Themes and Big Questions
1) What should we tax? Some general considerations:
a) Is this regressive/progressive?
b) What does a tax on X incentivize?
c) Bigger base  lower rates; narrower base  higher rates
d) Obvious tax  easier to avoid (consumption tax only)
e) Hidden tax  people don’t worry about it as much (VAT)
f) Horizontal v vertical equity
2) The tax code affects basically everything
a) Big economic pictures and questions
b) American suburban life is driven by the tax code – subsidies for gasoline and
owning your own home make suburb living possible
c) Structure of corporate deals is driven by this (think tax-shelters)
d) State and local funding issues (municipal bonds)
3) Distinguishing between:
a) Gain or loss, realization, recognition, capital gains?
Introduction
4) History:
a) First income tax created during Civil War, but repealed after the war, and tariffs
were used instead.
b) Another income tax was passed in 1894 (Cleveland’s second term) after much
struggle. Tax was on only those people with a certain level of income, so it
basically amounted on a tax of the rich.
c) Pollock v. Farmers’ Loan & Trust Co. (SCOTUS, 1895) – declared the tax
invalid, in part because it was in essence a tax on property, and as such was not
levied on states in proportion to population, hence it violated the prohibition on
unapportioned direct taxes in Art I § 9 cl 4 of the constitution.
d) 16th amendment, 1913: “The Congress shall have the 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.”
e) Tax Reform Act of 1986 reduced the maximum marginal rate to 28%, but there
are ways of getting around this by certain “penalties.”
5) Percentage of federal revenue as taxes:
a) 1913:
2%
b) WWI:
20%
c) New Deal:
5%
d) WWII:
40%
e) After WWII: 18-19%
i) Essentially no changes since here. Clinton pushed it above 20% a bit. Bush
brought it back down to historic level of 18-19%.
ii) Unless we can somehow decrease Medicare and Medicaid expenses, however,
we need to get more money from somewhere.
6) How do you figure out how much tax you owe?
a) Basic definitions:
i) Gross income
ii) Exclusions – things that theoretically could be in gross income, but are not.
iii) Deductions – subtractions from gross income. Our tax code breaks these up
into two pieces because we want to treat the below-the-line ones differently.
This different treatment is done in two ways. First, you can get a standard
deduction (this year $10,700 for married jointly). Second, as your income
goes up, itemized deductions are phased out. Where something fits in (above
or below), matters. For instance, charitable donations are below the line. This
matters, because you can’t get a deduction for them unless you itemize, which
mostly only rich people do. So non-rich people who give to charity don’t get a
deduction for it.
(1) Above-the-line: mostly production-related expenses, like moving expenses
incurred for a job
(2) Below-the-line:
(a) Standard
(b) Itemized
(3) Note: exclusions and deductions are effectively the same thing.
b) General Process:
i) Calculate your gross income (§ 61). Things that don’t go into your gross
income are called exclusions. They never even make it into the calculation of
gross income.
ii) Subtract the amount of above-the-line deductions (§ 62). The result is adjusted
gross income. Note that above-the-line deductions are functionally the same
as exclusions. Exclusions are never included, atl deductions are included, then
subtracted.
iii) Next, do one of the following:
(1) Subtract standard deductions (§ 63(c)), or
(2) Subtract the below-the-line (itemized) deductions (§ 63)
(a) Calculate gross amount of allowable itemized deductions
(b) Subtract from that calculation the lesser of the following two:
(i) 2% of the amount by which the income exceeds and inflationadjusted threshold of $100k
(ii) 80% of the gross amount
iv) Subtract personal exemptions (§ 151). The result at this point is taxable
income. Calculating personal exemptions is a two-step process.
(1) Multiply personal exemption amount by the appropriate number of people.
(2) Reduce that amount by 2% for each $2500 by which AGI exceeds an
inflation adjusted threshold of $100k.
v) Apply the appropriate tax rate schedule to TI. If this TI includes capital gains
(§ 1222(11)), then apply the proper rate to them. At this point, you have
amount of tax owed.
vi) Subtract any credits from the previous step, to get total liability.
7) After Tax Income: The after tax income tells us something about what the tax system
is doing, but for that matter, even the pretax amount in a sense is affected by the tax
system, because if you know how the tax system will affect your income, it might
change how much work you do, or what type you do.
8) Average and marginal tax rates
a) What does average tell us about? Average tells us who’s paying what. These show
us about progressivity.
b) What does marginal tell us about? Marginal rates are important because they tell
us about behavior. Marginal tax rate is the rate that applies to the next dollar of
income earned. They are not in general equal to average rates. What are my
incentives to earn the next dollar? Marginal rates have nothing to do with
progressivity. Deduction phase-outs are used (ex in § 151) to increase (effective)
marginal rates beyond the maximum 28%. Disallowing deductions increases the
taxpayer’s taxable income, and hence, tax liability.
c) Was a time when marginal rate was 90%. People sometimes looked to this as
really socking the rich, but that wasn’t true. There were ways the rich could avoid
this. The marginal rate is now much, much lower, but the progressivity of the tax
is much stronger, because now the base is much broader—that is, the rich can’t
avoid the tax as easily. So even though marginal rates are lower, the progressivity
is higher.
9) Sources of authority
a) Constitution – 16th amendment as a response to Pollock, allows income tax based
not on number of people
b) Congress responded within months to pass IRC. IRC divided into sections. Courts
can’t overturn these laws unless they’re unconstitutional, but that’s never really an
issue.
i) Who interprets the code?
(1) Primary interpreter is the agency delegated to do so—treasury department.
IRS is part of treasury. Treasury issues regulations. Under Chevron, these
regs generally have the force of law.
(2) Lots of courts can interpret the code, which makes being a tax litigator
complicated, because it involves choice of forum.
c) Revenue Rulings. These are essentially baby fact patterns with a holding and an
explanation. These have no authority . . . if you don’t like it. If you like it, you can
rely on it. The IRS won’t go against its own ruling. But if you don’t like it, you
can challenge it and win . . . you’ll be stuck on audit, though. We won’t deal with
these much.
d) Private Letter rulings. No binding authority. Can go to IRS and get the results
from a fact pattern. They’ll sometimes give you a document with results. They’re
bound by it, but no one else is, and no one else can cite it for anything, even if
their fact-pattern is exactly the same.
10) Some basic theory:
a) “Ability to pay” – term used to describe the attribute that might justify requiring
some people to pay more tax than others
i) What does this term even mean?
(1) Narrow view – convenience in paying, such as holding liquid assets
(a) Problem: this incentivizes unliquidating your assets.
(2) Broad view – look to economic well-being
(a) Problem: what does this encompass? It’s hard to measure.
(3) Broader view – look at person’s underlying wage rate, the rate at which
you could earn money
(a) Problem: What in the world does that mean?!
ii) Assuming an agreed-upon definition of ability to pay, how do you implement
it?
(1) Income
(a) What is the definition of income?
(i) Receipts less allowances for the costs of producing those receipts
(ii) Sum of taxpayer’s consumption plus change in net worth, each
defined in terms of market value (Haig-Simons)
(b) The statutory concept of “taxable income” is influenced heavily by the
notion of ability to pay and its implementation via the notion of
“income.”
(2) Consumption
(a) Andrews – consumption tax is just an income tax with a deduction for
savings; that is, what of your income you don’t consume (savings),
isn’t taxed (deduction)
(3) Wealth
b) Tax Expenditure Budget
i) Concept is that all is taxable, and the deductions the government allows are
viewed as government expenses (since you are exempted from paying tax on
X, the government loses that $, so it’s an expense to them), and hence the $
must be included in the budget.
ii) The tax expenditure budget depends on the notion that there is a natural,
neutral, or normal income tax and that it is possible to identify departures
without great difficulty or dissent.
iii) This is a valuable tool in exposing tax policy issues.
c) Tax incidence – the ultimate burden; who really is burdened
i) Ex: tax incidence on production of refrigerators probably falls on the
customers of refrigerators, not on the manufacture; higher prices to customer
d) Taxable unit – the individual or group that is being taxed
i) Married people
(1) May file jointly or separately
(a) Married single-earner couples are better off than they’d be under a
system with one schedule
(b) Married couples with two incomes may face marriage penalty;
marginal rates for second earner are key here
ii) Heads of households
iii) Unmarried individuals
11) Compliance and Administration
a) No statutory limit on civil penalties; 6-year limit on criminal penalties
b) Taxpayer must pay interest on all underpayments
c) Taxpayer must pay penalty on any underpayment due to negligence; penalty may
be waived if taxpayer can show good faith
d) Taxpayer is generally entitled to the benefit of the doubt in a close call; taxpayer
may further undercut government’s basis for asserting fraud by “red flagging”
something on their return
e) Mistakes
i) Error becomes evident after report filed – correct in next year’s return
ii) Plain error in time of reporting – file an amended return
f) Judicial review
i) Tax court – available only if tax hasn’t been paid as of date of petition
(1) No jury trials
(2) Reviewable by fed circuit court of appeals, and ultimately by SCOTUS
(3) These are article III courts; judges have 15 year appointments
ii) Pay tax and sue for refund in fed district court, appeals to regular circuit court
iii) Pay tax and sue for refund in US Court of Federal Claims, appeals to federal
circuit
iv) Note: if you don’t want to pay the tax before contesting, you have to go to the
tax court
12) Related Code
a) § 1 – Tax rate schedules
i) § 1(a) – Married individuals filing joint returns and surviving spouses
ii) § 1(b) – Heads of household
iii) § 1(c) – Unmarried individuals (other than surviving spouses and heads of
household)
iv) § 1(d) – Married individuals filing separate returns
v) § 1(e) – Estates and trusts
vi) § 1(f) – phaseout of marriage penalty for 15-percent bracket; bracket
adjustments for inflation
(1) § 1(f)(1)-(7) basically talk about how to adjust for inflation, how to use the
CPI, how to round, etc.
(2) § 1(f)(8) – elimination of marriage penalty in 15-percent bracket; the way
it was before 2003, the 15% bracket for unmarried individuals was more
than half of the 15% bracket for married couples, so the unmarried people
got to include a higher proportion of income in the lowest bracket; this
fixes that
vii) § 1(h) – maximum capital gains rate
b) § 11 – tax on corporations
i) § 11(a) – corporate incomes are taxable
ii) § 11(b) – four corporate tax brackets
c) § 62 – definition of adjusted gross income
i) § 62(a) – adjusted gross income is, for an individual, gross income minus
allowed deductions, which include:
(1) § 62(a)(1) – trade and business deductions attributable to a trade or
business carried on by the taxpayer, if not consisting of the performance of
services by the taxpayer as an employee (basically these are the costs of
producing business income)
(2) § 62(a)(2) – certain trade and business deductions of employees
(a) § 62(a)(2)(A) – reimbursements to employees
(b) § 62(a)(2)(B) – expenses of performing artists
(c) § 62(a)(2)(C) – expenses of officials
(d) § 62(a)(2)(D) – expenses of elementary and secondary school teachers
for certain years
(e) § 62(a)(2)(E) – expenses of US armed forces reserve members
(3) § 62(a)(3) – losses from sale or exchange of property
(4) § 62(a)(4) – deductions attributable to rents and royalties
(5) § 62(a)(5) – certain deductions of life tenants and income beneficiaries of
property
(6) § 62(a)(6) – pension, profit-sharing, and annuity plans of self-employed
individuals
(7) § 62(a)(7) – certain retirement savings
(8) § 62(a)(9) – penalties forfeited because of premature withdrawal of funds
from time savings accounts or deposits
(9) § 62(a)(10) – alimony
(10)
§ 62(a)(11) – reforestation expenses
(11)
§ 62(a)(12) – certain required payments of supplemental
unemployment compensation benefits
(12)
§ 62(a)(13) – jury duty pay remitted to employer
(13)
§ 62(a)(14) – deduction for clean-fuel vehicles and certain
refueling property
(14)
§ 62(a)(15) – moving expenses
(15)
§ 62(a)(16) – archer MSAs
(16)
§ 62(a)(17) – interest on education loans
(17)
§ 62(a)(18) – higher education expenses
(18)
§ 62(a)(19) – health savings accounts
(19)
§ 62(a)(20) – costs involving discrimination suits
ii) § 62(b) – specifics regarding qualified performing artists
iii) § 62(c) – exceptions not treated as reimbursement arrangements
iv) § 62(d) – definitions re: education stuff (educator, school)
d) § 63 – taxable income defined
i) § 63(a) – generally, it means gross income minus deductions allowed by this
chapter, other than standard deduction
ii) § 63(b) – if you don’t itemize deductions, taxable income is adjusted gross
income minus the standard deductions and minus the deduction for personal
exemptions provided in § 151
iii) § 63(c) – standard deduction
(1) § 63(c)(1) – “standard deduction” is the sum of the basic standard
deduction and the additional standard deduction
(2) § 63(c)(2) – “basic standard deduction” defined
(3) § 63(c)(3) – additional standard deduction for aged and blind
(4) § 63(c)(4) – inflation adjustments
(5) § 63(c)(5) – limits on basic standard deduction for certain dependents, if
that dependent is claimed by another
(6) § 63(c)(6) – people not eligible for standard deduction
iv) § 63(d) – “itemized deductions” defined
v) § 63(e) – election to itemize
(1) § 63(e)(1) – must elect to itemize, or nothing gets itemized
(2) § 63(e)(2) – must elect to itemize on the tax return
(3) § 63(e)(3) – ways to change election after filing of the return
vi) § 63(f) – aged or blind additional amounts
vii) § 63(g) – marital status determined under § 7703
e) § 67 – 2% floor on misc itemized deductions
i) § 67(a) – misc itemized deductions allowed for individual only if they exceed
2% of adjusted gross income
ii) § 67(b) – “miscellaneous itemized deductions” defined (stuff relating to
interest, taxes, charitable contributions, medical expenses, impairment-related
work expenses, etc.)
iii) § 67(c) – disallowance of indirect deduction through pass-thru entity
iv) § 67(d) – definition of “impairment-related work expenses”
f) § 68 – overall limitation on itemized deductions
i) § 68(a) – if individual’s adjusted gross income exceeds applicable amount,
itemized deductions are reduced by the lesser of
(1) § 68(a)(1) – 3% of excess of adjusted gross income over applicable
amount
(2) § 68(a)(2) – 80% of amount of itemized deductions otherwise allowable
ii) § 68(b) – definition of “applicable amount”; adjusting for inflation
iii) § 68(c) – exception for certain itemized deductions
iv) § 68(d) – this section shall be applied after the application of any other
limitation on the allowance of any itemized deduction
v) § 68(e) – this section doesn’t apply to any estate or trust
vi) § 68(f) – phaseout of limitation, certain years
vii) § 68(g) – this section doesn’t apply to years after 2009
g) § 151 – allowance of deductions for personal exemptions
i) § 151(a) – “In the case of an individual, the exemptions provided by this
section shall be allowed as deductions in computing taxable income.”
ii) § 151(b) – exemption amount for taxpayer, and for spouse if a) no joint return
filed and b) if spouse has no gross income and is not the dependent of another
taxpayer
iii) § 151(c) – exemption amount for each dependent
iv) § 151(d) – exemption amount
(1) § 151(d)(1) – definition of “exemption amount”
(2) § 151(d)(2) – when there’s a disallowance of the exemption amount for
certain dependents
(3) § 151(d)(3) – phaseout stuff, involving percentage to reduce by, threshold
after which to reduce, etc.
(4) § 151(d)(4) – inflation adjustments
v) § 151(e) – “No exemption shall be allowed under this section with respect to
any individual unless the TIN (taxpayer identification number) of such
individual is included on the return claiming the exemption.”
Fringe Benefits: Valuation Problems
13) What constitutes income?
a) Old Colony Trust Co. v. Commissioner (1929, p. 41) – employer’s payment of
federal income taxes on behalf of its employee constituted income to the
employee; this case preceded income tax withholding
b) Benaglia v. Commissioner (1937, p. 42)
i) Summary: free room and board that a hotel manager and his wife (who filed
taxes jointly) got from his employer were not considered as income
ii) Reasoning:
(1) “From the evidence, there remains no room for doubt that the petitioner’s
residence at the hotel was not by way of compensation for his services, not
for his personal convenience, comfort or pleasure, but solely because he
could not otherwise perform the services required of him.”
(2) Residence at the hotel was necessary
(3) Not income just because it relieves employer of an expense he’d otherwise
bear
(4) Key language: “The advantage to him was merely an incident of the
performance of his duty, but its character for tax purposes was controlled
by the dominant fact that the occupation of the premises was imposed
upon him for the convenience of the employer.”
iii) Dissent:
(1) First of all, there’s evidence that this manager could do his job without
having to live there, so there’s something wrong.
(2) Second, contractual language indicates this was bargained for, understood,
and intended as compensation for employment
(3) Solely for employer’s convenience does not imply that employee wasn’t
benefited to the extend that it’s income . . . “I do not think the question
here is one of convenience or of benefit to the employer. What the tax law
is concerned with is whether or not petitioner was financially benefited by
having living quarters furnished to himself and wife.”
(4) This was a mutual beneficial arrangement.
iv) Class Discussion:
(1) Is this result here right?
(a) What facts point to the convenience of the employer?
(i) This is a 24-hour a day job.
(ii) Condition of employment – wouldn’t take job if couldn’t live
there.
(iii)Forced consumption. Rather than giving employee extra cash, the
employer forces Benaglia to consume a certain residence.
(b) What can dissent use?
(i) Not really necessary to live there
(ii) Doesn’t need a suite
(iii)It’s bargained for
(iv) Sure, it’s convenience to employer, but it’s a big benefit to
employee, too.
(v) Reg says nothing about spouse, so at minimum half of the income
should be taxable . . . though this in 1937, so maybe different
perceptions of wives at the time wouldn’t make this a winner.
(2) Notice that § 61 makes no distinction between cash and in-kind. So the
problem here has nothing to do with the fact that this is in-kind.
(3) Notice if the IRS is going to tax this stuff, it has to do so right away.
There’s not a “second chance” to tax this, as there might be for something
like an annuity given to an employee. (Tax when given v. tax when $
withdrawn.)
(4) The test here is convenience of employer.
(a) Isn’t salary convenient? Doesn’t the employer pay the employee
because it’s convenient to have someone come and do stuff for him?
(b) How helpful is that language? What does that mean? Possible tests:
(i) Business necessity (ex: Navy must provide food and housing, b/c
you can’t get it otherwise in the middle of the ocean)
1. What goes against this here is that Benaglia is away for some
times . . . so is it really necessity?
(ii) Forced consumption. Did the employee have a choice?
“Convenience of the employer” gets to this idea, a bit. It indicates
the method of payment might not be the employee’s first choice,
and so we take account for that a bit.
1. How much should someone be taxed for forced consumption?
a. The law – 0
b. IRS – fair market value; probably overestimates value
c. Another option – subjective value; this is completely
accurate, but this is impossible to administer, and people
will just underestimate . . . “oh, I really hate gorgeous,
luxurious hotels . . . staying there was worth about $1/day
to me”
(5) See § 119 (“Meals or lodging furnished for the convenience of the
employer) for modern-day handling. Exclude meals/lodging from GI in
given to him, spouse, or any dependents by or on behalf of the employer
“for the convenience of the employer,” but only if:
(a) § 119(a)(1): “meals are furnished on the business premises,” or
(b) § 119(a)(2): lodging . . . “employee is required to accept such lodging
on the business premises of his employer as a condition of his
employment”
(6) § 119, though, doesn’t fix everything. It contains many ambiguous terms
that subsequent decisions disagree over. See pp. 47-48:
(a) What is a “meal”? Groceries? No – Tougher v. Commissioner. Yes –
Jacob v. United States.
(b) What does it mean to “furnish”? Is giving cash for meals furnishing a
meal? No – Commissioner v. Kowalski (cash for cops to buy food).
But yes, for a fireman to deduct $ paid to participate in an obligatory
organized mess at the station house – Sibla v. Commissioner.
(c) What is “convenience of the employer”? Often established by proof
that the employee is on call outside of business hours.
(d) What are the “business premises”? Roads and highways are included
for state police – US v. Barrett. House across the street from
beachfront hotel included – Lindeman v. Commissioner.
(e) Examples from class:
(i) NJ state trooper gets $20/day meal allowance. Maybe on business
premises, but the meal isn’t furnished by the employer, they just
give you cash. SCOTUS held this not furnished, but didn’t decide
what premises were. But later, something decided premises were
basically everything.
(ii) Waiter at a restaurant. Give you breakfast when you have an early
shift. It’s on premise, furnished. What about convenience of
employer? Does it matter if there’s a Starbucks next door?
Breakfast is harder to order convenience. Just get up a half an hour
earlier. Lunch is easier, especially if you have a restricted time in
which to eat . . . regs actually talk about this.
(iii)Lunch provided by law firm. On premises and furnished are easy.
What about convenience? Make an emergency argument . . . if
something comes up, you’re there. Might be convenient to have
law firm cafeteria because you can talk about client info in a secure
place. No confidentiality worries.
(iv) Happy hours at work? Probably not a meal, so not excludable.
(v) Hospital provides bed for doctors in hospital? Yes. What if the
room provided is at a hotel right across the street? Convenience is
there, required to accept is there. But it’s not on the business
premises. Need to argue that the hotel is your premises. Maybe if
you have a standing agreement with the hotel, you can do this.
(7) If you make something tax free, you’ll incentivize people to do more of it
than they normally would. (Free parking example on p. 57. If you give
people free parking, then maybe more people will drive to work than
really want to do so.)
(8) Source of authority is Regulation 1.119-1. This reg requires two inquiries:
(a) Furnished on premises? Factual determination.
(b) Furnished for convenience?
(i) Substantial non-compensatory business reason  convenience.
(ii) Furnished so employee is available for emergency  convenience.
(iii)Mostly as additional compensation  no convenience.
(iv) Meal before or after work, or non workday  no convenience.
(v) Restricted meal time  convenience.
(vi) Insufficient eating places nearby  convenience.
(9) See handout 5 for some specific numbers that show how different rules
(FMV, subjective, excluded) allocate $ differently.
c) Arguments for deciding how much to tax
i) Efficiency argument
(1) Free parking example on p. 57
(a) Cost to employer of parking is $50; employee values it at $40
(b) No tax – employee wants $50 cash; in fact, can make a deal with
employer, because any amount of cash between $40 and $50 makes
both better off than providing the free parking
(c) Both cash and parking are taxed (at 40%) – if we value the parking at
$50, benefit to employee is $40 minus 40% of $50, which is $20; if we
value the parking at the subjective value of $40, then the benefit to
employee is $40 minus 40% of $40, which is $24 . . . either way, these
are lower than $50 cash minus tax of $20, which yields $30.
(d) Only cash is taxed – here value of parking is $40, and value of taxed
cash is $30, so employee chooses parking
(e) Schoup article on p. 58 notes that tax system can create too much of
something people didn’t really want to begin with. Here, we might end
up with more people driving into cities than would normally occur,
because parking is tax free. Relating this to Benaglia, if we favor him
by not requiring tax on the room/food he gets, then what we might get
is too many people going to work for fancy hotels, then maybe too
many fancy hotels open up, and then this trickles through the economy
and skews it. We see this in health insurance. (p. 56)
(2) Fairness argument
(a) Horizontal equity/fairness
(i) Take two people, A and B. Assume a 40% tax rate.
1. A gets $15k per year. Pays $6k in tax.
2. B gets $10k per year, plus $5 for housing. If housing isn’t
taxed, pays $4k in tax.
(ii) Fairness argument says: why should B get off with lower taxes
than A?
(b) Vertical equity/fairness
(i) Unfair to let fringes be tax-free, because this benefits those people
who are more highly compensated. This manager is benefited,
whereas the maid who doesn’t get fringe benefits such as free
housing doesn’t enjoy any tax benefit. This may end up imposing a
level of regressivity.
(ii) Another way to conceive this is that tax free stuff is more valuable
to the wealthy, because their marginal tax rate is (most likely)
higher.
(3) Administrability
(a) Fairness and efficiency arguments argue for taxing. This one does not.
(b) Classic example in book by Henry Simons (UofC law prof in 20s) is
an attendant to a prince. What does the attendant have to do? Go with
the prince and take care of him. Goes to the opera, horseback riding,
vacationing, etc. Does all the luxurious things. But in Simons example,
he would really just prefer a burger and a football game. But it’s his
job to be fancy. Should he be taxed on these benefits? If yes, how do
we value it? Obvious analogies in the current world: rock star, sports
hero.
(c) Things like satisfaction from job are super-hard to tax. What about
more mundane stuff . . . what about President of the United States . . .
tax the fact that he has free housing? What about an associate who gets
a three-martini lunch? What about the navy guy who gets a cot on a
destroyer? What about a foxhole while in army?
(d) The common thread through these things is that they are mixed-use.
They have a business purpose, even things like three-martini lunches,
but they also have independent consumption value.
d) Valuation of fringe benefits
i) Basic valuation rule is “fair market value” (Regs § 1.61-21(b)
(1) “In general—An employee must include in gross income the amount by
which the fair market value of the fringe benefits exceeds the sum of . . .
[t]he amount, if any, paid for the benefit by or on behalf o f the recipient,
and . . . [t]he amount, if any, specifically excluded from gross income by
some other section of subtitle A of the IRC of 1986.”
ii) Optional safe-harbor rates apply
iii) Cafeteria plans – allow employee to choose an excludable benefit (maybe
parking benefit) or opt out for a taxable amount of cash;
(1) These are expressly authorized by § 125
(2) § 125(d)(2)(A) is the use it or lose it rule – the book says this, thought I
don’t totally see it from the language; the idea is that if you take $5X
worth of some benefit at the beginning of the year, and don’t use it all, you
don’t get the difference back; think of pre-tax withholding of money for
healthcare
e) § 132 – Certain fringe benefits
i) Historical background: for years, tax rates were very low, and the IRS just
didn’t bother enforcing a lot of these small items. So lots of fringes were
historically excluded, and this continued to be the case after WWII even after
taxes went up a bit. Coming into the 70s and 80s, there’s a long history of
things’ being excluded from people’s earnings. They were a pattern of
American life, and so the IRS/Congress couldn’t just go back and include
these things. So they just tried to codified it, and put some clear boundaries on
things. So many of these exclusions aren’t there for some efficiency/policy
reason, but based only on history and tradition.
14) Related Code
a) § 61 – gross income defined
i) § 61(a) – “Except as otherwise provided in this subtitle, gross income means
all income from whatever source derived, including (but not limited to) the
following items:”
(1) Notice that this defines gross income as basically everything, and then
stuff is excepted. So the default is inclusion.
(2) § 61(a)(1) through § 61(a)(15) includes things like compensation, fringe
benefits, gross income derived from business, gains from dealings in
property, interest, rents, royalties, dividends, alimony, annuities, life
insurance, endowments, pensions, income from discharge of indebtedness,
distributive share of partnership income, income in respect of a decedent,
and income from an interest in an estate or trust
b) § 119 – meals or lodging furnished for the convenience of the employer
i) § 119(a) – gross income doesn’t include food or lodging given to employee by
employer if its one of the following
(1) § 119(a)(1) – “meals are furnished on the business premises of the
employer” (Note: no requirement that you eat it)
(2) § 119(a)(2) – “employee is required to accept such lodging on the business
premises of his employer as a condition of his employment”
ii) § 119(b) – special rules
(1) § 119(b)(1) – K terms aren’t determinative of whether meals or lodging
are intended as compensation; that is, you can’t just say in a K, “this has
been bargained for” and that’s that, or vice versa
(2) § 119(b)(2) – in deciding what’s deductible, don’t take into account
whether a charge was made for the meals or whether the employee may
decline the meals
(3) § 119(b)(3) – if employee is required to pay on periodic basis a fixed
charge for meals, and they are furnished for employer convenience, they
aren’t included
(4) § 119(b)(4) – served on business premises  are treated as furnished for
employer convenience if more than half of employees who get the meals
are given the meals for the employer’s convenience
iii) § 119(c) – stuff about living in camps
iv) § 119(d) – stuff about food and lodging provided by educational institutions
c) § 132 – certain fringe benefits
i) § 132(a) – those excluded from gross income
(1) § 132(a)(1) – no-additional-cost services (offered to customers in ordinary
course and line of business, no substantial additional cost)
(a) What’s the purpose of taxing something that’s costless? It just
incentivizes waste. Why not use that empty airline seat?
