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FEDERAL INCOME TAX

Professor Gabilondo
Fall 2013
INTRODUCTORY COMMENTS TO THE COURSE ............................................................. 9
CHAPTER 1 ................................................................................................................................ 10
I. PROBLEM ............................................................................................................................ 10
II. VOCABULARY ................................................................................................................... 11
III. OBJECTIVES ..................................................................................................................... 12
IV. OVERVIEW ....................................................................................................................... 12
1. A brief History of Federal Income Tax ........................................................................................ 12
2. The Tax Practice ........................................................................................................................... 12
3. Resolution of Tax Issues Through the Judicial Process ................................................................ 12
A. Trial Courts ....................................................................................................................................... 12
a. The Tax Court .................................................................................................................................... 13
b. Federal District Court ........................................................................................................................ 13
c. The United States Court of Federal Claims........................................................................................ 13
B. Appellate Courts ............................................................................................................................... 13
C. Selection of Forum ........................................................................................................................... 13
V. ANALYSIS OF THE COMPUTATION OF TAX LIABILITY OF CAROLINE
TAXPAYER ............................................................................................................................. 13
A. Basic Questions Addressed by an Income Tax System ..................................................................... 13
B. Evaluating the Taxpayers Tax Liability ........................................................................................... 14
o Gross Income 61[everything] ...................................................................................................... 14
o Adjusted Gross Income [Gross income - above the line deductions] 62 ..................................... 15
o Deductions .................................................................................................................................... 15
o Calculating Adjusted Gross Income = $230k ................................................................................ 16
o Taxable Income [AGI - (below line deductions/standard deductions + personal exemptions)] 63
16
o Tax Rates = 1 ............................................................................................................................. 16
Class Notes: 08-13 (Mon.) .............................................................................................................................. 17
TAXATI ON OF I NDI VI DUAL I NCOME, J. MARTIN BURKE AND MICHAEL K. FRIEL,
10
TH
EDITION, LEXISNEXIS, ISBN 978-1-4224-8241-4. ..................................................... 17
Class Notes: 08/15 [Wed.] .............................................................................................................................. 18
CHAPTER 2 61 ......................................................................................................................... 19
I. PROBLEMS .......................................................................................................................... 19
II. VOCABULARY ................................................................................................................... 19
III. OBJECTIVES ..................................................................................................................... 20
IV. OVERVIEW ....................................................................................................................... 20
A. The Search for a Definition of Income .............................................................................................. 20
B. Income Realized in any Form 1.61-1(a) .......................................................................................... 20
C. Realization, Imputed Income & Bargain Purchases .......................................................................... 21
a) Commissioner v. Glenshaw Glass Co. ............................................................................................21
b) ........ income is: (1) any undeniable accession to wealth (improved situation), (2) which is clearly
realized (change in value) by the taxpayer, (3) over which the taxpayer has complete dominion
(can use it). ......................................................................................................................................21
c) Cesarini v. US .................................................................................................................................22
d) .......... The rule requiring all income to be included as gross income is intentionally broad to allow
Congress to use its taxing power broadly under the Sixteenth Amendment. ..................................22
e) Old Colony Trust Company v. Commissioner ................................................................................22
f) ....... The discharge of a taxpayers obligation by a third party is equivalent to direct receipt by the
taxpayer [receive a benefit] = taxes paid by company = additional income of person. ...................22
g) REVENUE RULING 79-24 ............................................................................................................23
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h) McCann v. US .................................................................................................................................23
i) ......... when a company pays travel expenses, a taxpayer must include such compensation in gross
income when the excursion is viewed as a reward for outstanding employee success within the
company. .........................................................................................................................................23
j) Pellar v. Commissioner ...................................................................................................................23
k) ............................................................. bargain purchases generally do not constitute gross income
.........................................................................................................................................................23
l) Roco v. Commissioner ....................................................................................................................23
Class Notes: 08-20 [Mon.] .............................................................................................................................. 23
Class Notes: 08-23 [Wed.] .............................................................................................................................. 23
CHAPTER 3: THE EFFECT OF AN OBLIGATION TO REPAY [1341 OVER $3K,
BTL DEDUCTION] .................................................................................................................... 24
I. PROBLEMS .......................................................................................................................... 24
II. VOCABULARY ................................................................................................................... 25
III. OBJECTIVES ..................................................................................................................... 25
IV. OVERVIEW ....................................................................................................................... 26
A. Loans - Loan proceeds do NOT constitute gross income. ................................................................. 26
B. Claim of Right if there is a contingent repayment obligation, have to treat it as income as soon as
you get it, then 1341 ................................................................................................................................ 26
C. Illegal Income ................................................................................................................................... 26
D. Deposits ............................................................................................................................................ 27
m) North American Oil Consolidated v. Burnet (1932) .......................................................................27
n) . if a taxpayer receives earnings under a claim of right and without restriction as to its disposition,
he has received reportable income, even if he may later be required to repay. If he does have to
repay, it will be a deduction in that year. ........................................................................................27
o) James v. US .....................................................................................................................................28
p) ........ receipt of illegal funds constitutes income taxable to the wrongdoer [if the taxpayer receives
income, lawfully or unlawfully, without consensual recognition of obligation to repay, that income
is taxable. ........................................................................................................................................28
q) Commissioner v. Indianapolis Power & Light Company ................................................................29
r) .. control standard [complete dominion standard] - Determining factor = control over conditions
of refund Q = who has the dominion in the end? ......................................................................29
Notes ............................................................................................................................................................... 29
CHAPTER 5: GIFTS, BEQUESTS & INHERITANCE ......................................................... 29
1. Gross income does not include a gift, bequest, or inheritance ...................................................... 29
2. Federal law determines what is a gift, etc. (esp. title 26) .............................................................. 29
3. 102(b) - ......................................................................................................................................... 29
I. PROBLEMS .......................................................................................................................... 30
II. VOCABULARY ................................................................................................................... 32
III. OBJECTIVES ..................................................................................................................... 32
IV. OVERVIEW ....................................................................................................................... 33
A. What is Excluded by 102? .............................................................................................................. 33
