Tax Outline
Prof. Kaplow
Spring 2011
Ethan Kent
TAX OUTLINE
Table of Authorities ..................................................................................................................................................... 4
Chapter 1 – Gross Income .......................................................................................................................................... 7
§ 1.01 – Employment .................................................................................................................................................7
[A] – In-Kind Payments.........................................................................................................................................7
[B] – Fringe Benefits .............................................................................................................................................8
§ 1.02 – The Concept of Income and Tax Expenditures ............................................................................................8
[A] – Income and What to Tax ..............................................................................................................................8
[B] – Tax Expenditures ..........................................................................................................................................9
[1] – In General.................................................................................................................................................. 9
[2] – Municipal Interest Bonds ........................................................................................................................ 10
[3] – Individual Retirement Accounts.............................................................................................................. 11
[a] – Deferral in General .............................................................................................................................. 11
[b] – Retirement Plans ................................................................................................................................. 11
[C] – Imputed Income .......................................................................................................................................... 11
§ 1.03 – Recovery of Capital ................................................................................................................................... 12
[A] – Basis and Related Concepts ....................................................................................................................... 12
[B] – Realization / Recognition ........................................................................................................................... 13
[C] – Capital Gains .............................................................................................................................................. 13
§ 1.04 – Compensation for Losses ........................................................................................................................... 13
§ 1.05 – Competing Claims and Offsetting Liabilities ............................................................................................ 14
[A] – Loans & Cancellation of Indebtedness ....................................................................................................... 14
[B] – Contributions to Capital ............................................................................................................................. 15
[C] – Illegal Income ............................................................................................................................................. 15
§ 1.06 – Gifts and Kindred Items ............................................................................................................................ 15
[A] – Business Gifts ............................................................................................................................................ 15
[B] – Prizes, Scholarships, and Government Transfers ....................................................................................... 16
[C] – Tax Consequences of Gifts, etc. ................................................................................................................. 16
[1] – Interest Income ........................................................................................................................................ 16
[2] – What Basis?............................................................................................................................................. 16
Chapter 2 – Deductions ............................................................................................................................................. 18
§ 2.01 – Business vs. Personal ................................................................................................................................. 18
[A] – Code Structure ............................................................................................................................................ 18
[B] – Tax Penalties .............................................................................................................................................. 19
[B] – Travel and Entertainment ........................................................................................................................... 20
[C] – More on the Border Between Business and Personal ................................................................................. 21
[1] – Clothing................................................................................................................................................... 21
[2] – Home Offices .......................................................................................................................................... 21
[3] – Childcare ................................................................................................................................................. 22
[4] – Not-for-Profit Activities .......................................................................................................................... 22
[5] – Legal Expenses ....................................................................................................................................... 22
§ 2.02 – Capital Costs: Businesses Only ................................................................................................................. 22
[A] – Capital Recovery and Investment Incentives ............................................................................................. 23
[1] – Depreciation ............................................................................................................................................ 23
[2] – Transferability of Tax Incentives ............................................................................................................ 24
[3] – Depletion ................................................................................................................................................. 24
[4] – Inventories ............................................................................................................................................... 24
[B] – Current Expense vs. Capital Expenditure ................................................................................................... 24
[C] – Allocation of Purchase Price ...................................................................................................................... 25
§ 2.03 – Personal Deductions .................................................................................................................................. 25
[A] – Interest ........................................................................................................................................................ 26
[B] – Taxes .......................................................................................................................................................... 26
[C] – Casualty Losses .......................................................................................................................................... 27
[D] – Medical Expenses....................................................................................................................................... 27
2
[E] – Charitable Contributions ............................................................................................................................. 27
[1] – What is a Contribution? .......................................................................................................................... 28
[2] – Unrelated Business Income ..................................................................................................................... 28
[3] – Contribution of Property or Services ...................................................................................................... 28
[4] – Qualification............................................................................................................................................ 29
Chapter 3 – Who is the Taxpayer?........................................................................................................................... 30
§ 3.01 – Taxable Unit .............................................................................................................................................. 30
[A] – Who is Taxed ............................................................................................................................................. 30
[B] – Marriage Penalty / Bonus ........................................................................................................................... 30
§ 3.02 – Dissolution/Alimony.................................................................................................................................. 31
§ 3.03 – Assignment/Family Trusts ......................................................................................................................... 31
[A] – Trusts and Similar Instruments .................................................................................................................. 31
[B] – Kiddie Tax .................................................................................................................................................. 32
[C] – Below-Market Loans .................................................................................................................................. 32
§ 3.04 – Income in Respect of a Decedent............................................................................................................... 32
Chapter 4 – Capital Gains & Losses ........................................................................................................................ 33
§ 4.01 – Mechanics .................................................................................................................................................. 33
§ 4.02 – Definition of Capital Asset ........................................................................................................................ 34
[A] – Theory ........................................................................................................................................................ 34
[B] – Property Held for Sale to Customers .......................................................................................................... 34
[C] – Substitute for Future Ordinary Income ....................................................................................................... 34
[D] – Sale of a Business....................................................................................................................................... 35
Chapter 5 – When is an Item Taxed ........................................................................................................................ 36
§ 5.01 – Nonrecognition .......................................................................................................................................... 36
[A] – Like-Kind Exchanges ................................................................................................................................. 36
[B] – Wash Sales ................................................................................................................................................. 36
§ 5.02 – Mortgaged Property ................................................................................................................................... 37
§ 5.03 – Annual Reporting....................................................................................................................................... 37
[A] – Claim of Right ............................................................................................................................................ 37
[B] – Previous Deductions and the Tax-Benefit Limitation ................................................................................ 38
[C] – Prepaid Expenses and Income and Future Expenses .................................................................................. 38
§ 5.04 – Deferred Payments..................................................................................................................................... 39
[A] – Discount Obligations and Other Deferred Payments ................................................................................. 39
[B] – Deferred and Contingent Payments on Sales.............................................................................................. 39
[C] – Annuities and Life Insurance ...................................................................................................................... 39
[D] – Compensation............................................................................................................................................. 40
Chapter 6 – Tax Shelters ........................................................................................................................................... 41
3
Table of Authorities
Cases
Ark. Best Corp. v. Comm’r, 485 U.S. 212 (1988) ........................................................................................................ 34
Benaglia v. Comm’r, 36 B.T.A. 838 (1937) ..................................................................................................................7
Bernice Patton Testamentary Tr. v. United States, No. 96-37T, 2001 WL 429809 (Fed. Cl. Mar. 20, 2001) ............ 39
Bessenyey v. Comm’r, 379 F.2d 252 (2d Cir. 1967) .................................................................................................... 22
Blair v. Comm’r, 300 U.S. 5 (1937) ...................................................................................................................... 31, 32
Bob Jones Univ. v. United States, 461 U.S. 574 (1983) .............................................................................................. 29
Burnet v. Sanford & Brooks Co., 282 U.S. 359 (1931) ............................................................................................... 38
Burnet v. Wells, 289 U.S. 670 (1933) .......................................................................................................................... 31
Carpenter v. Comm’r, 25 T.C.M. (CCH) 1186 (T.C. 1966) ........................................................................................ 27
Clark v. Comm’r, 40 B.T.A. 333 (1939)...................................................................................................................... 13
Comm'r v. Gillette Motor Transp. Co., 364 U.S. 130 (1960) ...................................................................................... 35
Comm'r v. Tufts, 461 U.S. 300 (1983) ......................................................................................................................... 37
Comm’r v. Duberstein, 363 U.S. 278 (1960) ................................................................................................... 15, 21, 28
Comm’r v. Flowers, 326 U.S. 465 (1945) ............................................................................................................. 20, 21
Comm’r v. Gleshaw Glass Co., 348 U.S. 426 (1955) .................................................................................................. 14
Comm’r v. Idaho Power Co., 418 U.S. 1 (1974) ......................................................................................................... 25
Comm’r v. Indianapolis Power & Light Co., 493 U.S. 203 (1990) ............................................................................. 39
Comm’r v. Lincoln Sav. & Loan Ass’n, 403 U.S. 345 (1971)...................................................................................... 18
Comm’r v. P.G. Lake, Inc., 356 U.S. 260 (1958) ........................................................................................................ 35
Comm’r v. Wilcox, 327 U.S. 404 (1946) ..................................................................................................................... 15
Corliss v. Bowers, 281 U.S. 376 (1930) ...................................................................................................................... 31
Cottage Savings Ass’n v. Comm’r, 499 U.S. 554 (1991) ............................................................................................. 36
Crane v. Comm’r, 331 U.S. 1 (1947)........................................................................................................................... 37
Dobson v. Comm’r, 320 U.S. 489 (1943) .................................................................................................................... 38
Dowell v. United States, 553 F.2d 1233 (10th Cir. 1977) ............................................................................................ 28
Eisner v. Macomber, 252 U.S. 189 (1920) .................................................................................................................. 13
Estate of Rockefeller v. Comm’r, 762 F.2d 264 (2d Cir. 1985) ................................................................................... 25
Estate of Sydney Carter v. Comm’r, 453 F.2d 61 (2d Cir. 1971)................................................................................. 15
Farid-Es-Sultaneh v. Comm’r, 160 F.2d 812 (2d Cir. 1947) ................................................................................. 31, 32
Hantzis v. Comm’r, 638 F.2d 248 (1st Cir. 1981)........................................................................................................ 20
Haverly v. United States, 513 F.2d 224 (7th Cir. 1975) .............................................................................................. 38
Helvering v. Clifford, 309 U.S. 331 (1940) ............................................................................................................. 7, 32
Helvering v. Horst, 311 U.S. 112 (1940) ............................................................................................................... 31, 32
Hort v. Comm’r, 313 U.S. 28....................................................................................................................................... 34
Irwin v. Gavit, 268 U.S. 161 (1925) ............................................................................................................................ 16
James v. United States, 366 U.S. 213 (1961)............................................................................................................... 15
Jordan Marsh Co. v. Comm’r, 269 F.2d 453 (2d Cir. 1959) ....................................................................................... 37
Lucas v. Earl, 281 U.S. 111 (1930) ....................................................................................................................... 30, 31
Malat v. Riddell, 383 U.S. 569 (1966) ......................................................................................................................... 34
McAllister v. Comm’r, 157 F.2d 235 (2d Cir. 1946).................................................................................................... 35
McWilliams v. Comm’r, 331 U.S. 695 (1947) ............................................................................................................. 37
Moss v. Comm’r, 758 F.2d 211 (7th Cir. 1985) ........................................................................................................... 21
Mt. Morris Drive-In Theater Co. v. Comm’r, 25 T.C. 272 (1955) .............................................................................. 24
N. Am. Oil Consol. v. Burnet, 286 U.S. 417 (1932) ..................................................................................................... 38
Old Colony Trust Co. v. Comm’r, 279 U.S. 716 (1929) ................................................................................................7
Pevsner v. Comm’r, 628 F.2d 467 (5th Cir. 1980) ...................................................................................................... 21
Poe v. Seaborn, 282 U.S. 101 (1930) .......................................................................................................................... 30
Raytheon Prod. Co. v. Comm’r, 144 F.2d 110 (1st Cir. 1944) .................................................................................... 14
Turner v. Comm’r, 13 T.C.M. (CCH) 462 (1954) ....................................................................................................... 16
United States v. Am. Bar Endowment, 477 U.S. 105 (1986) ....................................................................................... 28
United States v. Correll, 389 U.S. 299 (1967) ............................................................................................................. 20
United States v. Gilmore, 372 U.S. 39 (1963) ............................................................................................................. 22
4
United States v. Kirby Lumber Co., 284 U.S. 1 (1931) ............................................................................................... 14
United States v. Lewis, 340 U.S. 590 (1951) ............................................................................................................... 38
Williams v. McGowan, 152 F.2d 570 (2d Cir. 1945) ................................................................................................... 35
Statutes
26 U.S.C. § 1 ......................................................................................................................................................... 30, 32
26 U.S.C. § 1001 ....................................................................................................................................... 12, 13, 17, 22
26 U.S.C. § 101 ........................................................................................................................................................... 40
26 U.S.C. § 1011 ......................................................................................................................................................... 12
26 U.S.C. § 1012 ......................................................................................................................................................... 12
26 U.S.C. § 1014 ......................................................................................................................................................... 17
26 U.S.C. § 1015 ................................................................................................................................................... 17, 31
26 U.S.C. § 1016 ......................................................................................................................................................... 22
26 U.S.C. § 1019 ......................................................................................................................................................... 13
26 U.S.C. § 102 ............................................................................................................................................... 15, 16, 17
26 U.S.C. § 103 ........................................................................................................................................................... 10
26 U.S.C. § 1031 ......................................................................................................................................................... 36
26 U.S.C. § 104 ........................................................................................................................................................... 14
26 U.S.C. § 1041 ......................................................................................................................................................... 31
26 U.S.C. § 107 .............................................................................................................................................................8
26 U.S.C. § 108 ........................................................................................................................................................... 15
26 U.S.C. § 109 ........................................................................................................................................................... 13
26 U.S.C. § 1091 ................................................................................................................................................... 36, 37
26 U.S.C. § 111 ........................................................................................................................................................... 38
26 U.S.C. § 117 ........................................................................................................................................................... 16
26 U.S.C. § 118 ........................................................................................................................................................... 15
26 U.S.C. § 119 ......................................................................................................................................................... 7, 8
26 U.S.C. § 1211 ......................................................................................................................................................... 33
26 U.S.C. § 1212 ......................................................................................................................................................... 33
26 U.S.C. § 1221 ................................................................................................................................................... 13, 34
26 U.S.C. § 1231 ......................................................................................................................................................... 33
26 U.S.C. § 1245 ......................................................................................................................................................... 34
26 U.S.C. § 125 .............................................................................................................................................................8
26 U.S.C. § 1250 ......................................................................................................................................................... 34
26 U.S.C. § 1272 ......................................................................................................................................................... 39
26 U.S.C. § 1274 ......................................................................................................................................................... 39
26 U.S.C. § 132 .............................................................................................................................................................8
26 U.S.C. § 162 ......................................................................................................................................... 18, 19, 20, 21
26 U.S.C. § 163 ............................................................................................................................................... 26, 27, 41
26 U.S.C. § 164 ........................................................................................................................................................... 26
26 U.S.C. § 165 ..................................................................................................................................................... 19, 22
26 U.S.C. § 166 ........................................................................................................................................................... 19
26 U.S.C. § 167 ............................................................................................................................................... 22, 23, 24
26 U.S.C. § 168 ........................................................................................................................................................... 23
26 U.S.C. § 170 ............................................................................................................................................... 27, 28, 29
26 U.S.C. § 172 ........................................................................................................................................................... 38
26 U.S.C. § 183 ........................................................................................................................................................... 22
26 U.S.C. § 197 ........................................................................................................................................................... 25
26 U.S.C. § 21 ............................................................................................................................................................. 22
26 U.S.C. § 212 ............................................................................................................................................... 18, 21, 22
26 U.S.C. § 213 ..................................................................................................................................................... 14, 27
26 U.S.C. § 215 ........................................................................................................................................................... 31
26 U.S.C. § 219 ........................................................................................................................................................... 22
26 U.S.C. § 24 ............................................................................................................................................................. 30
26 U.S.C. § 262 ..................................................................................................................................................... 18, 20
5
26 U.S.C. § 263 ............................................................................................................................................... 22, 24, 25
26 U.S.C. § 263A......................................................................................................................................................... 25
26 U.S.C. § 265 ........................................................................................................................................................... 26
26 U.S.C. § 267 ........................................................................................................................................................... 37
26 U.S.C. § 274 ............................................................................................................................................... 16, 20, 21
26 U.S.C. § 280A......................................................................................................................................................... 21
26 U.S.C. § 280E ......................................................................................................................................................... 19
26 U.S.C. § 32 ............................................................................................................................................................. 30
26 U.S.C. § 445 ........................................................................................................................................................... 37
26 U.S.C. § 448 ........................................................................................................................................................... 37
26 U.S.C. § 451 ........................................................................................................................................................... 37
26 U.S.C. § 461 ........................................................................................................................................................... 39
26 U.S.C. § 465 ........................................................................................................................................................... 41
26 U.S.C. § 469 ........................................................................................................................................................... 41
26 U.S.C. § 501 ........................................................................................................................................................... 28
26 U.S.C. § 61 ......................................................................................................................................... 7, 8, 14, 18, 31
26 U.S.C. § 62 ............................................................................................................................................................. 18
26 U.S.C. § 63 ............................................................................................................................................................. 18
26 U.S.C. § 64 ............................................................................................................................................................. 33
26 U.S.C. § 65 ............................................................................................................................................................. 33
26 U.S.C. § 6662 ......................................................................................................................................................... 41
26 U.S.C. § 6663 ......................................................................................................................................................... 41
26 U.S.C. § 67 ............................................................................................................................................................. 19
26 U.S.C. § 68 ....................................................................................................................................................... 18, 19
26 U.S.C. § 691 ........................................................................................................................................................... 32
26 U.S.C. § 71 ............................................................................................................................................................. 31
26 U.S.C. § 72 ............................................................................................................................................................. 40
26 U.S.C. § 7201 ......................................................................................................................................................... 41
26 U.S.C. § 7206 ......................................................................................................................................................... 41
26 U.S.C. § 74 ............................................................................................................................................................. 16
26 U.S.C. § 7482 ......................................................................................................................................................... 38
26 U.S.C. § 7872 ......................................................................................................................................................... 32
26 U.S.C. § 85 ............................................................................................................................................................. 16
Other Authorities
New York State Renters Tax, Rev. Rul. 79-180, 1979-1 C.B. 95 (1979) ..................................................................... 26
William D. Andrews & Peter J. Wiedenbeck, Basic Federal Income Taxation (6th ed. 2009) .. 7, 9, 13, 14, 15, 16, 18,
20, 21, 22, 23, 24, 25, 26, 27, 28, 29, 30, 31, 32, 33, 34, 35, 36, 37, 38, 39, 41
Regulations
26 C.F.R. § 1.119-1 .......................................................................................................................................................7
26 C.F.R. 1.1001-2 ...................................................................................................................................................... 37
26 C.F.R. 1.446-1 ........................................................................................................................................................ 37
Constitutional Provisions
U.S. Const. amend. I .......................................................................................................................................... 8, 19, 29
U.S. Const. amend. XVI .................................................................................................................................... 7, 13, 31
U.S. Const. art. I, § 9, cl. 4 ............................................................................................................................................7
6
Chapter 1 – Gross Income
The concept of income is important because of the language of the Sixteenth Amendment: “The Congress shall have
power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several
States, and without regard to any census or enumeration.” Things that aren’t income don’t fall within the Sixteenth
Amendment and thus aren’t permitted “unless in Proportion to the Census or Enumeration . . . .”1
Though early Supreme Court cases wrestled with the constitutional definition of income, this has increasingly
become a pointless or makeweight argument.
Today, the definition of income is codified at 26 U.S.C. § 61. “[G]ross income means all income from whatever
source derived.”2 The Court now routinely recognizes “the purpose of Congress to use the full measure of its taxing
power,”3 and declines to split hairs over the meaning of income.
The Haig-Simons definition of income is I = C + ∆NW: Income = Consumption + Change in Net Worth.
§ 1.01 – Employment
[A] – In-Kind Payments
The 1929 case Old Colony Trust Co. v. Commissioner4 is important because the Court considers the meaning of
income. The petitioner company paid its president’s taxes. The Court reasoned that
[t]he payment of the tax by the employers was in consideration of the services rendered by the employee
and was a gain derived by the employee from his labor. The form of the payment is expressly declared to
make no difference [by the Act]. It is therefore immaterial that the taxes were directly paid over to the
Government. The discharge by a third person of an obligation to him is equivalent to receipt by the person
taxed.5
The Court was unswayed by the petitioner’s argument that taxing a tax would compel it to pay taxes on taxes in a
kind of feedback loop.
In Benaglia v. Commissioner,6 the Board of Tax Appeals held that it wasn’t income for the petitioner’s employer to
pay his room and board. Benaglia was a hotel manager, and the Hawaiian hotel that employed him permitted him to
live with his family in the hotel and take meals for free. The court reasoned that this was “solely because he could
not otherwise perform the services required of him.” 7
An interesting issue in Benaglia is how the employee’s in-kind compensation would be valued if it were taxable.
Likely it has a nonzero value to Benaglia, particularly in light of his background interest in working at a hotel in
Hawaii. But obviously he wouldn’t pay the room’s rack rate—it might even exceed his in-cash income. Though the
economically soundest rule would value income in terms of the utility it creates, this is unadministrable, and so rules
of this sort are usually blunt, either excluding or including monetary valuations. 8
Now 26 U.S.C. § 119 and 26 C.F.R. § 1.119-1 control in cases like Benaglia. The details are complex, but the rules
aim to determine that room and board are not offered as a stealth form of compensation. Among other things, they
require the employee to live or take his meals on the premises. Commissioner v. Kowalski9 also dealt with this issue.
In Kowalski, the Supreme Court held that a system of meal allowances for police officers constituted income.
Originally the police ate at barracks along the highway, apparently in a rather absurd attempt to qualify for the
1
U.S. Const. art. I, § 9, cl. 4.
26 U.S.C. § 61(a).
3
Helvering v. Clifford, 309 U.S. 331, 334 (1940).
4
279 U.S. 716, as reprinted in William D. Andrews & Peter J. Wiedenbeck, Basic Federal Income Taxation 35 (6th ed. 2009).
5
Old Colony, 279 U.S. at 729, as reprinted in Andrews & Wiedenbeck, supra note 4, at 36 (citation omitted).
6
36 B.T.A. 838 (1937), as reprinted in Andrews & Wiedenbeck, supra note 4, at 39.
7
Benaglia, 36 B.TA. at 839, as reprinted in Andrews & Wiedenbeck, supra note 4, at 40. Cf. text accompanying note 55 (discussing a similar test
for the deductibility of business travel).
8
But cf. Turner v. Comm’r, 13 T.C.M. (CCH) 462 (1954), infra note 38.
9
434 U.S. 77 (1977).
2
7
Benaglia rule. But because this proved too cumbersome, the department allowed the officers to eat at restaurants
(i.e., not on-premises). Even worse for the department, the meal allowances varied based upon rank and made up a
significant proportion of the officers’ pay. This fell well outside of § 119.
It’s interesting to contrast 26 U.S.C. § 107, which makes the Benaglia / § 119 rule more generous for “ministers of
the gospel.” Section 107 appears pretty dicey under the First Amendment. It’s also our first encounter with special
interest legislation in the course. And it points up the difficulty of potentially unconstitutional tax statutes ever
receiving judicial review: there are significant standing problems.10
[B] – Fringe Benefits
Certain fringe benefits aren’t income though they fall within § 61 and outside § 119. These exceptions are codified
at 26 U.S.C. § 132, which enacted what was already a practice of employers and the IRS. The fringe benefits
excluded:








