TAXATION
1/12/04
Exam – 3 hours; MC (about 1 hour, 15 minutes); remaining time is tax problems. No long issue-spotting essays. Closed book exam.
No class next Wed or Thu.
Where does fed. gov’t get its money? (see Overhead HO 1)
 Federal Revenue Sources 2003
o Individual income tax
o Corporation income tax
o Social insurance taxes (social security; Medicare)
 These are pretty inflexible; there’s no planning you can do to reduce your tax burden here (that’s why there
are no law school courses on this).
o Excise taxes (e.g., telephone, cigarettes, alcohol)
o Other (estate, gift, etc.)
 For estate taxes, you can do an enormous amount of planning to reduce.
 Major California Revenue Sources (est. circa 2000) – state taxes – principles of federal tax apply to state tax.
o Individual income tax
o Bank and corp. tax
o Sales and use tax
o Loans, transfers, other
o Motor vehicle-related
o Tobacco-related items
o Local property
Rate Structure
 Social Security and Medicare Rates: 2004 (HO 1)
o Social Security: Paid on first $87,900 of wages earned in a year.
 If you earn $200,000, you only pay SS tax on first $87,900; the rest is entirely tax-free.
 Rate is 6.20% of wages paid to gov’t in SS tax; employer also pays 6.20% in wages. Total burden is
12.40% (half paid by you; half by employer).
 If you’re self-employed, you pay both ends (full 12.40%).
 Suppose employer had to pay the entire amount (12.40%). Peoples’ wages would be reduced by 6.20%; it
would not help employees one bit. Every economist would agree with this. There’s no difference whether
employer or employee has to pay the SS tax.
o Medicare: 1.45% for employer and employee (total: 2.9%) on all your wages (unlimited).
o Total: Individual: 7.65% on first $87,900; then 1.45% on the rest.
 SS and Medicare tax are only on wages. If you have a trust fund, then you pay $0 taxes.
 So most people pay more in tax on SS than they do for income tax. For poor and lower middle class, they
don’t pay a lot of income tax, but they pay big SS tax burden.
 When people talk about tax cuts, they talk about income tax cuts, but SS isn’t part of that.
o Arguments for why SS is different from income and should be differently treated.
 When you pay more in SS tax, you get more benefits than when you retire. There’s some connection b/t
amount you pay for SS and amount you get when you retire.
 Remember that what you pay now in SS is not put aside for you when you’re old; it’s immediately
spent and given to the old folks.
o Poor people pay higher percentage of their income than rich people on their income since the limit is $87,900. SS
tax is heavily paid proportionately by poor people.
 Counterargument is that SS benefits disproportionately more to the poor. It actually helps poor and lower
middle class. Depends on how you look at the big picture.
o Why SS is so popular is that it isn’t seen as a welfare system. If you took SS away from Bill Gates, who doesn’t
need it, it doesn’t save system much money, but it changes psychology of the people receiving it.
 Overall, SS has been an amazing success. Prior to passage of SS, many elderly were poor; now, most
elderly aren’t poor. It also benefits younger people b/c w/o SS, younger people don’t have to support their
parents.
Read pp. 1-8; 13-16; 16-25 (for whole week)
1/13/05
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For tomorrow: read 1st two parts to William Gale series (Intro & Background; Distributional Effects). Also read 1st 13 pages of MidSession Review and Chris Edwards article.
Basic Structure of the Income Tax (see handout)
§ 61. Gross income defined
 (a) – lists types of gross income (including, but not limited to)
o Exceptions – some of these things aren’t always taxed. First, code is structured to tax everything, then there will be
provisions that won’t tax something.
o Even though this is extremely broad, it still allows for litigation to dispute what’s income.
 1040 Form
o Itemizing Deductions – you’re likely to itemize deduction if you’re paying mortgage or have income over $100,000.
o Income Section
 (13) - Capital gain/loss – gain/loss from sale of property that is not inventory.
 Inventory is property that is sold as part of your ordinary business (e.g., Nordstrom shoes,
McDonald’s hamburgers; artwork sold by art gallery; home sold by home developer). These
would be reported either under wages/salaries or business income/loss.
 Gains/losses from investment property are treated under capital gains/losses (e.g., if you run
apartment building and then sell it, it’s not inventory and counted as capital gain/loss).
 Capital gains/loss under many circumstances are taxed at lower rate.
 Dividends are also taxed at a lower rate.
 Although reported under regular income, it’s structured to pay lower effective rate on your capital
gains.
 When property goes up or down in value, and you don’t sell it, you don’t pay a tax. You don’t get
a deduction until you sell it.
 For property, you only pay tax when your gain/loss is realized. Until you realize it by sale or transfer, no
gain or loss will be paid.
 Once you transfer it, you will pay tax (or get loss) unless there’s a provision to the contrary.
 Recognize – once gain or loss is realized, if there is no special provision to the contrary, that gain
or loss will be recognized. Recognized means pay tax or get loss.
o Suppose I bought a painting for $1,000, and is now worth $5,000, and trade it for a
baseball card worth $5,000. Now, I’ve transferred my property. I have realized a gain of
$4,000 (amount I got – amount I paid). Here, this gain will be recognized.
o Suppose I have this painting and gave it to my adult daughter as a gift. I have realized
the gain (since you transferred it), but special provisions in code say that when you
transfer property as a gift, the gain isn’t recognized.
 Business income/loss (item 12)
 See Schedule C to calculate
§ 62 – Adjusted Gross Income (AGI)
 Definition: gross income adjusted by certain modifications
 62(a) – outlines deductions to get adjusted gross income (look at handout)
o No common thread among these deductions.
o Most important deduction is the first one: trade and business deductions.
 Gross income minus these deductions give you adjusted gross income.
o 1040 Form – Adjusted Gross Income section
 AGI is basic term in income tax to indicate what a person’s income is.
Profit or Loss From Business (Schedule C of Form 1040)
 Part I – Income – how to calculate business income
o Gross receipts or sales minus Returns and allowances minus Cost of goods sold (see Part III)
 Part II – Expenses
 Part III – Cost of goods sold
 Subtract Expenses from Part I and gives you your gross profit/loss (this then would go into line 12 of Form 1040).
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§ 63 – Taxable Income Defined
 Taxpayers divided into 2 categories: itemizers and non-itemizers
 Non-itemizers (most taxpayers) – they take their AGI (e.g., $40,000) and subtract standard deduction and personal
exemption.
o Example: Married couple with AGI of $40,000 can subtract $9,700 (standard deduction). Personal exemption is
$3,100 for each person in household, so they would have around $24,000.
 Then they look at rate schedule, which gives the amount of taxes they owe.
 Remember: Workers are still paying SS taxes, sales taxes, property taxes.
o Amount of income you pay in taxes is equal to the taxes you calculate minus your tax credits.
 Back to couple example: Suppose taxes owed is $3,000. This could be reduced by tax credits. Tax credits
include child care tax credits. Child care credit is $1,000 per child. If they had 2 children, they would pay
only $1,000.
o Credit v. deduction
 Deduction reduces your taxable income (such as standard deduction and personal exemption). Credit
reduces the taxes you owe directly.
o Actual tax you have to pay: AGI – deductions. Then look at rate schedule to determine how much you ower. Then
subtract any credits from that amount owed to get final taxes owed.
 Itemizers – look at Schedule A
o Schedule A
 Medical and Dental Expenses
 Taxes you Paid
 Interest you paid on home mortgages
 Gifts to Charity
 Casualty and Theft Losses
 Job Expenses and Most Other Miscellaneous Deductions.
o If you add these deductions and this is bigger than standard deduction, you take this number. If it’s less than
standard deduction, then take the standard deduction.
o Two positive things about this structure:
 For most taxpayers, it simplifies paying taxes dramatically.
 For taxpayers earning up to $15,000, they pay nothing in federal income tax. And for people earning
around $30,000, standard deduction can dramatically reduce tax burden on poorer people.
 Standard deductions help poor and working class people.
1/14/05
 Line 41 – if AGI is $107,025 or less, then they get $3,100 for every exemption claimed on line 6d. If you make more than
$107,025, you lose some of those exemptions (phased out over a period of time).
o Under Bush tax plan, the rich people won’t lose their exemptions.
o Actual impact of losing exemptions is the same as paying an extra 1% on their AGI.
 Suppose tax owed is $3,000, you have to figure out your tax credits.
o Most important is Child Tax Credit (line 51) – get $1,000 off for each child.
 Alternative Minimum Tax (line 44)
o Two tax structures – regular income tax and alternative minimum tax.
 If income is above around $100,000 or so, there is a chance that alternative minimum tax you will owe is
higher than regular tax.
 Calculate tax under regular system; calculate tax a second time using completely dif. forms, and that’s the
alternative minimum tax.
o AMT doesn’t allow some deductions allowed under regular tax. Denies many deductions, and then taxes at lower
rate. First $50,000 of income isn’t taxed at all under AMT. You pay whichever one is higher of the two.
o Historical background of AMT
 Before Reagan era, tax rates were higher, but with lots of loopholes. Some people could take advantage of
these loophole and not pay any taxes.
 To prevent his, they enacted AMT to gather tax dollars from wealthy people who would otherwise pay next
to nothing. Originally designed to affect tiny amount of tax abusers. Today, this is no longer true for two
reasons:
 1) Bush tax cuts lowered tax rates generally, but didn’t lower the AMT rate. Even if AMT didn’t
change, but you lower regular tax rate, then AMT rate is higher than regular tax rate.
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 2) AMT is not fully adjusted for inflation.
o Bottom line: AMT rate is hitting far more people than ever before.
o What’s stupid about this is to fill out two tax returns. Seems to be big waste of resources.
o AMT especially hits two-income families.
You can’t withhold money owed to gov’t and pay at the end. If you have underwithheld, how much do you pay back gov’t?
o If you’re underwithheld by a small amount, you don’t pay interest so long as you send check by April 15th. If you
don’t send check you owe by April 15th, but apply for postponement, you pay reasonable interest.
Rate Structure (see handout)
 Marginal v. Average Rate
o Suppose tax rates were:
 10% on income up to $10,000
 20% on income over $10,000 but less than $40,000
 30% on income over $40,000
o Alice has a taxable income of $25,000. Alice’s tax owed would be:
 10% of $10,000 or $1,000, plus
 20% of $15,000 or $3,000 (total tax owed of $4,000).
o Alice’s marginal rate is 20%. That is what she would pay on an extra dollar of income.
 Marginal rate is how much tax you would pay if you earned an extra dollar, or how much tax you save if
your income was reduced by an extra dollar.
o Alice’s average rate (on her taxable income) is 16%.
 Average rate is the total amount you pay in tax divided by the taxed base.
 Here, it’s $4,000/$25,000 = 16%.
 Which rate counts? Depends on what question you ask.
o Marginal rate reduces amount you get from additional labor. That is rate that has effect on your work effort, on
savings decisions, etc.
 Suppose Alice is debating whether to work another week for $1,000 or go to the beach instead. She would
earn $800 after taxes. Then marginal rate matters.
 Suppose Alice wants $900 to work an extra week. Since $1,000 would only give her $800 after taxes, then
she would say it’s not enough to forego the beach.
 Suppose everyone in America gets an extra $500 bonus. Since everyone is getting $500 no matter what, it
doesn’t encourage work effort at all.
o But when you talk about the actual tax burden Alice is paying, then you deal with average rate.
 Ex: Child care credit gives everyone $1,000 tax credit for having a child. That reduces their tax burden.
Child care credit does nothing to encourage work.
 It’s still good idea for fairness concerns. You have less ability to pay taxes if you have kids, who
are expensive. Give them tax credit to achieve fairness goal of redistributing money from people
w/o kids to people who have kids and are needier.
2004 Rate Schedule (see handout)
 Types of Rate Structures
o Single Individuals (not Heads of Household or Surviving Spouse)
o Married filing jointly and surviving spouses (filing tax return in year that spouse has died)
 Brackets double (so you pay less in tax).
 But if there are two incomes, you aren’t necessarily better off (since you have more money).
o Head of Household – gets most favorable rate structure b/c they’re single with kids, but they have single rate
structure that’s similar to single individual rate structure. You get head of household rate, exemptions for kids, and
child care credit.
o Married filing separately – worst tax schedule (punitive tax schedule)
 Still have this for married couples in midst of divorce.
Tax Policy Goals (see handout)
 Efficiency
o Minimize undesirable tax-induced changes in behavior
 Reduction in work effort
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Ex: Don’t want tax structure to discourage people from working. It isn’t that work is good and
leisure is bad; we just don’t want taxes distorting behavior.
 General model people use is what would people do if there weren’t any taxes? When tax
structures discourage or encourage extra work, then that’s no good.
 Ex: Alice gets paid $900 to work for firm. Value firm receives from Alice’s work is $1,000. If
going to beach is worth $900 to Alice, is it efficient for her to work? Yes, b/c beach is worth $900
to Alice, but she’s producing $1,000 in value for working. If she works, she destroys $900 in
value, but creates $1,000 in value  net plus of $100. It’s good for economy for her to work.
 Ex: Suppose beach is worth $1,200 to Alice. Is it good for economy for her to work? No, b/c that
would lead to net of -$200. It’s better for economy for her to be lazy.
 Suppose tax is 20%, and Alice will only get $800 from working. She’ll go to beach b/c it’s worth
more than the after-tax $800. Tax has discouraged her from working. So one tax policy goal is to
try to avoid distorting peoples’ behavior through tax system, especially not discourage people
from working.
 Purchase of suboptimal goods
 Under Clinton administration, there was tax on luxury cars.
 Argument in favor of this was to get at rich people.
 Argument against it was that there should be higher tax rate on rich people, not on cars.
Rich people can avoid this tax by not buying Mercedes and go around this tax on luxury
cars (such as buying cheaper Mercedes and buying a custom-made Harley). To the
extent that it forces people to change their behavior from what it would have been w/o
the tax, it can lead to wacky decision-making.
 Ex: Tax on soft drinks, but no tax on juices. This will lead to debate on what’s soft drink and
what’s juice. When people are changing their behavior in suboptimal ways, then this is not
meeting tax policy goal.
 Efficiency goal is not to have tax code discourage people from engaging in behavior they want to
engage in as long as it’s not harmful.
Encourage desirable behavior through tax incentives
 Deduction for charitable giving
 People will give more for charity. They may give so much more than if gov’t gives them tax
deduction, it may raise a lot more for charity.
 Investment incentives for business
 Ex: Feel free market would not produce enough pollution-free cars, so you give tax credit to those
who do build pollution-free cars.
 Ex: In CA, if you buy energy-efficient washing machine, you get a check from gov’t. This can
change behavior.
 Also discourage undesirable behavior with high taxes
 Example: Cigarette smoking
 Harm to others such as second-hand smoke
 Harm to smoker who doesn’t know his own best interest
Minimize administrative costs (for both gov’t and taxpayers) associated w/tax collection
 Ex: Good idea to eliminate AMT b/c it’s good idea not to fill out two tax returns.
 Ex: Standard deduction – by allowing people to choose not to itemize their deductions, that could also
minimize administrative costs and simplify filling our tax returns.
Government v. Private Enterprise – which is more efficient? Would we be better off with low tax rates and small
gov’t, or high tax rate and large gov’t?
 Private Enterprise
 For PE: Firms that produce poor or overpriced goods will be driven out of business.
 Against PE: Firms may attempt to increase profits by practices such as cheating consumers (Sears
auto repair), selling harmful, addictive products (tobacco), or improperly shaping consumer
preferences through advertising (Sat. morning cartoons).
 Sears – had incentive program to give bonuses to repairmen who found more problems
with cars to get more money out of customers  cheating consumers.
 Tobacco – making millions of dollars on products that kill people
 Saturday morning cartoons – make kids want products that are unhealthy for them.
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PE seem to dwell a lot on what’s harmful to you and create anxiety for average
consumer. Makes you want things you don’t need.
Government – doesn’t have same motivation as PE to get more money.
 For Gov’t: Some goods and services cannot be effectively produced by the private sector (national
defense, police, parks, highways)
 For many products, it’s more efficient to run by gov’t in a monopoly than by private
enterprise.
 Against Gov’t: Without competition or need to make a profit, gov’t workers may lack incentives
for hard work and innovation.
 There could be laziness and no incentive to improve things b/c they don’t make any more
money to improve things.
Two factors making private market work best
 High level of competition – when there’s lots of dif. firms competing for your business, it’s more
likely that private market will work better.
 Product that people can evaluate properly – far more likely for private market to work
 If these two conditions both exist, then private market will probably be more effective than gov’t.
 Ex: Clothing. There are scores of clothing companies. Easy to evaluate quality of
clothing (feel and try it on).
 Ex: Food. You can tell whether food is good or bad. Only weakness in food market is
sanitary conditions (people have difficulty evaluating sanitary conditions).
OTOH, auto industry and insurance industry – people can’t readily tell whether they need to fix their cars
or need insurance. It’s more important to have gov’t regulation to prevent problems within these
industries.
Fairness
o Apportion the tax burden fairly b/t taxpayers with different incomes and needs. Want to put tax burdens on people
in the “right” way. What’s “right” or “fair?”
 Utilitarian theories
 Structure tax system and gov’t spending in a way to maximize social welfare. “The greatest good
for the greatest number.”
 Ex: Mr. Poor works full-time and makes $15,000. We take $1,000 from Bill Gates and give it to
Mr. Poor. Utilitarians say that extra happiness for Mr. Poor is better than unhappiness that Bill
Gates feels in losing $1,000 of his billions.
 This increases total welfare in society b/c money is worth more to poor person than it is to a rich
person.
 Utilitarian is also worried about discouraging work effort. Utilitarian tries to balance need to help
poor and discouraging work effort.
 Right-based theories
 Could either be very conservative or liberal.
 Conservative – right to keep what you earn. Don’t want tax system to redistribute money
from rich to poor. Want tax system that’s flat-rate tax system.
 Liberal – every person has right to good education, health care, etc. Tax system should
make sure that all these economic rights are guaranteed.
Distributional Effects of Bush Tax Policy
 Rate Changes from Bush Tax Cuts: 2001-2004 (see handout)
o On first $7,000, you pay only 10% (down from 15%). Poor class got a tax break.
o On income from $7,001-$27,050, you still pay 15%. Lower middle class got no change in their marginal rates.
o If you’re in higher tax bracket than first one, you still save $350 (b/c you’re taxed at 10% on first $7,000).
o For higher tax brackets, there are tax cuts. Very poor got 5% tax cut; very rich got 4.6% tax cut. Most other tax
brackets got 3% tax cuts.
 Definitions
o Percentage cut in taxes
 For poor tax bracket, they received a 1/3 percentage cut in tax rate. Makes it look bigger (argument pro
Bush).
 For rich tax bracket, they received a much lesser percentage cut in tax rate.
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Percentage point cut in taxes
 For poor tax bracket, they received a 5% point cut in tax rate.
 For richest tax bracket, they received a 4.6% point cut in tax rate.
Tax cuts to poor were more favorable to poor and less favorable in other ways. Effects of Bush Tax Cuts (besides looking at
the data):
o Limitation on itemized deductions and personal exemptions for high bracket taxpayers will be phased out over 5
years beginning in 2006. (Helps rich).
o Child tax credit increased from $500 to $1,000. Credit is partially refundable in limited cases. (Helps poor/middle
class)
o Increased standard deduction for married filing jointly to twice the amount for singles, rather than 167% of the
single amount. More favorable for all married couples filing jointly. Slightly helps poor families, since rich
probably itemize.
o Tax rates on corporate dividends and on capital gains were substantially reduced. Overwhelmingly helps rich
families.
o Estate tax exemption increased and estate tax rates lowered. Eventually, estate tax will be eliminated by 2010. This
helps wealthier families.
No Financing Chart (see handout)
o Top Quintile gets 73% of tax benefit (in dollar amount).
o 80-99 percentile gets 43.1% of tax cut; top 1 percent gets 30% of tax cut.
 For Bush: This stat is distorted in part b/c since they earn a lot of income, even a tiny tax cut would give
them a lot of money. In terms of dollar amount, this is true.
 Against Bush: Even if you look at percentage change, the rich still did the best of any group.
o The top 1/10 of the 1% get even more tax cuts.
1/21/05
Distributional Effects of Bush Tax Policy (Gale and Orszag) (see handout)
o Financing:
 Any tax cut must be paid by some combination of:
 Reduced spending; and
 Increased future taxes
 Such financing should be included in any distributional analysis of the tax cut.
o Distributional Effects Without Financing  seemingly misleading results – open to interpretation in dif. ways by
either democrats or republicans.
 “Contradictory Measures”
 Compare:
o Share of tax cut
 Democrats: You could show that top 20% of taxpayers got a 73% of tax cut.
o Average tax change (dollars)
 Democrats: You could show that middle class got only a change of $387, while
richest 20% got almost $7,000 off.
 With:
o Change in share of income tax paid.
 Republicans: Share of taxes rich folks are paying hasn’t gone down at all, but
rich are paying 2.6% more of federal income tax than before.
 Would also argue that middle class are paying less in taxes with these tax cuts.
Overall, they would say tax cut is fair.
o Griffith: You should look at change in after-tax income (%).
Gale/Orszag says we should take into account the financing (make sure you understand why).
o Two financing alternatives that they propose:
 Equal dollar financing
 Each person/family will lose an equal dollar amount of gov’t benefits (direct and indirect) or will
pay an equal dollar amount in a future tax increase.
 This model works best if you believe best solution of problem is to cut benefits.
 Proportional financing (more realistic than equal dollar financing)
 Each person/family will lose an amount of gov’t benefits or pay future additional taxes in
proportion to their current income.
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This is better model if you believe that there’s cuts in services plus increase in percentage points
in taxes.
Under either of these financing methods (but especially equal dollar financing), the Bush tax cuts are regressive by
all measures.
 For example, under proportional financing, only the top 1% of the population received a net tax cut.
 Similarly, small business owners and families w/children receive no tax cut when financing is considered.
Suppose tax cuts have stimulated economy, so that more is being produced, and therefore, even though they are
weighted toward wealthy, everyone will be better off through economic stimulation.
 The above results aren’t changed even if (as the authors believe is unlikely) the tax changes foster
additional economic growth which increases each individual/families cash income by 1%.
 1% is a huge increase (even though it doesn’t seem like it).
 Even if this is true, most of the country is still worse off after Bush’s tax cuts.
Are Gale and Orszag correct? What is the best response to their argument?
 Bush would argue it has positive effect on economy. Look at Cato Institute handout
 Cato Institute said that the rich get most of the benefit, as well they should. They were paying too much in
taxes. They earned their money through hard work and industry and were treated unfairly.
 Says Bush was wrong in increasing child care credit b/c that didn’t boost economy. Didn’t like
child care credit b/c key was to lower marginal tax rates, which encourages working and saving.
Child care credit is just about social engineering (incentive for people to have kids), not increasing
work ethic.
 Says that people earning over $200,000 were paying 26% AGI rate, whereas people earning $50100,000 were paying 11% AGI. This is unfair.
 Fundamental underlying notion of Cato Institute’s argument: You have a right to what you earn.
Two different approaches
 1) Utilitarian – perfectly fine for gov’t to engage in social engineering by taking money from rich to give to
poor. This is done all the time.
 We could debate how much is taken away, but where to draw the line is within framework of idea
that gov’t should help one group and take money away from others to do so.
 Turns out that utilitarian types tend to think that high tax rates aren’t that bad. But today, most
people believe that high tax rates are not beneficial. Many liberals won’t argue for extremely high
tax rates.
 2) Gov’t should not be in business of redistributing income from rich to poor.
Normative Theories of Fair Income Redistribution (see handout)
 Benefits-received Theories
 Rights-based theories
o Conservative Rights-Based Theories: Robert Nozick:
 Imagine society where liberals have done all the redistribution they want. Imagine that in society, people
are working (with taxes taken away, given to poor, etc.). In society, there’s Wilt Chamberlain, who agrees
to work an extra day, and all people who go to game pay an extra quarter. Who would object to Wilt
working extra day and getting extra money, and people voluntarily paying the quarter? If we allow Wilt to
do that, everyone in society will do that, and society will become unequal again.
 But can we structure this society for perfect redistribution and allow people to work more for tax-free?
 To redistribute in our perfect world, we have to have tax system where we tax the rich at a higher average
rate (e.g., 25%) and middle class at average rate at 10%. There’s no way to create this perfect distribution
w/o taxing people at a marginal tax rate.
 Argument against Nozick – as a practical matter, you can’t have this society where you first create this
redistribution, then have people work tax-free. You must have changes in marginal tax rate, which will
prevent Wilt working for tax-free the extra day.
 Criticism of this argument:
o Read Griffith’s law review article (no reason we should object to this argument).
 Suppose Wilt gets $10,000 for working extra day, but he values his time at $9,000. W/no tax
structure, he’ll be better off by $1,000. All people paying quarters will be better off as well.
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Now with 25% tax rate, he only gets $7,500, but values his leisure at $9,000, so Wilt
won’t work. Wilt is worse off; people who would have gone to see him are worse off,
too.
 When tax system prevents Wilt from working in standard model, everyone’s
worse off (Wilt and potential consumers).
o If tax rate is 5%, Wilt will get $9,500, so Wilt will still work. As tax rate goes higher, it
becomes more likely that it will prevent Wilt from working. Higher marginal tax rates
can discourage work effort and cause efficiency loss to society. This is argument
accepted by everyone (liberal and conservative).
 Nozick says that it’s not an argument for low tax rates. He’s making moral argument that doesn’t favor
progressive taxation.
o Liberal Rights-Based Theories
Utilitarian Theories
o For redistribution
o Against redistribtution
John Rawls: A Theory of Justice
o Veil of Ignorance agreement
 Imagine you’re in a veil of ignorance and trying to establish society, but you don’t know where you’ll be in
society and don’t know your particular characteristics. You ought to think about what people would decide
if they didn’t know where they would end up (this is good way of figuring out just society).
 People will want to make sure their basic liberties are protected (right to vote, free speech, etc.). This
would matter the most.
 Distribution – doesn’t see tradeoff b/t liberties and distribution.
 Leximin: People accept inequality only if it improves the welfare of the least well off.
 This goes beyond utilitarianism. Only reason people would accept inequality would be to make
the least better off. This is so b/c it would increase work effort.
 This is widely criticized aspect of theory of justice.
o Economists’ argument: Utilitarians think that Rawls’ original analysis is correct, but result he reached is not what
people would reach in original position.
Readings on Lives of Poor People (reread readings for next class)
 “The Marriage Cure”
o Corean – lives in high-crime, poor neighborhood. What were impediments she faced in moving to better life?
 What can we do to improve the situation of people like Corean and Kim?
 “Not Poor Enough” – what would you do to improve life of Cassie?
Lotteries - Do lotteries make sense as a way of raising revenue? Is this a good idea?
 The State Lottery as an Alternative Source of Revenue
o Estimated return from various $100 wagers
 Video poker (with perfect play): $98-101
 Craps: $98
 Blackjack: $98 (higher w/counting)
 Slot machines: $92-98
 Roulette: $94
 Sports Book: $90
 The Numbers: $60
 State Lottery: $53 – BAD RETURN!
o State lottery is the worst bet you can make.
 Consider two investments: (1) Invest a dollar a day in the state lottery; or (2) invest a dollar a day in the stock market (with
8% rate of return). From age 25 until retirement at age 62:
o Stock market at 8% return: $74,000
o State lottery: $400 (not good)
 Who buys lottery tickets?
o MD: Poor spend higher in absolute amount than middle-income individuals and 4-5 times as much as a percentage
of their income. 5-10% of players account for half of sales. Top 5% of players spend over $3,000 per year.
9
One economist noted: “Low income people actually see things like lotteries as a way to make money, an investment
opportunity; higher income people view it as a form of play or entertainment.”
o Per capita sales in Georgia were twice as high in African-American neighborhoods.
o Advertising example: A billboard near Washington Boulevard, a street in one of Chicago’s poorest neighborhoods,
pitched the lottery as “How to go from Washington Boulevard to Easy Street—Play the Illinois State Lottery.”
Who benefits?
o Example: Georgia uses money for college scholarships
 In the 9th wealthiest county in Georgia, young adults receive 68 cents in educational aid for every dollar
spent in lottery tickets.
 In the 3rd poorest county, young adults receive only two cents in aid for every dollar spent on lottery
tickets.
 25% of Georgia’s population is African-American but only about 6% of the students at the University of
Georgia.
Distinction b/t should we ban something and should gov’t be encouraging it?
o Griffith: Have lottery that gives better return. Instead of using advertising revenues to promote lottery, you would
use it to limit how many lottery tickets you could buy (this sends message to society that you shouldn’t do it). Try
to reduce its negative impact on the poor.
o


