FEDERAL INCOME TAXATION OUTLINE
TAX POLICY: THEORIES AND CONCEPTS .....................................................................................................5
TAX COMPUTATION SUMMARY ......................................................................................................................5
I.
Tax computation.........................................................................................................................................5
WHAT IS INCOME? .................................................................................................................................................6
I.
Definitions of Income .................................................................................................................................6
a.
b.
c.
II.
Section 61 .............................................................................................................................................................. 6
The Haig-Simons definition ............................................................................................................................... 6
Judicial definitions............................................................................................................................................... 6
Form of Receipt, Generally .........................................................................................................................6
a.
III.
b.
c.
d.
e.
f.
g.
IV.
a.
V.
VI.
a.
b.
c.
d.
VII.
The doctrine of "constructive receipt." .............................................................................................................. 6
Fringe Benefits .......................................................................................................................................7
Fringe benefit tax policy concerns ..................................................................................................................... 7
General rule: Section 61 and fringe benefits .................................................................................................... 8
Tax expenditure fringe benefits ......................................................................................................................... 8
Work-Related Fringe Benefits ............................................................................................................................ 9
Meals and Lodging ............................................................................................................................................ 13
Property transfers as compensation (Section 83) ........................................................................................... 15
Below-Market Loans ................................................................................................................................. 16
Section 7872 ........................................................................................................................................................ 16
Imputed Income ........................................................................................................................................ 17
Non-Work income .................................................................................................................................... 18
Gifts ..................................................................................................................................................................... 18
Bequests .............................................................................................................................................................. 19
Government transfer payments ....................................................................................................................... 20
Prizes, Awards and Scholarships .................................................................................................................... 20
Capital Appreciation and Recovery of Capital ..................................................................................... 21
b.
c.
d.
e.
Capital Recovery and Basis .............................................................................................................................. 21
Realization .......................................................................................................................................................... 28
The Realization requirement as a constitutional imperative ....................................................................... 28
When is income realized? ................................................................................................................................. 29
VIII.
Annuities ............................................................................................................................................. 31
c.
d.
I.R.C. § 72 ............................................................................................................................................................ 33
Tax arbitrage and annuities: I.R.C. § 264 ....................................................................................................... 35
IX.
X.
a.
b.
c.
d.
Life Insurance ........................................................................................................................................... 36
Treatment of Debt..................................................................................................................................... 38
In General ........................................................................................................................................................... 38
Illegal Income ..................................................................................................................................................... 38
Discharge of Indebtedness income .................................................................................................................. 41
Borrowing and basis.......................................................................................................................................... 45
XI. Damages and Sick Pay ............................................................................................................................. 52
XII.
Tax-Exempt Interest: I.R.C. § 203—State and Municipal bonds ...................................................... 54
DEDUCTIONS AND CREDITS ........................................................................................................................... 57
I.
Overview .................................................................................................................................................. 57
BUSINESS EXPENSES................................................................................................................................................ 59
I.
Tax Code Provisions: I.R.C. §§ 162 & 212, generally ............................................................................. 59
a.
b.
c.
I.R.C. § 162: Trade or Business Expenses ....................................................................................................... 59
I.R.C. § 212: Expenses for Production of Income .......................................................................................... 60
§ 162 and § 212 compared................................................................................................................................. 60
1
II.
"Ordinary and Necessary" ....................................................................................................................... 61
a.
What is ordinary and necessary? ..................................................................................................................... 61
III.
Reasonable Allowances for salary ........................................................................................................ 63
IV. Public Policy Exceptions .......................................................................................................................... 67
V. Lobbying Expenses ................................................................................................................................... 69
VI. Domestic Production Deduction .............................................................................................................. 69
VII.
Employee Business Expenses: The Structural Treatment of Deductions ........................................... 70
DISTINGUISHING PERSONAL AND BUSINESS EXPENSES ........................................................................................ 72
I.
General ..................................................................................................................................................... 72
a.
b.
c.
e.
f.
g.
h.
II.
Nature of the distinction ................................................................................................................................... 72
Policy issues ....................................................................................................................................................... 72
Statutory Architecture....................................................................................................................................... 72
Tests for Distinguishing .................................................................................................................................... 73
Working Condition Fringe v. Deductible Business Expense ....................................................................... 76
Public Employees .............................................................................................................................................. 76
Domestic Services and Child Care .................................................................................................................. 77
Travel Away From Home ......................................................................................................................... 78
b.
c.
d.
III.
a.
b.
IV.
c.
"While away from home"—food and lodging ............................................................................................... 78
Transportation ................................................................................................................................................... 80
Limitations.......................................................................................................................................................... 82
Meals and Entertainment .................................................................................................................... 83
General ................................................................................................................................................................ 83
Statutory architecture: I.R.C. § 274 ................................................................................................................. 83
Home Offices ............................................................................................................................................ 85
I.R.C. § 280A ....................................................................................................................................................... 85
CAPITALIZATION .................................................................................................................................................... 86
I.
General ..................................................................................................................................................... 86
a.
b.
II.
The distinction between expenses and capital expenditures ....................................................................... 86
The impact of the capitalization requirement ................................................................................................ 87
Capitalization, Retirement, and IRAs ...................................................................................................... 89
a.
b.
III.
a.
IV.
a.
b.
c.
d.
e.
f.
g.
h.
V.
Code Architecture.............................................................................................................................................. 89
Roth IRAs v. Traditional IRAs ......................................................................................................................... 89
The distinction between deductible expenses and capital expenditures ............................................... 90
Code Architecture.............................................................................................................................................. 90
The Acquisition and disposition of assets ................................................................................................. 91
General Rules ..................................................................................................................................................... 91
Effects of Capitalization .................................................................................................................................... 91
Acquisition and capitalization under the tax code........................................................................................ 91
Borrowing costs ................................................................................................................................................. 91
Costs of construction ......................................................................................................................................... 91
Capitalization to avoid conversion ................................................................................................................. 92
Costs of disposition ........................................................................................................................................... 92
Costs of demolition ........................................................................................................................................... 92
Acquisition of Intangible Assets or Benefits ............................................................................................. 92
c.
d.
e.
f.
General rules/principles .................................................................................................................................. 93
Hostile v. Normal takeover .............................................................................................................................. 94
Transaction costs................................................................................................................................................ 94
Expenses for new businesses & Section 195 ................................................................................................... 95
VI. Deductible Repairs v. Nondeductible Rehabilitation or Improvements ................................................... 96
VII.
Environmental Cleanup ...................................................................................................................... 97
JOB SEARCH AND EDUCATION EXPENSES.............................................................................................................. 97
I.
Job-Seeking ............................................................................................................................................... 97
II. Education Expenses .................................................................................................................................. 98
OPTIONS TO DEDUCT ........................................................................................................................................... 101
DEPRECIATION, AMORTIZATION AND DEPLETION ............................................................................................. 101
2
I.
II.
Depreciation, generally ........................................................................................................................... 101
Depreciation: Code Architecture ........................................................................................................... 103
d.
I.R.C. § 197: Amortization of intangibles ..................................................................................................... 105
III.
Depletion ........................................................................................................................................... 105
INTEREST............................................................................................................................................................... 107
I.
General ................................................................................................................................................... 107
c.
II.
What is interest?............................................................................................................................................... 108
Specific Types of interest ........................................................................................................................ 109
a.
b.
c.
d.
e.
f.
Business ............................................................................................................................................................ 109
Investment ........................................................................................................................................................ 109
Interest on Tax-Exempt Income ..................................................................................................................... 112
Personal Interest .............................................................................................................................................. 112
Home Mortgage Interest................................................................................................................................. 113
Interest on Education Loans ........................................................................................................................... 113
III.
IV.
Arbitrage, Abuse, and Shams ............................................................................................................ 114
Inflation and interest .............................................................................................................................. 114
LOSSES .................................................................................................................................................................. 115
I.
General ................................................................................................................................................... 115
b.
c.
II.
III.
IV.
a.
b.
c.
d.
e.
V.
When is there a loss? ....................................................................................................................................... 115
The Amount of the Loss.................................................................................................................................. 115
Business v. Nonbusiness (but profit-seeking) losses .............................................................................. 116
Personal Losses .................................................................................................................................. 116
Loss Limitations and Bad Debts ............................................................................................................. 118
Property losses ................................................................................................................................................. 118
Transactions between related taxpayers....................................................................................................... 119
I.R.C. § 1091: Wash Sales ............................................................................................................................... 119
Capital Losses .................................................................................................................................................. 119
"Straddles" ........................................................................................................................................................ 120
Tax Shelters ............................................................................................................................................ 120
a.
b.
c.
VI.
a.
c.
d.
e.
f.
g.
h.
Section 183 and Tax Shelters .......................................................................................................................... 120
I.R.C. § 465: At-Risk Rules ............................................................................................................................. 120
I.R.C. § 469: Passive Loss Limitations .......................................................................................................... 120
Bad Debts ............................................................................................................................................... 121
I.R.C. § 166 ........................................................................................................................................................ 121
The Trade or Business of Lending ................................................................................................................. 122
Loans to family and friends ........................................................................................................................... 122
Validity of indebtedness ................................................................................................................................. 122
Loan Guarantees .............................................................................................................................................. 122
Political Contributions .................................................................................................................................... 122
Voluntary Cancellation ................................................................................................................................... 123
PERSONAL DEDUCTIONS ...................................................................................................................................... 123
I.
The standard deduction .......................................................................................................................... 123
a.
b.
II.
Purpose ............................................................................................................................................................. 123
I.R.C. § 63: Taxable Income defined ............................................................................................................. 123
Personal Exemption and Child Credit .................................................................................................... 124
a.
b.
III.
IV.
c.
d.
e.
I.R.C. § 151: Allowance of Deductions for Personal Exemptions ............................................................. 124
I.R.C. § 24: The Child Credit.......................................................................................................................... 125
I.R.C. § 32: The Earned Income Tax Credit ..................................................................................... 126
Personal Itemized Deductions ................................................................................................................ 126
Taxes.................................................................................................................................................................. 127
Charitable Deductions .................................................................................................................................... 129
Medical Expenses ............................................................................................................................................ 133
WHOSE INCOME? ............................................................................................................................................... 135
TAXATION OF THE FAMILY................................................................................................................................... 135
3
I.
II.
III.
c.
IV.
b.
General ................................................................................................................................................... 135
I.R.C. § 1: Taxable Units ....................................................................................................................... 135
Children ............................................................................................................................................. 137
The "Kiddie Tax" .............................................................................................................................................. 137
Divorce ................................................................................................................................................... 138
Alimony and Support ..................................................................................................................................... 138
ASSIGNMENT OF INCOME..................................................................................................................................... 139
CAPITAL GAINS AND LOSSES ....................................................................................................................... 140
CAPITAL GAINS .................................................................................................................................................... 140
I.
Mechanics ............................................................................................................................................... 140
II. Policy of Preferential Treatment............................................................................................................. 141
III.
I.R.C. § 1221: Definition of Capital Asset ........................................................................................ 141
a.
I.R.C. § 1221 ...................................................................................................................................................... 141
b.
Exception: assets "held by the taxpayer primarily for sale in the ordinary course of his trade or
business." ..................................................................................................................................................................... 142
IV.
a.
b.
Depreciable Property and Recapture ...................................................................................................... 144
I.R.C. § 1231(a): Property Used in the Trade or Business and Involuntary Conversions ...................... 144
Recapture .......................................................................................................................................................... 145
V. Derivates, Hedging and Supplies ........................................................................................................... 146
NONRECOGNITION TRANSACTIONS..................................................................................................................... 147
I.
Non-recognition, generally ..................................................................................................................... 147
II. I.R.C. §§ 1031 & 1033: Like-Kind Exchanges ....................................................................................... 148
a.
b.
III.
I.R.C. § 1031 ...................................................................................................................................................... 148
Involuntary Conversions ................................................................................................................................ 150
Sales of Principle Residences ............................................................................................................. 151
4
TAX POLICY: theories and concepts
TAX COMPUTATION SUMMARY
I.
Tax computation
a. Step One: Determine Gross Income1
i. Note items specifically included in gross income
1. See I.R.C. §§ 71 - 90
ii. Determine excluded income
1. See I.R.C. §§ 101 - 140
iii. Determine capital gains
1. See I.R.C. Subchapter P
iv. Determine gains from property
1. See I.R.C. Subchapter O
b. Step Two: Determine adjusted gross income2
i. Take account of the taxpayer's trade or business expenses
c. Step Three: Determine taxable income3
i. Subtract the personal exemption
1. See I.R.C. § 151
ii. Subtract either the
1. standard deduction; or
2. itemized deductions
a. See I.R.C. §§ 67-68; 161 – 221. But see §§ 261-280(H)
(noting items that are nondeductible)
d. Step Four: Determine baseline tax liability
i. Apply the tax rate schedules in § 1 to taxable income
e. Step Five: Calculate total tax liability
i. Subtract applicable tax credits
1. See I.R.C. §§ 21 – 54
a. Note that some credits are refundable and others are
not
f. The Alternative Minimum Tax (AMT)
i. The AMT is imposed whenever it is greater than the regular tax for
which the taxpayer would otherwise be liable.
ii. See I.R.C §§ 51 – 59.
See infra p. XX. See also I.R.C. § 61
See infra p. XX. See also I.R.C. § 62 (defining adjusted gross income as gross income less certain costs of
earning income and various other items).
3 See infra p. XX. See also I.R.C. § 63 (defining taxable income as adjusted gross income minus the
taxpayer's personal exemption plus the greater of (a) the standard deduction or (b) itemized deductions.
1
2
5
WHAT IS INCOME?
I.
II.
Definitions of Income
a. Section 61
i. "Gross income means all income from whatever source derived."
b. The Haig-Simons definition
i. "Personal income may be defined as the algebraic sum of (1) the
market value of rights exercised in consumption and (2) the change
in the value of the store of property rights between the beginning
and end of the period in question."4
c. Judicial definitions
i. Eisner v. Macmober (1920)
1. "Income may be defined as the gain derived from capital,
from labor, or from both combined, provided it be
understood to include profit gained through a sale or
conversion of capital assets."
ii. Commissioner v. Glenshaw Glass Co.
1. "Accessions to wealth, clearly realized, and over which the
taxpayers have complete dominion."
2. Graetz: "This definition stands for the proposition that
'income' should be broadly construed in the absence of a
specific congressional directive to the contrary."5
3. This definition allows examinations of gross income to be
divided into three categories6
a. What constitutes a "gain?"
b. When is income "clearly realized?"
c. When is the source of the income relevant?
Form of Receipt, Generally
a. The doctrine of "constructive receipt."
i. Income is constructively received—and subject to taxation—if it is
made available to the taxpayer but the taxpayer decides to defer
actual receipt.
1. This assumption holds unless a statute expressly provides
otherwise.
b. Generally, Section 61 makes no distinction between cash and income "in
kind."
i. See Reg. § 1.61-2(d)(1)
Graetz, 90.
Graetz, 91.
6 Chirelstein, 12.
4
5
6
III.
1. if compensation is paid in the form of property or services,
the fair market value of the property or services is included
in income.
ii. See Reg. § 1.61-2(d)(2)(i)
1. If property or services are transferred as compensation to an
employee or independent contractor for less than fair market
value, the difference between the amount paid for the
property and its fair market value is compensation that must
be included in income
a. Basis of the property is the amount paid for the
property plus the amount included gross income.
iii. See Old Colony Trust Co. v. Commissioner (1929) where Supreme
Court held that money provided to an employee for the purposes
of paying that employee's taxes was taxable income.
c. Tax-inclusive rates v. tax-exclusive rates
i. The federal income tax is imposed on a "tax inclusive" basis: the
amount of the tax owed is included in the amount of taxable
income to which the tax rates are applied.
1. If the federal tax was on a "tax-exclusive" basis, then
taxpayers would deduct their federal taxes from adjusted
gross income.
Fringe Benefits
a. Generally
i. The term "fringe benefits" is used to describe in-kind benefits
transferred to an employee.
b. Fringe benefit tax policy concerns
i. The current tax code creates an incentive to provide fringe benefits
in lieu of cash compensation
ii. Equity concerns
1. Horizontal equity
a. Even if two persons have the same income, if one gets
more of their income in fringe benefits, they are better
off because those fringe benefits are tax-free.
2. Vertical equity
a. Untaxed fringe benefits are more valuable, and more
available, to employees in higher tax brackets (and to
certain industries and professions)
iii. Efficiency
1. The tax advantages of fringe benefits leads employers to
offer, and employees to accept, wage and benefit packages
that they really don't want (the employee, for instance,
might want cash instead).
7
2. creates a deadweight loss—economic value is lost because
the tax creates incentives for sub-optimal forms of
compensation
iv. Complexity
1. It is difficult to distinguish between in-kind compensation
from goods or services related to an employee's work that
also provide the employee incidental economic benefits.
2. creates somewhat arbitrary distinctions between non-cash
compensation that is excludable and that must be included.
c. General rule: Section 61 and fringe benefits
i. Section 61 provides that "gross income means all income from
whatever source derived, including, (but not limited to) the
following items: (1) compensation for services, including . . . fringe
benefits."
1. Fringe benefits are included in income unless Congress
has explicitly provided otherwise. See Reg. 1.61-21(a)(2) ("to
the extent that a particular fringe benefit is specifically
excluded from gross income pursuant to another section of
subtitle A . . . that section shall govern the treatment of that
fringe benefit. . . . The fact that another section of subtitle A .
. .addresses the taxation of a particular fringe benefit will not
preclude section 61 and the regulations thereunder from
applying, to the extent they are not inconsistent such other
section."
ii. Reg. 1.61-21
1. (a)(3): "A fringe benefit provided in connection with the
performance of services shall be considered to have been
provided as compensation for such services."7
d. Tax expenditure fringe benefits
i. Tax "expenditures," generally
1.
ii. Employer-provided Health Insurance
1. Policy considerations
2. Section 104
a. Gross income does not include compensation for
injuries or sickness (i.e., disability pensions, and
worker's compensation)
b. Note that sick pay is taxable
3. Section 106
7
See infra, p. 6.
8
a. "Except as otherwise provided in this section, gross
income of an employee does not include employerprovided coverage under an accident or health plan."
iii. Retirement Income
1. Sections 401-404 and 410-416 provide favorable tax
treatment for qualified pension, profit-sharing and stock
bonus plans.
iv. Life insurance
1. "Generally, if the employer pays life insurance premiums on
the life of an employee and the employee's estate or family is
the beneficiary, the employer's premium payments are
income to the employee. See, e.g., Frost v. Commissioner, 52
T.C. 89 (1969)."8
2. Section 79
a. Premiums for life insurance are excludable if
i. The insurance is for less than $50,000; and
ii. The plans do not discriminate in favor of key
employees.
v. Education Benefits
1. Section 127
a. Only applies to the first $5,200 of such assistance.
vi. "Cafeteria plans"
vii. Dependent Care Assistance
e. Work-Related Fringe Benefits
i. Definitions
1. Reg. § 1.61-21(a)(4)(2): Employee
a. "for convenience the term 'employee' includes any
person performing services in connection with which
a fringe benefit is furnished . . ."
2. Reg. § 1.61-21(a)(5): Employer
a. "For convenience, the term 'employer' includes any
provider of a fringe benefit in connection with
payment for the performance of services, unless
otherwise specifically provided in this section."
ii. General concerns
1. Graetz: general principles for distinguishing "working
condition benefits" from "in-kind compensation."
a. The "benefit of the employer" principle
i. Is there a substantial non-compensatory
business purpose for providing the good or
service?
8
Graetz, 101.
9
b. Is the benefit related to the employee's work and
ordinarily useful to someone in the employee's
position?
2. Valuation
a. Chirelstein: "In General . . . economic benefit is
measured in objective terms for tax purposes;
individual preferences, real or feigned, are treated as
irrelevant."9
b. The "benefit of the employer" principle
i. Can be justified on the grounds that it would
be impossible to account for the discounted
value of "benefits" forced upon an employee as
part of his or her job (i.e., food and lodging).10
It would also be infeasible to tax the "consumer
surplus" for employee who value the benefits
more than their fair market value.
ii. Example: Benaglia v. Commissioner
1. Here, the manager of a resort was given
luxury accommodations and meals so
that he could perform his duties. The
court held that it was non-taxable
because the services were provided for
the convenience of the employer. Thus,
even though the manager may have
subjectively benefited from the fringe
benefit, because we can't take account of
the discount of the manager's forced
consumption, we don't tax it (out of
administrative convenience).
c. Reg. § 1.61-21(b): valuation of fringe benefits
i. Non-excludable fringe benefits are taxed at
"fair market value."
ii. "In general, fair market value is determined on
the basis of all the facts and circumstances.
Specifically, the fair market value of a fringe
benefit is the amount that an individual would
have to pay for the particular fringe benefit in
an arm's length transaction."
iii. Benefits from non-employers
9
Chirelstein, 20.
Chirelstein, 21.
10
10
1. benefits provided for the convenience of a prospective
employer or for that employer's business, are excludable.
a. See United States v. Gotcher in which the Fifth Circuit
held that exclusions are not limited to those
enumerated and that a trip to Germany paid for by a
foreign car dealership was not taxable income
because the trip was designed to benefit the
corporation, not the taxpayer.
iv. Benefits to non-employees (benefits to spouses of employees)
1. See United States v. Disney where the Ninth Circuit held that
reimbursements for travel expenses incurred by Roy
Disney's wife during his business travels were includable in
gross income, but deductible as business expenses under §
162 because the wife assisted the husband's performance of
business duties.
2. But see Meridian Wood Products Co. Inc. v. United States where
the Ninth Circuit denied deductions under § 162 because the
wife's purpose was only to socialize, not to serve the
interests of the business.
3. See I.R.C. § 274(m)(3)
a. Provides that travel expense are deductible for a
spouse of an employee only if there is a bona fide
business purpose and the expense would otherwise
have been deductible.
4. See Reg. § 1.132-5(t)
a. Allows
employee
to
exclude
a
spouse's
reimbursement for travel, even when the employer
cannot deduct the spouse's expenses so long as the
spouse's presence had a bona fide business purpose.
v. Section 132: Excludable fringe benefits
1. § 132(a)(1) & (b): no-additional cost service
a. Requirements
i. "such service is offered for sale to customers in
the ordinary course of the line of business of
the employer in which the employee is
performing services"
1. The regulations add the word
"substantial"—the service must be
offered for sale to the customers in the
ordinary course of the line of business of
the employer in which the employee is
performing substantial services. See Reg.
§ 1.132-2(a)(i).
11
ii. the employer incurs no substantial additional
cost
1. "cost" includes revenue that is foregone
because the service is provided to an
employee rather than to a nonemployee. Reg. § 1.132-2(a)(5)
2. "Whether
an
employer
incurs
substantial additional costs must be
determined without regard to any
amount paid by the employee for the
service." Reg. § 1.132-2(a)(5).
b. Example: excess capacity services
i. "Services that are eligible for treatment as noadditional cost services include excess capacity
services such as hotel accommodations . . ." See
Reg. § 1.132-2(a)(2)
c. Example: reduced price and cash rebates
i. The exclusion applies "whether the service is
provided at not charge or at a reduced benefit.
[It] also applies if the benefit is provided
through a partial or total cash rebate of an
amount for the service."
d. This fringe cannot discriminate in favor of highly
compensated employees. Reg. § 1.132-2(a)(4).
2. § 132(c): qualified employee discount
3. § 132 (d): working condition fringe
a. Definition
i. "A 'working condition fringe' is any property
or services provided to an employee of an
employer to the extent that, if the employee
paid for the property or service, the amount
paid would be allowable as a deduction under
section 162 or 167."
b. See Reg. 1.132-5
4. § 132(e): de minimis fringe
a. Definition
i. "In general, the term 'de minimis fringe' means
any property or service the vale of which is
(after taking into account the frequency with
which similar fringes are provided by the
employer to the employer's employees) so
small as to make accounting for it
12
unreasonable
or
administratively
impracticable."
5. qualified transportation fringe
a. See I.R.C. § 132(f)
6. qualified moving expense reimbursement
a. See I.R.C. § 132(g)
7. qualified retirement planning services
a. See I.R.C. § 132(m)
8. qualified military base realignment and closure
a. See I.R.C. § 132(n)
9. Situations in which section 132 does NOT apply
a. Reg. § 1.132-1(f)
i. Section 132 does NOT apply if the tax
treatment of a particular fringe is expressly
provided for in another section.
10. Note 132(o): "The Secretary shall prescribe such regulations
as may be necessary or appropriate to carry out the purposes
of this section."
f. Meals and Lodging
i. Section 119
1. Meals are excludable when
a. The meals are furnished on the business premises
b. The meals are furnished for the convenience of the
employer
2. Lodging is excludable when
a. The lodging is furnished on the business premises of
the employer
i. See Adams v. United States in which the Court of
Claims held that a company owned-house
used by the head of a corporation was
excludable from income, though it was
separated from the main business office,
because the house served important business
functions and was therefore part of the
business premises.
1. See also Lindeman v. Commissioner in
which Tax Court held that house
provided to the manager of a large hotel
was excludable from income, even
though the house was across the street
from the hotel, because the taxpayer
performed significant duties for his
employer from the house.
13
ii. But see Dole v. Commissioner in which the First
Circuit refused to exclude from income lodging
provided by a wool manufacturer even though
the employees needed the housing to be "on
call" because the lodging was about one mile
from the factory.
b. The lodging is furnished for the convenience of the
employer
c. The employer is required to accept such lodging as a
condition of his employment.
3. "Convenience of the Employer"
a. the meals or lodging must be provided for a
"substantial noncompensatory business reason. Reg.
1.119-1 (a)(2). This requirement is not met if the meals
are furnished to promote morale or to attract
prospective employees.
4. Examples
a. See Benaglia v. Commissioner where the Board of Tax
Appeals held that meals and lodging provided to the
manager of a luxury resort were excludable because
they were provided for the benefit of the employer
(the manager was required to have a continuous
presence at the hotel)
ii. The valuation problem and the control principle
1. How do we determine the value of meals and lodging
provided to an employee when the employee is forced to
consume them (i.e., even though the meals and lodging are
provided as part of the job, what do we do if the employee
gets a subjective benefit?)
a. Arguably, the inability to answer this question is
what led to section 119—we can't subjectively value
the discount of forced consumption.
2. See Commissioner v. Kowalski where the Fifth Circuit held that
cash meal allowances provided to a New Jersey State trooper
were not excludable from income under section 119 because.
a. But see Sibla v. Commissioner in which the Ninth
Circuit held that cash payments by firefighters to
purchase food used to stock the firehouse kitchen was
excludable. The court noted that it did not believe
that Kowalski categorically denied exclusions from
income for cash used to buy meals.
b. Together, these two cases suggest that the vital
element in determining excludability is the
14
employee's
allowance.
degree
of
control
over
the
meal
iii. Section 107
1. Excludes from income the rental value of a home provided
to a "minister of the gospel" or a rental allowance paid for
such a home.
g. Property transfers as compensation (Section 83)
i. General rule: When an employee receives property in exchange for
services, the employee must include in gross income
1. the fair market value of the property minus any amount
paid for the property.
2. NOTE: the value of the property at this point is taxable as
ordinary income, not as a capital gain.
ii. Risk of substantial forfeiture
1. Defined (I.R.C. § 83(c))
a. "The rights of a person in property are subject to a
substantial risk of forfeiture if such person's rights to
full enjoyment of such property are conditioned upon
the future performance of substantial services by any
individual."
2. If the property is subject to a substantial risk of forfeiture
and is non-transferrable, then the property is still treated as
owned by the transferor and no income is realized by the
transferee.
a. This non-realization rule is waiveable by the
transferee (he or she may include the value of the
property in income at the time of the transfer even if
non-transferable and subject to risk of substantial
forfeiture.
iii. Treatment of stock options under § 83
1. Section applies only to stock options with a "readily
ascertainable fair market value"
a. the value of an option is generally not ascertainable
unless the option is actively traded on an established
securities market. Reg. § 1.83-7
2. Section 83 does not apply to incentive stock options as
defined in section 422.
15
IV.
Below-Market Loans
a. Section 7872
i. Generally
1. § 7872(c): Scope
a. Gift Loans
b. Compensation-related loans
c. Corporation-Shareholder loans
d. Tax avoidance loans
e. Other below market loans
i. § 7872 applies to the extent provided by
regulations if the interest arrangements have a
significant effect on any Federal tax liability of
the lender or borrower.
f. Loans to qualified continuing care facilities
g. § 7872(i)
i. The Secretary has the authority to issue
regulations exempting transactions from § 7872
so long as the interest arrangements have no
significant effect on any federal tax liability.
