
a. See Generes case (p.428) re business or non-business debt choice.
i. Dominant motive must be business related.
1. Here, lending was primarily for investment and not to save job.
2. Note the “facts & circumstances” analysis.
b. Cf., the business of money lending and bad debts incurred as being business
bad debts.
To Be a Business Bad Debt
I. Dominant Business Motivation
a. Significant not enough
b. Compare with investment (person who lends for investment in company rather
than business related)
II. Trade or Business
a. Person must be in the trade or business
i. Several loans – Not enough
ii. Substantial amount of time
iii. Advertising
iv. Separate office
v. Keeping books
vi. Holding one’s self out as participating in that business
1. Tax return said executive and not lender
Loans to Friends and Family
I. Loan or gift to a family member? How document the loan promissory note and a
market rate interest and an actual payment of interest by the debtor?
II. What about a loan “guarantee”? Cf.,
a. trade or business guarantee,
b. transaction for profit or
c. personal situation guarantees.
III. Code §271 – no deduction for bad loans made to political organizations. Why?
a. Because “in substance” these in nondeductible political campaign
contributions.
Existence of Loan and Basis
I. Must be bona fide debt with debtor-creditor relationship
II. Must have valid and enforceable obligation to pay
III. No deduction for debt worthless when acquired
a. Or for unpaid wages or rent
Loan Guarantees
I. Treated the same as business bad debt
a. Guaranty agreement must be related to trade or business for business bad debt
II. Agreement related for profit but not business – nonbusiness bad debt
III. Payments based on personal motivation not deductible.
IV. Must have reasonable consideration
V. Deduction only in year that payment is made and only in the amount paid.
Voluntary Cancellation of Debt
I. TP who voluntarily cancels a debt is not allowed to take deduction for bad debt.
Timing
I. The debt must become worthless in that taxable year
a. Must show that had value at beginning and not at the end of the year
Personal Deductions
Standard Deduction
IRC § 63(c) – Standard Deduction
I. as indexed for inflation for:
a. joint return ($24,000) for 2018),
b. head of household ($18,000),
c. unmarried individuals ($12,000) and
d. married filing separately ($12,000, & neither spouse can itemize).
II. Objective of the standard deduction - tax administration simplification (including
removing some from tax liability) & tax rate adjustment.
Personal Exemption and Qualifying Child Credit
IRC § 151 – Personal Exemptions
I. The 2017 Tax Act set the exemption at zero through 2025. See §151(d)(5).
II. §24 provides a $2,000 tax credit for each child under the age of 17, but this credit
is phased-out for high-income taxpayers
a. AGI greater than $400,000 for MFJ and above
b. $200,000 for all other taxpayers.
c. The tax credit is partially refundable.
Earned Income Tax Credit
IRC § 32 – Earned Income Tax Credit
I. A “refundable credit” – i.e., file a tax return and get a rebate (even with no income
tax liability).
II. §32 provides for allowance of the credit – amount depending upon
a. number of dependent children and
b. income limitations/phaseouts.
III. Objective – reduce Social Security taxes on the poor.
a. A pro work incentive?
b. Cf., welfare payments.
Baker v. Comm’r – Must have Principal Place of Abode with Child
I. Facts
a. Petitioner land Ms. Wus had two children, lived part of the year together but
apart for the remainder of the year.
II. Holding
a. Petitioner was ineligible for the EITC because the taxpayer did not maintain “a
principal place of abode” with the child for more than one-half of such taxable
year” as required by §32(c)(3)(A)(i) and (ii) and (B)(i)(I).
Elderly and Disabled Credit
IRC § 22 – Elderly and Disabled Credit
I. Provides a credit for the elderly and the disabled – up to 14% of the §22 amount.
II. This amount is $7,500 for a joint return – subject to reduction for Social Security
and pension benefits which are excluded from gross income.
Education Credit
IRC § 25 – Education Credit
I. provides Opportunity Tax Credit of up to $2,000 for the first $2,000 of tuition and
provides an additional credit for 25% of the next $2,000 of tuition for a maximum
credit of $2,500
II. This credit is phased out for single taxpayers with income above $90,000 and for
joint filers with income above $180,000.
III. A taxpayer is ineligible to claim a deduction for education expenses under §222 if
that person claims a tax credit under §25.
Personal Itemized Deductions
Taxes
IRC § 164 – State and Local Tax Deduction
I. allows a deduction for state and local taxes but §164(b)(6) caps the deduction to
$10,000 through 2025.
II. State and local (personal & real) property taxes are deductible - even though
related to personal consumption items.
III. Property taxes are based on ownership - but are not imposed at the federal level. Is
this property tax equivalent to a wealth tax?
Who Has the Deduction?
Reg. § 1.164 – 1(a) – Deductions
I. Parent pays real estate taxes incurred by daughter. Who has the deduction?
II. Taxes are only deductible by the person upon whom they are imposed. Reg.
§1.164-1(a).
III. Treat this payment as
a. a gift to daughter (not included in her gross income, §102), and
b. (for income tax deduction purposes) as if the real estate taxes are actually paid
by the daughter?
