I.Basic Principles (Unit 1)........................................................................................................................................

3
Overview of the income tax system.....................................................................................................................3
Time value of money...........................................................................................................................................5
Overview of tax treatment of income and deduction items.................................................................................5
5 step process for determining tax liability for an individual..........................................................................5
Distinguishing between business and investment activities..............................................................................10
Intro to § 212 deduction.................................................................................................................................10
Full-time gamblers.........................................................................................................................................12
Rental income/deductions..............................................................................................................................12
Distinguishing personal from business/investment expenses............................................................................13
Intro to the tax treatment of capital expenditures and of gains and losses from the disposition of property....16
capital expenditure.........................................................................................................................................16
§ 1011  “basis compass provision”............................................................................................................17
Realization.....................................................................................................................................................17
character.........................................................................................................................................................18
Capital gains  start with § 1222..................................................................................................................19
Capital losses - § 165 (c)(2) ..........................................................................................................................19
depreciation of capital assets.........................................................................................................................20
amortization – § 197......................................................................................................................................21
§ 1245  recapture........................................................................................................................................21
More on capital expenditures vs. current deductions.........................................................................................22
Repairs vs. permanent capital improvement..................................................................................................22
Takeover expenses: Indopco..........................................................................................................................23
II.Intro to Consumption Taxes; Policy Considerations: Evaluating Systems/Provisions (Unit 2)........................24
Annual consumption taxes.................................................................................................................................24
equity/fairness ...............................................................................................................................................24
economic efficiency.......................................................................................................................................25
neutrality........................................................................................................................................................26
complexity......................................................................................................................................................26
Wage tax........................................................................................................................................................26
Optimal taxation.............................................................................................................................................26
substitution effect/income effect....................................................................................................................26
Tax expenditures............................................................................................................................................26
Progressivity: arguments for and against.......................................................................................................27
Examples of different systems at work..............................................................................................................28
III.The Outer Limits of Gross Income (Unit 3).....................................................................................................30
Tax Treatment of Windfalls...............................................................................................................................30
court-awarded damages.................................................................................................................................30
Treasure trove................................................................................................................................................31
bargain purchase at arm’s length – “good deal” exception............................................................................32
Tax treatment of illegal or unethical activities..................................................................................................32
Deductions for illegal businesses...................................................................................................................33
Civil damages and deductions.......................................................................................................................34
Introduction to the Realization Requirement.....................................................................................................35
Corporate tax and dividend info....................................................................................................................35
Pro-rata stock dividends ................................................................................................................................35
Subdivision of property..................................................................................................................................37
Improvements to rental property made by lessee..........................................................................................37
when improvements are essentially substitute for rent..................................................................................38
Remember that RECAPTURE DOESN’T APPLY TO REAL ESTATE.....................................................38

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 Like-kind exchanges......................................................................................................................................38
Non-Liquid Property Received in Kind as Compensation................................................................................39
§ 83  bargain purchases between an employer and a service provider .....................................................39
substantial risk of forfeiture – 4 definitions...............................................................................................40
§ 83(b) election..............................................................................................................................................41
Barter Exchanges of Goods and Services..........................................................................................................42
Imputed Income from Self-Provided Services and Ownership of Consumer Assets........................................42
IV.Tax Treatment of Borrowing and Lending (Unit 5).........................................................................................43
Basic rules related to borrowing and lending....................................................................................................43
Straight borrowing and loan repayment transactions.....................................................................................43
Below-market loans.......................................................................................................................................43
§ 7872: recharacterizes supposedly interest-free loan into component parts............................................43
Contingent payment obligations ...................................................................................................................45
Phantom repayment obligations.....................................................................................................................46
Relief of one’s obligation to a third party as income.........................................................................................47
Transfer of property to satisfy debt as a realization event.................................................................................48
Compensatory use of property  § 83(h).....................................................................................................48
Davis-Keenan ................................................................................................................................................48
in property-for-property exchange, you have a realization event..................................................................49
§ 1041 – Transfers of property between current spouses, or former spouses incident to a divorce.............49
§ 1032  NO realization event when stock used to compensate..................................................................49
Cancellation of indebtedness income and the § 108 exclusion..........................................................................49
Kirby Lumber  if you don’t pay back loan, have “freeing of assets”........................................................49
§ 108 exclusion and Title 11..........................................................................................................................50
§ 108 exclusion and insolvency.....................................................................................................................51
Purchase money debt.....................................................................................................................................51
COD income and lawsuit settlements............................................................................................................52
Tax treatment of mortgage relief: Crane and its progeny..................................................................................53
Crane and progeny essentially say that non-recourse debt is a loan for income tax purposes .................54
Estate of Franklin  when it’s a sham transactions.....................................................................................54
After-acquired non-recourse debt..................................................................................................................55
sale of property subject to non-recourse debt................................................................................................55
when property is worth less than the mortgages it secures: non-recourse.....................................................55
when property is worth less than the mortgages it secures: recourse & bifurcation......................................57
Accounting methods and bad debt losses..........................................................................................................58
worthlessness.................................................................................................................................................58
where creditor has 2 relationships with closely held corp.............................................................................59
Accounting methods and bad debt.................................................................................................................59
loan forgiveness and bad debt .......................................................................................................................60
Timing of bad debt deductions......................................................................................................................60
V.Gratuitous Transfers: Intervivos Gifts & Testamentary Gifts (Unit 6)..............................................................61
definition of “gift”..........................................................................................................................................61
§ 274(b)  $25 max for business gift deduction..........................................................................................62
Where 102(c) doesn’t apply  service provider relationship.......................................................................62
where T an employee of donor......................................................................................................................63
Basis of property acquired by intervivos gift.....................................................................................................63
basic rule is carryover basis under § 1015 ....................................................................................................63
How exceptions work....................................................................................................................................63
Basis of property acquired by testamentary gift................................................................................................64
current rule  if a death gift, basis is FMV at the time of death..................................................................64
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 Gift rule  § 1014(e) ..................................................................................................................................65
VI.Calculation of the Federal Income Tax Liability of Individuals .....................................................................66
SUMMARY OF ANSWERS TO PROBLEM 8...............................................................................................66
VII.Another Look at Gains/Losses from Disposition of Property; Alternative Methods of Cost Recovery.........72
Basis of Property Acquired in Taxable Property-for-Property Exchange.........................................................72
Depreciation and Amortization Deductions.......................................................................................................72
Wasting Assets...............................................................................................................................................72
Real Property.................................................................................................................................................72
Equipment......................................................................................................................................................73
Personal Property...........................................................................................................................................73
Self-Created Goodwill/Customer List...........................................................................................................73
Existing Goodwill/Customer List..................................................................................................................74
Business License............................................................................................................................................74
Patents & Copyrights ....................................................................................................................................74
Gains on the Sale of a Personal Residence........................................................................................................75
Principal Residence: Married.........................................................................................................................75
Principal Residence: Single...........................................................................................................................75
Capital Gains and Losses...............................................................................................................................75
VIII.Tax Treatment of Personal Injury Recoveries...............................................................................................79
Personal injury lawsuits: § 104(a)(2) rule..........................................................................................................79
Basis  Permanent exclusion ..........................................................................................................................79
Where D uses property other than cash to settle a lawsuit ...............................................................................79
Medical expenses...............................................................................................................................................79

FEDERAL INCOME TAX OUTLINE

I. Basic Principles (Unit 1)

o Overview of the income tax system
o income tax - what we have now - hybrid between income and consumption tax
 idea  allocating the tax burden based on ability to pay
 theory: this is the fairest allocation of the burden and income the best measure of ability to pay
o consumption tax
 allocating burden based on consumption - difference is that in this system, we don’t tax savings
until you consume them
 one form  income tax but exempt savings
 borrowed funds for consumption - if being theoretically consistent should include this; or could
disallow interest deductions
 likely to get a theoretically impure consumption tax
o sales tax
 idea is to get rid of income tax system and have a national sales tax
 value added tax - different than a sales tax
1. collected in stages at each step of the process, but looks the same to the consumer b/c it’s
reflected in the price
 issues
1. very regressive unless you have all kinds of exemptions b/c as your income goes up, you
spend a smaller portion of it

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 a. those in lower income brackets will pay a larger percentage of their income in
taxes
2. the rate needed to replace income tax would be 30% - huge price increases for goods and
services
3. interference with retail sales taxes which are important for the states as a source of
income
4. only countries that use a sales tax are those with smaller economies
o Three trial courts
 Tax Court - Article I court - limited terms for judges
1. judges usually are tax specialists
2. appeals: go to COA for circuit in which TP resides. TC follows as precedent decisions
from that circuit (e.g. 5th Circuit in case of taxpayer from Texas)
3. don’t have to pay deficiency before you go to court (whereas with Fed Claims and Dist.
Ct., have to pay and then fight to get your money back); tax court only deals with
deficiencies - once you’ve paid, no longer a deficiency and can’t go here.
a. if you end up losing, you also owe interest
b. if you wanna go to Dist. Ct. or Fed Claims, have to pay the deficiency - if you
win, you get interest on the refund
4. make sure you file within 90 days b/c of 90-day notice; don’t have this option once that
90 days expires.
 Fed. District Court
1. judges are generalists
2. jury an option here; no jury in tax or fed claims courts
3. appeal goes to COA for circuit in which TP resides
 Court of Federal Claims - handle tax, IP and gov. contracts
1. Appeals go to COA for Fed. Cir.; if you want to avoid binding adverse precedent in home
circuit, sue here.
o other sources of law - pp. 99-100
 regs have the force and effect of law; difficult to challenge - have to show the reg. is unreasonable
 revenue ruling
1. “opinion letter” from the IRS - represents their opinion on the matter; courts don’t have
to follow - they are merely the opinion of the IRS office of chief counsel; if proper
analysis of the law, court may follow
2. important b/c they give you the opinion of the IRS on an issue; can tell you if you’re ok
to do something; if what you are doing is consistent with the ruling; rulings are binding
on the IRS unless the revenue ruling is revoked
 revenue procedures - same as rulings, but have to do with procedure
1. binding on IRS
2. less analysis than rev. rul’s, so even discussion of substantive issues will be more sparse
 private letter rulings, technical advice memoranda, FSA
1. only binding on IRS with respect to TP to whom they’re issued; technically only this
person can rely on them as long as what they told the IRS was true, etc.; still helpful in
figuring out how IRS views an issue.
2. PLRs instigated by taxpayer; TAM and FSA instigated by IRS
a. If transaction is big enough, they want a PLR.
3. can’t be relied on as precedent by other taxpayers; but, if you follow a ruling, you’re safer
4. downside
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 a. higher transaction costs
b. you want to do something; IRS gives negative ruling; IRS now knows what the
taxpayer had planned, will be looking at what they are doing - asking for an audit
 Closing agreements
1. taxpayer and IRS close an agreement by agreeing to certain things
2. binding on both; not public
 GC memoranda
1. used to analyze fact situations that would end up being rev rulings, revenue procs
2. don’t do them anymore; but if you have an old issue, can still find them
 Administrative pronouncements that are weaker than regulations
1. Notices: Congress passes legislation; then there’s more pressure to pass guidelines and
regs; notices will be drafted to give temporary guidance.
o Sunsetting
 Has become important in tax legislation; Peroni: it’s ridiculous!
 Ex.: Bush tax cuts sunset in 2010 unless extended by Congress. Code will go back to way it was
in 2001. If you make them permanent, revenue loss is much greater.
o Time value of money
o Basic idea: A dollar today is worth more than dollar 10 years from now; you can consume it or invest it
and earn interest. A dollar of taxes paid today has more sting than dollar paid 10 years from now.
o A lot of tax planning involves taking advantage of this – trying to defer taxes and accelerate tax benefits
(deductions, credits).
 Deferral reduces effective amount of tax; kind of like an interest-free loan.
 Longer the deferral and higher the interest, the closer deferral comes to exemption.
 And if you combine deferral with other benefits, may create a negative tax.
 Charging interest on deferred tax takes away this benefit.
o Overview of tax treatment of income and deduction items
o 5 step process for determining tax liability for an individual
 General steps:
1. GI: § 61 (income without deduction or credits)
2. AGI: § 62 (GI minus above-the-line deductions)
3. Taxable income: § 63(AGI minus itemized deductions)
4. Tentative tax: TI multiplied by tax rate
5. Bottom line: tentative tax minus credits (credits = dollar-for-dollar offset)
 Gross income - § 61(a) - all income from whatever source derived
1. see list of “including” - is it within the meaning of income?
a. Important: if not on list, still can be income
2. 61(b) cross-references:
a. specific inclusion provisions - §§ 71-100
i. confirm something you think would be income is indeed included
ii. but also say that the following things can be excluded, so some excluded
items are in these sections dealing with inclusion
b. specific exclusion provisions - §§ 101-150
i. things Congress has said aren’t income; not deductions, but affect GI
ii. usually strictly construed; legislative grace
3. REMEMBER - deductions NOT taken into account in this step.
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 a. caveat: basis - e.g. gain from sale of prop that should be taxed - have to take into
the basis  the price paid for it (§ 1011)
b. caveat: costs of goods sold - like basis; gross sales minus costs of goods sold
(e.g. $1M in gross sales, $500K costs of production  gross income is $500K)
c. caveat: costs of selling property - e.g. commission to real estate agent - offset to
the amount realized - not treated like a deduction
4. SUMMARY  specific inclusion provisions + specific exclusion provisions
a. income items - if income within the meaning of § 61, have to include them unless
a specific statutory provision lets you take them out
5. Two theoretical alternatives
a. Schanz-Haig-Simons: “theoretically pure” comprehensive income tax.
i. income = consumption +/- savings
ii. measures change in value of the store of property rights between
beginning and end of period in question.
b. Cash flow consumption tax: drops savings out of the equation.
i. Tax only the current amount of income consumed
ii. Discourages consumption, encourages savings
iii. Problem: to implement CFC tax, have to tax borrowing for consumption.
 Adjusted gross income - § 62 - income minus § 62 deductions (have to go to other code parts to
actually see what the deductions are)
1. above-the-line deductions - most favored
2. deductions - allowed as a matter of legislative grace  unless the deduction is
specifically authorized by the code, it’s not deductible (look for an allowance provision);
also have to look for where Congress may have taken back part of an allowable deduction
(disallowance provisions)
3. Close ≠ enough. If not precisely within §62, then it’s below-the-line itemized deduction.
 Taxable income - § 63 - actual tax base to which the tax rate is applied
1. AGI minus (1) deductions for personal exemptions (§ 151, § 152) and (2) greater of
either the standard deduction or total itemized deductions.
a. (1) personal exemptions - family allowance designed so that you get a personal
exemption, spouses (if filing jointly), and dependents - social policy
determination; phased out as income increases so that once you hit a certain level
of income, you don’t get the exemption
b. (2) standard vs. itemized deductions - election to itemize
i. standard deduction is social policy determination (subsistence
allowance), listed in § 63 but indexed for inflation (in Code and Reg.
Book every year)
ii. standard deduction not subject to income-phaseout (most high-income
people itemize, don’t use standard deduction); SD based on filing status
2. choice between step 2 and step 3 - have already decided that we have a deduction; have
to figure out where to take it into account  is it above or below the line?
a. why § 62 deductions are “favored”:
i. allowed no matter what happens in § 63 (e.g. whether you itemize or use
standard deduction)
ii. various code provisions for deductions with floors on deductions based
on percentage of AGI (e.g. med expense deduction  can take the

6
 deduction but only to extent that total expenses exceed certain percentage
of income  lower your AGI, more likely to get the deduction)
iii. Congress’s inclination to enact separate disallowance floors on groups of
itemized deductions  e.g. before you can compare itemized to standard
deduction, have to take into account certain floors  § 67, which can
eliminate certain itemized deductions (the more you can take out in § 62,
the lower the percentage that the 2% rule applies to); § 68, applies to
most IDs (all but 68(c)), but only kicks in if income is above a certain
amount (currently about $150,500 – see p. xi) and tends to disallow only
a small amount of the ID
iv. WANT A LOWER AGI so that percentage rules apply to a smaller
amount of income - hurts less
 Tentative tax - taxable income multiplied by tax rates
 Bottom line - tentative tax minus credits
1. NOT DEDUCTIONS  offset tax liability dollar-for-dollar
2. if you end up with a refund (credits exceed tentative tax)  means you paid in too much,
making an interest-free loan to the govt.
3. if you owe and it’s too much - have to pay a penalty - strive to hit 90%
o Tax rates
 p. 1 of code book; § 1(i) has Bush 43 tax cuts
 35% - top tax rate
1. no one pays this on all income – we have a progressive rate system
2. early amounts taxed at lower rates - only marginal dollars taxed at a higher rate
3. top rate goes back to 39.6% in 2010 unless Bush tax cuts extended
 Myth #1  a salary increase will kick me into a higher bracket
1. theory  the higher the marginal rates, the greater the disincentive to work
2. but  incentive to work harder to hit that amount you want as tax rates increase
 Stability of tax rates has declined.
o Income
 always think about timing, amount, and character
 character - § 1221 – defines capital asset
1. all items of income and all items of deductions have a character - whether the item is
ordinary income or capital gains, ord. loss or capital loss
2. why care about character: we prefer income items as taxpayers to be capital gains vs.
regular income b/c of preferential treatment in the tax code - preferential rates in § 1(h)
a. also care b/c the contrary is true for deductions - taxpayers want ord. deductions
and govt. wants it to be capital loss - have a tax detriment for capital losses,
which are subject to a special limitation.
b. § 1211 - limits capital losses to extent of capital gains plus up to a certain amount
 delays deduction for capital losses; ord. deductions not limited this way
o Alternative minimum tax: § 55: Functions as side-by-side, second system.
 Created during Nixon admin.; problem was that high-income TPs were combining tax breaks to
reduce taxes to an unacceptably low level. Instead of getting rid of the breaks, set up a 2nd system.
 AMT like a floor. You pay it only if you’d more under that than under normal tax system.
1. Means high-income TPs have to have taxes computed both ways.

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 2. Problem: Bush tax cuts only apply for regular rates; so AMT kicks in more often.
3. Problem: Hurts poor people, because child tax credit only available under normal system.
o § 62 deduction – salary deduction
 salaries § 62(a)(1) - trade or business deduction - deductions allowed by this chapter
 § 162(a)(1) – “shall be allowed as a deduction all the ordinary and necessary expenses paid or
incurred in the year in carrying on a trade or a business, including” – this list gives you examples
of common items and adds limitations to the named items (e.g. reasonable allowance for salaries
or other compensation for personal services actually rendered)
1. ordinary  2 meanings both of which have to be met
a. (1) common and accepted in that type of business
b. (2) not a capital expenditure
i. capital expense  you have to take into account over time vs. an
ordinary expense that you have to account for in one year
2. necessary = appropriate and helpful  business judgment of the taxpayer usually
respected  trying to show an appropriate factual nexus to the business
3. paid or incurred  (or sometimes accrued in other provisions) - reason for words here:
tell us whether general tax accounting method applies; when applied:
a. cash method - get deduction when paid
b. accrual method - get deduction when incurred or accrued
c. “paid”  being told to use the cash method for this deduction
d. “incurred or accrued”  being told to use accrual method for this deduction
e. “paid or incurred”  use your normal tax accounting method
4. carrying on a trade or business
a. deduction for start-up expenses not deductible under this provision; have to be
actually in the business already
i. look to § 195 to see if you can write off some of your startup expenses;
section only applies if you actually enter the business in the taxable year
ii. § 195: allowed deduction for start-up expenses < $5,000
b. § 212 doesn’t specifically have “carrying on” language, but courts read it in
because §§ 162 and 212 are companion provisions.
c. what is trade/business: some say must offer goods/services; others argue it only
needs to be a regular income-producing activity (not hobby), main income source
i. Commissioner v. Groetzinger: full-time gambling
1. Dealer = trade/business
2. Mere investor ≠ trade/business
3. Active trader = trade/business (so includes full-time gambling)
ii. Have to be involved in activity with continuity and regularity, and
primary purpose is for income or profit.
5. with 3 kinds of expenses, there are additional limitations
a. § 162(a)(1) – salaries or other compensation for personal services - has to be a
reasonable allowance for services actually rendered
i. reasonableness requirement  sorting out compensation from disguised
payments; IRS putting substance over form
ii. usually used by the IRS to recast what are really gifts or dividends
b. § 162(m) – certain employee excessive remuneration
i. limits compensation deduction to $1M ; cliff effect: > $1M disallowed.
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 ii. only applies to publicly held companies and covered employees (CEO
and four next highest-paid employees).
iii. concern about high-level execs doing a bad job; goal of trying to reduce
compensation; cap doesn’t apply to performance-based compensation.
c. § 162 (a)(2) – travel expenses
i. including amount for meals/lodging (not extravagant under
circumstances) while away from home in pursuit of trade/ business
d. § 162(a)(3) – business rent
i. where you conduct your business; can’t have equity interest in property
leased - targets rental payments disguised to hide purchase payments
 Always make sure no disallowance applies.
 TIP  if § 62 allows, it’s above the line; default rule is itemized deductions if not within § 62
o § 62 deduction – unreimbursed employee expenses  Intro to itemization under § 67
 e.g. assoc. at law firm, salary of $100K, pays $1K in expenses for practice of law including bar
dues which firm doesn’t pay for
1. trade or business not an issue; includes being an employee, so §162 covers employees.
a. In theoretically pure system, employees would be treated as sole proprietorships.
Nothing in § 162 makes this distinction.
b. Emp. expenses often very small, and significant expenses are usually reimbursed.
But Congress did nothing to touch 162 in this regard. (But underlies § 67.)
2. expenses – ordinary/necessary requirements met; paid in carrying on a business  § 162
allows the deduction (not a club for tax purposes)
3. Where do we take it into account?
a. § 62(a)(1) cannot apply to an employee
i. § 62(a)(2)(A): above the line treatment only app. to reimbursed expenses
b. § 62 doesn’t allow it  itemized under § 63
i. § 67 limit: can only deduct misc. itemized deductions to the extent they
exceed 2% of AGI. Only excess of 2% is allowed.
ii. § 68: overall limit on itemized deductions
 NOTE: Congress has treated employees less favorably in a number of respects
1. the above or below the line distinction
a. once we know we have a deduction under § 162, have to look to §§ 62 or 63 to
know where in the process to take it out (e.g. above the line, can get whether she
itemizes or doesn’t; below the line, subject to 2% floor on misc. IDs in § 67)
b. § 62(a)(2) only allows these expenses to be above the line if reimbursed  if she
uses the standard deduction, gets no benefit
2. misc. itemized deductions  floor applies no matter your AGI
a. § 67(b) defines all misc. itemized deductions by looking at what is NOT on the
list provided; if your deduction doesn’t fit on the list, it’s a § 67 misc. itemized
deduction (e.g. unreimbursed business expenses)
i. Remember: § 67 floor of 2% applies to misc. IDs
1. Only allows misc. IDs in excess of 2% of AGI
2. Many times, this floor eliminates the deduction
3. Applies to individual TP regardless of income; but greater the
income, more that’s disallowed.
4. Another reason why you want a lower AGI where possible.
9
 5. Violates a theoretically pure SHS system
ii. § 67 added to raise revenue, prevent cheating.
b. other big ones  § 212  not on § 67(b) list  (1) expenses related to an
investment activity other than rents and royalty income (these 2 are above the
line) (2) expenses relating to tax determination, collection and planning
i. Congress allows a deduction in § 212 for cost of preparing taxes, dealing
with tax issues, but thinks it’s on shaky ground; by making it a misc.
itemized deduction, can get rid of it in a lot of cases.
ii. what Congress didn’t think about  e.g. civil rights claim and recovery
of damages; prior to 1996, there was an argument that you should be able
to exclude the damages from GI; in 1996, Congress decides to limit the
exclusion to personal injuries re: physical sickness and injuries,
excluding most civil rights claims; result  juries give larger awards if
they’re going to be taxable; created problem - by making the awards
taxable, the attorneys fees became deductible (related to the collection of
taxable income under § 212 and subject to § 67 2% floor); P has to report
the full gross amount of the award, deducts under § 67 if meets
requirements  P’s end up subject to AMT, which disallows misc.
itemized deductions such that low income people getting hit with a tax
bill exceeding their net recovery; SCOTUS screws the taxpayers; 2004
jobs acts, Congress tries to fix it  applies to civil rights recoveries,
made attorneys fees in certain civil rights cases above the line deductions
 § 68 - overall limitation on itemized deductions
1. kicks in only if AGI exceeds the applicable amount (unlike § 67 which always applies)
2. amount was originally $100K, now have to look at rev. proc. – for 2008, it’s $159,950
a. doesn’t matter whether you’re single or married filing jointly (marriage penalty)
b. married filing separately: threshold is $79,975
3. applies to all itemized deductions
a. 68(c): exceptions  med expenses which have own floor; deduction for
investment interest; deduction for casualty or theft losses
4. disallows the lesser of 3% of the excess of AGI over the applicable amount or 80% of
amount of the itemized deductions otherwise allowable for the year
5. Compare. Unlike §67, §68 has a threshold requirement and applies to a much broader
range of deductions; it’s a stronger disallowance rule, with fewer exceptions, and it’s
calculated differently.
6. Anything that survives § 67 goes through § 68 if income high enough
o Distinguishing between business and investment activities
o Intro to § 212 deduction
 Higgins  passive investment activity no matter how much it contributes to your income, not a
trade or business - § 162 doesn’t apply
 § 212 - a response to Higgins  § 212(1) and (2) - allow deduction for expenses in investment
activity
1. “ordinary” and “necessary” have same interpretation as in § 162
a. Ordinary = common/accepted for this investment or other income-producing
activity that isn’t a trade/business.
2. doesn’t say you have to be carrying on - although it’s been read into  prep. expenses
wrt entering an investment not deductible
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  Expenses allowed under §212
1. for production/collection of income
2. for management, conservation, or maintenance of property held for production of income
3. in connection w/ determination, collection, or refund of any tax
 Itemized under § 63  § 67 applies, § 68 probably also applies depending on income
1. below the line b/c not subject to the exception under 62(b)
2. compare: §162 deductions are above the line
3. only §212 deduction above the line: production of rental/royalty income: § 62(a)(4)
o Broker dealers -- §162
 Charlie = broker dealer, pays $500 in expenses in connect w/ broker dealer activity. How to treat?
 GI - broker dealers thought of as being a trade or business for § 162 purposes.
 Above the line or below the line: depends whether C owns his own business
1. if an employee not covered by § 62(a)(1), not (a)(2) No indication that it was reimbursed
 below the line, subject to § 67 (not on the list of those deduction excluded) and maybe
§ 68 depending on income)
 If he’s an independent contractor  has own trade or business  line between IC and employee
depends on relationship between the person and the “employer” and if a lot of control 
employee  IC determines manner of the employment
 broker dealers  there are often non-tax reasons why the principal will make the relationship
either IC or employee; once arranged as an employee relationship, tax results follow
1. exception to disadvantage of being an emp’ee: employer pays half of employment taxes
 fact that he’s a broker dealer  need to know more facts before we can make determination
1. if IC  § 62(a)(1)  above the line; § 67 and 68 don’t apply b/c not itemized
o Investors -- §212
 Not broker-dealers; no customers; doesn’t do it for someone else, doesn’t make market for stock
 to be an active trader  has to be quite frequent and a primary source of your income
1. e.g. if primarily a doctor, probably not active trader; look at how he spends most his time
 Groetzinger  passive investor not a trade/business; result is different for active traders 
trade/business for § 162 purposes
1. b/c no employer, in his own trade/business
2. § 62(a)(1) makes it above the line; §§ 67 and 68 don’t apply
 how to think about it  continuum  active traders between broker dealers and passive investors
1. look to securities as primary source of income but doesn’t have customers
 BIG issue is whether someone falls within the definition of an active trader
1. most of the case law involves the issue of whether the person is a dealer vs. a trader
2. why does this matter  how to treat it wrt capital gains and losses purposes
a. if active trader, can deduct expenses under § 162, but gains/losses will be capital
b. NOT KICKED OUT BY 1221(a)(1) – stock not held for others
3. taxpayer argues for dealer; govt. argues for active trader
a. only way to be broker dealer is to have customers or make a market for the stock
b. active traders, like investors, subject to capital loss limits (although the good
news is that you get the deduction for trade or business)
4. §263: Make sure a code section allows deduction & that no other section disallows it
a. Broker commissions: no current deduction; they go in your basis
b. Legal fees = capital expenditure; advice costs are CE
11
 c. Most things incurred in connection with stock will not be deductable because
they’re CE (significant future benefits, life longer than a year).
5. Traders can make §475 election: mark-to-market accounting method (475(f))