This is the corollary of the rule above.
2. De Minimis exception
a. § 7872 (c)(2) & (3): this section does not apply to any
gift loan that does not exceed $10,000 or to a
compensation-related and corporate shareholder
loans that do not exceed $10,000
3. § 7872(e): Below-market loan is defined
a. A demand loan in which the interest rate is less than
the applicable federal rate in effect under section
1274(d)
b. A term loan in which the amount loaned exceeds the
present value of all payments due under the loan.
ii. § 7872(a): Gift and demand loans
1. Re-characterizes the loan to reflect economic reality.
Below-market
loan
7872(a)(1)(B)-Interest
7872(a)(1)(A)—
context
specific
transaction
X
X
X
$100,000
$10,000
$10,000
Y
Y
Y
16
a. The lender reports interest income on his or her tax
return
b. The borrower has either a gift, a demand loan, a
dividend, income, etc. depending on the context.
V.
11
Imputed Income
a. Defined
i. "a flow of satisfactions from durable goods owned and used by the
taxpayer, or from goods and services arising out of ht personal
exertions of the taxpayer on his own behalf. Imputed income is
non-cash income or income in kind. But all non-cash income, or
income in kind, is not . . . imputed income. For example, where
income in kind is received in return for services rendered, we have
an ordinary market transaction without a transfer of cash but with
a direct monetary valuation implied. . . [The] distinguishing
characteristic [of imputed income] is that it arises outside of the
ordinary processes of the market."11
ii. Examples
1. You purchase a home and live in it. You live in the home
tax free, even though you would have income if you had
leased the home to a tenant.
b. Section 61 and imputed income
i. In Morris v. Commissioner the Board of Tax Appeals held that the
value of farm products consumed by the owners of the farm is not
income. The court grounded its decision on the assumption that
Congress did not intend to tax this kind of compensation.
1. But see Dicenso v. Commissioner, where the owner of a grocery
store was required to include in income the value of
groceries used for home consumption.
c. Policy implications
i. Inefficiency
1. Causes taxpayers to make economic choices they would not
make in a tax-free world
2. Examples
a. You purchase a home even though you would rather
rent
b. You paint your own house rather than hire someone
to do it (even though you are terrible at painting
houses and make more money doing something else)
ii. Horizontal equity
Graetz, 126.
17
VI.
1. two similarly situation individuals may be taxed at different
rates.
2. Example: Both spouses of AB work outside the home and
earn $50,000. They hire a housekeeper. Only one spouse of
couple CD works outside the home and earns $40,000. The
other spouse works as a housekeeper. AB is taxed more
even though there is no economic difference between the
two couples
iii. Vertical equity
1. Poorer people are often forced to rent rather than buy.
Non-Work income
a. Gifts
i. Section 102(a): General Rule
1. "Gross income does not include the value of property
acquired by gift, bequest, devise, or inheritance."
ii. What constitutes a gift?
1. In Commissioner v. Duberstein the Supreme Court held that
"[a] gift in the statutory sense . . . proceeds from a detached
and disinterested generosity, our of affection, respect,
admiration, charity or like impulses. And in this regard, the
most critical consideration, as the court has agreed in the
leading case here, is the transferor's intention."
2. Section 102(c)
a. The general rule "shall not exclude from gross income
any amount transferred by or for an employer to, or
for the benefit of, an employee."
iii. Section 274(b): deduction of the costs of a gift
1. No business deduction [under 162 or 212] for "any expense
for gifts made directly or indirectly to any individual to the
extent that such expense, when added to prior expenses of
the taxpayer for gifts made to such individual during the
taxable year, exceeds $25."
iv. Tips
1. Tips are taxable income. Reg. 1.61-2(a)
2. See Olk v. United States in which the 9th Circuit held that
"tokes" received by a craps dealer from casino patrons were
income.
v. Political contributions
1. Political contributions are not taxable to a political candidate
so long as they are used for the expenses of a political
campaign and not for personal use.
vi. Gifts of Property
1. Section 1015(a)
18
a. General Rule
i. A gift of property acquired after December 31,
1920 shall has the donor's basis.
b. Loss transfer barrier
i. if the basis of the gift property is greater than
the property's fair market value, then for the
purpose of determining loss the basis shall be the
fair market value.
1. See infra p. 19-20
c. Basis unknown
i. If the donee cannot determine the property's
basis, then the basis is the fair market value.
2. Gifts between spouses
a. Handled by section 1041 and NOT 1015
b. Section 1041
i. No gain or loss is recognized on a transfer of
property to a spouse
ii. The transferee's basis in the property is the
same as the transferor's.
b. Bequests
i. Section 1014(a)
1. General
a. "[T]he basis of property in the hands of a person
acquiring the property from a decedent or to whom
the property passed from a decedent shall, if not sold,
exchanged, or otherwise disposed of before the
decedent's death by such person be fair market value
of the property at the date of the decedent's death."
b. Death is not a realization event
i. But note exceptions in Section 691
ii. Section 1014(e)
1. states that property acquired by the decedent within one
year of the decedent's death shall have a basis equal to the
decedent's adjusted basis in the property (Not FMV)
iii. 1014(f)
1. Section 1014 does not apply to anyone who dies after
December 1, 2009.
iv. Section 1022 Special Rule: Proper acquired from decedent dying
after December 31, 1009
1. Purpose
a. The step-up basis rule of §1014 is repealed effective
December 31, 2009, replaced by a modified carryover
basis provision
19
2. General rule: Property acquired from a decedent dying after
12/31/09 is treated as a gift, the basis of which is the lesser of
a. the decedent's adjusted basis; or
i. under this section, basis is increased to a
maximum of $1,300,000.
b. the fair market value of the property at the date of the
decedent's death.
3. See also infra p. 20 (for discussion of adjusted basis)
c. Government transfer payments
i. General rule
1. The IRS has an administrative policy of excluding most
government benefits and welfare payments from taxation
(even though they are probably income under the statutes).12
ii. Unemployment compensation
1. Section 85: General rule
a. "In the case of an individual, gross income includes
unemployment compensation."
iii. Social Security Payments
1. A portion of social security payments are taxed under
Section 86
2. Section 86
a. Gross income includes social security benefits in an
amount equal to the lesser of (A) one half of the social
security benefits received during the taxable year, or
(B) one half of the excess described in section 86(b)(1).
d. Prizes, Awards and Scholarships
i. Section 74: Prizes and Awards
1. "Except as otherwise provided in this section or section 117
(relating to qualified scholarships), gross income includes
amounts received as prizes and awards.
2. Charity exception
a. if the prize is given to charity it may be excluded
from gross income so long as
i. The prize recipient was selected without any
action on his part to enter the contest or
proceeding
ii. The recipient is not required to render
substantial future services as a condition to
receiving the prize or award; and
iii. The prize or award is transferred by the payor
to a governmental unit or organization
12
Graetz, p. 134.
20
VII.
described in paragraph (1) or (2) of section
170(c)
3. Employee achievement award exception
a. Gross income does not include the value of an
employee achievement award if the cost to the
employer of the award does not exceed the amount
allowable as a deduction for the award ($400).
ii. Section 117: Qualified Scholarships
1. General Rule
a. Gross income does not include any amount received
as a qualified scholarship by an individual who is a
candidate for a degree at an education organization
described in section 170(b)(1)(A)(ii)
2. Exceptions
a. Any portion of a "scholarship" received for teaching,
research or other services required as a condition for
receiving the scholarship is NOT excludable.
b. Any amount used to pay for room and board is also
non-excludable
Capital Appreciation and Recovery of Capital
a. Calculating Present Value
b. Capital Recovery and Basis
i. Section 61
1. Gross income includes all income from whatever source
derived. This includes gains from capital
2. Section 61(a)(3) includes gains derived from dealings in
property.
ii. History and theoretical underpinnings
1. In order to tax gains or losses the tax system must take into
account the money already invested in the property.
a. "Whatever difficult there may be about a precise and
scientific definition of 'income,' it imports . . .
something entirely distinct from principal or capital
either as a subject of taxation or as a measure of the
tax; conveying rather the idea of gain or increase. . . .
In order to determine whether there has been gain or
loss, and the amount of the gain, if any, we must
withdraw from the gross proceeds an amount
sufficient to restore the capital value that existed at
the
commencement
of
the
period
under
consideration. Doyle v. Mitchell Brothers Co. (S. Ct.
1918).
2. Three ways to account for costs
21
a. Immediately deductible expenses
b. Capitalization
i. The purchase price or cost is taken into account
only when the asset is sold or exchanged (no
immediate expense)
c. Depreciation
i. Period deductions are allowed to account for
the capital's cost.
iii. Gain
1. Section 1001(a)
a. Gain = Amount Realized – adjusted basis
2. Section 1001(b)
a. Amount realized = money received + fair market
value
3. Section 1001(c): Recognition
a. The entire amount of the gain or loss, determined
under this section, on the sale or exchange of property,
shall be recognized.
4. See also infra p. 44 (noting the inclusion of a discharge of
liabilities in amount realized under Reg. § 1.1001-2).
iv. Losses
1. General Rule: the loss may be carried over to other income
2. Exception: Gifts under section 1015(a)
a. When the basis is greater that the fair market value of
the property at the time of the gift, then for the purpose
of determining loss, the basis is the fair market value
of the property
b. Example
i. Facts
1. Basis = $1,000
2. FMV = $600
ii. Result under 1015(a)
1. If gain, basis = $1,000
2. If loss, basis = $600
Sale
Gain
Loss
1200
200
0
1000
0
0
800
0
0
600
0
0
500
0
100
3. This rule makes it very difficult to
transfer losses.
c. See also supra p. 15-16
22
v. Basis
1. Section 1012
a. "The basis of property shall be the cost of such
property."
2. "Cost"
a. Graetz: This is true even if the buyer over- or underpays for the property.
i. "Where a bargain purchase is in substance a
substitute for salary, the amount of price
reduction is included in income and purchaser
is created as acquiring the asset for fair market
value. The cost basis of the asset would then
be its recharacterized purchase price.
b. Cost generally means the value of the property
received
i. See Philadelphia Park Amusement Co. v. United
States where the Court of Claims held that
where the value of the property given up
differs from the value of the property received,
the taxpayer's basis in the property received is
its value.
3. Basis of property acquired by gift
a. See supra p. 16
4. Basis of property acquired by decedent
a. See supra p. 16-17
vi. Adjusted Basis
1. Section 1011(a)
a. "The adjusted basis for determining the gain or loss
from the sale or other disposition of property,
whenever acquired, shall be the basis adjusted as
provided in section 1016."
2. Section 1016: Adjustments to Basis
a. General Rule
i. "Proper adjustment in respect of the property
shall be made for
1. expenditures
2. receipts
3. losses
4. other items properly charged to capital
account
ii. For any period since February 28, 1913, proper
adjustment shall also be made for
a. Exhaustion
23
b. Wear and tear
c. Obsolescence
d. Amortization
e. Depletion
2. to the extent of the amount
a. allowed
as
deductions
in
computing
taxable
income
(ITEMIZED deductions) under
this subtitle or prior income tax
laws
b. resulting in a reduction for any
taxable year of the taxpayer's
taxes under this subtitle, or prior
income, war profits, or excessprofits tax laws, but not less than
the amount allowance under this
subtitle or prior income tax laws.
b. Default depreciation method: 1016(a)(2)(B)(flush
language)
i. "Where no method has been adopted under
section 167, the amount allowable shall be
determined under the straight line method."
c. Other depreciation notes
i. I.R.C. § 167
1. Basis on which exhaustion, wear and
tear, and obsolescence are to be allowed
is the adjusted basis in section 1011 (by
extension—1016).
ii. See also infra p. XXX on depreciation
d. Exceptions to general rule
i. No adjustments to basis for
1. taxes or carrying charges in I.R.C. § 266
2. Expenditures described in I.R.C. § 173
e. Special rule for property acquired from a decedent
dying after December 31, 2009
i. See I.R.C. § 1022
ii. See supra p. 17
vii. Allocation of basis
1. General issue
a. How should the tax code account for partial transfers
of property? If the transfer income is entirely
allocated to basis, then the taxpayer can defer the
realization of that income. If the basis cannot be
24
allocate until final disposition of the property, then
gross income is accelerated
2. Reg. § 1.61-6: General rule
a. Provides that when a portion of property is sold, the
basis must be allocated among the parts
b. Example 2
i. Facts
1. taxpayer purchases filling station with
adjoining used car lot for $25,000. FMV
of filling station is $15,000. FMV of car
lot is $10,000. Five years later taxpayer
sells filling station for $20,000 when
$2,000 has been depreciated.
ii. Allocation of basis
1. Gain = $7,000 ($20,000 -[$15,000-2,000])
2. The basis must be allocated to each
portion of the property
3. Difficulties in allocation
a. When it is impossible to allocate basis in a reasonable
way, the consideration received on the sale may be
credited against basis for the entire property.
i. See Inaja Land Co. v. Commissioner where court
allocates the income from a settlement arising
out of the pollution of a river for which the
taxpayer had purchased fishing rights, may be
allocated entirely to basis.
b. Stock
i. If a taxpayer cannot adequately identify the lot
of stock (the price at which it was purchased)
which he is selling or transferring the stock, the
stock sold will be charged against the earliest
lots of stock acquired by the taxpayer to
determine gain or loss. See Reg. § 1.1012-1(c)(1)
c. Part sale-party gift
i. General rule: Reg. §1015-4
1. the initial basis of the transferee is the
greater of the amount paid by the
transferor for the property or the
transferor's basis under §1015.
2. the transferor's gain is equal to the
amount realized minus the adjusted
basis.
ii. Losses: Reg. §1015-4
25
1. No loss is sustained when the amount
realized is less than the adjusted basis.
viii. Basis allocation, "interest carve-outs" and realization: Hort v.
Commissioner
1. Holding
a. In Hort v. Commissioner the Supreme Court held that
an amount received for the cancellation of a lease
could not be allocated to basis and must be included
in gross income.
b. I.R.C. § 167(c)(2) codifies this holding
i. "If any property is acquired subject to a lease
1. no portion of the adjusted basis shall be
allocated to the leasehold interest
2. the entire adjusted basis shall be taken
into account in determining the
depreciation deduction (if any) with
respect to the property subject to the
lease.
c. I.R.C. § 167(e): general rule against interest carveouts
i. General rule
1. No depreciation deductions are allowed
for a "term interest"13 in property for
any period during which the remainder
interest in the property is held.
ii. Exception: § 167(e)(2)
1. If this section disallows depreciation
that would otherwise be available, the
taxpayer shall decrease basis in the
property by the amount of the
depreciation deductions.
2. the basis of the remainder is increased by
the
amount
of the
disallowed
deductions
a. but not by a tax-exempt
organization
2. Allocation of basis: temporal divisions of property
a. Nature of Hort's property
i. Hort actually had two pieces of property
Defined in I.R.C. § 1001(e)(2) as (A) a life interest (B) an interest in property for a term of years or (C) an
income interest in a trust.
13
26
1. The revenue stream of rent under the
lease
2. The remainder interest in the property
ii. The court concludes that purchasing the
revenue stream in its entirely simply
substitutes for rent—which would be included
in income.
b. Realization difficulty
i. Issue: When can basis be allocated?
1. Shuldiner suggests that the key to the
result here was the fact that the taxpayer
retained the remainder interest.14
2. Example: property purchase with lease
a. Facts
i. FMV = $10,000
ii. Rent is $1,000 year
iii. Rate = 10%
b. Divide into two pieces of
property: the rental stream (for
one year) and the remainder
i. Rental steam: $909 (PDV)
[1,000/ 1 +.10]
ii. Remainder: $9091 (PDV)
[10,000/ 1+ .10]
iii. This makes it clear that the
$1,000 really consists of
$909
in
unrealized
appreciation
on
the
remainder and $91 in
rental payments.
c. The problem with allocation basis
across time is the realization
requirement.
By splitting the
property in two (temporally), the
taxpayer acquires present income
for the future steam and gets the
unrealized gain on the property.
c. Note that Hort is the example that actually disproves
the rule: the result does not reflect economic reality
Hort v. Commissioner: "We may assume that petitioner was injured insofar as the cancellation of the
lease affected the value of the realty. But that would become a deductible loss only when its extent had been
fixed by a closed transaction."
14
27
i. In Hort the taxpayer was forced to pay a tax on
unearned income—the payment was for
cancellation of the lease, not for the revenue
stream.
c. Realization
i. General
1. Nature of issue
a. I.R.C. § 61 taxes all gains from whatever source
derived. In a perfect income tax, annual gains
property would be taxed as accessions to wealth.
However, courts have interpreted the Internal
Revenue Code to include a realization component—
the gains are recognized only when "realized."
2. Purpose of realization requirement
a. The realization requirement is founded on the
doctrine of administrative convenience. Without it,
three insurmountable problems would arise
i. The administrative burden of annual reporting
ii. The difficulty and cost of determining asset
values annually
iii. The potential hardship of obtaining funds to
pay taxes on accrued but unrealized gains (the
liquidity problem)
b. The realization requirement also contributes to the
political legitimacy of the code—it would be difficult
to tax "paper" gains.
3. Criticism of realization requirement
a. It is relatively easy to value some assets annually (i.e.,
stocks).
b. Liquidity cannot be a major concern
i. We tax in-kind benefits
c. Equity problems
i. Horizontal equity
1. Taxpayer A earns $1,000 in salary.
Taxpayer B owns a building that
appreciates in value by $1,000. A is
taxed immediately, B is taxed only when
the gains are "realized."
2. the incentive to acquire assets that
produce unrealized gains distorts
investment decisions.
d. The Realization requirement as a constitutional imperative
i. Eisner v. Macomber
28
1. In Eisner the court held that a stock dividend is not taxable
as income under the Sixteenth Amendment until the
taxpayer sells the stock
ii. Doubts about the constitutional nature of the realization
requirement
1. The Supreme Court has not overruled Eisner, but it has
limited the decision to its facts.
a. See Cottage Savings Association v. Commissioner, noting
that the realization doctrine is based on
administrative convenience
b. See also Helvering v. Horst (saying same as above).
e. When is income realized?
i. Economic benefit reduced to "undisputed possession"
1. Income is realized when the taxpayer demonstrates his
"complete dominion" over an asset or when an economic
benefit is reduced to "undisputed possession."
a. See Cesarini v. United States where the Court held that
$5,000 found in an old piano was includible in gross
income under § 61. The income was realized in the
year in which it was reduced to "undisputed
possession."
i. Treasure troves: Reg. § 1.61-14
1. "Treasure trove, to the extent of its value
in United States currency, constitutes
gross income for the taxable year in
which it is reduced to undisputed
possession."
2. Note that this regulation would apply if,
for example, the Cesarinis had found a
diamond ring in their piano instead of
cash
ii. "Accidental" income
1. In United States v. Irvin, 67 F.3d 670 (8th
Cir. 1995), the court held that the
plaintiff, who had just been discharged
from the army, received gross income in
the amount of $836,939.19 when he
accidentally received a check in that
amount from the army.
2. But Graetz notes that he would be
entitled to a deduction when the money
was paid back.
29
b. See Haverly v. United States where the court concluded
that a high-school principle who received free
textbooks from publishers received gross income
when he gave those books to the library and took a
charitable deduction.
i. Here, the deduction was the realization
event—it marked the moment in which the
taxpayer's accession to wealth was clearly
evident.
ii. The court notes that the IRS could tax the
samples directly when received, but has made
an administrative decision not to.
c. See Eisner v. Macomber in which the Supreme Court
held that the receipt of a stock dividend was not
income under the Sixteenth Amendment until the
stock was sold.15
1. But see Helvering v. Bruun, 309 U.S. 461
(1940), where the court held that a
landlord received income when, at the
end of a lease, he came into possession
of a capital improvement built by a
tenant.
2. OVERTURNED by I.R.C. § 109
a. "Gross income does not include
income (other than rent) derived
by a lessor of real property on the
termination
of
a
lease,
representing the value of such
property attributable to buildings
erected or other improvements
made by the lessee.
ii. Stock Dividends: I.R.C. § 305(a)
1. "Except as otherwise provided in this
section, gross income does not include
the amount of any distribution of the
stock of a corporation made by such
The court's dicta indicates that a key issue was the fact that a cash dividend could be used for any
purpose, whereas a stock dividend remained part of the company and was not subject to the taxpayer's
individual ownership and control: "[A]n actual cash dividend, with a real option ot the stockholder
either to keep the money for his own or to reinvest it in new shares, would be as far removed as possible
from a true stock dividend, such as the one we have under consideration, where nothing of value is taken
from the company's assets and transferred to the individual ownership of the several stockholder and
thereby subjected to their disposal."
15
30
VIII.
corporation to its shareholders with
respect to its stock."
ii. The "material difference" requirement: exchange of property as a
realization event
1. Reg. § 1001-1(a)
a. "[G]ain or loss realized from the conversion of a
property into cash or from the exchange of property
differing materially either in kind or extent, is treated as
income or as loss sustained."
b. When is the exchanged property "materially
different"?
i. See Cottage Savings Association v. Commissioner
where the Supreme Court held that a taxpayer
realizes a gain or a loss on the exchange of
property when the exchanged properties
embody "legally distinct entitlements."
2. Potential scope of Cottage Savings
a. Some commentators believed that Cottage Savings
would require the realization of income for any
change to a debt instrument.
b. Reg. § 1001-3(e)(2)(ii)(a)
i. A debt instrument is "significantly modified" if,
for example, the parties agree to change the
yield by more than a quarter of 1%.
Annuities
a. Generally
i. What is an annuity?
1. An annuity is a contract whereby the taxpayer pays a lumpsum of money in return for a promise to pay a certain sum at
pre-determined intervals
2. Annuities are often keyed to life expectancy
b. Basis Recovery for annuities: three options
i. Basis, generally
1. A taxpayer's basis in an annuity is the taxpayer's initial
lump-sum investment in the annuity.
2. The question that arises here is what portion of the periodic
payments is basis recovery and what portion is income.
ii. Option 1: Basis recovered first
1. Historical treatment
a. Before I.R.C. § 72, this was the method used for taxing
annuities. The argument was that, since you might
not have any income, you should not be taxed until
31
you definitely begin to receive payments in excess of
the investment.
b. See Burnet v. Logan, 283 U.S. 404 (1913) (holding that
royalties from oil production should be allocated to
basis under the terms of an oil lease until the
transaction is closed).
2. Operation
a. Under this method, the taxpayer would not be taxed
on the annuity income until the aggregate receipts
equaled the amount paid.
Year
1
2
3
Total
PDV
Payment
100.00
100.00
100.00
300.00
267.30
Initial
Basis
267.30
167.30
67.30
Basis
Recovery
100.00
100.00
67.30
267.30
239.85
Ending
Basis
167.30
67.30
0.00
Income
0.00
0.00
32.70
32.70
27.45
3. Effect
a. Allowing the taxpayer to recover her basis first would
allow the taxpayer to defer the payment of income.
iii. Option 2: The Bank Account method
1. Operation
a. Under this method, the taxpayer would be taxed for
the interest accruing on the taxpayer's investment.
Year
1
2
3
Total
PDV
Starting
Balance
267.30
183.34
94.34
Interest
16.04
11.00
5.66
32.70
29.67
New
Balance
283.34
194.34
100.00
Withdrawal
-100.00
-100.00
-100.00
-300.00
-267.30
Ending
Balance
183.34
94.34
0.00
Principal
Withdrawn
83.96
89.00
94.34
267.30
237.63
2. Effect
a. Under the bank account method, the taxpayer's tax
liabilities are accelerated. The taxpayer pays more tax
(taking PDV into account).
b. Note that this is the only method that corresponds to
economic reality.
iv. Option 3: Straight line allocation over the expected life
1. Operation
a. Under this method, the entire amount that is expected
to be received is compared to the amount paid for the
annuity. A ratable portion of each payment received
32
is then excluded from income such that the taxpayer
will have recovered his basis when the final payment
is received
b. Example
i. Investment in contact: $267.30
ii. Expected return; $300.00
iii. Exclusion ratio: 89%
Year
1
2
3
Total
PDV
Payment
100.00
100.00
100.00
300.00
267.30
Basis
Recovery
89.10
89.10
89.10
267.30
238.17
Income
10.90
10.90
10.90
32.70
29.13
2. Effect
a. This method occupies a middle ground between the
basis recovery first method and the bank account
method—the taxpayer's taxable income is spread
evenly throughout the life of the annuity.
v. Comparison
Year
1
2
3
Total
PDV
Open
Transaction
0.00
0.00
32.70
32.70
27.45
Section
72
10.90
10.90
10.90
32.70
29.13
Bank
Account
16.04
11.00
5.66
32.70
29.67
1. As noted above, the taxable income is greatest under the
bank account method, and least under the open transaction
method.
c. I.R.C. § 72
i. General rule: § 72(a)
1. "Except as otherwise provided in this chapter, gross income
includes any amount received as an annuity (whether for a
period certain or during one or more lives) under an
annuity, endowment or life insurance contract."
ii. The Exclusion ratio: § 72(b)
1. This section excludes from gross income a portion of gross
income equal to the ratio of the expected return of the
contact to the investment in the contract.
a. Example
33
i. See supra "Option III":
$267.30 (initial
investment)/$300 (expected return) = 89%
(exclusion ratio)
2. Mortality gains and losses: § 72(b)(2) & (3)
a. Generally
i. Life expectancy
1. I.R.C. § 72(c)(3)
a. "Expected return" is determined
from the life expectancy of the
individual, computed according
to actuarial tables provided by
Treasury.
2. Reg. § 1.72-9
a. provides life expectancy tables
for use in calculating the
exclusion ratio
b. Note that an annuity contract
entered into after June 1986 is
subject to the unisex tables (tables
V – VIII)
i. The table overestimates
the lives of men, giving
them a higher exclusion
ratio and a lower tax rate
than they would have
under a gender-based
table.
ii. What are mortality gains and losses
1. A mortality gain exists when the
annuitant lives longer than expected
and continues to receive income
payments that exceed the expected
return
2. A mortality loss occurs when the
annuitant dies earlier than expected and
does not receive the expected return on
the investment
b. Tax treatment of mortality gains
i. Mortality gains are taxed, in their entirety, as
ordinary income. See I.R.C. § 72(b)(2)
c. Tax treatment of mortality losses
34
i. Mortality losses may be deducted up to the
amount of the unrecovered investment. See
I.R.C. §72(b)(3)
d. Conceptual problems/issues
i. Over the long term, mortality gains and losses
represent a revenue-neutral issue for Treasury.
Why tax them?
1. Under this system, the lucky taxpayer
who exceeds life expectancy is suddenly
taxed at a higher rate.
ii. The old system, in which mortality gains and
losses were untaxed, was taxpayer-friendly
without affecting government revenues.
iii. Deferred annuities
1. Tax-free interest treatment
a. When a taxpayer purchases a stream of income at a
point far in the future, she is not taxed on the interest
that accrues on her initial investment. See I.R.C. §
72(b)
2. Early withdrawal penalties
a. Cash withdrawals before the annuity starting date are
included in gross income to the extent that the cash
value of the contract exceeds the initial investment.
See I.R.C. § 72(e)
b. Cash withdrawals before the age of 59½ are subject to
a penalty of 10% of the amount withdrawn being
included in income.
3. Treatment of explicit interest
a. If the contract includes an express agreement to pay
interest, the interest payments are included in gross
income
d. Tax arbitrage and annuities: I.R.C. § 264
i. General principle
1. When a tax rule exists that does not correspond to economic
reality, it is possible to create a situation in which the
taxpayer is under-taxed.
2. Here, the bank-account method of annuity taxation is the
only method that corresponds to economic reality.
ii. Shuldiner's annuity "tax shelter"
1. Section 72 provides for a straight-line recovery of basis—
some income is deferred later than it otherwise would have
been.
2. Operation of tax shelter
35
a. Borrow money and purchase an annuity
b. The borrowed money will be taxed on the bank
account method—you may, under certain tax
provisions, deduct the interest (accruing under the
bank account method).
c. The lent money, however, is taxed on a straight-line
method
3. Consequence
Year
1
2
3
Total
PDV
IX.