Charitable Contributions
IRC § 170 – Charitable Contributions
I. Issues
a. Is the recipient eligible for a contribution?
i. §170(c); and 501(c)(3)
1. §170(c) – gift to State, US, political subdivision (e.g. Universities)
2. (c)(2)(B) – religious, charitable, scientific, literary, educational purposes,
amateur sports
 SAME AS §501(c)(3) – what the organization will file with the IRS to
get the designation of a charitable organization and will publish a list
every year
i. Churches DO NOT have to file
ii. Determining what organizations you can make a gift to that is eligible as a
charitable organization
iii. Does not include an individual (e.g. homeless person on the street) – just
groups/organizations that qualify
b. Is a percentage limitation applicable to deduction against AGI?
i. §170(b)
1. 2 Main Limitations:
 If contribution to a broad public charity (think United Way) – the
amount of charitable contribution cannot exceed more than 50% of
AGI
i. If more, then you have to carry it over
 If a private (smaller) charity (established by an individual; e.g. the
Ford Foundation) – amount of contribution cannot exceed 30% of AGI
c. What is the type of donated property and is any special percentage or other
limitation applicable because of the type?
i. General rule, if you donate property you get deduction for FMV at time of
disposition
ii. §170(e) – EXCEPTION – if property would generate ordinary income if you
sold it then you only get deduction limited to the basis in the property
1. If you sold a capital asset, which would give a capital gain – these get a
FMV contribution
2. But if you give inventory away – that would be limited to the basis
iii. Not restricting someone to getting the benefit of the gain if it would be
eligible to preferential rates
d. What is the specific type of eligible charitable donee?
i. Skipped the eligibility standards – more focused on if the gift to the charity
qualifies as a charitable contribution deduction
II. Justification
a. Partnering type idea, the government doesn’t have to collect taxes and spend
the money on these things to improve the community
b. Are there any arguments against charitable contributions?
i. It is a personal consumption decision
c. Think: Is the charitable contribution tax deduction justified? Is the charitable
contribution a consumption item for tax purposes? Is the contribution a
substitute for direct governmental support? What other reasons exist for
allowing a charitable contributions deduction? (e.g., to facilitate wealth
redistribution? To circumvent constitutional concerns?) Is this item a tax
expenditure?
Timing and Intent – Quid Pro Quo Analysis
Hernandez v. Comm’r – Detached and Disinterested Generosity?
I. Facts
a. Payments made to the Church of Scientology to obtain services such as
"auditing" and "training,” based on the Scientology "doctrine of exchange”.
II. Holding
a. An identifiable benefit was received & no tax deduction was available.
i. Correct result? Note §§170(f)(8) & 6115.
ii. Church Defined on p. 462
III. Athletic “Booster Club”:
a. Note 3(c): Opportunity to purchase college football tickets was originally ruled to
be deductible in full. Rev. Rul. 86-63.
b. But, Congress responded to allow 80% deductible via §170(l).
i. How does one value the “opportunity” to purchase the football tickets made
available to the donor by the donee university? Why are athletic tickets
treated differently?
Ottawa Silica v. U.S. – Indirect Benefit Still Quid Pro Quo
I. Facts
a. Ottawa Silica mined silica sand and owned a bunch of property; and they
donated about 50 acres of their property to the expanding city (local govt) to
build a high school
b. But the company did so knowing that the city would build roads, which would
make the mining property much more valuable
II. Issue: Was this a charitable contribution?
III. Holding:
a. No. TP received a substantial benefit in return and this this was not a
charitable contribution.
b. If the land is relinquished to induce action by the public agency or charity, it
may not be deducted as a charitable contribution.
IV. Define substantial benefit:
a. A substantial benefit is one that is greater than those that inure to the general
public from transfers for charitable purposes.
i. Those benefits that inure to the general public from charitable contributions
are incidental to the contribution, and the donor, as a member of the
general public, may receive them.
ii. It is only when the donor receives or expects to receive additional
substantial benefits that courts are likely to conclude that a quid pro quo for
the transfer exists and that donor is therefore not entitles to a charitable
deduction.
V. No donative intent here, as there was a substantial benefit to be received by Ottowa
Silica (IRS’ argument)
a. They cited the Singer case:
i. Singer donated sewing machines to a school and claimed them as a
charitable contribution
ii. Court said no – because there was an expectation of a future sales
1. Essentially advertising to the students so they purchase the machines
down the road – they are the retail market of the future
iii. There is a substantial return benefit here – not given with detached and
disinterested generosity (standard from Duberstein)
VI. There was going to be an enhanced value to the Ottawa property as a result of
these donations
Other Holdings
I. Naming rights is not enough to retain a substantial benefit
a. Still a charitable contribution
b. Naming rights and advertising can be a difficult line to determine
II. Just telling people you gave a charitable contribution doesn’t cancel it either
a. Remember – if the thing being benefited is your property/inventory, then it may
be a substantial benefit (as it provides a specific benefit to a specific
product/property) and not be deductible
i. George Mitchell and The Woodlands example
§170(l) – Athletic Event Tickets – May Be Disallowed Currently
I. Charitable contributions to have the right to buy the ticket at a college
a. Case law we have looked at would not classify it as a charitable contribution (if
they were a requirement to buy the ticket – the tickets will not be sold “but for”
the contribution)
II. Congress enacted this to deal specifically with this quid pro quo
a. You get 80% of the donation that you make to have the right to buy the tickets
(required charitable contribution)
III. This is explicitly for schools of higher education (NFL CANNOT do this same thing)
a. Why wouldn’t the school just charge the whole value for the ticket price?
i. Huge incentive to alumni to pay for the tickets to get the tax benefits – get a
tax deduction to go to the ballgame!
Lombardo v. Comm’r – Must Have Donative Intent
I. Facts
a. Lombardo arrested for selling pot; in his plea bargain he was required to give
$145,000 to the Board of Education
i. If he didn’t do this, he would go to prison
II. Holding
a. No charitable or donative intent. Payment was made to stay out of jail.
b. Lombardo tried to claim it as a tax deduction as a contribution to an
educational institution
i. School is definitely an eligible recipient for a charitable contribution
c. He was not; even though it was a true loss to Lombardo
i. It wasn’t detached and disinterested generosity – it was in order for him to
avoid prison
ii. Doesn’t represent donative intent
d. Did the criminal court judge have the authority to state that this wasn’t
donative intent?
i. Probably not – the max payment under statute was just $5,000 – but
ultimately didn’t matter and there was enough evidence to go to the donor’s
intent at the time of the transfer
Services Contributions
I. Contribution of services to charity.
II. No deduction is available for the value of the contributed services. Reg. §1.170A1(g).
III. Deduction would produce a double tax benefit since value of the services is not
included in donor’s gross income (under §61(a)).
a. Cf., the deduction rule for the charitable contribution of certain appreciated
property to certain charities.