Investor (passive) Trader (active) Broker/dealer

Code provision §2121 §162 §162
Character CG/CL CG/CL OI/OL
§475 election no yes yes
available?

o Full-time gamblers
 Full-time gambler treated like broker/dealer under §162; don’t have to hold self out as trading
goods or services to be in trade/business.
 Groetzinger  what does it tell us about trade or business
1. continuous and regular; primary purpose is income or profit
2. picks up the active trader with no customers
3. court rejects govt.’s test, which would require that you hold yourself out to customers
 If full-time gambler  trade/business; expenses deductible under § 162 as long as meet reqts.
1. above the line  own trade or business under § 62(a)(1)
2. If not a full-time gambler, no in-between status like trader – no deductions under §212;
tax law treats gambling other than full-time as personal consumption.
 what about the losses of a full-time gambler?
1. § 165(d) - wagering losses -- applies the same to all gamblers
a. deduction allowed only to the extent of gains
b. losses don’t go back or carry forward
i. as applied to full time gamblers, this is inconsistent with how we treat
other costs of doing business.
c. Important: If wagering losses exceed gains, can’t use them against other income.
165(d) walls off net gains/losses.
i. Supporting theory: we’re a puritanical society
ii. And in most cases, it’s consumption.
iii. Also hard to keep track of it.
2. above or below the line?
a. if a casual gambler  nothing in § 62 would make it above the line, so itemized.
i. can only take if all IDs exceed standard deduction.
ii. losses are below the line IDs, not subject to 2% rule because not misc.
IDs; and not subject to §68 phaseout (according to § 63(c)(3)).
b. but, if a professional  § 62(a)(1) applies and loss deduction is above the line
3. All winnings go into income, not just net.
o Rental income/deductions
 Is it business or investment?
1. deductions above the line no matter if it’s business or investment
2. if a business  § 62(a)(1)
3. if investment  § 62(a)(4) if a § 212 deduction
 real estate dealer or investor
1. rule is  one rental is enough to put you in the trade or business of real estate (notice
how it’s treated differently than stock stuff)
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 2. people treated as having 2 trades/bus.’s  doesn’t have to be primary source of income
3. hard to fall within the investor category (e.g. has to be extremely passive)
 ex: investment rental income  if John own unimproved land passively leased to cattle rancher.
1. investment activity  § 212 allows it, but still above the line b/c of § 62(a)(4)
2. difference has to do with characterization; active rentals generally trade/business while
passive rentals are usually investment activities.
o Welch  paying off debts to build up goodwill
 not an ordinary expense
1. treated like a capital expenditure
2. not clear whether common and accepted…
a. even if common and accepted, it’s a capital expenditure - buying goodwill which
is a corporate asset
 what to do with the cost  becomes cost of goodwill - basis; if you sell the business later, part of
the sale price will include goodwill, this cost will reduce your gain for tax purposes
 also  have to be carrying on the business
1. question of whether these expenses are paid in carrying on the business or a start up
expense of a new business (§ 195 for start up expenses)
 generally, employment and starting own business treated as different bus.’s even if in same field
o Distinguishing personal from business/investment expenses
o Under all three systems (current, SHS, CFC), important issue is dividing line between
business/investment expenses and personal expenses. Important in our system because you get deductions
under §§ 162 and 212, but most personal expenses aren’t deductible.
o S-H-S
 concept of income  commonly used as a reference point
1. personal income  algebraic sum of the market value of rights exercised in consumption
and the change in the value of the store of the property rights
2. income = consumption + savings
 NOTE: doesn’t have a realization reqt.; but our tax system is likely to retain that reqt  we don’t
tax property gains unless you sell/dispose of and don’t allow loss deduction until you sell
1. major departure from the SHS model
2. some areas we do relax the realization requirement (mark to market)
 § 162 and § 212 thought to be consistent with SHS
1. idea = decrease in wealth that’s not consumption ought to reduce tax base under SHS
2. what about wagering losses?
a. if a pro, there’s a strong argument that there should be a complete deduction,
even if they exceed winnings (decline in wealth that isn’t personal consumption)
i. counterargument  excess is probably recreational
b. nonpro § 165(d) probably gets it right- treats excess like personal consumption
 summary on p. 42 - SHS with a realization requirement
1. outlays and expenditures that do not reduce current wealth should not reduce income
even if outlays and expenditures are not for consumption items (e.g. cap. expenditures)
2. pers. consump. outlays/expenditures shouldn’t reduce income even if they reduce wealth
3. realized decreases in wealth that don’t represent consumption (i.e. realized declines in
value of prop. and expenditures relating to product’n of income) should reduce income
o § 262  specific disallowance: no deduction for classic personal consumption items

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  e.g. personal rent, meals
o § 274  specific disallowance of certain entertainment expenses
 substantiation requirement  § 274(d)
1. history – Cohan rule  business meals, business entertainment, travel expenses all
deductible if TP can make a reasonable approximation.
2. §274(d) enacted in response –reasonable approximation isn’t good enough
 Moss – taking “ordinary/necessary” language and trying to apply it in context of business meal to
sort out what’s personal consumption and what’s really business.
1. Posner: difficult to sort out; refers to Sutter case – and IRS’s administrative reaction to it:
a. If the TP can succeed in establishing business nature of the meal for the client,
then generally the TP’s own meal will be deductible as well, provided the TP
doesn’t overdo it (extravagant); even though TP’s portion is pers. consump.,
deductible as long as not abused. (saying every dinner is business = likely abuse)
2. Posner: stuff bothers him: 1) frequency; 2) no clients involved – each person over time
deducting only his own meal; meal itself not necessary, b/c can discuss business at places
other than this restaurant for lunch (neither ordinary nor necessary) – so never get out of
§ 162, so never get to § 274
3. NOTE: Moss not like meeting w/ client before trial; that’s likely deductible, at least under
§ 162; once you establish meal itself meets business deduction, it includes L’s portion.
4. Taking client to lunch is classic business meal; ordinary/necessary under § 162; look for
issue of trying to claim too many meals. But: if you pass §162, have to go to §274(d).
 § 274(a)(1) and (2) for business entertainment
1. requires you have business discussion before/after/during; same true with entertainment.
 rest of 274
1. (k): just in case ordinary/necessary standard of § 162 is not clear, Congress says: we
mean it  no deduction for expense that’s lavish and extravagant under the
circumstances (in practice, this is rarely the thing that disallows the deduction – the
employer won’t pay for lavish or extravagant meals)
2. either TP or employer of TP has to be present (can’t just send client on his way to go eat).
3. 274(l) – entertainment tickets, skyboxes; special limitations on all that stuff
 274(n) – disallow 50% of whatever’s left after going through § 274
1. theory: after all this stuff, 50% is still personal consumption (on average)
2. have met every other reqt, including substantiation; you can deduct 50% of what’s left
a. above the line under 62(a)(1) if employer or owner fo own trade or business
3. 274(n) generally applies to the ultimate payor of the expense; way you get there – §
274(n)(2)(a) – the 50% disallowance rule does not apply to an expense if it’s described in
(e)(2), (3), (4), (7), (8), & (9); means: if you’re an employee, and your employer
reimburses you for that meal, you don’t have to mess with figuring out the 50%,
your employer does (employer only gets to deduct 50%); so in typical setting, where
associates take out recruits for position, and get reimbursed, the law firm loses the
50%, not the associate; 274(n)(2)(A) exempts the associate from losing it
a. business expenses  above the line; $100 business meal, deductible; employer
has employee pick it up; employee has: $100 additional compensation, deduction
of $100, a wash – income matches the deduction; (if reimbursed employee
business expenses, and income matches expense, you can leave it off the return,
as long as they all match)
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 b. employer loses 50% of potential deduction; with one exception – the employer
has the option to screw the employee – if employer says: we designate this not
as reimbursed expense, but as compensation to you, then we can report it as
wages, deduct 100% of it and employee has to figure out the 50% limit rule.
o Work clothes – very difficult to deduct these expenses
 objective std (p. 632), rev ruling and Pevsner establish 3 reqts to deduct work clothes under § 162
1. of a type specifically required as condition of employment
a. stronger than the normal “appropriate and helpful” standard of necessary; more
mandatory than usual meaning of necessary.
2. not adaptable to general usage as ordinary clothing
a. objective std.: you couldn’t have worn it off the job; not that you don’t like to.
3. it is not in fact worn outside the job
a. subjective – you didn’t in fact wear it outside the job
 what is deductible: 1.262-1(b)(8)
1. military uniforms – has to be such that you can’t wear outside the job (i.e., reservists)
2. uniform that has the employer’s info all over it
a. note: as clothing stds change, harder to argue even those unis can be deducted
b. nurses probably qualify
 note: not just a portion disallowed; all of it disallowed by § 262 as personal/family/living expense
1. all or nothing approach – we’re probably disallowing too much here; theory – no
practical way to sort that out; tough std, recognizing in most cases, it’s pers. consumption
2. TPs usually lose under this kind of rule.
3. Even where you can meet the reqts, CE rule stands in the way. Most uniforms have useful
life beyond year paid/incurred, so they ought to be depreciated, which most people don’t.
o commuting expenses
 commuting to/from work each day  not deductible; pers. expense (you choose where you live)
1. 1.162-2(e) – personal commuting expenses not deductible; §262 specifically disallows it;
1.262-1(b)(5) – no deduction
 heavy tool exception  e.g. cost of hauling equipment adds $500 to commuting expenses  only
the extra $ 500 is deductible; TP must show extent to which he incurred tool transporting
expenses in excess of what he would have otherwise incurred in transporting himself.
1. Fausner – p 633. and IRS reaction to it; rarely comes up
2. § 162  if sole proprietor; above the line under 62(a)(1)
 notice, not talking about travel expenses away from home (on a temporary trip away from normal
tax home); talking about general § 162 deduction
 The transportation expense between two work locations is not commuting; so it’s deductible; if
sole proprietor, not only deductible but above the line (so not subject to any floors)
 Example of “away from home” but not overnight  longer commutes
1. A construction worker whose regular location is where she lives; but has to go to temp
work sites in other cities; not so far away that she stays overnight or moves, but for
periods of months/days travels from home, outside reg metro area where she lives/works
2. IRS says: she can deduct the expense as long as she has reg work location; and as long as
these temp locations are outside that area; temp means less than a year
3. Employee: unreimbursed expense, so deductible under § 162; but itemized deduction, so
subject to § 67, if income high enough subject to § 68
o Country club dues – disallowed under §274(a)(3)
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  § 274(a)(3); no deduction allowed for amts paid for membership at any club for business,
pleasure, or any other social purpose

o Intro to the tax treatment of capital expenditures and of gains and losses from the disposition of
property
o Background
 With gains from property, a 3-part analysis:
1. Is the gain realized? (Realization)
2. Is there any nonrecognition provision to defer taxation? (Recognition)
3. Is there an exclusion provision? (No exclusion)
 With losses, 4-step analysis:
1. Is it realized? (Realization)
2. Is there some nonrecognition provision that defers the loss? (Recognition)
3. Is there some provision that allows it? (Allowance)
a. e.g.: § 165(a), (c) and (f)
4. Is there any provision that disallows it? (No disallowance)
a. e.g. §267
 If gains pass the analysis, it goes in step 1 (GI -- §61(a)(3))
 If losses pass analysis, it goes in either step 2 (AGI; above the line) or step 3 (TI; itemized).
1. Normally, most losses will fit in §62(a)(3) – losses from sale/exchange of property.
2. So most property losses are above the line deductions.
 NOTICE: You don’t net gains and losses in our five-step process. Take each individually.
o § 1001 – amount and recognition of gain/loss from on disposition of property computation section
 Computation is triggered by sale or disposition of property
1. There are disposition events that aren’t sales/exchanges; in code sections like 62(a)(3),
distinction is important.
2. And not everything that’s property under state law is treated as property by tax code.
 (a) – Amount realized minus adjusted basis = gain/loss
1. A/B  1011, 1012, 1016
 (b) – A/R = sum of cash rec’d + FMV of prop. other than money rec’d (e.g. in a prop. exchange)
1. Notice: Doesn’t talk about services rec’d in return for property, but that’s included here.
2. When it’s something other than cash, we have to value it. In tax cases, standard for FMV
is objective – price at which prop. would exchange hands between willing buyer and
willing seller, both having knowledge of relevant facts and neither being under
compulsion to buy/sell.  the “willing buyer/willing seller” standard.
 (c) - default rule; entire amount of gain or loss recognized unless you find some specific other
provision providing for nonrecognition.
 § 61(a)(3) - GI - realized gains go into GI; no exclusion provision that applies; as with other gross
income items, have to make sure no exclusion provision applies (different from non-recognition
b/c takes out of tax base forever rather than deferring them)
o capital expenditure
 CE= benefits beyond yr. expense was paid/incurred; no current deduction, expense added to basis
 SHS: income = consumption + savings  don’t allow a current deduction for CE. (Under CFC
system, would allow for a CE deduction as long as not personal)
 costs related to acquisition of a capital asset
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 1. e.g. purchase price; fees related to title disputes (these fees may come later but have
origin in acquisition, so get added to basis & no current deduction); acquisition of land:
cost basis (what you pay = basis)
 expenses related to sale of a capital asset  treat as offset of amount realized – e.g. broker fee
o § 1011  “basis compass provision”
 Default rule: adjusted basis  initial basis as provided in § 1012 (cost), adjusted upward or
downward as required § 1016
1. (a)(1): upward adjustment for CE; those are added to basis
2. (a)(2): reduced for depreciation, amortization, depletion, obsolescence, exhaustion, wear
a. If you take any of these, have to reduce basis, or else you get a double tax benefit
b. Essentially for wasting assets
i. w/ something like stock - probably won’t have adjustments under § 1016
ii. no depreciation on corp. stock - not a wasting asset
 Default basis: § 1012 cost - not defined
1. when you pay cash for something in an arm’s length transaction, the cost basis under
§1012 is the cash paid
2. Underlying policy: cost represents amount already run through the system; point is not to
tax it again. (Or it wasn’t taxed, and govt. doesn’t want to tax it now.)
o Realization
 Required to determine gain/loss; 1001 requires a “sale or disposition” – realization has to happen.
 Realization reqt. is for admin. convenience, both for TPs and for govt. If you got rid of it, you’d
have to appraise everything.
 Also encourages savings and investment, long-term ownership
1. Problem: “lock-in” effect. Prevents capital from moving to another user.
2. But if you tax it earlier, might force liquidations in order to pay the tax.
3. Puts pressure on the system to lower tax on these kinds of gains.
 Departure from realization: “mark to market” doctrine – §475.
1. MTM: compare value at beginning of year and end of year to calculate gain/loss.
2. SHS would rely on this because theoretically pure SHS system abandons realization reqt.
Realization is a major departure from a theoretically pure system.
3. But if we adopted MTM, you also have to adjust basis so that when you sell, you don’t
pay tax again.
o money paid to acquire stock - related to income-producing activity under §212 but can’t take a current
deduction b/c not an expense  fails one of the definitions of “ordinary” b/c it’s a capital expenditure,
not a current expense (remember  have to meet both definitions of ordinary)
 § 212 implies no current deduction for capital expenditures
 § 263 - specific disallowance for current deductions for capital expenditures
 what about a broker fee?
1. Origin is in acquisition of stock, but still CE, curr. deduction disallowed under 263.
2. all of the cost of acquisition included as a capital expenditure - those expenditures
that have their origin in the acquisition of property
 The purchase price and the broker fee goes into the basis
o if your expenditure has origin in the disposition of prop  CE and not currently deducted
 BUT, for purposes of determining gain or loss on sale  get to take into account the sale cost,
reduce the gross proceeds by costs related to disposition

17
o character
 we care about capital gains b/c if you have a net capital gain, that portion of your income in step 3
that’s net capital gain is subject to lower rates (§1(h)).
 capital losses are subject to a special limit in § 1211 (can only deduct up to gains plus $3000);
allows you to carry forward some losses, so not a permanent disallowance
1. NOTICE - if a loss deduction, wouldn’t effect step one; loss deductions taken into
account either in step 2 or 3
 every item of income or loss has a character - it’s always a part of the analysis
1. 2 major practical reasons  if it’s gain, then this may be part of a net CG and may get
preferential rate on capital gains; if there are capital losses, limited in the deduction of
those losses as in § 1211 (can only deduct losses to the extent of gains plus $3K excess
against ord. income); anything else gets carried forward (limited to 5 future years)
2. if capital losses  need to know amount of capital gains so can figure out amount of
deduction (deduction doesn’t affect step one)
 capital asset  has to be a sale/exchange of a capital asset; capital asset means property held by
the taxpayer other than the 8 things excluded in §1221(a).
1. dealer prop. exclusion - things like inventory or other prop. help for sale to customers
2. services aren’t prop (why compensation for services is ord. income)
3. apply the analysis to the property sold  looking at the policy behind the law
 if held for more than a year  see § 1231  real prop. used in trade or business; depreciable or
amortizable personal (as opposed to real) prop. used in trade or business  kicks these out of
§1221 (but 1231 may give you capital gain or loss treatment)
1. corp. stock is personal prop. no way it can be kicked out of 1221
 short term or long term  if more than one year  long term
1. if one year or less  short term
2. what is really taxed preferably is long term capital gains
 Why do we give capital assets different treatment?
1. one of the prime reasons we care about the character  preferential tax rates for net
capital gains
2. opponents
a. distributional argument: CG rates favor high income people
b. cap gain and loss provisions too complicated - lots of errors made in trying to
figure it out
c. economic efficiency: if we’re in favor of the free market, shouldn’t favor one
kind of income over another (distorting economic activity in favor of particular
kinds of investments, like stock.)
3. proponents
a. encourages long-term investment; to encourage investment in risky endeavors
that have high chance of failure (doesn’t make sense b/c no matter whether high
risk or low risk and treatment in capital losses actually discourages this);
encouraging investment or savings in general
b. economic theory: counteracts lock-in effect of realization reqt. (see above)
c. “theory of the second best”: Ideally, with no distortions and no barriers to free
market, CG preference steering investment a certain way may be good. But in
second best world, we have lots of distortions in the market; can’t be sure that a
CG preference doesn’t offset other distortions. So instead of moving away from

18
 unimpeded free market, CG preference might move us back into a free market –
by offsetting distortions. Can’t clearly argue that it’s economically inefficient.
o Capital gains  start with § 1222
 net capital gain - this is the part that’s subject to the lower rate in § 1(h)
1. excess if any of the net LTCG over net STCL(can never be negative)
 realization event has to be a sale/exchange for § 1222 to apply
 STCG can’t qualify for preference; it’s taxed at ordinary income rates.
o Capital losses - § 165 (c)(2)
 allows for a deduction for an investment loss
 § 165(f) - limit on capital losses  go to § 1211 and § 1212
 § 1211  loss deduction limited to the amount of gains plus lower of $3K or the excess of such
losses over such gains
1. allows you to deduct capital losses (long and short term) to the extent of capital gains
2. loss not deducted  carries over - § 1212 - start the next year with long term capital
losses that you couldn’t deduct the previous year; can’t carry back, but can carry
forward until you use it up. but if you don’t carry it forward, you lose it for that year
(can’t pick and choose which years you want to carry forward)
3. If you have no CG: only deduct $3,000. Doesn’t matter that the $3K isn’t a cap. asset.
4. where to take it: in step 2. Fits under §62(a)(3) (losses from sale or exchange of property)
5. corps only get losses to extent of gains; and carryforward and carryback limited
 example  Have $20K long term capital loss and $5K from a long term capital gain in an
unrelated transaction
1. Whatever we do with the loss - capital gain goes into gross income - 61(a)(3)
2. know we have $20K loss under § 165 and § 1001
3. § 1211(b)  $8K deductible as a loss (amount up to gains plus $3K)
4. $12K carry forward
a. NOTE - 1211 doesn’t distinguish between long term or short term capital gains
5. what if Bob doesn’t want the extra $3K this year to deduct against ordinary income  he
loses it  have to take the full $3K  carry forward will be $12K no matter if he wants
the $3K this year
6. what if the next year no capital gains  $3K deduction.
o IMPORTANT: To have CG/CL, need sale/exch. of capital asset; not just any realization event, but S/E.
o Losses not compensated by insurance: § 165(c)(3) - almost no practical effect on most taxpayers
 (a) - deduction allowed for loss sustained and not covered by insurance or otherwise; if there’s a
reasonable prospect for recovery, have to see how it’s resolved before you can take deduction
 (b) - loss for taxpayers limited to basis - no basis, no loss
1. e.g. depreciable asset: you’ve taken deductions - have recovered via deductions, so now
basis is 0
a. assume no insurance - loss deduction is zero  no basis, no loss
b. assume $100K insurance proceeds  basis still zero  now have a gain of
$100K
 (c): limits deduction to:
1. losses incurred in trade/business (i.e., selling business property at a loss)
2. losses incurred in any transaction entered into for profit, though not connected w/
trade/business (i.e., sale of stock)
3. losses arising from fire, storm, shipwreck, other casualty, or theft
19
 a. assume you got through definition of casualty, etc…  § 165(h) - $100 floor;
section essentially says there’s a 10% of AGI floor
b. has to be sudden physical effect on your property (not slow-acting termites)
 Losses from personal consumption items are not deductible (homes, cars, etc.)
 won’t affect step one gross income  only step 2 or 3
o depreciation of capital assets
 consistent with SHS  net income plus savings  decline in the value of an asset that’s
producing value, should take into account to avoid overstating income
1. SHS would use economic depreciation – measure actual decline in value. But we violate
SHS and set up most depreciation allowances to be greater than economic depreciation,
to encourage investment. Plus, admin reasons – TPs and govt. would be mired in disputes
over valuations.
2. if using SHS would use economic depreciation - the actual decline in value and limiting
deduction to basis  would result in small allowances in earlier years, getting bigger.
Our system is a departure b/c it doesn’t try to measure actual decline in value, and
sometimes almost purposely gives you a greater allowance. Some years, it’s a greater
departure than others.
3. Under CFC, all of the cost would be currently deducted. Actually, the more we allow
greater writeoffs more rapidly, the closer our system gets to CFC model.
 Three types
1. depreciation - tangible property (e.g. machinery, buildings)
2. amortization - intangibles that are wasting assets (e.g. copyright, customer list, covenant
not to compete, trademark)
3. depletion - oil, gas, minerals, timber, other natural resources
 depreciation - §§ 167, 168 -
1. under current rules  involve 3 things – 168(a)
a. applicable depreciation method 2x straight line or 1.5x straight line
i. shorter periods get 200% (e.g. machinery with 3-year recovery period;
professional violinist buying $50K violin bow)
ii. tangible personal property
iii. can always elect straight line
b. recovery period – designed to be shorter than useful life
c. applicable convention – when you put in into use, when do we treat it as being
put into use (e.g. mid year no matter when you actually put it into use)
2. Real Property
a. straight line is only method you can use for real property
b. residential rental property (straight line over 27.5 years)
c. non-residential real property (straight line over 39 years)
3. current depreciation rules come up with recovery periods that don’t try to measure the
actual economic life of the asset, but Congress decides how much time to give for the
writeoff, want shorter periods than the actual economic life
4. can only take depreciation on an asset that you use in a trade or business or income
producing activity (e.g. personal home may depreciate, don’t get depreciation deduction)
a. purpose  will allow you to recover your basis over time
b. Thus, if you have a zero basis - no depreciation
5. Example – a piece of machinery
a. $30K cost is adjusted basis (§ 1011, § 1012)
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 b. $10K each year in depreciation - § 167, § 168
c. is the deduction each year above the line or itemized?
i. § 62 (a)(1) – applies to 162 deductions as well as expenses related to
trade/business. It’s ordinary deduction not subject to 1211 limitations.
ii. above the line
iii. Depreciation deduction less favorable if it’s an unreimbursed expense of
an employee – again, deduction would be below the line, itemized.
6. Basis is reduced by the amount of the deduction every year so that by the end of 3 years
no basis, so what you sell it for will all be gain
a. if you choose not to take the deduction allowed by the statute, you lose it (e.g.
basis can go down to zero even though you never took a depreciation deduction)
o amortization – § 197
 doesn’t include anything self-created unless listed in § 197(d)(1) (D), (E), or (F)
1. if self-created and listed in (A)-(C) – not § 197
a. but if doesn’t fall within 197 – check § 167
2. if self-created and listed in (D)-(F) – is § 197
 straight line over 15 years, no matter the life of the asset
 measuring point  adjusted basis
 examples:
1. self-created customer list with a definite term
a. not within § 197 - § 197(d)(1)(C)(iv)
b. BUT, see § 167
i. amortizable over useful life (e.g. basis in list is $6K, life of 6 years =
$1K per year)
2. self-created goodwill  not amortizable  listed in (d)(1)(A)
3. the inventor with costs in developing the invention
a. not a § 197 intangible that can be amortized
b. look at § 167 – write off over legal life of the patent
 purchased amortizable assets
1. even if self-created by the seller, purchaser will get to amortize § 197 intangibles
2. e.g. I buy assets, including goodwill, customer list, cov. not to compete
a. all is purchased  § 197  (c)(2) has nothing to do with this situation (b/c not
self-created by the purchaser)
3. e.g. I pay $30K in expenses wrt license with 30 year term
a. 15 year write off, straight line – 197(d)(1)(D)
o § 1231 - property used in trade/business held > 1 year – intermediate characterization
 § 1221(a)(2) – certain kinds of property that gets kicked out
 § 1231 picks what gets kicked out under § 1221(a)(2) - treated like a quasi capital asset, but better
1. net differently - if the gains equal or exceed the losses, then everything in § 1231 gets
capital gain treatment
2. if the losses exceed the gains - gets treated like ordinary loss - better b/c no special limit
like in § 1211
o § 1245  recapture
 ex: you had $10K a year in depreciation deductions that were ordinary deductions, could offset
any income; bought for $100K, depreciated for 6 years ($60K); sell for $130K
1. have gain of $90K ($130K amount realized minus $40K remaining basis)