1. The Nature of a Gift ........................................................................................................................... 33
2. The Nature of a Bequest or Inheritance ............................................................................................. 33
3. Statutory Limitations on the Exclusion -- 102(b)............................................................................. 33
B. Basis of Property Received by Gift, Bequest or Inheritance ............................................................. 33
1. Gifts of Appreciated Property LIFE 1015 ................................................................................. 33
2. Gifts of Property Basis in Excess of FMV ................................................................................ 34
3. Basis of Property Received by Bequest or Inheritance DEATH 1014 ....................................... 34
C. Part-Gift, Part-Sale - HYBRID ......................................................................................................... 34
s) Commissioner v. Duberstein ...........................................................................................................34
t) Look at the transferors intent when determining whether it was purely altruistic, with no invested
interest. ............................................................................................................................................34
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Notes: .............................................................................................................................................................. 35
u) Wolder v. Commissioner.................................................................................................................35
v) Olk v. US.........................................................................................................................................35
w) ..................... payments made by persons of whom the taxpayer provides services = compensation
.........................................................................................................................................................35
x) Goodwin v. US ................................................................................................................................35
y) Its not always the transferors intent. Adds to the Duberstein test. Looks to the mechanics of how
the gift is structured. ........................................................................................................................35
CHAPTER 12: BUSINESS & PROFIT SEEKING EXPENSES ............................................ 36
I. PROBLEMS ....................................................................................................................... 36
II. VOCABULARY ............................................................................................................... 37
III. OBJECTIVES.................................................................................................................. 37
IV. OVERVIEW .................................................................................................................... 37
A. Business Deductions 162 ............................................................................................................... 37
1. The Expense Must be Ordinary & Necessary - 162 .................................................................. 38
2. Carrying On a Trade or Business - 162 ..................................................................................... 39
B. 212 Deductions ............................................................................................................................... 40
z) Welch v. Helvering .........................................................................................................................41
aa) Higgis v. Commissioner ..................................................................................................................41
bb) Commissioner v. Groetzinger .........................................................................................................41
cc) Revenue Ruling 75-120 ...................................................................................................................42
dd) Pevsner ............................................................................................................................................42
CHAPTER 34: ASSIGNMENT OF INCOME ......................................................................... 44
I. PROBLEMS .......................................................................................................................... 44
II. VOCABULARY ................................................................................................................... 44
III. OBJECTIVES ..................................................................................................................... 44
IV. OVERVIEW ....................................................................................................................... 44
A. The Progressive Rate Structure ......................................................................................................... 44
B. Development of Rules Limiting Income-Shifting ............................................................................. 44
C. Application of the Assignment of Income Rules .............................................................................. 44
D. Income-Shifting Within Families & Between Related Parties .......................................................... 45
Notes: .............................................................................................................................................................. 45
ee) Lucas v. Earl (1930) ........................................................................................................................46
ff) Helvering v. Horst ...........................................................................................................................46
Next Chapter: Basis ........................................................................................................................................ 47
CHAPTER 4: GAINS DERIVED FROM DEALINGS IN PROPERTY ............................... 47
I. PROBLEMS .......................................................................................................................... 47
II. VOCABULARY ................................................................................................................... 48
III. OBJECTIVES ..................................................................................................................... 48
IV. OVERVIEW ....................................................................................................................... 48
V. ............................................................................................................................................... 50
A. Tax Cost Basis .................................................................................................................................. 50
B. Impact of Liabilities .......................................................................................................................... 51
1. Impact on Basis ............................................................................................................................ 51
2. Impact on Amount Realized ......................................................................................................... 51
3. Basis of Property Acquired in Taxable Exchange ........................................................................ 51
C. Basis of Property Acquired in Taxable Exchange............................................................................. 51
gg) Philadelphia Park Amusement Co. v. United States (1954) ............................................................51
CHAPTER 13 CAPITAL EXPENDITURES ........................................................................ 52
I. PROBLEMS .......................................................................................................................... 52
II. VOCABULARY ................................................................................................................... 53
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III. OBJECTIVES ..................................................................................................................... 53
IV. OVERVIEW ....................................................................................................................... 53
Main rules to take out of this chapter: Cheat Sheet On Rules to Know ....................................... 53
A. Deductible Expense or Capital Expenditure ..................................................................................... 53
B. Defining Capital Expenditure INDOPCO ...................................................................................... 53
C. Selected Categories of Capital Expenditures .................................................................................... 54
1. Cost of Acquisition & Costs Incurred in Perfecting & Defending Title ....................................... 54
2. Repair & Improvement ................................................................................................................. 54
3. Intangible Assets .......................................................................................................................... 55
4. Expansion Costs ........................................................................................................................... 55
5. Advertising Expenses ................................................................................................................... 55
D. Purchase or Lease ............................................................................................................................. 55
hh) Commissioner v. Idaho Power Co. ..................................................................................................55
Next 2 cases difficulty in determining if expense KEEPs in working order, or PUTs in new working order
........................................................................................................................................................................ 56
ii) Midland Empire Packing Company v. Commissioner ....................................................................56
jj) Mt. Morris Drive-In Theatre Co. v. Commissioner .........................................................................57
kk) Revenue Ruling 2001-4 ...................................................................................................................58
Its not about the nature of the expense, its how that expense relates to everything else that is being done
58
CHAPTER 14 DEPRECIATION ........................................................................................... 58
I. PROBLEMS .......................................................................................................................... 58
II. VOCABULARY ................................................................................................................... 58
III. OBJECTIVES ..................................................................................................................... 58
IV. OVERVIEW ....................................................................................................................... 58
A. Depreciation ...................................................................................................................................... 58
