OVERVIEW OF TAX RETURN
Gross Income (§61)
- Above the Line Deductions (§§ 162, 165, 168, 179, some of 212)
= AGI (§62)
- Below the line deductions (standard §63B or itemized §63D deduction, exemptions)
= Taxable Income (§63)
x Tax Rate
= Tax Liability
- Credits
= TOTAL TAX
Exam: 1) First mention §61 (income.) 2) Then look for exclusions. 3) then look for
nonrecognition provisions. 4) Then look for deductions (§162 “ordinary & necessary”,
§212, personal deductions.)
GROSS INCOME
Definition of Gross Income. IRC § 61: All Income From Whatever Source Derived.
Also Regs §1.61-1a. All gains are taxed except those specifically exempted.
GLENSHAW GLASS
AGI §62
Defined as Gross Income minus the following deductions:
1) Trade and business deductions that a TP can take if he is not an employee §62(a)(1)
2) Certain trade and business deductions of employees §62(a)(2)
a) Reimbursed expenses of employees
b) Certain expenses of performing artists
c) Certain expenses of officials
3) Losses from sale/exchange of property
4) Deductions attributable to rents & royalties
5) Deductions for life tenants and income beneficiaries of property
6) Pension, profit-sharing, and annuity plans of self-employed people §401, 404
7) Retirement savings (see §219)
8) Alimony (see §215)
9) Moving expenses (see §217)
10) Medical Savings Accounts (§220)
11) Interest on education loans (§221)
Exclusions from gross income
Specific items excluded from gross income are specified in Subchapter B, Part III
(roughly §101 - 150)
Present value = future value / (1+r)n
Food & Lodging: IRC § 119: (Spouses and dependents are also covered)
Value of meals furnished by employer are excluded from gross income if they are
furnished for the convenience of the employer. (§119a)
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1) Meals must be furnished on the premises of the employer.
2) Employee must be REQUIRED to accept lodging on the premises of the employer as
a condition of employment.
3) Can’t exclude cash given by employer for meals.
Benaglia Case (87)
Meals and lodging given for employer’s convenience are not taxed to TP. It is an
implicit part of TP’s obligation.
Dissent: Meals and lodging were part of TP’s compensation, thus taxable.
Business necessity test: Comm. v. Kowalski. Job could not be done unless meals and
lodging were provided.
Nondiscrimination provisions apply to §119
Employer provided Insurance § 105, § 106:
§ 105 excludes from gross income amounts employees receive from their employers as
reimbursement for medical expenses under employer-provided health care plan.
(Medical costs in these cases would be paid by before tax dollars.)
Plan cannot discriminate in favor of highly compensated employees.
§ 106 excludes from gross income the value of health and accident insurance premiums
paid by employer to cover employees.
Excludable fringe benefits §132:
1) no additional cost services
2) qualified employee discount
3) working condition fringe
4) de minimis fringe
5) qualified tuition reduction
NO ADDITIONAL COST SERVICES §132B (Spouses, dependents, retired employees
are covered too):
Defined as any service provided by employer to employee (“employee” includes spouse,
dependants, and retired employees) for use by employee as long as:
1) such service is offered to customers in the ordinary course of the line of business of
the employer in which employee is performing services, and
2) employer incurs no additional cost in providing service to employee.
Charley v. Comm (supp.)
Travel credits converted into cash by employee is not a no additional cost service. Cash
is taxable to TP.
QUALIFIED EMPLOYEE DISCOUNT §132C (Spouses, dependents, and retired
employees are covered):
Employee can deduct the amount of discount up to
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1) In case of property, the Gross Profit Percentage of the price at which employer is
offering property to customers.
GPP = (sales price – cost of property to employer) / cost of property to employer
2) In case of services, employee can deduct 20% of price at which services are offered
by employer to customers.
WORKING CONDITION FRINGE BENEFIT §132D (Spouses, etc. are NOT covered):
Defined as an item which would be deducted under § 162 or §167 if employee had to pay
expenses himself. (e.g. employee can exclude value of journal subscription that is
provided by employer)
DE MINIMIS §132E:
Defined as any property or service the value of which is so small as to make accounting
for it unreasonable or administratively impracticable
IMPUTED INCOME
Not taxable. Examples are home ownership (no rental income) or doing chores around
the house.
Exceptions are working for oneself where an employer-employee relationship is present
(Minzer case 125 – Insurance agent who sold himself policies is taxed on policies’ value)
and barter (e.g. where an attorney provides legal services for housepainter, who paints
attorney’s house in return.
WINDFALLS:
Glenshaw Glass (126)
Punitive damages are taxable, even though they are not compensatory in nature.
Congress did not intend to limit definition of gross income (§61) to exclude punitive
dams. Compensatory damages for lost profits are also taxable. Compensatory damages
for lost capital is not income.
If you give a gift and take a deduction, then get the gift back: You recognize income at
the time you get the gift back.
GIFTS §102(A):
Gross income does not include value of property acquired by gift, bequest, devise, or
inheritance.
Comm. v. Duberstein (130)
Where the payment is in return for services rendered, it is ALWAYS income to payee,
regardless of donor intent. It is a question of fact whether a payment in a business setting
is a gift or compensation. (But now §102C says that transfers from employers to
employees are not gifts.)
Donor must give gift to donee as a result of “detached and disinterested generosity.”
(Look to intent of donor)
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US v. Harris (139) - gifts
Amounts received by TP’s during long term personal relationships are not taxable income
to recipients. In order to be found guilty in criminal tax case, gov’t must show that TP’s
willfully violated clear rule of law.
DONOR GETS NO DEDUCTION FOR GIFT AND DONEE DOES NOT REPORT
GIFT AS INCOME. CARRYOVER BASIS (Taft v. Bowers.) Donor is called the
“surrogate taxpayer” for donee.
Part sale/part gift transaction: Reg 1.1015-4
Transferee’s basis = greater of (amount paid by transferee or transferor’s basis in
property) + amount of increase in property’s basis due to gift tax paid.
(if amount paid by donee > donor’s basis)
Gain to donor = amount paid by donee – donor’s basis in property.
Basis to donee = amount he paid to donor.
Donee realizes full gain on sale of asset (amount realized upon sale – donee’s basis.)
(Donor never recognizes a loss on a part sale/part gift transaction)
Transferor’s basis
|
|(Compare: Greater of equals…) -> ->
|
Transfer Price
Transferee’s gain basis
|
|(Compare: Lesser of equals…)
-> ->
|
|
FMV of property at time of transfer
T’ee
Loss
Basis
If Transferee sells at greater than gain basis, gain = selling price – gain basis
If Transferee sells at less than loss basis, loss = loss basis – selling price
If Transferee sells at a price between gain and loss bases, there is no tax
See § 1015D and Reg 1.1015-5 on effect of gift tax on basis.
Increase in basis of property due to gift tax paid equals:
Increase in basis (the variable) / total gift tax paid = appreciation in value of gift / (value
of gift – 10,000)
Gift tax = gift tax rate * (value of gift - $10,000 exclusion.)
Scholarships & Prizes § 117.
Don’t include scholarships/prizes that are used for tuition, books, supplies, and
equipment. Part of total payment by school to TA’s that is compensation for teaching
services is taxable §117C. Qualified tuition reductions are not included in income
§117D.
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RECOVERY OF CAPITAL
Sale of Easements (Partial Sales)
If basis can be apportioned to portion sold, then gain/loss must be computed (amount
received – basis apportioned) §1001 and Reg. §1.61-6. Must apportion basis if possible.
Inaja Land v. Comm (166)
When no apportionment can be made between real estate and an easement which TP
holds, no tax liability exists until the entire cost of capital has been recovered. No tax
liability to TP because recovery due to damaged property was less than entire cost of
property. Also, the fact that the sale was involuntary is important.
Annuities and Pensions §72: (see handout)
§ 72A states that gross income includes annuity payments. Calculate recognized income
of annuity payments using “exclusion ratio” §72B. Exclusion ratio = investment in
annuity contract (price or basis) / expected total return on investment.
Apply the ratio to each payment received. Total payment minus exclusion = income.
The exclusion is characterized as a return on capital. This treatment is different from
Inaja Rule.
Haig-Simons Annuity Income:
Income in year 1 = Proceeds – (PV0 – PV1)
Income in year 2 = Proceeds – (PV1 – PV2)
PVx = FV / (1 + r) ^ (n-x+1)
Gambling Gains & Losses § 165D:
All gambling gains are taxable. Losses are only deductible to extent of gambling gains
made that year. Applies to both professional and amateur gamblers.
Recovery of Loss §165:
Clark v. Comm (183)
Is the reimbursement of unnecessary tax paid due to lawyer’s bad tax advise income to
TP? Not taxable. Payment by lawyer is not a payment of TP’s taxes (which would be
taxable under Old Colony Trust.) Rather it was a compensation for TP’s losses. So it is
not taxable. Fact that payment was related to tax liability is irrelevant. (this case is still
good law.)
§165A: Deductions are allowed for any loss sustained during the taxable year which is
not compensated for by insurance or otherwise.
§165C: Limitations – Deductions shall be limited to:
1) losses incurred in a trade or business
2) losses incurred in any transaction entered into for a profit (doesn’t have to be a trade
or business)
3) losses that arise from fire, storm, shipwreck, or other casualty, or from theft.
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Use of Hindsight:
Burnet v. Sanford & Brooks (192)
TP is required to include in gross income all items received during taxable year. Just
because TP suffered losses in previous years doesn’t mean that TP can exclude profits
made this year. Case stands for notion that income tax system uses annual (not
transactional) accounting.
Harshness of holding is mitigated by §172 (allowing Net Operating Loss carryovers for
businesses.) NOL carryover rule for individuals is 2 yrs back and 20 yrs forward.
Claim of Right/Tax Benefit:
North American Oil Consolidated v. Burnet (199)
Impounded funds in the hands of a receiver is only taxed to TP when TP has the
unqualified right to receive the funds. It doesn’t matter when TP actually receives the
funds, it only matters when TP has a right to the funds.
Even when the ownership of income is in dispute, it is taxable to TP. If TP has to hand
over income later, he gets a deduction in that later year. Alternatively, he can take a tax
reduction (a credit) in the later year equal to the tax assessed in the earlier year when he
claimed income (§1341).
§1341 is not available to embezzlers who get caught. TP had to have “some semblance”
of a right to income in the earlier year when TP included money in income.
US v. Lewis (203)
TP received $22K bonus in 1944 and had to pay $11 of it back in 1946. Can he amend
his 1944 return or does he take a $11K deduction in 1946? He must take deduction in
1946. Claim of Right Doctrine has long been used to give finality to the annual
accounting period.