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 2. when you sell that depreciable machinery, the amount of gain as a result of the
depreciation doesn’t go into § 1231 pot – gets treated as ordinary income
3. so  in this case, you’d have $60K ordinary income and $30K in § 1231 gain
4. § 1245 overrides § 1231 and § 1221
o What if a loss on the sale of depreciable property?
 § 165(c)(1) allows, no disallowance unless § 1211 applies
 character of the loss - does § 1211 apply to limit the loss?
 character
1. § 1245 doesn’t help you - only applies to gains, not losses
2. § 1221(a)(2) kicks it out to § 1231 - held for more than a year
3. treated like ord. loss
4. but, have to know if there’s any other § 1231 gains or losses b/c different netting - all
depends on whether § 1231 gains exceed losses
o §1(h)(6): Unrecaptured §1250 gain – for depreciable real property
 Kind of a misnomer; old 1250 recaptured as OI excess of accelerated over straight-line
depreciation. Only connection of 1(h)(6) to 1250 is that they both apply to depreciable real prop.
 1(h)(6) doesn’t make it ordinary income, but simply subjects it to 25 percent preferential rate.
 Means that 1231 gain from sale of real property, if it survives as CG, will get 25 percent rate.
o definitional provisions of § 1222
 sale or exchange of capital assets
 is the realization event a sale or exchange
 is it a capital asset
 those eight items listed are things that aren’t capital assets (in § 1208)

o More on capital expenditures vs. current deductions

o Keep in mind differences between three systems we’re studying:
 SHS: tax consumption + savings. Important to have a rigorous CE rule, preventing current
deduction for CE.
 CFC: Any expense related to business/investment deductible in full. No CE rule.
 Actual system: mishmash, incoherent. Mostly enforces CE rule, with a bunch of special rules.
o How does this get translated into rules:
 For long time, 263 said no current deduction for something with future benefits; but it was loose.
 Idaho Power: Expenses incurred to create/produce property = CE.
 1986: Congress comes up with 263A: uniform capitalization rule – codifies Idaho Power
o 263A: Tangible property produced by TP or property acquired for resale (inventory): requires direct and
indirect costs to be capitalized. Broad capitalization rule.
 Then came Indopco regs, 1.263(a)-4 and -5. Intangibles can be CE.
1. Problem: Lots of exceptions. Guidance became a bunch of special interest rules.
 Then came regs on acquiring/improving tangible property not governed by 263A (tangible
preoprty not produced by TP, and not for resale  1.263(a)-2. Only proposed, so don’t have
force/effect of law. Brings treatment of tangible property closer to how we treat intangibles.
 Very complicated. Means that when you have an expense, you have to figure out which category
it falls into. We’ve taken basic CE rule and turned it into a bunch of complex rules that vary
based on which category you’re in.
o Repairs vs. permanent capital improvement
 reg. 1.162-4
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 1. repair = something keeping the property in ord. and efficient operating condition
2. permanent improvement =
a. materially adds to value
i. Compare value of property after expenditure with value before condition
arose that gave rise to need for expenditure.
b. appreciably prolongs the life, or
c. adapts property to new/different use.
d. Depends on a facts/circumstances analysis, determined objectively. Consequence
is that the only way these rules can be applied is through litigation – high
transaction costs and potential for inconsistent results.
 consequences
1. trade/business vs. investment vs. personal use
2. if business: repair is currently deductible under §162; perm. improvement adds to basis
3. investment asset: repair currently deductible under § 212; permanent improvement adds
to basis
4. personal use asset: repair = no deduction; permanent improvement added to basis
 Examples
1. repainting – normally treated as a repair
2. patching up a roof – repair
3. replacing a roof – normally a permanent improvement
4. touch-up on walls – probably repair
5. major reconstruction on where walls are located: probably perm. improvement
a. can develop facts supporting current deduction – e.g. moving walls to shore up
existing structure.
 environmental remediation
1. ruling says if you bought the property without env. problem, then have manuf. operations
that created problem and then remediate  cost deductible as repair
2. suggesting that if you bought the prop. knowing it had a problem & got a discount, then
remediate, that’s a permanent improvement that’s added to basis
3. what if you bought it not knowing of the problem, then remediated?
4. private rulings – suggest the following perverse incentives
a. if you have an asbestos problem and you just encapsulate it (temporary) – that’s a
repair & currently deductible
b. if you perm. remediate, that’s a permanent improvement, added to basis
c. incentive if to not fix the problem permanently
 prepaid expenses – where you prepay for benefits in future years  capital expenditure
1. Zininovich: If you prepay more than 12 months beyond current year, you can deduct it all
currently.
2. The law: §1.263(a)-4(f): Prepay expense rule: You don’t have to capitalize if expense
creates benefit not extending beyond the earlier of:
a. 12 months after the first day the TP realizes the right or benefit, or
b. the end of the taxable year in which the payment is made.
c. So if you pay last six months of Year 1 and first six months of Year 2, you can
deduct it all in Year 1.
o Takeover expenses: Indopco
 Expenses to arrange friendly takeover instead of hostile: Can you deduct these currently, or are
they CE?

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 1. TP’s argument: It’s like a repair; defensive expenses
2. Counter: These expenses create/enhance an existing though intangible asset.
a. This is the argument that wins in Indopco. If expenditures create significant
future benefits, they’re CE.
b. Significant future benefits: SCOTUS cited proxy statements soliciting favorable
vote of the shareholders.
c. So TP was hoist on its own petard.
 How to deal with these CE?
1. No amortization provided under regs for 263; 197 won’t apply.
2. So there’s no write-off, ever. Unless company goes out of existence, but then CE is
worthless.
 Amounts spent on employee compensation, de minimus costs and overhead are treated as
amounts that don’t facilitate a transaction like this. Limits reach of Indopco.
 If defensive transaction fails: expenses probably currently deductible. See § 1.265(a)-5.

II. Intro to Consumption Taxes; Policy Considerations: Evaluating Systems/Provisions

(Unit 2)
o Annual consumption taxes
o Different kinds of consumption taxes
 retail sales tax or VAT
1. advantage is that in many ways, it’s simpler to collect that other kinds of consumption
taxes or an income tax; can use one rate or a couple of rate; no very many exemptions
2. VAT – a little more complicated than a retail sales tax, but similar in that, at the end of
the day, taxing consumption and consumer bears the burden
3. Cost of collection lower than other kinds of consumption taxes or the income tax
4. Issue - rate would have to be high – 30% - prices go up on everything you buy
 wage tax
1. no proponent of this calls it a wage tax – calls it a flat rate income tax
2. since taking a lot of stuff out of the base, have to make the rates higher
3. would tax wages currently, regardless of whether you save/consume them; tax is upfront
4. FICA resembles wage tax
 cash-flow consumption tax
1. going after consumption, exempts savings and investment; comes close to an income tax
2. doesn’t tax wages you invest (unlike under a wage tax)
3. current tax system is really a hybrid – has elements of a cash-flow consumption tax and
an income tax

• Tax policy considerations - things to understand

o equity/fairness
 major focus of policymakers; primarily a legislative concern
 horizontal equity
1. those w/ same amount of income should pay same tax – equals should be treated equally
2. what measure of income do we use – by definition, the code does this
3. economic income – anything that removes income from the base violates horizontal
equity; not pure SHS

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 4. if treating people with same amount of economic income differently, should think about
why doing it –
5. Provisions that vary based on type of income violate horizontal equity.
 vertical equity
1. controversial
2. looks at those with different amounts of income  those with different amounts of
income ought to bear an appropriately different burden
3. what’s appropriate? Three measures
a. progressive – suggests that as your income goes up, you pay more total tax and,
at each level of higher income, pay a larger percentage
i. generally, theory that we should distribute burden based on ability to pay
ii. declining marginal utility of money – as your income goes up, each extra
dollar provides less utility
iii. for poorer people, every dollar earned goes towards necessity; someone
like Bill Gates – only so much you can do with your money, taking a
higher percentage from these people means less overall sacrifice for the
rich people
iv. how progressive? Highest rate ever was over 92% (although very few
people paid this)
1. top rate now is 35%
2. look at rates and base – can’t just look at the rates
b. flat rate – everyone pays same rate – decreasing marginal utility doesn’t matter
i. even in this system, those with higher income pay more tax
ii. true proportional system would tax all income and no exemptions
1. once you add exemptions, have a 2 rate system – some income
won’t be taxed (0% rate for exempted income; tax rate for other
income)
2. this is why there’s never been a true flat-rate system.
c. regressive – no one ever says they’re in favor of regressive taxation
i. As income goes up, you pay lesser percentage of total income in tax.
ii. VAT  a supporters in favor of regressive taxation
iii. Most consumption taxes are regressive even though just one rate
1. Not all, though. You can make a CFC tax progressive, but
requires higher rates – more steeply progressive.
iv. Poorer people pay a higher percentage of total income in taxes
v. This is a factor that holds up the imposition of a VAT
o economic efficiency
 Virtually impossible to achieve pareto optimality and superiority in regulation for taxes.
1. Pareto = leave someone better off but nobody worse off.
2. This measure of efficiency is useless.
 Tax law focuses on cost-benefit analysis (Kalder-Hicks). If benefits > costs, it’s efficient.
1. Policy move is desirable as long as the winners exceed the losers and the winners could
compensate the losers for their loss
2. Just b/c benefits exceed the cost, doesn’t mean you do – have to consider other things;
but this informs the analysis
3. Makes sense to know the costs and benefits of a particular move

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 4. Often used in tax law when deciding on whether to make a change – on the whole, is this
a good move
5. Greater role in other kinds of regulations outside of tax
o neutrality
 theory is that tax policy should have as little as possible an effect on behavior
 suggests that the best systems are those with the less distortion
 assumption that free market is the best way to allocate resources – allow invisible hand to allocate
rather than the gov.
o complexity
 idea is that a tax system should be as simple as possible b/c complex systems impose high
transaction costs for government and taxpayers
 those costs spent on lawyers and accountants; administrative costs  deadweight losses –
resource wasters
 effect of this criteria obviously not great, but once you figure out other goals, try to make it as
simple as possible
o Wage tax
 Problem is that is slams those who get all or most of income from wages, as opposed to
investment income (horizontal equity)
 Also an issue with vertical equity  capped, so that the more you make, the less percentage you
pay in FICA tax  regressive
 Proposal  fund social security reform – eliminate the cap, but keep the percentage the same 
trying to do it without calling it a tax increase
o Optimal taxation
 Says we should try to tax or tax more heavily those things that have a lesser substitution effect;
where behavior is elastic, relatively unchanged by the tax
1. E.g. sin taxes
 Won’t find much effect on the income tax system
1. E.g. gambling winnings should be taxed higher than ordinary income
 more of an effect on other kinds of taxes, not the income tax
o substitution effect/income effect
 with an income tax, the return on savings is taxed no matter consumption; consumption system,
wouldn’t pay a tax unless and until you consume
 proponents of consumption tax say that it would increase savings and investment
 Substitution effect  says that having an income base that taxes savings no matter consumption
timing and having an income tax makes people substitute income for savings  If I have to pay
the tax anyway, no need to delay gratification
1. issue  offsetting income effect – says that if you have a targeted goal (e.g. you need $X
to retire), have to save more to get to that target
 same idea with work and leisure
1. income tax that taxes your wages regardless of consumption has a substitution effect 
work less consume more
2. income effect  if you want so much income after tax in order to consume, when they
tax it and take 35% have to work that much more
o Tax expenditures
 Tax expenditure theory divides tax system into two types of provisions

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 1. “Baseline” or normal provisions: provisions that properly help define income, basis.
2. Tax expenditures: everything else. Serve some social or economic program purposes;
figure out which ones they are, find out how much they are costing, and compare doing
program through tax system vs. more direct method to see which is more effective
a. criticism – under this analysis, likely to flunk.
b. Hard to argue that IRS ought to be in charge of a certain program. Interferes with
IRS’s major revenue-raising goal; and it has to have regs to implement certain
deductions.
 problems
1. putting govt program in tax code puts wrong agency in charge (e.g. energy policy,
housing policy, etc)
2. by having it buried in the tax code, makes it easier to hide the programs from taxpayers –
no one really doing a cost benefit analysis or asking if a program makes sense
3. what comes out of it – tax expenditure budget – one that lists tax expenditures in the
budget – know what the programs are costing – when someone proposing something,
trying to avoid having it be called a tax expenditure – will try to call it baseline
a. argument that it’s too hard to make the distinction, so shouldn’t do it – but
distinctions and decisions are always hard to make
 Why Peroni likes tax expenditure theory – both left and right hate it
1. left – way to sneak in government programs
2. right – assuming that money belongs to the gov –
a. answer – the money’s already there – the issue is whether it makes sense to divert
resources to the program done in this specific way
 benefits: why tax expenditures may be better than direct programs
1. Surrey always found tax expenditures wanting
2. may be better to administer some programs through the tax programs  less of a stigma
for some benefits for poor people
3. charitable contribution deduction – lets people decide where to donate money rather than
the govt. Gov can’t decide wrt church donations – constitutional issue
4. deductions for state/local property taxes: kind of like revenue-sharing. And you’ve paid
taxes to one sovereign, which reduces your ability to pay the other; so this is more like a
baseline provision. (Still, treated like a tax expenditure.)
5. Don’t have to create a new bureaucracy to carry out a program.
 why allowed this way when couldn’t do directly – SCOTUS says so
 In TE, identification of expenditures as govt. programs is meant to bring transparency and
accountability; Surrey didn’t want govt. programs hidden in code provisions to avoid scrutiny.
1. Shift toward doing programs through tax system creates lack of accountability, which
makes making programs popular. Politically, it’s harder to get direct govt. programs
through Congress.
2. End result with tax preferences is that they’re normally captured by someone else,
through capitalization of benefits, so intended beneficiary is no better off.
a. i.e., credits/deductions for education – universities just raised tuition.
b. i.e., home mortgage interest deduction: helps existing homeowners more than
prospective homeowners; allows house prices to be higher than they normally
would be. Sellers are better off.
o Progressivity: arguments for and against
 Against:

27
 1. Substitution effect: As you progressively take more in tax from someone’s income,
people will substitute leisure for work, and encourages current consumption over savings.
2. Redistribution: It’s un-American, against the capitalist system. (Or, you don’t believe in
redistribution through the tax system.
3. More transaction costs: More gaming; higher the rates, the more pressure to create
explicit preferences and have more aggressive tax maneuvers.
4. Off-the-books economy: Progressivity encourages bartering, underground economy
5. Libertarian/property rights (counter to “ability to pay”): So what if I earned more? I
should get to keep it!
6. Discourages productive activity; takes away more from those who produce econ. activity.
 For:
1. Income effect (counter to substitution): You have to work more and play less to get same
after-tax income, and you have to save instead of consume.
2. Redistribution: Take from the top and use it to direct govt. programs for people who are
less well off.
3. “Veil of ignorance”: If you entered world with uncertain outcomes and could contract
with others, you’d come out with something like a progressive rate structure with
redistribution. If you don’t know whether you’ll be a winner or loser, you’ll take the
chance that if you’re a winner, you’ll pay more.
4. Ability to pay/utilitarian theory/declining marginal utility of money
a. Technical argument: As income goes up, you not only have more ability to pay,
but a greater ability to pay a greater amount.
b. Each progressively higher dollar provides less utility than the lower dollars. So
you can afford to sacrifice more.

o Examples of different systems at work

o loans under cash flow consumption tax: you always get a deduction for the principal repayment and the
interest payment, regardless of whether the loan is used for business and investment or consumption.
And the loan proceeds always go in income. The only difference between loans used for
business/investment versus loans used for consumption is that if the loan proceeds are used for
savings/investment, there is a deduction in the year that they are so used.
o Year 1: $60K income; borrows $10K cash to buy stock; puts $1K in savings account
o Year 2: $60K income; sells stock for $9K; pays $400 interest on the loan; withdraws $40 from savings
account
o income tax
 Year 1
1. $60K – goes into gross income
2. $10K for stock – not income; no deduction; it’s basis, have to keep track of it
3. $1K in savings account – no deduction; that her wages won’t be spent on consumption,
doesn’t matter
 Year 2
1. $60K – goes into gross income
2. $40 interest – goes into GI
3. $9K sale – (loss on the sale of $1K) – loss doesn’t go into gross income
a. LTCL – deduction of $1K
4. $400 interest payment – deduction – cost of producing income – subject to limitation in
613(d) – limited to total investment income for the year
a. as long as the loan is still outstanding, no income
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 b. what if in year 4, the loan is discharged  forgiveness = income
o Cash flow consumption
 Year 1
1. $60K – taxed
2. $10K loan – taxed normally if for consumption
a. get a deduction for the cost of business or investment assets
b. b/c loan going for investment  deduction
3. $1K in savings – deduction
 Year 2
1. $60K – taxed
2. $9K – taxed
3. $400 interest payment – deduction
a. if going to creditor – principle payments on the loan get a deduction – taxed you
on the proceeds up front
4. withdrawal of $40 – taxed
o wage tax
 $60K taxed
 everything else not wages  not taxed
1. presumes that wages are consumed, so a kind of consumption tax; for wage earners that
are savers, they get overtaxed
o treatment of loans
 in an income tax system, we don’t tax borrowed funds when they are borrowed (asset increase
offset by increased liability)
1. principle payments don’t get a deduction (interest may or may not be deductible)
2. if the borrowed funds don’t produce income  argument that no deduction for interest
should be allowed (e.g. cost of producing income)
 compare with cash flow consumption tax
1. borrow $1M in year 1 and pay back in year 4
2. borrowed funds go in the base
3. if you consume it in year 1, get taxed
4. repayment is deductible
5. net result is the same  you still pay a tax on the money; income tax = consume first pay
later; consumption = pay as you consume
 Treatment of borrowed funds is one big reason CFC hasn’t taken hold. We’re a debtor nation; any
system that delays tax pain on borrowing is more consistent with our national traits.
1. But, our system is complicated because we have to keep track of borrowed funds; creates
a need for cancellation of indebtedness doctrine; and encourages borrowing for
consumption, and borrowing to engage in a tax shelter.
2. Some politicians have proposed a CFC that leaves out savings and leaves borrowed funds
out of the tax base. Peroni: Terrible idea! That expands shelter opportunity and
undermines savings potential by creating incentive to consume.
o How does our actual income tax, as opposed to SHS, differ from CFC?
 Realization reqt.
 Nonrecognition provisions: If you reinvest in certain kinds of exchanges, we tax you later, not
when you make the exchange.
 Pensions, Roth IRAs: reflect CFC treatment; money set aside but not taxed b/c not consumed.

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  Tax-exempt bond interest: §103 allows you to exclude interest income. In CFC, all interest would
be excluded as long as you save it.
 Many elements are CFC-like in their approach; as we add more features like this, we come closer
to CFC tax.
 Borrowed funds is one area where the two are still very far apart.