Contribution of Appreciated Property
IRC § 170(e) – Contributions of Ordinary Income and Capital Gain Property
I. General Rule: Deduction is FMV.
a. §170(e)(1)(A) Exception: Limited to basis if gain would not be long term capital
gain.
b. §170(e)(1)(B) Exception: Limited to basis if tangible personal property that will
not be used by charity.
c. §170(e)(5) Exception: Limited to basis for any appreciated property to a private
foundation other than marketable securities.
Questions – Contribution of Appreciated Property
I. T contributes stock with an adjusted basis of $100 and a fair market value of $300
to the Red Cross, a public charity.
a. Answer #1: If the stock has been held for more than a year, it would have
produced long-term capital gain when sold and thus T’s charitable deduction is
$300.
b. Answer #2: If the stock had been held for only six months, the $300 fair market
value is reduced by the appreciation of $200, which would have been treated as
a short-term capital gain had the stock been sold. Thus, T’s deduction is limited
to his basis of $100.
II. (Same as (1) except property is a painting and Red Cross does not intend to hang
the painting.
a. Answer: Since T held the painting for more than a year, the appreciation would
have been taxed as long-term capital gain if the painting had been sold. But,
the charity does not intend to use this tangible personal property in its
charitable function, so the deduction is limited to $300 minus the long-term
capital gain of $200 or T’s $100 basis.
III. T contributes the same painting in (2) to an art museum.
a. Answer: If T held the painting for a year or less, the amount of the charitable
deduction is only $100 because the fair market value is reduced by the shortterm capital gain. If held the for more than a year, the deduction is the full
$300 unless the museum sells the painting in the year of contribution the
deduction is limited to $100 unless it could certify that the related use is
impractical. If the museum sells the painting two years after the contribution,
the deduction would be $300, but in the year of sale the donor would recapture
$200 as taxable income.
IV. T contributes real estate with a basis of $100 and a fair market value of $300 to a
private foundation.
a. Answer: Because property other than marketable securities has been donated
to a private foundation, the deduction is reduced by the amount of the capital
gain.
Limitations on Contributions
I. Percentage Limitations on this Deduction:
a. Generally 50% (raised to 60% for cash) of the contribution base Public charities
- §170(b)(1)(B); (G).
b. 30 percent or a lesser percentage.
c. A “ceiling” rather than a “floor.”
II. Important Variables in Making Deductible Charitable Contributions:
a. cash or other property?
b. is the donee a public or a private charity?
Charitable Gift of Partial Interests
I. Tangible personal property
a. no deduction shall be allowed for a contribution of an undivided portion of a
TP’s entire interest in tangible personal property unless all interests in the
property are held immediately before such contribution by (i) the TP or (ii) the
TP and the donee.
b. Remainder interest gift - See Code §170(a)(3), restricting a current deduction.
II. Trusts, etc.
a. Code §170(f) limitations re partial interest gifts
i. Income interest to charity.
ii. Remainder interests to charity - CRATs & CRUTs (Code §664(d)).
iii. Charity remainder in a residence or farm.
Self-Created Asset Donated to Charity
I. Painter donates his own self-created painting to the charity auction. 20x tax basis
& 300x FMV.
a. See Code §1221(a)(3). Not a capital asset (since self-created).
b. Sale would produce ordinary income.
II. Donor can deduct only to the extent of the donor’s tax basis for the self-created
asset. See Code §170(e)(1)(A).
a. Cf., gift of one’s personal & business papers to charity? §1221(a)(3).
Medical Expenses
IRC § 213 – Medical Expense
I. Provides a deduction for medical expenses in excess of 10% of the taxpayer’s
“adjusted gross income.”
a. Cf., §165(h)(2) 10% loss floor.
II. Medical expense is a uniquely personal cost, but the cost is (partially) deductible.
Why?
a. Same thought process behind casualty losses – you typically have day to day
medical expenses; but significant events should be deducted as they will affect
your ability to pay
i. Not a consumption item?
ii. Yes, but
iii. Consider the “tax expenditure” cost.
What is a Medical Expense?
I. §213(d)(1)(A) – medical care defined
a. Amounts paid for diagnosis, cure, mitigation, treatment, or prevention of a
disease
b. Transportation to and from hospital
c. Parking
II. §213(d)(9) - Cosmetic surgery
a. To correct injury/abnormality would be a medical expense
i. E.g. burn victim and needs skin graft – would fall under this deduction
ii. Cleft lip
b. Improving appearance/Elective Cosmetic Surgery does not fall under the
purview of this provision
III. Other Definitions of Medical Care (these are all deductible medical expenses)
a. Stop smoking program – IS MEDICAL CARE – Rev Rul 99-28
b. Birth control? See code §213(b) & (d)(3) re prescribed drugs
c. Psychological Counseling?
IV. Limitation to lodging under §213(d)(2)
a. not lavish, $50 per night
b. No similar limitation on the transportation costs, so long as they are reasonable
V. Not Considered Medical Expense
a. Travel from the cold north to warm weather during the winter as a prescription
i. Courts have held this is not a medical trip
b. Cost for general fitness v. specific cure – a line in the sand
i. General fitness is NOT a deductible expense
1. E.g. working out at the gym and taking supplements
c. Activities have to be medically necessary
i. ACL tear and physical therapy – could be a medical type event
VI. Additions to Residence
a. Swimming pools example of split in the circuits on the basis of diving boards
and swimming pools being in the area.
b. Assuming that the swimming pool is medically necessary, and you do get the
medical itemized deduction, the increase in the market value of the property is
tax deductible. (medically necessary capital assets)
VII. Deduction for medical insurance premiums.
a. Code §213(d)(1)(D), (6) & (7).
b. Self-employed coverage costs - §162(l).