no-additional-cost service;
qualified employee discount;
working condition fringe;
de minimis fringe;
qualified transportation fringe;
qualified moving expense reimbursement;
qualified retirement planning services; and
qualified military base realignment and closure fringe.
Parts of these exemptions reflect an interest in administrability, but other parts are examples of special-interest
legislation.
On the first head, it would be quite difficult to determine the value of pleasant working conditions to any employee.
Although an employee likely gives up some in-cash pay to enjoy a nice office with beautiful views, it would be
impracticable to tax the value this creates. Even this creates distortions: a coal miner will demand higher pay due to
unpleasant conditions, and this higher pay will be taxed, leading to even higher pay to make up for the tax. In
contrast, a professor who enjoys her job and surrounds will enjoy these noncash emoluments tax-free, putting her
employer to less cost. Ultimately, the tax system subsidizes consumers who purchase goods and services resulting
from pleasant jobs.
The special-interest fringe benefits work similar distortions but without the cover of administrability. For example,
§§ 132(a)(5), (b), (i), and (j)(5) together conspire to allow airline employees untaxed travel benefits. This lowers the
salary airlines must pay, and thus ultimately transfers money from the government’s fisc to airline travelers. This in
turn leads to erroneous price signals and to greater-than-socially-optimal consumption of certain goods.
Another kind of benefit employers offer is a “cafeteria plan” (which pertains to insurance, not food). Cafeteria plans
give employees a choice between types of insurance or cash. If it weren’t for 26 U.S.C. § 125, money paid into
insurance under the auspices of a cafeteria plan would be taxed. That’s because it’s tantamount to the employer
saying, “Here’s some extra income that we really think you ought to put into insurance.” But § 125(a) says “no
amount shall be included in the gross income of a participant in a cafeteria plan solely because, under the plan, the
participant may choose among the benefits of the plan.” (Emphasis added.)
§ 1.02 – The Concept of Income and Tax Expenditures
[A] – Income and What to Tax
We could have a capitation tax: everyone pays $5,000. We don’t because it would be regressive and would bankrupt
some people. But this is enough to show that distributional considerations permeate our tax system.
10
Cf. text accompanying note 54.
8
We tax income, but we could tax consumption. Income partly serves as a proxy for ability to pay, but ability to pay
isn’t the whole story—if it were, you could spend all your money before April 15 and claim you have no ability to
pay; we also wouldn’t exempt things like money used to earn income, money for disabilities, etc.
Our tax system is in broad strokes progressive, but marginal tax rates on some dollars of income are huge on the
poor and middle class. This is due to phaseouts at certain incomes of programs like the Earned Income Tax Credit
and the Child Tax Credit.
11
[B] – Tax Expenditures
[1] – In General
A tax expenditure is an exception from the background taxation principles, and so functions like an appropriation.
But it’s sufficiently esoteric that it can provide political cover for politicians to spend money without constituents
noticing. The government defines a tax expenditure as a
revenue loss[] due to the preferential provisions of the Federal tax laws which allow a special exclusion,
exemption, or deduction from gross income or which provide a special credit, a preferential rate of tax, or a
defferal of liability.12
A conceptual problem with defining tax expenditures is the need to articulate a baseline. To understand what
deviates from normal, we must define normal. But the tax system isn’t theoretically consistent. Some bits tax
income; others, consumption.13 Some income is never taxed, other income is taxed two or more times. 14
Apart from how difficult tax expenditures can be to define, they can be inequitable because they are often upside
down. That is, they are more generous to higher-bracket payers than lower. Professor Kaplow gives this example:
imagine Congress excluded food from tax. “Version 1” involves everyone paying the same amount for food.
“Version 2” recognizes that the wealthy spend more.
Mark Thoma, Effective Marginal Tax Rates on Labor Income, Economist’s View, Nov. 16, 2005
http://economistsview.typepad.com/economistsview/2005/11/effective_margi.html.
12
As reprinted in Andrews & Wiedenbeck, supra note 4, at 510.
13
See generally Analytical Perspectives, Budget of the U.S. Government, Fiscal Year 2009, as reprinted in Andrews & Wiedenbeck, supra note
4, at 510. See Section 1.02[B][3][a], below.
14
Id.
11
9
Food Expenditures
Version 1
Version 2
$5,000
$8,000
$5,000
$6,000
$5,000
$5,000
Tax Bracket
40%
15%
0%
Value of Tax Expenditure
Version 1
Version 2
$2,000
$3,200
$750
$900
$0
$0
Framed as an appropriation, this would be ludicrous: “Congress shall pay Americans in the 40% tax bracket a food
stipend of $3,000; those in the 15% bracket a stipend of $900; those in the 0% bracket no stipend.” Moreover, tax
expenditures may lead to overconsumption, creating a deadweight loss underwritten by the tax system.
And so the IRS spends government money at the rate of about a trillion dollars a year. It has its fingers in a dizzying
number of policy areas, and much of this passes under the radar politically.
[2] – Municipal Interest Bonds
With some exceptions, “gross income does not include interest on any State or local bond.”15 The point of this is to
subsidize municipalities, but there are nonobvious consequences. The tax exemption typically leads to an upsidedown effect, and much of the subsidy finds its way into different pockets than municipalities.
Tax Bracket
50%
30%
20%
10% Corp. Bond
5%
7%
8%
After-Tax Yield
7% Mun. Bond
7%
7%
7%
Benefit
2%
0%
0%
In this example, only the top-bracket taxpayer gets a benefit. Interest from a corporate bond that pays 10% is taxed
at 50% and thus yields only 5%. For all brackets, a municipal bond pays untaxed interest, and so yields the same
interest rate to all taxpayers. Thus, for a taxpayer at or below the 30% bracket, the corporate bond is as or more
attractive. Only the top-bracket payer benefits.
It’s interesting too to see where the money is going. Absent § 103, the rich taxpayer would require the municipality
to match the corporation and pay 10% interest to be competitive. The municipality would pay the taxpayer 10%. 5%
would go to the taxpayer and 5% to the IRS.
In the § 103 world, the municipality can pay 7% rather than 10% and thus keeps 3% interest. The rich taxpayer,
rather than paying 5% of the interest to the IRS, pays 0%. In net, the rich taxpayer goes from earning 5% after-tax
interest to earning 7% after-tax interest, and so is up 2%. The municipality goes from paying 10% interest to paying
7%, and so is up 3%. The IRS is down 5%.
Thus, under § 103, the IRS has paid a subsidy of 3% to municipalities and 2% to wealthy taxpayers, taking a 5% hit.
Although this isn’t actually inefficient (in that it doesn’t lead to actual investment departing from the socially
optimal level), it’s an unusual distributional consequence. It is less effective than a direct subsidy.
Professor Kaplow touched briefly on Build America Bonds, which avoided the upside-down effect by paying a
subsidy directly to the municipality. This was part of the stimulus bill but they’ve now expired.
Private activity bonds were a bastardization of municipal bonds. Municipalities were able to use their tax-exempt
capacity to issue debt in order to subsidize local business. Municipalities could also use their tax-exempt status to
profit by investing in corporate bonds—so-called arbitrage bonds. Congress killed much of this with amendments to
§ 103 and by enacting 26 U.S.C. §§ 141–48.
15
26 U.S.C. § 103(a).
10
[3] – Individual Retirement Accounts
[a] – Deferral in General
An important preliminary idea, and one that permeates tax law, is the value of deferral. Pensions and 401(k)s are
examples of advantageous deferral. Thus, IRAs are a form of tax expenditure.
The example below considers a 50% taxpayer who earns $100 at the beginning of Year 1, then invests it in an
account that pays 10% interest per year. Deferring tax on the investment until the end of Year 2 has exactly the same
outcome as making the yield from the interest tax-exempt. Another way of imagining this is to say that deferral is
like the government giving you an interest-free loan of the tax you’d otherwise have to pay. You have the
opportunity to earn interest on the money the government loans you before paying it as tax at the end.
Regime
Income Tax
Deferral
Exempt Yield
Year 1
Income
Tax
$100
$50
$100
$0
$100
$50
Investment
$50
$100
$50
Interest
$5
$10
$5
Year 2
Tax
$2.50
$55
$0
Consumption
$52.50
$55
$55
Also, deferral functions like a consumption tax rather than an income tax:
Regime
Income Tax
Cons. Tax
Tax Base
$100
$0
Year 1
Tax Investment
$50
$50
$0
$100
Interest
$5
$10
Year 2
Tax
Tax Base
$5
$2.50
$110
$55
Consumption
$52.50
$55
The more that tax is deferred, the more the tax system functions like a consumption tax rather than an income tax.
The wealthy often have much of their wealth in deferred accounts. Home ownership functions as a deferral account.
So the poor live in a world of income taxation; the rich largely live in a world of consumption taxation.
This again raises the baseline question mentioned in Section 1.02[B][1], above.
[b] – Retirement Plans
In a traditional IRA, both the interest and principal are tax-deferred. In a Roth IRA, tax is paid before the funds are
invested, but there is no further tax. A Roth can be better in two ways: First, it allows the investor to save more in
the preferred way: the contribution cap is in after-tax dollars, so the limit is actually higher. Second, because it is
taxed up front, it is immune to higher tax rates in the future, whether due to the taxpayer’s income increasing or
taxes going up.
[C] – Imputed Income
Much that creates value or would be saleable is not taxed. For example, housework could be taxed: by dusting and
mopping, one avoids hiring a cleaning person. But the value thereby created is not taxed. The reasons are
straightforward: administrability and politics.
The incentives are significant: for example, people do more housework than is socially optimal. The measure of the
inefficiency is the person’s tax bracket. Without taxes, a person who makes $50 per hour and is neutral between
doing his job or cleaning will hire a housekeeper if that person charges less than $50 per hour. That way, the person
can earn more money at his job. But if that person is a 30%-bracket taxpayer, he will only hire a housekeeper who
charges less than $35 per hour. Yet if we assume the market correctly values labor, there are foregone social gains
from the $50-per-hour earner not hiring a $40-per-hour housekeeper.
11
Imputed rent is critical to explaining why the mortgage interest deduction is attractive. 16 A person living in her own
home can be imagined to have a landlord half and a tenant half. To make this even clearer, we can imagine two
people with identically priced houses paying each other rent to live in the other house. Although the tax-free version
of this transaction has a zero sum, the version with taxes causes both parties to lose money. That’s because each
must pay tax on the income paid to the other as rent. By the simple expedient of trading deeds, they could avoid this
tax. The amount of tax thereby avoided is imputed rent. The same dynamic occurs within a single individual who
owns her home: she is both a homeowner and a tenant. After all, she could rent her house to someone else, and by
not doing so, she proves that she values the house as much as the market value for rent. But her “rent” isn’t taxed.
Formalized bartering is taxed, but informal bartering is not—you don’t have to report the exchange of pie you bring
to a neighborhood potluck dinner for the food others brought; this is another example of imputed income.
One of the distortions that not taxing imputed income works is that leisure / non-market activity is heavily
subsidized. Imagine a person is contemplating either going to the park immediately or instead going to a movie after
working an extra hour to afford movie tickets for his family. If the person only slightly prefers the movie plan, the
fact that the imputed income from going to the park is untaxed may prove decisive. Yet this is technically
inefficient.
§ 1.03 – Recovery of Capital
[A] – Basis and Related Concepts
The key issues when it comes to capital are the amount of gain or loss, timing, and whether the tax rate is ordinary
or discounted.
The following example highlights the key variables: A person buys a casebook for $150. She spends $5 to buy tabs,
which she uses to mark the important passages in the book. Because she is so insightful, she is able to sell the book
for $200. In the alternative version, she sells the book for $50.
Term
Example 1
Example 2
Section
Basis
$150
$150
§ 1012(a)
Adjusted
Basis
$155
$155
§ 1011(a)
Amount
Realized
$200
$50
§ 1001(b)
Gain /
Loss
$45
($105)
§ 1001(a)
Language
“The basis of property shall be the cost of such
property . . . .”
“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.”
“The amount realized from the sale or other disposition
of property shall be the sum of any money received plus
the fair market value of the property (other than money)
received.”
“The gain from the sale or other disposition of property
shall be the excess of the amount realized therefrom
over the adjusted basis . . . and the loss shall be the
excess of the adjusted basis provided . . . over the
amount realized.”
Professor Kaplow suggests two ways of thinking about adjusted basis:


It’s the amount of money that has passed through the tax system already, so it doesn’t make sense to tax it
again.
It’s the number that, when put in the formula, yields the correct answer.17 This isn’t absolutely foolproof,
but most of the time the commonsense answer to this question is correct.
16
See Section 2.03[B] (providing a numerical example of the role of imputed rent, and the mortgage interest and property tax deductions).
But see Section 1.06[b][2], below (discussing carryover and stepped-up basis for gifts and bequests); Section 3.02, below (discussing divorce
settlements); and Section 2.03[E][3], below (discussing donating appreciated assets).
17
12
[B] – Realization / Recognition
The realization statute is pretty straightforward: “Except as otherwise provided in this subtitle, the entire amount of
the gain or loss, determined under this section, on the sale or exchange of property shall be recognized.”18
The early (and unnecessarily lengthy) Supreme Court case Eisner v. Macomber19 held that a stock dividend was not
a realization event. A stock dividend is a dividend paid in additional shares rather than cash. As Professor Kaplow
put it, a shareholder isn’t excited when he gets a stock dividend—it’s merely an accounting tool a corporation uses
to adjust the books. So it isn’t income because the shareholder is no better off afterwards.
Eisner is clear enough (although see the case for lengthy marshalling of analogies), but it raises a variety of
fundamental issues.
Why do we wait for realization to assess taxes on gains? It’s not necessary: partnerships and many investments are
taxed periodically. And cash dividends are taxed. The efficient market hypothesis suggests that share prices already
reflect things like dividends: the value of a share will go up as a dividend nears, then should drop by the amount of
the dividend, all things otherwise held constant. So perhaps we oughtn’t tax even cash dividends.
The answer is one we’ve seen before: although the real moment of income is the change in market value, realization
is a concession to administrability. Some assets are difficult to value, and so rather than trying to determine this
yearly, the tax system goes with the easier metric of the amount realized.20 Though even this can present vexing
valuation problems.21
Also note that Eisner is apparently a constitutional decision. These days, it’s not particularly useful to argue that
something violates the Sixteenth Amendment: the Court is not so persnickety about the word income now.
Sections 109 & 1019 of the Code overruled the Supreme Court case Helvering v. Bruun.22 Helvering held that a
lessor realizes a gain at the time the lease terminates, not at the time the tenant makes improvements to the
leasehold. Part of the motivation for this rule is that a lessee could improve the land, then completely use up the
improvement during the lease term; under these circumstances the lessor cannot be said to have had income.
Now there is no gain at any time during the lease or after it’s terminated.23 But also basis is not adjusted,24 so when
the lessor finally disposed of the property at some future date, his amount realized will include the increased value
that any extant improvements create.
[C] – Capital Gains
It’s important to distinguish between ordinary income and capital gains, and it’s a topic taxpayers attempt to
massage—all because capital gains are taxed at a substantially lower rate. Indeed, under the Bush tax cuts, the
capital gains rate tops out at 15%.25
A capital gain or loss exists when (1) a capital asset (defined in 26 U.S.C. § 1221) is (2) sold or exchanged.
Note that a capital gain is income under § 61. The question isn’t whether it’s income, only what tax rate applies.
§ 1.04 – Compensation for Losses
In Clark v. Commissioner,26 the Board of Tax Appeals held that money a lawyer repaid his client wasn’t income.
The lawyer had given the client bad tax advice, which cost the client about $20,000. The lawyer repaid the client for
18
26 U.S.C. § 1001(c).
252 U.S. 189 (1920) as reprinted in Andrews & Wiedenbeck, supra note 4, at 207.
See note 6, supra, and accompanying text.
21
See, e.g., Section 5.04[B], below.
22
309 U.S. 461 (1940) as reprinted in Andrews & Wiedenbeck, supra note 4, at 242.
23
26 U.S.C. § 109.
24
26 U.S.C. § 1019.
25
26 U.S.C. § 1(h)(1)(C)
26
40 B.T.A. 333 (1939) as reprinted in Andrews & Wiedenbeck, supra note 4, at 83.
19
20
13
this error. Another way of looking at this case is to imagine that a tenant overpaid rent. The check the tenant
received to repay the error would surely not be income.
The key to determining the tax on damages is that they are taxed based upon what they’re in lieu of. Pay for lost
income is income, for example.
In Raytheon Production Co. v. Commissioner,27 the First Circuit what the money paid to settle a lawsuit replaced in
a world without the delict. The court held that the damages were for destroyed goodwill. Goodwill is the value of the
business as a going concern minus all of the tangibles.
Goodwill usually has an adjusted basis of zero. That’s because goodwill is generally created by employees, but their
pay is already deductible. And to the extent a company creates goodwill by tailoring its business activity (e.g., by
choosing not to carry products tested on animals), foregone profits are already not taxed. In other words, a business
didn’t sink any money at some earlier time in order to get the goodwill it now has.
So in Raytheon, even though the damages were in lieu of a return on capital, the money was still taxable to the
extent it represented a gain. And since the basis of the goodwill was zero, it was all gain: only the portion of return
on capital that recovers adjusted basis is nontaxable. The court analogized the situation to a business property
bought cheap that went up in value, that was then was destroyed by negligence. Tort damages would include the
appreciation of the property and that portion would be taxable income.
Commissioner v. Glenshaw Glass28 held that punitive damages are taxable income. The Court’s discussion suggests
that Eisner is pretty much dead: the Court didn’t trouble itself at all to fix a precise definition on income.
Now 26 U.S.C. § 104, “Compensation for injuries or sickness,” sets the rules. Note, § 104 coordinates with 26
U.S.C. § 213 to avoid double deductibility of medical expenses.
Category
Medical expenses
Loss of earnings while
hospitalized
Permanent loss of earning
power
Pain and suffering
Punitive damages
Treatment under classic rule
No (compensatory)
Treatment under § 104
No
Yes (earnings)
Yes
Yes (earnings)
No (compensatory—you don’t pay not to have
pain and suffering)
Yes (Glenshaw rule)
Yes
Maybe (if mental: § 104(a)
knocks out § 104(a)(2))
Yes
There’s an interesting incentive: if you’re negotiating a personal-injury settlement, it behooves both parties to record
as much as possible as compensatory rather than punitive.
§ 1.05 – Competing Claims and Offsetting Liabilities
[A] – Loans & Cancellation of Indebtedness
Loans and loan repayments aren’t income or losses. A balance sheet would show that a borrower has received cash,
causing an upward change in net wealth, but also an IOU in the same amount. The net of these entries is zero change
in net wealth. Thus, because there’s no consumption nor change in net wealth, there is no income.
But if a taxpayer is able to cancel indebtedness, that is income. In United States v. Kirby Lumber Co.,29 a corporation
was able to buy bonds back for less than the issue price. This difference in price constituted income. This rule is
codified at § 61(a)(12).
There’s an exception to this rule for LRAP programs: “In the case of an individual, gross income does not include
any amount . . . of any student loan if such discharge was pursuant to a provision of such loan under which all or
27
144 F.2d 110 (1st Cir. 1944) as reprinted in Andrews & Wiedenbeck, supra note 4, at 86.
348 U.S. 426 (1955), as reprinted in Andrews & Wiedenbeck, supra note 4, at 90.
29
284 U.S. 1 (1931), as reprinted in Andrews & Wiedenbeck, supra note 4, at 415.
28
14
part of the indebtedness of the individual would be discharged if the individual worked for a certain period of time
in certain professions for any of a broad class of employers.”30
[B] – Contributions to Capital
“In the case of a corporation, gross income does not include any contribution to the capital of the taxpayer.”31 This is
quite similar to the general rule about loans: the corporation is simply paying off one account from another.
[C] – Illegal Income
The old rule treated embezzled income as nontaxable, in keeping with the loan paradigm (that is, the embezzler has
a standing obligation to repay the embezzled funds).32 But the Court reversed itself in James v. United States,33
holding that embezzled funds are income. If the embezzler repays the embezzled funds, he can claim a loss on that
year’s return. While this rule avoids some peculiarities (the defense in tax court that something was actually stolen;
more favorable treatment for criminals), it does make it harder for the crime victim to get his money back—he may
be fighting the IRS.
§ 1.06 – Gifts and Kindred Items
Gifts are income under the Haig-Simons definition. But 26 U.S.C. § 102(a) says, “Gross income does not include the
value of property acquired by gift, bequest, devise, or inheritance.” There are various arguments and
counterarguments. The money has already been taxed. But gratuitous payments are often taxed. And there is surely
value created for the donor in giving a gift.
Note also that § 102 isn’t the complete rule: though gifts are exempt for the recipient under income tax, there is a
standalone gift tax that affects the donor.34 This interacts with the estate tax to prevent a wealthy person from giving
everything away before death.
[A] – Business Gifts
Section 102(c) says the gift exception “shall not exclude from gross income any amount transferred by or for an
employer to, or for the benefit of, an employee.” Thus, employees can’t get gifts from employers.
Before those statutory provisions enacted bright-line rules, Commissioner v. Duberstein35 controlled the issue of
employer gifts. In Duberstein, the Court held that whether consideration from an employer constituted a gift or
compensation was a question that “must be based ultimately on the application of the fact-finding tribunal’s
experience with the mainsprings of human conduct to the totality of the facts of each case.”36
Duberstein created the difficulty of like cases being resolved differently. In Estate of Sydney Carter v.
Commissioner,37 Judge Friendly determined that an employer gave a gift to an employee’s widow by paying the
employee’s salary and bonus through the end of the year he died. He based this upon lower-court precedent. He read
Duberstein to allow wide discretion to the factfinder but not to entirely displace the notion of the rule of law.
The statutes displaced most of this difficulty by adopting a bright-line rule, at least respecting employees.
But § 102 doesn’t fix the problem for gifts to non-employees. So there remain some questionable areas and
enforcement difficulties. For example, celebrities sometimes get swag, perhaps in the hope they will consume the
goods in the public eye. This is taxable but generally not taxed.
30
26 U.S.C. § 108(f)(1).
Id. § 118(a).
32
Comm’r v. Wilcox, 327 U.S. 404 (1946).
33
366 U.S. 213 (1961), as reprinted in Andrews & Wiedenbeck, supra note 4, at 446.
34
See 26 U.S.C. §§ 2501–10.
35
363 U.S. 278 (1960), as reprinted in Andrews & Wiedenbeck, supra note 4, at 179.
36
Duberstein, 363 U.S. at 289, as reprinted in Andrews & Wiedenbeck, supra note 4, at 184.
37
453 F.2d 61 (2d Cir. 1971), as reprinted in Andrews & Wiedenbeck, supra note 4, at 200.
31
15
Section 274(b) says, “No deduction shall be allowed under § 162 or § 212 for any expense for gifts made directly or
indirectly to any individual . . . . For purposes of this section, the term ‘gift’ means any item excludable from gross
income of the recipient under section 102.” The goal here is to prevent the IRS from being whipsawed by the
business and gift recipient taking inconsistent positions—the employer deducting the payment as a business expense
and the employee reporting it as a gift. Per Professor Kaplow, this doesn’t work because of the word “excludable.”
If the word were “excluded,” the sections would actually coordinate.
[B] – Prizes, Scholarships, and Government Transfers
Prizes and Awards
Prizes and awards are covered by 26 U.S.C. § 74(a): “Except as otherwise provided in this section or in section 117
(relating to qualified scholarships), gross income includes amounts received as prizes and awards.” This prevents a
taxpayer from arguing that a prize was really a gift. Subsection (b) exempts from (a) some prizes and award to
charitable organizations.
In Turner v. Commissioner,38 the Tax Court ruled that a radio contest winner received income when he won a cruise.
The court found that the value of the cruise to Turner was less than its face value, but more than zero. The court
appears simply to have made up a number.
Scholarships
“Gross income does not include any amount received as a qualified scholarship by an individual who is a candidate
for a degree at an educational organization described” elsewhere in the Code.39 But the scholarship can only go to
“qualified tuition and related expenses,”40 the latter referring to “fees, books, supplies, and equipment required for
courses of instruction . . . .”41 Note, this isn’t too much lost revenue—most students are in a low tax bracket.
Government Transfers
IRS rulings have excluded welfare benefits from income. But unemployment compensation is different: “In the case
of an individual, gross income includes unemployment compensation.”42 Social Security benefits are also taxed, but
in a more complicated way: sometimes half of the benefits are taxed, sometimes a different amount. 43
[C] – Tax Consequences of Gifts, etc.
[1] – Interest Income
Section 102 says that although “[g]ross income does not include the value of property acquired by gift, bequest,
devise, or inheritance,”44 “the income from” those things is gross income.45 Also, “where the gift, bequest, devise, or
inheritance is of income from property, the amount of such income” counts as gross income.46 This is consistent
with Irwin v. Gavit,47 a 1925 Supreme Court case that held taxable interest income from a property put in trust for
the respondent for life with the corpus to a remainderman. This rule avoids monkey business in which people could
assign cross-payments of interest from identical corpuses.
[2] – What Basis?
There is no tax on a gift when it’s given: the recipient is covered by the gift exemption of § 102 and the donor didn’t
realize anything under § 1001(b). But there is a tax if recipient sells it for enough money. The question is, what basis
should be used to calculate the gain?
38
13 T.C.M. (CCH) 462 (1954), as reprinted in Andrews & Wiedenbeck, supra note 4, at 43.
26 U.S.C. § 117(a).
40
Id. § 117(b)(1).
41
Id. § 117(b)(2)(B).
42
Id. § 85(a).
43
Id. § 86. See also Andrews & Wiedenbeck, supra note 4, at 205–06.
44
26 U.S.C. § 102(a).
45
Id. § 102(b)(1).
46
Id. § 102(b)(2).
47
268 U.S. 161 (1925) (Holmes, J.), as reprinted in Andrews & Wiedenbeck, supra note 4, at 157.
39
16


