TAXATION OUTLINE
I.
WHAT IS INCOME, AND WHO CARES?
a. The Basics:
i. Tax Planning:
1. Escape: Never pay tax
a. Buy
i. Buy assets that don’t spit out cash (i.e. Stock)
ii. Sell your losers
b. Borrow
i. Borrowing is not income
ii. The proceeds of debt are not taxable
iii. Borrow against your assets
iv. Under Haig-Simon’s borrowing is negative savings
c. Die
i. Under §1014: If you get assets form a dead person, the built in gain (gain =
FMV – basis) goes away and the person receiving the assets takes with a
“stepped up” basis
2. Delay: Time Matters
a. The longer you put off the tax, the less the money is worth—inflation
b. Time is value
c. Deferral is money
3. Shift: Pass the buck to the lowest actor
4. Recharacterize: Make wages look like property OR convert
5. Policy: Tax planning 101 is good for the individual, but you are not saving and it is not helping
the system—buying things and clutching them till death is called a lock-in (not good), it is not
wealth maximizing b/c resources aren’t getting to the best and highest users.
ii. Introduction
1. What are you taxing? (BASE)
a. What is income? 2 Sources of Income
i. Capital (K): If you have K and property, you don’t have to pay tax
ii. Labor (L): If you have wages, you have to pay tax
b. What is NOT income?
i. Debt
ii. Psychic income (pleasure you get in a non-monetary way)
iii. Statutory
iv. Life insurance
c. Basis: After tax dollars
i. Any amount that you pay taxes on becomes your basis
ii. Taxable Gain = FMV – Basis: Taxable Income = Value – Basis
1. Ex. Buy stock for $50 (that $50 is the basis). It goes up in value to
$1K. Now there is basis plus FMV. The rise in value is the tax time
bomb—waiting to explode at time of realization. Better to hold on to
the gain b/c if you sell, you have to pay taxes.
d. What are the deductions?
i. No deduction for personal things, §262
ii. Unlimited deductions for business expenses, §162
1. The government is doing it in the effort to spur the economy
2. You have to spend money to make money
3. What is personal and what is business?
iii. Miscellaneous deductions
1. Medical
2. Charitable
3. Home mortgage
2. How much? (RATE)
a. (Base)(Rate) = Tax
i. People want to decrease their base or else it is subject to tax rate
b. Average/Effective rates
i. Income Tax: Progressive Marginal Rate Structure
1. For table of marginal tax rate see Section 1
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2.
3.
4.
“Step Function”: Your marginal tax rate is what is happening with the
next dollar
a. It is not a flat percent
Inclusions are going to cost you money/taxes at your marginal rate.
a. Ex. You are at 30K, you get another 1K and you have to pay
more in taxes b/c you fall into the next bracket.
Deductions save you money at your marginal rate.
a. Ex. If you are getting 30K and then you make a deduction to
29K, you are going to get to save $150 that you would’ve had
to pay in taxes.
3.
When are you taxing?
a. Income is taxed annually, however, this class focuses on when something becomes
income.
b. People will try to escape (buy, borrow, die), and defer because of the time value of
money
4. Who are you taxing?
a. Policy: Taxing Women, etc.
iii. Problems of Definitions and Definitions of Problems
1. Eisner v. Macomber: Stock dividends case
a. Defines Income (bad definition, but never overruled): Gain derived from labor, from
capital, or from both combined; it is not enough to have the change in value, you
have to cash out.
i. Appreciation Doctrine: Mere/Unrealized appreciation with no realization is not
income
ii. Connects the when question to the what question; you don’t have income until
you have cashed it out.
b. Realization Doctrine: The profit must be realized in order to be taxed
i. As a legal definition of income, you don’t have income until you have realized
it/cashed it out!
ii. The realization event is the SALE! --some non-sale things are realization events
as well.
iii. Policy: Greatly benefits capital owners (i.e. Bill Gates)
c. Government’s Argument: Good argument, but incorrectly failed
i. It was the antecedent rise in value of M’s stock that triggered the tax obligation
and Congress has the right to tax this rise in value—it was not the stock
dividend that triggered the tax obligation but the stock dividends marked a
convenient time to tax the rise in value.
2. Economic definition of income: Haig-Simon
a. Income = Consumption + Savings
i. You can get to a consumption tax by having C = I – S
b. Sources (inflows) = Uses-outflows
3. Glenshaw Glass: Didn’t report punitive damages as income and argued that it is not taxable
income.
a. Defines Income: An undeniable accession to wealth, clearly realized, and over
which the taxpayer has complete dominion.
i. Undeniable accession to wealth (this gets you out of Macomber)
ii. Clearly realized (affirming Macomber). and
iii. Over which the tax payer has dominion (Drescher)
b. Issue: What happens when you get money that is not from labor or capital?
c. Holding: The amounts recovered as punitive damages clearly represent an increase in
wealth. If contract damage awards are taxable, it would make no sense to exclude from
taxation those amounts recovered which do not represent compensation for losses but are
accession to wealth.
4. IRC §61 Gross Income
a. Income from whatever source derived, including (but not limited to) the following items:
i. Compensation for services, including fees, commissions, fringe benefits, and
similar items
ii. Gross income derived from business
iii. Gains derived from dealings in property
iv. Interest
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b.
v. Rents
vi. Royalties
vii. Dividends
viii. Alimony and separate maintenance payments
ix. Annuities
x. Income from life insurance and endowment Ks
xi. Pensions
xii. Income from discharge of indebtedness
xiii. Distributive share of partnership gross income
xiv. Income in respect of a decedent; and
xv. Income from an interest in an estate or trust
5. §1.61-1 Gross income
a. Gross income includes income realized in any form, whether in money, property, or
services. Income may be realized, therefore, in the form of services, meals,
accommodations, stock, or other property, as well as in cash.
6. §1.61-2(a) Compensation for services, including fees, commissions, and similar items
7. §1.61-14 Miscellaneous items of gross income
a. Punitive damages
b. Another person’s payment of the taxpayer’s income taxes
c. Illegal gains
d. Treasure trove
Slightly Beyond the Basics
i. Beyond Cash
1. Not Just About Cash: The realization requirement says that you don’t have income until you
have cashed it out, BUT it cannot be just about cash b/c then the economy will get rid of cash and
will move to a barter system.
2. Valuation Principle: If you get paid in something other than cash, it will be taxed on the FMV
(objective standard).
3.
Conceptually, you have 3 things that trigger tax issues:
(a) Receipts
(b) Transaction
Is it income under §61; do we have to
pay tax?
 If no, 
 If yes, go to statutory: Is
there an exception? (e.g. a
gift)
If no statutory exception, how much
is it taxable at?
 Valuation
 Should be FMV, if not the
FMV, you have distortion
 Valuation has to be an
objective value, can’t be
subjective
Article II.
What is the basis?
 Macomber
 It is wrong to think of basis
as cost
 Basis is after-tax dollars
 Pay tax, get basis
 Don’t pay tax, don’t get
basis
Basis: Your right not to pay tax on
that portion
4.
(c)
Basis
Basis
Regulation §1.61-2(d)(1)
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Expense
a.
5.
6.
7.
8.
9.
Compensation paid other than in cash:
i. In general: If services are paid for in property or for other services, then the
FMV of such property or other services taken in payment must be included in
income as compensation…
Drescher: The company bought D a non-assignable $5K annuity in lieu of salary (distinguished
with Ward which was assignable).
a. Annuity: Promise to pay you an annual stream of cash; it changes the present interest
into a future interest.
b. Issue: A question of timing (when?): Is deferred compensation in the form of an annuity
includable in present income?
i. Taxpayer wants to defer paying taxes on the annuity because of the time value
of money, And he wants to shift this money to himself when he is in a lower tax
bracket so that he will be taxed at a lower marginal rate
c. Holding: Yes. It cannot be doubted that D received some current value from the
purchase of the annuities. It was compensation and represented an economic benefit to
D. At a minimum, he must be taxed on the FMV of the life insurance feature of the
annuity.
i. He will pay tax now, but he will get basis on the money taxed ($5K)
ii. This doesn’t go against Macomber because taxpayer is getting an entirely new
thing (the future interest), which HASN’T been taxed yet
d. Rule: If the employer funds deferred compensation by purchasing a nonforfeitable
annuity K for the employee, the employee is currently taxed on the purchase price when
the employer purchases it (FMV=$5K)—even though he cannot collect under the annuity
K until retirement.
i. Employee received “present economic benefit”
ii. The FMV has to be objective, not subjective—have to pay tax on $5K annuity
Benaglia: Hotel manager who gets food and lodging.
a. Issue: Is lodging and meals received from employer taxable income?
b. Holding: No. Meals and lodging provided for the benefit of the employer are not
income, this passes the Employer Preference Test. This is bad b/c the motivation of the
source of the money should be irrelevant.
c. Policy: The hotel industry can have lower wages b/c they can provide employees with
tax free accommodations.
d. Dissent: The majority ignores two aspects of this case. First, it appears from
correspondence between the parties that room and board was a part of the compensation
for the job. Second, even if it were found that this was not the case, B has received a real
economic benefit. B stated that it would cost him $3,600 to reside and eat elsewhere. B
should at least be taxed to this extent.
i. The dissent has it right
e. Reimbursement Principle: When an employer reimburses his employee for business
expenses paid, this is income according the Glenshaw. However, you don’t pay taxes on
it b/c the employee gets a deduction for business expenses—so it’s a washout
f. This case is codified by §119.
IRC §119 Meals or lodging furnished for the convenience of the employer (Employer
Preference Test)
a. Meals and lodging furnished to employee, his spouse, and his dependents, pursuant to
employment shall be excluded from gross income only if:
i. Meals are furnished on the business premises
ii. The employee is required to accept lodging on the premises as a condition of his
employment.
Charley: Selling frequent flyer miles.
a. Timing Issue: When is receipt of fringe benefits income?
i. Income was realized when he received the frequent flyer miles—it is income b/c
he has dominion over it and it has value
ii. Income was realized when he sold the frequent flyer miles—he received cash for
them; furthermore, he hasn’t paid tax yet so he has a 0 basis in them
b. Congress passed a law that said “the receipt of frequent flyer miles is income” but then
they said they would not enforce this law
Regulation §1.61-21 Taxation of fringe benefits and §132
a. General Rule—fringe benefits are income and should be taxed for their FMV
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b.