Tax Benefit Doctrine:
Alice Phelan Sullivan Corp. v. US (206)
TP donated land in 1939 and got it back in 1957. Gov’t said that recovery of land was
income and taxed TP on income at 1957 tax rates. TP wanted to pay income tax at 1939
tax rates. 1957 tax rates apply. Ct wanted to ensure viability of single-year accounting
concept.
Tax Benefit Doctrine  If Alice Phelan had not taken a deduction on donation in 1939, it
would not have had to report income on the donation’s recovery in 1957. TP benefited
from 1939 deduction, so we take away benefit when he gets land back.
§111 says that income attributable to recovery of bad debt, prior tax, or “delinquency
amount” is not taxable unless TP benefited from the earlier deduction of these debts.
(Kind of like taxing a windfall.)
Recoveries for Personal & Business Injuries §104:
These types of payments attributable to personal injury are tax-free.
1) Worker’s Comp is tax free
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2) Compensatory damages on account of personal physical injuries or physical sickness
whether by suit or agreement and whether by lump sum payment or by periodic
payments (recoveries for pain and suffering are also excluded)
3) Amounts received through accident or health insurance
4) Amounts received through pensions, annuities, or other allowances for personal
injuries or sickness when serving in armed services.
Exclusion does not apply to recoveries to medical expenses already deducted under §213
PUNITIVE DAMAGES ARE TAXABLE (they are windfalls)
When employer pays premiums on employee’s medical insurance, the amount is
deductible by employer but is not included in employee’s income. §§106, 162.
Discharge of Indebtedness:
Recourse Loans:
TP must include amount of debt discharge (amount of total liability – amount paid to
discharge debt.) §61(a)(12).
EXCEPTIONS:
TP does not include amount of debt discharge if he filed bankruptcy. §108(a)(1)(A) and
108(d)(2). If insolvent TP has not filed bankruptcy, he can only exclude debt discharge
to extent that he is insolvent. §108(a)(1)(B).
Debt discharge income is limited to TP’s (assets – liabilities), but we tax TP on the
difference when he becomes solvent.
If debt cancellation is a gift, then it is not income. §102A
If cancellation of debt is a compromise of a disputed claim (rather than a fixed debt) then
the cancellation does not create income.
Also, no income if debt reduction is a purchase price reduction 108(e)(5) – if you “sell”
property back to creditor.
Non-recourse Loans:
Debt relief is included in amount realized for a property transaction (so debt discharge
income will be recognized upon sale of asset.) When TP purchases property, the value of
the debt is already included in the TP’s basis in the property. Crane v. Comm (handout)
and Reg. §1.1001-2(a).
US v. Kirby Lumber (220)
Retirement of debt at less than its face value (in this case, corporation repurchased some
of the bonds it issued earlier) is income.
Zarin v. Comm (224)
Settlement of contested liability does not result in discharge of indebtedness income. TP
was not liable to casino for the debt (under New Jersey law), so TP does not have
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income. §108. TP did not have debt subject to which he held property, as required under
§108(d)(1)(B) in order for TP to have tax liability.
Dissent: Casino’s giving TP gambling chips is like casino giving him a loan. TP was
liable for debt, so TP should be taxed for forgiveness of debt.
Crane v. Comm
A TP who obtains property subject to a mortgage must add value of mortgage in basis.
When TP sells property and thus gets herself out of mortgage liability, the amount of the
debt discharged is recognized as income. This was a non-recourse debt. In this case, the
amount of the mortgage was less than the value of the property
Dissent: Since debt was non-recourse, TP did not relieve herself of any preexisting
liability when she sold property.
If TP takes out a loan secured by the property but uses proceeds for other purposes, then
basis does not increase by amount of the loan.
Transfer of Property Subject to Debt
Comm v. Tufts (241)
When amount of nonrecourse mortgage ($1,851,500 in this case) exceeds value of
property ($1,400,000 in this case), TP has to add the amount of the mortgage in the basis
of the property (the Crane Rule.) TP also recognizes the full amount of the mortgage
then outstanding. Thus, it does not matter whether the amount of the nonrecourse
mortgage is more than the value of the property.
Gain recognized by TP here is capital gain.
Concurring opinion of O’Connor:
Gives approval to the bifurcation approach to mortgages. Purchase and sale of property
would be treated a transaction separate from obtaining and paying off a loan.
BIFURCATION:
1) ONLY WORKS FOR RECOURSE DEBT, AND
2) WHEN FMV OF PROPERTY IS LESS THAN THE BALANCE OF THE LOAN,
AND
3) WHEN MORTGAGE CREDITOR TAKES PROPERTY AS FULL
SATISFACTION OF THE LOAN
Example (Thanks, Gil.)
T transfers property to someone. Sales price = debt relief
Basis = 4,000
Mortgage = 9,000
FMV = 8,100 (FMV < mortgage)
If debt is nonrecourse, Gain on property sale = 5,000 (9,000 debt relief – 4,000 Basis).
All is Capital Gain
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If debt is recourse (bifurcation), Gain on property sale = 4,100 (8,100 FMV of property –
4,000 Basis). Capital Gain
Plus, Debt cancellation income = 900 (9,000 debt relief – 8,100 FMV). Ordinary Gain
If T is insolvent, then he does not recognize 900 ordinary gain.
ONLY DIFFERENCE BETWEEN RECOURSE AND NON-RECOURSE DEBT IS
THE CAPITAL/ORDINARY DIFFERENCE IN TREATMENT OF DEBT
CANCELLATION INCOME.
Illegal Income
Gilbert v. Comm (257)
Agreement between TP and his company that he will repay funds that he embezzled
allows the funds to be considered a non-taxable loan rather than taxable income to TP.
It is important that TP intended to repay the funds when he took them in the first place,
and he thought that the company’s board would ratify his taking of the funds. There was
no increase in TP’s real wealth from this transaction.
Tax exempt bonds § 103:
exempts from taxation the interest on certain state and municipal bonds. Holders of the
bonds still pay a “putative tax” on these bonds in the form of a decreased interest rate that
the non-taxable bonds pay.
Bonds that finance traditional government purposes (e.g. schools, roads, and sewers) are
always non-taxable. “Private-activity bonds” which finance airports, wharves, hazardous
waste facilities, certain electric and gas facilities, and mass commuting facilities are also
non-taxable.
§ 265(2)  Cannot deduct interest incurred on loans whose proceeds are used to buy taxexempt bonds.
GAINS AND LOSSES ON INVESTMENT PROPERTY:
Eisner v. Macomber (272)
Stock dividend is not realization of income. Shareholders do not receive anything of
value, they simply maintain their share in the corporation. A gain must be realized before
it can be taxed. Therefore, Sixteenth Amendment forbids Congress from taxing this
transaction. (Ct also said that income is gain derived from labor, capital, or both. It is not
a gain accruing to the capital asset. This view is not supported today.)
Dissent (Holmes): 16th Amendment does allow taxation of this transaction.
Dissent (Brandeis): Since TP can sell the stock at any time for cash, the receipt of
additional stock through a stock dividend should be a taxable event. Substance over form
argument.
Generally, stock dividends are not taxable. §305A. § 305B  Stock dividend is taxable
if shareholder had the option to take cash or other property in lieu of the dividend.
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Helvering v. Bruun (287)
Lessor is taxable for improvements to his property that are made by a tenant. Lessor is
taxed at the time that he repossesses the property. The value of the land increased
because a nicer building was built there. Ct distinguishes this case from Eisner (where
the value to the shareholder stayed the same.)
Present law: §109 overrules the holding in Helvering. Realization is deferred until lessor
sells the property.
Cottage Savings Ass’n v. Comm (294)
The exchange of one lender’s interests in a group of mortgages for another lender’s
interests in a different group of mortgages qualifies as a taxable disposition of property.
The different mortgages were “materially different” (a requirement of §1001 for TP’s
realization of the loss) because they embody legally distinct entitlements (the mortgages
were issued to different people and were secured by different homes.) So TP realized
losses in its disposition of its mortgages.
Like-Kind Exchanges §1031:
§ 1031  No gain or loss is recognized upon an exchange of property held for productive
use in trade or business or for investment solely for property of a like kind to be held
either for productive use in trade or business or for investment. Real property is like kind
Exceptions (§1031(a)(2)) (Not like kind assets):
1) Stock in trade or other property held primarily for sale (i.e. inventory)
2) stocks, bonds, or notes
3) other securities or evidences of indebtedness or interest
4) interests in a partnership
5) certificates of trusts
6) choses in action
Rev. Rul. 82-166:
TP’s exchange of gold bullion for silver bullion is not like-kind. They are intrinsically
different metals and are used for different purposes. Words “like-kind have reference to
the nature or character of property and not to its grade or quality.
Jordan Marsh Co. v. Comm. (308)
Property that is sold to then leased back from a 30 year period from an unrelated party is
not a like-kind exchange. TP liquidated its capital investment in the property in exchange
for cash equal to the value of the property. TP’s involvement with the property is not
substantially equal to its involvement before the transaction. Transaction was a sale (a
taxable event.)
Reg. §1.1031(a) deems a lease for over 30 years to be equivalent of a fee ownership.
Exchanges of real property are deemed by the IRS to be like-kind (see Reg. §1.1031(a)1(b)).
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BOOT:
Amount of boot received is taxable up to the amount of the realized gain on the
transaction. §1031(b). Thus gain is recognized to the extent of boot.
BASIS (§1031(d)):
There will generally be a substituted basis. Basis is allocated to boot.
DO NOT recognize debt relief boot you receive to extent that you receive cash!
Example (Basis Calculation):
A = original basis in property transferred out
B = amount of gain recognized (gain received to extent of boot)
C = total amount of basis to be allocated between like-kind property received and boot
D = portion of total basis allocated to the boot (the FMV of boot)
E = substituted basis of the like-kind property received (the property transferred in)
A + B = C, and C – D = E
If there is no boot, then B and D both equal 0, so A = C = E
If gain recognized is equal to amount of boot (B=D), then basis in like-kind property
received equals basis of the like kind property surrendered.
New Basis = Old basis + Boot Paid + [Gain Recognized – Boot Received]
Realized gain = [FMV of property received + Cash received + Debt relief] – Basis in
old property – Debt assumed – Cash paid out
(Realized gain = FMV of property transferred out – basis of property transferred out +/boot received/paid
Rev. Rul. 79-44 (315)
Transfer of interests in real property held by tenants in common that resulted in the
conversion of 2 jointly held parcels into 2 individually owned parcels is a §1031
exchange. Person who receives boot on this transaction will recognize gain to extent of
boot. Other person will not recognize gain if he did not receive boot. SEE PG. 35, 36
OF HANDWRITTEN NOTES
Starker v. US (322) – Three Party Transactions
TP transferred land to 3rd party. 3rd party promised to acquire and give to TP suitable
replacement property within 5 years (which he would buy from other people) or pay the
remaining balance in cash. 3rd party transferred replacement land within 5 years and TP
reported no income on this transfer (claiming §1031). Ct held for TP, saying that the
possibility that TP would receive cash in the exchange does not prevent application of
§1031. TP did not intend to receive cash on the transaction. In this case, TP also
received 6% “growth factor” each year that 3rd party did not complete the transaction. Ct
held that this was an interest payment, so it is taxed as ordinary income.