1. Depreciable Property .................................................................................................................... 58
2. Recovery Period The Useful Life Concept ................................................................................ 59
3. Depreciation Methods .................................................................................................................. 60
4. Conventions ............................................................................................................................... 61
B. Computing the Depreciation Deduction ............................................................................................ 61
C. Amortization of Intangibles - 197 .................................................................................................. 61
D. Relationship Between Basis & Depreciation .................................................................................... 61
E. 179 Expensing Tangible Personal Property .................................................................................... 61
F. The Relationship of Debt to Depreciation ......................................................................................... 62
G. Conclusion ........................................................................................................................................ 62
ll) Revenue Ruling 68-232 ...................................................................................................................62
mm) ................................................................................................................... S
imon v. Commissioner ....................................................................................................................62
nn)Liddle v. Commissioner ..................................................................................................................62
oo) Revenue Procedure 87-56 ...............................................................................................................62
Look at tax topic map = helpful organize outline according to this scheme ................................................. 62
CHAPTER 39 LIKE KIND EXCHANGES ........................................................................... 62
I. PROBLEMS .......................................................................................................................... 62
II. VOCABULARY ................................................................................................................... 62
III. OBJECTIVES ..................................................................................................................... 62
IV. OVERVIEW ....................................................................................................................... 64
A. Continuity of Interest ........................................................................................................................ 64
B. The Like Kind Requirement .............................................................................................................. 64
C. The Holding Requirements ............................................................................................................... 64
D. Solely for Like Kind Property: The Presence of Boot (Broadening) ......................................... 64
E. Treatment of Liabilities ..................................................................................................................... 65
F. Basis Calculations ............................................................................................................................. 65
G. The Relationship Between Sections 276(a)(1) & 1031 ..................................................................... 66
H. .. ........................................................................................................................................................ 66
I. Three-Way Exchanges & Deferred Exchanges (these 2 Broadened) ................................................. 66
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pp) Revenue Ruling 72-151 ...................................................................................................................66
EXAMPLE OF SIMULTANEOUS EXCHANGE ........................................................................... 66
A WANTS A 1031 EXCHANGE FOR RANCH 1 B SAYS HE WILL FIND A LIKE KIND PROPERTY
THAT A WANTS, BUY THAT PROPERTY, AND DO A LIKEKIND EXCHANGE ................................. 66
A SELLS TO B FOR $1000 A RANCH USED BY A IN BUS. ...................................................... 67
B PLACED $100 INTO ESCROW AND AGREED TO PAY AT CLOSING AN ADDL $200 CASH AND
ASSUME $160 LIABILITY OF A AND TO EXECUTE A NOTE FOR $540 .......................................... 67
A LOCATED ANOTHER RANCH OWNED BY C AND B ENTERED INTO A K WITH C TO
PURCHASE THE 2ND RANCH FOR $2000 ..................................................................................... 67
B PLACED $40 INTO AN ESCROW ACCT, AGREED TO PAY $800 AT CLOSING, ASSUME $400
LIABILITY OF C, AND EXECUTE A NOTE FOR $760 ..................................................................... 67
AFTER B PURCHASED THE 2ND RANCH THEN B EXCHANGED THE 2ND RANCH W A FOR THE
FIRST RANCH (A ASSUMED CS $400 LIABILITY AND BS NOTE FOR $760) ................................. 67
ESCROW AGENT RETURNED BS $100 ................................................................................. 67
A AND B ENTERED INTO A SALES AGREEMENT W AN EXCHANGE OPTION IF SUITABLE
PROPERTY WERE FOUND ............................................................................................................ 67
qq) o .. Treat as like-kind exchange even though the original agreement called for a sale of the property
.........................................................................................................................................................67
rr) o .................................. As $160 liability assumed by B was offset by Bs liabilities assumed by A
.........................................................................................................................................................67
ss) o ..................................... A- the exchange of ranches qualified for nonrecog. Of g or l under 1031
.........................................................................................................................................................67
tt) o ..... B- the exchange of ranches does not qualify for nonrecog. Under 1031 bc B did not hold the
second ranch for productive use in a trade or bus. or for investment ..............................................67
Acquired the property solely for the purpose of exchanging it for like kind-property ............................. 67
uu) o ............... However- in this case B did not recog a g or l as a result of the exchange since the total
consideration received by B is equal to Bs basis in the property given up ....................................67
WORKSHEET ON TWEN ........................................................................................................ 67
CHAPTER 31 CAPITAL GAINS & LOSSES....................................................................... 68
I. PROBLEMS: ......................................................................................................................... 68
A. Definition of Capital Asset: .............................................................................................................. 68
A. Historical Overview .......................................................................................................................... 68
1. Preferential Treatment for Long Term Capital Gain .................................................................... 68
What is at stake in determining if Capital Asset? ............................................................................................ 69
Capital asset status is the default characterization ........................................................................................... 70
2. Limitation on the Deduction of Capital Losses ............................................................................ 71
3. Justification for Preferential Capital Gain Treatment ................................................................... 71
B. Current Law: Section 1(h) ................................................................................................................. 71
1. Maximum Rates on Long-Term Capital Gain under the Current Law ......................................... 71
C. ...................................................................................................................................................... 71
D. Definition of Capital Asset [exclusions] ........................................................................................... 71
1. Section 1221(a)(1): Inventory, Stock in Trade, & Property Held Primarily for Sale to Customers
in the Ordinary Course of the Taxpayers Trade or Business ............................................................... 71
2. Section 1221(a)(2): Property Used in the Taxpayers Trade or Business ..................................... 71
3. Section 1221(a)(3): Copyrights, Literary, Musical, or Artistic Compositions .............................. 71
4. Section 1221(a)(4): Accounts Receivable for Services Rendered or Inventory-Type Assets Sold71
5. Section 1221(a)(5): Certain Publications of the U.S. Government ............................................... 72
6. Section 1221(a)(7) ........................................................................................................................ 72
7. Section 1221(a)(8): Supplies Used or Consumed in the Taxpayers Trade or Business ............... 72
8. Judicially Established Limits on Capital Asset Characterization .................................................. 72
E. The Sale or Exchange Requirement .................................................................................................. 72
F. The Arrowsmith Rule: Characterization of Certain Gains or Losses Dependent on Prior Tax
Treatment of Related Gains or Losses ....................................................................................................... 72
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G. Holding Period ................................................................................................................................. 73
Determining Net Capital Gain ......................................................................................................................... 73
Netting steps in 1222 ..................................................................................................................................... 73
REVIEW: ........................................................................................................................................................ 74
vv) Arkensas Best Corp. v. Commissioner ............................................................................................74
ww) ................................................................................................................... H
ort v. Commissioner ........................................................................................................................75
CHAPTER 28 CASH METHOD ACCOUNTING................................................................ 75
I. PROBLEMS .......................................................................................................................... 75