VIII. Medicare contributions.
a. Code §213(d)(1)(D).
IX. Long term care premiums. p.144
a. Code §213(d)(1)(C) & (10).
Morrisey v. U.S. – IVF Related Expenses Not Medical
I. Facts
a. Man paid for services related to IVF and tried to deduction them as medical
expenses.
II. Holding
a. No. The services did not affect his own body and the other people are not
sufficiently related to the TP to be covered under the law.
Taylor v. Comm’r – Lawn Care Not Medical Expense
I. Facts
a. Taxpayer instructed by doctor to not mow his lawn, so taxpayer deducted the
lawn care costs as a medical expense deduction.
II. Holding
a. Hell No.
Whose Income Is It?
Who is the Taxpayer?
Identification Choices
I. Choices for possible income/deduction shifting:
a. spouses;
b. children;
c. other family members;
d. family entities (trusts, corporations & partnerships)
II. Alternative: the entire family (how defined?)
a. Cf., perspective of other cultures
III. Tax Rate Comparison
a. Rate Brackets and Marginal Rates for individuals – Code §§1(a)-(d) & (h)
b. Marginal rates - tax rate applicable to the last taxable dollar.
i. Cf., effective rate (or average rate).
c. Tax rates for corporations: Code §11.
The Taxable Unit
I. Taxation of the Family, etc.
a. Druker v. Commr. – p. 496 – concerning the constitutionality of the marriage
penalty.
b. Married, filing separately taxpayers, but used “unmarried
II. individual” rates - §1(c).
a. Note Poe vs. Seaborn (p.497) and ½ allocation of community income among
spouses.
Poe v. Seaborn – Community Income & Property Splitting Allowed
I. Rule: Community property and income, however derived, may be divided
equally between spouses for federal tax purposes.
II. Facts: Husband and wife filed separate tax returns for the year in which they each
claimed one half of the income earned for the year; and deducted the other half of
the property as expenses
a. The couple lived in Washington which was a community property state
III. Holding: The split of the income into community property here was valid; as the
state was not reassigning the fruit like in the previous case
a. Here it was a matter of state law, with no tax payer discretion, the income was
assigned elsewhere
b. Split Income and Joint Returns
c. Determination of Marital Status
Rev. Rul. 2013-17 – Same-Sex Couples
I. Historically, the IRS stated that the Defense of Marriage Act prevented the IRS from
allowing same-sex couples from filing tax returns as married couples
II. California changed its law to allow community property between same-sex couples,
and the IRS said that they would respect this income-splitting in C.C.A.
201021050.
III. In U.S. v. Windsor, the Supreme Court held that section 3 of DOMA violates the
principles of equal protection.
IV. In Rev. Rul. 2013-17, issued on August 29, 2013, the IRS ruled that post-Windsor
that marriage would be construed to include same-sex marriages if the marriage
were entered into in a state that recognized such marriages. Once entered into,
that married status would be respected for federal tax purposes regardless of the
laws of the state where the couple resides.
The Marriage Bonus and the Marriage Penalty
I. Effect of joint return income tax status – twice the tax on ½ of combined income
II. Objective: To enable equality with community property jurisdictions – where an
automatic split of the income occurs under state law
Marriage Penalty/Bonus: Code §1 (2018 Rates)
I. Bonus (only one earner): Single taxpayer & married taxpayer have taxable income
of $600,000 – 187,690 tax (single) vs. 161,379 (married); $26,311 benefit for
marrieds.
II. Historically, there was a marriage penalty if two equal earners were married versus
single, but current law eliminates that historic penalty. Example: Two single
taxpayers and each married taxpayer has income of $300,000 – single taxpayers
have 80,689.50 tax each (total – $161,379); married taxpayers have $161,379 of
tax on $600,000 of combined income; under 2018 law, no penalty for two-income
marrieds.
Reasons to Treat Married Couples Differently:
I. Costs of children (limited to marriage?)
II. But, imputed income of the “non-working” spouse; provide deduction for the
second wage-earner?
III. Costs of working for both spouses (rather than collecting investment income).
a. Should the “ability to pay” tax liabilities be based on the wealth accession for
the “family unit”?
b. Should parents be required to include income of minor children? §73 provides
for separate taxpayer treatment of the child.
Innocent Spouse Relief
I. Joint spousal tax return means joint and several liability for the several spouses.
II. What if an “innocent spouse” does not know of unreported income of the other
spouse? Code §6015 innocent spouse relief.
a. Code §66 for community property innocent spouse relief – if income not shared
with other spouse (§66(b)).
Taxing Children
I. Net unearned income of the under age 18 (previously 14) child is taxed at the
parent’s marginal income tax rate and not at the child’s tax rate (assuming the
parent’s marginal tax rate to be higher).
a. Why is this provision applicable only to unearned income?
b. What tax planning techniques can be used to avoid this rule?
c. Growth stock investments?
II. Dependent Personal Exemptions (p. 511) available under §152 if parent provides
more than half of the child’s support for the year, but remember these are not
allowed through 2025 by reason of §151(d)(4).
III. Child Tax Credit under §24.
Dissolution of Marriage
I. §7703(a)(2) – “an individual legally separated from his spouse under a decree of
divorce or of separate maintenance shall not be considered as married.”
II. Rev. Rul. 76-255, p.507 – was the annulment/divorce real for federal tax
purposes? Holding divorce and remarriage in long-term marriage situation was a
sham divorce arrangement.
Sham Marriage Transactions
Boyter v. Comm’r
I. Facts
a. Taxpayers got divorced in Haiti in December 1975 and came back home and got
remarried in January 1976. Taxpayer then got divorced in Dom. Rep. in
November 1976 and got remarried in February 1977. Taxpayers claim they were
unmarried at the end of 1975 and 1976 and filed as single taxpayers. IRS
argued that the taxpayers were taxable as married individuals regardless of
what state law would say.