Congress changed the law so that the outcome in Starker would not ever occur again.
Now, like-kind property to be exchanged must be identified within 45 days after the first
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property has been transferred §1031(a)(3)(A). Like-kind property must be exchanged
within 180 days after the first property has been transferred §1031(a)(3)(B).
Involuntary Conversions §1033:
§1033 provides for nonrecognition where property is compulsorily or involuntarily
converted (e.g. by theft, destruction, or condemnation) and is replaced with property that
is similar or related in service and use. Nonrecognition of gain is mandatory where there
is a direct conversion. When TP receives cash and buys new property, nonrecognition is
optional. Gain is realized to extent that proceeds (e.g. from insurance) are not used to buy
new property. Losses are recognized w/ involuntary transactions
Basis of new property = cost of new property – any nonrecognized, but realized,
gain §1033(b)(2). Also basis in new property = basis in old property + additional
cash/debt invested in new property + recognized gain in transaction – proceeds
NOT invested in new property
Sales of Personal Residences old §1034 (now §121):
Homeowners are permitted to permanently exclude up to $250,000 ($500,000 for married
TP’s) of gain realized on sale of personal residences.
Constructive Receipt:
Reg. §1.446-1(c)  all items which constitute gross income (whether in the form of cash,
property, or services) are to be included for the taxable year in which they are actually or
constructively received.
Amend v. Comm. (358)
A cash basis taxpayer does not constructively receive income when he receives a promise
to pay in the future. Constructive receipt doctrine states that income is realized when it is
made subject to the will and control of the TP. In this case, TP had no legal right to
demand money from his customer.
(Remember Claim or Right Doctrine  If TP receives money or property and claims he
is entitled to it, and can freely dispose of it, the income is immediately taxable.)
Reg. §1.451-2(a)  If cash basis TP has unqualified right to money or property, plus the
power to obtain it, he has constructively received it and is taxed. (Examples would be a
noncashed check, interest not withdrawn from a bank account
US v. Drescher (79)
A nonforfeitable annuity is includable in an employee’s income when the annuity is
purchased for him by his employer. The right to receive income payments represented a
present economic benefit to TP. The present value (i.e. cost) of the annuity should be
taxed to TP now.
Dissent: The entire amount of the annuity should be taxed now.
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ECONOMIC BENEFIT DOCTRINE:
Pulsifer v. Comm (363)
TP and his children won $48K in a horse race. Under Irish law, money had to be placed
in trust until children were 21 (they were 18 at time of winning.) Are TP’s children taxed
on $48K now, or when they are 21? Ct said that they are taxed now, under the economic
benefit doctrine. TP had an absolute right to the money, and the money was placed
beyond the reach of creditors.
Economic Benefit Doctrine applies if the current value of the person’s promise to pay can
be given an appraised value. That value would be taxable to TP.
Deferred Compensation:
Rev Rul. 60-31, 1960-1
Set forth basis rules for taxation of deferred compensation. Cash-method employee is not
currently taxable due to employer’s mere promise to pay, even if the promise is
unqualified. However, when money is placed in trust for employee (and thus out of
employer’s hands), employee is taxed.
Minor v. US (367)
TP was paid deferred compensation that was placed in trust. Money was payable to TP’s
beneficiaries upon TP’s death, retirement, or disability. TP’s interest in the money was
forfeitable, however. There was no constructive receipt, because the deferred
compensation did not make funds available to employees currently. Economic Benefit
Doctrine does not apply because the deferred compensation is incapable of valuation. TP
is not taxed on the amount of money in trust. TP’s money was not safe from employer’s
creditors, therefore no economic benefit (Regs. §1.83-3(e)).
If there is substantial risk of forfeiture and the rights to the $ are nontransferable, then
there is no economic benefit, and thus no tax §402(b)(1).
Amount of deferred compensation by tax-exempt organizations is limited:
State agencies are limited in amount of deferred compensation they pay §457.
Charitable organizations are limited by §501(c)(3) (e.g. churches)
Public educational institutions are limited by §403(b).
Al-Hakim v. Comm. (373)
TP negotiated professional baseball player’s K. His fee was $112,500. Player agreed to
give TP an interest free loan of $112,500, to be repaid in $11,250 increments annually
over 10 years. Ct held that this was a bona fide loan, and that TP did not recognize fee
income when player gave TP $112,500.
Comm v. Olmsted Inc. (376)
When TP obtains an annuity, is he taxed on entire FMV of the annuity when he receives
it or only on the actual payments that TP received during the tax year? Ct held that TP
was only taxable on the actual payments that TP received during that year. Ct said that
no “sale” of property occurred under §1001 (TP sold life insurance company his
exclusive rights to sell insurance in return for the annuity.) Also, TP did not have the
right to demand the entire annuity amount during the current year.
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QUALIFIED EMPLOYEE PLANS
Employers are permitted to establish qualified pension, profit-sharing, or stock bonus
plans. Payments by employers are deductible by employers §404. Employees do not
report income until they get the money after they retire §402(a).
§401(k):
Employees are not taxed on the money that employer places in the plan on employee’s
behalf, even if the rights to the money are vested in the employee. Employee only pays
tax when he receives payments.
Employers are entitled to an immediate deduction for amounts paid into the plan
Earnings on the funds paid into the plan are not taxed (only tax is to employee when he
withdraws money from plan.)
Employer cannot discriminate in favor of highly-compensated employees, or else the
employer (and employee?) cannot receive the tax benefits of §401(k). See §401(a)(4)
§408 (IRA’s)
TP can set aside $2000 or amount of compensation, whichever is less, in an IRA.
Contributions into IRA are excluded from income. Phaseout begins at $25,000 for
individuals and $40,000 for married TP’s. Cannot participate in IRA if you are
participating in another qualified plan.
STOCK OPTIONS:
Grant of option is taxable if the value of the option has an ascertainable value.
Basis in stock = amount taxed at grant (option price) + amount paid for stock
When the grant is not taxed, the exercise of the option is a taxable event. Difference
between current market price and the option price = ordinary income.
Basis in the stock = option price + amount included in income = MARKET PRICE
Example:
Option to buy 1 share of stock for $10 (no ascertainable value of the option, so no tax at
time of grant). TP buys the share worth $19. Ordinary income to employee = $9 (19-10).
Basis = $19. Company also gets a $9 deduction.
If stock option is an incentive stock option (ISO) (§422A), then there is no tax on the
grant or the exercise of the option. Employee is only taxed when he sells the stock.
Employer never receives a deduction. Basis in stock = amount paid for stock on exercise
Requirements for ISO:
1) Employee may not dispose of stock for 2 years after option was granted and 1 year
after exercising it.
2) Option price must equal or exceed value of stock when option was granted.
3) Term of option must not exceed 10 years and the option must not be transferable
4) Employee may not own more than 10% of employer’s stock
5) Not more than $100,000 of stock per year can be subject to options
14
Comm. v. LoBue (388)
Stock options should be taxed when the options are exercised. Options are not a gift, so
options in general can be taxed. TP realized taxable gain when he purchased the stock
(Ruling implies that if the stock option is freely transferable and marketable though, the
value of the option is taxed at the time of the grant. So this decision is in accord with the
current law of non-ISO stock options.)
Dissent: Options should be taxed when they are granted. The option itself is an
immediate economic benefit to TP.
§83 (compensation) and options:
If any property (including options) is transferred to a person as compensation for
services, without restriction or risk of forfeiture, the difference between the value of the
property and the amount paid for property by the employee is included in employee’s
income.
If there is a substantial risk of forfeiture and the property is not transferable, the value of
the property is not taxed until either TP elects to have the property included in income or
until the property becomes nonforfeitable or transferable (i.e. the right to the property
vests in the employee.) Amount included then equals value of property when it vests (or
when employee takes the inclusion election) minus the amount paid by employee for the
property.
Employer only deducts compensation when employee includes it §83H.
Transfers incident to Marriage or Divorce (ALIMONY):
US v. Davis (397)
A property settlement pursuant to divorce is a taxable event. (TP transferred 1000 shares
of stock to ex-wife as settlement for wife’s claim of inchoate rights to TP’s other
property.) TP argued that settlement was not a transfer, but a mere division of property.
Ct said that wife was not a co-owner of the property because she had no vested right to it.
Therefore, when TP gave wife shares of stock, it was a transfer, not a division. TP’s
amount recognized on the transfer = FMV of the stock – Basis in stock.
(Congress changed the law, so Davis does not control anymore.)
Noncash transfers of property incident to divorce (§1041)  No gain or loss is
recognized by either party on transfer of property to a former spouse as long as the
transfer is incident to divorce. Transferee assumes the transferor’s basis in the property.
ALIMONY §71  Alimony payments are included in payee’s income and are deducted
by payor. In order for payment to be considered alimony:
1) Alimony must be paid in cash (§71(b)(1).)
2) Payment must be made pursuant to written divorce decree.
3) Payor and payee must live in separate households
4) Payment must not be for child support
5) Payment obligation must not continue after death of payee spouse
6) §71F  Payments are only treated as alimony to extent that they payments are
substantially equal in the first 3 years of payment. (Front-loaded payments in the 3
15
year period are recharacterized as property settlements, which are not deductible by
payor.)
How to compute “excess alimony payments” under §71F:
1) Determine excess payments for the second year. Excess = alimony payment made in
2nd year – (alimony payment made in 3rd year + $15,000).
2) Determine excess payments for first year. Excess = alimony paid in first year –
(Average alimony payments made in 2nd and 3rd years, net of 2nd year excess
[which is 2nd year payment – excess] + $15,000)
3) Total first year and second year excess will be added into payor’s income in year 3
and deducted by payee in year 3.
§71F doesn’t apply when alimony payments cease because payee remarries or dies. Also
doesn’t apply when payor agrees to pay a fixed percentage of his earnings as alimony.
CHILD SUPPORT AND OTHER TRANSFERS Child support is not deducted by
payor and not included in payee’s income.
ANTENUPTUAL SETTLEMENTS:
Farid-Es-Sulaneh v. Comm (404)
TP entered into prenuptial agreement whereby she received stock from husband in
exchange for her relinquishment of her rights to support. Husband’s original basis of
stock = $0.16/share. When he transferred stock to her, FMV of sock = $10.67/share. TP
sold stock later and decreased recognized income by $10.67/share, not $0.16. Issue was
whether husband’s transfer to TP was a gift or whether it was for consideration. If it’s a
gift, TP gets carryover basis of $0.16. If for consideration, then TP gets basis of $10.67.
