FEDERAL INCOME TAX OUTLINE
FALL ‘13, BUCHANAN
I. INTRODUCTION
a. Terminology
 §7701(a)(1) – “Person” is defined as an individual, trust, estate or corp.
 Ability to pay: the attribute that might justify requiring some people to pay more tax than others.
 Average tax rate = total tax/total income
 Cash-flow consumption tax: simply an income tax with a deduction for savings and with the inclusion in the
tax base of amounts drawn down from savings and used for consumption, as well as amounts borrowed for
current consumption.
 Double Taxation – taxing the same basis twice
 Endowment or wage rate (the rate at which one can earn money): the opportunity to earn wealth whether or
not exercised.
o Flat tax is generally not proportional and it’s appeal has more to do with simplification and ease of
administration than fairness
 Flow variable – defined with respect to passage of time (e.g. income as it goes up and down)
 Flow variable: variable whose value is determined with reference to the passage of time
 Global approach: income from all sources is combined and taxed under a rate schedule that applies to the
taxpayer's entire income, net any allowable losses or deductions
 Imputed income: the value of goods and services provided to oneself.
 Incidence – the ultimate burden of tax, who actually pays for the cost
 Marginal tax rate = tax rate paid on the next dollar of income
 Marginal utility of income: the wealthier you are, the less each dollar lost to the tax collected diminishes your
well-being.
 (Non)Recognition – once you’ve realized income there are still situations where Congress has said you do n’t
need to pay taxes yet
 Progressive tax – average tax rate rises as income rises
 Proportional tax – average tax rate is constant as income rises
 Realization – have income, but it doesn’t become taxable until an event occurs, generally when the taxpayer
can claim the income in cash form
 Regressive – average tax rate falls as income rises
 Schedule approach: a sep rate schedule applies to several different categories of income and losses within
each category are allowed only with respect income from that category (**we use both)
o Seen in IRAs (individual retirement accounts) – amounts set aside in an IRA for retirement are
currently deductible in computing the amount subject to taxation and amounts withdrawn from the
IRA account are included in the income in the year of withdrawal.
 Stock variable – defined based on moment in time (e.g. bank account number) (new lawyers with high
incomes but large student loans have high flow variable and really low stock variables)
 Stock variable: variable whose value is not determined with reference to the passage of time
 Tax Base – what is being tax (can tax either the flow or the stock)
 Tax Gap: Revenue that we should be collecting and were not? 450 Billion or 17% owed to fed gov't was not
paid initially; 65 Billion was collected by the IRS after the fact
 Tax Expenditures: Revenue a government foregoes through the provisions of tax laws that allow
(1) deductions, exclusions, or exemptions from the taxpayers' taxable expenditure, income, or investment,
(2) deferral of tax liability, or (3) preferential tax rates.
 Taxable unit=individual, or group, who is or are treated as a taxpaying unit in the sense that they must
aggregate their income for purposes of calculating tax payable
o The broader view looks at people’s material well-being without regard to liquidity
o This is so as to avoid possibly discouraging the exercise of wage-earning ability to avoid paying
taxes.
 To the extent: by the amount
 Zero bracket – amount of money, not subject to tax (is excluded from gross income and therefore not part of
taxable income due to personal deductions and standard deduction)
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b. Economic Consequences
i. Economists typically describe the effects of taxes by reference to income effects and substitution effects
1. Income Effects are changes in behavior induced by the fact that the tax reduces the money available
to the taxpayer
2. Substitution effects are changes in behavior that arise from a change in the relative attractiveness of
different commodities or activities
ii. Income tax should have both effects
c. Theory & Policy
i. About half of fed revenue (55%) comes from income tax
1. 45% from individual income and 10% from corporate income
ii. Taxation and Ability to Pay
1. Tax scholars have long used the term ability to pay to describe the attribute that might justify
requiring some people to pay more tax than others
2. The view that the rich should pay more than the average rate of tax, and the poor less or none, rests
on a nation of declining marginal utility of income
iii. Taxing & the Budget
1. The general approach is to identify various exclusions, deductions, deferrals, and credits that are seen
as departures from a neutral concept of income taxation; then to figure out the cost of these
provisions; and then attribute these costs to various budget functions
2. Some provisions of income tax law are designed to measure ability to pay, others are instead
intended to subsidize or penalize particular activities
a. Mostly non-ability to pay provisions
3. Tax payments are not a zero sum game – either someone else has to pay to cover it or some program
will not be funded or you’re going to have to raise the deficit, and if you’re okay with raising the
deficit or cutting a program why not do it anyways and give a broad tax cut to everyone
4. Tax Expenditures: see chart on 17 (incomplete table)
a. Three big areas: homeownership subsidies, pension contributions and earnings (employer
plans), healthcare [middle class people who vote!]
iv. Tax Incidence
1. Incidence=ultimate economic burden of a tax
a. Person bearing the burden may not be the same as who remitted the tax to the govt, i.e. passing
tax to customers, SHs, suppliers etc
b. Burden of income tax usually falls on individual (different for corps)
2. To the extent that the tax system favors one type of investment over another, money and other
resources will be shifted from the disfavored type of investment to the favored type
3. People will structure their behavior based on tax scheme and will act to lower their tax bill, people
who would otherwise turn down a handout feel as though they are entitled to “their” money
a. Implicit taxes – tax code can change the take home amount even when you don’t pay money
into treasury (e.g. municipal bonds can be competitive at a lower interest rate because people
don’t have to pay taxes on income from municipal bonds)
v. ** Though it may be indirect, a tax break is never a freebie, taxes should be understood as compared to
something (to fund public schools you either need to raise taxes or get rid of schools)
vi. Inflation
1. Inflation makes it difficult to levy the right amount of tax on investment income
2. Congress required an increase in the standard deduction to reflect increases in the Consumer Price
Index so as not to penalize taxpayers for inflation
d. Taxable Unit and the Marriage Penalty
i. Married people are permitted to file a joint return, so it doesn't matter who earned what; they get the lowest
rate schedule
1. Married people are better off than they one would be under a system with one schedule for all
because they have the best rate=marriage bonus
2. On the other hand, two earner married couples are typically worse off than if they had remained
single because of the requirement that they file jointly=marriage penalty
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3. Secondary Worker: the person whose income is lower and whose attachment to the workforce is
weaker AKA marginal income
a. Subject to marginal tax rates determined by primary worker
ii. Heads of households are unmarried person with dependent living with him or her
iii. Unmarried individuals AKA single people have third most favorable
iv. Married people filing sep returns have least favorable-almost always leads to increased taxes as opposed to
filing jointly
e. IRS
i. IRS is not a government agency, it’s the treasury – and is politically unpopular and has no friends in
Washington
ii. §7491 – Changed burden of proof to IRS once taxpayer provides any credible evidence (IRS never cared
about legal burden, only about burden of production so requiring credible evidence keeps burden on
taxpayer while providing for a politically friendly cosmetic change)
iii. RRA-98 – Investigated abuse by IRS found 4 cases total, also created office of taxpayer advocate, but so
few complaints they’ve helped make it more efficient in other ways
iv. Acquiescence – when the court of appeals decides a tax case, the service will announce whether it
acquiesces or not which acts as advice to the rest of the service whether they should rely on the outcome or
whether the service will re-litigate the same issue in a different circuit in hopes of a circuit split and cert by
SCOTUS
f. Compliance and Admin
i. Evasion…you are on the illegal side of aggressiveness
ii. Avoidance…you are on the legal side of aggressiveness
1. **Cheating on your taxes is not a victimless crime!! Affects everyone
iii. A person who fails to file an income tax return may be subject to both civil and crim penalities
1. Criminal portion is very small -- difficult to meet the heightened mens reas requirement of Cheek so
prosecutors don't want to bring these cases
2. Civil penalties
a. Trying to put the tax payer in the same position they would have been if they had paid the tax
i. So you'll pay interest, but that’s not a penalty! You just had free use of money for the
time it took for you to repay (as if it was a loan)
b. Possible different degrees of penalties
iv. Risk of being caught is high, since employers are required to file information returns
1. Opposite incentives for reporting-the less you report, the less taxes you owe BUT for the employer,
the more salary they report, the more they can deduct and reduce their taxable income
v. IRS audits-some random, some because there is a greater than average probability of error
vi. Judicial Review
1. Original jurisdiction through 3 different courts AKA where you can file your case
a. your district court-->your circuit court-->SC
b. tax court: special, article 1 judges on appointed 14 year terms (may have to apply different law
depending on state of P)-->your circuit court-->supreme court
c. federal court of claims-->fed. circuit-->supreme court
vii. Opinion Practice and the Market for Tax Advice
1. Tax opinions are often expressed in terms of varying levels of confidence regarding the likely
outcome of litigation if a return position is challenged
a. Reasonable basis: 15-30
b. Substantial authority: 30-50
c. More likely than not: 50+
d. Should prevail: 70+
e. Will prevail: 90+
f. Also an obligation to report, or at least not lie, if there is NO support
g. Sources of Tax Law
i. IRS Code: Title 26 of USC
1. No matter how long, it will never be complete aka loophole free
2. It is written logical backwards
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a. Section 1 says apply these rates to your taxable income, but what is your taxable income
(section 63)
ii. Treasury Regulations
1. Not law, but very, very persuasive authority
2. Because there are gaps in the tax code, Treasury given the power to make interpretative rules
a. A reg. is highly persuasive guidance, but is not law
iii. Revenue Ruling
1. Similar to a judicial opinion with hypothetical facts
2. Essentially advisory opinions
3. Helpful and persuasive, but not as much as the Regs.
iv. Private Letter Ruling
1. Taxpayer finds a gap in the law, wants to know how the gap applies to them, and sends a letter to the
IRS to answer it
2. They could create a reg for this issue, but instead they send a letter that says we comitt ourselves to
nothing, but here's the interpretation, if you follow it we won't come after you, but not necessarily if
someone else does it
a. But in reality IRS has been coerced into not going after anyone who follows any PLR even if it
wasn't issued to them
v. Common law: Substance dominates form
1. You don't want hypertechnical arguments to subvert the purpose of the tax law
h. Rate Structure
i. Average vs. Marginal Tax Rates
1. Overall the US fed tax system is progressive, though the degree of progression varies depending on
the tax
a. SS and Medicare are regressive
2. Within the individual income tax, progression is accomplished primarily by with the use of
increasing marginal tax rates-with increases in rates that apply only to higher increments of income
a. Progression is also accomplished by exempting a certain amount of income from taxation, as
well as limiting the availability of certain deductions and credits to persons with income below
some threshold
3. Income – (exclusions + above the line deductions) = AGI
4. AGI – (personal exemptions + (standard deduction OR itemized deduction) = TI
5. (TI – credits) x (marginal r]ate) = tax due
6. Alternate minimum tax  26% for first $175K and 28% for amounts over that and is payable only if
greater than the amount otherwise paid
ii. There is a zero rate bracket, the amount of money which people pay no taxes on
iii. §63 (b) [Individuals who do not itemize their deductions]  In the case of an individual who does not elect
to itemize his deductions for the taxable year, for purposes of this subtitle, the term “taxable income”
means adjusted gross income, minus (1) the standard deduction, and (2) the deduction for persona
exemptions provided in §151
1. Average tax rate= total tax/total income
2. Marginal tax rate=% of dollar of income paid on the next dollar earned
3. Tax brackets: apply different marginal tax rates to blocks of income
4. Zero bracket: the income substracted from GI, to which no tax rate is applied
a. Let's say youre a fam of four
i. 12,200 + 4x3900-27,800=zero bracket
5. Progressive: tax rate increases with income
6. Proportional: tax rate is constant
7. Regressive: tax rate decreases with income
8. Deductions: standard deduction $12.2 K
9. Exemptions: personal exemptions $3,900/person
iv. Federal income tax rate is the only one in the US designed to be, and actually is, progressive
1. Both in terms of marginal and average tax rates
v. Examples:
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a.
b.
c.
d.
0 % 0-15k
20% 15k+
TI= 14k, tax =.1* 14k=1,00, net income=12,600
TI= 16k, tax=.2*16K= 3,200, net income=12,800 WRONG
i. 10% on first 15000
ii. 20% on (16-15k)=1k
iii. So tax is 1,500 + 200=1700
iv. Net income= 14,300
e. Cliff effect: you make more pre tax but less after taxes
2. Married filing jointly with 2 kids
a. ZB= 27,800
b. GI=22,000
i. TI=22,000-27,800=0 (can't be negative)
ii. Tax=0, Average Tax Rate=0% (0/22000), Marginal Tax Rate=0% (22,001 they would
still be in zero bracket)
c. GI= 35,000
i. TI=35000-27800=7200
ii. Tax=.1*7200=720, Average Tax Rate=720/35000=2.06%, Marginal Tax Rate=10%
(what bracket theyre in-they are still within the bracket)
d. GI=75,000
i. TI=75000-27800=47200
ii. Tax=1785+.15(47200-17850)=6187.50, Average Tax Rate=6187.50/75000=8.25%,
Marginal Tax Rate=15%
e. GI=130,000
i. TI=130000-27800=102,200
ii. Tax=9982.50+.25(102,200-72500)=17,407.50, Average Tax
Rate=17407.50/130000=13.39%, Marginal Tax Rate=25%
f. GI=450,000
i. TI=GI-ZB=450-27.8=422,200=107,768.5+.35(422,200-398,350)=116,116
ii. Average=116,116/450,000=25.8
iii. Marginal=35%
g. GI=750,000
i. Tax=233,637.20
ii. Average=31.2%
iii. Marginal=39.6%
3. ***Your average rate is never higher than your marginal rate
a. If you earned 72500, your marginal rate you be 25% because your next dollar would knock you
into that bracket
b. High income families benefit from lower brackets
i. Accounting & Deferral
i. Cash method – amounts are treated as income when received in cash and are deductible when paid
ii. Accrual method – items are treated as income when earned regardless when received
1. Most individuals use cash method, businesses use accrual method-more accurately reflects economic
realities
iii. Money has a time value associated with it – money is more valuable the longer you can hold on to it (see
table pg 39) (although liquidity or procrastination can also be factors)
1. So long as interest rates are +, TPs generally find it advantageous to find ways to defer their tax
liability to future years
2. The advantage increases with interest rates, but may be surprisingly high even when they are
relatively low
j. Complexity, Congress, and the Code
i. Why is the tax code complicated?
1. Life is complicated
2. Loophole plugging
3. Political favors-it would be nice to do less of this; but easy to hide, anonymous favor
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4. Tax expenditures....sometimes just easier to lump all these things into your taxes, instead of having
multiple agencies involved
ii. Why can't we just have everyone pay the same amount of tax? They tried a poll tax or per capita tax,
in England 30 years ago and everyone flipped
1. But this doesn't seem fair, we want the tax code to reflect certain social judgments
2. We want people to approve of the system when they think about it
iii. that you cannot take a tax deduction when you donate to, but the organization can operate
nonprofit to engage in social welfare
II. Income – what exactly is it
a. Basics
i. Gross income: all income from whatever source derived Sec 61a
1. Except as otherwise provided in this subtitle, gross income means all income from whatever source
derived, including (but not limited to) the following items – (1) compensation for services including
fees, commissions, fringe benefits, and similar items (2) gross income derived from business, (3)
gains from dealings in property, (4) interest, (5) rents, (6) royalties, (7) dividends, (8) alimony and
separate maintenance payments, (9) annuities… (up to 15)
2. 1.61-2: need to use available evidence
3. What is income ought to reflect what we actually want to tax because we think income is a
proxy for ability to pay-who should be treated the same and who should be treated differently
4. Eisner  “Income may be defined as the gain derived from labor, from capital, or from both
combined”
5. Glenshaw  “Undeniable accession to wealth, clearly realized, and over which the taxpayers have
complete dominion [is income]. The mere fact that the payments were extracted from the
wrongdoers as punishment for unlawful conduct cannot detract from their character as taxable
income to the recipients.”
a. The touchstone of income questions thus became enrichment; gains are taxable (if realized and
not non-recognized) whether traceable to labor, capital, or good fortune
ii. Haig-Simon  Income is accrual (property goes up in value) regardless of whether it has been realized
(and you’ve cashed out)
1. Y=C + S where Y is income, C is consumption, and S is saving
a. You can either spend or save your income
2. Y= C+ dW where dW=change in networth
a. Would require taxation of such items as unrealized asset appreciation, value of gov't services
such as education at state universities, even the value of leisure
b. Wouldn't reward or penalize activities thought by Congress to merit special treatment
3. Real world problems with HS…they don’t create exceptions, but “holes in the cheese”
a. Realization v. Accrual
i. Accrual…you have gotten wealthier
ii. Realization…you have turned that wealth into cash
1. If we focus on the realization of income, we are not really taxing the person’s
change in net worth, but rather how much they cashed out
b. Imputed income
i. Things that have fair market values that you have received or consumed, but are not
taxable
1. Ex: increase in home value
c. Below-market sales
i. Paying a different price for the same product (e.g. in-state tuition)
ii. This skews the FMVc variable
d. Leisure
i. Leisure is often described as a consumption choice—could be making $ but instead don’t
ii. Its never in actually included though
e. Valuation
i. Often difficult to determine fair market value
ii. How do you determine the FMV?—it’s what you would’ve paid if the tx were armslength
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1. 1.61-2(d)(1): if the services are rendered at a stipulated price, such price will be
presumed to be the fair market value of the compensation received in the absence
of evidence to the contrary
iii. Tax Equity
1. Vertical  ensuring that people pay only up to an amount that it would be fair to make someone in
that situation pay (what everyone situated is paying is fair for someone in that situation)
2. Horizontal  treating people in similar situations the same way
iv. Non-Cash Benefits
1. The definition of gross income makes no distinction whatsoever between cash and noncash
transactions
a. If you didn't get taxed on these things, people would be incentivized to take jobs with non cash
benefits and wages would fall and efficiency may be reduced
2. Grossing Up
a. Old Colony : holding that an employer's payment of federal income taxation on behalf of its
employee constituted income to the employee
i. Due to withholding, it is now routine for the employer to make federal income tax
payments on the employee's behalf, and yet for those payments to be included in gross
income
ii. Grossing up: negotiating with your employer to pay income taxes – you have a target
after tax net income
1. N = G(1-t) where N = net pay; G = gross pay; t = tax rate
2. G = N/(1-t)
3. If you cross an upper limit of a bracket with the gross income, it becomes more
complex
4. Example:
5. 80k pay, t=.2
a. GI=TI=80,000 so tax=16,000
6. But 16+80=96, need to pay .2
a. Tax=3,200 more income....infinite series
7. JUST reverse the income
a. G-t*G=N
b. G(1-t)=N
c. G=N/1-t
d. G=80000/1-.2 then G=100k
3. Meals and Lodging provided to Employees
a. Bengalia
i. Petitioners are husband and wife living in HI, husband has been employed as a hotel
manager, and constantly on duty, so him and his wife occupied a suite of rooms at one
hotel and received their meals from the hotel
ii. Uses a convenience of the employee test – if the lodging and meals are for the
convenience of the employer then it is not taxable as income to the employee
iii. PROF: rule and holding WRONG
1. Prof—majority correctly limited the opportunity for collusion between the employer
and the employee under the COE test by shifting the burden of proof away from the
Service and onto them
b. SECTION 119, enacted in 1954, ended the common law realm of convenience of the
employer cases by adopting a specific version of the general approach
i. Rule  Excludes from income the value of meals and lodgings furnished to an employee
by his employer, provided that the meals and lodgings are furnished on the employer’s
business premises and for the employer’s “convenience.
ii. Meals and lodging furnished to employee, his spouse, and his dependents, pursuant
to employment
1. (a)(1): Meals shall be excluded from income only if furnished on business premises
(not the fanciest restaurant in town)
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2. (b)(4): Meals must be furnished to at least half of the employees for the meals to
meet the convenience of the employer standard
a. egalitarian provision
b. geared at preventing special treatment
3. (a)(2): Lodging shall be excluded from income only if it is a condition of
employment that you must live on the premises
4. (b)(1): A trier of fact may consider evidence of a contract saying that lodging is for
the convenience of the employee; however, such contract will not be determinative
a. this is to prevent collusion between the employer and employee
** Doesn't define convenience, relies on courts and regs for that
iii. Lodging furnished to certain EDUCATION INSTITUTION employees
1. (d)(1): in the case of an employee of an educational institution, gross income shall
not include the value of qualified campus lodging
2. (d)(2): Exception – cases of inadequate rent (cases when the employer charges
below “reality rent” (regardless of whether it is charging FMV to others) to its
employees
a. Paragraph (1) shall not apply to the extent of the excess of
i. (A): the lesser of:
ii. (i) 5% x appraised value of the qualified campus lodging, or
iii. (ii) the average yearly rent paid by those not favored by the
university (non-employees)
iv. non-favored yearly rent (per/month x 12)
v. (B): Lesser of (i) and (ii) – employee’s yearly rent (per/month
x 12)
vi. If this number is positive, this is TI
b. 119 D (2)
i. You need several key pieces of information
ii. Appraised value of lodging $ 300,000
iii. Rent paid by nonemployees $12,000/yr
iv. Rent paid by employees $3,000/yr
v. 119 d 2 A i: .05 *300,000=15,000; ii: 12,000 [the lesser]
vi. So we want the excess over 12,000-3,000 [the rent paid]=9,000
vii. So 9,000 are not covered by D1 so you have to include it in
your taxable income
3. Qualified campus lodging
a. 119(d) applies when it is a university, and the university is providing
rental apartments. However, if you are living somewhere for the
convenience of the university (the employer) – such as a RA – then
119(a) applies instead.
4. Policy behind 119(d)
a. The policy behind 119(d) is that when a university wants to provide its
employees with discounted housing, then the university has to provide
that benefit to all people. If it does not provide discounts to everyone,
then the employee will have to pay taxes on some level of income.
i.
Horizontal equity
ii.
Also, remember the employee is not living at the convenience of the
employer here
c. Example:
i. Facts
1. Reality rent = 7,200
ii. Analysis (119)
1. (d)(2):
a. reality rent = 7,200 per year
b. rent charged = 200 per month (2,400 per year)
c. below reality rent
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2. (d)(2)(A): lesser of:
a. (i): 5% x appraised value of qualified campus lodging
i.
200k is the FMV if the unit went condo
ii.
.05 x 200k = 10k
b. (ii): for comparable units, what the university is charging to not favored people
(non-employees)
i.
Monthly rent = 800
ii.
Annual rent = 9,600 (800 x 12)
3. (d)(2)(B): employee’s rent
a. monthly rent = 200
b. annual rent = 2,400
4. 9,600 (lesser of (i) and (ii)) – 2,400 (employee’s annual rent) = 7,200
a. $7,200 would be included in TI
d. Application of §119
i. Convenience of the employer: business reasons other than compensatory intent for
having the employee accept free or below-cost meals and lodging
1. Difficulty lies in determining how strong the nontax motives must be and how they
are to be demonstrated
ii. Kowalski (SCOTUS)  meal vouchers to highway patrols were not excludable b/c not
furnished by employer
iii. Sibla (9th Cir)  $3/day to participate in obligatory organized mess was excluded from
income (9th Cir essentially overrules SCOTUS but is left unchallenged)
iv. RR 71-411  Employer’s convenience is most often established by proof that the
employee is ‘on call’ outside of business hours
1. 119 b 1: Provisions of an employment K shall not be taken as determinative of
whether the meals or lodging are intended as compensation
v. RR 75-540  Official residences of the governors of the states, and presumably the
White House also qualify as location of employment
e. Business premises of the employer: circuits have split on what this constitutes for state police,
could be every highway etc
i. Some courts say across the street ok, others say 2 blocks away is not
f. Employee: rules out self employed people, but what about a SH who owns all the shares of a
corp, appearing self-employed
i. J Grant Farms Inc
1. Grant owned and operated a farm
2. In 1976 he formed a corp, all of whose shares were owned by himself and his wife
3. Grant transferred or leased to the corp all of the assets used in the farming business,
hired Grant as its employee as manager, and required that Grant live in the house as
a condition of employment
4. Tax Court allowed the corp deductions for depreciation and utility costs or the house
which had not previously been allowable to anyone, and Grant was not required to
include any amount in his gross income by virtue of its use
Other fringe benefits statutes
 American approach to fringe benefits
o Fringes started to be provided, and the if IRS doesn’t notice or doesn’t care, then the fringes get more popular
o Among the most important fringe benefits are life insurance, medical insurance and payments, discounts on
merchandise, parking, company cars, airline travel, club memberships, and tuition remissions
 This is a huge morale issue
 Loss aversion
o People are more bummed out when they thought they had something then lost it,
rather than knowing they never had it at all
 Raise problems of valuation, enforcement, and political acceptance
 Valuation problem
o Value of a benefit depend on the circumstances of that person
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o
o
o
Through the years, some fringe benefits were excluded as a result of the Service's
inaction or acquiescence
Others were excluded by express statutory provisions, i.e. life and medical insurance
In 1984, Congress enacted 132, providing comprehensive coverage of fringe benefits
132: fringe benefits
 Drew a line at the fringe benefits people have gotten used to receiving as non-taxable
o There is no commonality amongst the fringes treated as non-taxable
 61 a 1 was amended to include a specific mention of fringe benefits, the main excludable ones are:
o No additional cost services such as free seating for airline employees that would not otherwise have sold out
o Qualified employee discounts, i.e. department store employee discounts
o Working condition fringes, i.e. business use of a company care
o De minimis fringes, or those of sufficiently low value to make accounting for them unreasonable or
administratively impractical, i.e. certain eating facilities
o Qualified transportation fringes
o Qualified moving expense reimbursement
o Qualified retirement planning services
o Certain on-premises gym and other athletic facilities
 No additional cost services and qualifies employee discounts are subject to certain restrictions
o One must work in a line of business of the employer in which the item at issue is ordinarily offered for sale to
customers
o Neither applies to highly compensated employees if the employee discriminates in favor of such employees in
determining to whom a given fringe benefit is available
o fringe benefits apply to families – i.e., spouses and dependents, and now same sex couples post-DOMA
 Also applies to retired and disabled employees and surviving spouses
o Can also make a reciprocal agreement with another business
 (b) no-additional-cost service
o e.g., empty seats on airplanes
 letting an employee fill an empty seat is of no additional cost service to the employer
 the employee receives something of value, but 132 allows the employee to exclude that
from the value of their income
o (1) “in the ordinary course of the line of business”
 intended for corporations with multifaceted businesses
 if you are a programmer for a corporation that happened to have an airline, you
CANNOT get the free airfare deal
o (j) “boys in the boardroom” provision applies
 (c) qualified employee discount
o as long as the employer sells something to an employee at cost
 in the case of services, the Code simply institutes 20%
 employee does not have to include the difference between cost and retail, even though
they are receiving a benefit
o (4) “in the ordinary course of the line of business”
 Same as 132(b)(1)
o (j) “boys in the boardroom” provision applies
 (j) special rules
o (1) exclusions under no-additional-cost service and qualified employee discount fringes apply to highly
compensated employees only if there is no discrimination
 goes against the boys in the boardroom problem
 for our purposes, highly compensated means highly compensated
 (d) working condition fringe
o It can be excluded when it is provided by the employer as fringe benefit if an employee could have
deducted it as a business expense itself
 (e) de minimis fringe
o most important fringe of all
 does not mean it is a small fringe, it means that it is an annoying fringe
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accounting for them would be unreasonable or impracticable
o not about “lines of business,” about annoyance
(f) qualified transportation fringe
o (1) you can exclude from your income, the costs of a
 commuter highway vehicle
 essentially employee vans taking employees from satellite parking lots to their offices
o More than 6 seats (excluding the driver) and 80% if mileage for transporting
employees to and from work where ½ of the seats are filled
 a transit pass
 qualified parking,
 bicycle commuting -- from your income
o (2) limitations on exclusion – an exclusion shall not exceed
 $230 per month for commuter highway vehicles and transit passes
 $230 per month in the case of qualified parking
 the applicable annual limitation in the case of any qualified bicycle commuting reimbursement
o this fringe is here to allow people to exclude commuting costs from their taxable income
o Hypo on page 59
 The more the transportation looks like a rolling office, ie phone and lamp, the more likely this
qualifies as a non taxable fringe benefit-he's working the whole time!
1.61-21(b)…taxation of fringe benefits
o Valuation
 The treasury has published detailed regulations on fringe benefits regs 1.61-21 and 1.132-1 to -8
 FMV if you can determine it
 If you can’t determine FMV, then there may be a safe harbor rule to turn to
 Sometimes it’s difficult to determine FMV. So if you follow a safe harbor rule, you can
avoid an IRS challenge.
o (b)(5) chauffeur services: use what the limo company paid the chauffeur
Frequent flyer credits
o When credits are earned from personal travel, they are best through of as reductions in the price of the flights
and there should be no tax consequence
o But its different for business trips, you can use these benefits for your personal trips-experts agree this is
income
o For many years the IRS made no effort to impose tax liability in these circs
 Finally threw in the towel in 2002 stating that the IRS will not assert than any TP has understated his
federal tax liability by reason of the receipt or personal use of frequent flyer miles, etc
 IRS says if you get them for opening an account, you have to pay taxes; if you get them for
using your card or for taking a promotional trip [these are more like rebate], then you don't
have to pay for taxes
Health Insurance
o Employers are allowed to deduct the cost of medical insurance that they buy for their employees
o The benefits received by employees are excluded from their from income (106a), and extends to spouse and
dependents
o Also excluded from wages for the purposes of determining payroll tax
o Self employed TPs are allowed to deduct the costs of medical care under 162 (1)
o The general effect of the exclusion of health insurance from income is that the government subsidizes a
portion of insurance costs, leading to employees trading up on health insurance policies
What if 132 was around when the Benaglia case happened?
o Food wouldn't count, he'd have to pay taxes (because its an additional cost service...except for the food
needed for him to stay late)
o But if the rooms he stayed in were going to be vacant any way, then he could have argued that to be tax free
o BUT wait this is moot because of 132 J
 These things are not being offered to other employees, highly compensated employee
ruleBenaglias lose
Cafeteria plans
11
125: cafeteria plans
 Another kind of fringe benefit
o A plan under which an employee may choose among a variety of noncash nontaxable benefits or may choose
to take cash
 Provide nontaxable fringe benefits to those employees who want them without disfavoring employees
who have no need for them
o Increases potential use of non taxable fringe benefits by removing the element of employee envy
o Limits the fringe benefits that can be included in a cafeteria plan and imposes a nondiscrimination rule
 Include group term life insurance, dependent care assistance, adoption assistance, excludable accident
and health benefits, elective contributions for 401k
 (a): the fact that you have a choice among benefits does not turn them into cash and make them taxable
o 132 (a bunch of isolated benefits that you may receive) v. 125 (an employer has to specify a cafeteria plan)
 (d): you can choose fringe benefits from the cafeteria plan tax-free, but if you opt out, take the cash, pay taxes on
that income
 (f): inclusion by reference (anti-abuse provision)
o other Sections of the Code tell you what can be included in a cafeteria plan
 Key examples of what CAN BE INCLUDED in a cafeteria plan
 Group-term life insurance
 Dependent care assistance
 Adoption assistance
 Excludable accident and health benefits
 Elective contributions under a qualified cash or deferred arrangements under 401(k)
 The idea of a cafeteria plan is to allow employees to pick and choose all, some, or none of the benefits provided by
the employer
 If you take all of the benefits, you will have a lower taxable income
o So, there is no horizontal equity
o But, there are psychological aspects to this
 You can personalize the fringes to your own situation
 Employee envy
 The fact that you can opt-out should allegedly reduce the element of employee envy
 Use-it-or-lose-it rule
o If you don’t use the whole benefit up, you just lose it (so employee must plan)
 This stems from an incorrect estimation of what you may need in a flexible spending account
 People go in for all kinds of unnecessary medical procedures on March 30 or 31
o To cure these problems, Prof suggests that Congress simply set limits rather than attempting to prevent people
from overspending on the preferred items by raising the risk associated with overestimating
o If you don’t use it, the funds go back to the employer
 The employer may pocket the excess funds
 Or, the employer may redistribute the excess funds across all the employees
 Cafeteria Plans Example:
o C: 50k salary
 Takes no 125 fringes
 Tax=10k, Net=40k-5,000 (to make meaningful comparison)=35,000
o D: 50k salary
 5k in 125 fringes
 tax=.2*(50-45k)=9,000, Net=36,000
o t=.2
o Makes cost to employer the same whether the employee takes fringe or not
Another Approach to Valuation
Turner (TCM 1954)
 Question Presented : the amount which should be included in income because of the winning of steamship tickets
by answering a question on a radio show
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o
Both sides agree that its HS income, that its section 61 income, etc
 They are willing to admit this
o The only question is what damages should be
 Court decides that the tickets are income of 1400
 Reasoning: don't provide any reasoning....notes say that they split the difference between Turner
and IRS valuations
 Suggests a subjective approach to valuation…incorrect
McCoy v. Commissioner
 A guy won a Lincoln worth 4.4K, traded it in for a station wagon worth 2.6 K + 1k cash
 Court held that the amount includible in income was 3.9K
Rooney
 The use of any such subjective measure of value as is suggested is contrary to the usual way of valuing either
services or property (this is right)
Rule