III. The Outer Limits of Gross Income (Unit 3)

o Tax Treatment of Windfalls
o court-awarded damages
 has to be a difference between how we treat certain elements of the award
1. look at the underlying claim that gives rise to each recovery  what were damages
received in lieu of?
 lost profits  ordinary income; replacing what would have been income, so tax the same way; no
sale or exchange of property
 §104(a)(2) allows some damages to be excluded - lost wages (if personal injury), pain/suffering
1. notice that analysis wrt lost profits falls apart wrt lost wages
2. Congress decided not to tax – idea that have suffered enough; you’ve given up something
and we can’t figure out what that basis is, so not going to try
3. corp. taxpayers can never qualify
 punitive damages = windfall
1. Glenshaw Glass: To be windfall and go into GI, has to be:
a. accession to wealth
b. realization
c. dominion and control by taxpayer
2. just b/c a windfall doesn’t make it not income
3. ordinary income – no sale or exchange of a capital asset, so not capital gains
a. all types of windfalls are generally income; § 74 – confirms that prizes and
awards are taxed; some small exceptions
b. 1.61-14(a): reinforces that windfalls go into GI.
 destruction of goodwill
1. self-created goodwill  zero basis
a. the kinds of costs that go towards creating goodwill are deductible
i. advertising a common source of goodwill, but it’s currently deductible.
ii. sometimes will have a basis in goodwill – e.g. Welch v. Helvering –
better analysis is that reason expenses not deductible b/c failed to meet
2nd definition of ordinary  a capital expenditure  one example where
someone who creates own business will have a basis in the goodwill
b. taxed – Raytheon treats kind of like a forced sale  sale/exchange  § 61(a)(3)
c. character
i. self-created goodwill is a capital asset under § 1221 – not amortizable
under the code (so, not kicked out under § 1221(a)(2))  § 197
(amortization of goodwill and other intangibles) doesn’t apply to self-
created goodwill
ii. more than a year – LTCG – preferential rate of 15%
2. purchased goodwill  amortizable basis

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 a. assets can be tangibles and intangibles plus goodwill – residual value that’s in
excess of other intangible assets
b. it’s an asset, so if you purchase a business rather than self-create it, generally
there’s a basis in goodwill
c. § 197 allows a taxpayer to amortize purchased goodwill over a 15 year period;
not allowed for self-created goodwill
d. gain for award for destruction of goodwill  amount realized (jury award) minus
basis (cost) plus you add back in to this amount any amount you took for
amortization
i. e.g. $30K cost basis; $10K in deductions; $100K award  $80K taxable
e. character – is it a capital asset (it’s goodwill)?
i. start at § 1221 – 1221(a)(2) kicks it out
ii. picked up by § 1231 if held for more than a year (trade or business held
for more than a year)
iii. if held for one year or less – would be ord. income
f. recapture
i. we treat amortization deductions under § 197 like depreciation
ii. recapture – to the extent of any amortization or depreciation taken –
before dealing with § 1231, have to first deal with § 1245  when you
sell at a gain, the part of gain traceable to prior ord. deduction will be
characterized as ordinary
iii. so, in above example, $70K is § 1231 gain; $10K is 1245 ordinary gain
3. when a purchaser acquires an existing business and it’s structured as an asset acquisition
as opposed to a stock acquisition
a. treated like a purchase of every asset and sale of every asset
b. have to allocate price among the assets per market value – IRS will only respect
allocation that reflects economic reality
o Treasure trove
 found money is income even though a windfall
1. income in the year it is reduced to undisputed possession
 1.61-14  reg wrt treasure trove
 ordinary income  no sale or exchange
 realization event? when is the realization event?
1. Peroni  2 possibilities (and a third if you try to find the rightful owner)
a. year 1 – when you literally have the treasure trove in your house – e.g. when you
bought the desk the expensive necklace is in
b. Year X (later) – when you find it and reduce it to your possession and
control
c. if you go to the cops and the police don’t give it back to you until a year later b/c
couldn’t find the owner – year 9 might be a possibility (wouldn’t be undisputed
possession until police give back to you)
2. Answer  year X (the year of discovery and reduction to undisputed possession)
a. but, doesn’t matter if title voidable under state law in determining possession
b. if T tried to find rightful owner, that delays income; there’s accession to wealth
and realization, but not dominion/control.
 when you get it in something other than cash, have to value it at its fair market value
1. same with Michael Jordan jersey hypo – what’s the relevant market?
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 a. probably collectors market (higher value), not sporting goods store market
b. seems like harsh result if TP doesn’t have cash to pay the tax; but also seems like
an optimal tax, because you wouldn’t harm economic activity or affect behavior.
c. Yet in a self-assessment system, we worry about taxing things people don’t see
as income. Leaves it to IRS to use discretion.
i. But if you sell it or contribute to charity, then IRS will tax it.
2. usually use objective valuation standards
a. doesn’t matter what the finder thinks about it
b. use “willing buyer/willing seller” standard.
 What about basis?
1. e.g. if necklace found in desk, can we reduce the income by allocating some of the basis
in the desk?
a. no – allocation of basis when you buy multiple things occurs at time you acquire
them – if you are unaware of jewelry, can’t allocate basis to it
2. what about land – don’t know about natural resources when you buy
a. can you allocate any of your basis in the land to the now-discovered natural
resources  no  to allocate, have to do at the time of purchase in relation to
the resources (e.g. finding costs)
3. T’s basis  when you acquire non-cash prop that you are required to report as income,
basis is the amount included in income  tax cost basis  idea that this money has
already been through the system once
a. e.g. discovery is $10K; sell for $20K  adjusted basis is $10K
b. baseball example  basis in ball is whatever you reported as GI from the ball
o bargain purchase at arm’s length – “good deal” exception
 discovery that what you bought is really worth a lot more than what you paid
 not gross income
 no realization until disposition of asset – discovery of the true value isn’t the realization event!!
 basis is the cost of the item you thought was just a regular item – what you paid.
 natural resources  learning about oil not a realization event; extraction of the resource is
 idea is that as long as you have an arms-length transaction (e.g. not relatives, employer/employee)
of property for cash, under the commercial bargain purchase doctrine, not income

o Tax treatment of illegal or unethical activities

o no exception for ill-gotten gains  no matter how heinous the act, proceeds are taxable income
o doesn’t matter if you have to pay back what you stole
 James  don’t care about vague state law title notions – all income
 under James  income in the year of embezzlement
o How does this affect our treatment of loans?
 here we’re saying that even if you have a legal obligation to pay back. it’s still income  what’s
the difference between a loan and ill-gotten gains?
1. not intending to treat a loan as something you don’t have to pay back….
 what if you’re a corp. officer and you are making withdrawals and the gov has decided to go after
you for tax fraud for failing to report as income (not charging you with embezzlement) – what
will tax payer try to establish to avoid criminal tax fraud charges?
1. with corp. officers, will depend on authority, what funds were used for, etc…
2. counsel trying to est. that it’s more like a loan than gains from embezzlement
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o embezzlement  even if you lose part of the proceeds, by gambling, for example, doesn’t affect the
amount you have to report as income – whole amount
 what about when amount taken is paid back?
1. Murphree; rev rule 65-254
a. ordinary loss on transaction entered into for profit - §165(c)(2)
i. itemized, below the line deduction
ii. subject to the 2% rule in §67 and 3% rule in §68
b. if in the business of embezzling, deduct under §165(c)(1)
 should public policy forbid the deduction
1. if deduction is under § 162 or § 212  are exclusive; Congress has decided when § 162
or § 212 deductions should be disallowed for public policy reasons
2. court’s only role is to apply limitations wrt public policy as imposed by Congress 
can’t come up with own public policy limitations  such a limitation doesn’t apply to §
165, courts free to use public policy
3. almost all courts have said that disallowing the deduction would discourage restitution;
allowing deduction in the embezzlement situation fosters public policy
a. whether public policy affects – three approaches
i. go back to § 162 and § 212 legislative history and apply to 165
ii. even if not bound by § 162 and § 212, will follow here – is this the kind
of situation like where congress disallows the deduction?
iii. no public policy limitations, Congress hasn’t put any in – very few courts
b. almost ever court would allow this deduction
i. situations other than embezzlement where outcome is different
4. if in Jail – no income for year 2
a. § 172 – net operating loss carry back/carry forward in certain cases where
certain deductions > income, you carry back so many years to see if you can use
b. THIS DEDUCTION DOESN’T QUALIFY FOR THIS CARRY BACK
c. Most courts not very sympathetic in stretching §172 to cover this.
o unlawful occupations/enterprises  ordinary income
 drug dealer  ordinary income  held for sale to customers so not a capital asset
1. § 280E – drug dealers, no deduction or credit allowed for carrying on a trade or business
– means you are taxed on gross income, not what would normally be taxable income;
ALL EXPENSES WOULD BE DISALLOWED
2. what about costs of goods sold? (analogous to basis)
a. not a deduction or credit….
3. is it constitutional to tax on gross income?
a. unclear; no one has brought a case
o Deductions for illegal businesses
 are expenses deductible? ordinary (both meanings), necessary, carrying on trade or business;
public policy limitations
1. if public policy limitation applies, don’t have to do any more analysis; by putting public
policy limitations in the code, Congress intended for limitations to be exclusive  meant
to override judicial public policy that had come before  limitations applied to § 212
2. judicial public policy doctrine if legislature has its way is dead under § 162 and § 212;
but may still be good for § 165
a. unless you can fit the situation under a public policy limitation under the code,
can’t use public policy to disallow
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 3. § 162(c)(1) – bribes disallowed – when payment is to a government official or employee,
issue is whether it’s an illegal bribe/kickback; doesn’t matter that law isn’t ever enforced;
if a foreign official, have to see if illegal under foreign corrupt practices act
4. § 162(c)(2) – other illegal payments – payments not falling under (c)(1) but constitute an
illegal payment under any law of the US or state law (but if state law, law has to be
generally enforced), which subjects the payor to criminal penalty or loss of license
a. have to know whether what’s being paid for is part of the crime and, if state law,
whether the law is generally enforced (e.g. motel room payments for a hooker –
would the other legal activity of paying for a motel room be treated as part of the
crime of prostitution? Unlikely – Congress making it clear under § 162 that it’s
only going to disallow otherwise legal expenses in narrow circumstances)
5. § 162(c)(3) – Medicare and Medicaid fraud
6. § 162(f)  no deduction allowed for any fine/penalty paid to govt. for violating any law
a. hypo – football player engages in violent behavior on field (more so than usual);
NFL imposes a fine of $100K; necessary and ordinary; not capital expenditure;
carrying on business; NFL not a government, so § 162(f) doesn’t apply; Congress
has decided not to extend (f) to civil penalties in private lawsuits; fine not
disallowed but is it deductible?  why not? if this were tennis, might be a
different answer, but in football, might be part of the normal conduct of a player
b. settlements with governments – if the purpose of the provision under which the
payment is made is supposed to punitive, falls under § 162(f); if purpose is
restorative, for example, doesn’t fall under (f); Exxon oil spill  costs of clean-
up; settlements  necessary, ordinary, not a capital expenditure  no public
policy disallowance  should statute be amended to disallow the deduction for
clean up expenses?  loss of deduction increases cost of accidents, more
incentive to be careful  but question of whether increased cost will deter
anything, so maybe will only discourage people to engage in this business
 legal fees – probably deductible if origin is in business activity
1. questions as to whether allowing this deduction is violative of public policy limitations in
§ 162  courts have said that incurring legal fees to defend yourself against a crime that
arises out of business activity fit within § 162
2. disallowing the legal fees would work against constitutional policy of right to counsel
3. have to look at underlying claim’s connection w/ bus. activities that gave rise to criminal
prosecution or civil action; if directly connected, proximately resulted from business,
under case law they’re deductible.
4. what about OJ’s legal expenses? didn’t arise out of business activity; if underlying thing
is personal, not within § 162, origin not business
o Civil damages and deductions
 Dancer  involved horse trainers who got in an accident while driving for business; car accident
not part of the business, but the driving happened while in pursuit of the business  court says
not unexpected that if driving is part of business, will get into accidents and have to pay money
 ordinary negligence accidents while driving in pursuit of business  meets ordinary and
necessary standard  allowed to deduct legal fees and damage award or settlement
1. what if commuting from home and decide to stop off at a bar before you get home  can
you argue you were on way home from work and therefore in pursuit of business 
commuting seen as personal; almost certainly a detour.

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 2. what if you stopped at the office party  can you argue it’s part of the business to show
up and be social and fit in by drinking  tougher case than the bar example, but court
might say depends on what kind of accident (e.g. drunk driving not ordinary and
necessary); ordinary and necessary requires an inquiry into whether there’s a nexus
between the activity and pursuit of the business
 Gilliam  just b/c arises from business doesn’t make it automatically deductible  business man
taking business trip; has an incident on the plane and attacks a flight attendant; argues that legal
fees and other costs should be deductible b/c he was on a business trip, in pursuit of business 
not unexpected that people might wig out on a plane  court says distinguishable from Dancer
 no deduction  fact that incident occurred on business trip didn’t mean that activity was in
direct pursuit of the business
1. as the behavior becomes more common  better argument that it’s ordinary and
necessary? But issue that assaulting a flight attendant not directly in pursuit of the
business
 Paying civil damages, punitives  deductible – Rev Ruling 80-211
1. underlying activity arises in the business and is ordinary and necessary

o Introduction to the Realization Requirement

o Corporate tax and dividend info
 tax system in the US for corporations is classical  tax income twice  treat the corp. as a
separate taxpayer from its shareholders
 pay tax at the rates in § 11 – top rate is 35%. no CG preference in corp. taxation – but still care
about character b/c still subject to capital loss limit in § 1211
 once the corp. takes net earnings and does a dividend, tax the distribution to the shareholders
 § 1(h)(11) treats dividend income at CG rates but ordinary income (expires in 2009)
 if you see dividend income
1. it’s ordinary income  § 61(a)(7)
2. except tax rate that applies, if it’s qualified dividend income, is same as CG rate
3. step 4 – tentative tax – apply lower rate
 corp tax issue – don’t know who bears the burden when there is actually a tax imposed  many
corps don’t pay any taxes at all
1. § 1(h)(11) – creates pressure to distribute dividends to shareholders
 closely held corporations  in theory a double tax; but self-help means paying things out in
salaries and deductible payments rather than dividends
1. § 162(a)(1) – reasonableness limit trying to limit salary to actual services
 some people can’t avoid the corp. tax  if corp. pays tax and then gives dividends  there are
double taxes, although dividends taxed at a preferential rate
1. qualified dividend income still ordinary income for § 1211 purposes – not capital gain
(but, taxed at preferential rate of capital gains)
o Pro-rata stock dividends
 § 305(a) - pro-rata stock dividends
1. generally not income
2. but it is income if:
a. shareholder can elect cash or stock
b. shareholders treated differently
c. if distribution is with respect to preferred stock
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 d. if distribution is with respect to convertible preferred stock common on common
with common being only class outstanding = no realization event
3. if something like common on common, no cash option and everyone gets treated the
same  no income on the dividend  idea is that your share of the corporate pie is the
same size, just cut into more, smaller pieces; no change in relative position.
a. not that it’ll never be taxed – when you sell it – tax will come into play then –
just a deferral
b. 305(a) codifies Eisner v. Macomber
c. Tax is deferred; you if/when you sell the shares.
 § 307 – basis in the new shares in the case of a pro-rata stock dividend
1. e.g. $12K basis in original 1,000 shares; pro-rata dividend gives 200 more shares; spread
original basis among 1,200 shares in accordance with FMV = $10 per share basis
2. 1223(a)(4): holding period for old shares applies to new shares – tacks on
3. have to keep track of the basis for when you sell
a. default rule – first in, first out. 1.1012-1(c)
i. if you make no special election – tax law treats shares sold as coming out
of first acquired shares
b. most people want specific identification – pick high-basis shares first and low-
basis shares later [e.g. have one basis for shares bought at one time (including
shares received as a dividend); and another basis for shares purchased later at a
different price]
i. in order to do this, have to identify shares at the time you sell
c. 3 option – average cost. once elected have to do so consistently -- complicated
rd

 § 305(b)(1): if there’s choice b/w getting shares or something else, it’s included in GI and
taxable. Choice is the key; doesn’t matter if everyone chooses cash or chooses shares. Fact that
you could elect takes you out of the Eisner protection.
1. what’s the measure of the income?
a. FMV – e.g. $20 per share; 200 shares  200 x $20 = $4K
b. character is OI, but taxed at CG rates – 1(h)(11) – qualified dividend income
c. realization event  not just more pieces of paper, but also increased proportional
share of the corp. b/c of those who chose to take the cash
2. basis:
a. basis = cost = tax cost; the FMV of the shares (remember – tax cost is the value
that you will be taxed on)
b. since we treat this as a separate realization event, have to give a basis as the
taxable amount b/c don’t want to run same money through the system twice
c. holding period? don’t get to tack on – different event. 1223(4).
 stock split - § 1036 – no tax on stock split
1. in splits and stock dividends, get more certificates in co. you’re already invested in
2. difference is in how treated internally within the company
a. with a split – getting more pieces of paper within the same corp. – can be positive
– e.g. one for one; or reverse – e.g. 1 for every 2 you already own
i. companies trying to mess with the price of each share
ii. theory is that more pieces of paper with a split, lowers price and makes
stock more attractive
b. stock dividend – like other dividends, requires that corp. have earned a surplus

36
 i. actually have some additional restrictions imposed b/c of having to move
money around at the corp. level.
ii. from shareholder’s POV – pro-rata dividend = more pieces of paper
(same as in positive split) – same proportional interest in the corp. –
control, earnings, liquidation preference.
iii. does combo of more pieces of paper along with accounting changes at
the corp. level enough to make stock dividend a taxable realization
event? NO.
o Subdivision of property
 The act of subdividing the property is not a realization event
1. even if total value of the property is enhanced!!!
2. basis and holding period remain the same.
 Determining basis when the lots are sold
1. if different values - probably have to hire an appraiser to determine how to allocate since
some lots are more valuable than others
a. based on FMV at the time you acquired the prop. (see p. 403)
2. if same value for each piece, divide basis proportionally among the lots; if size
difference, but nothing more valuable – allocate based on size and proportional value
 Investor property may become dealer property through subdivision or conversion. (like condos)
o Improvements to rental property made by lessee
 § 109  lessor does not realize gross income on reversion/termination of the lease even when the
property is worth more at that time b/c of improvements made by lessee
 Basis for lessor doesn’t increase b/c of improvements; no basis in the building per § 1019
1. L’s basis in the land not impacted by the construction of the building
 When lease terminated  whether or not there’s a realization event will determine basis in the
building (NOTE: this issue doesn’t effect realization for the land – this won’t be taxed until
transferred or sold)
1. interest has changed from future contingent interest to actual ownership  Helvering
says it’s a realization event (says it doesn’t matter whether it’s windfall or disguised
rent); therefore, OI in amount of FMV at date of reversion
2. BUT Congress changed this  reversion not a realization event in some instances 
§109  improvements on land at termination of lease are not included in GI if not rent
 if the building is disguised rent, § 109 doesn’t apply
3. § 1019  if § 109 applies, § 1019 tells us common tax sense  your basis is 0; if
Congress wanted § 109 to be a permanent exclusion (never taxed) would have to give
you a basis equal to the amount taxed  netting out to zero; without § 1019, would have
to speculate about what § 109 does
 when selling raw land and building, have to take the price and allocate it between the 2 assets;
purchaser has to do the same thing
1. why – b/c the land isn’t depreciable; classic non-depreciable capital expenditure
2. amount realized – example  $325K ($175K allocable to land; $150K for the building)
(basis in land = $50K)
3. gain  $125K for land ($175 amount realized minus $50K basis)
a.  $150K for building – no basis
4. character
a. land –§ 1231 gain of $125K

37
 i. § 1221(a)(2)  kick out real prop. used in trade or business whether
depreciable or not  go to § 1231 b/c held for more than a year
b. building – § 1231 gain of $150K – prop used in trade or business, held for more
than a year (if held a year or less, not a capital asset or a § 1231 asset – ordinary)
c. suppose some depreciation – depreciation recapture doesn’t apply to real estate
i. capital gain here that might come through § 1231 – to the extent that it’s
traceable to depreciation, no recapture, but the rate preference is 25%
o when improvements are essentially substitute for rent
 e.g. under the terms of the lease agreement with L, T had agreed to construct the building; fair
rental value of L’s land was $9K per year, T only had to pay rent of $4K per year?
 it’s at least some disguised rent b/c of the lower rent and maybe something of a windfall
 Helvering applies; § 109 exception applies b/c this is rent
 Upon termination of the lease, have GI equal to FMV of the improvement (ordinary income)
 Basis  § 1012 tax cost basis is equal to FMV
1. Thus, if you then sold the building for $150K and its FMV at the time of termination of
the lease was $125K have a gain of $25K ($150K minus $ 125K = $25K)
2. § 1231 gain
 character – does T’s characterization on disposition (sale) depend on T’s characterization upon
termination of lease (ord. income)?  generally no; we determine character at time of disposition
 whether he had to report income in year 3 or not doesn’t affect treatment of character in year 4
 what if held for 1 year or less but used in a trade or business? Not a capital asset and not a 1231
asset  ordinary income and ordinary loss
o Remember that RECAPTURE DOESN’T APPLY TO REAL ESTATE
 what about § 1250 – kind of recapture that applies to real estate
 unrecaptured § 1250 gain in § 1(h)  label doesn’t make any sense
1. it’s in 1(h), so this unrecaptured § 1250 gain is still capital gains for purposes of the gain
 not ordinary income recapture like § 1245 is
2. created in 1997  argument that if gain is attributable to past depreciation deductions,
should be able to recapture as ordinary income  real estate industry hates this
3. congress splits the baby  § 1245 won’t apply, but gets taxed as capital gains, but not
the lower 15% rate, 25%
a. problem above  since L gets a basis in the building in some cases, in theory L
would probably start taking depreciation in the year of termination  basis
would be lower, more gain upon sale  gain on the building would be part §
1231 gain (that part of gain not attributable to any depreciation); other gain
would be taxed at 25% under § 1250
o Like-kind exchanges
 if an economic substitute (e.g. risk and everything else is the same)  not a realization event
1. exchange  materially different  realization event
 2 classic realization events involving property  cash sales and property-for-property exchange
 if a realization event – go to § 1001: amount realized is FMV of what you receive
 Cottage Savings – most recent SCOTUS case on realization issue
1. court had to deal with whether exchange of mortgage pools – where different debtors and
property, but economic substitutes – was a realization event

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 2. differing materially in kind or extent  in defining a realization event, regs seem to
suggest that when you have an exchange, the prop has to be materially different in kind
or extent  court had to deal with what these words meant
a. Materially different in kind or extent  what does it mean?
i. important b/c could use loss to offset income; want t a deduction sooner
rather than later
b. under banking regs and economic market evals – swaps only took place where
the pools were economic substitutes – swappers not changing economic positions
i. engaging in the swap to get a deduction and a loss
3. b/c of why swaps taking place, govt wants test to be = different in economic substance
(not economic substitutes)
a. reg wording in there for many years, so have a tough time b/c this test not in the
regs and now trying to tell the court its meaning although couldn’t point to
anything that said that this was really the interpretation
4. SCOTUS 
a. looking at prior corp. tax cases  stand for principle that materially different if
legal entitlements different in kind or extent
i. e.g. different debtors, different properties
ii. realization here – corp. gets loss deduction
5. Peroni 
a. what if gov won the case?
b. Peroni: court did govt. favor by rejecting its proposed standard
c. test gov proposed would end up being major loss for the government; would
avoid taxpayers taking loss deductions, but in a self-assessment system based on
facts and circumstances, for every loss case the govt wins, will lose 30 gain cases
d. in gain cases, this test would allow you to elect whether to report income; could
come up with some reason why trade was/wasn’t economic substitutes
e. such a test = high transaction costs for TPs figuring it out, IRS trying to enforce
f. § 1031 – test proposed by gov would make this section superfluous b/c it’s a non-
recognition provision, which assumes a realization.
g. most exchanges that come under § 1031 as non-recognition would never be
realized
h. test that says no realization unless diff. in economic substance would read § 1031
out of the code – court refuses to do this
i. § 1031 commonly applies to swaps of one piece of investment real estate for
another piece of real estate. theory: properties are economic substitutes, therefore
not an appropriate occasion to impose tax.

o Non-Liquid Property Received in Kind as Compensation

o remember  comm.. bargains at arms length for cash: don’t tax unknown value – basis is still cash paid
 if I go buy a car and get a better deal than someone else, I don’t pay tax on the difference
o Key to the above  arms length
 once a relationship between buyer and seller, bargain element will be treated differently; e.g. if
related, presumption is that it’s a gift
o § 83  bargain purchases between an employer and a service provider

39
 § 83 added to the code to fortify § 61 analysis that form of compensation doesn’t matter  non-
cash property taxed to service provider no matter to whom the property is actually transferred –
e.g. doesn’t matter is property goes to service provider or someone else that he wants it to go to
 have to have property – 1.83-3(e) definition of property – real and personal property, tangible or
intangible other than money or unfunded and unsecured promises to pay cash in the future
1. investment real estate obviously applies
 only restrictions that will affect timing and amount of income are those listed in § 83; if
restriction doesn’t meet one of the tests, doesn’t affect the timing and amount of income
1. if no restrictions, no risk of forfeiture, & transferable – no deferral of the income
 Valuation
1. value it without regard to restrictions unless the restrictions don’t lapse
a. valuation: at time property = transferable or not subject to subst. risk of forfeiture
2. Only restrictions looked at when valuing property are perm. limitations on transferability
of property that never leave property (e.g. right of first refusal at formula price).
3. e.g. formula prices in an agreement  if you ever want to sell, have to offer to X at a
certain price  will affect valuation under § 83
 Timing
1. included in gross income at the time the rights are transferable OR are not subject to a
substantial risk of forfeiture, whichever is earlier
2. to delay timing – have to have a substantial risk of forfeiture AND non-transferability – if
one of these falls, tax it when that happens
 Income: FMV minus what you have to pay for it = income (ordinary)
 initial adjusted basis  cash paid plus amount reported as GI
1. basis tied to the timing and amount of income
 beginning of holding period: when property is reported as income, clock starts ticking
 property transferred in connection with performance of services (not in consideration for; applies
to past, present and future services; includes bonuses)
1. gift argument? very hard to make and win; transfers from employers generally not gifts.
 transferable = only if any transferee of property wouldn’t be subject to subst. risk of forfeiture
1. SRF follows the property no matter who it’s transferred to = non-transferable
2. where restriction doesn’t follow the property = transferable
 substantial risk of forfeiture – 4 definitions
3. Basic definition. Rights to full enjoyment are conditioned upon future performance of
substantial services by someone (“earn out” provision, common in start-ups). § 83(c)(1).
4. Treas. Reg. 1.83-3(c)(1): Broader than the statute: Defines SRF as present if rights are
conditioned on 1) future performance of substantial services by someone or 2) the
occurrence of a condition related to the purpose of the transfer.
a. incentive (includes negative stuff) – e.g. covenant not to compete – if you violate,
you lose the property (related to what’s in the reg.)
b. if you have a condition like where T will forfeit property if after year 4, the
earnings of the company have not increased by at least 5% per year  incentive
kind of condition (incentive-LIKE, not like straight up compensation)
5. Robinson v. Comm’r (1st Cir.). Broadest test (which violates leg. history of § 83): if
restriction serves significant noncompensatory business purpose of employer, it’s SRF.
a. Facts: Corp has purpose to restrict insider trading, imposed limit that once TP
purchases stock under an option, he could not sell it for 1 year. Held: a SRoF.
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 b. The uncertainty this causes in other circuits means, for TPs to report income
upon transfer, they should take § 83(b) election instead of saying: no SRoF.
6. § 83(c)(3)  sales which may give rise to liability under § 16(B) of Sec. Exchange Act
o § 83(b) election
 can elect to include in gross income in the year of transfer
 have to make the election within 30 days and can’t change your mind later
 accelerates timing of the tax, but this means that any appreciation in value is capital gains when
sold = better tax rate
1. contrast with situation where get prop. with FMV of $50K in year one for $10K; free and
clear in year 4, when value is $90K  amount included in gross income is $80K
2. increase in value is treated as OI (although when sold will be capital gain/loss)
 Valuation is the same: TP’s income is the FMV at the time of transfer, minus any amount paid for
the property. Only permanent restrictions affect value. The basis is §1012 cost: price paid +
amount included as income (FMV). The holding period starts when the property is transferred.
1. Upon making the § 83(b) election, § 83(a) will not apply to the property: any subsequent
appreciation is not taxable upon the removal of restrictions on the property.
 Upon forfeiture of property, no deduction allowed for amount previously included as income.
 When to use it?
1. When it seems tax cost of accelerating the § 83 OI inclusion will be more than made up
by the tax savings from converting ordinary income on appreciation into capital gain.
2. Factors: Is the property a cap. asset? Is the upfront reported income low? Is it 0 (then TP
should always make the election)? Is the property expected to appreciate substantially?
Does the TP have control of the condition (loss of forfeiture deduction not a risk)?
3. When you have very speculative interests worth very little upfront – use the election.
4. Also consider what will happen with tax rates – stay stable, or go up/down in future?
 taxpayer gets prop. subject to substantial risk of forfeiture, non-transferable; worth $10K, pays
$10K. At year 4, worth $90K (Alves)
1. when do you measure the bargain element?
2. if you make the election, you have income of $0
3. if you wait until year 4 – have $80K of income
4. taxpayer argues no bargain, so how can I have compensation? court says you didn’t make
the election; measure it in year 4 b/c no election made
5. lesson – make the election in this situation
 combine Alves and Robinson  client says I got stock in closely held corp. and they are worried
about securities regs, so company putting a 1 year restriction on sale. Restriction not related to
incentive or anything like that. Client says that I am having to pay $10K and it’s only worth
$10K. Looks like § 83, have to value it and report it upfront b/c not subject to substantial risk of
forfeiture. Client follows advice.
1. Year 5 and stock is worth $90K. We didn’t make election b/c reported up front b/c not
subject to a substantial risk of forfeiture. IRS agent says you have $80K in income b/c
restriction meets Robinson test and you didn’t make election, so we measure bargain
later. LESSON  make a protective § 83(b) election if you’re not sure about substantial
risk of forfeiture and if client wants to report up front
2. if you make money on the property before it’s substantially vested and you wait to report
(e.g. don’t make election) – any income earned is additional compensation income
a. e.g. dividend on stock, rental income
 Deduction by employer
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 1. Use of property other than cash in satisfying obligation is a realization event. §1.83-6.
2. §162 allows deduct,, but timing determined under §83(h) – then you run it through 162.
3. §83(h): deduction allowed for taxable year in which service provider includes it in GI.