II. VOCABULARY ................................................................................................................... 76
III. OBJECTIVES ..................................................................................................................... 76
IV. OVERVIEW ....................................................................................................................... 77
A. Income Under the Cash Method ....................................................................................................... 77
1. In General ..................................................................................................................................... 77
2. Constructive Receipt .................................................................................................................... 77
3. Cash Equivalency Doctrine .......................................................................................................... 78
4. The Economic Benefit Doctrine (comes out of the HS test for income) ...................................... 79
B. Deductions Under the Cash Method.................................................................................................. 80
1. In General ..................................................................................................................................... 80
2. Cash Method Prepayments ........................................................................................................... 80
xx) Ames v. Commissioner ...................................................................................................................80
CHAPTER 29 ACCRUAL ACCOUNTING METHOD ....................................................... 81
I. PROBLEMS .......................................................................................................................... 81
II. VOCABULARY ................................................................................................................... 82
III. OBJECTIVES ..................................................................................................................... 82
IV. OVERVIEW ....................................................................................................................... 82
A. The All Events Test = performance .................................................................................................. 82
B. Accrual of income ............................................................................................................................. 83
1. General Rules ............................................................................................................................... 83
2. Income Prior to Receipt: Accrual Issues....................................................................................... 83
3. Income Prior to Earning: Prepayments & the Earliest of Test .................................................. 83
SCHLUDE V. COMM. - INCLUDE ADVANCE PAYMENTS AS INCOME AS WELL
AS PAYMENTS THAT HAD NOT YET BEEN RECEIVED OR EARNED BUT
NONETHELESS W ERE DUE. ................................................................................................. 84
O SCHLUDE GAVE RISE TO EARLIER OF TEST WHICH PROVIDES THAT
ALL THE EVENTS THAT FIX RIGHT TO RECIVE INCOME OCCUR WHEN: ...... 84
O 1) PAYMENT EARNED THROUGH PERFORMANCE (FIXED STANDARDS
ABOVE), ...................................................................................................................................... 84
O 2) PAYMENT IS DUE THE TAXPAYER, OR ................................................................. 84
O 3) PAYMENT IS RECEIVED BY THE TAXPAYER (PREPAID) WHICHEVER
HAPPENS EARLIEST ............................................................................................................... 84
ARTNELL CO V. COMMISSIONER (TICKET SALES CASE) WHERE TIME AND
EXTENT OF PERFORMANCE ARE CERTAIN AND WHERE INCOME CAN BE
PROPERLY ALLOCATED TO PERFORMANCE, DEFERRAL OF INCOME UNTIL
YEAR OF PERFORMANCE WILL BE FOUND TO REFLECT INCOME CLEARLY.
FIXED SCHEDULE = (THEY KNOW THAT THEY WILL BE REDEEMD WITHIN
THAT YEAR) .............................................................................................................................. 84
REV PROC. 2004-34 GIVES AN OPTION TO TAXPAYER RECEIVING A
COVERED ADVANCE PAYMENT TO: ................................................................................. 84
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1. FULL INCLUSION METHOD = INCLUDE THE FULL AMOUNT OF THE
ADVANCE PAYMENT IN INCOME IN YEAR OF RECEIPT (FULL INCLUSION
METHOD) ................................................................................................................................... 84
2. DEFERALL METHOD = INCLUDE ADVANCE PAYMENT IN INCOME IN
YEAR OF RECEIPT TO EXTENT RECOGNIZED IN REVENUES IN APPLICABLE
FINAINCIAL STATEMETNS ................................................................................................... 84
3. IF NO FINANCIAL STATEMENT, RECOGNIZE TO THE EXTENT EARNED
THAT YEAR (DEFERRAL METHOD) ................................................................................... 84
O UNDER ANY METHOD THE PORTION OF THE ADVANCE PAYMENT NOT
INCLUDED IN INCOME IN THE YEAR OF RCEIPT MUST BE INCLUDED IN
INCOME IN THE NEXT TAX YEAR ..................................................................................... 84
O PREPAYMENTS FOR RENT OR INTEREST AND CERTAIN OTHER
PREPAYMENTS ARE NOT ALLOWED TO BE TREATED THIS WAY. ........................ 84
DEPOSITS ARE NOT INCOME ........................................................................................ 84
ADVANCE RENTALS ARE INCOME ON RECEIPT REGARDLESS OF
TAXPAYERS ACCOUNTING METHOD ............................................................................... 84
C. Deductions Under the Accrual Method............................................................................................. 84
1. General Rules ............................................................................................................................... 84
EXPENSE IS DEDUCTIBLE FOR THE TAX YEAR IN WHICH ALL THE EVENTS
HAVE OCCURRED WHICH DETERMINE THE FACT OF LIABILITY, THE AMOUNT
OF THE LIABILITY CAN BE DETERMINED WITH REASONABLE ACCURACY,
AND ECONOMIC PERFORMANCE HAS OCCURRED WITH RESPECT TO THE
LIABILITY. ................................................................................................................................. 85
MATCH INCOME WITH THE EXPENSES INCURRED IN PRODUCING THAT
INCOME ...................................................................................................................................... 85
WHAT EVENTS ESTABLISH A LIABILITY? ...................................................................... 85
MOST OFTEN ACCRUES WHEN TAXPAYER RECEIVES PERFORMANCES
FROM ANOTHER ...................................................................................................................... 85
EARLIER OF 1) THE EVENT FIXING THE LIABILITY (REQUIRED
PERFORMANCE OR OTHER EVENT) OR 2) PAYMENT IS DUE .................................. 85
FINANCIAL CONDITION OF TAXPAYER AT TIME OF ACCRUAL DOES NOT
BAR A DEDUCTION BECAUSE THE LIABILITY TURNS ON THE FIXING AND NOT
THE PAYMENT ......................................................................................................................... 85
DOUBT OF PAYMENT IS DIFFERENT FROM A CONTINGENCY DOUBT OF
PAYMENT STILL ENTITLES TO DEDUCTION ................................................................. 85
Premature Accruals ....................................................................................................................... 85
2. The Economic Performance Test Section 461(h) [This test is formally applied to deduction side
but is helpful way to think of all events test on income side too] ...................................................... 85
THESE RULES REAFFIRM WHAT THE EVENTS RULE IS ALL ABOUT ............. 85
O..................................................................................................................................................... 86
FOR THERE TO BE A CURRENT DEDUCTION, THE LIABILITY MUST BE
FIXED, THE AMOUNT OF THE LIABILITY CAN BE DETERMINED WITH
8
REASONABLE ACCURACY, AND ECONOMIC PERFORMANCE MUST OCCUR
(CURRENT LIABILITY)........................................................................................................... 86
461(H)(2) ESTABLISHES RULES FOR DETERMINING WHEN ECONOMIC
PERFORMANCE OCCURS ...................................................................................................... 86
O SERVICES ECONOMIC PERFORMANCE OCCURS AS SERVICES ARE
PROVIDED .................................................................................................................................. 86
O USE OF PROPERTY ECONOMIC PERFORMANCE OCCURS RATABLY OVER
PERIOD THE TIME THE TAXPAYER CAN USE THE PROPERTY ............................... 86
O RECURRING ITEMS DEDUCTION IS AVALIABL EVEN THOUGH ECONOMIC
PERFORMANCE HAS YET TO OCCUR BUT THERE ARE 4 STATUORY
REQUIREMETNS THAT MUST BE MET (461(H)(3) ........................................................ 86
Capitalization................................................................................................................................. 86
Contested Liabilites ....................................................................................................................... 86
O THE TAXPAYER MAY NOT ACCRUE A DEDUCTION WITH RESPECT TO ANY
LIABILITY WHICH SHE IS CONTESTING. ........................................................................ 86
CONTESTED LIABILITY REDNDERS THE LIABILITY CONTINGENT WHICH
PREVENTS IT FROM BEING FIXED OR ESTABLISHED NO CURRENT YEAR
DEDUCTION ............................................................................................................................... 86
CONTESTED LIABILITIES ACCURE AT THE EARLIER OF PAYMENT OF THE
LIABILITY OR WHEN THE DISPUTE IS RESOLVED. ..................................................... 86
O ACCRUAL DURING A CONTEST RQUIRES THAT TAXPAYER TRANSFER
MONEY OR PROPERTY IN SATISFACTION OF THE LIABILITY TO SOMEONE OR
SOMEPLACE THAT IS BEYOND HIS CONTROL .............................................................. 86
D. Choice of Accounting Methods ........................................................................................................ 86
446C TAXPAYER HAS A CHOICE OF ACCOUNTING METHOD AND CAN SELECT
ONE METHOD FOR ONE BUSINESS AND ANOTHER METHOD FOR THE OTHER
BUSINESS. YOU COULD ALSO USE COMBO OF METHODS WITHIN ONE
BUSINESS BUT THERE ARE CERTAIN LIMITATIONS. ................................................. 86
1. METHOD OF ACCOUNTING CHOSE MUST BE ONE TAXPAYER USES TO
COMPUTE INCOME IN KEEPING BOOK (IF NO BOOKS OR RECRODS ARE
DEEMED ON CASH METHOD) .............................................................................................. 86
2. METHOD MUST CLEARLY REFLECT TAXPAYERS INCOME ............................. 86
3. METHOD MUST PROVIDE CONSISTENT TREATMENT OF INCOME AND
DEDUCTION ITEMS FROM YEAR TO YEAR AND ONCE A METHOD IS CHOSEN IT
CANT BE CHANGED WITHOUT COMMISSIONERS CONSENT ................................... 86
4. IF INVENTORY IS INVOLVED, ACCRUAL IS REQUIRED FOR PURCHASES
AND SALES ................................................................................................................................. 86
5. C CORPS MUST USE ACCRUAL.................................................................................... 86
yy) Schlude v. Commissioner (Supreme court 1963) ............................................................................86
SEND QUESTIONS BY SUNDAY ............................................................................................ 88