Exceptions:
i. §105 and §106—Employer provided medical insurance and pensions are not
taxable income
1. However, anti-discrimination requirement
ii. §132 Certain fringe benefits—Miscellaneous rule about exceptions besides
pensions and medical expenses
1. (a) Exclusions from gross income
a. No-additional-cost service
i. Ex. Free stand-by flights to airline employees
b. Qualified employee discount
i. Sales of merchandise to store employees at cost
c. Working condition fringe
i. Parking facilities, security guard protections
d. De minimis fringe
i. Occasional supper-money, night-time taxi fare,
company picnics, baseball tickets (but not a box for
the season), etc.
e. Qualified transportation fringe
f. Qualified moving expense reimbursement OR
g. Qualified retirement planning services
2. Fringe benefits which do not qualify for exclusion are now includable
in gross income under §61 unless specifically excluded by some other
Code (like §119)
ii. Gifts and other Oddities
1. Gifts are income as defined by Glenshaw and Haig-Simon
2. But they are not taxable income b/c of §102
a. IRC §102 Gifts and inheritance
i. General rule: Gross income does not include the value of property acquired by
gift, bequest, devise, or inheritance.
3. Duberstein: Received Cadillac for providing a business associate with favorable business leads.
a. Stanton: He is working at a church, gets fired, and they give him a $10K as a gratuity.
b. Issue: Are these gifts?
c. Holding:
i. Duberstein: Not a gift
ii. Stanton: Is a gift
d. “As a general rule, a gift will be found where it proceeds from a detached and
disinterested generosity, out of affection, respect, admiration, charity, or like impulses,
and it is the donor’s intention which is controlling as to those factors. In determining the
donor’s intention, one must look at the facts surrounding the transfer of property.”
i. The SC test is fact based and subjective
e. The government wants a specific test to determine whether s/t is a gift.
For instance, there can be no gifts in employer and employee relationship. The court
mocks these arguments and gives us a “totality of the circumstances” test. Statutes step
in to clarify things and help the govt out, these have all become law-§102(c):
i. Payments by an employer to an employee ought to be taxable
ii. Giving a gift is inconsistent with deducting a business expense
iii. Gifts involve personal relationships
iv. A company can’t make a gift of its assets
4. Olk: Received tokes as tips
a. Issue: Are tokes taxable income?
b. Holding: Yes. In this case, the court found that “our understanding also requires us to
acknowledge that payments so motivated are not acts of detached or disinterested
generosity. Quite the opposite is true. Tribute to the gods of fortune which it hoped will
be returned bounteously soon can only be described as an involved and intensely
interested act.”
i. Olk overturns Duberstein in substance (not really b/c it was at the appellate
level). It makes up a bogus motive and makes it look like anything can be
income. Today, we classify personal things as gifts and business related
transactions as non-gifts. (see above statutes)
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5.
Taft v. Bowers: Mrs. Bowers has gotten the gift of stock for $2000 from mom, and she sells it
later for $5000. Grandma buys it when it is worth $1000 which is the basis.
a. Issue: Is her basis the value it was when she received it or when it was originally
bought?
b. Holding: The basis is the value of when it was originally bought—carry-over basis.
When a gift is given, there is no stepped up basis; the basis carries over to the new tax
payer
c. Good rule b/c the tax time bomb doesn’t go off at the time the gift is given AND people
are encouraged to give gifts because the receiver must pay the tax
d. Policy: If it was a stepped up basis, then people would just be giving gifts back and forth
to avoid paying tax on it.
6. IRC §1014 Basis of property acquired from a decedent is the stepped up basis
7. Property:
a. Lesson: Anytime you have property, it is either a non-taxable event (basis stays the
same, gain stays the same) OR it is a taxable event (tax bomb has gone off)
i. Ex. A gift is a non-taxable event (§102)
8. Property vs. Income from Property
a. BAD DISTINCTION
b. The reason that property is worth anything is b/c it represent future income from property
c. The way you appraise property, is the rental stream/potential flow of future earnings
i. FV = PV (1 + r) [to the nth power]
d. Irwin v. Gavit: Somebody dies, left estate in trust to be divided among beneficiaries.
Taxpayer was given an income producing interest for a set number of years. 2nd
beneficiary was given the remainder.
i. Issue: Is this interest (LE) excluded from gross income per §102? Furthermore,
how do you allocate costs between taxpayers with separate claims in property
divided over an extended period of time? (A question of who pays tax?)
ii. Holding: §102 applies to the corpus of the trust only. Income generated from
property is NOT excluded from gross income. Furthermore, the remainder gets
the entire basis.
1. But see FSA = LE + R: Both have a present value
a. However, for purpose of Gavit, only the remainderman gets
the full benefit of the gift exclusion just as if the property had
been left to him outright instead of being placed in trust.
e. McAllister: If you sell the life estate interest you get to use a basis. M had a life
estate in the income from a trust. In order to meet expenses, she sold her life estate to the
remainderman for $55K. This was approximately $8,800 less than the actuarial value of
the life estate discounted to present worth. She attempted to deduct this amount as a
capital loss. Commissioner found that this sale was merely the advance receipt of income
and should be taxed accordingly.
i. Issue: Is a LE a capital asset which will result in capital gains or loss treatment
when it is sold?
ii. Holding: Yes. M’s right to income for life from the trust was a right in the
estate itself. The transfer of a substantial life estate is a disposition of a capital
asset. M assigned her interest in the estate as well as her right to receive
income. The release signed by her relinquished all rights she had in the trust.
iii. Dissent: Congress never intended to grant capital against treatment in this
situation. M had the right to receive income during her lifetime. She had no
interest in the corpus. Yearly payments to her would be considered ordinary
income. The sale of the life estate was no different than an advance payment of
dividends, income, or interest. It is doubtful that Congress intended to change
such payments into capital gains or losses.
f. McAllister gets partially codified and overruled by §1001(e)
9. Solicitor’s Opinion 132:
a. “Whether under agreement of the parties or pursuant to judgment of a court, on account
of damages for alienation of affections or defamation of personal character or in
consideration of the surrender of the custody of a minor child, does not constitute income
within the meaning of the 16th Amendment.”
10. §104: Payments for physical personal injury
i. Any settlement for personal injury is tax exempt b/c the gain is zero (no income)
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1.
2.
c.
Even if you got $100K for losing an arm, economic world/gain is
different from taxable world/gain.
Tax World: Gain = Amount realized – basis; thus if there is no gain,
then basis equals the FMV
11. Illegal Income
a. Gilbert: He embezzled $2M from the company and the government says he owes
$1.7M; (Unauthorized withdrawals of corporate funds).
i. Issue: Does a taxpayer realize taxable income on unauthorized corporate
withdrawals made with the intent to repay?
ii. Holding: No, this is not income b/c this is a loan and he almost immediately
executed the notes and assigned his property to ensure repayment.
iii. The real winner is the corporation b/c they get their money back and it is not
given to the government in the form of taxes.
iv. You borrow money, you have basis, b/c you will pay it back with after-tax
dollars!
v. Rule: Borrowing is not income, and the repayment of debt is not a deduction!
1. Haig-Simon’s and Glenshaw
Far Beyond the Basics
i. Debt and its Discharge
1. The discharge of debt is income, but whether it is going to be taxed or not depends on WHY you
got the discharge of debt.
2. The book says that the discharge of debt is not really income b/c saying that discharge is income is
saying that cash is income
a. Discharge of debts is a form of payment or value just like cash
3. When a lender loans money, they “purchase” a promissory note; they have basis and now only
have to pay tax on the interest income, not on the principle. If they forgive the debt, they take a
loss.
4. Kirby Lumber: Company issues $1M worth of bonds (which are IOU’s) and they buy them back
for $860K due to the change in interest rates (this decreases the company’s liability by $140K).
a. Holding: Holmes majority says you have income b/c of the freeing up of assets which is
an undeniable accession to wealth.
i. Holmes is wrong; you have income b/c of the discharge of debt whether or not
you have assets
5. Zarin: Z racked up gambling debts of $3.4M and the amount of debt that was discharged was in
the settlement amount of $500K.
a. Issue: Does a gambler who settles an unenforceable gambling debt realize income in the
amount of the debt discharged by the settlement, minus the settlement amount?
b. Holding: No. 2 reasons why Z cannot have income from the discharge of his debt:
i. Z was not liable on the debt he allegedly owed b/c of the state law
ii. Z did not hold property subject to that debt
6. IRC §108 Income from discharge of indebtedness
a. A judicial discharge of debt (bankruptcy) is not income
i. Policy: You need this to have the government back off. It would undercut the
purpose of bankruptcy.
b. Exclusion from gross income
i. In general: Gross income does not include any amount which would be
includable in gross income by reason of the discharge of indebtedness of the
taxpayer if:
1. The discharge occurs in a title 11 case
2. The discharge occurs when the taxpayer is insolvent
3. The indebtedness discharged is qualified farm indebtedness, or
4. In the case of a taxpayer other than a C corporation, the indebtedness
discharged is qualified real property business indebtedness.
c. Reduction of tax attributes
d. Treatment of discharge of qualified real property business indebtedness
e. Student loans
f. Special rules for discharge of qualified farm indebtedness
7. Old Colony: CEO owes 70% tax rate of his income and corporation has resolution to pay the tax
for him.
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a.
II.