You want to look for objective manifestations of value
o Important distinction
 Opinions and the like can affect fair market value if people put their money where their mouth is
 What we don’t want to do is take into account people’s unique situations
Windfalls and perks
Treasure trove
 1.61-4: treasure trove, to the extent of its value in US currency, constitutes gross income for the taxable year in
which it is reduced to undisputed possession
 If you gave back such a windfall immediately, as in the case of the record-breaking home-run balls, you are
treated as if you never possessed it at all.
 There is a realization requirement for found treasure.
o Only when you sell it and turn it into cash are you taxed on it.
 HS income but not taxable income.
Taxes and Space
 Company should gross up and pay for the taxes of the gifts they give because they get free publicity
 So if you don't turn it into cash but you use it then its taxable
o ie trip to space, so you’re going to need a gross up
 Gross up example
o Car costs 35,000
o What would the taxes be??
o 35000=G-tG=G(1-t)=> 35000/(1-t)=G
o Lets say its 25% so 35000/.75=>about 48K so you give 13K in cash
IMPUTED INCOME
 People may use their property or their own services to provide benefits directly to themselves or to members of their
households
o The benefits they derive are not part of any commercial transactions, and experts refer to these kinds of
benefits as imputed income
 Benefits that are not part of a commercial transaction and are therefore generally not thought of as income for tax
purposes are generally not included in a TP’s taxable income
o Though failure to include them results in problems of fairness and economic rationality
 Property (other than cash) – increase in value of a house is not taxed so long as it is unrealized and if passed at
death with a stepped up basis will never be taxed and so the investment will escape taxation  shows a congressional
preference for home ownership and that tax system will influence actions
 Owner-occupied home: the imputed income is simply the rental value of that home
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Some assert that the treatment of homeowners discriminates against renters, but there are significant
tax benefits to landlords, mainly in the form of deductions for cost recovery that may be unrelated to
economic reality
 Presumably these benefits are passed onto tenants in the form of reduced rent
 The real reason people are not taxed on imputed income from home ownership is because it would be
impractical to do so because of problems of valuation
Services – the benefit of the services that one performs for oneself is not taxed
o Service of homemakers are of substantial value and are not evenly distributed among households
 One way to make this more fair is the section 21 and 129, allowing credit for child and household
care and tax free employer reimbursement for childcare expenses, combined with 125, allowing
employers to offer employees a choice between tax free benefits and cash
o The value of services that one performs for oneself in creating human capital
 I.e. studying to become a doctor
Physic income and leisure – there is a tax on the earnings, but not the benefit of leisure that one “buys” by not
working – so there is a tax benefit to being underemployed, you can buy leisure time with pre-tax dollars
Bartering
Rev. Ruling 79-24
 Barter income IS taxable
 Valuation
o Section 1.61-2 d 1 provides that if services are paid for other than in money, the FMV of the property or
services taken in payment must be included in income
 If the services are rendered at a stipulated price, such price will be presumed to be the FMV of the
compensation received in the absence of evidence to the contrary
o FMV
 If the FMVs are different, you have to look at the FMV of what the person received in order to
decipher their taxable liability
 As an administrative choice, you almost always anchor the work of the thing easily valued to
the thing not so easily valued
o With a presumption for stipulated value
 This value can be challenged by the IRS with affirmative evidence of their own
 Other examples:
o Ownership timeshare condos exchanged for a week
 IRS has not ruled on this
o Exchanges of babysitting income never gonna get taxed in the real world even if its HS
o Pool resources to create commune
 It’s a family so it’s an exchange of services with family so the tax code doesn’t touch
 Hypos
o Situation 1
 Barter club
 Lawyer provides a house painter trade with legal work in exchange for the painter to paint his house
 The FMV of the services received by the lawyer and the painter are includible in their
gross incomes
 Tax analysis
 Lawyer values his work at $1,000
o Lawyer is taxed on $500 (received)
 Painter values his work at $500
o Painter is taxed on $1000 (received)
 Situation isn’t normal as this is an example of a crappy deal
 …if the FMVs are different, you have to look at the FMV of what the person
RECEIVED in order to decipher their taxable liability
o Situation 2
 A professional artist provides an owner of an apartment building with a painting in exchange for 6
months rent
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The FMV of the work of art and the six months of FMV of the apt are includible in
gross incomes
Tax analysis
 6 months worth of rent…FMV easy to find
 piece of unique art…FMV not easily found
 As an administrative choice, you almost always anchor the work of the thing easily
valued to the thing not so easily valued
o This becomes even more difficult when you have two things that are not easily
valued. Then, you just hire and appraiser.
6045: Barter Clubs
 Requires information reporting by any “barter exchange”
 1.6045-1(a)(4): the term barter exchange does not include arrangements that provide solely for the informal
exchange of similar services on a noncommercial basis
o The IRS does not want to get into trivial matters, even if they are HS income.
o This sometimes applies to trivial matter with commercial bases as well.
 Credits from a barter club...pile on a bunch on them but don't have to include them in gross income until you cash
them out
WINDFALLS AND GIFTS
Punitive damages
Glenshaw Glass (US SC 1955)
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Question Presented: Whether money received as exemplary damages for fraud or as the punitive 2/3 portion of a
treble-damage AT recovery must be reported as gross income
The Court holds that punitive damages ARE includable in taxable income
o Nothing limits the definition of gross income under §61
 Punitive damages falls under “any source whatever”
 SC sets super precedent (super precedent…decisions that is entrenched and if changed
would be a big deal)
o Income has never been limited before
§104(a)(2): personal injury recoveries
 Compensatory and punitive damages are excluded from taxable income when it is a personal injury case
o Even though they are HS income
o Theory…all you are doing is making someone whole
 But, this doesn’t really draw a distinction to the GG case
 Mental or psychological injuries are not covered, just physical injuries

Pain and suffering is not taxable
o

So when, through a suit, you get something non-punitive that is non-taxable, like pain and suffering YOU
don't want to pay tax on it
o If you got lost wages-then that’s taxable, if you got punitive then its taxable
***Need to look for these explicit exclusion sections to not have to tax
Gifts
 Gift: the Basic Concept
o Gifts have always been excluded from taxable income under what is presently section 102
o Exclusion extends to gifts (such as cash) that involve no valuation difficulty, and is not simply a de minimis
rule of administrative convenience; it applies to large gifts as well as small
o Things to know:
 If you receive a gift and it’s really a gift, you don't have to worry about income tax or gift tax
 Gift tax is paid by the giver not the recipient
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 Under the gift tax there is an exclusion for gifts up to 14k
Example on bottom of page 82
 D gives E 30k; her income is now 70k and his is 30k for income tax reasons
 As if he was an employee
 D gives E 30 k; her income stays 100k and his is considered 30k
 As if he was hired to do personal services
 No income to E and no deduction to D
 This is the real rule on gifts
§102: gifts and inheritances
 (a): Gifts are excluded from taxable income, but does not income from property received or where the gift is of
income from property
 (b): you can exclude the initial gift, but not any income you derive from that gift
o e.g., if you get stock dividends as a gift
 Example (p. 16 (Notes)) Three possible ways to deal with gifts:
o Donna 100k  Edward 30k
 (a) Income to E, deduction for D: [70k GI Donna; 30k GI Edward]
 E provides non-personal services to D
o How business expenses are treated
 (b) Income to E, NO deduction for D: [100k GI Donna; 30k GI Edward]
 E provides personal services to D
o E.g., E cooks for D
 How personal expenses are treated
 (c) No income to E, NO deduction for D: [100k GI Donna; 0 GI Edward]
 THIS IS HOW WE TREAT GIFTS…allowed by fed income tax
 Gift as long as transfer is a “gift”
o Precisely because E did not work for D
 E works, in some degree, in each of the other two situations
o
Defining “gift” (this is the hard part)
o Duberstein (US SC 1960)
 Berman called D one day and said the info he had given him was so helpful he wanted to give him a
present and gave D a car
 B later deducted the Cadillac as a business expense on its corporate income tax return
 IRS thought it was renumeration for services rendered, not a gift
o No 506, Stanton
 Stanton worked for a church, making 22.5k a year
 When he resigned the church gave him a gratuity of 20k because the church really liked him and
wanted to give him a gift
o Holding:
 The D Cadillac was a recompense for D's services, or an inducement for him to be of further service
in the future
 Court is in disagreement about Stanton; district court later found that the money in Stanton was a gift,
affirmed on appeal
o RULE: Gift, statutorily: proceeds from a ‘detached & disinterested generosity, out of affection, respect,
admiration, charity or like impulses.”
 Court should look at the intent of the transferror not on the transferee
 Court basically saying we don't know what a gift is! If it looks gift it’s a gift
o Factors
 (1) “Detached generosity”
 Detached and generosity seems to be an internally inconsistent phrase
 (2) “Affection, respect, admiration, charity or like impulses”
 At least the court is getting somewhere here
 The transferor has to feel “happy”
 (3) Transferor’s “intention”
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o
o
o
 The stance of the recipient is irrelevant to determining if it’s a “gift” for tax purposes
 “Gift” determination does not rest on the donor’s conduct, but rather his intention
Objective/subjective test
 We are reading their mind to get an objective determination of the donor’s subjective intent
 Court will not look to language expressing that a “gift” is a gift as outcome determinative
 Court will look at the totality of the circumstances
 Whether a gift is from employer to employee is relevant, but will not determine the court’s
outcome [LATER CHANGED BY 102c)]
 Whether a gift is given by a corporation is relevant, but will not determine the court’s outcome
 Whether a gift is deducted is relevant, but will not determine the court’s outcome
Gifts defined as “gifts” are excludable in the recipient’s tax income [also CHANGED by 274b]
Standard for gift cases in the future
 If there is an appeal, anything short of “clearly erroneous” will lead to an affirmation
 “Clearly erroneous” is highly deferential to triers of fact…wrong because legal finding
seems to be getting the standard of review afforded to factual findings
o Pertains to fact
o Trial courts can handle these kinds of situations better than appellate courts
o Reasonable minds could differ
Congressional action (post-Duberstein)
 §102: gifts
o (a): Gross income does not include the value of property, acquired by gift bequest, devise, or inheritance
o (c): value of gifts from an employer to an employee is not excludable from taxable income
 this is about gifts to employees from companies
 In these situations, the employer may deduct the value of the gift and the employee must
include the value of the gift in his income.
o We just treat such a gift as compensation.
 274(b): businesses are not allowed to deduct expenses for gifts to individuals to the extent they exceed $25 (defines
‘gift’ by reference back to 102)
o this is about gifts to individuals from companies
 This standard governs the Duberstein situation
 If business gift, the business can deduct no more than $25. The recipient, however, may
exclude the entire value of the gift from his income.
o This disincentives business gifts.
 If not gift, and is instead determined to be an ordinary and necessary business expense, it is
deductible to the gift giver under 162. For the recip, however, the value of the gift is
includable in their income.
 The determination of a gift for one party would hold true for the other party as well.
Further defining “gift”
 Harris
o Facts: Kritzik was a wealthy widower partial to the company of young women, including twins Conley and
Harris; K gave C and H each more than 500k over the course of several years
 No one paid tax on this money, and C and H were convicted of evading their income tax
o Only Crim case—SOR = Sufficiency of evidence, in light most favorable to gov’t
o A person is entitled to treat items from lovers as gifts as long the relationship consists of something more
than specific payments for specific sessions of sex
 to treat it as a gift, you could arrange for sex on a non-transactional basis
o Doesn't matter if she thought she was earning what he was giving to her, what matters is what HE thought
(could have thought she really loved him)
 We need to look at his intent...these letters can show us that!
 In the case of married couples, taxability of transfers of money does not hinge on the application of the
“detached and disinterested generosity” test of Duberstein
Tips and unusual gifts
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Tips
o
1.61-2(a)(1): a tip is included in taxable income because it is compensation for services
 Regulation 1.61-2:
 Discussing how many restaurants esp chains now have "team tips" and share with the whole
team
 Employer is required to give employee tax return information which includes information on
tips
 Safe harbor rule: Now waiters can say tip income is 10% of the business you did...low
average
o With regards to Duberstein, the unusual nature or unique motives of a tip may cut in favor of counting it
as a “gift,” rather than if the tip was just generally provided as additional compensation for the given
transaction
 But it also may not cut that way
Tipping a minister for performing a wedding; minister must include in TI
Gamblers who tip out of compulsion or superstition: dealers/servers must include in TI
Scholarships: excluded from TI
o Section 74 created a rule requiring inclusion of such benefits in gross income with minor exceptions for
charitable contributions
o Section 117 leaves only a limited exclusion for scholarships provided to degree candidates
 Only for the portion used for tuition, fees, books, and supplies and required equipment
Surviving spouses – payments from corporations to surviving spouses  [5 factors to determine if it’s a gift] (1)
payments made to wife and not to estate; (2) no obligation of corporation to pay anything additional; (3) corporation
derived no benefit from payments; (4) wife performed no services for corporation; (5) services of husband had been
fully compensated
RR 76-144 – Government Payments:
o Traditional welfare payments and other government payments are generally not excludable under 102 but
rather not within the contemplation of income under 61
 Unemployment is now fully includable under 85
 Under current law, the treatment of SS benefits depends on the TP's adjusted gross income,
augmented by one-half the benefits received, tax-exempt interest and other items
Bonuses -- starting with most likely to be included as income (1) regular bonus from employer, (2) irregular bonus
from employer, (3) regular bonus from 3rd party, (4) irregular bonus from 3rd party
Transfer of unrealized gain by gift while the donor is ALIVE
 Section 61 a 3 includes in gross income gains from dealings in property
 Section 1001 provides that the amount of the gain is the excess of the amount realized over the adjusted basis
o The adjusted basis is the basis, defined under 1012 as cost adjusted as provided in 1016
o There is an exception in 1015 for property acquired as gift
 Generally the donee's basis is the same as the donor's basis aka transferred basis 7701 a 43
o Exception: if at the time of the gift the donor's basis is greater than the FMV of the property so the donor
would have a loss if he or she sold the property, then for purposes of computing the donee's loss on any
subsequent sale, the donee's basis is the FMV at the time of the gift
 Taft (US SC 1929)
o Facts: A purchased 100 shares of stock for 1k, then sold them to B when the FMV was 2k, B sold them for
5k. IRS says B must pay income tax on 4k, B says only on 3k-the appreciation during ownership
o Held: Donee has to pay tax on entire realization even though some of it was “earned” before she got the
property – both because the law is clear and because the receiver of a gift is still better off
 Donee assumes the place of his predecessor
 Carryover basis
o Threshold issue: Is the property you are receiving a gift?
o 1015(a): basis of property (not cash) acquired by gifts
 you go back to the last person who paid money for the property that you are getting as a gift
 future gain…carryover basis (you use what the original purchaser paid for that property)
 future loss…FMV at the time of the transfer
18
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o
o
o
o
This rule somewhat clumsily limits carryover loses and accompanying strategic tax
moves
What Congress said we we're going to stop family members giving each other property at a loss so that
the receiver can get a better tax advantage than the lower income gifter
Calculation example
 Original owner paid = $1500
 FMV at transfer = $1000
 (1) Recipient sells for $800; income = 800 (sale) – 1000 (FMV at transfer) = - 200 ($200 loss can be
subtracted from his income)
 Loss calculation (negative value when you subtract FMV)…subtract money from taxable
income
 (2) Recipient sells for $1600; income = 1600 (sale) – 1500 (carryover basis) = + 100 ($100 can be
added to his income)
 Gain calculation (positive value when you subtract carryover basis)…include money in
taxable income
 (3) Recipient sells for $1200
 carryover…1200 (sale) -1500 (carryover basis) = -300
o no gain
 FMV…1200 (sale) -1000 (FMV) = +200
o No loss
 Neither loss nor gain calculation (negative value when you subtract carryover basis AND
positive value when you subtract FMV)…thus, no tax consequence
Policy behind carryover basis rule
 Gain side…progressive rule
 You are giving away something of value, and also ridding yourself of a potentially large tax
liability
 Giving it away does lose you money, but some people make tax motivated decisions
 One of the things that this does encourage is downward distribution of wealth
 Prevention of losses side…regressive rule
 A poorer person may transfer gifts up to a wealthy person in order for the wealthier
person to avoid tax liability
o Not a policy generally espoused by Congress
 Hypothetical
o 100k loss in real estate
o May transfer this losing property to a wealthier person who would like to be able to
deduct the amount of the “gift” from his GI
 …1015 does not force transfers of wealth to just the poor
o incentive to move assets in the right direction is removed
 The hole…no gain or loss
Remember: 1015 ONLY applies to gifts, so if there is an arm’s length transaction, the person receiving the
property will take basis based on FMV rather than donor’s basis – so if shares were transferred as
compensation, the basis would be FMV and payer would pay tax based on “sale or disposition” of property
Double Taxation
 No rule against double taxation
 Double taxation means taxing the same base more than once
o Buy an item at the store at it is $100
o Taxed at sales rate and if it was taxed again as a separate taxation
 Asking how many times a dollar has been taxed is a meaningless question because money gets reused
 Is double taxation twice as bad?
o Doesn't tell you anything! You need more information
ESTATE TAX: Transfers of unrealized gain by gift at death
19