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Introductory comments to the course

Federal income tax law differs from first year courses and upper-level common law courses in some
important ways, including (i) the constitutional status of Congress taxing power, (ii) the statutory nature of
federal income tax, (iii) the autonomy of federal taxation vis--vis other sources of law, and (iv) the historic
emphasis in taxation on economic rather than moral reasoning.

Constitutionality

First of all, since the Supreme Court has liberally construed Congress Constitutional taxing power, so few
constitutional questions remain about federal income tax. (The same is not true about state tax law.)

Sources of federal tax law

Second, unlike the common law classes with which you are familiar, tax is pervasively statutory. Title 26
of the United States Code is the primary source of law. Statutory interpretation often requires
constructing a particular subsection in the larger context of related statutory provisions. For an example
of the type of active reading involved in statutory construction (and legal reading generally), consult the
schematic in TWEN on 26 U.S.C. 483. Because this is an introductory course, we will tend to look at
particular code sections in relative isolation more often than in advanced tax classes, which focus on a
narrower range of provisions read in dynamic context (although we will do this too). In addition to the
statute, federal cases do matter a great deal both cases from Article III courts like the district court and the
Article I Tax Court. We will consider some of the seminal cases. Importantly, federal adjudication you
can think of this as tax common law because it involves rule-making through judicial decisions has
produced many of the important doctrines which have come to be codified statutorily, e.g. the tax benefit
rule, the claim of right doctrine, and the business purpose doctrine.

Structural independence of tax law

A third important feature of tax law is that it can be a somewhat hermetic and independent area of law, not
bound by commercial standards, state law, and even other forms of federal law. Though often similar to
generally accepted accounting principles (GAAP), tax accounting may deviate from GAAP accounting. As
you would imagine from your study of the Supremacy Clause in Professor Bakers course, federal tax
law trumps state law. So, for example, state law determinations of domicile do not control the concept
under Title 26 of a tax home. Moreover, federal tax determinations do not generally depend on other
federal law determinations. So, for example, being a nonresident alien for tax purposes differs from the
meaning of that phrase for purposes of federal immigration law. And even other federal financial
accounting standards do not necessarily bear on resolving tax accounting questions.

Economic versus normative reasoning

Finally, unlike many of your other courses, tax is decidedly not normative, in the sense that the law does
not attempt to instill or enforce any particular set of values in human relations. This is not to say that tax
law does not powerfully influence consumption and production decisions; it clearly does, and is intended
to, but usually in a very explicit and argued-for manner rather than by hiding the ball through unarticulated
assumptions. For example, historically taxpayers who ran illegal businesses were allowed to deduct their
(illegal) business expenses when calculating their tax liability, just as with legal businesses. This comment
from Senator Williams, who managed the adoption of what came to be the 1913 Income Tax Act, says it
best:
The object of the bill [to enact the first federal income tax] is to tax a mans net income; that is to say, what
he has at the end of the year after deducting from his receipts his expenditures or losses. It is not to reform
mens moral character. (sic re: sexism)
10
Moralizing has, though, entered the tax code such that deductions for illegal activities are increasingly
disallowed for so called policy reasons, e.g. 280E prohibiting the deduction of expenses in connection
with the distribution of illegal drugs.

Structure of course

Virtually every issue which we cover falls into one or typically more of five questions which are
mapped on the Topic Map included as a TWEN exhibit for Chapter 1:
What is income?
What is a deduction?
When has the tax event occurred?
Who is the taxpayer?
What is the character of the tax item? (By character we mean that some types of income or loss
are deemed to have a special nature, e.g. capital gain.)

Do not expect to understand what each item on the grid means. The point is to demonstrate that federal
income tax has a coherent deep structure which will be revealed as the course progresses. We will not
cover all the items on this grid, but everything that we do will relate to one of these basic five questions.
Although most of the examples in the course deal with the taxation of natural people, i.e. human beings,
rather than legal people, e.g. corporation, the principles introduced in this course apply in each area of
federal income taxation.


I hope that federal tax can be for some of you what it was for me: a class which made a great deal of sense
and which helped me to visualize having a career in the law. Again, tax is a great course. This interview
with TaxProf Blog from couple of years ago tells you about my take on tax teaching and tax law generally
http://taxprof.typepad.com/taxprof_blog/2007/04/jos_m_gabilondo.html.
Chapter 1
I. Problem

Caroline Taxpayer is a business consultant who owns and operates her own unincorporated business and
uses the cash method of accounting and reports her income on a calendar year basis. She has provided you
with the following information concerning her financial affairs during the calendar year and asks you to
compute her tax liability:
1. With regard to her consulting business:

a. She received $275,000 in fees through a combination of cash and checks from clients;
b. She provided $10,000 in consulting services to one client, a landscaping company, in exchange
for $10,000 in landscaping services the client provided, at Carolines request, for Carolines
mother;
c. Clients still owed her $30,000 for services she provided during the year;
d. She paid an employee $60,000 in wages during the year; [162 = trade/business expenses = above
the line deductions]
e. She paid $20,000 for building maintenance, utilities, and office supplies during the year; and
f. She purchased an office building for $500,000 which she expects to use in her business for the
next 30 years.
a. 263 = requires cost of the building to be capitalized
b. 168 = allows building to be depreciated
i. Depreciation represents an allowance for the reasonable exhaustion, wear, and
tear of property used in a trade or business or property held for production of
11
income = 167(a) = above the line deduction
2. Caroline incurred $5,000 in commuting costs in traveling from her home to work during the year.
3. Caroline received $19,000 in interest income this year from an investment account managed by her
bank. She paid the bank $1,000 for its management services.
o Management services not deductible under 162, but under 212 (under the line)
o Would be above the line if it was a business expense
o As a personal expense = will only be significant if the daxpayer ahs below-the-line expenses
greater than the standard deduction.
o $1000 for management services is subject to the 2% floor rule [clearly does not exceed 2% of
230k]

4. Caroline owns her home, on which she made mortgage payments in the amount of $24,000 during the
year. Included in the $24,000 were $18,000 in interest payments and $6,000 in principal payments.
o $18k interest payments = qualified residence interest = deductible
o 168(a) (interest accrued in indebtedness = deductible) qualified by 163(h), not including
personal interst however it is qualified residence interest (exception to rule)
o above the line if incurred in business
o This case = below the line
5. Two years ago, Caroline purchased 100 shares of stock in ABC corporation for $15,000. At the end of
last year, the stock had a fair market value of $25,000. This year she received $1,000 in dividends on
the stock. She sold the stock at year-end for $30,000. [$10k appreciation of stock is not realized by
caroline]
6. Caroline made cash contributions of $9,000 during the year to the church she attends.
a. 170(b)(1)(A) limits the Taxpayers deduction to 50% of her contribution base. Section
170(b)(1)(F) provides that contribution base means adjusted gross income. Thus, so long
as Caroline has an adjusted gross income of at least $18,000, she will be entitled to a full
$9,000 deduction for the charitable contribution. The charitable contribution deduction, as
you might expect, is a below-the-line deduction.