(2) § 132(a)(2) – qualified employee discounts
(a) Has to be stuff employer regularly sells; employer can’t lose $ on it
(3) § 132(a)(3) – working condition fringe (if you could deduct it yourself,
and employer gives it to you for free, it’s excluded)
(4) § 132(a)(4) – de minimis fringe (so small accounting for it is silly)
(5) § 132(a)(5) – qualified transportation fringe
(6) § 132(a)(6) – qualified moving expense reimbursement
(7) § 132(a)(7) – qualified retirement planning services
(8) § 132(8) – qualified military base realignment and closure fringe
ii) § 132(h) – certain individuals are treated the same as employees for purposes
of subsections (a)(1) and (2): people retired from the co, spouses of deceased
employees, spouses and dependent children of company workers, and a
special rule for parents with the airline industry
iii) § 132(i) – ok to have reciprocal agreements with other employers
iv) § 132(j)(1) – can’t make special exceptions only for highly-compensated
employees; must be available in general to all
Gifts and Disguised Compensation
15) Basics of gifts
a) § 102(a) exempts from income
b) Probable that transferor is in higher bracket
c) Gifts from employer to employee become profitable over salary when the
employee’s marginal rate exceeds the employer’s marginal rate. For some
numbers, see handout 6.
16) Commissioner v. Glenshaw Glass (1955, p. 70)
a) Summary: punitive damages from antitrust suits count as income under then § 22
(now § 61)
b) Reasoning:
i) § 22 (current § 61) uses extremely broad language (“gains or profits and
income derived from any source whatever”) to exert “the full measure of its
taxing power”.
ii) Court has given a liberal construction to this phrasing, and has applied no
limitations except to those specifically exempted.
iii) Why exclude punitive, when not compensatory damages? No logical reason.
iv) Court distinguishes Eisner v. Macomber, because in that case (considering
whether dividend was a realized gain to stockholder or changed only the form,
not the essence, of the stockholder’s holdings) the court was distinguishing
gain from capital. Note that there was a little bit of a difference of income
definition in Eisner, where the language used was “the gain derived from
capital, from labor, or from both combined.”
v) “Here we have instances of undeniable accessions to wealth, clearly realized,
and over which the taxpayers have complete dominion.”
c) Class discussion:
i) How would you define income after this case? “undeniable accession to
wealth” is a good place, probably
ii) How can we apply this rule to some other examples, like those we went over
in fringe benefits?
(1) Quiz show prizes.
(a) What if you win 1,000,000 Snickers bars? Under Glenshaw this is
income. How might you argue based on our fringe benefits case that
it’s not. The contestant probably didn’t really want this. This is forced
consumption. There are also valuation problems. You can’t possibly
consume all these before they go bad, can you? Are they liquid assets?
(b) What if you win a car with insane options that you never would pay
for yourself? Same arguments as above.
(2) Oscars.
(a) If you win an Oscar, you get a goody bag that can be worth many
thousand dollars. One of the things you get is invitations on cruises.
And as a celebrity, you can’t really go on these cruises. The IRS
actually sent out a memo specifically warning Oscar winners that their
prizes are taxable, and they’d be prosecute. What can the celebrity do?
Might be able to donate it to charity. But otherwise, probably stuck.
Also, probably can’t just deny this, because that’d be bad for publicity.
(3) Home Run Ball.
(a) IRS said, if you do anything but get cash for it, it’s not taxed.
(b) If you sell it, and get the $1mill, then it’s taxable.
(c) It seems here that the IRS just made an exception because of things
like traditions of baseball.
(4) Oprah’s cars.
(a) After she gave cars, the IRS told her she had to send tax forms to all
the people, because the cars are taxable. Later she sent money to all
the people to cover the tax.
17) Gifts are clearly going to be an exception to Glenshaw glass. But what is a gift? § 102
doesn’t really define it. We just have a little idea. Is it only within the family?
Probably not. Can be generous to other people, too. But how do we tell? Don’t want
to count salary as a gift. But where to draw the line?
a) Commissioner v. Duberstein (1960, p. 75, SCOTUS)
i) Summary: this decisions combines two cases, Duberstein and Stanton
(1) Duberstein – Duberstein gave Berman some very helpful information that
got Berman lots of business from some customers; Berman thanked
Duberstein with a Cadillac; Duberstein didn’t include it as income, calling
it a gift; Duberstein was basically forced to take the car; Duberstein
admitted Berman wouldn’t have given it without the info Berman got re:
the customers; Berman deducted the car as a business expense
(2) Stanton – upon resigning, Stanton got a gratuity from his company that
was to release any pension, etc. obligations the company might have to
him, and it was also given “in appreciation of the services rendered by Mr.
Stanton”; “we were all unanimous in wishing to make Mr. Stanton a gift”;
there’s dispute as to whether this is gift or some sort of severance pay
ii) Issue: Are these things gifts, and hence not included as income by their
recipients?
iii) Holdings:
(1) Duberstein – SCOTUS reverses the appeals court, and reinstates the trial
court’s decision that this was not a gift, it is income to Duberstein;
SCOTUS didn’t see anything clearly erroneous with trial court’s facts
(a) Note: trial was in tax court
(b) Good general rule: treat things symmetrically. If you allow it tax free
on one side, you can’t allow a deduction on the other side. So we can’t
both allow Duberstein to take tax free as a gift, and for Berman to
deduct as a business expense.
(2) Stanton – trial court found this to be a gift, appeals court reversed,
SCOTUS remanded because weren’t enough factual findings done by trial
court
(a) Note: trial was in federal district court; tax lawyers generally think that
the district court judges are easily duped
(b) Weisbach finds this completely bogus. This is money given for past
services, so it’s got to be income.
(c) If this were decided today, § 102(c) says that it’s definitely taxable,
because you can’t “exclude from gross income any amount transferred
by or for an employer to, or for the benefit of, an employee.”
iv) Reasoning (Brennan):
(1) Go case-by-case and look at donor’s intent.
(2) When considering whether something is a gift, you have to look to the
transferor’s intent, not the transferee’s intent.
(3) Government wanted to promulgate a new test to help determine whether
something is a gift. SCOTUS rejects this invitation. These cases are basic
examples of when payments are made in a context with business
overtones, and so we can just review similar cases that are on point to this
pretty common situation.
(4) To figure out what gift means, we need to consider it in a colloquial sense.
(5) Old Colony Trust v. Commissioner – mere absence of a legal or moral
obligation to make a payment doesn’t mean it’s a gift (employer paid
employee’s tax burdens; this was included in employee’s income)
(6) Bogardus v. Commissioner – if the payment proceeds primarily from the
constraining force of any moral or legal duty, or from the incentive of
anticipated benefit of an economic nature, it’s not a gift; the most critical
consideration is the transferor’s intention
(a) Doesn’t moral duty encompass a lot? Couldn’t you say that giving
Christmas presents to your kids comes from a moral duty? Is that
taxable, then?
(7) What the parties hope the tax treatment will be has nothing to do with it.
(8) The conclusion whether a transfer amounts to a gift is one that must be
reached on a consideration of all the factors. Because of this, we have to
give major deference to the trial courts. We won’t make a more precise
and tidy definition here. Congress can do that if it so desires. But now, we
must go case-by-case, and as such, appellate review should be quite
restricted.
v) Frankfurter’s Dissent:
(1) “business implications are so forceful that I would apply a presumptive
rule placing the burden upon the beneficiary to prove the payment wholly
unrelated to his services to the enterprise”
vi) Class discussion:
(1) Are these gifts?
(a) Tip you give to a server in a restaurant, and you know you’ll never be
in the restaurant again. Not a gift, because it’s given for past services
due. But can make a clever argument that it’s a gift. Recall, it’s the
donor’s intent. What if they feel as though they’re just being nice, and
they don’t have to give it. Does that mean not taxable?
(b) Strike benefits. Seems like it is income. May have a bit of an issue
with where this money comes from. If it’s from union dues, and you
already paid some union dues in. You’ll likely be taxed on whatever
you get back that exceeds the amount you paid in.
18) Related Code
a) § 102 – gifts and inheritances
i) § 102(a) – General rule is that gifts aren’t income: “Gross income does not
include the value of property acquired by gift, bequest, devise, or inheritance.”
ii) § 102(b) – gifts that are included in income include:
(1) § 102(b)(1) – income from any property referred to in (a) – if you give me
land, and I rent it out, I have to include that rental income as income
(2) § 102(b)(2) – if the gift comes from income of property – I can’t give you
$ from profits I make on land, and allow you to exclude it from income
iii) § 102(c) – gifts from/on behalf of employers aren’t excluded; there is a de
minimis exception
(1) Stanton would be different under this. It would come out the other way.
(2) Example from book. If a surgeon saves your life, and you want to give her
a lavish gift—a ski trip—is the trip taxable?
(a) Is the surgeon your employee? No. So § 102(c) doesn’t apply.
(b) Weisbach says this language is extremely problematic, because it
draws the line between employer/employee, not just in relation to
service providers in general. This case came up with Clinton’s first
attorney general nominee. Was her nanny an employee?
(i) What if your boss comes to your kid’s wedding, and gives your kid
a wedding gift. We don’t expect this to be taxed, but § 102(c)
seems as though it can cover it. Weisbach says a strict reading of
the language must cover it.
b) § 274 – disallowance of certain entertainment, etc., expenses
i) § 274(b) – gifts
(1) § 274(b)(1) – if you give a gift of more than $25 to someone, you can’t
deduct it; gift is defined as any item excludable from gross income of the
recipient under § 102 non excludable any other provisions
(2) § 274(b)(2) – this limitation in part (b)(1) applies to partnerships and each
member of the partnership; married people count as one taxpayer for these
purposes
(3) Enacted in the 50s and the #s have never been changed
ii) § 274(j) – employee achievement awards
(1) § 274(j)(1) – “No deduction shall be allowed under § 162 or § 212 for the
cost of an employee achievement award except to the extent that such cost
does not exceed the deduction limitations of paragraph (2).”
(2) § 274(j)(2) – deduction limitations for employer who gives gift to
employee
iii) § 274(n) – 50 percent of meal and entertainment expenses allowed as
deduction. Example:
(1) Employer
(a) Pays employee $90. Can deduct this as a salary expense.
(b) Gets $100 for the widget made by employee.
(c) Makes $10 profit.
(2) Employee
(a) Gets $90.
(3) Total benefit here is $100 ($90 to employee, $10 to employer). So what
we want to make sure happens is that $100 worth of stuff is taxed. How?
(a) Employee got $90 benefit, so tax them on $90. Employer got $10
benefit, so tax them on $10.
(b) What if it’s really hard to tax the $90 given to employee? Maybe
because that figure includes three-martini lunches, etc. Then just tax
the $100 all at once when the $100 sale takes place. And so long as the
tax rates are the same, the government gets the same. This is known as
substitute taxation. This happens all over the tax code. § 274(n) does
this (sort of) for three-martini lunches.
(c) Why the 50% only here? Recall this business meal is a split-use thing.
There’s consumption value, and business value. So since access to the
actual subjective values in each of these categories is basically
impossible, Congress just drew a bright line and said half will be
attributed to consumption value, so that’s the half that’s taxed. Used to
be 20% or something.
(d) This section was highly influenced by restaurant lobby. Tons of $ is
spent here each year.
The Concept of Gain and its Relation to Basis
19) Introductory Comments:
a) Buying and Selling Stock Examples
i) Example #1
(1) 1/15/08 – you buy 10 shares of stock for $1,000
(2) 2/15/09 – sell all 10 shares of stock for $1,250
(3) What gets taxed and when? You’re taxed on the $250 gain at the time of
the sale.
ii) Example #2
(1) 1/15/08 – you buy 10 shares of stock for $1,000
(2) 2/15/09 – you sell 8 shares or $1,000
(3) 2/15/12 – you sell 2 shares for $250
(4) What gets taxed and when?
(a) Possibility 1 (no gain till basis is covered)
(i) At 2/15/09, you get taxed nothing, because the amount realized is
the same as the basis ($1,000), so you haven’t “gained” anything
yet.
(ii) At 2/15/12, you get $250 more, but have $0 left in the basis, so you
gain $250 at this point, and are taxed on it at this point.
(iii)Note: this is good for seller, because taxes are delayed 3 years.
(b) Possibility 2 (no basis deduction till all is gone)
(i) At 2/15/09, you get $1,000 gain (taxed then)
(ii) At 2/15/12, you get -$750 gain (taxed [deduction] then)
(iii)Total gain again of $250, but taxed differently
(iv) Note: This is not as good for the seller, because the tax comes
earlier
(v) Note: Something like this also allows for manipulation like that in
Gavit. How? If all of the basis is attached to a couple of stocks,
you can then sell these stocks early and generate a huge loss
immediately that can cover future tax obligations. This is discussed
more under Gavit.
(c) Possibility 3 (pro rata)
(i) At 2/15/09, you receive $1000 for 80% of the original, so 80% of
basis is $800, so gain here is $200
(ii) Similarly, at 2/15/12, your gain is $50
(iii)Total gain is again $250
(iv) Note: this is economically the most accurate, but things can get
harder to calculate when it’s not shares of stock, but instead is land
or something like that (Inaja)
iii) Government prefers the third possibility above, taxing the gains as they are
realized. They don’t prefer 2, because it allows for manipulation. People can
create trusts (like in Gavit), then allow the people sell the remainder, and then
realize a loss, and then essentially end up not paying taxes, because they have
losses to distribute to their actual realized gains.
b) How is basis assigned in gifts?
i) Gross income includes “gains from dealings in property” (§ 61(a)(3))
(1) How do you calculate the gain? The amount of the gain is the “excess of
the amount realized . . . over the adjusted basis” (§ 1001).
(2) What is the adjusted basis? The adjusted basis is the basis, defined under §
1012 as “cost” (with certain exceptions), “adjusted as provided in section
1016.”
(a) There is an exception in § 1015 for property acquired by gift.
ii) Donee’s basis (this phrase is used in § 1015, and it means the adjusted basis)
is the same as the donor’s basis. So if A gives B a gift, B gets A’s basis. The
donee takes a “transferred basis” from the donor (§ 7701(a)(43))
(1) Exception: if at the time of the gift the donor’s basis is greater than the fair
market value of the property (so the donor would have a loss if he or she
sold the property), then for purposes of computing the donee’s loss (but
not gain) on any subsequent sale, the donee’s basis is the fair market value
at the time of the gift.
20) Taft v. Bowers (1929, p. 96)
a) Summary: A buys stocks for $1000; value rises to $2000; A gives stocks to B; B
sells for $5000
b) Issue: whether B should be taxed on the $3000 gain from $2000 to $5000 or the
$4000 gain from $1000 to $5000
c) Holding: donee must pay tax on the whole $4000 difference
d) Reasoning:
i) “the settled doctrine is that the Sixteenth Amendment confers no power upon
Congress to define and tax as income without apportionment something which
theretofore could not have been properly regarded as income”
ii) Case notes Eisner v Macomber – “gain derived from capital, from labor, or
from both combined”; so if you work for it or if you have it through
investment. It also cites Phellis to explain what a “gain derived from capital”
is: it is “not a gain accruing to capital, nor a growth or increment of value in
the investment, but a gain, a profit, something of exchangeable value
proceeding from the property, severed from the capital however invested, and
coming in, that is, received or drawn by the claimant for his separate use,
benefit and disposal.”
iii) If we don’t do it this way, there’s $1000 gain that isn’t taxed, and this creates
a loophole to avoid taxes. A’s basis is $1000 . . . if B’s is $2000, the $1000 in
between isn’t taxed. Oh, you think this is unfair to B, because B didn’t really
“experience” this gain? Then B doesn’t have to take the gift. “She accepted
the gift with knowledge . . .” It basically just makes the gift not as good, that’s
all, because there’s more tax to pay on it.
e) Class Discussion:
i) The holding of this case is codified in § 1015 – “basis shall be the same as it
would be in the hands of the donor or the last preceding owner by whom it
was no acquired by gift”; exception if basis is higher than FMV, in which case
donee’s basis becomes FMV
ii) Some options here:
(1) First – general rule, outside of gifts
(a) A pays tax on $1000, since the stocks gained $1000 in his hands
(b) B pays tax on $3000, since the stocks gained $3000 in his hands
(c) Total taxed is $4000
(d) This is the most accurate, but it presents valuation problems (how
much was it worth when A gave it as a gift?), and also presents a
liquidity problem (maybe A doesn’t have any money to pay the tax)
(2) Second – Taft v. Bowers rule
(a) A pays tax on $0
(b) B pays tax on $4000
(c) Total taxed is $4000
(d) This is the rule in Taft v. Bowers. Easy to administer, because just
value and tax on the sale, and don’t have to follow it all through any
gift-giving stuff. Also, it’s not really unfair to the recipient. It just
means the gift is less valuable, perhaps.
(3) Fourth – anti-Taft v. Bowers
(a) A pays tax on $4000
(b) B pays tax on $0
(c) Total taxed still $4000
(d) Seems a bit unfair, but it does close a loophole for evading taxes by
shifting the value to someone in a lower tax bracket. For instance, if A
is the father in a higher tax bracket, and B is his daughter, he can give
it as a gift to B, so she has to pay less tax. But this disallows that.
iii) Notice that here, the question is not whether to tax this appreciation while the
donor held the stocks, but whom to tax. It would be administratively
ridiculous to tax donor, and treat this like a sale.
21) Questions on p. 102
a) A buys stock for $1k, gives to B when FMV is $2.5k.
i) B sells for $3.5k  B recognizes $2,500 gain
ii) B sells for $1.5k  B recognizes $500 gain
b) C buys stock for $2k and gives to D when FMV is $1k.
i) D sells for $2.5k  $500 gain
ii) D sells for $1k  $500 loss – note here, that since it’s a loss (transferred basis
> amount realized), FMV of $1000 is used
iii) D sells for $1.5k  $0 gain or loss. No gain or loss. This is the case whenever
the following holds: Original basis > price sold for > FMV.
22) Irwin v. Gavit (1925, p. 103)
a) Summary: Remainder of trust given to daughter; father gets the interest payments
from each of the 15 years the trust pays interest till the daughter turns 21; father
has to pay tax on the interest payments, daughter doesn’t on the receipt of the
principal, because the basis attaches to what the daughter has, not what the father
has. The father’s argument amounted to arguing that taxpayers could arrange to
exempt from tax the income from property through the simple expedient of
making “split gifts,” whereby one person gets a term or life interest and another
gets the remainder interest.
b) Arguments:
i) Both sides agree that granddaughter isn’t taxed.
ii) Father: argues that the annual interest payments are also included in the gift,
and as such, shouldn’t be taxed. He should’ve argued that taxing him on the
interest was undoubtedly incorrect, because he had a basis of $49,975.
iii) Gov’t: each time you get an interest payment, you still have the $100,000
amount in the trust, so these are earnings, and as such, are taxed
c) Class discussion:
i) See handout folded up in my book.
ii) Present Values of Gifts
(1) How much is granddaughter’s interest worth on the day her grandfather
dies? Discounted value of $100k, which turns out to be $50,025.
(2) How much is dad’s interest worth on the day the grandfather dies?
Discounted value of the interest payments. On the handout, this is the
discounted value of 9 payments of $8,000.
iii) Tax advice for Marcia in the world of the holding of the case: Sell
immediately, and recognize a loss. She’s got a basis of $100k for something
worth $50,025, so she gets a $49,975 loss now, which is good for her. This
might not matter for stuff like a family trust, since they might not be sellable,
but the issue of a possible tax shelter is there. Also, she probably doesn’t have
any tax liabilities, but it might help if she can carry those through into future
periods. This advice for Marcia is basically a tax shelter. You can create one
of these on your own through bond-stripping. You buy a bond, and sell the
interest to person A, and sell principal to person B. If person B has all the
basis (as Marcia did) he can sell immediately and get a loss.
iv) Amount taxed under either theory (giving Marcia all the $100k basis, or
giving Palmer and Marcia each about $50k . . . ) is the same. The difference is
in timing. Also, presumably Marcia is in a lower tax bracket when she turns
21 than the bracket her father is in right now.
(1) Way 1: all basis for Marcia. What’s taxed? Each year of the nine years, the
$8k of interest the father gets is taxed. So that’s $72k taxed total.
(2) Way 2: (basically) split the basis.
(a) Dad is taxed on $72k minus his $50k basis = $22k
(b) Marcia is taxed on $100k minus her $50k basis = $50k
(c) Total here is $72k again
(3) Way 3: Another way, if we think it’s unfair to make Marcia pay tax each
year even though she doesn’t get any actual money, she just gets closer to
getting real money, is to make her pay, once she gets the $100,000, the
present value of the taxes she would have paid along the way.
(4) Notice: really what’s going on is that, no matter who we say owns what,
each year this thing (the trust) is generating $8000 more money, and that’s
what’s getting taxed. So if we say that all the basis is Marcia’s, then Dad
has to pay all that tax. Or otherwise. Whatever. No matter how we split it
up, we’re taxing the same amount.
v) We could tax Marcia each year on the amount she “gains.” She gains 8% each
year, because she gets a little closer to realizing the $100,000, so the present
value rises. We could tax her on that little gain. We could tax Dad on all of it,
instead.
23) Inaja Land Co. v. Commissioner (1947, p. 107)
a) Summary: taxpayer bought 1,236 acres of land on the banks of a river in CA for
$61k (this is his basis, because it’s his cost) for fly fishing; LA began to divert
foreign waters into the river that basically ruined part of his land and made his
fishing suck; so he settles with LA for $50k, but incurred $1k of legal expenses;
LA gets to keep polluting, and taxpayer relinquishes all rights to suit; taxpayer
reports none of this $49k on his tax return; gov’t says he should report all $49k as
income because it’s for lost profits,
b) Arguments:
i) Gov’t says basis comes last, because you actually own the land still, and this
was a payment for lost profits
ii) Landowner says basis comes first, as this was for payment of an easement and
for damage done to the land; also, it’s really hard in this case to apportion
basis, and in such a case a taxpayer should not be charged with gain on pure
conjecture unsupported by any foundation of ascertainable fact
c) Normal rule: allocate the basis sort of pro rata; this is easy with stocks, but here
this is tricky; how much is portion X of the land worth?; how much is a set of
limited rights to a portion of the land worth?
d) Holding: taxpayer wins; “Apportionment with reasonable accuracy of the amount
received not being possible, and this amount being less than petitioner’s cost basis
for the property, it can not be determined that petitioner has, in fact, realized gain
in any amount. Applying the rule as above set out, no portion of the payment in
question should be considered as income, but the full amount must be treated as a
return of capital and applied in reduction of petitioner’s cost basis.”
e) Chirelstein: “the courts have permitted the taxpayer to offset the condemnation
award by the full cost of the property and to report no gain unless the amount
received exceeds his entire initial investment”
f) Class Discussion:
i) This is an interesting result, because notice everyone agrees that if taxpayer
got rent money for the land, that’d be taxable income. Why? Because he still
owns the land. So what if he got pre-paid rent that ended up being $49k up
front? He’d have to pay taxes on that, and couldn’t enjoy his basis. So what’s
the deal here? Interesting. It’s a little taste where the form of the transaction
seems to matter.
ii) Could treat this as . . .
(1) Unit-sale approach. Purchase of a portion of the land. Then break the land
into pieces, allocated portions of the basis to each piece, and then deduct
this $ against the proper proportion of basis. Chirelstein likes this one the
most.
(2) Payment for a leasehold. Then these are rents. Then receipts should be
immediately included in income.
(3) Open-ended installment sale. This is the law. Offset the value received
against the value of the property. Reduce basis appropriately, and realize
gain or loss upon ultimate disposition of property.
iii) Case is probably still good law.
iv) Rule of getting recovery of basis first against cash flows in known as the open
transaction doctrine.
24) Hort v. Commissioner (1941, p. 695)
a) Summary: father gave petitioner property, a lot and ten-story office building; part
of land was leased to Irving; lease became unprofitable to Irving, so the parties
agreed to cancel the rest of the lease for $140k; petitioner didn’t include this in
gross income, and rather counted as a loss the money he didn’t get from this
cancellation
b) Issue: whether, in computing net gain or loss for income tax purposes, a taxpayer
can offset the value of the lease canceled against the consideration received by
him for the cancellation
c) Holding: no!
d) Class Discussion:
i) Petitioner’s argument: amount received for cancellation was capital not
ordinary income, hence it’s covered by capital gains and losses stuff; even if
it’s ordinary gross income, there’s still a loss from § 165
ii) The loss calculated by Hort was the difference between the present value of
the future lease payments minus the $140k and also minus $96k, which was
the value of having the use of the building back.
iii) This is during the depression; probably why the lease was no longer beneficial
for Irving Trust Co.
iv) Hort actually loses money here . . . the calculation mentioned above (and in
footnote 12 on p. 698) shows this. He’s got a loss of essentially $21k. But the
IRS says the $140 is income. So, for this all to balance out, the IRS must be
acknowledging a $161k loss somewhere that Hort will eventually get (b/c
$140-$161=-$21). So where does the IRS put/hide this loss? It’s in the
property. Hort inherited the property with a lease on it. The property at first
was worth $257k (includes lease value), but now it’s worth only $96k. So
that’s the $161 loss. So why the different theories, if both essentially have the
numbers the same. It’s just the loss is in a different place—Hort wants it
earlier, but instead he won’t get it until he sells the property.
(1) IRS: whole $257 basis stays with the property.
(2) Taxpayer: $160 basis goes with the rental, $96 (FMV) goes with the
property.
v) The fundamental disagreement here is where the basis is allocated.
vi) Is this consistent or inconsistent with Gavit? Yes, this is consistent, because
it’s the same basis. Here’s the analogy:
(1) Gavit’s interest payment = Hort’s rental payments
(a) Gavit and Hort want all the basis to go here
(2) Gavit’s remainder (to Marcia) = Hort’s FMV of property
(a) Holding puts basis here . . . just as Marcia could’ve sold her piece for a
loss, Hort could’ve sold the property for a loss
vii) Is Hort right? This is a simple rule, but can be abused.
(1) A wants to sell B land for $100k. Normally, B would get basis of $100k,
A would have a net realization of $100k.
(2) We can generate a tax loss by introducing a third party.
(3) C steps in and buys from A for $100k, so A gets same. C rents to B for 99
years for PV of $100k. So C is same.
(4) C still has $100k basis, if none of it goes to the property, you can have that
$100k basis tied to the remainder of the property. This remainder is
essentially worth 1 cent, since the remainder after a really long lease is
basically worthless. C can then sell the remainder for 1 cent, but the basis
is $100k, so he gets a huge loss.
(5) Now, C still gets taxed on the rental payments, but again it’s a timing
issue. C gets the loss today, and doesn’t have to pay the taxes on the
rentals until they take place, some of which is way off in the future.