Gifts use carryover basis, with a few exceptions. 26 U.S.C. § 1015.
Bequests use stepped-up basis (FMV at time of decedent’s death). 26 U.S.C. § 1014.
Gifts
There’s a tricky part in the language of § 1015(a):
If the property was acquired by gift . . . the basis shall be the same as it would be in the hands of the donor
or the last preceding owner by whom it was not acquired by gift, except that if such basis . . . is greater than
the fair market value of the property at the time of the gift, then for the purpose of determining loss the
basis shall be such fair market value.
So a gain gets carryover basis, a loss gets stepped-up basis. But what if something is not a gain under carryover basis
but not a loss under stepped-up basis? The basis then is zero.
For example, imagine A bought a rare book for $1,000. Five years later, A gave the book to B as a gift. At that time,
its fair market value was $500. Five years after that, B sold the book to C for $750. To calculate the gain, we would
see how much the book increased in value from when A bought the book ($1,000) until B sold the book ($750). But
that’s not a gain—it would be a loss if we could use carryover basis. But to calculate a loss, we use stepped-up basis.
So the basis is the fair market value at the time of the gift ($500), the amount realized is the sale price ($750). But
that’s not a loss! We’re stuck in a loop. Here, though there’s no clear answer in the statute, the basis is simply zero.
Two points are worth noting. The commonsense way of defining basis doesn’t apply. Under the stepped-up basis
rule (in a loss), some losses can disappear. Related to the first point, this creates an incentive for donors to sell their
depreciated assets but to give gifts of their appreciated assets (particularly if the donor is in a lower tax bracket).
Bequests
People like stepped-up basis because it makes certain gains disappear. This is another exception to the commonsense
definition of basis. For example, a stock with 1¢ basis that appreciates to $5,000,000.01 before passing to devisee
will have basis of $5 million for the devisee. If the devisee sells the stock immediately, he will pay no tax on the
gain.
This creates an incentive to hold onto appreciated assets until death, but to sell depreciated assets to avoid steppeddown basis. This may lead to an older person having a portfolio that isn’t optimal except for the tax consequences.
The lock-in effect leads some people to suggest that a lower capital gains rate would actually raise revenue by
decreasing the disincentive for older people to sell appreciated assets.
17
Chapter 2 – Deductions
Chapter 9 of the casebook48 provides a good rundown of where the deductions are in the Code and what they mean.
§ 2.01 – Business vs. Personal
If we didn’t observe the business–personal borderline, nothing would be taxable under our system because personal
expenses would become deductible, just like business expenses.
[A] – Code Structure
Per Professor Kaplow a stripped-down version of our tax system would be the following:





§ 61: Defines income.
§ 62: Lays out itemized deductions—most importantly, business deductions.
§ 162: Allows deductions for carrying on a trade or business.
§ 212: Allows expenses for generating income to be deducted.
§ 262: Says personal and living expenses are not deductible.
Above- and Below-the-Line Deductions (Sections 62 and 63)
Deductions can either be above-the-line, falling under 26 U.S.C. § 62, or itemized (a.k.a, below-the-line), falling
under § 63.
Above-the-line deductions are preferable. That’s because many people take a standard deduction49 and therefore get
no tax benefit from itemizing. Also, there are partial itemized deduction phaseouts above certain income levels,50
and a 2% AGI floor for miscellaneous deductions.51 Wealthy people and homeowners are the usual itemizers.
The key above-the-line deduction is business expenses. This is most relevant for a business a person carries on not
as an employee. But there are also deductions available for reimbursed business expenses and some other forms of
business expenditures as an employee.
Other above-the-line deductions can drift above or below the line, depending upon the political winds.
Section 162
Section 162(a) allows “as a deduction all the ordinary and necessary expenses paid or incurred during the taxable
year in carrying on any trade or business . . . .” The Supreme Court has said to fall within § 162, an item must:
1.
2.
3.
4.
5.
be ‘paid or incurred during the taxable year,’
be for ‘carrying on any trade or business,’
be an ‘expense,’
be a ‘necessary’ expense, and
be an ‘ordinary’ expense.52
As in § 212, elements (4) and (5) are routinely ignored.
Section 212
Section 212 has some language that is now routinely ignored. It says:
In the case of an individual, there shall be allowed as a deduction all the ordinary and necessary expenses
paid or incurred during the taxable year—(1) for the production or collection of income; (2) for the
48
Andrews & Wiedenbeck, supra note 4, at 539–51.
See generally id. at 543–44.
50
See 26 U.S.C. § 68.
51
See generally Andrews & Wiedenbeck, supra note 4, at 546.
52
Comm’r v. Lincoln Sav. & Loan Ass’n, 403 U.S. 345, 352 (1971).
49
18
management, conservation, or maintenance of property held for the production of income; or (3) in
connection with the determination, collection, or refund of any tax.
But the words “ordinary” and “necessary” are all but meaningless now. The IRS doesn’t consider whether you
absolutely had to buy new doormats for your convenience store, nor whether chartreuse is the standard color.
Section 212(3) can be tricky because it may be hard to discern when someone is getting tax advice and when not.
For example, a lawyer may help a client draft a will in a way that avoids tax consequences. So how much of that is
deductible? It turns out 26 U.S.C. § 67 largely moots this.
Losses and Bad Debts (Sections 165 and 166)
Section 165(a) allows “as a deduction any loss sustained during the taxable year and not compensated for by
insurance or otherwise.” But subsection (c) limits this for an individual to “losses incurred in a trade or business; . . .
in any transaction entered into for profit, though not connected with a trade or business; and . . . losses of property
not connected with a trade or business or a transaction entered into for profit, if such losses arise from fire, storm,
shipwreck, or other casualty, or from theft.” Subsection (h) places further restrictions: casualty losses must meet
both dollar and AGI-percent limits.53
Section 166(a) covers bad debts: they’re deductible for businesses. But under subsection (d), nonbusiness bad debts
are treated like losses on the sale of short-term capital assets.
[B] – Tax Penalties
Section 67
Section 67 sets a two-percent floor on miscellaneous itemized deductions. That is, those itemized deductions that do
not fall within the list of deductions under subsection (b) are not claimable unless they total 2% of AGI.
Section 68
Section 68 limits the amount of itemized deductions that can be taken above a particular income. Because phasing
out a benefit is like a marginal tax rate increase, this is basically a 1% tax hike for some payers (these payers lose
deductibility for 3% of their itemized deductions; at the top bracket, this comes out to about 1% after-tax).
Illicit Earnings, Lobbying, Certain Penalties, and Excessive Pay (Sections 162 and 280E)
Various provisions of 26 U.S.C. §§ 162 and 280E limit the deductibility of some expenses.






53
54
§ 162(c): Illegal bribes and official bribes that violate the Foreign Corrupt Practices Act cannot be
deducted. The same is true of kickbacks for goods or services funded by Medicare or Medicaid.
§ 162(e)(1): Lobbying monies aren’t deductible. Note that this would be murky under First Amendment
grounds if lobbying money were taxed at a higher rate rather than excepted from deduction. Once again,
standing law shields a constitutional challenge. 54
§ 162(f): Fines and penalties paid for violations of law cannot be deducted. This enhances the deterrent
effect of those schemes.
§ 162(g): One-third of treble damages for antitrust violations can be deducted; two-thirds cannot.
§ 162(m): Publicly held corporations cannot deduct any employee’s pay that exceeds a million dollars.
§ 280E: Expenses incurred in trafficking in illegal drugs cannot be deducted.
See Section 2.03[C], below.
Cf. text accompanying note 10.
19
[B] – Travel and Entertainment
Travel, Lodging, and Food (Section 162(a)(2))
People sometimes try to deduct the expense of getting to work or living in one place rather than another in order to
work. They are often unsuccessful. Although § 162(a)(2) allows a deduction for “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,” this section receives a strict
construction, and the words away, home, and in the pursuit of a trade or business all have special meanings.
Therefore, § 262 usually controls: “Except as otherwise expressly provided in this chapter, no deduction shall be
allowed for personal, living, or family expenses.”
Section 274(d)(1) requires substantiation for these expenses.
Commuting is straightforward. For example, in Commissioner v. Flowers,55 the Court refused to allow a deduction
for an employee who was allowed to live and work in a remote city, but travel to headquarters when required by the
circumstances. This was nothing but commuting, and the Court reasoned that § 162(a)(2) only applied to travel if
three conditions existed:
1.
2.
3.
The expense must be a reasonable and necessary traveling expense, as that term is generally understood.
This includes such items as transportation fares and food and lodging expenses incurred while traveling.
The expense must be incurred “while away from home.”
The expense must be incurred in pursuit of business. This means that there must be a direct connection
between the expenditure and the carrying on of the trade or business of the taxpayer or of his employer.
Moreover, such an expenditure must be necessary or appropriate to the development and pursuit of the
business or trade.56
Because the employer didn’t need for Flowers to live in a different city, element (3) wasn’t met.57
A similar rule applies for temporary lodging. In Hantzis v. Commissioner,58 the First Circuit denied a Harvard Law
student’s deduction of a second residence maintained for a summer associateship in New York. The court bottomlined the rule this way:
the ultimate allowance or disallowance of a deduction is a function of the court’s assessment of the reason
for a taxpayer’s maintenance of two homes. If the reason is perceived to be personal, the taxpayer’s home
will generally be held to be his place of employment rather than his residence and the deduction will be
denied.59
Note that courts manipulate the statutory word “home,” using it to refer to the place of employment. Note too that
law school is not a business, so the situation would be different if someone were maintaining a second residence to
complete a temporary work assignment. The IRS uses a one-year rule-of-thumb for what constitutes temporary
housing.60
Short-term travel is another circumstance that presents the issue of deductibility, and again finds courts analyzing
“away from home” in the statute. In United States v. Correll,61 the Court upheld an IRS rule that allows a taxpayer
to deduct expenses under § 162(a)(2) “only if his trip requires him to stop for sleep or rest.” The case involved a
traveling salesman who drove great distances but slept in his own bed; thus, his expenses weren’t deductible.
55
326 U.S. 465 (1945), as reprinted in Andrews & Wiedenbeck, supra note 4, at 654.
Flowers, 326 U.S. at 471, as reprinted in Andrews & Wiedenbeck, supra note 4, at 656.
57
Cf. Benaglia, supra note 6, and accompanying text.
58
638 F.2d 248 (1st Cir. 1981), as reprinted in Andrews & Wiedenbeck, supra note 4, at 662.
59
Hantzis, 638 F.2d at 253, as reprinted in Andrews & Wiedenbeck, supra note 4, at 663.
60
See Andrews & Wiedenbeck, supra note 4, at 666–67.
61
389 U.S. 299 (1967), as reprinted in Andrews & Wiedenbeck, supra note 4, at 650.
56
20
In the background of the Correll Court’s opinion is the knowledge that without a bright-line rule, everyone would
deduct every meal and wait for an audit. So the Court takes the opposite tack of the Duberstein Court, announcing a
bright-line rule in lieu of a fact-driven un-rule.
And in the case of business meals, courts have held some nondeductible. In Moss v. Commissioner,62 a law firm met
daily at a particular restaurant to discuss cases. While it was undisputed that business was done in the restaurant, the
Seventh Circuit held that meeting in the restaurant wasn’t a business necessity, and thus not covered by § 162.
Entertainment
Section 274 limits and qualifies some things that would otherwise be deductible under § 162 or § 212. The statute
has several provisions:




There is no deduction for an activity “generally considered to constitute entertainment, amusement, or
recreation, unless the taxpayer establishes that the item was directly related to” business or a business
discussion.63 But some expenses are deductible: food served on the premises; certain entertainment treated
and reported as compensation to employees, etc.64
The cost of food, beverages, and entertainment that are deductible must be divided by two. 65
There is a substantiation requirement.66
Due to special-interest lobbying, qualifying conventions are tax deductible. 67 This leads to silly
boondoggles like conferences for lawyers in Hawaii (at Bengalia’s hotel, perhaps).
[C] – More on the Border Between Business and Personal
[1] – Clothing
There’s a bright-line rule for business clothing. Roughly speaking, only uniforms are deductible. In Pevsner v.
Commissioner, the Fifth Circuit summarized the elements that clothing must meet in order to be deductible as
follows:
1.
2.
3.
“the clothing is of a type specifically required as a condition of employment,”
“it is not adaptable to general usage as ordinary clothing, and”
“it is not so worn.”68
In Pevsner, the court upheld the IRS’s decision not to allow an employee of a fancy boutique to deduct the cost of
the stylish clothing she was required to wear to work there. Although she may have valued the clothes differently, 69
the court applied a simpler rule.
[2] – Home Offices
Although home offices were once common deductions, the current statute—26 U.S.C. § 280A—is pretty harsh. The
general rule for residences is, “in the case of a taxpayer who is an individual or an S corporation, no deduction
otherwise allowable under this chapter shall be allowed with respect to the use of a dwelling unit which is used by
the taxpayer during the taxable year as a residence.”70 And while an exception is made for home offices,71 the
requirements are steep. The area must be used exclusively for business, and if the person is an employee, the office
must be maintained for the convenience of the employer.72
62
758 F.2d 211 (7th Cir. 1985), as reprinted in Andrews & Wiedenbeck, supra note 4, at 676.
26 U.S.C. § 274(a)(1)(A).
64
Id. § 274(e).
65
Id. § 274(n).
66
Id. § 274(d)(2).
67
Id. § 274(h).
68
628 F.2d 467, 469 (5th Cir. 1980), as reprinted in Andrews & Wiedenbeck, supra note 4, at 648–49.
69
Cf. Turner, supra note 38.
70
26 U.S.C. § 280A(a).
71
Id. § 280A(c)(1).
72
Id.
63
21
[3] – Childcare
The deductions and credits for childcare are codified at 26 U.S.C. §§ 21 & 219.73 These rules change frequently. But
the idea of deducting childcare as a business expense is distinct.
In Smith v. Commissioner,74 the Board of Tax Appeals held that the cost of childcare was not deductible as a
business expense, even though it may have been necessary to allow the parents to work. The choice to have children
can be viewed as personal consumption: although work is the but-for cause of childcare, so is the decision to have
children.
Taxing money spent on childcare serves as a disincentive for both rather than only one parent to work for pay. This
is an effect of imputed income not being taxed.75
[4] – Not-for-Profit Activities
Sometimes a person runs something that’s ambiguously a business or a hobby. In Bessenyey v. Commissioner,76 a
wealthy person raised horses, hemorrhaging money for years. But she claimed she had a vision for turning a profit in
the future, and that the money lost to that point was part of growing the business. The Second Circuit upheld the Tax
Court’s finding that the petitioner’s motive was not profit under the clearly erroneous standard of review.
Now 26 U.S.C. § 183 covers “Activities not engaged in for profit.” The statute does two things. First, it helps
taxpayers by setting up a presumption that a taxpayer has engaged in activity for profit if the person has profited
three of the last five years (or two of the last seven in the case of equestrian pursuits). 77 Second, it allows the
taxpayer a deduction that equals gross income less other tax deductions.78
[5] – Legal Expenses
Getting sued isn’t fun, but the tax code treats it as consumption if it’s not connected to profit-seeking activities. In
United States v. Gilmore,79 the Supreme Court held that although the respondent might have lost his business if he
hadn’t defended himself in divorce litigation, the expense was not to “conserv[e] . . . property held for the
production if income.”80 The rule is as follows: “the characterization, as ‘business’ or ‘personal,’ of the litigation
costs of resisting a claim depends on whether or not the claim arises in connection with the taxpayer’s profit-seeking
activities.”81
§ 2.02 – Capital Costs: Businesses Only
Capital costs are only relevant if you’re a business. There’s no related concept for personal expenses. You can’t take
depreciation on your car because the decrease in value is due to consumption. It’s a personal cost, not a cost of doing
business.
The key Code sections:




Section 167(a). Allows a deduction for depreciation.
Section 263. Generally prohibits immediate deduction for capital expenditures, but has a list of exceptions
that thereby allow immediate deductibility.
Sections 165 and 1001. Deal with gain or loss on a sale or other disposition.
Section 1016(a)(2). Discusses how depreciation changes basis.
73
See also Section 3.01, below.
40 B.T.A. 1038 (1939), aff’d 113 F.2d 114 (1940), as reprinted in Andrews & Wiedenbeck, supra note 4, at 643.
See Section 1.02[C], above.
76
379 F.2d 252 (2d Cir. 1967), as reprinted in Andrews & Wiedenbeck, supra note 4, at 688.
77
26 U.S.C. § 183(d).
78
26 U.S.C. § 183(b).
79
372 U.S. 39 (1963), as reprinted in Andrews & Wiedenbeck, supra note 4, at 714.
80
26 U.S.C. § 212(2).
81
Gilmore, 372 U.S. at 48, as reprinted in Andrews & Wiedenbeck, supra note 4, at 718.
74
75
22
[A] – Capital Recovery and Investment Incentives
[1] – Depreciation
A business can’t deduct the whole cost of building a factory once its built. The reason is similar to loans not being
taxable: the business has spent money, but in return it has an asset whose value is the same as the cash just spent.
Only once the factory starts to get used up does the company start to lose value. Deducting the full cost immediately
is called expensing.
The Platonic ideal of depreciation is economic depreciation—the up-to-the-moment value of the asset. This is
impracticable to compute constantly, so the tax system uses rules that aim to approximate economic depreciation.
And sometime, the depreciation rules also include policy choices: for example, to allow certain industries to realize
future losses that economic depreciation would not. Fundamentally, a depreciation method is a tax expenditure to
the extent it’s more rapid than economic depreciation. In the 1980s, some depreciation methods were even more
generous than expensing.
The corollary of depreciation is adjusting basis. If a factory cost $100 million to build, and tax law allowed $10
million-per-year depreciation, the taxpayer could claim a $10 million loss at the end of year one and would revise
basis downward $10 million. If the taxpayer then sold the factory for $91 million, the gain would be the amount
realized ($91 million) minus the adjusted basis ($90 million): $1 million. If the amount realized were $89 million,
there would be a loss of $1 million.
Methods
Several different means of calculating depreciation are possible. 26 U.S.C. §§ 167 & 168 govern the choice.
Straight-line depreciation is a simple linear equation that takes into account the acquisition price and useful life of
the asset.
The declining-balance method uses 150% or 200% of the yearly rate of decline used by the straight-line method,
then multiplies the outstanding balance by that figure each year. This offers accelerated depreciation at the
beginning, which taxpayers favor because of the time value of money. The method switches to straight-line
depreciation when the slope of the asymptotic line is less steep than the straight-line method slope.
The sinking fund method is rarely used, but functions like the principal in a mortgage. It is a form of decelerated
depreciation, and would thus seem unfavorable for most purposes.
There is even a policy debate as to whether depreciation should be used at all. The basic idea is that only expensing
allows capital investments to receive similar tax treatment to financial investments.
Section 168(b)(5) allows a taxpayer to elect a slower method. This makes sense if you’re in a startup phase (lower
bracket) or expect Congress to enact higher taxes in the future.
Useful Life
The useful life of an asset helps determine the rate. The IRS has various publications setting out the useful lives of
different kinds of assets.
Other Details
As the method gets nearer to expensing, the tax effect becomes nearer to an exemption for the return on that
investment. Chapter 15.B–F of the casebook82 explains all this stuff and provides numerical examples.
The most generous accelerated depreciation now available—tantamount to expensing—affects R&D, advertising
and marketing, “overhead,” and small businesses.
82
Andrews & Wiedenbeck, supra note 4, at 861–79.
23
[2] – Transferability of Tax Incentives
Corporations can’t sell their tax losses. Tax policy often has reasons to allow benefits to companies that lose money.
But companies deep in the hole (think GM and Chrysler last year) or that are just getting going (think early
Amazon.com) can’t take advantage of tax losses because they don’t have enough income to offset.
The answer to this problem, at least sometimes, is leasing. A new airline may have little income, but its airplanes
may begin depreciating quickly. An option for the airline is to lease from, e.g., GE Capital. Because GE has a huge
amount of income, it can take advantages of the depreciation deduction, thereby lowering the lease price of the
aircraft, and passing a subsidy indirectly to the startup airline.83
This form of leasing has become less prevalent. In part, this is because the rules tightened since the 1980s. There
was significant political backlash when people discovered that some corporations had very low taxes or that huge
corporations were able to undercut other market players with the leases they could offer. Now the rules are more
complicated,84 so there are high transaction costs associated with navigating them that undermine the gains of safeharbor leasing. The key is that the lessor must really and truly be the owner.
These provisions also create incentives for entities that can’t take advantage of certain deductions—nonprofits, the
military, and local governments, for example.
[3] – Depletion
Depletion is the equivalent of depreciation except that it relates to things like mines, oil and gas, and timber. Chapter
15.F of the casebook runs down the relevant statutes and considerations. 85
An interesting policy consideration is the correct treatment of exploration. In some sense, digging a hole and finding
no oil is a loss. But in another sense, it’s part of the broader activity of finding oil. So it’s not entirely clear whether
it ought to be expensed or capitalized. The Code allows most exploration and development to be expensed.
[4] – Inventories
Like depreciation, inventories made in an earlier year involved the exchange of money for goods of an equivalent
value and similarly require the business to track their value. 86 The wild card is that both input and output; that is, the
price to manufacture widgets and at which they can be sold can change—the casebook summarizes the relevant
statutes and regulations.87
[B] – Current Expense vs. Capital Expenditure
Section 263(a)(1) denies a deduction for “[a]ny amount paid out for new buildings or for permanent improvements
or betterments made to increase the value of any property or estate.” The rest of the section lays out exceptions.
Whatever § 263 excludes is a capital expenditure and must be depreciated under § 167(a).
A good example of the dividing line between a current expense and a capital expenditure, then, is the difference
between a repair and an improvement. The best way to visualize both is to imagine a downward-sloping line tracing
depreciation. A repair deals with a breakdown in equipment that caused the value to depart downward from the line
that it had been tracking. The repair simply sets the depreciation diagram back to normal. In contrast, an
improvement bumps the line up from its original trajectory; from then on, the value of the equipment stays above the
original line.
In Mt. Morris Drive-In Theater Co. v. Commissioner,88 the Tax Court held that a drive-in theater’s drainage system
was a capital expenditure, even though the business only built it after a neighbor sued for nuisance. The court
reasoned that it didn’t matter why the drive-in company built the drainage system. What counted was that the
83
Cf. Section 1.02[B][2], above (discussing municipal bonds).
See generally Andrews & Wiedenbeck, supra note 4, at 911–12.
Andrews & Wiedenbeck, supra note 4, at 876–79.
86
See Section 4.02[B] (discussing the ordinary income treatment of inventory goods).
87
Id. at 357–58.
88
25 T.C. 272 (1955), as reprinted in Andrews & Wiedenbeck, supra note 4, at 766.
84
85
24
property was improved, and so it fell under § 263(a). This rule avoids a taxpayer intentionally doing something halfassed—like installing substandard tanks at a gas station—and then treating the “repair” as a present expense.
Taking the same idea a step further, the Supreme Court in Commissioner v. Idaho Power Co.89 held that a company
that used its own equipment and personnel to improve its facilities had to capitalize the salaries and equipment
expenses to the extent they were used for capital improvements. The company had to disaggregate the work done to
operate the plant (deductible immediately) from the work done to improve it (capital expenses). This achieved the
same result as hiring outside contractors.
The line blurs a bit. Imagine a construction company that built property over several years, then sold it. Should the
construction costs be capitalized? How about a housing subdeveloper? This pushes the boundary towards inventory.
And thus we have 26 U.S.C. § 263A, which says developers and resellers must capitalize their costs.
“[A] taxpayer’s expenditure that serves to create or enhance a separate and distinct asset should be capitalized under
§ 263.”90 In INDOPCO, Inc. v. Commissioner, the Supreme Court held that legal and investment bank fees spent
during a going-private merger were capital expenses. The Court determined that the taxpayer bears the burden of
showing that an expense falls under § 162 rather than § 263, and that the reduced transaction costs and synergies of
going private were improvements under § 263.
Two points bear mentioning. First, Professor Kaplow says the “separate and distinct” test isn’t very good: some
capital assets aren’t separate and distinct. Second, there’s a regulation that reaches this situation now. 91
Expenditures to increase human capital are not deductible: they’re considered personal consumption, even though
you could make the argument it ought to be a business deduction capitalized over your working life. The only sliver
of an exception is for job searches in the “same trade or business,” with a “high degree of identity” required for
sameness.92 Thus, in Estate of Rockefeller v. Commissioner, Judge Friendly determined that Nelson Rockefeller
could not deduct his expenses incurred during his Senate confirmation as Gerald Ford’s Vice President. Though
Rockefeller had for a long time been essentially a public pooh-bah, this was too indistinct to be a professional field
in which he was seeking a new job. The expenses were thus personal.
This is how law school is treated, too. The Code treats our tuition as consumption. Some forms of continuing or
vocational education are deductible: CLE; some business degrees after which the person remains in the same field.
The regulations fill out the details.
[C] – Allocation of Purchase Price
Some things aren’t depreciable at all. In particular, things with an indefinite or unlimited useful life aren’t—land is
the key here. The rules regarding intangibles were murky but were clarified after 2003. 93
As a result, taxpayers are likely to claim that most of the value of a purchase came from the buildings, not the land,
for example.
§ 2.03 – Personal Deductions
What’s special about personal deductions is that they’re also personal. Any of these is deductible by a business.
The huge categories here are interest and state / local tax: together, they add up to 70% of personal deductions.
89
418 U.S. 1 (1974), as reprinted in Andrews & Wiedenbeck, supra note 4, at 770.
INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 86 (1992) (citation and quotation marks omitted, internal punctuation altered), as reprinted in
Andrews & Wiedenbeck, supra note 4, at 779, 783.
91
26 C.F.R. § 1.263(a)-5.
92
Estate of Rockefeller v. Comm’r, 762 F.2d 264, 268 (2d Cir. 1985), as reprinted in Andrews & Wiedenbeck, supra note 4, at 796.
93
See generally Andrews & Wiedenbeck, supra note 4, at 830, 857–61; 26 U.S.C. § 197.
90
25
[A] – Interest
Although 26 U.S.C. § 163(a) says, “There shall be allowed as a deduction all interest paid or accrued within the
taxable year on indebtedness,” it exempts most personal interest. This is contrary to what many economists think is
the best policy.94 A few categories of personal interest are deductible, most importantly:




“interest paid or accrued on indebtedness properly allocable to a trade or business” except as an
employee;95
“investment interest”;96
“qualified residence interest”;97 and
some interest for qualifying educational loans.98
“Qualified residence interest” has several features. It includes both “acquisition indebtedness” and “home equity
indebtedness.”99 Acquisition indebtedness is money used to buy or improve the house, and it must be secured by the
house.100 It cannot, in aggregate, exceed $1 million. 101 Home equity indebtedness means loans secured by the house,
and cannot exceed $100,000 (or the value of the house).102 And the taxpayer can keep a primary home and one other
home under the provisions of the section.103 See the next section for an example of how the mortgage interest and
property tax deduction work together with imputed rent to create strong incentives for home ownership.
Section 265(a) tries to prevent one means of tax avoidance made possible by interest deductibility: “No deduction
shall be allowed for . . . [i]nterest on indebtedness incurred or continued to purchase or carry obligations the interest
on which is wholly exempt from the taxes imposed by this subtitle.” So a person who owns municipal bonds, but
rather than liquidating them borrows money to invest in a business deal, has presumptively borrowed the money to
carry the municipal bonds. Thus, any interest deduction on the new loan will be disallowed. 104
The rules discussed by the source cited at note 104 aim to keep track of what money is used for what purpose. But of
course, money is fungible, so coming up with rules that seek to track particular dollars is a difficult enterprise.
[B] – Taxes
Per 26 U.S.C. § 164(a), money paid for “[s]tate and local, and foreign, real property taxes,” “personal property
taxes,” and “income, war profits, and excess profits taxes” are deductible.
Sales tax is missing from this list of easy deductibility. A taxpayer can choose to deduct sales taxes, but must then
give up the deduction for state and local income taxes.105
There are some interesting issues of federalism here. States have sought to manipulate their own tax laws to
influence their citizens’ treatment under federal tax law. The IRS disallowed a scheme in which New York created a
sham taxable interest for tenants in rental property so that some rent could be deducted from federal tax. 106
The example below is the second half of the imputed rent story (the first half is described in Section 1.02[C], above).
Because mortgage interest and property taxes are exempt, the homeowner in the example below comes out $800
better off than the renter.
94
Andrews & Wiedenbeck, supra note 4, at 577–79.
26 U.S.C. § 163(h)(2)(A).
96
Id. § 163(h)(2)(B).
97
Id. § 163(h)(2)(D).
98
Id. § 163(h)(2)(F).
99
Id. § 163(3)(A).
100
Id. § 163(3)(B)(i).
101
Id. § 163(3)(B)(ii).
102
Id. § 163(3)(C).
103
Id. § 163(4)(A)(i).
104
Cf. Andrews & Wiedenbeck, supra note 4, at 565–69.
105
26 U.S.C. § 164(b)(5). See also Andrews & Wiedenbeck, supra note 4, at 583.
106
New York State Renters Tax, Rev. Rul. 79-180, 1979-1 C.B. 95 (1979), as reprinted in Andrews & Wiedenbeck, supra note 4, at 581.
95
26
Renter
$1,000
($500)
($100)
($100)
($100)
$200
Monthly rent
Interest
Taxes
Utilities
Depreciation
Taxable Income


Owner
(No tax on imputed income)
($500)
($100)
$0
$0
($600)
Relevant Section
§ 163
§ 164
§ 262
There’s a policy question as to whether this is desirable: why should we set a giant tax incentive only available for
middle- and upper-class taxpayers? The real issue is the failure to tax imputed rent, taken together with the
deductions outlined here. Unless we eliminate the deductions, there will be distortions.
[C] – Casualty Losses
Section 163(c)(3) allows a deduction for “losses of property not connected with a trade or business or a transaction
entered into for profit, if such losses arise from fire, storm, shipwreck, or other casualty, or from theft.” But
subsection (h) limits this: it places a $100 floor on each deduction and a 10%-AGI floor on the aggregate of casualty
losses (with a few complications—there are special rules for a federally declared disaster, for example).
Courts have given the “fire, storm, shipwreck” language a taxpayer-friendly construction. In Carpenter v.
Commissioner,107 for example, the Tax Court held that an engagement ring inadvertently run through the garbage
disposal qualified as a casualty loss. The language doesn’t require that there be some sort of exciting disaster, only
that a hidden or unpreventable fortuity occur.
The conceptual difficulty is one of line drawing. Everything is subject to unfortunate losses—the difference is one of
probability. A person who owns a car in the northeast can expect, with a high probability, that it will rust
prematurely. But this is considered simply a cost of consumption. Yet a low-probability but high-cost misfortune is
exempted from this principle of discounted probabilities by the casualty-loss provision.
[D] – Medical Expenses
Section 213(a) allows a deduction for uncompensated medical expenses that exceed a 7.5%-AGI floor. Subsection
(d) lays out what “medical care” means.
The casebook provides the following table, which summarizes the various methods of funding medical care. The
details are rather elaborate, and are summarized in Chapter 3.C.1 of the book. 108
Funding Method
Employer-Provided Coverage
Individually Purchased Insurance
Self-Insurance
Tax Treatment of Insurance for “Medical Care”
Premiums
Proceeds
Excluded, § 106
Excluded, § 105(b)
Limited Deduction,
Excluded, § 104(a)(3)
§ 213(d)(1)(D)
Limited Deduction,
N/A
§ 213(a)
[E] – Charitable Contributions
The general rule, codified at 26 U.S.C. § 170(a)(1), is, “There shall be allowed as a deduction any charitable
contribution[,] . . . payment of which is made within the taxable year. A charitable contribution shall be allowable as
a deduction only if verified under regulations prescribed by the Secretary.” The tricky bit is what qualifies.
Note that two code sections work in parallel: 26 U.S.C. § 501(c)(3) allows tax-exemptions for the recipient of
charitable gifts; § 170 allows deductions for the donor.
107
108
25 T.C.M. (CCH) 1186 (T.C. 1966), as reprinted in Andrews & Wiedenbeck, supra note 4, at 596.
Andrews & Wiedenbeck, supra note 4, at 119–26.
27
[1] – What is a Contribution?
A charitable contribution is a “a contribution or gift to or for the use of”:




federal, state, or local government;
an entity organized “for religious, charitable, scientific, literary, or educational purposes, or to foster
national or international amateur sports competition . . ., or for the prevention of cruelty to children or
animals” (with exceptions);
a veterans’ organization;
some cemeteries.109
In Dowell v. United States,110 the Tenth Circuit held that contributions to Oral Roberts’s ministries were charitable
contributions even though most people who lived in an Oral Roberts’s nursing home made the contribution. Much
like Duberstein, the court made relied on the factfinder and standard of review, noting that some people hadn’t made
the donation, the donation was given after the nursing home admitted the residents, etc.
The casebook gives some examples of borderline cases and policy considerations.111
[2] – Unrelated Business Income
Sometimes a charitable organization will pursue a line of business that is disconnected from the organization’s
function. On one end of the spectrum, the Girl Scouts sell cookies to raise money. On the other end, a church might
run a hedge fund.
The Supreme Court has approved the IRS’s test for potentially unrelated lines of business: “First, the payment is
deductible only if and to the extent it exceeds the market value of the benefit received. Second, the excess payment
must be made with the intention of making a gift.” 112 Thus, in United States v. American Bar Endowment, the
Supreme Court held that purchasers could not deduct insurance premiums they paid for coverage by a bar
organization. Although the premiums helped pay for charitable works, the insureds failed to show both elements:
some failed to prove they could get cheaper insurance; others failed to establish they intended the premiums as a gift
to the charity.
The bar organization’s behavior belied its claims. It could have won by making contribution amounts above the
organization’s costs discretionary. That it didn’t undermines the gift idea.
[3] – Contribution of Property or Services
Property
The tax treatment of appreciated assets is quite generous: the amount deductible is (with qualifications) the fair
market value, not the donor’s basis. 113
This was even more generous when higher ordinary and capital gains rates were in effect. With high enough rates,
even a person with no charitable intent would still choose to donate appreciated assets. For example, a 70% bracket
payer with $0 basis in stock now worth $100 per share could donate it and take a deduction of $100—worth $70
after taxes. At a 35% capital gains rate, liquidating and spending the proceeds would yield $65 after tax.
The current treatment still favors donating appreciated assets rather than liquidating them and donating the proceeds,
although now that lower tax rates prevail, charity rarely results in more after-tax money in the donor’s pocket. For
example, given the same facts as above, donating the stock would allow the donor to receive a deduction worth $100
x (100% - 35% (ordinary tax rate)) = $65. Selling the stock would give the taxpayer $100 x (100% - 15% (capital
109
26 U.S.C. § 170(c).
553 F.2d 1233 (10th Cir. 1977), as reprinted in Andrews & Wiedenbeck, supra note 4, at 631.
Andrews & Wiedenbeck, supra note 4, at 636–37.
112
United States v. Am. Bar Endowment, 477 U.S. 105, 117 (1986) (citation and internal quotation marks omitted), as reprinted in Andrews &
Wiedenbeck, supra note 4, at 621, 627–28.
113
26 U.S.C. § 170(e). See generally Andrews & Wiedenbeck, supra note 4, at 636–37.
110
111
28
gains rate)) = $85 after tax to donate; the donation, in turn, would allow a deduction of $85 x (100% - 35%) =
$55.25 after tax.
The overall incentive, then, is to donate appreciated assets but realize the losses for depreciated assets, then perhaps
donate the proceeds and take a charitable deduction.
The verification and confirmation rules are now more stringent, even for cash. 114 For in-kind contributions, the
organization must provide written acknowledgment.
Services
Services performed for a charity generally aren’t deductible. But this makes sense because there’s no taxable income
created: the person isn’t being paid for her volunteering, and she’s not working at her normal job.
[4] – Qualification
In Bob Jones University v. United States,115 the Supreme Court held that the IRS could deny charitable status to a
university that had antimiscegenation admission policies. Note again the First Amendment issues here and the
standing obstacles that prevent judicial challenge. Basically, the IRS seems to be allowed to decide what’s worthy of
a subsidy116 via tax expenditures.
114
26 U.S.C. § 170(f)(8). See generally Andrews & Wiedenbeck, supra note 4, at 636–37.
461 U.S. 574 (1983), as reprinted in Andrews & Wiedenbeck, supra note 4, at 607.
116
See Regan v. Taxation With Representation of Washington, 461 U.S. 540, 544 (1983) (“Both tax exemptions and tax-deductibility are a form
of subsidy that is administered through the tax system.”).
115
29
Chapter 3 – Who is the Taxpayer?
§ 3.01 – Taxable Unit
[A] – Who is Taxed
The tax system could say that every transaction carried out by every person ought to be treated separately. But
clumping things together makes administration easier. But it raises problems, because different people may be in
different brackets or have some other difference that makes it worth trying to shift things like attribution of income
around.
One of the things that distinguishes the U.S. tax system is the way it treats the family—there is a lot of social policy
bound up here. The tax system treats married couples differently from individuals.117 It also allows a child tax
credit118 and varies an earned income credit based on the number of children in a family. 119
Lucas v. Earl120 is no longer the whole story for married couples,121 but it establishes basic principles about income
attribution. In Lucas, the Supreme Court refused to recognize—for tax purposes—a contract between spouses that
said all income was held in joint tenancy. But the Court said that substance rather than form controlled, and that the
person who earned the income was the taxpayer.
Poe v. Seaborn122 reached the opposite result based on state property law rather than contract law.
The Earls’ and Seaborns’ aim was bracket shifting: for taxpayers in different brackets, each dollar shifted from the
higher to the lower bracket saves collective tax, at least until the tax brackets equalize.
[B] – Marriage Penalty / Bonus
A modern concern is the marriage bonus / marriage penalty. 123 The marriage penalty is a side effect of policy
designed to correct the marriage bonus. The marriage bonus is the result of progressive taxation.
Single
30, 30
50, 10
Married
30, 30
=
<
Couple 1
Total Tax
Couple 2
50, 10
Without any corrections, Couple 1 would pay the same collective tax whether single or married. But Couple 2 would
receive a marriage bonus due to “bracket straddling.” So long as the “30” bracket is lower than the “50” bracket, the
result of averaging a wage of 60 is lower total taxes than the tax for 50 plus the tax for 10. By getting married,
Couple 2’s total tax goes down.
The marriage penalty is created by efforts to solve this problem by making the married-filing-jointly rate more than
twice the single rate. This means that marriage will penalize the Couple 1. For low income earners, the marriage
penalty can be enormous, particularly taking phaseouts into account—perhaps as much as 25% of the collective
wage.
The marriage penalty is another factor that creates an incentive for a spouse not to work. 124
117
26 U.S.C. § 1.
See, e.g., id. § 24.
119
Id. § 32.
120
281 U.S. 111 (1930) (Homes, J.), as reprinted in Andrews & Wiedenbeck, supra note 4, at 941.
121
See Andrews & Wiedenbeck, supra note 4, at 948 (discussing the adoption in 1969 of joint returns).
122
282 U.S. 101 (1930), as reprinted in Andrews & Wiedenbeck, supra note 4, at 942.
123
See Andrews & Wiedenbeck, supra note 4, at 961–62 (diagrams showing the incomes levels the bonus and penalty affect).
124
Cf. Section 1.02[C] (discussing the effects of not taxing imputed income).
118
30
§ 3.02 – Dissolution/Alimony
Income includes “[a]limony and separate maintenance payments . . . .”125 But alimony is deductible for the payer. 126
In contrast, child support is not deductible for the payer, but is not income for the recipient. Since the choice is
elective,127 and because the payer is usually in a higher bracket, it makes sense to designate as much as possible as
alimony. (Note that lots of contingencies about the child’s age, etc, make the IRS more likely to find that alimony is
really child support.)
In Farid-Es-Sultaneh v. Commissioner,128 the Second Circuit held that a prenuptial transfer of appreciated assets was
not a gift but an exchange. The fiancée agreed to give up her inchoate dower rights in consideration of the transfer.
Thus, her basis in the stock was its fair market value rather than the carryover basis for gifts under § 1015. The Code
doesn’t say anything about the anticipation of marriage.
Transfer of property incident to a divorce is treated like a gift, with carryover basis.129
§ 3.03 – Assignment/Family Trusts
[A] – Trusts and Similar Instruments
The Lucas rule is still good: we tax the person who earned the income. But what about unearned income? Note,
there is no question about whether income is to be taxed. The issue is to whom the income is taxed—this only
matters when people are in different brackets.
The cases mostly involve people trying to retain control but pass on the benefits. A person who has complete control
but gives away the benefits—say, a parent who gives money to his kids—is taxed on the income. A person who
completely surrenders control—say, an uncle who gives his niece a income-producing asset—is not taxed on future
income. The tricky bit comes when the bundle of rights is sliced and diced, as in a trust (in which the beneficiary
may have the income but no control).130
In general, the person who receives or can receive income from a trust is taxed. The trust itself is taxed on income it
generates but that is not distributed or distributable. And sometimes the grantor is taxed.
The cases that follow generally involve a trust or other instrument set up to allow the grantor to maintain some
control but not be the taxpayer. The key issue is control.