Invest:
Section
72
10.90
10.90
10.90
32.70
29.13
Borrow:
Bank
Account
-16.04
-11.00
-5.66
-32.70
-29.67
Tax
Shelter
-5.14
-0.10
5.24
0.00
-0.54
a. The results are even more dramatic when the annuity
is deferred
iii. Section 264 disallows the deductions that would allow this scheme
to work
Life Insurance
a. What is life insurance?
i. "Term" life insurance
1. A term insurance policy promises to pay the insured a
specified sum should the insured die during a certain period
of time, in return for payments.
2. Essentially, the insured is gambling that his life expectancy
is shorter than the insurance company believes it to be.
ii. "Whole" life insurance
1. A whole life insurance policy promises to pay the insured a
specified sum at the insured's death in return for payments
throughout the life of the insured.
iii. Both term and whole life insurance have a pure insurance element
and a savings element
1. Insurance component
a. You buy a life insurance policy in which the insurance
company promises to pay $5,000 if you die anytime in
the next 5 years. You die the next day. Here, your
life was "insured" with a guaranteed sum
2. Savings component
a. You buy whole life insurance. Normally, the annual
premium of term insurance would rise to account for
the increased risk of death. With whole insurance,
the initial payments are quite high compared to the
36
risk—here, the payments exceed the actuarial cost of
term insurance. The excess amount is deposited as a
cushion for when the insured dies.
b. Theoretical and policy issues
i. The savings element of life insurance is untaxed. Why?
1. Shuldiner's answer is that it would really be impossible to
tax—a pure income tax does not tax risk.
a. Example
i. Facts
1. τ = 33%
2. premiums= $100
3. insurance = $100,000
ii. No-tax
1. In this world, the insured receives a
deduction for each $100 payment
iii. Tax
1. Here, since the tax rate is 33%, any
taxpayer who wants to receive $100,000
at death would purchase $150,000
insurance policy with payments of $150.
Term
life No Tax
Pre Tax (1/3)
After tax (1/3)
insurance
Premium
100
150
100
Insurance
100000
150000
100000
You live
0
0
0
iv. Because some will live and some will lose,
treasury comes out even whether there is a tax
or not.
c. Tax treatment of life insurance: I.R.C. § 101
i. General Rule: § 101(a)
1. gross income does not include amounts received under a life
insurance contract if paid because of the death of the insured
ii. Agreements to maintain life insurance proceeds
1. § 101(c)
a. If there is an agreement to pay interest on the
proceeds from the life insurance contract, the interest
payments are included in gross income.
2. § 101(d)
a. if the life insurance keeps the proceeds of a life
insurance contract in return for a promise to pay an
even larger sum to the beneficiary at a later point in
time, Treasury pro-rates the proceeds and includes it
in the beneficiary's gross income
37
X.
iii. Abusive "life-insurance" contracts
1. The insurance element of a contract must be "genuinely
present" and "significant." Congress has acted to prevent
taxpayers from receiving tax-free treatment of interest for
contracts that don't really have a life insurance component
a. See Graetz p. 170
2. I.R.C. § 7702A(b)
a. Abusive life insurance policies are called "modified
endowment contracts" and do not receive preferential
tax treatment
b. The basic test for determining whether a policy is a
modified endowment contract looks to the amount of
the premiums paid in the first seven years and asks
whether that amount paid is greater than what would
have been paid had the contract provided for paid-up
future life insurance benefits after seven level
premiums.
c. See also I.R.C. § 72(e)
3. Borrowing against insurance policy
a. Taxpayers who borrow from their life insurance
policies are not taxed on the loan proceeds—the form
of the transaction is respected. I.R.C. § 72 (e)(4)(A).
Treatment of Debt
a. In General
i. Definition of loan
1. Collins v. Commissioner: "Loans are identified by the mutual
understanding between the borrower and lender of the
obligation to repay and a bona fide intent on the borrower's
part to repay the acquired funds."
ii. Tax treatment of loans
1. General rules
a. A borrower does not realize income upon the receipt
of a loan.
b. A lender does not deduct the amount of a loan as a
loss and does not realize income when the principal is
repaid.
2. Rationale
a. Loans are not taxed because there is no change in the
net worth of either party—one person receives money
but simultaneously receives a liability (the promise to
pay it back).
b. Illegal Income
i. General issue
38
1. How should the tax law react when an individual embezzles
funds but claims that they were only "borrowed" and thus,
not subject to taxation.
2. This is really a question about how the tax law should
respond to non-recourse debt. In general, non-recourse
debt, like recourse debt, is untaxed.
ii. Doctrinal development
1. United States v. Sullivan
a. The Supreme Court held that gains arising out of
illegal activity are not necessarily excludable from
gross income—the origin of the income is irrelevant
for tax purposes.
b. The Supreme Court also held that the requirement
that illegal income be disclosed on a tax return does
not violate the Fifth Amendment
2. James v. United States16
a. The Supreme Court held that all unlawful gains are
taxable.
3. Gilbert v. Commissioner
a. The Second Circuit held that money taken from a
corporation by its President and used to purchase the
stock of another company, on margin, was not
includible in the President's gross income, despite the
lack of a loan agreement, because (1) the President
expected "with reasonable certainty" to repay the
sums, (2) he believed the withdrawal would be
approved by the company board and (3) he made
prompt assignment of assets to secure the amount
that he owed.
4. Collins v. Commissioner
a. The Second Circuit held that a ticket vender and
computer operator at an Off-Track-Betting parlor
received gross income of $38,105 when he took
$80,280 in betting tickets but only won $42,175.
b. The court also held that the $38,105 could not be
deducted as a loss under I.R.C. § 165(d) because
gambling losses could only be offset against gambling
winnings.
Overturning Commissioner v. Wilcox (holding that, since an embezzler is legally obligated to return the
funds, an embezzler, like a legitimate borrower, realizes no income upon receipt of the cash) and Rutkin v.
United States (distinguishing an extortionist from an embezzler and concluding that the former must
include ill-gotten gains in gross income).
16
39
c. Distinguishes Gilbert because that case involved a
situation in which the taxpayer believed "with
reasonable certainty" that he would be able to repay
the money taken.
iii. General legal principles
1. Taken together, the above cases indicate that the criminal
taxpayer realizes income when he acquires an economic gain
from his nonconsensual "borrowing" and there is no
"reasonable certainty" that the money can be repaid.
iv. Special rules for losses: I.R.C. § 165(c) and (d)
1. § 165 (c)
a. Limits individual loss deductions to
i. Losses incurred in a trade or business
ii. Losses incurred in a for-profit transaction
iii. Losses of property not covered as casualty
losses in 165(h) but arising out of fire, storm,
shipwreck or theft.
2. § 165 (d)
a. General rule
i. Wagering losses:
losses from "wagering
transactions" can only be deducted to the
extent of the gains from the transactions.
1. Reg. § 1.165-10 provides that the losses
are only allowed to the extent of gains in
the taxable year.
ii. See Collins v. Commissioner (holding that
taxpayer was not entitled to gambling loss
deduction when he borrowed $80,000, won
$42, 175 and lost $38,105).
iii. See Zarin v. Commissioner (holding that
taxpayer was not allowed to deduct almost $3
million in gambling losses because the debt
and its discharge occurred in different years)
b. Purpose
i. Recognizes the consumption value of gambling
ii. Gambling losses would be difficult to prove—
taxpayers could take unearned deductions.
v. Policy issues
1. Enforcement of criminal law for tax purposes
a. In United States v. Baggot, the Supreme Court refused
to allow the United States's to obtain the grand jury
transcripts and documents created during a tax-fraud
40
investigation, for use in an audit to determine tax
liability.
2. Enforcement of tax laws to target criminals
a. See Rutkin v. United States (Black, J., Dissenting)
i. Criticized the court for taxing income acquired
from extortion because
1. it
allowed
the
government
to
appropriate sums that had originally
belonged to the victim
2. pursuing the taxes is a wasteful expense
3. the practice gives the government more
power to punish purely local crimes.
c. Discharge of Indebtedness income
i. Discharge of indebtedness, in general
1. General rule
a. If a borrower's debt is paid by another party, the
borrower must include the amount paid in gross
income. Cf. Old Colony Trust Co. (holding that
taxpayer must include his employer's payments of his
tax liability in gross income).
i. See
also
I.R.C.
61(a)(12)
(specifically
enumerating "income from discharge of
indebtedness" as includible in gross income).
2. Rationale
a. The taxpayer realizes income when the loan is not
repaid because the taxpayer's liability disappears—he
has realized an accession to wealth.
ii. When is there a "debt" that has been discharged?
1. Definitions of loan
a. See supra p. 38. (citing definition in Collins v.
Commissioner)
b. Enforceability
i. There can be no "discharge of indebtedness"
income if there is no debt, and there is no debt
if the a loan is legally unenforceable. See Zarin
v. Commissioner, 916 F.2d 110 (3d Cir. 1990).
1. Note that this decision overturned the
tax
court's
determination
that
enforceability was irrelevant to tax
liability, citing United States v. James
iii. Realization of discharge of indebtedness income
1. The "freeing up of assets" approach
41
a. The taxpayer realizes discharge of indebtedness
income when he acquires the gain of freed up assets
that would otherwise have been required to pay the
debt.
b. See United States v. Kirby Lumber Co. (holding that a
corporations re-purchase of its bonds at less than par
was a clear gain subject to taxation).
c. See also Zarin v. Commissioner, 92 T.C. 1084 (1989)
(citing Kirby Lumber in support of argument that
gambler received income when he received chips
from a casino in the amount of $3,435,000 and later
paid a settlement of only $500,000).
iv. Discharge of Indebtedness: I.R.C. § 108
1. Exclusions from gross income: I.R.C. § 108(a)
a. Gross income does not include discharge of
indebtedness income if
i. The discharge occurs in a chapter 11
bankruptcy
ii. The discharge occurs when the taxpayer is
insolvent
1. "insolvent" means "the excess of the
liabilities over the fair market value of
assets." I.R.C. § 108(d)(3)
iii. The debt is qualified farm indebtedness
b. The exclusion is only equal to the amount of the
insolvency
2. Adverse consequences of exclusion under § 108(a): I.R.C. §
108(b)
a. When a taxpayer excludes gross income under §
108(a), the following is reduced by the amount
excluded
i. Net operating losses from previous year are
reduced (so deduction limited)
ii. Basis in property
1. See also I.R.C. § 1017
a. § 1017 (a): confirms rule that
amount excluded from income
under 108(a) reduces the basis in
property.
b. § 1017(b)(3): The basis is reduced
only in depreciable property if the
taxpayer elects the reduction in
108(b)(5).
42
i. See
note
below—a
taxpayer would prefer to
take a reduction in the
basis of non-depreciable
property.
2. The taxpayer may elect to take
reductions in basis as to opposed to
reductions elsewhere under 108(b)(5).
a. But note that because the
taxpayer must take a reduction in
the basis of depreciable property,
she may decide not to make the
election because otherwise she
might be able to reduce the basis
in non-depreciable property and
continue to take deductions in
the present.
b. The reduction in operating losses, the minimum tax
credit, foreign tax credit carryovers, and passive
activity losses and carryovers is to be 33 1/3 cents per
$1 excluded.
3. Discharge of qualified real property business indebtedness:
I.R.C. § 108(c)
a. General rule: the amount excluded under 108(a)(1) is
applied to reduce the basis of depreciable real property
held by the taxpayer.
b. Limitations
i. The amount excluded may not exceed the
aggregate adjusted bases of the depreciable real
property held by the taxpayer immediately
before the discharge. I.R.C. § 108(c)(2)(B)
4. Definitions: I.R.C. § 108(d)
a. "Indebtedness"
i. means any indebtedness for which the
taxpayer is liable or
ii. subject to which the taxpayer holds property
iii. See also Zarin v. Commissioner (3d Cir.) in which
court holds that a legally unenforceable loan is
not "indebtedness" under § 108.
b. "Depreciable property" I.R.C. § 108(d)(b) I.R.C. §
1017(b)(3)(B)
i. "any property of a character subject to the
allowance for depreciation, but only if a basis
43
reduction under subsection (a) would reduce
the amount of depreciation or amortization
which otherwise would be allowable for the
period immediately following such reduction.
5. General rules for discharge of indebtedness income: I.R.C. §
108(e)
a. No other insolvency exception: I.R.C. § 108(e)(1)
b. Lost deductions: I.R.C. § 108(e)(2)
i. Income is not realized to the extent that
payment of the liability would have been
allowed as a deduction.
ii. This makes sense because the IRS would not
have the tax receipt anyways (this can be
thought of as an administrative provision)
c. Purchase price reduction: I.R.C. § 108(e)(5)
i. Three statutory requirements
1. the debt must be that of a purchaser of
property to the seller which arose out of
the purchase of the property
2. the taxpayer must be solvent (and not in
chapter 11) when the debt reduction
occurs
3. except for the section, the debt reduction
would have been discharge of
indebtedness income
ii. Requirements derived from legislative history.
See Zarin v. Commissioner:
1. the price reduction must result from an
agreement between the purchaser and
the seller (not because of statute of
limitations)
2. there has been no transfer of debt by the
seller to a third party
3. there has been no transfer of the
purchased property from the purchaser
to a third party
iii. In Zarin v. Commissioner the Tax Court held (I)
that gambling chips were not "property" under
108(e)(5) and (II) that a settlement of $500,000
for gambling debts of $3,000,000 was not a
purchase price adjustment to the price of the
gambling
d. Corporate debt to shareholder: I.R.C. § 108(e)(6)
44
i. If a shareholder forgives a debt owed to him by
the corporation, the corporation is treated as
having paid an amount equal to the basis of
the debt
ii. This will usually result in no discharge of
indebtedness income to corporation
e. Corporate stock issued in exchange for debt: I.R.C. §
108(e)(8)
i. A solvent corporation realizes discharge of
indebtedness income when it issues stock to
cancel its debt.
f. Discharge of indebtedness treated as gift
i. The statute is silent: this would have to be
determined from the context of the transaction
g. Discharge of indebtedness or salary
i. This would have to be determined in context.
ii. In some situations, you might prefer to have
the payment classified as discharge of
indebtedness income so that you can take
advantage of Section 108
h. Student loan forgiveness: I.R.C. § 108(f)
i. Excludes from gross income the discharge of
student loans if the discharge was conditioned
on working in a certain profession
d. Borrowing and basis
i. Basis problems/concepts
1. How should the tax system take borrowed money into
account when computing basis and amount realized?
ii. Types of debt
1. Recourse debt
a. This type of debt occurs when the borrower is
personally liable for the repayment of the debt
2. Nonrecourse debt
a. This type of debt occurs where the borrower is not
personally liable—the lender can look only to the
assets that secure the debt for payment.
i. Here, the lender assumes the risk that the
property securing the loan will fall in value.
iii. Tax treatment of discharge of non-recourse debt
1. Doctrinal development
a. Crane v. Commissioner
i. Rule
45
1. In Crane v. Commissioner the Supreme
Court concluded that a loan, whether
recourse or Nonrecourse, is included in
the basis of the asset it finances.
ii. Rationale
1. This rule creates parity between a
purchaser who borrows from a bank
and pays the seller cash and a purchaser
who uses seller financing.
iii. Effects
1. Depreciation deductions
a. This rule allows the taxpayer to
take depreciation deductions for
costs that the taxpayer has not
paid
b. Commissioner v. Tufts
i. General rule
1. In Commissioner v. Tufts the Supreme
Court concluded that a taxpayer who
sells a property subject to a nonrecourse
mortgage must include the unpaid
balance of the mortgage in the
computation of the amount realized
when the unpaid amount of the
nonrecourse mortgage exceeds the fair
market value of the property sold.
2. Graetz notes that "Tufts should be
understood as holding only that a
taxpayer must treat a nonrecourse
mortgage consistently when he accounts
for basis and amount realized."
a. See
Estate
of
Franklin
v.
Commissioner in which the Ninth
Circuit held that where the
amount of the mortgage exceeds
the fair market value of the
property securing it when the
debt was first incurred, the
mortgage is not included in the
basis and thus will not be
included in the amount realized
upon
disposition
(probably
foreclosure). See infra p. 46.
46
Example:
 Facts
o Debt = $12,000
o FMV= $10,000
o Basis = $7,000
 Nonrecourse debt in Tufts
o AR – B
o $12,000 - $7,000 = $5,000
 Recourse debt under Tufts
o AR (FMV) – B
o $10,000 - $7,000 = $3,000
o SEPARATELY, there is
$2,000 of discharge of
indebtedness income
o See Reg. § 1.001-2(c)(8)
ii. Rationale
1. Crane was not based on economic
benefit, but on the desire to treat
recourse and nonrecourse debt similarly
2. The court focuses on the obligation to
repay the loan, not on the fact that the
taxpayer could take deductions from the
basis.
c. General rules/principles
i. For tax purposes, both recourse and
nonrecourse loans are treated similarly: both
are included in the basis of the property.
1. Criticism
a. Recourse and nonrecourse debt
are not really treated the same.
ii. NOTE THAT I.R.C. § 7701(g) CHANGES THE
RESULT OF TUFTS
1. I.R.C. § 7701(g) provides that the fair
market value of property shall be
treated as being not less than the amount
of any nonrecourse indebtedness to
which the property is subject.
47

iii. Justice O'Connor's concurrence in Tufts
1. Justice O'Connor would split the
Shuldiner suggests that, in these situations, the
transaction in two
rules for ordinary income and gains on property
a. Property transaction
end up converging on the same result anyways
i. The fair market value on
o Example 1
the date of the acquisition
 Facts
 Debt = $100,000
is the basis in the property.
 Deprecation = $20,000
ii. Fair market value on the
 Adjusted Basis = $80,000
date of disposition is used
 FMV - $80,000
to calculate the amount
 Nonrecourse loan (Tufts majority)
realized (in this case, a
 Gain = AR – Adjusted basis
loss).
 Gain = $20,000
b. Discharge of indebtedness
 Nonrecourse loan (O'Connor)
i. The taxpayer acquires cash
 Gain = $0
from the mortgagee.
 COD = $20,000
ii. When the property is
o But under O'Connor
transferred for less than
you could claim that
the debt, the taxpayer
this was a basis
acquires
discharge
of
reduction under §
indebtedness income
1017
c. This treatment accounts for the
o OR, if the nonfact that the types of income at
recourse debt is
issue are treated differently by
seller-financed, you
the tax code: one is a capital gain
could say that this
amount is simply a
(or loss) and one is ordinary
purchase price
income.
reduction
2. Problem's with O'Connor's analysis
 Recourse loan
a. O'Connor assumes that the
 COD = $20,000
amount of the debt above the fair
 BUT, I.R.C. § 1017(b)(3)(F)
market value of the property is
provides for real property
cancelled. That was not the in
indebtedness
Tufts.
b. The rules for property gains and
discharge
of
indebtedness
converge to reach the same result
anyways.
2. Policy issues
a. Who should receive depreciation deductions when
property is secured with a nonrecourse loan?
i. In general, the tax code provides for
accelerated deductions. This means that it
might be possible for the owner of property
48
purchased with non-recourse debt to receive
deductions in excess of his investment in the
property.
ii. If, instead, the lender received the deductions,
we might expect the economic benefit to
manifest itself in lower interest rates.
iii. Someone gets this benefit. Shuldiner suggests
that there are no real compelling arguments
either way).
iv. Acquisition and Disposition of property encumbered by debt:
Statutory treatment
1. See generally supra p. 18-21
2. Reg. § 1001-2
a. General rule (Tufts)
i. "The amount realized from a sale or other
disposition of property includes the amount of
liabilities from which the transferor is
discharged as a result of the sale or disposition.
b. Discharge of indebtedness
i. Amount realized does not include income from
discharge of indebtedness when a recourse
loan is secured with property
c. Special rules
i. Foreclosure by a nonrecourse lender is a
realization event—the borrower is discharged
from the liability
v. Real Estate Tax Shelters: Estate of Franklin v. Commissioner
1. Real estate tax shelters, generally
a. By purchasing property through nonrecourse debt
and then taking deductions, the property owner is
able to acquire a tax benefit at no cost
b. Example (10 year sale and lease-back)
i. Assumptions
1. assume straight line depreciation
ii. Consequences
1. At disposition
a. Gain = AR – adjusted basis
i. Adjusted basis = purchase
price – deprecation
ii. Under
Tufts,
Amount
realized equals the amount
of the debt. Here, that
49
amount is zero because the
debt = price
2. During ten years
a. Total income would be the rent
over the ten years
b. Total deductions would be the
deductions from interest and
depreciation
c. Net income would be (Rent –
Income) + (Gain – Depreciation)
i. This would be 0
d. BUT, the present value of the
deductions is greater than the
present value of the gain from the
property. So, in the end, you get
a net deduction.17
2. Estate of Franklin v. Commissioner
a. In Estate of Franklin v. Commissioner the Ninth Circuit
held that a taxpayer ought not be permitted
deductions on a property purchased from the owners
using nonrecourse debt and then leased back to the
owners in such a way as to offset the debt payments.
i. Estate of Franklin seems to hold out the rule that
depreciation is based not on ownership but on
investment—the court attributed importance to
the fact that the owners of the property never
acquired equity in the property (because the
purchase price was inflated and the
nonrecourse mortgage contained a large
"balloon" payment at the end of the lending
period).
b. Tax code provisions relating to the abuse in Estate of
Franklin
i. I.R.C. § 461(g)
17
Example
1. Facts
a.
b.
c.
d.
2. Results
a.
b.
c.
P = $1,000
Discount rate = 10%
τ = 70%
capital gains τ = 35%
PDV (gains) = $385 * 35% = $135
PDV (depreciation) = $615 * 705 = $430
Net deduction = 230 $300
50
1. allows homeowners to deduct prepaid
mortgage points.
2. The service takes the position that
refinancing a mortgage with points that
are nondeductible requires those points
to be spread over the life of the home.
ii. Tax Penalties
1. I.R.C. § 6662: penalty for overvaluation
of property
2. I.R.C. § 6663: penalty for fraud
iii. I.R.C. § 465: "at risk rules"
iv. I.R.C. § 469: passive loss rules
1. See infra, Losses, p. XXX
c. A note on prepaid interest
i. Shuldiner notes that the "prepaid" interest
doesn't make any sense conceptually.
ii. Example
1. Facts
a. You give $1,000, and immediately
receive $100 back.
b. Just a little while later, the $1,000
is returned.
2. This can be characterized in two ways
a. You can say that their was a loan
with $100 of prepaid interest.
b. You can say that there was a loan
of $900, repaid for $1,000.
i. Economically,
this
characterization
makes
more sense
iii. See also Knetsch v. United States, infra p. XXX
vi. Borrowing, basis and realization: other issues
1. Borrowing in excess of basis
a. In Woodsam Associates Inc. v. Commissioner the Second
Circuit held that a loan, even when secured only by
untaxed appreciate on property, does not constitute
realized income to the borrower—the borrowing is
not a realization event.
b. Shuldiner criticizes this result
i. There is no liquidity problem
ii. There is no valuation problem
2. Post-acquisition indebtedness
51
XI.
a. Here, the taxpayer borrows more money on the
property through a second mortgage or an equity
loan.
i. This second debt is not included in basis under
I.R.C. § 1012 (because not part of the cost of
acquisition)
ii. If the money is used to finance improvements
on the property, then basis would be increased
under I.R.C. § 1016
b. On disposition of the property, the outstanding
amount of the indebtedness would be included in the
amount realized.
3. Contingent liabilities
a. A contingent loan is not included in basis because it is
unclear whether the borrower will ever actually make
payments. Estate of Franklin; Rev. Rul. 78-29, 1978-1
C.B. 62.
vii. Part sale/ part gift
1. General rule
a. Transfer of property by gift is not a realization event.
2. Exception
a. If the donee transfers consideration—including the
assumption of a liability of the donor—there is a part
sale, part gift.
b. In Diedrich v. Commissioner the Supreme Court held
that the transfer of stock on condition that the donees
pay the federal gift tax owed by the donor resulted in
gross income to the donor to the extent that the gift
tax exceeded the donor's basis.
Damages and Sick Pay
a. General
i. The nature of the injury determines the tax consequences to the
taxpayer.
ii. Personal damages must be distinguished from business damages
because the former get preferential treatment.
b. Policy Issues (Graetz p. 214)
c. Commercial/Business damages
i. General rule/guiding principles
1. The tax consequences of a compensatory damages award of
reimbursement depend on the tax treatment of the item for
which the reimbursement is intended to substitute.
ii. Examples
1. Damages in antitrust
52
a. Recoveries that represent a recovery of lost profits are
income.
2. Damages for lost goodwill
a. Often, the taxpayer will have no basis in goodwill, so
the entire amount recovered is realized income.
3. Compensation for loss of property with adjusted basis
a. The amount of income equals the amount received
minus the adjusted basis.
iii. Punitive damages are entirely taxable. See Commissioner v. Glenshaw
Glass, 348 U.S. 426 (1955)
iv. I.R.C. § 1033: involuntary conversions
1. If the taxpayer loses a factory and receives damages, he
would not normally be able to replace the factory because
the damages would be taxed.
2. Section 1033 fixes this problem by providing a nonrecognition rule.
d. I.R. C. § 104: General exclusion of personal injury damages from income.
i. General rule
1. "The amount of any damages (other than punitive damages)
received on account of personal physical injuries or physical
sickness" is excluded from gross income.
2. Note that § 104(a)(2) allows for the exclusion of damages
whether they are paid in lump sum or as periodic payments.
a. If the interest is unstated in the periodic payments, it
will be untaxed. See Graetz 212.
ii. Exceptions (if an exception, then includable in income)
1. The personal v. business distinction
a. Requirement that the damages be for personal injury
i. I.R.C. § 104(a)(2) expressly requires that the
injuries be "personal"
b. See supra for treatment of business damages. See infra
p. XXX for more on the business/personal distinction
in the context of I.R.C. § 162.
2. "Physical" injury
a. The legislative history indicates that damages for
physical injury or sickness resulting from emotional
distress are not excluded
b. damages for emotional distress resulting from
physical injury may be excluded.
3. Amounts attributable to deduction allowed under I.R.C. §
213.
a. I.R.C. § 213
i. General notes
53
XII.
1. § 213 is only available as a below-theline deduction.
ii. I.R.C. § 213 does not apply when the medical
costs are paid by an insurance company.
iii. Employer-purchased insurance proceeds
1. I.R.C § 104(a)(3) provides that amount received through
accident or health insurance for personal injuries are
included in income.
2. I.R.C. § 105(b)
a. Gross income does not include amounts received
through employer-provided health insurance if the
amounts are paid directly to the taxpayer to
reimburse medical costs NOT allowed as deductions
under § 213.
3. I.R.C. § 106
a. Provides that the gross-income of the employee does
not include employer-provided coverage under an
accident or health plan.
e. Personal injury damages included in income
i. Lost wages
ii. Pain and suffering
iii. Punitive damages
f. Damages paid in the form of property
i. If damages are paid in property, the full-market value of the
property is included in basis.
g. Murphy v. Internal Revenue Service, 493 F.3d 170 (D.C. Cir. 2007)
i. General Holding
1. In Murphy the D.C. Circuit, en banc, vacated an earlier
decision in which it had declared I.R.C. § 104(a)(2)
unconstitutional on that physical damages do not constitute
income under the 16th Amendment and did not fit under
any of the other taxing provisions in Article I.
ii.
Tax-Exempt Interest: I.R.C. § 203—State and Municipal bonds
a. General exclusion of interest from state and local bonds: I.R.C. § 103
i. I.R.C. § 103: "Except as provided in subsection (b), gross income
does not include interest on any State or local bond."
ii. Exceptions
1. "private activity" bond not qualified under § 141
a. A private activity bond is one for which more than
10% of the proceeds are used for a private business
use and for which more than 10% of the principal or
54
interest payments are secured by an interest in a
private business. See I.R.C. § 141 (a)-(b)
2. Arbitrage bond defined under § 148
a. See infra on tax arbitrage
3. Bond not in registered form under § 149
a. This was done to prevent states and municipalities
from creating unregistered bonds that would
essentially function as currency.
b. Policy issues
i. The subsidy to state and municipal governments
1. Section 103 acts as a subsidy to state and local governments:
they can pay lower rates of interest on their debt than a
corporate bond of comparable risk.