Ct said that stock was given for consideration, since she had to relinquish other rights in
order to get stock. It was a sale (and thus husband should have recognized income on
HIS return when he transferred the shares.)
Dissent: It was a gift. Husband wanted to take care of TP and get her to marry him.
Defaulting on child support:
Diez-Arguelles v. Comm. (413)
TP’s husband was supposed to pay child support, but defaulted. He was $4,325 in
arrears. Lack of child support forced TP and her new husband to bear all support of the
children. TP took a $4,325 nonbusiness bad debt deduction as a short-term capital loss.
Next year, she took another $3,000 deduction. Ct said that TP was not allowed to take
this nonbusiness bad debt writeoff. TP had no basis in these debts, and the amount of the
writeoff allowed is limited to TP’s basis in the debt. Cts have ruled that TP’s do not have
basis in delinquent child support payments.
BAD DECISION, says Prof. TP does have basis here, because she had an entitlement
(Basis = FMV of debt?)
Consumption Tax
Idea of consumption tax is to tax income and allow deductions for all money saved. It is
like taxation of 401(k) plans. No tax at all on money saved until TP withdraws the
16
money and consumes it. Consumption taxes do not cause choice distortions (i.e. people
will not make a particular decision exclusively for tax reasons.)
There is also the yield exempt taxation plan (like Roth IRA’s.) Here, there is no
deduction on investment, but you get to withdraw your money tax free. All the earnings
you make on a Roth IRA are tax free (there’s only a one time tax when you invest the
money.)
Flat Tax:
1) Businesses are taxed through VAT (value added taxes), which are imposed on
businesses at each step of production of a good or service. Businesses then raise
prices to consumers to cover some of their VAT tax liability.
2) Businesses get deductions for wage payments, and employees get taxed on their
wages through the yield exempt taxation plan.
Flat tax gets rid of double taxation issue.
DEDUCTIONS:
§162 (Above the line business deductions):
May deduct all ordinary and necessary expenses paid or incurred during the taxable year
in carrying on any trade or business.
Includes: (§162A)
1) Reasonable allowance for salaries and other compensation for services actually
rendered.
2) Traveling expenses while away from home in pursuit of trade or business
3) Rentals or other payments required to be made as a condition to the continued use or
possession of property to be used for business.
Types of §162 deductions:
1) Traveling expense (must meet overnight test)
2) Meals and entertainment (50% deduction)
3) Hobbies (must intend to make a profit)
4) Education expenses (must qualify TP for new trade or business)
5) Home Office/Vacation home (§280A)
6) Attorney’s fees (must be arise from a business origin)
§212 Deductions (do not have to be business related) – mostly below the line
(investment deductions):
All ordinary and necessary expenses paid or incurred during the year:
1) For the production or collection of income
2) For the management, conservation, or maintenance of property held for the
production of income
3) In connection with the determination, collection, or refund of any tax.
§262  “No deduction shall be allowed for personal, living, or family expenses.”
17
Current Expenses versus Capital Expenditures §263 and §263A:
Business expenses for an asset with a useful life that extends beyond the year in which
the expense was incurred must be capitalized. §263
Must capitalize certain costs, such as costs of inventory and maintenance of property
(§263A)
Must capitalize costs of acquiring new machinery, making permanent
improvements on property, securing a copyright, defending or perfecting title to
property, an architect’s services, and commissions paid in purchasing securities.
Reg. §1.263(a)-1 and –2.
UNICAP §263A(b):
Applies to manufacturers, wholesalers, retailers, and any other TP’s who produce real or
tangible property for sale to customers in the ordinary course of business. Must recover
expenses when goods are sold (COGS) §263(a)(1). UNICAP rules apply to direct costs
(wages and cost of materials) of producing and selling goods and the portion of indirect
costs allocable to the goods sold. §263A(a)(2).
Encyclopaedia Brittanica v. Comm. (609)
Advances paid by TP for a completed manuscript written by 3rd party is NOT currently
deductible by TP, since the manuscript will yield income to TP over future years. Object
of §162 and §263 is to match expenditures with the income they generate. Expenditures
to create a book must be capitalized just like expenditures incurred to build a building.
Rev Rul. 85-82 (617)
TP may not deduct the portion of the purchase price of a farm that is allocable to the
growing crops in the year in which the farm was bought, but may recover that portion of
the price when the crops are sold (i.e. must capitalize the cost of purchasing the crops on
the farm.)
INDOPCO case (note on p.620)
Expenses that do not create an identifiable asset but instead provides long-term benefits
for an organization’s business must also be capitalized. (In this case, the expenditures
were banking fees paid incident to a merger.) IRS does not rigidly enforce this rule
though. The INDOPCO Rule is very encompassing.
Repair and Maintenance Expenses:
Repairs can be deducted currently if the repairs neither materially add to the value of the
property nor appreciably prolong its life, but keep it in an ordinarily efficient condition.
Reg. §1.162-4. Compare to value of property before the damage.
Use foreseeability test to determine whether it is repair or maintenance.
Expenditures that substantially increase the useful life of an asset, or that produce
improvements that will endure over and beyond the taxable year, or comprise part of an
overall plan of remodelling or rehabilitation are capitalized (they are “maintenance”
expenses)
18
Midland Empire Packing Co. v. Comm. (621)
A building improvement which does not add to the useful life or value of the building can
be deducted currently (it is a “repair” expense.) It is an ordinary and necessary business
expense.
CONTRA:
Mt. Morris Drive In v. Comm (note p.625)
Cost of correcting a drainage system is capitalized since the need for it was foreseeable
and was part of the process of completing TP’s initial investment for its original intended
use.
Loss vs. Repair deduction:
Sometimes TP can either take a loss deduction or a repair expense deduction when an
asset is destroyed.
Example: Farmer buys barn for $50K. Tornado takes off the roof of the building.
Damage = $10K.
If farmer takes loss deduction:
Basis at time of purchase = 50K
Loss deduction (current deduction) decreases basis to 40K
The $10K cost of repair must be capitalized (no double deductions allowed), so barn’s
basis after repair = 50K
If farmer takes repair deduction:
Basis will always remain at $50K and farmer takes a repair deduction of $10K.
So the tax treatment is the same.
Rev. Rul. 94-38 (627)
Costs incurred to construct groundwater treatment facilities are capitalized under §263 (it
is not a current “repair expense” under §162). The groundwater facilities have a useful
life substantially beyond the current year. Costs incurred for soil remediation and
groundwater treatment are currently deductible under §162, because these treatments do
not increased the value of the property (he merely restored the value of the land to the
level it was before the accident.)
Depreciation:
We use the Accelerated Cost Recovery System (ACRS) §168. Depreciation is an
ordinary expense. May depreciate value of real property and §1231 property. §1231
Property = Real or depreciable property used in trade or business and involuntary
conversions. Section 1231 property is NOT capital property!
Under §168, TP’s annual depreciation deduction is determined by
1) The applicable depreciation method
2) The applicable recovery period
3) The applicable convention
Tax law ignores salvage value of the asset
19
Each type of property is arbitrarily assigned a class life, which is the estimated useful life
of the asset. Under theory of ACRS, the applicable recovery period is always less than
the estimated useful life. For example, an asset in the 9-year class life has a 5-year
recovery period. Short recovery period means more deduction per year. §168
Intangible property, such as patents, copyrights, films, and sound recording has a 15-year
class life. §197
The applicable convention (§168(d)):
Determines the date on which the depreciable property is deemed to have been placed in
service. The date on which the asset is placed in service is used to determine how much
depreciation deduction can be taken.
If the asset is not real property, we use the “half year convention” (§168(d)(1)), so the
asset is deemed to be placed into service halfway through the year.
The mid-quarter convention is used if a TP places a disproportionate amount of
depreciable property into service in the last 3 months of the year (this is meant to combat
abuse.) §168(d)(3). If mid-quarter convention applies, then the property is deemed to be
placed into service on the date that is halfway through the quarter in which the property is
actually placed into service.
If the asset is real property, the mid-month convention is used.
The applicable depreciation method is determined under §168(b). For property that is
not real property, TP can use straightline method, or may elect to use either the 150%
declining balance method (for property with class lives of 15-years or 20-years) or double
declining balance for all other classes of property.
TP must use straightline to depreciate real property
Depreciation recapture:
§1231 (non-real property)  The portion of any gain on the sale of these assets that is
attributable to depreciation taken in earlier years is recharacterized as ordinary gain.
Example:
Asset bought for 1000, and 50% depreciated, so now basis = 500
Asset sold for 1500. Total gain = 1000 (1500-500). Ordinary gain = 500 (1000-500),
Capital gain = 500 (1500-1000).
Business/Personal Distinction (§162)
Ordinary & Necessary  beginning of analysis for exam
Gilliam v. Comm (651) “Extraordinary Behavior”
TP was travelling via plane for business reasons. He forgot to take his happy pills and
went insane on the plane. He struck and injured a passenger. Can TP deduct his legal
fees and his settlement with the passenger under §162? Ct said no, because the expenses
were not directly connected to TP’s trade or business. The payments were not ordinary
for the type of business TP was conducting. They were personal expenses.
20
Reasonable Compensation §162(a)(1)  IRS only denies deduction for “unreasonable”
compensation when the salary is not truly a salary, but is rather a nondeductible payment
masquerading as a salary. §162(m)  Publicly held corporations may only deduct $1M
for salaries (but not for bonuses) for each employee.
Costs of illegal or unethical activities:
1) Cannot deduct a fine or similar penalty paid to a government for violation of a law
§162(f)
2) Cannot deduct a bribe or kickback §162(c)
3) Cannot deduct the two-thirds punitive portion of damages paid for criminal violation
of antitrust law §162(g)
4) Cannot deduct expenses incurred in drug trafficking §280E
Stephens v. Comm (664)
TP may claim a deduction for restitution payment of embezzled funds. It is important
that TP paid taxes earlier when he obtained the embezzled funds. Ct did not want to
“double sting” TP (first by imprisoning him, and second by not allowing the deduction.)
Disallowing the deduction would not frustrate public policy (so §165 did not apply –
provision said that deductions that would frustrate public policy would not be allowed.)
§162 does not preclude deduction here because this case does not fall under the “illegal
or unethical activities” outlined above.
§67 – The 2% Floor – Below the Line Deductions: Unreimbursed employee
expenses and §212 deductions
Certain deductions are only allowable to the extent that they exceed 2% of AGI. Most
notable of these deductions are §212 deductions and §162 deductions claimed by
employees. Self employed people may claim §162 deductions without regard to §67.
Hobby Losses §183:
Must reasonably expect to make a profit from the venture. Courts sometimes use
subjective test. IRS wants to use objective test.
§183 distinguishes activities that are engaged in for profit and those which are not.
§183(d)  There is a rebuttable presumption that an activity is engaged in for profit if
the activity generates a profit in 3 or more of 5 consecutive years.