25) Related Code
a) § 61(a)(3) – gross income includes “Gains derived from dealings in property”
b) § 1001 – determination of amount of and recognition of gain or loss
i) § 1001(a) – gain is the excess gotten over adjusted basis (“the excess of the
amount realized therefrom over the adjusted basis provided in section 1011”)
and the loss is “the excess of the adjusted basis provided in such section for
determining loss over the amount realized”
ii) § 1001(b) – how to calculate “amount realized”; $ + FMV of other property;
there are some special rules on inclusion/exclusion of certain real property
taxes under § 164(d)
iii) § 1001(c) – subject to exceptions, “the entire amount of the gain or loss,
determined under this section, on the sale or exchange of property shall be
recognized”
iv) § 1001(e) – certain term interests
(1) § 1001(e)(1) – that portion of the adjusted basis of a term interest in
property that is determined under §§ 1014, 1015, or 1041 is disregarded
(2) § 1001(e)(2) – definition of “term interest in property”:
(a) § 1001(e)(2)(A) – “a life interest in property”
(b) § 1001(e)(2)(B) – “an interest in property for a term of years”
(c) § 1001(e)(2)(C) – “an income interest in a trust”
c)
d)
e)
f)
g)
h)
(3) § 1001(e)(3) – exception; paragraph 1 doesn’t apply to a sale or other
disposition that is part of a transaction where the entire interest is
transferred to any person or persons
§ 1011(a) – adjusted basis is basis in § 1012 adjusted according to § 1016
§ 1012 – basis is cost of property
i) Real property cost doesn’t include taxes
§ 1014 – Basis of property acquired from a decedent
i) § 1014(a)(1) – basis is the fair market value of the property at the date of the
decedent’s death (or 6 mos later, whichever is greater)
ii) This section is called stepped-up basis for death. Why stepped up? Because if
you are going to realize a loss on death, you sell. This creates enormous
potential to keep property. For example: Bill Gates has $50billion in stock of
Microsoft. His basis? $0, because he put no money into the company, he just
started working it. And on his death, his kids get FMV basis, which helps
them enormously.
iii) Why treat bequests different than inter vivos? Not really a good answer.
iv) This section ends at end of 2009. § 1022 comes in after.
§ 1015 – basis of property acquired by gifts and transfers in trust
i) § 1015(a) – for gifts after 12/31/1920, basis is same as in hands of donor, or
last preceding owner who didn’t get it by gift, unless that basis is greater than
FMV of the property at the time of the gift, then for the purpose of
determining loss the basis shall be such FMV; if can’t figure out basis, use
FMV
ii) The different calculation for the loss makes it so that you can’t give away your
losses to a person in a higher tax bracket.
§ 1016(a) – adjustments you make to basis
i) § 1016(a)(1) – for expenditures, receipts, losses or other items, properly
chargeable to capital accounts, but not for taxes of § 266 or expenditures of §
173 for which deductions have been taken in determining taxable income for
the taxable year or any prior taxable year
ii) § 1016(a)(2) – (after 2/28/1913) for exhaustion, wear and tear, obsolescence,
amortization, and depletion, to the extent of the amount allowed, and resulting
in a reduction for any taxable year of the taxpayer’s taxes, or prior income,
war-profits, or excess-profits tax laws . . .
Treasury Regs § 1.61-6 – gains derived from dealings in property
i) “When a part of a larger property is sold, the cost or other basis of the entire
property shall be equitably apportioned among the several parts, and the gain
realized or loss sustained on the part of the entire property sold is the
difference between the selling price and the cost or other basis allocated to
such part.”
ii) Sales of separate parts of something are treated as separate transactions.
Transferred and Imaginary Basis
This reading is not on the updated syllabus, so probably isn’t that important.
26) Examples under § 101
a) Life insurance covering plane crash; pay $5 for $50k if you die
i) $49,995 gain upon death is excluded under § 101(a)
ii) If no death, $5 paid for insurance isn’t deductible
iii) In the aggregate, if insurance companies do a good job setting their rates, then
the amount lost (sum of $5 payments, not deductible) will equal the amount
gained (sum of $49,995 payments, excluded), so tax effects balance. This is
not so in the individual cases, however. Some people gain big and aren’t taxed
($49,995 excluded), and others lose a little, and can’t deduct.
27) Clark v. Commissioner (1939, p. 121)
a) Summary: Taxpayer’s tax man made a mistake which caused him to have to pay
$19k more in taxes; tax man paid taxpayer the $19k, but included this in the
taxpayer’s income the next taxable year. Is this $19k taxable income? No.
b) Arguments:
i) Respondent tax guy: this payment is income because it constituted taxes paid
for by a third party (like Old Colony)
ii) Petitioner taxpayer: this payment is not taxable as it constituted compensation
for damages or loss caused by the error of t he tax counsel
c) Reasoning:
i) This $19k was paid to petition not qua taxes, but as compensation to petitioner
for his loss. “The fact that such obligation was for taxes is of no moment
here.” It mattered instead that it was “compensation for a loss which impaired
petitioner’s capital.”
ii) The theory of the cases that back this up “is that recoupment on account of
such losses is not income since it is not ‘derived from capital, from labor or
from both combined.’ . . . And the fact that the payment of the compensation
for such loss was voluntary, as here, does not change its exempt status.”
d) Class Discussion:
i) Glenshaw Glass  the ultimate reason for the holding is no good, as it was
based on the “derived from capital definition.” But the holding itself is fine. It
has been limited to cases where the taxpayer has to pay more than the actual
amount that should have been required, not to cases where the taxpayer has to
pay more than the tax preparer originally said.
ii) Clark is really a choice between two types of errors. Do we overtax the
taxpayer (require him to pay tax on the $19k) or undertax him (no tax on the
$19k, which puts him in a situation better off than someone who doesn’t get
the $19k payment from his tax preparer who made the same mistake). See ex.
on p. 124.
iii) Note that you aren’t taxed on an income tax refund.
28) Related Code
a) § 72 – annuities; certain proceeds of endowment and life insurance contracts
i) § 72(a) – “gross income includes any amount received as an annuity . . . under
an annuity, endowment, or life insurance contract”
ii) § 72(b) – exclusion ratio
(1) § 72(b)(1) – you can exclude a certain amount of the gross income from
annuity, endowment, etc. . . . how much? The exclusion ratio is
determined by dividing the investment in the contract by the expected
return, which is the aggregate fixed annuity (or whatever) payments you
can expect to receive under the contract.
(2) § 72(b)(2) – the amount excluded can’t be more than the unrecovered
investment in the K immediately before the receipt of such amount
(3) § 72(b)(3) – deduction where annuity payments stop before entire
investment is recovered
(a) § 72(b)(3)(A) – if payments stop because of death and there is still
unrecovered investment, the amount of unrecovered investment can be
deducted for annuitant’s last taxable year
(b) § 72(b)(3)(B) – if annuity pays another person as under § 72(c)(2)(B)
and (C), then that person can deduct from taxes in year were supposed
to have received payments
(c) § 72(b)(3)(C) – deduction under this section is treated as if attributable
to a trade or business of the taxpayer (references § 172)
(4) § 72(b)(4) – how to calculate unrecovered investment at a certain date:
investment in the contract minus aggregate amount received under K after
K’s starting date and before calculation date, so long as that amount was
excludable from gross income under this subtitle
iii) § 72(c) – definitions
(1) § 72(c)(1) – “investment in the contract” as of the start date is the
aggregate amount of premiums or other consideration paid for the K
minus the aggregate amount received under the K before the start date, “to
the extent that such amount was excludable from gross income under this
subtitle or prior income tax laws”
(2) § 72(c)(2) – “adjustment in investment where there is refund feature”;
deals with situation when return depends on life expectancy, etc.
(3) § 72(c)(3) – “expected return”
(a) § 72(c)(3)(A) – if depends on life expectancy, use actuarial tables
(b) § 72(c)(3)(B) – otherwise, it’s the aggregate of the amounts receivable
under the K as an annuity
(4) § 72(c)(4) – “annuity starting date” is the first day of the first period for
which an amount is received as an annuity under the K, unless that was
before 1/1/1954, in which case just use 1/1/1954
b) § 101 – certain death benefits
i) § 101(a) – proceeds of life insurance contracts payable by reason of death
(1) § 101(a)(1) – gross income doesn’t include amounts received under a life
insurance K, if they are paid by reason of the death of the insured (there
are exceptions to this)
(2) § 101(a)(2) – if a life insurance K or any interest in it is transferred for
valuable consideration, the amount excluded from gross income by the
previous section 1 shall not exceed the sum of the value of the
consideration plus the premiums and other amounts subsequently paid by
the transferee, but there are exceptions:
(a) § 101(a)(2)(A) – if the K has a basis for determining gain or loss in the
hands of a transferee
(b) § 101(a)(2)(B) – if transfer is the insured, to a partner of insured, ro a
partnership in which insured is a partner, or to a corp in which insured
is a shareholder or officer
c) § 104 – compensation for injuries or sickness
i) § 104(a) – except in the case of amounts attributable to (and not exceeding)
deduction under § 231 (medical expenses, etc.) for any prior taxable year,
gross income doesn’t include:
(1) § 104(a)(1) – workmen’s comp
(2) § 104(a)(2) – damages (save punitive) for personal physical
injuries/sickness
(3) § 104(a)(3) - $ from accident or health insurance (except $ from an
employer to the extent that the # is attributable to contributions by the
employer which were not included in gross income or were aid by the
employer)
(4) § 104(a)(4) – pension, annuity, or similar allowances for persona injuries
or sickness from active service in armed forces, etc.
(5) § 104(a)(5) – disability income attributable to injuries incurred as a direct
result of a violent attack that the Sec of State determines to be a terrorist
attack that occurred while the individual as a US employee and was
working at time of injuries
d) § 165 – losses
i) § 165(a) – generally, can deduct any loss not covered by insurance
ii) § 165(b) – basis for deduction is the adjusted basis from § 1011
iii) § 165(c) – for an individual, deductions under (a) are limited to:
(1) § 165(c)(1) – losses from trade or business
(2) § 165(c)(2) – losses from any transaction entered into for profit, though
not connected with trade or business
(3) § 165(c)(3) – exceptions in (h), losses of property not connected with trade
or business or a transaction entered into for profit, if losses arise from fir,
storm, shipwreck, or other casualty, or from theft
iv) § 165(d) – “losses from wagering transactions shall be allowed only to the
extent of the gains from such transactions”
v) § 165(e) – theft losses are counted during taxable year when discovered
vi) § 165(f) – capital losses are limited by §§ 1211-1212
vii) § 165(g) – worthless securities
(1) § 165(g)(1) – “If any security which is a capital asset becomes worthless
during the taxable year, the loss resulting therefrom shall, for the purposes
of this subtitle, be treated as a loss from the sale or exchange, on the last
day of the taxable year, of a capital asset.”
(2) § 165(g)(2) – definition of security (share, right, bond, etc.)
viii) § 165(h) – treatment of casualty gains and losses
(1) § 165(h)(1) – (c)(3) stuff allowed only to the extent that it exceeds $100
(2) § 165(h)(2) – net casualty loss allowed only to the extent it exceeds 10%
of adjusted gross income
(a) § 165(h)(2)(A) – “If the personal casualty losses for any taxable year
exceed the personal casualty gains for such taxable year, such losses
shall be allowed for the taxable year only to the extent of the sum of”
the amount of the gains plus the excess over 10% of the adjusted gross
income of the individual
(b) § 165(h)(2)(B) – when personal casualty gains > personal casualty
losses, all those gains are treated as gains from sales/exchanges of
capital assets, and all the losses are treated as losses from
sales/exchanges of capital assets
(3) § 165(h)(3) – definitions
(a) § 165(h)(3)(A) – “Personal casualty gain” is the recognized gain from
any involuntary conversion of property described in (c)(3)
(b) § 165(h)(3)(B) – “Personal casualty loss” is any loss described in
(c)(3)
ix) § 165(i) – disaster losses
(1) § 165(i)(1) – any loss from a disaster in an area later determined by Pres to
get Fed aid under Stafford Disaster Relief Act may be taken into account
for taxable year immediately preceding the taxable year in which the
disaster occurred
(2) § 165(i)(2) – casualty is treated as having occurred in year for which loss
is taken
(3) § 165(i)(3) – amount of loss taken into account in preceding taxable year
can’t exceed uncompensated amount determined on the basis of the facts
existing at the date the taxpayer claims the loss
(4) § 165(i)(4) – this § doesn’t affect prescription of regs or other guidance for
federal funds, etc.
Annual Accounting
29) Introduction
a) § 446: “Taxable income shall be computed under the method of accounting on the
basis of which the taxpayer regularly computes his income in keeping his books.”
But certain methods can be rejected by the Commissioner if they don’t really
reflect income well.
b) § 441: “Taxable income shall be computed on the basis of the taxpayer’s taxable
year,” (§ 441(a)) where “taxable year” means “annual accounting period.” (§
441(b))
c) Why have this?
i) Government needs some revenue every year. So it can’t wait for you to die,
etc. to tax you on your total lifelong gains.
ii) The government doesn’t really trust you that much, so it wants you to pay
taxes every year.
iii) We want to have things finalized. We like these things filed and done. Statute
of limitations is open for three years. And IRS can audit you for three years
after the date you file. Normal case, after three years, return is closed.
d) An effect of annual accounting:
i) Bob’s income stream: 50, 50, 50, 50, 50, 50, 50 . . .
ii) Judy’s income stream: 100, 0, 100, 0 , 100, 0, 100 . . .
iii) Same average income, but Judy is more volatile.
iv) Suppose tax rate is 0% up to $50, 50% above that. Here Bob pays no tax ever,
and every other year, Judy pays $25 (50% of top $50). This is an artifact of
annual accounting.
30) Burnet v. Sanford & Brooks (1931, p. 126)
a) Summary: Taxpayer entered into a dredging contract with the US, but ultimately
abandoned the undertaking and sued the gov’t for breach of warranty. B/w 1913
and 1916, the taxpayer incurred expenses of $176k in excess of the payments
received under the contract. In 1920, as a result of the lawsuit, the taxpayer
recovered the excess expenses of $176k, plus $16k of interest conceded to be
taxable. The taxpayer apparently had other sources of revenue during the periods
b/c it reported a positive net income for 1914. For 1913, 1915, and 1916, though,
it reported net losses from business operations after deducting the expenses just
mentioned.
b) Issue: Is this $ received in 1920 as a result of the breach of K income?
c) Arguments:
i) Taxpayer: Since the K didn’t produce any profit, there’s no way this $ was
meant to be included as “income” within the meaning of the 16th amendment.
Taxpayer proposed three options to solve this:
(1) Allow operating losses from 1913, 1915, 1916 to be carried forward, so
this gain would offset them
(2) Treat K as one contract, and apply this $ to the losses of earlier
(3) Treat earlier expenses as loans to the gov’t, basically as capital expenses,
and then charge them off against the award
ii) Gov’t: we have an annual accounting system, and you pay year-to-year,
d) Holding: SCOTUS holds for Commissioner; it’s taxable income in 1920
e) Reasoning:
i) Each acct’g period must be regarded as a discrete unit for tax purposes
ii) “Income” under the C
iii) Constitution could be understood to refer to accessions taking place solely
within the taxable year.
iv) Court just doesn’t want to take a position that keeps alive past tax returns.
v) If we’re going to allow stuff to be carried over, that’s something the leg needs
to do.
f) Class Discussion:
i) This is about loss carryovers.
ii) How can we help him? Congress eventually adopted § 172 – loss carryovers.
We have this concept of annual accounting, where whatever happens in that
year determines your tax return. But there are problems in doing that, as seen
here. So we do things to soften those problems. One such thing is that, if there
are losses you can’t use in one year, you can use it in other years. If we want
to stick to annual accounting, we can use concept of refundability. If you lose
$100 in year 1, and are in 30% tax bracket, you get $30 back at the end of the
year. However, no income tax system in the world has refundability. All
consumption taxes are refundable.
iii) Why no refundability? We might be afraid the taxes aren’t real. Maybe they
result from tax shelters or something like that.
iv) Under § 172, losses incurred in business can be carried back to the 3 years
preceding the loss year, and then forward for the 15 succeeding year, as a
deduction from the positive income of each of those prior or subsequent
periods. This mostly helps businesses, though, because people don’t really
have losses. Notice that this doesn’t fix the example personal income streams
above. It averages stuff out nicely only if there are losses. There were some
attempts to average income out for people who had spikes in income—ex, an
author who gets royalties one year—but they were done away with in 1986.
31) North American Oil Consolidated v. Burnet (1932, p. 131)
a) Summary: Π operated some oil fields whose title was in the govt’s name; gov’t
set up a receivership early in 1916; in 1917, lower court said Π got $, but wasn’t
settled til after appeal in 1922; tax rates were lower in 1916 and 1922, high in
1917, so Π wanted it as income in either 1916 or 1922
b) Issue: whether $ received income in 1916 (earned), 1917 (lower court decision),
or 1922 (dispute finally over)
c) Holding: 1917
d) Reasoning:
i) “The net profits were not taxable to the company as income of 1916. For the
company was not required in 1916 to report as income an amount which it
might never receive . . . There was no constructive receipt of the profits by the
company in that year, because at no time during the year was there a right in
the company to demand that he receiver pay over the money .. . It was not
until 1917, when the District Court entered a final decree vacating the
receivership and dismissing the bill, that the company became entitled to
receive the money.” Basically, in 1916, Π just had a disputed claim. In 1917,
it actually had a cash income, which it then held under a “claim of right.”
e) Class Discussion:
i) Chirelstein: “In effect, current inclusion was required where the taxpayer (a)
received the funds in question, (b) treated them as its own, and (c) conceded
no offsetting obligation.”
ii) From Wikipedia:
(1) The claim of right doctrine established in North American Oil requires that
a taxpayer claim profit as income once a claim of right has been
established, even though the taxpayer might not be entitled to retain the
profits indefinitely. A taxpayer is not required to claim income that has
significant restrictions, and which the taxpayer might never have access to.
In such a situation, if there is no constructive receipt of the earnings,
regardless of whether the company has recorded the income on their
books, the taxpayer does not have to claim the profit as income until they
have control over the earnings.
(2) In the case that a taxpayer receives earnings without restriction or
significant limitations, they have received a claim of right to the earnings,
and as a result must claim it as income. This does not mean that the
taxpayer is certain that they will be able to retain the earnings after some
later legal action, but that the taxpayer now has accession to and ultimate
control over the realized gain. If the taxpayer later loses the right to that
profit, they would be entitled to a deduction to restore that amount.
iii) This decision can best be explained and defended on practical grounds.
Treasury has a plausible interest in immediate taxation. Postponement creates
the risk that the taxpayers might become insolvent before the tax is paid. Also,
this helps with administrability.
32) US v. Lewis (1951, p. 134)
a) Summary: guy gets $22k bonus in 1944 and pays taxes on it; realizes in 1946 he
should’ve gotten only a bonus of $11k; he was honestly mistaken, so we wanted
to reopen the 1944 return and recomputed his tax for that year by excluding the
excess amount; he returns the $11k; he wants a refund of the extra taxes he paid in
1944; Court says no to the refund, and instead that he should take it as a loss in
1946
b) Reasoning:
i) NA Oil – “he has received income which he is required to return”; this
language doesn’t contain an exception for being mistaken; he got this money
and treated it as his own; claim of right doctrine  tax it all now
ii) “Income taxes must be paid on income received (or accrued) during an annual
accounting period.”
iii) Sanford & Brooks – The “claim of right” interpretation of the tax laws has
long been used to give finality to that period, and is now deeply rooted in the
federal tax system.
c) Dissent:
i) Basically an equitable argument: this isn’t fair; he paid taxes on it when he got
it; now it’s not income, so he should get the taxes back; this won’t shake the
foundations of the tax law
d) Class Discussion:
i) This is basically the opposite of NAOC. Lewis got too much $ early, and had
to give some of it back later, but paid taxes on the full amount. Lewis didn’t
want to postpone anything, but treat things as a unified transaction.
ii) Note also this differs from NAOC because when Lewis gets the $, there’s no
dispute about it. It’s treated as his. This is an argument that the claim or right
doctrine doesn’t even apply here.
iii) In the absence of specific legislation, the Court refused to apply transactional
approach. This is why it’s similar to Sanford, as cited above. But Congress
responded with § 1341, which allows people like Lewis to choose between
giving back the taxes that would’ve been paid, or paying the taxes later. This
helps avoid a possible penalty due to the progressive rate structure. (For actual
numbers see handout 8.)
iv) WWII period was responsible for the disparities in tax rates.
v) Same theory as NAOC. Theories are consistent. Note, though, that § 1341
doesn’t apply to NAOC.
vi) Claim of right – receive cash and treat it as if you own it, and you believe that
there is no offsetting obligation
33) Indianapolis Power & Light Co. (1990, p. 333)
a) Summary: IPL got cash deposits from (unreliable) customers to secure obligations
for services
b) Issue: Are these deposits taxed now, and counted as deductions later if returned?
Or are they just taxed if and when they are applied as payments on behalf of the
customers?
c) Holding: Not taxed until applied to customer bills.
d) Reasoning: Customer never gave up legal right to recover the deposit and could
always insist upon full repayment in cash if their bill was paid up.
e) Note:
i) This is basically an issue of timing.
ii) Compare this case to:
(1) AAA v. US – prepaid membership dues have to be included in the year of
the receipt, even though the individual’s membership almost always
extended into the following year; the club’s allocation of dues on a
monthly basis was “artificial” because it bore no necessary relationship to
the particular time or times when a member might actually require road
services
(2) Schlude v. Commissioner – prepayments for dancing lessons needed to be
included in year received, even though the taxpayer was careful to
allocate the fees to the periods when the lessons happened, since students
who had paid might allow their K rights to lapse
iii) Full inclusion of prepayments has merits—simplicity, Treasury doesn’t have
to wait, etc.
iv) § 455 – permits deferral of prepaid subscriptions for magazines and other
periodicals
v) § 456 – overturns AAA by allowing postponement of prepaid dues received
by membership organizations such as auto clubs
34) Related Code
a) § 111 – recovery of tax benefit items
i) § 111(a) – GI doesn’t include “income attributable to the recovery during the
taxable year of any amount deducted in any prior taxable year to the extent
such amount did not reduce the amount of tax imposed by this chapter”
ii) § 111(b) – credits
iii) § 111(c) – treatment of carryovers
iv) § 111(d) – special rules for accumulated earnings tax and for personal holding
company tax
v) This section applies really only when you couldn’t have used the loss at all.
b) § 1341 – computation of tax where taxpayer restores substantial amount held
under claim of right
i) § 1341(a) – If you include something in your income in a previous year that
you thought you had an unrestricted right to, but it’s later established that you
don’t have a right to it, you get to choose the taxes between the two years that
give you the benefit
ii) If an item was included in income in a taxable year because of the claim of
right doctrine, and if in a later year it is established that the taxpayer did not
have an unrestricted right to the item, so that a deduction exceeding $3k is
allowable, the tax for the later year will be whichever is less – tax in later year
computed with deduction, or tax in later year without deduction, but reduced
by amount of taxes that would’ve been avoided in earlier period
iii) Example:
(1) Year 1: get $100, tax rate is 50%; tax owed is $50
(2) Year 2: must give $100 back; 30% tax rate; tax you get back is $30
(3) § 1341 says you can choose the Year 1 tax rate because it’s beneficial to
you . . . so you can not include the $100 deduction in Year 2, and then just
subtract $50 from your Year 2 taxes
The Treatment of Loans and Their Repayment (or Not)
35) Loan basics: Borrow $20k from a bank. This isn’t income. Why? You’re not any
better off. Why? Because you have an obligation to pay it back. Think of this in terms
of a balance sheet. Think of this in terms of a claim of right. You don’t really have
full control over that money. You have to give it back eventually. What about the
bank? The bank doesn’t get a deduction, because it’s no worse off. It lost $20k, but it
has a promise to get that amount (and more, in interest, actually) back.
36) Kirby Lumber (1931, p. 147)
a) Summary: Kirby borrowed money by issuing bonds; it bought back the bonds
early for less than their face value; in other words, it paid off its debt for less than
the original amount owed; is this difference a taxable gain to the borrower?
b) Holding: yes, this is a gain
c) Reasoning: “the excess of the issuing price or face value over the purchase price
is gain or income for the taxable year”
d) Class discussion:
i) § 61(a)(12) and § 108 work together to include COD as income, but to
cushion its effect a bit.
ii) What about the lender? They get a deduction for this, as it is a loss—they
received less than they were supposed to. The loss matches up with the gain
accounting-wise.
iii) Why this buy-back for lower price? Interest rates went up, so the lenders want
their money back to lend it back out at a higher interest rate. In a sense, Kirby
made a good bet. He bet interest rates would go up, and they did.
iv) Note what’s going on with a loan.
(1) A borrows money that’s not included in income, so not taxed.
(2) But A spends this money on stuff that gives taxable benefits. For instance,
A can by real estate that depreciates. How is this made up for from the
treasury’s perspective? . . .
(3) A creates some income with the loan, and has to pay the loan $ back in
after-tax dollars.
(4) But what happens if A doesn’t have to pay all of it back? Then he should
have to give back some of the benefit he got from getting the loan and
realizing tax benefits (maybe depreciation deductions, etc.) from the loan
money. How do we do that? Count the amount not required to be paid
back as income.
(5) So . . . Two basic sources of $: income or borrow
(a) Income is taxed when you get it. So all your income has already been
taxed when you spend it. So you earn X, after taxes it’s down to Y, so
you can spend Y after taxes.
(b) Borrowing isn’t taxed. So if you borrow Y, you can spend Y (same
amount you can spend if you earned income of X which was then
taxed down to Y) . . . but what if you then only have to pay back Z < Y
. . . then you have to give back only Z after tax dollars . . . so it’s as if
Y-Z dollars aren’t taxed. We need to make up for that missed taxation,
so this Y-Z is treated as income.
v) This Kirby result holds even if the COD is a result of the borrower’s financial
troubles. § 108 accounts for this, though, and no income is included if COD
occurs in bankruptcy proceeding, etc. At first this option was made available
to all debtors, but solvent ones took advantage of it. Corps would buy back
their own bonds at a discount, so they’d have COD income that wasn’t
taxable. So shareholders would see income and get happy, and corp wouldn’t
need to pay tax on the income.
37) Bowers v. Kerbaugh-Empire
a) Kirby is confusing because of a prior case called Bowers v. Kerbaugh-Empire,
and Kirby distinguished this case, rather than overruling it.
b) Bowers
i) Take-home: gain from foreign currency inflation will generally qualify as
income within the meaning of § 61
ii) Summary: taxpayer had borrowed $ on its subsidiary’s behalf; $ repayable in
German marks; mark had declined at time of repayment, so the $ cost of
paying of loan was less than $ amount of loan at time of borrowing; SCOTUS
ruled for taxpayer, but it’s unclear why; probably ruled this way because the
subsidiary’s unsuccessful business operations had actually produced and
overall loss for the parent
c) Another version of Bowers: Borrow $20k from the bank and buy a piece of land.
Land goes down in value. You say to the bank: I can give you only $18k back,
because of this. Banks says ok. Are you $2k better off? No. You paid back all that
you had. Bowers does not reflect what the law does. Think of it instead as
separate transactions: You get a $2k gain when you have to pay back only $18k,
but you have a $2k loss when you sell the land for FMV of $18k, because your
basis on the land was $20k.
38) On inflation:
a) Basic setup: D borrows $1k from C to repay in a year; D invests it in land;
inflation of 12% occurs over the year, so the purchasing power of $1k at
beginning of year is same as purchasing power of $1120 at end of year; assume
land grew in value to $1120
b) Example 1: D borrows $1k from E and pays it back to C. In this transaction, D
has made a gain of $120 (equity in land). Does D have taxable income? No.
c) Example 2: D sells land for $1120 and pays back C, has $120 left. D have a gain?
Yes, of $120. D have taxable income? Yes, of $120.
d) Conclusion: Actual economic gain isn’t what’s being taxed, only the amount of
dollars you get. Not really much to do to fix this. Just notice that a tax mechanism
that measures gains and losses in nominal dollars operates poorly during periods
of sharp inflation.