Issue: Did the payment by the employer of the income taxes assessable against the
employee constitute additional taxable income to such employee?
b. Holding: Yes. The payment of the tax by the employer was in consideration of the
services rendered by the employee and was a gain derived by the employee from this
labor. The form of the payment makes no difference.
c. CEO’s 2 arguments:
i. The taxpayer is going to say that is tax on tax—unfair
1. But this is always true because we have a tax-inclusive tax structure
(we are always taxed on a tax)!
ii. This resolution says that they are suppose to pay my tax—it is mathematical
argument
1. Xenos Paradox
a. If you keep cutting a distance in half, you will never get
there>there will always be taxes to pay (but this is not
mathematically true)
SOME MATTERS OF SUBTRACTION: ARRIVING AT A NET INCOME CONCEPT
a. Deductions: Something that falls outside of the definition of income; save you money at your marginal rate—they
are happening before you multiply your rate
i. Ex. You have $10K and you’re in the 30% bracket—you get $7K and the government gets $3K
1. On your 1040 form, you show the $10K - $1K (charity), so then you get $6300 and government
gets $2700
2. The $1K you spend only cost you $700
3. Policy: Deductions in a progressive system are regressive
ii. §61: Gross income
1. In order to move to §62, you take out business expenses
iii. §62: Adjusted gross income
1. Moving from §62 to §63 involves individuation: Standard deductions vs. itemized deductions
iv. §63: Taxable income
v. Meta Rules
1. §262: No deduction for personal, family, or living expenses
a. Consumptive
b. Policy: No deduction for fun b/c then people would spend all their money
2. §162: Unlimited deduction for business expenses
a. Profit seeking
b. Policy: Follows from the fact that when you act from a profit maximizing perspective;
spending money to make money
3. §212: Gives deduction for the management conservation of income producing property, but NOT
a part of an active trade or business.
a. This is passive or investment business: recognizes that you don’t have to have an active
business or trade to make money
b. Netting Rule: You can only take these expenses against certain type of income (passive)
i. This is the middle between unlimited business deductions and no deduction in
the personal realm
vi. Dichotomy: Unlimited deductions for business and no deductions for personal expenses
1. In between: Passive business = netting rules
vii. §163(h): No deduction should be allowed for personal interest accrued.
1. No personal, except for home mortgage interest
a. Exceptions to the rule of deductions:
i. Medical expenses
ii. Casualty losses
iii. Home mortgage interest deductions
b.
viii. The Particular & Peculiar Case of Tax-Exempt Bonds
1. IRC §103 Interest on state and local bonds
a. Exclusions: Gross income does not include interest on any state or local bond
b. Exceptions:
i. Private activity bond which is not a qualified bond
ii. Arbitrage bond
iii. Bond not in registered form
Personal Matters
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i. Medical and Casualty Deductions
1. IRC §161 Allowance of Deductions
2. IRC §162(a) Trade or Business Expenses
3. IRC §165(a)-(d), (h) Losses
a. Gives you your basis back
i. if you lose $10K, we’re not giving you 10K back—that’s insurance—but tax
law will give a deduction for the loss
b. §165(a) General: Generally, you can deduct your losses
c. §165(b) Amount of a loss = basis: It is your basis that you get a deduction on
i. If you have property and you lose it at the value you bought it at, it becomes
your basis
d. §165(c) Limitation on losses of individuals: Usually your losses are limited to a business
transaction, but this allows for personal losses provided that they arise from fire, storm,
shipwreck, other casualty, or theft.
i. §1211 Capital loss offset rule:
1. There is a netting rule for capital losses
a. When you buy, you buy assets that go up in value, sell your
losers, and hold your winners
i. If the ability to sell your losers and hold your winners
IS unchecked, then the economy is going to get too
risky, so that’s where §1211 comes in.-It matches
2. The rule says, “your capital losses are only deductible against capital
gains”
e. However, see Foreign Corrupt Practices Act
i. §165 has no public policy exemption, so, you can deduct for practices that are
otherwise illegal and immoral
4. IRC §213 Medical, Dental, etc., Expenses
a. Medical deductions only if it exceeds 7.5% of your adjusted gross income.
5. Dyer: Epileptic cat knocked down an expensive vase
a. Not analogous to other casualties under §165(c)
6. Blackman
a. Burns down his house after finding out that his wife cheated on him.
b. This is not a casualty under §165(c)(3)
c. Policy Limit: Can’t make your own casualty
7. Taylor: Someone is mowing your lawn b/c you can’t—
a. Can’t have a mushy medical expense deduction, court won’t allow for nickel and dime
type cases
b. It is comparable to no deduction for commuting to and from work, buying work clothes,
etc.
i. It is a personal decision
ii. Exception: When you travel within the work
8. Ochs: Back in the 1940s, woman has cancer and they have kids. They send the kids off to
boarding school on doctor’s orders b/c the kids are too stressful.
a. The majority says no
b. Compelling dissent: The majority’s decision was wrong b/c it was either the kids go to
boarding school or the woman goes to a sanitarium—the boarding school was cheaper.
ii. Charitable Contributions and Policy
1. The more money you have, the more beneficial it is to give to charity, b/c your money is worth
more, b/c you can deduct it.
2. IRC §170 Charitable Contributions and Gifts
a. One of two exceptions to tax time bomb (also, death).
b. FMV deduction for contribution to charity
c. §170(a): Deduction is allowed whether the taxpayer makes the contribution in money or
in “property”
i. Where property has appreciated, the taxpayer will want to just donate the
property rather than cash it out and be subject to capital gains tax.
ii. This is a double benefit: the full value of the property is deductible AND the
appreciation is NOT regarded as realized by virtue of the gift.
d. §170(b): Can only deduct charitable contributions up to 50% of your income
i. Ex. You make $200K, can only take $100K charitable deductions
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3.
4.
5.
6.
7.
ii. If you take excess, it carries over to the next year
iii. Somewhat nonsensical: don’t we want people to give a lot to charity
e. §170(c): Can give money to an organization and get a deduction for it
i. §170(c)(2)(B): Individual income tax provision
1. Defines who qualifies as a charity under this rule
f. §170(e):
i. (1)(A): Reducing the amount of charitable contribution by the amount of gain,
so you get a basis deduction (if applicable)
1. Tax rates above 50%, you are better off contributing to charity than
selling it
ii. (1)(B): You only get a deduction in the amount of your basis if you give away
unrelated tangible personal property
1. Unrelated tangible property is where the gift is of a tangible personal
property (not including cash, bonds, etc.) unrelated to the charity’s
purpose or function.
2. Category that has tangible personal property is art for a museum
a. You give art to Art museums b/c they keep it and use it—you
get FMV deduction
b. Policy: So that people have an incentive to give
their appreciated art to art museums
iii. Here, you always get a deduction equal to the value of your basis, except for the
exception of art where you get a FMV deduction.
IRC §501 Exemption From Tax on Corporations, Certain Trusts, etc.
§170(c)(2)(B) and §501(c)(3) are the same thing
a. Contributions made to organizations that qualify under §501(c)(3) will qualify for
charitable deductions
TAX PLANNING--Can’t double deduct losses and charity: You should sell your losses first, then
give it to charity
a. Ex. Asset went from $600K to $500K. If you give it to charity, can’t deduct for $100K
loss and for FMV of charitable giving. Can’t double deduct. Sell your asset, get the loss
deduction, then give the money to charity and get §170 deduction too.
Ottawa Silica: Donates land b/c the school was going to build roads on his land which, it
therefore knew its donation would substantially increase the value of its land for residential
development and, as a result, bestow a substantial benefit on OS.
a. Issue: May a taxpayer who anticipates receipt of a substantial benefit in return for his
charitable donation claim a charitable deduction under §170?
b. Holding: No. In order to receive a charitable deduction, a taxpayer must make his
contribution exclusively for a public purpose. This public purpose intent requires that he
not receive nor anticipate receiving a substantial benefit as a result of the contribution.
c. Arguments:
i. OS is arguing that it is a charitable contribution (§170)
1. If charity: $400K deduction NOW
2. NO tax time bomb which is better
ii. The government is saying it is a business expense (§162)—government WINS!
1. If business: $400K over time
2. Capital gain now
3. Problem if it is a business expense:
a. If you buy a road for cash, you will get the deduction
d. They site the Singer case: S was giving away last year’s model for free to high schools to
get them addicted to Singer machines. That is either an offset case, or NO deduction.
i. If you are getting a benefit back, we are not giving you a deduction.
ii. Not a charitable contribution, but a business expense.
Bob Jones: Private school with racially discriminatory policies
a. Issue: Must an institution pursue policies consistent with public policy in order to
qualify for tax exempt status as a charitable institution?
b. Holding: Yes. Charitable takes on its common law meaning, which is that it is
consistent with public policy.
c. Note: If you lose §501(c)(3) status, payments to you are not deductible
10
d.
e.
f.
Burger (majority): We give deference to IRS b/c taxes are complex; the government has
an interest in not allowing a charitable deduction for anti-miscegenation (against public
policy) b/c there is no constitutional right to charitable deduction.
Powell (concurrence): He’s troubled by the air of conformity.
Rehnquist (dissent): This is judicial overreaching, something for Congress to decide.
i. However, Congress would not have done anything and Bob Jones is our law
1. Charities have to satisfy the public interest test
2. The IRS has the power to define what that test is—common law
notions of charity—anti-miscegenation.
8.
c.
Hernandez: Scientology
a. Arguments:
i. Government: You were getting a service
ii. Scientology: The auditing is not worth anything, you are not getting anything
b. Holding: Government wins, there is quid pro quo, so it is a not a charitable contribution
c. Dissent: A lot of religions use quid pro quo things where you’re paying (e/o is
deducting) and getting something.
iii. Interest and Such (Other Misc. Deductions)
1. IRC §163 Interest
a. (a) General rule. Can deduct all interest paid or accrued within the year on indebtedness
(Remember, this is for corp., personal can only deduct interest on home mortgage).