Estate tax
o Meant to interact with gift tax, known as the generation skipping tax
o Designed to tax transfers of wealth at the death of the giver
 Threshold issue: Is the property you are receiving a gift?
o Under 1014, the basis of property acquired by reason of death is the FMV on the date of death or at the
election of the executor or adminstrator under 2032 on the optional valuation date
o The basis is either stepped up or stepped down from the decedent's basis to the DoD value (usually see
stepped up)
 §1014 (a): basis of property acquired from a decedent
o (1): basis of property is stepped up (or stepped-down) to the FMV of the property at the date of the
decedent’s death (2032 provides an optional valuation date of six months after death)
 Way different from carryover basis
 Much more favorable
 Example
o 1m at decedent’s death
o 1m when you received it
o you sell at for 1m the next day, then taxable income is 0
 Estate tax comes in to compensate for this lack of taxable income
o Estate tax
 When a person dies
 you tax the value of their property
o take out the expenses of dying
o take out charitable gifts directed by the estate
o take out $5.25m zero bracket
 When the first spouse dies, the estate can be transferred to the surviving
spouse tax free
 When the second spouse dies, the estate can be transferred to beneficiaries
with a $10.5m zero bracket
 Marginal tax rate = 40%
o Policy rationales for an estate tax
 (1) Highly progressive
 Only high-wealth people pay it
 Satisfies vertical equity in spades
o Only those capable to pay it do so
 (2) If you collect money from this tax, you don’t have to collect as much from other taxes
 The estate tax allows you have lower rates on income, allows you to have 1014, etc.
 (3) Estate tax serves as a back-up tax on capital gains
 estate tax indirectly taxes capital gains that 1014 would let go untaxed forever
 (4) Encourages gifts to charity
 charitable gifts taken out of an estate are not subject to estate taxes
 If you hold onto property long enough there will not be income tax liability on the gain
 1014 creates an incentive to hold on to property and not sell it
 Is it double taxation with the gift tax which taxes transfers of wealth before tax? No
 People argue that all the money is this estate has been earned and already been taxed once
and now when I die I will be taxed again
o Buchanan says this isn't the right way to think about it
o You're not taxing the dollars, your taxing the transmission of an estate (or large
gift)...different base than income tax
 The only way to ask whether the estate tax is good or bad is to ask what would we do in its absence?
 **Buchanan is against repealing the estate tax and thinks we should tax more of the estates that are
currently not taxed
LOANS AND DISCHARGE OF INDEBTEDNESS
Loans
20
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





Equity v. debt
o Very different from legal perspective
o Borrowing money is like selling a bond to someone
Rule
o When you take out a loan, even though you have money coming in, because it has an offsetting liability, you
do not need to include that money in your income.
o When you pay back the loan, you do not deduct the payments that you make
o Section 61 a 12: the rationale
 Loan proceeds do not improve one's economic condition because they are offset by a corresponding
liability (doesn't increase net worth)
Interest payments are taxable income to the lender
o In this way, a loan operates as a savings account
o Principal is not income
Are interest payments deductible for borrowers?
o Interest payments on loans are deductible to business but not individuals
 Policy: Congress decided Americans were spending too much money and getting into too much debt
We ASSUME that people actually make good on their loans
o If we don't know for sure if you're gonna pay it back so we should add 200k to your income and then deduct
repayments
What if someone loans you money (a bond) and then just tears up the piece of paper
o That's discharge of the indebtedness, and therefore you have income
If the borrower defaults, the loss is deductible to the lender
Discharge of indebtedness
 “cancellation of debt” = “discharge of indebtedness”
 Discharge of indebtedness income (DOI income) becomes relevant when loans are not paid back
o We trust that you are going to pay back the loan until we decide that we cannot trust you
 KEY…The driving factor in determining DOI Income is whether the principal loan is paid in
full
 61(a)(12)
o “income from discharge of indebtedness”
 if a debt is discharged, then the borrower essentially has received income equal to the amount of the
indebtedness
Kirby Lumber (US SC 1931)
 Facts: Kirby issued $12M in bonds in July 1923; later than year, they extinguished $1M of principle by paying
$826k. IRS claims the $138k is DOI income.
 D did not have to pay tax when they sold bonds because it was a loan, but when bought back bonds at lower price it
was DOI income and thus taxable income
 Discharge of indebtedness income really is income
o Income is included in the year of the discharge, not the year of the loan
 Kerbaugh-Empire Co case
o The TP had borrowed money repayable in marks or their equivalent for an enterprise that failed
 Court found it was a profitable exchange on the currency exchange market, there was no DoI
o Kerbaugh Empire muddies the waters because it seems to say in order to answer the DoI question, you need
to know what happens to the business
 Courts have not treated this as true. They make Kirby as simple as it seems; fate of an enterprise is
irrelevant.
108: income from discharge of indebtedness
 Congressional cure to KL
o Section 108 contain elaborate rules relating to discharge of the indebtedness of insolvent debtors
o “One should not hit a person when he is down” theory
 DOI not considered income if
21
o
o

Bankrupt (linked to bankruptcy principles)
Insolvent (you can be insolvent but not bankrupt if you haven't filled the bankruptcy papers...all law students
are insolvent!)
 (a)(1):
o (B): if your net worth is negative then you are insolvent, and if you are insolvent you do not
have to include discharge of indebtedness income in your taxable income
o Qualified farm indebtedness (farmer doesn't need to be insolvent or bankrupt)
o (C): you can be a farmer who is not in bankruptcy and who is not insolvent, and you do not have
to include discharge of indebtedness in your income, so long as the farm indebtedness qualifies
 Congress loves farmers
o Mortgage forgiveness
 Section 108 h provides relieve for TPs who would otherwise recognize income from the discharge of
indebtedness when mortgage lenders foreclose on the TPs principal residence
 Statute provides for an exclusion of up to $2M of forgiven qualified principal resident indebtedness
 Added after financial crisis when a whole lot of people are losing their homes
 You give up your underwater house, may not have been necessary because people were prob
insolvent or bankrupt anyway
 Probably won't be extended past 2014
o (d)(1): for the purposes of 108, “indebtedness of taxpayer” means any indebtedness:
 (A) for which the TP is liable, OR
 (B) subject to which the TP holds property
o (e)(5): purchase price adjustment
 after the fact, we act as if the price was different
 in the very limited situation in which the person you bought the good from also financed the loan, the
amount which you settle the loan for in not considered DOI Income
 Department store credit card situation:
 You say this cost 1000 dollars, but then you both agree to pay it off for 900
 So instead of 100 in DOI income, tax code says let’s just say that it’s as if it was on sale and
they sold it for 900
 Increasingly not available as department stores vanish
o 108 (f): Student loans
 Loan forgiveness program relief
 (f)(2): excludes cancellation or repayment of student loan that is made contingent to work on
charitable or educational institution
** When you think about it, it makes sense why DOI should be considered income, but it also makes sense why there
are so many exceptions as a matter of policy
GAINS AND LOSSES FROM GAMBLING
 The Basic Rule: all gains are taxable but losses are deductible only to the extent of gains from the same taxable year
o 165(d): wagering losses
 1.165-10: You pay taxes on net winnings, but you cannot deduct net losses
 You can only use losses to offset winnings, however you cannot make deductions for
additional losses
 The IRS has ruled on comps and the Tax Court has said the taxpayer can offset the comps as if
they are winnings from gambling.
 Comps are considered gambling income.
 Gambling income can be offset by gambling losses WITHIN THE SAME YEAR [IRS is rigid
about the year]
 Theory:
o Not just punishing gambling for moral reasons--isn't having fun at a casino and spending $100 and losing it
the same as $100 non-deductible consumption elsewhere?
o Gambling transactions are place in a separate basket from all of the TP's other transactions to ensure that no
net loss from the basket will be deductible
 Basketing rules give unfortunate prominence to the question of which transactions fit in the basket
 Jasinski: purchase of high risk junk bonds is not gambling
22


Enforcement
o Since gambling is a cash business, enforcement is a problem
o For relatively large transactions, 3402q requires that the race track or other payor withhold taxes at 20%
o Payors usually only have to report winnings of $600 or more to the IRS
 But just because you win less than $600 doesn't mean you don't owe taxes
Misconceived Discharge Theory: Section 108
o Suppose Z borrowed $10k to finance her law school education and her employer pays the debt on her behalf
as a Xmas bonus
o Should be viewed for tax purposes as if the employer had paid Z a cash bonus of $10k and she had used her
money to pay her debt
 Should be taxed under 61 a 1 not 61 a 12
o Indirect payment or economic benefit might best capture the essence of the transaction
Zarin (3rd Cir. 1990)
 Facts: Zarin appeals from a holding that he recognized $2.9 million in income from discharge of indebtedness
resulting from his gambling activities and that he should be taxed on the income
o Zarin was a high roller, and despite an investigation by Gambling enforcement, casinos continued to give
Zarin lines of credit and he became a compulsive gambler
o Zarin was finally cut off when he was giving casinos checks with insufficient funds, checks totaled $3.4
million
 Resorts sued Zarin for the 3.4 million, they settled for 500k
o IRS said that Zarin had recognized$ 2.9 million of income in 1981 from the cancellation of indebtedness that
resulted from the settlement (3.4-500k) so he owed 70% of that in taxes
o Majority holds in favor of Zarin
 MAJORITY GETS IT WRONG: Law is clear that D should have had to pay taxes on DOI, but that is too
inequitable for court and so they find ways around it
o 108 d 1: The problem with using this definition of indebtedness
 61 includes DOI is income, but 61 does not define indebtedness and so court looks to 108(d)(1)
which refers to a charge on which the taxpayer is liable or subject to which the taxpayer holds
property and finds D satisfies neither of these
 Majority: he's not liable because the debt is unenforceable because the casino made you a
loan in violation of NJ law
o Buchanan: Zarin said he was going to pay it in full after he argued that it was
unenforceable...therefore it could be a K between private parties and it would be
enforceable OR
 Majority: chips are just an accounting method to prove indebtedness...but aren't they trying
to show that there's no indebtedness??
o Court says that chips were Resorts property and Zarin couldn't use them to buy
whatever he wanted...but then they said the chips were not Resorts property when he
had them WHAT?!)
o Contested liability doctrine
 If a taxpayer, in good faith, disputed the amount of a debt, a subsequent settlement of the dispute
would be treated as the amount of debt cognizable for tax purposes and any excess over amount
determined to have been due is disregarded for both loss and debt accounting purposes (judicially
created). This particularly involves situations concerning illiquid damages.
 DOI= Original loan-Payment Amount--->IRS says 3.4million-500k; Majority says 500k500k therefore DOI=0 because it is a contested liability [would not be zero only if you don't
pay back your settlement amount]
o Buchanan: This is not proper here because it would essentially read DOI income
out of the Code.
 Dissent: Zarin never reported the 3.4 million as income because he recognized it was a loan that he had to repay
o Income not earlier recognized should be recognized when the debtor no longer recognizes an obligation to
repay and the creditor has release the debt or acknowledged its unenforceability
o ** Every other circuit has repudiated it, good law is the opposite of what the majority said
 Alternatives: as a matter of equity, you can figure out an equitable arrangement without messing up the law
23
o
o
IRS could have been ordered by the court to do a compromise aka make him less...so this means YES he has
DOI income but no you can't get all the money
OR through the insolvency exception from section 108
GAIN ON HOME SALES
 Congress has turned to the tax code to curry favor with America's homeowners
 Average homeowner only lives in their home for 6 years in the US
o If you let your house appreciate enough and then their gain dwarfs their income they may be pushed into a
higher tax bracket
o Also do we want to tax someone on their only appreciable asset?
OLD RULE:
 1034 – If income on sale of home, taxpayer can exclude that income if she buys a home of greater or equal value
within 2 years
o Well just treat it like you’ve been living in the bigger home the whole time
 121 – At age 55, one one-time 125k exclusion, even if not used to buy home of greater or equal value within 2 years
 Policy for OLD rule
o Government was creating this new ethos of home ownership
o The path cut by Congress
 Continue to buy nicer houses until you want to cash out
 If you continue to follow this path of owning a house – then considered the ultimate middle
class asset – then you will receive a nice exclusion
o Difference in incentives comparing old rule to new:
 Old rule encouraged people to move into bigger homes whether they needed it or not. Got built into
the psychology that when you move you move bigger
 Difficult for people moving from high income areas to low income areas
 Also made people all sell their houses the year they turned 55
NEW RULE:
121: exclusion from a gain from sale of principal residence
 (b)(1): Singles
o Requirements for singles to get 250k exclusion:
 (1) Used home as principle residence for 2 (in the aggregate, not consecutively) of the last 5 years
o Any GAIN over 250k is taxed at 20% [capital gain tax rate]
 (b)(2): Couples filing jointly
o Requirements for couples filing jointly to get 500k exclusion:
 (1) either of them have owned the home for 2 (in the aggregate, not consecutively) of the last 5 years,
AND
 (2) both of them have used it as a principal residence for 2 (in the aggregate, not consecutively) of
the last 5 years, AND
 (3) they are not subject to any other exceptions
o Any GAIN over 500k is taxed at 20%
 Reg. 1.121-1: “principal residence”
o Totality of the evidence test
 What you need to do is look at all of the circumstances that indicate whether it is this TP’s personal
residence
 Does the TP have other residences? If no, then…
 Where are they registered to vote?
 Where is the car registered?
 Where are the kids in school?
o You can only have 1 principal residence
 (c)(2)(B): “unforeseen circumstances”
o You can get a proportional exclusion if you don’t meet the above requirements, but you moved you
changed your place of work, for health reasons, or unforeseen circumstances.
o What does “unforeseen circumstances” mean?
24

“such sale or exchange is by reason of a change in place of employment, health, or, to the extent
provided in regulations, unforeseen circumstances.”
 Congress is trying to limit people who simply want to move prior to their two years being up
 Reg. 1.121-3
 Facts and circumstances test
o Safe harbors (these instances are considered unforeseen circumstances):
 Occupants of the house have a multiple births or single births bunched
in a two year period
 This would be a situation where you would want to move out more
quickly than normally
 Divorce
 Change in economic circumstances
o However, you do not fall under “unforeseen circumstances” when you simply
want to move to another house out of preference
 Private letter rulings (PLR) (not quite a powerful of authority as Regs.)
 Not safe harbors, but things that have met “unforeseen circumstances in private letter
rulings…
o A blended family moves to some of the children’s school district
o When adult child moves back in with his parents
o If you need a bigger house because you have adopted kids
o If a disabled parent moves back into house
o Problems with airport noise
o A child was assaulted on a school bus
o Narcotics officer received death threat from someone who found out where they lived
 In short, we are trying to weed out people who are simply moving because they felt like moving
o (c)(1)(B): “unforeseen circumstances” calculation
 For a single:
 The shorter of:
o (1): the length of time you were in the house you are selling
o (2): The last time that you used the 121 exclusion
 “bears to”
o (x/250k) = (n from above/24)
o exclusion =
 20% tax on all income over exclusion granted
 **Its a proportionality test to determine how much you can exclude if its been less than 2
years since the last time you excluded the gain
 BUT STILL NEED TO HAVE JOB HEALTH OR UNFORESEEN CIRCS
o Otherwise you need to wait two years
o (f): election to not have 121 apply
 Sometimes you are better off refraining from applying 121
Policy effects
 Employs a transaction basis
 Congress recognized that an across the board exclusion would inappropriately, from a policy standpoint, give houseflippers an inappropriate tax break
o Congress still wants to reward middle-class homeownership, albeit not to the degree promoted by the old rule
 Congress is limiting the benefit to deserving people… “less than 250k for a single and 500k for married”
Incentive effects
 Problem stemming from universal application of numbers no matter where the house
o People were engaging in tax motivated sales as their houses would hit the 250k or 500k marks
 This occurred in the more expensive, hot markets
o 121 was never amended for regional variation because there is no longer really big gains, let alone big
regional disparities in gains due to the decline of any hot markets.
Hypo 1(a)
 NB lives in Newark; wants to move after 19 months
o Can’t get tax break.
25
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

Can he get a proportional break due to unforeseen circumstances?
o Instead of getting a 250k exclusion, he is trying to get a proportional exclusion based on 121((c)(1)(B):
 The shorter of…
 (1)
o NB moved out of his house in Newark after 19 months.
o 19 months
 (2)
o When was the last time NB used 121? How long has it been since you used the 121
exclusion?
 He used 121 to exclude a gain on sale while in law school when he sold his
house there. This also was 19 months prior.
 You might own a house when you move into your new house, then
you might sell the old house after you moved into your new house.
o 19 months
 “bears to”
 (x/250k) = (19/24)
o 250k because NB is a single
 exclusion = 180k
o 20% tax on all income over 180k
But does unforeseen circumstances apply?
o Employment? No, he didn’t change schools.
o Health? No.
o “Unforeseen circumstances” in Regs? No.
He moved because he was bored, so he does not even get the 180k
Hypo 1(b)
 NB keeps his Ann Arbor house for 12 months while he’s living in Newark
o Only 3k gain on this
 NB still sells his Newark house still after 19 months
o Gain will be greater on Newark
 “Shorter of” is now 7 months
o However, if you refrain from applying the 121 exclusion to the sale of the Ann Arbor home, you still get the
19 months to apply in formulating your exclusion from selling the Newark house
Hypo 2 (re: 121(b)(2)(B))
 Wilma (W) -- wife
o Lived in and owned A in 2008-2009
 Harry (H) -- husband
o Lived in and owned B in 2008-2011
 W lived in B in 2010 and 2011
 W sells A on 1/1/11
o Gain = 350k
o W excludes 250k
 Pays 20% taxes on 100k remaining
 H sells B on 1/1/12 due to change in health
o Gain = 400k
 121(b)(2)(A)
o Either spouse meets the ownership requirements? Yes.
o Both spouses meet the use requirements? Yes.
o Is either spouse ineligible due to the recent use of the 121 exclusion? No.
 If no 121(b)(2)(A), then 121(b)(2)(B) applies:
o Her use of 121 a year ago means they don’t get the whole 500k, so you run H through the three prong mill
(right above) as a single.
 H meets all three, so you get the full 250k
26
o
o
W will only get the proportionality rule (the change in H’s health still applies because it his change in health
that prompts them to sell the house)
 Shorter of…
 Owned and used…24 months
 Last use of 121…12 months
 …calculation
o (x/250k) = (12/24)
 exclusion = 125k
together, H and W can exclude 250k +125k = 375k
 400k (gain) – 375k (exclusion) = 25k taxable income
 20% tax on 25k
Hypo 3 (re: 121(b)(2)(B)):