Compliance and Administration
 Self-assessment system in US
 Limited assistance from IRS in filling out return
o Help line
 Even if IRS gives you faulty information, and you follow it, you’re still liable for tax owed. They may
make mistakes, but you still have to pay the tax that you owe.
o Free publications (not all on Web)
 Commercial books contain mostly the same info as in free publications.
o Will do certain calculation for you
 Pre-payment – discourages cheating on taxes
o Withholding
 Lessens motivation to cheat since money is already in hands of gov’t
o Quarterly returns
 If you’re businessperson, you submit quarterly returns.
 If you’re an employee w/side business, you can avoid quarterly returns by increasing amount for
withholding.
 Penalties:
o Civil: Negligence, fraud, and substantial underpayment (more like recklessness)
 Seldom applied except in egregious cases.
 No penalty for resolving debatable cases in your own favor.
 Interest always due on underpayments.
o Criminal: Only applied to serious intentional fraud, usually involving large amounts.
 Leaving aside moral question, being aggressive works. You could probably get away w/exaggerating the
truth.
 As attorney, it’s unethical to advise client to take positions that are clearly fraudulent.
 Likelihood of Apprehension:
o High for income subject to informational returns
o Low for most other forms of evasion
 Low audit rate
 Hard to disprove taxpayer claims
o Why is our tax system successful?
 Excellent informational returns
 US has efficient tax system
 Americans, as an ethical matter, feel a greater moral obligation to pay taxes they owe.
 Lawyer’s ethical obligation: Do not advise your client to take a tax position that would not be defensible if all the facts were
known.
 Compliance problem: given low penalties and likelihood of detection it makes sense financially to take aggtresive positions.
10


Suppose IRS writes you a letter and says they have problem with your return. They tell you how much more money they
owe in your taxes. If you don’t respond to the letter, you lose many of your procedural rights. Don’t ignore a letter from the
IRS. If you don’t respond to letter and don’t pay money, IRS can just come and take it. Make sure you protect your
procedural rights and respond to IRS letters.
Audit: Suppose you’re audited. Taxpayer may appeal within the IRS. Often disputes are settled by negotiation and
compromise. If no agreement, then IRS orders payment and taxpayer can:
o 1) Decline to pay tax and file petition for review in Tax Court.
o 2) Pay tax and sue for a refund in Federal District Court.
o 3) Pay tax and sue for a refund in the United States Court of Federal Claims.
o Which should you do? Depends on whether you want to pay tax, precedent of your claim, etc.
o Appeals process is same as in other cases.
Sources of Tax Law
For next week: Read Krugman reading, reading on lives of poor folks (what do you do to help them?), in book, Banagly case (are you
taxed on your money or salary)?
1/26/05
Sources of Tax Law
 Internal Revenue Code of 1986
 Judicial Decisions – binding authority in their jurisdictions
o District Court
o Tax Court
o Service may acquiesce (acq. or A) or may continue to challenge (nonacq. or NA) the decision\
 Acquiesce: Service has accepted its loss and won’t challenge it again.
 Nonacquiesce: service is so convinced it’s right and will challenge again.
 Treasury Regulations
o Treasury interpretations and/or delegated legislative enactments
 They explain/interpret provisions of tax code.
 If you try to go against treasury regulation, you’re highly unlikely to win.
 These regulations help substantially clarify a tax statute b/c they often contain examples.
o Notation: 1.[Code Section] for income tax regulations
 Ex: Regulation for IRC §132 is Regs. §1.132”
o Adopted after notice and comment from the public
 Committee Reports
o Example: Staff reports of the Joint Committee on Taxation (includes House Ways and Means Committee and
Senate Finance Committee members)
o These report explain the legislative history and give legislative interpretation of the law. This is collected in the
“Blue Book” (book of explanations of bills).
o Given less weight than regulations b/c what committee is saying isn’t always what is passed.
o Advantage of Committee Reports is that they come out right away (regulations take more time).
 Revenue Ruling (Rev. Rul.)
o Treasury opinions on matters of laws arising in particular factual settings
o These are different from regulations b/c treasury reports have not gone through the rule-making process; they are
simply the opinion of the treasury and are given no weight (in theory) by courts. Nevertheless, they explain what
the treasury’s position on an issue is, so they’re helpful to you to avoid fights with treasury.
o They also cover things not covered by the Regulations. So it gives you additional information as to Treasury’s
position.
 Revenue Procedures (Rev. Proc.)
o Treasury opinions regarding rights or duties of taxpayers or other matters.
 Private Letter Rulings (LTR)
o Responses to taxpayer inquiries regarding specific factual situation. Rulings are valid for requesting taxpayer only
and may not be cited for other cases (only valid for specific tax situation to which it pertains, no one else).
o You send letter to IRS describing the transaction you’re going to engage in. After giving them all information they
need, IRS issues letter, which repeats the relevant things you’re told them and the tax result of the transaction (ex:
transaction is tax-free). After doing transaction, it turns out that it wasn’t tax-free. Do you still have to pay taxes?
No. Once you have LTR, that is an absolute guarantee for you only that you will get the tax result promised in the
11
LTR. However, it’s explicitly stated in LTR that it may not be used as precedent for any purpose other than the
present transaction.
o If not citable as precedent, why look at them later on?
 They still give you insights into what IRS is thinking. There are so many LTRs that you can find
something that’s very similar to your transaction and see how IRS might respond. Since there aren’t many
tax cases, these can be useful to get idea of what IRS will do w/your transaction.
o These aren’t precedent b/c these LTRs are done by low-level employees. Don’t want to be accountable for a
mistake of a low-level employee.
o If you lie on the LTR, it’s invalid.
Practical Tax Advice – Research Tools for Tax Issues
 Tax Management Portfolios
o Bunch of paperback books on different topics of taxation. Have much more details and information than reporters
(also easy to carry).
Poor – what would you do to improve situation of low income taxpayers? (New Yorker articles)
 Marriage Cure
o Kim Henderson
 22-year old, single, telemarketing job.
 Had this job b/c she was able to get to it (had a ride); also easy job to get.
 She felt bad about bamboozling customers about overpriced security alarm systems.
 Couldn’t get job at mall
 Hard to get to mall
 Her phone was cut off b/c she couldn’t pay bill. What could she have done to get job? Used
someone else’s phone number.
 There are things that Kim could have done differently that would have led to better result. OTOH, most
people do stupid things. When they poor people make mistakes, consequences are far more devastating
than those in higher income bracket (b/c they can probably recover from it).
o Corean
For tomorrow:
What can we do as matter of gov’t policy to improve things here?
Discuss Krugman article
Economic analysis of non-cash benefits (Banaglia)
For Friday: Read § 119.
1/27/05
New Yorker articles
Ex: You’re involved w/social policy and want to do something w/law to improve situation of Kim and Corean. What social policy
changes are useful to improve situation of Kim or Corean?
 College help
o Better financial aid (even covering books and fees)
o Better guidance on how to apply for college
 Employment services
o Phone Calls
o Improved information (improving job skills, interview skills)
 Public transportation
o For Kim, bus wouldn’t pick up black people.
o Undercover people to make sure that buses stop for blacks
o Video cameras
o Ride Share program
 Subsidized phone service
 Scatter housing – living close to the city and spread throughout the town (not on the outskirts)
 Healthcare
 To implement these programs, it usually requires raising taxes, which isn’t that popular.
“Not Poor Enough”
12




Cassie Stromer (age 76)
o Medical conditions
 Neuropathy – numbness in peripheral nerves
 Depression
o Income: $9,654 per year.
 Official poverty line: $9,310 per year.
o Per Month
 $686 Social Security
 $119 Newspaper pension
o Fixed monthly expenses
 Rent: $72 (HUD subsidy)
 Electricity: $66
 Phone: $50
 Cable TV: $45
 Prescription Drugs: $328
o Remaining after fixed expenses: $230 plus $10 food stamps
She needs better health insurance.
o If you take away health problem (meaning she’s mostly covered by insurance), she would probably be OK.
Bush-Kerry debates about medical care
o Trial lawyers are driving up health insurance costs due to seeking of high damages
o Overuse of medical insurance when free – if free, people will just go when unnecessary.
 Suppose there are 2 drugs: A costs 50 cents, but is free to you; and B costs $3.00, but is free to you.
Everyone would want B.
 To solve overuse, you should have some mechanism whereby people pay a portion of the cost (high
enough so people won’t overuse it, but low enough so people won’t suffer a financial burden). For
example, charge 50 cents for B (have a co-pay).
Adding on full prescription costs for people like Cassie would require a lot of money, which requires raising taxes. Is it
worth it to raise taxes on people to provide subsidized health care insurance?
Paul Krugman Article – “For Richer”
 There’s increase in quality of wealth—wealth has become more unequal recently.
 Salary Growth
o Average salary (1998 dollars) rose about 10%, from $32,522 in 1970 to $35,864 in 1999.
o Top 1000 CEOs rose from $1.3 million to $37.5 million (in same period of time).
o 1970: CEO earned 39 times pay of average worker.
o 1999: CEO earned more than 1000 times pay of average worker
o People who have made greatest increases are people at the very, very top.
 Census Data
o 1979 to 1997 after-tax incomes of top 1% (over $230,000 in 1997) rose 157%. During the same period, the gain for
middle income families was 10%.
 Inequality
o Top 1% get 14% of the after-tax income, about the same as the bottom 40%.
 Reasons for Growing Inequality: Three Potential Theories (Krugman disagrees w/them)
o Globalization
 Idea that American blue-collar workers were losing ground in the face of competition from low-wage
workers in Asia  stagnation or decline in wages of ordinary people, w/growing share of national income
going to highly educated.
o Increased relative demand for skilled workers
 Within country, we see more of a split b/t low-skill and higher-skill jobs. Premium for being more
educated is higher now than before.
o “Superstar” hypothesis
 Modern technologies of communication often turn competition into a tournament, in which the winner is
richly rewarded, while the runners-up get far less. Less jobs for ordinary folks, but people at the top get a
whole lot more.
 Krugman hypothesis (as partial explanation)
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o

Cultural/value changes
 Back in 1970s, it was seen as inappropriate for CEO to ask for more than $3 million (CEOs choose their
own salaries), so there was a cultural self-restraint. Today, it seems to be greed unbridled as CEOs set their
salaries really high.
 In entertainment/sports world, you’re paid only what you’re worth (market determines your pay).
In contrast, for CEOs, market doesn’t determine their pay.
o Celebrity CEOs
There’s a trade-off: Inequality in free market leads to boom and economic growth, but if you have extremely high tax rates,
that will reduce motivation to work. Maybe it’s true that transfers to poor in a socialist-type system will decrease the
productivity of citizens.Is the average American “better off” than citizens of other nations b/c we are the “richest country in
the world?” Krugman articles that the cases are unclear
o The Swedish Corporation
 Swedish GDP is similar to Mississippi but:
 Higher life expectancy
 Half the infant mortality
 Longer vacations
 Still real productivity 16% lower than US, but:
 Median Swedes have standard of living similar to median American
 Bottom 10% of Swedes much better-off than bottom 10% of Americans.
 In essence, Swedes at top are doing worse than Americans; Swedes in middle are same; and
Swedes at bottom are doing better than Americans at same level.
 It’s a question of how you value the lives of different people in society.
Non-cash benefits
 Banaglia
o Manager of Royal Hawaiian Hotel received free food and lodging. Question is whether he should be taxed on FMV
on the free food and lodging for himself and his family? Court held no. Rules that determine whether you’re taxed
on food and lodging are found in § 119.
o Should he be taxed on this?
o Taxation can distort behavior and lead to inefficiency.
1/28/05
Non-cash benefits Handout
Example 1 (Alice)
1) $300 (30% of $1,000)
2) Yes.
3) Apartment is worth at least $1,000 to Alice. Worth = how much person is willing to pay for item, given his current income. Here,
Alice is willing to pay $1,000 rent for the apartment.
4) It is worth at least $700 to her, b/c that’s the after-tax cost to Alice.
 If Alice thinks apartment is worth $800, and employer pays for apartment at $1,000 value, would she take the apartment?
Yes. She’d rather have an apartment that’s worth $800 to her than taking the extra $1,000 (which becomes $700 after tax).
o If there was a tax advantage, it induces people to purchase things they wouldn’t purchase on their own. If you
didn’t buy after having tax advantage, that would lead to an inefficiency.
o If something is tax-favored, it can induce you to purchase it, even if you don’t value it equal to its market value.
5) Yes, if and only if she’s an itemizer for deductions.
6) Yes. Barring a provision in the Code to the contrary, an individual who receives property or services in exchange for their labor is
taxed on the FMV of what they receive.
Example 2
Company is buying her an annuity. She doesn’t get anything now; but 20 years later, she gets $50,000.
1) Yes. If you receive property or services in exchange for your work, you’re taxed on FMV of that property or services. She will be
taxed on $10,000 payment to insurance company.
 There’s assumption that market price of item is the value of the item, unless there’s indication of wrongdoing or self-dealing.
14

There’s problem in taxing Alice on $10,000 immediately b/c she doesn’t have the money (she doesn’t get it until year 20).
Solution is that she could reject the annuity and just demand the cash. But if she wants the annuity, she will have to pay
taxes on it.
2) Easy answer: $40,000. Tax her on $40,000 (gain she has made on the property).
 Had she bought a painting with $10,000, or was given the property worth $10,000, then she would pay tax on the $10,000
painting in year 1. In year 20, she sells it for $50,000. She’s then taxed on difference b/t what she got for painting and what
she paid for initially ($40,000).
 Suppose she put $10,000 in bank account and it built up interest over 20 years. If there was 5% interest, she would get $500
in the first year. She’d be taxed immediately on that interest, in addition to base of $10,000. Over 20 years, you’ll be taxed
each year on interest gains.
 Depending on how you construct the annuity, you can get different tax results.
 Alice will be paying a total tax of $50,000 no matter how you look at it. She could split it in year 1 and year 20, or pay
whole tax in year 20, or pay tax on $10,000 in year 1 and pay interest earned each year.
3) Yes. You should always pay tax later. By paying later, you have the use of money you would have used to pay tax, and that
money can earn interest. Delaying payment of taxes can be a useful technique to minimize taxes.
 This assumes you’ll remain in the same tax bracket in the future.
4) The growth in value is actually equal to the interest rate. You could tax her annually on increase in value of right to receive
$50,000, which is equal to the interest rate. This is assuming interest rates stay the same.
 Each year you get closer to the time that you’ll get the $50,000, the value increases.
Example 3
1) No, it’s not different. Having Unitek let her have the apartment is no different from having Unitek pay for the apartment. It costs
Unitek the same. In either case, Unitek is effectively losing $1,000 by letting Alice live in apartment tax-free.
2) Yes, unless the special rule that apply to Banaglia kick in. You’re taxed on FMV of what you receive.
3a) Yes, they are taxed on gift certificate’s value.
3b) No, they’re not taxed on outside office’s value.
 You’re not taxed on value of outside office b/c 1) it’s not seen as either property or services; and 2) even if it were
considered to be property, it turns out that special provision of tax code makes working condition fringes tax-free. So in any
event, it would be exempt.
 There seems to be unfairness to this, b/c winning associates get outside value and are paying less in taxes. Associates w/gift
certificates are taxed on $500 of gift certificate, even though they’d rather have the outside office. It’s very hard to value
intangible items.
 Pretty much everything from an employer to an employee is taxable, except for de minimis items.
Benaglia
 Benaglia was manager of Royal Hawaiian Hotel. He gets salary and also free room and board. Under contract, he’s required
to live in the Royal Hawaiian. Is he taxed on the FMV of the room and board, which provided for himself and his family?
 Court holds that no, he’s not taxed on this, b/c this is a condition of his employment. He’s not getting the room and board
b/c he enjoys it; he’s getting it b/c as hotel manager, he must work at hotel, and therefore, it’s not deemed to be
compensation.
 § 119 – established what you must do to qualify for this favorable tax treatment.
 Policy question: How much should he be taxed on the room and board?
o Suppose he was given choice of getting $10,000 salary plus room and board (he could have received $15,000). How
much should he be taxed on the room and board?
How Much Taxable Income Should Benaglia Report from the Room and Board He Receives?
1) Retail value:
$7800
 IRS argued he should be taxed on the FMV of room and board, which was $7800. They said that standard tax rule is if you
receive property/services in exchange of your labor, you are taxed on FMV of that property and services. This rule should be
applied to Benaglia.
 This rule might be good b/c it’s easy to determine what FMV is. What are some of the arguments that this is not a good idea
to tax on FMV?
o Benaglia values room and board less than the FMV. This is probably a strong argument b/c very few people choose
to live in a luxury hotel for a whole year.
 If this were the rule, what are the consequences of this rule?
15
o
Benaglia might demand a higher wage to compensate for his additional tax burdens.
 Hotel could say no to a higher wage, but problem is that everyone else might have same value for hotel as
he has.
 Likely result would be that hotel would have to pay him more to compensate him more.
o By paying Benaglia more, they will have to charge the customers more, which would lead to fewer people traveling,
less airline travel (and less money for airlines), etc. But they actually shift spending: jobs might be reduced in some
areas, but increase in other areas.
 Gov’t should try to be neutral among the two decisions—do not want to have tax policy distort peoples’
choices unless there’s good reason to distort them. Would taxing Benaglia FMV of what he receive distort
choices? Probably so. In situation where there is a good business reason for him to live in the hotel, but
the value to him is worth less than FMV, and you tax him on FMV, that will distort behavior and lead to
suboptimal results.
o Another thing that hotel could do is give Benaglia higher salary, but not give him the room and board (and give it to
paying customers). If he’s willing to take an extra $5000 in salary, hotel is willing to take that b/c they can get
$7000 to rent out room.
 But there’s problem: If it’s good for business purposes to have Benaglia at hotel and b/c it’s being taxed at
higher rate that people don’t engage in it, then that is an inefficiency.
 If taxed on full retail value (where full retail value is not worth it to Benaglia), this can distort behavior and discourage him
(manager) from living at hotel.
2) Nothing
$0
 If you don’t tax him at all on this value, and it weren’t useful for manager to live at hotel, hotels would have managers live
there anyway. Manager would rather have tax-free room and board than the higher salary (just like Alice example).
 If something can be provided tax free, there is an opposite distortion: more and more people will have managers living at
hotel for tax-free.
 If something is tax favored, they’ll give it to you, even if it’s not efficient (meaning you don’t value it at what it costs).
3) Cost of other arrangements
$3600
 You tax Benaglia on how much people in his income bracket would generally pay to find food and lodging elsewhere. Tax
on how much he’s saving by living at Royal Hawaiian.
4) Subjective value to Benaglia
??
 You could find out how much Benaglia values the food and lodging. Maybe he values it at $5,000 and tax him on $5,000.
 It turns out that if we did this, you will always get the efficient result. In a perfect world, this is what you would want to do.
Taxing on subjective value always leads to the correct result.
 But problem is: how do we know what the subjective value is?
o If asked, Benaglia has strong motivation to lie about his subjective value of living at hotel (and underestimate
value).
 It still isn’t stupid and irrelevant b/c our goal should be to try to estimate what the subjective value is. How much money he
saved by living there might be a reasonable marker as estimate of how much he subjectively values living at hotel.
o To estimate his subjective value, you could look at cost of other arrangements as good estimate. Problem with this
is that it’s not easy to determine either, but courts do this all the time.
5) Cost to hotel
??
 If hotel could fill room every night, it would cost $7,000-8,000, but reality is they won’t fill it out every night. So you have
to figure out what hotel’s loss revenue is. This might be something that you could calculate, and could help estimate
subjective value to Benaglia.
Summary
 Unless there’s some good reason to distort behavior, you don’t want to see tax rules shifting peoples’ behavior.
 If something is taxed favored than something else, then this will shift peoples’ behavior toward tax-favored activity. Vice
versa is true as well. These types of distortions can cause inefficiencies.
 The higher the tax rates, the more the inefficiencies, and people are likely to shift their behavior.
IRC § 119 – Taxation of food and lodging
 After Benaglia, Congress decided to set up rules under which employer providing food and/or lodging would not be taxed.
 Excludes meals and lodging provided to the taxpayer or spouse and dependants if:
o Meals and lodging were furnished by or on behalf of employer
o For convenience of employer
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
Meals
o
o
o
o

Must be furnished on the business premises.
 Ex: If cafeteria is located in law offices, it meets requirement. But if cafeteria is on 1st floor of office
building where law offices are, it’s not on the business premises and doesn’t meet requirement.
 Ex: Police officer on duty. He can eat anywhere in the district and will be reimbursed for cost of his meals.
Is this tax-free?
 One court decided for police officer, but most courts say it’s not tax-free. Problem is that the
meal was not provided by the employer.
 If you were policeman’s employer, you could require them to eat at certain restaurants, and have
contract w/those restaurants so police officers would have to eat there. This is argument that
meals were provided by employer and on business premises (they’re w/in the district) and for
convenience of employer b/c you don’t want police officer to ignore his duties.
 Ex: Police officer on stakeout, and calls in pizza delivery. Is this taxable?
 This is not taxable, under other rules. On stakeout, it doesn’t matter who provides food; it’s taxfree. It’s a business necessity.
 These rules here deal w/situation where employees are generally provided w/meals.
Employer must have a good business reason for providing the food rather than a compensatory reason. It would be
useful for the business to keep the people around (convenience of employer).
 Good reasons include:
 Need for employees for emergencies
o Ex: Military. During war, you need to be ready for emergencies at any time.
o Ex: Firefighter. Never know when fires will occur, so you have to eat on firehouse
premises.
 Short lunch is required - There has to be some reason for the short lunch.
o Ex: Bank employees. Busiest time for bank is during lunch hour, when most people
come in. If bank decided to give employees 15-min lunches and set up catering in the
back, this would be OK.
 Argument for good business reason is undermined if you allow employees to go elsewhere to eat.
 There’s also no requirement that employees eat the meal.
No exclusion for meals on non-working days
Special rule for restaurants: Food may be served before and after work, even if the above conditions are not met.
 If you work for a restaurant, it can give you a free meal. It only has to be provided by the meal, but there
doesn’t have to be a good business reason for the meal.
 They have this special rule b/c of tradition to give employees of restaurant a free meal. Taxing them would
lead to outrage.
Lodging
o Must be a condition of employment; typically you must be on duty at all times
o Must be on the premises of the employer
For next week: Finish § 119, read pp. 49-62, and read examples and explanations of fringe benefits
2/2/05
§ 119 Continued
 If no one is going to report such small things (like meals on days off), why have the rule in the first place?
o It’s basically a tax on really honest people.
o If you don’t have this rule, firehouses can advertise meals 7 days a week as a gov’t benefit, which can potentially
lead to abuse. IRS doesn’t want widespread, blatant abuse that could undermine the tax system.
 Lodging – to get lodging tax free, you:
o Must be a condition of employment; typically you must be on duty at all times (24-7).
o Must be on the premises of the employer
 Suppose you work at Disney World (specifically in the Magic Kingdom) You stay for free in a hotel that’s
not part of the Magic Kingdom, but still at Disney World. Is this tax free?
 Probably on the premises (within Disney World). But you need good business reason for why
you have to be there (typically, have to be on duty all the time).
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Little/Miscellaneous Rules
 Firefighters
o Suppose you’re required to have meal in fire house and not allowed to eat anywhere other than firehouse. Suppose
you also have right to bring your own lunch. Some people bring own lunch; others take free meal. Are the people
who eat free meal taxed on value of free meal?
 No, mere fact you have choice whether to eat free meal or not will not make the meal taxable.
o Suppose you have choice of having free meal at firehouse, or eating at your own expense at a restaurant located
across the street from firehouse. Are people who eat free meal taxed on value of free meal?
 Yes, they are taxed on free meal’s value b/c if it’s possible to go across the street to eat, that suggests no
good business reason for requiring firefighters to eat at firehouse.
 The moment you don’t require people to eat at firehouse undermines the notion that there’s good business
reason to make the meal tax-free.
o Suppose there’s good business reason to eat at firehouse and you can either eat free meal or bring own lunch. If you
eat at firehouse, the meal’s free. If you choose to bring meal from home, firehouse will give you extra $15 in salary.
 Are the people who bring meals from home taxed on the $15 they get each week?
 Yes, they are. There’s no rule that excludes that $15.
 Are the people who get the free meal at firehouse taxed on the meal?
 Yes, they are taxed on value of firehouse meal. By allowing some people to get money rather
than the meal, it means that everyone is taxed, even those who don’t take the money.
 If you want to qualify for tax-free treatment under § 119, don’t give people choice of free meal or
cash. Require the meal.
 If a tax benefit is normally tax-free and have the choice of getting that tax benefit or money
instead, then you’re usually taxed on whatever you choose. Choice of cash makes tax-free benefit
no longer tax-free.
o Similar to Constructive Receipt (later in course)
 Free meals for police officers
o If city requires officers to eat within district and reimburse them for meals, then it’s not tax free.
o If city had made contracts with restaurants to provide officers w/meals in kind, that might be tax-free.
 There are circumstances where police officer could get reimbursed for meals and not be taxed under
different rules (ex: stakeout).
 Law Firm/Associates
o Suppose firm has food cart that comes to each office to provide meals at their desks. Firm says this is full-service
firm which requires lawyers to be available on the spot.
 Meals are probably not tax-free to associates.
 Meals were provided by or on behalf of employer; were on business premises, but is there a good
business reason?
 How similar is lawyer to firefighter in the sense that they need to be on call at any moment?
Probably not strong analogy.
o The fact that lawyers can go out to lunch suggests there’s no business necessity to have
them eat at their desk.
o Suppose you’re in panic mode and working through lunch. Is this tax-free? Yes, but not under § 119. Different
rule allows you to deduct expenses if it’s a business necessity.
Efficiency Costs of Taxation: An Example
 Deadweight Loss (or Inefficiency): In general, a deadweight loss occurs when a tax causes an individual to change her
behavior.
 Look at example on handout
o Consumer surplus (difference b/t what you value something at and how much you actually pay for it).
 You never have a negative consumer surplus – if it costs more than it’s worth to you, you won’t buy it.
o In the tax world, Alice is worse off by $400. Gov’t is no better off than it if had not passed the tax b/c Alice avoids
it by changing her behavior (buying the red car instead of the blue car).
o Inefficiency is caused here by Alice making herself worse off (having consumer surplus of $600 instead of $1000)
and gov’t isn’t better off.
 Inefficiency – by changing behavior, taxpayer is made worse off.
o If tax rates don’t change your behavior, then it isn’t an inefficiency.
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
Determining inefficiency (tangential point)
o Substitution Effect – higher tax rate will make you work less b/c you’ll get less after taxes.
o Income Effect – the poorer you are, the harder you’ll work.
 As you raise taxes, you work less b/c of substitution effect and more b/c of income effect.
o In determining inefficiency, you look only at substitution effect. Income effect is not an efficiency concern. In
standard economic analysis, we only care about person’s marginal decision—will I work that extra hour?
 At basic level, the higher tax rates always cause an inefficiency b/c there will be some people who will change their behavior
as a result of higher tax rates.
o So you want to look at how many people change their behavior. If not many people, then inefficiency is small. If
lots of people change behavior, then inefficiency is great.
 Economic studies say:
o For men (18-55), higher tax rates seem to have little change of behavior. When you look at just inefficiency effect
(by looking at substitution effect), effect is very small.
o For single females (18-55), they’re fairly resistant to change of behavior (not quite as much as men).
o For married females or in relationship (18-55), higher tax rates seem to have large change of behavior (3 times the
rate of males).
 Older married females change their behavior even more.
o Culture seems to force men to work no matter what. Married women w/kids tend to have more expenses (daycare,
etc.) that it’s almost not worth it to go to work.
2/3/05
How are you taxed if law firm is corporation? Individuals v. Partnerships v. Corporations
 Individual Proprietorship
o Pay regular income tax rate. Fill out Form 1040 as normal. Mostly the same as if you were an employee.
 Partnership
o P-ship is group of 2 or more people that form an activity designed to make money.
o P-ship fills out a tax return, but the profits/losses are allocated to the partners. P-ship itself pays no tax. It’s a “passthrough” tax (entity itself pays no tax, but instead the profits/losses are “passed through” to the partners).
 Corporation
o C Corporations (rules contained with subchapter C of Code).
 Most corporations are C Corporations.
 They have a separate corporate tax at its own tax rate. Basic principles of this course determine how
corporation calculates its tax.
 What’s different: Money of corporation is taxed. Then when the money is distributed to its shareholders,
the money is taxed again at a lower rate in the form of a dividend.
 Under Bush, dividend is taxed at a lower rate to try to avoid double taxes. Most experts think this
is a good idea.
o In theory, most economists would like to tax corporations just like p-ships. In practice,
you can’t do that, so they say tax dividends at lower rate b/c we don’t want tax rates to
change behavior and lead to inefficiency.
o Criticism of Bush dividend policy is that it applies to old capital. Some economists says
that if we lower dividends, we’re giving one-time windfall to old capital, and does
nothing to help efficiency.
 If we tax corporations and p-ships at exact same rate, people will make decision
to form either one based on what’s best for them—that’s a good thing.
 If we give a tax break to current shareholders of existing corporations, we
have done nothing to change their future behavior. We’re just giving them
a one-time bonus (one-time windfall gain) to current shareholders.
Criticism isn’t that it creates inefficiency; it just doesn’t create any more
efficiency.
 Counterargument to this is “so what?” It’s easier than more complicated tax
scheme.
o In the long run, we want p-ships and corporations taxed at the same rate (for new
capital).
 Old capital v. new capital
 The value of your stock is based upon the projected future income flow from that stock.
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o