o Barter Exchanges of Goods and Services

o gross income is the value of services received
 Rev. Ruling 79-24 – targeted bartering clubs
 may have potential deductions
o Substance over form: treat as if each party had paid for services and used it to pay the other one
o Ex.: T is solo legal practitioner. X is a dentist. T performs $5K of legal services for X in exchange for X
performing $5K worth of dental surgery on T. T’s legal work for X involved the defense of X in a prof.
malpractice suit. Determine the federal income tax consequences to T and X on account of this exchange.
 § 213 (a), (d)(1) – deductions for medical expenses not compensated for via insurance or
otherwise, to the extent that such expenses exceed 7.5% of gross income
 income of $5K for both
 each has to value the service of the other in determining amount of income (e.g. look at what you
get in exchange) – ordinary income b/c compensation
 clear that each has income – does each have a potential deduction?
1. each party is, in effect, paying the other for services and then just exchanged the money
back – so have income, but also a “payment”
 T - § 213 – dental expenses can be an itemized, below the line deduction – could qualify (if total
amount exceeds 7.5%, only the excess is deductible)
1. problem of trying to deduct is the 7.5% floor in § 213 – unless really expensive and you
don’t have insurance, no deduction
2. cosmetic stuff not included
 X - § 162 deduction – deduction b/c a malpractice suit  trade or business

o Imputed Income from Self-Provided Services and Ownership of Consumer Assets

o imputed income is a form of economic income
o decision not to tax it raises serious policy concerns
o departing from SHS and comprehensive definition of economic income
o imputed income = rental value that one has in the property they own (e.g. if they didn’t own it, how much
would they have to pay to rent it)
 big benefit of home ownership is rent-free use of the property – we don’t tax this form of
economic income (e.g. compare benefit of taking money and buying a house versus taking money
and buying stock  on one, the return (dividends) is taxed; on the other, the return (rent free use
of the house) is not taxed
 Or imputed income from services: could argue that it’s taxable, but where to draw the line?
1. Tax system has bias in favor of stay-at-home partners, because two-earner couples have
to pay someone else for household services; makes it more costly for them to do so.
 Psychic income: we don’t increase income to reflect psychic benefit you get from your job. And
no benefit for psychic loss. Means that jobs w/ lots of psychic income are favored in tax system.
o purposes = administrative issue – although you can value, it would be a pain in the ass; policy to
encourage home ownership (issue is that when you encourage people to do something they wouldn’t do in
the absence of preferences is called inefficiency)

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IV. Tax Treatment of Borrowing and Lending (Unit 5)
o Basic rules related to borrowing and lending
o Straight borrowing and loan repayment transactions
 One of the major differences between CFC and income tax system is way we treat loans.
1. CFC  proceeds of loans go into income; investments (savings) get deduction; personal
consumption not deducted; principal and interest payments deductible
2. with savings and investment loans – prevents sheltering; loan goes into income; with an
income tax, there’s a mismatch between when we tax and allow deductions
3. if you only take the feature of not taxing saving and investment income, you have a very
poorly designed consumption tax system
 in an income tax system, loans are not income
1. loans aren’t an accession to wealth; you have the offsetting obligation to repay
 big difference between IT and CFC: timing
1. SHS: consume now, pay later – incentive to borrow for consumption
2. CFC: pay tax upfront when you consume
 if an individual, start with presumption that personal interest isn’t deductible – if you want to
deduct, has to fall into certain categories
1. § 163(h)(2) – says what’s not “personal interest”
2. § 163(f)(2)
3. § 221 – income phase out making most education loan interest non-deductible
4. b/c we don’t tax you up front, can’t get a deduction for the principal; but you get taxed on
the income used to pay off the loan
o Below-market loans
 § 7872: recharacterizes supposedly interest-free loan into component parts
 idea: no such thing as below-market or interest-free loan; substance over form reflected in statute
 if no exceptions apply and it’s a loan and it’s interest free or below market, have to do recasting
1. idea that these “loans” are disguised transfers – gift, dividend?
2. e.g. employer loan  idea that it’s really compensation; if lender is corp.  idea that it’s
really a dividend; if it’s between family members  presumed to be a gift
 tells you 2 things
1. takes the amount of foregone interest and treat as a transfer from lender to transferee –
then have to analyze in accordance with the facts
2. then assume this amount of foregone interest is transferred back to transferor as interest
a. recipient has a potential interest deduction (§ 163(a))
b. transferor has interest income
3. bottom line: foregone interest is a transfer back from lender and then transferred back
 employer loan – example  On Jan. 1 of year 1, T’s employer makes an interest-free loan of
$20K to T. The loan is repayable on a demand basis. (If T’s employer had charged interest on this
loan at the applicable federal rate, the amount of T’s interest expense for year 1 would have been
$1200.) T uses the loan proceeds to finance an expensive around-the-world vacation trip.
1. foregone interest = $1200
2. § 7872: is this a loan? yes - (c)(1)(b) – compensation-related loan
3. exceptions
a. (c)(3) – de minimis exception for comp-related and corp-shareholder loans –
doesn’t apply here (exclusion if amount of loan doesn’t exceed $10K)
b. (c)(2): de minimis for gift loans < $10K (like parent-child) – not applicable here
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 c. (d): special rules for gift loans where aggregate proceeds don’t exceed $10K
4. treat forgone interest as a transfer from employer to T and, on the same day, a deemed
transfer back to the employer
a. SO, transfer to employee of $1200
i. $1,200 is ordinary compensation income to T
ii. what about to employer  § 162 deduction
b. AND transfer to employer of $1200
i. ordinary income = $1200 of interest - § 61(a)(4)
ii. what about transferee  potential deduction under § 163 (e.g. if used for
personal consumption, not deductible unless falls within an exception)
c. so, in some cases, both parties will have washes
i. notice this is consistent w/ rent-free use of property: e.g. allowing service
provider to use property rent free = sometimes income to serv. provider
 what if a shareholder loan?
1. lender is corp. T is shareholder/debtor
2. § 7872(a) exactly the same
3. from corp to T  exactly the same
a. transfer foregone interest to T as dividend and then back to corp. as interest
b. shareholder has a dividend instead of compensation and if a qualified dividend,
can get favorable tax treatment – §1(h)(11)
c. corp  no deduction for payment  can’t get deductions for dividends
i. no wash on this side
4. transfer back from corp. to T
a. same as before
b. interest income to corp.; T has potential deduction if interest deductible under
some code provision
 what if a gift loan?
1. from donor to donee  still go back and forth wrt transfer
2. transfer from donor to donee is a gift
a. 2 potential consequences:
i. donee has no income tax on it - § 102; if he has a deduction, it’s better
than a wash.
ii. for donor, it’s covered by gift tax
b. § 7872 focuses on donor -- tries to prevent avoiding gift tax, or assigning income
3. transfer back from donee to donor
a. remember that § 7872 calls this transfer back interest
b. still potential deduction for borrower
4. what changes in terms of consequences is treatment in transfer to taxpayer (first transfer
to donee/recipient)
a. special rules with gift loans
b. $10K de minimis amount (similar to exception for compensation); cliff effect, if
amount of loan proceeds exceed $10K, exception doesn’t apply
i. exception to the de minimis exception
ii. doesn’t apply if one of the principal purposes for the loan arrangement is
tax avoidance; makes the rule inapplicable in most cases
5. Gift loans for under $100,000: The § 7872 deemed retransfer of forgone interest from
borrower to lender applies only if the borrower’s net investment income is over $1,000
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 for the year. If it is, all of the forgone interest (no cliff effect) up to the net investment
income is deemed retransferred. § 7872(d).
a. this limitation doesn’t apply where more than $100K of loans outstanding
between lender and borrower
b. if borrower’s net investment income from all sources doesn’t exceed $1K (cliff
effect) special rule doesn’t apply (d)(1)(E)(ii)
i. e.g. if $900 in net investment income, we’ll treat as $0 and § 7872
doesn’t apply; you get an exemption from application of the retransfer
o Contingent payment obligations
 James  stands for proposition that even though you may have to pay back victim, the ill-gotten
gain is income upfront and issue is whether you’ll get a deduction when you have to repay.
 if not really a loan, fact that criminal law says you have to repay  not a loan, so have to pay
taxes upfront. To be a loan, has to be a consensual acknowledgment of obligation to repay.
 claim of right doctrine  one of things James is applying; N. American Oil  in this case, T
gets $ under a legal cloud, dispute about entitlement to income  still income in that year; if you
treat it as if it belongs to you and it’s under your control, fact that you may lose it in litigation and
have to pay it to someone else, still income
 in case of either contingent or phantom – either way it’s income and potential deduction if you
have to pay it back
 Why claim of right matters:
1. Timing. TP would rather report income later because of time value of money.
2. Integrity of the taxable year
3. §1341 – tax computation provision for certain items of income, when you have income in
earlier year under claim of right, then later you have deduction on payback.
a. Doesn’t apply if deduction is $3K or less.
b. Has to be clear that you had a right to it, then something else happened that made
you repay. If no semblance of a right, you lose.
c. 1341 deals with tax rate differential.
i. 1341 says: when you get that deduction in the later year, if you meet
certain reqts. ($ amt) and you have a semblance of a right, then 1341
comes in; when you get to tax rate calculus in step 4, you get a break.
Kinda violates ITY. When deciding at what rate you’re taxed at, it’ll be
better of earlier year or lower year. It’s a tax rate calculation.
ii. Tricky thing is authorities narrowed application to semblance of right; so
classic bonus situation would fit. On other hand, doesn’t fit in criminal
activity. That’s not semblance of a right – you’ll get deduction on the
payback, but 1341 doesn’t apply.
iii. Usually BTL; ord deduction, doesn’t relate to trade/business of being
proprietor. How could it be ATL? If you own trade/business and payback
relates to that, it’s 62(a)(1) – above the line. If earlier income was CG, so
under Arrowsmith payback is a CL, it could be ATL under 62(a)(3).
4. Reverse of §1341: You take deduction in earlier year, then get money back in later year –
tax benefit rule. Refund may be treated as potential income.
 security deposits
1. Indianapolis Power and Light: treats utility deposits (true deposit) as a loan even though
landlord or power company may use it to offset unpaid rent or bills;

45
 a. characterizes transaction: it’s not advance payment for services, no income up
front, as long as set up so that not automatically applied to last bill (e.g. if paid
up, you’ll get it back)
b. if deposit always applied automatically, it’ll be income
2. can argue these deposits are like conting. repayment obligs. that aren’t enough like a loan
a. e.g. assume there’s not restrictions on how to use, interest, etc. - looks more like
claim of right, where we say there’s income with a potential deduction later
3. what happens when tenant doesn’t pay and deposit applied to outstanding debt? 
income in the year applied. Contingency in the hands of the debtor, not the creditor.
 what if premises trashed although rent paid; deposit applied to clean up?
1. more complicated – may depend on how specific it is in terms of damage  can think of
it as an involuntary disposition and apply against basis, so income unless deposit exceed
basis, but it would reduce your basis
2. whatever we do with the deposit – income or reduction of basis – to the extent you use to
repair  if you spend all on repair and not a permanent improvement - § 162 deduction;
if a permanent improvement, add to basis
3. deal with receipt and use of money in different steps (e.g. is it income or reduction in
basis; then once you’ve spent, how to treat it – an addition to basis or 162 deduction)
a. which possibility applies depends on facts
b. assume withheld deposit to extent of damage, then it’s most likely treated as a
forced sale  apply the basis in the property against the damage proceeds and
only to the extent the damage exceeds the basis do you have income
i. Rev rulings that involve power plants where the IRS treats the damage
payment as a forced sale that reduces the basis in the property
4. First step is what to do with retention of the deposit instead of paying it back  then
have to consider how to treat what she ultimately does with the money
5. however we treat her retention of the deposit, then follow what she actually does with the
money to figure out the consequences
a. repair – current deduction under 162 or 212
b. if have to make a permanent improvement, add to basis as a capital expenditure
6. third way  rough justice way  plenty of basis, so no issue of gain generally; most
people just net it out to zero, keep the money and make the repair, no income, no
deduction, etc…. BUT, what you can’t do is ignore the income and the take a repair
deduction  not the right answer on an exam, but comes out the same way
7. if basis in property is $0 (e.g. you’ve depreciated it down to zero) and you get $1K in
damage proceeds  $1K in gain
o Phantom repayment obligations
 Jim borrows $10K from his sister, Lori, evidenced by a 5-year note with a market rate of 6%
interest. How, if at all, are the “normal” tax results for Jim only altered if:
1. Jim intends to repay but is insolvent, w/o job, and suffers from assorted problems that
will likely prevent him from obtaining/holding job? Does it matter whether Lori knows
about Jim’s status?
a. If no reasonable expectation of repayment, not a loan
b. Assuming there’s an acknowledgement of an intent to repay  loan
c. but, intent determined by looking at surrounding facts and circumstances
i. so, issue of whether intent to repay is real

46
 d. if Lender at outset never intends repayment, it’s not a loan – both parties have to
intend loan treatment, so if Lori knows that he can’t repay  brings loan status
into question  if not a loan, it’s a gift
i. If gift, Jim has no income, but Lori doesn’t get option of bad-debt
deduction
2. Jim has financial resources but subjectively intends not to repay the loan, and Lori is
unaware of this intent? Does it matter if Jim signs a note or verbally acknowledges that
it’s a loan?
a. in reality, if Lori is TP seeking bad-debt deduction, Jim’s subjective intent
matters, but she’s got good argument that it’s properly structured and she didn’t
know of his intent
b. if Jim didn’t sign a note, it’ll look bad for Lori (esp. if she asked him to and he
wouldn’t)
3. Jim has financial resources, but Lori has no intention of enforcing the loan? Does it
matter if Jim is aware of this intent?
a. probably doesn’t matter, but practically speaking, it depends on who’s in court
b. If Lori is trying to take a bad-debt deduction, then she’s probably going to lose
 Fred embezzles $10K. In Year 2, he’s caught. Employer agrees not to press charges so long as
Fred pays back $10K plus $3K. He pays back full amount in Year 4. What are tax consequences?
1. James: embezzler has to report income in Year 1. Obligation to repay doesn’t matter.
2. No consensual acknowledgment of obligation to repay, so no loan treatment.
3. Agreement in Year 2 doesn’t negate income in Year 1. No tax consequences until Year 4,
when Fred tries to run $13K through the system.
4. Year 4:
a. §165(c)(2) probably allows $10K deduction. Below the line, itemized. Not sale/
exchange of property, so not subject to CL limit. But is subject to §§67 and 68.
b. $3K like fine/penalty, so could argue under §165 no reason to allow deduction.
But not clear.
c. §265(a)(1): specific disallowance for amounts otherwise allowable as deduction
to extent the expense is allocable to one or more classes of tax-exempt income.
i. Casebook: this disallows the $3K, since not related to taxable income
ii. Peroni: Not clear, but it’s extra ground for disallowing the extra $3K.
d. §1341: shouldn’t apply; wasn’t included in income of earlier year under
semblance of right. Doesn’t help either the $3K or the $10K.

o Relief of one’s obligation to a third party as income

o Substance controls over form – take transaction (discharge of obligation) and break it up into two steps.
Actions of an agent are attributable to the principal.
o e.g. where company pays $500/month for the lease payments on your personal car
 $500/month in extra compensation income (in substance, company paid you and you turned
around and paid the lease). Employer has potential extra salary deduction; run through 162.
 if car were used for business only, you might get a deduction
o e.g. company pays $1,000 year in investment advice for T
 $1,000 a year in extra compensation income. Likely § 212 deduction (BTL/itemized/67/68)
o what about employer  when it’s discharging obligations, treat as though acting on T’s behalf

47
  $ 7000 in potential salary exp. deduction – have to analyze under § 162; doesn’t matter what the
employee is doing with the money  it’s just compensation $$ as far as company is concerned
o net lease  lessor charges stated amount of rent plus some of lessor’s expenses (e.g. tax payments)
 Old Colony applies  to the extent lessee is discharging lessor’s obligations, that’s rental income
 lessor here has ord. rental income of total rental payments, plus extra ordinary rental income b/c
of discharging of obligations (e.g. tax obligation)
 What about lessee?
1. if a personal use premises  no deduction - § 262
2. if business rent: total paid as rent is potentially deductible under § 162 as long as no
equity interest being hidden in the scheme
3. Real estate taxes deductible under § 164
a. when lessee discharges lessor’s tax obligation, presumed to act on his behalf
b. lessor has potential deduction
 Landlord-tenant law (state) determines whether it’s lessor or lessee’s obligations.

o Transfer of property to satisfy debt as a realization event

o Compensatory use of property  § 83(h)
 company can take a § 162 deduction when using property to fulfill an obligation to an employee
 conceptually  treating it like 1) employer paid employee and 2) employee then turned around
and bought the land from employer
1. have potential salary deduction for step 1
2. have realization event for employer for step 2
 This compensatory use of prop. is realization event, causing employer to realize gain/loss on the
property. Under substance-over-form principle (U.S. v. Davis), we treat this as employer giving
employee cash (for which deduction is taken), and then employee purchasing property at FMV.
1. Thus, the amount realized is the FMV: the cash amount actually received from the
employee plus the amount the employee reports as income (difference between cash paid
for property and FMV). By subtracting the employer’s adjusted basis, we arrive at the
either the employer’s includable gain or potentially deductible loss.
2. Timing – Realization occurs when the employee includes property in gross income.
3. Exception – If prop. transferred is corp’s own stock, § 1032 says no gain/ loss realized.
4. Remember – Corporations do not get a capital gains preference.
 Upon forfeiture of property, if employee had made 83(b) election and thus the employer had
taken a business expense deduction and/or loss deduction, the amount of these deductions is
includable in the employer’s income in the taxable year of forfeiture.
 Character  can be capital gains if property transferred is a capital asset or § 1231 asset
1. investment land  classic capital asset
2. if a corp., no capital gain preference; care b/c capital gains subject to capital loss limits; if
capital losses, could take current deduction under § 1211
o could be situations where the compensation expense is a capital expenditure
 nothing in § 83 tells you that it overrides normal rules; salary expenses, just like any other can be
a capital expense
 e.g. using employees to build power plant; under § 263A, compensation expense of employees
building long-life asset is capitalized as part of basis of plant; not a curr. salary expense deduction
o Davis-Keenan
 case involved estate transferring appreciated securities to one of the parties in a will; $10K basis
48
  A to get $50K  instead of paying cash (no realization even to estate), estate gives A securities
 issue was whether the estate had a realization event  YES
 use of property other than money to satisfy an obligation
 realization even is a sale/exchange within meaning of § 1222
 gain or loss is FMV minus basis
o in property-for-property exchange, you have a realization event
 supposed to look at amount realized by what was received
 in marital situation, hard to value what was received; can assume that what was received was the
value of what was given up  barter equation method of valuation
o § 1041 – Transfers of property between current spouses, or former spouses incident to a divorce
 Ignored for tax purposes – If property is transferred b/w (a) current spouses or (b) former spouses
incident to a divorce (related to and w/in 1 year of cessation of marriage) then:
1. No gain or loss is realized (neither transferor or recipient has any current tax).
2. Recipient gets carryover basis.
a. This rule applies even if there’s a cash purchase of the property. Recipient’s
basis is not the cash paid, it carries over.
b. So recipient will pay tax on pre-transfer gain on the property. This is a
bargaining chip and if you don’t know it, it’s easy to commit MALPRACTICE.
c. e.g. for high value, low basis asset gets worse off than someone with a high
value, high basis asset
i. ask for more property b/c of amount you’ll owe in taxes
3. Recipient gets the transferor’s holding period. § 1223(2).
 This rule covers child support, property settlements, and plain spouse-to-spouse transfers.
 This rule trumps any application of the § 1015 basis rule for inter vivos gifts. §1015(e).
 § 1041  changes facts of Davis but doesn’t change broad principle Davis stands for  use of
property other than cash to satisfy an obligation is a realization event to the transferor
o § 1032  NO realization event when stock used to compensate
 employer now still has a realization event in theory  BUT says that employer using own stock
= no realization event. (More like permanent removal than nonrecognition provision.)
 even though stock issued for services, treat it like paying cash and employee buying the stock
 rule only applies if property transferred is employer’s own stock
 employer still gets a compensation deduction the same as if land was involved
1. § 83 and § 1032 make this clear – substance over form.

o Cancellation of indebtedness income and the § 108 exclusion

o our income tax system
 don’t treat loans as income; no accession to wealth
1. see that sometimes we treat things like loans that aren’t (e.g. security deposit)
 cash flow consumption tax would increase efficiency (b/c income tax systems favors debt) and
decrease complexity
 We assume you’re going to pay it back and as long as you do, principal payments aren’t
deductible (interest may be), but if you don’t pay it back, have income there
o Kirby Lumber  if you don’t pay back loan, have “freeing of assets”

49
  corp. issues bonds to finance debt  corp. able to buy back the bonds at less than face amount
and retire them  reason they could do this was b/c of probable increase in interest rates; other
possibility is that debt rating went down, investment became riskier
 court held that under a freeing of assets rationale, this was gross income (see § 61(a)(12) –
income from discharge of indebtedness)
1. this kind of income is ordinary b/c cancellation of debt isn’t a sale or exchange
 point is that you have an increase in net worth and under Glenshaw Glass  accession to wealth,
clearly realized, under dominion and control  met here
o Distinguish COD income from “Crane gain” (which is treated as gain from property)
 difference matters b/c of character, (ordinary versus capital or § 1231)
 § 108, which deals with exclusions of COD income, only applied to Kirby Lumber COD income,
not gain from disposition of property
o § 108 – sometime operates as a permanent exclusion for COD income, sometimes not
 108(b) – amount of COD income excluded used to reduce tax attributes, making them less
effective wrt offsetting incomes
1. same idea as “carryover”
2. BUT, if you don’t have any of the tax attributes listed in (b), can still meet § 108  this
is why § 108 is only sometimes a permanent exclusion
 Insolvency  § 108(a) doesn’t apply if you’re solvent
1. SO, when you’re solvent, even if you’re in shaky financial condition, cancellation of debt
= COD income and no exclusion under § 108
 If someone else pays a compromised debt
1. the whole amount comes back to you as income
2. e.g. I owe $100K; lender agrees to settle debt for $70K; employer pays the $70K
a. COD income = $30K
b. ordinary compensation income = $70K (Old Colony)
i. compensation income not eligible for § 108 exclusion
ii. employer gets potential salary deduction
3. e.g. reduction in debt between mother and daughter
a. Key: detached and disinterested generosity, then the 30K is excludable by donee;
same as if mother gave her a break in the debt as a gift
b. point is: reason for cancellation is donative intent on mom’s part; if that’s the
case, donee can exclude it under § 102
c. unlike § 108, no reduction of attributes; a gift
d. Notice: for gift tax purposes, mom has possible gift that would have to be run
through the fed transfer tax system/gift tax system
i. b/c it’s a gift, you can’t deduct gifts in IT system; so C doesn’t get bad
debt deduction under 166, or loss deduction in § 165; so might not want
to express the donative intent here
o § 108 exclusion and Title 11
 when you have tax attributes to offset – have 2 choices
1. have to go in order under (b) of what to reduce in what order (e.g. NOL carryover first)
2. OR, you can make an election under 108(b)(5) and reduce basis in depreciable property
 NOL carryover does the most good if you can take advantage of it the very next year  if T
expects to reverse financial fortunes and will have income, NOL carryover will allow them to
offset that income
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 1. why you might elect to reduce basis; can’t take advantage of NOL carryover immediately
2. reduce basis if you want to spread out the pain over several years
 What if she has no attributes (e.g. no NOL or capital loss carryovers, no adjusted basis in
depreciable property)
1. doesn’t affect her ability to exclude the full $30K
2. (a)(1)(A) would work to be a permanent exclusion  have to reduce attributes if you
have them, but if you don’t have them, still qualify for the exclusion
o § 108 exclusion and insolvency
 § 108(d)(3)  calculating insolvency
1. negative net worth (assets over liabilities)
 § 108(a)(3)  can only exclude up the amount of insolvency
1. e.g. insolvent by $50K; COD income is $30K  can exclude all of the $30K (not
permanent exclusion unless you don’t have tax attributes to offset)
2. point is  cancellation would take her negative net worth from $50K to $20K  still
insolvent after the discharge
a. if the cancellation doesn’t bring taxpayer to positive net worth  all of it
excludable (e.g. if insolvent before and after the exclusion, all excluded)
3. Can do something in-between: 108(b)(5) says you can apply any portion of attribute
reduction to reduce basis in depreciable property.
 If no tax attributes, § 108 works as a permanent exclusion for the $30K excluded COD income
1. just b/c no attributes to reduce doesn’t mean no benefits of exclusion
2. if Congress wanted this to be a deferral in all cases, could have done so, but they didn’t
3. Policy: help debtors get back on their feet to become productive; they’ve suffered enough
 Where COD income exceeds amount of insolvency
1. e.g. liabilities exceed assets by $10K; COD income of $30K
a. Before discharge  negative net worth of $10K
b. after discharge  positive net worth of $ 20K
2. can exclude $10K  all it would take to get her back to zero
3. to the extent the discharge occurring outside Title 11 – can only exclude amount of
insolvency - § 108 (a)(3)
a. rest is income  $20K
b. attributes reduced by $10K
i. e.g. NOL carryover from $40K to $30K
ii. or could make election to reduce basis in depreciable property
o Purchase money debt
 purchase-money debt  when the debt involved is used to purchase property
1. when the person making the loan is the seller  it’s seller-financed PM debt
2. when third party making loan  third-party PM debt
3. Recourse PMD: debtor is personally liable.
4. Nonrecourse PMD: debtor isn’t personally liable; creditor can only look to the property
securing the debt. (Only recourse is to seize the property.)
 Seller-financed PM debt
1. § 108(e)(5)  treat as a purchase price adjustment, not income  no income to
buyer/debtor  means reduction in basis of the asset