W lived in (principal residence) and owned her house A in 2009 and 2010
H lived in and owned B from 2009-2012
WH get married January 1 2011, W moves in with H
W lived in B in 2011 and 2012
So they have an extra house, A, and they put it up for sale
W sells A on July 1, 2011 for $450,000 gain
o Excludes $250k using 121 from 2011 income
o Pays 20% of 200k =40k in taxes
End of 2012, H gets very sick and they need to move into another house without stairs
o Need to sell B
o H sells B on 1/1/2013 due to health for a 500k gain
o How much does he get to exclude?
 121 b 2 A
 i yes-he owned it
 ii yes-they've both lived there for at least 2 years
 iii-NO, W a year and a half ago used an exclusion
 SO go to OTHER JOINT RETURNS
 121 b 2 B
 Not going to get the full 500k
 Treat them separately: H fulfills all recs so he gets 250k; W more complicated
 W meets i, she meets ii because she is deemed to own it because her husband used it
 SO now onto proportionality test 121 C 2 applies
 W=x/250k=18/24 (18 months since she sold her home)==>x=187,500
 187,500+250,000=437, 500 so taxable gain is 62,500 on which they'd pay 20%
DEPRECIATION
 Basic idea that property loses value over time through use AKA wear and tear
 Definitely a deduction – you want to correctly measure income
 Rationale:
 This is an income tax, measure income correctly please
 Correct to undertax
 This is a way to reduce tax on businesses...let’s make sure we measure income incorrectly in favor of the
business
 Overcorrect to undertax even more
 Building blocks of depreciation rules
 Any depreciation system revolved around the spreading, or allocation, of cost over time and has three
elements:
 The determination of useful life
 Taking account of salvage value
27
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


The application of a method of allocating the cost, in excess of salvage value, over the useful
life
Useful lives
 Basic idea is simple, but it is very difficult in practice
 Section 168
 Gives you applicable recovery periods that have nothing to do with reality
o Personal Property: basic recovery period
 For personal property there are now recovery periods for six different
classes of property: 3 year, 5 year, 7 year, 10 year, 15 year, and 20 year
o Real property: basic recovery periods
 The recovery periods for real property are 27.5 years for residential
rental property and 39 years for other real property
o Intangible assets
 Intangible assets such as patents and copyrights are subject to section
167 and are not eligible for the accelerated statutory methods of
depreciation described above
 168 is not correct depreciation-its meant to be a tax break to shovel funds back into
businesses
o Policy: Congress subsidizes business because they think itll make the economy
stronger
Salvage values
 Under the MACRS that now applies to all tangible assets, salvage value is disregarded; that is
salvage value is assumed to be zero
 Favors TP, sacrifices accuracy for simplicity
Depreciation Method
 Straight-line
 Initial cost -salvage value= x/ divide by useful life in years=annual depreciation amount
 Not very realistic, most things depreciate quickly at first and then tail off after that
 Accelerated
 Double Declining Balance Depreciation (DDB)
o Determine each years depreciation on a SL method and doubl eit, but then use
the remaining value and number of years the follow year
o So when 35000-0/5000=7000 so you double it the first year and get 14k
o Then you act like you only paid 21000 (35-14)-0/4=5,000...etc
o At some point you realize its better to default back to straightline
 Personal property: basic method
 The method prescribed for personal property is 200 percent declining balance for 3 5 7
and 10 year property and 150 percent for 15 and 20 property, shifting to straightline when
that produces larger deductions
 Real property: basic method
 The method for real property is straightline
 First year applicable convention is that the full year deduction is prorated according to the
number of months during which the property is in service during the year
 Deduction is prorated by month in the year of disposition
 Component depreciation is not permitted
 Intangible assets
 In general such assets must be depreciated on a straightline basis
Year
Straight Line Depreciation
Double-Declining Balance
Adjusted Basis
1
20% * $100,000 = $20,000.00
40% * $100,000 = $40,000.00
$100,000 - $40,000 = $60,000.00
2
25% * $60,000 = $15,000.00
40% * $60,000 = $24,000.00
$60,000 - $24,000 = $36,000.00
3
33.33% * $36,000 = $11,998.8
40% * $36,000 = $14,400.00
$36,000 - $14,400 = $21,600.00
28
4
50% * $21,600 = $10,800.00
5
100% * $10,800 = $10,800.00
40% * $21,600 = $8,640.00
$21,600 - $10,800 = $10,800.00
$10,800 - $10,800 = ($0.00)
HYPO: How to do double declining depreciation
 The straight-line method in year 1 determines the percentage of depreciation to be 20% (100% spread over 5
years), which can be doubled for the DDB method, or 40%.
o That means that the taxpayer can use 40% for DDB every year for five years.
 The "trick" is that, per section 168(b)(1)(B), at the end of each year, you recompute the possible straight-line
depreciation amount based on the number of years remaining (changing the denominator, and thus the straightline percentage), even though you do NOT change the depreciation percentage for DDB purposes.
 For example, after deducting $40,000 in year 1, the remaining adjusted basis is $60,000. If you switched to
straight-line after that year, you'd spread $60,000 over 4 years, or 25% of the remaining basis each year. This
$15,000/year is still less than the $24,000 that is possible using DDB in year 2, so you wouldn't switch yet. In
year 4, however, you'd switch, because the DDB method only allows $8,640, whereas straight-line allows you to
deduct $10,800 each year in years 4 and 5, and then you're done.
WHEN IS INCOME TAXED?
ANNUAL ACCOUNTING AND ITS CONSEQUENCES

Rules created by Congress over the years to get you out of arbitrary situations
Sanford and NOLs
Sanford (US SC 1931)
 Dredging case
 Income tax system uses annual accounting rather than transactional accounting
o Court gets the law right even though the result is unfair; Congress always adopts laws with annual accounting
so they knew what they were doing, both before and after the 16th Amendment
 The reason annual accounting produced such harsh results in this case is that losses do not result in
negative taxes
 Congress says no we're not going to give you money for maxing out the generous
depreciation rules we already gave you!
o Transactional accounting would require distribution of overhead, etc—too difficult
 Big policy argument
o Any government is going to have to collect income on a regular basis in order to meet revenue requirements
Net Operating Loss (NOL) carryovers
 Cured Sanford problem stemming from the unduly drastic consequences of taxing income strictly on an annual basis
o The harshness of annual accounting is mitigated by the provision in 172 for new operating loss carryovers
o The losses that may be carried over are primarily losses incurred in a trade or business (1212 is for capital
losses)
 Operating losses are different than capital losses, where you have an asset that loses money over time
o Operating losses=Expenses>Revenues
 Essentially a business provision
 Allows you to use extra losses to offset income in other years
o NOL can be carried 2 years back, 20 years forward
 If you calculate a loss, your tax goes to 0 but we’ll let you hold on to that loss to offset gains in later
years
 You continue to offset your gains until you offset all of your losses
o ***If you don't use it in 20 years it goes away
 §172: net operating loss deduction
29
o
(b)


o
(2): the loss must be carried back to the earliest year possible… start as far back as possible and
work your way forward
(3): allows choice to only go forward and not carryback (but then you can’t carryback for any
year)
(d)


(3): when computing NOL deduction you cannot include deductions from personal exemptions
(4): non-corporation…when computing NOL deduction, then you cannot include non-business
deductions
 “trade or business” never defined by the Code

Hypo 1:
o 2009: 40k taxable income [YEAR 0=2010]
o 2010: -41k TI
 60k salary
 -80k business loss
 -6k personal exemptions
o (d)(3) knocks out the 6k
 -15k nonbusiness itemized deductions
o (d)(4) knocks out the 15k
 No tax liability
 The business loss takes him into the negative (and thus the zero bracket) for taxable income
 He would like to carryback or carryover
 He can only carry the 20k of the 41k because 172 disallows carrying the 6k or 15k
o However, he can use the 6k and 15k in 2010
 However, they do him no good cause he is already in the negative (way in
the zero bracket)
 The 21k in deductions is essentially gone
 So, only 20k is his NOL for 2010
o What is his strategy?
 Allowed strategy
 (1) You can go back to year -2 then follow suit, OR
o -2…-1…+1…+2…+20
 special circumstances allow for a three year carryback
 (2) You can opt not to carryback to year -1 or -2, and start at year +1
o +1…+2…+20
 Cannot just carry to year -1, unless you have nothing to offset in year -2
 Here,
 Assume in 2008, he had nothing to offset
o He can go to 2009 and subtract 20k from the 40k and create only 20k in TI for 2009,
OR
o He can apply it to 2011, etc.

Hypo 2: (see page 132)
o 2009 Company has net loss of 30 k
o 2010 30k net taxable income
 Does Co. pay tax on 30k income in 2010?
 NO See 172 b 1 A ii, c
o No earlier year to carry back to because Corp didnt exist until 2009
o Does this change if 2010 30k net income were attributable to sales of other companies, rather than to profits
on the govt k?
 NO its NOT transactional accounting...its ALL revenues and ALL expenses
Hypo 3:
o Bob had 2012 salary of 60k

30
o

Deduction for personal exemptions for 4 k, and itemized nonbusiness deductions of 16k so his taxable income
in 2012 was 40k
o In 2013 Bob again earned 60k but suffered an 80k loss from his wholly owned business
 Personal deduction 6k
 Itemized 15k
 SO loss of 41k
o How much income can Bob carry back against his 2012 income
 Bob had no income in 2010 or 2011 to carry back to
 He can carry back 40k? NO he can't use all of it
 WHY
 172 c d 3 and 4: Can't carry back personal exemptions, can't use those across years-Congress
OR your itemized non business deductions
 SO no 6k OR 15k, can only use the 80k (ACTUAL NOL), offset by income, to carry back
 So he can carry back 20k, and reduces 2010 taxable income to 20k
o **IRC never defines trade or business, uses common law definition instead
Hypo 4:
o 2008 2009 2010 2011 2012 2013
o 400
700 -3k
700 700 600
o
0
0
0
0
0
100
o (2600) (1900) (1900) (1200) (500) ----o How is the 3k NOL allocated to the other year
 Disregarding any special elections...see 172 b 3
Claim of right
North American Oil (US SC 1932)


Facts: There's a lease between NAO and the feds and the feds oust them because NAO did something to upset them
 They dont have them stop operations they say until we sort this all out we will have a receiver run the
company instead of NAO and they get the oil, sell it, and hold on to the money depending on the
results of the ousting case
o Court holds for NAO and they get 172k, which was earned in 1916
 Lawsuit not resolved until 1917, then NAO gets paid
 Gov't doesn't give up though and they appeal, finally give up in 1918
o NAO files an amended tax return to have money count as income in 1916, oh and by the way it happens to
have the lowest tax rate
SC holds that it’s def income, just a matter of what year its attributable to so they create the claim of right doctrine:
 You must include funds as income when you have:
o (1) legal right to the funds
o (2) received the funds without restriction
Illinois Power (7th Cir. 1986)
 The TP, an electric company, was ordered by the IL Commerce Commission to raise its rates
 Commission made it clear that its purpose was to discourage the consumption of electricity and that the TP would not
be allowed to keep the extra revenue resulting from the increase or any interest on it
 IRS argued the money was taxable under North American Oil, but the court rejected this and likened the TP to a
custodian with not greater beneficial interest in the revenues collected than a bank has in the money deposited in it
 Custodian has no COR and thus does not have to pay taxes on the money they are holding
o However, what about the interest earned on that money?
Lewis (US SC 1951)
 In 1944, TP gets a 22k bonus (high tax rates)
 In 1946, TP has to send 11k back to the employer (low tax rates)
31
o


No exception to the claim of right doctrine just because the taxpayer is mistaken about the validity of
his claim to the money (taxes paid on mistakenly large bonus which he gave back but which he
had used completely as his own)
o Income in earlier years, loss in later years, court says tough luck, gotta deduct from later year,
when your claim over the money evaporated (DD wanted to deduct from earlier yr, bc higher taxes,
and more income then)
Amended returns  used to claim a refund of overpayments but only about facts that were or should have been
known before end of earlier year AND amendment is within 3 year SOL period
But outcome of this case really is truly unjust, just like S and B
 When you have arbitrary lines that’s what happens
 So the Court says let Congress fix it
o Which they do with section 1341
 Congress is overcorrecting the Lewis case
 Let's people like Lewis game play based on what's best for them
1341: computation of tax where TP restores substantial amount held under claim of right
 income in previous years that is later lost
 Congressional overgenerous response to inequity in Lewis…situations involving people who find themselves
in different marginal rate tax brackets in different table years
 Start with a deduction in the year of repayment (rather than reopening the earlier year)
o Two prong rule:
o But, if deduction exceeds 3K, then the tax is the lesser of
 The amount determined by claiming a deduction in the ordinary manner, OR
 By forgoing the deduction and claiming a credit in the year of repayment for the tax that
would have been saved by excluding the item in the earlier year
 Essentially allows the taxpayer to reopen the earlier year except for the interest on the
overpayment
o In essence, the TP may strategically decide what outcome is better for him, rather than forcing
amendment in the year where funds were included in the income
 Depends on what year’s rates are higher…that’s when you want it
 §1341 applies ONLY to those items to which it appeared that the taxpayer had an unrestricted right in one
year and to which a repayment is made in a later year because it was established after the close of the earlier
year that the taxpayer did not have unrestricted right to the funds
 §1341 does NOT apply to restorations based on mere errors or on subsequent events (refunds pursuant to K
rights), or to repayment by an embezzler of stolen funds
Tax benefit rule
 Situation: wrongly taken deduction that you may have to later include (opposite of Lewis—deduction in earlier
year and income in later year)
o Took a deduction for a perfectly legitimate reason under your understanding of the facts at the time
o Later, you discovered the facts were not as you thought and you were not eligible for the deduction
§111: recovery of tax benefit items
 If (or to the extent that) a deduction did not reduce the TP’s tax liability for any year AND any loss carryovers
resulting from it have expired without being used, the recovery of the amount deducted need not be included in
income. (i.e., if you are already in the zero bracket, the deduction you wrongly took did you no good…really if it
didn’t shift your brackets in any way it did you no good)
o But, if you got any benefit, then you have to include it as income
 If valuation is difficult you can include it to the extent you deducted it, even though this ignores
inflation
 Safe harbor: the exact dollar amount you wrongly deducted in the first place is what you
later include
 Plain English: Deduction did me no good in earlier year, let’s say because you were in 0 bracket, but then I have to
include it in later year, then you don't have to include it
32



BUT it’s all or nothing...even if you only had a tax benefit of $1 then you have to report it all in the
later year
Exclusionary Aspect Example:
o Earlier deduction 10k
o TP was 6k away from ZB so TI=0
o If 10k is restored to you later, you only have to include the 6k because it’s the only amount that helped you in
the earlier year
Inclusionary Aspect of the Tax Benefit Rule :
o Arises when the TP has indeed received a tax benefit from a deduction and the includability or amount of the
subsequent offsetting gain is not otherwise clear cut
o The rule requires that income in the amount of the prior deduction be included, thus moving toward
transactional rather than strict annual accounting
o Most difficult cases are where the event that matches the earlier deduction is not a recovery of property in the
most direct and literal sense
 Alice case: The valuation problem
 Lots of years have passed so we don't really know how much this unique land is worth any
more, then just used the amount you used for your deduction in earlier year
 Basically a safe harbor---unless you have evidence its worth a lot less you'd use this
Summary of rules created by Congress over the years to get you out of arbitrary situations
Claim of right
 The way you choose the year in which you have to include income is on the basis of the two prong test
NOLs: Loss in earlier year, income in later year
 You have losses in one year that aren’t helpful in one year and you want to carry them over to other years
o Fixing Sanford problem, 2 years back, 20 years forward
 Even with NOLs under 172, there is no transactional accounting
Tax benefit rule
 How to deal with a situation in which you had deduction first and income later
o Tax Benefit Rule: treating NOL's as tax benefits
 TP includes restore amounts to the extent that the deduction reduced taxes
o Inclusionary Aspect: safe-harbor valuation, simple offset (use earlier number)
1341
 How to deal with a situation in which you had income first and lost it later
 1341 is an overgenerous response to Lewis
REALIZATION AND RECOGNITION



Timing issue
o A taxpayer has income, can they delay paying taxes on that income?
 Even if you lost on the merits, you may be able to argue it’s not taxable yet.
Why do people care so much about timing?
There are several reasons for wanting to defer payment of your taxes
o (1) Taxpayer is hoping for a change in rate
 In this way, it is a gamble that Congress will lower the tax rates
 So this is a good reason to use doctrines like realization and non-recognition
o (2) Procrastination
 a real, albeit not highly defensible, reason
o (3) They do not have the money right now
 They are either illiquid or waiting on the cash to come in
o (4) As a financial matter, it is valuable to put off paying taxes as long as possible
33


Even if you don’t think rates will change, you’re not a procrastinator, or you’re liquid…
Time value of money
 If you owe a certain amount in the future, planning to pay that debt through the application of
interest rates from putting it in a CD, etc., will allow you
 Example
o Tax bill = $105
 How valuable is it for me to pay that tax bill a year from now rather than
right now?
o Interest rate = 5%
o $100 today (present value) in a bank at a 5%  $105 (future value)
 by not waiting the year, you are costing yourself $5
 You can generalize this concept to any number of rates and any number of interest rates
 Rule of 72
o Present value doubles in 72/r years
 r = 4%, then 72/4 = 18 years
 Your present value will double with the interest rate at 4% in 18
years
 Because the federal government does not charge interest on legal deferrals
o So, every year you defer could earn some money
o However, interest is charged on illegal deferrals
 So, how and why do we allow deferral? Because if it’s beneficial to the taxpayer, it is
harmful to the government…
Realization doctrine
 You do not have to pay taxes on HS income until you have realized the gain
o Realization usually means the sale or disposition of an asset, roughly speaking
 With a ton of exceptions
 Why do we have a realization doctrine a part of our tax Code? (p.225, n.9)
o Only when you sell property is the increased value realized!!
o (1) Valuation issues
 A lot of property that would be subject to taxation under HS income would be very hard to value
o (2) Liquidity problems
 You might have the money, but it is not in a form that you can easily cash out
o (3) Divisibility of assets
 You can’t just sell the fraction of a house to foot your tax bill
o (4) Variability
 If we had a really rigid HS system, then every year you would have people doing this valuation, and
frankly we have better things to do with our lives
 Unrealized gains in one year may turn into unrealized losses in another year
Recognition doctrine
 Some situations in which you have income, and have even realized income, Congress gives you the opportunity
to opt not to recognize income and not pay taxes [AKA defer even longer]
 Why do we have a recognition doctrine a part of our tax Code? (p.247)
o (1) Liquidity problems
o (2) Valuation issues
o (3) Nature of the investment has not changed
 gain may be realized but you took the gain and plowed it right back into something that looks
identical
o (4) This is a way for Congress to give people money aka CAPITAL MOBILITY
 Congress can pass recognition rules that amount to tax breaks, but which don’t look enough like tax
breaks to get on the news
REALIZATION
34
Legal origins of the realization doctrine
Macomber (US SC 1920)
 Facts: Macomber is wealthy and owns a whole lot of shares in Standard Oil CA
 2,200 shares of So Cal, par value 100/share, FMV=800k
 1916: SOCAL issues stock dividend for internal accounting reasons, essentially a 3:2 "split"
 Now 3300 share of SoCal, par value 100/share, FMV=800k
1. IRS says income=3300*100-2200*100=$110k
 US SC held that stock dividends are not to be treated as realization events
o Gov’t: Stock dividend is income
 Court: par value is not how to measure income, not H-S income
 For Court to reject Congress' def of income (see below) they have to say that the law is
unconstitutional
o Gov’t: Stock dividend is a realization event (equivalent to a sale)
 Clear that her stocks have gone up in value in her hands and she has never paid tax on the this
increase of net worth
 So there is untaxed income there, gov't says this is realized when the dividend is issued
 Court blows past this argument
 Brandeis, dissent: Stock dividend is essentially selling and repurchase SO IT IS A
REALIZATION
 The law at the time of this case would have allowed this argument even though it’s stupid
o Gov’t: increases in wealth can be taxed at any time
 No legal realization theory at this time!! So under current law again, they could have taxed
 Constitutional argument from majority
o 16th amendment allows taxes on income but we don't know what income is-good
o Need to regard substance over form-good
o Then they go south...
 Court says because it’s in stock form and not in cash that proves it’s not income WHICH IS NOT
TRUE...income includes more than cash
o **Immediate holding correct under current law but constitutionality argument no longer good law
 Brandeis’ dissent points out loophole where form was elevated over substance and the tax outcome is based on
whether it’s called a pure dividend (not taxed) or if SH is given option to buy (dividend is taxed)
o Would have been realization if corporation paid M to extinguish shares on the condition that she used the
money to buy new shares
305: modern rules on taxing stock dividends
 (a): except as otherwise provided, gross income does not include the amount of any distribution of the stock of a
corporation made by such corporation to its shareholders with respect to its stock
 (b)(1): stock dividend is taxable IF the shareholder has the option to take cash or other property in lieu of that
dividend
 1.307-1(a): taxpayer’s total basis of the old shares is allocated between old and new shares based on FMV after
distribution of stock dividend
The decline of realization as a constitutional requirement
Bruun (US SC 1940)
 narrowed Macomber to its facts without overruling
 Facts:
o 1915 lease starts
o 1929 new building errected
o building had FMV $64k, which replaced another building worth about $12k, so net FMV +50k
o bad timing, right before depression
o 1933 lease cancelled
o 1979 building useful life supposed to end
35