Corliss v. Bowers.131 Income from a trust that the grantor could terminate at will was taxable to the grantor.
The grantor had too much control over the trust.
Burnet v. Wells.132 The grantor set up a trust to pay life insurance premiums; the life insurance proceeds
were to be used to buy securities held in trust for the grantor’s heirs. Again, the grantor retained too much
control, so the income was taxable to the grantor. (This is a constitutional holding.)
Blair v. Commissioner.133 A trust beneficiary received a life estate in a trust’s income. He assigned this
right to his heirs. The Court held that he could not be taxed on the income because he had surrendered all
control.
Helvering v. Horst.134 The respondent gave his son an unmatured bond. The bond had earned interest
before maturing, but the respondent did not have a claim to the bond’s appreciated value. The Court held
that the respondent had exerted enough control over the bond that its income was taxable to him.
Helvering v. Clifford.135 A husband could not transfer income to his wife by setting up a trust for her with a
short duration and over which he exercised complete control.
125
26 U.S.C. § 61(a)(8).
Id. § 215.
127
Id. § 71(c)(1).
128
160 F.2d 812 (2d Cir. 1947), as reprinted in Andrews & Wiedenbeck, supra note 4, at 996.
129
Id. § 1041.
130
See generally id. §§ 641–85.
131
281 U.S. 376 (1930), as reprinted in Andrews & Wiedenbeck, supra note 4, at 1008.
132
289 U.S. 670 (1933), as reprinted in Andrews & Wiedenbeck, supra note 4, at 1013.
133
300 U.S. 5 (1937), as reprinted in Andrews & Wiedenbeck, supra note 4, at 1019.
134
311 U.S. 112 (1940), as reprinted in Andrews & Wiedenbeck, supra note 4, at 1030.
126
31
What lurks beneath the surface of these cases is some commonsense notion of what constitutes a whole property
interest and what is only a part. The Blair Court appears to consider a life estate a whole thing. In contrast, the Horst
Court appears to consider a bond that paid both interest and appreciated during its life as comprising parts.
Note that Clifford is now controlled by statute—it’s very hard to set up a trust that works the way the taxpayer there
wanted.136
[B] – Kiddie Tax
Unearned income going to people under 18, and students under 24 supported by their parents, is treated as though it
were the parents’ income. This is true even if neither parent is the grantor. The goal here is to avoid parents putting
their income in trust to support the kid, whose tax bracket is presumably 0%. The Kiddie Tax provision is codified at
26 U.S.C. § 1(g).
[C] – Below-Market Loans
The IRS doesn’t believe in below-market loans. 26 U.S.C. § 7872 deals with below-market loans by pretending they
aren’t really below-market loans.
The tax code treats an interest-free or below-market loan as though the lender made a loan at the market rate, then
gave the interest to the borrower as a gift. For shareholders, the amount less than market interest is treated as a
dividend. For employees, the amount less than market interest is treated as a wage.
This is quite an elegant rule. By imputing and linking tax consequences to interest income flowing from the
borrower, the tax code simply makes below-market loans disappear. Section 7872 is simply a definition. Then, the
rest of the tax system takes over.
§ 3.04 – Income in Respect of a Decedent
Section 691 is pretty straightforward. It basically says, The dead person’s income is the dead person’s income. Like
§ 7872, it leaves it to the rest of the tax system to sort out what that means.
135
136
309 U.S. 331 (1940), as reprinted in Andrews & Wiedenbeck, supra note 4, at 1024.
Andrews & Wiedenbeck, supra note 4, at 1042–43.
32
Chapter 4 – Capital Gains & Losses
§ 4.01 – Mechanics
It is important to distinguish capital gains and losses from ordinary income137 and losses.138 They:



are taxed at a lower rate,
interact with capital losses, and
are the subject matter of lots of litigation.
Chapter 19.A of the casebook139 summarizes the history and major provisions of capital gains.
Section 1222 describes the formula for computing the capital gains or losses for the year. Professor Kaplow suggests
the following steps:
1.
2.
3.
Calculate the net long-term capital gain or loss.
Calculate the net short-term capital gain or loss.
Cross (1) and (2) (if necessary). The larger category (short- or long-term) sets the overall character.
Long-term capital gains are taxed at the capital gains rate (15%). Short-term capital gains are taxed at the ordinaryincome rate.




Example: long-term capital gain is $70 and the short-term capital loss is $50. In net, this is a long-term
capital gain of $20. The tax is $3.
Example: top-bracket taxpayer with a short-term capital gain of $50 and a long-term capital loss of $70.
There is in net a short-term capital gain of $20, and a tax of $7.
Example: short-term gain is $5,000, short-term loss is $10,000. $5,000 knocks out this year’s short-term
gains. $3,000 can be deducted from ordinary income. 140 $2,000 carries forward.141
Example: long-term gain of $70; short-term gain of $30; long-term loss of $20; short-term loss of $50:
Long-term
Short-term
Combining
Gain
$70
$30
Loss
$20
$50
Net
$50
($20)
$50 long-term gain
If long-term capital gain treatment predominates, it can be favorable to realize short-term capital gains up to but not
over the amount that would trip the algorithm to treat the net gain as short-term. Then you can use short-term capital
losses to offset long-term capital gains. (See the class notes from April 5 for a numerical example.) The upshot is
that sometimes long-term gains are taxed at the short-term rate and vice-versa.
Section 1211(b)(1) limits the deductibility of year-by-year capital losses at $3,000 in order to prevent taxpayers
switching back and forth between realizing losses and gains without having to offset—because the capital gains rate
is lower, the taxpayer would enjoy the capital gains rate for gains but offset losses taxed at the ordinary income rate.
Indeed, someone could buy an asset and its mirror image as a hedge. This would allow a top-bracket taxpayer
mechanically to deduct the 20% difference between the capital-gains and ordinary-income rates.
Section 1231 allows “quasi-capital asset” treatment for some corporate-held assets. This treatment treats gains as
capital gains and losses as ordinary income. There is a five-year averaging window that prevents the alternating-year
ploy, but the section is an example of special-interest lobbying.
Depreciation recapture prevents a corporation from taking a depreciation deduction against ordinary income, then
repaying a subsequent gain at the capital gains rate. This would happen if an asset sold for more than its adjusted
137
Defined at 26 U.S.C. § 64.
Defined at id. § 65.
139
Andrews & Wiedenbeck, supra note 4, at 1053–65.
140
See 26 U.S.C. § 1211(b)(1).
141
See id. § 1212.
138
33
basis—what happens when the depreciation method outpaces economic depreciation. Without a rule to the contrary,
this would be a capital gain, even though an earlier deduction was allowed at the ordinary-income rate. So §§ 1245
and 1250 require the gain to be reported as ordinary income.
§ 4.02 – Definition of Capital Asset
[A] – Theory
There’s no generally agreed-upon reason that capital gains are taxed at lower rates. It may simply be to spur
investment. Some argue that the progressivity of tax, calibrated as it is for a single year, is inappropriate for an
investment piled up over time. But Prof. Kaplow says this is a weird rule to solve that problem, and most people
with lots of capital assets are rich, anyway. It may be to counter distorted incentives (e.g., lock-in), but distorted
incentives typically follow from other tax goodies, so why heap distortion upon distortion? Finally, it might be to
counter inflation, but again, we’d be better with a policy that actually addresses inflation.
Taxpayers will argue that an asset is capital as it goes up but ordinary as it goes down.
Section 1221 defines capital assets, but the definition is sort of backwards: it says “the term ‘capital asset’ means
property held by the taxpayer (whether or not connected with his trade or business),” then lists a bunch of
exceptions. But courts don’t treat everything not specifically exempted as capital assets.
[B] – Property Held for Sale to Customers
Items in inventories aren’t capital assets.142 A subdeveloper owns inventory, not capital assets. But a hotelier owns a
capital asset. There are some perverse incentives here: there’s better tax treatment if you hold on to property hoping
it will appreciate rather than converting it to productive use.
Malat v. Riddell143 holds that “primarily” means “primarily.” Malat owned property, planning either to rent it out or
maybe to sell it. Because the IRS didn’t show he held it “primarily for sale to customers in the ordinary course of his
trade or business,” thereby falling into the exception at § 1221(a)(1), it was a capital asset.
A taxpayer’s intent is not relevant to § 1221: the statute sets out an objective test. Thus, in Arkansas Best v.
Commissioner,144 a company could not take a loss against ordinary income by explaining its subjective motivation
for investing in a company. The petitioner claimed it pumped money into a bank in part to prop up a business it was
trying to operate—not with the hope that it would receive a return on investment. The Supreme Court held that it
was all capital assets. The Court thereby avoided the consequences of earlier cases that allowed taxpayers to come
up with post hoc explanations of their goals for particular investments.
[C] – Substitute for Future Ordinary Income
Is a lump sum in lieu of ordinary income in the future ordinary income or a capital gain? It seems likelier that it’s
ordinary income. But there’s a deep problem: built into the price of every asset is some concept of the net present
value of its future income. The price of a house includes the discounted value of future rents. A stock’s price
incorporates expectations about future dividends. So in a sense, appreciation—a capital gain—represents the present
value of future earnings. Which is to say, ordinary income. And so the cases are a bit muddled.


Hort v. Commissioner.145 The petitioner received a property by devise; there was an extant lease on the
property. When the lessee paid to cancel the lease, the petitioner claimed a capital loss for the foregone
rent. The IRS assessed a deficiency, asserting that the lessee’s payment was ordinary income. The Supreme
Court affirmed.
McAllister v. Commissioner.146 A life tenant of a trust sold her interest to the remainderman. She claimed
that the sale constituted a capital loss in the amount of the foregone payments. The Second Circuit agreed,
142
26 U.S.C. § 1221(a)(1).
383 U.S. 569 (1966), as reprinted in Andrews & Wiedenbeck, supra note 4, at 1083.
144
485 U.S. 212 (1988), as reprinted in Andrews & Wiedenbeck, supra note 4, at 1101.
145
313 U.S. 28 (1941), as reprinted in Andrews & Wiedenbeck, supra note 4, at 1109.
146
157 F.2d 235 (2d Cir. 1946), as reprinted in Andrews & Wiedenbeck, supra note 4, at 1112.
143
34