2. Example
a. Facts
i. National (τn) = 50%
ii. Municipal (τm) = 30%
iii. Local (τl) = 10%
iv. T (Tax rate) = 1 – τ
v. Tax Exempt (TE) = T (1-τ)
b. Resulting tax situation
Taxable
Tax Exempt
Implicit tax rate18
Long-term
5.55%
4.12
26
Short Term
4.97%
3.51%
29%
3. Why not simply give a direct subsidy to the states and
municipalities?
a. Under this scheme the costs of the subsidy are
hidden—they are not included as a line on the
budget.
ii. Distributional aspects of the tax exemption
1. In order to attract middle-income taxpayers, states and
municipalities offer higher interest rates. This results in
high-income taxpayers receiving significantly greater tax
benefits
iii. Crowding out
1. Subsidizing the municipal bond rate might also lead to
"crowding out"—money is invested in municipal bonds
rather than in private investments (which are more efficient).
c. Tax arbitrage
i. Two types of bonds
18
τ = 1 – TE/T
55
1. General obligation bond
a. A general obligation bond is one for which the state
assumes liability—it assures the bond with its full
faith and credit.
2. Revenue bond
a. A revenue bond is a bond for a specific project (i.e., a
toll road) which will be paid back from the project's
revenue.
ii. State/Local government arbitrage
1. Without limits on the tax-free status of the bonds,
municipalities could essentially print money.
a. Example: a municipality issues a $1,000 bond at 7%
interest. This would get them $30 in income. Could
they multiply this by a factor of a billion? Let's say
the municipality tries to issue a $trillion bond. There
credit would probably not be enough to sustain this.
i. To get around this, the municipalities could
use the money they get from the bond to buy
treasury bonds from the federal government.
They can then use the interest from the federal
bonds to pay their own debt. Essentially, they
back their bonds with the full faith and credit
of the Federal government.
b. Sections 103 and 148 prevent this.
i. Section 103 excepts "arbitrage" bonds from taxfree status.
ii. Section 148 defines arbitrage bond.
1. Essentially, an arbitrage bond is a bond
used to purchase other debt at a higher
yield
iii. Bondholder arbitrage
1. Bondholder arbitrage occurs when an investor borrows at a
commercial rate and invests at a tax-exempt rate. 19
2. Example
a. Facts
i. τ = 50%
ii. Commercial Interest Rate = 10%
iii. Tax Exempt Rate = 7%
iv. So, interest deduction on $10 is worth $5.
b. Arbitrage
This is profitable because the investor might be able to deduct his interest payments on the commercial
debt. See infra, p. XXX
19
56
Pre-Tax
After-tax
10%
5%
7%
7%
-3%
2%
3. Tax Code solution: Section 265(a)(2)
a. I.R.C. § 265(a)(2)
i. No deduction shall be allowed for "Interest on
indebtedness incurred or continued to
purchase or carry obligations the interest on
which is wholly exempt from the taxes
imposed by this title"
b. Policy issues
i. Allowing the arbitrage would simply bid up
the price of the municipal bonds, lower the
spread and decrease the after-tax interest rate
on the bonds—the market would correct for
the problem.
ii. 265(a)(2) thus seems unnecessary. In fact, it is
rarely enforced.
d. Constitutional issues
i. Federal Power
1. Recent decisions of the Supreme Court had made it clear
that the Constitution grants Congress the power to repeal
the tax exemption in state and local bonds. South Carolina v.
Baker (1988) (upholding congressional statute requiring that
bonds be issued in registered form in order to acquire taxfree status).
ii. Dormant Commerce Clause
1. If I have time, perhaps note the case here.
Borrow at
Invest at
Profit margin
DEDUCTIONS AND CREDITS
I.
Overview
a. Recurring themes and issues
i. The nature of the federal tax system
1. Not allowing a deduction for business expenses would turn
the income tax into a consumption tax. See infra, p. XXX
2. The income tax is a tax on net income, not gross income—the
expenses of producing income must be deductible.
ii. Deductions as a matter of legislative grace
iii. Credit v. Deduction
57
1. A credit saves a dollar of taxes—it is the same for every
taxpayer
2. A deduction saves the taxpayer a fraction of a dollar,
depending on the tax bracket.
iv. Policy issues
1. deductions often function as a tax subsidy for certain
behaviors
v. Limitations on deductions
1. Personal deductions
a. Generally, the tax code allows a deduction only for
business expenses.
However, the dividing line
between business and personal is often hard to find
2. Capital expenses
a. For certain items, we require that taxpayer's capitalize
their expense rather than take an immediate
deduction.
3. Public policy limitations
a. For example, we do not allow a deduction for fines
imposed for violating the law, even if the fine was
incurred in the course of business.
4. Taxable Year
a. Generally, a taxpayer can use deductions only to the
extent of her income for the taxable year
5. Timing
a. Whether a cost is expensed or capitalized has a
enormous tax consequences
b. Depreciation also has a significant impact on
temporal tax liability.
b. "Substantive" sections
i. I.R.C. §§ 151 – 153: Personal exemptions
ii. I.R.C. § 162: "Ordinary and Necessary" business expenses
1. See infra p. XXX
2. See also I.R.C. § 262: Personal expenses
iii. I.R.C. § 163: interest
1. See infra p. XXX
iv. I.R.C. § 164: Taxes
1. See infra p. XXX
v. I.R.C. §§ 167, 168, 197: Depreciation and amortization
1. See infra p. XXX
vi. I.R.C. § 212: For Profit Activities
1. See infra p. XXX
vii. I.R.C. § 263A: Capitalization
1. See infra p. XXX
58
c. "Structural " sections
i. General
1. These code sections determine whether a deduction will be
"above the line" or "below the line"
2. Importance of distinction
a. "Above the line" deductions can be taken without
limit
b. "Below the Line" Deductions are subject to limitation
i. Must be greater than standardized deduction
ii. May be subject to restrictions on miscellaneous
itemized deductions
1. two percent floor
2. three percent haircut
iii. itemized deductions are eventually phased out
ii. I.R.C. § 62: The definition of adjusted gross income
iii. I.R.C. § 63: Standardized or Itemized deductions?
iv. I.R.C § 67:
Two Percent Floor on Miscellaneous Itemized
Deductions
v. I.R.C § 68: Phaseout of Itemized deductions
1. Note that this effectively increases the marginal tax rate
Business Expenses
I.
Tax Code Provisions: I.R.C. §§ 162 & 212, generally
a. I.R.C. § 162: Trade or Business Expenses
i. I.R.C. § 162 in structural context
1. "Trade and Business" deductions are "above the line"
a. I.R.C. § 62(a)(1)
2. Other Above the Line Deductions
a. I.R.C. § 62(2): Trade or Business Deductions for
employees
i. I.R.C. § 62(a)(2)(A): Reimbursed Employee
Expenses
1. But see also § 62(c) (limiting
reimbursement arrangements)
ii. I.R.C. § 62(a)(2)(B): Expenses for "qualified
performing artists"
1. See § 62(b)
iii. I.R.C. § 62(a)(2)(C): Expenses of Officials
iv. I.R.C. § 62(a)(2)(D): Expenses for Elementary
and Secondary School teachers
1. See also § 62(d)
59
v. I.R.C. § 62(a)(2)(E): Expenses for members of
Armed Forces Reserve
b. I.R.C. § 62(a)(3): Losses from sale or exchange of
property
c. I.R.C. § 62(a)(4): Deductions for rents and royalties
d. I.R.C. § 62(a)(5): Deduction of Life Tenants and
beneficiaries
b. I.R.C. § 212: Expenses for Production of Income
i. History
1. In Higgins v. Commission (1941) the Supreme Court held that
an investor could not treat the management of his own
investments as a trade or business.
2. Section 212 was an attempt to overrule Higgins.
ii. I.R.C. § 212 in structural context
1. Section 212 expenses may be either below or above the line.
a. In general, they will be below the line.
b. If a section 212 expense is below the line, it will be a
miscellaneous itemized deduction
2. Above the line Section 212 expenses
a. Expenses of renting out property (that do not rise to
the level of a trade or business).
iii. I.R.C. § 212 in substance
1. Individuals may deduct the "ordinary and necessary"
expenses paid or incurred in the taxable year for
a. The production nor collection of income
b. Property management
c. Determining, collecting, or refunding a tax
c. § 162 and § 212 compared
i. How to distinguish between trade or business expense and an
income-producing activity
1. What is a "trade or business"?
a. There is no clear definition.
i. In Commissioner v. Groetzinger the Supreme
Court held that a professional gambler engages
in a trade or business if "involved in the
activity with continuity and regularity" and
with the primary purpose of earning income or
profit.
ii. The taxpayer cannot simply call something a
"trade or business" and make it so—the courts
will look beyond the label.
Levin v.
Commissioner (1987)
b. Guiding principles
60
II.
i. Should be an activity engaged in with
continuity and regularity
ii. The primary motive should be a desire for
profit
ii. Structural differences
1. Application
a. Section 162 applies to a trade or business
b. Section 212 applies only to individuals
2. Section 62 sorting
a. Section 162 expenses are above the line
b. Section 212 expenses are generally below the line,
miscellaneous itemized deductions.
"Ordinary and Necessary"
a. What is ordinary and necessary?
i. Code References
1. Substantive
a. I.R.C. § 162(a)
i. General rule
1. A deduction is allowed for
a. Ordinary and necessary expenses
b. Paid or incurred in the taxable
year
c. In carrying on
i. Start up expenses cannot
be deducted—the business
must
already
be
in
existence
ii. But see § 195 (allowing
amortization of certain
start up expenses)
d. a trade or business
b. I.R.C. § 212
i. Also contains the requirement that expenses be
"ordinary and necessary."
ii. Reg. § 212-1(d)
1. Requirements
for
ordinary
and
necessary
a. Must be reasonable in amount
b. Must bear a reasonable and
proximate
relation
to
the
production or collection of
taxable income.
ii. Doctrinal development
61
1. In Welch v. Helvering the Supreme Court held that denied a
deduction to a taxpayer who had paid off the debts of an old
bankrupt company in order to improve his reputation and
ability to get clients. The court explained that "the standard
set up by statute is not a rule of law; it is rather a way of life.
Life in all its fullness must supply the answer to the riddle."
2. In Gilliam v. Commissioner the Tax Court denied a deduction
for the expense of a criminal defense lawyer used to defend
the taxpayer from charges arising from violent behavior on
his plane ride to an art show.
iii. Synthesis/Summary
1. Necessary
a. Necessary simply means "appropriate and helpful."
Welch v. Helvering.
b. In determining whether an expense was appropriate
or helpful, courts use a subjective standard—they
look to see whether the taxpayer through they would
be appropriate and helpful. Welch v. Helvering
2. Ordinary
a. Three principles/themes
i. Ordinary means non-capital
1. Welch v. Helvering
a. Noted that the expense was like a
capital asset—the desire to
receive good will
2. See I.R.C. § 263(A)
3. See infra p. XXX
ii. Ordinary means non-personal
1. Welch v. Helvering
a. Noted that the expenses were
incurred
to
improve
the
taxpayer's own standing and
credit.
2. See I.R.C. § 262
3. See infra p. XXX
iii. Ordinary means not uncommon or bizarre
1. The expense must not be unusual and
related to the peculiar quirks of an
individual. Gilliam
2. The cost should further the trade or
business
iv. Purpose of the ordinary and necessary requirement
62
III.
1. Shuldiner suggests that the "ordinary" requirement is really
trying to distinguish between personal and business
expenses.
b. Specific expenses
i. Legal expenses
1. The "origin of the claim test"
a. Expenses for litigation are deductible if the origin of
claim lies in the conduct of the trade or business.
b. In United States v. Gilmore the Supreme Court used
this test to deny a legal expense deduction to a
taxpayer who claimed that the legal fees—incurred in
a divorce—were necessary to save his business.
2. Expenses to defend criminal charges that did not result in a
loss of employment are not deductible if the conduct that
gave rise to charges did not arise in the course of business.
ii. Payments to third parties
1. When payments to a third party are made to protect a
business, they may be deductible (notwithstanding
intimations to the contrary in Welch)
Reasonable Allowances for salary
a. Code Reference
i. Substantive
1. I.R.C. § 162(a)(1) specifically allows, as an ordinary and
necessary business, a deduction for "a reasonable allowance
for salaries or other compensation for personal services
actually rendered."
ii. Structural
1. Above-the-line
a. I.R.C. § 62 makes this an above the line deduction
because it is a "trade or business" deduction.
b. "Reasonable" allowances
i. Case treatment
1. The seven-factor test of reasonableness
a. The test (described in Exacto Spring Corporation v.
Commissioner)
i. The type and extent of the services rendered
ii. The scarcity of qualified employees
iii. The qualifications and prior earning capacity
of the employee
iv. The contributions of the employee to the
business venture
v. The net earnings of the employer
63
vi. The prevailing compensation paid to
employees with comparable jobs
vii. The prevailing compensation paid to
employees with comparable jobs
viii. Peculiar characteristics of the job
b. Criticism
i. The test is non-directive: there is no indication
of how the factors should be weighed
ii. The factors do not bear a clear relation to each
other or to the purpose of s 162(a)(1)
iii. The test invites courts to set themselves up as
super personnel departments.
iv. Because the test is non-directive, it leads to
arbitrary decisions
v. The unpredictability of the test imposes great
risk
on
corporations
determining
compensation for employees
2. The McCandless Rule
a. The Rule
i. Failure to pay a dividend necessarily means
that an employee's salary has been inflated
even if the salary seems reasonable. Charles
McCandless Tile Service v. United States (Ct. Cl.
1970)
b. Criticism
i. Investors may have many sound business
reasons not to pay a dividend, including a
desire to reinvest profits.
3. The "independent investor" test
a. The Test
i. Under this test, the court looks to see whether
the salary paid to an employee generates a
return.
ii. When the investors in a company are receiving
a fair higher return than they had any reason to
expect, the salary receives a presumption of
reasonableness
iii. Factors dissolving the presumption
1. where a company's returns are not due
to the employee's contributions
iv. Factors supporting the presumption
1. independent assessment and levying of
the salary by owners who have no
64
incentive to disguise a dividend as
salary
b. Criticism
i. This simply asks the court to be a super
investment bank instead of a super personnel
department.
4. Synthesis/Summary
a. Note that the Tax Court continues to use the sevenfactor test.
b. Factors to consider
i. Whether
the
corporation,
despite
its
profitability, has never issued a dividend.
1. The McCandless rule has been criticized
but still remains.
ii. Whether
the
money
given
has
a
"compensatory"
intent
(versus
simple
distribution of excess profits).
iii. Whether the corporation's investors receive a
reasonable rate of return in their personnel
investment.
c. Improper accumulation of Surplus
i. Note that I.R.C. §§ 531-537 provide for a
scheme to deal with extreme accumulations of
assets.
ii. Purpose of the reasonableness requirement
1. Historical origins
a. Shuldiner notes that if § 162(a)(1) did not exist,
taxpayer would probably still be able to deduct
reasonable salaries as a business expense.
b. The provision was originally added during World
War I to reduce the excess profits tax
2. The "reasonableness" test
a. § 162(a)(1) currently serves as a check on taxpayer
attempts to re-characterize non-deductible expenses
as deductible "salary."
c. Tax treatment of recipient
i. Current approach
1. The "reasonableness" test is really a way to make sure that a
transaction is characterized in an appropriate way for tax
purposes—not necessarily as the taxpayer characterizes it.
a. See Smith v. Manning (payments made by owner to
daughter who worked in the business that were held
65
to be unreasonable could not be treated as excludible
gifts because there was no donative intent.)
ii. Shuldiner
1. The correct approach is not to look at whether the
compensation received is "reasonable." Instead, the court
should be consistent: allow a deduction for salary, but not
one for the portion of the amount that can be designated as a
gift, etc.
d. "Reasonable" allowances: specific situations
i. Unreasonable rent payments
1. this is not provided for by statute
2. Generally, in this situation a court will recharacterize the
transaction to reflect its substance
ii. Repayment of Unreasonable Salary
1. The Eight Circuit has concluded that a repayment agreement
is evidence of unreasonableness. Charles Schneider & Co. v.
Commissioner (8th Cir. 1974).
iii. Executive Compensation
1. Closely held v. Publicly held corporations
a. In practice, the problem of salary being disguised as
dividends is more likely to occur in closely held
corporations in which there are fewer checks
b. While the statute makes no distinction, the IRS never
challenges the salaries of CEOs of big corporations.
Corporate governance mechanisms, independent
directors, and shareholder rights, along with the stock
market itself, are seen as correctives.
2. "Certain Excessive Employee Remuneration:"
I.R.C. §
162(m)
a. Section 162(m) denies a deduction for compensation
in excess of $1 million paid to the CEO or the four
most highly compensated employees of a publiclyheld corporation UNLESS the compensation is
performance based.
iv. Undercompensation
1. In the case of an S-Corporation or a partnership, there might
be an incentive to undercompensate in order to shift income
from a high-bracket shareholder to a related shareholder or
partner.
2. The Service has authority to prevent this.
a. I.R.C. §§ 706, 1366(e).
v. Payments other than salary
66
IV.
Public Policy Exceptions
a. Tax Code References
i. I.R.C. § 162(c), (f),(g): expenses not deductible for reasons of public
policy
1. Illegal payments to government officials or employees
2. Bribes and kickbacks
3. Fines and Penalties
4. Treble damage payments under the Antitrust laws
ii. I.R.C. § 280E
1. Drug trade
a. No deduction allowed for any amount paid or
incurred during the taxable year in carrying on any
trade or business when the trade or business consists
of trafficking in controlled substances
b. Scope
i. Illegal businesses, generally
1. The Supreme Court has held that illegal businesses are to be
taxed the same as legal businesses. United States v. Sullivan
2. The court has expressed severe doubts about the propriety
of using the tax code to punish criminal violations.
a. See United States v. Tellier ("To deny a deduction for
expenses incurred in the unsuccessful defense of a
criminal prosecution would impose such a burden in
a measure dependent not on the seriousness of the
offense or the actual sentence imposed by the court,
but on the cost of the defense and the defendant's
particular tax bracket. We decline to distort the
income tax laws to serve a purpose for which they
were neither intended nor designed by Congress.")
ii. Congressional Intent
1. Congress intended that the public policy limitations in § 162
be the exclusive grounds for denying a deduction. This
severely limits judicial discretion in making a public policy
exception.
2. See Reg. § 1.162-1(a): "A deduction for an expense which
would otherwise be allowable under section 162 shall not be
denied on the grounds that allowance of such deduction
would frustrate a sharply defined public policy."
iii. General Standard: When should a public policy exception be
recognized?
1. United States v. Tellier: A public policy exception should only
be recognized when
67
a. Allowance of the deduction would "frustrate sharply
defined national or state policies proscribing
particular forms of conduct
b. The public policy must be a national or state policy
evidenced by governmental declaration
c. "the test of nondeductibility always is the severity and
immediacy of the frustration resulting from the
allowance of the deduction."
c. Substantive Exceptions
i. Criminal Defense
1. Expenses for criminal defense ARE deductible when
a. It meets the "origin of the claim" test
2. See United States v. Tellier (allowing a deduction for the
expense of hiring a criminal defense attorney to defend
against securities fraud, noting that no public policy is
violated when taxpayer exercises his constitutional right to
be represented by an attorney).
ii. Fines
1. I.R.C. § 162(f): disallows any deduction for a fine imposed
for violation of the law
2. Courts, however, have distinguished between compensatory
and punitive fines. Compensatory fines are deductible.
a. See Reg. § 1.162-21(b)(2) (compensatory fines are not
"fines" or "penalties" under § 162).
b. See Tank Truck Rentals v. Commissioner (denying a
deduction for fines incurred for violating
Pennsylvania weight limitations for trucks).
c. But see True v. United States (denying a deduction for a
fine that had "deterrent and retributive" functions
even if it also had compensatory and remedial
aspects.)
iii. Payments to third parties
1. Where payments to a private party are akin, or in lieu of, a
fine, a deduction is not allowed.
a. Examples
i. Restitution to victims of fraud
ii. Court-order charitable donations
iv. Other:
1. Losses
a. Losses under § 165 that would frustrate sharply
defined national or state policies proscribing
particular types of conduct.
68
V.
VI.
20
Lobbying Expenses
a. Code References
i. I.R.C. § 162(e)20
b. Summary of general rules/principals
i. General Rule
1. The general rule is that lobbying expenses are
nondeductible.
ii. Exceptions
1. Lobbying expenses for local legislation
2. de minimis—in house expenditures that do not exceed
$2,000
c. Constitutional Limitations
i. See Graetz 244
d. "Advertising"
i. See Graetz 244
Domestic Production Deduction
a. Code Reference
i. I.R.C. § 199
1. General Provision
a. Provides that a taxpayer may take a deduction equal
to 9% of the lesser of
i. Taxable income
ii. "qualified production activities"
1. generally: manufacturing, production,
extraction.
2. This
is
a
somewhat
arbitrary
designation
2. Phase-out
a. The amount of the deduction is phased in until the
full 9% applies in 2010
3. Limitations
a. The deduction cannot exceed 50% the amount paid in
wages for the taxable year
b. General notes
i. Purpose of Section 199
1. U.S. taxpayers are subject tax on their worldwide income.
General Rule: No deduction is allowed for any amount paid or incurred in connection with
1. Influencing legislation
2. Participating in, a political campaign or on behalf of a candidate for public office
3. Any attempt to influence the general public, or segments thereof with respect to elections,
legislative matters or referendums
4. A direct communication with an executive branch official to influence official actions
69
VII.
2. Businesses thought this put them at a competitive
disadvantage, since many foreign corporations are not taxed
that way.
a. Congress responded with a provision to benefit
exports. This was declared illegal by the WTO
b. Congress responded to this with a much broader
deduction for domestic production intended to
reduce tax rates on manufacturing.
ii. Criticism
1. Shuldiner notes that this is ill-advised. It is very difficult to
define "manufacturing." This leads to a lot of arbitrary linedrawing.
2. Economic distortion
a. Businesses will often try to inflate the price of their
manufacturing operations to transfer profits from
their sales divisions.
3. The arbitrariness of the definition of manufacturing creates a
lot of expensive litigation.
Employee Business Expenses: The Structural Treatment of Deductions
a. General
i. Statutory Flow
1. Step one: § 162
a. determine whether the expense is ordinary and
necessary to carry out the trade or business
b. Step 1.5—are there limitations on the deductible
business expense? (i.e., § 274—only 50% of food
deductible)
2. Step two: § 62
a. Determine whether the expense is above or below the
line
3. Step Three: §67
a. Determine whether a below-the-line expense is a
"miscellaneous itemized deduction"
b. Employee Expenses under § 162
i. The expense must be part of a trade or business, not personal.
ii. See infra, p. XXX-XXX
c. Itemized Deductions under §§62, 68
i. Reimbursements
1. Reimbursed expenses are subtracted from gross income
(above the line). § 61(a)(2)(A).
a. The reimbursement itself can be initially included in
income and then offset with the deduction, or the
entire transaction can be ignored. Reg. § 1.62-2(c)(4)
70
2. Unreimbursed expenses are available only if the taxpayer is
an itemizer.
a. If an expense is reimbursable, but is NOT reimbursed,
the expense is nondeductible. Cavitt v. Commissioner
ii. Purpose of the distinction
1. administrative simplicity/efficiency
a. Having the employer reimburse the employee makes
it more likely that the expense was actually business
related.
2. Note that the expense must still be "reasonable and
necessary"
d. Miscellaneous Itemized Deductions
i. I.R.C. § 68
1. Defines miscellaneous itemized deductions by exclusion. A
miscellaneous itemized deduction is NOT
a. Interest (§ 163)
b. Taxes ( § 164)
c. A casualty or theft loss (§ 165)
d. A charitable donation (§ 170)
e. A medical expense (§ 213)
f. An impairment-related expense
g. An estate tax (§ 691(c))
h. A deduction allowed in connection with personal
property used in a short sale
i. A mortality gain (§ 72)
j. Etc—see § 67(b)
2. The 2% floor
a. I.R.C. § 67(a)
i. To deduct a miscellaneous itemized deduction,
the aggregate of the deduction must exceed 2%
of AGI
b. Purpose
i. Revenue creation
1. § 67 either increases the effective tax rate
or limits deductions, depending on how
you want to characterize it.
c. Effect
i. Below the floor
1. If you are below the 2% floor, then this
provision does not affect your tax rate,
but it does affect your ability tot take
deductions.
ii. Above the floor
71
1. If you are above the floor, your
deductions are limited, so your AGI—
and potentially your tax rate—may be
increased.
3. The 3% "haircut"
a. I.R.C. § 68
i. Limits the total amount of certain deductions
for high-bracket taxpayers
ii. The mechanics
1. Threshold: $100,000 (indexed)
2. Itemized deductions are reduced by 3%
of the excess AGI over the threshold.
3. Reduction cannot exceed 80% of the
deductions
Distinguishing Personal and Business Expenses
I.
General
a. Nature of the distinction
i. Importance
1. The income tax is a tax on net income—this requires that the
expenses of producing that income be deducted.
2. If personal expenses were deductible, the income tax would
be severely undermined. It would essentially tax only
savings at that point.
ii. Arbitrary nature
1. Because it is difficult to separate personal from business
consumption, the IRS often relies on somewhat arbitrary
bright lines.
2. At other times, Congress simply decides to allocate the
personal and business elements by fiat
a. Example: I.R.C. § 274(n) (limiting meal deductions to
50%)
b. Policy issues
i. Equity
1. Certain occupations will find it easier to make deductions
2. Higher income taxpayers would have more opportunities
for deduction.
ii. Efficiency
1. Allowing personal deductions would distort economic
decision making by encouraging spending on consumption.
c. Statutory Architecture
i. I.R.C. § 162(a)
72
1. allows a deduction for "ordinary and necessary business
expenses paid or incurred ruing the taxable year"
ii. I.R.C § 262(a)
1. "Except as otherwise expressive provided in this chapter, no
deduction shall be allowed for personal, living or family
expenses."
iii. I.R.C. § 274
1. Expressly disallows certain deductions.
2. See infra p. XXX
iv. I.R.C. § 280A
1. Regulates expenses for business uses of a home
2. see infra p. XXX
v. I.R.C. § 280F
1. disallows deductions for "luxury" automobiles
2. see infra p. XXX
d. The relationship between §§ 162 and 262
i. Hantzis v. Commissioner
1. "Section 262 of the Code. . . declares that except as otherwise
provided in this chapter, no deductions shall be allowed for
personal, living or family expenses." Section 162 provides
less of an exception to this rule than it creates a separate
category of deductible business expenses."
ii. Moss v. Commissioner
1. "In closes contests it is essential to bear in mind that the
provisions of § 262 take priority over section 162."
e. Tests for Distinguishing
i. Clothing
1. In Pevsner v. Commissioner (5th Cir. 1980) the Court, adopting
an objective test, disallowed a deduction for the purchase of
expensive Yves St. Laurent clothing, purchased by an
employee as required by her employer.
a. Three-part test (Donnelly v. Commissioner)
i. Clothing is deductible as a business expense
only if
1. the clothing is of a type specifically
required as a condition of employment
2. it is not adaptable to general usage as
ordinary clothing
3. it is not so worn
b. The objective test
i. "Under an objective test, no reference is made
to the individual taxpayer's lifestyle or
personal taste.
Instead, adaptability for
73
personal or general use depends upon what is
generally accepted for ordinary street wear."
ii. "Inherently Personal" Standard
1. Some courts have disallowed deductions after concluding
that they are "inherently personal"
a. See Fred W. Amend v. Commissioner (7th Cir. 1971)
(disallowing deduction for payments by business
made to a minister for business advice based on
personal prayer).
iii. "For profit" standard: Hobby Losses and § 183
1. General
a. The hobby loss provision prevents a taxpayer from
deducting losses incurred in activities that are really
personal in nature (i.e., mud wrestling).
b. The tension here is between § 165 and § 183
i. § 165 allows a deduction for losses incurred in
a trade or business.
§ 183 disallows a
deduction for any activity engaged in "not for
profit."
2. I.R.C. § 183
a. General Rule
i. "In the case of an activity engaged in by an
individual or an S corporation, if such activity
is not engaged in for profit, no deduction,
attributable to such activity shall be allowed. . .
."
ii. Reg § 1.183-1(d)(1): What is an activity?