o 2014 lease supposed to end
o Bruun ends up paying taxes in 1933
SC held that there is indeed a realization requirement
o SC held that the cancellation of a lease because of the default of the renter is one of those non-sale
realization events
 Realization does NOT = liquidation (non-sales can be realization events)
 Realization is not limited to cash exchanges
Bruun had to pay taxes on the increase in value of the property from the new building that the leaseholder built on his
land before he defaulted on the lease
o Is Bruun a better case for realization doctrine than Macomber? Yes he doesn't have any cash freed up by this
to pay tax bill
o But let's say he has to sell his property to get cash to pay tax, is that so bad? He doesn't use this property; he
didn't want it again until 2014
§109/1019: Bruun statutory aftermath
 Non-recognition provisions
o You have income, but you don’t have to call it income this year
o Congress doesn't like what happened to Bruun so they pass section 109
 Basically just Bruun facts...now he wins and doesn't have to pay tax
 109: gross income does not include income (other than rent) derived by a lessor of real property on the
termination of a lease, representing the value of such property attributable to building erected or other
improvements made by the lessee
o You can temporarily exclude the value of a building at the end of a lease
o But, to prevent abuse, you can NOT exclude value of property if building is in place of rent
 1019: Neither basis nor adjusted basis will be changed based on income generated for lessor that was not taxed due to
109
 109/1019: when the lease gets cancelled, technically it’s still a realization event, but you don’t have to recognize it.
o Still income, but you just get to put it off, until you choose to sell the land, if you ever choose to sell it.
 You will pay tax on the same amount of money at some point
 But clearly you’d rather be in the tax-friendly realm of 109/1019
o While this isn’t the kind of giveaway we’ve seen before, the taxpayer can surely earn
interest by delaying paying taxes
 1.61-8(c)
o No safe harbors; no specificity
o But, makes the rule clear
 A building intended as rent has to be treated as a perfect substitute for the FMV of the annual
rent, thus the realization event cannot be delayed as in the 109/1019 situation above
 Applying this in real life situations will be really difficult
o This is the better way to handle it, but this isn’t how we handle it. We use
109/1019.
 We act as if the building is not yet in the possession of the lessor and thus he
pays no income taxes on it, but also gets no deductions
Hypo 1 (p.26 (Notes)), P. 212 BOOK
 Facts
o Building = 50k
 10 years of life
o Annual rent = 7k per year
 Bruun treatment
o 1933: 50k income
 Gives Bruun 50k in basis (important if he goes to sell it)
 If Bruun sold it a minute later for 50k, he would have no income on which to pay taxes
o 1933-1943: 7k per year in rent
 Building is losing 5k in value per year – depreciation
36
 Theoretically, a 1/10th of the building crumbles each year
 So, he has 2k per year in income that is taxable
 20k over ten years
o A total of 70k (50k + 20k) is included in his income from 1933-1943
 109/1019 treatment
o 1933: 0 income
 gives Bruun 0 in basis in the new building (important if he goes to sell it)
o 1933-1943: 7k per year in rent
 Because Bruun didn’t pay taxes on the 50k when he received it, he doesn’t get deductions on the
building’s decay
 Bruun did not buy the building up front
 So, he has 7k per year in income that is taxable
 70k over ten years
o A total of 70k is included in his income from 1933-1943
 Bruun will pay tax on $70k at some point
 But clearly you’d rather be in the tax-friendly realm of 109/1019
o While this isn’t the kind of giveaway we’ve seen before, the taxpayer can surely earn
interest by delaying paying taxes
Hypo 2 (p.63-64 (Notes))
 You are the owner of the land
 Person renting the land puts a 400k building on it
o HS income…400k increase in net worth
o Other possibilities…
 Wait until year 10
 The building is half used up and worth only 200k
 Include 200k in income and take your depreciation deductions for every year after that
o Acting as if the building is not in your possession for the first 10 years
 Here, we are pro-taxpayer a la 109/101
The limits of realization: nonrecourse borrowing in excess of basis


It is now widely understood that any sale or other deposition of an asset will be regarded as a realization event,
thus requiring the TP (in the absence of an applicable non-recognition provision) to report any gain or loss
from the sale on her fed income tax return
Recourse v. non-recourse loans
o Recourse
 Borrower is personally liable
o Non-recourse
 Lender can only get whatever is secured
 Lender has no access to borrower’s personal assets
Woodsam (2nd Cir. 1952)
 Facts: Mrs. Woodsam had bought the property in 1922 for 296k
o Basically got a bunch of mortgages and kept consolidating them until she got a 400k mortgage that was
nonrecourse (aka she was not personally liable)
 So how do you treat the 381k mortgage balance when the building get foreclosed in 1943?
o Example of a non-realization event (new kind of loan)
 Court held: Foreclosure is a disposition event and gain/loss would have to be realized then, however the change in
the type of loan (from recourse to nonrecourse) is not a disposition of the property
o Despite change in loan terms, taxpayer has control of building therefore it has not been not disposed of,
therefore not realized
o Foreclosure may result in DOI income, but 108(b) has exemption if D insolvent
 **Very narrow holding based on complicated facts
37
Contemporary understandings of the realization doctrine
SL crisis:
 The response of regulators to the SL crisis was to allow SLs to go ahead and gamble in the hopes that they would get
through the crisis until the interest rates come back down and the SLs become solvent again
o Dramatic increase in interest rates during the 1970s
o Reduced the value of existing fixed-rate mortgages held by thrift institutions
o Fair market value of mortgages by the nation's savings and loan institutions had declined by over a trillion
dollars
 Recognizing these losses for tax purposes would generate valuable loss deductions for the thrifts, but
an outright sale of the mortgages was off the table for accounting reasons
 To have their cake and eat it too, the thrifts would have to find a way to sell their mortgages for tax
purposes without selling their mortgages for accounting purposes
 Problem: maturity mismatch
o Now have to charge more on mortgages to pay more interest on deposits
o But the mortgage are all maturing can't start charging more interest yet until you get
new mortgages
 So now those are skyrocketing
 Latest recession: how was this different than S and L crisis 25 years earlier?
o Banking structure changed, no more wall between investment banks and deposit institutions
o Financial institutions investing in boring mortgages, but regulations allowed them to invest in risky
mortgages
o Mortgage-backed assets then began to fail; everyone was invested in same undiversified portfolio, system
unraveled bailout occurred
Cottage Savings ***NB thinks the majority decision is awful in every respect; the dissent gets it right
 Facts: FHLBB responded to S and L crisis by relaxing its requirements for the reporting of losses: memo R-49
determined that S and L need not report losses associates with mortgages that are exchanged for substantially identical
mortgages held by other lenders. P sold 90% participation in 252 mortgages to four S and Ls and simultaneously
purchased 90% participation interests in 205 mortgages held by these S and Ls
o On its 1990 return, P claimed a reduction for 2.4 million which represented the adjusted difference between
the FV and the FMV
o As permitted by the memo, it did not report these losses to FHLBB
 SC
o Acknowledge that there was no sale…but was there a realization
o Whether there is a realized loss depends on a two-prong analysis
 (1) There is “material difference” requirement built into the realization doctrine. 1001.
 1.1001-1: “differing materially in kind or in extent”
 (2) “Material difference”
 Distinct legal entitlements make an exchange of properties materially different
o Essentially the Court adopts the taxpayer’s argument that any difference is a material
difference
 properties may very well be substantially identical, but materially
different
 properties are different in the sense that is material to the IRC so long as their
respective possessors enjoy legal entitlements that are different in kind or
extent
 Here, because P's participation interests exchanges were made to different
obligors and secured by different homes, the exchanged interests did embody
legally distinct entitlements
 Dissent (Blackmon) (Prof: DISSENT IS RIGHT)
o Majority applied form over substance

What's the harm of CS?
38
o
o
o
Court wanted to call it a realization event so they said if theres ANY distinction between the two things
exchanged, then you get a realization
But ppl who are exchanging things that have GAINS they dont want a hair trigger requirement
IRS also wants a predictable rule and doesn't want to deal with hair trigger rule
Standard going forward:
 Establishment of a “hair-trigger” standard… any difference = realization event
o Any difference at all, under CS, is going to lead to a disposition and therefore a realization event
 Ever since CS, the regulators have been trying to establish a “materiality” requirement
 The Regs have tried to reduce the hair-trigger standard produced by CS
o Put materiality back into materially different –“significant modification”
o Any refinancing would be a realization event
Applying CS
Hypo 1:
 J and B
o Cotton dealers
o Business acquaintances
 Both have cotton in a warehouse
 Price of cotton has fallen
o So both have substantial unrealized losses on the cotton they have in storage
 Both would like to avoid selling, but both have large gains and would like to avoid losses
 2 ways of running the transaction
o Leaving your bale of cotton in a warehouse for storage and getting a bail back
 This is the non-tax, most sensible way to store cotton
o Leaving your exact bail of high-grade cotton in a warehouse for storage and getting an equally high-grade
bail, albeit not the exact same one, back
 Could report losses here under CS
 Under CS, whether there is a loss is YES but under IRS regs after CS the answer is NO
o Under CS if they got a warehouse receipt that same you could come get YOUR bails
o So you have to separate the cotton in the warehouse...wasteful
Hypo 2:
 S, in NYC, has the legal entitlement to Streaker 13 and J, in Miami, has the entitlement to Streaker 14
o Cars are sent to the wrong city; each dealer has the docs establishing ownership
 Both cars have 750k FMVs, both have a 500k basis (What they paid)
 The sensible thing to do would be to send the papers through the mail
o But, the papers are distinct legal entitlements
 And because they are distinct legal entitlements, the exchange of them is a realization event
 The trade of papers is a 250k realized gain for both S and J
o If they did the sensible thing, it would weirdly trip to CS rule and provide both taxpayers with a gain that they
don’t want
 S and J may very well go through the ridiculously wasteful process of shipping the cars rather than the paper
 We apply notions of symmetry here
o CS triggers a realization event in situations that aren’t beneficial for the taxpayers
NONRECOGNITION
Introduction to nonrecognition rules

Section 1001c: Except as otherwise provided in this subtitle, the entire amount o the gain or loss, determined under
this section, on the sale or exchange of property shall be recognized
39




In most cases, this language ensures an automatic connection between realization and recognition ; TP who realizes a
gain or loss from the disposition of property must recognize such gain or loss for tax purposes
Except as otherwise=nonrecognition
o Chief function of a non-recognition rule is to ensure that a TP disposing of property in a manner that would
otherwise be a taxable event will not recognize gain or loss on the disposition of the property
 Not a permanent exclusions but a deferral to a later time
Rationale
o Gain should not be recognized if the transaction does not generate cash with which to pay the tax (admin)
o Gain or loss should not be recognized if the transaction is one in which the gain or loss is or might be difficult
to measure (admin)
o Gain or loss should not be recognized if the nature of the TPs investment does not significantly change
(fairness)
o Gain should not be recognized in order to avoid discouraging mobility of capital (econ)
Underlying incentives stemming from the realization doctrine
o If people have lost money on assets, the realization doctrine gives people with losses the ability to realize
those losses
o On the other hand, if you have gains, you want to hold off paying gains as long as you can by avoiding
realizing them
 If you can hold off on realizing gains until you die, then you have completely avoided paying
taxes on those gains
 Congress doesn’t like some the incentives in some of the situations created by having a realization regime…
o So, they created a nonrecognition rule
Realization v. Recognition



Realization: You exchanged your property for cash or some other property...and is it materially different?
Non-regconition: Congress says some of the realization events are going to get special treatment
o Nonrecognition rules are “giveaways”
 Defers when a person has to pay taxes—valuable!…think about the time-value of money
Hypos on p 229:
o Yes, taxable (swap exception)
o No, 1031
o Yes, happens the next week, can't cash out and buy back in under 1031
o Yes, tractors (farm equipment) and farms are not like kind
Like-kind exchanges
 Most prominent non-recognition rule: 1031, applies to exchanges of certain business or investment property that are
held to be of a like kind
§1031: exchange of property held for productive use or investment
 Like kind exchanges are granted non-recognition status (even when substantially different)… it IS income, and
it IS realized, but congress exempted it from recognition
o (a): no gain or loss is recognized upon exchange of property held for productive use in trade or business or
for investment solely for property of a like kind to be held either for productive use in trade or
business.
 Excludes:
 inventory held for sale
 Financial assets easy to value and liquidate
o E.g., stock, bonds, notes, securities
 Partnership interests
 Certificates of trust/beneficial interests
 Choses in action
 Policy
o This is supposed to be a business-enhancing rule
 1.1031(a)-1
40
o


LK means two things that are darn close to the same thing
 LK is much broader than “substantially identical”
o Focus is on the nature and character of the property and not on its grade or quality
 Private Letting Ruling: Therefore, TPs exchange of a PCE in real property, for fee interest in other
real estate that is also subject to a PCE will qualify as a tax deferred exchange of like kind property,
provided that the properties are held for productive use in a trade or business or for investment
1.1031(a)-2
o Creation of classes
 If you are in a like class, means you are LK
 If you are not in a like class, you might be LK
o General Asset Classes (GAC)
 Fairly arbitrary distinctions created by Regs. Writers
 Even though arbitrary, they act to provide guidance to those seeking it
Hypos in book 232-233
o Exchanging computers for printers are OK because both in same asset class
o Buses for airplanes....not in same asset class..but are they are like kind still?
 Good business judgment about using it for same general purpose of transporting people
Boot and Basis






Boot
o
o
Basis
o
The extra money/property need to even out an exchange deal=boot
Transfer of boot will affect basis and may result in the recognition of gain
Basis is correctly keeping track of how much you paid for the asset so that you can realize the proper
gain/loss
o Section 1031 d sets forth the rule for determining the basis of property received in an exchange OF LIKE
KIND and nothing else
 Generally there will be a substituted basis, that is the basis for the property received will be the same
as the basis of the property relinquished
o Rule becomes slightly more complicated when there is boot
 If you have an exchange with boot, you only recognize the gain up to the amount of the boot
 You recognize the lesser of the gain realized or the total value of the boot
 When you have a loss you have no recognized loss
 Which makes sense because you should just sell the thing instead of exchanging it so you can
recognize the whole loss
1031(a): pure LK exchange
o You are exchanging only LK things…non-recognition rule
o Provides a safe harbor if exchanged items in same asset class (13, defined p. 630 SUPP)
1031(b): mixed LK exchange
o If you give up a piece of LK property and receive back LK property and non-LK property and that is a gain to
you, then you will have to pay tax on some of the gain, but not necessarily all of it depending on how much
you got back was boot
 Mixed LK exchange…some of the gain is recognized
o Shorthand
 You will have to recognize the lesser of the gain or boot
1031(c): mixed LK exchange
o Mixed LK exchange…none of the loss is recognized
 Asymmetry between (b) and (c)
o Shorthand
 Losses are not recognized
 But losses are easy to take advantage of because you can sell the thing rather than engaging in
a LK exchange
Mixed LK exchange summary
41
o


Recognize the lesser of the gain or boot
 However, losses are not recognized
o Formula (Calculations on p.33 (Notes))
 Proceeds of the disposition
 Proceeds – Basis you had in property disposed = gain realized
 Recognized gain
 Lesser of
o boot received in proceeds, OR
o gain realized
 If gain realized is negative, do not recognize losses
1031(d): what you do with the basis after applying (b), and (c)…mixed LK exchange
o Formula (Calculations on p.33-34)
 A (original basis) + B (gain recognized) = C (total basis) – D (FMV of the boot) = E (new basis of the
like-kind property received)…useful equation
1. First compute realized gain!!
2. A + B = C
3. C – D = E
a. A (original basis) + B (gain recognized) = C (total basis)
b. C (total basis) – D (FMV of boot received) = E (new basis of the LK property received)
 Total basis (C)
o If you’ve recognized the gain, then you paid taxes on it, and you are done paying
taxes on that income. So, we insert the gain into the basis so that you can later
deduct that amount when you sell
 You want to figure out the new basis because you won’t hold onto the new property forever and
you’re going to want to know what basis you have in that property
 How the equation comes out depends upon whether you are the payor or the payee of the boot
Whether an exchange is pure or mixed depends on whether you are the payor or the payee of the boot
Sample complete calculations: mixed LK exchange problems
 (1) S owns Farm X and has a 10k basis in it; T owns Farm Y
o Exchange: T owns Farm X; S owns Farm Y
 S also gets 15k in cash and an 8k tractor
 So, there is a 23k boot
o FMVs
 Farm Y FMV = 100k, so
 Farm X FMV = 123k
 This is deciphered from the 23k boot (and also assuming that this is an arm’s length
transaction
o Boot/Basis
 Proceeds from the disposition of X
 100k + 15K +8k = 123k
 Amount realized = Proceeds – Basis
 123k – 10k = 113k
 S has a 113k realized gain
 Recognized gain is the lesser of the realized gain or boot = 23k boot (rather than 113k realized gain)
o New Basis
 10k (original basis) + 23 (gain recognized) = 33k (total basis)
 33k (total basis) – 23k (FMV of boot) = 10k (new basis of the LK property received)
 B = D…E remains the same (substituted basis)
 Basis when you sell property = 10k
 (2) S owns Farm X and has a 110k basis in it; T owns Farm Y
o Exchange: T owns Farm X; S owns Farm Y
 S also gets 15k in cash and an 8k tractor
 So, there is a 23k boot
o FMVs
42




Farm Y FMV = 100k, so
Farm X FMV = 123k
 This is deciphered from the 23k boot (and also assuming that this is an arm’s length
transaction
o Boot/Basis
 Proceeds from the disposition of X
 100k + 15K +8k = 123k
 Amount realized = Proceeds – Basis
 123k – 110k = 13k
 S has a 13k realized gain
 Recognized gain is the lesser of the realized gain or boot = 13k realized gain (rather than 23k boot)
o New Basis
 110k (original basis) + 13 (gain recognized) = 123k (total basis)
 123k (total basis) – 23k (FMV of boot) = 100k (new basis of the LK property received)
 Basis when you sell property = 100k
 The basis you had in the original property was 110
o The 10 in boot that you didn’t pay taxes on is made up for by knocking off 10 of
your basis
(3) S owns Farm X and has a 130k basis in it; T owns Farm Y
o Exchange: T owns Farm X; S owns Farm Y
 S also gets 15k in cash and an 8k tractor
 So, there is a 23k boot
o FMVs
 Farm Y FMV = 100k, so
 Farm X FMV = 123k
 This is deciphered from the 23k boot (and also assuming that this is an arm’s length
transaction
o Boot/Basis
 Proceeds from the disposition of X
 100k + 15K +8k = 123k
 Amount realized = Proceeds – Basis
 123k – 130k = -7k
 S has a -7k realized gain…no recognized gain because it is a loss
o New Basis
 130k (original basis) + 0 (gain recognized) = 130k (total basis)
 130k (total basis) – 23k (FMV of boot) = 107k (new basis of the LK property received)
 Basis when you sell property = 107k
 The rule says you have 7k loss that 1031 prohibits you from reaping a tax advantage
o When you sell your property later you subtract 107k instead of 100k…there is your
7k loss
(4) Example of when you are giving up boot, rather than receiving boot
o T owns Farm Y (100k FMV)
 T has 10k basis in Farm Y
o T exchanges Farm Y + 15k cash for Farm X
o Boot/Basis
 Pure LK exchange for the person giving up boot…so no recognized gain
o Basis
 10k (original basis) + 0 (gain recognized) = 10k (total basis)
 10k (total basis) – (-15k) (FMV of boot) = 25k (new basis of the LK property received)
 Basis when you sell property = 25 k
(5) Exam review hypo
 Formula
o A (original basis) + B (gain recognized) = C (total basis)
o C (total basis) – D (FMV of boot received) = E (new basis of the LK property received)
43

Facts
o Y owns Greenacre
 Basis in GA is 50k
 FMV of GA is 130k
o Z owns Redacrre
 Basis in RA is 10k
 FMV of RA is 200k
 So, Z will require boot
o Exchange
 Z gets GA + 70k in boot
 Y gets RA
o Z’s basis in GA
 200k (130k + 70k) (proceeds) – 10k (basis) = 190k
 Z has a realized gain of 190k
 Recognized gain is 70k (lesser of boot or gain)
 Thus 70k TI here, and it is paid up front
 10k + 70k = 80k – 70k = 10k
 Basis = 10k
o If she sells GA tomorrow (or in some time where FMV doesn’t change)…
 130k – 10k = 120k TI
o Y’s basis in RA
 (200k – (50k basis in GA + 70k boot)) = 80k
 Pure LK exchange for the person giving up boot…so no recognized gain
o Thus no TI here
 50k + 0 = 50k – (-70k) = 120k
 Basis = 120k
o If she sells RA tomorrow (or in some time where FMV doesn’t change)…
 200k – 120k = 80k TI
o Coming full circle
 Z is ultimately paying tax on her 190k gain
 Y is ultimately paying tax on his 80k gain
Timing Review


Realization
o Macomber
 Creates realization requirement
 Stock dividend is not only not realized, it is not even income
o Bruun
 Non-sales can be realization events
 Bruun is partially overridden by 109 and 1019 (these help fix, DO NOT overrule—limit to facts)
 Particular situation involving lease ending and property coming back to the owner
o Woodsam
 There are non-cash transactions’s that are NOT realization events, and there are non-cash
transactions’s that ARE realization events
o (Cottage Savings)
 Distinct legal entitlements,
 In brackets because it has been appropriately (very) narrowed
Nonrecognition
o Like-kind
 Non-recognized except to extent of boot
o Private Letter Rulings
 Nature or character defines what is LK
o Regs.
 Give you rules and examples to determine LK, safe harbors
44
o
Basis equation
 Tells you how to adjust basis after a LK exchange
TRANSFERS INCIDENT TO MARRIAGE AND DIVORCE
Introduction