II. Holding
a. Upheld IRS
b. Sham Transaction Doctrine
Alimony & Support
Gould v. Gould
I. no deduction and no income inclusion of alimony. Support payments made to the
former spouse are:
a. not income to the recipient, and
b. are not deductible to the payor.
II. But, Gould v. Gould was decided before Glenshaw Glass. Does that matter?
a. What about transfers to a current spouse?
b. These items do constitute an accession to the wealth of the recipient (former)
spouse.
III. Prior law changed this result to provide that “alimony” is included in gross income
of recipient and provided a deduction to payor.
IV. The 2017 Tax Act changed the law again to now provide no income for the recipient
(old §61(a)(8) deleted) of alimony and no deduction for payor (old §215 repealed).
Income Tax Treatment
I. No deduction and no income inclusion for child support and all other payments. All
alimony & non-alimony payments (as alimony is defined in the tax code) made to
the former spouse are:
a. not income to the recipient, and
b. are not deductible to the payor.
II. These items do constitute an accession to the wealth of the recipient (former)
spouse.
III. Custodial parent entitled to child’s dependent personal exemption but parents can
agree otherwise but the exemption is not allowed through 2025 per §151(d)(4).
Property Settlement Issues
I. Federal tax issues concerning income & property allocation upon divorce:
a. Income inclusion for alimony and deduction for payor?
b. Treatment of child support payments – deduction? Income?
c. Tax treatment of property divisions.
II. Code §1041 concerns transfers of property between divorced spouses.
III. Davis case as the predecessor - treating the property transfer in the divorce context
as a gain recognition event.
IV. Code §1041 provides
a. no recognition occurs to the transferor on the property transfer, and
b. a transferred tax basis applies to property held by the recipient.
U.S. v. Davis – Taxable Divorce?
I. Issue: Is transfer of separate property to estranged spouse taxable?
II. Holding: Transfer of appreciated property to spouse (pursuant to a separation
agreement that was later incorporated in a divorce decree) was a taxable
disposition on which the husband realized and recognized gain equal to the excess
of the property's fair market value over its adjusted basis.
III. Subsequent Events: the Davis case was largely supplanted by Congress in 1984,
when it enacted§1041 to provide nonrecognition of realized gains and losses on
transfers of property between spouses or, if the transfer is incident to a divorce,
between former spouses.
IV. Remaining Validity: Davis continues to control transactions between spouses that
fall outside the aegis of § 1041 (e.g., transfers to a nonresident alien spouses and
an antenuptial transfers of property in settlement of any later-arising marital rights
is not expressly covered by § 1041).
IRC § 1041 – Property Transfers at Divorce
I. Code §1041 concerns transfers of property between divorced spouses.
II. Davis (p.511) case as the predecessor - treating the property transfer in the divorce
context as a gain recognition event.
III. Code §1041 provides:
a. no recognition occurs to the transferor on the property transfer, and
b. a transferred tax basis applies to property held by the recipient.
Example
I. John and Martha own investment property.
a. Blackacre – 90x basis and 100x fair market value (appreciated).
b. Greenacre – 110x basis and 100x fair market value (depreciated).
c. They sell the properties to third parties, split cash equally and then divorce.
d. On a joint return they report 10x gain and 10x loss and no tax liability. They
divide the proceeds equally.
e. On separate returns each has 5x gain and 5x loss and no tax liability. They
divide the cash proceeds equally.
II. Divorce
a. Martha takes Blackacre and John takes Greenacre and they divorce and then
they sell the properties to third parties.
b. Martha has all the gain. John has a loss (from the loss property), but only
deductible to the extent of $3,000 per year (unless other capital gains).
i. The split is unequal on an after tax basis.
Farid Es Sultaneh v. Comm’r – Tax Basis Received Pre-Nuptial is FMV at Time
I. Issue: The tax basis for shares received in pre-nuptial transfer.
II. What timing of
a. stock delivery and
b. agreement?
III. Effective as of the pre-nup?
IV. Why was a tax basis step-up permitted to her for the stock she received (and not a
transferred tax basis attributable to a gift transfer, i.e., §1015)?
V. Held: FMV basis at time of receipt of stock.
a. What did she transfer as consideration?
b. Treatment to him on the stock transfer?
Accounting Problems – When Is It Income or
Deductible?
The Taxable Year
The Sanctity of the Annual Accounting Period
Burnet v. Sanford & Brooks – Accounting Period Must be Recognized
I. Facts
a. From 1913 to 1916, Sanford & Brooks Company (S&B) (plaintiff) performed
contractual work for the United States government (government).
b. The government failed to adequately compensate S&B for the contract
expenses.
c. Consequently, S&B’s federal tax returns showed net losses for 1913, 1915, and
1916. S&B sued the government to recover its losses on the contract and was
finally reimbursed in 1920 for those losses. S&B did not report the
reimbursement as part of its gross income for 1920, reasoning that federal tax
law imposed income taxes only on the net profits of a transaction.
d. The reimbursement compensated S&B for its losses on the contract, but left
S&B with no net profit. The commissioner of internal revenue (commissioner)
(defendant) determined that S&B should have included the reimbursement in
its gross income for 1920, and assessed back taxes. S&B petitioned the Board
of Tax Appeals for review, which ruled for the commissioner. S&B appealed. The
United States Court of Appeals for the Fourth Circuit reversed, holding that the
reimbursement was not income to S&B, but rather a return of S&B’s losses on
the contract. The United States Supreme Court granted certiorari to review.
II. Holding
a. A federal taxpayer’s income must be assessed annually, even if it is derived
from a multiyear transaction from which the taxpayer ultimately makes no
profit.