1. Determined by taking all of the facts
and circumstances into account
a. The most significant facts
i. Degree of organizational
and
economic
interrelationships
of
various undertakings
ii. The business purpose
served by carrying on
various
undertakings
separately or tighter in a
trade or business or
investment setting
iii. The similarity of the
various undertakings
74
2. Generally, the commissioner accepts the
taxpayer's characterization of several
activities as either one activity or as
separate activities
a. This is not acceptable where it is
artificial
and
cannot
be
reasonable supported
3. Multiple activities
a. If the taxpayer is engaged in two
or more separate activities,
deductions and income from
them are not aggregated for
applying section 183
4. Farms
a. Where land is purchased for
speculation, but farming also
occurs, the holding of the land
and the farming are considered
one activity only if the farming
educes the net costs of carrying
the land.
iii. Reg. § 1.183-1(d)(2): Allocation of expenses
1. If the taxpayer is engaged in more than
one activity, an item of deduction or
income may be allocated between two
or more of the activities.
b. Exceptions
i. Deductions that would be allowed without
regard to profit-seeking21
ii. Deductions that would be allowed for profitseeking activities, but only if the activity was
actually engaged in for profit and only to the
extent that the gross income from the activity
exceeds the deductions
c. Not for profit defined
i. Defines the terms as any activity other than
one for which expenses would be deductible
under § 162 and § 212.
d. Presumption
Notes that this is a pro-taxpayer provision. It allows a deduction for expenses
occurred in a not-for-profit exercise (i.e., real property taxes on a farm).
21
75
i. If gross income from the activity exceeds
deductions for the activity for 3 or more of the
taxable years in a period of 5 consecutive
taxable years, it is presumed to be "for profit."
3. Plunkett v. Commissioner
a. In Plunkett v. Commissioner (Tax Ct. 1984), the Court
held that the taxpayer could not deduct losses
associated with mud-racing because the profit
potential was low and unrealistic, but allowed a
deduction for truck-pulling activities because the
taxpayer had a bona fide objective of making a profit.
i. Reg. § 1.183-2(b):
Nine-Factor tests to
determine whether an activity is engaged in for
profit
1. The manner in which the taxpayer
carries on the activity
2. The expertise of the taxpayer or his
advisors
3. The time and effort expended by the
taxpayer in carrying on the activity
4. The expectation that the assets used in
the activity may appreciate in value
5. The success of the taxpayer in carrying
on other similar or dissimilar activities
6. The taxpayer's history of income or loss
with respect to the activity
7. The amount of occasional profits, if any,
which are earned
8. the financial status of the taxpayer
9. whether elements of personal pleasure
or recreation are involved
ii. The Dreicer Standard
1. "Did the individual engage in the
activity with the actual and honest
objective of making a profit?"
2. This standard is objective—it looks at all
of the facts and circumstances
f. Working Condition Fringe v. Deductible Business Expense
i. § 132(a)(3) allows for the exclusion of a working condition fringe,
defined as a property or service that would be deductible by the
employee under § 162.
g. Public Employees
i. General rule: a trade or business must be profit-seeking.
76
ii. Exception: public employees
1. In Frank v. United States (9th Cir. 1978) the Court allowed
Franke to deduct expenses incurred as an unpaid aid to a
United States Senator.
h. Domestic Services and Child Care
i. I.R.C. § 21: Expenses for Household and Dependent Care Services
Necessary for Gainful Employment
1. Provides a NONREFUNDABLE tax credit
a. Who qualifies?
i. Those with one or more "qualifying
individuals"
ii. I.R.C. § 21 (b)(1): qualifying individual
1. Dependent less than 13 years old
2. Dependent who is physically or
mentally incapable of caring for himself
who has the same principal place of
abode as the taxpayer for MORE than ½
the taxable year
3. The spouse of the taxpayer if the same
conditions as above are met
iii. Those with "employment-related expenses"
1. See I.R.C. § 21(b)(2)
2. See Brown v. Commissioner (employment
motive must be present, but need not be
exclusive or dominant motive).
2. Amount of Credit
a. Credit Amount Ceilings
i. One dependent: $3,000 of expenses * 35% =
$1,050
ii. More than one: $6,000 * 35% = $2,100
b. Expense limitation
i. Cannot exceed the LESSER of
1. An individual's earned income
2. The earned income of a spouse
3. Phaseout
a. Threshold: $15,000 or less
b. Maximum credit percent: 35% * (dependent care
expenses)
c. Phaseout amount: 1% per $2,000
d. Ceiling: Taxpayer with income of $43,000 will receive
credit for 20% of dependent care expenses
4. Policy issues
77
II.
a. Very few people are likely to be able to take
advantage of the credit because of its nonrefundable
nature—it is unrealistic to expect someone making
$15,000 a year to spend $6,000 on child care!
5. Cross-reference
a. The maximum amount of the dependent child care
credit under § 21 is reduced by amounts excluded
from income under § 129
ii. I.R.C. § 129: Dependent Care Assistance Programs
1. General
a. Allows an employee to exclude up to $5,000 from
income for dependent care services provided during a
taxable year by an employer.
2. Limitation
a. The amount excluded cannot exceed the LESSER of
earned income of the employee in the taxable year or
the earned income of the employee's spouse in the
taxable year
3. Dependent care assistance program
a. See I.R.C. § 129(d)
Travel Away From Home
a. General Rule for Transportation and commuting expenses
i. The "costs" of being an employee (clothes, commuting, food at
work) are usually not deductible.
ii. Justification
1. Your decision to live in a certain place is a personal decision
because work places are
b. "While away from home"—food and lodging
i. I.R.C. § 162(a)(2)
1. "There shall be allowed as a deduction all the ordinary and
necessary expenses paid or incurred during the taxable year
in carrying on any trade or business including traveling
expenses (including amounts expended for meals and
lodging other than amounts which are lavish or extravagant
under the circumstances) while away from home in the
pursuit of a trade or business."
ii. Purpose of deduction
1. § 162(a)(2) is intended to distinguish everyday living
expenses from those incurred by business travel.
2. To mitigate the burdens of a taxpayer who must maintain
two abodes—to ease the burden of duplicative expenses.
iii. The overnight rule
78
1. In United States v. Correll (1967) the Supreme Court upheld
the commissioner's rule that the phrase "away from home"
does not include any trip not requiring "sleep or rest" no
matter how far away the taxpayer travels.
iv. Temporary job doctrine
1. Where a taxpayer leaves for a temporary job at another
location, the taxpayer's regular residence is treated as his
home, as long as the temporary job is not expected to last
longer than one year.
v. What is a "home"?
1. IRS's position
a. "home" for the purposes of § 162(a)(2) is the
taxpayer's principle place of business.
2. In Hantzis v. Commissioner (1st Cir. 1981) the Court held that
a law student whose lived with her husband in Cambridge
during the school year, could not deduct the costs of
traveling to and living in New York to work as a legal
secretary.
a. The Flowers test
i. A traveling expense is deduction ONLY if it is
1. Reasonable necessary
2. Incurred while away from home
3. Necessitated by the exigencies of
business
b. "While away from Home"
i. The court holds that to be "away from home in
the pursuit of a trade or business" the taxpayer
must establish
1. A business relation to the place claimed
as home
2. A business relation to the location of
temporary employment
3. That the relation is sufficient to support
a finding that the duplicative expenses
are necessitated by business exigencies.
3. Second Circuit approach
a. You home is, indeed, your home: the focus is on
whether the expenses are incurred in the pursuit of a
trade or business.
4. No regular abode
a. No deduction. James v. United States (9th Cir. 1962)
vi. Two-earner families
79
1. The decision not to live separately from a spouse is
considered personal, even if the taxpayer incurs significant
travel costs in pursuit of a trade or business that takes place
mostly in another city.
c. Transportation
i. General rule
1. Transportation expenses may be deducted when the
taxpayer is away from home for business (see above).
2. The cost of commuting from home to work is a
nondeductible personal expense. Reg. § 1.162-2(e).
ii. Purpose of general rule
1. The work location is fixed and the decision to live beyond
walking distance is a personal choice. Commissioner v.
Flowers (1946)
iii. Commuting
1. McCabe v. Commissioner
a. In McCabe v. Commissioner the Court held that a police
officer could not deduct his commuting expenses
when his business required that he carry a gun but,
because the State of New Jersey would not allow a
permit, he was required to take a longer route
i. The Flowers Test
1. must be reasonable and necessary
2. must be away from home
3. must be incurred in pursuit of business
ii. The court held that the expense was not
incurred in the pursuit of business-rather, it
was incidental to the taxpayer's decision to live
in a suburb.
2. Tools of the trade
a. In Fausner v. Commissioner (1973) the Court held that a
taxpayer may deduct the extra expense incurred for
transporting job-required tools to and from work, so
long as the costs are allocated between business and
personal expense.
b. Revenue Ruling 75-380: necessity means appropriate
and helpful.
3. Working and driving
a. In Pollei v. Commisioner (10th Cir. 1989) the Court held
that a police officer who begins active patrol when
she departs from work may deduct the costs of
driving to and from work
4. Commuting to temporary employment
80
iv.
v.
vi.
vii.
viii.
a. Rev. Rul. 99-7
i. A taxpayer may deduct daily transportation
expenses incurred in going between the
taxpayer's residence and a temporary work
location outside the metropolitan area where
the taxpayer lives and normally works.
1. Generally, the expense incurred in going
to a temporary work location within the
metropolitan area is a nondeductible
commuting expense
ii. If a taxpayer has more than one regular work
location, the taxpayer may deduct daily
transportation expenses incurred in going
between the taxpayer's residence and a
temporary work location in the same trade or
business.
iii. If a taxpayer's residence is the taxpayer's
personal place of business, the taxpayer may
deduct daily transportation expenses incurred
in going between the residence and another
work location in the same trade or business.
Transportation between multiple business
1. When a taxpayer has two businesses, the service concludes
that one of them is "home" (the principal place of business)
and the other is a minor place of business—expenses can
only be deducted for the latter.
Mixed personal/business trips
1. If a trip is for mixed business and personal reasons, travel
costs are deductible only if the trip is primarily for business
reasons.
2. See United States v. Gotcher, supra, p. XXX
Employer-provided transportation
1. If an employer pays for commuting expenses, the payments
generally constitute gross income
a. § 132(d) does not apply because the amount would
not be deductible if paid by the employee
2. Regulations allow for the provision of transportation to
employees if the transportation is furnished due to unsafe
conditions.
Luxury Expenses
1. See I.R.C § 280F
Foreign Conventions/Travel
1. I.R.C. § 274
81
a. § 274(c): travel
i. Provides that no deduction is allowed for the
portion of expenses no allocable to the trade or
business (under regulations issued by
Treasury)
ii. Exceptions
1. travel that does not exceed one week
2. the portion of time not allocated to the
trade or business is less than 25% of
total time traveled
b. § 274(h): conventions
i. No deduction is allowed for expenses allocable
to a convention outside North America unless
it is just as reasonable to hold the meeting
outside North America as it is inside.
ii. Factors taken into account
1. the purpose of the meeting and its
activities
2. the purposes and activities of the
sponsoring groups
3. the residence of the active members of
the sponsoring groups and the places at
which other meetings have been held.
d. Limitations
i. I.R.C. § 274(d): Substantiation
1. No deduction is allowed under 162 or 212 for
a. Traveling expense
b. Entertainment
c. Amusement
d. Recreation
e. Gifts
f. Listed property
2. Unless the taxpayer substantiates the expenses with
adequate records to corroborate the taxpayer's own
statement.
ii. I.R.C. § 274(m): Additional limitations on travel expenses
1. No deductions for
a. Luxury water transportation
b. Travel as education
c. Travel expenses for a spouse on business unless
i. The spouse is an employee
ii. The travel of the spouse is for a bona fide
business purpose
82
iii. The expense would otherwise be deductible by
the spouse
iv. See United States v. Gotcher, supra, p. XXX
III.
Meals and Entertainment
a. General
i. Business/Personal
1. The problem with meals and entertainment used for
business purposes is that there will always be a personal
consumption element.
ii. Fringe Benefits
1. Note that a meal or business that is not deductible under §
162 may be excludable under § 132 as a fringe benefit (or
under § 119 as a meal furnished for the convenience of the
employer.
b. Statutory architecture: I.R.C. § 274
i. § 274(a): Entertainment, Amusement and Recreation
1. No deduction is allowed for an amusement, entertainment
or recreation activity unless the item was directly related to a
substantial and bona fide business discussion
2. no deduction allowed for club dues
ii. § 274(e): miscellaneous
1. a deduction may be allowed for the following if otherwise
provided for in the code
a. food and beverages for employees
b. expenses treated as compensation
c. reimbursed expenses
d. recreation expenses for employees
i. But see Danville Plywood Corporation v. United
States (Fed. Cir. 1990) (not allowing a
deduction for a Mississippi River Cruise to the
Super Bowl after concluding that the purpose
of the trip was for business rather than
employees).
e. Exployee business meetings
f. Meetings of business leagues
g. Expenses for items made available to public
h. Entertainment sold to customers
i. Expenses includible in income of persons who are not
employees.
iii. § 274(g): entertainment facilities
iv. § 274(k): business meals
1. No deduction allowed unless
a. The expense is not lavish or extravagant
83
c.
d.
e.
f.
b. The taxpayer is present at the furnishing of the food
or beverages
v. § 274(l): Limitations on entertainment tickets
1. Deduction limited to the face value of the tickets
vi. § 274(n)
1. Any deduction for food and beverage and an entertainment,
amusement or recreation, is limited to 50% of the item's cost
2. Purpose
a. This is an allocative rule—simply allocates 50% of the
cost to personal expenses and 50% to business
3. applies to meals while away from home
4. if the taxpayer is reimbursed, the 50% limitation applies to
the person who makes the reimbursement.
a. If the taxpayer is unreimbursed, the 50% limitation
still applies, as well as the § 67 limitation.
Moss v. Commissioner
i. In Moss v. Commissioner (Tax Ct. 1983) the Court held that a partner
at a Chicago law firm could no deduct the costs of a daily business
lunch under § 162, even though the lunches were concede to have a
business purpose because the taxpayer could not establish that the
expense was "different from or in excess of that which would have
been made for the taxpayer's personal purposes.
1. The Sutter test
a. A deduction is permissible where the expense is
"different from or in excess of that which would have
been made for the taxpayer's personal purpose."
Sutter v. Commissioner (Tax Ct. 1953).
Employer-subsidized meals
i. Note that meals provided "for the convenience of the employer" are
excluded from gross income under § 119.
ii. See supra p. XXX
Meals with clients
i. When is a business meal "directly related" to business?
1. The legislative history implies that the meal is directly
related if
a. the taxpayer has more than a general expectation of
deriving income or a specific business benefit
b. the taxpayer has engaged in business discussions
during or directly before or after the meal or
entertainment
c. the principal reason for the expense was the active
conduct of the taxpayer's trade or business.
The taxpayer's meal
84
IV.
i. The portion of the taxpayer's meal that costs more than he would
normally spend on himself is deductible. The service only seeks to
enforce this rule in cases of abuse. Rev. Rule. 63-144
g. Reform
i. Equity concern
1. The deduction for meals and entertainment expenses are
generally thought to be captured by mostly high-income
taxpayers who can take advantage of business opportunities.
ii. Reforms are usually opposed by restaurant employee unions.
Home Offices
a. General
i. In Commissioner v. Soliman (1993) the Court held that an
anesthesiologist could not deduct the cost of a room used
exclusively as an office for administrative tasks
1. "principal place of business"
a. no objective, clear formula
b. two primary considerations
i. the relative importance of the activities
performed at each business location
ii. the time spent at each place
c. The point where services are delivered is given great
weight
ii. Congress responded to Soliman by amending § 280A
b. "Exclusive use"
i. A home office expense may be deducted if a room is divided off
spatially, but not if the room is divided temporally—the office must
be used exclusively for business.
c. I.R.C. § 280A
i. Purpose
1. Prior law often allowed a business deduction for expenses
attributable to the home even though no additional costs
resulted from the business use.
2. the various standards applied by the court and the IRS were
considered confusing to taxpayers
ii. General Rule
1. No deduction is allowed for the used of a dwelling unit
which is also used by the taxpayer during the taxable year as
a residence
iii. § 280A(c): Requirements for deduction
1. Must be used exclusively and on a regular basis
a. As the principal place of business for a trade or
business
85
V.
i. PPB="a place of business which is used by the
taxpayer for the administrative or management
activities of any trade or business of the
taxpayer if there is no other fixed location of
such trade or business where the taxpayer
conducts
substantial
administrative
or
management activities of such trade or
business."
b. As place used by patients, client, or customers in
meeting or dealing with the taxpayer in the normal
course of his trade or business
i. If a separate structure, must be used in
connection with trade or business.
iv. Limitations on deduction
1. 280A is limited to the costs of running the home office
(utilities and depreciation)
2. Home mortgage interest is allocated between the personal
and business use
3. I.R.C. § 280A(c)(5)
a. Ceiling on deduction
i. The deduction cannot exceed the excess of
1. Gross income derived from the use – the
deductions allocable to the use
b. Carryover
i. Any amount not deducted can be taken into
account as a deduction in the next year.
v. vacation homes
1. Definition
a. A vacation home is a dwelling unit used by the
taxpayer for more than 14 days or 10% of the number
of days the unit is rented.
b. Expenses are pro-rated and deducted up to the
amount of the rent reduced by interest and taxes
Synthesis/Summary
Capitalization
I.
General
a. The distinction between expenses and capital expenditures
i. Capitalization
1. When an expense is "capitalized" it is added to the basis of
2. These expenses are then recovered when the asset is sold or
through depreciation/amortization
86
ii. Expenses
1. Expenses (i.e., most expenses under § 162) are immediately
deducted—the cost is recovered immediately.
iii. This distinction is really about time, but it is extremely significant.
b. The impact of the capitalization requirement
i. General importance: tax deferral
1. Why capitalization is necessary to avoid imposing a
consumption tax
a. All savings and investment would be subtracted from
receipts to determine consumption during the year.
Without a capitalization requirement, investment
would be immediately deductible.
2. Capital gains
a. If long-term capital gains are treated preferentially,
but long-term capital losses are restricted, then
conversion of a cost from capital gains to expense or
vice-versa will affect the total tax burden.
3. Value of tax deferral
a. See Graetz, 288-289 (showing the value of deferred
income)
b. The total value of the tax deferral will depend on
three factors
i. Tax rates
ii. Interest rates
iii. Length of the deferral
ii. The value of the tax deferral: three characterizations
1. Equivalence to a tax-free loan
a. Example
i. facts
1. τ = 50%
2. Asset = $100
3. Time = 10 years
ii. Result
1. Savings if immediately expensed: $50
2. Amount realized when asset sold: $100
3. It is as if the taxpayer received a loan of
$50 for ten years
2. Equivalence to a reduction of tax rates or tax forgiveness
a. Example
i. facts
1. τ = 50%
2. Asset = $100
87
Interest income
No tax
100
Tax
67
Interest Income
Pre-tax
1000
Tax
333
After tax
667
Interest Income
Pretax
1500
3. Time = 10 years
4. Tax free loan = 50$
ii. Result
1. If the taxpayer places $27.92 of the $50
in a bank account at 12% interest, he will
have $50 at the end of ten years (after
withdrawing money each year for taxes
on interest income).
2. The ten-year deferral is thus worth
$27.92. $22.08 is forgiven.
3. The effective tax rate decreases from
50% to 27.9%
3. Equivalence to a tax-free return on investment
a. If investment costs are immediately deducted instead
of capitalized and recovered over time, the income
from the asset will be tax free.
b. Assumptions
i. Constant tax rates
ii. The deduction can be taken immediately
iii. Tax savings is invested at a return equal to the
original investment
c. Example
i. Facts
1. Bond: $1000
2. Bond income: $100 a year
3. Bond interest rate: 10%
4. τ: 33%
a. As a result, yield on the bond
should only be 6.7%
ii. Basic tax treatment
Yield
100
100
10%
67
67
6.7%
iii. Tax treatment with immediate deduction
Yield
100
100
10%
33
33
67
67
10%
iv. Immediate deduction, with gross-up (tax
saving invested)
1. Gross-up: 1/ 1-τ [3/2(1500)]
Yield
150
150
10%
88
Investment of (500)
tax saving
Your share of 1000
investment
II.
(50)
(50)
100
100
10%
v. Essentially, the government has co-invested in
the asset.
d. Example 2: Losses
i. Facts:
1. Total investment: $10,000
2. τ = 50% ($5,000)
3. Return on investment: $2,000
ii. Results
1. Intuitively, a loss of $8,000.
2. But amount realized = $2,000 – 0 =
$2,000 (because costs were not included
in basis)
Capitalization, Retirement, and IRAs
a. Code Architecture
i. I.R.C. § 25B: Low Income Retirement Credit
ii. I.R.C. § 72(t): Tax Penalty for Early Distribution
iii. I.R.C. § 219: Retirement Savings
iv. I.R.C. § 408A: Roth IRAs
v. I.R.C. § 408: IRAs
b. Roth IRAs v. Traditional IRAs
i. See attached table
ii. Which is preferable?
1. Conventional IRA: deduct at higher tax rate and then
withdraw later at a lower tax rate (when you retire)
2. Roth IRA: No deduction when at higher rate, but tax-free
withdrawal.
a. So whether this is preferable will depend on your
predictions for future tax rates. (if you think they will
be lower in future, better to take deduction now).
iii. Limitations
1. § 408A(c)(2)
a. Limits the contribution to $4,000. Since a deduction is
not immediately taken, this means that the
government does not "co-invest" with you—your
share of the investment is thus larger.
2. Income limitations
a. Roth IRA phaseout
89
III.
i. The IRA is phased out for single taxpayers
with income between $95,000 and $110,000 (or
$150,000- $160,000 if married filing jointly)
The distinction between deductible expenses and capital expenditures
a. Code Architecture
i. I.R.C. § 263: Capital Expenditures
1. General Rule
a. No deduction allowed for "any amount paid out for
permanent improvements or betterments made to
increase the value of any property or estate."
2. Exceptions
a. Mines
b. R&D
c. Soil and water conservation
d. Fertilizer
e. Expenditures for handicapped access
f. Etc.
ii. I.R.C. § 263A: Capitalization of certain expenses
1. Applicable Property
a. Real and tangible property produced by taxpayer
b. Property acquired for resale
i. Cross-reference: § 1221(a)(1)
2. Expenses capitalized
a. "direct costs"
b. proper share of "indirect costs"
3. Exceptions
a. Capitalization not required for personal use assets
b. Capitalization is not required for research and
development expenses under § 174
4. § 263A(f)Interest
a. Requires the capitalization of interest allocable to
property with a long useful life, a production period
exceeding two years, or a cost exceeding $1,000,000
and one year.
b. Effect
i. This prevents an immediate deduction of
interest from income.
ii. § 263A(f)(2): No borrowing
1. If you do not borrow to finance the
construction, this rule looks at all other
debt and capitalizes the interest your
paid for other debt—this is an
imputation rule.
90
IV.
b. Important questions/principles
i. What is the nature of the asset?
1. tangible v. intangible
ii. What is the connection with the asset?
1. is the cost "direct" or indirect
iii. Nature of the cost
1. internal or external
The Acquisition and disposition of assets
a. General Rules
i. "The cost of acquisition, construction, or erection of buildings,
machinery, and equipment, furniture and fixtures, and similar
property having a useful life substantially beyond the taxable year"
is to be capitalized. Reg. § 1.263(a)-2(a)
b. Effects of Capitalization
i. Capitalization reduces capital gains (because it increases basis).
ii. Investors under § 212 and capitalization
1. A deduction would for a business expense would be a
below-the-line miscellaneous itemized deduction. If the
taxpayer is not an itemizer or below the 2% floor, then
capitalization is preferable because it allows some recover of
cost.
c. Acquisition and capitalization under the tax code
i. In Woodward v. Commissioner (1970) the Court held that a business
must capitalize the costs of litigating in federal court over the value
of stock, because the stock had to be valued before the company
could be acquired.
1. Court notes Reg. § 1.263(a)-2(a), providing that the cost of
acquisition of property having a useful life substantially
beyond the taxable year is capital expenditure
2. Court also uses an "origin of the claim" test to determine that
the litigation expenses were a cost of acquisition
d. Borrowing costs
i. Example: You borrow to purchase stock. Is the interest part of the
"cost of acquisition"?
1. I.R.C. § 163(d):
creates a special matching rule for
investment interest
2. Note that matching the interest expense to the annual return
does not work well when there is no dividend.
ii. The general rule is that the interest is a current expense
e. Costs of construction
i. The depreciation deductions that would otherwise be taken for
equipment used in the construction of an asset must instead be
capitalized. Commissioner v. Idaho Power Co. (1974) ("Construction-
91
V.
related depreciation is not unlike expenditures for wages for
construction workers. The significant fact is that the exhaustion of
construction equipment does not represent the final disposition of
the taxpayer's investment in the equipment; rather, the investment
in the equipment is assimilated into the cost of the capital asset
constructed).
1. See I.R.C. § 263A
f. Capitalization to avoid conversion
i. Negative Tax Rates and capitalization
1. If an expense is immediately deducted, it offsets ordinary
income. When the asset is disposed of, the taxpayer has a
higher amount realized than she would have had the
expense been capitalized—and this income is taxed at the
preferential rate for capital gains. The combination of these
two effects can lead to a negative rate of taxation!
a. Example: see Graetz p. 300
ii. Despite this effect, a taxpayer's desire to achieve the above outcome
is not prohibited outright. Instead, courts look at such a transaction
with closer scrutiny.
g. Costs of disposition
i. When an asset is disposed of, the costs of that disposition are
capitalized, thus reducing the amount realized.
h. Costs of demolition
i. I.R.C. § 280B
1. Requires capitalization of expenses or losses for demolition
into the basis of the land.
ii. Criticism
1. If you build a temporary structure on the land and then
demolish it, you have added to the basis of the land without
meaning to—this is the wrong answer.
i. Costs of title defense or recovery
i. Expenses incurred in the defense or perfection of title or property
must be capitalized. Reg. §§ 1.263(a)-2, 1.212-1(k)
Acquisition of Intangible Assets or Benefits
a. Two main questions
i. When should a future benefit require capitalization?
ii. If there is a future benefit what transaction costs facilitating the
creation of the asset should be capitalized?
b. Case treatment
i. Cases
1. In INDOPCO v. Commissioner (1992) the Court held that
investment banking and legal fees incurred by the target
92
company in the court of a friendly takeover should be
capitalized under § 263
a. Court says that deductions are the exception to a
capitalization norm
b. The creation of a separate and distinct asset may be
sufficient, but is not necessary for capitalization
c. Court focuses on the realization of benefits in future
years
2. In PNC Bancorp v. Commissioner (3d Cir 2000) the Court
allowed a deduction for loan origination costs because, the
court concluded, those costs were recurring and did not
provide a future benefit and were not used to create a
separate and distinct asset.
a. Criticism
i. Shuldiner criticized the outcome in this case
because the loan origination costs often did
produce a future benefit—the credit reports
acquired provided advice that did have a
future benefit. Also, the bank did create a
separate and distinct asset—the loans
themselves, which could easily be transferred.
c. General rules/principles
i. Separate and Distinct
1. Rule/principle
a. Expenditures need not create or enhance a "separate
and distinct asset" in order to be capitalized.
INDOPCO
2. Definition of "separate and distinct"
a. "a property interest of ascertainable and measurable
value in money's worth that is subject to protection
under applicable State, Federal or foreign law and the
possession and control of which is intrinsically
capable of being sold, transferred or pledged. . .
separate and apart from a trade or business." Reg. §
1.263(a)-4(b)(3)
ii. Future benefit
1. Whether an asset will produce a future benefit is an
important consideration in determining whether the cost of
acquiring that asset should be capitalized. INDOPCO.
2. However, the IRS has repeatedly narrowed the definition of
"future benefit"
a. A future benefit does not automatically imply
capitalization (i.e., advertising, promotions).
93
iii. Matching rule
1. One-year guidepost
a. Where an expenditure is expected to produce income
over a period of time rather than in the current
taxable year, capitalization is the standard practice.
b. This helps insure that income and expenses in the
taxable year are matched to determine net income.
2. costs should be matched with revenue
3. Reg. § 1.263(a)-4(f): permits deduction of payments who
benefits last 12 months after the taxpayer first realizes the
benefit or the end of the year in which the payment was
made—whichever is shorter.
iv. Nonrecurring expenditure
1. An expense that is non-recurring is more likely to require
capitalization. Encyclopedia Britannica Inc. v. Commissioner
(7th Cir. 1982).
d. Hostile v. Normal takeover
i. Is the cost of defending against a hostile takeover an ordinary and
necessary business expense or is it rehabilitation that must be
capitalized?