Recognition question:
o When a spouse, pursuant to a divorce, transfers wealth to the other spouse, should the transfer be treated as a
realization event for the transferring spouse?
Current law re transfers incident to divorce
o Property v. Alimony
 Property (on-going financial obligations)
 Treated like a gift
o Property is not treated as income to the recipient and is not treated as a deduction
to the payor
o Payee takes basis of payor
 Alimony
 Not treated like a gift
o Alimony is income to the recipient and is a deduction to the payor
o Payee does not take basis of payor
 Child support
 Child support is not treated as income to the recipient and is not treated as a deduction to
the payor since money is same as would be paid as a personal expense if living with child
and not deductible
Property settlements
Transfers incident to a divorce or separation agreement
Davis (US SC 1952)
 Facts: As a division in settlement of their property, the TP agreed to transfer to his wife 1,000 shares of stick in the
DuPont company
o Mrs. Davis agreed to accept this division in full settlement and satisfaction of any and all claims and rights
against the husband whatsoever
 SC’s analysis
o This was a taxable event
 Mr. Davis’s Gain
 Taxable gain = Proceeds (Inchoate marital rights = FMV of shares) – Basis in shares
held by Mr. Davis
o Inchoate marital rights are equal in value FMV of the shares (re: Proceeds)
o We assume that the parties acted at arm’s length and that they judged the marital
rights to be equal in value to the property for which they were exchanged
 You have to treat it as if she bought the shares with something of equal value
o Otherwise, it becomes problematic
 Mrs. Davis’s basis in the shares bargained for:
 Her basis is the FMV of the shares on the day of divorce
o Exchange was not a gift, so basis does not transfer…1041 cures this…
§1041: transfer of property between spouses or incident to divorce
 Congress’s response to Davis
o It is not a gift, but by legislative fiat, it is given gift treatment
 Basis is transferred to recipient of property (it is no longer the FMV of the shares on the day of
divorce/transfer)
45





(a) No gain/loss shall be recognized on a transfer of property from an individual to a spouse or former spouse (if the
transfer is incident to the divorce [defined in 1041(c) to mean occurring within 1 year after marriage ceases OR
related to the cessation of the marriage]
o 1.1041-1T, A-7: a transfer of property is treated as related to the cessation of the marriage IF the transfer is
pursuant to a divorce or separate instrument AND the transfer occurs not more than 6 years after the fate
on which such marriage ceases
(b) In this case the transfer is treated as acquired by gift and the basis of the transferee will be the adjusted basis of
the transferor
Statute makes the difference between community and separate property irrelevant
Recipient of property will have to pay tax on original basis
***ONLY APPLIES TO MARRIED COUPLES (not i.e. same sex couples who separate)
H and W married then get divorced (p 296 notes)
1. Had a house for 400k with basis of 100k
2. Pursuant to the divorce, H took the title of the house and executed a promissory note for 200k payable to Wilma
and secured by the house
1. What amount of gain, if any, is recognized by Wilma? What's W's basis for the note?
1. First, how much was realized
1. They jointly owned the house
2. W had half the basis and she sold her half to him
3. W's realized gain=200-50k=150k
2. Recognized gain=0 under 1041 a 2
3. Basis for the note=$200k....she's selling him the note for 200k
2. H's basis for house=100k=50k (his basis) + 50k (her basis) under 1041 b 2
1. Skews the logic
2. Under 1041 if the husband then sells the property for 400k, his gain is 300k (instead of 150k like
below)
3. From H's perspective this isn't really a 50 50 split
4. You need a lawyer to tell you that 1041 will apply
3. If both H and W have a tax rate of .2
1. 1041: W pays 0
2. 1041: H pays .2*(400k-100k=300k)=60k
3. If you want to advice him well, you need to tell him he's going to pay her tax bill essentially
4. Now apply 121
1. No longer married so not filing jointly, he only gets up to 250k exclusion of the gain
2. 300-250k=50k*.2=10k
4. Davis: What would be your answer to A and B in the absence of 1041
1. Realized gain would be 150k, so recognized gain would be 150k
2. His basis without 1041=50k (his basis)+200k (her basis)=250k
3. NO 1041, tax rate=.2
1. W will pay=.2*(200-50k)=30k
2. H will pay=.2*(200-50k)=30k
4. Now apply 121
1. Still only gets 250k but gain is 150k so no tax
2. And she would get the same all excluded
5. They could plan around this if they are amicable
3. Question 2
1. 121 d 3 B
1. Divorced six years ago
2. 121 says ownership or use within last 5 years
3. Continued to each own half of the house until the kids grow up and then they are ready to sell the
house
4. 121 only available as non-joint buyers because they are divorced
1. For H its easy he's lived there and hes owned it
46
2. For W shes owned it but in the last 6 years she hasn't lived there...so she can't exclude her
half of the gain IF it weren't for 121 d 3 B:
1. Individual should be treated as living in the property in this exact scenari-->other
spouse stayed in house to raise kids
Prenuptial settlements
Mercer (2nd Cir. 1947-pre-dates Davis)
 Facts: Kresge is married (very wealthy, owns K-mart), and 57 (basically dead)
o 32 year old woman is his newer model, decide to get married but sign a prenup
o As part of the prenup he gives her 800k in stock of K-mart aka 11-12 million before marriage
 His basis $.15/share, FMV at transfer $10/share, Ultimate sale price $19/share
 Prenump calls the 800k both a gift and consideration
 Mr. Mercer’s Gain
o Taxable gain = Proceeds (Inchoate marital rights = FMV of shares) – Basis in shares held by Mr.
Mercer
 Mrs. Mercer’s basis in the shares bargained for:
o Her basis is the FMV of the shares on the day of transfer
 Exchange was not a gift, so basis does not transfer
 Congress overruled Davis with 1041, but Congress did not overrule Mercer because the transaction occurred
before marriage
o However, you can elect yourself into 1041 by specifying for the transfer of property in the pre-nup to
occur after the marriage
 Remember: Davis treatment is equal tax treatment, 1041 is not equal tax treatment
Basis in Davis and Mercer
 Timeline
o 0…1…2….3
 0 – husband buys shares
 this gives husband his basis
 1 – husband marries wife
 2 – transfers shares to W; also, divorced
 3 (not necessarily one year later) – W sells shares
o Tax-relevant transactions
 (1) In Y2, H realizes gain on sale of shares
 We are looking at it as H sold the shares on the open market and W bought them back
 TI (Y2) = value of the inchoate marital rights in Y2 – basis of shares in Y0
o Value of inchoate marital rights is presumptively equal to the values of the
shares themselves
 This is less compelling in the Mercer case because divorce is more of an
adversarial situation
 Pre-nups are not as adversarial and it may very well be that this
equivalence is really off
 When do inchoate marital rights come into existence?
 Davis…year 1, when they took the vowels
 Mercer…not as clear as Davis
o Inchoate marital rights occur even before marriage
o W signed away marital rights contractually
 So, inchoate marital rights may come into existence before year
one, but when exactly?
o If we can’t point to the exact moment, should her basis in
transaction (2) be 0?
 …TI (Y2) = FMV of the shares in Y2 – basis in Y0
 (2) In Y2, W realizes income from selling her inchoate marital rights
47

o
TI (Y2) = FMV of shares in Y2 – FMV of shares in Y2
o Under 1041, H’s Y0 basis is in the shares that transfer to W
 But isn’t this problematic? Shouldn’t the basis be 0 as suggested above?
 (3) In Y3, W realizes income from stock sale
 TI (Y3) = FMV of shares in Y3 – basis in Y2
o Under 1041, W gets transferred H’s basis in the share from Y0
 (4) … Hypothetically… In Y4, H disposes of inchoate marital rights for 0
 TI (Y4) = 0 (Proceeds) – Basis (Y2)
o So is there a tax loss that H never realizes
In summation…this discussion…
 Highlights tax logic
 Congress did a smart thing by saying that inchoate marital rights should not be viewed as
property
 So, considering that they are not property, we treat inchoate martial rights as gifts
 However, you still need to be aware of Mercer
 If the nexus of the transfer is not tied so closely to marriage, you have to make sure to define
the transfer of the gift
 …Key to this discussion: as a matter of understanding divorce transactions, this is what 1041
avoids (or gift transactions if not in marriage)
Alimony and child support




Aside from transfers of property, the only other transfers incident to divorce are alimony and child support
Again, only applies to marriage, so DOMA is relevant
Basic Scheme
o Code establishes a coordinated system in which, following divorce, certain payments received by the payee
spouse are taxable to him or her under 71 a and those payments become deductible by the payor spouse under
215
 Other payments are not taxable to the payee spouse and are not deductible by the payor spouse
o Alimony is taxable to the payee and deductible to the payor, while child support and property
settlements are not taxable to the payee and not deductible by the payor
Child support v. alimony
o Which one did he pay? In full? proportional?
o Matters because alimony is deductible and child support is not
o 71 c 3 is a clumsy way of saying it’s not proportional
 You presume the payment is for child support first until the child support is paid in full and then the
rest of it goes toward alimony
Alimony
215/71/62: the recipient includes alimony in their income and the payor deducts it
 The requirements (71) to receive alimony treatment
o (1) Payment must be in cash
 In cannot be stocks, land, a car
 It can be a check
 Cash means not property
o (2) It has to be a written instrument
 If there is a written instrument of divorce, you can presumptively get 215/71 treatment
o (3) You can opt-out of 215/71 treatment
 However, you can opt out of 215/71 treatment in such an agreement
o (4) Parties cannot be living in the same household
 Anti-fraud part of the Code
o (5) Payments have to end at the death of the recipient
 If they don’t, then apparently they weren’t alimony
o (6) Cannot be payments for child support
48



Substance over form…i.e. if it terminates when a child is 18 but you call it alimony…clearly not
alimony
o (7) Must be substantially the same the first three years [see front loading below]
62: alimony is an above the line deduction
Remarriage  Generally alimony payments are deductible to payor and included as income to recipient, but if W
remarries…
o RR 82-155 – if recipient remarries and payor is no longer under a legal obligation to pay but does anyways,
recipient still has to include it in income if payor does not know that legal obligation no longer exists
o If payor does know that obligation know longer exists but pays anyways, then not included as income by
recipient
Child support
71(c): the recipient DOES NOT include alimony in their income and the payor DOES NOT deduct
 Alimony does not apply
 The custodial spouse is going to be receiving money and the divorce instrument has to say how much is for alimony
and how much is for child support
 Child support, unlike alimony, is not included in the income of the custodial spouse
o Child support payments are not taxable to the recipient because the recipient essentially has basis in
that money
 The recipient is really a pass-through that spends the money on the children
o Not taxable to the recipient because this is not a gain
 Not deductible to the payor
o The tax logic is that if they had not divorced he would be paying this money to support his children and that
would not be deductible
 These kinds of expenses are personal expenses
 71(c) maintains a structure that is consistent with the rest of the Code
 **Incentive to lie and call child support alimony
o Often push on that during divorce negotiations
Examples p 303
 Problem 1
o Answer: amount of money involved is under an oral agreement and therefore not part of a divorce decree and
therefore not treated as alimony
 not income to max, not deductible to W
 Problem 3
o Not alimony because its payable after death; and insurance policies are not deductible because they aren't
cash
 Problem 4
o child support, non deductible to M and not includable for W
 Problem 5
o Not cash, therefore not alimony so be treated as transferred basis
Excess front-loading
71(f)
 Tough tax provision
 Essentially, this is a very clumsy way for Congress to make sure that substance dominates form
o Remember:
 There is a tax advantage to be had here (p.323 (Klein))
 Most times…wealthier spouse gets the deduction and poorer spouse has to include the sum in income
 Poorer spouse is a lower bracket, if not the zero bracket…so, there is a revenue loss to the
Treasury
49
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


If there are excess alimony payments, the payor spouse shall include the amount of such excess payments in gross
income for the payor spouse's taxable year beginning in the 3d post-sep year
o Means taxable year beginning in third post sep year
 So if you get divorced in Oct 2013, first taxable year is Jan 1, 2014
 So third post sep year starts Jan 1, 2016
 Includes months more than 3 years after divorce
o But for our purposes we are going to assume that taxable year and post-sep years start the same
So what does this mean? We took payors word for it that it was alimony in first year when he paid 50k
o But two years later there hasn't been alimony payment so we say hmm well then that wasn't really alimony
was it
o And then we say okay you can only treat the first 15k as alimony and you have to include the 35k to offset the
50k deduction they got the first year
o Could still hurt payee spouse
Formula (Calculations p.90- (Notes))
o Payments (numbers in ks)
 Y1 = ?; Y2 = ?; Y3 = ?
o Analysis (71) (13 steps)
 (f)(4)(B)(i): (Y3 payment)
 (f)(4)(B)(ii): 15k
 (f)(4)(B): (Y3 payment) + 15k = (f)(4)(B)
 (f)(4)(A): (Y2 payment)
 (f)(4): (Y2 payment) – (f)(4)(B) = (excess payment for Y2)
 negative number = no excess payment for Y2
 (f)(3)(B)(i)(I): (Y2 payment) –(excess payment for Y2) = (f)(3)(B)(i)(I)
 (f)(3)(B)(i)(II): (Y3 payment)
 (f)(3)(B)(i): [(f)(3)(B)(i)(I) + (Y3 payment)]/2 = AVERAGE
 (f)(3)(B)(ii): (average from above) + 15 = (f)(3)(B)
 (f)(3)(A): (Y1 payment)
 (f)(3): (Y1 payment) – (f)(3)(B) = (excess payment for Y1)
 negative number = no excess payment for Y1
 (f)(2): (excess payment for Y1) + (excess payment for Y2) = (f)(2)
 (f)(1): In Y3, payor includes (f)(2), recipient deducts (f)(2)
The point of all of this is curing the one-time payment termed alimony, but which in effect wasn’t alimony
because alimony is to be received over time
o Recapture
Exam review hypo
 Facts
o Y1 = 75; Y2 = 35; Y3 = 10
 Analysis
o (f)(4)(B)(i): 10 (Y3 payment)
o (f)(4)(B)(ii): 15
o (f)(4)(B): 10 (Y3 payment) + 15 = 25 (f)(4)(B)
o (f)(4)(A): 35 (Y2 payment)
o (f)(4): 35 (Y2 payment) – 25 (f)(4)(B) = 10 (excess payment for Y2)
o (f)(3)(B)(i)(I): 35 (Y2 payment) –10 (excess payment for Y2) = 25 (f)(3)(B)(i)(I)
o (f)(3)(B)(i)(II): 10 (Y3 payment)
o (f)(3)(B)(i): [25 (f)(3)(B)(i)(I) + 10 (Y3 payment)]/2 = 17.5 AVERAGE
o (f)(3)(B)(ii): 17.5 (average from above) + 15 = 32.5 (f)(3)(B)
o (f)(3)(A): 75 (Y1 payment)
o (f)(3): 75 (Y1 payment) – 32.5 (f)(3)(B) = 42.5 (excess payment for Y1)
o (f)(2): 42.5 (excess payment for Y1) + 10 (excess payment for Y2) = 52.5 (f)(2)
o (f)(1): In Y3, payor includes 52.5 (f)(2), recipient deducts 52.5 (f)(2)

Hypo p 302
50
o


Alimony 50k in first year and no payments in years 2 and 3
 Why? its deductible if they call it alimony
o Does this violate the excess front loading rules?
 Clearly it does
o 71 f 4 B
 0+ 15k=15k
 4A=0
 4: 0-15k=0 (because it would be a negative number)
o 71 f 3
 3 B i I: 0-0=0
 3 B i II: 0
 Average of two numbers under i is 0
o 3B: 0+ 15k=15k
o 3A: 50k
o 3: excess if any of 50k-15k=35k
o 71 f 2: sum of excess payments of first post sep years (35k) and excess payments for 2nd post sep year
(0k)=35k
Another hypo
o 50 k, 30k, 10k
o 71 f 4 B: 10 +15=25k
o 4A: 30k
o 4: 30k-25k=5k
o 3 B i I: 30k-5k=25k
o 3 B i II: 10k
o B i: 25+10k=35k/2=17.5k
o B: 17.5k+15k=32.5k
o 4 f 3 A: 50k
o 3: 50-32.5=17.5k
o 2: 17.5 +5k=22.5k payor spouse has to add back into income in year 3 and payee can deduct it
***Not going to ask us to do ALL of the calculations, but he might say assume you know X part of the
equation...what's the next move with language from 71?
1. Alimony paid in 2nd year.............................................. . 1. ______
2. Alimony paid in 3rd year................................................. 2. ______
3. Floor............................................................................... 3. $15,000
4. Add lines 2 and 3............................................................. 4. ______
5. Subtract line 4 from line 1............................................... 5. ______ (excess pay. for 2d post-sep. year—0 if neg.)
6. Alimony paid in 1st year .................................................6. ______
7. Adjusted alimony paid in 2nd year (line 1 less line 5).....7. ______
8. Alimony paid in 3rd year ............................................... 8. ______
9. Add lines 7 and 8 ............................................................ 9. ______
10. Divide line 9 by 2 ........................................................ 10. ______
11. Floor...............................................................................11. $15,000
12. Add lines 10 and 11.......................................................12. ______
13. Subtract line 12 from line 6.......................................... 13. ______ (excess payment for 1st post-separation year)
14. Recaptured alimony. Add lines 5 and 13......................14. _______
If alimony was deducted, this amount must be reported as gross income in the third year. If alimony was received, this
amount is deducted in the third year.
Child support obligations in default
Diez-Arguelles (Tax Court 1984)
 Facts: Husband becomes dead beat and stops paying child support. Wife wants to write off the bad debt he owes
her and deduct it
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


See 166: Bad Debts
1. IRS says she can't take this as a non business bad debt
2. 166 d says that are deductible in the year that they become completely worthless
1. Even if when you reach the point that you despair that husband will be a dead beat forever, there is
no SOL on child support
2. So it will never become completely worthless because she has a legally enforceable right
3. Instead court goes to 166 b
1. She has no basis and therefore she has no deduction
 Court says she wouldn't even get her foot in the door if she hadn't supported the children
1. And then the court says she has no basis
2. Tax court has never explained why they don't have basis
1. No actual reasoning
 Doesn't make them whole even if she did get it because its only a deduction
 Has not been overturned or modified in tax court
 So if you're her lawyer how do you do this?
 Go back and challenge again...but need to make it non frivolous, i.e. with a law review article saying
why it’s dumb
166(d): non-corporate taxpayer can deduct non-business bad debts as a short-term capital loss in the year such debts
become completely worthless.
166(b): bad debts are deductible only to the extent of the tax-payer’s basis
Here, court continues to deny the deduction since there is no basis due to the fact that she had not “out of pocket”
expense
o NB thinks this is just wrong and that it has been established that she (1) has basis and (2) the debt is
hopelessly lost and unrecoverable
Perry
 Deduction for bad debt again not allowable, court tells taxpayer to go to Congress and get it fixed there
 1.166-1(c): to claim a deduction for a bad debt there has to be a valid an enforceable obligation to pay a fixed or
determinable sum of money
o But, in Diez, the debt was valid, enforceable, and clearly could not be collected
 When the law is bad like this, you should use persuasive commentary or get professors to write a note or amicus brief
on the issue [especially in tax where you can go for a split in the law between tax court, court of claims, circuits]
HOW CAN TAXABLE INCOME AND TAXES BE REDUCED?
DEDUCTIONS (Itemized), EXEMPTIONS, AND CREDITS
When considering income, after you determine how much and when, you want to see if you can whittle down your
taxes due to the lowest amount possible
 Our rules on deductions, exemptions, and credits (DEC) work in such a way that people may have very
different zero brackets even if they have the same family size
o It all depends on how they take advantage of the various DEC
 Phaseouts
o Phaseouts…Personalized exemptions and itemized deductions are reduced as adjusted gross income
rises above certain threshold amounts
 As income rises, the tax benefit of something incrementally declines
o Phase-outs amount to little more than back-door increases in the marginal tax rates.
 But, these hidden taxes are in no way large
o The Tax Code is being changed so as that phase-outs may no longer exist in the near future
 Personal deduction
o In addition to itemizing or claiming the standard deduction, all taxpayers are entitled to a personal exemption
deduction for themselves and for each of their dependants.
 Standard deduction v. itemized deduction
o You can take either the SD or the ID, but not both
o From here forward, we will be considering itemized deductions…
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

 You only standard deduction if your itemized deductions do not exceed it
Deductions operate like public subsidies
o We have to consider under what circumstances people in this country would be willing to take on a high tax
burden…KEY RATIONALE
Topsy-turvy benefit of itemized deductions
o Generally, Higher income  higher marginal rates  deduction is more valuable per $  regressive effect
 Could change this, as WI has, by making deductions into credits so that they are the same dollar
amount for everyone
Flow chart (p.333)
Gross income (§61)
 This is NOT an exhaustive list, no common theme
 Includes
 Explicit exclusions
 Implicit inclusions
Minus Above the Line Deductions (§62a)
 Above the line v. below the line
 If it is above the line, then you don’t lose it if you decide to take the standard deduction
below the line
o If you are a lobbyist and you can move a deduction from below to above, you have
made you clients a lot of money
 But the value of the deduction may depend on your marginal tax rate
 Above the line deductions work the same way as exclusions from income
 This is an exhaustive list
 These are the 20 things, that’s it…no other deduction is an above the line deduction
 Examples mentioned by NB (§62a)
 (a)(2)(D): certain expenses of elementary and secondary school teachers
 (a)(3): losses from sale or exchange of property
 (a)(7): retirement savings
 (a)(10): alimony
 (a)(15): moving expenses: 50 miles and changed employers
 (a)(17): interest on education loans
o If you make more than 50k you can’t deduct student loan interest, phase out
provision
 (a)(18): higher education expenses
o tuition and fees
 (a)(19): health savings account
Equals ---------------------------Adjusted Gross Income (§62) -------------------------------------------------------Minus Below the Line Deduction (EITHER standard ded. [§63(c)] OR itemized deductions [63(d)])
 STANDARD DEDUCTION
 SD Amounts:$6,100/per person standard deduction; 12,200/married jointly; 8,950 head of
household;
 Chose between standard deduction and itemized--whichever is bigger
 ITEMIZED DEDUCTION
 Not an exhaustive list:
o gifts to charity
o state and local taxes
o medical expenses
o interests paid on home mortgages
o casualty and theft losses
o job expenses
 ***Below the line deductions are not listed in one place
 In essence, every other deduction
 Notice that for some itemized deductions that there are thresholds
…always consider whether the SD would be greater than the total amount you could deduct for itemizing
53



And Deduction for Personal Exemptions (§151)
PE Amount = $3,900 per person in 2013
So zero bracket is at least equal to 10,000
Zero bracket can be different for every person!
 Many will have the same because they don't itemize
Equals Taxable Income (§63)