39) Zarin v. Commissioner (1990, p. 150)
a) Summary: Zarin keeps getting “loans” in the form of casino chips even after he
was supposed to have been cut off by the NJ gaming commission; eventually he
couldn’t pay back $3.4 mill; he settles with the casino for $500k (the court
doesn’t hold that the debt is or is not unenforceable)
b) Procedural Posture:
i) IRS said this was a gain of $2.9 mill as a cancellation of debt, on the theory
that he was released from a liability of $2.9 mill, and as such realized a gain of
that amount. Tax court rules against Zarin.
ii) 3d circ reverses, saying Zarin realized no gain through this settlement
c) Reasoning:
i) Look to § 108(d)(1) for definition of debt.
(1) § 108(d)(1)(A) – this debt was unenforceable, so no liability
(2) § 108(d)(1)(B) – this was not property; it was services
ii) The settlement implies that the value of what Zarin got was $500k, so he
doesn’t gain/lose anything. They claim there is a disputed value here.
(1) Weisbach says this discussion is stupid and irrelevant. He got $3.4mill
worth of stuff. There’s no question here. There’s a market for these chips.
He got $3.4 mill of them. End of story.
iii) Majority’s second theory is that he really got only $500,000 worth of stuff,
due to the restrictions in what he can do with the chips.
(1) Problem with this is again, there’s no question on the value of what he got.
He got $3.4 million worth of stuff. There’s no argument about this!
d) Dissent:
i) He got $3.4 million worth of stuff and paid back only $500k. He gained $2.9
million!
e) Class discussion:
i) Why would the casino settle?
(1) Probability Zarin can pay is less than 1, so why continue with the case,
paying lawyers, etc., when he doesn’t have that much money anyway?
(2) Maybe casino is afraid the court will find the debt unenforceable, so
there’s a chance they’ll get nothing at all.
ii) Two problems with this case:
(1) § 108’s definitions apply only to that section (“For purposes of this section
. . .”), and they used those definitions in looking at § 61(a)(12), income
from discharge of indebtedness.
(2) If this whole thing depends on the fact that the debt is not enforceable,
then why wasn’t Zarin taxed from day 1? Look at his balance sheet on the
day he gets the loan. He gets $3.4 million but has to pay back only $500k.
He’s $2.9 million better off. $3.4mill go in assets column, $500k goes on
liability side. He should be taxed on day 1, according to third circuit’s
theory.
iii) Cancellation of debt has nothing to do with enforceability. It is an accounting
system. On the day you get a loan from a loan shark, you have a huge asset.
Doesn’t matter that it’s not a legal/enforceable debt.
iv) So majority is a bad piece of workmanship. But what about the dissent. Is this
right? After all, the more he loses, the more tax he’d owe. Can this dissent
possibly make sense? Is there a way to save poor Zarin?
(1) Maybe can offset this income of $2.9 million with his gambling losses (§
165(d)). But notice that § 165(d) allows you to take losses only to the
extent of gain from such transactions. So since he had no gains, he can’t
claim any gambling losses. Can we rescue him from this? We can say that
the $2.9 million was a gain from wagering, not a gain from cancellation of
debt. A stretch, but it might be your only option to save Zarin. There’s
another problem, however, noted in Note 3 on p. 158. See regulation §
1.165-10, which provides “Losses sustained during the taxable year on
wagering transactions shall be allowed as a deduction but only to the
extent of the gains during the taxable year from such transactions.” He
doesn’t get this gain till 1981, when the debt is forgiven, but he lost the
money in 1980. So this backfires too. So your only real way to say this is
to hold the $2.9 mill as a wagering gain, and claim the regulation is
wrong.
(2) What about bankruptcy? This is more of a deferral mechanism, so it would
help only a little bit.
(3) Maybe can use § 108(e)(5), which basically says if you reduce the debt
where you’re not in a title 11 case and not insolvent, then it’s treated as a
purchase price reduction. Problem here is that this deals only with
property, and the court here treats these chips as services, not as property.
So this argument would be dismissed. Is this then the case for all services?
If you go to the doctor, get a discount on a procedure because you can’t
afford it, do you have to pay taxes on that reduction? Seems like no.
Maybe argue some sort of common law right to purchase price reduction.
The wording of § 108(e)(5) seems to hint at a general idea of purchase
price reduction beyond this section.
(4) Can argue that Zarin’s addicted to gambling, so that he was really not
getting a benefit out of this. This idea is hinted at at the end of the first
note on p. 158. To flush this out more, we want to tax people who are
better off, and Zarin wasn’t better off because he wasn’t better off at all
from this. Maybe this is common law ability-to-pay stuff.
(5) Treat the $2.9 million debt forgiveness as the recovery of the loss of the
$2.9 million in a common law way.
40) Diedrich v. Commissioner (1982, p. 159)
a) Summary: donor makes a gift of property (stocks) on the condition that the
recipient pay the resulting gift tax; gift tax paid here by recipients ($63k)
exceeded the basis in the stocks ($51k); question is whether this $12k difference
is a taxable gain to the donor
b) Holding: yes, the donor has received income
c) Class Discussion:
i) Main issue here is basis allocation. Who gets the basis? Kids get it all? Dad
gets it all? Split it somehow?
ii) This case seems to follow from Old Colony Trust Commissioner (1929) –
employer’s payment of federal income taxes on behalf off its employee
constituted income to the employee; this case preceded income tax
withholding.
iii) Court treats it here like part gift part sale. If this is the case, what’s the basis?
Because basis for gifts is the donor’s basis. Basis for sale is amount paid. So
what is it? Turn to Reg § 1.1015-4(a), which says the basis in the hands of the
donee is whichever is greater.
iv) Example:
(1) P owns 1000 shares
(2) Basis is $15k ($15/share)
(3) Value of shares is $100k
(4) Gives to kids. Kids pay gift tax of $20k.
(5) How much is realized by parents? $20k.
(6) Their basis is $15k, so their gain is $5k.
(7) What have the kids gained in this transaction?
(a) What’s their basis? Might say $15k, that is Taft v. Bowers. But haven’t
the parents used up the basis?
(b) Remember, basis is just a way of keeping track of how much gain is
happening in the system, and making sure it’s taxed exactly once. As
long as exactly one person gets to use the basis, then it’s ok. Maybe
tax the parents on all the $20k, and give the kids the basis. Maybe give
the parents the basis, and the kids get none of the basis.
(8) What if the parents tried to pay the tax themselves, and used the stocks to
pay this tax? That is, they sell some stock to cover the gift tax of $20k.
(Here, for simplicity’s sake in the example, we’ll assume they won’t pay
taxes on the gain they received from sale of stock, and also that the tax on
the gift of fewer shares [now only $80k of stock] is the same $20k as
before.) Then the parents would proportionately allocate 2/10 of the basis
($3k) to the sale, so the kids get $12k of the basis for the $80k gift.
(a) Note here that this is (perhaps) an odd result—it’s at least a different
result—than the actual one. If the people in the actual case did this,
they’d have sold $60k of stock (1/5). Basis would be 1/5 of the $51k,
around $10k. So gain would’ve been $50k. So gift givers save more
money this way. I guess it’s not such a big deal you get different
results. As long as you know ex ante, you have two timing options.
v) Some alternative treatments here. (Assume FMV of $200k.)
(1) Treat children’s paying of the $63k tax as nothing. They get a basis of
$51k, so when they sell they realize a gain of $149k. So $149 is taxed.
(2) Treat children’s paying of the $63k tax as purchase of the stock. Parents
get a gain of $12k. Kids get basis of $63k. When they sell, they get $137k
gain. Total gain is $149k. So $149k is taxed.
(3) Treat children’s paying of the $63k tax as purchase of some shares,
followed by gift of remainder. Gain from all transfers will be the same
here. To do specific numbers, need to pick a proportion of stocks to
allocate the $63k to.
(4) Treat children’s paying of the $63k tax as an increase in basis. So basis in
children’s hands is $114k. When they sell, they get $86k gain. Where did
the rest of the gain go? Parents should get $63k of gain, too. For they get
$63k, and none of the basis is used, so this is all gain to them. In a sense,
it’s as though the kids paid $126k to the parents, $63k to cover the basis,
and then $63k beyond.
41) Related Code
a) § 61(a)(12) – gross income includes “Income from discharge of indebtedness”
b) § 108 – income from discharge of indebtedness
i) § 108(a) – exclusions from gross income
(1) § 108(a)(1) – discharges occurring in title 11 case; discharges occuring
during insolvency; qualified farm indebtedness that is discharged; other
than for a C corp, indebtedness discharges of qualified real property
business indebtedness
(2) § 108(a)(2) – gives priority of exclusions; tells how to “coordinate”
exclusions
ii) § 108(b) – reduction of tax attributes
(1) § 108(b)(1) – “The amount excluded from gross income under
subparagraph (A), (B), or (C) of subsection (a)(1) shall be applied to
reduce the tax attributes of the taxpayer as provided in paragraph (2).”
(2) § 108(b)(2) – except for paragraph 5, reductions are made to the following
in the following order
(a) § 108(b)(2)(A) – net operating loss for the taxable year of the
discharge, and any net operating loss carryover
(b) § 108(b)(2)(B) – general business credit
(c) § 108(b)(2)(C) – minimum tax credit
(d) § 108(b)(2)(D) – capital loss carryovers
(e) § 108(b)(2)(E) – basis reduction
(f) § 108(b)(2)(F) – passive activity loss and credit carryovers
(g) § 108(b)(2)(G) – foreign tax credit carryovers
(3) § 108(b)(3) – reductions are dollar-for-dollar, except for (B), (C), (G), and
part of (F), which are one-third of a dollar per dollar
(4) § 108(b)(4) – ordering rules
(5) § 108(b)(5) – election to apply reduction first against depreciable property
iii) § 108(c) – treatment of discharge of qualified real property business
indebtedness
(1) § 108(c)(1) – “The amount excluded from gross income under
subparagraph (D) of subsection (a)(1) shall be applied to reduce the basis
of the depreciable real property of the taxpayer.”
(2) § 108(c)(2) – limit to the amount excludable under (a)(1)(D) wrt qualified
real property business indebtedness is the excess of outstanding principal
amount of such indebtedness minus FMV
(3) § 108(c)(3) – “qualified real property business indebtedness” defined
(4) § 108(c)(4) – “qualified acquisition indebtedness” defined
(5) § 108(c)(5) – secretary may issue regulations to accomplish the above
iv) § 108(d)(1) – “indebtedness of taxpayer” means that “for which the taxpayer
is liable, or . . . subject to which the taxpayer holds property”
v) § 108(e)(5) – reduction of debt incurred to purchase property is treated as
reduction in sale price, not income to purchaser
(1) Example: Go to GM, they give you keys, you give them a promissory note
to pay $20k. The car is a lemon. Car dealer says: you keep the car, I don’t
want it, but you pay back only $18k. Under the new § 108, we treat this as
if the original purchase price was $18k. We admit that at the time of the
transaction, there is info we don’t know—here that the car is a lemon.
Congress is unwilling to do this in the 3d party lender case, because we
can’t go back and change the fact that you actually borrowed $20k and
then paid that $20k for the car.
c) § 165(d) – “Losses from wagering transactions shall be allowed only to the extent
of the gains from such transactions.”
Transfer of Property Subject to Debt
42) Introduction to Crane and Tufts.
a) Some basics on mortgages
i) Get loan $ to buy property; property stands as security for loan
ii) Default  mortgagee gets property, can sell, apply $ to rest of loan
iii) Excess in sale goes to debtor; any amount under outstanding amount is taken
as loss to lender
iv) Mortgage-loan is repayable—amortizable—in equal installments over a
specified time period
v) If mortgagor sells before complete amortization, portion of the sale price must
go to satisfy outstanding installments
b) Question for Crane and Tufts: Person buys property with 20% their own money,
80% nonrecourse loan. What can purchaser include in basis? Just the 20%? The
whole purchase price? This is important for depreciation purposes.
c) For simplicity, pretend Crane involves the following numbers:
i) Purchase property for $2million.
ii) Rent property for $300k/year. This is clearly (rental) income.
iii) First piece of background we need is on depreciation deductions. We could
just wait till the property is sold, and do all the deductions then. But we think
that’s waiting too long. So we instead estimate annual depreciation
deductions. All investment property gets this other than land.
iv) Assume the property will decline in value by $100k/year. So this is your
deduction per year. Rental income is $300k. So each year you have a net gain
of $200k. If you do this for 5 years, you’ve gained $1mill total over those 5
years. Then in year 6, you sell the building for $1.5mill. How much gain or
loss do you have? The answer is none. Why not? Haven’t you sold something
you bought for $2mill at $1.5mill? Well, yeah, but also you’ve deducted a
total of $100k from the $2mill basis each year of the five years, so when you
sell for $1.5mill, there’s no loss. In a sense, you’ve already used the loss each
year in the form of a depreciation deduction.
v) Suppose you borrowed $2mill from the bank on a nonrecourse basis, then
bought the property for $2mill. These are two distinct transactions. The above
is just the same. What happens here? This is Crane.
43) Crane v. Commissioner (1947, p. 165)
a) Summary: Mrs. Crane inherits property with a nonrecourse mortgage on it. She
holds property for a while, takes depreciation on the property, doing so by in part
including the value of the mortgage in the basis. She eventually sells the property
with the nonrecourse mortgage still attached for $2,500. She at this point claims
her basis is $0, saying when she inherited the property, she inherited only the
equity in the property, which was $0, because the building was encumbered by a
mortgage. She says she shouldn’t have taken that depreciation, but the statute of
limitations has passed, so oh well . . . also, she claims it didn’t even reduce her
taxes at all, so it wasn’t that bad. IRS claims that her amount realized must
include the value of the mortgage . . . so her AR is $2,002,500 (using the
simplified numbers from the above introduction).
b) Table:
Amount Realized
Initial Basis
Depreciation
Adjusted Basis
Gain
Net Gain
Crane
$2,500
$0
$0
$0
$2,500
$2,500
IRS
$2,002,500
$2,000,000
$500,000
$1,500,000
$502,500
$2,500
c) Holding: the amount realized by the seller of mortgaged property included both
the case received from the buyer and the face amount of the mortgage to which
the property was subject
d) Reasoning:
i) Mrs. Crane is relieved of the mortgage obligation; that’s a gain.
e) Class Discussion:
i) This is mostly about including assumption of loan in amount realized.
ii) With a nonrecourse loan, the buyer gets the upside of a rise in value without
the risk of the downside of a drop in value. If value goes up, can sell or just sit
on increase. If value drops, can just leave and not be on the hook for the debt.
It’s likely, however, that in order to get this nonrecourse, there’s a higher
interest rate attached.
iii) Note because of timing issues, the IRS’s position is the pro-taxpayer position.
She’s allowed to deduct earlier, hence defer payment of taxes. Why is the govt
doing this? Maybe just trying to prevent whipsaw because of the statute of
limitations. But who cares about Mrs. Crane and this one apartment building?
The IRS has to care about a lot more things, so it’s really hard to explain this.
Many say this is the single worst victory for the IRS; that no victory has cost
the IRS so much money before. If you exclude the mortgage, numbers come
out the same, but tax payments are done more up front, so it’s better for IRS.
iv) Better argument for SCOTUS: any loan has to be treated like cash. So her
basis at the beginning had to be $2,002,500. And so when she sells, her
amount realized, for consistency/symmetry, must include this $2mill, also. We
see some support for this in the Tufts decision: “Because of the obligation to
repay, the taxpayer is entitled to include the amount of the loan in computing
his basis in the property; the loan, under § 1012, is part of the taxpayer’s cost
of the property.”
v) If Crane’s interpretation were right, then who would get the depreciation
deductions? Well, it’s got to be somebody, and bank can’t take them, so Crane
gets them.
vi) Congress responded to this creation of tax shelters by saying that no one gets
the benefits. They put anti-tax shelter rules in place requiring true equity
(Crane had none) and you had to manage the property, too.
vii) This case is about symmetry and depreciation.
(1) Symmetry – doesn’t really matter how we treat the mortgage, just treat it
the same way on each end. If you include it in basis, included it in amount
realized. If you don’t include it in basis, don’t include it in AR.
(2) Depreciation – this is where more importance comes in, because if you
include the mortgage in basis, you have more you can deduct
44) Woodsam Associates, Inc. v. Commissioner (1952, p. 211)
a) Summary: Key idea here is that Mrs. Wood has property with a value greater than
the basis. Say value is $100, basis is $15. She borrows on a nonrecourse basis
more than the basis in the property, securing the loan with the property. For
example, say $25. Does she have a realization event when she does this? She does
get cash that’s hers to keep. She’ll never be obligated for the cash, since it’s
nonrecourse.
b) Issue: Is the money received through a nonrecourse loan over the basis in the
securing property a realization event?
c) Holding: not a realization event
d) Class Discussion:
i) This is still good law.
ii) Notice that Mrs. Wood doesn’t have to worry about all the downside in the
property anymore. She can benefit if the property’s value goes up – she can
sell it and pay off the loan, and keep the excess. But if the value drops below
$25, she can default and the property will fill in for the $25 debt.
iii) What’s another way? Tax the amount over basis immediately. Then calculate
corresponding gain or loss on later disposal of property.
iv) Taxpayer here was arguing for realization, because SOL had passed, so no tax
would’ve been levied. But the sale of the property hadn’t yet occurred, so gain
from that would still be subjected to tax. That’s part of what IRS wanted. But
also, maybe IRS is concerned with administrability. If they went the other
way, not only is there a second step to analyze/tax, but the IRS would have to
look at the status of the borrower for each such transaction, and see if this is
really “nonrecourse.” If the property—say a house, or something—is all the
borrower has, then it’s not really nonrecourse. You can’t say they aren’t
personally liable if they lose their house, their only valuable asset.
v) Can characterize this transaction in two ways:
(1) Right of borrower to “put” the property to the lender to satisfy the debt.
(2) Right of the borrower to “call” the property by paying for it the cost of the
debt.
45) Crane + Woodsam Example:
a) A buys building for $4k ($1k cash, $3k loan). FMV goes up to $10k. Buyer
borrows an additional $6k against that increase. Then sells for $10k.
i) What’s the initial basis? $4k under Crane.
ii) What’s the basis after the $6k loan? Still $4k under Woodsam.
iii) On sale, A gets a gain of $6k, and this is taxed. So that’s where the loan
proceeds are taxed.
b) Note: Crane includes initial borrowing in basis, Woodsam excludes subsequent
borrowing from basis. But this “difference” will most likely be illusory for
purposes of calculating applicable taxes. In the above example, if you include the
gain, A is taxed a bit earlier on the $6k, and then has no gain on next sale. Just a
timing issue, as usual. But also, there’s a bit more basis to be depreciated, so this
earlier taxation may be offset a bit.
c) One last thing on Crane and Woodsam—both are ironic victories for the IRS.
Both allow for deferred gain realizations.
46) Commissioner v. Tufts (1983, p. 173)
a) Summary: Basically the same facts here as Crane, except that the amount of the
mortgage exceeds the FMV of the property. $44k of cash + $2mill nonrecourse
loan secured by the property. Taxpayer took depreciation of $500k, which
reduced the basis to about $1.544mill. Taxpayer “sold” the property with the
nonrecourse mortgage attached. Got no money, but mortgage responsibility was
gone. At time of sale, FMV was less than the adjusted basis of $1.544mill.
b) Issue: Does it matter here that there’s discrepancy between the FMV of the land
and the value of the mortgage?
c) Holding: No, it doesn’t matter. Crane applies the same way  taxpayer realized
the full unpaid balance of the mortgage debt—$2mill. Thus taxpayer has a gain of
around $500k.
d) Taxpayer’s argument: Since the value of the property represented the limit of the
taxpayer’s liability, they argued that no more than $1.544mill could be included in
AR, and hence no gain should have occurred on the transaction (since basis was
$1.544mill.)
e) Class Discussion:
i) Someone not personally liable for a debt more than FMV value of the
property has no reason to pay back the whole loan. It’s as though the person
has a choice. Pay off the loan with cash or property. And property is worth
less. Duh. Choose property.
ii) They really lost only $44k, or whatever they just put in. But according to this
rule, when it’s all said and done, they’d be reporting a $600k loss (difference
between the $2mill value of the loan and the $1.4 million FMV of the
property. Taxpayer’s position is laughable. It can’t be the case that the tax
accounting system gives you a $600k loss when you really lost only $44k.
iii) Important to see difference between concurrence and majority theory.
(1) Majority theory includes loans and cash you receive, and value of land
doesn’t matter.
(2) O’Connor’s theory in concurrence is to look at this as two different
transactions. The two transactions are 1) sale of the asset itself for the
FMV (here that would be for FMV of $1.4mill). This would result in a
loss of $100k in the case at hand, since adjusted basis was $1.5mill. And
2) use of the proceeds from the sale ($1.4mill) to satisfy the dept of
$2mill. Thus there’s $600k in COD, and so total gain, as above, of $500k.
Amount Realized
Initial Basis
Depreciation
Adjusted Basis
Gain
Loan:
Amount Paid Back
COD gained:
Net gain:
$1,400,000
$2,000,000
$500,000
$1,500,000
($100,000)
$2,000,000
$1,400,000
$600,000
$500,000
(a) What’s the purpose of separating this out? They get the same numbers.
Well, it may be important to know what comes from property and
what comes from loan. These different categories may be treated
differently. Her rule is more accurate, though the majority’s rule is
simpler. Majority did note, however, that if the issue were de novo,
they’d probably go this way.
(b) For recourse liabilities, O’Connor’s is the rule. Why? Because if you
really do have to pay it back, then if you’re relieved of that, then it’s
COD.
iv) Either way, we have tax shelters driven by all this stuff. The basic shelter is
still driven by the economics of Crane. You can borrow money, and get the
benefit of the depreciation of property along the way, and then you only have
to take that benefit when you sell.
v) A limitation on Tufts.
47) Related Regs
a) Treas Reg § 1.1001-1(e) – if transfer is part gift part sale, transferor has gain to
the extent that the AR > adjusted basis; no losses for AR < adjusted basis
b) Treas Reg § 1.1001-2(a)(1) – “Except as otherwise provided in paragraph (a)(2)
and (3) of this section, the amount realized from a sale or other disposition of
property includes the amount of liabilities from which the transferor is discharged
as a result of the sale or disposition.”
c) Treas Reg § 1.1001-2(a)(2) – “The amount realized on a sale or other disposition
of property that secures a recourse liability does not include amounts that are . . .
income from the discharge of indebtedness under § 61(a)(12).”
d) Treas Reg § 1.1001-2(a)(3) – “In the case of a liability incurred by reason of the
acquisition of the property, this section does not apply to the etent that such
liability was not taken into account in determining the transferor’s basis for such
property.”
e) Treas Reg § 1.1001-2(c), example (7)
i) Year 1, A buys herd of cattle from B for $1k and $19k nonrecourse note
secured by cattle
ii) Years 2-3, some cattle die, depreciation makes A’s basis $16,500
iii) Year 4, B gives cattle back to A in satisfaction of debt; all $19k of debt
remained at the time
iv) A’s gain is AR – adjusted basis = $19k - $16,500 = $2,500
f) Treas Reg § 1.1001-2(c), example (8)
i) A uses asset with FMV $6k to satisfy debt of $7,500
ii) Amount realized is $6k, income is of $1,500
g) Treas Reg § 1.1015-4
i) (a) – unadjusted basis of something in transferee’s hands as result of sale/gift
is sum of:
(1) the greater of how much transferee paid and the transferor’s adjusted
basis, and
(2) the amount of increase, if any, in basis authorized by § 1015(d) for gift tax
paid
ii) Also part of part (a) . . . FMV is the upper bound of unadjusted basis in hand
of transferee.
Imputed Income and Imputed Taxes
48) Introduction
a) Some definitions of income
i) Income = consumption + change in wealth
ii) Income = labor earnings + capital income
b) Exclusion of imputed income is important in dollar terms, but rests on no specific
Code provision, and simply results from a long-standing administrative practice
of the IRS, which never attempted to bring it into the tax base
(1) Examples
(a) Bonuses to people who own and live in their own homes
(b) Bonuses to people who watch their own kids; disincentives for second
person to work
49) Weisbach’s presidential campaign speech. Tax relief to America’s working families.
Trust people with own money. Pass provision allowing deduction for each family for
first $7,000 they spend on food. Not fair to tax what you need. This helps starving
kids, too. Helping them would save money by reducing welfare for these individuals.
Also need to protect American farmer—where your food comes from. Limit to
$7,000 per family weeds out people who spend money on luxury stuff.
a) 4 things going on within this speech/4 reasons given for this plan:
i) Food is necessity.
(1) This isn’t the only necessity. Why food? What about clothes? Housing?
What about education? This is really getting to the question of what the
tax base includes. If you exempt necessities, there’s very little left in the
tax base. So the argument that we don’t tax or shouldn’t tax necessities
just has to be wrong. Further, to the extent that we shouldn’t tax people to
the extent that they need a certain amount to live, we have the rate
structure for that. Poor people really don’t pay income taxes, because their
deductions exceed their income. Also, lower rates for lower incomes. So
in a way, this $7,000 exemption/deduction/whatever ends up helping only
those people who actually have enough money to be taxed and also spend
$7k on food. So this isn’t the poorest people, it’s another group. This ideas
is shown a bit more right here . . .
ii) Helping starving children.
(1) Consider 4 people. How much does the deduction for food save these
different people?
(a) Rich. Spends $5k on food. In 40% bracket. Savings is 40% of the $5k,
which is $2k.
(b) Upper middle. Spends $5k on food. In 30% bracket. Similarly, savings
is 30% of $5k, which is $1,500.
(c) Middle. Spends $5k on food. In 15% bracket. Savings is $750.
(d) Poor. Spends $5k on food. In 0% bracket. 0% of $5k is $0. Helped not
at all.
(2) Lesson here is that deductions help the people in the higher tax brackets.
Why? Their rate is higher, so they save more. This amounts to giving poor
people nothing, giving middle class people $750, giving upper middle
class people $1,500, and giving rich people $2000. Can’t propose this. It
would be ridiculed. But that’s essentially what can be done by proposing
deductions. They seem good. But they’re bad. They’re even worse than
above, because probably the richer people spend more on food, so their
deduction does even more. Might be able to fight against this by saying
this problem is already accounted for in the rate structure. That is, the rate
structure already accounts for this. The rich people are paying 40% of
their income, for instance, so when they get the $2,000 back, that accounts
only for a portion of the higher taxes they’ve already paid.
(3) And this food thing wasn’t intended to change behavior, because everyone
needs to buy food. But consider a tax plan that was meant to change
behavior. Say there’s some deduction for recycling or something like that.
Who has the incentive to recycle? The rich person.
(4) Note that deductions and exclusions are basically the same under this. So
phrasing something as an exclusion is effectively the same thing.
(5) What about a credit? Credits get subtracted after tax liability has been
subtracted. Maybe offer a credit of $1.5k per person spent on food. As
long as you owe $1.5k in tax, it treats people evenly. But the bottom guy,
who pays 0% in tax isn’t a taxpayer. There’s no tax liability to use against
the credit. So this poor person gets no benefit. So while this credit does hit
the top three people evenly, the poorest gets nothing. Might say that we
could just give this poor person $1.5k. This is called a refundable credit,
and it’s rarely done. Republicans uniformly oppose these, saying that tax
refunds should go to taxpayers, and since the poor aren’t taxpayers, they
shouldn’t benefit from these.
(6) Is this an efficient way to help starving kids? In trying to give a poor kid
$1 for food, how much are we wasting to transfer that money? Don’t want
to have a leaky bucket—when we move it from one person to the poor kid,
how much are we losing along the way?
(7) Stick with these same 4 people and consider some stuff related to bonds.
Assume corporate bonds are taxable and return 10%. Say municipal bonds
earn 7% aren’t taxable.
(a) 40% bracket person earns 6% (40% off 10%) on corporate. Earns 7%
on muni. Benefited by 1% when buying munis.
(b) 30% person earns 7% on corporate. Earns 7% on muni. No benefit for
buying muni.
(c) 15% person earns 8.5% on corporate. Earns 7% on muni. Harmed by
buying munis.
(d) 0% person earns 10% on corporate. Earns 7% on muni. Harmed by
buying munis.