III. Reasoning
a. A federal taxpayer’s taxable income is assessed annually, even when it is
derived from a multiyear transaction from which the taxpayer ultimately makes
no profit. Income tax must be consistently assessed each tax year based on a
taxpayer’s income and tax-deductible expenses for that year.
b. This applies regardless of whether a taxpayer’s income and expenses relate to a
transaction that is completed in a single year or a transaction that continues
over several years.
c. A taxpayer could make a net gain on a multiyear transaction in one year and
lose money in the next year, with or without a net profit. There is no reason
why a taxpayer’s liability for tax payments on a multiyear transaction should be
deferred until the transaction is concluded.
d. The government relies on annual accounting because this method regularly
ascertains and produces tax revenue upon which governmental operations
depend.
e. The government cannot realistically be expected to defer its receipt of tax
revenue until a taxpayer’s transaction is concluded, which may be years into
the future.
f. In this case, S&B was able to deduct its 1913, 1915, and 1916 losses on the
multiyear transaction from its gross income for those years. S&B cannot escape
paying taxes on the reimbursement in 1920, even though the reimbursement
simply offset S&B’s earlier losses and the contract was ultimately not profitable
for S&B. Therefore, S&B must pay back taxes on the reimbursement.
IV. Response
a. Code §172(a) provides a net operating loss carryover that can exclude up to
80% of the taxable income in the carryover year.
b. Code §172(b) allows indefinite carryforward of net operating loss but a two-year
carryback only for farming losses.
c. Code §172(c) and (d) defines an NOL to exclude certain capital losses and
certain nonbusiness bad debts.
The Tax Benefit Rule and the Inconsistent Events Rule
Tax Benefit
I. When a TP deducts an amount from income in one year and recovers or fails to pay
the deducted item in a later taxable year.
II. The amount recovered or not paid must be included in income in the later year.
III. Sometimes, there could be a hardship related to the imposition of a particular tax
year.
a. Relaxing the fundamentality of the rule may create inconsistent events in future
years.
Inconsistent Events Rule
I. The tax benefit rule does not require an economic or physical recovery of an item or
a cancellation of a liability
a. All that is required is that the event be fundamentally inconsistent with the
earlier deduction.
Bliss Dairy
I. Facts
a. Bliss Dairy deducted under § 162 the full cost of cattle feed purchased for use
in its operations.
b. Bliss adopted a plan of liquidation in the next taxable year and distributed a
substantial amount of remaining feed to its shareholders in a nontaxable
transaction.
c. The IRS asserted that Bliss Dairy should have taken into income the value of
the feed distributed to its shareholders.
II. Issue: Should Bliss Dairy have taken into income the value of feed distributed to its
shareholders?
III. Holding
a. Yes.
IV. Reasoning
a. The § 162 deduction is predicated on the consumption of the asset in the trade
or business. If the TP later sells the asset rather than consuming it in
furtherance of his trade or business, it is quite clear that he would lose his
deduction, for the basis of the asset would be zero, so he would recognize the
full amount of the proceeds on sale as gain.
b. In general, if the TP converts the expensed asset to some other, nonbusiness
use, that actin is inconsistent with his earlier deduction, and the tax benefit
rule would require inclusion in income of the amount of the unwarranted
deduction.
c. While § 162(a) permits a deduction for ordinary and necessary business
expenses, § 262 explicitly denies a deduction for personal expenses. Thus, if a
corporation turns expensed assets to the analog of personal consumption, as
Bliss did here, it would seem that it should take into income the amount of the
earlier deduction.
d. However, Bliss tried to be sneaky through § 336 “gain shielding” (not
important). But the court analyzed it and said nah, §336 does not permit a
liquidating corporation to avoid the tax benefit rule, so yeah you gone have to
pay up.
Hillsboro
I. Facts
a. Hillsboro National Bank (bank) (plaintiff) was incorporated in Illinois. Hillsboro’s
shareholders were subject to a state property tax on their shares.
b. Hillsboro paid the property tax on behalf of its shareholders, and then deducted
the payments from its federal income taxes.
c. In 1970, the state repealed the property-tax law, but the repeal did not take
effect until 1973. From 1970 to 1973, the state continued to enforce the
property tax and escrow property-tax collections.
d. When the repeal finally took effect, the state refunded the escrowed property
taxes directly to Hillsboro’s shareholders, not to Hillsboro itself. Hillsboro
reasoned that it had recovered none of its 1970-1973 tax payments, and
therefore did not need to report the tax refunds as income. The commissioner of
internal revenue (commissioner) (defendant) determined that the refunds
should have been included in Hillsboro’s tax return.
e. Hillsboro petitioned the tax court for a redetermination. The tax court ruled for
the commissioner, and the United States Court of Appeals for the Seventh
Circuit affirmed. The United States Supreme Court granted certiorari.
II. Issue: If a federal TP’s prior deduction is fundamentally inconsistent with an event
that occurs in the current year, must the amount of the deduction be included in
the TP’s income for the current year?
III. Holding
a. Yes.
IV. Rule: “Inconsistent Events Rule”: If a federal TP’s prior deduction is fundamentally
inconsistent with an event that occurs in the current year, the amount of the
deduction must be included in the TP’s income for the current year.
V. Reasoning:
a. A tax deduction claimed in a prior year must be included in the taxpayer’s
income for the current year if an event occurs in the current year that is
fundamentally inconsistent with the prior deduction.
b. The federal tax system relies on annual accounting. However, a single year’s
taxes may relate to a multiyear transaction. A tax deduction taken in an earlier
year of a multiyear transaction may require reconsideration in light of an event
that takes place in a later year of the transaction.
c. The tax-benefit rule is intended to provide transactional equity in this type of
situation. Under the tax-benefit rule, a taxpayer is required to offset a deducted
expense that is recovered in a later year by including the amount as income in
the later year.
d. In this case, Hillsboro deducted its property-tax payments from 1970 to 1973.