Suppose stock is worth $100 and is paying you $8/year in taxable dividends. Instead of
being taxed at 30%, it’s now taxed at 10%. Now, it’s worth more to you. This is a onetime windfall to current owners of shares (helps owners of old capital). But the dividend
reduction doesn’t help new buyers.
o If a new person buys stock from old person, they’re not getting a single benefit from
dividend relief b/c the value of the stock goes up. The tax advantage of dividend cut
flows entirely to the owners of old capital, b/c owners of new capital will have to pay
higher amount to buy the shares, which completely offsets the tax advantage that Bush
has given.
 Arguments for Bush:
o Suppose Mary wants to start a new business w/$10,000 start-up money. Should she
choose p-ship or corporation? To avoid double corporate tax, she distorts her behavior
and creates p-ship. So, this is bad for economy. Bush says that his dividend cuts makes
decision for Mary more neutral (creating level playing field for Mary’s decision b/t pship and corporation), and that will help economy out.
o Suppose GM is considering issuing new stock and bringing in new donations. Should
Mary buy newly issued stock (that would increase capitalization of GM) or stock from an
old investor in GM?
 With respect to new capital, it has a positive efficient effect, and doesn’t help
the rich b/c Mary is going to invest her money somewhere anyway.
 Negative distributional effect is entirely from one-time bonus to current holders of capital.
o Suppose we have law firm that’s a private corporation. How are they taxed?
 They’re taxed as ordinary income. They’re S Corporations (or limited liability companies). If you’re a S
Corporation, you’re basically taxed the same as a p-ship. They don’t get double tax, nor do they get
benefit of lower rates of dividends.
Sunset Clauses – provisions where tax provision will be automatically eliminated after certain number of years.
o Reasons for sunset clauses
 (1) Cannot get the provisions passed w/o sunset clauses
 (2) Mislead the public w/revenue estimates (assuming the sunset clause expires instead of being waived).
o When do sunset clauses make sense?
 If country is going through temporary recession, you might want a 1-year tax cut to alleviate the recession
and generate revenue.
 If you have a provision that you need to pass rapidly, but you’re worried at the time it might not be the
right thing (ex: Patriot Act in light of 9/11, but not knowing if this might lead to greater abuse of power by
gov’t).
Social Security – Bush’s State of the Union Speech
 Do we need private accounts for our SS? Private accounts are the equivalent of 401(k)s.
o Private accounts may be a good idea; it depends.
o Private accounts have next to nothing to do with SS crisis (potential shortfall of SS). It may or may not be a good
idea to privatize SS.
2/4/05
Efficient Taxation That Changes Behavior (see handout)
 The behavior is undesirable b/c it produced a negative externality.
o In other words, negative externality is behavior that hurts a third party.
o Ex: Smoking hurts a third party in form of second-hand smoke. Price of cigarettes doesn’t reflect social harm that
cigarettes cause third party in form of second-hand smoke. Even if very few people die from second-hand smoke,
lots of people are simply bothered by second-hand smoke.
 This is justification for using excise taxes on such “sins,” like smoking and alcohol.
o Standard economic analysis suggests that a tax set in the amount of the negative externality will improve efficiency.
Taxation as a tool to make activities pay for their true social costs is a powerful tool.
o These penalty taxes hurt the poor more than the rich b/c they pay out a higher percentage of their income for these
goods (alcohol, cigarettes, etc.).
o Bottom line: It is the right thing to do for efficiency to require all activities to bear their true costs.
 More controversially, the behavior is undesirable b/c the individual will not act in her own best interest w/o the tax.
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o
o
This is “paternalism.” Paternalism isn’t necessarily bad. Maybe it’s good for society to tell people what’s best for
them.
Ex: Smoking may not be in the enlightened self-interest of the smoker.
 It’s probably true that most smokers would be happier if they could kick the habit. They probably started
smoking when they were young. You could make argument that if you put high tax on cigarettes, people
won’t become addicted when they’re young, and we’re protecting them.
 If cigarettes cost too much, kids would rather spend their money on something else (movies,
CDs).
 Libertarians wouldn’t like this position b/c they believe in people being free to do whatever they want (but
they could accept the first argument—negative externality).
BUSH SOCIAL SECURITY PLAN
401(k) (Qualified Pension Plans)
 Tax Treatment
o Employer can deduct contributions at the time of contribution.
o Employee is not taxed on amounts contributed by employer until those amounts are withdrawn.
o Employee is not taxed on the interest or other gains (inside buildup) on amounts invested in the pension plan until
withdrawal.
o Amounts withdrawn from the pension plan are taxed to the employee as ordinary income at the time of withdrawal.
 [EXAMPLE] USC Professor with $100,000 salary. He agrees to put away 5% of his salary into 401(k), and USC agrees to
contribute 10% (double matches your investment). So, he will have pay of $95,000 before taxes, and $15,000 going into
payment plan. How is he taxed?
o If USC were a taxable entity, it would deduct the entire gift to employee ($100,000 + $10,000). Employer gets
deduction of $110,000.
o Employee is taxed on $95,000. Amount employee contributes to pension plan is not taxed, nor is the amount
employer puts into pension plan.
o The $15,000 in qualified pension plan will be invested (bonds, stocks, or real estate trust). Suppose there’s 5%
return. In first year, you would get $750. All increase in your pension plan is not taxed at all, as long as it remains
in your plan.
o After you retire, the amount you take out of your pension plan is fully taxed.
o This is favorable to taxpayers. You will end up w/much more money saving it this way than if you received
everything and set aside $15,000 yourself.
 Calculating the Benefits of Qualified Pension Plans: An Example (see handout)
o Larry example
 Tax advantages of investing in qualified pension plan over investing w/o any tax deferral are almost 2 to 1.
 This is best investment you can make (if you’re being matched by your employer).
 Types of Plans
o Defined Benefit
 Promises specified benefits, typically in the form of a monthly retirement pension based on levels of
compensation and years of services.
 Ex: Public school teachers. You put money into your account; employer is putting money into an account
for all its employees. Employees get a “defined benefit” from this big account upon retirement.
 For example, they get 2% of average best 5-year salary for each year worked. If you work 30
years, you get 60%. They then look at 5 highest yearly salaries, which average $60,000/year.
After retirement, you get a pension of 60% of $60,000/year, or $36,000/year, or $3000/month.
 Advantages: Very attractive b/c you know how much you’re going to get at retirement. It’s very secure
(don’t have to worry about whether investments will do well or poorly). Unlikely to be in poverty b/c
you’re getting 60% of your salary. He’s taxed on full $36,000/year when he receives it after retirement.
 Disadvantages: They can be over- or under-funded. Depending on stock market (doing really well or
really bad), employers might over or underfund the account (due to excess or lack of funds to fund
account).
o Defined Contribution
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
The employer promises a specific contribution for each employee (usually expressed as a percentage of
compensation). Contributions typically are invested in stocks, bonds, mutual funds, etc. Retirement
benefits, therefore, will depend on the return to those investments.
 Employees decide how to invest the account. They can play it safe or risky. You should buy
index funds (b/c most people can’t pick stocks).
Majority of new plans are defined contribution b/c you don’t have to worry about problem of under- or
over-funding.
Social Security (Nightline Video)
 Bottom line: Only solution to solve SS problem is to (1) raise taxes, (2) cut benefits, or (3) borrow trillions of dollars to fund
private, individual accounts.
 Peter Orszag (Brookings Institute); Robert Bixby (Concord Coalition)
 Social Security v. Medicare
o Medicare is in crisis b/c medical costs are rapidly rising. Koppel doesn’t want to discuss Medicare problem; just at
SS.
 Funding Social Security: 12.4% of wages up to $90,000.
 Where it goes today:
o About 75% pays current beneficiaries
o The rest purchases gov’t bonds which are held in trust for payments in the future.
o Side note: In calculating the current federal deficit, the money borrowed from SS doesn’t “count.” This, arguably,
means that current federal deficits are seriously understated.
 Iceberg looming in the future if nothing is done
o 2018: Payroll taxes will not cover payments to current beneficiaries. But such taxes plus the interest on the
government bonds held by the trust fund will.
o Several years after 2018: Taxes plus interest on bond won’t cover payments to current beneficiaries, so SS trust
fund will need to sell some of the bonds to cover payments.
o 2042: Payroll taxes will not cover payments and SS trust fund will have already sold all its bonds. Thus SS will not
be able to cover promised payments.
 Will SS be bankrupt in 2042 if nothing is done?
o No. However, it will be able to cover only what is put in.
 You still get something (not nothing).
 Griffith: If we do something (raise taxes or cut benefits) now, the problem will not be as big as it will be by 2042. Early
action (raising taxes or cutting benefits) is the best solution.
o Argument for doing something now is that you can do something much less drastic than what you would have to do
in future. So we should raise taxes somewhat today and cut benefits somewhat today.
 Bush’s private accounts plan
o Bush genuinely believes private accounts are good, but he knows that private accounts do little or nothing to solve
the problem.
o Politically, he knows that private account are more sellable than cutting benefits (so he hopes to shift focus away
from cutting benefits to private accounts).
o Private accounts may be a good thing, but they can’t solve the SS problem.


What is the unfunded liability of the Social Security system?
o President Bush: $10.4 trillion—the present value of the shortfall over an infinite horizon.
o Peter Orszag: $3.7 trillion over the next 75 years.
o But is either number relevant?
o Compare to calculating the cost of the 2001 tax cut.
Personal Retirement Accounts
o How do they compare to 401(k) accounts?
 Structurally, they’ll be just like 401(k) accounts.
 Suppose taxpayer pays $4000 into SS system. Bush proposes that taxpayer should be able to take
modest portion (say 20%) and put it in private account. So $3200 in SS; $800 in private account.
Fight right now is whether you should have this choice.
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o
o
o
o
If private accounts passed, most people will probably choose private accounts b/c they’re scared
of SS crisis. If so, then gov’t has $800 less in money coming in, and very quickly, gov’t doesn’t
have money to pay the beneficiaries.
 Bush says that he’ll borrow that money ($1-2 trillion). This is good b/c in the long run, you’ll be
decreasing the benefits that are paid out b/c people are putting in less money to begin with. This
argument is mostly true. Borrowing money now doesn’t put us in worse position than if we
didn’t.
 OTOH, this means that we’re currently borrowing more money (so on the books, it looks bad),
making the deficit even bigger. This alone shouldn’t be a reason not to borrow money (as a matter
of practicality).
Do such accounts solve the shortfall? No (see above)
What is the “cash flow” problem w/such accounts? Is the problem serious?
 Need to borrow money now, but it’s not that serious (as a matter of practicality).
Are they a good idea?
 Private accounts do not solve SS problem, but are they still a good idea?
 Democrats believe richer should put in more money. Democrats believe stock market is too risky.
 Republicans believe people should get what they put in. They also believe that stock market will do better
than SS system that even the poor will do better, in addition to the rich.
 David Brooks: Fundamental/philosophical difference b/t Democrats and Republicans
 Republicans—want a floor so that private accounts don’t wipe out the system. It will give people
a feeling of ownership and investments will do better in the long run.
Argument that private accounts could help African-Americans more (b/c they die younger than whites).
2/9/05
Solving the Shortfall
 Decreasing benefits
o Change from wage base escalator to inflation escalator.
 Debate is whether SS benefits should go up each year to account for inflation or wage-based escalation.
 Inflation-based escalation – generally speaking, price of goods goes up over time. If we increase
SS benefits to account for inflation, the buying power of recipients of SS benefits would remain
unchanged. If this was our goal to keep buying power the same in 2042 as today, then we would
want to adjust the benefits for inflation. That means there is no drop in standard of living when
they retire, but in 2042, what is considered normal is much higher than it is today. They will be
much worse off in comparison to the rest of society. But we don’t do it that way.
 Wage-based escalation – in most years, workers as a whole become more productive, so wages go
up faster than inflation, in general. For example, wages go up 2.5% a year, and inflation goes up
2.0%. Over twenty years, people are better off at higher living standard. That means that people
receiving SS benefits are getting higher standard of living when they retire. So SS will continue
to provide to average worker 35% of their average wages they got when they were working. So as
inflation rises, they’ll get more money to keep up with inflation.
o If we adopted inflation-based, then they would only get 20% of their average wages prior
to retirement.
 If our goal of SS to ensure that workers don’t live in abject poverty, then inflation-based
escalation is OK. If our goal of SS is to ensure people live a reasonable standard in the future as
compared to what you had before, then wage-based escalation is OK.
 There are arguments on both sides.
 Real benefits would remain at current level.
 Retirement income would replace a much smaller portion of working wages.
 Current level: 33-35%. Year 2045 level: 20%.
o Raise retirement age and/or reduce benefits more sharply for early retirement.
 TANGENT: When you and your spouse die, there is no residual benefit to your kids (under SS). Under
personal accounts, money is passed on to kids.
 Griffith: Says this is a minus b/c the more money you pass on to kids, the less money to give to
peoples’ pension.
o Phase out benefits for the wealthy elderly.
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