(e) So this municipal bond exemption, though maybe having
constitutional roots, can be thought of as a way of helping state and
local governments finance themselves. It’s a way to make finance
cheaper for municipalities. This creates an environment in which the
benefit to the municipality is partially bid away. Why? There’s
competition between these two types of bonds. Bond rates become
closer to one another, which means in part regular bond prices drop,
meaning poor people who could benefit for the higher taxed rates
don’t benefit.
(f) How does this translate to food for poor people? If you give
deductions for food, people start spending more money on food, which
bids up food prices. This then ends up hurting poor people. Notice
these higher food prices help farmers (point 4 below), but hurts poor
people. So you can’t end up helping starving people and farmers at the
same time.
iii) Keeping govt out of decisionmaking.
(1) Tax deduction for food is probably not consistent with any conceivable
notion with smaller government. Having a smaller government means
having less government interference. But then giving a tax
benefit/cut/whatever is telling people, “if you do X, I’ll give you Y,” or
vice versa, “if you don’t do X, I won’t give you Y.” This is interference.
Perhaps a sly way of interference, but it’s interference.
iv) Helping farmers.
(1) Same stuff as helping starving kids.
b) These arguments led Congress to enact into law an idea called tax expenditure.
This is done in the budget act of 1974. This basically says that an exemption for X
(say food) is essentially a subsidy for X (food). Why? Well if the government is,
in a sense, losing tax money because of something (exemption), it’s a cost to
them—not getting money is a type of cost. So when the government has a cost,
that’s the same as a government subsidy.
i) What is the tax expenditure budget?
(1) Concept is that all is taxable, and the deductions the government allows
are viewed as government expenses (since you are exempted from paying
tax on X, the government loses that $, so it’s an expense to them), and
hence the $ must be included in the budget.
(2) The tax expenditure budget depends on the notion that there is a natural,
neutral, or normal income tax and that it is possible to identify departures
without great difficulty or dissent.
(3) This is a valuable tool in exposing tax policy issues.
ii) Shows subsidies that are built into the tax code (see list on p. 10), so we can
actually tell where the money is going.
iii) Language of budget act of 1974 refers to special stuff. Problem is, we don’t
know what “special stuff” is. Unless you think there’s some Platonic
definition of income, it’s going to be very hard to figure out what goes on a
list like that on p. 10.
iv) What about the realization requirement? Ex: deferrals on capital gains from
the sales of stock. If it goes up $20 in first year, but you don’t sell till year 3,
why not taxed early?
v) Most academics believe that tax expenditures are terrible. Most tax profs
would say they’re bad. Why?
(1) Distributional problems—not efficient methods of getting resources to the
right people.
(2) They’re easy to hide. Clinton did all sorts of social programs through tax
code. Did all sorts of stuff he couldn’t have done through direct
expenditures.
(3) This is complicated stuff, and the tax people don’t know really know
about social problems and their solutions, so why are they the ones
devising solutions to these things?
(4) What’s the academic solution? Have a broader base with lower rates. The
lower the rates the less distortions (no one works less because of taxes). In
1986, this was the basic direction of reform. Rates were lowered to 28%
by broadening base and getting rid of exclusions.
50) Revenue Ruling 79-24 examples, p. 69
a) Lawyer exchanges services with a painter for getting his house painted. Taxable?
Yes. Why? If we didn’t tax this, we’d incentivize a barter system instead of cash
exchange, which is silly because it would increase transaction costs and reduce
efficiency. Law is § 1.61-2(d)(1) of the regulations, which says that if services are
paid for other than in money, the fair market value of the property or services
taken in payment must be included in income.
b) What if lawyer stays home, gives up a week’s salary, and paints his own house?
The house painter doesn’t have work to do, so he stays home and does his own
legal services, say, writes his own will. So the outcomes are the same as above.
Taxable? No. Why not? Isn’t this the same as above? Basically, but perhaps here
we’re more comfortable differentiating because of privacy issues (you are at your
own home, painting it), and also, we don’t find that much of a danger, because
there’s a limited amount of stuff you can do by yourself at home, so this essential
tax subsidy won’t incentivize away from purchasing services as much as the
above barter system might have if it were not taxed. That is, you can’t do it all
(Adam Smith, specialization, etc.), so most stuff will still take place in the regular
economy. This decision not to tax the work you do for yourself incentivizes
against specialization and rewards generalization. Might say this is inefficient,
because specialization allows you to get better painting (done by professional
painter) for cheaper.
i) What do we include in this exemption? Cooking for yourself, shoveling your
driveway, brushing your own teeth? (He also included sucking your own
thumb, which is strange. I don’t know where you can hire someone to suck
your thumb. Or I don’t want to know, at least.)
ii) What about if you stay home from work, giving up $10k, and decide not to do
any work, but instead take naps. Can we say those naps must be worth at least
$10k, so you should be taxed on it? You could’ve painted your house, which
would’ve been worth $10k, but you didn’t, and instead napped. Napping must
be worth more than $10k to you, so we might think of taxing that, but don’t.
c) Childcare is one really important example that shows all of this is not complete
silliness. Some numbers:
i) Case 1
(1) First earner has income of $50k.
(2) Second earner provides at-home child care worth $10k.
(3) 40% tax rate applies only to $50k, so after tax income is $60k - $20k =
$40k.
ii) Case 2
(1) First earner has income of $50k.
(2) Second earner goes to work and earns $10k.
(3) 40% tax rate applies to both of them, so to all $60k, so after tax income is
$60k - $24k = $36k. So they are worse off here.
iii) This creates a disincentive for a second earner to go to work. It’s worth more
for the second earner to stay home. Feminists say this creates a huge incentive
for the second earner—a woman in the vast majority of cases—to stay home,
or put differently, not to go to work. Theoretically, the above is a sex neutral
analysis, but practically it is not.
iv) How can we deal with this?
(1) Allow a deduction for child care. We currently do have a very small
deduction for child care. There’s no movement to increase the number,
because it would cost too much money.
(2) Could tax housework. That’s the true way to equalize the situations, and
also it is a way to recognize the value of staying home. This would
equalize things, but it seems unintuitive to most of the population.
v) We just mentioned in passing that another issue of second earners is that the
marginal tax rate really hits them hard. The first earner earns enough to push
them up into a higher tax bracket, so the marginal rate hits the second earner
pretty hard, making it even less attractive for that worker to work.
51) Property and imputed rent
a) Example
i) Landlord/renter
(1) $60k in wages
(2) Owns a condo in Chicago that he rents out at $8k
(3) Rents an apartment in San Francisco to live in for $8k
(4) What’s the taxable income? $68k, because rent payments received are
income, but can’t deduct rent payments.
ii) Owner/occupier
(1) $60k in wages
(2) Owns a condo in Chicago that lives in, thus saving $8k in rent
(3) What’s the taxable income? $60k. Effectively this person is paying
himself $8k in rent. He is the same as person #1, but lives in the place he
owns, rather than renting it to another. The failure to tax the landowner on
that return of living in the place he owns is the non-taxation of imputed
rent.
iii) Note: So there is an incentive to own your own home and to live in it. How
can we fix this?
(1) One way is to tax the $8k benefit the owner/occupier has. England did this
for a while. They had some formula that gave a crude estimate of the value
of owning your place.
(2) Another way is to allow deduction for rent. But this then makes
investment in land even more attractive, so there’d be an over-investing in
housing.
iv) Mortgagor – person who borrows to buy his home
(1) $60k income
(2) Has $100k in cash invested at 8%, so gets $8k a year in payment
(3) Mortgage: Borrows $100k at 8%, so has to pay $8k a year in interest
(a) If mortgage interest is deductible, you get taxed like a homeowner
(i) $68k in income, “rent” payment of $8k is deductible, so taxed at
$60k, like the owner occupier in the second example above
(b) If mortgage interest is not deductible, you get taxed like a renter
(i) $68k in income, “rent” payment of $8k is not deductible, then you
have tax on $68k of income, like the landlord/renter in the first
example above
(c) Which is right? There’s not really an answer to this question.
Changing the mortgage system is not going to eliminate the difference
between owning and renting. Basically the homeowner is the rich
person, the renter is the poor, and the mortgagor is the middle class. So
this question is basically like asking: Should we make the middle class
more like the rich or the poor?
52) Related Code
a) § 103(a) – gross income doesn’t include interest earned on state and local bonds
b) § 163 – interest
i) § 163(a) – can deduct interest paid or accrued during a year
ii) § 163(h) – disallowance of deduction for personal interest
(1) § 163(h)(1) – no deduction for personal interest paid or accrued during
taxable year
(2) § 163(h)(2) – “‘personal interest’ means any interest allowable as a
deduction under this chapter other than . . .” trade/business interest,
investment interest, qualified residence interest, etc.
c) § 265 – expenses and interest relating to tax-exempt income
i) § 265(a)(2) – “No deductions shall be allowed for . . . Interest on indebtedness
incurred or continued to purchase or carry obligations the interest on which is
wholly exempt from the taxes imposed by this subtitle.”
ii) So you can’t deduct interest you have incurred in order to pay for muni bonds
or something like that.
More on Timing: Realization Issues
53) From Chirelstein: “realization is strictly an administrative rule and not a
constitutional, much less and economic, requirement of ‘income’”
54) Background on Eisner v. Macomber
a) Example 1:
i) A invests $10k on 1/1/1
ii) Investment value is $11k on 12/31/1
iii) Investment value is $12k on 12/31/2
b) Example 2:
i) B invests $10k on 1/1/1
ii) Sells for $11k on 12/31/1
iii) Reinvests the $11k on 12/31/1
iv) Sells for $12k on 12/31/2
c) Under current law, A is never taxed, and B is taxed twice, once upon each sale.
This comes from § 1001. Amount realized . . . A never realizes anything, but B
does on each sale.
d) Why do we care? Because there’s an incentive to be A over B. This is known as
the locked-in effect. So maybe capital is distorted in our economy, because people
keep them too long, rather than switching when they think something is better,
because there’s a tax cost in doing so. This is even worse, because if A just keeps
this till he dies, then any gain is forgiven. But this isn’t the whole picture—it
might go down in value, and in that case, you don’t get the loss. But in that case,
you’d just sell before death, and get the loss then.
e) Is there an alternative? The alternative, which is used in occasional places in
current law, is valuing assets at the end of the year, and taxing them on their
change in value. This goes under a variety of names, including “mark-to-market”
taxation and “Haig-Simons” taxation. This is used under § 475 (for dealers in
securities, § 475(f) allows traders in securities to choose this treatment) and §
1092 (elective rule in some circumstances).
f) Why don’t we do this mark-to-market thing for everything?
i) What if you never really have that $11k . . . it might go back down in value.
It’s uncertain.
(1) Well, you have the money then . . . and if it goes down, you get a loss, so
that balances.
(a) But it might incentivize too much away from the locked-in effect . . .
people might sell too often.
ii) Liquidity. If you’re taxed before you sell, you might have the cash.
(1) Can say you don’t have to pay until you sell, but will be charged interest
for holding.
iii) Valuation problems.
iv) Administrability costs. Even if we could value this stuff every year, do we
want to?
v) Disincentivizes certain investments. If you’re going to be taxed more often, it
costs more to have the investment.
55) Eisner v. Macomber (1920, p. 194)
a) Summary, using simplified facts:
i) Originally has 2,000 shares, each worth $360 (total value = 2k times $360 =
$720k)
ii) New shares from stock dividend: 1,000.
iii) Total shares after issuance of dividend: 3,000, each worth $240 (total value =
3k times $240 = $720k)
iv) Issue is whether this is a realized gain on which Mrs. M has to pay taxes.
b) Holding: no income here
c) Reasoning:
i) Income is a gain “derived from capital.” Here, this was just a shifting . . .
nothing was derived from capital here. Everything remained inside the
corporation. Mrs. M has the same value, it’s just divided into a few more
stocks than before the disbursement.
ii) Three arguments made by the government
(1) Economic argument. Claim is that distribution of stock increases Mrs.
Macomber’s wealth, so she should be taxed. Notice that realization events
never increase wealth. Why? Because you trade one thing for another, and
because it’s an exchange, they are treated as being of equal value. So it’s
not even a change in wealth, it’s just wealth in a different form. I sell a car
for $10k. Has my wealth increased? No. Before I had a car worth $10k,
now I have $10k in cash. So looking for a change in wealth attached to a
realization event is foolish; it never helps to look at an event as if it
increases wealth to decide if it’s a taxable event. Here, even a cash
dividend wouldn’t increase her wealth, but certainly we know that’s
taxable. So this argument must fail. Can never look to possible increase in
wealth for if there’s been realization, because the answer will always be
no. Increase in wealth  no realization.
(2) Realization argument. Best to get at this argument by looking at
Brandeis’s dissent. He says this is one of two things: 1) distribution of
cash used to purchase more stock, or 2) a distribution of stock that can be
sold for cash. These two things have historically been used as substitutes,
long before the enactment of the 16th amendment. And the first one is
surely taxable—it’s a cash dividend. What if the company held—did
nothing? It’s essentially the same as the stock dividend, too, because the
stock dividend, as mentioned, is just like cutting the pizza up into more
pieces. And certainly a hold is not taxable. So we’ve got a spectrum of
transactions that are very similar in some ways, and some are treated as
taxable, others certainly not. So how do we decide how to tax? Consider
the policy arguments. If you begin to tax stock dividends, the IRS won’t
raise money (because corps won’t do it), you’ll just cause distortions in
behavior. Corps won’t give stock dividends anymore, so there won’t be
tax revenues from these, and you’ll just distort behavior. So why tax cash
dividends? Such a tax does make them less worth, but we think they are
important enough that even such a tax won’t completely drive behavior
away from them.
(3) Constitutional argument. Company’s accumulation of profits increased
Mrs. M’s wealth, and that the increase in wealth could be taxed at any
time. Court says no, realization is required. Here, the Court actually uses
the definition of income in the 16th amendment to narrow what is taxable.
This is the only time this has ever been done, and as such, this is not taken
to be the law. We currently have an extremely broad reading of what can
be taxed as income. The language has been read broadly, not narrowly, as
here.
d) Class Discussion:
i) Only case in history where Court has struck down a definition of income on
constitutional grounds. So don’t think the Constitution is important in this
class. This is the only case!
ii) Note that the issuance of the dividend doesn’t change the value of the
company, which is why, when the company issues more shares, the value of
each share decreases. It’s just like cutting a pizza into more slices—you have
more slices, but they are just smaller and not as good!
iii) What if Brandeis won, and so this stock dividend is taxable? And at the same
time, stocks in your corp are at $1000, and you want to lower them to $100
each. So you essentially want to issue 9 new shares for each old share, but you
want to avoid the taxes. How can you do this? Get a bank involved. Put the
shares into a trust. And the trust will issue certificates of interest in the trust,
each certificate representing 1/10 of a share. So each shareholder puts their
shares into a trust and in return gets certificates. This transaction is nontaxable.
iv) Bottom line is you want to let people slice their pizza in as many slices as they
want. Doesn’t make any sense to say if you slice it more, you get more tax.
It’s just about coming up with a sensible definition of when something’s
taxable and when it’s not.
v) So we’ve got a realization requirement. What comes next? We’re stuck
defining what realization is . . . so we have Helvering v. Bruun and Cottage
Savings.
56) Helvering v. Bruun (1940, p. 206)
a) Summary:
i) 1915: lease of land for 99 years, which included permission to destroy
buildings on property, and build new buildings on property
ii) 1929: new building built that was to have a 50-year useful life
iii) 1933: lease cancelled due to nonpayment (depression)
iv) 1979: supposed end of building’s useful life
v) 2014: supposed end of lease
b) Issue: Is the gain in property value (lessor gets the property back with a new
building on it) taxable income to the lessor upon the cancellation of the lease?
c) Holding: Yes, income received when the lease is cancelled and you get more
property back.
d) Class Discussion:
i) This result is eventually undone by § 109 and § 1019.
(1) § 109 – excludes from a lessor’s income the value of a leasehold
improvements realized on termination of a lease
(2) § 1019 – denies the lessor a basis for the property that is excluded by §
1019
ii) The new stuff gives you zero income, but also zero basis. So you get income
when you sell or rent the property out. And basically, it’s helpful to the lessor.
Income is basically the same, but you end up paying less taxes . . . or, your tax
obligation is the same, but it’s delayed, so the present value of the tax
obligation under the new code is lower than under Bruun. See Chirelstein p.
89.
iii) It’s pretty obvious that this extra building is like more rent to the lessor. The
key is when it should be included in lessor’s income. What options are there?
To see this better, consider Question 3a on p. 209.
(1) Landlord allows tenant to occupy land rent free for 10 years if tenant
builds a building that will last expected 20 years, worth $400k now, and
worth expected $200k after the 10 years. What are ways to count this as
income? How can we tax this?
(a) Tax on $200k in year 10.
(i) This is what the Bruun court decided. It is practical. No
speculation is required. Just look at the leftover value at the time
the lease is over.
(b) When the building is completed. So income of $400k right away.
(c) $20k/year. The tenant is essentially paying $20k/year in rent . . .
because he’s there 10 years, and you get $200k. This is actually pretty
close to what we do.
(d) PV($200k) paid now + increase each year.
(e) No tax at all
(f) Tax landlord only if he sells.
iv) Deciding among these is again a policy issue. There’s no inherently correct
Constitutional answer, and there’s no inherently correct economic answer.
v) Constitutional holding of Eisner is invalid, but the factual holding has been
validated by statutes. So it’s a statutory rule now, but not well-founded in
Constitution. Conversely, this case is Constitutionally valid, but has been
overturned by statute.
vi) Why no gain in 1915? He just gives up a piece of land and gets market value
in $ back.
vii) Why no gain in 1929? Landlord doesn’t expect to get anything back, since the
building should be unusable/gone by the time the lease is over in 2014. The
only benefit is that the lease is a little more secure. The investment by the
tenant in the land makes the leaseholder more likely to pay.
viii) Did Bruun really make any money in 1933? No. It’s the depression. It’s a
bad year for him. He’s got to figure out a way to pay this tax on this supposed
“gain,” but it’s the depression!
57) Cottage Savings (1991, p. 215)
a) Summary: Savings and loan companies hold mortgages that go down in value.
They want to realize a loss, but accounting regulations of FHBB, which would
require the S&L’s to record the losses on the books, would make them insolvent,
killing them. So they needed a way to take advantage of these losses to offset tax
liabilities, without having to record them on the books. So these S&L companies
try to do this by swapping mortgages to realize a tax loss, but not a book loss.
They kept servicing the same mortgages, though, so the homeowners don’t have
any idea who they are actually paying. It’s basically a nominal swap; nothing
functionally changes.
b) Issue: is this a realization event?
c) Holding: yes, can take losses because this is a realization event
d) Reasoning:
i) Two questions the court answers in reaching its conclusion
(1) Does § 1001 require the properties exchanged to be materially different?
Yes, because there’s a treasury regulation on point that requires this. (§
1.1001-1)
(2) Are these things here materially different? Yes. Why?
(a) Because they represent different legal entitlements – different obligors
and different properties. Gets the answer to this question by looking at
caselaw: Phellis, Marr, and Weiss v. Stearn say a change in the state of
a corporation is a material difference. Why? You are holding different
things here. Different properties secure these obligations. There’s a
legal difference.
(i) Court didn’t realize that Phellis and Marr were actually
(essentially) overruled by Congress 50 years ago. Congress said a
change in place of incorporation or a recapitalization are nonrecognition events (§ 368(a)(1)(E)-(F).) Congress basically said the
results in these cases were stupid . . . not literally overruled.
(b) Also, Court says this is the easier rule to administer.
(i) This is Marshall telling the Commissioner of the IRS which rules
are easier to administer. He knows much less re: this as compared
with the Commissioner. This can’t be reasonable.
e) Dissent:
i) Let’s look to substance, not form. This is the same stuff.
ii) Also, has some sympathy for the idea that the Court shouldn’t be telling the
Commissioner which rules are easier to administer: “I find it somewhat
surprising that an agency not responsible for tax matters would presume to
dictate what is or is not a deductible loss for federal income tax purposes.”
f) Class Discussion:
i) If they sold these mortgages to take a loss, then buy new mortgages, they’d
have to, under the regulations, take a loss on their books. They’d then be
insolvent. FHLBB doesn’t want this to happen . . . the regulator wants to keep
them alive. (This is a bad thing to do . . . should’ve shut them down.) So the
FHLBB wants to save them, and allows what happens here. They want a tax
loss, but not a book loss. Tax loss basically is an injection of money from the
federal government. Why didn’t they just go to the federal government for this
money? Congress wouldn’t have approved it. So the regulator here is raiding
the treasury department without Congress’s approval. All the companies had
to do was meet these R-49 requirements handed down by the FHLBB.
(1) The list of these requirements is in footnote 3 on p. 215.
ii) Notice there’s no mention of the 16th amendment here. This is a big change
from Eisner v. Macomber. Has Eisner been overruled?
iii) Cottage Savings is still cited today for the point that economic substance
doesn’t apply in the setting of § 1001.
iv) Did the taxpayer really have a loss? Yes. He’s broke. There’s a bona fide loss
here. It’s just a matter of how to realize it.
v) R-49 was stupid. It kept these guys alive longer, and bailed them out of tax
liabilities that all the other taxpayers had to make up for.
vi) Weisbach says dissent is not tenable, so it’s not clear the case could’ve come
out the other way.
vii) SCOTUS says its approach is easier to administer than Commissioner’s. Is
that true? There are hundreds of thousands of transactions like this across
commodities markets all the time. These are now taxable events. That’s not
very easy to administer.
viii) Problems on bottom of 223, top of 224:
(1) Joe and Barbara swap title to cotton stored in same warehouse to realize
loss. Harder case than Cottage Savings. But it’s unclear. Seems as though
there would be absolutely no difference after the swap. But hasn’t legal
title changed? Is that enough? What if there is some delay between cotton
exchanges – so a timing difference? What if the cotton is of different
quality, so the person who trades for the lower quality cotton also gets a
little money?
(2) Maserati example. Probably a recognized gain when you swap the titles,
under Cottage Savings. They’re not fungible (different colors).
ix) Bank lends money to business. Circumstances change. Business wants to
modify loan. Bank might be able to lower interest rate, extend maturity of the
loan, or won’t foreclose, give a holiday, etc., but have to make it up in future
somehow. These slight modifications happen all the time. If you modify a
loan, what happens under Cottage Savings? You have a different legal
entitlement. Is this a realization? So every time you get out the loan document
and change a comma, you have a realization event. This shows that Cottage
Savings is impossible to administer.
(1) Treas reg. § 1.1001-3 helps this out a bit, by saying there needs to be a
level of substantiality for a realization even to take place. See pp. 222-23
for a brief discussion of this right after the case.
58) Related Code
a) § 109 – “Gross income does not include income (other than rent) derived by a
lessor of real property on the termination of a lease, representing the value of
such property attributable to buildings erected or other improvements made by the
lessee.”
b) § 305 – distributions of stock and stock rights
i) § 305(a) – generally, gross income does not include amount of any
distribution of the stock of a corp made by the corp to its shareholders
ii) § 305(b) – exceptions that are treated as distributions of property
(1) § 305(b)(1) – if the distribution is, at the election of any of the
shareholders, payable either in its stock or in property.
c) § 1001 – determination of amount of and recognition of gain or loss
i) § 1001(a) – gain is the excess gotten over adjusted basis (“the excess of the
amount realized therefrom over the adjusted basis provided in section 1011”)
and the loss is “the excess of the adjusted basis provided in such section for
determining loss over the amount realized”
(1) Material difference is the key test under this, according to Cottage
Savings.
ii) § 1001(b) – how to calculate “amount realized”; $ + FMV of other property;
there are some special rules on inclusion/exclusion of certain real property
taxes under § 164(d)
iii) § 1001(c) – subject to exceptions, “the entire amount of the gain or loss,
determined under this section, on the sale or exchange of property shall be
recognized”
iv) § 1001(d) – deals with installment sales
v) § 1001(e) – certain term interests
(1) § 1001(e)(1) – that portion of the adjusted basis of a term interest in
property that is determined under §§ 1014, 1015, or 1041 is disregarded
(2) § 1001(e)(2) – definition of “term interest in property”:
(a) § 1001(e)(2)(A) – “a life interest in property”
(b) § 1001(e)(2)(B) – “an interest in property for a term of years”
(c) § 1001(e)(2)(C) – “an income interest in a trust”
(3) § 1001(e)(3) – exception; paragraph 1 doesn’t apply to a sale or other
disposition that is part of a transaction where the entire interest is
transferred to any person or persons
d) § 1019 – property on which lessee has made improvements
i) Basically if you exclude some improvement a lessee made from your income,
you don’t get a basis in that improvement.
e) § 1091 – loss from wash sales of stock or securities
i) § 1091(a) – no loss on sale of stocks if you buy substantially the same stocks
within 30-day window before or after the sale; exemption for dealers dealing
in ordinary course
ii) § 1091(b) –if amount of stocks acquired is less than amount sold, turn to
Secretary to deal with possible loss
iii) § 1091(c) – same as (b), but when acquired amount is not less than sold
amount
iv) § 1091(d) – if it’s a wash sale, the basis of the stuff you get is the basis of the
stuff you sold for a loss
v) § 1091(e) – some rules for short sales and futures contracts
vi) § 1091(f) – cash settlement
Still More on Timing: Non-recognition Rules
59) Three requirements before something can show up on tax return
a) Realized (what we just talked about above)
b) Recognized – certain non-recognition rules exist; main one for us is § 1031
c) Taken into account (we won’t really talk about this)
60) Intro on § 1031 – non-recognition of gain or loss from exchanges solely in kind
a) What does 1031 require?
i) Property
ii) Held for trade or business or investment
iii) Exchanged
iv) For like kind
v) Held for trade or business or investment
b) Why do we have § 1031? Not exactly clear, but some possibilities:
i) Valuation problems
ii) Liquidity
iii) Limit lock-ins – allowing swaps without tax, you don’t have to worry about
people either holding land longer than they really want or getting rid of it
when the really wanted to keep it
iv) There are lots of casual exchanges that would be complicated did we not have
this rule.
c) Gold and Silver Bullion Example
i) Summary: Gold bullion held for investment is exchanged for silver bullion
held for investment.
ii) Issue: Does this qualify for non-recognition?
iii) Holding: No.
iv) Reasoning:
(1) These have different uses—gold is used as an investment in and of itself,
whereas silver is used as an industrial commodity.
(a) Do we think the taxpayer knows this difference? Probably not. And
note the language looks at why the taxpayer is holding it, not other
hypothetical purposes that may be used. So the other possibility is
whether this is like kind.
(2) These are not like kind.
(a) This is a hard question. Weisbach thinks maybe the court is ruling this
way because these things are a little bit like securities. But you can
counter-argue that the language of the statutes don’t really say that.
d) Land Exchange with some boot.
i) What’s your new basis after a land exchange? It’s the basis in the old property
(called carryover), minus the boot, plus gain. That is:
(1) Basis in new = basis in old – boot + gain.
(2) This comes from § 1031(d).
ii) So here’s an example:
(1) You have: $10 basis in land valued at $90
(2) You exchange that for: $70 FMV, Boot of $30
(3) You recognize the lesser of the boot or gain. Gain here is $90. (Why?
Because you get stuff worth $100 over a basis of $10.) Boot is $30, as
given. So your gain is $30.
(4) So your basis is: $10 - $30 + $30 = $10.
(5) In the end, we want $90 of gain taxed. Does this happen? Yes. Because
you are taxed on the $30 boot right away, and then have a basis of $10 (as
calculated above) remaining for the FMV of $70, which is a gain of $60
waiting to be recognized upon sale.
e) Another example:
i) You have: $120 basis in land valued at $100
ii) Exchange it for: FMV of $70, Boot of $30
iii) How much gain do you have? $0 (it’s actually a loss of -$20)
iv) This is less than boot of $30. So you recognize the $0.
v) New basis = carryover – boot + gain = $120 - $30 + $0 = $90
vi) Does this make sense? Yes. You have a $90 basis in $70 FMV property, so
your loss is preserved there.
vii) Remember: § 1031(c) says you don’t recognize loss from exchanges not
solely in kind.