7. Caroline paid state and local general sales taxes of $3,000 on the purchase of various items for
personal use or consumption. She also paid real property taxes of $5,200 on her home. She also paid
$14,000 in estimated state income taxes and $40,000 in estimated federal income taxes with respect to
her business.
a. $5200 real property taxes = below the line
i. 164(a)(2) for certain taxes even though they are personal in nature
b. $14k state/local taxes = below the line deduction
i. Section 164(a)(3) allows a deduction for state income tax.
ii. Section 164(b)(5), however, puts to Caroline an election: deduct either state and
local incomes taxes or state and local general sales taxes.
c. $40k federal tax is not deductable


II. Vocabulary
Gross income
o 61: Except as otherwise provided in this subtitle, gross income means all income from
whatever source derived, including (but not limited to) the following items: A list of 15
items follows.
12

adjusted gross income
Above-the-line deductions - deductions a taxpayer may consider in determining his or her
adjusted gross income
Below-the-line deductions - deductions a taxpayer may take into account only after the adjusted
gross income has been determined
standard deduction
personal exemption
Taxable income
o 63(b) for individuals who do not itemize their deductions, the term taxable income
means adjusted gross income minus (1) the standard deduction, and (2) the deduction for
personal exemptions provided in section 151.
o 63(a) for all other taxpayers, taxable income means gross income minus the
deductions allowed by this chapter
tax credit
rate schedule - determines deduction rates
joint return
tax bracket
marginal rate
timing
withholding tax
tax base
imputed income


III. Objectives
1. To list and explain fundamental questions our income tax system must address.
2. To identify receipts and expenditures likely to have tax significance.
3. To recall the formula for determining an individuals tax liability.
4. To explain the significance of adjusted gross income.
5. To explain the significance of the standard deduction.
6. To recognize there are some deductions taken into account in determining adjusted gross income
(above-the-line deductions) and some deductions which taxpayers may only claim if they elect
to itemize their deductions. (These latter deductions are referred to as below-the-line
deductions.)
7. To distinguish a tax credit from a deduction.
8. To explain the differing tax savings produced by tax credits and deductions depending on a
persons tax bracket.
9. To describe the general organization of the Internal Revenue Code with respect to income,
exclusions, deductions and credits.

IV. Overview

1. A brief History of Federal Income Tax
2. The Tax Practice
3. Resolution of Tax Issues Through the Judicial Process
A. Trial Courts
If the Commissioner of the Internal Revenue Service asserts a deficiency in income tax, i.e.,
claims that the taxpayer has failed to pay all that is owed, the taxpayer may:
o (a) refuse to pay the tax and petition the Tax Court for a redetermination of the
deficiency; or
13
o (b) pay the deficiency, file an administrative claim for refund, and upon denial of the
claim, sue for refund in federal district court or the United States Court of Federal
Claims.
Three courts have original jurisdiction in federal tax cases: the Tax Court, the United States
District Courts and the United States Court of Federal Claims.
a. The Tax Court
Most important
Constitutional status under Article 1, Section 8, Clause 9 of the Constitution
Cases are tried without a jury by one judge, who submits an opinion to the chief
judge for consideration. The chief judge will either allow the decision to stand or
refer it to the full court for review.
b. Federal District Court
The United States District Courts have jurisdiction in any tax case against the United
States seeking a refund of tax, regardless of the amount involved.
Juries available
Must be brough in district in which the taxpayer resides, or, in the case of a
corporation, in the district in which it has its principal place of business.
A taxpayer cannot litigate a tax action in the federal district courts without first
paying the amount in dispute and then commencing a refund action.

c. The United States Court of Federal Claims
Federal Courts Improvement Act of 1982.
Has jurisdiction over all tax suits against the United States regardless of amount
Where one resides makes no difference
No Jury trial
No jurisdiction to hear deficiency cases. The taxpayer must pay the deficiency, thus
converting the suit into a refund suit, before bringing an action before the court.

B. Appellate Courts
Appeals from the Tax Court are heard as a matter of right by the Federal Courts of Appeals
of the United States.
Jurisdiction is in the court for the circuit in which the taxpayer resides.
Decisions of the federal district courts may, as a matter of right, be appealed to the
appropriate federal court of appeals.

C. Selection of Forum
Ones finances may prove controlling in choosing a court.
o In tax court one may commence an action there without having paid the asserted
deficiency.
Other factors:
o jury trial,
o the expertise of the Tax Court judges,
o and the past record of the particular court on a given issue.


V. ANALYSIS OF THE COMPUTATION OF TAX LIABILITY OF
CAROLINE TAXPAYER

A. Basic Questions Addressed by an Income Tax System
o First, what items of economic income or gain will be includable in gross income?
o Second, what costs will be allowable as deductions?
14
o Third, when is an amount included in income? When is the taxpayer entitled to claim a deduction
for an amount that is deductible?
o Fourth, who is the taxpayer who is going to be taxed on items of income?
o Fifth, what is the character of the items of income or the deductions?
o Example = long term capital gain = character is different
o Ex: passive income = investing (sit back & dont really do anything)

B. Evaluating the Taxpayers Tax Liability
1. What is the applicable tax rate? Look to USC 21 $1

(c)
1
Unmarried individuals (other than surviving spouses and heads of households).--There is hereby
imposed on the taxable income of every individual (other than a surviving spouse as defined in section 2(a)
or the head of a household as defined in section 2(b)) who is not a married individual (as defined in section
7703) a tax determined in accordance with the following table:
If taxable income is: The tax is:
Not over $22,100 15% of taxable income.
Over $22,100 but not over $53,500 $3,315, plus 28% of the excess over $22,100.
Over $53,500 but not over $115,000 $12,107, plus 31% of the excess over $53,500.
Over $115,000 but not over $250,000 $31,172, plus 36% of the excess over $115,000.
Over $250,000 $79,772, plus 39.6% of the excess over $250,000.

2. What is the tax rate applied to that is, what is the tax base?
3. Taxable income
a. 63(b) for individuals who do not itemize their deductions, the term taxable income
means adjusted gross income minus (1) the standard deduction, and (2) the deduction for
personal exemptions provided in section 151.
b. 63(a) for all other taxpayers, taxable income means gross income minus the
deductions allowed by this chapter
4. There are two categories of deductions.
a. The first category = deductions a taxpayer may consider in determining his or her
adjusted gross income; these are referred to as above-the-line deductions.
i. Congress is giving you a break with these (big items)
ii. What do they have in common = congress (politically motivated deductions)
b. The second category = deductions a taxpayer may take into account only after the
adjusted gross income has been determined; these are referred to as below-the-line
deductions.


o Gross Income 61[everything]
a. Gross income = all income
zz) 61: Except as otherwise provided in this subtitle [Subtitle A = 1 - 1563], gross income
means all income from whatever source derived, including (but not limited to) the following
items: A list of 15 items follows.
aaa) Regulation 1.61-1(a) gross income includes income realized in any form whether in
money, property or services. Regulation 1.61-2(d)(1) provides that if services are paid for in
exchange for other services, the fair market value of such other services taken in payment must be
included in income as compensation. . . .
bbb) 451(a) = must be actually or constructively received to be considered gross income
ccc)
b. Problem
i. $275,000 in fees through a combination of cash and checks 61
ii. $10,000 value of the landscaping services 61
iii. $19,000 in interest income this year. 61(a)(4).
iv. $15,000 stock gain 61(a)(3) = long term capital gain = rate is
different!! 1(h) = basis [1001]
15
v. $1,000 in dividend income 61(a)(7) [dividends]
vi. = $320,000 Gross income
o Adjusted Gross Income [Gross income - above the line deductions] 62
a. 62 defines adjusted gross income as gross income less certain deductions.
b. Doesnt create the authority
ddd) it is not a deduction granting provision! In general, only those deductions listed in 62
are taken into account in computing adjusted gross income.
c. =above the line deductions
d. need adjusted gross income to be determine to figure out the 2% floor in 67 [you
can claim the below the line to the point where the aggregate does not exceed the 2%
floor]
e. interim measure of taxable income
f. tax simplification act taxpayers given the right of a standard deduction = If a
taxpayer elected to use the standard deduction rather than itemizing all of her
personal deductions, the taxpayer would be entitled to deduct the amount specified
by Congress regardless of what deductible personal expenses the taxpayer had
actually incurred.
eee) If the taxpayers personal deductions exceed the standard deduction, does not use the standard
deduction
fff) Ultimately, it helps people with small amounts of personal deductions = eliminates the need for
them to itemize those deductions
g. Taxable income = difference between AGI & itemized deductions/standard
deduction