Personal Exemptions: You get 2 personal exemptions for joint returns and for married separate where the spouse has
no gross income and is not another's dependent 151 b
o 151 c provides an exemption for each dependent as qualified in 152
 Must be either a qualifying child or relative
 CHILD:
o is a child, a child's descendant, or a sibling of the TP
o is less than 19 years old, or if a student, less than 24 years old
o has not provided more than half of his or her own support; and
o has the same principal place of abode as the TP for more than one-half of the taxable
year
 RELATIVE
o Child or child's descendant, parent or parent's ancestor, sibling, aunt, uncle, cousin, or
in-law, or has the same principle place of abode as the TP and is a member of the
TP's household
o has a gross income less than the exemption amount
o received more than half his or her support from the TP and
o is not a qualifying child of the TP
 For parents not filing a joint return, the exemption for a qualifying child goes to the parent with whom
the child reside for the longest period of time, and in case of a tie, to the one with the higher AGI
 Divorced or legally separated parents are allowed to assign exemption however they agree
 SIMPLE EQUATION
o Gross income – ATL = AGI – [(greater of BTL OR standard deduction) + personal exemption] =
Taxable Income
Exam Review Hypo
Single person with 2 kids
 Personal exemption = 3,700 x 3(2012 number)
o 11,100 total
 Standard deduction
o Head of household
 So, SD = 8,500 (2012 number)
 Itemized deductions
o Charitable contributions = 2,000
 2,000 deduction
 you can take up to 50% of your adjusted GI
o Unreimbursed employee expenses = 8,000
 7,000 deduction
 2% threshold
o Mortgage interest = 1,500
 1,500 in full
o State and local taxes = 1,200
 1,200 in full
o Medical expenses = 3,000
 None
 7.5% threshold
 AGI = 50,000
54
o
o
Possibilities
 (1) AGI – SD – PE = TI
 No itemizing (SD)
o 50,000 – (11,100 + 8,500) = 30, 400 TI
 Itemize if you can do better than 30,400
 (2) AGI – ID (itemized deductions) – PE = TI
 Itemizing
o 50,000 – (11,100 + 12,000) = 26,900 TI
We go with Possibility (2)
DEDUCTIONS
 Below, we are dealing with all itemized, below-the-line deductions
o Aside from Section (1) Health Insurance, which is not even income
Health Insurance
 §162: deductible for employer
 §106: excludable from gross income for employees
 Health insurance is a completely nontaxable event
o The purest subsidy you can get through the Code
 Examples
o (1)
 E (employee) receives
 70k in salary
 5k in health insurance
 HS income: 75k
 Because of 106…
 5k is excluded and 70k is her gross income
o (2)
 S (self-employed):
 75k in receipts
 5k in health care expenses
o deductible under 162
 GI: 70k
o (3)
 N (employed, but not provided with health insurance by employer):
 75k in salary
o both E and N cost employer 75k a year
 doesn’t matter for the business tax-wise because salary and health are both
deductible for the employer
 5k in health care expenses
o This 5k is a huge assumption because if you are a non-covered employee looking
for health insurance, you will get nowhere near as close to the same deal
 GI: 75k
Medical expenses

Extraordinary Medical Expenses
o Under 213 a, medical expenses are deductible to the extent that they exceed 10% of adjusted gross income
 Threshold seems to reflect the same kind of effort to distinguish between extraordinary misfortunes
and the ordinary vicissitudes of life
 Also reduces both the number of TPs who need to figure out each year precisely how much they spent
on medical care and the resources the service and the courts must devote to the process of verifying
medical expense deductions
55

o

Reduces your expenses by your marginal tax rate...doesn't mean American public picking up your
entire bill
 No double counting, can't be covered by health insurance
Because deductibles incentivize people to be less wasteful, Congress in 2003 enacted a new tax benefit for
Health Savings Accounts
 The idea behind this program is that people with money in HSA accounts will be relatively careful in
incurring medical expenses because they will be spending their own money
 HSAs do cover all medical expenses though, usually much more broad than medical insurance-spending tax free dollars on these things
Policy:
o Amounts spent for extraordinary medical expenses do not provide consumption in the ordinary sense and
therefore are simply not part of income
o Individuals who pay their own medical costs relieve the gov't of an expense that it would otherwise be obliged
to bear
o The deduction is a proper encouragement to people to take good care of themselves, it is a useful subsidy for
medical care
o In many instances, an injury or illness stems from work or interferes with ability to work so the cost of
medical care should be regarded as cost of producing income
Introduction
 What about medical expenses that are NOT REIMBURSED BY ANY MEDICAL COVERAGE you may have?
§262
 Deductions cannot be personal, living, or family expenses except as otherwise permitted in the Code
§213
 (a) allowance of deduction
o You can deduct medical expenses, not covered by insurance or otherwise, for yourself, spouse, or
dependents to the extent that such expenses exceed 7.5 percent of adjusted gross income.
 My aside: 213 kind of works like insurance…however, the funds after the “deductible” threshold are
not covered, just merely not included in income
 213 creates a disincentive to purchase health insurance
o If your AGI is 80k, 10% is 8k
 So if you have 8.5k medical expenses beyond what health insurance covers
 BUT you can only deduct that which exceed 8k so 500!
 (b) limitation with respect to medicine and drugs
o We are talking about prescription medicine, not Advil
 (d) definitions
o (1) “medical care”
 medical care is deductible
 a bit of broad definition
 fleshed out below
 (1)(A): for the diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of
affecting any structure or function of the body
 (1)(B): for transportation primarily for and essential to medical care
 (1)(C): for qualified long-term care services, when provided by licensed health care practitioner
o (2) amounts paid for lodging
 lodging away from home, that is part of the medical care, is deductible
 you are not there for pleasure or spending money lavishly because you know it is deductible
 amount taken into account for each individual shall not exceed $50 per night
o (9) cosmetic surgery
 “medical care” does not include cosmetic surgery unless it is performed to cure a birth defect,
an injury stemming from an accident or trauma, or a disfiguring disease
o Gender reassignment surgery?
 Yes, but post re-assignment surgeries like breast implants are cosmetic and don't count
56
 9th Circuit split the difference
Service has to be provided by a license provider
 Can't be a family member taking care of you, like a woman taking care of her parents
RR 75-318 – the cost of Braille books was deductible over the cost of regular books
RR 64-173 – deduction allowed for cost of person to walk with a blind child through the halls
Regs §1.213-1(e)(1)(iii): Outlays to make a house handicap accessible, or as necessitated by illness are only
deductible to the extent they do not increase the FMV of the house
o E.g., Constructing entrance/exit ramps; Widening doorways; Modifying hallways ; Installing railing, support
bars, or other modifications to the bathroom; Lowering or making adjustments to kitchen cabinets; Installing
porch lifts or other forms of lifts; Modifying fire alarms, smoke detectors; Modifying stairs; Adding handrails
or grab bars; Modifying hardware on doors; Modifying areas in front of entrance and exit doors; AND
Grading of ground to provide access to residence.
o




The rules on what constitute “medical care” are very much socially contingent
o While falls under “cosmetic” and therefore a little too weird to constitute a deduction for “medical care” will
change over time as different procedures become more mainstream
Health Savings Accounts
 Allow you to saving money for health care
 223(c)(2) – deductible must be at least $1K and not more than $5K
 An employee that has a health care plan within this can claim tax deductible contributions to the LESSER of (1) the
amount of the deductible or (b) $2250 (self coverage)/$4500 (family coverage)
o Contribution to HSAs by employers are deductible to employers and nontaxable to employee recipients
 These contributions are considered an adjustment to gross income under §62(a)(19) and t/f can be claimed by those
who do NOT itemize
o Deduction is also not subject AMT
 §233(e) – Amount earned in the accounts are not taxable
 §223(f)(1) – Amounts paid from the account to reimburse employees for medical expenses are nontaxable to the
employee
 §223(f)(2) – Amounts paid out that are not for medical expenses are taxable as ordinary income
 In effect this serves as a retirement account as the deduction is allowed even though amounts were left over from prior
years coupled with the broad allowable use of this money (213 term is generally broader than insurance definition)
gives people an incentive to careful in incurring medical expenses because they will be spending their own money
Further defining “medical care”
 Taylor (Tax Court 1987)
o Court held that TP could not deduct lawn mowing fees as a medical expense (it was a personal expense)
 Some factors to consider
 (1) The expense is not necessarily directly tied to healthcare providers, etc.
o Someone in the family could have helped
 However, some things are medical expenses that don’t have anything to
do with healthcare providers (consider lodging provisions)
 (2) Causation
o It is not clear whether “but for” his allergy he would have otherwise mowed his own
lawn
 Important to look to the past here
 (3) Doctor recommended activities do not always constitute deductible medical expenses
o Pointed to Altman case...guy with emphysema trying to get deduction for doc-recommended golf
 Court basically says if we’re not giving emphysema guy a deduction hay fever guy isn't getting one
o Gym memberships also not going to count
o TP has the burden in these situations
 Default is 262..rebuttable presumption against deduction

Henderson I (Tax Court Memo 2000-231)
57
o
o

Ochs
o
o
o
o
Depreciation of the van used from disable kid will not be deductible as a medical expense because
deprecation does not constitute “amounts/expenses paid”
 The lift installed was deductible in itself
 “Amounts/expenses paid”
o When you pay an expense, money must change hands
 Court is saying that “amounts paid” means dollars changing hands, but this
isn’t really the case in an accounting sense (consider the change in HS
income that the parents experience here)
However, it reasonable to say that the depreciation constitutes an amount paid in that it lowers their
HS income (NB thinks this case came out wrong)
Facts: During the taxable year, P was the husband of Helen and they had 2 kids
 On Dec 10, a thyroidectomy was performed on P's wife which revealed cancer
 P sent kids to boarding school and deducted the cost of 1450 as a medical expense under 213
 Doctor told them to separate the children from the wife so her health could improve and she
would stay in remission
 Kids stayed at boarding school until mom deemed recovered from cancer
Majority dismisses this as 262 personal expenses since someone would have needed to take care of kids even
if there was no sick mother – but this ignores the fact that there IS a sick mother
 Majority is worried about permitting a deduction for what they view as a personal expense that also
happened to result in a medical benefit to the wife
 Prof: THIS IS WRONG WAY TO ANALYZE
Dissent acknowledges that the majority is worried about a slippery slope and so proposes his own test
 Would taxpayer normally spend their money in this way? No…didn’t got to private school before or
after illness
 Did the taxpayer buy such luxuries in the past? No
 Did a doctor prescribe this? Yes
 Did taxpayer act in most economically efficient way? We can assume they did, even if its deductible,
they don't have an incentive to throw away their money on something they can't afford with their
budget
 Was this over and above normal living expenses? Yes
 Was this closely geared to a particular condition rather than general health? Yes
Dissent: Allow the deduction since Ochs’s wouldn’t otherwise have sent kids to boarding school but for
mom’s cancer—deduction is for medical care, NOT for cost of hiring someone else to raise the kids/do
the laundry etc…
 PROF agrees with the dissent
Charitable Contributions
Introduction
 One of the safest bets in the world that big time tax reform efforts will never get rid of this
 Charitable contributions account for large sum of money, but it is not going anyway because it is considered
absolutely fundamental to American values
 Also, charitable contributions are highly abused
Two sides of the story for charitable contributions
 170: governs deductibility of charitable contributions
o If you make a contribution to a charity, and you are itemizing, you can take the amount you give as a
deduction
 Charitable contributions are allowed as itemized deductions…above the line
o Any given year the maximum you can take is 50% of your adjusted gross income
 But, 5 year carrover allowed
 Thus, another place, in addition to the medical expenses context (think the 7.5% threshold),
where adjusted gross income is important
o (b)(1)(B): if donation is principally for a private foundation it is limited to 30% of AGI
58
o
o




(b)(2): corporations are limited to donations of 10% of taxable income
(c): categories of charities
 (1): governments
 (2): non-governmental charities
o (e)/(f): compliance provisions
 (f)(8): TPs who claim a deduction for any form of contribution in excess of $250 must be able to
substantiate the reduction with a written acknowledge of the donation by the donee.
 (f)(8)(D): the donee organization can alternatively file information with the IRS directly
 (f)(11): for contributions which are not readily valued and for which the deduction is more than $500,
the TP must include with the return a description of the property
 (f)(12): when vehicles are donated the deduction is limited to the proceeds of the sale
 Charity has to give you a receipt that says that
 For NB’s donation had to bluebook FMV because the charity didn't turn around and sell it-it
was a HS autobody class
501: governs the recipients of charitable contributions
o (c)(3): if you organized properly as a charity, the charitable contributions that you receive are not
taxable
o Slight non-overlap -Buchanan doesn't care about this non overlap
 Just assume 501 c 3 charities can accept donations that the donor can deduct
o Can't lobby, can't contribute to political campaign, can't inure to the benefit of any private SH or individual
 Hard to enforce the last part....very difficult where there are lots of followers and power
170 charities = 501 charities
o Requirements for “charity” status
 (1) Charitable institutions cannot privately benefit individuals from the tax-exempt status.
 The private benefit is interpreted to mean “extraordinary benefit”
o There is a reasonable element to this
 (2) You cannot engage in electioneering
 You cannot engage in candidate advocacy
o But this doesn’t seem to be enforced so strictly.
Contributions of Property p 357
o The difference between long-term and short-term
 This is really important because the tax treatment on short-term is not very generous
 Short-term: If you have held the property for less than a year, the only thing you can deduct
is the basis
 Long-term: If you have held the property for more than a year, you can deduct the FMV of
the property.
 Deductions for gifts of property that would be long term capital gains are limited to 30% of AGI
(20% to a private foundation)
Policy
o Way for the government to help subsidize charities
 But, where do we draw the line when deciding what TPs are going to be subsidize?
o Is this gov'ts way of supporting charitable gifts or does it just a windfall to those who would give anyway?
o A decline in the marginal tax rates of donors reduces the value of the tax deduction
 If the tax deduction is an important factor in charitable giving, then donations should decline with
falling marginal rates
 Donations would conversely rise as marginal rates rise, as the deduction becomes more valuable
o Economists say that the dollar efficiency of the deduction is quite high
 Deductions stimulate donations and the dollar gain to the supported organizations equals or exceeds
the dollar lose to the fisc.
o Congress could establish a floor for deductions, i.e. only to the extent that they exceed 3% of TPs AGI
 Could change the charitable contribution deduction!
 Reduce value of the deduction to the TP that undoes the topsy turvy nature of this caused by
progresive tax rates
o If you give 1k to charity and youre in the 40% tax bracket, it costs you 600
o If you give 1k to charity and you're in the 10% tax bracket, it costs you 900
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Prob not going anywhere
Gifts with private objective or benefits: BUSINESSES
 Ottawa Silica (Fed. Cir. 1983)
o Facts: TP acquired a bunch of ranch properties in Oceanside
 Oceanside asked the TP if it would donate 50 acres of its land for a HS, and it was clear to TP that
they would be required to build access rods to the HS which would benefit the TP
 TP eventually decided to donate plus an extra 20 acres for right of way for two access road and
claimed a deduction of 415k for the value of the property contributed
o OS loses deduction for charitable contribution because of the roads they expected to be built in return
o Substantial benefit test
 You will NOT be allowed to deduct if you receive a substantial benefit in return for your
charitable contribution, regardless of whether the predominant purpose of the contribution was
charitable abd not business-related
 “substantial benefit”
o Something beyond what everyone else from the supposed act of charity
 It is okay for a donor to get a benefit from a nominally charitable deduction
so long as long as the benefit is not uniquely beneficial to the donor
 Contra e.g., you can get a deduction for donating to an anti-gang
organization
 When do we know its a QPQ?
 Its okay if EVERYONE benefits, including the person who makes the donation
 This is distinguished from things that substantially benefit the donor
o Substantial doesn't necessarily mean big it means of substance
 So if you get a benefit that is of substance to you and to the public at large,
then this is not a deductable donation
 So much information in the record that shows that they did this for
themselves
 How much does it matter that Ottawa planned it in advance?
 Even anticipating receiving it is enough! even if you don't ever get
the benefit
o If this is really a business transaction in disguise than a deduction is not allowed
o Very TP unfriendly
o What happens when OS loses its charitable donation?
 Although OS loses the charitable donation, they get to take advantage of the basis
 The basis in the land that they gave away can now be added to their basis.
o Had the taxpayer won, it would have recognized a current deduction equal to the
FMV of the contributed property. Instead, the TP received no current deduction and
could only add to the basis of the contributed property to its other land. The TP
would, in effect, be able to deduct that basis when and if it sold its other land.
 The effect of the government victory was twofold. First, the taxpayer was
forced to defer any tax benefit for what might turn out to be many year.
Second, the eventual tax benefit would be limited to the basis of the
contributed property, rather than the fair market value of the contributed
property
 Singer case
o Singer wants students to buy their sewing machine in the future! That's valuable to them

Duval (Tax Court)
o Tax Court went other direction from OS
o Predominant purpose test (predominant purpose of the donation must be for a public purpose)
 (1) Intent-based
 (2) More than incidental
o Very TP friendly
60
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
For the IRS to win a case under this test, they have to prove that the TP knew they were going
to get a benefit AND that’s the biggest reason why they engaged in the transaction.
 “biggest” v. “substantial”
Law from OS and Duval
o There are at least two different standards out there
 (1) substantial benefit
 (2) predominant purpose
o There is a possibility that a business may lose its charitable deduction for engaging in a quid pro quo
 The two different standards explore how much self-dealing is allowed
o Businesses who take charitable deductions need to be able to prove that they did not intend to receive a
substantial benefit in exchange
o All or nothing test
 If you fail the standard, then you lose the entire value of the charitable deduction
 All you get to do is take advantage of the basis of the property given away
 This rule seems very harsh… (next section)
o Important aside: The deduction itself cannot be the economic benefit that disallows the charitable deduction
…you need to get something beyond the tax benefit
Gifts with private objective or benefits: NON-BUSINESSES
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


The same two contrasting standard may apply:
o (1) substantial benefit
o (2) predominant purpose
Important distinction between business and non-business
o If a business makes a charitable contribution and gets too much benefit, then they lose the whole thing
o RR 67-246: For non-businesses, there can be a quid pro quo
 The existence of the quid pro quo means you lose only the value of the thing you receive as a part of
that deal
 This does not exist for businesses because, as a policy matter we strongly suspect businesses
as seeks profits…so we need a relatively severe regime
 An OS-like rule would kill much of charitable giving, so instead we have a partial reduction
rule
 It has long been the rule that the amount of any non-business deduction for a charitable contribution is
limited to the excess of the payment to the charity over the value of any benefit received by the donor
 It is the value to the donor that counts: assumed to be the FMV of whatever is received by the donor,
i.e. what it would cost donor to purchase the item or service
Non-businesses
o Charity gets full advantage
o Donor gets partial deduction
 The deduction you get comes from the amount of your donation minus the value of the goods you
received in exchange
 The deduction is offset by the substantial benefit you receive in return
o De minimis exception
 You don’t have to offset your charitable deduction when the only thing you
receive is very minimal (e.g., swag).
One of the problems is substantiating values
o 6115 polices this by requiring that for any quid pro quo contribution over $75 the charity must provide the
donor with a written statement that the entire amount is not deductible and must provide a “good faith
estimate of the value of the goods or services” received.
 Items below the $75 threshold are still not entirely deductible, there is simply no rule requiring
charities to provide documentation
o TPs who claim a deduction for any form of a contribution in excess of $250 must be able to substantiate the
deduction with a written acknowledgment of the donation by the donee organization
 Must state FMV of the goods or services 170 f 8
61
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
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 Cancelled check not sufficient
 Or donee organization can file with the IRS 170 f 8 D
o 170 f 11: For contributions of property that is not readily valued and for which the deduction is more than
500, the TP must include with the return a description of such property and such other information as the
Secretary of the Treasury may require
Although there are huge psychic benefits to charitable donations, the IRS does not offset the psychic benefit you get
from the amount of the charitable deduction
Religious Benefits and Services
o Can deduct regular contributions to the church and high holy day attendance
 But not for attending religious schools
o Hernandez case
 SC upheld the Commissioner's disallowance of a deduction for amounts paid by members of the
Church of Scientology for individual training and auditing
 IRS said that they were not contributions, they were QPQ for an identifiable benefit: auditing and
training sessions
Voluntariness
o Lombardo case
 Because of felony charges, D was required to pay 145k to the county school fund which he claimed
charitable deductions for
 Court denied deductions because he made the payments in order to avoid going to prison so clearly
not a gift
Private charitable contributions in short:
 Business…all or nothing rule
 Non-business…quid pro quo reduction rule
The special case of collegiate athletics
 170(I): allows for a deduction of 80% when contribution would be deductible but for the direct/indirect option to buy
tickets
o NB says this is an example of law taking a backseat to politics
What is charitable?
Bob Jones
 Facts: University has interracial students but they can't date each other
o IRS says because of this policy you are not a charitable organization
 Even though there’s nothing about this in the IRC, the charitable deduction is meant to embody the
common law understanding that in order to qualify for the charitable deduction the charity cannot
violate public policy
 IRS promulgates a revenue ruling that has a non discrimination requirement for university 501 c 3s:
says you can't have race based rules
o Bob Jones challenges this in court
 To qualify for tax exempt status an organization must (1) fall into one of the enumerated (8) categories AND (2)
promote a general public policy of charity
 Revocation of charity status on PUBLIC POLICY GROUNDS
o Really heavy burden
 There has to be “no doubt” that the charity violates a “fundamental public policy”
 In short, there is a public policy exception, but the reading of “public policy” is so narrow that the exception is
essentially limited to the fact of BJU (race-based discrimination).
o We have to consider what the average TP would be willing to “subsidize”


501(i): disallows charitable deductions for racially discriminatory social clubs, let alone educational institutions
o does not disallow charitable deductions for gender-biased social clubs
 fraternal organizations wouldn’t have it
TAKEAWAY:
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o
o
o
Only outright racism in education will violate public policy
 Powell concurrence, basically limits Bob Jones to its facts
Never been applied since-almost
Overly sexist doesn't violate fundamental public policy (see 501 i --sex is not in there)
TAX CREDITS
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