1. cf. rules for title defense (must be capitalized)
2. If you believe that fending off the takeover was for the good
of the company, then it would have a future benefit
3. But if you believe that the hostile takeover attempt simply
reduced the value of the company, then defending it is akin
to a repair.
a. See A.E. Staley Manufacturing Co. v. Commissioner (7th
Cir. 1997) (allowing deduction for legal costs of
unsuccessfully fighting hostile takeover.)
e. Transaction costs
i. Costs that "facilitate" the acquisition of an intangible asset must be
capitalized.
ii. Exceptions:
1. Overhead costs: internal v. external expenses
a. Overhead costs, including the expense of an in-house
staff used in acquisitions, may generally be expensed.
b. See PNC Bancorp v. Commissioner (3d Cir. 2000)
(allowing the "normal and routine" expenses of loan
origination costs to be deducted).
c. See Wells Fargo v. Commissioner (allowing deduction
for the costs of seeking a target for acquisition)
i. Shuldiner believes that the costs of finding
targets—even when not acquired—should be
94
part of the cost of acquisition because
eliminating targets has a future benefit.
iii. External costs
1. In Dana Corp v. United States (Fed. Cir. 1999) the Court held
that a retainer paid to a law firm each year to prevent that
law firm from advising an opposing company in a hostile
takeover was to be capitalized when the corporation finally
used the law firm to help acquire a company. The court said
that the focus was on the transaction, not the motive for
incurring the legal fee.
a. The question whether the retainer should be
expensed as part of the costs of defending against
takeover or capitalized as part of the acquisition is
essentially one of allocation.
b. Court does not look at "origin of the claim." Instead,
it looks at the cost of the current transaction.
f. Expenses for new businesses & Section 195
i. The issue
1. Is the expense incurred to maintain an existing business
(deductible under § 162) or to change or expand to a new
business (capitalized)?
ii. General rule
1. Start-up expenses incurred prior to entering the business
must be capitalized. I.R.C. § 195(a)
iii. I.R.C. § 195 deduction
1. Allows a deduction of up to $5,000 in start-up costs
2. Phaseout
a. Threshold: $50,000
b. Ceiling: $55,000
c. Reduced dollar-for-dollar for amount over $50,000
iv. Capitalization of intangibles
1. Taxpayer may elect to amortize expenses over a five year
period.
2. Costs capitalized include those that would be deductible if
incurred in connection with an existing trade or business
a. This includes costs of determining whether to enter a
new business
b. BUT does NOT include the costs of seeking a specific
business
g. Author's expenses
i. § 263A exempts writer, photographers and artists from the
capitalization requirement
95
VI.
Deductible Repairs v. Nondeductible Rehabilitation or Improvements
a. General
i. Reg. § 1.162-4: General rule
1. Deductible
a. Costs that do not materially add to the value of
property AND
b. that do not appreciably prolong the life of the asset
AND
c. keep the asset in an ordinarily efficient operating
condition
2. Capitalized or depreciated
a. Replacements
that
arrest
deterioration
and
appreciably prolong the life of the property
ii. Guiding principles
1. "To determine whether costs should be classified as capital
expenditures or as repair and maintenance expenses it is
appropriate to consider the purpose, the physical nature,
and the effect of the work for which the expenditures were
made." American Bemberg Corp. v. Commissioner (6th Cir.
1948)
2. Reg. § 1.263(a)-1(b)
a. Capital expenditures are those that
i. Add to value or substantially prolong life
ii. Adapt property to a new or different use
3. "General plan of rehabilitation, modernization and
improvement"
a. "Where an expenditure is made as part of a general
plan
of
rehabilitation,
modernization,
and
improvement of the property, the expenditure must
be capitalized, even though, standing alone, the item
may be classified as one of repair or maintenance."
United States v. Wehrli (10th Cir. 1968).
i. This is a case-by-case determination.
4. Extension of life or material increase in value
a. "An expenditure which returns property to the state it
was in before the situation prompting the expenditure
arose, and which does not make the relevant property
more valuable, more useful, or longer lived is usually
deemed a deductible repair."
i. The key is to look at the condition of the asset
immediately before the repair.
b. Revenue Ruling 2001-4
i. Three situations
96
VII.
1. Situation 1: A heavy-duty repair that does not extend the
useful life of an airplane and did not require extensive
replacements
a. Deducted
2. Situation 2: a heavy duty repair that does not extend the
useful life of the airplane but that involves replacement of
skin panels and addition of some new features
a. Allocated between deductions and capitalization
3. Situation 3: Heavy duty repairs that are party of a
comprehensive plan of rehabilitation, that extend the useful
life of the aircraft and that involved extensive replacement of
skin panels and the addition of new features
a. completely capitalized.
ii. See Graetz p. 316-317
Environmental Cleanup
a. Revenue Ruling 94-38
i. Soil remediation expenses need not be capitalized because they
bring land back to its state before contamination.
b. Land purchase
i. Revenue Ruling 94-28 has not been extended to cases where the
taxpayer purchases contaminated property. There, the expenses
are not for maintenance, but to make the property usable.
Job Search and Education Expenses
I.
Job-Seeking
a. Revenue Ruling 75-120
i. Expenses incurred in seeking new employment in the same trade or
business are deductible under § 162 if they are directly connected
wit the trade or business
ii. Expenses are not deductible if the individual is seeking
employment in a new trade or business, even if employment is
secured.
iii. If unemployed, the trade or business consists of the services
performed in the last job (and there must not be substantial
discontinuity between the time of the past employment and the
seeking of new employment)
b. "New trade or business"
i. Tax Court approach
1. "If substantial differences exist in the tasks and activities of
various occupations or employments, then each such
occupation or employment constitutes a separate trade or
business."
97
II.
c. Expenses of seeking public office
i. Non-deductible.
ii. See Gratez p. 321
Education Expenses
a. General
i. Reg. § 1.162-5
1. Education expenditure are deductible as ordinary and
necessary business expenses if the education
a. Maintain or improves skills required by the
individual in his employment or other trade or
business
b. Meets the express requirements of the individual's
employer, or the requirements of applicable law or
regulations, imposed as a condition to the retention of
the individual of an established employment
relationship, status, or rate of compensation."
b. The business/personal distinction
i. The regulations distinguish business and personal education
expense by determining whether the education leads to
qualification for a new trade or business
c. When does a trade or business begin?
i. In Wassenaar v. Commissioner (Tax Ct. 1979) the Court rejected
deduction for the costs of acquiring an LLM in taxation because the
taxpayer, a recently graduated law student, as not in an established
trade or business when he took the classes. The law student had
not yet taken the bar.
ii. But in Ruehmann v. Commissioner (1971) the Court determined
that an individual could deduct the costs of a Harvard LLM, begun
within months of graduation law school. The taxpayer had started
a job in the law right after graduation.
d. Minimum educational requirements
i. This is usually determined according to the standards of the
employer, rather than the profession.
1. See Toner v. Commissioner (allowing a deduction for the costs
of a taking classes while employed as a private school
teacher when the employer required that teachers have a
bachelor's degree).
e. What is a "new" trade or business?
i. McEuen, Zhang
f. Travel Expenses
i. Travel expenses incurred for education are not deductible. §
274(m)(2)
g. Employer Subsidies
98
III.
i. I.R.C. § 127
1. Up to $5,200 may be excluded from an employee's income
for the costs of an educational assistance program
ii. I.R.C. § 117
1. excludes "qualified scholarships" from income.
h. General Education Deduction
i. I.R.C. § 222
1. Allows a deduction of up to $4,000 for tuition and related
expenses
2. Must not be a dependent
3. Must be below income ceiling
4. This is an above-the-line deduction. § 62(a)(18)
Special Education provisions
a. Tuition Deduction
i.
b. I.R.C. § 530: Educational Savings Accounts
i. General Requirements
1. Must be cash contribution
2. Can only be up to $2,000 a year
3. before the child turns 18
4. trustee must be a bank or someone else designated by
Secretary
5. no part of the trust assets can be invested in life insurance
6. the assets of the trust cannot be commingled
7. any balance to the credit of the beneficiary must be
distributed within 30 days of the beneficiary's 30th birthday
ii. Requirements of money used
1. Must be used to pay for qualified education expenses
iii. Benefits
1. tax-free status
iv. Phaseout
1. Phaseout amount = contribution * (MAGI - $95,000)/ $15,00
2. Phaseout range
a. Single: $95,000 - $110,000
b. Married: $190,000 - $220,000
v. Tax treatment of distributions
1. General distribution
a. same as an annuity under § 72
b. Amounts of income not used for qualified education
expenses are subject to an additional 10% tax
2. Distribution for qualified education expenses
a. Excluded from gross income
99
b. If qualified education expenses are less than the
amount distributed, the expenses are deemed to come
proportionately from invested capital and income.
vi. § 530(d)(2)(C): coordination with Hope, LLC and Qualified
Tuition.
c. I.R.C. § 529: Qualified Tuition Program
i. General
1. Under these plans, a person contributes to an account that
will be used to pay college tuition at any university or
purchases tuition credits at a designated university. Both
the earnings and the distributions are exempt from the
income of the beneficiary and the contributor.
2. There is income limitation
3. a taxpayer can claim a Hope or LLC and exclude proceeds
under § 529 so long as the distribution is not used to pay
expenses for which the credit was claimed.
d. I.R.C. § 25A: Hope and Lifetime Learning Credits
i. § 25A(b): Hope Credit
1. Generally
a. The credit is NONrefundable
b. The credit is indexed for inflation
c. Per student rather than per taxpayer
2. § 25A(b)(1): The Credit
a. Allows for a credit of up to $1500 (100% of first $1,000
and 50% of next $1,000).
3. § 25A(b)(2): limitations
a. Credit only allowed if you have not taken it in two
prior years
b. Must be a ½ time student
c. Only allowed for first two years of post-secondary
education
d. The credit is denied for a student convicted of a drug
offense
ii. § 25A(c): lifetime learning credit
1. Generally
a. The credit is NONrefundable
2. § 25A(c)(1)
a. Amount equal to 20% of qualified tuition that does
not exceed $10,000
3. § 25A(c)(1)
a. Applies to any course of instruction at an eligible
education institution.
b. Per taxpayer rather than per student
100
e.
f.
g.
h.
iii. Phaseout of eligibility for both credits
1. Phaseout = Credit Amount * (MAGI - $40,000)/ $10,000
2. Phaseout ranges (adjusted for inflation)
a. Single: $40,000 b. Married:
iv. Coordination
1. The Hope and Lifetime learning credits cannot be taken for
the same student in the same year
2. Amounts that qualify under both expenses are allocated to
the HOPE credit first.
Scholarships and Employer-Provided Assistance
Student Loan Interest
U.S. Savings Bonds
i. § 135
See Graetz p. 422
Options to Deduct
I.
Costs for which the taxpayer can either expense or capitalize
a. I.R.C. § 173: Circulation Expenses
b. I.R.C. § 174: Research and Development
c. I.R.C. § 175: Soil and Water Conservation
d. I.R.C. § 198: Environmental Remediation Costs
e. I.R.C. § 179A: Qualified Clean Fuel Vehicles
f. I.R.C. § 189: Fertilizer
g. I.R.C. § 190: Expenses of accommodating for handicapped
Depreciation, Amortization and Depletion
I.
Depreciation, generally
a. Purpose of deprecation
i. Allocates the costs of an asset over an appropriate period of time
b. How to measure proper depreciation
i. Economic depreciation as ideal
1. Economic depreciation would allow a deduction for the
actual decline in an assets value during the taxable period.
2. Advantages
a. This would produce least amount of distortion
b. Would properly measure net income during the
period
3. Disadvantages
a. Conflicts with realization requirement
b. Impossible to administer
101
c. Would not allow for the current subsidy
ii. General terms/methods of depreciation
1. General terms
a. Depreciable base
i. This is the basis of the property, determined
under § 1011
ii. See supra p. XXX
b. Depreciation rate
i. This is a function of the method of depreciation
and the recovery period.
c. Salvage value
i. The amount a taxpayer would expect to
recover when she stops using the asset for the
production of income
ii. NOTE:
Congress ignores this because of
frequent controversies over its value.
2. Methods of depreciation
a. Straight line
i. The costs of an asset is allocated in equal
amounts over its useful life.
b. Declining balance method
i. Allocates a larger portion of costs to early
years.
ii. A constant percentage is used, but it is applied
to the amount remaining after depreciation in
previous years
3. Determining the recovery period
a. General
i. This is necessarily an estimate.
ii. For administrative convenience, this must be
determined when the asset is placed in service
b. Method one
i. Look at the length of time that similar assets
have been used by the taxpayer
c. Method two
i. Look to the average length of time that similar
assets have been used throughout the
economy.
d. Method three
i. Look to the average length of time that similar
assets have been used in the particular
industry.
c. Start up Expenses
102
II.
i. See I.R.C. § 195
ii. See supra p. XXX
d. Recapture
i. When a taxpayer takes depreciation on property and then sells it,
the taxpayer may too much gain.
ii. I.R.C. §§ 1245(personal property), 1250 (real property
1. Provides that certain amounts of amount realized are to be
considered ordinary income rather than capital gains
e. Personal Use allocation
i. Deductions may only be taken for depreciation of assets used in a
trade or business. If an item is used for both business and personal
use, the basis must be allocated between personal and business
uses. Depreciation is only allowed from the business basis. Reg. §
1.167(g)-1.
f. Land
i. Land is not depreciable. (note, however, that resources on or in the
land may be depleted).
g. Antiques
i. The IRS's position is that antiques are not depreciable because they
do not have a determinable useful life defined by the physical
condition of the art work. Rev. Rul. 68-232
ii. But see Simon v. Commissioner in which the court allowed
professional musicians to depreciate two 19th century violin bows
they had purchased for $30,000 and $21,500. (graetz p. 336-337)
h. Luxury Automobiles
i. I.R.C. § 280F
1. Limits depreciate on luxury automobiles
a. See §280F(a)(a)(A)
2. luxury automobiles are defined by weight.
i. Depreciation as a subsidy
i. The acceleration of deprecation under MACRS understates income,
providing an incentive to invest in depreciable assets.
Depreciation: Code Architecture
a. I.R.C. § 167: Depreciation
b. I.R.C. § 168: MACRS
i. General
1. Three Steps
a. Determine depreciation method
b. Determine Recovery period
i. Determine property classification
c. Determine Convention
2. Salvage value = 0
3. Depreciation methods summary
103
Depreciation
method
3, 4, 7, 10-year 15,
20-year Residential
property
property
Rental Property
Greater of:
Greater of:
Straight-line
1.
Double- 1.
150%
declining
declining
balance
balance
2. straight line
2. straight line
ii. § 168(b): Depreciation methods
1. Double-declining balance/straight line
a. Example
i. Car worth $100. 5 years.
ii. This means 20% per year
1. Year 1 (1/2 year convention)
a. $100 * 20% = $20
2. Year 2
a. $80 * 40% = $32
3. Year 3
a. $48 * 40% = $19.20
4. Year 4
a. 28.80 * 40% = $11.52
5. Year 5 (switch to straight line)
a. $11.52
6. Year 6 (1/2 year)
a. 5.76
iii. § 168(d): Conventions
1. Conventions, generally
a. The convention is used to determine appreciation
allowed when the property is not in used for the
entire year.
2. General rule is ½ year convention
a. ½ of year's depreciation is allowed in year of
acquisition and disposition, regardless of whether the
asset is actually used.
3. Exceptions
a. Real property: mid-month convention
b. Last quarter exception
i. Where a substantial amount of depreciable
property is purchased in the last quarter, a
mid-quarter convention applies.
iv. § 168(e): Classifications of property
104
III.
c. I.R.C. § 179: Election to Expense
i. General
1. This section permits a deduction for up to $125,000 of
tangible business property where the taxpayer's annual total
investment in the property is $500,000 or less.
2. Any excess over $500,000 is subject to normal depreciate
rules
3. This is adjusted for inflation
d. I.R.C. § 197: Amortization of intangibles
i. General
1. The rule now is that intangible assets may be amortized so
long as the asset's useful life can be determined with
reasonable accuracy.
a. In Newark Morning Ledger Co. v. United States (1993)
the Court allowed amortization of a newspaper
subscriber list because the list could be valued and
had a limited life that could be ascertained with
reasonable accuracy.
ii. § 197(a): General Rule
1. "197" intangibles are amortized on a straight-line basis over a
15 year period.
iii. § 197(f): special rules
1. If a § 197 intangible is disposed of, no loss is recognized.
The taxpayer can, however, adjust the bases of other 197
intangibles
2. This sets up a "basket" approach
iv. Non-197 intangibles
1. The rule now is that intangible assets may be amortized on a
straight-line basis over the course of 15 years so long as the
asset's useful life can be determined with reasonable
accuracy. Reg. § 167(a)-3
Depletion
a. I.R.C. § 611: Allowance of deduction for depletion
i.
b. Methods
i. Cost depletion
1. Estimates the total amount of natural resource in the
property and allows deduction of its cost in property to each
year's extractions.
2. Example
a. Facts
i. Estimated total oil: 1,000,000 barrels
ii. Removed barrels: 100,000
105
c.
d.
e.
f.
iii. Basis is $5,000,000
iv. 10% of the oil was removed.
b. Result under cost depletion
i. 10% * $5,000,000 = $500,000
3. Adjustments are made if the initial estimate is wrong
4. See I.R.C. § 612
ii. Percentage depletion
1. Allows the depreciation of a specific percentage of the gross
income from the property without regard to the recovery of
cost. It remains deductible even when basis has been
recovered.
a. Example
i. Facts
1. You harvest 100,000 barrels of oil
2. They sell at 10$ a barrel
3. total income is $1,000,000. You deduct a
certain percentage of this amount.
b. The net present value of these deductions can be quite
high
2. See I.R.C. § 613: Percentage depletion, generally
3. See also I.R.C. § 613A: limitations for oil and gas wells
Water
i. Cost depletion has been allowed for water when it is shown that
the water will not be replaced. See United States v. Shurbet (5th Cir.
1965)
Intangible Drilling Costs
i. Intangible expenses associated with drilling an oil well—i.e., labor,
fuel, repairs, hauling, and supplies—may be immediately deducted
or capitalized and recovered through depletion.
Recapture
i. I.R.C. §1254
1. provides that some intangible drilling expenses deducted
will be recaptured as ordinary income when the property is
sold
Specific Tax Incentives
i. I.R.C. § 617: Exploration and Development expenditures
ii. I.R.C. § 616(a): Mine Development expenditures
iii. I.R.C. § 193: Tertiary injectants
iv. I.R.C. § 194: Reforestation
106
Interest
I.
General
a. How should interest be treated
i. Economic nature of interest
1. Interest as the return on negative assets
a. Under a pure income tax, interest would be
deductible: the interest deduction is the return on a
"negative asset" (the debt liability)
b. Example
i. Facts
1. Loan: $100,000 at 10%
a. Interest: $100
2. Treasury bond at 10%
a. Income: $100
ii. In this example, you are not better off because
of your interest income—you real income is
zero
c. Shuldiner says that this is the correct, economic way
to think of interest
2. Interest as the cost of consumption
a. Some analysts think of interest as simply part of the
cost of consumption, no more deductible than the rest
of the item's price.
b. See infra p. XXX, "personal interest"
b. "Tracing" Interest
i. The tax treatment of interest is often dependent on the purpose of
the loan giving rise to the interest. Since money is fungible, this is
almost impossible
ii. Treasury regulations
1. Generally, the regulations determine the purpose of an
interest expense by tracing loan proceeds to their use. The
expenditure of the loan proceeds—and not the security of
the debt—governs.
2. Bank Accounts
a. When loan proceeds are intermingled in a bank
account, the regulations provide that expenditures
from the account are deemed to have been made first
from borrowed funds, and then from unborrowed
funds, and proceeds from different loans are used in
the order that the loan proceeds are deposited.
107
c. What is interest?
i. Generally
1. Definitions
a. "The amount which one has contracted to pay for the
use of borrowed money." Old Colony Railroad v.
Commissioner (1992)
b. "Compensation for the use or forbearance of money."
Deputy v. du Pont (1940)
2. Form or substance?
a. Courts are generally reluctant to characterize as
interest payments that are not labeled as such: when
interest is unstated, it is usually not taxed as income
or allowed as a deduction.
i. This is dealt with via the Original Issue
Discount rules
b. Credit card fees
i. Not deductible interest (but may be deductible
under § 162)
c. Late payments
i. Courts generally hold that this is a fee—a
payment for the costs of collection.
d.
ii. Distinguishing interest from other types of income
1. Debt v. Equity
a. Inflation makes it even more difficult to tell whether
payments are for equity or debt
b. Form or Substance?
i. Form
1. In United States v. Mississippi Chemical
the Court held that mandatory "stock
purchases" were really investments,
even
though
they
were
nontransferrable and not worth their face
value.
ii. Substance
1. In Knetch v. United States the Court
refused to allow a deduction for interest
on indebtedness, concluding that the
only purpose of a complicated
transaction was to reduce taxes. The
court refused to accept the form of the
transaction.
2. Corporate debt v. equity
108
II.
a. I.R.C. § 385
i. Allows the secretary to promulgate regulations
distinguishing debt in a company from stock in
the company.
3. Interest v. Principal
a. The timing problem: money is fungible so it can be
seen as either interest of principle.
i. See Estate of Franklin, supra p. XXX
b. "prepaid" interest
i. see supra p. XXX
c. unstated interest
i. This is dealt with under the Original Issue
Discount Rules
1. See I.R.C. §§ 1271-1278
4. Equity-kicker loans
a. Some arrangements provide that a lender will receive
a portion of the amount realized upon disposition of
the property.
i. Is this a loan or a co-investment?
ii. The cases generally emphasize the intent of the
parties to enter into a debtor/creditor
relationship.
b. Lender v. Owners
i. Who gets to depreciate from the basis and how
much?
ii. Often, by matching lenders with interest
income and borrowers with interest expenses
and depreciation the correct result is reached
iii. When one of the actors is tax exempt, however,
courts are more cautious and less willing to
accept the parties' characterization.
Specific Types of interest
a. Business
i. Interest on indebtedness used to operate a trade or business is
deductible. § 163(a)
ii. Exceptions
1. interest that must be capitalized into the cost of producing
an asset
iii. Passive loss rules
1. See I.R.C. § 469
b. Investment
i. Problems with investment interest
109
1. Property acquired with interest is often taxed incorrectly
because taxpayer can often take deductions for interest AND
depreciation. This allows for tax arbitrage when the rates
different.
2. § 163(d)(1): Basket approach
a. Purpose
i. This section acts as an anti-arbitrage rule.
ii. Example
1. Suppose you have $3,000 of interest on a
debt. If you buy stock with the debt that
appreciates, but pays no dividend, then
you get deductions for the interest and
deferred income at a preferential rate.
2. 163(d) prevents this by matching income
and interest. BUT, now we have the
problem of figuring out whether the
debt was really used for investment.
a. See supra p. XXX
iii. This section will disallow some legitimate
interest expense deductions.
b. § 163(d)(1): Matching approach
i. Deduction for investment interest cannot
exceed net investment income.
c. § 163(d)(2): Carryforward
i. If interest cannot be deducted under §
163(d)(1), the taxpayer can treat it as
investment interest accrued in the succeeding
year.
d. § 163(d)(4): Net Investment Income
i. Net investment income does NOT include net
capital gains or dividends, unless the taxpayer
elects to forgo the 15% preferential rate
1. See I.R.C § 1(h)(2) (net capital gains
decreased by the amount taken into
account as investment income under
this section).
2. See I.R.C. § 1(h)(11)(D)(i) ("qualified
dividend income shall not include any
amount which the taxpayer takes into
account as investment under § 164(d))
ii. A taxpayer can now elect to treat their
dividends as capital gains. I.R.C. § 1(h)(11)
iii. Example
110
1. Year One
a. Facts
i. $2,000 of capital gain
ii. $2,000 of interest on loans
for investments
b. Two choices
i. Keep the capital gains
 $2,000 * 15% = $300 in
taxes
ii. Elect to treat the capital
gains
as
ordinary
investment income
 $2,000 of ordinary
income
 $2,0000 deduction
 net income = 0 * 35%
= 0 in taxes
2. Year Two
a. If no year two, then you should
have elected to treat the capital
gains as ordinary income
b. Facts
i. $0 of interest on loans for
investments
ii. $2,000 investment income
c. If you did not elect to treat capital
gains as ordinary income in the
last year, then the interest income
that was not deduction last year
can be carried forward
i. $2,000
of
investment
income - $2,000 of interest
on loans = $0
d. If you elected to keep your
preferential capital gains, then
there is no carryforward
i. $2,000 of income * 35% =
$700 in taxes
3. Whether you will want to elect to forgo
the capital gains preference depends on
whether you will have investment
income in the next year and whether
111
you can take advantage of the
carryforward.
ii. Distinction between business and investment
1. Dealers
a. Are involved in the trade or business of being a
dealer. This is ordinary income not subject to § 163(d)
b. See also I.R.C. § 475 (mark-to-market rules eliminating
realization requirements).
2. Traders
a. Those 'whose profits are derived from the 'direct
management of purchasing and selling.'" § 163 does
not apply
3. Investors
a. Those who are engaged in the production of income,
intrest in the long-term growth potential of stocks.
c. Interest on Tax-Exempt Income
i. I.R.C. § 264(a)(2)
1. Prevents deducting interest for borrowing used to purchase
an annuity or life-insurance contract
ii. I.R.C. § 265(a)(2)
1. Prevents deductions of interest on indebtedness to purchase
bolds that yield tax-exempt interest
iii. I.R.C. § 461(g)
1. Requires that the taxpayer allocate and deduct prepaid
interest over the loan period.
2. Exception for points on a home mortgage.
d. Personal Interest
i. Why is personal interest disallowed?
1. In a pure income tax, it would not be taxed—it is part of the
cost of carrying a negative asset.
2. Could be thought of as an anti-arbitrage provision
a. Example: a taxpayer purchases a car using debt.
Income from the use of the car would not be taxed
(because imputed).
ii. I.R.C. § 163(h)
1. General Rule
a. No deduction is allowed for personal interest
2. Definition
a. Personal interest is anything OTHER than
i. Interest paid or incurred in a trade or business
ii. Investment interest
iii. Interest that would be deductible in connection
with a § 469 passive activity
112
iv. Qualified residence interest
v. Interest of deferred estate tax payments
b. Interest on an income tax deficiency is personal
interest.
e. Home Mortgage Interest
i. Note that the regulations promulgated for home mortgage interest
are out of date.
ii. I.R.C. § 163(h)(3)
1. Acquisition indebtedness
a. Defined
i. Used to acquire, construct or substantially
improve a qualified residence. The loan must
be secured by the residence
b. Limitation
i. $1,000,000 (unindexed)
2. Home equity indebtedness
a. Defined
i. "any indebtedness secured by a qualified
residence to the ext the aggregate amount of
such indebtedness does not exceed the fair
market value of the residence reduced by the
amount of acquisition indebtedness.
b. Limitation
i. $100,000 (unindexed)
3. Two residences may be used for deductions
f. Interest on Education Loans
i. I.R.C. § 221: Interest on education loans
1. § 221(a)
a. Allows a deduction for "qualified education loans."
b. This deduction is above the line
2. § 221(b): limitations
a. Maximum
i. maximum amount deductible is $2,500.
b. Phaseout
i. Begins at $50,000
ii. (MAGI - $50,000)/$15,000
ii. Third-party payments
1. If a person who is not legally obligated to do so pays the
interest on behalf of the taxpayer who owes the interest, the
third party is treated as making a gift to the child, who is
then treated as paying the interest and gets the requisite
deduction. Reg. § 1.221-1(b)(4)(i)
113
III.
IV.
Arbitrage, Abuse, and Shams
a. What is "indebtedness?"
i. Objective tests: "Sham transactions"
1. In Knetsch v. United States, the Court held that transaction
between Knetsch and the Sam Houston Life Insurance
Company in which Knetsch purchased annuity bonds after
receiving a loan from the company had no other purpose
than to reduce taxes. As such, it was a "sham transaction"
for which the taxpayer was not allowed a deduction.
a. The court focused on the definition of "indebtedness"
i. "Knetsch's transaction with the insurance
company id not 'appreciately affect his
beneficial interest except to reduce his tax."
ii. Here the supreme court used an objective test,
focusing on the purely economic nature of the
transaction—the question is not the motive of
the taxpayer but the intent of the statute.