2. IRC §164 Taxes
3. IRC §151 Allowance of Deductions for Personal Exemptions
4. IRC §32 Earned Income Credit
5. IRC §22 Credit for the Elderly and the Permanently and Totally Disabled
6. IRC §23
7. IRC §24 Child Tax Credit
The Usual Business Stuff
i. Flow Chart: Business Expense:
1. Is it a business expense?
a. Personal (§262)? If yes, go to §262
b. Active trade or business? If yes, go to §162; if no, go to §212…
2. If it is §162, then when?
a. If it is ordinary and necessary (wages—get regularly), then you get the deduction:
i. Now
b. If it is a capital expenditure (transactions in property—get occasionally), then you get the
deduction:
i. Later (Depreciate it over time)
ii. Way Later (Ultimate sale of business or dissolution)
ii. Timing Matters
1. Encyclopedia Britannica—EB paid $3K to this guy to write s/t. The work was intended to yield
EB income over a number of years (Where the income is generated over a period of years, the
expenditure should be titled as capital.)
a. Issue: Are expenditures made by EB capital expenditures?
b. Holding: Yes b/c it is intended to yield money over a number of years rather than a short
period of time.
i. Posner Rule: Temporal matching; shouldn’t be able to get a deduction now
when the income is going to be made over time.
c. Problem:
i. Author Rule: There is a line of cases where authors and artists get to deduct
their expenses immediately even though they were created to generate income
over time.
d. §263(a): Homebuilders have to capitalize everything (Posner rule)—Uniform
Capitalization Rules: Theory is what Posner said you have to do, but there is a
tremendous transaction cost.
i. Why would Congress do this? B/c Congress gets the benefit today/gets the
money now
2.
Midland Empire—Want to fix up their basement where they make meat products
a. Issue: Did you repair the cellar or create a new asset?
11
b.
d.
Holding: This was a repair. A structural change which does not increase the useful life
or use of a building and which is the normal method of dealing with a given problem is a
“repair” for tax purposes.
c. Repair vs. Improvement
i. You need temporal matching—Can’t give deductions now for income that you
have not seen in the current period: The improvements will generate income in
the future and if we give you a deduction for the entire expenditure now, we will
be giving you a deduction for income you have not yet received.
3. Starr’s Estate—Rental payment vs. installment (sprinkler system)
a. Issue: Is this is a lease or an installment purchase?
b. Holding: It is a purchase.
c. Why is the sprinkler company doing this?
i. If it is a lease: The tax consequences are ordinary business expense (§162) and
every year they take $1240 a year for 5 years—get a deduction
ii. If it is an installment sale: The tax consequences are that you take the purchase
price and you put it over the depreciated value
d. Labels are not always what they seem thus the government and the courts recognize
substance over form!
iii. The Ordinary, the Usual, & Other Oddities
1. IRC §162 Trade or Business Expenses
a. The language is “ordinary and necessary” and in business almost everything is ordinary
and necessary
b. The word ordinary is about a temporal sense—regularly, periodically as opposed to
bizarre
i. If it is an ordinary expense, you get a deduction now, if it is an extraordinary
expense, you have to capitalize the expense and take the deduction over time.
ii. The only counter-example is Gilliam
iii. So ordinary means 2 things:
1. Bizarre—Gilliam
2. Not regular, not immediate, timing—Welch
2. Welch v. Helvering—Man makes resolve to pay off creditors after he goes bankrupt. Repayment
of legally discharged debt.
a. Issue: Is that ordinary and necessary? Is that §162 deductible? A timing issue: Does he
get to deduct it now or later?
b. Holding: It is an extraordinary expense to pay off discharged debts b/c it is a capital
investment—he is building up his reputation, so he will have to pay taxes NOW, but he
will get basis that he will be able to deduct LATER (when he finally sells the business)
c. Generally this case is about expenses for goodwill and payments for goodwill are capital
expenses; it is not a case knocking you out of §162.
3. Gilliam—Traveling on business, went nuts on plane.
a. Not deductible b/c not ordinary
b. In this case, they distinguish the Dancer case (salesperson who runs over a kid on
business), this was ordinary, but Gilliam was bizarre—no deduction, not §162 b/c weird,
not ordinary.
c. McCaffery’s alternative: Call this a personal expense, rather than a non-ordinary
business expense.
4. Stephens—The guy loses a case and has to pay the plaintiff and then tries to take a loss on his tax
returns.
a. Case about §165(c)(2)—a loss deduction
b. If it meets the requirements of the statutes, you get the deduction, regardless of whether it
meets the policy requirement of it.
Hard Cases: Mixing Business with Pleasure
i. Hobbies, Home Offices, Lawyers at Lunch and a Plant for the Office
1. IRC §212 Allowance of Deductions
2. IRC §262 Personal, Living, and Family Expenses
3. IRC §183: Activities engage in as a hobby
a. (a) General rule: No deduction is allowed for activities not engaged in for profit
b. (b)(2) You get your deductions but only to the extent that there is income—you are
allowed to take deductions to the extent that there is income
12
i. Looks like gambling netting rule—if it weren’t for the rule, you would get taxed
on your winnings and your losses would be treated as personal consumption;
thus, §165(d)/183(b)(2) blocks the application of §262. Gambling is not going
to make it under §183(b)(2) b/c it is not an activity, but the 2 statutes work the
same way, so you can cite to either.
c. (c)(1) Defines non-profit activities. Establishes a presumption that if you make money 3
of 5 years, the activity was engaged in for profit.
4. Nickerson—Guy is 40 years old and is an advertising agent in Chicago. He goes and buys a dairy
farm in Wisconsin. He pays $40K for it. The farm was in very bad condition and he did not
expect to make a profit for 10 years during which time he rented the property out to a tenant who
agreed to cultivate the farm. Not making a profit 3 out of 5 years, not making profit ever—not
meeting the statute.
a. Holding: N got involved in this business to make money in the future, thus it is not a
hobby, rather it is a business and therefore he gets a deduction.
b. McCaffery:
i. Ask: Are you doing this for leisure or are you doing it to make money?
ii. Tax Shelter: N is making money b/c he is getting ordinary deductions now and
inclusions later.
5. IRC §280A Disallowance of Certain Expenses in Connection With Business Use of Home,
Rental of Vacation Homes, etc.
6. Moller—H and W are managing their stocks out of a room in their home (40hrs/wk).
a. Issue: Whether they get a business expense deduction for their home office?
b. Holding: Rule §280A—It has to be a separate part of your house and exclusively for
active trade or business; can’t be passive business. As such, the couple do NOT get a
business deduction b/c it is a passive/investment business.
7. Henderson—AG of SC bought plant, rug, and poster for office and wants to write it off.
a. Issue: Are office decors deductible as a business expense?
b. Holding: No b/c it is too personal.
c. §132—Fringe benefits
i. If the employer thinks that you need a plant, then it is a deduction under §132;
but if you go out and buy it yourself, then it is not a deduction under Henderson.
ii. There is a conflict, b/c under §162 this should be a business deduction.
8. Moss—Law firm lunches at a crappy restaurant everyday.
a. Issue: Can the firm deduct the lunches as a business expense?
b. Holding: Not in this case.
ii. Closer to Home: Clothes and Education
1. Pevsner—Lower class women gets a job in a clothing boutique and she has to wear the clothes;
She wants to get a deduction.
a. Test: It basically comes down to a work uniform that you don’t wear outside of work:
i. Required by employer,
ii. Not generally used for fun, AND
iii. Can’t have been so used.
b. She doesn’t get a business deduction for the clothes
2. Gilmore—Divorce proceedings, litigation to determine assets in a business of couple. H wants to
write off divorce negotiation as a business expense.
a. Issue: Are the litigation expenses deductible b/c he is trying to protect his business
(income producing asset)?
b. Holding: It is the origin of the claim test: In this case, the origin of the claim is divorce,
which is personal, so no deduction. It is true that losing a suit may impair profit-making
potential by depleting resources, but, permitting this to be the basis of a business
deduction would stretch Congressional intent in passing §212 too far.
i. Note: Legal expense—If you are paying legal fees to protect your property, it is
deductible.
3. Carroll—Cop in Chicago is getting an undergraduate degree in philosophy.
a. Issue: Is this education improving his job as a cop?
b. Holding: No. His courses were general and basically unrelated to his duties as a
policeman. Getting a certain human capital, so no deduction
i. Note: Education—The cost of education may be deducted as a business expense
where it maintains or improves skills required in the taxpayer’s employment.
(e.g. CLE)
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III.
4. Regulation §1.162-5 Expenses for Education
MATTERS OF TIMING
a. Timing Matters
i. The Realization Requirement, Revisited
1. Timing with a big (T) is about transactions:
a. Realization = Income; anytime you get something materially different
b. Recognition = Taxable
2. IRC §1001
a. Determination of amount of and recognition of gain or loss
3. Regulation §1.1001-1(a)
4. Helvering v. Bruun—Tenant (of ground lease) defaults and the landlord gets stuck with
department store
a. Holding: The 50K is income (accession to wealth clearly realized)—consequence:
income to the LL In the amount of 50K and he gets basis of 50—bad news is that he pays
tax but he gets basis
b. Overruled
i. §109—Gross income will not include a lessee’s improvements upon the
termination of the lease (no income of 50K)
ii. §1019—Tax time bomb is preserved, so no basis adjustment
5. United States v. Davis—Mr. Davis gets divorced. As a property settlement, he gives Mrs. Davis
stocks with FMV of 200K.
a. Holding: The transfer of property pursuant to a marital settlement agreement is a
realization event. Taxes are computed based on the FMV of the property at the time of
transfer.
i. Tax the bastard b/c this is a realization event b/c he is getting something in
exchange (release of inchoate marital rights)
1. When parties bargain at arm’s length, it is presumed that the properties
exchanged are of equal value. This being the case, D received property
equal to the FMV of the stock he gave to his wife. D should be taxed
on this amount less the original purchase price of the stock.
ii. Tax the bitch b/c she has a realization event too
1. Gain = 200K – Basis
2. But her basis is 200K b/c we assume what she gave up was worth 200K
since the parties engaged in an arm’s length transaction
b. Overruled:
i. IRC §1041—A transfer of property between spouses or between former spouses
where the transfer is incident to divorce shall be treated as gift for income tax
purposes—meaning that they only get a carry over basis.
1. This statute is better for both the wife and the husband:
a. The husband will be willing to give more b/c he will have
more after tax dollars
b. The wife will get more even though she will get a carry over
basis b/c she can use this fact to negotiate a better deal for
after tax dollars b/c he has more to give.