Griffith: This is terrible idea b/c in countries where this has happened, SS turns into a welfare system and is
stigmatizing to people. When it becomes a needs-based system, it dramatically changes the way people
think about the system.
 It would also cut middle class peoples’ incentives to save.
o Tax benefits at 100% of normal rates (rather than 85%)
 Griffith: This is a good idea b/c it reduces complexity.
o Bottom Line: Big issues are the first two suggestions to decrease benefits.
 W/o understanding what impact of decreasing benefits is, then it’s hard to adjust taxes.
 If we change from wage-based to inflation-based escalation, and that’s fine, then problem is
solved.
 If that’s not OK with you, then you have to raise revenue.
Increasing revenue
o Raise the payroll tax rate.
 If you raise by 2 % points from 12.4 to 14.4%, then that would solve the problem.
o Raise the payroll tax base.
 Today, people are taxed on their wages up to $90,000. So that means 85% of all wages get taxed. You
could have a modest increase in the wage base over a period of time. This would bring it to same level in
the past, where 90% of wages were getting taxed. This modest increase raises a lot of money.
 If you tax people on their entire wages, then that wouldn’t fly b/c that would repeal all of Bush’s tax cuts
and have a tax increase of over 6 percentage points. That would be largest tax increase on wealthy in
history.
o Fund with general revenues.
The Bush Administration’s position
o Flexible, but President Bush rejects either raising social security tax rate or reducing benefits for individuals who
are now age 55 or older.
How well would your private account have to do to beat the return you’re getting from SS?
 Right now, SS has a 3-3.5% return. The expected return on a safe, secure, diversified mix of stocks and bonds in a private
account is 1 % point higher.
o Bush argues that this is a win-win situation. By getting an effective rate of return of 4.5%, you’ll be better off at no
cost to the gov’t.
o There are two arguments against this:
 1) The fact that this is the best projection means you’re taking a higher level of risk. When stock market
doesn’t do well (such as in Britain), it’s been a disaster. We shouldn’t let people bear this risk.
 2) Suppose investments in stock market have higher expected return than investments by gov’t. If this is
true, gov’t should just invest in the stock market. But counterargument is that it’s unseemly for gov’t to do
this, whereas it’s OK for individuals to do so.
2/10/05
SS Continued
 If you were divorced after 10 or more years of marriage, you get full SS benefits. If married for less than 10 years, you get
nothing.
§ 132 Fringe Benefits
 § 61, which contains basic definition of income, states that income includes property or money you get from any source
derived. Basic principle is that anything you get is taxable. But there are rules that are exceptions to this general rule.
Non-Cash Fringe Benefits: Exclusions from gross income
 § 132(a) provides that gross income shall not include aty fringe benefit which qualifies as a:
o (1) no-additional-cost service
o (2) qualified employee discount
o (3) working condition fringe
o (4) de minimis fringe
o (5) qualified transportation fringe, or
o (6) qualified moving expense reimbursement.
 § 132(b). No-additional-cost service defined.
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o
o
Any service provided by an employer for use by such employee if:
 (1) Such service is offered for sale to customers in the ordinary course of the line of business of the
employer in which the employer is performing services; and
 Ex: If you work in bowling alley, business can provide you w/free bowling.
 Ex: If you work in bowling alley, which also owns in a separate building a skeet shooting range,
can you do skeet shooting for free? Probably not.
 Ex: In bowling alley, there’s adjacent pool hall. Can you play pool for free? If it’s in same
building, it’s probably in same line of business.
 (2) The employer incurs no substantial additional cost (including foregone revenue) in providing such
service to the employee (determined w/o regard to any amount paid by the employee for such service).
 Examples: Extra airline seats, telephone service, empty movie seats, use of a golf course during
non-peak hours.
 Ex: Suppose you work for airline and airline has rule that you can fly for free on airline on
standby basis. This satisfies the rule b/c (1) it’s service in line of business you’re working for; and
(2) you’re flying on standby so they’re not losing any business when you fly.
o Suppose you got a reserved seat instead of flying standby. This could not be offered taxfree b/c now airline would be losing money.
 Ex: You work for phone company and lets you talk to anyone for free. This doesn’t really cost
company any money.
 Ex: Empty movie seats. If seats are empty anyway, then no problem.
 Ex: If airline allows you to fly anytime you want, they can legally do that, but you’ll be taxed for
it if it doesn’t meet the requirements here.
 (3) Nondiscrimination rules must be followed. This means that the service must be provided to all (or
most) employees, not just to managers or highly compensated employees. It is permitted to discriminate
against highly compensated employees.
 Any other discrimination based on how long you’ve been at business doesn’t count for these rules.
Only level of employment counts.
 Basic idea: you cannot discriminate in favor of highly compensated employees and managers.
That doesn’t mean you have to provide to every single employee, but you must provide to at least
the vast majority of employees.
 This rule doesn’t necessarily apply to other non-fringe benefits.
 (4) For purposes of § 132, employee includes a current employee, retired or disabled employee, the widow
or widower of the employee and the spouse and dependent child of the employee.
 Ex: Gay marriages and partnerships. These aren’t covered by federal law, in general. Though
many companies provide benefits for gay partners, will IRS go after these benefits to be taxed?
o These would be reported by the employee, but important issue for the next few years.
Tax law doesn’t conform to companies that provide benefits to domestic partners.
 (5) Reciprocal agreements: Any service provided by an employer to an employee of another employer
shall be tax-free if:
 a) It is under a reciprocal agreement and all the employees are in the same line as the service they
use.
 b) Neither employer incurs a substantial additional cost in the provision of the service.
 Example: Standby airline flights on airlines other than that of the employee.
o Suppose you work for 1 airline; can they give you a free flight on another airline? Yes, if
they have this reciprocal agreement and neither airline incurs a substantial additional
cost.
 Ex: You work at a 20-screen multiplex theater. Another works at a small independent movie
theater. Both theaters have reciprocal agreement that employees can go to both theaters.
Policy rationales of no-additional-cost services rule.
 1) Encourage employers to provide such services, otherwise service would be economic waste and not go
into use.
 Ex: Owner of pool hall and employees want to play pool. Imagine that pool tables aren’t full.
Having pool table just sit there and not be enjoyed by anyone is economic waste. Allowing
employees to play pool for tax-free prevents economic waste.
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2) Tradition of adminsterability. Who really reports employee use of employer’s services? No one. It’s
better to pass a rule that allows this. Can’t force the contrary rule anyway, so why penalize the tiny
number of honest taxpayers who would report it.
 Allowing this rule doesn’t undermine the structure of the tax system.
 Providing this benefit isn’t worth so much to employees that it will reduce their pay dramatically
in ways that cut the tax base.
o Provide we had rule that allowed employers to provide any service tax-free. If so, major
corporation with lots of different services could give employees so many tax-free
services, and that would undermine tax system.
o But this rule doesn’t abuse tax system.
o Trivial Aspects of this rule
 1) Relatively modest additional costs still get advantage of this rule.
 Suppose airline says that it has a delicious meal and employee gets it for free after flying standby.
Though airline has paid a little extra to provide this delicious meal, this won’t waive the tax-free
benefit of the statute.
 2) If costs to company are not trivial, that would be a substantial additional cost, and thus the statute
doesn’t apply.
 Suppose you work at skeet shooting range. What are costs associated with this? Ammunition,
clay target, electricity, fixed costs (maintaining range, etc.). Suppose the cost of the clay targets is
a significant portion of the variable costs. Would this be a substantial additional cost? Yes.
 3) If employees have to pay for any aspect of service, then they lose the tax-free protection.
 Suppose that costs of ammunition aren’t cheap. Company says they will let employees use
services, but they have to pay for targets and ammunition. Can they provide this service tax-free?
o No, b/c statute says that employer must not incur substantial additional cost “determined
w/o regard to any amount paid by the employee for such service.”
o This is an all-or-nothing tax provision.
 Suppose skeet shooting range wants to provide this service to employees tax free. What can they
do to accomplish this?
o You would tell employee that employer will provide employee with free use of facility
and devices to throw target, but not provide ammunition and clay targets (employee must
provide its own).
o Difference here is that if you reimburse employees for the price, you’ll be taxed. But if
employee provides its own ammunition and targets, IRS might try to argue that it’s really
like paying for it, but employee will probably win anyway b/c they define the service as
just using the facility and using machine to shoot targets (not providing ammunition and
targets).
 4) What is considered the line of business?
 Suppose you work in dept. store and you work at perfume counter. You can probably get another
service of the dept. store for free.
§ 132(c). Qualified employee discount defined.
o This rule allows store employee to get discount and not be taxed on it.
o Any employee discount with respect to qualified property ot services to the extent such discount does not exceed:
 1) in the case of property: the gross profit percentage of the price at which the property is being offered for
sale to customers
GPP = (ASP – ACOGS) / ASP
 ASP = aggregate sales price
 ACOGS = aggregate cost of goods sold
 This formula provides for largest discount store can give you tax-free.
 Suppose you work at store and you buy items that cost $100, and store can give you 40%
discount. This is largest discount the sore can give you tax free.
 Does this suggest that store can sell employees goods at cost?
o In general, that is true, but that’s not exactly the rule.
o These numbers are calculated not on good by good basis, but on basis of overall sale.
This rule says that you look at each individual item individually at cost; it just looks at
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the aggregate sales and goods and see what the general markup is in general (not
individually).
 Issues to consider:
o Do you take goods by the entire store or divide it up by each department?
 Designer clothes v. electronic equipment. Which has higher markup? Designer
clothes have higher markup b/c it costs more to sell clothing.
 It’s very expensive to sell clothing b/c of how many people try things
on, returns, security costs, clothes get damages when tried on, etc.
 For electronics, no one wants to try on DVD players, etc.
 Prices of clothing have to be kept up, otherwise firms would go bankrupt.
2/11/05
 2) in the case of services: a 20% discount.
 Ex: Golf lessons. You can get 20% discount, but anything more than that would be taxable b/c
lessons are services.
 3) Qualified property or services are those property or services ordinarily offered in the line of business in
which the employee works, but not real estate or investment property.
 4) Nondiscrimination rules apply.
§ 132(d). Working condition fringe defined.
o Any property or service provided to an employee of the employer to the extent that, if the employee paid for such
property or services, such payment would be allowable as a deduction under § 162 (trade or business expense) or §
167 (depreciation).
 If what your employer is providing you is something related to your job and is considered a valid business
expense, then you’re not taxed on it.
 This is a very broad provision – covers anything employer buys for you that is business-related.
 Ex: USC purchases computer for professor; is professor taxed on value of computer? No, b/c if
professor were running his own law school and bought computer, he wouldn’t be taxed on the
computer (it’s a valid business expense).
 Ex: Firm buys lawyer a super Palm pilot. This is tax-free too.
 Ex: Firm flies you to NYC to take a deposition. This is tax-free.
 Ex: USC gives professors a $5,000 room redecoration budget. This is tax-free, b/c it’s a working
condition fringe. IRS doesn’t interfere w/judgment call of whether old desk and chair were fine.
 Ex: Griffith wants a plasma TV with surround system system for his office (to preview his videos
for class). This is also a tax-free, working condition fringe, as long as it’s not totally ridiculous.
All you have to show is a plausible connection to work.
o Nondiscrimination rules do not apply.
 People who are more highly paid than others may have different jobs and needs, so the nondiscrimination
rules don’t apply.
o Suppose school doesn’t supply these items to professor, but professor buys them himself.
 Ex: Griffith buys magazine The Economist. Can he deduct the cost of the magazine? Yes, but in practice,
the deduction is probably not worth it to him. These deductions only apply if you itemize and get past 2%
floor.
o Suppose you own your own business, you can deduct all your business-related expenses. 2% floor only applies to
employees.
o So, if something can’t be classified as one type of fringe, you could try to categorize it as something else (such as a
working condition fringe).
 Skeet shooter example. Skeet shooter couldn’t get deduction on basis of no-additional-cost fringe for
targets, but he might get it for working condition fringe (by needing to be a better shooter to demonstrate
shooting to customers).
 Worker at golf course example. Working at golf course, you have to be a better golfer to demonstrate
swings to someone else, so you could also classify this as a working condition fringe, even if you couldn’t
do it as an qualified employee discount.
§ 132(e). De Minimis Fringe defined.
o 1) Any product or service the value of which is (after taking into account the frequency with which similar fringes
are provided by the employer to its employees) so small as to make accounting for it unreasonable or
administratively impracticable.
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Examples: Free donuts, cokes, and coffee. Occasional personal use of copiers and computers.
Ex: Late evening meals at firm.
 These don’t qualify under § 119. Also wouldn’t qualify as working condition fringe (unless it
was emergency).
 It may be tax free under de minimis fringe, as long as you’re not working late at firm every night.
 If firm gives you $40 for meal, but you just spend $5, you must report the other $35. So might as
well spend the money.
 Nondiscrimination rules do not apply.
 New attorneys can get fresh pastries, while mailroom staff can get stale cookies. That’s OK.
o 2) Special rule for certain eating facilities.
 An eating facility for employees shall be treated as a de minimis fringe if:
 a) Such facility is located on or near the business premises of the employer, and
 b) Revenue from the facility normally equals or exceeds the direct operating cost of such facility.
 c) Highly-compensated employees can benefit from this provision only if the eating facility is
offered on a nondiscriminatory basis.
 Ex: Hospital or studio canteen. Hamburger is $1, when it normally is $2.50. Can’t qualify as employee
discount b/c they’re not in business of selling food.
 As long as amount they charge you covers cost of food and cost of salaries of people who are
offering it, then it’s OK.
132(f). Qualified Transportation Fringe.
o Includes any of the following provided by an employer to an employee:
 A) Transportation in a commuter highway vehicle to and from work (usually a mini-bus).
 CHV must seat driver plus at least 6 adults, 80% of the mileage occurs in commuting or in other
travel with at least a ½ passenger load.
o This prevents a person’s private car from being a CHV.
 Separate section for mileage: once you arrive at work, all the driving expenses you pay during
work can be paid by employer.
 B) Transit pass. Public transit pass or private transit on a CHV.
 C) Qualified Parking. Must be at work site or at a commuter drop off point for a carpool or commuter
highway vehicle.
 Maximum benefit is $105/month for CHV and transit pass and $200/month for parking (year
2005).
 No constructive receipt applies even if the taxpayer could have chosen cash instead of the transit
benefit.
o Suppose employer doesn’t pay for your parking, you can’t deduct the parking you pay on
your tax return. But if employer agrees to have salary reduced by cost of parking, the
amount you have your salary reduced for parking won’t be taken into account for your
income. Take advantage of this.
§ 132(g). Qualified moving expense reimbursement.
o Reimbursement for amounts that would have been deductible as a moving expense under § 217.
o § 217. Moving Expenses (simplified)
 Permits a deduction for moving expenses of the taxpayer and his household in connection with the
commencement of work by the taxpayer at a new principal place of work.
 The new workplace must be at least 50 miles farther from the taxpayer’s former residence than was his
former workplace. (If the taxpayer had no former workplace, then the new workplace must be at least 50
miles from his former residence.).
 Taxpayer must be a full-time employee for a significant period of time (generally 39 weeks).
 Moving expenses include:
 (1) Cost of moving household goods from former residence to new residence, and
 (2) Cost of traveling (including lodging) from former residence to new residence.
o Ex: If you’ll be gone for a year on business, then you could apply this rule (cause it’s permanent). But moving for a
deposition, it would be deducted under working condition fringes.
§ 132(h)(5). On Premises Athletic Facility
o Use of an employee-provided athletic facility is not income if it is:
 1) located on the premises of the employer;
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 2) operated by the employer; and
 3) substantially all the use is by employees and their spouses and dependant children.
If you work for gym, it wouldn’t be tax-free under this rule, but would be tax free under no-additional-cost fringe.
Pensions Reviewed
Calculating the Benefits of Qualified Pension Plans (review handout)
 If you qualify for 401(k), be sure to put money in there, especially if your employer matches your 401(k) contributions.
Qualified Pensions § 401(k) – Selected Rules
 1) Elective deferrals. Employees are not taxed on amounts up to $13,000 per year (for 2003) set aside for retirement even if
the employee could take cash instead. Under EGTRRA, this limit rises $1,000 per year to $15,000 in 2006.
o If you have option to take money or not, you’re taxed whether or not you take it. This rule overrides that rule; if
you take money, you’re taxed; if you don’t take the money up to $13,000, then you’re not taxed on that.
 2) Matching contributions from employers are not treated as elective contributions and are, therefore, not subject to the
annual limit.
o Example: Employees may elect to contribute 5% of their salary to a pension plan and, if they do, the employer will
contribute 10% of their salary to the plan. The 5% employee contribution is considered an elective deferral but the
10% employer contribution is not.
 3) Amounts in the plan generally may not be distributed w/o penalty except at:
o a) Death or disability
o b) Retirement at age 59½ or older.
o Subject to various restrictions, amounts may also be withdrawn for certain hardships such as: medical need,
purchase of a principal residence (first home), tuition payments, and prevention of eviction from one’s home.
 4) Plan must not discriminate in favor of highly compensated employees (but plan is permitted to provide benefits
proportional to compensation).
o It’s legal to give people who make more money more in absolute dollars, but you can’t give them more in terms of
percentage. Purpose of retirement benefits is replacement of your current working-year salary. So this makes sense
b/c it relates to your percentage of salaries.
 5) Employee contributions must vest immediately (vest = can’t lose the benefits). Employer matching contributions must
vest within a specified period of employment (generally 3 years).
o Contributions you put in must vest immediately (must be available for you permanently). After you work for 3
years, all money that employer puts in must be yours permanently.
 6) Amounts held by a qualified pension plan generally may not be assigned or alienated. Generally amount held by a
pension cannot be reached in bankruptcy or tort actions.
o Money you put in your 401(k) for retirement is yours, even if you go bankrupt or subject to a huge tort action.
 7) The maximum annual defined benefit is the lesser of:
o (a) 100% of the employee’s average compensation for his or her highest three years, adjusted for inflation, or
o (b) $160,000 (year 2001, inflation adjusted annually)
 This means you can get a lot under a defined benefit plan.
 9) Maximum annual contribution to a defined contribution plan is the lesser of:
o (a) 25% of annual compensation or
o (b) $40,000 (year 2001, inflation adjusted annually).
 Total contribution includes employer contributions.
 Total amount you put in cannot be more than 25% of annual compensation or $40,000/year.
 The two limitations b/t defined benefit and contribution are about the same ($40,000 of $160,000 is 25%).
 10) Taxpayer is permitted to borrow certain amounts (typically a maximum of the lesser of $50,000 or one-half of the present
value) from the pension plan. Larger amounts may be borrowed for certain purposes such as a down payment on a first
home.
o You have to pay this back with interest, but the interest goes to yourself.
o Is it a good idea to borrow from your pension plan?
 In general, it’s OK to borrow from pension plan, but there are other better options.
 It’s better to borrow against equity in your home than your own pension plan b/c you can deduct
the interest.
 Suppose you owe nothing on your mortgage, and nothing in your 401(k).
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Value of house will rise, and it’s tax-free until $500,000. Value of living in home is taxfree. If it goes over $500,000, you just pay a low capital gains tax rate.
 Suppose you owe $500,000 on your home mortgage, and you have $500,000 in your 401(k).
o This is better. Suppose you pay $25,000 in interest on your home mortgage, and you’re
earning $25,000 in interest on your 401(k). You can deduct the interest on your home
mortgage, and the interest in 401(k) is tax-free.
o You’re much better off if you follow this scheme by borrowing against your home
mortgage and leaving the interest in your 401(k), b/c interest in 401(k) is tax-free.
o In general, the 401(k) is fantastic. This will save you lots of money.
Other tax favored retirement accounts
o These include “regular” individual Retirement Accounts (“IRAs”), “Roth IRAs,”
o These are good if you want to take money out early.
o Look at handout for rest of paragraph. (haven’t received it yet).
o
Imputed Income
 Definition: The untaxed economic benefit from the use of one’s own property and one’s own services.
 Imputed Income from Property
o Example: Owner-occupied housing.
 Alice: Salary $50,000. Has $100,000 to invest. Buys bond paying 10% interest. Earns $10,000 interest on
the bond. Uses the $10,000 to rent condo. Alice’s taxable income is $60,000.
 Bob: Salary $50,000. Has $100,000 to invest. Buys condo for $100,000 and lives in it. Bob’s taxable
income is $50,000.
 Alice and Bob have the same economic well being, but Alice pays higher taxes.
 This illustrates two things:
o Under the law, certain kinds of economic value that are produced are not taxed. The
$10,000 rental value of the home is just as valuable to Bob as the $10,000 interest is to
Alice. But the person who receives income in form of imputed income will receive
lower tax rate than person who receives the income in terms of cash.
 Does this violate horizontal equity. Is this unfair to Alice?
 Not really, even though some argue this is fundamentally unfair. But it isn’t (see below).
 Why doesn’t Alice buy a home?
 If it’s unfair to Alice, the easy answer should be that she should just buy the condo. There are 2
reasons why she doesn’t buy the condo.
o 1) There is some reason why renting is better for Alice than buying a home, such as she
plans to move quickly (and there are lots of costs associated w/buying and selling a
home) or less responsibility in not owning the home or value of home could decrease.
o 2) If buying a home is at least as good as renting a home, another reason she doesn’t buy
the condo is b/c the tax advantages of buying a home are built into the price so that she
could not buy the home for the same amount of money, making this example unrealistic.
 You could not buy the home for a mortgage payment that is equal to the rental
payment. You also have to take into account the tax advantages that are built
into the house’s selling price.
 The tax advantages (or disadvantages) of any investment will be built into
the price of the investment. This is called capitalization.
 If asset has tax advantage, it will cost more to buy (and vice versa).
 Suppose there are 2 cars, one with 10-year warranty and the other with
a 3-year warranty. Since 10-year warranty car is better, you’ll pay
more for that car than the 3-year warranty car.
 The reason why houses are expensive is b/c the prospective purchaser knows
she will be able to deduct the interest from their mortgage.
 All tax advantages and disadvantages will be capitalized into the price of the
asset (home, in this case).
 Same principle applies to Bush’s dividend deductions, which had one-time
windfall for current shareholders. Though new shareholders will get deduction,
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they’ll also have to pay for it (b/c they pay higher price for their shares).
2/16/05
 If tax advantage are built into price of home, who should buy a home? Who
should rent?
 High-bracket taxpayers who itemize should buy a home; low-bracket
taxpayers and those who don’t itemize shouldn’t buy a home b/c the
price of home includes this tax advantage.
 If you’re not getting tax advantage b/c you’re low-paying taxpayer,
then you shouldn’t buy home.
 If you’re only going to hold a home for a few years, it’s better not to buy due to
high transaction costs. If you’re going to own a home for a long time, then it’s
worthwhile to buy a home.
 Before, you could deduct all your interest on money borrowed. Changed to
maximum interest you can deduct is interest on first $1.1 million borrowed on
your home. There’s grandfather clause for old owners (they’re not affected).
What would happen?
 Lock-in effect: Moment you lock someone into a tax-advantage, it’ll
reduce the chance of him selling the property.
 Price effect: Other big effect is that the price of homes worth over $1.1
million went down (after taking away tax advantage).
 So new millionaire wanting to buy new mansion is not hurt. Persons
hurt are current owners of mansions b/c if they try to sell mansions,
they will get less for the sale (even though they have grandfather
clause, b/c price of homes in the market drops).
What are the likely economic effects of the tax advantage of owner-occupied housing?
 People will spend more of their money on owner-occupied housing than on other things.
o B/c there’s tax advantage to expanding the home, people are motivated to spend money
on their home (instead of going on trip around the world, which is not tax deductible).
o It’s a myth that if you close off one sector of the economy, that that will totally lose
money that originally went into that sector. Instead, people will use money elsewhere
(e.g., cancellation of hockey season; people will spend money on other things).
Imputed Income from Services
 Individuals are not taxed on the values of the Services they perform for themselves.
 Impact on work-effort (example)
o Jack can earn $20/hr. as an accountant.
o Jack can hire Harriet to paint his house at $15/hr or he can paint the house himself in the same amount of time.
o Harriet can do her own taxes, but it takes her twice as long as it takes Jack (Thus Harriet could earn $10/hr as an
accountant).
o Jack and Harriet each enjoy painting and preparing tax returns equally well.
o 1) Is it efficient for Jack to hire Harriet to paint his house? Is it efficient for Harriet to hire Jack to do her taxes?
 Answer: Yes to both. Jack produces $20/hr of value as an accountant, but only $15/hr of value as a
housepainter……….[look on handout]
o 2) In a no-tax world, will the more efficient result be reached?
 Answer: Yes, as explained below.
 Jack: Suppose that it would take 10 hours for either Jack or Harriet to paint Jack’s house. If Jack paints the
house himself, it will cost him nothing. If jack works 10 hours as an accountant hew will earn $200. He
can then hire Harriet at $15 per hour to paint his house for a total cost of $150. This makes Jack $50 better
off than if he painted his own house.
 Harriet: Suppose that it would take Harriet 10 hours……..[look on handout]
 Both parties are better off by doing what they’re best at.
o 3) If Jack and Harriet are in the 40% tax bracket, will the more efficient result be reached?
 Answer: No.
 Jack: Suppose again that it would take 10 hours for Jack or Harriet to paint the house. If Jack paints the
house himself, it will cost him nothing. If Jack works 10 hours as an accountant, he will earn $200 pre-tax,
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pay $80 in taxes and have an after-tax income of $120. If Jack hires Harriet at $15 per hour to paint hi
house the total cost is $150. This is $30 more than Jack’s after-tax earnings as an accountant, so Jack is
better off painting his own home.
 Harriet: [look at handout]
 Addition of 40% tax induces Jack and Harriet to do their own work b/c they won’t be taxed on value of
their own work.
 This generally discourages people from hiring housekeepers or gardeners (when they could do the
work themselves).
 A lower tax rate would not change their behavior. In general, if tax rate is low, then it won’t
change behavior.
o Secondary earner: person who would not work if one person in couple would not work (more likely it’s woman).
Secondary earner is determined by 2 factors: (1) person who earns the most usually is the primary worker; (2) social
convention would usually dictate who’s primary worker (e.g., men are usually socially expected to go out and work
and not stay at home); and (3) who’s best at working at home? (men are clever at pretending to be incompetent at
home).
 Traditionally, women are secondary earners. If a woman enters paying labor force, her income will be
taxed at a high rate b/c husbands are already working. Wife’s income will be stacked on top of husband’s
income, so secondary earners (typically women) tend to start off at higher tax bracket. Also, secondary
earner wife will pay into SS benefits, but they only get 1½ times the SS benefits (husband and wife)
compared to singles.
 Value of imputed income at home is much higher if you have kids. When you add kids, you have a lot
more expenses.
 For women who are secondary earners when there are kids involved, the high tax brackets for working
compared to the tax-free value of their imputed work at home discourages working outside the home for
secondary earner women.
o Some people have suggested that we should change tax structure to reduce tax rates on secondary earners. How?
 1) Allow couples to file singly. When woman enters labor market as secondary earner, she doesn’t
automatically start at higher tax bracket.
 Counterargument: Family unit should be taxed as one unit.
 Counterargument: If you lower tax rates here, you’ll have to raise tax rates on other people (such
as single individual earners).
 The fact that we tax market income, but don’t tax imputed income, leads to distortions.
 2) Before, the lower earning taxpayer of two people could reduce their taxable income by 10%. This could
be reinstituted very easily.
 This gibes some sort of tax break to secondary earners.
 3) Could increase the amount of deductions given to people who are working, such as expanding child care
deductions.
 Problem is that this can distort other kinds of behavior. If you had choice to send child to
grandma or daycare, and daycare is tax deductible, but grandma is not, then more people will send
their kids to daycare.
 Democrats want to use more of tax savings to give to working women. Republicans say this would
discriminate against married couples in traditional families.
 This all goes back to culture wars.
Read Harris case (gifts)
2/17/05
Current Events
 Social Security - Bush is thinking about raising income subject to SS tax (raising $90,000 limitation to higher number). This
would be popular among Democrats and some Republicans worried about the federal deficit.
 Traffic – how could you use something similar to taxation to reduce traffic?
o Could put huge tax on gasoline (done in Europe), making it more expensive to drive and reduce total amount of
driving. If you’re worried about congestion, tax on miles is better; if you’re worried about pollution, tax on gasoline
is better.
o Could tax cars, but probably won’t be effective.
o ***Pay $10 tax to drive in certain area during rush hour. Would require GPS in every car and sensors everywhere
to monitor.
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o
o
In London, you have to pay toll to bring car into Central City during peak times. This caused huge change
in behavior of driving.
 This would significantly reduce traffic during rush hour.
 Conservatives like this b/c when you drive, you’re giving off a negative externality (harm to other people).
You’re contributing to traffic jam by causing congestion. So generally speaking, making people pay for
their externalities is a good thing.
 Liberals also like this b/c they want to help the environment.
 You can use the added revenue to build up public transportation to help the poor.
Optimal social policy:
 First tax everything according to its externalities (how much harm of activity is caused to others)
 Do other things in society to create proper distribution of income.
 Could help poor people by lowering overall tax rate, covering medical expenses, and increasing
public transportation.
 This will help some poor people and hurt other poor people. This is just a cost of making this change in
creating an overall socially desirable goal to reduce congestion.
 Also people who continue to drive at peak hours would be worse off.
This plan won’t get passed b/c middle people don’t like it b/c they focus on individual person who will be harmed
by this program.
Haig-Simons Income
H-S Income = Consumption plus Change in Wealth
or
Y = C + ΔW
Example 1
 Mary has a salary of $50,000. In addition, she owns stock in Xenon Corp. worth $100,000.
 During the first year, Mary spends $5,000 on food, rent, entertainment and other consumption and puts the $5,000 that she
doesn’t spend in the bank. At the end of the year, her enon stock is worth $110,000.
 What is Mary’s H-S Income?
o Answer: Mary’s consumption was $45,000
o Her wealth at the beginning of the year was $100,000.
o Her wealth at the end of the year was $115,000, so her wealth increased by $15,000.
o Therefore Mary’s H-S Income is $45,000 + $15,000 = $60,000.
 This formula is good b/c it separates the consumption and change in wealth. This is useful to separate analytically.
Example 2
 Ned has a salary of $50,000. In addition, he owns and lives in a Condo worth $100,000.
 During the year, Ned spends $45,000 on food, entertainment and other consumption and puts the $5,000 that he doesn’t
spend in the bank. At the end of the year his condo is worth $110,000.
 What is his H-S Income?
o Answer: Ned’s consumption was $45,000 plus the rental value of the condo.
o His wealth at the beginning of the year was $100,000.
o His wealth at the end of the year was $115,000, so his wealth increased by $15,000.
o Therefore Ned’s H-S Income is $60,000 + the rental value of the condo.
 True income must also take into account not only the cash you spend, but also the rental value of the assets you’re getting use
of.
Example 3
 Suppose Bill makes $100,000, and buys car worth $30,000. At end of year, car is worth $22,000. Rental value of car is
$8,000. He spends $70,000 on rest, food, and other consumable items. What is his H-S Income?
o C + ΔW
o C = $70,000 + rental value of car
o ΔW = value of car at the end of the year.
o Here, H-S Income = $78,000 + $22,000 = $100,000.
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
Suppose rental value of car was $8,000, but at end of year, he got in car accident, making value of car worth $17,000.
What’s his H-S income?
o $78,000 + $17,000 = $95,000.
Why is H-S Income important?
 Some people believe that as a matter of policy, it would be desirable to tax people on their H-S Income b/c it really reflects
peoples’ real income during the year.
2/18/05
Haig-Simons Income
 H-S income = Consumption + Δ Wealth
 Benefits of H-S Income Formula
o Suppose you own property and it goes up in value. You’re better off, but that growth in value is not taken into
account for your income under current tax structure.
 Under H-S Income, you would be taxed on that increased value of home.
 H-S Income is to think of comprehensive base to truly reflect all the ways you’ve gotten richer or poorer
over the year. Current tax structure just takes into account amount of money you’ve earned and any
income you receive after selling property. H-S Income takes into account all of your gains during the year.
o Also, some people think we should just tax people on what they consume (when they spend the money). If they
save money, they shouldn’t be taxed on saved money.
 If you have just a consumption tax, then under H-S Formula, you would just be taxed under C
(Consumption). H-S formula makes it clearer what difference is b/t consumption tax and income tax.
A Primer on Externalities (See Handout)
 Externality – one’s actions affect the well-being of another individual
o Negative externality (external diseconomy, external cost) – part of the cost of producing a good or service is born by
a firm or household other than the producer or purchaser.
 Ex: When person decides to smoke a cigarette, he doesn’t take into account the cost of harm to other
people. True cost of cigarette is lower than social costs.
o Positive externality (external economy, external benefit) – part of the benefit of producing or consuming a good or
service accrues to a firm or household other than that which produces or purchases it.
 Gov’t regulations often are seen as “correcting” the outcome of the market for goods involving especially sizeable
externalities, esp. negative externalities.
o Taxes can change behavior by discouraging negative externalities and encouraging positive externalities.
 If you put a tax on cigarettes, less cigarettes will be sold, which will lead to fewer costs imposed on third
parties. But here, it is the gov’t who keeps the money, not the unfortunate bystanders who still suffer the
damage (of second-hand smoke).
 For positive externalities, gov’t might encourage these by giving subsidies to education or other
goods/services that provide social benefits.
o Problem with tax/subsidy approach to remedy externalities may be that it’s impossible to determine size of external
costs/benefits, and thus determine what an appropriate tax or subsidy rate would be.
 Conservative v. liberal economists
o Both agree with this analysis of externalities, but there are some differences
 Liberal economists would be more confident that they can correct those externalities. Conservative
economists wouldn’t be so confident.
 Cigarettes and alcohol clearly provide social harm. Traffic is more difficult (see discussion from yesterday).
Externalities, Tax Policy and Traffic Control: An Example (see handout)
 1) What are the likely results of this plan?
o People will probably stop going into L.A. People who don’t have to go will stop going. People who have to go
will still go.
 Rich v. Poor
 Rich will probably not care and still go to L.A.
 Poorer will probably take the money and stop going to L.A.
o Who is worse off?
34


No one is worse off under this plan. If you want to keep taking the trips, you still have $36 that covers the
added costs of going to LA
o Who is better off?
 People who keep going to LA are better off b/c there’s less congestion. Even though they pay $36, there’s
less congestion.
 People who stay home are also better off b/c they value staying home more than the $6/round trip.
 Everyone is better off under this plan.
2) In what ways are the stated facts unrealistic?
o Not true that 100,000 will travel to LA the same amount. In real world, people who don’t need to go to LA are
much better off; for those who have to go to LA for jobs, they will be worse off.
o How would making the facts more realistic change the results in #1?
 If trips are cut by 10%, gov’t will take in less money for charging for the trips than the money they’re
giving out. Gov’t will have to raise money elsewhere (by raising taxes).
o System of congestion taxes doesn’t necessarily hurt the poor. The money that gov’t raises from congestion taxes
can be recycled to help the poor. So taxes aren’t necessarily a bad idea.
o If you start taxing people for trips, people will start living closer to work (not live in the valley). In the long run, it
may help reduce congestion (b/c people will change behavior and live closer to work, reducing traffic time).
2/23/05
Windfalls and Gifts
 Commission v. Glenshaw Glass Co. (1955)
o Look at handout
o Glenshaw Glass received both compensatory and punitive damages.
 Compensatory damages were taxable (b/c they replaced your lost profits, which were also taxable).
Punitive damages didn’t reflect any economic loss. Question was whether punitive damages were also
taxable.
o Glenshaw argued punitive damages were not taxable.
 Said it was a windfall, saying that income was just “gain derived from capital, labor, or both combined.”
Since punitive damages didn’t fit in this definition, it was just a windfall and not taxable.
o However, Glenshaw’s case came before new Tax Code, which redefined income.
o Court held that unless there’s provision to the contrary, any income is taxable, whether it’s from labor, capital, etc.
 Thus, punitive damages are taxable.
o It turns out that many things are not taxable, according to provisions in code.
 Ex: §§ 119, 132.
Gifts


The general rule is that the receipt of gifts is not taxable, nor are they deductible to the payor. So what is a gift?
Commissioner v. Duberstein
o Holding: Whether or not a transfer is treated as a gift depends on the motivation of the donor.
o Here, Duberstein was recommending customers to Mohawk Medals. Berman, who worked for MM, called up
Duberstein and expressed appreciation of customers Duberstein recommended to MM. Berman wanted to give
Duberstein present (Cadillac). Duberstein accepted Cadillac. Issue was whether Cadillac a tax-free gift to
Duberstein.
 Duberstein argued it was a gift b/c Berman had no obligation to give it to him.
 IRS argued it was taxable b/c since Berman deducted it as a business expense, it can’t be a gift to
Duberstein. There was fundamental inconsistency b/t treating it as business expense on one side and
treating it as a tax-free gift on the other.
 IRS does not accept this position.
o IRS says that a gift proceeds from the donor’s “detached and disinterested generosity”…”out of affection,
respect, admiration, charity or like impulses.”
 Key is to look at motivation of donor in determining whether this is a gift.
o In this case, what was evidence that this was not a gift?
 Most important factor is that it doesn’t seem to be disinterested; it’s motivated by inducing Duberstein to
continue making recommendations to MM.
 Also, Duberstein and Berman had never met, so it’s hard to say they had a deep level of affection.
o Today, it is good law that in order to be a gift, it must be given from detached and disinterested generosity.
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



§ 102(c) precludes gift treatment for any transfer by an employer to an employee
o Deals with taxation of employee. So any gift you receive from employer is subject to these restrictions.
o Exceptions:
 Modest achievement awards under § 74
 De minimis fringe under § 132
§ 274(b) limits deduction for business gifts to $25 per recipient per year
o Deals with taxation of employer. In Duberstein, even if employer met requirement that it was a gift, employer
could only be tax-free for first $25 of value of car. Instead of taxing recipient, they will disallow the deduction for
first $25. This is “surrogate taxation” – denied a deduction over $25.
o Exception: Imprinted items worth less than $4 and promotional materials to be used on the business premises of the
recipient.
If recipient will be taxed on item, then it’s not a gift, and giver could get the deduction.
In employer-employee context, it will either be a deduction for employer and taxable for employee (with exception of
achievement awards).
o In business context, it will be either a gift (no deduction and no tax) or tax-free gift to employee, but not deductible
by corporation.
o You don’t get deduction by firm and tax-free for employee.
United States v. Harris
 Kritzik was a wealthy, elderly widower. He befriended and became intimate w/twin sisters Leigh Ann Conley and Lynette
Harris. Court refers to Harris as K’s mistress. Over time, K transferred to each sisters more than half a million.
o IRS argues that the payments were for services and the sister’s failure to report the income was criminal tax evasion.
 To win, IRS must show that (1) payments are not gifts; and (2) the recipients (Harris twins) knew they
were not gifts and intentionally failed to file return, even though they knew they had legal responsibility to
file a return
 Issue: Are the transfers gifts?
o First look at donor’s intent.
 IRS said that K didn’t have donor’s intent b/c he wrote off some of the checks as business expenses and
didn’t file a gift tax return. This was indication of K’s non-donative intent.
 It was wrong for court to introduce evidence from K’s tax returns to show that he didn’t intend
checks as a gift b/c it would be hearsay. K was dead, so bringing in outside document in which K
says he didn’t intend them as gifts would probably be hearsay.
 Harris twins said they were gifts b/c of K’s letters to them, in which he’s happy to give money to the twins.
These were excluded as hearsay, but they should have been admitted for the effect on the listener (Harris
twins thought letter indicated that money was gift to them).
 Issue is what the receivers thought—as long as they thought it was given, they cannot be held
liable criminally.
 What is the tax treatment if the transfers are gifts?
o If transfers were gifts, tax treatment would be:
 Tax free to the recipient; donor gets no deduction.
 No deduction by corporation as business expense, but K would be required to pay a gift tax.
 Gift tax: Each individual can give $11,000 each year per recipient completely tax free. Anything
above that would require gift tax (separate from income tax).
o If filing a joint return, a couple can give away $22,000/year/recipient.
o For K, he should have reported any amount he gave over $11,000.
 What is the treatment if the transfers are not gifts?
 Are the motives of the Harris twins relevant?
 Should the letter from K have been excluded as hearsay?
o No, b/c it had effect on listener.
 As a matter of policy, should the Harris twins be taxed?
 This case is egregious miscarriage of justice b/c giving criminal charges in this case are out of line b/c they believed based on
the letter that they were gifts.
2/24/05
Gift Taxes
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


Distinction b/t income and estate and gift taxes.
o Income tax purposes: no tax consequence to either side.
o Gift tax: Donor can give $11,000/year/recipient tax-free (or married couple is $22,000/year/recipient).
 If you give more than $11,000, you have to file gift tax return and pay gift tax on excess amount. Person
who pays gift tax is the donor. Donee pays nothing.
 Gift tax rate can reach level of 40%.
Suppose someone gave away $31,000 in a year to a friend. First $11,000 is not subject to gift tax, but additional $20,000 is
subject to gift tax. Every individual is entitled to an exclusion for the estate and gift tax of a certain amount—this is called
the unified credit.
o Exclusion varies from year to year. Now it’s at $1.5M. It will go up to $3M and be repealed by the year 2010
(maybe permanently). Rates are changing every year.
o So, the first $1.5M is not subject to tax.
o Suppose you have an extra $20,000 gift. You can pay tax on that now, or apply it to your $1.5M unified credit.
 Suppose you donate $500,000 and you use the unified credit, leaving $1M. The amount left in your
unified credit when you die is the amount of your estate that is excluded when you die.
 Suppose person has estate of $3M. During his lifetime, he’s given away $500,000 of gifts that would
otherwise be taxable, reducing unified credit from $1.5M to $1M. After dying, you have to pay estate tax.
You don’t pay estate tax on first $1M, just on the $2M in excess that’s greater than unified credit.
From estate tax point of view, if you die and your estate is less than $1.5M, you pay no estate tax at all. Estate tax only
applies to people with estates worth more than $1.5M (and this is scheduled to rise until $3M).
o When you die, it goes to your spouse tax-free. Estate tax only applies when it doesn’t go to spouse.
o In looking at revenues that come from estate tax, when unified credit was $1M, only 1 out of 50 estates made
enough to pay some estate tax.
 Most people who pay estate tax now make just enough to make the $1.5M limit. If you raise the estate tax
limit, then less people will pay estate taxes at all.
 Most of the money from estate taxes are from the filthy rich.
 Democrats argue that if we’re worried about small business owners, you should continue raising estate tax
limit to $3M, but don’t repeal it in 2010.
o Argument for eliminating estate tax entirely:
 1) Practical argument: Estate tax is very complex and doesn’t raise much money. Rather than trying to
collect this hard-to-collect tax, you might as well repeal it, even though much of the benefit would go to
the super rich. So might as well simplify the tax code.
 2) Philosophical argument: You should only pay taxes when you’re actually enjoying your income and
“living lavishly.” If you live modestly and just accumulate vast sums of wealth, why be taxed on that? We
should only tax money when it’s spent. This is an efficiency argument to encourage savings and a fairness
argument to tax people on the wealth they enjoy, not the wealth they own. So, there should instead be a
consumption tax. Two ways to have consumption tax:
 1) Cash-flow consumption tax – keeps track of what yon consume during the year (including
rental value of your home).
 2) Never tax any investment returns, income from property, but no deduction for them.
 3) Fairness – just not fair to have estate tax. If you work for it, you should be entitled to keep it. Also,
there would be “double taxation” (income and estate tax).
o Argument to keep estate tax:
 1) Practical argument: Repealing the estate tax would just be a windfall to the super rich. Giving this
windfall wouldn’t make our country any better. It wouldn’t have any major efficiency effect. Changing to
a consumption tax right now wouldn’t necessarily improve efficiency. Effect is small.
 2) Philosophical: Amount of income into your house is better measure than amount of consumption. The
fact that you chose to save money just reflects a decision of what you wanted to do with your income.
Controlling wealth is power; it isn’t true that measure of your wealth is solely reflected in spending it.
Having wealth itself should be a measure of taxation.
 3) Fairness – though you’ve worked for it, it’s the same as income tax (you’re taxed on your income that
you’ve earned, too).
 You’re also being double taxed all the time (such as paying income taxes, then paying sales tax on
items you buy).
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Griffith: Reality is that we have a mix of consumption tax and income taxes  indefensible policy (having tax-free
earned interest and deductions for home mortgages).
Sound strategy: To avoid more estate taxes upon death, elderly people should give $11,000 (or $22,000) every year to
everyone they want to get money when they die. This will never be taxed. This is wise strategy to avoid heavier estate tax
penalty.
o For gifts to little kids, you can set up a trust (as long as you can’t get money back).
o