1. Cf. Estate of Franklin (in which court uses
a subjective test to determine what the
motive of the transaction was).
ii. Subjective tests: tax avoidance motives
1. In Goldstein v. Commissioner the court held that a taxpayer
who won $140,000 in a contest and subsequently borrowed
money at 4% interest to buy treasury bonds at 1.5% interest
had engaged in a transaction with no other purpose than to
secure a deduction.
a. Instead of looking at whether there was real
indebtedness (here there was), the court reads a forprofit requirement into § 163.
2. In Lifschultz v. Commissioner the Court noted that in
examining an agreement involving the purchase and
repurchase of Treasury bills, that "financing transactions will
merit respect and give rise to deductible interest only if there
is some tax independent purpose to the transaction."
b. Three ways to combat "tax shelters."
i. Inquire into whether there is really indebtedness. Estate of Franklin
v. Commissioner
ii. Invalidate the entire transactions on the grounds that it lacks
economic purpose. Knetsch v. United States
iii. Recharacterize the transaction to reflect its economic reality (i.e., the
"prepaid interest" in Estate of Franklin).
Inflation and interest
a. Inflation is not accounted for under the income tax
114
i. This is one of the justifications for MACRS
b. Inflation results in an overstatement of interest income and deductions
i. Traditionally, it was believed that this was washed out because
both sides of the transaction are taxed equally incorrectly.
ii. But because of the progressive nature of the tax system, borrowers
are likely to save more than creditors, so the tax consequence is
negative.
c. Inflation also pushes people into higher tax brackets.
Losses
I.
General
a. There are two types of losses
i. Property losses
1. See I.R.C. § 165
ii. Operating losses
1. See I.R.C. § 183 (hobby losses)
2. See I.R.C. § 172 (net operating losses)
b. When is there a loss?
i. Realization
1. The realization requirement: gains and losses are recognized
only when there is a realization event.
2. A casualty is often treated as a realization event, even if it
does not result in a total loss.
ii. Worthless property
1. When can a taxpayer deduct the loss of an item that has
become worthless?
a. I.R.C. § 165(g)
i. General rule: "If any security which is a capital
asset becomes worthless during the taxable
year, the loss resulting therefrom shall, for the
purposes of this subtitle, be treated as a loss
from the sale or exchange, on the last day of
the taxable year, of a capital asset."
ii. Objective test
1. In Boehm v. Commissioner the Court held
that a loss on a security was sustained
when the security actually became
worthless, not when the taxpayer had a
good-faith belief that the security was
worthless.
c. The Amount of the Loss
i. I.R.C. § 165(b)
115
II.
III.
1. The basis for determining the amount of a deduction for a
loss is the adjusted basis of the property.
Business v. Nonbusiness (but profit-seeking) losses
a. I.R.C. § 165(c)(1)
i. Allows a deduction for losses incurred in a trade or business.
ii. This is deductible from gross income as an above-the-line
deduction. I.R.C. § 62(a)(2)
iii. These losses can also be carried forward and backward under § 172.
b. I.R.C. § 165(c)(2)
i. Allows a deduction for losses incurred in any transaction entered
into for profit.
ii. Above-the-line: sales or exchanges of property and rents or
royalties
iii. Below-the-line: Any other loss under this section
1. They may also be capital losses whose deductibility is
further limited.
c. Business v. Nonbusiness
i. In Yerkie v. Commissioner the Court concluded that a repayment by
an embezzler to his employer was not a loss incurred in a trade or
business.
ii. In Reese v. Commissioner the Court concluded that the losses on a
general contract for constructing a manufacturing plant of a
company for which the taxpayer was the president, treasurer,
chairman of the board and the principal stockholder was not
engaged in the trade or business of contracting (he was instead, an
investor.
Personal Losses
a. General
i. General Rule
1. Personal loss deductions are generally disallowed.
ii. Purpose of general rule
1. The general assumption is that losses of personal property
represent consumption.
iii. Criticism
1. This isn't taken into account elsewhere in the code
a. Example: You buy a car for $10,000. You consume
$2,000 and then sell it for $12,000. You would be
taxed on $2,000 of gain, not $4,000.
b. Mixed-use property
i. When property is used for both personal and business purposes,
losses must be allocated between the different uses.
1. Example
a. Facts
116
i. You purchase a boat for $40,000
ii. ¼ is used for business. ¾ are used for personal
reasons.
iii. The business basis is $10,000. The personal
basis is $30,000.
iv. Business basis is depreciated by $8,000
v. Total basis is $32,000
vi. The boat is sold for $28,000
b. Results
i. The business portion was depreciated by
$8,000. It has a basis of $2,000.
ii. The business-side amount realized was $7,000
($28,000/4).
iii. You have a gain of $5,000 on the business side.
c. Casualty Losses
i. General Treatment under § 165
1. I.R.C. § 165(c)(3)
a. Allows a deduction for losses arising from fire, storm,
shipwreck, or other casualty, or form theft.
2. I.R.C § 165(h): treatment
a. Limitations
i. The loss must exceed $100
b. Matching
i. Deductions for casualty losses equal to
casualty gains are deductible from gross
income
c. Excess losses
i. Casualty losses that exceed casualty gains are
limited to the amount that exceeds 10% of
adjusted gross income.
d. The deduction is a below-the-line deduction.
3. "Other" casualty
a. The cases suggest that the loss must be sudden and
unforeseen
i. Some courts have allowed the deduction even
when the taxpayer is negligent so long as there
is not sign of willfulness. Krahmer v. United
States.
b. Suddenness is necessary, but not sufficient
i. The courts also seem to require actual physical
damage.
ii. Amount of the loss
1. Reg. § 1.165-7(b)
117
2.
3.
4.
5.
6.
IV.
a. The amount is the lesser of the adjusted basis or the
(fair market value immediately before the casualty –
the fair market value immediately after the casualty).
Example 1: General
a. You buy a car for $10,000. It's fair market value is
$6,000. You can only deduct the $6,000 FMV.
Example 2: Gifts
a. You buy a car for $10,000. It depreciates to $6,000.
You then give it away as a gift and it appreciates to
$8,000. Here, you must split the basis
i. The giftee has a basis of $10,000 for gains and
$6,000 for losses. See I.R.C. § 1015
Example 3: unrealized appreciation
a. You purchase a painting for $10,000. It is actually
worth $100,000. The painting perishes in a fire. The
loss is only $10,000. This makes sense because you
have not paid taxes on the $90,000 gain.
Example 4: Loss with insurance
a. You purchase a building for $100,000. After taking
$40,000 of depreciation deductions, the building has
an adjusted basis of $60,000. The building itself has
appreciated to $150,000. The building is destroyed
and you receive insurance of $50,000. What is the
loss?
i. The loss was $60,000. Since you cannot deduct
the insurance proceeds, the total casualty loss
is $10,000
Example 5: Partial loss
a. You own a painting with a fair market value of
$100,000 and a $10,000 basis. It receives $15,000 of
damage. The loss can be offset against basis—you get
a $10,000 loss (as opposed to allocating the loss to the
unrealized gain upon disposition).
d. Insurance
i. See Graetz p. 379.
Loss Limitations and Bad Debts
a. Property losses
i. Abuses of the realization requirement
1. In Fender v. United States the Court refused to allow loss
deductions resulting from a trust's sale of hard-to-transfer
bonds to a bank in which the trust had only a 40.7% interest
on the grounds that the transaction had no other purpose
than to secure the deduction.
118
a. The court also noted that the loss was not "genuine" in
the sense that there was no real risk of being unable to
recover the loss
b. Transactions between related taxpayers
i. I.R.C. § 267
1. Disallows a deduction for losses incurred in transactions
between related taxpayers.
2. § 267(d): Allows for recovery of otherwise disallowed loss
a. A seller's loss under § 267 is generally lost
permanently because the purchaser's basis for
computing loss when he sells property is his cost.
b. This section allows the purchaser to increase his basis
for determining gain by the seller's disallowed loss.
i. Example
1. You buy property for $1,000. You sell it
to a brother for $600. His basis is $600.
2. He sells for $400loss of $200
3. He sells for $800$400 loss from
original transaction can be used to offset
gains.
3. Purpose of § 267
a. Prevents abuses of the realization requirement by
making sure that someone has really disposed of the
property.
b. Also helps to limit valuation problems that would
otherwise be prevalent
c. § 267(a)(2) provides a matching rule to prevent abuses
by taxpayer on different tax accounting rules.
c. I.R.C. § 1091: Wash Sales
i. Disallows a loss from a sale preceded or followed by the purchase
of substantially identical securities within a 30-day period.
ii. The basis of the stock purchased is the basis of the stock sold, plus
any additional amount—losses are deferred rather than lost
forever.
iii. Limitations
1. Applies only to losses—not to gains
2. The securities must be "substantially identical"
d. Capital Losses
i. I.R.C. § 165(f)
1. Limits losses to those provided for in §§ 1211 & 1212
ii. I.R.C. §§ 1211 & 1212
1. Limits capital losses to the extent of capital gains plus $3,000.
119
V.
2. capital losses not allowed in current year may be carried
forward or backward indefinitely.
e. "Straddles"
i. Described
1. A straddle occurs when the taxpayer acquires offsetting
positions in related assets. The taxpayer sells the losing
assets and retains the gains—losses are accelerated and gains
are deferred.
ii. I.R.C. § 1092
1. Limits the deduction of losses from straddles to the amount
by which losses exceed unrecognized gains on offsetting
assets.
iii. I.R.C. § 1256: Mark-to-Market rules
1. Under this rule, contracts held by the taxpayer at the end of
the taxable year are treated as sold—gains and losses are
recognized.
Tax Shelters
a. Section 183 and Tax Shelters
i. General
1. Courts have used the "not for profit" language of section 183
to prevent deductions for losses.
ii. In Fox v. Commissioner the court stated that a primary profit motive
was necessary to deduct a loss under § 165(c)(2), taking the position
that, notwithstanding the fact that many situations in which
transactions are motivated by tax laws, the court should determine
whether the loss is one that Congress would have intended to allow
as a deduction under § 165(c)
b. I.R.C. § 465: At-Risk Rules
i. I.R.C. § 465(a)
1. Prevents deduction for losses on an investment in which the
taxpayer did not have an amount at tirks.
ii. A taxpayer is considered at risk only to extent of
1. investment of cash in the activity
2. adjusted basis of property contributed to the activity
3. debt on which the taxpayer is personally liable for
repayment
4. net fair market value of personal assets that secure
nonrecourse borrowings.
iii. A taxpayer is not at risk when he is guaranteed reimbursement.
c. I.R.C. § 469: Passive Loss Limitations
i. Purpose
120
VI.
1. Intended to prevent taxpayers from using losses derived
from tax shelter investments to reduce taxes on earned
income and on investment income.
ii. General operation
1. Basket approach
a. Aggregate deductions from passive activity may be
used only to offset the income from these activities.
2. I.R.C. § 469(c): Definition of passive activities
a. Conduct of a trade or business in which the taxpayer
does not materially participate
b. Rental activities
3. "Material participation"
a. I.R.C. § 469(h):
material participation must be
regular, continuous and substantial.
b. Reg. § 1.469-5T: tests for determining whether
material participation exists
i. See Graetz p. 406
c. "Significant participation activities"
i. See Reg. § 1.469-1(f)(2)(i)(C)
4. Rental activities
a. See Reg. § 1.469-1(e)(3)
5. "Activity"
a. If activity is defined narrowly, it is difficult for a
taxpayer to show material participation. But a
narrow definition would also make it easy to dispose
of the activity and get a deduction for suspended
losses under § 469(g)
b. Activity is indemnified according to the facts and
circumstances
6. Coordination with § 465
a. Section 465 as threshold
i. In general, whether a loss is subject to the
passive loss limitations depends on whether
the at-risk requirements under § 465 have been
met
7. Capital gains
a. Passive loss and capital gains rules are applied
simultaneously
b. See Reg. § 1.469-1(d)
Bad Debts
a. I.R.C. § 166
i. I.R.C. § 166(a)
121
b.
c.
d.
e.
f.
g.
1. Allows a deduction for any debt that becomes worthless in
the taxable year.
ii. I.R.C. § 166(b): Amount of loss
1. The amount of the loss for a bad debt is the adjusted basis.
iii. I.R.C. § 166(d): Nonbusiness debts
1. Nonbusiness bad debts are treated as short-term capital
losses.
a. Capital losses can only be offset to the extent of
capital gains + $3,000.
iv. §§ 165 and 166 are mutually exclusive. Spring City Foundry Co. v.
Commissioner.
The Dominant business motivation requirement
i. See Graetz p. 411-412
The Trade or Business of Lending
i. In Estate of Bounds v. Commissioner the Court rejected the taxpayer's
claim that his lending activities were sufficiently extensive and
continuous to place him in the business of lending money because
1. the activities did not occupy a substantial amount of time
2. the activities were not advertised
3. the taxpayer did not maintain a separate office or books and
records.
4. the taxpayer did not describe himself as a lender on his tax
returns.
Loans to family and friends
i. See Reg. § 1.166-1(c)
1. treats losses on debts to friends or family members as gifts.
Validity of indebtedness
i. Reg. § 1.166-1(c): A debtor-creditor relationship must exist base
don a valid and enforceable obligation to pay a fixed or
determinable sum of money.
ii. No deduction is allowed for a debt that is worthless when acquired.
Putnam v. Commisioner
Loan Guarantees
i. A taxpayer who sustains a loss from guaranteeing a loan is treated
in the same manner as a taxpayer who sustains a loss from a loan
that she made directly.
ii. Payments on loan guarantees based on personal motivation are not
deductible. Reg. § 1.166-9
Political Contributions
i. See I.R.C. § 271 (disallowing deductions for worthless debts owed
by a political party)
122
h. Voluntary Cancellation
i. A taxpayer who voluntarily cancels a debt is not entitled to a bad
debt reduction.
i. Timing
i. A taxpayer must determine when a debt becomes worthless.
ii. § 6511(d) provides a seven year statute-of-limitations for refund
claims based on the deduction of bad debts.
Personal Deductions
I.
The standard deduction
a. Purpose
i. Two rationales
1. The standard deduction is a substitute for itemized
deductions—it is a simplification measure.
a. When itemized deductions are designed to encourage
specific behaviors, the simplification rationale of the
standard deduction and the Congressional incentives
policy come into conflict.
2. The standard deduction is an adjustment of the tax rate: the
standard deduction, combined with the personal
exemptions, creates the floor under which Congress has
determined that no income should be taxed.
b. I.R.C. § 63: Taxable Income defined
i. I.R.C. § 32(c): the standard deduction
1. Amounts
a. MFJ=$6,000
b. HOH=$4,400
c. Single, MFS=$3,000
2. Marriage "penalty"/bonus
a. The current tax code eliminates the marriage penalty
until 2011
b. In fact, there is now a marriage bonus—the marriage
standard deduction is twice the single deduction even
if only one spouse is working.
3. Additional amounts for the deduction are allowed for the
aged and the blind.
4. Dependents
a. The standard deduction of an individual who can be
claimed as a dependent is limited to the greater of:
i. $500 (indexed for inflation)
ii. $250 + Earned Income
c. Filing status
123
II.
i. Five possibilities
1. married filing jointly (MFJ)
2. married filing separately (MFS)
3. surviving spouse
4. head of household (HOH)
5. single
ii. Filing MFJ is generally advantageous
Personal Exemption and Child Credit
a. I.R.C. § 151: Allowance of Deductions for Personal Exemptions
i. General
1. This section allows a personal exemption of $2,000 (indexed
for inflation)
2. This exemption may taken for the taxpayer, an the
taxpayer's spouse and dependents
3. Despite the exemptions, these taxpayers must still pay the
Social Security Wage Tax of 15%
ii. I.R.C. § 152: Dependents
1. Qualifying Child
a. Does not have to be a child
b. Four tests for qualification
i. Relationship
1. must be child or a descendant of the
child, a brother, sister, stepbrother,
stepsister or a descendant of such
relative.
ii. Age
1. Must be 18 or under, unless student (23)
iii. Personal place of abode
1. Must have the same principal place of
abode as the taxpayer for at least ½ the
taxable year
iv. Support
1. The qualifying child must not provide
over ½ of their own support.
2. If more than half of child's support
comes from government assistance, then
this qualification will not be met.
c. Qualifying child as dependent of more than one
taxpayer
i. See § 152(c)(4)
2. Qualifying Relative
a. Three tests
i. Relationship test
124
1. Somewhat broader than child test—
includes a member of the household
with the same principal place of abode
for more than ½ the year
ii. Gross income test
1. The qualifying relative must have
income less than the exemption amount
iii. Support
1. the qualifying relative must not provide
over ½ of her own support.
3. Dependents can not themselves have dependents
iii. § 151(d): Phaseout for high-income taxpayers
1. Threshold amounts
a. MFJ=$150,000
b. HOH=$125,000
c. Single=$100,000
d. MFS=$75,000
2. For every $2,500 ($1,250 for MFS) over the threshold, the
exemption is decreased by 2%
3. Phaseout range
a. $150,000 - $275,000
4. Effects
a. Over this range, the marginal tax rate is increased by
1% (a "rate bubble")
b. Not indexing the numbers has the effect of shrinking
the phase-out range and of increasing the tax rate in
that range.
5. The phase-out is itself phased out
a. See § 151(d)(3)(E)
6. Purpose of the phase-out
a. If the purpose of the exemptions is to differentiate
based on family size, the rate bubble will be
counterproductive: families with large numbers of
dependents will have a higher marginal tax rate in the
phase-out range
b. But if the exemptions are simply a part of the "zero
bracket" then the phase-out does not hurt
progressivity—progressivity is measured by average,
and not marginal, tax rates.
iv. § 151(e): Divorced parents
b. I.R.C. § 24: The Child Credit
i. Allows for a partially refundable credit of $1,000 per child
(unindexed)
125
III.
IV.
1. This reverts back to $500 in 2010
2. The child must be a qualifying child (see above) under the
age of 17
ii. Phase-out
1. Threshold amount (MAGI)
a. MFJ=$110,000
b. Single=$75,000
c. MFS=$55,000
2. Mechanics
a. Reduced by $50 for every $1,000 over the threshold
iii. Partial refund
1. The partial refund is essentially a refund of the taxpayer's
social security taxes
I.R.C. § 32: The Earned Income Tax Credit
a. Nature/purpose
i. This is a fully refundable credit.
ii. It was originally intended to reduce the burden of social security
taxes on the poor
iii. Now, the EITC is seen as a negative income tax guaranteeing a
certain minimum standard of living.
b. Eligibility
i. Anyone with a qualifying child
ii. Anyone without a qualifying child who
1. lives in the united states for more than ½ the year
2. is between the ages of 25-64
3. is not a dependent
c. The Credit
i. The credit is a percentage of earned income.
1. See § 32(b)(1)
ii. The taxpayer receives a credit equal to the credit percentage of the
taxpayer's earned income that does not exceed a specified amount
1. The credit is phased out when the taxpayer reaches a certain
income—the phaseout percentage is also proscribed.
2. Note that the credit percentage range is a negative tax rate;
the phase-out rate is then the taxpayer's marginal tax rate in
the phase-out range
d. § 32(c)(2): Earned Income
i. Must be earned (wages, salary, etc) and not interest or dividends.
Personal Itemized Deductions
a. I.R.C. § 68: Limitations on Itemized Deductions
i. General
a. § 68 imposes a limitation on itemized deductions of
the lesser of
126
i. 3% of the AGI over $100,000(indexed)
ii. 80% of the amount of itemized deductions
otherwise allowable.
ii. Effects of 3% haircut
1. Shuldiner: this is often described as a phase-out, but it's
really a surtax of 1%.
2. When this is combined with the personal exemption phaseouts, the marginal tax rate is increased by 5%
3. On the margin, itemized deductions are still fully usable,
even when the 3% haircut applied—it simply means that
AGI is taxed at a higher rate (deductions are worth 35%,
additional AGI is taxed at 36%)
iii. The 80% limitatoins
1. The reduction in the itemized deductions cannot exceed 80%
of the deductions
2. Effects
a. Empirically, very few people are affected by this.
b. For individuals who are affected, every $1 of itemized
deductions is only worth $0.20.
c. This is really a limitation on itemized deductions (as
opposed to simply a surtax on AGI).
iv. Phaseout of limitations
1. 2006 & 2007 reduced by 2/3
2. 2008 & 2009reduced by another 1/3
3. The 3% limitation ends in 2010
b. Limitations on Miscellaneous Itemized Deductions: Tax Consequences
c. Taxes
i. I.R.C. § 164: Taxes
1. § 164(a): General Rule
a. A taxpayer may deduct
i. State, local, and foreign real property taxes
ii. State and local personally property taxes
iii. State, local, foreign, income, war profits, and
excess profits taxes
iv. Etc
b. The taxes are deductible regardless of whether they
were incurred in pursuit of a trade or business.
2. Structural
a. The deduction for taxpayers is a below-the-line
deduction, but is not a miscellaneous itemized
deduction.
3. State, local and foreign taxes on real property
127
a. § 164(c)(1): deduction allowed only for taxes imposed
on interests in real property—not for taxes assessed
against local benefits. See Graetz p. 424.
b. Tenants may not deduct payments of property taxes
passed on to them by their landlords. Rev. Rule. 79180. This is the so-called "renters tax."
4. State and Local Taxes on Personal Property
a. Reg. § 1.164-3(c):
must meet three criteria for
deduction
i. Tax must be ad valorem or based on annual
value
ii. Tax must be imposed on annual basis
iii. Tax must be on personal property
5. State, Local and Foreign Income, War Profits and Excess
profits Taxes
a. I.R.C. § 275
i. Prevents deductions for payroll taxes under
Social Security
ii. Employers can deduct their matching
contributions, but only if incurred in the course
of a trade or business
1. The self-employed may also deduct ½ of
their social security taxes
6. Capitalization requirement
a. § 164(a): "any tax which is paid or accrued by the
taxpayer in connection with an acquisition or
disposition of property shall be treated as part of the
cost of the acquired property or, in the case of a
disposition, as a reduction in the amount realized on
the disposition."
b. This does not apply to
i. State, local, and foreign real property taxes
ii. State and local personal property taxes
iii. State, local, foreign, income, war profits, and
excess profits taxes
7. The AMT
a. May prevent deductions for state and local real or
personal property taxes or income taxes.
8. Tax refunds
a. If the taxpayer later receives a refund for their state
and local taxes, they must include that refund in
income.
ii. Policy issues
128
1. See Graetz p. 426-427
d. Charitable Deductions
i. Policy issues/Purpose
1. Charity is itself a form of consumption
a. Under this view, there should be no deduction.
2. Amounts given to charity will not be consumed by the
taxpayer
a. Some have argued that this supports the deduction—
there is no consumption by the taxpayer.
3. Efficiency
a. Does the charitable deduction actually encourage giftgiving? It depends
b. See Graetz. P. 428
ii. I.R.C § 170
1. § 170(a): General Rule
a. There shall be allowed as a deduction any charitable
contribution payment made in the taxable year. The
contribution must be verified according to
regulations.
2. § 170(c): Definition of Charitable contribution
a. A charitable deduction is a gift to
i. A state or government to help the public
ii. A corporation, trust, fund, or foundation
organized in the United States and operated
exclusively for religions, charitable, scientific,
literary, or educational purposes or to foster
national or international amateur sports
competition
1. No part of the gift can guarantee the
benefit of a particular individual
2. Cannot be used for lobbying
iii. A post or organization for war veterans
iv. A domestic fraternal society but only if used
exclusively for religious, charitable, scientific,
literary or educational purposes
v. A cemetery owned and operated for the benefit
of its members
3. § 170(b): Limitations
a. Individual limitations
i. Generally, deductions may not exceed 50% of
adjusted gross income
ii. Gifts of appreciated property are limited to
30% of adjusted gross income
129
4. § 170(d): Carryovers
a. If contributions exceed the limitations in 170(b), they
may be carried over and deducted over the course of
the next five years. But the carryover in each year
must be the lesser of
i. 50% of AGI – charitable deductions
ii. OR
1. In the first year
a. the amount of the excess
2. in years 2, 3, 4, 5
a. the portion of the excess not
otherwise treated as a charitable
deduction
5. § 170(f): Exceptions
a. No deduction is allowed for
i. Gifts of a remainder interest in property
ii. Property transferred in trust unless certain
conditions are met. 170(f)(2)(B)
b. No deduction if payment was intended to influence
legislation
c. 170(f)(8): Substantiation
iii. When is a transfer to a charity a contribution?
1. In Hernandez v. Commissioner (1989) the Court held that
payments to the Church of Scientology for "auditing" and
"training" were not deductible payments to a charity because
the payment was made with the expectation of a quid pro
quo., even if that quid pro quo is an intangible religious
benefit.
a. Impact of Hernandez
i. Congress added § 170(f)(8), stating that the
receipt of intangible religious benefits must be
substantiated.
2. The Duberstein standard
a. Many courts rely on the Duberstein test—"detached
and disinterested generosity"—in order to meet the
requirements of a charitable deduction
3. Seats at college sporting events
a. § 170(l) allows an 80% deduction when the
contribution makes the donor eligible to receive
athletic tickets.
4. Gifts to schools/nursing homes
a. Private religious schools
i. Rev. Rul. 83-104. See Graetz p. 437
130
b. Nursing homes
i. In Estate of Wardwell v. Commissioner (1962) the
court allowed a deduction for a charitable
contribution to a nursing home, even though
the taxpayer later received reduced rent,
because the gift, when made, was motivated by
generosity.
5. Gifts earmarked for individuals
a. In Davis v. United States the Court denied parents of
missionaries of the Church of Jesus Christ of LatterDay Saints a deduction for payments used to support
the missionary activities of their children.
They
payments were made directly to the children, though
supervised by the Church.
6. Gifts of services
a. A person may not deduct the value of services
rendered to a charitable institution, but they may
deduct out-of-pocket expenses incurred in connection
with donating services.
b. Contributions of blood cannot be deducted.
7. Substantiation
a. 170(f)(8): Substantiation requirements
i. General rule
1. No deduction is allowed for a
contribution of $250 or more unless the
taxpayer substantiates the contribution
by
a
contemporaneous
written
acknowledgement of the contribution
by the donee organization.
ii. The organization must provide a good-faith
estimate of any goods or services provided to
the donor (so, for instance, a taxpayer doesn't
take a donation of $500 after winning a church
raffle that provides for a vacation worth
$1000).
iv. Gifts of appreciated property
1. Generally, a taxpayer may deduct the full fair market value
of appreciated property.
2. I.R.C. § 170(e): limitations
a. Application
i. Applies, generally, to all contributions of
property that would produce ordinary income
or short-term capital gain if sold.
131
ii. Also applies to contributions of property that
would produce long-term capital gain if the
property is given to a private foundation
iii. Also applies to personal property given to a
charity, that is unrelated to the exempt
function of the charity (e.g., diamond necklace
to a library).
b. Three considerations under § 170(e)
i. Is the recipient a private foundation or a public
charity?
ii. Would the appreciation be taxed as capital
gains or as ordinary income
iii. Does the gift consist of tangible property or
securities?
iv. RESULT
1. A contribution of any property other
than a marketable security, to a private
foundation, allows a deduction equal to
fair market value minus capital gains or
ordinary income (usually, this leaves
just basis).