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 a. (e)(5) DOESN’T APPLY TO THIRD PARTY PM DEBT  only applies to
seller-financed PM debt
2. theory is that when the seller is also the creditor and the debtor is the buyer, we can
assume that what’s really going on is a dispute about the value of the property (e.g.
quality – reduction in price b/c of defect)
3. only applies if the other exclusions don’t - § 108(e)(5)(B)
a. e.g. if a Title 11 case, have to use (a)(1)(A); insolvent, have (a)(1)(B)
4. SO, can exclude all b/c it’s NOT COD income, but a price reduction
5. what if she has no basis in the property?
a. nothing the (e)(5) says anything about this
b. other theories that would cause her to be taxed
i. e.g. if she’s depreciated the property to zero –tax benefit rule  when
you take deduction and get money back later  income; deal with that in
the later year when you get it.
ii. this situation might trigger this rule
6. meant to apply to original seller and buyer; when debt sold and then discharge  (e)(5)
might not apply – not clear
o § 108(e)(2) – potential deduction had you paid and COD (i.e. liability compromised = business rent)
 to the extent that you would have had a deduction, you don’t have COD income  makes sense,
you would have had a deduction anyways, why have income here. Kind of a “wash” theory.
 if able to deduct upon payment (only available to cash-method taxpayer), no income on discharge
 if accrual method TP  economic performance w/ rent occurs day by day with use of premises
1. would have already taken a deduction for this amount on her return (payment not
required before you can take a deduction)
2. now, when she doesn’t pay it off, have to give her the income  kind of like tax benefit
doctrine – got the deduction, but never had to pay the bill – have to event things out
o COD income and lawsuit settlements
 Where fact/amount of liability are in dispute  NO income from settlement for < amt. claimed
 when settling, settling the amount of the debt and T pays it off when she settles
1. until case is finally resolved in court (appeals, etc.), parties determine amount of debt
when settling. settlement sets the debt.
2. e.g. Just b/c $100K in damages alleged, unless there’s a judgment, no liquidated debt and
nothing to apply COD doctrine to
 Zarin  gambler who doesn’t get COD income from cancellation of lots of debt to a casino
1. 3rd Circuit relies on disputed debt doctrine to rule that there’s no COD income
a. broad interpretation of disputed debt doctrine
b. not likely this opinion will have much effect on doctrine outside gambling arena
c. e.g. a straight loan from a creditor charging usurious interest rate  just b/c
usury laws make debt bad  disputed debt doctrine won’t save you from getting
COD income here
2. court failed to see that disputed debt doctrine usually deals with issues of existence and
amount of debt, not enforceability. In all COD cases, have an issue w/ enforceability –
otherwise why is debt cancelled?
3. § 108  discussion in case  crap
a. don’t get to § 108 until you figure out if there’s COD income (except in limited
cases under (e)(2) and (e)(5)
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 b. demonstrates what many judges do  asking what the right answer is and
finding a way to get there
4. argument for why not to treat loan as the full amount
a. Zarin could only use line of credit to get chips that he could only use in casino
b. no way, unless he won, that he could have spent $ outside the casino
c. issue of whether we should treat the amount borrowed as the full amount given
the restriction
d. casino also assumes that Zarin will lose given his record
e. although doesn’t fit neatly into disputed debt doctrine, neither does it fit within
rubric of a pure loan
5. one argument for no COD income and why no income from comping  rationale is
Gotcher  can’t be § 132(d), not personal services  looking at the primary purpose 
if to serve transferors interests and only incidental benefit to recipient  not income
a. unless you conclude that he’s acting as a shill for the casino
6. at heart  a dispute about gambling
a. either understand the nature of it or you don’t
b. argument for taxing Zarin here  fact is that taxpayer has $30K personal
consumption that she didn’t pay for with after tax dollars
c. if she had gone to bank and borrowed, then gambled  different outcome.
7. should she be able to exclude when not insolvent?
a. we tax windfalls, illegal gains, etc…
b. why not this
8. Peroni  this case should be COD income
a. under case law, if it fits the exact facts of Zarin, no COD income
b. if not exact same facts  COD income

o Tax treatment of mortgage relief: Crane and its progeny

o Crane
 govt. won the case, but it represents the single biggest loss to the govt. in tax history
 established the principle that non-recourse debt goes into basis.
1. this is the heart of tax shelters
2. required legislative solution: Tax Reform Act of 1986: passive loss rules. Only killed tax
shelters of a certain type.
 what was wrong with the case
1. arose as a death basis case (special rule under § 1014 – if acquire property by death gift,
the donee’s basis is FMV of the property at the time; with appreciated property, no
realization on death, and the donee will never pay tax on gain b/c get a stepped up basis
reflecting appreciation)
2. Crane inherited property from H, so basis was FMV
a. first issue  government not thinking about the basis issue
b. second issue  case arose out of sale of property; is amount realized net cash
minus commission, or does it include mortgage debt; govt. asks – big or small
amount realized  go for big amount that includes full, unpaid non-recourse
debt
i. 1.1001-2 – codifies  if you dispose of property, amount realized
includes unpaid debt

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 3. govt. had to argue that non-recourse debt was real debt
a. court says: if debt is real  goes into basis under § 1014
b. issue really under § 1014  is basis the property’s value or, if property is subject
to mortgage liens, the equity?  court says: value of the property, not equity
4. Crane, although she took depreciation, later argues that b/c mortgage equaled value of
the property, she had equity of zero, and therefore, basis of zero
a. Tufts later will say that Crane was affirming govt.’s decision to treat nonrecourse
debt like recourse debt
b. court said to not put the mortgage in basis would lead to having basis go up over
time as you pay off the property  administrative convenience is prime reason
for court’s holding.
 acquisition debt, recourse and nonrecourse (§ 1014 or § 1012) is included in the debt; unpaid
principle of this debt included in the basis
1. If you acquire property with recourse or non-recourse debt, your § 1012 cost basis
includes the principal amount of the debt
a. even though if you fail to pay, all the creditor can get is the property itself and
debtor not personally liable
b. if property value falls below amount of mortgage, debtor can walk away from
what turned out to be a bad deal  loss of economic incentive to pay off the debt
2. Mayerson  99 year term, nonrecourse debt, all principle repayable in one balloon
repayment  court says basis includes the full 99 year debt
 if you dispose of property and it has recourse or nonrecourse debt and purchaser takes subject to
debt or assumed the debt, the amount realized includes the debt
o Going to treat non-recourse debt like a loan for all purposes?
 if you get a loan on a non-recourse basis, are we going to treat as a loan (e.g. receipt of the cash
isn’t income)?
 Crane and progeny essentially say that non-recourse debt is a loan for income tax purposes
1. so, receipt of non-recourse loan proceeds doesn’t result in income to the borrower
 §§ 465, 469 collaterally attack tax shelters, but don’t change the rules of Crane wrt basis, etc….
o § 1012 basis = whole amt. of cash paid + outstanding nonrecourse debt, just as if it were a mortgage
 REMEMBER when you buy land and building, have 2 assets  so have to allocate basis to each
asset based on FMV at the time of acquisition
1. e.g. of the $250K paid (cash and debt), $50K to the land; $200K to the building
a. get depreciation deductions on the amount allocable to the building
o Estate of Franklin  when it’s a sham transactions
 Romneys – motel depreciated down to zero; getting income but no offsetting benefits; want to
come up with a way to stay in the business and get more out of if than just the rental income
 doctors form an LP  partnership not a taxpayer, all of the income and deductions flow through
to the partners; liability limited to what they invest in the venture
 LP enters into a deal with the Romneys  LP buys the motel  lease it back to the Romneys 
almost all the principal repayment to take place in 10 years (no reportable income to the Romneys
under installment sales method)  so docs don’t have to pay anything until the end, but pay
interest of $75K per year, which matches the rent the Romneys owe on the leaseback
 doctors have to pay Romneys prepaid interest of $150K, this is the only cash that exchanges
hands
 non-recourse note is for $1.2M, FMV of the property is $700K
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 1. if prop stays cheap, docs can walk away and Romneys get their motel
2. if prop goes above $1.2M, docs pay off the note and have made a deal
 IRS argues that this is an option purchase
 9th Circuit in Franklin:  Crane assumes that the non-recourse debt is real, and to be real, there
has to be economic incentive at the outset to pay off the debt
 so, if FMV of property is lots below the amount of nonrecourse debt  Crane doesn’t apply
1. Franklin  treating the debt as a sham, didn’t go into basis
2. minority of courts following the doctrine would allow nonrecourse debt to go into basis
up to the value of the property
o After-acquired non-recourse debt
 not used in connection with acquisition of the property, but secured by the property
 no income from mortgage proceeds
 basis  with after-acquired debt, have to follow what you do with the loan proceeds
1. so, if used to make a capital improvement on the property, goes into basis
2. if used to buy stock  get a basis in the stock, not in the property
o sale of property subject to non-recourse debt
 adjusted basis will be reduced by any depreciation
 payment on an after acquired mortgage only affects amount realized
 as long as we treat recourse and non-recourse as real debt, when the seller disposes of the
property without paying off the debt, but has the buyer assume or take the property subject to the
debt, Crane and cases stand for proposition that amount realized includes cash and unpaid
principal amount of acquisition non-recourse debt and after-acquired non-recourse debt
1. Amount realized = cash paid, plus amount property was taken subject to (acquisition and
after-acquired debt)
 Remember to allocate  will have different gains
1. character  rental real property  if an active rental  trade or business  if held for
more than a year, go to § 1231  won’t know if gain or loss without knowing about all
other § 1231 transactions
a. REMEMBER  § 1245 depreciation recapture doesn’t apply to real estate, so
doesn’t apply here
b. APPLY § 1250 to a building  amount taken in deprecation deductions subject
to 25% rate (unrecaptured § 1250 gain  still CG but less preferential rate)
 Purchaser’s basis
1. under Crane, acquisition cost includes both mortgages that the purchaser takes the
property subject to (second mortgage not after-acquired for purchaser like it was for
seller)
2. plus cash paid
3. would have to allocate basis between the land and building  goes back up (e.g. even
though previous owner had depreciated down to zero, can start all over again once a new
owner buys the property)
o when property is worth less than the mortgages it secures: non-recourse
 e.g. sell to buyer – take no cash, just sell by having him take the debt
 Not COD income  affects character
 Tufts  had to decide the significant of FN 37 in Crane which talked about one of the rationales
for why the court treated non-recourse as real debt (even though not personally liable, have an

55
 economic incentive to pay off the debt as long as value of the property stays at or above mortgage
amount); lots of lawyers knew that FN 37 was dicta, but relied on it nonetheless
1. Supreme Court  could have reversed Crane, but instead affirmed while rewriting
2. courts says that Crane’s reasoning wasn’t the primary rationale – as long as prime reason
backing up FN 37 wasn’t the primary rationale, can do away with FN 37
3. said that Crane merely affirmed the government’s decision to treat non-recourse debt as
recourse debt  once you walk away, full amount treated as debt  have to treat as
amount realized
 when you walk away and tell creditor to take the property, have to include unpaid debt in amount
realized, even if property worth less
1. e.g. sale without cash but property subject to mortgages worth $250K  have amount
realized of $250K minus basis, allocation of basis (etc.)
2. includes both acquisition and after-acquired mortgages
 debate between O’Connor and majority wrt characterization
1. O’Connor wanted to treat some as COD income
2. Majority  this is disposition gain, not COD income
3. means that § 108 doesn’t apply  only applies to COD income
4. if not COD income, can’t exclude any of this gain under § 108
 purchaser’s basis in this situation
1. purchaser’s basis not 0 nor limited to amount of mortgage (assuming not a sham
transaction  purchaser thinks it will go up in value  see Estate of Franklin and shady
deals)
2. Basis  FMV or amount of mortgages property is subject to?
a. argument for FMV  only have economic incentive to treat as real debt if don’t
go above FMV; will have a basis higher than the FMV, unusual in cost-basis
situation
i. this is portion of debt that would reflect the economic incentive rationale
b. argument for value of mortgages  Tufts didn’t overrule Crane  treating non-
recourse debt as real debt for tax purposes  if you took out recourse debt to
purchase, no doubt your basis would be amount of that debt
i. if not a shady deal, rules would say acquisition debt is amount of basis
3. answer  basis is either one  no clear authority  good arguments for either one as
amount of basis
a. Peroni  amount of mortgages as basis follows from Tufts and Franklin
 How have at-risk rules in § 465 and the passive activity loss rules in § 469 undercut the
importance of Crane basis rule? How have §§ 465 and 469 eliminated the market for most types
of tax shelter investments designed to take advantage of this Crane basis rule?
1. Crane basis and amount realized rules still the law
a. but statutory reactions to tax shelters created in wake of Crane
b. § 465  doesn’t change basis rule  but says that if you have deductions from
an activity in excess of income (whole idea of a shelter – use deduction against
salary income)  you can only deduct currently if you have an amount at risk
(e.g. have to have recourse debt)
c. exceptions ate up the rule, so ended up weak
d. theory was that if you’re willing to be liable, more likely to be a real deal
2. § 469  passive loss rule
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 a. Crane basis rule not changed nor was Tufts amount realized rule
b. if activity in which you don’t materially participate  then if have deductions in
excess of income, can only deduct to extent of other passive income (doesn’t
include salary or standard investment income like dividends and interest)
i. walls off the tax shelter – isolates from other income and kills the reason
ii. but exemptions for corporations  why tax shelters not killed off
c. § 469 applies to more than tax shelters  so legit deals can come within it  so
both under and overinclusive
o when property is worth less than the mortgages it secures: recourse & bifurcation
3. if you transfer the property back to the creditor and the creditor cancels the debt
a. the difference between FMV of the property and the principal amount of the
recourse debt is COD income (ordinary income under § 61(a)(2) -- but
remember, can qualify for § 108 exclusion)
b. excess of the fair market value of the property transferred to the creditor over the
transferor-debtor's basis in the debt = gain from disposition.
4. e.g. Machinery secured by recourse debt
a. have basis in machinery $100K cost
i. has recovered $80K of basis via depreciation
1. reduced basis = $20K
ii. now worth $70K
b. $30K COD income
i. owe $100K, give something worth $70K  $30K diff. is COD income
c. $70K FMV (see above, FMV assumed to be amount realized) minus $20K basis
= $50K § 61(a)(3) gain (gains from dealings in property)
i. could be CG, but here it’s OI  § 1245  b/c gain only $50K and T
took $80K in depreciation, all gain is recaptured under § 1245 and
treated like ordinary income
5. creditor getting $70K back on $100K basis - $30K deduction (business bad debt under §
166(a)) and gets basis in the prop equal to what it’s worth when he gets it back ($70K)
a. loan repaid to extent of $70K repaid
b. get basis in property of $70K
c. bad debt deduction of $30K
d. whether debt is recourse or non-recourse, effect on creditor is the same
 REMEMBER  non-recourse = no bifurcation
1. if you walk away from non-recourse debt and give up the property, the authority for
treating this like amount realized is Crane, Tufts and 1.001-2, full unpaid principal
amount is amount realized – NOT LIMITED TO FMV OF PROPERTY AS WITH
RECOURSE DEBT
2. GAIN TREATED LIKE DISPOSITION OF PROPERTY – NO COD INCOME
3. for example above  same basis result  $20K after depreciation deductions
a. where nonrecourse, need Crane and Tufts to support prop. that basis includes
non-recourse debt
4. $100K (amount realized equals, in this situation, the unpaid principal amount of debt)
minus $20K = $80K § 61(a)(3) gain
a. OI § 1245
b. all is ordinary income b/c have $80K gain and $80K in depreciation, so all
recaptured and treated like ordinary income
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  § 108 doesn’t apply AT ALL – § 108 ONLY APPLIES TO COD INCOME
1. O’Connor – concurrence in Tufts  if we are going to treat non-recourse and recourse
debt the same, should bifurcate in non-recourse case as well.
2. weight of academic commentary supports bifurcation
3. argument for no bifurcation in either situation – to treat amount realized as $100K and all
gain from disposition of property  no legal authority
4. have we read § 108 out of the code when it comes to non-recourse debt?
a. argument that no bifurcation goes against language of the statute?
5. can be COD Income with non-recourse debt
a. if creditor says I know I can only collect $70K, but I don’t want your machinery;
I’ll keep the loan going, but cancel $30K, so that principal is now $70K
b. creditor lets you keep the property, you pay $70K cash

o Accounting methods and bad debt losses

o NOT TALKING ABOUT partial bad debt
 when you see the words “partial bad debt” deduction, not talking about the end of the transaction
when you know how much you’re going to get paid, but rather at the beginning, when you can
say that you probably won’t get X amount, but keep loan going  NOT INVOLVED IN ANY
PROBLEM IN THIS COURSE
o worthlessness
 § 165 versus § 166
 determine what the nature of the realization event is
1. as long as debt is bona fide and an income producing asset  basis in the loan is the
amount loaned
2. if all the creditor does is get back loan proceeds  return of basis, no gain/loss
3. when the creditor doesn’t get back what he paid, one way he might realize his loss is to
sell the debt instrument in a bona fide sales transaction
a. probably deductible under § 165(a) and/or (c)
4. character – is it a capital asset? We have sale of property.
a. if in business of buying/selling debt instruments  dealer property and not CA
b. if received in exchange for service  not a capital asset
c. loss on sale or exchange  may be a capital loss (not a good thing)
i. least desired is long-term capital loss
 where realization even is worthlessness  not selling/exchanging, it’s just become worthless debt
 § 165(g) & § 166  these can make worthlessness a sale/exchange even though it’s not thought
of as one  Congress can make them a sale or exchange, which it’s done in certain cases
1. is the debt instrument that’s worthless a security as defined in § 165(g)(2)
a. if yes  § 165(g) will determine the timing and character of the realization event
b. security  includes shares of stock, right to subscribe to stock, a bond,
debenture, note or certificate or other evidence of indebtedness issued by a corp
or government; has to have interest coupons attached or be in registered form
i. if debtor not a corp. or govt.  not a security
ii. if no interest coupons attached or in registered form  not a security
2. if § 165(g) applies b/c dealing with a security
a. general rule is: if instrument is capital asset in hands of creditor (go back to §
1221), loss is treated as the loss from sale or exchange on last day of taxable year
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 b. doesn’t matter when it becomes worthless, the loss accounted for on the last day
of the taxable year  LTCL
c. where it applies  and where the event is worthlessness  almost always have
LTCL treatment
d. subject to § 1211 and for individual, will reduce base of preference for CG
3. if realization event is worthlessness and debt instrument isn’t a security  § 166 bad debt
a. business bad debt  § 166(a)
b. no special rule regarding how to treat the worthlessness  case law applies 
ordinary loss (absent statute, worthlessness not a sale or exchange – code silent
here, so it’s ordinary)
i. preferred b/c don’t have to worry about § 1211 or capital gains issues
c. non-business bad debt  § 166(d)
i. any loss is a considered a loss from sale or exchange of a capital asset
held for less than a year  STCL
ii. subject to § 1211
iii. but harm under 1(h) not as bad as LTCL
iv. any debt other than debt created/acquired in connection w/ trade/business
v. default rule  unless you can tie to a trade or business  non-business.
includes most investment-motivated debt.
o where creditor has 2 relationships with closely held corp.
 creditor is major shareholder and an employee
 tax payer wants business bad debt  to protect interest as an employee  trade or business
 gov. wants non-business  protect stock interest  non-business
 SC  dominant motive controls
1. determined by looking at objective surrounding facts and circumstances
2. relative amount of stock investment value versus amount of compensation
3. e.g. big salary, small investment  better argument for business bad debt
4. e.g. if large investment  probably non-business even if you have a large salary
 large shareholders  hard to claim it’s a business bad debt
 if trying to protect employment relationship  business bad debt
o Accounting methods and bad debt
 accrual method
1. when debt becomes due, it’s includable in income, even if not received (e.g. bill due in
year 1, don’t get paid until year 2, still have income in year 1)
2. deduction taken on payor’s side (assuming expense is for business) when obligation to
pay is fixed and amount can be determined with reasonable accuracy, and economic
performance reqt. (e.g., bill due in year 1, deduction in year 1)
a. only gets the deduction in the year that debt becomes due, etc. so if paid in a later
year, don’t get another deduction year 2
b. if payor contests bill and says she’ll pay less, she can only deduct lesser amt.
(arguably, payee would only report lesser amount).
 what if debtor doesn’t pay?
1. effects on the creditor  bad debt deduction 

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 a. when  when objective facts evidence worthlessness  may be in year 2, 3, 4,
etc…  look for signs such as fact that someone can’t pay, insolvency,
bankruptcy (although may become clear prior to this)
b. if arose in business of providing service loss will be ordinary when it gets
accounted for
c. limited to basis (the amount due)  once you have, under accrual method,
included in income  then have a basis
2. effect of non-payment on debtor
a. COD income (simple, she got a deduction for something that she never actually
paid, have to even things out by including as income)
i. note that § 108(e)(2) wouldn’t apply b/c payment wouldn’t give rise to a
deduction b/c under accrual method, deduction not tied to payment
b. OR: tax benefit rule; debt becomes income in later year.
c. Why it makes a difference:
i. If COD income, might be able to use other 108 exclusion rules
ii. If TBR, 108 doesn’t apply.
iii. Peroni: Unclear
 cash method
1. income reported when you have actual or constructive receipt (constructive  earned or
made available without restriction, you turned back on it)
2. deduction for payor when paid
3. what if, in year 2, payor says she’s about to send check and lender tells her not to hurry,
etc.. take time  income in year 2 (constructive) even if he doesn’t actually get the
money in year 3
a. wrt debtor  deduction is in year 3  not tied to what lender does wrt reporting
income b/c of constructive receipt  no constructive payment on deduction side
4. if debtor doesn’t pay  bill sent in Y2 for $3K of services in Y1 (both cash method)
a. service provider  no income
i. no bad debt deduction  no basis  never claimed it as income  to
net out to zero, don’t have to do anything  no income, no deduction
ii. for cash method taxpayer who performs services and never gets paid 
bad debt deduction  ZERO
b. debtor  § 108(e)(2)  could have deducted it  SO NOT TREATED AS
COD INCOME
o loan forgiveness and bad debt
 Lori lends $10K cash to Jim. Lori has $10K basis in the debt instrument.
1. what if lori decides that Jim doesn’t have to pay?
2. if dominant motive for the creditor to forgive the loan is donative  detached,
disinterested generosity: then, at the time she makes the gift  Jim can exclude under
§102 (and no reduction of attributes)
3. Lori  no bad debt deduction
a. for gift tax purposes, would be making a gift subject to the tax
 what if Lori never intended to enforce the loan terms?
1. same result as above, but the timing is different
2. gift occurs at time of gift, not like above where it happens when she decides to forgive
o Timing of bad debt deductions
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  Year 5  Lender seeks to enforce, can’t collect
1. debtor  COD income when the debt is cancelled  may be before SOL runs out 
lender may cancel when clear to her she won’t collect
2. Lender  when debt is deemed worthless  when Lender gets deduction 
worthlessness is the realization event  gets a bad debt deduction (no evidence of
donative intent)  fact that it’s a family member doesn’t matter, as long as real loan and
is really worthless
 Debtor returns and decides to pay Lender  what does Lender have to do?
1. if Lender is cash method  no bad debt deduction b/c she never claimed as income (b/c
never got the $$)
a. if accrual  gets the bad debt deduction since claiming it as it becomes due
2. now have a later event in a different tax year
3. first thing to note  don’t go back and amend old returns; integrity of the taxable year
a. leave everything in the past alone  didn’t do something wrong
4. debtor would get a deduction of some kind if he claimed the COD income earlier
5. Lender  tax benefit rule  have an earlier event that was kosher at the time and then
have a fundamentally inconsistent event  § 111  deal with the recovery when it
happens  income under the tax benefit rule if the earlier deduction produced the benefit
a. assuming she took a bad debt deduction  would have repayment amount as
income
b. what if no benefit  e.g. didn’t have income, the deduction was worthless  no
income  if no benefit, no income
6. character: Under Arrowsmith:  when an integral relationship between income and
earlier deduction  will look at earlier deduction and apply the character to the income
 e.g. is loss was non-business bad debt and STCL, Lender will get STCG treatment on
the repayment income