61) Jordan Marsh v. Commissioner (1959, p. 227)
a) Summary: Jordan Marsh owned property worth $2.3 million with a basis of $4.8
million. He takes the property, sells is to Boston, then leases it back for 30 years
plus option to renew for 30 years. So essentially nothing changes for 60 years.
They just wanted to recognize this $2.5 million loss right away.
b) Holding: IRS says they can’t recognize this loss.
c) Reasoning:
i) This is a like kind exchange of property. Their theory is that if you have a
rental for 30+ years, then it’s basically a fee interest, so it’s a like exchange.
(1) They had basis of $4.8 mill in property worth $2.3 mill
(2) They got the right to rent the property at the FMV – the value of that right
is $0. Why? Because the rental payments take care of the exchange. They
also got boot of $2.3 million.
ii) Why is § 1031 involved? § 1031(c) says they can’t recognize a loss here.
d) Class Discussion:
i) What would be the basis in the new property?
(1) New basis = $4.8 mill - $2.3 mill + $0 = $2.5 mill, so their loss is
preserved.
ii) Arguments against: How can this be an exchange when you get boot for a
$2.3million, the FMV of the land, in exchange for the land?
iii) Better argument for the IRS:
(1) This is really just a loan. Jordan Marsh gets cash in now at $2.3 mill, and
they have to pay it out over time, in the form of lease payments, over 60
years. The only difference is that Boston gets the land at the end of 60
years. But getting land at the end of 60 years is basically worth 0. The IRS
should’ve argued that this was a loan. And they would’ve won. Same
result, but better argument.
62) Related Code
a) § 1031 – exchange of property held for productive use or investment
i) § 1031(a) – nonrecognition of gain or loss from exchanges solely in kind
ii)
iii)
iv)
v)
(1) § 1031(a)(1) – in general, you don’t get a gain or loss on the exchange of
property held for productive use in trade, business, or investment if you
exchange it for likely kind property that was also held for use in trade,
business, or investment
(2) § 1031(a)(2) – exceptions for stock in trade or other prop held primarily
for sale, stocks, bonds, or notes, other securities or evidences of
indebtedness or interest, interests in a partnership, certificates of trust or
beneficial interests, or choses in action.
(3) § 1031(a)(3) – requirement that property be identified and that exchange
be completed not more than 180 days after transfer of exchanged property;
prop is treated as not like kind if it’s not identified as prop to be received
w/in 45 days of exchange or it’s received after 180 days
§ 1031(b) – if you get in kind + else, gain is recognized, but no more than
FMV of other prop
§ 1031(c) – same as (b) but for losses
§ 1031(d) – basis is same as that of property exchanged, decreased in the
amount of any money received by taxpayer and increased in amount of gain or
decreased in amount of loss to taxpayer that was recognized on the exchanges
(1) If boot  Basis = orig basis + gain recognized - boot
(a) Gain recognized is the lesser of boot and gain
§ 1031(e) – exchanges of livestock of different sexes
Charitable Contributions
63) Introduction
a) Two different rules that run parallel: § 170 and § 501
i) § 170 – this gives you or a corporation a way to get deductions for charitable
contributions; lists entities to whom deductions are tax deductible
(1) Deductions include FMV of any property you give, but no deductions for
services. Can’t deduct work you do.
(2) Limited to 50% of adjusted gross income for individuals, 10% for
corporations. If you give more than that amount, you can carry it forward,
though.
(3) Some interesting donation areas:
(a) Cars to charities – they give you a high valuation
(b) Art – IRS has a valuation panel; art is hard to value; risk of high
valuation leading to high deduction
(c) Patents – basis is always 0; donate, and claim it’s going to be worth
lots of money
ii) § 501 – list of entities that are tax exempt
(1) § 501(c)(3) includes lots of stuff.
(a) One branch is charities – get public support; $ comes from a broad
support base
(b) Another branch is private foundations – don’t have public support; $
comes from a narrow set of contributors; these have their own specific
rules; have to spend 5% of endowment each year
b)
c)
d)
e)
f)
g)
iii) Generally, 170 is a subset of 501. That is, not every tax exempt organization is
one that if you donate to it do you get a deduction. For instance, political
parties can be tax exempt, but if you donate to a campaign, you can’t deduct
it.
Two ways to lose charitable status
i) Private enurement – give someone a benefit through charitable deductions
(beyond salaries, etc.)
ii) Political lobbying
§§ 511-514 – govern activities of tax exempt orgs if they do things unrelated to
their tax exempt orgs
i) § 514 – tax exempt orgs have to pay taxes on income earned from debt (debt
financed income; borrow money, invest, earn profit  taxed)
Why have tax exempt status?
i) Take hospitals and schools, for instance. Both of these compete with taxable
equivalents. (There are taxable schools, nontaxable ones. Same with
hospitals.) What is the theory for having a non-profit sector?
(1) They provide public goods.
(2) They delegate part of the government’s function to the private function.
(3) We want to subsidize “doing good things.”
(4) It increases consumption, because the giver gets warm-glow benefits, and
the recipient still gets to consume it. Whereas if the giver kept it, only he
would get benefit. So overall benefits are increased by including the
warm-glow ones.
ii) What about churches? If you view tax exemptions as a subsidy, then this
implicates First Amendment issues.
Is tax exempt status efficient? That is, if we let you deduct a dollar (govt loses 3040 cents of tax), how much is the government losing? In theory, we haven’t a
clue. Why? Suppose a loaf of bread costs a dollar. You’d normally buy three
loaves a week for $3. What happens if the price drops to 0.50? It’s unclear. You
might still buy three loaves and save of $1.50, or maybe you’ll start buying more
bread. Maybe, then, you’ll start buying less potatoes. Same with charity. The tax
deduction makes the cost of “buying charity” go down. So maybe you’ll give less
to it, save money, like in above when buying same amount of bread for less
money. Maybe will buy more. Maybe substitute. Who knows. How might we
measure this? Look at change in charitable deductions as tax rates change. But it’s
a complicated question. Can’t just say gov’t is losing $ from this. Not that simple.
Does a charitable deduction allow the gov’t to spend money in ways it otherwise
couldn’t have done? Maybe it gives the wealthy an undue influence on how things
operate. Why? They have more money to give and have more benefits to reap by
donating. So maybe we see more money going to operas and less money going to
soup kitchens. Government couldn’t do this. But you could argue the other way
and say this is virtuous, because it allows individuals, not the govt, to have control
of where money goes.
What else could we do besides this § 170 deduction?
i) Make it a credit
ii) Replace it with a matching grant program
iii) Repeal it and reduce tax rates
64) Ottawa Silica v. US (1983, p. 368)
a) Summary: Ottawa wants to develop land, but there are no roads. Area asks for
Ottawa to donate some of the land for schools. Ottawa does so, in part because
when schools come, roads come, too, which makes the land they want to develop
much more valuable.
b) Issue: is this donation deductible?
c) Holding: not deductible
d) Reasoning:
i) This is a quid pro quo here. Not deductible.
ii) If the benefits received by the donor are substantial, then no deduction.
e) Class Discussion:
i) Notice the business rule is that if you get back a substantial quid pro quo, you
can’t deduct anything. The personal rule says you can deduct anything over
the value of what you get back. Ex: you pay $1000 on an opera ticket worth
$100, you get a $900 deduction.
ii) § 6115 – If an organization described in section 170(c) receives a quid pro quo
contribution in excess of $75, the organization shall, in connection with the
solicitation or receipt of the contribution, provide a written statement which—
(1) informs the donor that the amount of the contribution that is deductible for
Federal income tax purposes is limited to the excess of the amount of any
money and the value of any property other than money contributed by the
donor over the value of the goods or services provided by the
organization, and
(2) provides the donor with a good faith estimate of the value of such goods or
services.
iii) § 170(f)(8) – rule that says if you donate more than $250 in cash, you can’t
claim it on tax return unless you get letter back from charity substantiating it
iv) What if the only way (due to high demand) you can get box seats to the opera
is by giving a $20k donation? Shouldn’t be able to get a deduction, since the
cost is really $20k plus. Here, what they are doing is just changing what seems
like the price of the tickets.
65) Hernandez v. Commissioner (1989, p. 375)
a) Summary: Scientology case. Scientology requires you to go through individual
training; religious education given to church member. Church holds it as a
religious duty that you must pay for these things. This amount is substantial, and
it’s the major source of church income. Question IRS raised is whether you can
deduct the auditing fees.
b) Holding: no
c) Reasoning:
i) These are fees for education, not for religious services.
ii) There are identifiable benefits: fixed price schedule, calibrated to length of
sessions, refund if you don’t go, can prepay, can never get service for free
d) Dissent:
i) O’Connor and Scalia dissent together, saying this is intangible stuff
e) Class Discussion
i) Scientology church argued that what you get back is religious, just like paying
for seats in Temple on holy days.
(1) Court said pew rents is an issue not before the Court, so we’ll come to it
when we come to it. But conventional wisdom says the Court won’t go
after Jews or Catholics. Is there a concern this is going after
Scientologists?
ii) Perhaps SCOTUS was thinking about payments to parochial schools. If they
allow this, they’d have to allow deductions for religious school tuitions.
iii) After winning in Supreme Court, IRS passes Rev Ruling 93-73, which says
auditing fees are now deductible for Scientology. Only for them, though.
Can’t deduct parochial school tuition payments. Now it’s sort of the
opposite—seems to be helping out Scientologists.
66) Bob Jones University v. US (1983, p. 376)
a) Issue: whether BJU, a nonprofit private school that proscribes and enforces a
racially discriminatory admissions standard on the basis of religions doctrine,
qualifies as a tax-exempt organization under § 501(c)(3)
b) Holding: no
c) Reasoning:
i) Court reads public policy requirement into the code.
d) Rehnquist’s Dissent: I agree that Congress could require a certain public policy
requirement, but the language at this point doesn’t. And § 501(i) (re: social clubs)
includes such language, so we know Congress knows how to do this, and they
expressly haven’t done it here.
e) Class Discussion:
i) Ok, this BJU policy is clearly bad, so the court needs to strike it down, but
how can it do so?
(1) Maybe if you call this a subsidy, then this deduction would count as a
state-sponsored promotion of a racially discriminatory organization, which
violates Brown. But then this makes all churches taxable, so the courts
don’t want to go there.
ii) Should the IRS be engaged in this type of business? Maybe for discrimination,
we’re ok with it, since pretty much everyone is against it. But what about
something else? Big Momma Rag v. IRS dealt with IRS deciding what kind of
newspaper they could publish.
iii) Should we just write a public policy requirement into the code? That’s tricky
to do? What about American Nazi Party?
iv) § 501(p) – sort of like § 501(i); deals with suspension of tax-exempt status if
you’re a terrorist organization; and if you’re suspended under this, you can’t
challenge that suspension in court
67) Related Code
a) § 170 – charitable, etc., contributions and gifts
i) § 170(a)(1) – “There shall be allowed as a deduction any charitable
contribution . . . payment of which is made within the taxable year.”
ii) § 170(b)(1) – for individuals, § (a) deductions are limited to . . .
(1) § 170(b)(1)(A) – in general: churches, educational orgs, medical or
hospital care or medical education, org that normally gets substantial part
of support from US or state, gov’t units, private foundations, § 509(a)(2),
(3) stuff
(2) § 170(b)(1)(B) – any other contribution [not in (A)] is deductible to the
extent that the contribution doesn’t exceed the lesser two things . . .
(3) § 170(b)(1)(C)-(F) – some special rules and definitions
iii) § 170(c) – definition of charitable contribution
iv) § 170(e) v) § 170(f)(8) – substantial requirement for certain contributions
(1) § 170(f)(8)(A) – contemporaneous written acknowledgment from donee
required for gifts > $250
(2) § 170(f)(8)(B) – acknowledgment needs to include amount of cash,
description of other property, whether donee org provided any goods in
return, description and good faith estimate of value of goods or services
the donee provides the donor
(3) § 170(f)(8)(C) – what contemporaneous means
(4) § 170(f)(8)(D) – substantiation not required for contributions reported by
the donee org
vi) § 170(j) – no deduction allowed for travel expenses while away from home,
whether paid directly or by reimbursement, unless is no significant element of
personal pleasure, recreation or vacation in such travel
vii) § 170(l) – treatment of certain amounts paid to or for the benefit of institutions
of higher education
(1) § 170(l)(1) – in general, 80% of stuff in (2) shall be treated as charitable
contribution
(2) § 170(l)(2) – amounts paid by taxpayer to or for benefit of an educational
org and you get athletic tickets in return
b) § 501 – exemption from tax on corporations, certain trusts, etc.
i) § 501(c)(3) – list of tax exempt orgs
Business/Personal Borderline
68) Introduction
a) Overarching question of this section: when consumption of something has a
mixed purpose (business lunch is classic example), when do we allow a deduction
for this?
b) Variety of personal deductions . . . you can deduct them, because IRS feels like
allowing it: medical expenses, deduction of state and local taxes, casualty losses,
interest payments, charitable donations. These are allowed as itemized deductions
(§ 63)
c) Chirelstein: Business expenses—the costs incurred by the taxpayer in earning
gross income—are nondiscretionary in the sense that the income is conditioned on
the outlay. Personal expenditures reflect the disposition which the taxpayer elects
to make of the wealth that she has earned.
d) § 162 and 212 allow deduction for all the ordinary expenses incurred in business
or other profit-seeking pursuits, thereby achieving generality of application which
is required if the income tax is to be a tax on net income.
e) Basic tests to determine if is a deduction for business expenses:
i) Ordinary and necessary?
(1) Ordinary is used to mean “everyday” or “recurring,” and in this way, often
seems to mean the same as “current expense” rather than “capital
investment.”
ii) Current expense or a capital investment?
(1) See next section for further discussion here.
iii) Incurred in business or for personal reasons?
f) Lots of decisions here are motivated by administrative necessity and dangers of
slippery slopes.
g) Some rules we didn’t get to in our cases
i) No deduction for work wear if you can use it outside of work
ii) Can deduct for work “uniforms”
69) Nickerson v. Commissioner (1983, p. 403)
a) Summary: Nickerson, who works full time in advertising, but starts a farm for the
future, wants to deduct losses from the farm. Nickerson doesn’t spend very much
time on the farm, but hires people to work the land, and actually through some of
Nickerson’s work and lots of his money, many improvements are made to the
farm. Tax Court says no, it’s not a profit-seeking venture, so he can’t deduct
losses.
b) Holding: Reversed, so it’s ok for Nickerson to take deductions
c) Class Discussion:
i) Types of farmers:
(1) True framer. This is their job. They get the tax benefits, no problem.
(2) Tax-shelter farmer. Wants to get benefits of the special farming rules. This
type of farmer is no longer allowed to get the benefits.
(3) Person who likes it, but isn’t there 24-7. Sort of like a hobby.
ii) Question here is whether Nickerson is type 1 or type 3.
iii) Court is looking at whether this is a for-profit engagement under § 183.
(1) How can it be that it’s a for-profit venture if there are losses every year?
Many reasons: start-up costs, bad worker, bad economy, etc.
iv) § 183(d) is a safe-harbor rule that says, we’ll treat losses as legit if you make
money in 3-out-of 5 years. (At the time of this case, it was only 2 of 5 years
needed.)
70) Popov v. Commissioner (2001, p. 414)
a) Summary: Home office case. She uses her living room as the place where she
practices violin. She performs with lots of high-end places, but doesn’t have a
place to practice provided by any of these places. She lives in a one-bedroom with
her husband and daughter.
b) Holding: yes, can deduct home office expenses
c) Class Discussion:
i) Statutory background – Congress is worried about abuse in this area. Take a
little work home in the evening, read some papers, maybe make a phone call.
Then you deduct mortgage payments? There’s risk for abuse. So § 280A is a
set of very strict rules on when you can deduct home office expenses.
ii)
iii)
iv)
v)
vi)
(1) General rule under § 280A(a) says no deduction for homes. So the default
is no deduction. Any deduction allowed is therefore an exception to this
rule, and such exceptions are found in § 280A(c).
(2) Must be exclusive, regular, principal place of business, or is a separate
structure.
(3) Also must be for the convenience of the employer.
IRS doesn’t challenge exclusive use question, instead looks at whether is
principle place of business.
Soliman – anesthesiologist who worked at a variety of hospitals, but none of
the hospitals gave him an office; he used a spare bedroom in his home;
SCOTUS denied him a deduction
(1) Two factors from this
(a) Where you deliver services
(i) In Popov, the court says music is special (cites a German poet!),
and says that this factor doesn’t matter here.
(b) Time spent
(i) In Popov, this prong is met because of lots of practice time (4-5
hours) at home every day.
Did she spend more $ on this rental than she otherwise would have if she
didn’t need practice space? This is tough. Probably didn’t spend more. How
much less can you spend? She’s got a one-bedroom. Can’t get a half bedroom
. . . maybe a studio? This is a tough argument. And because of this, it’s hard to
figure out how much could be deducted as a business expense, because we
can’t figure out how much more she’s got in order to use it as practice space.
What about § 280A(c), the flush sentence: “For purposes of subparagraph (A),
the term ‘principal place of business’ includes a place of business which is
used by the taxpayer for the administrative or management activities of any
trade or business of the taxpayer if there is no other fixed location of such
trade or business where the taxpayer conducts substantial administrative or
management activities of such trade or business.”
(1) This probably wouldn’t help Popov, since her practice isn’t administrative
or managerial.
(2) This was put in to reverse Soliman.
(3) The drafters probably wanted to cover something like Popov, but they just
didn’t draft it that way.
P. 413 examples:
(1)
(a) Susan uses her study at home for law firm work, but family uses for
half the time. May she deduct half the cost of the office? No. Not
exclusive use for work, it’s for her convenience, and it’s not the
principal place.
(b) What if the study is used exclusively for work? Still no. Still not
principal place, and not for employer’s convenience, but for her
convenience.
(c) Same as (b), but also sees clients in study. No. This seeing of clients
puts you in § 280A(c)(B), but this is probably not “in the normal
course of his trade or business.”
vii) Telecommuters are a big issue in this stuff.
71) Moss v. Commissioner (1985, p. 440)
a) Summary: no deduction for law firm lunches that happened every day
b) Class Discussion:
i) To get around this, the law firm just hired the chef.
ii) Hard to tell the rationale of the holding.
iii) Only way to make sense of the case is that Posner just can’t handle the fact
that it’s every day. That’s got to be the only reason, because it’s very hard
otherwise to figure it out.
iv) § 274(n) – Only 50 percent of meal and entertainment expenses allowed as
deduction
72) Related Code
a) § 61 – gross income
b) § 62 – adjusted gross income (this is just gross income minus above the line
deductions)
c) § 63 – taxable income
d) § 67 – 2% floor on miscellaneous items; keeps a lot of crap out of the system;
can’t deduct stuff unless “the aggregate of such deductions exceeds 2 percent of
adjusted gross income”
e) § 68 – phaseout; hidden way to raise taxes
f) § 162 – ordinary and necessary expenses are allowed as business deductions;
general rule that gives deductions for costs incurred in a trade or business
i) § 162(a) – regular home to work commuting not deductible, but traveling
between businesses, even in the middle of the workday, is deductible
ii) § 162(a)(1) – no deduction for excessive salaries, just reasonable salaries
(a) Posner measures this by “indirect market test”
iii) § 162(a)(2) – traveling expenses while away from home
iv) § 162(c) – no deductions for kickbacks
g) § 163(a) – deduction for interest paid or accrued during the year; interest is
subject to the capital expenditure limitation
h) § 165 – this is for losses; above the line
i) § 183 – activities not engaged in for profit
i) § 183(a) – no deduction for any activity that’s not engaged in for profit
ii) § 183(b) – any loss in these activities is limited to gains
iii) § 183(c) – definition of activity engaged in for profit is done wrt §§ 162, 212
iv) § 183(d) – presumption that if 3 of 5 years are profitable, it’s a for-profit
activity
v) § 183(e) – special rule
j) § 212 – deduction when costs are incurred, and you’re seeking a profit, but not as
a part of a trade or business; good example here is investing
i) Why do we care about § 212 or § 162? § 212 is subject to a variety of
restrictions, like the 2% floor.
k) § 262 – no deduction for personal expenses
l) § 274 – disallowance of certain entertainment, etc., expenses
i) § 274(a) – in general, no deduction allowed for entertainment, amusement, or
recreation, unless taxpayer shows it was directly related to business
ii) § 274(b) – gifts
(1) § 274(b)(1) – if you give a gift of more than $25 to someone, you can’t
deduct it; gift is defined as any item excludable from gross income of the
recipient under § 102 non excludable any other provisions
(2) § 274(b)(2) – this limitation in part (b)(1) applies to partnerships and each
member of the partnership; married people count as one taxpayer for these
purposes
iii) § 274(d) – substantiation required
iv) § 274(e) – specific exceptions to application of (a): food and beverages for
employees, expenses treated as compensation, recreational expenses for
employees, business meetings, items available to public, entertainment sold to
customers, expenses includible in income of persons who are not employees
v) § 274(f) – interest, taxes, casualty losses, etc.
vi) § 274(g) – treatment of entertainment, etc., type facility
vii) § 274(h) – attendance at conventions
viii) § 274(i) – qualified nonpersonal use vehicle
ix) § 274(j) – employee achievement awards
(1) § 274(j)(1) – “No deduction shall be allowed under § 162 or § 212 for the
cost of an employee achievement award except to the extent that such cost
does not exceed the deduction limitations of paragraph (2).”
(2) § 274(j)(2) – deduction limitations for employer who gives gift to
employee
x) § 274(k) – business meals
xi) § 274(l) – additional limitations on entertainment tickets
xii) § 274(m) – additional limitation on travel expenses (luxury water
transportation, travel as form of education, travel expenses of spouse,
dependent, or others)
xiii) § 274(n) – 50 percent of meal and entertainment expenses allowed as
deduction.
m) § 280A – disallowance of certain expenses in connection with business use of
home, rental or vacation homes, etc.
i) § 280A(a) – general rule is no deduction allowed with respect to use of a
dwelling unit which is used by the taxpayer as a residence
ii) § 280A(c) – exceptions for certain business or rental use; limitation on
deductions for such use
(1) § 280A(c)(1) – exceptions to (a) included “portion of the dwelling unit
which is exclusively used on a regular basis . . . as the principal place of
business, as a place of business which is used by patients, clients, or
customers . . ., or a separate structure which is not attached to the dwelling
unit, in connection with the taxpayer’s trade or business.”
(2) § 280A(c)(5) – limitation on deductions for portions of residence used
Capital Recovery
73) Really basic overview:
a) Expenses are deductible immediately
b) Capital expenditures with life of X years are deductible over X years
c) Capital expenditures with virtually infinite life are deducted when sold
74) Tricky areas:
a) Repairs (expense) v. alterations (cap expend) [Midland]
i) Alterations exs: adding three stories, making old building new
ii) Repairs: for incidental breakages, not wear and tear
(1) These things resemble the casualties of § 165(a).
(2) Defined in regs as an outlay whose limited purpose is to continue the
property’s operation for the duration of its expected life or to maintain its
normal output and existing capacity
b) Business intangibles [INDOPCO]
c) Purchase v. lease
d) Education expenses
i) General rule is that it’s an expense if the aim of the expenditure is to maintain
or improve skills used by the taxpayer in an existing trade or business, or if
the education is required by the taxpayer’s employer as a condition of
continued employment. Ex: refresher course on tax or something like that. If,
however, you acquire new skills, then not deductible. Ex: education that leads
to a degree.
75) Some Conceptual Background
a) A simple transaction. Buy a machine for $1000. It’ll produce widgets every year
for a certain time period. On the day you buy the machine, all your assets are
$1000. Then you buy the machine. What’s your net worth after? $1000. So you
still have the same net worth. So there’s no deduction. Instead you get basis of
$1000 in the machine. The basis is an account that keeps track of your investment.
Suppose it produces a widget every year for 5 years, and each can be sold for
$250. Then the machine dies after 5 years.
i) Cash flows go: -$1000, +$250, +$250, +$250, +$250, +$250
ii) How do we handle income in these years?
(1) One way is to give $250 income each year, and at the end, deduct a loss of
$1000. Why a loss of $1000? You had a basis of $1000 in the machine,
and at the end of the five years, it is worth $0, so you have a $1000 loss
there.
(a) Why this one? It recognizes a level of risk in the transaction. Don’t
make the person pay taxes on gains until their original expenses are
made up for. But why should cost-recovery be based on risk?
(2) Another way is to figure out the value of the machine at the end of every
year, and adjust income by that lost amount. This is tricky, though. What
is the accurate value to use here? It’s not a traded asset, so we can’t
(a) This is the one that’s used. Stuff gets taxed earlier. Can’t use the
$5000 to offset until the sale. So why is this used? Dividends are in a
sense seen to be “excess” – so the $5000 value is still there, as the
corporation theoretically can go on forever. So this $400 dividend is
excess of the $5000. This also is nice for simplicity, and for
accounting purposes. How much did it cost the taxpayer to earn that
$400? Nothing, really. Some might argue that it cost the $5000. But
that $5000 is still there.
(3) Instead, we take a middle ground – depreciation/amortization. Each year
you depreciate a bit, and reduce the basis by that amount as well. Notice
that this is only an estimate. Maybe you get lucky and your machine lasts
twice as long as you expect. Say at the end of five years, it’s still worth
$700. But you’re out of basis. So you sell it, and have to realized a gain
(taxed).
(a) Why this one? This is the most “accurate,” because it acknowledges
that the $5000 paid up front is really the price of the future expected
dividend stream. So allocate a little of that price to each piece of the
dividend stream.
b) Stock example. Have $5000 of stock. Keep for 15 years. Each year you get a
dividend of $400. At the end of 15 years, you sell it for $5100. How should this
be handled?
i) Treat each dividend as recovery of investment until $500 has been regained.
Then tax everything after that as gain.
ii) Treat each dividend as income, treat $100 gain on sale as income. $5000
investment is recovered upon the sale.
iii) Something in between .Allocate the $5000 cost to the future expected
dividend stream by using some PV calculations. This of course depends on
estimating a time the stocks will be owned. Upon sale, all $5100 is realized.
c) Computing Depreciation
i) Need three things
(1) How long is the life of the asset?
(2) What method for depreciation?
(a) Linear
(b) Faster than linear at beginning, and slowing at end (called accelerated
depreciation)
(i) One kind is double-declining balance
(c) Slower than linear at the beginning, faster at end
(i) Economic depreciation looked like this
(d) Deduct it all at the beginning, and nothing later
(3) Salvage value.
(a) How much is this worth at the end of the depreciation?