h. Problem
ggg)
o Deductions
a. Every time you have an expense that you believe is deductible, you must find a
specific Code section authorizing the deduction.
b. notion that our tax system permits a deduction for the costs incurred in producing
income.
c. Personal expenses are generally not deductable
d. Problem
hhh) Above the line expenses: = $90k
1. $60k Paid Wages 162(a), 62
2. $20k business expenses 162(a), 62
3. Depreciation on $500k = $10k [30 yrs]
iii) Below the line expenses = $47,200 [$1,000] = $46,200
4. $1,000 management fee [can subtract this because subject to 2%
floor] 67 = everything not on the list IS (safe harbor for those on
the list)
5. 18k Interest 163
6. 14k state income tax (income vs sale)
7. $5,200 Real property taxes
8. $9k charitable contributions 170
a. 170(b)(1)(A) limits the Taxpayers deduction to 50% of
her contribution base. Section 170(b)(1)(F) provides
that contribution base means adjusted gross income.
Thus, so long as Caroline has an adjusted gross income of
at least $18,000, she will be entitled to a full $9,000
deduction for the charitable contribution. The charitable
contribution deduction, as you might expect, is a below-
the-line deduction.

16
jjj) AGI: $320,000 $90,000 = $230,000


o Calculating Adjusted Gross Income = $230k

o Taxable Income [AGI - (below line deductions/standard deductions +
personal exemptions)] 63

i. First Question: Itemize or Use Standard Deduction?
a. If the taxpayer decides not to itemize, the taxpayer is only entitled to take
standard deduction, in lieu of any below-the-line deductions
b. Standard deduction for this year $5950
c. Itemized deduction = defined in 63(d)
d. Clearly, if a taxpayers below-the-line deductions exceed the standard
deduction, as will be the case with Caroline, the taxpayer should be
advised to itemize.
ii. Itemize:
a. Subtracting from her gross income of $320k all her allowable deductions
63(a)
b. If you have charitable contributions or other expenses, you should
compute adjusted gross income, even though not specifically required by
63(b)
c. all we have to deduct from Carolines AGI is the below-the-line
deductions & the personal exemption
d. 67 2% Floor on Miscellaneous Itemized Deductions:
$1k management fee is subject to the rule [clearly does not
exceed 2% of 230k]
- by how much does the aggregate misc. itemized
deductions exceed the 2% floor.
- That number is what you eat
iii. Personal Exemptions 151(a)
a. If married = two personal exemptions
b. Additional deductions for each dependent (that means 152 requirements]
c. Assume here that the current inflation-adjusted exemption amount is
$3800.
d. Personal exemption & standard deduction provide a floor assuring that
taxpayers will not be taxed unless they have income greater than the
combined amount of the personal exemptions allowed and the standard
deduction.
iv. Calculating Taxable Income: 63
a. AGI = $230,000
b. Itemized deductions [net below the line deductions (gross would be
$47,200)] [$46,200]
c. Personal exemptions [$3,800]
d. = $180,000
o Tax Rates = 1
o A net figure
Net of all the deductions..
o Have to determine capital gain
o Dividend of $1k
o Net of sale = $15k
o =$16k x 16% = $2400
o = ordinary income is $164k
o 1(f) = every year has to change
17
o (c)
1
Unmarried individuals (other than surviving spouses and heads of households).--
There is hereby imposed on the taxable income of every individual (other than a surviving
spouse as defined in section 2(a) or the head of a household as defined in section 2(b)) who is
not a married individual (as defined in section 7703) a tax determined in accordance with the
following table:
o Over $85,650 but not over $178,650
o $17,442.50 plus 28% of the excess over $85,650
o = 78,350 x 28% = $21,938 + $17,442.50 = 1(c) = $39,380.50 + $2400 = 1 = $41,780.50
[gross tax liability]
o One other thing you could net is a tax credit [education credit, etc.]
o In real life, she would have alternative minimum tax [same thing, only difference,
fewer deductions, rates are simpler (lower & less progressive).
o Marginal rate = 28% [its the rate that your last dollar of income is taxed on its a
progressive rate structure]
o what is the average rate/effective rate/blended rate/etc.? [would be lower than 28%]
o all the netted items = zero rate of tax
o
Class Notes: 08-13 (Mon.)

Rules of Thumb:
Item [economic] Taxpayer IRS [Treasury] Title 26
Cash flow +++ === dont care
Income 61-63 later = better +++ sooner = better
Tax Loss +++ sooner = better later = better
Other Loss === dont care
* As attorney, want to minimize statutory income, maximize statutory loss
Taxation of I ndividual I ncome, J. Martin Burke and Michael K. Friel, 10
th
Edition,
LexisNexis, ISBN 978-1-4224-8241-4. on reserve

A. Policy
1. Revenue raising
a. Taxation
b. Borrowing
2. Administrable
a. Can we enforce it?
b. Withholding
3. Horizontal Equity
a. Like-situated people being treated the same
b. Much like equal protection, staring decises, etc.
c. If under same law, should be treated the same.
4. Vertical Equity
a. Increasingly contested
b. Progressivity in marginal rate structure
i. Higher income = higher rate
c. Rate of lower class vs higher income class

Income & Exclusion Chart
Individual = actual person
Taxpayer = person, corporation, etc.
o Individuals have to go through adjusted gross income [AGI]
18
172
Tax credit vs tax rate
o Tax credit is better
Dollar for dollar reduction in tax liability
o Tax rate
Reduction in income subject to
55 Alternative minimum taxable liability:
o recalculate the whole thing (go through the same basic structure), only we are going to
get rid of most of the deductions (thats where all the gamesmanship is), but also going to
lower the rate of taxation then run analysis through 1, and then run analysis through
55 = you pay the higher.
This is here because ppl exploit their taxes
Disallows a series of deductions that are usually allowable for 1

Class Notes: 08/15 [Wed.]


GG Ces Old C
Item
Outcome
Reason Agree?