V. Gratuitous Transfers: Intervivos Gifts & Testamentary Gifts (Unit 6)

• The § 102 exclusion for intervivos gifts
o § 102 exclusion from income
 The value of gifts received is not includable in gross income for donee
 §102 does not exclude the income from property, just the value of such property. basis = FMV
 Exception – Gifts to employees. Any property transferred by (or on behalf of) an employer to
an employee (or for her benefit) is not excluded from income under § 102.
1. Independent contractors are not subject to this §102(c) exception.
2. The §102(c) exception will not apply to (1) extraordinary transfers (2) to the lineal
descendants of TP (3) not for employment reasons (e.g. because of the familial
relationship). Prop. Reg. 1.102-1(f)(2).
 If not gift, might be in-kind compensation to emp’ee, or use of property to satisfy an obligation
 Death ≠ realization event; generally, gift of noncash property is not realization event to donor.
o definition of “gift”
 income tax rules not the same rules as federal transfer taxes, which is broader
 Duberstein  Duberstein provides business contact info to another guy who gives him a car
1. can he exclude as a gift (BTW, other guy deducted the car for business purposes)

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 2. SC  gift for income tax purposes depends on motive of donor  detached and
disinterested generosity  not for past, present or future benefit
a. determine by objective facts and circumstances
b. Factors include: (1) traditional holiday? (2) personal relationship? (if not, not
likely to be a gift) (3) normal trading of like-size gifts? (4) did others similarly
situated get a gift? (5) did TP deduct it as a business expense?
c. Not disinterested and detached: tips to waiters, casino dealers (Olk), generating
goodwill for TP’s company, rewarding a volunteer who rescued you.
d. A person is entitled to treat cash/property received from a lover as gifts, so long
as the relationship consists of something more than specific payments for specific
sessions of sex. Harris (criminal case, probably a different result for civil case).
e. § 102 does not apply to prizes and awards or scholarships and grants.
 Congress 1986  facts and circumstances analysis sucks; gift ought to be personal, not between
people with business relationships
1. Congress enacts anti-Duberstein provision, but it doesn’t apply to Duberstein facts
a. most business-related gifts don’t meet Duberstein anyways
2. § 102(c)  when it applies, Duberstein doesn’t apply; and vice versa
o § 274(b)  $25 max for business gift deduction
 if recipient can exclude under § 102, at most transferor gets $25 deduction under § 212 or § 162
 way many people interpret  allows a deduction of $25 for each business gift
1. Peroni  if you properly apply Duberstein, § 274 can never apply  not supposed to be
able to get a deduction
2. “ordinary/necessary” and Duberstein are mutually exclusive  if you can meet
Duberstein, you can’t meet § 162
3. correct answer should be that you get zero deductions for business gifts
4. maybe reason for § 274(b) is we know people will still try to deduct, so at least limit it
 Hypo - why Duberstein is silly
1. You save a drowning man. They give you $2K as a reward. Not a gift
a. not detached/disinterested generosity  reward isn’t gift  includable as income
o Where 102(c) doesn’t apply  service provider relationship
 b/c not technically employee, 102(c) doesn’t apply  still have to go through Duberstein analysis
 facts and circumstances to go through
1. e.g. fact that transferor is a relative  in favor of finding a gift
a. would want to know what kind of gift X generally gives outside work
relationship  if usually really nice, doesn’t look suspicious
2. if T is under-compensated by the firm  less like a gift
3. is it a traditional gift-giving time?  looks more like a gift
4. hard to show gift not connected to, i.e., a big deal that went through?  less like a gift
5. if meet Duberstien  detached generosity  T can exclude
 T’s basis  carryover basis for life gifts
1. if not a gift  ordinary compensation income = FMV of the gift
2. basis = tax cost basis (FMV)
 What are consequences to donor in this situation?
1. 2 consequences
a. if a gift  gift generally not realization for donor, but may generate a transfer tax
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 i. donor has no Davis-Keenan realization transaction (remember, may still
be federal gift taxes)
ii. Still have to go through §162
1. ask – is this ordinary and necessary?
2. if a gift that meets the Duberstein Test  can’t see a valid
argument that it’s ordinary and necessary (because if it meets the
Duberstein test, it’s supposed to be detached and disinterested)
3. hard to find a gift in a business setting
iii. if a gift to T, X gets zero deduction
iv. § 274(b)  even if you come up with some argument that it’s a gift 
can only deduct $25
b. if not a gift  § 83 transfer
i. donor has a realization event on the transfer; would get deduction
2. X and T have conflicting tax interests essentially  T wants to exclude, but X wants a
deduction  can’t generally have both
o where T an employee of donor
 § 102(c)  means no Duberstein analysis
 T has gross income of $3K
 donor probably has a deduction; and § 83 realization event

o Basis of property acquired by intervivos gift

o basic rule is carryover basis under § 1015
 e.g. donor’s basis is $1K, donee’s basis will generally be $1K
 2 exceptions
1. if you’re determining a loss to donee on later realization and, if at the time of gift, the
FMV was less than the carryover basis  the basis for loss purposes only is FMV
a. why: don’t want donors to be able to pass off losses to others via gifts
b. way around this: donor can sell instead of transfer, realize the loss and deduct it,
then give cash to donee so donee can buy whatever he wants.
2. between spouses  always carryover basis
o holding period also tacked on in cases of gifts – 1223(2)
o How exceptions work
 FOR GAIN PURPOSES, ALWAYS CARRYOVER BASIS
 Loss where exception doesn’t apply  Assume donor’s cost basis is $40K in stock. On the date
of the gift, FMV is $50K. The stock is worth only $35K on the date of sale, and Donee receives
only $35K cash from Buyer on the sale.
1. EXCEPTION DOESN’T APPLY  FMV is still more than the carryover basis
2. amount realized = $35K
3. $5K loss  LTCL
 Loss where exception applies  Assume the same facts as above, except that the stock was worth
only $30K on the date of the gift and is worth only $25K on the date of sale to the buyer.
Accordingly, Donee receives only $25K cash from Buyer on the sale.
1. here is where exception applies  calculating a loss and FMV at time of transfer is less
than carryover basis
2. get to use loss basis (FMV at time of gift) = $30K

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 3. So, have amount realized of $25K and a basis of $30K  loss is $5K– LTCL
4. NOTE: if FMV at time of gift was more than carryover basis or equal to  loss basis
wouldn’t apply
 Grey area  Assume the same facts as above, except that the stock was worth only $30K on the
date of the gift and is worth $35K on the date of the sale to Buyer. Accordingly, Donee receives
only $35K cash from Buyer on the sale.
1. Gain basis of $40K and a loss basis of $30K and sell anywhere in between  get neither
a gain or a loss. zeroes out.
2. Issue  carryover basis less than FMV at the time of the gift, but if we use FMV (loss
basis), we’ll have a gain, which doesn’t make any sense b/c supposed to use FMV when
calculating a loss
a. e.g. Would have a basis of $30K, amount realized of $35K  gain of $5K 
makes no sense – not a loss
3. Issue  if use carryover basis of $40K, have a loss of $5K  it’s OK to have a loss
using gain basis (if FMV is greater than carryover basis at the time of the gift)  but here
FMV at time of transfer was less than carryover basis, so doesn’t make sense

• The § 102 exclusion for testamentary gifts

o §102(a) – excludes bequests, devise or inheritance from income
 bequest  from a will; personal property (“movables”)
 inheritance  passing property, but no will; determined by laws of intestacy
 devise  real property and improvements (“immovables”)
 all excludable
o Does settlement of will content count as an inheritance?
 SC  look to state law to see if T is a putative heir (e.g. at least some valid claim to being an
heir)  if so, treat the settlement as an inheritance
 § 102(a) exclusion applies
o Situation of gifts in will for those who have performed a service for the decedent
 Duberstein kind of analysis, but less strictly applied in the will context
 merely saying precatory thanks for long service, etc… they don’t help show it’s a gift, but it
won’t kill you under § 102(a)
 question  really donative or compensation?
1. gift in a will between employer and employee  § 102(c) exclusion applies probably
2. where not an employee  ask
a. was service provider fairly compensated?
b. was there a personal relationship?
c. Duberstein-like analysis to see if § 102(a) applies

o Basis of property acquired by testamentary gift

o current rule  if a death gift, basis is FMV at the time of death
o stepped up basis
 means if the property has appreciated during dead guy’s lifetime, basis is stepped up –
appreciation will never be taxed
1. result of § 1014  tell the parties to hold on to gain property until death, sell loss
property before death  lock-in effect
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 a. impairing mobility of capital  lock in effect gives rise to capital gains
preferences (in order to fight lock-in effect)
2. but if loss property, basis is stepped down to FMV
a. so no one ever gets to take the loss
o Example
 Five years ago, Theresa purchased 100 shares of Lucky Corp. stock for $80K and 100 shares of
Loser Corp. stock for $180K. Theresa died on Jan. 1 of the current year when the FMV of the
Lucky Corp. stock was $200K and the FMV of the Loser Corp. stock was $120K. (Assume that
the executor of Theresa’s estate did not make an election under §§ 2032 or 2032A.) In accordance
with Theresa’s will, the 2 blocks of stock were distributed to Peter, Theresa’s beloved son, on
Sept. 1 of the current year when the Lucky stock had a FMV of $225K and Loser stock had a
FMV of $125K. On Nov. 1 of the current year, Peter sells the Lucky stock for $230K and the
Loser stock for $130K. What is the amount and character of Peter’s gain or loss on the sale of
each block of stock?
 Basis  FMV (at time of death) basis
1. Lucky  $200K
2. Loser  $120K
 Amount realized/gain/loss
1. Lucky  $230K amount realized  minus basis of $200K  $30K gain
a. character  see § 1223(9)  if from decedent and sold within a year  holding
period = more than a year (automatic long term holding period)  LTCG
2. Loser  $130K amount realized minus basis of $120K  $10K gain
a. character  see § 1223(9)  if from decedent and sold within a year  holding
period = more than a year (automatic long term holding period)  LTCG
 NOTE THAT VALUE AT TIME OF TRANSFER OR AT TIME OF ORIGINAL PURCHASE
DOESN’T MATTER! ONLY VALUE AT TIME OF DEATH!
o Gift rule  § 1014(e)
 if appreciated property given to decedent by gift during the 1-year period ending on date of death
and property is acquired from the decedent by the donor of the gift,
 basis = adjusted basis of the decedent immediately before death
1. gift basis = carryover basis – donor can’t get stepped up basis by doing this
2. person getting the property back from dead guy is the one who can’t benefit  can go to
someone else who can benefit from the stepped-up basis
 NOTE: only appreciated property affected by § 1014(e)
o Policy stuff about the estate tax
 why is estate tax repeal now in trouble? people looked at consequences  people figuring out
that if we get rid of estate tax, § 1014 will be repealed for a lot of people, so would affect not-rich
people and make them have to jump through these hoops
 reasons argued for repeal of estate tax and 1014
1. with § 1014, b/c we have an estate tax system, would have double taxation (problem with
this: estate tax applies to a small number of people, whereas § 1014 applies to everyone)
2. if we don’t get carryover basis  will screw families, small businesses, etc…  makes
no sense b/c basis not an issue until you’re selling it (estate tax isn’t really an issue here
 applies to so few people  if it’s happened to anyone, not a lot)

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  main argument in favor of § 1014  if we’re going to keep realization as a requirement, it’s
simplicity  may be hard to figure out what the carryover basis is (e.g. original basis,
adjustments to basis, etc…)
 §1022 kicks in for one year when repeal of estate tax kicks in
1. carry-over basis (treat testamentary gifts as Intervivos gifts), takes away §1014
2. this will be a PITA b/c many estates do not keep track of basis, no need if it’s held until
death
 main argument in favor of § 1014  if we’re going to keep realization as a requirement, it’s
simplicity  may be hard to figure out what the carryover basis is (e.g. original basis,
adjustments to basis, etc…)

VI. Calculation of the Federal Income Tax Liability of Individuals

SUMMARY OF ANSWERS TO PROBLEM 8

Lonny and Laura Loophole, ages 35 and 32, are married and reside in Richmond, Va. They have two children, a
son and a daughter, ages 10 and 8. Lonny and Laura are cash method, calendar year taxpayers.

Lonny conducts a solo law practice in Richmond and in 2008, collects $200,000 of fees from clients. Lonny’s
expenses relating to the law business (all paid by check in 2008) for office rental, salaries for an associate,
paralegal, and secretary, office supplies, subscriptions to professional journals, and bar dues were $30,000. Being
self-employed, Lonny made estimated tax payments of $38,000 on his 2008 federal income tax liability,** and made
estimated tax payments totaling $11,000 to the State of Virginia on his state income tax liability. Lonny also paid
an appropriate amount of self-employment tax under § 1401 (a substitute for F.I.C.A. by self-employed
taxpayers).***

Laura works as an engineer for a corporation engaged in the electronics business. Her employer paid her a salary
of $50,000 in 2008, of which $16,150 was withheld ($3,150 for F.I.C.A.; $3,000 for Virginia state income taxes;
$10,000 for federal income taxes). In 2008, Laura's employer also contributed $5,000 to a “qualified” retirement
plan for her benefit.**** During 2008, Laura paid $500 for various engineering journals of current professional
interest, $1,000 for her 2008 annual dues to the National Association of Engineers, none of which were reimbursed
by her employer, and $500 for her annual engineering license fee to the State of Virginia.

In 2008, Lonny and Laura paid $25,000 of interest on a home mortgage loan, which is secured by a mortgage lien
on their principal residence and the proceeds of which were used to purchase that residence. During 2008, Lonny
and Laura also paid $1,500 of interest on the outstanding balances on their personal credit cards, which they used
to purchase consumer goods and personal vacation trips, and they paid $5,000 interest on their still outstanding
student loans from their days as graduate students prior to entering the workforce.

During 2008, Lonny and Laura made contributions by check to various charitable organizations of $2,000 (all of
which are deductible under § 170). During 2008, Lonny and Laura also gave $50 to various homeless people that
they encountered in the downtown area of Richmond.

During 2008, Lonny and Laura received $1,000 of savings account interest on their bank accounts. In addition,
Laura owns 1,000 shares of stock of ABC Corporation, a large publicly traded corporation, which she has
purchased four years ago. In February of 2008, she received dividends of $2,000 on this stock. In December of
2008, she received another $2,000 of dividends on this stock.

Lonny owns 500 shares of the stock of XYZ Corporation (a large publicly held corporation), which he purchased in
1988 for $10,000 cash (the fair market value of the stock on the date of purchase). On December 31, 2008, Lonny
sold the 500 shares of XYZ Corporation stock for $70,000 cash (the then fair market value of the stock). In
November 2008, Lonny also sold 500 shares of General Motors stock for $10,000 cash (the then fair market value
of the stock). Lonny had purchased this stock in February 2008 for $30,000 cash (the fair market value of the
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stock on the date of purchase). In July 2008, Laura sold 200 shares of LM Corporation stock for $20,000 cash (the
then fair market value of the stock). Laura had purchased this stock in March 2008 for $10,000 cash (the fair
market value of the stock on the date of purchase).

During 2008, Lonny paid $300 for a safe deposit box in which he stored the XYZ Corporation stock certificates
and various other investment assets. In March 2008, Lonny and Laura paid $3,700 to an accountant to prepare
their federal and state income tax returns for the 2007 taxable year and to help them with tax planning advice for
the 2008 taxable year.

Assuming that Lonny and Laura properly elect to file a joint return determine:

Part (1)(a)
Their GROSS INCOME for the 2008 taxable year.

Since Lonny and Laura are filing a joint return, their federal income tax liability is determined by generally treating them
as a single taxpaying unit and combining their income and deductions. Their gross income for 2006 is:

$200,000 ordinary income from Lonny’s law practice under Section 61(a)(1)
50,000 ordinary income from Laura’s salary as an employee for the
corporation under Section 61(a)(1)
1,000 OI from savings account interest under Section 61(a)(4)
4,000 ordinary income from dividends on the ABC Corporation stock
under Section 61(a)(7) (taxed under Section 1(h)(11) at rates as if it
were additional net capital gain)**
60,000 long-term capital gain from the sale of the XYZ Corporation stock
$70,000 amount realized minus the adjusted basis of $10,000 ($10,000 cash paid for the stock—
cost basis under Section 1012)—gross income under Section 61(a)(3)
10,000 short-term capital gain from the sale of the LM Corporation stock
$20,000 amount realized minus the adjusted basis of $10,000
($10,000 cash paid for the stock—cost basis under Section 1012)—
gross income under Section 61(a)(3)
________
$325,000 Gross Income

Part (1)(b)
Lonny and Laura’s ADJUSTED GROSS INCOME for the 2008 taxable year

Lonny may deduct $30,000 in total business expenses under Section 162. Since Lonny is a sole proprietor (i.e.,
not an employee), his trade or business deductions are above the line under Section 62(a)(1).
Lonny has $20,000 of short-term capital loss from the sale of the General Motors stock (amount realized of
$10,000 minus Lonny’s adjusted basis of $30,000, the cash paid for the stock, under Section 1012). This loss is realized,
recognized (no nonrecognition provision applies to this sale), allowed under Section 165(c)(2), and not disallowed under
Sections 165(f) and 1211 because Lonny’s and Laura’s capital losses do not exceed their capital gains for 2006. Thus,
Lonny has an allowable deduction of $20,000 and this deduction is above the line under Section 62(a)(3).

These are the only above-the-line deductions that Lonny and Laura have. Thus, their adjusted gross income for 2006 is:

$325,000 Gross Income

- 30,000 Section 62(a)(1)

**
Section 1(h)(11), enacted in 2003, treats the “qualified dividend income” as if it were “net capital gain” only for purposes of the
capital gain rate preference for individual taxpayers in Section 1(h), but not for other purposes in the Code, i.e., qualified dividend
income is still ordinary income for purposes of the capital loss limitation in Section 1211. Section 1(h)(11) will sunset for taxable
years starting after 2010 and, hence, qualified dividend income received in those taxable years will again be taxed at ordinary income
rates, unless Congress extends the effective date of Section 1(h)(11).
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 - 20,000 Section 62(a)(3)

$275,000 Adjusted Gross Income

Some Notes:
• Employer contributions to pension plan: She will not pay tax on it until she w/draws it
o Timing is huge benefit – can become like an exemption
o Still a current deduction for ER
• Deduction for ½ self-employment tax, and it’s above the line
o But ignored here, he didn’t give a number for it

Part (1)(c)
Lonny and Laura’s TAXABLE INCOME for the 2008 taxable year (to determine Lonny’s and Laura’s standard
deduction and personal exemption deductions for the 2008 taxable year, use Rev. Proc. 2007-66 set forth in the
front of the CCH Code and Regulations—Selected Sections book)

To calculate their taxable income for 2008, Lonny and Laura must subtract from adjusted gross income two items:
• their personal exemption deductions under Sections 151 and 152, as reduced by Section 151(d)(3)
• the greater of
o (i) the standard deduction ($10,900 for 2008, i.e., 200 percent of the $5,450 standard deduction for
unmarried individuals for 2008—see Section 63(c)(2)(A), as amended by the 2003 Act, and Rev. Proc.
2007-66) or
o (ii) total itemized deductions (after taking into account both §§67 and 68), if they elect to itemize.

Personal Exemptions
Since Lonny and Laura are both “taxpayers” on the joint return, they have two personal exemptions of $3,500 for the year
2006, or a total of $7,000 (see Rev. Proc. 2007-66, §.19). In addition, they will be entitled to two additional personal
exemptions for their two minor children if the requirements in §152 are met. Since the two dependents here are
“qualifying children” within the meaning of §152(c) because they meet the four requirements in Section 152(c)(1), Lonny
and Laura will be able to deduct two additional personal exemptions of $3,500 each, or a total of $7,000. Thus, their
tentative total personal exemption deductions for 2008 are $14,000.

However, since their adjusted gross income ($275,000) exceeds the “threshold amount,” within the meaning of §151(d)(3)
(D), $239,950 for the year 2006 (see Rev. Proc. 2007-66), §.19(2)), their personal exemptions will be reduced by the
“applicable percentage” in Section 151(d)(3). The “applicable percentage” is 2 percentage points for each $2,500 (or
fraction thereof, meaning that you round up to the nearest whole number) by which Lonny’s and Laura’s adjusted gross
income for 2008 ($275,000) exceeds the threshold amount for ($239,950)—namely, $35,050. So you divide $35,050 by
$2,500, which is 14.02, round it up to 15, and then multiply it by 2 percentage points, which equals 30 percent. So
Lonny’s and Laura’s personal exemption deductions of $14,000 are tentatively reduced by 30 percent, or $4,200.
However, under legislation enacted in 2001, §151(d)(3) is scheduled to be phased out, starting in taxable years beginning
in 2006. For 2008, this means that under §151(d)(3)(E)(ii), the reduction of Lonny’s and Laura’s personal exemption
deductions will be only 1/3 of what it would have been without this provision, or 1/3 multiplied by $4,200, which equals
$1,400. So, under Section 151(d)(3), Lonny’s and Laura’s personal exemption deductions for 2006 would be reduced to
$12,600 (i.e., $14,000 minus $1,400).

Itemized Deductions
Lonny and Laura have the following itemized deductions for 2008:
State and local income taxes (§164(a)(3)): $11,000 + $3,000 = $14,000
Unreimbursed employee business expenses of Laura (§162): $500 + $1,000 + $500= $2,000
Home mortgage interest (§ 163(a), (h)(2)(D), (h)(3), (h)(5): $25,000
Charitable contributions (§ 170): $2,000
Safe deposit box for storing investment assets (§ 212(2)): $300
Tax return preparation and tax planning (Section 212(3)): $3,700

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 Note:Lonny and Laura are not allowed to deduct the $1,500 of credit card interest because it is “personal
interest” within meaning of §163(h). The graduate student loan interest of $5,000 is also “personal interest”
within meaning of §163(h) and not deductible (this interest also does not meet the requirements for deductibility
in §221 because Lonny’s and Laura’s adjusted gross income greatly exceeds the limit in § 221(b)(2)).

Note also that Lonny and Laura are not entitled to any charitable contribution deduction for the $50 given to
the homeless people because such amounts are not contributed to a charitable organization within the meaning of
§170(c) and therefore do not constitute “charitable contributions” within the meaning of § 170.

But we have to apply the floors in §§ 67 and 68.

Section 67 applies only to those itemized deductions not within any exception in §67(b)—called “miscellaneous itemized
deductions.” Here, the itemized deductions subject to the 2% floor in Section 67 are:

Unreimbursed employee business expenses of Laura (§ 162) $2,000

Safe deposit box (§ 212(2)) 300
Tax return preparation and tax planning (§ 212(3)) 3,700
TOTAL $6,000

Under §67, these deductions are allowed only to the extent that the total ($6,000) exceeds 2% of Lonny’s and Laura’s
AGI ($5,500) (i.e., 2% of $275,000 is $5,500)—namely, $500. So only $500 of the $6,000 is deductible.

Section 68 applies to all itemized deductions (including those allowable after applying the 2% floor), except those listed in
§ 68(c). We have no deductions listed in §68(c), so all of the itemized deductions in this problem are subject to §68:

2% rule deductions that survived §67 $500

State and local taxes 14,000
Home mortgage interest 25,000
Charitable contributions 2,000
TOTAL $41,500

Under §68, these deductions are reduced by the lesser of (i) 80% of the total itemized deductions subject to §68
($33,200), or (ii) 3% of the excess of Lonny’s and Laura’s adjusted gross income ($275,000) over the “applicable
amount” ($159,950 for 2008—see Rev. Proc. 2007-66 §.12), or $115,050 x 3% = $3,451.50. Note that, under
legislation enacted in 2001, § 68 is scheduled to be phased out, starting in taxable years beginning in 2006. See §68(f).)
For 2008, this means that under §68(f)(2), the reduction of Lonny’s and Laura’s itemized deductions will be only 1/3 of
what it would have been without this provision, or 1/3 multiplied by $3,451.50, which equals $1,150.50. So the
itemized deductions of $41,500 are reduced by $1,150.50 to $40,349.50, and that is the amount of their total itemized
deductions for 2008.