2. §1041 allows you to “defer” and “shift”
a. Defer tax payment until tax bomb goes off and in the event of
death, escape tax all together
b. When it does go off, it is likely to be in the hands of the
taxpayer in the lower bracket
6. Farid-Es-Sultanheh—Her husband gives her 800K worth of stocks in exchange for her to sign a
pre-nuptial. When they divorce, she sells the stocks. This is a realization and recognition event.
a. Arguments:
i. She argues that her basis should be what it was worth when she got it b/c that
was a taxable transaction
ii. The government is arguing that the original transfer was not a taxable
transaction b/c it was a gift so she has a carry over basis
b. Holding: The taxpayer wins. Again we assume an arm’s length transaction and so she
gave up something worth 800K so her basis is 800K. For these types of cases, we
assume you have a basis in yourself equal to the value of the thing you are receiving
14
i. Solicitor’s opinion 132—you have basis in yourself when you sell you
personhood
ii. §1041 doesn’t apply to this case b/c it doesn’t apply to pre-nups.
b.
c.
ii. A Digression on Consumption Taxation, and a Note on Losses
1. What is happening in these cases
a. On the gain side>unfortunate things
b. On the loss side>there needs to be some reason why they can’t just sell the asset
2. Cottage Savings—Best realization event case; about losses. The Federal government comes up
with a plan and says that if you bundle together your loans and trade them, we will not force you
to write them down, but you do get a tax loss.
a. Commissioner argues that you should not be able to get a tax loss if you are not required
to write them down. These are like kind materials so there is no realization event.
b. Holding: A financial institution realizes tax-deductible losses when it exchanges its
interest in one group of residential mortgage loans for another lender’s group of
residential mortgage loans because they are not like kind materials.
c. Policy: This definition of a “realization” makes paying taxes an election for the bank as
is the case with stockbrokers (sell your losers and declare a loss, keep your winners and
not pay tax).
3. Revenue Ruling—The airlines were given monopoly rights to certain routes originally. The
government deregulated the airlines, so no more monopoly so the airlines claim a loss b/c they lost
their monopoly rights. Their basis came from the money they spent to get the routes and now the
routes are not worth as much. They want to right off their losses, but they can’t sell their losers
because they want to use the routes.
a. Holding: If you don’t sell, then NO tax loss!
4. IRC §1259
Planning Matters
i. Recognition or Not
1. We need both realization (income) and recognition (taxable) in order to tax something
a. If R+R>then tax, either:
i. Tax gain=FMV-basis, OR
ii. Basis=FMV
b. If no R or R>>then no tax and carry-over basis
c. Recognition statutes: §1031 et seq., §1033, §1041, §109, §1019, §102, §1015
2. IRC §1033
3. IRC §1034
4. Jordan Marsh—JM sold it’s a department store and then leased it from the buyer for a term of 30
years with a renewable option. When JM attempted to claim a loss for the difference between the
property’s basis and the cash received, the Commissioner disallowed the deduction. D claimed
that the exchange was of a fee interest for a long-term lease, constituting like-kind properties (bad
argument).
a. Holding: Property sold and leased back for 30 years is not like-kind exchange. JM
liquidated its capital investment in the real estate involved for cash fully equal to the
value of the fee. JM was not continuing involvement with an investment substantially
equal to that previously held.
5. IRC §1031
a. Provides that gain or loss will not be recognized if business property (other than
inventory) or investment property (other than stocks and bonds) is exchanged for other
business or investment property of like kind.
6. Starker—§1031 case; Someone wants to buy property for $2M and instead of getting cash, you
have them buy other property that you want and have them trade it to you so you don’t recognize
the cash and the other party can put it as a business expense.
a. You can exchange real estate property for property (in US) and if you don’t touch the
cash, there is no realization event and don’t have to pay tax.
Accounting Matters
i. Timing with a little (t) is about accounting:
1. Methods of accountancy
a. Cash vs. accrual
b. Inventory accounting vs. installment method (the way to account for the sale of property)
15
ii. Some Questions of Accounting
1. Burnet v. Logan—As part of their compensation for the sale of their stock in Andrews and
Hitchcock Co., the shareholders were to be paid $.60 per ton of ore taken each year from a leased
mine.
a. Holding: Where property is sold for less than its fair value, and, as part of the
compensation, the seller is to receive an additional indeterminate and speculative amount
in the future; no tax is assessed until the seller recovers his basis in the property.
i. Government hates this case
ii. Taxpayer is happy
2. Amend—Farmer sells his grain and every year says “don’t pay me in October, pay me in January.
He is pushing off the income to next tax year—gives him another 12 months to pay the
government
a. Holding: A cash basis taxpayer cannot be deemed to have realized income at the time a
promise to pay in the future is made, and the doctrine of constructive receipts should not
be applied to such income (he hasn’t touched the cash, thus, doesn’t have to pay tax).
b. Accrual taxpayer: He is taking his business deductions one year and getting inclusions
the next year.
c. In the steady state of things, this doesn’t matter b/c he pays tax every year—
Encyclopedia Britannica.
i. However, this DOES matter, he is pushing his very first income forward
(deferring and shifting)
ii. The taxpayer wins—what really helps him was that he was consistent—he
didn’t change the timing of collecting depending on the tax rates
3. Pulsifer—Minor children win sweepstakes; money held in a trust by some Irish authority.
a. Arguments:
i. Children: Children will say that we don’t have cash until we are 18.
ii. Government: Here we have an undeniable accession of wealth...
b. Holding: Under the economic benefit theory, a cash basis taxpayer may be taxed on the
economic and financial benefit derived from the absolute right to income in the form of a
fund which has been irrevocably set aside in trust for him and is beyond the reach of the
payor’s debtors. In this case, the children had a absolute right to the winnings and all
they needed was a legal representative to claim it.
4. Minor—Rabbi trust…You have doctors that are putting aside money in a trust, when they retire,
they can draw money down from this. It is available to the general creditors of the individuals.
a. Doctors are saying “Not only is this deferred and not assignable, but it is forfeitable, I
may never get it” (unlike Drescher).
i. Risk of forefeiture means that you may never get it, so it is not income and you
are not taxed on that.
b. Tax planning: This doesn’t take away any of the taxpayer’s snorting b/c he can still
borrow against the non-assignable annuity; but note, the trust has to be subject to the
employers’ creditors claims.
c. Holding: Where a taxpayer participates in a deferred compensation plan which
establishes a trust to which the participating taxpayer has no vested, funded right, the
contributions to the plan are not currently taxable.
i. Note: In Pulsifer, the trust was not open to creditors
iii. What Year is it, Anyway: The Annual Accounting Rule and its Variants
1. Annual accounting rule: You report everything as of 12/31 and if things change, you deal with it
in a later year—Burnet v. Sanford and §441
2. §441: Taxpayers’ income shall be computed on the basis of annual accounting period which is
usually the calendar year.
3. §111 Recovery of Tax Benefit Items
4. Burnet v. Sanford & Brooks—A long-term K results in net losses for company b/c the net losses
exceeded the income in 3 years (1913, 1914, 1916). The company brought suit in 1916 to recover
the losses and received the losses plus the interest on that in 1920. They did not include that as
income in 1920—Commissioner wants to tax this in full amount in 1920.
a. Holding: The entire reward is taxable at the end of the taxing year b/c every year is
treated as an independent taxing year.
b. Rule: Money earned is properly taxed to the period in which it is received, even if it is
attributable to work performed in a previous taxable year.
16
North American Oil—The govt uses some military power to take over and run NA’s mines—
they sue. They win the suit and the court says that the money the govt has been collecting is
theirs. NA argues that they should be taxed either in 1916, when they made the money, or 1922,
when they finally got the money from an affirmed appeal (tax rates were lower in these two years).
On the other hand, the govt argues they should be taxed with the 1917 rates because that is when
they first received the income under a claim of right (lower court decree).
a. Holding: This case says that you have money when you got it under the claim of right.
Once the court said that you have the money, you have a claim of right. The court said
that they need to pay in 1917, when the claim of right was issued.
b. Rule: No income has been earned where a company might never receive it and has no
right to demand payment.
6. U.S. v. Lewis—L erroneously received a $22K bonus from his employer and reported it as
income. He was later forced to repay $11K and he sought to refigure his tax return for the year of
receipt. The IRS contended the $11K returned should be taken as a loss in a later year.
a. Holding: He had a claim of right to the bonus that was taxable in 1944. In 1946, when
that right was taken away, it has nothing to do with 1944—he had to take a deduction at a
lower rate than the previous inclusion.
b. Consequences: B/c the rates have changed, you may have paid more in taxes when you
received the money, and then received a lower deduction when you had to give back the
money—TOUGH!
c. Overruled:
i. §1341: Gives a choice to take a deduction in the later year or a credit for the
amount overpaid in the earlier—if tax rates have dropped you choose the credit,
if tax rates have increased you choose the deduction
ii. End result: Cannot be worse off than before—advantageous for the taxpayer
d. Policy: When we are dealing with methods of accounting, the courts are reluctant to
overrule any administrative law that would make it more technical; they tend to wait for
the legislation to do it.
7. Alice Phelan Sullivan Corp. v. U.S.—Alice donated 2 parcels of land on the condition that they
are used for charitable purposes. The property was returned in 1957 at which time Alice excluded
it from income.
a. Holding: Taxpayer must include inclusions of 2 parcels in 1957 at the value equal to the
amounts deducted in 1930 and 1940 respectively.
b. Tax Benefit Rule—When a deduction in an earlier year is followed by a recovery in a
later year of the amount deducted, the taxpayer must include the amount previously
deducted as income in the later year. However, the recovery is not includible in income
to the extent that the earlier deduction did not reduce the amount of tax.—a recovery is
not income unless the earlier outlay produced a tax benefit (unless they took a deduction).
i. What you are doing with the tax benefit doctrine, is that you are unraveling it—
you are undoing it as if NOTHING has HAPPENED!
c. Ex. You gave art when it was worth $20K (deduction) and then when you get it back it is
worth more (inclusion). The measure of your income is not the FMV of the thing, it is
the unraveling of the assumption, the untruth of that deduction that triggers income.