Taft v. Bowers (1929)
 Timeline
o 1916: A purchases stock for $1000
o 1923: Gives stock to B when worth $2000
o 1923: Later that year, B sells for $5000
 Issue: Does B owe $4000 tax?
 Holding: Yes.
o Is this result unfair to B?
 No, b/c B took the gift, knowing this was the rule.
o Why not tax the $1000 to A?
 Complexity. Only tax gains on sale of property when it’s sold or transferred. You want to tax it to the
person who owned it at time it was sold. That is the rule.
Transfers of Property with Unrealized Gain or Loss
 § 1001: Gain is the “excess of the amount realized over the adjusted basis.”
 § 1012: Adjusted basis is cost “adjusted as provided in § 1016.”
o Gain Realized = Amount realized – Adjusted Basis.
 Suppose you purchase stock at $100. You sell it for $250. Amount realized is $250. Adjusted Basis, in
general, is what you pay for the property, but this can be changed. Here, adjusted basis is $100. So Gain
Realized = $250 - $100 = $150.
o Your basis in property can be changed by other factors.
 Suppose you bought a bike for $100 and sold it for $250. Suppose that before you sold it, you spent $50
on better tires for the bike. Now, Adjusted Basis is $150. What you paid for it was $100 plus the $50 in
capital improvements. Gain realized is $100.
 Adjusted basis can also decrease (through depreciation).
o Amount realized is FMV of what you got for the property.
 Suppose you bought bike for $100 and you sold it for $150 plus a “cool vintage T-shirt” worth $50 plus 2
backrubs (worth $25 each). How much tax do you pay?
 $150 + $50 + $50 = $250. Amount received was $250 (FMV of everything you got in exchange
for that property.
 These rules are designed to make sure the total amount of tax paid on the property is equal to the actual gain on that property.
2/25/05
Special Rule for Calculating Gain on Transfers of Property Received as a Gift (See handout)
 1) If, at the time of the gift, the FMV of the gift property is higher than its basis, then the adjusted basis of the gift property is
the same as it would be in the hands of the donor. This is called a substitute basis.
o Ex: In Taft, FMV of gift to B was higher than basis of property ($2,000), so B’s basis was the old basis ($1,000).
 2) If, at the time of the gift, the FMV of the gift property is lower than its basis, then if the gift property is sold or exchange:
o a) for purposes of gain, the adjusted basis of the gift property is the same as it would be in the hands of the donor.
o b) for purposes of loss, the adjusted basis of the gift property is its FMV at the time of the gift.
 Examples (make sure you know for final).
o Ex: Grandma gives daughter stock. Suppose stock has FMV of $5,000, and basis of $2,000 (what Grandma paid for
it).
 Case A: Daughter sells stock 2 years later for $7,000. She recognizes a gain of $5,000.
 Case B: Daughter sells stock 2 years later for $4,000. She recognizes a gain of $2,000.
 Case C: Daughter sells stock 2 years later for $1,500. She recognizes a loss of $500.
o Ex: Grandma gives daughter stock. Suppose basis of stock was $5,000, and FMV was $3,000.
 Case A: 2 years later, daughter sells stock for $7,000.
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
o
For purposes of gain, it’s the same as it would be in the hands of the donor (basis of $5,000), so
she would have gain of $2,000.
 For purposes of loss, daughter’s basis is FMV ($5,000), but here’s, it’s N/A (because daughter
didn’t have a loss).
 Case B: 2 years later, daughter sells stock for $2,500.
 For purposes of gain, her basis is substitute basis (same as if in hands of donor), so basis is
$5,000. But there’s no gain here, so it’s N/A.
 For purposes of loss, her basis is FMV at time of gift, which was $3,000. So she has loss of $500.
 Case C: 2 years later, daughter sells stock for $4,500.
 For purposes of gain, her basis is $5,000, but she has no gain here, so N/A.
 For purposes of loss, her basis is $3,000, but she has no loss here, so it’s N/A.
 Thus, she has no gain or loss.
Look in Examples and Explanations for more detail.
Transfers at Death
 Income Tax Consequences
o § 102: Bequests are tax-free to the beneficiary.
 There is no federal inheritance tax (and probably no more state inheritance taxes).
o § 1014: The basis of property acquired by reason of death is the FMV of the time of death (or, optionally, 6 months
after death). This treatment will change to a carryover basis system if the estate tax is repealed (will be very
complex).
o Examples
 Suppose Grandma owns stock with FMV = $50,000 and basis = $10,000. How much tax has Grandma
paid on the growth and value of stock? Zero. If Grandma sold stock, she would pay capital gains tax of
$40,000. If she gave stock to granddaughter, and granddaughter sells it, granddaughter would pay capital
gains tax of $40,000. What if she dies and it’s given to granddaughter?
 The basis will become $50,000, so granddaughter doesn’t have to pay any tax. So no tax will ever
be paid on this growth in value of property (as long as she doesn’t reach the $1.5M estate tax
limit).
 Suppose Grandma is 80, and Grandma wants to sell some of her stock to go on a cruise. Granddaughter
tells her not to sell her stock now and should wait to give stock to granddaughter when Grandma dies (to
not pay taxes). But Grandma wants to take a cruise. Granddaughter says to borrow against the stock. That
way, Grandma enjoys the value of the stock by not paying taxes in selling it. All Grandma will have to pay
is the interest on the loan. Then when Grandma dies, she pays back the loan that she borrowed from the
stock, but it’s tax-free.
 This is sound tax advice.
 Suppose Grandma bought stock at $50,000, but it’s now worth $10,000. She should sell stock now before
she dies and take a loss (otherwise, at death the basis will become FMV at time of death, which was
$10,000).
 Suppose you get your money from capital (stocks) and have $2M in ten stocks (totaling $20M in stocks).
Stock market goes up 5%; now stocks are worth $21M. But not all of them go up 5% (some go up and
some go down). You sell losing stocks to offset your winning gains. Though your whole stock portfolio
goes up $1M, but you sell losers at a total of $1M, sell winners to balance losses off.
 Key is that really rich people can buy a diversified portfolio of stocks, get money out by selling all
their losers, recognizing those losses, and then selling winners for the exact amount of gains.
Portfolio is designed to keep all the winners and only some of the losers.
 So owners of capital pay little tax on their gains. The actual tax rate on returns to capital is
approximately 5%. It’s very easy to shield.
o This has inefficiency result b/c it encourages people to buy and sell things only for tax
purposes.
 Poor people don’t pay much taxes b/c they don’t have much income capital. Middle class don’t
pay much taxes b/c they have tax advantages in home mortgages and 401(k)s. Really rich don’t
pay much taxes b/c of these capital gains tax advantages.
 Tax Consequences
39
o
o
o
o
Estates are subject to an estate tax to the extent that the estate exceeds a certain size. Only about 1 in 50 estates
currently pay any taxes.
Changes under EGTRRA (2001)
 The exemption gradually increases from $1M to $3.5M from 2002 to 2009.
 During the same period, the top marginal rate drops from 50% to 40%.
 In 2010, the estate tax is repealed entirely.
 In 2011, EGTRRA is repealed and the estate tax is reinstated.
 It’s open question whether estate tax will ever be repealed. It may be repealed entirely, or it may
remain, but marginal rate will stay at around 40% and have $3.5M exemption.
Benefits of repealing estate tax
 Still have old rule to increase basis of property up to a specialized amount. This (1) preserves simplicity
(b/c carryover basis is very complex) and (2) helps out the “small businessman” who’s only worth $1.3M.
In favor of estate and gift tax
 This is considered as a “backup” for income tax since there are so many ways to get out of income taxes.
RECOVERY OF CAPITAL
Examples
 Ex 1: Juan purchase a copy
o Amount Realized: $35.
o Basis in book: $20
o Gain Realized - $15
o He recognizes this gain (no provision to the contrary).
 Suppose you buy Stephen King book for $20 and sell it used for $10. There are no tax consequences here. No losses are
recognized on sale of personal, non-investment property. Gains are recognized for personal, non-investment property.
o But if you bought book that was used for business or investment, then you recognize both gains and losses.
 Suppose you buy Stephen King book for $20, and now you give it away to charity. Can you get a deduction? Yes, you can
get deduction for FMV of book.
 Ex 2: Hilda
o How should H account for the $10,000 cost of the printing press?
 H’s basis will include $5,000 for royalty and $15,000 for cost of running printing press, in addition to
buying printing press for $10,000.
 Under tax system, you need way to account for value of printing press b/c you still have the printing press
after a year. You need to allow person to deduct decline in value of any equipment they currently own.
 This is done mostly under our tax system. This is called depreciation.
 Depreciation applies to assets that at time of purchase will be predicted to go down in value (ex:
car, computer, machines, trucks, buildings).
 In business context, you should be given deduction for decline in value of assets.
o Problem: How do you calculate the “decline in value” of the printing press?
 Gov’t arbitrarily divides assets into certain classes of property and decides how many years property of that
class will last.
 Property also goes down in value at different rates (some property declines a lot at beginning and little later
on, and vice versa). IRS sets forth depreciation schedules to tell taxpayer how much of price of property
taxpayer can deduct each year. See below.
Depreciation Overview
 Straightline (Simplest system) (only way you need to know for this course)
o Deduct an equal amount of the cost of the equipment during each year of its useful life.
 Accelerated Depreciation
o Permits a larger portion of the cost to be deducted in the early years of the equipment’s useful life.
 Amortization
o Describes “depreciation” of intangible assets. Generally amortization is straightline over the asset’s useful life.
 Intangible asset – examples include patent that lasts 10 years. After 10 years, it’s worth nothing.
 Impact on Basis: Asset’s basis is decreased by the amount of depreciation or amortization.
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o
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If she has $10,000 printing press, she has $10,000 basis. In first year, she has $2,000/year depreciation. Her basis is
reduced from $10,000 to $8,000.
 H’s costs of goods sold is $22,000 ($20,000 in costs + $2,000 depreciation). She would pay tax on
$13,000. At same time, basis of printing press is $8,000 (from $10,000). IF she sells printing press, her
gain realized from printing press will be amount of sale minus adjusted basis.
o If H forgets to take deduction, and SOL runs, you get hit in both ways (you lose the deduction, but treated as if you
took deduction).
Special rules such as the “half-year convention” can limit the amount of depreciation taken in the first year. For simplicity,
we will ignore such complications.
Depreciation Example
o Assume straightline depreciation and 10-year useful life. Alonzo purchases equipment for $30,000. Takes $3,000
depreciation per year for first 3 years. Total depreication taken is $9,000. New adjusted basis is $21,000. Sells
machine for $35,000. Alonzo is taxed on gain of $14,000 ($35,000 amount realized - $21,000 basis).
o Basic principle: Tax the difference between the amount received and the adjusted basis.
Depreciation Recapture Rule
Another rule: For first $100,000 of equipment you purchase that would depreciate over a certain period of time, you can
deduct immediately. This is designed to (1) have simplicity for small businessmen and (2) encourage investment.
PARTIAL SALES
Inaja Land Co. v. Commissioner (Tax Court 1947)
 1928: taxpayer buys land for fishing club on river for $61,000. LA pollutes river and kills fish. City pays taxpayer $50,000
for release of liability for pollution. Taxpayer’s legal fees are $1,000.
o Taxpayer’s basis in property is $61,000.
 Issue: Should the $49,000 received by taxpayer be treated as:
o (a) taxable ordinary income?
o (b) capital gain?
o (c) recovery of capital?
 What is argument for treating payment as recovery of capital?
o Taxpayer said he paid $61,000 for land and got $49,000 back. He is still down $12,000. He hasn’t gotten anything
to recover money he’s paid for.
 What is argument for treating payment as taxable income?
o IRS said that taxpayer still has the property (it hasn’t been taken away from taxpayer), so he shouldn’t treat it as
recovery of basis (he still has the land).
o IRS also said that if taxpayer had rented right to pollute river for $5,000, that would be taxed as ordinary income.
So, since LA gave money for right to pollute land, that should be taxed as ordinary income.
 What is the correct tax treatment?
o There are two things to keep track of: value of polluted land and value of easement to keep land clean. You go back
to 1928 and find these values, but this is too difficult to determine.
o Court felt that right result was that it was too hard to make calculation, so you shouldn’t be taxed at all.
 Result that IRS wanted was grossly unfair. If you had actually made the calculation, there would probably
be little taxes anyway.
o Courts today will make the valuation. They won’t just give up and say they can’t do the calculation.
Partial sales in general
 Problem 1: Suppose Alicia purchases 6 acres of land for $60,000. A few years later, she sells 2 acres of land for $25,000.
Each acre is equally good. What are the tax consequences?
o Each acre of land had basis of $10,000. She sold two acres for $25,000. So she would be taxed on $5,000 ($25,000
amount realized minus $10,000 adjusted basis per acre of land).
 Suppose acres were not the same. There are 3 rocky acres and 3 green acres. At time she purchased land, rocky acres had
total value of $15,000, and 3 green acres had total value of $45,000. Each rocky acre is worth $5,000, and each green acre is
worth $15,000. She sells two acres for $25,000.
o Amount realized is $25,000. Her basis depends on which acre she sold. Where acres have unequal value, you
allocate original purchase price to the different acres according to their FMV at time of purchase.
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Next week: Life insurance, gambling, annuities, recovery of personal/business injuries, forgiveness of debts, illegal income
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3/2/05
Problem 2: Suppose Benny purchases land with oil or mineral deposits for $60,000. During the first year he earns, after
expenses, $10,000 …….(see handout)
o Apply receipts first against his basis so that he is taxed only after recovering his $60,000 cost?
 He’s earned $10,000 this year, but land is less valuable (b/c some minerals have been taken out of it).
 This would make $10,000 tax-free, but reduce basis from $60,000 down to $50,000. This is used for land
in which you don’t know how much the land has declined in value (this is too good for the taxpayer).
o Recover basis only on the sale of the underlying property?
 Totally tax him on the $10,000 that he earns.
 If do this for 8 years, when land is now worth $2,000, and he tries to sell land, he would get a loss of
$58,000.
 This is bad for him b/c (1) he doesn’t get to recognize loss until he sells the land (he’s paid taxes for years
w/o recovery of cost); and (2) it might only be a capital loss (which is less valuable than an ordinary loss).
This rule is too bad toward taxpayer.
o Recover a percentage of his basis each year?
 Use arbitrary formula to allow him to recover percentage of basis each year.
 You could tax 50% and use other 50% to reduce basis. This is measure used for recovery of basis which
has mineral deposits and oil.
 Take amount of money you got from sale of product, and exclude a portion from taxation (such as taxing
only 50% of what you earn), and portion that’s not taxed is used to reduce basis. This method is “just
right” for the taxpayer.
Look at Examples and Explanations for more information. Do problems.
LIFE INSURANCE
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Whole life insurance has 2 basic elements:
o (1) Term insurance element.
o (2) Savings element.
Term Insurance Element
o Provides purchaser’s heirs with cash “death benefit” in the event of the purchaser’s death. For term life insurance,
this is the only element of the policy.
o Term insurance might be thought of as a gamble where the purchaser “wins” if she dies and “loses” if she lives.
 Person with policy is betting he will die; insurance company is betting he will live.
o If term insurance is actuarially fair, then the amount paid in death benefits will equal the amount collected in
insurance premiums.
 In real world, life insurance company couldn’t operate that way b/c they need to pay for their expenses and
have a profit.
Example
o There are 100 policyholders. There is a 1% chance that each policyholder will die during the year. An actuarially
fair insurance policy paying a $100,000 death benefit would cost $1,000.
 Suppose that, as expected, one policyholder dies during the year.
 Thus, one policyholder’s beneficiaries would collect $100,00 for a gain of $99,000. Other 99
policyholders each would suffer loss of $1,000. Ins. co. would break even.
Tax Treatment of Term Life Insurance
o (1) Amounts received as a death benefit generally are excluded from taxation under IRC § 101.
o (2) Life insurance premiums generally are not deductible.
o Assuming all the policyholders are in the same tax bracket, this has the same revenue effect (for gov’t) as taxing
death benefits and permitting a deduction for premiums.
 You could allow deduction for premium and tax people for their gains. 99 people would take loss, and 1
person would have gain of $99,000, and taxed on it. All people who live would get deduction of $1,000
(b/c they paid it out and got nothing for it) and person who died would gain $99,000, which is taxed. But
this is not followed.
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o
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Term life insurance, as constituted by these rules, is taxed “correctly.” It’s not overtaxing or undertaxing
taxpayers.
 Why don’t they adopt another policy to deduct insurance premiums and tax people on gains of death
benefits?
 Too complex.
 Seems unseemly for people to be taxed when relatives are dead. If we tax death benefits, we have
high tax rate in year person died, but that death benefit will probably be used to make up for
income that deceased would have earned for entire life.
Suppose USC buys Griffith a life insurance policy.
 First $50,000 of life insurance death benefit is tax-free to Griffith and is deductible by USC. Special
exception is that first $50,000 of life insurance of death benefit purchased by employer for employee is taxfree to recipient, and is also tax-free to beneficiary. Benefits are tax-free to the recipient.
Suppose USC buys Griffith a $100,000 life insurance policy. How is extra $50,000 going to be taxed? Suppose
USC has to pay $250 for first $50,000 and another $250 for the next $50,000.
 Griffith would be taxed on value of additional tax. First $50,000 is tax-free, but next $50,000 is taxed to
Griffith (for value that USC paid for it). So Griffith would have extra income of another $250.
 How to report this? USC would include this on Griffith’s W-2 (as another form of income).
Whole Life Insurance: Term Insurance plus Savings
 Whole life insurance has a death benefit AND savings element.
o Why do life insurance companies have such a bad reputation?
 It’s not an easy product for consumer to judge what’s good and bad value. Whenever consumers can’t tell
what’s good and bad, then companies will tend to try to cheat people.
o Term life insurance is something that average consumer can evaluate. For whole life insurance, it’s hard to figure
out if you’re going to get a good deal.
 Why would anyone want to buy a whole life insurance policy?
o If you didn’t get a fair return from insurance company, there are many tax advantages associated w/whole life
insurance.
 Single Premium Life Insurance:
o The purchaser makes a single payment in exchange for a death benefit (and perhaps retirement benefits) in the
future.
o Example: A 25-year old individual pays $10,000 to an insurance co. in exchange for a $50,000 death benefit to be
paid whenever death occurs.
 What’s really happening w/your $10,000 investment?
o Alternative to buying whole life insurance would be to buy a term life insurance for $500, and put rest of $10,000 in
other investments (that earn interest).
o When you pay a single premium policy, part of it is paid for the term insurance, and the rest is going to the savings.
That savings is earning a return for the insurance company, and the insurance company is paying you a return.
 Insurance company makes money b/c the actual return they offer you is much smaller than what they earn.
 When you buy single premium policy, insurance company takes small amount of your big premium and
use it to buy term life insurance (something you could have done on your own). Insurance company takes
the rest of the premium and earn probably 5% interest; they pay you probably 2-3%. That’s how insurance
companies make money.
o Example:
 Suppose you’re 30 years old and want to save money. Insurnace company says you can pay $100/month,
and death benefit is $100,000.
 Of that $100/month, $20 is going toward term life insurance; $80 is going toward savings.
Insurance company keeps record of how much money you save.
 Insurance company guarantees you will get more money than you put in; they also guarantee
you’ll get your savings if you pay out. Insurance companies make money by guaranteeing you a
lower % return than what money actually earns.
 Are you better off just buying term life insurance, and taking money to invest it in the market?
o You want to go with insurance company b/c the growth in value is not taxed until the money is withdrawn.
 Tax Policy and Life Insurance
o The saving element of life insurance is taxed quite favorably:
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o
The interest on the saving element of life insurance is not taxed until money is withdrawn under the policy.
The increase in value of the savings element is often called the “inside build-up.”
 If the inside build-up is withdrawn in the form of a death benefit, it is never taxed b/c § 101(a) excludes
death benefits from the tax base.
This is better than having savings on your own b/c earnings on separate savings might be taxed. Whole life
insurance has a huge tax advantage.
3/3/05
Whole Life Insurance
 Whole life insurance policy always has savings element to it—you pay more in premium than you would pay for term
insurance. This larger amount goes into “savings.” As savings builds up in value, you won’t be taxed on it. What can you
do with savings?
o (1) You could use it for retirement savings and take money out to supplement your SS when you retire.
 Growth in value of savings is not taxed until withdrawn under policy. When you take money out, you’re
taxed only on your gains (earnings amount). How does this compare with 401(k)s?
 Contributions: For insurance policy, there is no deduction when contributed. For 401(k), amounts
contributed are “deductible” (not taxed). So far, 401(k) is better.
 Inside Build-up: For insurance, growth is not taxed. For 401(k), growth in value is also not taxed.
 Withdrawal: In insurance, death benefit is not taxed and for retirement income, only gain is taxed
(not the whole money you get out). In 401(k), all withdrawal is all taxed.
 For retirement savings, 401(k) is better; it’s better to get deduction upfront and be completely
taxed than to not get deduction upfront and taxed later on gains.
o So, 401(k) is best investment vehicle for retirement. So why buy life insurance for
purpose of getting retirement savings?
 401(k) may not be available to you b/c you’re too rich and maxed out, or
employer you’re working for doesn’t offer it. If you can’t use 401(k), life
insurance can give you another forum of tax-favored savings.
 Life insurance is also not subject to same rigid rules as 401(k).
o (2) You could use it to buy more death benefit and pay for more insurance in the future.
 If earnings are used to buy greater death benefit, the death benefit that goes to your heirs is not taxed.
o So big advantage of life insurance are the two tax advantages.
 Death benefit not taxed at all.
 Gains from inside build-up are only taxed upon withdrawal.
 Is life insurance a good deal?
o It’s not a good deal b/c insurance company takes too big a cut. They charge a lot of money b/c they have lots of
costs (to provide higher level of service). Illegitimate reason for taking too big a cut is that they’re bamboozling
customers who don’t understand how it works.
o If you have lots of money and invest huge amounts, insurance company will give you a good deal. Transaction
costs of huge policy isn’t much more than transaction costs of small policy, so it’s a better deal.
Annuities
 Annuity: Contractual right to receive payments for a fixed term or for the life or lives of some person or persons.
o Ex: At age 50, Greta pays an insurance company $50,000. In return the company agrees to pay her $10,000 per
year for life, beginning at age 60.
 Classic use of annuity is to guarantee you will have income for the rest of your life.
o If you’re worried that you’ll be living for a long time, annuity can give you secure income each year. If you buy an
annuity, insurance company will guarantee payments for a fixed time or for life.
o If you have leftover money from your 401(k), sensible thing to do is to buy an annuity, guaranteeing income for the
rest of your life. You can structure it so it pays for your life and for the life of your spouse. You can structure it
however way you want.
 § 72: The purchaser of an annuity is not taxed until payment is received (inside build-up isn’t taxed). Each payment consists
partly of return of capital and partly of income earned. The portion taxed is calculated as follows:
o A percentage of each annuity payment (“exclusion ratio”) is excluded from taxpayer’s gross income. The
remainder of the payment is taxed.
 Ex: Part of $10,000 will be excluded from gross income.
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Once the total excluded payments equals the taxpayer’s investment in the annuity, all additional payments are
included in income.
 Ex: Greta’s basis in $50,000 policy is $50,000. As she gets money out, part of payments will be excluded
from tax. If $2,000 is excluded (not taxed), that would reduce basis to $48,000. If she lived for 25 more
years, and she’s excluded $2,000 per year, her basis is now zero. So, by now, every additional payment is
included in income.
o If taxpayer dies before she has recovered all of her investment, she is granted a deduction for the amount of the
“unrecovered investment.”
Exclusion Ratio: The exclusion ratio is a fraction
o (Investment in the annuity) / (Total expected payments)
o Ex: A purchases annuity at age 70 for $100,000. The annuity pays her $10,000 per year for life. Her life
expectancy is 15 years.
 Total expected payments are $150,000 (for 15 years). The exclusion ratio is $100,000/$150,000 = 2/3.
Thus, 2/3 ($6,666) of each payment is excluded from income and 1/3 ($3,333) is taxed.
 If she lived 20 years, then for first 15 years, you would apply exclusion ratio (2/3). She can exclude 2/3 of
payment each year. After 15 years, the full $10,000 will be taxed.
 Suppose she dies early (lives for only 10 years). She’s collected a total of $100,000; each year she’s been
excluding $6,666. She’s excluded total of about $66,660. She hasn’t excluded the last 1/3. In last year,
she gets tax deduction for amount she didn’t exclude for last 10 years ($33,330).
 Whatever money she put in to her annuity, she will recover that tax free. If she lives long (past the life
expectancy), she’s fully taxed once she’s recovered the full amount. If she lives short (doesn’t meet the
life expectancy), then she’s entitled to tax deduction for amount she didn’t exclude for years she received
annuity payments.
Tax advantage of annuities: deferral
o 1) No tax is paid unless payments are made, even though the investment is increasing in value (i.e., earning interest)
each year.
o 2) Taxable gain on the annuity is assigned equally to each payment received (assuming equal payments) even
though the actual gain is higher in the early years and lower in the later years.
 It’s better to pay taxes later rather than earlier.
o This tax treatment is more favorable than straight income tax.
Why buy annuity? Advantages of buying annuities:
o Be sure you have money to live for the rest of your life.
o Has important tax advantages (see above).
Bad sides to annuities
o For many people who retire, it may not be a good deal b/c:
 Insurance companies may try to cheat you (but you can avoid this by cleverly shopping around); or
 Annuity pays you income for the rest of your life. If you live a long time, you deal really well with
annuity, but if you die early, you do poorly. So, really healthy old folks buy annuities. This leads to
adverse selection—only really healthy people buy annuities, so insurance companies can’t use regular age
expectancy charts.
o LA Times Article regarding blacks and SS
 Once you hit 60, difference b/t white and black males’ life expectancy is only a year or so. Reason why
there’s age expectancy discrepancy b/c there’s higher infant mortality rate for blacks, and black males are
likely to die 18-24 (b/c they’re likely to get murdered).
 Difference b/t black and white mortality rates mainly refers to problem of black male murder rate. SS
argument that private accounts are better for blacks is a lie b/c young blacks don’t contribute much to SS at
all.
o
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3/4/05
Gambling Income
 Gambling gains are taxable income.
 Gambling gains can be reduced by gambling losses during the same tax year. But these losses are deductible only as
itemized miscellaneous deductions. Thus, one is required by law to report winnings even if one is a net loser for the year.
o Ex: If you won $1,000 gambling one week, and lost $1,000 gambling the next week, you could deduct losses “only
as miscellaneous deductions.” So you still have to report winnings, even if you have net losses.
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Gambling expenses, such as travel expenses to tournaments, are deductible only for professional gamblers.
o You prove you’re a professional gambler by persuading IRS that you have an actual intent to make money. You
have to behave like a professional gambler (like it’s your full-time job) and you have to have net winnings.
o The more “fun” the activity, the more suspicious IRS will be.
The value of “comps” are treated as gambling winnings.
Reporting Requirements: W2-G
o The payer must issue you a W2-G form if your winnings are $600 or at least 300 times the amount wagered. This
applies to winnings events such as dog racing, horse racing, and state lotteries. It also applies to certain casino
games such as “Let It Ride.”
o For Bingo or Slots (including video poker), a W2-G must be issued for a win in excess of $1,200. For Keno, a W2G applies to net proceeds (win amount minus cost) greater than $1,500.
o Large winnings in table games such as blackjack and roulette are not reported to the IRS.
 Why does IRS require you to report winnings of $1,200 in slot machines, but not for winnings on table
games?
 Law doesn’t require you to report every $10,000 win and then take itemized deduction for each
loss. What it does require is to keep track of winnings per session.
o Ex: Session A: +30,000; Session B: $-40,000, etc. At end of year, you have 10 winning
sessions of $300,000 and 10 losing sessions of -$400,000. You take loss as itemized
deduction, but that doesn’t reduce alternative minimum tax. Even though he’s a net
loser, he’s seeing his tax go up b/c he doesn’t get full value for his deduction.
 As policy matter, you should just combine wins and losses, and just take net amount. It would be
easier that way, but that’s not how the law is.
 As practical matter, IRS doesn’t go after the average gambler.
o To keep track of your winnings and losses, you should keep a contemporaneous log/diary.
Personal Injury Recoveries
 § 104: Compensation for injuries or sickness
o (a) Gross Income does not include:
 (1) Workmen’s compensation for personal injuries or sickness.
 (2) Damages (other than punitive damages) received (whether by judgment or settlement) on account of
personal physical injuries or physical sickness.
 Damages for emotional distress or other non-physical injuries are taxable.
 If you suffer physical injury, and as result of injury you get mental distress, then it’s tax-free.
 (3) Amounts received through health or accident insurance for personal injuries or sickness (if the
premiums were paid for in after-tax dollars).
 (2) deals with concept of tort recoveries. (3) is separate issue and deals with amount you get paid
from insurance policy for disability.
 If you can’t deduct insurance payments/premiums, then money you receive is tax-free. For
disability insurance, taxpayers have choice whether to deduct premium.
o If employer offers disability insurance, and employee takes it, he has choice whether to
deduct premium. If he chooses not to exclude disability payments, and then he becomes
disabled, money he receives is tax-free.
o OTOH, if he excludes premiums, then he is taxed on money he receives after disability.
 (4) Pensions received for certain disabilities such as those due to injuries in combat.
 (5) Amounts received for disabilities by US employees arising out of terrorist attacks in foreign countries.
 Paragraphs (4) and (5) affect very few taxpayers. Don’t need to know (4) and (5).
 Additional Rules
o (1) Emotional distress generally is not a physical injury. However, recoveries for emotional distress may be
excluded from gross income up to the amount of medical expenses incurred as a result of the emotional distress.
o (2) Punitive damages in a civil wrongful death action can be excluded from gross income if, under state law, only
punitive damages can be awarded in such an action.
 Treatment of Attorneys’ Fees for Taxable Recoveries
o Cases: Commissioner of Internal Revenue v. Banks and Commissioner of Internal Revenue v. Banaitis
 Taxpayer must take into income the full recovery, without deduction for attorneys’ fees.
 Taxpayer can deduct attorneys’ fees, but only as miscellaneous deductions subject to a 2% of AGI floor.
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o
 Fees are not deductible at all for purposes of the alternative minimum tax.
 Thus both the attorney and the client are taxed on the fee portion of the award.
However: Congress recently passed a provision allowing taxpayers who win awards in employment, whistleblower,
and civil rights litigation not to count attorneys’ fees and court costs as taxable income.
Structured Settlements
 Interest earned on damages is taxable (like ordinary interest).
 However, if otherwise tax-free personal injury settlements are paid over a period of years, the entire recovery is excluded
from income even if the payments to be made in the future include implicit interest as compensation for the delay. This
exclusion may create an incentive to pay the award over time.
o Options
 A: Pay $500,000 at once.
 B: Buy annuity that pays $80,000 per year for 10 years. You’ll be able to exclude $50,000 per year and
pay tax on $30,000/year (based on exclusion ratio).
 C: Just take yearly payment over 10 year period.
o You may be able to structure settlement such that D pays out money in a deductible manner, and the recipient is not
taxed on it.
 Using a set of complex transactions with an insurance company, the tortfeasor business may be able to obtain an immediate
deduction.
 Ex: Amy (see handout)
o Amy is injured in auto accident. She is considering 2 settlements from the insurance company.
 Settlement 1: Lump sum of $100,000 which she can use to purchase an annuity paying $15,000 per years
for 10 years.
 Settlement 2: A structured settlement under which she will receive $15,000 per year for 10 years.
o If Amy chooses Settlement 1, the receipt of $100,000 is tax-free.
 Amy’s basis in the annuity will be $100,000. She will receive a total of $150,000 over the 10 year period
from the annuity. Under the annuity rules, $5,000 of each $15,000 payment will be taxed.
o If Amy chooses Settlement 2, the entire $15,000 she receives each year will be tax-free.
Personal Injury Recoveries: What Should Be Taxed?
 Types of Recoveries
o 1) Recoveries for Loss Wages
o 2) Recoveries for Medical Expenses
o 3) Recoveries of Pain and Suffering
o 4) Punitive Damages
 One argument is that you have to pay lawyers, so you should offset this liability by making recovery tax-free.
o Counterargument is that juries generally recognize recipients have to pay lawyer, so they knowingly jack up
settlement to compensate for attorneys’ fees.
 If it’s a personal, physical injury, law says that 1, 2, 3 are tax-free, and 4 is taxable. As policy, what should the law be?
o Should you be taxed on amount of recovery for loss wages?
 Yes, b/c had you earned the money, you would have been taxed on the wages. Hence, the replacement of
the money you would have earned should be taxed, too. You shouldn’t be more compensated for loss; you
should be compensated in amount equal to what you would have earned.
o Should you be taxed on amount of medical expenses?
 These should be tax-free. Goal is to completely compensate the victim, but no more. IF person had not
been injured, he wouldn’t have had any medical expenses. After injury, he has medical expenses. IF we
tax those medical expenses, he’s worse off than if he hadn’t been injured.
o Punitive Damages?
 These should be taxed b/c punitive damages don’t represent any loss whatsoever. They just represent pure
windfall gain to the recipient.
 Counterargument is that punitive damages should be tax-free b/c it would encourage people to sue
corporations if their policies are particularly egregious.
o Should recoveries of pain and suffering be taxed?
 Whether this should be taxed depends on your theory of taxation. See below.
 What is the correct treatment under each of the following theories?
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o
o
o
Tax by financial well-being. Persons should be taxed according to their financial well-being (taking proper account
of both income and needs).
 If you subscribe this, you would tax recoveries of pain and suffering. If you suffered terribly for 6 months
after operation, your medical expenses are paid for; your wages are compensated for; but you get extra
money for pain and suffering. They’re not better off overall, b/c money just compensates for their pain and
suffering. But they’re better off financially. So, they ought to be taxed on pain and suffering recovery.
 Utilitarians would tax b/c utilitarians want to maximize total welfare, and thus wants a tax system
based on the marginal value of money. People with high marginal value of money should pay less
taxes, and people with low marginal value of money (like Bill Gates), should pay more taxes.
o Utilitarian would want to tax the person for whom the extra money is worth the least
(low marginal value of money).
o Suppose Alice earns $100,000/year, is healthy, and Bob has $40,000/year and is healthy.
Both have to pay an extra $1000. We’d rather tax Alice b/c paying the extra $1,000
doesn’t matter as much to Alice.
o Suppose we also have Carol, who earns $100,000/year, is sick, and pays $20,000 in
medical expenses. It’s as if she just earned $80,000/year.
o Suppose we also have Doug, who’s healthy and earns $80,000/year. He’s as financially
well-off as Carol. Though Doug is better off overall than Carol, they’re on the same
level in terms of financial level.
o Suppose Earl earns $100,000/year, is healthy, but he has pain and suffering which
medical treatment can do nothing about whatsoever. Paying an extra $1,000 doesn’t
mean more to him than to Alice since they make the same amount of money. If it’s
something that money can’t do anything about, then utilitarian says that you should only
consider financial well-being.
Tax by overall well-being. Persons should be taxed according to their overall well-being.
 If you subscribe to this, then you should not tax recoveries of pain and suffering b/c person is no better off.
Though he has more money, he has pain and suffering worth the amount of recovery for pain and suffering.
There is no right answer b/c the right answer depends on your personal moral philosophy.
Accident and Health Plans
 § 105: Amounts Received under Accident and Health Plans
o a) Are included in income if attributable to contributions by employer (or to deductible payments by employee).
o b) However, amounts received under accident and health plans are not included if such payments are reimbursement
for medical expenses for the taxpayer, her spouse or dependents, unless the medical expenses previously were
deducted by the taxpayer.
o c) Payments for the permanent physical impairment of the taxpayer, spouse or dependent also are excluded from
income if the payments are not related to period of absence from work.
 Disability payments are related to how much work you miss. These will be taxable to you.
 Ex: An insurance policy pays $50,000 if the insured person loses use of a hand.
o Money you receive for lost hand is tax-free (as long as it’s not related to how much work you miss).
Insurance Provided by the Employer
 § 106: Employer-paid medical insurance (and contributions to certain medical savings accounts) is not included in the
employee’s income. (But the employer can deduct payments made.).
 § 79: Employer-paid life insurance up to a death benefit of $50,000 is not included in the employee’s income. But the
employer can deduct payments made. Nondiscrimination rules must be followed with respect to the provision of the
insurance.
3/9/05
Use Tax – no one really pays this tax b/c no one knows how much they’ve bought from other states. Mainly applies to Internet sales.
 This is a poor law b/c it’s too complex to ask individuals to do this. No one will obey it except for tiny group of timid/honest
people.
 How do you stop businesses from taking advantage of use tax and buying tons of equipment across state lines (w/o paying
use tax), while at the same time, not burdening regular people with complexity of use tax calculations?
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o
Make an exemption for first “x” dollars of purchases. Pick some number to allow people to make small amounts of
purchases not to report anything. That way, companies that make big purchases do not get away with not paying
use taxes.
Personal Injury Recoveries (continued)
Additional Rules
 (1) Emotional distress generally is not a physical injury. However, recoveries for emotional distress may be excluded from
gross income up to the amount of medical expenses incurred as a result of the emotional distress.
 (2) Punitive damages in a civil wrongful death action can be excluded from gross income if, under state law, only punitive
damages can be awarded in such an action.
Treatment of Attorneys’ Fees for Taxable Recoveries
 Cases: Commissioner of Internal Revenue v. Banks and Commissioner of Internal Revenue v. Banaitis
o Taxpayer must take into income the full recovery, without deduction for attorneys’ fees.
 The entire amount you recover is taxable to you, even though some of it goes to attorney.
o Taxpayer can deduct attorneys’ fees, but only as miscellaneous deductions subject to a 2% of AGI floor.
o Fees are not deductible at all for purposes of the alternative minimum tax.
 If you’re in high tax bracket and recover huge settlement, you’re taxed on entire amount (even though
some of it goes to attorney). You’ll still be paying taxes on entire amount.
o Thus both the attorney and the client are taxed on the fee portion of the award.
 Attorney is also taxed, so the money that goes to attorney is taxed twice.
 However: Congress recently passed a provision allowing taxpayers who win awards in employment, whistleblower, and civil
rights litigation not to count attorneys’ fees and court costs as taxable income.
Loan Transactions and Relief from Indebtedness
Basic Rules Regarding Loans
 1) Loan proceeds are not income and loan payments are not deductible.
o This rule applies both to:
 Recourse loans (borrower is personally liable); and
 Nonrecourse loans (borrower is not personally liable).
 Ex: In CA, amounts borrowed for original loan to purchase home is a nonrecourse loan. If you
don’t pay it back, the only remedy the lender has is to repossess the home. They can’t sue to get
money back.
o The moment you refinance, the loan becomes a recourse loan.
o Ex: Joe buys home for $500,000; put $50,000 down payment and borrowed $450,000
(nonrecourse loan). After few years, home is worth $600,000, and mortgage is now at
$430,000. When Joe signed up for mortgage, interest rate was 7%. Now, interest rates
are at 5%, so he wants to refinance. He then borrows another $430,000, which pays off
the $430,000 of his original mortgage. The tax consequences of paying off mortgage are
nothing (b/c you’re borrowing money to repay loan). Now it’s become a recourse loan
b/c you can get the home plus sue the person for unpaid loans.
o If they refinanced and took a payment of cash from portion of refinanced mortgage, there
are no tax consequences on taking out cash (b/c loan proceeds are not income).
o This treatment is consistent with a Haig-Simons income tax b/c the increase in consumption is offset by a decrease
in wealth (due to obligation to repay loan).
o Alternative rule (not the law): Loan principal could be income when received and deductible when paid. This is
consistent with a consumption tax (if the loan proceeds are consumed).
 2) Discharge of Indebtedness
o Rule: Individuals are taxed on the discharge of indebtedness.
o Ex: Bob borrows $50,000 at 8% interest and takes a trip to Australia. When he returns 6 months later, he learns that
interest rates have risen, so the loan is worth less to the bank. Bank says it is willing to accept $45,000 in payment
of the loan. Bob pays the $45,000 (he has inherited some money).
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o
o
o
 The taxpayer is taxed on $5,000 of gain.
When you pay a loan back for less than you borrowed, you are taxed on your gain from that transaction.
United States v. Kirby Lumber (1931)
 1923: Kirby Lumber issued $1M of bonds. Later in year, Kirby Lumber repurchased bonds for $862,000.
 Issue: Does this sale and repurchase generate taxable gain?
 Holding: Yes, he must pay tax on that gain.
3/10/05
Discharge of Indebtedness is treated as if you had gotten cash.
 If you’re taxed on the cash, you’re taxed on the discharge.
Transfers of Property Subject to Debt