Reg. §1.183-2(b)  “in determining whether an activity is engaged in for profit, greater
weight is given to objective facts than to TP’s mere statement of his intention.
(“9 Business factors” pg. 363 BGP)
Nickerson v. Comm (516)
TP ran a rundown farm 5 hours away from his home. TP did not expect to earn a profit
for 10 years after he acquired farm. TP lost money in first few years and took deduction.
IRS did not allow deduction. Can TP take deduction on the farm. Ct said yes. TP
expected future profit. There were facts to show that TP had definite business plans for
the farm and expected to earn money someday. Farming was not a pure hobby for TP.
21
TP was able to get deduction even though he didn’t turn a profit on the venture for 3 out
of 5 consecutive years.
Passive Losses (§469)
Individuals with passive losses may deduct those losses:
1) to offset passive income for that year
2) to offset passive income for later years, or
3) at the time the investment which generated the loss is sold.
If activity is for profit (like Nickerson’s farm), then losses offset any gain (passive or
active.) If activity is passive, the rules above apply. If activity is a personal hobby, no
deductions for losses are ever allowed.
Home Offices:
Where a person does use part of his home exclusively or primarily for business, the
expenses relating to that part of the home are deductible business expenses.
In order to curtail abuse, Congress passed §280A
§280A: General Rule: No business deduction for any use of the home for business
purposes (§280A(a)). Exceptions to the general rule are at §280A(c).
Exceptions to general rule disallowing deductions:
1) When home is principal place of business for business/trade of TP
2) As a place of business used for clients, patients, or customers in meeting with TP in
the normal course of trade or business
3) In case of separate structure which is not attached to the dwelling, which is used in
trade/business.
4) When part of the home is storage space for inventory or product sample.
5) When home is used for child care as a business.
6) Employees can only use residence as an office if it is for the employer’s convenience
i.e. when employer does not provide adequate office space at workplace. §280A(c)(1)
Moller v. US (529) – “investor” vs. “trader”
Can an investor who spends 40 hours per week in the home tracking his investments
qualify for a trade/business office in his home (and thus get home office deductions)? Ct
said that he could not, because TP was not in the market to make short-term gains from
market fluctuations, so it did not seem like TP generated a substantial amount of income
from his activities at home. If TP was a “day-trader” working out of his home (who
generated income/losses from short term gains from market fluctuations), he would
probably get a home office deduction.
Vacation Homes owned by TP §280A: (pg. 371 BGP)
Property tax x (# of days rented / total # of days used) = above the line property tax
deduction. Rest is below the line.
22
Profit related expenses paid x (# of days rented / total # of days used) = allowable
profit related expenses deductible.
If property is used for personal purposes for more than 14 days or 10% of days
rented (whichever is greater), then:
Total allowable profit related expenses = income from rent – property taxes
deducted
Allowance of deductions depend on number of days the home was used for personal
purposes and the number of days the home was used for rental.
I.
II.
If TP does not use home for personal purposes at all, he can deduct all expenses
of the property. But these are passive activity losses, and can only be deducted to
extent of passive activity gains.
If TP does use home for personal purposes for 1 or more days, he is limited to the
expenses (“non-profit motivated”) he can always deduct (property taxes and home
mortgage interest) (§164), plus the portion of other (“profit-motivated”) expenses
that are allocable to the period during which the property was rented. Remember
passive activity loss limitation. (Cannot deduct more than amount of rental
income)
Allocate profit-motivated expenses by taking:
ratio = number of rental days / total number of days property was used
(ignore days that property wasn’t used)
Take profit motivated expenses times the ratio and this is the amount of expenses
allocable to rental activity.
For property taxes and mortgage interest payments, the amount of these that are allocated
to rental activity is an above the line deduction, and the amount that is allocated to
personal purposes is a below the line deduction. §62(a)(4)
If dwelling is “used as a residence,” business and investment deductions are limited to
income generated by the property (remember to prorate if dwelling was used even for one
day for personal purposes!)
“Used as a residence” is defined in §280A(d). It is a personal residence if it is used for
personal purposes by any of its owners or relatives for more than 14 days or 10% of the
days it was rented to others, whichever is greater.
Travel & Entertainment Expenses:
§162(a)(2) specifically allows a TP to deduct travel expenses as long as 3 requirements
are met:
1) Travel expenses are reasonable and appropriate, and
2) Expenses are incurred when TP is away from home, (overnight test) and
3) Expenses are motivated by TP’s business, not for personal reasons (ordinary &
necessary)
23
If a TP maintains two residences and incurs duplicate living expenses because of the
exigencies of TP’s business, the expenses are deductible (TP must be away from home to
get deduction.) However, if TP has two residences for personal reasons, then expenses
are not deductible.
“Homeless TP’s” do not get travel deductions.
Costs of entertainment (e.g. meals, recreation) are only deductible if: §274(a)(1)(A)
(50% limitation)
1) The item was directly related to the active conduct of TP’s trade or business (as
opposed to creating goodwill,) or
2) The item preceded or followed a bona fide business discussion (discussion held
principally for business reasons) AND was associated with TP’s trade or business.
Travel and entertainment expenses must qualify under §162 or §212, AND §274
“Directly related to” means (Reg. §1.274-2(c))
1) TP had more than a general expectation of making some income or other specific
benefit other than goodwill (TP must show that a business benefit was derived from
each item deducted.), and
2) TP actively engaged in a business meeting or transaction during the entertainment
period, and
3) The “principal character” of the combined business/entertainment was the active
conduct of trade or business.
Spouse, dependent, or other person’s travel costs may be deducted only if: §274(m)(3)
1) The person accompanying TP is an employee or employer of TP, and
2) The person accompanying TP is travelling for bona fide business purposes, and
3) The travel expenses of the person accompanying TP are otherwise deductible
All deductions for meals and entertainment expenses are limited to 50% of the amount
spent §274(n). If an employee is reimbursed by employer for such expenses that
employee incurred, employee can deduct all the meal and entertainment expenses, but the
employer can only deduct 50% of the reimbursement given to employee.
Deductions for entertainment tickets are limited to face value of tickets §274(l)(1)(A) and
cannot deduct fees paid to clubs unless TP establishes that the facility was used primarily
for TP’s business. §274(a)(2)(C).
Business/personal travel expenses: Full cost of domestic airfare may be deducted as long
as TP shows that primary purpose of trip was business §274(c), but may deduct cost of
lodging and meals only for days that were spent for business purposes §274(n).
Airfare to foreign countries to do business is partially disallowed if there is a personal
element to trip. (§274(c)).
No expenses for attending a meeting outside North America may be deducted unless it is
reasonable to hold meeting outside North America §274(h)(1). No deduction is permitted
24
for travel as a form of education (e.g. French teacher travels to France to talk to French
people.) §274(m)(2).
Rudolph v. US (540)
TP and wife took one week trip to NY. One day spent on business and rest of week for
fun. Trip is included in gross income. Not a fringe benefit under §61, but is rather a
reward (which is taxable.) Purpose of trip is personal.
Dissent: TP was expected to take trip, and was for benefit of employer. Cost of trip was
not a “wage” paid to TP.
Schulz v. Comm (544)
TP spent $9300 to entertain buyers and others connected with TP’s business, but no
business was done during the entertainment. Cost of entertainment not always
deductible. Purpose of entertainment was not business. Expenses should be apportioned
between business expenses and personal expenses. Ct allowed $5500 deduction for
business expenses. Ct followed the direct business purpose test of §274.
Levine v. Comm (551)
Must substantiate by adequate records or other evidence the amount, time and place, and
business purpose of each expenditure claimed as a deduction (§274(d)(2).) Reg. §1.2745(b)(3). Mere estimates are not enough. Since TP cannot substantiate, no deductions
allowed. See also Carver v. Comm (554).
Moss v. Comm (556)
TP was a partner at small law firm. Every weekday, he and his partners met for lunch to
discuss business. Deductions for these lunches were not all allowed because TP tried to
deduct too much lunch expense. Lunches were a personal, not business expense because
the meal was not necessary to accomplish a business objective. Outcome in case might be
different if TP took clients out to lunch. Ct said that expense must be different from or in
excess of that which would have been made for TP’s personal purposes.
Danville Plywood Corp. v. US (560)
Expenses incurred for a Super Bowl trip are not ordinary and necessary business
expenses, so they are not deductible. Costs of bringing spouses and children were not
deductible because they were not there for a bona fide business purpose. Cost of bringing
customers to Super Bowl were not deductible because the central purpose of the trip was
not business.
(Had Danville Plywood given employees Super Bowl tickets or money to purchase
tickets, Danville Plywood can deduct these costs as salary. The problem in this case
really was that the employees did not report Super Bowl trip as income. The IRS just
wanted to tax somebody.)
Commuting Costs:
1) Commuting costs to and from work are not deductible, because these costs reflect
TP’s personal choice about where to live. Regs. §§ 1.162-2(e), 1.262-1(b)(5).
25
2) TP can deduct costs of travelling to and from a temporary work site. Rev. Rul. 90-23.
The deduction is a §162(a) deduction, not a §162(a)(2) deduction. (must be ordinary
& necessary)
3) If TP is away from home, commuting costs to and from work as well as lodging and
meals are deductible (§274(n)) if TP is out of town for business purposes.
4) Expense incurred by travelling from one place of business to another is deductible.
§162(a)(2) specifically allows a TP to deduct travel expenses as long as 3
requirements are met:
1) Travel expenses are reasonable and appropriate, and
2) Expenses are incurred when TP is away from home, and
3) Expenses are motivated by TP’s business, not for personal reasons
Comm. v. Flowers (572)
TP lived in Jackson, MS and worked in Mobile, AL as an employee. TP chose to live in
Jackson. He took 40 trips to Mobile and tried to deduct transportation costs. Ct said no
deductions because expenses were not incurred in pursuit of employer’s business.
Expenses were nondeductible living expenses. TP’s business did not force him to travel
all that way. It was TP’s personal decision to live in Jackson. He could have lived in
Mobile and saved all those commuting costs.
(If TP did substantial business activity in Jackson as well, IRS would probably allow the
deduction. TP’s “home” is considered the place where his “principal business post” lies.)
Hantzis v. Comm (578)
TP (second year law student) lived in Boston and lived in NY for her summer job. She
kept her house in Boston and an apartment in NY. TP tried to deduct the costs of living
in NY (apartment, transportation, and meals.) Ct said no deduction allowed because she
did not have a business reason for keeping house in Boston. (Ct said that TP’s “home” for
the summer was NY, so she was not “away from home.”) TP had no business ties to
Boston. Determining factor in deciding whether to allow deduction for two homes is the
reason why TP is maintaining two homes. TP here was maintaining Boston home for
personal purposes.