WHO’S RESPONSIBLE FOR THIS TAX?: QUESTIONS OF ATTRIBUTION
a. Life with Family
i. Impossibility Theorem:
1. Progressive Marginal Rates
2. Marriage Neutrality
3. Couple’s Neutrality
ii. History:
1. 1913-1948: Individual filing
a. Marriage Neutrality; No couple’s neutrality
i. Economic Distortion:
1. The economic value of the homemaker is zero
2. Imputed Income = Additional income from self-provided labor or
capital which you are not taxed on
3. Ways to solve the distortion:
a. Make it includible as income—can’t happen
b. Give a deduction for those who pay for it—ex. Rent
deduction, child care deductions
5.
IV.
17
b.
2.
Tax Planning:
i. The game now is to look like equals, but not actually be equals. W works for H
and he should pay her half of his salary b/c if he makes $60K/year, if he pays
her $30K, he will end up taking a deduction under §162 and inclusion for her.
1. What is going on with the equals is that they get 2 zero brackets=they
are paying $6 when married; they get to do that b/c it is individual
taxation
2. People want to look like the equals, but they don’t want their W to
work; the way to do that is Lucas
1948-1969: Joint filing
a. Second earner bias comes from joint filing
b. The double rate bracket thing is going to lower taxes of all married families, but you still
have joint filing—as long as you have joint filing, you have the second earner bias—the
wife’s first dollar is getting taxed at the 30%, but OVERALL they are being taxed less.
c. Couple’s Neutrality (double the tax bracket)
Income
(a) Marginal Tax
Rates
0-20K
20-60
60+
0
15
30
d.
3.
Income
Economic Distortion:
i. 2 people working, so they have to pay for child care; but this is out of after tax
dollars, and they can’t deduct this!
1. Can’t deduct b/c courts treat this as a personal expense
2. McCaffery said they should treat this as a business expense—people
aren’t paying for child care b/c they had a child, they need to go to
work to earn money
ii. Secondary Earner Bias: Disincentives facing secondary earners (quit often
women)
1. Marginal burden on women: In a rate structure with joint filing, the
wife’s wages come “on top of” the husband’s; Her first dollar of salary
is taxed at the bracket where the H’s salary has left her.
2. 3 Sources: Evidence that when people made these laws, their intent
was to get women to stay home
a. The system of joint filing/aggregated rates—this is the
marriage penalty story—that makes a secondary worker enter
the labor force at the primary earner’s marginal tax rate
i. Women are losing money by working!—average
working wife loses 2/3rds of her income due to taxes
and work related expenses
b. The failure to tax imputed income, which encourages a spouse
to stay at home generating tax-free value
c. The failure to allow deductions for the mixed businesspersonal expenses of entering the workforce (childcare,
commuting, etc.)
1969-Present: Joint filing
a. Second earner bias comes from joint filing
b. Couple’s Neutrality
(b) Marginal Tax
Rates
18
0-16K
16-48
48+
0
15
30
4.
There are now 3 different rate structures
a. There is single’s filing
b. Married filing jointly
c. Married filing separately
i. Set out .8—1/2 the married filed jointly
1. It is not optional separate filing—you still pay a marriage penalty
2. There is not an incentive to do this
5. Policy: Some of the predictions
a. Poor people are not going to get married, can’t afford to have 2 earner spouses
b. Rich people are going to have stay home wives (if the wife works it will be for other
benefits, not for money)
c. Minority: Men with working wives
d. The work force is going to assume that you are going to quit as soon as you have a kid
i. Major gender discrimination
ii. How is a woman going to convince an employer otherwise—women are
marrying later, having fewer kids, if you can prove to act like a man, we’re
going to pay you like a man—but there is such distortions.
iii. The taxable unit, a look at marriage and divorce
1. Lucas v. Earl—Couple are in CA (Under the CP laws, the wife did not have a vested interest) and
write a private K that declares all of their separate and any other property as CP. Mr. Earl claims
he can be taxed for only half of his income.
a. Rule: Tax he who earns it!
i. One cannot, by agreement, attribute fruits to a different tree from that on which
they grew.
b. Can’t shift
2. Poe v. Seaborn—The Seaborns filed separate tax returns, each treating ½ of the community
income as their separate incomes, although most of it consisted of Mr. S.
a. Rule: In a state in which the wife has a vested property right in the community property
equal with that of her husband, and in the income of the community, each spouse files a
separate tax return treating ½ of the community property as their separate income.
b. Can shift
c. Distinction from Lucas: In Lucas, the salary income would have belonged to the husband
alone in the absence of the K entered into with his wife. Here, by contrast, the earnings
are never the property of the husband, but that of the community, owing to the operation
of the state law. (the CA community property statute in Lucas wasn’t as strong as the one
here)
3.
4.
Household model of taxation (model of taxation that includes kids as consumers
a. Money comes in, it is taxed to mom and dad who file jointly
b. Mom and dad give kids money, necessities>these are treated as gifts
i. No deduction, no inclusion
ii. But we have an additional dependency deduction: §151, §152
1. Ex. $8000 standard deduction or itemized deduction PLUS per
dependent deduction
c. Kids are separate taxpayers, to the extent they have their own income (see Kiddie Tax, p.
27)
There are 3 things that can go on with divorce:
a. Property division
i. Non-event—Neutral face
ii. Davis (taxable)
iii. §1041 (not taxable)
iv. Not taxable, non deduction
b. Alimony
i. Happy face
ii. Deduction to the payor, inclusion to the payee (usually, wife)
19
b.
iii. Husband can deduct the money he gives ex-wife, so he’s happy; and b/c she is in
a lower tax bracket, she’s happy, b/c he has more money to give her ex-ante.
c. Child support
i. Unhappy face
ii. No deduction, no inclusion
iii. No alteration in the relationship; still have to support them with after-tax dollars
5. Tax Planning:
a. Make everything look like alimony
i. Make child support look like alimony
ii. Make property divisions look like alimony
b. Front-loading alimony: Pay tons of money up front, instead of dividing the property, so
that you can deduct
i. An alimony that is really high initially and then drops off, is highly suspect.
6. Diez-Arguelles—Woman is suppose to get child support, the H defaults, so she claims a loss—
she takes a deduction.
a. Holding: The court says no loss b/c she has no basis.
b. Bad decision: If she had received the child support, she wouldn’t have had to pay taxes
on it, so technically she did have basis in it.
c. What should have happened: She gets to take the deduction for the loss, and he has to
pay tax, b/c he has income, in the form of discharge of debt.
i. Give her a deduction
ii. Give him an inclusion
iv. Taxing Women
Life with Entities
i. Fruits and trees and to entities: All of these cases are going to be about shifting.
1. The shifting game is created by progressive tax rates.
2. How does the govt try to stop the shifting game?
a. Put the kids in the parent’s tax bracket (Kiddie Tax, p. 27)
b. Statutes step in to save the common law
3. In the meantime, some general rules:
a. It is easier to shift the tree than the fruits of the trees;
b. It is easier to shift an asset if you relinquish all ties to it, rather than if you maintain a
reversion interest;
c. People will try to make wages look like capital and shift to their children b/c they are in
the lower tax rate
4. Armantrout—A company is willing to pay a child’s tuition in lieu of wages.
a. Holding: Doesn’t work b/c Lucas. The employer earned the stream, the employer is
controlling this, this is not a shift (Lucas)—not a deferral (Drescher).
5. Blair—S/o dies, there is a term interest, and the LE interest goes to the dad. He takes the LE
interest and divides it and gives it to his daughters.
a. Holding: That is an okay shift
6. Horst—Father was a coupon clipper, he would give the coupon to child to cash out, and he was
trying to make it look like it was the child’s income.
a. Holding: Doesn’t work:
i. This is another property vs. income from property distinction, and he has not
given away the property, but the income from property, so it doesn’t work
ii. He already had the income and walking to the bank to shift was too late
iii. He was too much in control
b. Horst could have given the entire bond to his kid, but he didn’t b/c he did not want to
shift the entire bond to him—he wanted to have control
7. Clifford: 10 years is enough for a shift
a. Congress overrules with §674: Time doesn’t matter, if the reversionary interest is worth
less than 5% of the whole, it is a shift—so if you give away 95% of the property, it is
enough for a shift
8. Eubank—Life insurance salesman gets paid with initial commission and then renewal
commissions, every time the person renews their policy. He gives the renewal commissions to his
kids forever (like coupon clips)
a. Holding: Not a shift (Horst)
b. McCaffery problem: This is like Lucas not Horst b/c it is tax he who earns it, not the
fruit of the tree
20
9.
Heim v. Fitzpatrick—Guy gets a patent for his invention. He is supposed to get money from the
patent (wage income). He sets up a Heim Co.; Dad has 1%, Wife has 41%, Son has 27%,
Daughter has 27%, In-law has 2%
a. Holding: He shifted effectively b/c he gave them the tree not the fruit. The idea that
enough control was shifted to satisfy the property shift.
i. Can shift: Lucas is not true, if you are clever enough, you can get around
Lucas.
ii. Shifting through and to entities
(c) Escape
buy, borrow, die—Untouched by the
1986 Act
(d) Deferral
(e)
Shift
(f)
Recharaterize
Pre- 1986
Tax shelters
1986 Act (structural solutions)
§469
§163
Tax shelters
§469
§163
§1(g)—Kiddie tax
Brooke
(i) Fogelsong
Convert ordinary income into capital
Get rid of capital gains
1.
V.
You can do 2 things:
a. Make the corporation pay tax instead of you b/c the corporation is in a lower tax rate—
have to it pay the corp income tax, then let the money sit there and have your stock grow
in value
b. Pass through all the income to the shareholder
2. Fogelsong—He incorporated himself and passed along earnings to his children as dividends.
a. Rule: Where a corporation is a viable, taxable entity and not a mere sham, the
assignment of income doctrine does not apply to disregard the corporate form.
i. Lucas doesn’t hold.
ii. Substance over form
3. Brooke—Physician gives his building to his kids and then he pays them rent and gets deductions
under §162 and the kids get an inclusion at a lower bracket (shifting strategy). The amount of rent
paid has to be FM rental and if it is, its okay (before the kiddie tax)
4. These cases are all before 1986 Act, then Congress comes in and applies the kiddie tax.
a. §1(g): Kiddie Tax: Kids under the age of 14, unearned income, and over $1K; Kids rate
equals parent’s rate; It doesn’t block the shift, but the kid’s marginal rate structure (under
14)
THE THING THAT WON’T DIE: CAPITAL GAINS
a. Capital gains as opposed to ordinary income
b. §1h: Net capital gains (the excess of long-term gains over short-term losses) are now taxed at a rate of 20% no
matter how much income a taxpayer has from other sources.
i. Lower rates on capital
0
10
20
ii. Ordinary income 1(a – d) rate brackets
0
15
25
28
40
ii. Policy: Specialized treatment is necessary or nobody will sell what they have b/c they will be in a huge tax
bracket (lock-in effect).