Amount borrowed are included basis and thus may produce depreciation deductions.
o Ex 1: Alan buys property for $500,000 and rents for the property for a net $70,000 after all expenses. A will be able
to depreciate the property. Suppose, for example, that the property is eligible for a $20,000 annual depreciation
deduction. A’s annual taxable income from the property would be $50,000 ($70,000 less $20,000) and Alan’s basis
would be reduced by $20,000 each year.
 After 8 years, Alan’s basis would be $500,000 less $160,000 or $340,000. If the property then were sold
for $500,000, Alan would recognize income of $160,000.
If property subject to a liability is transferred to another, the discharge of debt is treated as a part of the purchase price.
o Ex 2: Suppose instead that Alan borrowed $500,000 to purchase the property and that the loan was interest only and
non-recourse with a 10% rate.
 Alan gets a $50,000 interest deduction and a $20,000 annual depreciation deduction. This completely
offsets the $70,000 rent he receives so Alan has no taxable income. But Alan has a positive cash flow of
$20,000 ($70,000 rent received less $50,000 interest paid). Suppose at the end of the 8th year, he
abandons the property and the bank retakes it. What are the tax consequences of the transaction?
 Answer: A is treated as if the property was sold to the bank for the liability of which he was relieved—in
this case $500,000. Thus Alan recognizes a gain of $160,000.
 This makes sense b/c during the prior 8 years, he received $160,000 of cash tax-free.
o When you purchase property, the amount you borrow for property is included in basis. Since it’s included in basis,
you can include it for depreciation. When you sell or exchange property, the amount of debt you’re relieved of is
treated as amount realized.
o Ex: Suppose you buy a home. You have a mortgage of $400,000, and a down payment of $100,000 (totaling
$500K). Basis in the home will be $500,000.
 Now imagine your home has gone up in value to $800,000. What is your basis in home now?
 Basis is still $500,000. You can only depreciate basis for business property, not personal
property.
 Now, you refinance property and have new mortgage of $700,000. Does this change their basis in the
home?
 No. When you borrow money to buy a home, that will increase its basis. But here, they didn’t
use money to buy home; they just refinanced. Their basis is still $500,000 (the amount they
bought the home for).
 After a few years, you’ve paid a little of the mortgage, which now is $650,000 and then sell the home,
which is now worth $1,000,000. You have to pay a broker 6%, so you get $940,000 after paying broker
and other fees. You then pay off bank for $650,000, leaving you with $290,000 in cash. What is your
taxable gain in the home, leaving aside exclusion for personal revenue?
 Gain in home is equal to amount realized ($940,000) minus basis of $500,000 = $440,000 gain.
How much tax do you pay?
o If you’re married, it’s zero b/c you can exclude first $500,000 of gain. If you’re single,
you exclude first $250,000.
o How much you got out after paying mortgage ($290,000) doesn’t matter for tax paying
purposes.
Commissioner v. Tufts (1983) (p. 172)
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

P-ship takes nonrecourse loan of $1,851,000, contributes $44,000 capital and purchases apartment house. P-ship’s basis in
apt house is $1,895,000. Over next couple years, p-ship takes $440,000 of depreciation. This reduces the p-ship’s basis in
the property to $1,455,000. Then p-ship transfers property to a third party for inconsequential amount on cash plus
assumption of the nonrecourse mortgage. At the time of the transfer, the property is worth no more than $1,400,000.
o How much gain should they realize on transfer of this property?
 The p-ship reports a $55,000 loss on the sale: $1,400,000 value less $1,455,000 basis. They said under
general principles, you can’t sell property for more than it’s worth, so it should be treated as worth
$1,400,000.
 The p-ship is out about $44,000 (money they put up to buy property). Their real economic loss is about
$44,000. What are the tax consequences to them?
 They have taken tax deductions equal to $44,000 already.
IRS argues that the p-ship should report a $400,000 taxable gain—the difference b/t the liability discharged and the p-ship’s
basis.
o Amount they realized was not FMV; it was amount they got (their debt of about $1.8M was discharged).
S.Ct. holds that the liability assumed must be treated as part of the sales price even if the liability assumed exceeds the FMV
of the property.
o When you transfer property subject to a liability, the amount of liability discharged will be treated as part of the
sales price of the property.
o Reasoning:
 P-ship has reported a loss of $440,000.
 However, the p-ship’s out of pocket loss is only their investment of $44,000.
 Therefore, the p-ship should report a gain of $396,000.
o Contrary result would permit a tax loss through depreciation where there has been no economic loss.
Illegal Income
 General Rule: Illegal income is taxable. Expenses associated w/earning illegal income (with a few exceptions) are
deductible.
o In theory, IRS is not supposed to be used to charge criminal for crimes. From tax point of view, you have to report
illegal income and can deduct expenses associated w/it.
 Embezzling Income
o Suppose you embezzle $100,000 and gamble it all away. What are tax consequences?
 You still have $100,000 of taxable income; you can’t deduct your gambling losses.
o Suppose you took that $100,000 and bet it on stock options, and lost it then. You would then have a $100,000 of
taxable income, and $100,000 in losses of stock options (maybe a capital or ordinary loss).
o There’s no special treatment of what you do with embezzled income. Whether you get a deduction depends on how
you lose the money.
o IRS takes priority over victims of embezzlement, which seems unjust. Only if victim is responsible for catching
embezzler, then can victim go first in line to get money.
 Gilbert v. Commissioner
o FACTS
 Gilbert was president and principal shareholder of Bruce Corp. He wanted Bruce to acquire Celotex and to
merge w/it.
 G purchased Celotex shares on margin (borrowing to purchase them) and also had Bruce buy shares. He
gave Bruce the option to purchase his Celotex shares at cost.
 Buying on margin – loaner bears virtually no risk b/c they’ll get the stock if not repaid.
o If stock drops close to loan amount, brokerage firm has provision that once stock drops
in value to area where it’s close to loan amount, initial purchaser must do one of two
things—margin call. Buyer has choice either to sell choice or immediately pay back
some of the loan (if he choose not to sell stock).
o This is what happened to Gilbert.
 Stock market declined and Gilbert had to meet the margin call or sell the Celotex shares. He used about
$1.9M of corporate funds to cover the margin call w/o proper board approval. But he intended to repay
amount and so informed the board.
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

Celotex stock declined further. Gilbert issues promissory notes secured by his personal property for the
amount taken from Bruce. But Bruce does not perfect its property interest in G’s property, so IRS has
priority right to assets.
Bruce takes a loss deduction for the $1.9M withdrawn by Gilbert b/c it will not be repaid.
o
ARGUMENTS
 IRS claims G owes tax on the money embezzled from Bruce.
 G argues he has no income from the embezzled funds b/c
 1) He intended to repay the funds at the time he embezzled them.
 2) He has a legal obligation to repay the funds.
 3) He gave Bruce a secured promissory note to cover the amount owed.
o IRS notes out that factors (1) and (2) alone do not prevent taxation of embezzled funds.
o Tax Court rules for the IRS – 2nd Circuit reverses.
o APPEALS COURT REASONS:
 1) Embezzled funds usually are taxable income.
 2) If embezzler spends the loot, he cannot avoid taxation by signing promissory notes in the same year.
However, actual repayment of the embezzled amount will avoid tax.
 3) Here, however, G always intended to repay and was acting in what he thought was the best interest of
the corporation—he quickly told the board of his intention. After the assignment of his assets, G’s net
accretion to wealth from the embezzlement was zero. Moreover, G’s assets securing the promissory note
fully covered the amount embezzled.
 General Rule: Once a thief steals money, he must report income and the tax liability to the IRS take precedence over
repayment of the victim.
3/11/05
Interest on State and Municipal Bonds
 § 103: Interest issued on state and municipal bonds is not subject to federal income tax.
 Result: State and cities can borrow more cheaply.
 Issue: Does this violate “horizontal equity?”
o Yes, it does. Argument:
 Ex: Alice and Bob have the same earned income and face a 40% marginal rate. In addition, Alice has
$100,000 of interest from corporate bonds. Bob has $100,000 of interest for municipal bonds. Alice will
pay $40,000 more in taxes than Bob even though they have the same income.
o No, it doesn’t. Argument:
 Municipal bonds pay a lower interest rate than corporate bonds with the same risk characteristics.
Otherwise, all investors would purchase municipal bonds.
 In the previous example, Bob would have to pay more for a municipal bond yielding $100,000 per year in
interest than would Alice for a corporate bond yielding the same amount.
 Another example:
o Suppose that corporate bonds have an interest rate of 10%. If Carol is in the 40% tax bracket, what interest rate will
equally risky municipal bonds need to pay in order to induce Carol to purchase municipal bonds?
 Answer: At least 6%. Since Carol is in 40% bracket, her after-tax return on an investment paying 10%
interest is only 6%.
 Putative tax: The difference b/t the interest rate paid on taxable bonds and the rate paid on municipal bonds is sometimes
called the putative tax on the bonds. For example, if taxable bonds pay 12% and tax-free bonds pay 9%, the putative tax is
25%.
 Who will purchase state and municipal bonds?
o Answer: Taxpayers with an actual tax rate higher than the putative tax. One effect of the tax preference for state
and municipal bonds may be to lower the effective tax rate on the wealthy.
 Suppose Group A is in 40% tax bracket (very rich), Group B at 30% rate, and Group C at 20% rate. State
gov’t wants to sell $100M in bonds. Assume that corporate bonds pay a 10% interest rate.
 Imagine states offer 5% interest rate on their bonds, which are as safe as corporate bonds. No one
would buy state bonds b/c if you bought corporate bonds, A will get 6% on bonds after taxes, B
gets 7%, and C gets 8%. No one wants the 5% rate.
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
Suppose states offer 6% on state bonds. A would equally like state and corporate bonds (since
both are 6% after taxes). If state makes it 6.1%, then more people in Group A would buy state
bonds.
 Suppose bonds are at 6% and state was able to sell $40M in bonds. That’s not enough, so it’s got
to raise interest rate. Until they reach 7%, only Group A folks are willing to buy the bonds.
 At 7%, state gets Group B people, so they sell $60M more in bonds. The key point is that state
can’t get $100M until they reach 7% to reach the B people.
 The rate paid on municipal bonds is higher than the rate that would be needed to bring in the highest
bracket tax payers. Municipal bonds are only attractive to people with high tax rates.
o Who benefits?
 State benefits. They are saving 3% per year on bond issue (7% vs. 10%).
 Group B taxpayers are either not benefiting or not benefiting much at all. They pretty much break even on
it.
 For Group B, federal gov’t is losing 30%, but state gov’t is getting 30% reduction in interest rate.
It’s a straightforward transfer from the federal gov’t to the state gov’t. This offsets what the
federal gov’t is losing. This is fine as a matter of policy.
 Group A taxpayers benefit a lot. If they bought corporate bonds, they would be paying 40% taxes. But if
they bought municipal bonds, they would only pay 29.9% on their taxes (with interest rate of 7.1% for
municipal bonds).
 If Group A had bought corporate bond, they would have to pay $40,000 to fed gov’t for $100,000
in bonds. For highest taxpayers, for whom putative tax is lower than normal tax rate, the amount
they save is greater than the state gov’t benefits. This is very beneficial for the very wealthy, but
not fair as a matter of public policy. It undermines the progressivity of the tax system. So this is
the argument against not subjecting state/municipal bonds to federal income tax.
o Why haven’t we eliminated this tax break, tax the municipal bonds, and just give the state a subsidy?
 1) States don’t want it. They are suspicious federal gov’t won’t give them the money.
 2) From point of view of people in federal gov’t, they like the fact that this is “off-budget.”
 If gov’t had abolished this rule and fully taxed municipal bonds, took that money and gave it back
to the states, there would be increased tax revenues and increased aid to the states. Current system
has tax revenues reduced by this tax advantage, and aid to the states (in terms of lower interest).
In both cases, federal gov’t is interfering w/the market.
o If you gave states block grant of cash, that wouldn’t necessarily encourage people to
borrow. But if you lower interest rates, that might encourage people to borrow.
How do investments in state and municipal bonds compare to investments in qualified pension plans?
Limitations on the Issuance of Tax-Exempt Bonds
 1) Unlimited tax-free bonds may be issued for traditional gov’t purposes like schools and parks, and roads and sewers.
 2) Other bonds called “private activity bonds” generally are not tax exempt at all.
 3) However, some forms of private activity bonds are permitted. Examples:
o a) “Exempt facility bonds” used for airports, docks, mass transit, water, and sewage, etc.
o b) Some bonds used for low and moderate income housing;
o c) Certain bonds for charitable purposes.
 4) There are, however, limitations on the amount of private activity bonds that can be issued by a state.
 5) Interest on private activity bonds may be subject to the alternative minimum tax and thus not truly tax-exempt.
 6) Regulations prevent states from engaging in “tax arbitrage” – borrowing money tax-free and reinvesting the money at
higher rates.
Sale of Principal Residence - § 121
 Basic Rule: Gross income does not include gain from the sale or exchange of property, if during the 5-year period ending on
the date of the sale or exchange such property has been owned and used as the taxpayer’s principal residence for period
aggregating 2 years or more.
 Limitations
o A) The amount of excluded gain cannot exceed $250,000 (or $500,000 on a joint return). In the case of a joint
return, only one spouse needs to meet the ownership requirement.
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o