2. A contribution of property to a public
charitable organization is generally fair
market value minus the amount of gain
that would not have been long-term
capital gain
3. If the property is tangible personal
property that will not be used by the
donee in its charitable function, the
deduction is the fair-market value
reduced by the full amount of
appreciation
3. Application of 170(e): an example
a. Facts
i. Ordinary Income Tax = 35%
ii. Capital gains tax = 15%
iii. Property basis = $2,000
iv. Property fair market value = $10,000
b. Gift to charity of proceeds from sale
i. Gain of $8,000 taxed at 15% = $1,200.
ii. A cash deduction is worth $3,500
iii. So the net benefit to the taxpayer is $2,300
c. Gift to charity of property
132
i. A deduction worth $3,500.
ii. No tax paid on appreciation.
d. The taxpayer would thus prefer to give the property
outright.
e. BUT, when 170(e) applies:
i. § 170(e) reduces the deduction by the amount
that taxable income would be increased if the
gain were taxable.
ii. Gain is not recognized, but the charitable
deduction is limited to $2,000 (basis).
iii. If appreciated property is taxed at a
preferential rate, then, the taxpayer would
prefer to sell the property first and then give
the proceeds (because net benefit would be
$2,300).
e. Medical Expenses
i. Policy issues: treatment of medical care, generally
1. Contradictions
a. § 104 allows an exclusion from income of all medical
costs, without limitation
b. self-employed individuals can deduction the cost of
health insurance and medical care. (with limitations)
ii. Structural Context
1. a deduction under § 213 is a below-the-line deduction (but is
not a miscellaneous itemized deduction)
iii. I.R.C. § 213
1. 213(a): General allowance of deduction
a. A deduction is allowed for expenses paid during the
taxable year that are not compensated for by
insurance or otherwise.
b. The expenses must exceed 7.5% of AGI
2. 213(b): limitations on medicine and drugs
a. only "prescribed drugs" or insulin are deductible.
b. Medical supplies that are not medicine or drugs (e.g.,
crutches, bandages, blood sugar tests) are deductible.
Rev. Rul. 2003-58
c. Birth Control
i. Birth control pills prescribed by a physician are
deductible. Rev. Rul. 73-200
ii. The costs of a vasectomy or lawful abortion are
deductible. Rev. Rul. 73-201.
3. 213(d): Definitions
a. Cosmetic Care
133
i. Cosmetic surgery is NOT deductible as
medical care.
ii. Cosmetic surgery does not include a procedure
to fix a congenital abnormality or a disfiguring
disease.
4. Therapy
a. See Graetz p. 451
5. Medical Expenses v. Nondeductible personal expenses
under § 262
a. Rev Rul. 87-106
i. "[E]xpenditures for medical care allowable
under section 213 of the code will be confined
strictly to expenses incurred primarily for the
prevention nor alleviation of a physical or
mental defect or illness. An expenditure that is
merely beneficial to the general health of the
individual is not an expenditure for medical
care."
ii. "In making a capital expenditure that would
otherwise qualify as being for medical care,
any additional expenditure that is attributable
to personal motivation does not have medical
care as its primary purpose and is not related
directly to medical care for purposes of section
213 of the Code."
6. 213(d)(1)(B): transportation
a. Medical care includes transportation primarily for
and essential to medical care.
b. Costs for care in an institution other than a hospital
depends on the services provided.
iv. I.R.C. § 223: Health Savings Accounts
1. Structural Context
a. A deduction under § 223 is an above-the-line
deduction.
2. General
a. An eligible taxpayer may claim a deduction from
gross income in computing AGI for the amount he or
she contributes to an HAS, but the total contribution
cannot exceed
i. $2, 250 for individuals
ii. $4,500 for families
3. Eligibility
134
a. The taxpayer must be covered under a "highdeductible" health plan, defined in 223(c)
b. The account must be established with a bank or
approved institution
i. Funds can only be used for the payment of
qualified medical expenses
ii. Account must be noforfeitable
c. Qualified medical expenses
i. Defined in 213(d)
4. Tax advantages
a. Distributions from a HSA to pay for qualified medical
expenses are excluded from gross income. § 223(f)(1)
b. Investment income on a HSA is not taxed. § 223(e)(1)
5. Coordination with § 213
a. Amounts paid or distributed from an HSA may not
generate an itemized deduction under 213.
WHOSE INCOME?
Taxation of the Family
I.
II.
General
a. Assignment of income
i. The tax code seeks to prevent the shifting of income from highbracket taxpayers to low-bracket taxpayers.
ii. This helps to preserve the integrity of a progressive rate structure.
I.R.C. § 1: Taxable Units
a. Generally
i. Taxable units
1. Married Individuals filing joint returns
2. Heads of Household
3. Unmarried Individuals
4. Married Individuals filing separate returns
5. Estates and Trusts
b. § 1(b) & (c): Single Individuals
i. Single persons file a tax return, reporting their own taxable income.
c. § 1(a), (d) & (f): Couples
i. § 7703: Marital Status
1. Determination of whether someone is married is made at the
end of the taxable year
2. an individual legally separated under a decree of divorce or
separate maintenance is not considered married.
ii. § 6013: Joint Returns
135
1. No joint return allowed if
a. Either husband or wife is a nonresident alien
b. If the husband and wife have different taxable years
2. Joint return may be made by surviving spouse.
iii. The Marriage Penalty
1. Defined
a. When a couple in which each spouse earns equal
amounts of income decide to get married, they pay
more in taxes than they would if they were still single
b. This is because they often move into a higher tax
bracket
2. Severity/Scope
a. The marriage penalty is exacerbated by low income
taxpayers eligible for the earned income credit.
b. The phase-out of dependency exemptions and the
reduction of itemized deductions are also marriage
penalties
c. Marriage bonus
i. There is sometimes a marriage bonus if one
spouse makes substantially more than the
other.
3. Efforts to eliminate marriage penalty
a. Option 1: permit married couples to file separate
returns using the single rate schedules
i. This would create differences between married
couples based on their relative earnings and
whether they lives in a community property
state
b. Option 2: Make the rate brackets for married filing
jointly twice as big for married couples as for singles
i. This would create a penalty for staying single
because two unmarried persons would pay
more than a married couple
c. Option 3: a two-earner deduction
i. This was done in 1981, but repealed in 1986.
d. The 2001 Marriage Penalty Relief Provisions
i. Increased the standard deduction for married
couples
ii. § 1(f)(8): Increased the size of the 15% bracket
iii. The earned income tax credit phase-out for
married couples was increased.
iv. Why are married couples treated differently?
1. Gratz p. 462
136
III.
Children
a. I.R.C. § 73: Services of Child
i. Under current law, a child is considered a separate taxpayer and
the child's earned income is NOT aggregated with the rest of the
family even if it is pooled to pay household expenses.
b. Calculation if income tax liability
i. Compute, generally, just as the adults would be.
1. the child is entitled to personal exemption and standard
deduction
ii. The standard deduction for the child cannot exceed the child's
earned income if the child can be claimed as a dependent.
c. The "Kiddie Tax"
i. Purpose
1. This provision is designed to prevent high-income parents
or grandparents from shifting income-producing assets to
their lower-bracket children
ii. I.R.C. § 1(g): Unearned Income of Child as parent's income
1. Tax
a. Net unearned income of those covered by the tax is
taxed at the parent's top marginal rate, regardless of
the source of the income.
2. Applicability
a. Applies to children under the age of 19
b. Applies to children ages 18 -24 who are full-time
students.
c. For those 18 or over, the kiddie tax applies only to
those who unearned income does not exceed one-half
of the amount of their support.
3. Net Unearned Income
a. Adjusted Gross Income (minus unearned income as
defined in § 911) – (standard deduction + the greater
of [standard deduction or itemized deduction directly
related to the production of earned income])
i. This means that a minimum of $1000 (indexed)
is not subject to the kiddie tax—it would be
taxed at the child's marginal tax rate.
4. Election under § 1(g)(7)
a. Parents may elect to report the gross income of a child
in excess of $1,000 on their own return.
i. The first $500 of unearned income is still not
taxed.
ii. The next $500 is taxed at 10%
137
iii. Any excess is charged at the parent's marginal
rate
b. The election is permitted where the child has income
between $500 and $5,000.
IV.
Divorce
a. Sham Divorces : rev. Rul. 76-255
i. The IRS's position is that a divorce simply for the sake of avoiding
income tax is a sham and is not recognized.
ii. The service looked at all the facts and circumstances to determine if
the divorce was simply designed to manipulate an individual's
marital status for income tax purposes.
b. Alimony and Support
i. Structural Context
1. Alimony payments are above-the-line deductions.
§
62(a)(10)
ii. I.R.C. § 71: Alimony and Maintenance Payments
1. 71(a): General rule
a. Gross income includes amounts received as alimony
or separate maintenance payments
2. 71(b): definitions of Alimony and Separate Maintenance
payments
a. Payment is alimony when:
i. The payments are in cash
ii. The parties do not earmark payments as
nondeductible to the payor and nontaxable to
the payee
iii. The parties do not live in the same if they are
already legally divorced or separated
iv. There is no liability any payment after the
death of the payee
v. The payments do not constitute child support
3. § 71(f): Re-Computation
a. Purpose
i. This provision limits the taxpayers' ability to
structure a property settlement to qualify as
alimony.
ii. It also prevents a payor from "front-loading"
alimony deductions as a way to defer income.
b. General
i. Excess alimony payments must be included in
the payor's gross income in the third postseparation year, with the recipient getting an
off-setting deduction
138
c. Excess alimony after second year
i. Second year payments/ [third year playments
+ $15,000]
iii. I.R.C. § 215: Deduction for Alimony
1. Payments that are excludable by the alimony recipient under
§ 71 are deductible by the payor under § 215.
iv. Child support
1. Child support is nondeductible to the payor and nontaxable
to the payee.
v. I.R.C. § 1041: Property Settlements
1. 1041(a): general rule
a. No gain or loss is recognized on a transfer of property
from an individual to a spouse or a former spouse, if
the latter transfer is incident to a divorce
2. 1041(b): The recipient takes a carryover basis in the property
equal to the adjusted basis of the transferor.
a. In effect, the transfer is treated like a gift.
b. BUT, unlike gifts in 1015, one spouse can transfer a
loss to another spouse.
3. 1041(c): When is it incident to divorce?
a. When the transfer occurs within one year after the
date on which the marriage ceases
b. Or is related to the cessation of the marriage
Assignment of Income
I.
Income from Services
a. General
i. Earned income is taxable to the person who earns it
ii. In Lucas v. Earl the court held that the salary and attorney's fees
earned by a taxpayer were taxable to him despite the existence of a
contract in which he pledged his salary to his wife as a joint tenant.
1. "There is no doubt that the statute could tax salaries to those
who earned them and provide that the tax could not be
escaped by anticipatory arrangements and contracts
however skillfully devised to prevent the salary when paid
from vesting even for a second in the man who earned it."
iii. In Armantrout v. Commissioner the court held that money paid by an
employer into a trust fund for the children of key employees was
taxable to the employee and not the children.
b. "Unique Factual Situations
i. Rev. Rul. 74-581
139
II.
1. Dominant purpose of the revenue laws is the taxation of
income to those who earn or otherwise create the right to
receive it and enjoy the benefit of it when paid.
2. A taxpayer's anticipatory assignment of a right to income
derived from the ownership of property will not be effective
to redirect that income to the assignee for tax purposes."
3. But in some unique factual situations this rule is not
followed
a. Amounts received for services performed by a faculty
member at a law-school clinic that are turned over to
the University.
ii. The "Agency Theory"
1. In assignment cases, the service looks at whether the person
earning the income is really just an agent of the institution to
which he turns over the income
Income from Property
a. General
i. Income from property is taxable to the owner of the property
ii. In Helvering v. Horst the Court held that interest coupons detached
from a bond were taxable to the bond-holder rather than to the
assignees.
1. "The power to dispose of income is the equivalent of
ownership of it."
2. This has been overruled by § 1286
b. Income interest in a trust
i. In Irwin v. Gavit the Court held that the beneficiary of an income
interest in a trust could not exclude the gift under § 102. One
implication of the decision is that § 102 applies only to the
remainderman of a trust.
CAPITAL GAINS AND LOSSES
Capital Gains
I.
Mechanics
a. Casebook Approach
i. Step One: Is this a realization event?
ii. Step Two: Calculate gain
1. I.R.C. § 1001(a)
a. Amount Realized = Adjusted Basis = Gain
iii. Step Three: Determine whether the gain or loss is recognized
iv. Step Four: Determine the Character of the Gain or Loss
b. Mechanics of Capital Gains and Losses
140
II.
III.
i. Step One: Determine whether assets are "short term" or 'long term
1. § 1222(1): short term capital gain = < 1 year
2. § 1222(3): long term capital gain = > 1 year
ii. Step Two: Net short-term gains against short-term losses
1. § 1222(5) & (6)
a. If short terms gains > short term losses then short
term gain
iii. Step Three: Net short-term gain or loss against long-term gain or
loss
1. § 1222(11): Net Capital Gain
a. Net Capital Gain = net long-term capital gain – net
short-term taxable gain
b. This is taxed at the preferential capital gains rate. §
1(h)(1)
2. If the net short term taxable gain > net long-term capital loss,
then the excess short-term gain is taxable in full as ordinary
income.
3. When the taxpayer has both a net short-term gain
iv. Step Four: Loss limitations
1. I.R.C. § 1211: Limitation on Capital Loss
a. Where the losses exceed the gains, the excess capital
loss offsets up to $3,000 of ordinary income.
b. Excess losses ma be carried forward indefinitely
c. Examples:
i. See Graetz p. 531-32
Policy of Preferential Treatment
a. See Graetz p. 533 – 38
I.R.C. § 1221: Definition of Capital Asset
a. I.R.C. § 1221
i. § 1221(a): General
1. A very broad definition of capital asset, with exceptions. A
capital asset is property held by the taxpayer (whether or not
connected with his trade or business) EXCEPT
ii. § 1221(a): Exceptions
1. The stock in trade or inventory of a business that is held
primarily for sale to customers in the ordinary course of a
trade or business
2. depreciable or real property held by its creator
a. See I.R.C. § 1231 (characterizing net gain on sales of
depreciable or real property used in a business as
capital gain and net losses on sales of such assets as
ordinary losses).
b. See also I.R.C. § 1245 (recapturing depreciation)
141
3. literary or artistic property held by its creator
4. accounts or notes receivable in the ordinary course of the
taxpayer's trade or business
5. U.S. government publications received from the government
at a price less than that which the general public is charged
6. commodities derivative financial instruments held by
commodities derivative dealers
7. identified hedging transactions under rules provided in
regulations
8. supplies regularly consumed in the ordinary course of the
trade or business.
b. Exception: assets "held by the taxpayer primarily for sale in the ordinary
course of his trade or business."
i. In Malat v. Riddel (1966) the court defined "primarily" as "of first
importance" or "principal" rather than simply substantial.
1. Rationale: The word primarily is intended to differentiate
between profits and losses on an everyday bases and the
realization of appreciation in value accrued over along
period of time.
2. Impact
a. Many courts get around Malat by saying that the
appropriate time to look for motive is just before the
sale which will be, by definition, when the taxpayer is
primarily interested in the sale.
ii. Three important issues
1. Whether the nature of the taxpayer's dealings in property
classify the taxpayer as a dealer who is holding the property
primarily for sale to customers in the ordinary course of
business
2. the tax treatment when a taxpayer initially acquires property
as an investment, but later becomes a dealer
3. Dual purpose cases: the taxpayer acquires property as both
an investment and to sell to customers.
a. In Bramblett v. Commissioner (5th cir. 1992) the Court
concluded that property acquired by a partnership,
sold to a corporation owned by the partnership's
members, and then sold by the corporation, was held
for investment and subject to the capital gains rate
i. The court emphasized the frequency of
transactions (but this is not sufficient)
ii. Applies a seven-factor test
1. See Graetz p. 547
142
b. Other principles used in dual-property cases (some of
these are in the seven-factor test)
i. In Adam v. Commissioner (1973) the Tax court
emphasized the passivity of the seller
ii. In Adam v. Commissioner (1973) the court also
noted that the activity at issue produced a
relatively small amount of the taxpayer's
income
iii. In Biehnharn Realty Co., Inc. v. United States
(1976) the Court suggested that taxpayers are
more likely to receive capital gains treatment if
they make a bulk sale, rather than a sales at
different times.
iii. Securities
1. Dealer
a. A dealer is a person who purchases the securities and
commodities with the expectation of realizing a profit
because they hope that customers will buy above cost.
b. Dealers have customers for the purpose of § 1221
(and therefore cannot get capital gains treatment).
i. See § 1236(a) ("Gain by a dealer in securities
from the sale or exchange of any security shall
in not event be considered as gain from the sale
or exchange of a capital asset. . . ")
2. Traders
a. Traders are sellers of securities or commodities who
depend upon such circumstances as a rise in value or
an advantageous purchase to enable them to sell at a
price in excess of cost."
b. Trader is in a trader or business if the trading is
frequent and substantial.
c. Traders do not have customers—get capital gains.
3. Investor
a. Similar to a trader, but makes purchases usually
without regard to short-term developments that
would influence prices on the market.
b. They have capital gains
4. Election under § 1236
a. § 1236(a)(1): gain by a dealer may be characterized as
capital gain if the dealer clearly identifies the security
as acquired for investment before the close of the day
it was acquired.
5. Other solutions to the mixed-motive problem
143
IV.
a. I.R.C. § 475(a)
i. Puts dealers on a mark-to-market rule so that
they cannot simply sell losses and hold onto
gains for tax deferrals
ii. Dealers can still "opt out" of this regime. §
475(b)
iii. Traders may "opt in" § 475(f)
Depreciable Property and Recapture
a. I.R.C. § 1231(a): Property Used in the Trade or Business and Involuntary
Conversions
i. Effect
1. This is an extraordinary pro-taxpayer provision that allows
the taxpayer to get capital gains when property is disposed
for a gain and ordinary losses when disposed at a loss.
ii. Applicability
1. Only applies to long-term assets (must have been held for at
least one year). § 1231(b)
2. Does not apply to
a. Property properly included in inventory
b. Property held by the taxpayer primarily for sale to
customers in the ordinary course of trade or business
c. A copyright, musical, or artistic composition, a latter
or memorandum
d. Government publications
3. BUT DOES apply to
a. Certain livestock, timber, coal, minerals, etc. See §
1231(b)(2) – (4)
4. § 1231 transactions: the section applies to
a. gains or losses from sales and exchanges of property
used in a trade or business
b. gains or loses arising from condemnations and
involuntary conversions or property used in a trade
or business
c. gains or losses from condemnations and involuntary
conversions of capital assets held in connection with a
trade, business or profit-seeking activity.
iii. Mechanics of § 1231
1. Step One: The "Firepot"
a. Net the gains from casualty and theft losses
i. Casualty and theft gains – losses from
involuntary conversions.
b. If losses > gains
144
i. § 1231 DOES NOT APPLY and the losses are
ordinary income
c. If gains > losses
i. Both gains and losses are carried over into the
"Hotchpot"
2. Step Two: The "Hotchpot"
a. Compare
i. total gains with
1. total
losses
from
involuntary
conversions
2. And condemnation sales and exchanges
of business property
b. If losses > gains
i. Gains includible and ordinary income and
losses deductible from ordinary income.
c. If gains > losses
i. Gains are long-term capital gains and losses
are long-term capital losses.
ii. These are then transferred to the tax return to
be combined with other long-term capital gains
and losses from other sources.
b. Recapture
i. General Purpose
1. When the taxpayer realizes a gain on depreciable property,
he has been permitted to take depreciation exceeding the
economic cost of holding the asset.
2. If the taxpayer could enjoy the depreciation deductions
AND capital gains treatment under § 1231, he would be able
to convert ordinary income into capital gain.
ii. I.R.C. § 1245
1. Mechanics
a. If depreciable property is sold for more than its
adjusted basis, any gain not exceeding the total
depreciation allowed is taxed as ordinary income
b. Three steps
i. Is the transaction a sale? If so, compute
amount realized (§ 1001). If it is not a sale,
determine the fair market value of the property
transferred
ii. Determine "recomputed" basis (adjusted basis
of the transferred property + cumulative
depreciation)
145
V.
iii. Subtract the lower of the amount in the above
steps from adjusted basis.
iv. The remaining amount is "recaptured"
ordinary income.
c. Example
i. Facts
1. you buy for $100,000
2. Depreciation of $15,000
3. Adjusted Basis of $85,000
ii. § 1245 applied
1. You sell the property for $70,000 (loss)
a. § 1221(a)(2): ordinary loss
b. § 1231: ordinary loss
2. You sell the property for $90,000
a. § 1221(a)(2): ordinary loss
b. § 1231: capital gain
i. BUT
§
1245
would
recapture as ordinary gain
3. You sell the property for $105,000
a. § 1221(a)(2): ordinary gain
b. § 1231: capital gain
c. BUT § 1245
i. The first $15,000 of gain is
ordinary income (because
recaptured depreciation)
ii. The rest is capital gains
iii. I.R.C. § 1250: Recapture rule for real property
1. General
a. Rule 1250 recaptures the excess of accelerated
appreciated over straight line appreciation on certain
real-estate.
2. BUT, because real property is already depreciated on a
straight-line basis, there is no § 1250 recapture
a. I.R.C. § 1(h) taxes un-recaptured § 1250 gain at a rate
of 25%
Derivates, Hedging and Supplies
a. What is a hedge?
i. A hedge is used to offset risk. They can be speculated upon by
investors and might be subject to capital gains
b. Corn Products and Arkansas Best
i. In Corn Products Refining Co. v. Commissioner (1955) the Court
considered the tax treatment of corn futures used by Corn Products
Refining to stabilize its inventory and guarantee a certain amount
146
of corn. The Court held that the futures contracts were non-capital
assets because they were an integral part of the profits and losses
generated by the business.
1. Note that this IRS "victory" allowed taxpayers to take
ordinary losses—offsetting ordinary income—that should
probably have been considered capital losses.
ii. In Arkansas Best Corp v. Commissioner (1988) the Court limited Corn
Products. The court considered a transaction in which Arkansas Best
purchased stock in a bank. Some of the stock was for investment
purposes, some—the taxpayer asserted—was to bail the bank out
and protect its business reputation. The court rejected the
taxpayer's argument that the loss should be ordinary because it was
connected with their trade or business, instead emphasizing the
language of the statute (WHETHER OR NOT connected with a
trade or business) to conclude that the sock was a capital asset.
1. This has since been adopted by the IRS through regulations.
2. The Court does not completely overrule Corn Products;
instead, it sees the case as a broad reading of the inventory
exception.
c. Post-Arkansas Best Developments
i. I.R.C. § 1221(a)(7)
1. Hedging transactions clearly identified as such are not
capital assets
ii. I.R.C. § 1221(a)(8)
1. Supplies of a type regularly used or consumed by the
taxpayer in the ordinary course of business are not capital
iii. IRS Regs
1. Hedges of ordinary items are ordinary income under the
accounting rules. Reg. § 1.446-4. If you are hedging
inventory, it becomes part of the inventory accounting.
2. Reg. § 1221-2(b): definition of "hedging transaction"
3.
Nonrecognition transactions
I.
Non-recognition, generally
a. Congress has provided that certain transactions that would otherwise be
realization events are not to be recognized for determining gain or loss.
b. You usually see these provisions when
i. There is a continuity of investment
ii. There is a hardship
iii. The provision is intended to help stop tax avoidance
147
II.
I.R.C. §§ 1031 & 1033: Like-Kind Exchanges
a. I.R.C. § 1031
i. 1031(a)(1): General
1. Under this section, not gain or loss is recognized when
certain property held for productive use or for investment is
exchanged for property "of a like kind"
ii. 1031(a)(2): Exceptions
iii. Basis
1. General
a. When like-kind property of equal value are
exchanged in a non-recognition transaction, the basis
of the property given up becomes the basis of the
property received. § 1031(d)
2. Basis with "boot"
a. The taxpayer recognizes gain, but not loss, on the
transaction to the extent of any boot received. §
1031(b) & (c).
b. The transferred basis in the new property is decreased
by any money received and increased by any gain
recognized. § 1031(d)
i. Examples
1. see handout
3. Basis with mortgage
a. When a mortgage is assumed, or the property is taken
subject to the mortgage, the outstanding mortgage is
treated as cash received and is recognized as boot to
the extent it exceeds any mortgage the seller must
assume or to which the property he receives is
subject.
b. Shuldiner's notes
i. Key principles: mortgage assume by other
party
1. A liability assumed is treated as
additional amount realized for gain
realization computation
2. A liability assumed is treated as boot for
gain recognition
3. A liability assumed is treated as cash
received for basis computation
ii. Exceptions:
1. a liability is not treated as boot to the
extent that cash is also part of the
exchange
148
iv.
v.
vi.
vii.
2. a liability is not treated as boot to the
extent that you assume liability
iii. Key principle: liability assumed by taxpayer
1. a liability assumed by the taxpayer is
treated as additional cash paid for
blackacre—simply added to the basis
(Tufts)
What is 'like kind"?
1. Like kind refers to the nature of the property exchanged
rather than its grade or quality
2. § 1031(e) has been used to infer that Congress intended "like
kind" to have a narrower definition with respect to personal
property (versus real property).
Multiparty Transactions
1. The courts often focus on whether the parties intended to
enter into a like-party exchange and whether the several
steps in the transaction were part of a single integrated plan.
2. Intent is important, but not dispositive
a. A transaction that is structured as an exchange may
be re-characterized as a sale if the taxpayer receives
not the property itself but cash that he uses to
purchase the property.
b. A taxpayer who purchases property for a like-kind
exchange has no gain or loss, but if there is a delay,
and the property appreciates, it may no longer be
possible to use § 1031 because at that point the
property is no longer being used for a business or
investment.
Delayed exchanges and options to receive cash
1. What if the seller locates a buyer before finding a
replacement property?
a. In Starker v. United States, the court held that a
taxpayer that transferred its interest in timber acreage
in exchange for a corporation's promise to transfer
suitable property within give years or pay the
outstanding balance in cash was eligible for § 1031
treatment when the property was finally delivered.
"Productive Use in a trade or Business or Investment"
1. Investment property may be exchanged for property to be
used in a trade or business (and vice-versa). Reg. §
1.1031(a)-1(a).
2. For how long after the exchange must the property be used
for trade, business or investment?
149
a. See Wagensen v. Commissioner (Graetz p. 629)
viii. Loss transactions
1. Where like-kind property is exchanged, § 1031 is
mandatory—not elective
2. If a party wants to avoid § 1031 (to recognize a loss or to
obtain a fair market value basis for depreciation of the
property received) § 1031 can be avoided by structuring a
transaction as a sale and reinvestment, rather than as an
exchange.
ix. Sale-Leasebacks
1. A exchange of a fee interest in a leasehold of 30 years or
longer is treated as a nonrecognition exchange. Reg. §
1.1031(a)-1
2. See Graetz p.630
x. § 1031(f): Sales to Related Parties
1. Where a taxpayer exchanges like-kind property with a
related party and either party disposes of the property
within two years, the gain on the original transfer is
recognized on the date of the disposition.
b. Involuntary Conversions
i. I.R.C. § 1033
1. General
a. This section permits nonrecognition of gain from
involuntary conversions, such as condemnation or
casualty.
2. Mechanics
a. If property is involuntarily converted, the taxpayer
will not recognize gain or loss if the taxpayer uses the
proceeds to acquire "property similar or related in
service or use to the property so converted." §
1031(a)(1).
i. The nonrecognition extends only to the
amount realized upon conversion that does not
exceed the cost of the other property.
b. The taxpayer must acquire the property by the end of
the second year following the involuntary conversion.
i. This time limit is extended to three years for
condemnations or real property used for
business or investment.
c. The section is elective, if the taxpayer has received
money rather than property in exchange for the
converted property (e.g., insurance proceeds).
3. What property has been converted?
150
III.
a. Rev. Rul. 59-361: The "one economic property unit"
standard
i. "Where all the facts and circumstances show a
substantial economic relationship between the
condemned property and the other property
sold by the taxpayer so that together they
constitute one economic property unit. . .
involuntary conversion treatment for the
proceeds of the voluntary sale will be
permitted.
4. When are conversions economically involuntary?
a. Rev. Rul. 80-175
i. The event is one specified by the statute
ii. The event rendered the property unfit or
impractical for its intended use.
iii. The property was sold and the proceeds
invested in similar property.
b. Generally, if an event constitutes a casualty under §
165(c), it constitutes an involuntary conversion, but
the events covered by § 1033 are somewhat broader.
5. "Replacement" property
a. The "Similar Use" test
i. Several courts have looked not at the two
properties themselves, but at the use to which
the properties were put by the taxpayer.
ii. The test is whether "the taxpayer has achieved
a sufficient continuity of investment to justify
the nonrecognition of the gain or whether the
differences in the relationship of the taxpayer
to the two investments are such as to compel
the conclusion that he has taken advantage of
the condemnation to alter the nature of his
investment for his own purposes."
Sales of Principle Residences
a. Section 121
i. Allows the taxpayer to exclude $250,000 of gain from the sale of her
principal residence provided it had been used by the taxpayer as
such for two of the previous five years.
151