reasoning that Blair rather than Hort controlled. Hort involved a lump sum that replaced rent. In contrast,
said the court, as in Blair, the taxpayer made a complete assignment. Prof. Kaplow says this is completely
ridiculous—Blair is about a totally different doctrine.
Commissioner v. P.G. Lake, Inc.147 Oil companies assigned oil payment rights in exchange for lump sums
or the cancellation of debts. The Court held that this did not convert the payment right into a capital
investment.
Commissioner v. Gillette Motor Transport, Inc.148 A temporary taking of a factory during wartime was not
a sale or exchange of a capital asset. Thus, the compensation was not a capital gain but ordinary income.
Once again, the different courts appear moved by some concept of whole versus part. But other than the sale or
exchange test, this shouldn’t be controlling.
[D] – Sale of a Business
Are businesses things or amalgams of pieces? If it’s the former, selling a business is selling a capital asset. If it’s the
latter, each piece must be examined on its own.
The sale of a partnership or privately-owned business is the sale of its components, at least according to the Second
Circuit in Williams v. McGowan.149 The Code now covers this.150
Corporations can be either, depending upon whether the transaction is a stock or asset sale.
147
356 U.S. 260 (1958), as reprinted in Andrews & Wiedenbeck, supra note 4, at 1117.
364 U.S. 130 (1960), as reprinted in Andrews & Wiedenbeck, supra note 4, at 1070.
149
152 F.2d 570 (2d Cir. 1945), as reprinted in Andrews & Wiedenbeck, supra note 4, at 1065.
150
See Andrews & Wiedenbeck, supra note 4, at 1069.
148
35
Chapter 5 – When is an Item Taxed
§ 5.01 – Nonrecognition
[A] – Like-Kind Exchanges
The general rule is that gains and losses are recognized “on the sale or exchange of property . . . .”151 But there are
some exceptions.
“No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for
investment if such property is exchanged solely for property of like kind which is to be held either for productive
use in a trade or business or for investment.”152 The key word is “solely.”
So if you exchange real property for real property—even if you add “boot” (extra cash)—you don’t have a
realization event. Your basis in the property you acquired is the sum of the basis in the old property plus the boot.153
If the situation flips and you exchange real property for real property plus boot, there’s a different rule. For a gain:
“the gain, if any, to the recipient shall be recognized, but in an amount not in excess of the sum of such money and
the fair market value of such other property.” 154 But for a loss: “no loss from the exchange shall be recognized.”155
In the boot situation, “the basis shall be the same as that of the property exchanged, decreased in the amount of any
money received by the taxpayer and increased in the amount of gain or decreased in the amount of loss to the
taxpayer that was recognized on such exchange.”156
Imagine a person exchanged Whiteacre, basis $24,000, for Purpleacre plus $17,000. The following table summarizes
the results for various values of Purpleacre:
Value of Purpleacre
$24,000
$23,000
$25,000
$5,000
Gain/Loss
$17,000
$16,000
$18,000
($2,000)
Taxable Gain/Loss
$17,000
$16,000
$17,000
$0
Basis in Purpleacre
$24,000
$23,000
$24,000
$7,000
[B] – Wash Sales
Generally speaking, a person cannot buy or sell stock, then within 30 days, sell or buy “substantially identical stock
or securities” and take a deduction on realized losses. 157 The purpose of this rule is pretty straightforward: otherwise,
people would sell not for portfolio reasons but merely to book their losses.
But things have to be pretty similar for wash sale-like rules to apply. In Cottage Savings Association v.
Commissioner,158 a federal agency allowed the savings and loan associations it supervised to churn mortgage in
order to realize losses under IRS rules, but set its regulations so that these didn’t appear as losses on the
associations’ books. The Court held that mortgages are like snowflakes—even though broadly similar, the
exchanges really did change the kind or extent of a legal entitlement, and so represented a true exchange.
Similarly, in Jordan Marsh Co. v. Commissioner,159 the Second Circuit held that a very long-term lease is different
enough from fee ownership that it’s a true exchange. The petitioner was a corporation that operated a store in
Boston, which it sold and leased back. By doing so, the corporation could realize its losses.
151
26 U.S.C. § 1001(c).
Id. § 1031(a)(1).
Id. § 1031(d).
154
Id. § 1031(b).
155
Id. § 1031(c).
156
Id. § 1031(d).
157
Id. § 1091(a).
158
499 U.S. 554 (1991), as reprinted in Andrews & Wiedenbeck, supra note 4, at 247.
159
269 F.2d 453 (2d Cir. 1959), as reprinted in Andrews & Wiedenbeck, supra note 4, at 265.
152
153
36
There was a different result in McWilliams v. Commissioner.160 A husband and wife were working in concert so that
one would sell stocks on the open market and the other would buy the same company’s stocks a moment later. The
Court held that the losses couldn’t be realized. 26 U.S.C. § 267 treats members of a family as though they were the
same unit; the Court disallowed the deduction under that section. (Section 1091, which would control, wasn’t
enacted until 1954.) It didn’t matter that the stocks had different serial numbers.
§ 5.02 – Mortgaged Property
Together, Crane v. Commissioner161 and Commissioner v. Tufts162 set the rule for nonrecourse mortgages. Taxpayers
owned property secured by nonrecourse mortgages. They took deductions for things like depreciation. They then
sold the mortgage for little or no money, requiring only that the buyer take over the mortgage.
Through this artifice, they were able to shelter significant losses by using the deductions created by the depreciation
of the property. By selling the property cheap, they claimed either a modest gain or a further loss.
The Court could have disallowed deductions for borrowed money. Instead, the Court said that the amount realized
must include the outstanding amount of the obligation. There are now regulations on this.163
The rule works like this: A takes a $200 nonrecourse loan to build a store. A takes depreciation deductions worth
$100. A then sells the store for $50. A says his adjusted basis is $100, his amount realized is $50, and thus he has a
$50 loss. In total, he would have claimed $100 of deductions for depreciation and $50 in the sale
The IRS will agree that his adjusted basis is $100. But they will say his amount realized includes the obligation
transferred. Thus, amount realized is $200 for the loan + $50 for the sale = $250. Thus, he has a gain of $150. This
has the effect of not letting A escape with the depreciation deductions, thereby using leverage to shelter his other
gains. (I think this example is right, but I invented it.)
§ 5.03 – Annual Reporting
The tax system interacts with companies and individuals who use different accounting methods. Overall, the tax
system is geared towards cash accounting. But many sophisticated businesses use the accrual method. There’s also
the complication that people try to influence the timing to defer gains and realize losses. Of course, the tax system
doesn’t say when you have to earn money—that’s up to you. The question is when it’s to be reported.
The Code allows a taxpayer (although not C-Corps or tax shelters164) the freedom to choose a method of accounting,
but requires permission to change. 165
The rule for when to report income seems hilariously vacuous on first read: “The amount of any item of gross
income shall be included in the gross income for the taxable year in which received by the taxpayer, unless, under
the method of accounting used in computing taxable income, such amount is to be properly accounted for as of a
different period.”166 The key seems to be the word “properly,” which presumably incorporates generally accepted
accounting principles.
[A] – Claim of Right
In North American Oil Consolidated v. Burnet, the Supreme Court held that money earned in 1916, but held in
receivership until 1917 was income in 1917. Although it was 1922 before all appeals were exhausted, the company
was entitled to the money and had control of it in 1917. It would be impracticable to wait until every conceivable
challenge to every bit of income played out. 167
160
331 U.S. 695 (1947), as reprinted in Andrews & Wiedenbeck, supra note 4, at 805.
331 U.S. 1 (1947), as reprinted in Andrews & Wiedenbeck, supra note 4, at 456.
162
461 U.S. 300 (1983), as reprinted in Andrews & Wiedenbeck, supra note 4, at 468.
163
26 C.F.R. 1.1001-2.
164
26 U.S.C. § 448 (forbidding cash accounting to those entities).
165
Id. § 445. See also 26 C.F.R. 1.446-1(c)(1).
166
Id. § 451(a).
167
286 U.S. 417 (1932), as reprinted in Andrews & Wiedenbeck, supra note 4, at 431.
161
37
A similar instinct undergirds United States v. Lewis.168 There, the Supreme Court held that an employee had income
the year he was accidentally overpaid and had use of the funds, even though his employer sued him and got the
money back some time later. Lewis could claim a loss that year.
[B] – Previous Deductions and the Tax-Benefit Limitation
Burnet v. Sanford & Brooks Co.169 was a case the Supreme Court decided before 26 U.S.C. § 172 was passed. The
Court held that even though a recovery on a breach of warranty claim loosely represented losses over the past
several years, the recovery was income in the present year. The losses could not erase the later gain.
Now § 172 allows a “net operating loss carryback to each of the 2 taxable years preceding the taxable year of such
loss, and . . . a net operating loss carryover to each of the 20 taxable years following the taxable year of the loss.”
Now companies will buy dying companies to use the latter’s tax losses. One difficulty is that, to preserve the tax
losses, the buyer has to accept the acquired company’s liabilities. A tricky part of the GM or Chrysler bailout (Prof.
Kaplow couldn’t remember which) was that the manufacturer was allowed to discharge liabilities in bankruptcy, but
to keep its carryover losses. This was a stealth bailout that didn’t show up as spending.
Dobson v. Commissioner170 came out differently than Sanford & Brooks. The petitioner bought stock that lost a ton
of money, but turned out to have been issued unlawfully. He reached a settlement with the seller, though the seller
didn’t make the buyer whole. The IRS assessed a deficiency against the buyer, but the Tax Court found that he had
received no economic benefit. The Eighth Circuit reversed, holding that the Tax Court lacked statutory authority to
find as it did. The Supreme Court reversed the Eighth Circuit. It held that the Tax Court was entitled to deference,
and that it wasn’t clearly erroneous in finding no economic benefit as a matter of fact.
Today, 26 U.S.C. § 111 controls: “Gross income does not include income attributable to the recovery during the
taxable year of any amount deducted in any prior taxable year to the extent such amount did not reduce the amount
of tax imposed by this chapter.”
Even if it didn’t, the capital loss would be allowed against that year’s income, then carried forward. If not already
consumed, the loss could be used to offset the settlement.
Note too that the Dobson Court’s call for deference to the Tax Court on an accounting matter is odd. It seems the
Court just wants to avoid doing tax stuff. But what is more clearly a question of law than how a set of rules applies
to undisputed facts? Congress shared the tax bar’s consternation and passed 26 U.S.C. § 7482, which gave appellate
courts more robust review of Tax Court decisions.
There is an inclusionary side (i.e., a side that, unless corrected, unjustly helps the taxpayer) for tax benefits. Section
111 says there’s no tax assessed when a payment this year offsets an earlier loss for which there was no benefit at
the time. But imagine the opposite: a person is denied an insurance benefit, pays out of pocket, and deducts the
payments. Then the insurance company changes its mind and repays the claim. While there is no rule that covers all
problems like this, there is a general principle: the taxpayer is charged with income this year to undo the
deduction.171
[C] – Prepaid Expenses and Income and Future Expenses
The Court has several times required treating prepaid expenses (e.g., prepaid piano lessons) as present income. But
the opinions hem and haw about accounting methods, so its unclear if this is in concept possible.172
In Commissioner v. Indianapolis Power & Light Co.,173 the Supreme Court held that customer deposits don’t
constitute income—they’re essentially a loan. The Court emphasized that the power company did not have dominion
168
340 U.S. 590 (1951), as reprinted in Andrews & Wiedenbeck, supra note 4, at 433.
282 U.S. 359 (1931), as reprinted in Andrews & Wiedenbeck, supra note 4, at 141.
170
320 U.S. 489 (1943), as reprinted in Andrews & Wiedenbeck, supra note 4, at 145.
171
See Andrews & Wiedenbeck, supra note 4, at 155. Cf. Haverly v. United States, 513 F.2d 224 (7th Cir. 1975) (holding that a teacher who
received unsolicited textbooks and clearly accepted them had income), as reprinted in Andrews & Wiedenbeck at 46.
172
See generally Andrews & Wiedenbeck, supra note 4, at 336–37.
173
493 U.S. 203 (1990), as reprinted in Andrews & Wiedenbeck, supra note 4, at 351.
169
38
over the payments. But this is a red herring: a bank can have “dominion” over a loan but it’s still a loan. A
prepayment doesn’t have an IOU for cash—but it does require the payee to perform a service, and in that sense is
like a loan.
On the other hand, the prepayment does seem to create Haig-Simons income: the value of the business goes up the
day it receives a prepayment. And maybe a prepayment is two things: a promise to buy and sell and a loan.
There was a change in the Code in 1984 to eliminate a loophole for accrual-method taxpayers who entered into
structured settlements to settle claims.174 Previously, a loss could be completely booked without discounting once
“all events” that created an obligation occurred. So for example, imagine that a corporation agreed to pay a tort
victim $100,000 per year for 40 years. Once the paperwork was finished, the corporation could book a $4 million
loss. At a 35% bracket, that’s worth $1.4 million after tax. Invested at 8%, this yields a $12,000 per year profit! The
incentive is to commit torts.
The problem can be stated either as allowing premature booking of losses or of failing to discount them to present
value. The Code now allows a deduction only at the time of “economic performance,” as defined in 26 U.S.C.
§ 461(h).
§ 5.04 – Deferred Payments
[A] – Discount Obligations and Other Deferred Payments
Zero-coupon bonds are bonds that say there’s no interest rate, but that the value will be X at maturity. Give us $100,
you’ll get $121 back in two years.
Much in the way the Code doesn’t believe in interest-free loans, it doesn’t believe in zero-coupon bonds.175 An
interest rate will be calculated. In the example above, it’s 10% per year: the IRS treats the bond as having paid 10%
per year, with the taxpayer having reinvested the interest. 176
Imagine instead that A sells Blackacre to B for $121, payable in two years. If the value of the property is clear
enough (say, $100), the IRS will infer a 10% interest rate. If the value of the property isn’t clear, the IRS will use the
federal interest rate to determine a value for Blackacre. 177
[B] – Deferred and Contingent Payments on Sales
In Bernice Patton Testamentary Trust v. United States,178 the Court of Claims refused to apply the “open transaction
method” to value a note with lots of contingencies. The open transaction method allows the taxpayer first to recover
basis, then to pay further income at the capital gains rate. Basically, the court held that accountants are now quite
good at valuing assets, and that the installment method under 26 U.S.C. § 453(b)(1) (“a disposition of property
where at least 1 payment is to be received after the close of the taxable year in which the disposition occurs”) should
nearly always apply.
Under the installment method, basis recovery and gains are taxed proportionately during the contract term; any
remaining payments are treated as interest.
Because the open transaction method is more taxpayer-friendly, there’s an incentive to make transactions too
complicated to value.
[C] – Annuities and Life Insurance
After trying a variety of methods, Congress has settled upon 26 U.S.C. § 72 to handle taxing annuities. 26 U.S.C.
§§ 72 and 101 cover some life insurance.
174
See generally Andrews & Wiedenbeck, supra note 4, at 376–80.
Cf. Section 3.03[C].
See 26 U.S.C. § 1272.
177
See id. § 1274.
178
No. 96-37T, 2001 WL 429809 (Fed. Cl. Mar. 20, 2001) aff’d, 31 F. App’x. 661 (Fed. Cir. 2002), as reprinted in Andrews & Wiedenbeck at
273.
175
176
39
Money is not taxed as it goes into an annuity. The amount coming out of an annuity that represents interest is taxed.
This is computed by taking into account life expectancy at the time of purchase. If you don’t live as long as your life
expectancy, you can deduct the unrecovered basis. If you die late, all of the payments from the annuity are treated as
interest. This is a bad rule because it undermines the whole purpose of annuities: to guarantee a steady stream of
income.
[D] – Compensation
Deferred compensation is significant in two circumstances: first, for money kept in an annuity or insurance account;
second, for an employer with a different tax bracket than the employee. For example, because Harvard is tax
exempt, it can grow money tax free under the right circumstances.
In Commissioner v. LoBue, the Supreme Court held that stock options are to be taxed when they are exercised. The
dissent argued that they should be taxed based upon their fair market value when given.
The example below shows the result of these two means of treatment for an in-the-money option. The share price is
$15, the option costs $10 to exercise.
Event
Option Granted
Exercise price = $10;
market value of shares =
$15
Option Exercised
Future
Option exercised; market
value of shares = $50
Share sold; market value = $100
Version (A)
-
$40 ordinary income ($50 for
stock less $10 basis)
$50 capital gain
Version (B)
$5 ordinary income
(option $5 in-the-money)
(no realization)
$85 capital gain ($100 realized ($5 basis in the option + $10 basis
in cash))
Now 26 U.S.C. § 83 allows the taxpayer to elect between version (A) and (B). The election must take place within
30 days. The employer and employee must choose the same method on their respective taxes. And if the version (B)
taxpayer leaves his job before exercising the option, he can’t deduct the tax already collected.
Which scheme is most beneficial depends upon the stock’s performance and the timing of the events.
40
Chapter 6 – Tax Shelters
A tax shelter is more than just an attempt to save tax money. Fundamentally, it is using an investment to throw off
deductions that can be used to shelter other income.
Limited partnerships were the preferred form for tax shelters to take. In 1983, limited partnerships accounted, in
aggregate (i.e., taking into account even those LPs trying to make money), for $20 billion in losses. They’re
attractive for two reasons: they are a pass-through entity, which allows the partners to use the losses; and the limited
liability aspect shields the partners from liability.
There are legitimate tax shelters (ones you could show the IRS), and abusive ones (ones that involve fraud).
The key mechanisms for tax shelters are:



deferral,
conversion of ordinary income into capital gains, and
leverage.
Imagine you stake $100 to borrow $900. You invest the money in an investment with a 10% rate of return. If the
loan’s rate is 10%, you still only make $100. But if the loan’s rate is 9%, you make 19% ($100 x 10% + $900 x 1%).
So leverage is good provided the after-tax return on investment is less than the interest rate. And because there are
means of deducting interest, a person can create enough space between the after-tax rate of return and the loan
interest to earn big rewards. (This is simply an example of leverage, not of leverage being used to shelter income.
See Section 5.02, above, for an example of a leveraged asset being used as a tax shelter.)
The 1986 Act made some big changes that affected shelters:






At risk rules.179 When they apply, they say that deductions are capped at what’s actually at risk (more or
less—this isn’t quite the law now). It might be preferable to change the underlying rules, but this may be
politically difficult. These rules also help counter fraudulent manipulation—for example, a seller can make
a nonrecourse loan to a buyer, who uses it to buy, say, the seller’s art at a ridiculous price.
Investment interest limitation.180 Says you can’t deduct more investment interest than your investment
income. This limits using leverage to shelter losses, unless they are investment losses.
The Alternative Minimum Tax.181
Passive loss limitations.182 Says passive activity deductions can only offset passive income. So you can’t
benefit from owning a restaurant in Kalamazoo that you’ve never laid eyes upon.
Increased duties on lawyers under the ABA rules, the Code, and regulations.
Heightened penalties.183
179
26 U.S.C. § 465.
Id. § 163(d)(1).
181
See Andrews & Wiedenbeck at 920–35.
182
26 U.S.C. § 469.
183
See, e.g., 26 U.S.C. §§ 6662, 6663, 7201, & 7206.
180
41