(b) Often this is set at $0.
ii) Deducting the basis earlier is more valuable. If Congress wants to spur
investment, it accelerates deduction, and by doing so, we tax less earlier.
d) Basic Statutory Background
i) § 162 – deduction of basic trade and business expenses
ii) § 167 – allows for depreciation deduction; main thing that doesn’t get this is
land; anything else gets depreciation deduction
iii) § 168 – tells you how to depreciate; gives depreciation schedules for virtually
every asset in the economy
iv) § 195 – in general, no deductions for start-up expenses
v) § 263 – in general, no deduction for capital expenditures, but there’s a list of a
bunch of exceptions
vi) § 263A – non-deductibility of certain direct and indirect costs
e) Example (expensing worksheet on chalk)
i) Deducting an expenditure can be characterized as an interest-free loan. You
get to deduct the $40 up front, and pay back the $40 whenever you sell the
asset . . . no interest in between.
ii) Can also see an immediate deduction as a reduction in tax rate, because you
can invest a lower amount presently, and have it gain interest to pay off the
$40 in tax at the end of X years. The longer the time you get this deferral, the
lower amount you have to invest early on.
iii) IRAs – Roth and regular are the same; only differences come in if tax rates
change (higher tax rates now means regular IRA better, vice versa) and you
can invest more in Roth because you can invest $100 after tax whereas in
regular IRA you can invest only $100 pretax.
f) History
i) Used to be only 167, and you could set your own depreciation rates
ii) People got more aggressive, set more accelerated rates, moved up deductions
iii) Treasury decided at same time to use tax system to spur investment
iv) Treasury wanted to push people into using accelerated depreciation schedules
to spur investment
v) Treasury issued a series of tables called ADR (asset depreciation range)
vi) Reagan elected and wants to drastically reduce tax rates, and wants to do so
on investment on the theory that reducing tax rates on investment increases
investment and actually increases tax revenue; doesn’t work; he creates
Accelerated Cost Recovery System (ACRS), which gives you dramatically
shortened lives, 0 salvage value, and very accelerated depreciation schedules
vii) Reagan wanted to help companies make big investment (auto, steel,
Midwestern rust belt)
viii) Safe-harbor leasing – sell tax benefits to others (1981-1982); this looked
bad to public because it seemed as though big companies weren’t paying
taxes; they were actually just buying tax benefits from other companies
ix) In 1984 and 1986, depreciation schedules were seen as too generous, so
modified accelerated cost recovery systems were adopted (MACRS) . . . sort
of accelerated, but not very much . . . pretty close to economic depreciation
x) In 2003, Bush wants to do supply side tax cuts to spur investment, and allows
bonus depreciation. He keeps MACRS, but only a bit . . . ½ of investment is
tax exempt (so keeps 162), and the other ½ is MACRS.
76) The big legal question: When is an expenditure deductible, and when is it capitalized?
a) What’s at steak here is everything. It’s whether you’re going to tax the thing at
all. This is one of the most litigated areas in tax law. You can’t really make sense
of all of them. This is a very confusing area.
b) Idea is this:
i) Set tax rate at 40%.
ii) Say you can invest at 150% return on cash. so you buy machine worth $4k,
can earn $6k. If there's no tax, you earn $2k profit.
iii) Then say that the $4k is deductible. Then you can afford to invest $6667,
because, when you deduct it, it saves you 40% of $6667 in taxes (which is
$2667), so it costs you the same as above, $4k. Now, since return on
investment is still 150% (that's an assumption), you make $10k this time.
Taxes are $4k. So net is $6k. Subtract the $4k cost of machinery up front (the
$6667 minus the tax savings of $2667), you have total profit of $2k again, just
as if there were no taxes.
iv) In a taxable world, you would earn the $2k profit, as in first example, but pay
some taxes on that $2k ($800 if tax is 40%).
c) Encyclopedia Brittanica v. Commissioner (1982, p. 491)
i) Summary: EB is publishing a dictionary of natural sciences; they are
shorthanded, so they hire another publisher to do all the work; EB will keep
the © and sell the book; EB pays other publisher, but retains all control of the
project; EB gives this publisher an “advance royalty payment”
ii) Issue: whether this expense of paying the other publisher is an expense that’s
deductible, or capital investment
iii) Holding: no deduction; these are the payments required to acquire a capital
asset, so are capital expenditures
iv) Reasoning:
(1) Work was supposed to earn EB money of a period of years; they are
buying something that’s going to earn money for them over a period of
years, just as a bond or stock would
(2) It’s net worth when it purchases this dictionary hasn’t changed; $ out for
© . . . so no deduction; instead, dictionary has a useful life, and produces
revenues over this useful life; match the decline in this value with the
revenues coming in
v) Class Discussion:
(1) Another Posner opinion.
(2) Court relies on Idaho Power – this is the formative decision in this line of
cases; taxpayer claimed current deductions for depreciation on the trucks
and other such equipment it used in constructing capital assets such as
transmission lines; Court upheld the Commissioner’s disallowance of such
deductions, reasoning that the cost of the trucks was simply part of the
cost of creating the capital asset itself
(3) Posner says it’s the same as if you are building a book . . .
(4) Petitioner says this is under 162 . . . ordinary and necessary expense,
relying on Faura, which is a case involving a company that produces
books in-house.
(a) What does Faura hold? You can deduct the cost of in-house
production of books, even though each book is itself an asset that lasts
a long period of time. Why is this the case for Faura? Posner notices
it’s because, when you’re making a bunch of books all at once, there’s
no need for administrative rigor in tracking the exact expenses,
because when you are making many books, the sum of the annual
depreciation costs is essentially the cost of one finished product
anyway. There is no difference, on average, between looking at
capitalization and deducting.
(b) Does Faura’s theory make sense? Not really. This doesn’t work at the
beginning and the end of the production, cycle, however, when you are
starting up only a few projects, and at the end, when you are finishing
up only a few products. At the beginning you get to depreciate too
much, and at the end not enough. But these discrepancies don’t
balance out b/c of timing.
(c) How does Posner distinguish this, then? This is out of the ordinary for
Encyclopedia Brittanica.
(d) Faura is no longer good law. § 263A is a rule that says that when you
are in the business of producing assets or selling inventory, all indirect
costs of production have to be capitalized.
d) Revenue Ruling 85-52 (p. 498, 1985)
i) Summary: farmer buys farmland with growing crops on it; wants to deduct the
cost of the growing crops
ii) Holding: purchasing farmer may not deduct the portion of the purchase price
allocable to the growing crops; you purchase something, that’s the basis you
get; you may take into account that portion in arriving at the net farm profit or
loss for the next year, when the growing crops are sold
iii) Class Discussion:
(1) There’s a special farmer rule. They don’t have to deal with 263 if their
crops are in the ground over year-round. Asset is corn seed. Put it in the
ground. Then next year, you sell the corn. Normally, you’d have to
capitalize it. Farmers can just deduct seed costs, and then next year include
income from sales. Remember: deducting the purchase price of an asset is
equivalent to not taxing them.
(2) Why should the person who purchased the land with crops in the ground
get to take advantage of that?
e) INDOPCO
i) Summary: this case involves takeover expenses by an acquiring corporation;
SCOTUS held that the lawyers and bankers fees for the takeover had to be
capitalized into the basis of the stock of the target company
ii) Class Discussion:
(1) “Although the mere presence of an incidental future benefit . . . may not
warrant capitalization, a taxpayer’s realization of benefits beyond the year
in which the expenditure is incurred is undeniably important.”
(2) The taxpayer loses very badly here; if you can deduct lawyers’ and
bankers’ fees immediately, but if you incorporate them into the stock, you
are delaying the benefits essentially indefinitely
(3) This is target expenses. Why does that matter? Target has lawyers’ fees,
bankers’ fees, etc, as does the acquirer. What target argued was that: “I
didn’t buy anything. The acquiring company bought me, and got my stock
as an asset. I paid a bunch of fees, but I didn’t buy anything. There’s no
identifiable asset here.” SCOTUS doesn’t care about separate and
identifiable assets. What SCOTUS cares about is whether the expenditure
has long-term benefits. Because this was a friendly takeover, you
obviously thought the merger had long-term benefits, so the fees you paid
had long-term benefits, so they are not current-period costs, but they are
263 long-term costs, and must be capitalized. But since there’s no asset
there, you have to make up one on your books. But since it’s made up,
there’s never a time you’ll sell that asset, so you never recoup these fees.
(4) This creates an enormously broad standard that no one really treats as the
law. It basically says that any expense that goes beyond a year must be
capitalized.
(a) Classic example: advertising. Everyone always deducts advertising.
But as you know, much of advertising is generating goodwill and
name recognition for your company.
(5) One way to interpret EBritt was that they purchased a separate asset. And
it’s hard to identify separate assets within a production cycle. What about
the heat in the building? Do you need to divvy up the heating costs across
the books?
f) Post-INDOPCO, things eventually change back to a test that looks to see if a
separate asset is created.
i) Rev Ruling 92-62 (Chirelstein): amounts paid or incurred for training,
including the costs of trainers and routine updates of training materials, are
generally deductible as business expenses under § 162 even though they may
have some future benefit
ii) INDOPCO does not affect advertising
g) Midland Empire (1950, p. 502)
i) Summary: using basement to cure ham and bacon; water always leaked into
basement, but then oil starting leaking into it; govt said they had to find an
alternate water source; they paid to repair it; they want to deduct the repair
costs because it didn’t do improvements, but just returned it to pre-oil stuff;
IRS argued that this repair extended the useful life of the building
ii) Holding: “expenditure of $4868.81 for lining the basement walls and floor
was essentially a repair and, as such, it is deductible as an ordinary and
necessary business expense”
iii) Class Discussion:
(1) Recall that if you can immediately deduct the purchase of an asset, it’s
economically equivalent to not being taxed at all.
(2) This is repairs. Repairs are a tricky area. Reason why is that after a repair,
your previously broken asset has a useful life much longer than it used to
be. Also, it’s hard to know what it means for an asset to break. After all,
lots of things are depreciated for. That is, lots of breakages are expected
and accounted for. So repairing those types of things should not lead to a
loss for them, because you are already getting a loss through depreciation.
For example, you depreciate your house for roof problems. So you’ve
already taken account of roof problems. Should you then get to deduct
them?
(3) Doctrine has evolved through Plainfield Union test, which says, look at
useful life before the breakage, and the useful life after the repair, and if
the life remains the same, then you can deduct repair expenses, because
you haven’t changed anything. The IRS test here says look before the
repair but after the break, and compare that to after the repair.
h) Revenue Ruling 94-38
i) Summary: EPA comes down hard on a manufacturing plant; plant removes
bad soil and also installs a groundwater treatment system; both expenses are
allowed to be deducted, as both are seen as just putting the plant back in the
original condition it was in before these problems/conditions occurred
ii) Class Discussion:
(1) How is the soil removal different from the water treatment system? Seems
like it’s maybe more forward looking, more like an improvement to the
land. Problem is, it doesn’t actually increase the lifespan of the asset.
Really, what it is, is avoiding continual cleanup costs up front. The value
of the treatment system is the present value of all the future deductions
you could get if you removed the bad soil each year. Instead of removing
bad soil each year and getting a deduction each year, just put in this
treatment system in year 1, and get a deduction for this.
(2) “appropriate test for determining whether the expenditures increase the
value of property is to compare the status of the asset after the expenditure
with the status of that asset before the condition arose that necessitated the
expenditure”
(3) 263A changes this. What’s going on here? Weisbach isn’t sure.
i) Norwest (p. 511, 1997)
i) Summary: need to remove asbestos from the building; normally don’t disturb
asbestos; but they’re deciding to rehab the building; as part of the rehab, they
incur extra expenses removing the asbestos; it is unquestionably true that if
they just got rid of the asbestos, and didn’t rehab, that they would’ve been
able to deduct; here they can’t
ii) Holding: combining asbestos removal with the rehab  can’t deduct asbestos
removal costs
iii) Class Discussion:
(1) Why does combining the rehab with the asbestos removal change the
treatment?
(2) Problem here is that if you really can split up the stuff—do repairs then
rehabs—then this doctrine doesn’t do much. Maybe the reason that the
court goes the way it does is because the fact that the company didn’t split
it up means maybe it was inefficient for them to do or they couldn’t, so the
asbestos removal was really just a part of the rehab/improvement, so
shouldn’t be deducted.
77) Single most important tax issue is what you’re going to tax.
a) What’s an income tax?
i) Haig-Simons: Income = Consumption + Change in savings
(1) Big difference between this and actual income tax is realization.
(2) Why have this? Good measure of ability to pay. Who can pay for the cost
of government? Ability to pay is useful for this, and the people who
support Haig-Simons say it’s a good measure of ability to pay. This is the
biggest argument in this favor.
(a) Consumption tax people have a response to this. Over anyone’s
lifetime, regardless of how rich they are, they generally consume all
they have. So we should consider this over a lifetime, not just
annually. And since everyone consumes everything, we should tax
consumption.
b) What’s a consumption tax?
i) Consumption = Income – Positive change in savings
(1) This is just a measure of your cash flows. A little unintuitive in some of its
mechanics, but simple in concept.
(2) We know that a cash flow tax, where you deduct the cost of the assets you
purchase, doesn’t tax the return to savings. This is the major feature of a
consumption tax. The taxation of capital is gone.
ii) Can think of this as an income tax where you get a deduction for savings.
iii) Another characterization of a consumption tax that it is a tax solely on labor
income. (Note here that labor is the same as consumption . . . your Labor =
PV(Consumption) . . . you can either consume now or you can consumer later
. . . but you’ll consume everything, and you can consume only what you earn,
and you earn what you work.) A couple ways we can see this. Instead of
thinking about uses of income, think of it as sources of income. You can earn
it through hard labor, or you can earn it through investment. It’s a tax only on
labor.
iv) Key feature of consumption tax is that it doesn’t distort when you do your
consuming.
(1) Have $100 now. If invest at 10%, next year you have $110, and when you
spend, you have $77 of power. If you are taxed now, you are left with $70,
then invest at 10%, and end up with $77. So when you consume isn’t
distorted. Only questions are how much you choose to consume. You
generally work less under consumption tax.
(2) This does assume a bit that tax rates don’t change. Maybe if tax rates are
lower in time X, you can lump some consumption in that period. Who
knows?
(3) But all that’s taxed is labor income, and that’s a smaller amount. So the
tradeoff of not taxing savings is a narrower tax base, which means higher
tax on labor, which means greater distortion on labor behavior. Why is this
wrong? Think of savings as future consumption. Then any tax on savings
has two effects: 1) distorts how much you save and 2) it reduces that
amount you can consume. What does that mean for you today? When
working today, the tax on savings (future consumption) is reducing the
current benefit to work. So it’s not clear that Haig-Simons does NOT have
this same effect. There’s essentially no tradeoff. Both pickup labor
income. Income taxes have the effect of determining when you consume.
So the argument is that income tax is a subsidy on current spending, tax on
later spending. And when you start to think of it that way, it’s hard to
support an income tax.
v) Retail sales tax is an example of a cash flow. Not a lot of places do this, but
the US does.
c) Which do you want? Your decision relates entirely to whether you want to tax
returns to savings or not.
d) Tradeoff Argument
i) Argument for consumption tax is it doesn’t distort savings decision. Given
any amount earned, savings decisions aren’t distorted. Income tax advocates
response by swaying that the consumption base is now lower than the income
base. Therefore rates must be higher. Therefore, Labor is distorted more. The
reason this argument is wrong, is that the income base is really the same, it
just taxes future consumption a little more. This extra tax on consumption also
distorts labor. So labor incentives are distorted in each. And savings are also
distorted in income tax.
e) How do you implement a consumption tax?
i) One way is a cash flow tax. This is pretty complicated.
ii) One way is to tax consumption. Tax where you purchase. Retail sales tax
(RST). It is tough to tax every type of consumption, though.
(1) Huckabee’s Fair Tax: broad based retail sales tax. It’s about 30% on
consumption. This is off the reservation in terms of mainstream tax policy,
because it’s so easy to avoid. The only taxable transaction is a retail sale,
and it’s so easy to do them under the table, and there’s a huge incentive to
do so. Fair tax people respond by saying people like WalMart and
Amazon won’t avoid. But there are lots of other players out there. No one
has ever tried a tax like this.
(2) People instead try to do a value-added tax (VAT). Example. Consider
bread. Farmer sells wheat to the Miller for $30 who sells it to the Baker
for $80 who sells it to the Customer to $100. So you can distribute the
30% tax rate across these purchases. The Miller pays 30% of it, so pays
$9. The Miller pays $15. The Customer pays $6. Now there are more
instances of taxation. Higher administration, but less incentive to avoid at
each step.
(a) Europe adds one more thing to their VAT. Chain or receipts showing
that the previous buyer (who is now the seller) paid taxes.
(b) Hard to get progressivity through this. Either no progressivity, or it
gets messy taxing different things (luxuries, for example) at higher
rates. But what about a product that combines luxuries and nonluxuries. (A meal with caviar [luxury] and tomatoes [non-luxury])?
Messy.
iii) Flat Tax. Attempt to take a VAT, and make it progressive. The irony is that
the right wing loves it, but it’s a progressive VAT. Problem with VAT is that
it’s all at the business-level. You have no idea who’s consuming. So this Flat
Tax personalizes the VAT. Value added at each stage is taxed, but wages are
taxed to the individual workers along the way. This wage tax—not income
tax, since no taxes on gains from things like savings—can be made
progressive. So for example, if the mill sells for $80, but $40 of that was labor
and $30 was other costs, they mill is taxed only on $10 ($80-$40-$30) and the
laborer is taxed on the $40.
f) Transition from Income to Consumption.
i) What if you switched from income tax to consumption tax overnight.
Consider a guy who paid $100 for an investment that gains $10/year. Under
the income tax, if he withdrew this $ after a year, he’d be taxed only on $10,
because he had basis of $100. Under consumption tax, though, this guy is
taxed on the whole $110, because he has a cash flow of $110.
(1) This is good because . . .
(a) The unexpectedness means you can’t distort behavior
(b) This hurts old people more (they’re the ones who will be withdrawing
$ they’ve had in such accounts) . . . and that’s ok, because lots of the
way taxes work is to take money from young and give to old, so this
tempers that a bit.
(2) This is bad because . . .
(a) “That’s just not fair.”
(b) It’s actually not efficient, because you can’t anticipate it.
78) Related Code
a) § 162 – trade or business expenses
i) § 162(a) – “allowed as a deduction all the ordinary and necessary expenses
aid or incurred during the taxable year in carrying on any trade or business,
including” . . .
(1) § 162(a)(3) – rental payments
b) § 168 – accelerated cost recovery system
i) § 168(a) – in general, “depreciation deduction provided by § 167(a) for any
tangible property” is determined using the applicable depreciation method, the
applicable recovery period, and the applicable convention
ii) § 168(b) goes over different depreciation methods
(1) § 168(b)(1) – 200% declining balance till straight line gives larger
deduction; this is the default mode
(2) § 168(b)(2) – 150% declining balance till straight line gives larger
deduction; 15- or 20-year property and farming stuff
(3) § 168(b)(3) – straight line for some stuff; includes nonresidential real
property, residential rental property, RR stuff, etc.
(4) § 168(b)(4) – salvage value = $0
iii) § 168(c) – list of recovery periods
iv) § 168(d) – applicable conventions (half-year, mid-month, mid-quarter)
v) § 168(e) – how to classify property (3-year, 5-year, residential, etc.)
vi) § 168(f) – properties excepted from this section (taxpayer opts, unitproduction method is used, video tapes, recording)
vii) § 168(g) – alternative depreciation methods for certain property
c) § 195 – start-up expenditures
i) § 195(a) – in general, there are no deductions for start-up expenditures
ii) § 195(b)
iii) § 195(c) – definitions
(1) § 195(c)(1) – start-up expenditures are those things paid/incurred in
investigating/researching/starting something for profit if they could be
deducted if you’d already had the business going
(2) § 195(c)(2) – Secretary proscribes the beginning of the trade or business
iv) § 195(d) – when you have to elect a certain depreciation method
d) § 197 – amortization of goodwill and other intangibles; overruled Newark Star
Ledger, which didn’t allow amortization for any goodwill
i) § 197(a) – amortization of any § 197 intangible is done by amortizing the
adjusted basis ratably over the 15-year period beginning with the month in
which the intangible was acquired
ii) § 197(b) – § (a) amortization is the only amortization allowed for these
intangibles
iii) § 197(c) – “amortizable section 197 intangible” is any section 197 intangible
(next section) used for trade or business described in § 212
iv) § 197(d) – “section 197 intangible” means . . . goodwill, going concern value,
workforce, business books and records, patents, customer-based intangibles,
etc.
v) § 197(e) – “section 197 intangible” doesn’t include . . . financial interest, land,
computer software, certain interests or rights acquired separately, mortgage
servicing, certain transaction costs, etc.
e) § 263 – capital expenditures
i) § 263(a) – in general, no deductions for any amount paid out for new building
or for permanent improvements of betterments made to increase value of any
property or estate. This does not apply to deductions allowed by §§ 174, 175,
179, 179A, 179B, 179C, 179D, 180, 190, 193, 616
ii) Note: if something fits in § 162 expenses, it’s currently deductible; if it fits
here, it must be recovered through depreciation over the useful life
f) § 263A – capitalization and inclusion in inventory costs of certain expenses
i) § 263A(a) – nondeductibility of certain direct and indirect costs
(1) § 263A(a)(1) – any of costs in (2) are included in inventory costs if the
property involved is inventory and are capitalized if the property is any
other property
(2) § 263A(a)(2) – allocable costs include direct costs and indirect costs
(including taxes) part of or all of which are allocable to such property
ii) § 263A(b) – this section applies to real or tangible personal property produced
by the taxpayer or § 1221(a)(1) real or personal property acquired by taxpayer
for resale
iii) § 263A(c) – exceptions
(1) § 263A(c)(1) – property made by taxpayer for personal use
(2) § 263A(c)(2) – § 174 research/experimental stuff
(3) § 263A(c)(3) – stuff deductible under §§ 263(c), 263(i), 291(b)(2), 616, or
617
(4) § 263A(c)(4) – stuff made pursuant to a long-term K
(5) § 263A(c)(5) – timber
iv) § 263A(d) – this section doesn’t apply to farming equipment
v) § 263A(g) – definition of production
vi) § 263A(h) exemptions for free lance authors, photographers, and artists . . .
no capitalization of any qualified creative expense
Anatomy of a Tax Shelter
79) Introduction
a) Basic idea: generate “artificial” losses that can be offset against actual gains
b) Main question: How do we distinguish legitimate tax strategies from abusive
ones? It’s pretty clear you have to have some category of things you’re not going
to allow. If you didn’t have some rule that says “X doesn’t work,” the tax base
would disappear. So you have to say if X is bad enough, it doesn’t work. And
then you need to be able to tell the good from the bad. But there’s no easy or clear
way to do this.
c) Dynamic duo of tax shelters
i) Accelerated depreciation
ii) Deductible interest on non-recourse indebtedness
d) Examples of exempt or partially exempt income that might lead to tax shelters
i) Depreciable assets
ii) Insurance policies
iii) Investment in appreciating securities
iv) Note: How do you handle this? Symmetry. If you don’t tax the income, then
tax the interest on the debt incurred to buy the stuff.
e) Some views on tax shelters overall
i) Learned Hand: “There is no patriotic duty to pay more taxes that are due. We
are free to arrange our affairs to minimize our taxes.” Basically the idea is, the
government sets the rules. Once it writes down the rules, you are free to due
what they want. If the mayor of City X sets RST of 15% and City Y says tax
is 3%, you’re allowed to move City Y just for tax reasons.
ii) These things are a mess. They create fairness concerns. People with same
incomes end up paying different amounts in taxes—this is a horizontal
concern. They also create progressivity concerns/vertical concerns, because
it’s only the wealthy who can do this. They’re inefficient, because people use
resources just to avoid taxes, and they’re not doing anything productive. They
are wasteful, because they force Congress to use resources to amend the code.
And they undermine confidence in the tax system, and may even undermine
compliance—if someone is using a tax shelter, those who aren’t start getting
mad and then start evading.
iii) Marty Ginsburg says these are funny.
f) Recall some economics
i) Borrow 80, put 20 down, and buy something for 100. Crane and Tufts say
basis of 100. Assume you can depreciate 40. Note that you get depreciation
more than what you put down. You can get tax benefits on more than you put
down. Now, eventually you have to pay the 80, so you have to put your
money in. But you can get the benefit now, rather than later. This is a timing
benefit.
ii) What if you sell for 0 + assumption of the mortgage? Crane and Tufts say that
your amount realized includes the borrowing. AR = 80 (getting rid of the loan
obligation), B = 60 (100 – 40 of depreciation), Gain = 20. Then you are taxed
on the 20. So the system sort of gets it right, but it’s a big timing advantage.
g) One more step before Knetsch.
i) Consider borrowing to purchase tax-exempt bonds—no tax on interest.
Borrow $1000 at 10%. Use it to buy tax-exempt bond that gets interest of 7%.
Each year you lose 3%—$30/year lost. Why would you do this? Suppose your
tax rate is 40%. You get to deduct the $100 in interest, saving you $40 in
taxes. So you lose $30 (10%-7%), but gain $40. So you gain $10. This called
tax arbitrage, and is pretty much the transaction in Knetsch. Not allowed.
ii) Consider taxpayer #2 who currently owns a bond with $1000 face, yield of
10%, and are in 40% tax bracket. Every year after-tax return is $60. So their
after tax return is 6%. Along comes a tax advisor and says you should sell
your regular bond, and buy a muni that’ll get you 7% tax free. This guy would
not do that if it weren’t for avoiding paying taxes. But this seems totally fine.
What’s the difference? Can make it even harder to distinguish. What if it’s
hard for this guy to sell the $1000 bond, which might be true. So what the guy
does is borrow $1000 at 10%. This is basically the same as selling—this loan
exactly offsets any benefits of the bond. Then he uses the loan $ to buy the tax
exempt one. This latter part of the transaction is exactly the same as the above.
Why is this one not abusive?
80) Knetsch (1960, p. 557)
a) Summary: borrows for 3.5%, invests with borrower for 2.5% in an annuity;
basically a bank account; after 30 years, annuity figures out value and pays annual
amount each year for the rest of your life; annuity cost $4mill; each year he pays
$140k interest up front, but gains only $100k, and this $100k falls under a special
rule for annuities and cash value life insurance policies that say that any increase
in value is not taxed until you withdraw the money; assuming Knetsch is in the
90% bracket, as assumed, this $140 deduction saves him $126k; figuring in his
$40k loss, his net gain is $86k
b) Holding: no deduction for the up-front interest payment
c) Class Discussion:
i) This class came after § 264(a)
ii) Nonrecourse debt, so nothing to lose. No business purpose.
iii) Did anything other than tax motivate this transaction?
(1) Couldn’t a valid reason be that Knetsch was saving for retirement? He’s
diversifying for retirement. Hedges for the risk that he lives for a long
time.
(a) But he only gets $43/month. Why? Isn’t it a $4mill annuity? Yeah, but
Sam Houston subtracts the interest owed before it pays him off. And
he had no net equity in the annuity, so there’s not much there for him.
How does he make sure there’s no net equity in the annuity for him?
Every time the equity increases, he borrows it out. He puts $ in the
account, then borrows it out. So the net amount he owes the bank and
the bank owes him is $0.
iv) Does SCOTUS say you have to have a nontax interest? No, and substantiates
this by citing Gregory v. Helvering (famous quote in that case: “The legal
right of a taxpayer to decrease the amount of what otherwise would be his
taxes, or altogether avoid them, by means which the law permits, cannot be
doubted . . .” – this is not really the law now; most courts look at what your
purpose is . . . this is just not the case in Knetsch). It instead looks to the intent
of the statute.
v) So why then does SCOTUS strike it down? Maybe because nothing really
happened. This is a fictional transaction, basically. There’s no real loan. This
is a sham. No economic substance.
(1) Responses to SCOTUS:
(a) There is a possibility of a profit. If interest rates go down to 1%, he
goes to another lender, gets another $4mill loan, pays off original loan,
then gets a positive arbitrage. Maybe he’s betting on interest rates.
There is a possibility of profit. This argument was not brought up.
(b) This isn’t a sham. These are legally binding Ks.
(c) He did what Congress said you had to do. He followed the legislation.
If you don’t like it, tell Congress.
(i) SCOTUS also notes the purpose of the legislation that allowed this
scheme. The legislation was not crafted to allow for schemes like
this. Obvious problem with this idea, however, is: What did the
legislation want? What was their purpose in passing statute X?
Congress didn’t intend to allow interest deduction for bogus
transactions.
(ii) Why should the Court have to step in here? Why isn’t going to
Congress the right thing to do? When there’s a complicated
system, there will always be loopholes for people to take
advantage of. So after Congress fixes this, there will be other
loopholes. These will always exist, so the Court needs to fix some
of these. But that leads to the problem: What are the features of
this transaction that makes it one of the bad ones?