1. All politicians will want to give the specialized treatment b/c when you lower the capital gains
rate, the government makes money in the short-term b/c it will lead to more sales, and it is more
efficient. Government would rather lower the tax rate and have you sell now, so they can at least
get some tax now.
21
c.
d.
Trying to Get a Definition Down
i. IRC §1221: All property held by the taxpayer (whether or not connected with his trade or business) is a
capital asset—except the specific types of property; the statutory exceptions are not exclusive (the
following are not capital assets, hence, any gain or loss on disposition thereof is treated as ordinary income
or loss):
1. Business inventory/Property held for sale: Property other than property used in a trade or
business, if it is depreciable property or real property, it is not capital
2. Salary claims/Receivables
3. Depreciable property and realty
4. Copyrights and patents
5. Options
ii. IRC §1222 – §1223: Holding periods
1. Holding period=1 year
2. You will get capital gain or loss that you’ve held for more than a year
iii. IRC §1211: Capital loss offset rules (Netting Rule)
1. In order to minimize record-keeping where the unused capital loss is relatively small, §1211
permits individual taxpayers to offset capital losses (whether short-term or long-term) against
ordinary income up to $3K annually.
iv. IRC §1231: Land, building, machinery
1. Assets which accountants classify as “fixed”—are dealt with by the tax laws in a curious,
nonsymmetrical fashion. Under §1231, gains and losses from the sale of real and depreciable
property used in the taxpayer’s business are swept into a special category. If recognized gains
form the sale of such property exceed recognized losses for the taxable year, the gains and losses
are all treated as long-term capital gains and losses. But if recognized losses exceed recognized
gains, then the gains and losses are treated as ordinary. The effect, quite simply, is to treat net
gain from disposition of fixed business assets as long-term capital gain, while treating net loss
from such transactions as ordinary loss deductible from ordinary income.
v. Van Suetendael—S/o has stocks and bonds and is selling them. Holding his winners and selling his losers.
He’s going to say that this is an ordinary business (active trade or business of stocks) b/c he wants higher
rates for his loss. Government says no way.
1. Holding: Taxpayers who buy securities for speculation or investment hold them as capital assets
and not primarily for resale to customers.
a. Government wins
vi. Beidenharn—Real Estate: At what point does an investor become involved in an active trade or business?
B wants to say that this is an investment, not in this for the active trade of business (I don’t have a license
to be in the business).
1. Holding: Government wins. It can’t be a capital asset b/c he was operating a business.
2. What he should have done was to sell it to a real estate developer in order to get the capital gain
recognized.
vii. Corn Products—Company sells corn syrup and they are worried about fluctuation in prices of corn so they
buy futures to lock in the price. He argues that this an accounting thing, and the government says that this
is inventory and it is an exception to capital.
1. Holding: Where the purchase of commodity futures is an integral part of a taxpayer’s business, it
is not a true capital investment, and gains or losses produce ordinary income or losses. The capital
asset provision of §1221 should not be so broadly applied as to defeat the intent of Congress.
2. What does this mean: It is an expansion of §1221 inventory exception—corn products futures are
quasi inventory OR the definition of property in §1221, is to be narrowly construed—property
means things that are abnormal, not in the course of ordinary trade or business.
a. Government wins
viii. Arkansas Best—A company that owns other banks, they are putting money into one of the banks that is
going down. The stock of the bank becomes worthless and this is what they do in their ordinary business
operations.
1. Holding: What AB is doing is reading §1221 as assets not in the ordinary course of business, the
court says that they don’t see that in the statute (rule is business or not business).
2. Rule: A taxpayer’s motivations in purchasing an asset is irrelevant to the question of whether the
asset is “property held by a taxpayer” and is, thus, within §1221’s general definition of a capital
asset. Corn Products is not about a narrow reading of property, it is about a broad reading of
inventory. Stock is not inventory.
a. Government wins
Playing with Definitions: The Sport of Tax
22
e.
i. Hort—Petitioner acquired the property from his dad who died. The floor was already sublet, agreed to
cancel the lease in exchange for a lump payment.
1. Issue: Is it a capital gain or ordinary income?
2. The Doctrine of Anticipated Ordinary Income: When you roll up ordinary income and try to
sell it as capital property, you should anticipate that you will be taxed at ordinary income rates.
3. Holding: Petitioner contends that the lease was capital and therefore subject to capital gains. The
court disagrees and says that income from the lease is ordinary income and anticipatory income is
still income. The lease is the fruit, not the tree, and thus it is not property.
4. McCaffery: This is bad finance: According to this rationale, the government could argue that the
absolute sale of the building should also be ordinary income b/c you are still rolling up your
ordinary income stream.
ii. McAllister (See above; this case is overruled)
1. §1001(e)(1): Overrules the general principle
2. §1001(e)(3): Upholds the specific principle (when the income beneficiary sells her entire interest
to the remainder beneficiary)
iii. PG Lake—Oil corporation collecting royalties. The oil they collect, and sell, is ordinary income
(inventory). There is a loan made to their CEO and in order to discharge the loan, they assign the oil rights
to cancel the debt.
1. Arguments:
a. Taxpayer: The company is saying that this is a capital gain b/c it is property.
b. Government: It is ordinary income
2. Holding: It is a substitute for ordinary income, so it is ordinary income.
a. It looks like bullshit, it is bullshit, you don’t have the capital gains rate.
iv. Clay Brown—Company with lumber, guy wants to retire and the kids take over. They got $1M of assets
of lumber. If they were to sell that lumber, they would get ordinary income (§1221(1)—inventory). What
they do is sell the stock in Clay Brown (sale). The cancer institute then leases all of the business to Fortuna
inc. (his lawyers) (lease—ordinary income). Fortuna sells off the lumber—the rent is 80% of the sales
price and keep 20% as atty fees. Then cancer inst. pays 90% of the 80% to CB for the sale. SO CB is left
with $720K at capital gain rates, the charity is left with $80K and the lawyers get $200K. Had they just
sold the lumber, they would pay 70% ordinary income rate taxes on the $1M. Overall they got keep $500K
rather than $300K.
1. Holding: This works
Stop Making Sense: Miscellaneous Issues of Capital Gains
i. Structure of a tax shelter and clever tax planning and common law responses to tax planning:
1. Common law doctrine
a. Step-transaction (the taxpayer took 2 steps, the court said that we are going to collapse
those steps and tax you as if you hadn’t taken those 2 steps)
b. Substance over form (lease vs. sale)
c. Sham: The court says, “I don’t know what it is, but it is bullshit, it is fraud”
ii. Miller—Miller dies, he is a musician. Then, they make a movie about him and pay his widow $409,000.
1. Issue: What is she getting paid for? Is spouse’s public image a capital asset?
2. Argument:
a. It is property (therefore capital gains) because it is property I got on death and it has
stepped up basis (§1014).
b. She can say that it was a gift (no tax)
c. It was a personal right that she had basis in. It is a loss that she is being compensated for
(Solicitor’s opinion)
3. Holding: Privacy rights are not property for capital gain, they are not self-created assets either;
thus just because privacy rights are not inventory, doesn’t make them property.
a. “Many things can be sold which are not property”
4. Footnote 32: In Universal Pictures, there were property rights in Elvis Presley.
a. Key distinction: No real distinction, but you can argue that his image was property,
whereas Miller’s movie was sold simply for the story.
iii. Gregory v. Helvering—Mrs. Gregory is the sole shareholder in a corporation. One of the big assets of the
corp has its stock in another company. She decides that she wants the stock. The key thing is that an
ordinary dividend is ordinary income (61). On the other hand, a liquidating distribution is capital gain
(carry over basis) (general utilities rules, but it has been overruled). Mrs. Gregory wants this stock, but if
she gets it, she has to pay ordinary income.
1. She makes 2 different steps: Step Transaction
23
a.
VI.
Corporate spin off: Not taxable (not recognized)—has to be nonrecognition or else no
one would ever merge
i. Corp 2: Put the stock in here
b. Liquidate: She liquidates corp 2 and as the only shareholder receives the assets (the
stock)
2. Holding: Business-Purpose Test. If there is no business reason for the 2 steps, and if the only
reason is to escape tax, then we are going to let you. The SC strikes down the 2 steps into one
(she got stock) and she has to pay ordinary tax for ordinary income.
3. Policy: There is no business reason why she would do this but to avoid taxes, but on the other
hand, that is a business purpose (avoiding taxes)
4. Learned Hand: There is no “general thing” that you have to have a business purpose. On the
other hand, if we see something that we know is to avoid taxes, we are going to look closely and if
we don’t find a business justification for it, you’re going down.
iv. Williams v. McGowan--William owns a hardware store and he is trying to sell it—he wants to argue that
b/c he is selling his entire business, it is not inventory being sold to customers, but rather it is capital.
1. Issue: Whether the whole business is property or he has to break it up?
a. 3 things:
i. Ordinary (inventory)
ii. Capitalize, depreciate
iii. Good will
2. Arguments:
a. Seller: Wants it to be goodwill b/c then it is capital (gain)
b. Buyer: Wants it to be ordinary (deduction)
i. The next thing the buyer wants is to assign capital depreciable things so he can
take the deduction over time instead of having to wait for ultimate sale or
disposition
ii. The last thing that the buyer wants is to characterize as capital assets that are not
depreciable (good will) b/c he would have to wait to sell to take the deduction
3. Holding: The court says that you have to break it up and sell it for ordinary and buyer gets
ordinary deduction.