When the property-tax law was repealed, Hillsboro did not recover its prior
payments. However, this is irrelevant. If the state had not collected property
taxes between 1970 and 1973, Hillsboro could not have deducted any amounts
for those years.
e. The repeal of the property tax is fundamentally inconsistent with Hillsboro’s
prior deductions. Therefore, Hillsboro must offset the tax benefit it received
from its 1970-1973 deductions by including the amount of those deductions in
its current taxable income. Accordingly, the judgment of the court of appeals is
affirmed.
Clark v. Comm’r – Recovery of Nondeductible Items
IV. Facts
a. Clark was married and asked professional to do taxes
b. Professional made error in filing joint or single and made unallowable deduction
V. Holding
a. The amount received from the professional is not considered income.
i. It is compensation for a loss incurred due to negligence
b. The notion that this was an Old Colony Trust payment of taxes is clearly
erroneous.
i. Clark OVERPAID taxes to the gov’t.
ii. Clark received his reimbursement from the professional instead of the IRS.
Dobson v. Comm’r – Tax Benefit Rule Limitations
I. Facts
a. Taxpayer purchased 300 shares of stock and found the stock was not registered
correctly and recovered $45,150.63
i. $23,296.45 allocable to 100 shares taxpayer had sold in 1930 (prior tax
deductible loss of $41,600.80)
ii. $6,454.18 allocable to 100 shares sold in 1931 (prior tax deductible loss of
$28,163.78)
iii. $15,400 related to 100 retained shares.
b. IRS treated $15,400 received for the 100 retained shares as a return of capital
but treated the amounts received for sold shares as income.
II. Issue: Must the proceeds of the settlement attributable to shares sold in 1930 and
1931 be attributable to gross income?
III. Holding
a. No, not in this case. The tax court found that the TP realized no taxable gain
from the 1939 recovery because it was a return of capital from which TP
realized no gain or income either actually or constructively and TP received no
tax benefit from the prior loss deductions and the Supreme court says that “no
statute/regulation/principle of law compels the Tax Court to find taxable
income in a transaction whereas a matter of fact it found no economic gain and
no use of the transaction to gain a tax benefit.”
b. The court talked a lot about how the Tax Court decision was a question of
accounting/fact and how the appellate court should have given deference to the
decision instead of reversing it just because they disagreed with how the Tax
Court found the questions of fact.
c. Rule: “Tax Benefit Rule”: Recoveries/reimbursements for losses are taxable only
to the extent that the previous years’ losses produced a tax benefit – i.e., a
reduction in taxes in the earlier years.
d. Transactions are treated as closed and completed transactions because of the
sanctity of the accounting period, but the tax treatment of the subsequent
transaction will be colored in light of the earlier transaction.
e. Exclusionary Prong: (§111) A recovery of loss in a later year is excluded from
gross income to the extent the earlier deduction produced no tax benefit.
f. Inclusionary Prong: (Alice Phelan/Hillsboro/Bliss Dairy) A recovery in a later
year is included in gross income if the loss in the earlier year produced a tax
benefit.
g. Inconsistent Events Rule (see below)
h. Reasoning: According to the Court, the question that the Tax Court decided was
“purely an accounting problem and therefore a question of fact for the Tax
Court to determine”: “What, in the circumstances of this case, was a proper
adjustment of the basis?” The court says that evidently, the Tax Court thought
that the previous deductions were not altogether “properly chargeable to capital
account” (see § 1016(a) provision for adjustment of basis in capital assets) and
that to treat them as an entire recoupment of the value of TP’s stock would not
have been a “proper adjustment” of basis, and the Court thinks there is
substantial evidence to support such conclusion as made by the Tax Court.
Alice Phelan
I. Facts
a. Alice Phelan Sullivan Corp. (corporation) (plaintiff) is a California corporation. In
1939 and 1940, the corporation made donations of two parcels of realty.
b. The corporation took deductions in the amount of $4,243.49 and $4,463.44 for
each charitable donation.
c. In 1939, the corporate tax rate was 18 percent. In 1940, it was 24 percent.
Under these tax rates, the corporation received a total tax benefit of $1,877.49.
d. In 1957, the donee returned both parcels to the corporation. The corporation
did not include the value of the parcels in its gross income for that year.
e. The Commissioner (defendant) determined the two parcels were income equal to
the amount of deductions taken in 1939 and 1940, which totaled $8,706.93.
f. The Commissioner applied the 1957 corporate tax rate of 52 percent and
assessed a tax of $4,527.60. The corporation paid the tax but filed suit for a
refund of $2,650.11, arguing that it should not pay in excess of the tax benefits
received in 1939 and 1940.
II. Issue: Under the tax-benefit rule, what year’s tax rate are recovered items of
income taxable at?
a. Note: Inclusion of returned charitable donation in donor’s gross income? Yes,
to extent of lesser of earlier deduction or fair market value of property.
III. Holding/Rule
a. Under the tax-benefit rule, recovered items of income are taxable at the rate
applicable at the time of recovery.
IV. Reasoning
a. In Perry v. United States, 160 F. Supp. 270 (1958), the Court of Claims ruled
that a taxpayer’s recovery of a prior charitable donation was taxable income to
the extent that the taxpayer previously deducted it in the year of donation.
b. It also held that the recovered income was taxable at the rate applicable when
the donation was made, not when the donation was recovered. The court
reasoned that the government is not entitled to receive more than what it had
previously lost by allowing the deduction.
c. It is well-established in tax law that recovered property that was once the
subject of a deduction is income in the year of recovery. The tax-benefit rule
limits this principle by excluding a recovered charitable donation from income if
the taxpayer did not receive a tax saving from the deduction.
d. But where the taxpayer has received a tax saving, the subsequent recovery of a
charitable donation is taxable as income to the extent of the deduction
previously taken.
e. Congress has codified the tax-benefit rule as applicable to bad debts, prior
taxes, and delinquency amounts. Corresponding regulations have expanded the
rule to apply to any losses, expenditures, and accruals that were once the
subject of deductions.