Temporary Employment Doctrine: A person who takes a temporary job away from home
is entitled to a deduction for costs incurred away from home. “Temporary job” must last
for a period of one year or less (Rev. Rul 93-86.) Jobs that last for a longer time are
permanent jobs, and no deductions for costs incurred away from home are allowed.
Moving Expenses §217:
Moving expenses are deductible when TP takes a job where she would have to commute
at least 50 miles more from her old home in order to get to the new job. TP must work at
least 39 weeks at the new job the year after the move to qualify (§217(c).)
Rev Rul. 94-47
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TP may deduct costs of transportation from home to work if her home is her principal
place of business. TP may also deduct costs of going from home to a temporary job site
outside TP’s metropolitan area.
Child Care §21 and §129:
May take a credit for care of qualifying individuals (e.g. children, elders).
Credit computation:
Credit = Applicable percentage x Amount incurred on care
“Amount incurred on care” is limited to $2400 for one qualifying individual and $4800
for 2 or more qualifying individuals.
“Amount incurred on care” is also limited by the earnings of the spouse who earns less.
So if I have three kids but only make $3000/year, the amount incurred on care is limited
to $3000, not $4800.
Applicable percentage is 30% for people with AGI up to $10,000. Applicable Percentage
decreases 1% for every $2000 (or fraction thereof) of AGI over $10,000 with a floor of
20%. So everyone making $28,001 or more takes 20%.
§129 provides an exclusion (not a credit) for employee child care expenses reimbursed by
an employer pursuant to a qualified program (§129(d).) May exclude up to $5000 per
year from income. TP who takes a §129 exclusion cannot get a §21 credit.
TP can choose whether to take §21 credit or §129 exclusion. (§129 is better for higher
income people, who are in a higher tax bracket.)
Smith v. Comm (old case) (568)
TP deducted cost of hiring child care so that she could work. (§21 or §129 were not
enacted yet.) TP argued that “but for” the expense, she would not be able to work. Ct
said no deduction. Child care expenses are personal. Indirect connection with business
pursuits do not cause expenses to be business-related. Ct rejected “but for” argument.
(The Smiths compared themselves with another couple with a child, but with one spouse
at home caring for it. Ct compared Smiths with a couple who were both employed, but
without children. Whose interpretation is better?)
Legal Expenses
Personal legal fees are nondeductible. Legal fees for business are deductible §162 (but
sometimes might have to be capitalized if they are incurred with regard to acquisition of
long-term property. Reg. §1.263(a)(1).
US v. Gilmore (597)
TP incurred legal expenses for divorce proceeding in which ex-wife tried to take all of his
assets. TP tried to deduct these expenses under §212, because he said that they were
incurred in order to “conserve property held for the production of income.” No deduction
allowed. The determining factor in the analysis is whether the claim arises in connection
with TP’s profit-seeking activities. We do not look at the consequences to TP had exwife won. Origin of the expenses was the divorce, which was a personal matter.
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(Comment: Generally a spouse is allowed a deduction for expenses incurred to collect her
alimony. Spouse must already have the right to alimony, but is suing in order to collect.)
§212: May deduct all ordinary and necessary expenses paid or incurred during the year:
1) For the production or collection of income
2) For the management, conservation, or maintenance of property held for the
production of income
3) In connection with the determination, collection, or refund of any tax. (So you might
be able to deduct costs of getting personal tax advice.)
Educational Expenses:
Reg. §1.162-5(a): May deduct educational expenses if the education,
1) Maintains or improves skills required by TP in her trade or business
2) Meets express requirements of TP’s employer or of law as a condition of doing work
of the type performed by TP.
Educational expenses incurred to meet the minimum educational requirements of a new
trade or business are nondeductible.
Carroll v. Comm. (604)
TP was a cop taking undergraduate courses in preparation for law school. TP took §162
deduction as an expense “relative to improving job skills to maintain his position as a
detective.” Ct said that only the educational costs that directly relate to TP’s duties as a
cop could be deducted. Costs of TP’s general education classes are not deductible, since
they are not relevant to TP’s skills as a cop.
(Note: Undergraduate education costs are usually not deductible, especially since there
are a lot of general education requirements. Law school costs are NEVER deductible.
There have been a lot of cases regarding this. Wonder why??? However business school
costs are deductible. B-school does not train you for a new trade or business.)
§25A (Hope Scholarship Credit):
Provides a nonrefundable 100% credit on first $1000 spent on “qualified tuition and
related fees” and a 50% credit on the next $500 (total credit = $1500) as long as TP
spends at least half-time at a school that awards a bachelor’s, associate’s, or vocational
degree. Credit may only be taken for first two years of post-secondary education
(undergraduate.)
§25A (Lifetime Learning Credit)
Provides a nonrefundable 20% credit on first $5000 of “qualified tuition and related
expenses” paid by taxpayer. Can be used for every year of undergraduate and graduate
education (i.e. even law school students can use this credit.) Cannot use Hope Credit and
Lifetime Credit together.
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If students are dependents, parents will take the Hope and Lifetime Credits. Both credits
are phased out for individual taxpayers with AGI between $40,000 and $50,000 and
married TP’s with AGI between $80,000 and $100,000.
§530 Education IRA:
May contribute up to $500 per year exclusively to pay for “qualified higher education
expenses.” §530(b)(1). Education IRA works like a Roth IRA.
§221 Deductibility of student loan interest:
May take a maximum $1000 above the line deduction on student loan interest.
Personal Deductions:
Include itemized deductions such as casualty losses, medical expenses, charitable
donations, interest, and state and local taxes. TP may instead choose standard deduction
(§63(b)). TP’s are entitled to a personal exemption deduction for themselves and for
each of their dependents (§151.) Both standard deductions and exemptions are phased
out for TP’s making more than the threshold AGI.
§32 Earned Income Tax Credit.
Casualty Losses §165:
TP may deduct casualty losses, defined as “property not connected with a trade or
business or a transaction entered into for profit if such losses arise from fire, storm,
shipwreck, or other casualty, or from theft.” §165(c)(3).
Must be an element of suddenness to the event (Rev. Rul. 63-232.) TP may only deduct
amount of loss not covered by insurance (165(a)).
Losses of property used in business or profit-seeking activity are deductible whether or
not they were lost due to casualty or theft. §165(c)(1,2).
You take the net amount (difference in FMV of property before and after accident) of the
loss (usually the basis of the asset), subtract $100 for each loss event, and then subtract
10% of AGI after determining the total loss. The result is the casualty loss deduction. If
FMV < Basis in lost asset, use FMV to determine casualty loss.
May get a casualty gain: If insurance pays you more than the basis of the asset lost.
Net the total casualty losses and the total casualty gains. If you have a net casualty gain,
it is treated as a capital gain. If you have a net casualty loss, you get the deduction,
subject to 10% AGI limitation (an ordinary loss.) §165(h)(2)(A).
Business Casualties §165: Can deduct ALL of the loss (no floor.)
Dyer v. Comm (464)
One of TP’s vases was knocked over by a cat in a neurotic fit. Ct said that sudden illness
of a pet does not qualify as an “other casualty” under §165. No deduction.
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Blackman v. Comm. (467)
TP cannot take casualty deduction for loss of his house due to the fire he intentionally
started and thought he put out. Though TP’s negligence will not bar a casualty loss
deduction, TP’s gross negligence will bar a casualty loss deduction. Allowing TP to take
casualty deduction would violate state’s public policy (policy against arson and domestic
violence.)
Medical Expenses §213: (Doctor’s orders are helpful! but not necessary…)
Medical care is defined as “the diagnosis, cure, mitigation, treatment, or prevention of
disease, or for the purpose of affecting any structure or function of the body.”
§213(d)(1)(A).
Medical expenses (not covered by insurance) that exceed 7.5% of AGI are
deductible under §213. Medical benefits supplied by employers and payments or
reimbursements of an employee’s medical costs are not included in employee’s gross
income at all. §§105(b), 106.
§162(l)  Self-employed people get to deduct 30% of the cost of health care premiums.
§220  Experimentation with Medical Savings Accounts. TP’s can withdraw before tax
funds from a trust account to pay for medical services.
Amounts spent on property improvements for medical purposes are deductible only to the
extent that the cost of the improvement exceeds the increase in the value of the property.
Reg. §1.213-1(e)(1)(iii).
No deduction for over-the-counter drugs. §213(b). Insulin & Prescription Drugs are
deductible.
Cosmetic surgery is deductible only to cure congenital deformity or deformity arising
from illness or disease. §213(d)(9).
Costs of qualified long term care is deductible. §213(d)(1)(C)
Cost of special schooling designed to rehabilitate ill or disabled individuals is deductible.
Reg. §1.213-1(e)(1)(v)(a).
Taylor v. Comm (472)
TP was denied a deduction for costs associated with having his lawn mowed. TP had
allergies and doctor told him not to mow his lawn. Expense falls under §262 (no
deductions for personal expenses), not §213.
Ochs v. Comm (473)
TP and wife placed children in boarding school while TP’s wife recovered. TP deducted
day school and boarding school expenses as medical expenses. Ct said that these are
family, not medical expenses. The expenses benefited the wife, so it was personal.
(Decision would also apply to babysitters)
Dissent: The expense fell within the category of “mitigation, treatment, or prevention of
disease” §213(d)(1)(A). Had TP sent wife to a sanitarium (rather than sending the kids to
boarding school) the cost of the sanitarium would be deductible.
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Charitable Contributions §170:
An itemized deduction for charitable contributions is permitted under §170(a)(1), as long
as you have a charitable intent..
TP may only deduct charitable contributions up to 50% of AGI. Any excess over 50%
of AGI may be carried forward to later years. §170(d). Deductions for donations to
“private foundations” are capped at 30% of AGI. §170(b)(1)(B).
TP must have any donated property valued at over $5000 appraised.
Written acknowledgment of receipt of a donation must be given to TP for any
contribution valued at over $250. §170(f)(8).
You may deduct FMV (not just the basis) of property donated to charity, as long as
you would not have recognized ordinary or short-term capital gain income had you
sold the property. TP may also only deduct the basis of tangible personal property that
would yield a long-term capital gain if the organization will not use the property for a
charitable purpose. §170(e)(1)(B).
Charitable organizations are defined in §170(c) as:
1) U.S. Government or state or local governments
2) Charitable corporation, trust, or other organization operated exclusively for religious,
charitable, scientific, literary, sporting, or educational purposes
3) Fraternal order or lodge, but only if gift is to be used for charitable purposes
4) Organization of war veterans.
Organization cannot try to influence legislation or political campaigns. §170(c)(2)(C).
Organizations derive their tax-exempt status from §§501 et seq. (especially §501(c)(3)),
not §170.
May only deduct a contribution under §170 to the extent that you did not offer a benefit
in return (example: if you donate $500 and get a $15 mug in return, you can only deduct
$485.)