1. Just as with yesterday’s example, we can change the facts of
this, so that the structure of the transaction is exactly the same
as in Knetsch, but it seems “ok.” For instance, say Knetsch
already had something earning him 3.5% interest. But this
2.5% tax-free interest is better, just the same as it is in Knetsch.
So you sell the item earning you 3.5% thing (which turns into a
loan obligation where you have to pay out 3.5%) and get the
2.5% thing. This seems different, but why? Is it just motive?
Sniff test?
2. Congress says equity investment is always different from
leveraged investment. Why? Maybe because there’s no real
check on debt. If it works, you can just keep borrowing. Why
not just borrow $4b instead of $4m? It’s essentially all fake. No
check. Equity is a check, because you actually have that at
stake.
(d) See Goldstein (1966, p. 562) – even in denying interest deduction,
court refused to call loan a sham transaction, because the loans were
made by independent financial institutions, the loans didn’t within a
few days return all the parties to the position where they started, the
banks could demand payment at any time, and the notes were with
recourse; court instead looked to motive – § 163 “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”
vi) Dealing with annuities
(1) Note that annuities are interesting because they are certainly finite (usually
terminate on someone’s death), but they are of indeterminate length.
(2) How should received annuity payments be treated?
(a) Option 1, days of yore: tax-free until invested capital amount has been
recovered; this was done in early days
(b) Option 2, instituted in 1934: tax 3% of the cost of the annuity each
year
(c) Option 3, instituted in 1954, present treatment (§ 72): impute the
contractual rate of interest to the annuitant by calculating life
expectancy, etc.; mortality losses and gains are now recognized
through § 72(b) (die prematurely, can deduct; die late, get more gains)
vii) Dealing with life insurance
(1) § 101(a) provides a blanket exclusion for insurance proceeds payable by
reason of death
(2) Does this make sense? Sort of. The amount paid in by the insured, and the
interest gained on that, should be tax free because it’s basically an interest
bearing bank account given to the heirs. But what about amounts over
that? That is, what if there’s profit on the death? Seems as though this
could be in § 61’s reach, and the exclusion is open to question. Note that
future earnings lost by death (which the insurance is supposedly making
up for) would have been taxed (but maybe also would’ve been greater, so
after tax income is same as actual insurance payment). Treasury comes out
equal on this.
(3) This is different for survivors of term policies. If a person survives, they
have to pay tax on the gain above premiums paid. (§ 72(e))
81) Franklin (1976, p. 566)
a) Intro via an ink pen tax shelter.
i) Seller sells pen to buyer for $10m. Buyer promises to pay this amount in the
future, and will pay interest payments along the way. Buyer then leases the
pen back to seller for $1m.
ii) What advantage to the buyer? Depreciation deductions. Can depreciate on the
$10m. Never have to pay the $10m for the pen. Nonrecourse, so you default
and give the pen back. The buyer will realize a $10m COD gain (cancellation
of debt), but the timing is helpful. Realize $10m of deductions before the
$10m COD.
iii) What advantage to the seller? Only taxed when he gets paid. That’s the future,
and it’s not actually going to happen (planned default). Seller defers the gain
(and never gets it, because it’s all fiction). Gets to use the pen in the
meantime, and the lease payments from the seller to the buyer cancel out the
interest payments owed by the buyer to the seller. So really nothing changes
for the seller. (There’s a possibility of making the interest payment not cancel
completely with the lease payment, making the seller have a little benefit that
doesn’t completely cancel the buyer’s benefit.)
b) Summary: same thing but with land
c) Holding: not allowed
d) Reasoning: this is really a purchase of an option to buy . . . purchase price of the
“pen” must be the actual purchase price of 50 cents.
82) Winn-Dixie (2002, p. 578)
a) Summary: Co takes out cash value (as opposed to term) life insurance policy on
36k employees. The Co also borrows against the policies, paying an interest rate
of 11%. This rate is deductible, though. So they are gaining interest-free
investment, and paying deductible interest rates. Instead of withdrawing from this
insurance “bank account,” they borrow against it, and claim there are applicable
deductions. In 1997, tax laws changed making this not favorable, so they eased
their way out of this program.
b) Issue: is this allowed?
c) Holding: no – it’s a tax shelter
d) Class Discussion:
i) In a cash value insurance policy, the policy owner pays higher premiums in
beginning of policy, so when you are older and your risk of death is higher,
your rates don’t go way up. This amount above actual risk paid earlier is
called investment. The key is that this investment is tax exempt. So the
company is making a tax exempt investment. Sort of like munis. It’s like a tax
exempt savings account.
ii) Life insurance is enormously subsidized by the tax code.
iii) It’s key here that Winn-Dixie buys 36k policies, because this diversifies their
risk. If they buy it on only a few people, the risk that none of them will die is
higher.
iv) Notice that the more interest they pay, the better off they are. That should
make us a little suspicious about the deal. Higher interest  higher initial
deduction, and also, if the interest rate on their investment is correspondingly
high, then they’re also gaining more that’s exempted.
v) Here, early mortality is bad. Why? Insurance policy costs for next year go up
to offset that amount. Policy prices adjust retroactively.
vi) Taxpayer argument #1: Congress specifically authorized their activities in §
264(d). This section says that, if, during the first 7 years of the life insurance
policy, no more than 4 of those years’ premiums are paid with borrowed $,
then you can deduct the cost of the policy. This is an exception to § 274(a),
which sets up the general rule of no deduction for life insurance premiums.
The taxpayer basically says, “hey, Congress not only passively authorized it
by not prohibiting it, but they specifically said this action is ok . . .” They then
concluded that the sham transaction concept shouldn’t even apply.
vii) Courts’ response #1: This looks too much like Knetsch. Knetsch made the
argument that b/c Congress didn’t close a loophole, the loophole was allowed.
What Congress was doing was not closing a loophole on “real” deals. It
wasn’t blessing a type of sham deals. Same here. Congress isn’t blessing sham
deals, and this is a sham deal.
viii) Taxpayer argument #2: Even so, this isn’t a sham transaction.
ix) Court’s response #2: Never could’ve made any $ in any year.
(1) Note: IRS stipulated that the taxpayer met the 4 of 7 rule (§ 264(d)). But,
if you look at the facts, they didn’t really. If it really did satisfy the 4 of 7
rule, it wouldn’t really look very much like Knetsch. If you really met 4 of
7, you’d have some economic substance. But they use tricks to make it
seem as though they meet 4 of 7, when they really don’t. We don’t have
these details in the case.
x) What if Winn-Dixie had borrowed from a third party? So their interest
payment is to someone else here. $ isn’t just going in a circle anymore, but
underlying economics are the same. Probably ok. So why didn’t they borrow
from a bank? It’s treated as real borrowing on your balance sheet, and hence a
real asset, so your other borrowing costs are likely to go up. But the
leveraging with the insurance co doesn’t show up on your balance sheet. So
the basic difference is accounting purposes makes 3d party lending not as
attractive.
xi) Also, you don’t have to meet 4 of 7 if you borrow from another party.
83) Modern Shelters
a) Much more complicated. You need a team of experts to create these. No way
Congress could see these. There’s no magic bullet for modern shelters like there is
in § 469 for earlier shelters. They’re just too complicated to eliminate like that.
There’s no easy way to stop it.
b) So what has Congress done?
i) Increase penalties.
ii) Changed the standard for getting out of penalties. Used to be a reasonable
belief that it would work was enough. Now you have to believe that it’s more
likely than not that it’ll work.
iii) List of features that makes something a reportable transaction. This means it’s
disclosed to the govt as something that’s open to higher penalties and audits.
(1) Listed transactions. Whenever IRS finds out about a new type of shelter, it
issues a notice, and makes it a reportable transaction.
iv) No more audit lottery. Promoter of shelters must keep a list, then IRS comes
and gets the names of those people on their client list. Gone after
attorney/client privilege. They’ve said it’s not atty/client privilege here, b/c
attorneys are acting as shelter providers, not attorneys. IRS almost always gets
the info.
c) What was the role of tax lawyers in this?
i) Some went in the business of promoting actual shelters. It was their full-time
job to make these things and sell them to clients.
ii) However, most sold penalty protection letters.
d) Govt’s response to lawyer’s involvement
i) Made it very difficult to rely on a protection letter to get out of a penalty. Did
this by forcing disclosure in order to use the letter, certain kinds of lawyers
couldn’t issue opinion (generally those who had a role in structuring the
transaction).
ii) Made the standard higher, as mentioned above. Enacted something this year:
tax-preparer can’t offer client anything below the standard of more likely than
not to succeed. Used to be “reasonable.”
iii) Tax lawyer is subject to a separate set of regulations under the IRS. These
aren’t malpractice rules, but are ethical rules issued by gov’t. Circular 230. §
10.35 governs tax shelter opinions. Basically this § says the shelter opinions
have to be really long. Can’t address limited issues. Must cover all possible
issues. Must make reasonable efforts to ascertain the facts  this whole
process is more expensive. If you violate this, you can be sanctioned by IRS
(disbarred, no practicing before IRS).
e) Tax lawyers could issue penalty protection opinion that was basically a get out of
jail free card to the company using the shelter. Pressures on the lawyer to issue
these are high. If you didn’t give the opinion, you’d lose the client. Another firm
would. Attorney shopping here. You could always find someone who genuinely
believed it was ok. After all, the rules are complicated. Even if you’re not sure it
will work, you’re almost never sure that it wouldn’t work. These things sold for
tons of $. Tax attorneys were pulling in the most money. Some lawyers actually
just shifted to shelter promotion as all that they did. They’d market these things.
That’s how much money was in this stuff.
f) KPMG got in trouble basically for selling tax shelters. Trials have yet to happen.
Indictments were for knowingly accepting false representations.
84) Related Code
a) § 101(a) – gross income doesn’t include $ paid upon death from life insurance
contract; there’s a limit to amount excluded if K is assigned
b) § 163(a) – “There shall be allowable as a deduction all interest paid or accrued
within the taxable year on indebtedness.”
c) § 163(d) – investment interest can be deducted only against investment income;
this creates an investment basket; can’t have interest losses used against
something else—say wage income
i) This basketing is a very common way of dealing with shelters; § 469 is
another example
d) § 165 – losses
i) § 165(a) – generally, can deduct any loss not covered by insurance
ii) § 165(b) – basis for deduction is the adjusted basis from § 1011
iii) § 165(c) – for an individual, deductions under (a) are limited to:
(1) § 165(c)(1) – losses from trade or business
(2) § 165(c)(2) – losses from any transaction entered into for profit, though
not connected with trade or business
(a) The language here might indicate that you look to the person’s intent (I
intended this endeavor for profit), but look at the objective stuff.
(3) § 165(c)(3) – exceptions in (h), losses of property not connected with trade
or business or a transaction entered into for profit, if losses arise from fir,
storm, shipwreck, or other casualty, or from theft
iv) § 165(d) – “losses from wagering transactions shall be allowed only to the
extent of the gains from such transactions”
v) § 165(e) – theft losses are counted during taxable year when discovered
vi) § 165(f) – capital losses are limited by §§ 1211-1212
vii) § 165(g) – worthless securities
(1) § 165(g)(1) – “If any security which is a capital asset becomes worthless
during the taxable year, the loss resulting therefrom shall, for the purposes
of this subtitle, be treated as a loss from the sale or exchange, on the last
day of the taxable year, of a capital asset.”
(2) § 165(g)(2) – definition of security (share, right, bond, etc.)
viii) § 165(h) – treatment of casualty gains and losses
(1) § 165(h)(1) – (c)(3) stuff allowed only to the extent that it exceeds $100
(2) § 165(h)(2) – net casualty loss allowed only to the extent it exceeds 10%
of adjusted gross income
(a) § 165(h)(2)(A) – “If the personal casualty losses for any taxable year
exceed the personal casualty gains for such taxable year, such losses
shall be allowed for the taxable year only to the extent of the sum of”
the amount of the gains plus the excess over 10% of the adjusted gross
income of the individual
(b) § 165(h)(2)(B) – when personal casualty gains > personal casualty
losses, all those gains are treated as gains from sales/exchanges of
capital assets, and all the losses are treated as losses from
sales/exchanges of capital assets
(3) § 165(h)(3) – definitions
(a) § 165(h)(3)(A) – “Personal casualty gain” is the recognized gain from
any involuntary conversion of property described in (c)(3)
(b) § 165(h)(3)(B) – “Personal casualty loss” is any loss described in
(c)(3)
ix) § 165(i) – disaster losses
(1) § 165(i)(1) – any loss from a disaster in an area later determined by Pres to
get Fed aid under Stafford Disaster Relief Act may be taken into account
for taxable year immediately preceding the taxable year in which the
disaster occurred
(2) § 165(i)(2) – casualty is treated as having occurred in year for which loss
is taken
(3) § 165(i)(3) – amount of loss taken into account in preceding taxable year
can’t exceed uncompensated amount determined on the basis of the facts
existing at the date the taxpayer claims the loss
(4) § 165(i)(4) – this § doesn’t affect prescription of regs or other guidance for
federal funds, etc.
e) § 183 – activities not engaged in for profit
i) § 183(a) – no deduction for any activity that’s not engaged in for profit
ii) § 183(b) – any loss in these activities is limited to gains
iii) § 183(c) – definition of activity engaged in for profit is done wrt §§ 162, 212
iv) § 183(d) – presumption that if 3 of 5 years are profitable, it’s a for-profit
activity
f)
g)
h)
i)
v) § 183(e) – special rule
vi) Nickerson (farmer) exemplifies this; if you engage in a bogus activity not for
profit, no deduction
§ 264 – certain amounts paid in connection with insurance contracts
i) § 264(a) – no deductions for . . .
(1) § 264(a)(1) – life insurance premiums
(2) § 264(a)(2) – amount paid/accrued on indebtedness incurred/continued to
purchase life insurance, endowment, or annuity K
ii) § 264(b) – certain annuities are exempted
iii) § 264(d) - exceptions
§ 265 – same as § 264, but for tax-exempt bonds
§ 465 – deductions limited to amount at risk
i) § 465(a) – deductions limited to amount at risk
ii) § 465(b) – what constitutes at risk
iii) § 465(c) – activities to which the § applies
iv) § 465(d) – definition of loss
v) Dilutes the Crane rule by restricting the amount of deductible loss from the
ownership of depreciable property to the total amount of the taxpayer’s
economic investment (the “at risk” amount); there are exceptions for realestate transactions where the nonrecourse loan comes from an uninterested
third-party
vi) There’s a hole in this rule that allows some nonrecourse financing to be
treated as at-risk. Because of holes like this, this section isn’t very effective.
§ 469 – basketing of passive activities; can’t claim deductions for passive
activities except against passive gains from activities
i) § 469(a) – default for individuals, estates, trusts, closely held C corps, and
personal service corps is no passive activity loss or credits
ii) § 469(b) – in general, treat any loss or credit as deduction or credit allocable
in next taxable year
iii) § 469(c) – passive activity defined
iv) § 469(d) – passive activity loss and credit defined
v) § 469(g) – can get a loss from passive activity if you sell the entire interest or
die
vi) § 469(h) – material participation defined (regular, continuous, substantial)
vii) § 469(i) – $25k offset for rental real estate activities
viii) Segregates “passive activity losses” and bars their use as an offset against
income from unrelated sources; can’t use passive losses to offset other gains;
an activity is passive if there’s no “material participation”
ix) What is a “passive activity”? Any activity that involves the conduct of a trade
or business in which the taxpayer does not materially participate.
x) What is “material participation”? Precise definition is very detailed.
xi) Note: this is just a limit to losses; you can still use depreciation generally
xii) You can carry losses forward within this basket. At the end of the day, if you
sell the whole activity and realize a loss, you can realize this.
xiii) This is overbroad and narrow:
(1) Overbroad: Can deny true economic losses. If you finance a restaurant,
and it loses $, you can’t use it unless you’re working there.
(2) Narrow: Fake losses (depreciation) in a restaurant, but you also have
passive income somewhere else. You can cancel the actual income with
the fake losses.
j) §§ 1245, 1250 – enormously complex provisions that to some extent recharacterize any gain you have wrt depreciation as ordinary; prevention of
character arbitrage
i) When you depreciate, you’re getting early interest deductions. Eventually
when you sell, it all turns around.
Capital Gains
85) Mechanics of Capital Gains
a) Capital asset is defined in § 1221. Defined expansively as “property,” then a
series of exceptions follow. Most important is inventory held to sell to customers
in the ordinary course of business.
b) § 1222 defines gains and losses from the sale or exchange of capital assets.
Gaining interest on a stock isn’t a capital gain, because there’s been no sale or
exchange. So dividends, for example, are ordinary income. (Footnote: Until 2010,
dividends are taxed as capital gains through a separate rule. They are, however,
treated as ordinary income.) This § divides up capital gains and losses into 4
categories.
i) LTCG = long-term capital gain
ii) STCG = short-term capital gain
iii) LTCL = long-term capital loss
iv) STCL = short-term capital loss
v) Net STC G/L = STCG – STCL
vi) Net LTC G/L = LTCG - LTCL
c) § 1223 talks about holding periods. General concept is when you get it, holding
period starts, when you sell it, holding period ends. There are some special rules,
though.
i) “Holding period tacking rules”
(1) § 1223(1) – missed this
(2) § 1223(2) – if you have prop whose basis is determined by reference to
basis as held in someone else’s hand, you continue their holding period
(a) Ex: gifts from § 1015
d) How do we use s-t gains/loss and l-t gains/loss and come up with what needs to be
assessed a cap gains tax?
i) First, get net stc g/l and get net ltc g/l.
ii) Then, there are a bunch of possibilities
(1) If both these nets are gains . . . your net capital gain is the net lt gain.
(2) If net ltc is gain, but net stc is loss, then you subtract stcl from ltcg, and
that’s what gets the preferential treatment.
(3) If both are losses, there’s nothing preferential to do.
(4) If stc is gain, ltc loss, nothing gets preferential
e) Capital gain net income is the sum of ltcg/l and stcg/l
f) Preferential rate treatment comes in § 1(h).
i) Why have these preferential rates?
(1) Not income. Some say capital gains are not income accd’g to the 16th
amend. Courts have rejected this, and economists don’t say this either.
(2) Bunching problem.
(3) Inflation. Lots of the gains are inflationary, not actual. Preferential rates
take care of this. This is mathematically false. If you wanted this argument
to work, rates should apply to STCG, not LTCG. Why? Because inflation
will always play a role. But LTCG get the benefit of deferral on the gains
due to inflation. So you are in a sense getting the benefit of deferring
gains. So you should apply this preferential rate to STCG, which don’t
enjoy the deferral option.
(4) Savings are important to growth, and capital gains are important to
savings. Problem here is that it’s hard to come up with #s big enough for
this to have any effect in even the most ambitious macroeconomic models.
(5) Incentive to risk taking. If you think this is affected by taxes on capital
gains, you’d do something like § 1202. Figure out what those types of
investment are, and favor them.
(6) Revenue neutrality and lock-in.
(7) Fairness.
ii) Most tax lawyers oppose these rules b/c they think the above reasons are
bogus, and also b/c they’re so stinking complex. Policy arguments have to be
really, really strong to support this complexity, and they just aren’t.
g) § 1211 – can’t use capital losses against ordinary income. So having capital losses
for the year is bad, because you have to generate capital gains to use them against.
If you are an individual, you can use $3k of it. This is basically nothing. But if
you really did lose money, it’ll probably be way more than $3k. Corps don’t even
get $3k amount, but corps can carryback cap loss for 3 years.
i) Why have such a rule? § 1211 is about selective realization. Defer gains and
realize losses early. § 1211 tries to limit this strategy by forcing you to realize
gains early, too.
86) Types of people in securities world
a) Dealers – buy and sell to make a market
b) Traders – § 162
c) Investors – § 212; speculating to make a profit
d) § 1221(a)(1) is big difference b/w traders and dealers
87) Biefeldt (2000, p. 671)
a) Summary: Biefeldt buys and sells treasury notes and bonds, and claims that his
losses are those of a dealer
b) Issue: Is Biefeldt a dealer or trader?
c) Class Discussion:
i) What’s Biefeldt’s theory? He claims this is his job, to create a market for the
treasury bonds. Posner says he’s more like Joseph. Just hordes these things
during the good times, sells them at a higher price during the famine.
ii) Why are dealers not entitled to capital gain? Idea is that what a dealer is doing
is just getting paid wages. But it’s tricky because the dealer gets paid for
making a market; dealer is an instrument that helps buyers and sellers find. He
doesn’t get a salary, but gets paid through making gains on an ask/buy spread.
iii) Posner says that Biefeldt doesn’t make money on this spread.
iv) Weisbach doesn’t think Posner’s distinction is tenable, but that the decision is
right. Why? The key word is customers. Traders make markets in some sense.
Biefeldt made a market across time. But what he didn’t have was customers.
He didn’t view the relationship b/w time 0 sellers and time 1 buyers as
customer relationship. How do we know? He just didn’t show up a lot of
times. He didn’t view these people as his customers. And they didn’t view
him as their service providers.
v) “The standard distinction between a dealer and a trader is that the dealer’s
income is based on the service he provides in the chain of distribution of the
goods he buys and resells, rather than on fluctuations in the market value of
those goods, while the trader’s income is based not on any service he provides
but rather on, precisely, fluctuations in the market value of the securities or
other assets that he transacts in.”
88) Biedenharn (1976, p. 675)
a) Summary: Π using this land as farmland, but then it becomes more profitable to
sell it to be used as suburbs. Makes gains, wants them taxed at capital gains rate.
b) Holding: gains taxed as ordinary income
c) Class Discussion:
i) Dominant purpose on the sales is what they cared about. At that time they
were a real dealer. Their original intent of investing in the land is outweighed
by their current activities.
ii) No “panaceatic” approach. This inquiry is
iii) This case indicates there’s an all-or-nothing rule here. Technically he
should’ve been taxed ordinary income on some, capital gains on others.
89) Private Equity
a) What does a private equity person do? They have a management company.
Company has owners (the rich guys). The management company forms a
partnership with a tax company. They put a little money into the tax com, but
other limited partners put a lot of money into the tax company (more rich guys).
Then the tax co buys companies, fix them up, then sell them. When they buy
companies, it’s often an LBO. They are not dealers or traders in those companies.
They are investors. They buy them and hold them for several years or maybe
longer. No question when the partnership sells it’s cap gain/loss. The gains or
losses are allocated to the partners. 20% of the gains go to the management
company, right to the rich guys. 80% goes to the other limited partners, even
though they pay 99% of the original money. What’s happening? The management
company gets paid for their work. But not at salary, so they get tax benefits.
Question here is whether this is capital gain (clearly is under current law) or
ordinary income (Congress is thinking about changing this).
90) Related Code
a) § 1(h) – maximum capital gains rate
i) § 1(h)(1) – tax on annual net capital gain shall not exceed sum of five things
listed in the code
b)
c)
d)
e)
f)
g)
h)
ii) § 1(h)(2) – annual net capital gain for a year is reduced by amount that counts
as investment income under § 163(d)(4)(B)(iii)
iii) § 1(h)(3) – definition of adjusted net capital gain
iv) § 1(h)(4) – definition of 28-percent rate gain
v) § 1(h)(5) – collectibles gain/loss means gain/loss due to sale of a collectible
that’s a capital asset held for more than 1 year but only to the extent the gain
is taken into account in computing GI and loss take into account in computing
TI
vi) § 1(h)(6) – what un-recaptured 1250 gain is
vii) § 1(h)(7) – what section 1201 gain is
viii) § 1(h)(8) – coordination with recapture of net ordinary losses under § 1231
ix) § 1(h)(9) – Secretary may apply appropriate regs to this section
x) § 1(h)(10) – pass thru companies include regulated investment cos, real estate
investment trusts, S corps, partnerships, estates or trusts, common trust funds,
certain foreign investing cos, qualified electing funds
xi) § 1(h)(11) – dividends taxed as net capital gains
§ 475(e) – allows traders to elect into mark-to-market
§ 1201 – max of 35% on capital gains
§ 1202 – 50-percent exclusion for gain from certain small business stock
i) § 1202(a) – for taxpayers who aren’t corps, GI shall not include 50 percent of
any gain from the sale or exchange of qualified small business stock held for
more than 5 years
§ 1211 – limitation on capital losses
i) § 1211(a) – corps can count losses from sales/exchanges of capital assets only
to extent of gain from such sales/exchanges
ii) § 1211(b) – same as (a) for reg taxpayers, but if losses exceed gains, also can
include up to $3k more of losses
§ 1212 – capital loss carrybacks and carryovers
i) § 1212(a) – corporations; basically can carryback 3 years (some exceptions)
and carryover for 5 years (some can carryover 8 or 10 years)
ii) § 1212(b) – other taxpayers
§ 1221 – capital asset defined
i) § 1221(a) – generally is very expansive; “property held by the taxpayer . . .
but does not include” stock that would be included in inventory if on hand at
close of taxable year, stuff held for sale, copyright-like stuff, AR, US govt
publication, commodities derivative financial instrument held by commodities
derivatives dealer, hedging transaction, supplies used/consumed in ordinary
course
(1) Most important exception is § 1221(a)(1) – “stock in trade . . . which
would be property be included in the inventory . . . or property held by the
taxpayer primarily for sale to customers in the ordinary course of his
trade or business.” So if GM sells you a car, that’s not a capital gain.
We’ll also discuss § 1221(a)(7) . . . “hedging transaction which is
ii) § 1221(b) – includes def of hedging transaction . . . primarily entered into to
manage risks
§ 1222 – definitions of other terms relating to capital gains and losses, some exs:
i) § 1221(1) – short-term capital gain  gain from sale/exchange of cap asset
held <= 1yr
ii) § 1221(2) – short-term capital loss  held <=1 if taken into account in TI
iii) § 1221(3) – long-term capital gain  held > 1 year, included in GI
iv) § 1221(4) – long-term capital loss  held > 1 year, included in TI
v) § 1221(5) – net short-term capital gain  (short-term cap gain)-(short-term
cap loss)
vi) Also: net short-term cap loss, net long-term cap loss, net long-term cap gain,
cap gain net income, net cap loss, net cap gain
i) § 1223 – holding period of property
i) § 1223(1) – holding period includes time if exchanged for cap asset with same
basis
ii) § 1223(2) – includes time in another’s hands if had same basis there
iii) § 1223(3) – if you had non-deductibility of loss from sale or other disposition
of substantially identical stock or securities, you include period you held the
stuff when you couldn’t deduct the loss
iv) § 1223(4) – time held in distributing corp if basis is determined by § 307
v) § 1223(5) – acquired form corp by exercise of rights includes only period
beginning with when right was exercised
vi) § 1223(6) – for residence + some nonrecognition of any gain under 1034
vii) § 1223(100 – sell something w/in 1 year of getting from dead person, your
said to have held it longer than 1 year
j) § 1231 – property used in the trade or business and involuntary conversions
i) § 1231(a) – general rule
(1) § 1231(a)(1) – if § 1231 gains > § 1231 losses, treat them as long-term cap
gains or losses, as case may be
(2) § 1231(a)(2) – if not, then treat as regular gains or losses (ordinary
income)
(3) § 1231(a)(3) – def of § 1231 gains and losses
(4) § 1231(a)(4) – some special rules
ii) § 1231(b) – definitions of property used in the trade or business
k) § 1245 – gains from dispositions of certain depreciable property
i) § 1245(a) – general rule
(1) § 1245(a)(1) – dispose of 1245 prop, get ordinary income
(2) § 1245(a)(2) – how to recomputed basis
(3) § 1245(a)(3) – def of 1245 property
ii) § 1245(b) – exceptions and limitations include gifts, transfers at death, certain
tax-free transactions (code sections ref’d), like kind exchanges, involuntary
conversions, etc.