B) The exclusion does not apply to a sale if, during the 2-year period ending on the date of the sale, there was
another sale to which the exclusion applied.
 Means you can only do this once every two years.
o C) Relief provisions permit a smaller exclusion if the taxpayer cannot meet the “2-year occupancy” or “once every 2
years” requirement b/c of a change in health, employment, or certain other unforeseen circumstances.
For most people who buy a home, and when they sell it, they pay no tax on the gain at all.
o Why only 2 year living requirement?
 Worried about situation where market is down and you can’t sell it. Gov’t is generous about allowing you
to get this exclusion, even if you’re currently not living in the property.
o This gives motivation to sell home before if goes up in value over $500,000 (for joint return), so you don’t have to
pay taxes on it.
Suppose you buy home for $500K, and you put $100K in improvements. Will basis increase by improvements when you
sell it?
o Basis includes what you paid for and any capital improvements you put into the home. So any gain would take into
account this new basis.
 If what you did improves the home and makes it better than it ever was, that would be considered a capital
improvement.
 Ex: Repainting home is not a capital improvement. But adding solar panels on the roof would be
a capital improvement.
Recognition of Loss
 Taxpayers want to recognize losses, but usually don’t want to recognize gains.
 Issue: When are business losses recognized?
 § 165(a): There shall be allowed as a deduction any loss sustained during the taxable year and not compensated by insurance
or otherwise. (These rules only apply to businesses or investment property.)
o Amount of the loss = Adjusted basis of the property
o 1) A loss will not be recognized simply b/c property has declined substantially in value.
o 2) Rather, a loss must be evidenced by a closed and completed transaction, fixed by identifiable events. See Reg.
1.165-1(d)
 A loss will be recognized if property is sold, exchanged or abandoned.
 A loss will be recognized in the year property becomes worthless.
 Ex: If you bought stock, and now it’s worth next to nothing. You don’t want to sell it b/c you hope it will go back up. A few
years pass, and now you admit it’s worth nothing and sell it. You can’t deduct it now. You must deduct it the year it became
worthless. If SOL has run, you won’t be able to deduct it. If you make a major purchase, and it goes down in value so that
it’s nearly worthless, you should sell it. Don’t take chance that you’ll be denied loss permanently.
o You must take losses when you’re entitled to take them. Don’t just sit on losses.
Revenue Ruling 84-145
 Before deregulation, airlines had exclusive or semi-exclusive rights to certain routes. These rights were quite valuable. It
often cost the airline a lot of money to get the routes. They were required to “capitalize” the cost—that is, they could not
deduct the costs, but the costs generated a “basis” for the routes.
o If it’s an item you use up during the year, you can deduct it. But if a business purchase something that has a longlasting value (like a machine), they have to capitalize it. Airlines couldn’t deduct it or depreciate it (b/c its value
won’t go down).
o After deregulation, airlines no longer had control over such routes. They became almost worthless. Barring some
disqualifying attribute, any airline could serve any route. Airlines wanted to deduct as a business expense the
amount they paid for those routes.
 Issue: Can an airline take a loss for the decreased value of the airlines routes after deregulation?
o No. The taxpayer can only take the loss when the routes are abandoned as worthless. Reg. 1.165-1(d) provides that
to be allowable as a deduction under § 165(a) a loss must be evidenced by closed and completed transactions, fixed
by identifiable events.
 Here, airlines had not sold, abandoned, or exchanged the routes (they were still running).
 IRS also said the routes hadn’t become entirely worthless, so company couldn’t take any deduction.
 Policy Issues:
o What are arguments for allowing the airline to take a deduction?
54
o
What are arguments against allowing the airline to take a deduction?
Original Issue Discount (OID)
Introduction
 Suppose that a $149 investment grows at a 10% rate. After 20 years, the investment will be worth $1000 for gain of $851.
 The above result assumes that the growth in value of the investment is not taxed annually. Taxing the annual return a
produces substantially smaller gain.
o If, for example, a taxpayer in the 40% bracket invested $149 in a savings account earning 10 interest, the after-tax
return would be 6%. At that rate, the $149 woul dbe worth $478 for a gain of $329.
Original Issue Discount
 Suppose Tina, a 35% taxpayer, purchases a bond for $149 that pays no annual interest but which can be cashed in for $1000
in year 20.
o When should the gain on the bond be taxed?
o Should the gain be taxed as ordinary income or capital gain?
 Option 1: Tax the bond like a growth stock or real estate.
o Under this option, the gain would be taxed in year 20 at long-term capital gain rates (currently 15% for higher
bracket taxpayers). Tina would pay a tax of $128 on her $851 gain, leaving her with an investment worth $872
($1000 - $128) and an after-tax gain of $723 ($872 - $149).
 Option 2: Tax the bond like a saving account.
o This option requires imputing annual interest and taxing that interest annually (at ordinary rates). The bond would
be treated as if it paid annual interest of 10% (the rate at which $149 grows to $1000 in 20 years) and that imputed
interest would be taxed annually.
o Although Tina would be required to pay the tax out of her other income b/c the bond does not pay out interest
annually, it is easier to think of the tax as reducing the return on Tina’s investment by her tax rate. Tina’s tax rate is
35% so her investment return is reduced from 10% to 6.5%. At this rate, Tina’s investment grows to $525 for a
gain of $376.
 By year 20, she doesn’t have to pay additional tax b/c she’s been paying tax every year on the interest.
 Option 3: Compromise Approach
o Tax the gain on the bond in year 20 at ordinary rates. Tina pays a tax of $298 on her $851 gain, leaving her with an
investment worth $702 ($1000 - $278) and an after-tax gain of $553 ($702 - $149).
 Which option is the law?
o In general, Option 2. The OID rules in § 1273 provide that interest will be imputed and taxed annually if there is no
(or inadequate) stated interest on a loan.
o As a matter of policy, which one makes sense? Hard to know.
 If you’re a diehard consumption tax guy, you ought not to tax investment returns at all. They like Option
1.
 Under income tax, some transactions are taxed more favorably than others.
 If you love Haig-Simons, you would say everything should be taxed under Option 2.
 IRS concluded it’s more like a savings account. Savings account have an absolute safe guaranteed return
each year, as do these bonds. OTOH, investments in real property and stocks vary (might go up or down).
Gov’t has decided to favor investments in real property and stocks. When we have fixed guaranteed
return, gov’t taxes it immediately. OID is similar to putting money in the savings account, so they tax
immediately.
 OID applies to bonds
o Zero coupon bonds
 Bond of coupons (don’t get interest on each year). For example, you buy bond for $149, and promised
$1000 in year 20. It’s easy to calculate interest rate, which was 10% in this case.
OID and Sales of Property
 OID also can apply to sales of property (a bit more complicated).
 Example:
o Cynthia agrees to purchase Greenacre from Troy. The purchase price is $1,000,000 to be paid 10 years. Cynthia is
not required to pay any interest to Troy. She simply must pay him the $1,000,000 in year 10.
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Under the OID rules, the form of this transaction will not be respected. Rather, Cynthia will be treated as if she
purchased Greenacre for a lesser amount and then paid interest on that amount for 10 years.
o The imputed interest rate is a federal rate that varies according to current market conditions. The lower the rate, the
higher the original purchase price.
 If, for example, the imputed interest rate is 10%, then Cynthia will be treated as having purchased
Greenacre for $386,000 (which is also the basis).
 If the imputed interest rate is 7%, OTOH, the purchase price will be $508,000 (which is also the basis).
 So each year, Troy will be taxed each year on the imputed interest. Cynthia will get a deduction for this if
it were a business transaction.
Rules of property require you to apply OID rules to get true property purchase price.
o Taxpayer can avoid OID problems in sales of property simply by stating that they will charge at least the federal
interest rate. As long as you have a reasonable interest rate stated, you don’t have to worry about the OID problem.
Some Exceptions to OID
 Tax-exempt obligations
 Obligations under 1 year
 Loans under $10,000 between natural persons
 Sales of principal residences
 Sales of farms for less than $1,000,000
 Sales of property for payments totaling less than $250,000
 § 483, however, generally will apply to these transactions and ensure that interest is taxed as ordinary income rather than
capital gain, even if interest is not imputed annually. This is the “Compromise Approach” described in Option 3.
o Even if an exception applies, IRS may apply OID rules, so that interest will be taxed as ordinary income instead of
capital gain.
3/23/05
For final: Know OID (don’t need to calculate it). Think of it as possible issue. If problem says there’s adequate state interest, then
you don’t have to worry about OID.
Installment Sales
 Burnet v. Logan (1931) (NO LONGER GOOD LAW)
o Mrs. Logan sells shares in a mining company. Basis was $180,000. Sales price: $120,000 cash plus annual
payments that depend on the mineral extracted.
o Gov’t estimates: Logan would receive payments of $9,000 per year for 25 years.
o How should she be taxed?
 Option 1: Closed Transaction (pro-IRS)
 Tax Mrs. Logan on $120,000 cash received plus present value of receiving $9,000 per year for 25
years. Apply rule of Amount Realized – Basis = Gain Realized.
 Amount Realized is FMV of what she got (which is $120,000 in cash + value of future payments,
which would be $9,000 per year for 25 years = $225,000).
 Present value was $100,000 (representing a discount rate of about 7.5%) so the total value of what
she received was $220,000. Thus, Mrs. Logan would pay tax on $40,000 gain ($220,000 $180,000 basis). Mrs. Logan would have a $100,000 basis in the future income stream that would
be amortized against future payment received. This is basis equal to amount you pay tax on (not
the amount of taxes paid).
 As she gets money each year, she will be able to exclude from taxation $4,000 (based on 25 years)
and pay $5,000 on each $9,000 payment per year.
 Option 2: Open Transaction (pro-taxpayer)
 Don’t tax Mrs. Logan until the payments she receives exceed her basis in the property. Thus Mrs.
Logan would not be taxed at all in the year of sale, but her basis would be reduced to $60,000
($180,000 basis minus $120,000 received). Future payments would be tax-free until the total of
such payments exceeded her remaining $60,000 basis and then would be fully taxed.
 It’s always better to pay taxes later, so this plan favors her.
 Option 3: Installment method.
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Allocate some portion of Ms. Logan’s basis to each payment received. This is the approach
generally used today.
Capital gains versus Ordinary income: How do the open and closed transactions differ?
 In theory, if we do the closed transaction doctrine, the initial gain of $40,000 will be capital gain.
But the additional payments she gets will be treated as interest on her property interest.
 If we don’t use installment method, then we use closed transaction method.
Installment Sales: § 453-453B
 The portion of each payment that should be included in income as gain from the sale is:
o Gross Profit / Contract Price
 Selling Price is the amount to be paid by the buyer (not counting interest, but counting assumption of debt).
o Gross Profit is the Selling Price less the seller’s adjusted basis.
o Contract Price is the Selling Price less the debt assumed by the buyer.
 Example 1 (without debt):
o Carlos had a basis of $75,000 in Blackacre. He sold Blackacre to Dara for $100,000 now plus $50,000 per year for
4 years plus interest.
o The total payments to be received are $300,000. This is the Selling Price and b/c there is no debt, it is also the
Contract Price. Carlos’s basis is $75,000, so his Gross Profit is $225,000.
 $225,000 / $300,000 = ¾
o Thus, ¾ of each payment will be taxable gain and ¼ will be recovery of capital.
o These installment rules make sense:
 You pay tax when you get the money. If you followed closed transaction model, you would pay taxes
before you get money. If you followed open transaction, that would be totally unfair toward the gov’t, so
this is a good compromise.
 Example 2 (with debt):
o Joxer had a basis of $150,000 in Whiteacre. Whiteacre was subject to mortgage of $100,000. Joxer sold Whiteacre
to A for $100,000 now, assumption of mortgage, plus $50,000 per year for 4 years plus interest.
o Total payments to be received are $400,000. This is Selling Price. There is $100,000 debt assumed, so Contract
Price is $300,000. Joxer’s basis is $150,000 so Gross Profit is $250,000.
 $250,000 / $300,000 = 5/6
o Thus, 5/6 of each payment will be taxable gain and 1/6 will be recovery of capital.
 This tends to favor Joxer b/c Joxer immediately gets $100,000 in cash, $100,000 in assumption of debt.
His immediate gain is $200,000, but not taxed on entire $200,000. He’s taxed on $100,000 he receives, but
not on assumption of debt. 5/6 doesn’t apply to assumption of liability; it’s not directly taxed.
o Suppose Joxer had mortgage of $200,000 on property. A says he’ll give $100,000 in cash, and $50,000/ year for 2
years. His Selling Price would be $400,000; Gross Profit = $250,000; Contract Price = $200,000 ($400,000 selling
price minus $200,000 mortgage).
 Formula gives you $250,000 / $200,000 = 5/4.
 SPECIAL RULE: A rule obviates this. Whenever the liability assumed exceeds the seller’s adjusted basis
in the property, do the following:
 1) Taxpayer is immediately taxed on the amount by which the liability assumed exceeds the
adjusted basis of property.
 Here, he would be taxed on $50,000.
 2) Taxpayer will be fully taxed on all future payments received.
 Notes on Installment Sales
o Installment sales are a rare case where debt discharge is not treated exactly like cash received.
o Installment sale rule applies to most sales where at least one payment for the property will be received by the seller
after the close of the taxable year in which the sale occurs.
o Installment sale rule does not apply to:
 Publicly traded property such as stock and bonds traded on an exchange.
 Revolving charge accounts for sales of personal property (credit cards).
 Sales of inventory (property that is sold in ordinary course of business)
 Inventory is taxed at ordinary rates, not as capital gain.
 Most important exception to installment sales is inventory sales.
 Depreciation recapture
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When you have depreciated property, and you later sell that property for a gain, your gain on that
sale is taxed as ordinary income to the extent of the depreciation previously taken).
 Sales at a loss
 You can recognize loss right away. Tax deduction is taken immediately.
 (Each of these transactions is taxed immediately)
A taxpayer may elect not to use the installment sale method, in which case the closed transaction method is used.
Installment gain is accelerated (generally) if the installment obligation is used to secure a loan.
 Suppose you sell property for $1,000,000 (paid out over 5 years), and you can’t wait to receive it. So you
borrow $800,000 and use the $1M installment obligation to secure this loan. So you’re immediately taxed
on entire installment obligation (full $1M, not $800,000). Don’t secure a loan via installment obligation.
The open transaction method is not available to taxpayers. Rather, uncertain payments must be estimated.
3/24/05
Constructive Receipt
 An accrual-basis taxpayer is taxed on income when she has earned it, even if she has not and cannot yet collect the income.
o Ex: An accrual-based plumbing firm is taxed on the work it has performed even if the customer has not yet paid for
the work.
o Ex: You’re a dentist. Did work on patient in November 2004; get paid in February 2005. Being an accrual-based
taxpayer means you’re taxed in 2004.
o Advantages of accrual-based taxpayer
 Accrual-based advantages means getting more accurate statement of financial status. It’s better for
financial reporting purposes.
 It’s also good for tax purposes for large businesses to be accrual-based b/c it’s more accurate of what
company has earned.
 A cash-basis taxpayer generally is not taxed on the work she has performed until she is paid.
o Ex: A cash-basis attorney who performs and bills work in December of year 1, but whose bill is not paid until year 2
does not report the income until year 2.
 Exception to cash-basis taxpayer: Constructive Receipt.
o If a taxpayer has an unrestricted right to income, she is taxed on the income even if she has not physically received
it. This is known as constructive receipt.
o These are situations where cash-based taxpayers, who ordinarily don’t report income until receipt, are nevertheless
required to report that income, even if they haven’t received it.
o Ex: Suppose an employee does not pick up her December paycheck until January. The employee is taxed as if she
received it in December b/c she had an unrestricted right to pick up the paycheck in December.
o Ex: Suppose attorney has client who brings envelope, which says “payment for services rendered.” Attorney
doesn’t want that envelope now; wants client to wait until next year to pay. Here, attorney has constructively
received money b/c he had unrestricted right to the income.
 Key is that income was there for the taking; he could have gotten the money immediately.
 Amend v. Commissioner
o Facts:
 Farmer sells wheat in summer 1944.
 Wheat is to be delivered in August 1944.
 Buyer is willing to pay on delivery, but the farmer doesn’t want payment at that time.
 Instead, contract provides for payment in January 1945.
o IRS argues: Farmer should be taxed in 1944 under constructive receipt doctrine since farmer could have contracted
to receive payment in 1944.
o Held: Farmer is taxed in 1945.
 Under the contract, the taxpayer did not have the right to the money until 1945. The fact that he could
have negotiated a different contract is irrelevant. Once contract is signed for 1945, buyer had no right to
get money in 1944.
 This could lead to problems of abuse (people structuring payments to avoid paying high taxes in
one year).
 There is no evidence of a tax avoidance purpose. Farmer had been delaying receipt of payment for several
years. If farmer did not consistently delay receipt of income, the IRS could apply § 446(b), which allows
the IRS to impose a method of accounting if the taxpayer’s method does not “clearly reflect income.”
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This is catch-all provision in Code which IRS can use when they believe taxpayer’s payment
method doesn’t reflect taxpayer’s real income.
 If a negotiable instrument or other cash equivalent had been received, the farmer would have been taxed in
the year of receipt.
 For example, if someone writes you a check, the year you receive the check is the year you get
taxed, not the year you cash the check.
Notes on Constructive Receipt of Wages
o (1) Payments to employees are not deductible by the employer until the payments are taxable to the employee. This
is true even if the employee is cash basis and the corporation is accrual basis. See § 404(a)(5).
 No matter what, the employer cannot deduct payments to employee until the employee takes that payment
into income.
 Ex: In year 1, work is done, so employer incurs obligation to pay. In year 2, employee is paid. Normally
for accounting purposes, the employer would take a deduction in year 1. But this rule overrides this. So
employer takes deduction in year 2 if employee is cash-basis taxpayer.
 Without this rule, this could allow for tax abuse. If employer is obligated to pay a lot of money for a
period of 20 years, but employee only gets payment each year, then employer might deduct entire
obligation for 20 years in year 1. This is not allowed under this rule.
o (2) If the employer and employee are in the same tax bracket, then the total tax received by the IRS will be the same
regardless of when the payment is taxable to the employee. However, if the employer is tax-exempt (like USC),
then the timing affects the total tax burden.
o (3) Amend under current law:
 Installment sale rules would apply. Thus Amend would report income in 1945 when he received the
payment.
 If Amend opted out of installment requirement, he would be taxed in 1944 under treasury regulation which
treats receipt of an installment obligation as the receipt of property in an amount equal to the FMV of the
obligation.
NFL Problem, p. 271*** REVIEW
o (a) Corporation buys annuity policy from insurance company for player. Player will get $1M at the end of 5 years.
Corporation pays $600,000 for the policy. How would this transaction be taxed?
 In Year 1, if there’s no provision to the contrary, if you receive property in exchange for your services,
you’re taxed on FMV of what you receive. When he receives annuity, it’s in exchange for promised
services of playing. He’s then taxed on FMV of what he receives. Since annuity is worth $600,000, he’ll
be taxed on that $600,000. Corporation can then deduct $600,000. Corporation deduction matches the
amount that the player takes into income.
 In Years 2-4, he’s not taxed. He’s only taxed in Year 5, when the policy pays out. In Year 5, he’s taxed on
$400,000 (the gain).
 So he’s not happy with this setup b/c he doesn’t want to be taxed until he gets the money.
o (b) Corporation contributes $600,000 to a trust, where player is beneficiary.
 Result is exactly the same as previous case. He’s taxed immediately on what’s paid into the trust
($600,000). The money is outside the corporation, and it’s a receipt of property to the player in Year 1.
He’ll be taxed under special trust rules on interest he earns in the trust. Taxaation occurs immediately on
growth in value of $600,000 to $1M, so it’s worse than (a).
o (c) Same as (b), but at end of 5 years, the $1M is to be paid to the corporation to provide funds that it can use to
meet its own contractual obligation to the player.
 This completely changes the result. As long as corporation retains ownership of the trust, it is not treated
as if the player received it. Player would only be taxed when he actually gets the money.
 As long as money is still owned by corporation, the fact that corporation put the money in a trust doesn’t
give player any protection. If corporation goes bankrupt, the trust will be gone, and player will lose the
money. So this is very risky for player.
o (d) Corporation signs an unconditional guarantee to pay $1M to the player at the end of 5 years. The real estate
tycoon who owns all the shares of the corporation signs a guarantee of its obligation.
 The fact that tycoon guarantees obligation doesn’t affect player. Corporation deducts this in year 5,
taxpayer doesn’t pay taxes until year 5, and player is protected by real estate tycoon if corporation becomes
bankrupt.
o Suppose instead there’s plan (e). Corporation sets up a 401(k) for player, and contributes money to 401(k). How
would that be treated?
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If corporation could do that, it would lead to best result possible. Contributions to 401(k) allow
corporation to deduct it immediately, and employee doesn’t take it into income until it’s paid out to him.
Problem is that you cant’ use 401(k) for this.
 There’s contribution limitations (about $40,000/year). He can’t get money until he retires. 401(k)
also must follow non-discrimination rules, and therefore he can’t do it b/c it discriminates in how
it compensates employees.
Too bad it can’t work out here.
EXAM: 1.5 hours of MC; no penalty for wrong answers. 1.5 hours of essay. Closed book.
 Explain reasoning either by citing code section or explaining code section.
 At least 1/3 of questions are directly from problems in Examples and Explanations.
 MC – based on reading. Know the little handout readings.
 Can use calculator (4 functions).
3/25/05
Commissioner v. Olmstead Incorporated Life Agency
 FACTS:
o Olmstead was insurance agent (who operated as a corporation) who had a right to commissions based on prior sales
for Peoples Life Insurance.
o At Peoples’ request, Olmstead exchanged the right to future commissions for a fixed payment annuity of $500 per
month over 15 years.
o O could have taken a cash buyout, but he preferred the annuity.
 Suppose O’s commission was $100. He would be taxed on this. Suppose also that you could predict that
even if O left company immediately, he would get $50 per year for 10 years. Commission’s promise to
pay commissions in future is mere promise to pay.
 He’s taxed on $50 when he gets it, and corporation gets deduction when it pays out each year. We
wait to tax until he gets money b/c (1) it’s simpler; and (2) he doesn’t have money to pay taxes
until he gets it.
o IRS said he traded his rights for cash buyout for the annuity.
 Issue: Is O taxable on the $68,000 value of the fixed payment annuity? Or is O only taxable when he receives the payments?
o IRS argued that in exchanging his rights in cash buyout, he got annuity. So, Amount Realized – Adjusted Basis =
Gain Realized. Here, it would be: $68,000 - $0 = $68,000 = Gain Realized. (Basis is $0 if he simply worked for it).
It would be ordinary income (not capital asset), b/c it was received for his labor.
 As a matter of policy, this structure doesn’t make sense to tax him b/c:
 (1) He doesn’t have money to pay the taxes now. He’s only going to get money over period of 15
years.
 (2) There’s no abuse going on here. Under old rule, if he didn’t do anything, he wouldn’t be taxed
unless he received money. He’s not doing any better now with annuity. This is different from
selling his right to receive commission.
 (3) Obligation is still coming from corporation. This isn’t situation in which he’s getting annuity
from outside 3rd party. Here, corporation is still promising to pay him with annuity.
 (4) If we did tax him, and he knew he would be taxed, he wouldn’t accept the deal, which would
prevent corporation from restructuring its payment. If corporation can’t restructure its payment,
that would be inefficient shift in behavior, and discourages all corporations from being efficient,
and would be bad for entire country!!
 So policy against taxation flies in the face of the standard rule for taxation.
 Court holds:
o Olmstead is not taxable on the value of the annuity. This was a cancellation of the old payment structure and a
replacement with a new payment structure rather than a taxable exchange of property rights with the meaning of §
1001.
 Here, he worked on commission, and he was cash-based taxpayer. When he received money from
commission, he then is taxed on them. However, when he exchanges his right to commission for different
set of commission rights, IRS said he had made an exchange, which means you’re taxed on the difference
b/t amount realized and adjusted basis. His adjusted basis is $0 b/c he hasn’t paid for it w/any cash and
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hasn’t paid any taxes on it. FMV to get money in future is $68,000. He would be taxed on $68,000. This
is not good policy to tax him (see reasons above).
Court claimed it wasn’t an exchange; rather it was a mutually-agreed upon novation (destruction of old contract and
creation of new contract).
 Result makes sense as a matter of policy. Court uses trick of novation by saying it wasn’t an exchange,
and was instead a novation (parties mutually agreed to end old deal and start new deal).
Why did IRS want to tax him now?
 They might be worried that if they don’t tax him now, in future, he’ll say they should have made him pay
taxes earlier and say it’s too late to do this. IRS worried about being “whip-sawed,” meaning that IRS
doesn’t get to tax either corporation or individual.
Employee Stock Options
 Stock option: Employee gets the right to purchase stock of his employer’s corporation at a specified exercise price during or
at the end of a defined period.
 Taxation of Stock Options (In General)
o Suppose you believe a particular corporation will have stock go up in value by a lot. Suppose it currently is
$10/share. Suppose you have $1,000 to invest. What are your options?
 1) You could buy 100 shares at $10/share. Suppose you were right and it goes up to $14/share, and you
sell for $1400, earning $1400 profit.
 2) You could buy corporation options and pay $1/option. Option gives you right to buy 1000 shares at
$11/share within 1 year. Option gives you right to buy the company’s stock at $11/share. You could buy
1000 shares at anytime in next year for $11/share.
 If company stayed at $10/share, you lost your entire investment in the $1/option b/c option is only
available if stock price exceeds $11/share.
 If company had reached $12/share, you break even.
 If company goes up to $14/share within the year, you can exercise your option, which is
$11/share. You’ll make $3000, then subtract the $1,000 you paid for the options. You end up
with $2000 profit.
o Options are for people who are high-risk investors and believe they can predict the market.
o Taxation of Ordinary Stock Options
 If you pay $11/share for stock and $1/option. Basis is $12/share. When you sell stock at $14/share, you
pay tax on $2/share. For ordinary stock options, basis in stock you acquire is equal to exercise price +
amount you paid for the option.
 You’re taxed only when you SELL the stock (on difference b/t amount you sell the share and adjusted
basis).
 Example on Employee Stock Options: Jill is President of Acme Corporation, whose stock is currently trading at $10 per
share. As part of her compensation in Year 1, she is given the option to purchase up to 1,000,000 shares of Acme at $8/share
at the end of Year 5 if she is still employed by Acme. She may be removed for “good cause.”
o It turns out that:
 Jill exercises the option in year 5 when the stock is worth $15/share.
 Jill sells the stock in year 8 when it is worth $18/share.
o How should Jill be taxed?
 Option 1: When she receives the option.
 Year 1: Tax Jill on the value of the option (OI - ordinary income). Jill gets a tax basis in the
option (Acme gets a matching deduction).
o So what was option worth? At first glance, it could be worth at least $2 (difference of
$10/share (current price) and $8/share (option price)). But then again, she could be fired
anytime. If we value option at $2/share, she’d be taxed on $2/share.
 Year 5: No taxation. Jill’s basis in the stock equals basis in the option plus exercise price.
 Year 8: CG (capital gain) on the sale of the stock.
 This approach follows most closely the taxation of stock options, but difficulty is that it requires
taxing Jill at the outset. Problems might include that she doesn’t have money to pay the tax on the
option (up to taxes on $2,000,000). Another problem is that option has unclear value, esp. if she
could lose it. Taxing her on full value right away might prove to be inappropriate.
o No abuse b/c deduction by corporation is precisely offset by taxation to taxpayer.
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Option 2: When she exercises the option.
 Year 1: No tax consequences.
 Year 5: Tax Jill on the difference b/t the FMV of the stock and the exercise price (OI) (Acme gets
a matching deduction). Jill gets FMV basis in the stock.
o Here, stock is worth $15/share. She’s buying shares in year 5 for $8/share, so we’d tax
her on $7/share (dif. b/t FMV of stock and exercise price).
 Year 8: CG on the sale of the stock.
o Basis is now $15/share. Gets taxed on CG on $3/share.
 Advantages:
o Don’t need to worry about how much option is worth in the beginning.
o Don’t have to worry about her forfeiting option b/c she’s actually exercising the option.
o She does have money to pay shares, but only if she sells the stock.
o No abuse b/c deduction by corporation is precisely offset by taxation to taxpayer.
 Disadvantages:
o Forces her to sell shares to pay taxes.
o May be inconsistent w/fair taxation b/c options had values in Year 1, so it’s fair to tax
her when value arises.
 Option 3: When she sells the stock.
 Year 1: No tax consequences.
 Year 5: No taxation. Jill’s basis in the stock equals the exercise price.
o Her basis now will be what she paid for them: $8/share.
 Year 8: CG on the sale of the stock (Acme never gets a deduction).
o When she sells shares, she gets CG on sale of stock. This system is good for Jill b/c she
pays no tax until she sells the stock, plus Jill gets capital gain on entire gain. She gets
$10/share of capital gain.
 Jill’s failure never to take into account any ordinary income is offset by fact that corporation can
never get deduction for this transaction.
Which option is used? All three are used, based on different circumstances.
o Incentive Stock Options - § 422
 Applies Option 3 (CG on sale of stock)
 Employee must retain stock for 2 years after option grant and 1 year after exercise.
 Exercise price must be no less than FMV of the stock at the time the option is granted.
 $100,000 limit on value of stock subject to unexercised option.
 Bottom Line: “Low” ceiling makes ISO of little importance to highly paid executives.
 $100,000 of stock just isn’t much for a major corporate executive.
 This is only instance when Option 3 is used.
o Nonstatutory Stock Options
 § 83: Applies to all property received for services (not just stock options).
 General Rule: FMV included in income in the year property is received.
 Exception 1: Property is subject to a “substantial risk of forfeiture,” which means “rights to full
enjoyment of such property are conditioned upon the future performance of substantial services by
any individual.” Taxed only when that substantial risk of forfeiture ends, which is typically year
when you exercise the option.
 § 83 Election: Employee is taxed immediately, despite substantial risk of forfeiture. FMV of property is
determined w/o regard to risk of forfeiture. No deduction if forfeiture occurs.
 Q: Why would anyone make the election?
o If no election, then the option becomes income to employee when property becomes
nonforfeitable (OI). Matching deduction by employer.
o People make election b/c they believe that they can undervalue the option. If company is
making no money, they can argue that it’s uncertain whether company will make any
money in future, so they’ll value option at very low number. Now, you’re taxed on this
tiny amount as OI. When they exercise option, they get capital gain. It allows them to
convert their OI into capital gain.
 Exception 2: If option has no readily ascertainable FMV, then employee is taxed when option is
exercised. To prevent taxpayers from making § 83 elections and then grossly undervaluing the
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stock or options, Treasury regulations provide generally that options/shares not traded on an
established market have no readily ascertainable FMV.
If options have readily ascertainable FMV:
o If there’re not subject to risk of forfeiture or if taxpayer makes § 83 election, the options
are taxed immediately (Option 1).