Bargain sale to charity: Contribute land to a charity:
FMV = $3000
Basis = $1000
Get a payment from charity of $1700
1) TP gets a $1300 §170 deduction as long as the $1300 gain ($3000 - $1700) wouldn’t
be ordinary or short term capital gain. If gain would have been ordinary or short-term
capital gain, deduction is only $430 (1000 basis – 1700/3000.)
2) What is the gain to the TP on the bargain sale? Depends on Basis, which must be
allocated to the sale and to the gift parts of the transaction.
Ratio of basis that is attributable to sale = Amount Realized on Sale / FMV = 57% in
this case
Basis attributable to sale = $570.
Gain to TP = 1700 realized – 570 basis = $1130
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Ottawa Silica Co. v. US (483) – Quid Pro Quo
Donor cannot receive a deduction for a contribution when it receives a “substantial
(business) benefit” (quid pro quo) from the charity (in this case, a school.) TP was not
allowed a current deduction. Instead, it was only allowed to add the basis of the
contributed property to the basis of the other land that it owned.
Hernandez v. Comm (note – p.490)
Money paid by Church of Scientology members for individual training courses were not
deductible. TP received an identifiable benefit from the money he gave.
Bob Jones University v. US (491)
Does TP, an educational institution which practices racial discrimination, qualify as a taxexempt organization under §501(c)(3). Ct said that it does not, because racial
discrimination in education is against established public policy. The institution does not
serve and is not in harmony with the public interest. IRS originally revoked TP’s
§501(c)(3) tax-exempt status. Since IRS has the power to grant §501(c)(3) status, it can
revoke the status if IRS determines that TP’s actions are against public policy (IRS does
not derive this power from statute.) But, Congress acquiesced with the IRS’s decision
here.
Dissent: Just because Congress failed to act against IRS’s decision to revoke TP’s status
does not mean that IRS has the power. Congress should give IRS the power to revoke
§501(c)(3)
Interest §163:
Interest on amounts borrowed in connection with a trade or business or for investment
purposes are generally deductible (§163(a)).
Personal interest:
No deductions are allowed unless the interest falls under qualified residence interest.
§163(h). Qualified residence interest is defined as interest paid on either 1) acquisition
indebtedness (indebtedness that is secured by the residence and was incurred in
acquiring, constructing, or substantially improving the residence - §163(h)(3)(B)) or 2)
home equity indebtedness (any indebtedness, other than acquisition indebtedness,
secured by a personal residence.) §163(h)(3)(C).
Limits:
1) Total of both types of indebtedness may not exceed FMV of residence.
2) Aggregate amount of acquisition indebtedness may not exceed $1 million
§163(h)(3)(C).
3) Home equity indebtedness may not exceed $100,000 in order to be totally deductible.
§163(h)(3)(C).
“Points” (1 point = 1% of principal borrowed) paid by TP are generally supposed to be
capitalized, but points may be deducted on qualified residence debt §461(g)(2) as long as
it is typical business practice for lenders in TP’s area to charge points.
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Taxes §164:
A personal itemized deduction is permitted for state and local income taxes and property
taxes on real and personal property. State and local sales taxes are not deductible. §164.
Fees for government services are not “taxes” and are thus not deductible.
Taxes paid for business purposes are above the line §162 deductions.
When real property is sold in the middle of the year, the property tax must be allocated
between the buyer and seller. §164(d)(1). If buyer pays seller’s property taxes, the
amount paid by buyer for the seller is added in seller’s amount realized for transaction.
WHOSE INCOME IS IT?
Transfers of Services and Property
Net unearned income of child under 14 is taxed at the greater of child’s marginal rate or
parent’s marginal rate. §1(g).
Transfer of services: Income remains with person who performs the services. Income
from services cannot be transferred to a person in a lower tax bracket.
Gratuitous services: Can provide FREE services for others without taxation
Shifting within a marriage (and without…):
Lucas v. Earl (742)
TP entered into a contract with his wife by which they agreed that any income earned by
either of them would be owned by them as joint tenants. Therefore each person would
only be taxed on half of his/her income each. Ct said that TP cannot apportion income
like this. Each TP would be taxed on income he/she earned. §61(a). Cannot shift income
within a marriage (this case is old and was decided before married people could file joint
returns.) (This was not really a tax avoidance case, but TP was trying to take advantage
of the progressivity of tax rates.) “One may not attribute fruits to a different tree from that
on which they grew.”
This case is still good law, because it still governs shift of income between people other
than married people between themselves.
Poe v. Seaborn (745)
In a state where a married taxpayer’s income is community property, each spouse may
claim one-half of the total income received between spouses. This rule only applies in
states where community property is the law.
Now all married people report all the income both spouses receive in a joint return. Poe
is still good law, but it is not relied on anymore.
Armantrout v. Comm (752)
Company put $10,000 in a trust for TP’s kids’ education. This $10,000 is taxed at
parent’s (not kid’s rate), said the court. The $10,000 benefit was really compensation to
TP, not a distribution to child. TP was in a position to influence where the money went.
“Anticipatory arrangements” like this one is prohibited by Lucas v. Earl.
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Transfer of income-producing property:
Blair v. Comm (762) (Horizontal Slice)
TP was to receive income from a trust created by his father. TP assigned rights to the
trust to children (and income was paid to children.) Ct held that the trust income was
taxable to TP’s children, not TP himself. The one who is to receive the income as the
owner is to pay the tax. If the interest in the income is assignable, then the assignee
recognizes income. In this case, TP gave all of his interest in the property (the trust) to
someone else, so TP is not taxed on the income.
Helvering v. Horst (764) (Vertical Slice)
TP delivered the interest on a bond that he owned to his children. TP kept the bond (he
just gave away some of the interest.) Ct held that TP is taxed on the interest (not his
children.) TP in a way enjoyed “compensation” by giving the money to the child.” Also,
it is important that TP here kept the “corpus” of the income (the bond itself.) If TP
wanted to avoid taxation, he should have given the entire bond to the child.
Dissent: The interest coupons are independent items of property from the bond. Child
had absolute property rights to the interest.
Horizontal vs. Vertical Slice
A gift of horizontal interest in income-producing property shifts the income from
donor to the donee. (See Blair). Horizontal interest means that the donee’s interest in
property that is coterminous in time with the donor’s interest in property. For instance, if
TP gives child a half interest in property, half the income will be taxed to child. Both TP
and child have half-interests in property at the same time.
A gift of a vertical interest in income-producing property is taxed entirely to donor.
(See Helvering v. Horst.) Here, the donee’s interest in the property is not coterminous in
time with the donor’s interest. For example, if TP gives her child an interest in 5 years of
interest payment on a bond, and that interest reverts back to the donor after 5 years, the
interest that donee gets during the 5 years is taxed to the donor.
Gifts that are both horizontal and vertical (e.g. donor gives donee a half-interest in the
property for 5 years), it is treated as a vertical gift, so donor is taxed on all income.
Irwin v. Gavit (186) – Claims in property divided over time
TP was given the right to interest on money in a trust for 15 years. He was not given the
right to the money in the trust itself. Is this a bequest (not taxable) or income (taxable)?
Court said that this is taxable income. The tax code provision that exempts bequests from
income assumes that the TP is getting the “corpus” of the trust (i.e. a right to the trust
itself), not merely income from the money in the trust. And Congress has the right to tax
income from whatever source derived (§61). (Basically, court is saying that TP has no
basis in the interest payments he receives, so he is taxed on the entire amount realized.)
Dissent: TP’s receipts from the trust were a nontaxable bequest of money arising from
the express provisions of the will. Money is property.
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Related basis issue to Irwin v. Gavit:
If father buys a $1000 bond and gives daughter the right to all the interest payments and
he gives the son the right to the principal to be paid at the end of the term (so father has a
$1000 basis in the bond), daughter gets zero basis on the interest payments (so she is
taxed on all of the interest payments) and the son gets $1000 basis (as long as he doesn’t
sell his interest early!) on the principal to be paid to him (so he pays no tax because
$1000 amount realized minus $1000 basis equals zero gain.) The father’s grant of the
principal (corpus) of the bond is considered a gift, so there is no income and the son gets
substituted basis.
This may not seem fair, but this is what the law is…
Father does not pay taxes on daughter’s gain, because he gave away the entire right to
the bond.
Haig-Simons Annuity Income SEE PG 189 KLEIN & BANKMAN:
Income in year 1 = Proceeds – (PV0 – PV1)
Income in year 2 = Proceeds – (PV1 – PV2)
PVx = FV / (1 + r) ^ (n-x+1)
Trusts:
Simple trust = a trust that is required annually to distribute current income (and only
current income) to the beneficiaries, and that does not distribute or set aside any amounts
to charity. This trust is (nominally) taxable on its income, but receives a deduction for
the distribution of that income. §651. Thus a simple trust does not pay tax. Income from
a simple tax is taxed to beneficiaries §61(a)(15) and §652(a).
Complex trust = a trust which is not a simple trust. A complex trust gets a deduction for
current income that it distributes to its beneficiaries. The beneficiaries are taxed on the
current income they receive. The complex trust however, is taxed on the current income
that it does not distribute under the rate schedule in §1(e).
Beneficiaries are also taxed on the undistributed or accumulated income in the year that
the money was finally distributed. §662. But the trust does not receive a deduction for
those distributions. The tax paid by the trust on this income may be credited to the
beneficiaries under the “throwback rules.” §667(b)(1) and §668. So the income that was
not currently distributed is only taxed once (to trust.)
Capital Gains and Losses:
Capital gain tax rate §1(h).
TP may deduct capital losses to extent of capital gains realized that year (§1211) and can
take an additional $3000 beyond capital gains realized §1211(b). The excess losses are
carried forward indefinitely to later years §1212(b)(1).
Long term capital gains are taxed at §1(h) rates, while short term capital gains are taxed
at ordinary rates. “Long-term” equals one year of holding the property §1222(1)-(4).
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There are three capital gains tax rates:
1) The 28% group – which includes collectibles and ½ of the gain on “qualified small
business stock” (a.k.a. §1202 stock – which is a C corporation with assets of $50
million or less.)
2) The 25% group – long term gain from the sale of depreciable real property held for
more than one year that is attributable to the straightline depreciation deductions
taken in earlier years.
3) The 20% group – all other long term capital gain.
§1231 property: Real or depreciable property held for more than 1 year and used in
a trade or business (or involuntary conversions.) If you sell §1231 property for a
gain, it is treated as a capital gain. If you sell it for a loss, it is treated as an ordinary
loss. But: 1) if TP has a net §1231 gain this year, but had §1231 (ordinary) losses in the
last 5 years, this year’s net §1231 gain is recharacterized as ordinary income to the extent
of the losses taken in the last 5 years. 2) The depreciation recapture rules still apply to
§1231 gains on non-real property (gains that are due to excess depreciation taken are
recharacterized as ordinary gains.)