f. These regulations clearly encompass recovered charitable contributions that
were once the subject of deductions. Here, the corporation recovered charitable
donations in 1957. These donations were the subject of deductions in 1939 and
1940, and resulted in a tax saving of $1,877.49. Under the tax-benefit rule, the
corporation’s recovered properties are taxable income in the year of recovery.
g. The regulations, however, do not indicate whether the tax rate in the year of
donation or in the year of recovery should apply. This court holds that the tax
rate applicable at the time of recovery should apply.
h. A basic principle of taxation is the single-year concept, in which income and
expenses within one year are determined without regard to losses sustained in
an earlier year.
i. A corollary of this principle is that income must be taxed at the current tax rate
without regard to any prior tax rates. Accordingly, this court rules that the
corporation gained income in 1957 on the recovered parcels of realty, and that
the income is taxable at the rate applicable at the time of recovery. Perry v.
United States is overruled and the plaintiff’s suit is dismissed.
V. Short Version
a. Property transferred to charity
b. Charitable deduction claimed for tax
c. Property returned to donor
d. Inclusion in donor’s gross income?
i. Yes to extent of lesser of earlier deduction or fair market value of property
Modifications to the Tax Benefit Rule
I. Transactions treated as closed and completed transaction
a. but the tax treatment of the subsequent transaction will be colored in light of
the earlier transaction.
II. Two Prongs:
a. Inclusionary Prong (Alice Phelan/Hillsboro): A recover in later year is included
in gross income if the loss in the earlier year provided a tax benefit.
b. Exclusionary Prong (§111): A recovery of a loss in a later year is excluded from
gross income to the extent the earlier deduction produced no tax benefit.
Claim of Right Doctrine
North American Oil v. Burnet
I. Facts
a. In 1916, $171,979.22 placed with receiver. In 1917, funds paid to taxpayer but
government continues to contest liability. In 1922, government claims are
terminated.
b. Tax Rates:
i. 1916: 2%
ii. 1917: 6% plus 20%-60% surtax
iii. 1922: 12.5% with no surtax
II. Issue: When are the funds taxable to North American Oil Consolidated?
III. Holding
a. Taxpayer receives earnings under a “claim or right” (and, therefore, to be
included in gross income)
b. Deduction if subsequently repaid.
i. What if tax rates changed in the interim?
c. Net profits earned on a property held in receivership are taxable to the
taxpayer (and not the receiver) in the year the taxpayer unconditionally
receives the earnings.
d. Court holds taxes should have been paid in 1917 – because that is when
the taxpayer has a claim of right to the income
i. 1917 is the first year the taxpayer has complete dominion and control
over the funds, and they are asserting a right of ownership over the
funds
e. Net profits earned on a property held in receivership are taxable to the taxpayer
(and not the receiver) in the year the taxpayer unconditionally receives the
earnings.
f. Court holds taxes should have been paid in 1917 – because that is when the
taxpayer has a claim of right to the income
g. 1917 is the first year the taxpayer has complete dominion and control over the
funds, and they are asserting a right of ownership over the funds
h. Hypo: What happens if taxpayers receive the funds, and has to pay them back
in 1922?
i. Irrelevant; you are just looking as to the claim of right as to 1917
U.S. v. Lewis
I. Facts
a. What if tax rates change in the interim? See §1341 re claim of right doctrine
b. Lewis has to pay back $11,000 of a $22,000 bonus – which he asserted a
colorable claim of right to
i. So he was taxed as to the $22,000
c. If the amount is repaid, the amount of the repayment is deducted
i. This “trues up” the inconsistency of the over-inclusion of income
1. Recall, you don’t go back and amend the tax return
d. IRS was willing to give Lewis the deduction here
i. Lewis wanted to amend his taxes of the past year – but court says NO –
“income taxes paid on the annual accounting period” – this gives finality as
to that period
1. Burnet v. Sanford & Brooks
e. Lewis wanted to amend, as if he could he would get better rates
i. Rates skyrocketed due to WWII which is what the bonus was subjected to –
and tax rates fell in the year of payback; so his deduction was lower
1. What if the tax rates were higher?
 He would get a benefit and we would have never gone to court!
II. Rule: A taxpayer who receives earnings under a claim of right must include
the earnings as taxable income even if his right to retain the money is in
controversy.
III. Congress came in and changed this result in §1341
a. §1341(a)(1) – if item was included in GI for prior taxable year because it
appeared taxpayer had an unrestricted right to the item
b. §1341(a)(2) – the claim of right was incorrect to some extent
c. §1341(a)(3) – has to be amount over $3,000
d. After you get past this – you get the lesser of:
e. §1341(a)(4) – can get deduction in year 2; just like in Lewis OR
i. Would claim this if the rates are higher in the later year
f. §1341(a)(5) – The tax for the year without the deduction; and claim a credit to
the tax in year 2 – equal to the amount of tax you paid in the prior year (due to
the over inclusion of the income)
i. E.g. (Compute regular tax + credit for over tax in prior year)
ii. Will choose this one if the tax rate was higher in the prior year
IV. NOTE: This provision is complicated – but Congress is doing this to preserve the
prior year; but remedying the prior problem under Lewis
U.S. v. Skelley Oil
I. Facts
a. Skelly sold natural gas at regulated price and claimed percentage depletion on
those sales of 27.5%.
b. Skelly Oil had to repay a portion of these proceeds ($505,536.54).
c. Only $366,513.99 had been subject to tax in the earlier year (i.e., $505,536.54
* 72.5%).
d. Taxpayer claims a 100% deduction on the $505,536.54 repayment while IRS
claims that the repayment should only give rise to a $366,513.99.
II. Holding
a. Deduction limited to only 72.5% of amount of repayment under tax benefit rule
principles, citing Arrowsmith.