o If there’s readily ascertainable FMV, but subject to forfeiture, then taxed in year when
risk of forfeiture lapses.
o If option has no readily ascertainable FMV, then you use Option 2 (tax when they’re
readily exercised).
If options do not have readily ascertainable FMV, then it’s treated like Option 2 (taxed on
dif/ b/t FMV of shares and exercise price).
If options do have a readily ascertainable FMV, it will be taxed under Option 1 in the
following cases:
o Not subject to risk of forfeiture  taxed immediately.
o If you make § 83 election  taxed immediately
o But if there’s readily ascertainable FMV but subject to risk of forfeiture, then
you’re taxed in year in which risk of forfeiture lapses (which is typically the year
you exercise option).
Transfers Incident to Marriage and Divorce
 Property Transfers Pursuant to Divorce
o US v. Davis (1962) – NOT GOOD LAW
 Husband transfers 1000 shares of stock held in his own name to wife pursuant to a divorce agreement. In
return, wife gives up request for alimony and other rights.
 Suppose husband had basis of $100,000 and had FMV of $250,000. IRS believes husband should
be taxed on $150,000 of gain b/c it’s gain realized (amount realized – adjusted basis).
 This was how court ruled.
 Issue: Does the husband recognize gain on the transfer of the stock?
 Held: Yes.
 Surrendered marital rights are assumed to be equal in value to the property husband gave up.
 Therefore, husband is taxed on the difference b/t FMV of property given to wife and his basis in
the property.
 Wife is treated as if she purchased the stock using her marital rights as payment.
o So husband pays taxes on $150,000 of gain realized; wife has basis of $250,000 now.
 This result only applied in non-community property states.
o In community property states, the division would be a non-taxable division of joint
property. Husband and wife had equal rights to property.
o Questions relating to Davis:
 Is the result in Davis good for the wife?
 No. While Davis case helped Mrs. Davis, it would not help future wives. This result hurt both
husbands and wives in non-community property states.
 Does the logic of Davis suggest that the wife should be taxed as well?
 Yes.
 Should gain be recognized on divorce property transfers?
 No. Policy: Divorce is worse time to pay taxes.
 Davis Rule overturned by Statute
o § 1041 provides that no gain or loss shall be recognized on transfers of property:
 to a spouse (in any case), or
 Giving spouse property is not taxed
 to a former spouse if related to a divorce or separation.
o Instead, property transferred pursuant to § 1041 shall be treated as if transferred by gift.
o Transfers within 1 year after the date of the dissolution of the marriage are deemed incident to divorce.
o After the 1-year period, the taxpayer must show that transfers are incident to the divorce.
Ante-Nuptial Settlements
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Farid-Es-Sultaneh (2d Cir. 1947)
o Facts:
 1924: Kresge, age 57, is engaged to Farid, age 32. Kresge transferred $800,000 of stock (basis $12,000)
pursuant to a pre-nuptial agreement in which Farid was released of all other rights in the event of a divorce.
Farid kept stock if K died before marriage.
 K treats the transfer as a gift and did not recognize gain on the transfer. K was worth about $375M.
 1928: The couple is divorced. Farid makes no claim against K.
 1938: Farid sells the stock for about $1.5M.
o Issue: What is her basis?
 Depends on taxation of original transfer. If original transfer was gift, then she would take carryover basis
(basis would be $12,000). But if it was an exchange/trade, then she would be treated as if she bought the
stock in exchange for her marital rights. In that case, her basis would be $800,000.
 Treasury argues that original transfer was a gift, so Farid’s basis is $12,000. Farid argues the original
transfer was a sale and basis was $800,000.
o Held: The original transfer was a purchase. Farid offered fair consideration for the stock—her marital rights.
 Although transfer, under then existing gift tax rules might have been taxable as a gift, this is not conclusive
as to whether it is a gift for income tax purposes.
 IRS wasn’t happy b/c IRS got whip-sawed. In 1924, it was taxed as a gift; and since it wasn’t taxed as a
gift back then, it’s too late to be taxed as a gift now.
 To avoid this problem, you can make the transfer after marriage. Have a contract and property transfer
upon the marriage. The moment you’re married, any property transfer is tax-free.
3/30/05
Alimony, Child Support, and Property Settlements
 Alimony and separate maintenance payments are deductible by the payer and taxable to recipient.
 Child support payments are non-deductible by payer and nontaxable to recipient.
 § 71(a) – general rule that gross income includes amounts received as alimony or separate maintenance.
 § 215 – alimony payments are deductible by the payer.
 § 71(b) – defines alimony as payments that meet the following requirements (avoids taxpayers trying to characterize child
support as alimony to get more favorable tax treatment):
o Payments are in cash.
o Payments are received by a spouse under a written divorce or separation instrument.
o The instrument does not designate such payment as not includible and not deductible under § 215.
o The payer and payee don’t live together.
o There is no liability for such payment after the death of the payee spouse (payment must end when recipient spouse
dies).
 § 71(c) – provides that child support payments are not considered alimony. Any payment that is contingent on factors such
as the age, schooling or marriage of a child will be considered a child support payment.
 Alimony is actually better than child support b/c person paying alimony can pay you even more to minimize tax burden and
allow him to get deduction for payment.
 Don’t need to know about front-loading rules.
Diez-Arguelles v. Commissioner (1984)
 Husband owes $4,325 in child support; wife unable to collect despite court orders. So she had a bad debt.
o General Rule: Nonbusiness bad debt can be deducted as a short-term capital loss in the year the debt becomes
worthless, but only to the extent of the taxpayer’s basis in the debt. In other words, if you loan someone money, and
it becomes worthless, you get deduction for the amount you loaned. Basis would be amount you loaned out.
 Wife deducts unpaid child support as nonbusiness bad debt. Wife argues her basis is the amount she spent out of pocket for
children’s expenses. IRS argued her basis was $0 (since she didn’t loan husband any money).
 Held: Wife has no basis in the debt, so she can take no deduction.
o Close case—wife made interesting argument, but also good illustration of nonbusiness bad debt.
o Court afraid of opening can of worms with all deadbeat dads – would allow tax deductions for millions.
 Some variations
o Suppose husband borrows $4,325 from Cindy and pays wife the child support due. Husband later defaults on the
obligation to pay Cindy. Does Cindy get a bad debt deduction?
 Yes, b/c she loaned husband money.
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Suppose husband pays wife $4,325 child support and a few days later, pleading a medical emergency, borrows the
money back. Shortly thereafter, husband dies penniless. Does wife get a bad debt deduction?
 Yes, b/c there’s no fraud involved (it was for medical emergency). Wife had basis in loan she made.
Suppose husband executes a negotiable promissory note to wife for $4,325 as payment for the child support due,
payable in three months with 1% interest per month. Shortly thereafter, husband dies penniless. Does wife get a
bad debt deduction?
 Unclear. IRS might treat this as a sham. In theory, it would be yes.
Same as 3, except before husband dies, wife sells the note to Doug for $3,000. What are the tax consequences to
wife?
 Wife probably gets no tax consequences. Unclear.
What are the implications in 4 above of the court’s statement that the wife has no basis in the debt owed by
husband?
 Unclear. Depending on how transaction is structured, wife may or may not have basis in the transaction.
Accounting Methods
 Cash Method: income is reported in the year in which it is received. Expenses are deducted in the year in which they are
paid.
 Accrual Method: Income is reported in the year “when all the events have occurred which fix the right to receive such
income and the amount can be determined with reasonable accuracy.” Reg. 1.461-1(a)(2). This is called the “all events
test.” A similar test is applied to the deduction of expenses.
o Ex: You’re a doctor and treat patient for infection in Nov. 2004. After treatment, all events test has been met.
You’ve done everything to fix rights to receive such income. Amount they owe you can be fixed with reasonable
accuracy. So income would be counted for 2004.
 If you’re a cash-based taxpayer, you would take income in the year the cash payment is actually made.
Choice of Accounting Method
 Cash Method: Individuals who do not own their own business must use the cash method.
 Accrual Method: Businesses that have inventories of unsold goods or material at the end of the year must use the accrual
method. Moreover, the IRS requires all larger businesses to use the accrual method.
 § 446(a) – Taxable income shall be computed under the method of accounting that the taxpayer regularly uses for financial
reporting.
o Requires all publicly traded corporations to be accrual-based.
 § 446(b) – If the taxpayer’s accounting method does not clearly reflect income, then the computation of taxable income shall
be made under such method as, in the opinion of the IRS, does not clearly reflect income.
o Taxpayer often has choices in how to report income. As long as choice clearly reflects income, IRS will respect that
method. But if it looks like a sham, IRS may overturn it and impose its own accounting method.
 This came into play in Amend, where farmer was being paid for crops one year after he sold the crops.
 § 446(e) – A taxpayer must obtain the consent of the IRS to change accounting method for tax purposes.
 GAAP: “Generally accepted accounting principles” (GAAP) used in financial accounting usually are followed in tax
accounting, but taxpayers sometimes are required to apply different rules where GAAP produces tax avoidance
opportunities.
3/31/05
o Such special rules are particularly likely in 2 circumstances:
 (1) Where a business does not accrue pre-paid income (i.e., money paid now for future services).
 In other words, a company has received the money, but under financial accounting rules, it would
not accrue the income (have right to get income).
 Ex: Dance studio has advertisement for lessons to improve your love life for $15/lesson instead of
$25/lesson over 5-year period. Customer pays, but hasn’t given dance lesson yet. Under accrual
method, dance studio hasn’t satisfied “all events” test b/c lesson hasn’t been given. IRS wants to
avoid abuse where business gets money immediately and don’t report it for a number of years.
 (2) Where a business accrues estimated future expenses (i.e., expenses it predicts it will have to pay in the
future).
 IRS again worried about cases where company has deducted expenses, but hasn’t paid money yet.
o General rule: If you’re an accrual basis taxpayer, you’ll follow accrual basis.
 Ex of No abuse: If you’re an accrual basis taxpayer, you do work for clients in year 1, but don’t receive
money until year 2. You have to report income in year 1 anyway. This also encourage expenses in year 1,
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but don’t pay until year 2. As accrual-basis taxpayer, you can deduct expenses in year 1. There’s trade-off
here, so no abuse going on.
 In special situations, like dance studio, where you say you’ll perform obligations over 5-year period, but
get all the money upfront, IRS says this is abusive, b/c company is using accrual-basis rules to avoid
paying fair amount of taxes.
o How do we know when IRS will step in? We just don’t know. No bright line rules, but look at examples.
Georgia School Book Depository
o School Book Depository was a broker that arranged for the purchase of textbooks for the state of Georgia. The
arrangement was as follows: (1) Georgia decided what books it wanted to buy; (2) Depository arranged book
purchase contracts with the publishers; (3) Books were shipped to Depository, which distributed them to the
schools. Depository never had title to the books; and (4) Depository collected money from the state, distributed
such money to the publishers and received an 8% commission. The 8% commission was received from the book
publisher when the state actually paid for the books.
o Issue: When should Depository accrue its commission?
 In the year that the contracts were signed and the books delivered to the state? This is IRS’ position (citing
“all events test”—all events have occurred which fix right to receive money and amount can be determined
w/reasonable accuracy). Here, Depository did its work by negotiating contract, so they should accrue that
income immediately.
 If buying stock in Depository, in determining financial well-being of Depository, you would want
to count as its assets the 8% commission.
 In the year that the state paid for the books and Depository thus was entitled to receive its commissions?
Taxpayer’s position (see below)
o Taxpayer argues:
 One of Depository’s jobs was to collect the money from the state. Therefore, all the events had not
occurred giving depository the right to the money.
 Depository might never get paid. All funds for the purchase of textbooks came from a tax on beer. In the
years in question, the state had not raised enough tax revenue from beer sales to pay for the books.
o Court holds against taxpayer on both arguments:
 (1) Collecting the money from Georgia was a trivial part of Depository’s job. Once the books were
delivered, Depository had earned its commission.
 (2) Georgia is a reliable debtor. The state would pay its debt even if beer sales were low.
o This case illustrates how people can argue about whether the “all events test” has been met.
Additional Notes on Accrual of Pre-Paid Income
o Dancing school lessons
 Amounts paid in advance for lessons are accrued in the year of the payment is made.
o Baseball team advance ticket sales
 Amounts paid in advance for tickets are accrued in the year the games are played.
 Baseball games are dif. from dance lessons
 Absolutely certain that the baseball game will be played; for the dance lessons, if people don’t
show up, it’ll be hard to know whether lesson will be held at all.
 Also, there’s only a 1-year delay for baseball games (if you bought tickets the year before games
were played). Ex: Dance studio selling 20 years of dance lessons to an 85-year old woman.
o Engineering Services
 Court rejected IRS claim that reporting should be in the year paid or the year services were performed,
whichever first. In the actual case, payments were received sometimes before and sometimes after the
performance of services.
 IRS can’t force you to take whichever basis is worse for you.
o Appliance Service Contracts
 Amounts paid in advance for such contracts are income in the year the service contract is sold, rather than
the year in which services are performed since it is unclear if or when services will be performed.
o Magazine Subscriptions
 § 455 provides that income from prepaid magazine subscriptions is accrued ratably over the life of the
subscription.
o Auto Clubs (AAA v. US)
 § 456 provides that prepaid dues may be spread over the life of the membership.
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Personal Deductions
 Deductions that are unrelated to the production of income. They are sometimes called itemized deductions because they are
itemized on a separate schedule on the tax return.
o Examples:
 Casualty losses
 Extraordinary medical expenses
 Charitable contributions
 Interest on home mortgages
 State and local taxes
o When you own your own home and mortgage, you’ll file itemized deduction b/c interest you pay on home will be
greater than standard deduction.
 An individual may choose either to take the itemized deductions or a standard deduction. The standard deduction for the
year 2004 is $4850 for a single individual and $9700 for a married couple filing a joint return.
 The standard deduction serves 2 purposes:
o (1) Simplifies filing returns for individuals with only a small number of deductions.
o (2) Help reduces taxes on poor individuals.
 General argument for personal deductions
o (1) Some deductions define income more accurately as a measure of ability to pay.
 For example, if you suffer huge catastrophic casualty loss, that might mean you have less money to pay
taxes overall, so deduction would be more accurate reflection of how much taxpayer has to pay.
 Ex: Person who has suffered casualty has less ability to pay than person with same income who has not
suffered casualty.
 Ex: Person with high medical expenses has less ability to pay than person with same income without high
medical expenses.
o (2) Some deductions encourage socially desirable activities.
 Ex: Charitable contributions.
 Ex: Deduction for home mortgages, seen as designed to encourage people to own their own homes.
 Arguments against personal deductions:
o They are upside down subsidies – personal deductions are worth more to a high-income taxpayer than to a lowincome taxpayer b/c the tax dollars saved by the deductions are proportional to the taxpayers’ marginal tax rate. In
addition, poorer taxpayers do not itemize and thus get no benefit whatsoever from personal deductions.
4/1/05
 Ex: A $1,000 deduction for child care saves a wealthy taxpayer in 35% bracket $350, but a working class
individual in 10% bracket only $100. Non-itemizers get no advantage from the deduction.
 This is just like passing law that says all poor people get nothing, working class gets $100, and all rich
people get $350. This law would never pass.
o Criticism of the upside down subsidy argument
 Though the facts are true, that doesn’t necessarily mean it’s wrong.
 Does the personal exemption favor the rich or the poor? In dollar amounts, it favors the rich b/c the
marginal tax rate of the rich is higher.
 But the personal exemption also:
 (1) Reduces the tax burden of the working class by a greater percentage than it reduces the tax
burden of the rich.
 (2) More importantly, increases the income of the working class by a greater percentage than it
increases the income of the rich.
 Ex: Consider a personal exemption of $3,000. For a wealthy 35% taxpayer, the exemption is worth
$1,050. For a poor 10% taxpayer, the exemption is worth only $300. This is the upside down subsidy
argument.
 But: (1) A single individual with a taxable income of $7,000 (pre-exemption) will pay a tax of
$700. The personal exemption reduces her taxable income to $4,000 and his tax owed to $400.
This is a greater than 40% reduction in her tax burden. In contrast, a single individual with a
taxable income of $330,000 (pre-exemption) will pay a tax of about $100,000. The exemption
will reduce her tax by $1,050 to about $99,000. This is only a 1% reduction.
 (2) The poor individual in example 1 typically will have an AGI of just under $12,000 and would
have an after-tax income of $11,300 w/o the personal exemption. The personal exemption
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increases the individual’s after-tax income by $300, slightly less than a 3% increase. The AGI of
the rich individual will be at least $350,000 and her after-tax income will be at least $250,000.
The $1,050 increase from the personal exemption will increase her income by less than one-half
percent.
 The point: The mere fact that the wealthy receive a greater dollar amount from the deduction does not
mean that the deduction is regressive.
 Note: In fact, personal exemptions are phased out under current law for wealthy individuals, although this
phase out is scheduled to end under Pres. Bush’s tax plan.
It’s not always bad to give rich a tax break.
 (1) How much should we redistribute money from the rich to the poor? This is a moral philosophical and
economic question.
 (2) For personal deductions, we might ask: do the personal deductions give us a more accurate measure of
ability to pay? Do some wealthy individuals deserve to have a lower tax rate b/c they are suffering
casualty losses, terrible medical problems, etc.? They might do a good job differentiating among wealthy
individuals with greater or lesser needs.
 Also, if personal deductions encourage socially desirable behavior, it might be good to influence
the wealthy.
No matter what you think about redistributing money from rich to the poor, you should decide on whether personal
deductions are a good thing on whether they (1) appropriately help us measure differences in ability to pay and/or
(2) appropriately encourage socially desirable behavior/activities.
 If so, then they should be passed. If not, then raise tax rates on the rich.
Casualty Losses
 § 165(c)(3) permits a deduction for losses from “fire, storm, shipwreck, or other casualty, or from theft.”
 Consider an individual who has just received a cash payment of $5,000 for services performed.
o Suppose the money is counterfeit.
 He never got the money, so he doesn’t have to report it.
o Suppose the individual is robbed on the way to the bank.
 Yes—casualty loss deduction.
o Suppose the individual purchases a vase that day and the vase is immediately stolen.
 Yes—casualty loss deduction (for theft) – FMV of vase.
o Suppose the vase is stolen 2 years later.
 Yes—casualty loss deduction for lesser of FMV or basis in vase. Ex: If vase went up in value over 2 years,
you pay basis b/c you never paid taxes on the gain.
o Suppose the vase is destroyed when his car is struck on the way home.
 Yes—casualty loss deduction (fits under “other casualty”). A violent, sudden action (such as a car wreck)
is treated like fire, storm, or shipwreck.
o Suppose the vase is destroyed when his cat knocks it over in an unexpected fit.
 No, this doesn’t qualify. It’s clear that an ordinary cat knocking over vase is not like a fire or shipwreck.
o Suppose the vase is counterfeit.
 Yes—casualty loss deduction.
o Suppose the vase is to be given to the taxpayer’s wife, but the taxpayer finds she is having an affair and, in a rage,
he take all of her clothing and sets it on fire. The fire gets out of hand and (despite his efforts to put it out) destroys
the vase.
 No, this doesn’t qualify. If casualty is your fault, you cannot take the deduction, if you were grossly
negligent or reckless. If you were ordinarily negligent, you can still take the deduction.
 Ex: You’re driving and not paying attention and run into a telephone pole and total the car. If you were
ordinarily negligent, then you take a casualty loss deduction. OTOH, you were doing a 360 degree spin
and ran into the pole, you’re grossly negligent or reckless, so no casualty loss deduction.
 Other Examples
o House destroyed by termites – not sudden, so no casualty loss deduction
o Earthquake destroys house – sudden, so casualty loss deduction allowed.
o Lose ring while duck hunting – no deduction
o Flush ring down toilet – no deduction
o Smashed ring in car door – this is deductible (b/c it’s violent)
o Ring destroyed in garbage disposal – deductible (violent)
 HEADLINE NEWS
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Neurotic cat destroys vase
OJ trial kills Brentwood housing
 Court held that a temporary decline in value of home due to any event will not be deductible. No physical
damage to property, and temporary losses not deductible.
o Spurned hubby burns own home
Rules on how to take the casualty losses
o Casualty losses are only deductible to the extent that it exceeds 10% of your AGI. First $100 of any particular loss
is non-deductible. The actual loss (not covered by insurance) must exceed 10% of your AGI.
 Ex: If you have AGI of $100,000, you can only take casualty loss to extent that it exceeds $10,000.
 Ex: If you have two casualty losses in one year. For first, you suffer $20,000 loss for your damaged car.
Second, earthquake knocks TV off wall, and causes $5,000 loss.
 For first, you would deduct $19,900, and for second, you would deduct $4,900. Total is $24,800.
So assuming AGI of $100,000, you would get $14,800 of casualty loss deduction (exceeding
$10,000).
 So, most people will not get to deduct casualty losses.
o A business that suffers casualty loss can always deduct the loss.
Extraordinary Medical Expenses
 Basic rule: § 213(a). Medical expenses are deductible to the extent that they exceed 7.5% of AGI.
o Comparison w/employer-provided care: Employer-provided medical care is excluded from the employee’s income
w/o any threshold. §§ 105(b), 106.
o Self-employed: Self-employed individual can deduct 100% of the cost of premium paid for medical expenses
o Arguments for treating employer-provided care more favorably than individual medical payments:
 (1) To encourage employers to provide such car.
 (2) Better monitoring. Employers and insurance companies are less likely to fund unnecessary health
expenditures than individuals.
 Who is left without medical coverage?
o Employees whose employer does not provide medical insurance.
o Unemployed individuals.
 What happens when uncovered individuals become sick?
o Can go to County and covered by taxpayers.
 This is a bad system. Leads to underprovision of preventative care, weird system of payment (making
taxpayers pay for others w/o insurance).
 Doesn’t seem to be most sensible way to provide medical care.
 Argument for the Medical Expense Deduction
o Consider 2 individuals: Alice has an income of $50,000
 Each has the same “ability to pay.” The medical expense deduction ensures they are taxed the same.
o Person with high medical expenses has less ability to pay.
 Arguments against the Medical Expense Deduction
o Some medical expenses have elements of personal consumption.
o The medical expense deduction disproportionately benefits the wealthy.
 Deduction is not going to go to people who are covered for insured expenses. People who have insurance
will not get this deduction b/c they have insurance.
 This will go to people with high, uninsured medical expenses. But what kind of people have high,
uninsured medical expenses AND itemize their deductions?
 People who have plastic surgery and have regular psychiatric treatment.
 What costs are deductible as medical expenses?
o § 213(d)(1): “Medical care” means amounts paid
 (A) for the diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of affecting
any structure or function of the body,
 (B) for the transportation primarily for and essential to medical care,
 (C) for qualified long-term care services (i.e., medically needed nursing home care), or
 (D) for insurance covering medical service or long-term medical care.
o § 213(b): Only prescription drugs and insulin are deductible. Over the counter drugs are not deductible.
 Taylor v. Commissioner (1987)
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Taxpayer has a bad allergy. His doctor instructs him not to mow his own lawn, so he hires someone else to do the
job.
o Held: The expense is not deductible.
 There was no showing that other family members could not mow the lawn.
 There was no proof that he would have mowed the lawn if he didn’t have an allergy (hiring people to mow
the lawn is something that ordinary people frequently do).
Henderson v. Commissioner (2000)
o Taxpayers’ son suffers from spina bifida. Taxpayers purchase a van for $26,000 and spend $4,406 adding lift and
other modifications. Van was used to transport son to hospital and to school. It was the only means of
transportation for son. Parents take depreciation deductions for the cost of the van and the modifications at a rate of
$5,500 per year. IRS denies the depreciation deductions.
o Held: Depreciation is not deductible for medical expenses. Under the statute, the deduction is only for “expenses
paid.” While the modifications are clearly deductible in the year they were paid, depreciation on the van is not.
 In year van was purchased, taxpayer entitled to deduct cost of those modifications.
o Could the entire cost of the van be deductible in the year it was paid?
 No. If you buy something you would have to buy anyway, you can only deduct the extra cost incurred b/c
of your medical problems.
Ochs v. Commissioner (1952)
o Wife has cancer of the thyroid and must rest. On the advice of doctor, the family sends kids to boarding school.
o Issue: Are the costs of the bording school deductible medical expenses or nondeductible personal expenses?
o Held: The costs of boarding school are nondeductible personal expenses. The court reasoned that the expenses were
made necessary by the loss of the wife’s services. If, for example, wife had died, it is clear that the costs of
boarding school would not be deductible by the husband.
 Court is worried that people will deduct all sorts of services (cleaning, cooking, etc.) if someone has a
medical problem.
o Dissent: Deductible medical costs are expenses for the “mitigation, treatment or prevention of disease.” If the wife
had been sent away to a rest home, the expense clearly would have been deductible. The treatment should be the
same if the kids were sent away. The suggested test: “Would the taxpayer normally spend money in this way
regardless of the illness?”
 We should look at totality of circumstances. If person is type of person who would not send kids to
boarding school, and only sent them to boarding school b/c of medical problems, then it should count as a
deduction.
o Was the boarding school needed:
 Because of the kids?
 Because of the illness? If so, then it should be deductible (under dissent).
 But asking these questions aren’t useful for policy reasons.
Notes on Medical Expense Deduction (see handout)
 1) Transportation costs for medical care are deductible.
 2) Costs of birth control pills…
 3) Costs of psychiatric treatment…
 4) Costs of general health activities….
 5) Trip to Florida in the winter on a doctor’s recommendation was not deductible.
 6) Hotel costs…
 7) Inpatient addiction treatment (drug or alcohol) is deductible.
 8) Cost of long-term care…
 9) Insulin and ….
 10) Costs of medical insurance are deductible.
 11) Extra costs of aids…
o Extra cost of Braille books and schooling deductible
 12) No deduction is permitted for cosmetic surgery….
Charitable Contributions
 § 70(a)(1) allows taxpayer to claim as an itemized deduction any “charitable contribution…payment of which is made within
the taxable year.”
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o Even if you’re an accrual-based taxpayer, you only get deduction in year you actually pay the money.
§ 170(c) – A charitable contribution is defined as a “contribution or gift to certain enumerated eligible donees:
o (1) States, possessions, or other political subdivisions of the United States if the contribution is made for exclusively
public purposes.
 Give money or property to gov’t—qualifies as charitable contribution.
o (2) Organizations that are “organized and operated exclusively for religious, charitable, scientific, literary or
educational purposes or to foster national or international amateur sports competition or for the prevention of cruelty
to children or animals.”
o (3) A post or organization of war veterans.
o (4) Individual gifts to a domestic fraternal society, but only if such contribution is to be used exclusively for
religious, charitable, etc. purposes.
 Donation to Elks or Masons alone would not be deductible; only if it was donation to a fund by Elks or
Masons, as described above.
o (5) Certain non-profit cemetery companies.
o Each of the above organizations must operate on a non-profit basis.
o The organization also must not attempt to influence legislation or intervene in any political campaign.
o What types of organizations are covered?
 Examples: USC Law School, local church, Olympics, charity that will feed people in India, NAACP
education fund, NRA’s charitable trust for gun education
 What doesn’t count: Gov’t of India, homeless person on street, Sierra Club (b/c it engages in political
activities), NAACP itself
 Trick is to set up separate entities within an organization to which you can make tax-deductible
contributions. Churches can’t endorse political candidates directly, but they can go up to the line and
approve of a candidate’s programs.
Limitations on deductible contributions
o The limit for gifts to churches, schools, medical institutions, and certain other institutions is 50% of AGI.
o Lower limits (30% and 20%) apply to certain other contributions such as those to private foundations.
§ 501(c) vs. § 170(c)
o Almost all organizations eligible for tax-deductible contributions under § 170(c) are tax-exempt under § 501(c).
 All charitable organizations are non-profits, but not all non-profits are charitable. You can be a non-profit
organization, but not a charitable organization.
o Contributions to many tax-exempt organizations, however, are not tax deductible. Some examples: pension funds,
social clubs and political organizations.
 Political contributions do not entitle you to a charitable contribution deduction.
Donations of Property
o If a person donates appreciated long-term capital gain property to a charitable institution, the taxpayer generally can
deduct the fair market value of the property, not just the basis.
 Ex: Taxpayer purchased a Han dynasty vase with a hole in it for $360 in a charity auction. The taxpayer
donated the vase to a museum and took a deduction of $15,000 and later $50,000. At trial the gov’t expert
valued the vase at $800.
 This can lead to very powerful tax planning.
 Suppose you bought stock for $100,000, and it’s now worth $1M. If you donate it to charity, you
will get deduction for whole $1M, and no one will ever pay tax on $900,000 of gain. If you had
sold it, you might have had only $400,000 left after taxes. This is a real deal.
o Current law: Independent appraisals are required for gifts of property with a value greater than $5,000 (to prevent
gross overvaluation of gift)
o For tangible personal property (as opposed to stocks and bonds), the charitable deduction is limited to basis unless
the property is related to the purposes of the charitable organization receiving it. If the property is related to the
purposes of the recipient charity, then the FMV may be deducted. You can never deduct more than FMV. If FMV
is lower than basis, you just deduct FMV.
 If taxpayer had given vase to Salvation Army, his basis would be limited to $360, b/c Salvation Army is
not in business of showing vases.
 If you want to deduct FMV of property, you need to make gift to organization that will use the property in
its business.
 This rule applies only when the taxpayer’s basis is LESS than the FMV of the property.
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Case 1: Bought stock for $1,000, which now has a FMV of $5,000. You give it to charity, and get
deduction of $5,000.
 Case 2: Bought painting for $1,000, which now has a FMV of $5,000. You give it to charity.
o If charity is a museum or is going to use/display the painting, the donor can deduct its
FMV.
o If charity was going to sell the painting afterwards, donor could only deduct the basis of
the painting.
 Case 3: Bought TV set in 1995 for $2,000. It still works great. You give it to charity. You might
have been lucky to sell it at yard sale for $100. What’s FMV?
o You can probably put down $200-300 for it. If you can prove it was in perfect shape,
you could put it down for this much. You often can pick a number which is higher than
what you would actually get selling it at a yard sale.
o You should donate your stuff to charity.
For property the sale of which would produce ordinary income, such as inventory, the charitable deduction is
limited to basis.
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