Deductions v. credits
o The basic difference is that the value of a deduction to a TP varies depending on what tax bracket they are in
 A deduction only reduces your tax income by your marginal tax rate
 Tax deduction is never worth more than 35 cents on the dollar
 A credit is always worth a dollar
 You get to reduce your tax owed by that amount
 Difference is further complicated by refundable and non-refundable credits
 Also, deductions are non-refundable
 Deductions are used to reduce your taxable income; however, credits are actually used to
reduce the tax itself.
o Order that you would lobby Congress:
 Refundable credit
 Most taxpayer friendly thing we have
 Non-refundable credit
 Above-the-line deduction
 Below-the-line deduction subject to no threshold
 Below-the-line deduction subject to some threshold
 Timing rule
Two types of credits
o Refundable
 You get the surplus of the credit minus the tax liability that you have if that number is positive.
o Non-refundable
 You tax liability goes down to zero, but you do not get the surplus if there is one.
Why do people have zero federal tax liability?
o You are poor
o You have attained the amount of credits that has completely offset your tax liability.
§32: Earned income tax credit (EITC)
 Refundable tax credit, does not just offset liability but also results in payments (refundable credit)
o Under 32, a TP is entitled to claim a credit equal to a specified percentage of earned income up to a certain
level
 Depends on the number of children, no children you get a small credit (max 475 in 2012) three+
children you get $5891
 (k):
o if you do anything wrong, you will lose the ability to attain future benefits
 this provision is to stop cheating---harsh penalty, these populations don’t know the law!
 The EITC is there for the working poor with kids
 Sometimes referred to as a wage subsidy or a negative income tax
 Phase-out
o At a certain threshold, you begin to lose benefits as your income increases
 You can go through an income range where you are worse off for earning more
 This creates a tax disincentive to work and earn more
 Downslope=implicit tax
o As I earn more, my income doesn't go up dollar for dollar
 I get a dollar but i lose a fraction EITC
o Can become very high-happens with a lot of entitlement programs
o "Cliff effect"
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 Disincentive for earning more
The EITC is biggest tax credit regime that we have
Tax credits, for the TP are…
o Better than a deduction
o Better when refundable
MIXED BUSINESS/PERSONAL DEDUCTIONS
Introduction
-
§162
 Allows deduction for “ordinary and necessary business expenses” paid or incurred during the taxable year in
carrying on any business or trade
o Doesn't have to be an incorporated business
 Businesses don't have above or below the line, so if you are a business use 162 to deduct all expenses
 For individuals, limited by 67
o 67: 2% of AGI threshold
 For this 2% threshold you can aggregate all of your miscellaneous “ordinary and necessary business
expenses”…..KEY: AGGREGATE 2% THRESHOLD FOR “ORGINARY AND NECESSARY
BUSINESS EXPENSES”
 Purpose of the threshold is to avoid dealing with de minimis expenses
 For businesses, there is no limiting threshold
o If self-employed, no threshold
 It’s not really “income” if paid out of pocket for production
 Below-the-line deductions
o Dealing with AGI threshold
§212
 Applies to individuals
 For “cost of producing income”
 212 was added specifically for income from sources other than a trade or business
o The expenses that go along with managing an investment portfolio
 212 is probably unnecessary
o 162 is the go to section in terms of business deductions
 Below-the-line deductions
 AMT: deduction under 212 of expenses of earning income are not allowed 56 b 1 A i
§262
 No deduction allowed for personal, living, or family expenses
o We will not subsidize people’s personal expenses
Controlling the abuse of business deductions
Hobby losses
Nickerson (7th Cir. 1983)
 Facts: TP bought a farm as a desirable means of generating income, rented it out, fixed it up but didn’t expect to
make a profit for 10 years—in the meantime he deducted his losses
 Must be sincere, though not necessarily realistic expectation of profit
o Doesn’t have to be a REASONABLE expectation
 §183: activities not engaged in for profit
o Deduction allowed only when the activity is engaged in for profit (but only to the extent that it exceeds
2% AGI threshold)
 Determined by a facts-and-circumstances test
 All-or-nothing approach…you fail 183, you get no deduction
64
o

(b)(2): expenses incurred in activities not engaged in for a profit can be deducted only to the extent that the
gross income derived from such activity exceeds otherwise allowable deductions (d): profit presumption
(rebuttable)
 If you made a profit in 3 of the last 5 taxable years, then you are presumed to have engaged in the
activity for profit
 If the TP does not meet the requirements for this rebuttable presumption, he has the
burden of proof, and must show a bona fide expectation that at some point you will be
making a profit
o 1.183-2(b): totality of the circumstances test
 Some factors considered:
 Manner in which taxpayer carries on activity
 Expertise of taxpayer or his advisors
 Time & Effort expended by taxpayer in carrying on the activity
 Expectation that assets used in activity may appreciate in value
 Success of the taxpayer in carrying on other similar or dissimilar activities
 Taxpayer’s history of income or losses with respect to the activity
 Amount of occasional profits, if any, which are earned
 Financial status of taxpayer
 Elements of personal pleasure or recreation
o Policy
 Again, we have to ask when we are willing to see the activity as business focused enough so as to
provide a “public subsidy” via a tax deduction?
Holding
o TP’s activity on the farm WAS for profit
 Court concludes that “[c]ommon sense indicates to us that rational people do not perform hard
manual labor for no reason, and if the possibility that petitioners performed these labors for
pleasure is eliminated the only remaining motivation is profit.”
 NB thinks that court comes out wrong in reversing the trial court on this rationale
Other hobby cases
 McCarthy: father was allowed to deduct managing costs of 13 year old son’s motorcross racing career even though
he had no likelihood of making a profit in any particular year
o Pre-opening expense doctrine under which expenses incurred before taxpayer begins business operations must
be capitalized [unless they are a farmer]
 Farish: Likelihood that taxpayer engaged in business to make a profit can be considered in light of geographical and
occupational factors – breeding horses was found deductible for Texans engaged in oil drilling
 Daily: Trips to Europe are not deductible as a business expense when antique dealers never advertised any items for
sale, never offered anything for sale, and never actually sold an item
Home offices
Introduction
 Where a person does in fact use part of his home exclusively, or even primarily, for business the costs of that part of
the home (including a pro rate share of utility bills and deprecation on that part) might properly be regarded as a
deductible business expense
 Congress intervened with home office fraud with 280A
o Begins with a general rule denying deductions for any use of a home for business purposes and then to list
specific concrete exceptions
Popov (9th Cir. 2001)
 Facts: Popov is a professional violinist
o Never given a place to practice from her employers
o Has a one bedroom apt, used the living room as a home office
 Only used for practice 4-5 hours a day
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Popov claimed a home office deduction for their living room and deducted 40% of their annual rent
and 20% of annual electricity bill
§280A: disallowance of certain expenses in connection with business use of home, rental of vacation homes, etc.
o (a) General rule is to deny deductions for any use of a home for business purposes
 technically unnecessary with 262 but serves as a reminder that personal expenses are non-deductible
o (c)(1): Subsection (a) shall not apply to any item to the extent such item is allocable to a portion of the
dwelling unit which is exclusively used on a regular basis
 (a) As the principle place of business for any trade or business of the taxpayer
 (b) As the place of business which is used by patients, clients, or customers in meeting or dealing
with the taxpayer in the normal course of his trade or business, OR
 (c) in the case of a separate structure which is not attached to the dwelling unit, in connection with
the taxpayer’s trade or business (if you set up a separate structure, the Code is more forgiving, and
does require that business be principle use)
 ...exceptions get gradually more lenient
***280A(c)(1) is at issue here (whether professional musician is entitled to deduct expenses for the portion of her
home used exclusively for musical practice)
o Court addresses whether this deduction is allowed on the grounds that it is a home office that is
EXCLUSIVELY used as the PRINCIPAL PLACE OF BUSISNESS for any trade or business of the TP
 Solomon test FOR DETERMINING PRINCIPLE PLACE OF BUSINESS
 (1) Relative importance of the activities performed at each business location
o Point of performance should not determine the principal place of business
o This prong is not too important to the court here
 (2) Time spent at each place
o Court knows this is the money factor
 Does the person spend significantly more time here than anywhere else
where business activities occur?
 This is where Popov wins—she spends more time here that at
recording studios
o SO FIRST, EXCLUSIVE USE? THEN APPLY SOLOMON TO DETERMINE PPOB
Take away
o Advise your client to engage in exclusive use
 There may be not that much left of (c)(1)(a) once your satisfy the exclusive use case
Office decoration
Henderson II (Tax Court)
 Facts: P was employed as an assistant attorney general by the state of SC
o Provided an office with furniture and furnishings
o Bought a framed print for $35 and a life plant for $35 to decorate her office, and a $180 parking spot for rent;
wanted to deduct them all
 Occasionally used her own vehicle for business purposes when a State auto was not available
 Where 162 and 262 may apply, 262 takes priority
o Court finds that plants and prints in Henderson’s office were not deductible
 Rule
o There essential inquiry is whether there is a “sufficient nexus” between the expense and the “carrying on” of
the individual’s trade or business to qualify the expenses for the deduction under 162(a), or whether they were
in essence personal or living expense and non-deductible by virtue of 262.
 To receive the deduction, the expense cannot be too “tangential,” “remote,” or “incidental” in
aiding in the performance of the taxpayer’s business or duties
 Her employer provided here with all the furnishings necessary to do her job

Questions after the case:
o Can’t deduct carpet while she’s there because that’s a private benefit
 It would have to be once she leaves---just doesn't want to move it and says she’s donating it
 BUT not if she wants to leave it for her replacement that she knows
66

 You’re allowed to help one person but you can't chose
Deduction=FMV on the day she leaves

Aside: commuting expenses are nondeductible (somewhat addressing the parking issue that the court seems to
ignore)
o Commuting expenses are personal

Automobiles, Computers, and other listed Property
o 280f provides special rules for listed property
 Computers
 Automobiles
 Cells
 Property generally of the type used for purposes of entertainment, recreation, or amusement
 Or anything else specified by regs
o Where listed property is used 50% or less for business purposes, depreciation is limited to straight-line under
the normal useful life (as opposed to the shorter life available under ACRS)
o Where an employee acquires and uses listed property the business use requirement of this provision is not met
except by use that is for the convenience of the employer and required as a condition of employment 280 f d 3
 Some courts have held the condition requirement to be objective
Travel and entertainment expenses


Introduction:
o If a person must go to another city on business, the cost of getting there and back is deductible
o If they stay overnight, cost of food and lodging is also deductible
o But what if there is substantial personal benefit from the trip?
 Rule: deductible if the primary purpose is business
 Alternative test: was there a sufficient business justification for the trip?
If your employer pays for the trip you are not taxed on the value of the trip or your personal benefit received
o section 132d
o Still raises the issue though: whether the outlay is properly characterized as business related
 Employer provided outlays that would have been deductible if paid for directly by the employee do
not constitute income to employee
 Outlays that would not have been deductible if paid for by the employee are treated as taxable salary
§132
 Employees are not taxed on whatever personal benefit they receive out of employer-provided business travel
o If the trip is characterized as non-business then it is treated as a form of salary and taxable income
o The cost of employee business travel is deductible for employers
o Non-business-related trip that an employer pays for is deductible to employer (along the same lines of
salary IF it meets ordinary and necessary business expense test) but is taxable to the employee
§274:
 In 1962, Congress enacted 274 which superimposes on the basic requirements of 162 additional rules for travel and
entertainment
o 274 a 1 allows TPs to deduct their cost of any activity which is of a type generally considered to constitute
entertainment, amusement, or recreation, only if the activity if directly related to business
o But deductions are allowed for expenses that are associated with business and directly proceed or follow and
substantial and bona fide business discussion
 Could stretch to a TP's entire life if he believes its all business
 Fifty percent limitation on meal and entertainment deduction
o Section 274n limits the otherwise allowable deduction for meals and entertainment to 50% of cost
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
EXPENSE OF SPOUSE
o Where a person is on a legitimate tax-deductible business trip, no deduction is allowed for the additional
travel expenses of the person's spouse, unless the spouse is an employee of the person claiming the
deduction, the spouse has a bona fide business purpose for going on the trip AND the additional
expenses would otherwise be deductible 274 m 3
 So can't just come along to entertain clients
Section 274's substantiation requirements
o 274d: no deduction may be taken for traveling expenses, entertainment, or business gifts unless the TP
substantiates by adequate records or by sufficient evidence corroborating the TP's own statement the amount,
the time, and place of the event or the date or description of the gift, the business purpose, and the business
relationship to the person entertained or the done
 Only that above $75
Rudolph
 Facts : An insurance co provided a trip from Dallas to NYC for group of its agents and their wives, including P
o Got the trip for selling a certain amount of insurance and got to bring his wife with him
o Only had one business meeting a group luncheon, rest of the week was for pleasure
o IRS assessed its value to them as taxable income
 No holding. US SC realizes that they should not have granted cert.
o Found that the trip was just a different form of compensation/income (61) and the employee cannot
deduct it because it is not a business expense (162) as there was no compulsion to attend the trip
 Even though the employee couldn’t deduct here, the employer can deduct the expense as if he were
deducting salary
 TEST:
o Dominant motive and purpose test
 Is it related primarily to business or is it personal/for-pleasure in nature?
 If for pleasure, the expense cannot be for business, and thus is not deductible.
o Basically 162 v. 262
 1.162-2(c): Where a taxpayer’s wide accompanies him on a business trip, expenses attributable to her travel are
not deductible unless it can be shows that the wife’s presence on the trip has a bona fide business purpose.
Incidental service does not qualify as a deductible business expense.
 Dissent says every other professional who takes these kinds of trips gets a deduction
 TAKE AWAY:
o When can you make a deduction in situations involving some degree of compulsion, but also entailing
something that an objective observer may find to be enjoyable?
 Very fact-specific inquiry

Planning guidance
o If you’re going on a trip, make sure that there is more business than pleasure going on
 Make sure you have a written-down plan
1.162-2: Traveling expenses
 The traveling expenses have an all-or-nothing rule
 Even if we determine that the overall purpose of the trip was personal, you can still take deductions for particular
items on the trip that were business-related
o However, you do not get to deduct a portion of your travel expenses
 You can only deduct the travel expenses when you can deduct all of them because the trip was
found to be business-related
 Thus, the all-or-nothing nature of traveling expenses rule
Clothing expenses
Pevsner (5th Cir. 1980)
 P tries to deduct clothing as an “ordinary and necessary expenses”
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
Facts:
o TP was a manager of a YSL boutique and is expected to wear YSL clothes while she works
o Also wears YSL commuting to work, to fashion shows, and to business luncheons
o TP did not wear the clothes during off work hours because they were too expensive for her simple everyday
life
 Also didn't want to ruin them
 Could have worn them out of work though
The generally accepted rule governing the deductibility of clothing expenses is that the cost of clothing is
deductible as a business expense only if: (THREE PRONGS)
o (1) the clothing is of a type specifically required as a condition of employment (answer here: yes);
o (2) it is not adaptable to general usage as ordinary clothing (answer here: no); AND
 Objective test
 The clothing cannot be considered generally accepted for ordinary streetwear
o While this analysis isn’t completely clear, it is more clear than a subjective analysis
o Also, this analysis is more horizontally equitable than a subjective analysis
 Tough argument to make here because horizontal and vertical equity
analyses seem both cut against one another and also collapse on themselves.
 Horizontal equity -- could be argued either way, that two managers
who both buy clothes should either both be allowed deduction or
neither should be allowed, BUT in other direction this doesn’t work
because if managers are of different socio-economic classes then it’s
not horizontal
 Vertical equity -- lower classes will be less likely to take advantage
of deduction because less likely to have specialized uniforms [seems
violative of vertical equity]
o (3) it is not so worn (answer here: yes)
Nelson- (Ozzie & Harriet CAN deduct clothes)
 They focus on situation specificness
o Which the Pevsner court seems to try to avoid
 The deduction was allowed because the even though clothing worn by the cast members was support to exemplify
Middle America, the show was filmed in Southern California
o i.e., cast members were not going to wear cardigans in Southern California
Mella case
 TP was a tennis professional
 Claimed deductions for tennis clothes and shoes, which only lasted 2-3 weeks
 Court denied deductions, people wear those clothes all the time
Williams case
 TP rode a motorcycle in his business as an Amway distributor
 He was allowed to deduct the cost of his leather uniform which had an Amway label on it
o But not the cost of the helmet or boots that he could use for non-business use
Hierarchy of Tax Reduction Techniques (most TP friendly to least)
 Getting a credit (most are 100%)
 Expense your costs (entire deduction in current year)
 Depreciate
 Add to basis
 Non recoverable (can't deduct credit nothing---full cost to you)
ALTERNATIVE MINIMUM TAX

Introduction
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o
Imposes a tax at a reduced rate on a broader base (taking out things people ordinarily use to lower their taxes)
 TP pays tax on the greater of the AMT or his tax liability as determined under normal tax
o AMT was designed to ensure that high-income TPs paid at least some tax, however they organized their
financial affairs
o Everyone agrees the AMT is a terrible provision
 BUT raises too much money for Congress to eliminate it
 AMT is defined as the amount over what taxpayer would otherwise owe, so it is not one or the other, but rather
both, since AMT is defined as the excess
 We are only looking at Sections 55 and 56 and the individual (non-corporate) AMT
 The basic idea for the AMT is kind of like a flat tax
o The AMT is really close to a single rate tax
 Two rates
o 26% (up to 175k) and 28% (over 175k)
 To the extent the AMT is imposed based on timing, the payment is treated as a credit and can be used in later
years to reduce regular tax
 Structure of the tax
o Really big zero bracket
 Stands in for preferences eliminated by AMT
55: AMT
 (a): AMT is an add-on
o AMT = TMT (tentative minimum tax) – Regular tax
 This is your AMT only if you get a positive AMT
 You have no AMT liability if you get a negative AMT
o Total Tax = Regular Tax + AMT
 (b)
o TMT
o Rate structure essentially flat
 26% below 175k
 28% above 175k
 (d)
o Zero brackets for AMT, indexed to Rev Proc
 Phases out
 Once you reach a certain income, exemption begins to fade out 25 cents of the dollar
 Higher the income the smaller the zero bracket
 Also indexed in rev proc
Equation: AMT=Tenative minimum tax -regular tax (if positive) 55 a
o What's the tentative min tax?
 tax at rates set by section 55 applied to the taxable excess
o What's the taxable excess?
 TE=Alternative minimum taxable income-exemption amount
o What is alternative min taxable income?
 taxable income +adjustments in 56-58
o **Everyone has to determine their TMT
 Parallel additional tax computation
 IRS website does a safe harbor computation for determining when you have to pay AMT....so you
don't need to figure out TMT
 Big picture
o The difference between the two tax systems
 The AMT eliminates a bunch of deductions, credits, and special accounting methods
 The question is which one’s get eliminated? … p.545
o (6) Itemized deductions
 Note that you still get your deduction for your home mortgage interest
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


This is the biggest area where the AMT cuts back on things that normal
people take as deductions
 You lose the state and local taxes deduction
 You lose the deduction for interest on home equity loans
 You lost the deduction for certain job related outlays
 The deduction for medical expenses is limited to the excess over
10% (rather than 7.5%) of AGI
You also lose the standard deduction and personal exemptions

The AMT has become problematic
o There are rich people still getting their incomes low by using non-AMT preferences
o There are poor people suffering due to ATM-preferences
o Roots of problems
 AMT is not indexed to inflation
 Administrative problems
 Hard for people to know whether they have to pay the AMT
NB sometimes calls the AMT the “enough is enough tax”
o The government (and thus the citizenry) will stop subsidizing you at some point
Klaassen
 Facts: TPs were parents of ten dependent children and earned an AGI of 83k
o IRS found that they were liable for 1k AMT pursuant to 55-59
 Required 3 specific increases to the taxable income
 Requires the entire deduction for state and local taxes to be added back
 Reduced deduction allowable for medical expenses
 Eliminated deductions for themselves and children
 AMT Calculation
o Normal/regular tax (1994) determination
 AGI = 83,056
 Minus Itemized deductions = 19,564
 Medical expenses = 4,767
 State and local taxes = 3263.56
 Minus Personal exemptions = 29,400
 12 personal exemptions: one for each of themselves and their 10 kids
 Equals TI = 34,092
 Regular tax = 5,111
o AMT determination
 (1) State and local taxes = 3263.56  0
 56(b)(1)(A)(ii): All state and local taxes have to be added back under AMT
 (2) Medical expense deduction = 4,767  2076.41
 56(b)(1): AMT reduces deduction for medical expenses from 7.5% AGI to 10% AGI
threshold
o so, they lose 2.5% AGI
o **NOW THAT’S GOING TO ALWAYS BE THE SAME YOU’LL LOSE ALL OF
THIS
 (3) Personal exemptions = 29, 400  0
 55(b)(1)(E): in computing the AMT, 151 personal exemptions are not allowed
o 55(d)(1): instead of 151 personal exemption, the AMT provides s substituted fixed
exemption for purposes of AMT computation
 AMTI = 68,832
 Then, you get to take out the AMT exemption amount
 Taxable Excess = 68, 832 (AMTI) – 45,000 (AMT exemption amount) = 23, 832
o 55(d): default and 2010/2011 AMT exemption amounts
 (A): joint return/surviving spouse = 74,450 for 2011
 (B): single (not a surviving spouse) = 48,450 for 2011
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


TMT = (26% and/or 28%) x 23,832 (Taxable Excess) = 6196
 55(b)(i): determines whether to use 26% or 28% for individual TPs
o 26% of so much of the taxable excess as does not exceed 175k
o 28% of so much of the taxable excess as exceeds 175k
 AMT = 6196 (TMT) – 5111 (Regular Tax) = 1085
 Positive AMT, so you have to pay it
o If negative, you don’t have to pay it
Majority’s legal analysis in K
o Congressional intent
 Even if the TP can show legislative history pointing to the fact that this is a millionaires’ tax, what
Congress ended up doing is not at all what it intended to do
 The Code sections are very unambiguous and need to be taken at face value
o Constitutional arguments
 TP suggests that the tax infringes on their freedom to exercise their religion because it makes
additional children more expensive than they would otherwise be
 Court says that this statute is facially neutral, so tough luck
o For the TP to win, Congress would almost have to explicitly target the group being
harmed
 Court knocks this out of the park and says no constitutional problem at all
Concurrence
o Pleads with Congress to solve the problems embedded in the AMT
Prosman (TC Memo 1999-87)
 56(b)(1): in calculating AMTI, no deduction is allowed for miscellaneous itemized deductions and State and local
taxes, unless such amounts are deductible in determining AGI (i.e., above-the-line deductions)
 56(b)(1)(E): there is no deduction for personal exemptions under 151
 Also, even though the court sympathized with the lower income TPs at bar, the plain meaning of the AMT suggests
that they too are subject to it.
o The AMT is not just for high income earners
Exam review Hypo
 H and W filed join return in 2009
 TI = 100k
o Regular tax = 17,375
 AMTI = 150,000
o Taxable excess = 150,000 – 45,000 = 105,000
 TMT = 26% of 105,000 (Taxable Excess) = 27,300
 AMT = 27,300 (TMT) – 17,375 (Regular Tax) = 9,925
o Positive AMT, so you have to pay it
 Total tax = 27,300 (9,925 + 17,375)
The 2013 exemption amounts are:
Single taxpayers:
Married taxpayers filing jointly:
Married filing separately:
Head of Household:
$51,900
$80,800
$40,400
$51,900
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