ANATOMY OF A TAX SHELTER
a. The Big Picture: When we are in the tax shelter realm, it is sheltering, hiding, or offsetting your wage income
i. Non-recourse: There is recourse against the property, but not against the person
ii. Recourse: Against the person
iii. Tax planning:
1. Borrow a $1M in non-recourse basis
2. Buy a depreciable thing
a. Depreciate and get $100K (deduction) over 10 years
b. Worst case: In the 11th year it is worthless
i. Walk away
1. What happens?
a. Discharge of indebtedness ($1M) (Crane, and Tufts)
b. You pay tax at capital gains rate (on $1M) b/c you gave the
thing away and got a discharge of debt
3. Best case: Die
iv. Crane—Woman inherits property subject to a non-recourse debt. She sells it for $2500. She got $2500 in
cash plus the discharge of $250K debt. The govt argues that she should be taxed on both $2500 + $250K.
She took depreciation deduction in the meantime.
1. What she should be taxed on:
a. §1001(a): Gain = FMV – Basis
i. FMV = $2500 + $250K
ii. Basis = $250K – Deductions
2. Holding: She gets taxed at capital gains rate b/c under §1221 it is not inventory. She realized a
benefit equal to the amount of the mortgage as well as the additional consideration received, thus
she now must pay (must match so that the definition of “property” be the same for acquisition,
depreciation, and disposition.
3. Footnote 49: People thought/hoped that you could just walk away without taking deductions into
account
v. Tufts—Formed partnership to construct apartment complex. Entered into mortgage loan agreement for
$1.8M (loan). Obtained loan on non-recourse basis. Total amount put down is $44K. $400K taken in
24
b.
depreciation. Value decreased to $1.5M. Investors decide to walk away (losing money). Tax
consequences of walking away (remember tax logic, not economic logic).
1. Gain = FMV – Basis
a. Basis = FMV – depreciation
b. Gain = FMV – (FMV – depreciation)
c. Gain = $400K in capital gain
2. Holding: It is okay to do this. He can take ordinary deductions and gain at capital rate.
Why Tax Lawyers are Well Paid: Some Terribly Clever Deals (Pre-1986 cases; Note that post-1986, Congress
implemented §469 = Have to offset losses of passive activity, against gain of passive activity)
i. Knetsch—High wage earner, he is making wages (90%). He decides to buy annuities -$4M worth (he has
to borrow to buy), it is guaranteed to increase at 2.5% interest a year ($100K), but he is going to pay 3.5%
in interest because he has to borrow money in order to buy the annuities ($140K). He is losing 1% a year
on this ($40K).
1. Every year, he takes interest deductions in the amount of $140K + $3,500=$143,500
a. He gets this amount by saying that he is paying interest on 3.5% x $4M annuity ($140K)
but ALSO that he is paying the annuity by borrowing $100K each year from insurance
co. at 3.5% ($3,500)
b. In actuality, he is just writing insurance company a check for $40,000 each year
($100,000 IS NOT CHANGING HANDS)
2. Holding: SC: No way, this is a sham—not clear why? They don’t like it.
3. Footnote 18: At a tax rate of 90%, there is saving of $126K + after tax—this guy is making $86K
a year, by writing a check for $40K a year to the life insurance company. He is making money.
Why did he pick $4M? He is working backwards b/c the $140K is the number he had as his
salary.
4. Comment: A transaction must affect the taxpayer’s beneficial interest to raise an interest
deduction. Interest is not deductible unless the taxpayer had some purpose other than tax savings.
a. But dissent: tax avoidance is a dominating purpose behind scores of transactions
ii. Estate of Franklin—Seller financing. Transaction one: Sale plus finance—LA professionals buy
Thunderbird Hotel for $1.2M and they pay $75K upfront and $108K every year for 10 years (interest plus
principle). At the 11th year, a balloon payment is due for the principle purchase price ($975K). Transaction
two: Lease back K—Romneys pay rent at $108K a year.
1. The Economic consequences are a wash
2. The cashflow (economic) consequences of this is nothing
3. The tax consequences:
a. Romneys:
i. Pay tax for the $75K
ii. The interest income and the rent expense under §162 wash out
b. Franklin:
i. Rent income under §61 and interest expense under §163 wash out
ii. Depreciation deductions:
1. Bought for 1.2M, 10 year deduction schedule (they get 120K a year)
2. In the 11th year, discharge of debt and capital gains
4. Holding: It doesn’t work
5. Problem: Purpose of the evaluation was for personal objective (offsetting wages), court didn’t
like this b/c it was not the FMV since there is no evidence that they properly appraised the value
of the hotel.
iii. Frank Lyon—Seller Financing 2 (Sale and Leaseback). Transaction one: Worthen Bank wants to build
new bank building. Instead of borrowing money itself, Frank Lyon takes title after borrowing $10 Million
from NyLife, for which he must pay back principle and interest over 30 years. Transaction two: Lyon
leases the building back to the bank for long-term use. Rent is equal to the principle and interest on the
loan.
1. Once again, the Economic consequences are a wash.
2. The tax consequences:
a. Worthen
i. He gets present rent deductions under §162 (as opposed to just getting interest
and depreciation deductions)
ii. In other words, this is a shift case
b. Lyon
i. He gets an interest deduction under §163
ii. And depreciation deductions under §167/§168
25
3.
c.
Holding: Unlike Franklin, this works
a. There is 3rd party legitimacy here: lawyers, lenders
b. There is no overvaluation
The System Strikes Back: A Reasonably Clever Answer
i. §469—Passive Activity Loss Rules(PAL)
1. The rules divide the universe into 2 different kinds of economic activities
a. “Passive”
i. Includes real estate, and limited partnership investments
b. “Active”
i. Includes wages
ii. Also, includes “portfolio income”: gains from interest and dividends
1. Although “portfolio income” is in some sense passive, it is in this
category because it is predictably positive
c. Aside Recap: combined with “personal” items, which are simply non-deductible (§262),
this creates the trichotomy that we have discussed all year
i. Business (§162), active here
ii. Investment (§212), passive here
iii. Personal (§262)
2. The key purpose behind the rules is netting: the government is no longer going to allow you to
offset passive losses against active income
a. Rule (§469): Passive losses may be netted against passive income, but NOT against
active income
3. Bottomline
a. Tufts tax shelter is shut down
b. However, there are still plenty of hard questions to answer
i. For instance, what is a “passive activity”?
ii. Also, Nickerson isn’t addressed so much by this rule because he is actively
working
VII.
Policy
Guest Speaker (Joel Slimrod)
1. Policy Question: Economic Approach to Taxation
a. When tax policy is debated, a lot of things get mixed up that are not about taxation
b. Economics of taxation:
i. What is distinctive?
1. Focus on taxpayers’ responses to the tax and the changes to the tax system
a. Efficiency
b. Equity
26
c.
d.
e.
c. Simplicity
ii. 3 aspects of the tax system:
1. A way of assigning the tax burden on citizens
2. Tax systems changes the price of goods and services
3. Tax system is a vast administrative bureaucracy
iii. Evaluating Efficiency:
1. Estimating behavior
a. A good rule of thumb: All behaviors are symptoms of inefficiency/waste b/c it is s/t you
guys wouldn’t have done if it wasn’t for the tax
2. The economist assumes that in the absence of taxes, all resources are spent efficiently.
a. Exception: Externalities
i. Behaviors that would have negative effects in the absence of tax
ii. Negative externality: Pollution
1. Tax can work as a corrective measure
3. Why is this important? It effects the true cost of revenue for the government
a. If taxation causes people to work less, or invest less, the consequences of tax could be
tremendous
4. There is a hierarchy of responses:
a. (Top) Most response: Timing of economic activity
i. Ex. If people know that the tax rate on capital gain will double, people will rush
out to sell before rate will down, if tax rate will decrease, then people will
postpone their sale.
b. Avoidance:
i. Income shifting,
ii. Financial restructuring,
iii. Renaming/re-labeling,
iv. Flat out evasion
c. Real variables: There is no evidence that changes in the following causes huge responses
i. Labor supply,
ii. Saving,
iii. Investment
1986 Tax Reform: Big drops in tax rates
i. In 1986 top rate was 50% vs. in 1988 it was 28%
ii. What was the change in behavior?
1. Reduction in charity?
a. It wasn’t that these high income folks worked more hours, nothing about their real
behavior changed, but it became a lot more attractive to small business owners to become
an S corporation (re-labeling)
2. Incidence: Study of who actually bears the burden of tax
3. In order to understand who bears the burden, is to understand the behavior of taxpayers
How could a tax reform be good for the economy? 3 ways
i. A structural tax reform
1. Level the playing field
2. Eliminate the double taxation on corporations/capital gains
ii. Reduce progressivity
1. The more progressive the tax burden, the higher the disincentives to become rich
2. The more progressivity there is, the higher the marginal tax rate
3. The higher the marginal tax rate, the less the incentive to work hard to become rich
4. Higher tax rates, there is more disincentive to work and become rich, there is a higher incentive to
look for tax cuts/deductions
5. Economists believe double taxation is not a good thing
6. It could make the economy better off
iii. Move from an income tax to a consumption tax
1. Many economists believe that it would be good for the economy
2. The Lump Sum Tax
a. A tax system that divides the tax need pro-rata between the society
i. Ex. E/o pays 10K no matter what you’re earning
b. Causes no disincentive b/c doesn’t penalize hard work or being rich
c. A flat tax is half way between a lump sum tax and what we have now
Tax cuts and their consequences:
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f.
i. A way to reduce the size of the government—has nothing to do with tax related incentives
ii. Increase deficit to reduce expenditure
1. Clever b/c don’t have to single out which expenditure should be cut
iii. Real issue is the size of government and tax cuts are the tactic to have a smaller government
iv. Use to fight recession
1. Cut taxes to get people to spend more money—good for the economy
v. Using taxes as a stimulus:
1. Most economists lost faith in this
Politics:
i. Economy goes up and down for reasons that don’t have to do with government policy
ii. Voters tend to think that when the economy is good, the government did it
1. This is a fallacy
iii. Governments are helpless
1. Placebo economics
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