In order to determine capital gains and losses, you must net the short term capital gains
and losses together and the long term capital gains and losses together. If there is a net
gain, the gain is taxed at the relevant rate.
For instance, if you have a short term capital gain which is larger than the long term
capital loss, the net gain is taxed at short term capital gain rate (which is the ordinary
income tax rate.)
If you have a capital loss to apportion among long term capital gain, you first
diminish the 28% capital gains, then the 25% capital gains, then the 20% capital
gains. LTCL carryovers are netted in 28% tax rate.
Definition of “Capital Asset” §1221: (beginning of capital/ordinary income analysis)
Capital asset is means property held by the TP (whether or not connected to a trade
or business) but does NOT include:
1) Inventory or property held for sale to customers in the ordinary course of
business. (Ordinary income)
2) Depreciable or real property used in TP’s trade or business (§1231 property)
3) Copyrights or literary properties
4) Accounts receivable or notes receivable acquired in the ordinary course of a
trade or business (ordinary income)
5) United States Government publications
Big question: When is property sold by TP “held for sale to customers in the ordinary
course of business” (and is thus ordinary income?)
Van Suetendael v. Comm (838)
Issue was whether TP sold securities to “customers.” Court ruled that if TP holds
securities primarily for personal speculation, the securities are a capital asset. Court held
that trading securities was not TP’s primarily for sale to customers even though he was
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listed as a securities dealer (he sold his securities through a broker to unknown buyers.)
Only a middleman (like a brokerage dealer) can hold securities primarily for sale to
customers. TP did not buy a large amount of wholesale securities. Rather, he only
bought and sold a small amount of diversified stock.
Biedenharn Realty Co. v. US (842)
TP subdivided land and resold the parts to buyers. Issue was whether TP held the land
for investment (capital gain treatment) or for resale (ordinary treatment.)
Court looked at several factors to determine whether land was used for resale or
investment:
1) Frequent or numerous sales (suggests resale)
2) Significant improvements (suggests resale)
3) Brokerage activities (could go either way)
4) Advertising
5) Purchase and retention of property with a goal of short-term resale
6) Importance of activity in relation to TP’s other activities and sources of income
Courts will make the investment/resale judgment on a case-by-case basis. Court here
held that TP held land for resale.
Substitutes for Ordinary Income:
For tax purposes, the sale of a right to income from property (for a limited period of
time), by TP who holds the right to the property:
1) Does not constitute sale or exchange of property (i.e. it is ordinary income
attributable to TP)
2) Does not generate capital gains or losses
3) Does not allow the TP to offset her basis in the property against the amount received.
Hort v. Comm (867) – payments for cancellation of lease:
$140,000 received by TP (lessor) by lessee to terminate a lease is ordinary income to
lessor. This is true even though the amount received is less than the value of all future
rental payments that TP would have received had lease not been broken. Court
analogized the payments to prepaid rent (which is also ordinary income to the lessor.)
This is a carved-out interest case, so TP is taxed at ordinary rates. The fact that TP
received less than he would have under the lease does not entitle him to a deduction for
the difference.
Note: However, a lease cancellation payment received by a lessee is treated as a sale or
exchange of a property interest (and is taxed as a capital gain under either §1221 or
§1231.)
Transfer of all substantial rights to a patent generates capital gain or loss. §1235.
McAllister v. Comm (873) – sale of income from a trust
TP owned a life estate in the income of a trust. She sold her interest to the remainderman
for $55,000 (which is $8,790 less than the actuarial value of the life estate.) TP tried to
claim this $8,970 as a capital loss. Commissioner assessed a $55,000 deficiency against
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TP, claiming that TP only received an advance on her life estate (all taxed as ordinary
income, since she has no basis in her life estate.)
Court found for TP, saying that if this were a fee interest, it would result in a capital gain.
There is no reason to treat life estates that are expected to run for a substantial amount of
time any differently. A life estate is a “durable property interest” and is thus a capital
asset. Court also held that TP has basis in her life estate.
Comm. v. PG Lake (878)
TP is a corporation that assigned its president an oil payment right (right to a part of the
profit from oil sales) of $600,000 in return for cancellation of debt. TP reported this
$600,000 as a debt forgiveness capital gain. Commissioner said that this is really
ordinary income. Court held for Commissioner, saying that there was no conversion of a
capital asset. TP only sold a portion of its oil rights to the president. (It’s a carve-out). If
TP sold the oil to its customers, it would be ordinary income, so we shouldn’t allow TP to
get capital gain treatment for the sale to president.
Note: §636 now treats assignments like these as loans to the company. Therefore TP
would not recognize income until the oil payments were paid.
Comm v. Brown (882) – Bootstrap sale to charity:
(Bootstrap sale: TP converts ordinary income to capital gain. He does so by selling the
stock of his business to a charity, which pays the purchase price from the profits of the
business. The charity then liquidates the business and lease the corporate assets to
another corporation formed by TP. This new corporation would pay most of its profits
from the corporate assets to the charity, which in turn would give those profits back to
TP.)
In this case, TP sold his sawmill business to a charity, to be paid for by a nonrecourse
note. Charity formed a new corporation (not a charity) and leased the business to it. This
new corporation was to pay charity for the lease with 80% of its profits, and the charity
was to forward to TP 90% of those profits the charity got from the corporation.
Commissioner said that this was ordinary income. TP said that this was a sale of a capital
asset.
Question was whether this is a legitimate sale (because there was no personal liability for
the debt and the charity paid nothing for the sawmill business.) Court said that this was a
legitimate sale, because the fact that the charity paid nothing for the business and
assumed no risk for the repayment is immaterial. This was not a sham transaction. The
price paid for the business was fair and resulted through arm’s length bargaining.
Commissioner rested its attack against TP on the ground that a capital gains transaction
requires the transfer of a risk bearing economic interest to the transferee. Court rejected
this argument.
NOTE: IRS now limits its attack on bootstrap sellers to cases where the price was
“excessive.”
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TAX SHELTERS:
Judicial Response See BGP pg. 310
Knetsch v. US (684) (Supreme Court)
TP bought a $4,004,000 annuity from an insurance company. He paid $4,000 for the
annuity with his own money and the rest of the $4,000,000 price with a nonrecourse loan.
The yield on the annuity was 2.5% and the interest rate on the $4 million loan was 3.5%.
Each year, TP was required to pay $140,000 in interest on his $4,000,000 loan, but was
able to borrow (nonrecourse) $100,000 more each year against the increased value of the
$4,004,000 annuity.
TP’s out-of-pocket costs in year one = $40,000 (the $140,000 minus $100,000) + $4,000
out of pocket payment for the annuity + $3,500 (3.5% prepaid interest rate multiplied by
the $100,000 extra loan) = $47,500. TP ended up saving $130,000 in taxes through an
interest paid deduction. Supreme Court affirmed Commissioner’s disallowance of the
TP’s interest paid deduction, saying that the transaction was a sham. The $100,000 was
really a rebate on the $140,000 that the TP had to pay in interest. The $47,500 out-ofpocket cost was recharacterized as a nondeductible fee paid to the insurance company for
the tax shelter.
Dissent: This was not a sham transaction. Many transactions geared toward tax
avoidance are legitimate. (There is a blurry line between tax reduction and tax
avoidance.)
Fabreeka Products Co. v. Comm (690) (Appeals Ct.)
TP bought bonds at a 15% premium (115.) These bonds were callable at 100 (so TP
would lose 15% if the bonds were called.) But TP could take a tax deduction on this loss.
This was legal. Commissioner determined that these transactions were shams, even
though they were legal. Court found for TP, saying that if the consequences of a tax
statute were negative to the government (like this case), it is up to Congress, not the
Court, to plug the loophole. Statute cannot be ignored only because TPs can take
advantage of it. This result is different from Knetsch, where the court allowed the
government to overturn a transaction that it felt was motivated solely by tax
considerations. Court in this case was reluctant to characterize this transaction as a sham.
THE COURT FOUND THAT A REASONABLE PERSON MIGHT ENTER INTO
SUCH A TRANSACTION
(Contra: Goldstein v. Comm (692)  Court held for Commissioner on same facts. Court
found that TP entered into this transaction solely for tax purposes. There must be a
“purpose, substance, or utility besides the tax consequences” in order for the transaction
to be upheld. HERE THE COURT FOUND NO REASONABLE PURPOSE FOR THE
TRANSACTION.)
IS SHAM DOCTRINE VIABLE?
Estate of Franklin v. Comm (694)
TP bought property using a seller-financed nonrecourse loan and leased the property back
to the seller (a sale-leaseback.) The “balloon payment” of $975K on the loan was
excessive. Basically, TP overinflated the price of the property in order to get more basis.
This means that TP would have been entitled to big depreciation deductions each year on
the property. Court held that this transaction is a sham and disallowed interest and
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depreciation deductions because TP did not have equity in the property (Equity = FMV of
the property – liabilities.) Court requires equity in the property in the cases of sellerfinanced nonrecourse loans in order to find that a bona-fide sale occurred. (This
transaction more closely resembled an option.) Prof says that if the amount of the
balloon payment required weren’t so large, the court probably would have found for TP.
Investment Interest Limitation §163(d): (Rental Income isn’t Investment Income)
Amount allowed as a deduction for investment interest shall not exceed net investment
income. “Investment interest” means interest on indebtedness allocable to the property
held for investment. This section does not apply to investments derived in the ordinary
course of a trade or business (in those cases, investment interest is totally deductible.)
Interest deductions in excess of §163(d) limitation is carried forward to subsequent years.
Investment income: Net income from investments that produce interest, dividends,
annuities, and royalties not derived from ordinary course of business. TP MUST
CHARACTERIZE GAINS AS ORDINARY INCOME IN ORDER TO QUALIFY
Passive Loss Rules §469:
Passive activity loss is deductible only to the extent of passive gains. Passive activity
losses disallowed can be carried forward to the next year. When TP sells his entire
interest in passive activity, TP may deduct the remaining losses from that activity.
There are three types of income, each of which must be accounted for separately:
1) Active
2) Passive
3) Portfolio
“Passive activity” is a trade or business in which TP did not materially participate (see
BGP pg. 324) Generally, real estate rental activities and acting as a limited partner in a
limited partnership are considered passive activities.
“At Risk” Rules §465:
Limits the deduction of losses from trade or business activities to the amount of TP’s atrisk investment. Losses disallowed under §465 may be carried forward to the next year.
“At risk” amount includes:
1) cash,
2) basis of other property contributed
3) recourse debt
4) “qualified nonrecourse debt” (in which creditor is an unrelated party who was not the
seller of the property bought by TP)
5) income generated by the activity
“At risk” amount is reduced by any money distributed by the activity to the TP and by
prior §465 losses taken. (This is conceptually similar to adjustments of basis.)
If TP has a negative “at risk” amount in his business, he must report that amount as
income §465(c). (This is a recapture provision.)
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