Since their total itemized deductions of $39,010 exceed the standard deduction ($10,300 for married taxpayers filing a
joint return for the 2006 taxable year), they would elect to itemize. So their taxable income for 2008 is:

$275,000.00 Adjusted Gross Income

- 12,600.00 personal exemptions (§§151 and 152)

- 40,349.50 total itemized deductions

$222,050.50 Taxable Income

Part (1)(d))
Lonny and Laura’s § 1 TAX LIABILITY (“tentative tax”) for the 2008 taxable year (Assume that, under § 1(h),
any of their taxable income in this Problem qualifying as “net capital gain” or as “qualified dividend income” is
taxed at a 15-percent rate and that the remainder of their taxable income is taxed at the tax rates set forth in §

69
1(a), as modified by the 2001 and 2003 tax cut legislation—to calculate Lonny’s and Laura’s 2008 tentative tax
liability, use the tax rate tables in Rev. Proc. 2007-66 set forth in the front of the CCH Code and Regulations--
Selected Sections book, which reflect the legislative changes.);

Lonny’s and Laura’s tentative tax for 2006 is:

15 percent*** multiplied by the “net capital gain” from the sales of stock during the year of $50,000 (Section 1(h)),
$7,500, plus 15 percent of the “qualified dividend income” of $4,000 received at any time during the 2006 taxable
year, $600, taxed under Section 1(h)(11), enacted in 2003, as if it were additional “net capital gain”—a total tax of
$8,100 under Section 1(h)
Lonny’s and Laura’s net capital gain under Sections 1222 and 1(h) is the excess of Lonny’s and Laura’s
net long-term capital gain of $60,000 ($60,000 long-term capital gain minus zero long-term capital
losses) over Lonny’s and Laura’s net short-term capital loss of $10,000 ($20,000 short-term capital loss
minus $10,000 short-term capital gain), or $50,000****

plus a tax at the normal rates in §1(a), as modified by the inflation adjustments, as set forth in Revenue Procedure
2007-66 in the CCH Code and Regulations–Selected Sections book, on the remaining $168,050 of taxable income
— (i.e, $222,050.50 - $50,000 - $4,000)  $25,550 + $10,248.14 (i.e., 28% x $36,600.50 ($168,050.50 -
$131,450)) $35,798.14.

So the total tentative tax liability for 2006, before credits is $43,898.14. (i.e., $8,100 + $35,798.14)

Part (1)(e)
Lonny and Laura’s NET TAX DUE TO THE UNITED STATES GOVERNMENT OR THE REFUND OWED TO
THEM for the 2008 taxable year.

Their bottom line tax liability (or refund owed to them) for 2008 is:

Tentative tax of $43,898.14 minus the credits of $38,000 (§6315 estimated income tax payments) and $10,000 (§31 wage
withholding). So they are entitled to a refund for 2006 of $2,249.20. (This means that Lonny and Laura paid too much in
federal estimated tax payments and federal income tax withholding during the year.)

Part (2)(a)
(2)(a) Tax benefit rule. In 2009, Lonny and Laura file their federal and state tax returns for 2008. Assume that
their Virginia state tax return shows that they are entitled to a refund of $1,000. They receive the refund check
from the state in June 2009. (Assume that Lonny and Laura's taxable income for 2009 is high enough to place
them in the 35 percent marginal federal income tax bracket for that year.) What are the federal income tax
consequences to Lonny and Laura on account of their receipt of this state tax refund?

Since Lonny and Laura properly took a deduction on the 2008 return for the state and local taxes paid during 2008, we
deal with the refund in 2009 (when it occurs) and do not go back and change their 2008 return. The refund of $1,000 is
fundamentally inconsistent with the earlier deduction of the state and local income taxes under §164(a)(3), thus triggering
application of the tax benefit rule in the taxable year 2009. Under the inclusionary component of the tax benefit rule,
Lonny and Laura have to include the $1,000 refund in gross income in 2009 to the extent that the earlier deduction of the
state and local taxes in 2008 produced a tax benefit by reducing their taxable income. Since, in the taxable year 2008,
they had more than $1,000 of itemized deductions that exceeded the standard deduction and more than $1,000 of
deductions that exceed the 3% floor in § 68, we can conclude that all $1,000 of the refund produced a tax benefit in the
earlier year when it was deducted and, thus, must be included in gross income in the taxable year 2009. The character of
the income is determined with reference to the character of the earlier deduction to which it relates (under the Supreme
Court decision in Arrowsmith)—since the state and local tax deduction is an ordinary deduction, the tax benefit rule
***
Note that long-term capital gain attributable to collectibles gain or section 1202 gain remains taxable at a preferential rate of 28
percent and long-term capital gain that is unrecaptured section 1250 gain remains taxable at a preferential rate of 25 percent. See
Section 1(h).
****
The preferential tax rates in Section 1(h) apply to the portion of an individual taxpayer’s taxable income that constitutes “net
capital gain” within the meaning of Sections 1(h) and 1222(11) and “qualified dividend income” as defined in Section 1(h)(11).
70
income in the taxable year 2009 is ordinary income as well. The $1,000 of tax benefit rule income is taxable at the rates
in effect in 2009, when the income is includible in gross income, not at the rates that applied in the earlier taxable year
when the deduction was taken.

Part (2)(b)
In addition to the facts in Part (2)(a), suppose that Lonny and Laura received in 2009 an $800 check from their
accountant in response to their complaint that the accountant had charged too much for his services rendered in
2008 (i.e., the accountant had refunded in 2009 part of the fee that he had charged Lonny and Laura in 2008).
What are the federal income tax consequences to Lonny and Laura on account of their receipt of this $800 check?

The $800 refund of the accountant’s fee in the taxable year 2009 is fundamentally inconsistent with the earlier deduction
of the accountant’s fee under §212(3), thus triggering application of the tax benefit rule in the taxable year 2009. Under
the inclusionary component of the tax benefit rule, Lonny and Laura have to include the $800 refund in gross income for
the 2009 taxable year to the extent that the earlier deduction of the accountant’s fee under Section 212(3) in the taxable
year 2008 produced a tax benefit by reducing their taxable income. However, under the exclusionary component of the
tax benefit rule in Section 111, the $800 refund is excluded from gross income to the extent that they did not receive a tax
benefit from the earlier deduction (i.e., to the extent that it did not reduce their taxable income). Since this deduction was
subject to the 2 percent floor in Section 67 and only $500 of the deductions subject to that floor were allowable as a
deduction, we know that only $500 of the accountant’s fee produced a tax benefit in 2008 and that is the amount Lonny
and Laura have to include in gross income in 2009 under the inclusionary component of the tax benefit rule. (Note that
since they had more than $500 of itemized deductions that exceeded the standard deduction and more than $500 of
deductions that exceed the 3% floor in Section 68, we can conclude that the $500 portion of the accountant’s fee that
survived the 2% floor in Section 67 produced a tax benefit in 2008.) The remaining $300 of the accountant’s fee refund is
excluded from gross income under the exclusionary component of the tax benefit rule in Section 111, because it was
disallowed as a deduction in 2008 by Section 67 and, thus, produced no tax benefit in the earlier year. The character of
the income is determined with reference to the character of the earlier deduction to which it relates (under the Supreme
Court decision in Arrowsmith)—since the deduction under Section 212(3) is an ordinary deduction, the tax benefit rule
income in the taxable year 2009 is ordinary income as well. The $500 of tax benefit rule income is taxable at the rates in
effect in 2009, when the income is includible in gross income, not at the rates that applied in the earlier taxable year when
the deduction was taken.

• Tax benefit rule and integrity of the taxable year

o ITY: Don’t go back to earlier years to make corrections, unless:
 mistake of law/fact
 statutory provisions for carryback/carryover
 nonstatutory case law (see claim of right)
o TBR: Triggered by later events inconsistent with earlier deduction/credit/etc.
 Inclusionary and exclusionary components: §111
• Inclusionary: later inconsistent event (like refund) will be income in the later year to the
extent you got a tax benefit in the earlier year.
• Exclusionary: to extent the earlier deduction didn’t produce a benefit (b/c it didn’t reduce
taxable income in some way), the refund or other inconsistent event isn’t income – it’s
excluded.
 Opposite of claim of right doctrine: Both caused by the fact that we look at finite 12-month
period and report things based on that. Unless mistake of law/fact, you don’t amend, just deal
with later events in later year.
• Absent 1341, which often doesn’t apply, you deal with income in earlier year at earlier
year’s tax rates, and later years at later rates, and has to be semblance of a right.
• TBR has no similar provision like 1341.
• The point is: Arrowsmith said when you have income in later year integrally related to
earlier amount, characterization of the later amount is determined wrt earlier amount.
 Stacking rule: when you get a refund, in determining how much TBR you have, you have to
figure out what stack the refund came out of.

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 • Rule: maximize chance for inclusion, minimize chance for exclusion.
• Assume deduction came out of stack that produced benefit. If total itemized deductions
produced benefit, there’s more than enough to have income.
• Most logical rule, not adopted, would be to require TPs to do the math – proration –
partial inclusion, partial exclusion.

VII. Another Look at Gains/Losses from Disposition of Property; Alternative Methods of

Cost Recovery
o Basis of Property Acquired in Taxable Property-for-Property Exchange
o 1001(b): Amount realized is FMV of property you receive, not FMV of what you’ve given up. Then you
subtract basis to get gain loss.
o Philadelphia Park: Most cited for proposition that in taxable arms-length exchange, you can use the
barter equation method of valuation, if you can’t directly value what you’ve received.
 Basically says, try to value what you received directly. In rare case you can’t as mandated by
1001(b), you can value by reference to what you gave up. Only a valid assumption if it’s an
arm’s-length exchange.
 More important: basis: Philadelphia Park says in property-for-property exchange that’s fully
taxable, initial basis in new property is the FMV of the asset received. 1012 tax cost basis.
1. Why FMV: b/c that’s what you had to report as A/R under 1001(b).
 1031/1041 nonrecognition provisions contain their own basis rules for property received.
 What if you can’t value either side?
1. Very rare. If you can’t, you can’t impose tax yet, so you attach basis in old property to
new property.
2. Essentially what you do with nonrecognition provisions like 1031.

o Depreciation and Amortization Deductions

o Wasting Assets
 Depreciation/Amortization requirements
1. Asset must be wasting asset (meaning it must have finite/terminate useful life), AND
2. Must be used in trade/business or investment activity
o i.e. can’t depreciate personal home/auto
 Code provisions: §§167, 168(d), 197, 611 (depletion – we don’t do this)
1. 167 authorizes depreciation and certain other amortization
2. 168 has actual method: accelerated cost recovery
3. 197: certain amortizable intangibles
 Recovery period calculated to be shorter than actual useful life
1. Accelerated depreciation (not real prop)
2. Amortization: 15 years
 Amortization: does not attempt to calculate actual loss in value.
1. Probably more generous than theoretically pure SHS
 Concept is totally consistent w/ SHS but how we do it is not (b/c not accurate measure)
 Departs from theoretically pure consumption
1. You should get current deduction for whole cost of asset
o No concept of amortization/depreciation
o b/c decline in value not attributable to consumption
2. theory: allowing current deduction for current expenditure is equivalent to exempting
income from investment from tax
o this would not trouble cash flow consumption tax proponent
o Real Property
 §1012 basis in land is $20k, $80k in bldg (On the day of acquisition), then apply the rule

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  Land is used in T/B investment activity, but lacks other, it is not a wasting asset
 So T will recover $20k basis in land when she sells
1. Treated as selling 2 assets (land & bldg)
 $80k bldg basis is depreciable
1. §168(b)(3)(A): w/ real prop: straight line – 39 years
 §168(b)(2): use mid-month convention for putting it in service
1. And disposed of midmonth in month you disposed of it, regardless of actual time
 §168: ignore salvage value (ACRS doesn’t care)
o Equipment
 Election under §179
1. Under dollar amt allowed, if she elects, could elect to depreciate it all (year is important)
 Assume she doesn’t elect, or she’s already used it
1. It’s 3-year recovery period
2. Must look at Regulations and tables to discover recovery period
o Ex: computers – 5 years; RP will tell us
3. §168(b)(1): as long as it’s 3, 5, 7, 10 year depreciable personal property, can use double
declining balance
4. §168(b)(2): 15/20 year can still use accelerated
o Use 150% declining value
o Less accelerated, but still faster than straight line
5. Can still elect straight line
o Default, she’s using accelerated
o Why use straight line
 Higher tax rates later, want more deduction later
 Don’t have enough income to use deduction this year, you will later
6. ½ year convention – whenever acquired, assume it as acquired (and disposed) mid-year
o Personal Property
 Simon/Liddle cases concern this
 Personal property – wasting asset?
1. Violin used in business (pro musician)
o If it is depreciable either 2 or 5 year, so use DDB
o ½ year convention
 Gov’t argued: this is not wasting asset
1. Some are, but b/c this one has value in collector’s mkt, it does not decline, it appreciates,
so this one is not depreciable
o Gov’t wanted to look at specific violin, not type of property
2. Inconsistent w/ what they do w/ other assets
 Decision: is property in general wasting asset
1. Is it wasting asset in general/in theory/in essence
2. Violin meets this test, violin is depreciable b/c violins are depreciable in general, even
though this particular violin is not
o Self-Created Goodwill/Customer List
 Customer list (6 year useful life)
 Good will (no determinable useful life)
1. 0 basis, but FMV of $30k
 Either in §197 or §167: amortization b/c intangible asset
1. Notice: SELF-CREATED intangibles (T started business, she did not buy business)
2. Self-created good will has no basis (unless in unusual facts of Welch v. Helvering – prior
ER’s debts to start own business)
o b/c advertising, etc. creates good will and we allow deduction for those things
 how much amortization
1. self-created good will: 0 basis, 0 amortization
73
 2. customer list: same (if self-created)
 requirements
1. T/B: yes
2. Wasting asset:
o Apart from §197, goodwill has no determinable useful life
 So unless §197 applies, it is not a wasting asset even if you have a basis
in it
o §167: asset is amortizable when (…)
 Notice, 168 does not apply to intangibles (ACRS)
o §197 does not apply to intangible not described in
 (d)(1)(a), (b), and (c) AND self created §197 does not apply
 Self-created good will and self-created customer lists are not qualified
for §197
o Go back to pre-§197 law, g/w not amortizable, Customer List is amortizable for 6
year straight line under §167
o Existing Goodwill/Customer List
 T buys existing business (unlike (d), not the creator of intangibles) and transaction creates
covenant not to compete
 Sale/purchase of business is treated as sale/purchase of each individual asset
1. So she’s purchasing each asset w/ basis in each
2. Take purchase price and allocate to FMV of assets, price above all that is good will
o Same for seller
 She has purchased
1. g/w $30k basis
2. customer list (5 year life) $7,500
3. covenant not to compete $15k
 wasting assets?
1. Cov not to compete – 3 year life
2. Customer list – 5 year life
3. g/w – no determinable life (outside of §197)
o pre §197 – purchased g/w not amortizable
o now, 15 year if §197 applies -- straight line
o good news for g/w, bad news for CNTC/CL
 §197 IS NOT ELECTIVE
1. Will apply to everything in this problem
 Nothing kicked out by (c)(2)
1. b/c g/w and CL not self-created
2. CNTC close b/c self created, but it’s w/in exception
o Described in (d)(1)(D)
3. CNTC is service income to recipient and will report it over 3 years as payment received
o Business License
 Business license: capital expenditure
1. Produces intangible
2. If there was no §197, have to write it off over 30 years
 197(d)(1)(D):
1. Not kicked out by (c)(2) b/c listed in (d)(1)(D)
2. Writes it off over 15 years
 [This is self-created in that she paid for it, she didn’t buy it from someone else when she bought
business]
o Patents & Copyrights
 Prior to §197, patents and copyrights amortizable over legal life in §167
1. That means, if §197 doesn’t apply, you’re back to legal life rule (however it’s calculated)

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  When does §197 apply to patents/copyrights
1. 197(d)(1)(C)(iii): potential
2. If it’s self-created §197(c)(2) kicks it out
 In (h) she is inventor, kicked out
1. So §197 doesn’t apply – legal life under §167
 In (g) she acquires patent as part of purchase of assets of business
1. Not kicked out by (c)(2) b/c not self-created
2. HOWEVER, make sure it’s created as part of the assets constituting T/B
o b/c (e)(4): won’t be 197 intangibles (even if purchased) even if purchase is not
part of purchase of T/B (i.e. you’re only purchasing patent…)
o but not kicked out in this problem b/c she is acquiring it as part of the purchase of
a T/B
3. so write off purchase price of patent over 15 years, straight line

o Gains on the Sale of a Personal Residence

o §163(h)(2)(d) (w/ (h)(3)) treats home mortgage interest as deductible
 Treated as not personal interest
o Principal Residence: Married
 Was it principal residence for at least 5 years?
 §121 only one sale/exchange for each 2 year period
 Limit
1. $250k gain is limit (single/MFS)
2. MFJ: $500k
3. Usually, personal residence, non-excludible gain is LTCG (subject to 15%)
 Remember selling expenses offset amt realized
1. Gain is under $500k limit so it is all excluded from GI – excluded from step 1
2. Does not require re-investment
o Principal Residence: Single
 Limit is $250k
 Above limit by $200k
1. Taxable – into GI
2. §1221(a), §1222 = LTCG
o In bracket above 25%, so she’ll get 15% preference
o (could be as low as 5%, if she was in lower bracket, but here she’s high bracket)
3. §121 applies automatically, not an election!!
o Capital Gains and Losses
 (a) Covered throughout the semester
1. No pref for corp CG, but losses subject to special limit (carry back/forward)
o Loss only to extent of gain
2. Individuals: loss = gain plus $3k
o Carry forward
 Coming up with Rate Preferences
1. Rates in §1(h)
2. 3 basic categories (25% and up tax bracket):
o NCG attributable to (1) collectible and (2) §1202 gain
 Keep as CG but shouldn’t qualify for preferential rate
• Ex: Collectables
 §1202 gain
• Can exclude from GI 50% of gain from qualified small business
stock
• Since that gain has had 50% taken out, so no further preference
• Gain that stays in GI is taxed at 28%, not 15%
75
  25% and above bracket
• 28%
 Below 20% bracket
• No preference
o NCG attributable to un-recaptured section 1250 gain (relates to real property)
 25% and above bracket
• 25%
 Below 20% bracket
• No preference
 No real relation to §1250, except that it’s real estate
o Everything else
 25% and above
• 15%
 20% and below
• 5% (through ’07)
• 0% (2008-2010)
 Investments
1. (c)
o Classic situation: §1231 asset (raw land subdivided, held for investment)
o Or apartment bldg for rent income, then convert and sell as condos
o From §1231 asset to dealer property
o Dealer property not capital asset or §1231, it’s just ordinary
 Most involve unimproved land
o Facts and circumstances analysis
2. (d) big losses in stock
o Wants it to be dealer prop b/c then OL not CL
o Argue: trading is like dealing
 Must be primary source of income
 Passive trader deduction under §212, primary source of income
deduction is §162
o Trader is not a dealer
 This is why court said “customers” a trader has no customers
o CG on gains/CL on losses
 Sucks, usually STCG and losses subject to limit
 Personal Services  IP
1. Both involve personal services (classic OI) crystallizing into IP, you would think you’d
treat them the same; you don’t
2. (e) author/copyrights
o Not capital assets
o Either by creator or whose basis is determined by basis of creator
 i.e. Intervivos gift
 death basis: new basis, you’re not creator §1221(a)(3) does not apply
o §1221(b)(3): musicians wanted to sell old musical works (special interest)
 Temporary
 Wouldn’t elect this if there is a loss
 Can elect out of §1211 as long as you sell before 2011
 Only MUSICAL work
3. (f) inventory/patents
o Not excluded from capital asset
o §1235 says even if you’re professional inventor, you get CG from sale of patent
(as long as you’re a holder)
o §1221 does not exclude patents
76
 o Why?
 Congress favors patents to copyrights
o 1235: whether professional/amateur, it’s CG
 Must be a holder
 Corp that buys it from inventor does not qualify if they don’t meet
requirements of “holder”
 (g) Accounts Receivable
1. No basis so $30,000 gain
2. No loss here
3. Character: §1221(a)(4): OI, not CA
4. (i) Accrual meathod
o All events occurred in Y1 and can determine amt w/ reasonable accuracy
o So report $40k income in Y1
o She’s paid tax on $40k, so $40k basis (§1012)
o Sale for $30k, she has $10k loss
o Nature of deduction:
 Not bad debt b/c not “worthless”
 §165(a), (b), (c)
• It’s (c)(1) loss
 Character: §1221(a)(4): not a capital asset
• Good news, it’s not CL, it’s OL
• So no limit
 (h) Depreciable Machinery
1. Character:
o not CA b/c does not include depreciable/amortizable prop used in T/B or real
prop whether depreciable or not
o §1231(b): picks up assets kicked out by (a)(2) but only if held for more than one
year
o OI recapture under §1245:
 Gain attributable to O deductions
 ONLY TO Dep/Amt PERSONAL PROP
 All OI under §1245, comes first, if it applies, it’s all OI
 Do it last, but it comes off first
2. (i)
 What if you sell for more than original basis?
• 8,000 is OI (§1245) the rest is through §1231 – know at the end
of the year
3. (ii) Amortizable Intangibles
o §§1231/1245 apply to amortizable intangibles as well as machinery
4. (iii) Land/Building
o Character:
 §1245 will not apply here b/c it is real prop/not personal property
 Office bldg? then it’s 1221 kicked out, §1231 picked up if held longer
than one year
• Factory, same
 Apartment building, her prime business is something else
• ONE ACTIVE RENTAL enough to make it T/B
o Bottom line: this will be 1231, not a capital asset, kicked out by (a)(2) may be
picked up by §1231
o CG? Depends on §1231
o REMEMBER: if $22k qualifies for CG
 $10k qualifies for 15%
77
  $12k is 25%
• Under 1(h)(6)
 $10k 15%

Income Base Cash Flow Consumption Base Wage tax Base

Y1: Income $60,000 $60,000 $60,000
$60,000
Borrowed funds* No; until she repays it, +$10,000 (b/c potential source of Ignored
$10,000 no deduction for consumption)
principal repayments *this is major difference btw CR
of loan (loans taxed on and ITB: no benefit of borrowing in
*Huge difference repayment, not when CF
here in ITB and borrowed) *So no politician has introduced
CFCB “true CF” b/c of this treatment of
loans
*this is reason we’ll never really go
here he says
Buy stock CE rule: declines in - $10,000 Ignored
$10,000 wealth that are savings Not b/c it’s borrowed funds but b/c
are NOT currently it’s an outflow for
deductible, so $10,000 business/investment; this is
basis and no deduction deduction no matter how it’s funded
(and no depreciation, **So, same treatment of $10k in
not wasting asset) ITB and CFCB but b/c used for
investment, not b/c it was a loan
Savings Ignored - $1,000 Ignored
$1,000 Net savings
Y1 Base: $60,000 $59,000 $60,000
(even though only 59k 1k saved, 59 k consumed only tax wages,
spent) *Follow the cash follow wages
Y2: Income $60,000 $60,000 $60,000
$60,000
Sells stock - $1,000 + $9,000 Ignored
$9,000 *Still gets her basis of Sales proceeds includable (no
$10,000 even though basis!) follow the money
that was borrowed *There was a deduction upfront so
money that won’t be pay now
repaid until future year *if $9,000 spent now (assumed for
[timing advantage this problem) then no offsetting
from borrowed funds] deductions for savings, if she had
*This is a $1,000 loss invested some, she could get
(assume it survives savings deduction
capital loss limit)
*§165, §1211
Interest Paid on - $400 - $400 Ignored
Loan §163 Regardless of type of loan
$400 *a lot to consider here, (personal/business/investment) b/c
what type of loan was money going to creditor… it’s not
it, does it fall w/in in your hands, you’re not
limit… on and on consuming it, so it’s deductible
*ALL INTEREST PAYMENTS
DEDUCTIBLE
*proceeds are income, deduction
for principal repayments AND
income
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Interest on savings + $40 + $40 Ignored
acct Interest taxable b/c she consumed it
$40 regardless of whether *if it stayed in the bank, there
it’s left in the account would have been a $40 offsetting
or she w/draws it deduction
(whether currently
saved or consumed)
unlike CFCB
Y2 Base: $58,640 $68,640 $60,000

VIII. Tax Treatment of Personal Injury Recoveries

o Personal injury lawsuits: § 104(a)(2) rule
o All damages “on account of personal physical injuries or physical sickness” are excludable from gross
income, except for punitive damages. Whatever gets taxed is ordinary income for the P.
o Scope of § 104(a)(2) – Claims with an origin in physical injury or sickness. Thus personal discrimination
or reputational claims are not included.
i. Minority view – If something like libel actually leads to physical illness, this is literally physical
sickness, so § 104(a)(2) applies.
o Interest – Pre-judgment interest on otherwise excludable damages is not excludable from income. And if
installment payments of the award bear interest, the interest is taxable.
o Basis  Permanent exclusion
o So plaintiff’s basis in property received from the suit is its time-of-receipt FMV. 104(a)(2) is a
permanent exclusion, so want to give him basis so he’s not taxed on it later
• Expenses
o Expenses for collecting taxable income are deductible. See § 212.
i. The expense is misc. ID – This large below-the-line deduction may cause large AMT liability.
ii. e.g. if award is 50% taxable, will get 50% of attorney’s fees
o Expenses for collecting tax-exempt income are not deductible. (§265?)
o For damage awards with exempt and non-exempt amounts, the expenses are apportioned pro rata
according to the verdict or settlement, or, lacking such information, according to plaintiff’s complaint
o Where D uses property other than cash to settle a lawsuit
o This is a realization event – treat as if sold property for FMV and turned around and paid P  treated as
sale or exchange  gain or loss will depend on character of the asset transferred (e.g. could be capital or
ordinary)
o deduction analysis is the same as any other lawsuit
• § 62(a)(19)[20]
o above the line deduction for costs wrt discrimination suits
o Medical expenses
o excludable under § 104
o but, if have taken deductions, have to include that amount deducted as gross income to avoid a double tax
benefit
i. § 213 makes it difficult to deduct  floor – to the extent they exceed 7.5% of AGI
ii. T probably didn’t get a deduction (covered by insurance; if reasonable prospect of recovery by
lawsuit, have to wait,etc…)
• Settlement
o allocation will generally be based on what’s in the complaint
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o if allocation is agreed upon by the parties, will usually be respected unless unreasonable

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