Rulebook:
i. Get a handle on the structure of 26
ii. We will spend most of our time in Subtitle A
a. normal tax = ordinary income tax
iii. Look at:
a. 1, 55,
b. lot of time on 61, 62, 63
c. some time 67
d. (everything starting with 100 is good = exclusion)
e. 111, 167, 168, 162 (very important provision to deduct expenses of business)
f. 262 (all 260s are bad news = say no to something that would help tax payer)
g. 263, 280(e)
h. 441, 446 (establish methods a taxpayer can use to keep track if they have income: cash
method, or accrual methods)
i. 1001 (basis) (dealing with property), 1011, 1012, 1014
j. 1031
k. 1200s (capital assets/losses)
l. 2001 (estate tax transfer tax tax on giving)
19
Chapter 2 61
I. Problems

1. Marcella is an associate at a large law firm. Which, if any, of the following items must she report
as gross income?
a. Salary of $75k per year. Take home = $50k. Firm withheld $15k for federal income
taxes, $5,500 in SS taxes, & $4500 for state income taxes
b. A year end bonus of $5k (from firm for quality of her work)
c. Bookcase purchased from firm for $150 (worth 400) [$250?]
i. Is this business related bargain purchase?
d.
II. Vocabulary
Accession to wealth any item that adds wealth - the income tax applies to all "undeniable
accessions to wealth, clearly realized, and over which the taxpayers have complete dominion."
o The requirement that accessions to wealth be "realized" means that increases in the value
of assets are not taxed to the owner as capital gains until the asset is sold
Appreciation - A rise in the value of an asset based on a rise in market price.
Bargain purchase when fair market value exceed the purchase price = income
o Bargain Purchase occurs when the fair value of all of the assets purchased of a company
exceeds the purchase price for the company. When a Bargain Purchase occurs, the buyer
records a gain on purchase for the fair value of assets above the purchase price.
Barter trading of product for service, etc. no cash involved.
Exclusion items excluded from being taxed
Fair market value The price that a given property or asset would be valued at in the
marketplace
o property tax is often assessed based on the fair market value (difference between
purchase price & fair value can be big = bargain purchase)
Gross income All your income
Imputed income income that comes in the form of a benefit [self help activities] NOT
TAXED
o Ex: The value of a car provided by your employer that you may use for personal use.
That value is imputed income.
Realization taxpayer has materially changed situation in value (that effects cash liquidity) (fly
ball example)
o Acme example:
#1 & #2 each got $50k in stock
they are given dividends of an extra share = value stays the same
= change in form, but not change in value. [not realized, because doesnt
constitute income]
not a realization event = unrealized gain
if they each had a stock change where their stock changed to $250 = unrealized
= still risk, still letting it ride.
Example = gambling until you leave the table, all you have is
unrealized gain you can still lose it.
To realize = sell.
Ex: instead of getting a end of year bonus, your employer pays with property
(new car) = realized (what if it were cash).
Appreciation on that car would be unrealized gain
If you go to sell it, & sell for $100k = basis of $50k

20
III. Objectives
1. To explain the characteristics of gross income
2.


IV. Overview
A. The Search for a Definition of Income
16
th
Amendment [1913] from whatever source derived
1913 Tax Act gains or profits, and incomes..
61 gains or profits and income derived from any source.. [residuary part] [list]
o Glenshaw Glass
5 points on income:
o income = economic income [broaden 61]
o the form of income doesnt matter [broaden 61]
o imputed income is not 61 [narrow 61]
o only net income is taxed [narrow 61]
o only realized things or losses are counted for purposes of tax [narrow 61]
Glenshaw Class is the standard for
Notion of tax expenditure [we wont discuss this, but want to know it exists]
1. Borrowed money
2. Tax code spending relieves taxpayer from obligation that he would already
have (congress does that instead of refunding?)
3. spending money by failing to collect money that they would collect if ___
wasnt tax deferred, etc.

1. income = economic income [broaden 61]
a. H-S = consumption + changes in wealth
b. Flow sheet vs balance sheet (picture in time of income)
i. This course is about flow (things that happen over the course of the year)
2. The form of income doesnt matter [broaden 61]
a. Cash, barter (services), property, assumes liability for money you owe, etc.
b. When in doubt, re-express the consideration for cash [if it were cash, what would the
outcome be?]
3. Imputed income is not 61 [narrow 61] = not taxed
a. property imputed income = ex: own your home (living there is worth something, you
arent renting = you get income from living there)
b. services imputed income = ex: mowing your own lawn [if you didnt do it yourself, you
would have to pay for it]
c. congress probably could tax this if they wanted to (dormant taxing power)
4. Only net income is taxed = 63[narrow 61]
5. Only realized gains or losses are counted for purposes of tax [narrow 61]
a. Realized vs recognized
i. Recognition = put it on your income tax return (you recognize it as an item of
income)
ii. Realization = taxpayer has materially changed situation in value (that effects
cash liquidity)

B. Income Realized in any Form 1.61-1(a)
Realization taxpayer has materially changed situation in value (that effects cash liquidity) (fly
ball example)
a) Cash/money, services, property, etc..
b) Minor value can be excluded from gross income due to problems in administration & enforcement
a. Ex: company allowing employee to keep flyer miles from business trips (too many
timing, administrative problems).
21

C. Realization, Imputed Income & Bargain Purchases
a) reasons in support of present system (regarding no tax on mere appreciation)
1. Measuring the appreciation on property of every taxpayer every year would create
administrative issues.
2. realized when sold?
b) Imputed income.. see definitions
c) Bargain purchases:
a. Fair market value of the asset is greater than the price you paid for it
b. Bargain purchases generally do not constitute gross income
c. Employment setting bargain purchases = gross income
d) If employer transfers $500 of stock to employee for $100 = $400 gross income (it has been
realized)

Commissioner v. Glenshaw Glass Co.
income is: (1) any undeniable accession to wealth (improved situation), (2) which is
clearly realized (change in value) by the taxpayer, (3) over which the taxpayer has
complete dominion (can use it).

in order for a tax to be an "income" tax, it must assess tax only against "undeniable accessions to
wealth, clearly realized, and over which the taxpayers have complete dominion."
Prof Q:
What is the issue?
SOL Q
What was their argument?
What happened at each level? Trial, appeal, etc.
What policy?
Revenue raising policy
Whats the analogy?
Horizontal equity
Are you persuaded?
Holding? Best saying from case.

Facts. Glenshaw Glass manufactures glass bottles and containers and was in litigation with the Hartford-
Empire Company, which manufactures machinery used by Glenshaw. Glenshaw made demands for
exemplary damages for fraud and treble damages for injury to its business for Hartfords violations of
antitrust laws. The parties settled and Glenshaw received $800,000. Of that, $324,529.94 represented
punitive damages. Glenshaw did not report that amount as income. In Commissioner v. William Goldman
Theatres, Inc., William Goldman sued Loews Inc. for violations of antitrust law and sought treble
damages. William Goldman received $375,000 in treble damages but claimed $250,000 of that represented
punitive damages and did not report it as income.
Didnt report (how does that effect SOL?) when you dont report something, IRS can come after
you ANYTIME.
Argument? It wasnt designed to be income.
Tax court found in favor of the taxpayer
Revenue raising policy. whats the dollar impact if we dont litigate?
Had congress wanted to tax it, they would have rationale
Analogy there is a situation that is similar to this one (renter made improvements that were
beneficial to owner those improvements taxed to landlord = considered income). If THAT is
income, punitive damages are too
o Horizontal equity

Issue. Whether money received as exemplary damages for fraud or as punitive damages of an antitrust
recovery must be considered gross income? YES.
22

Synopsis of Rule of Law. Gross income includes gains or profits and income derived from any source
whatsoever.

Holding: The Supreme Court found no exception applicable to punitive damages. Further, the Court could
not ignore the plain language of the statute that gross includes any income from any source.
Cesarini v. US
The rule requiring all income to be included as gross income is intentionally broad to allow
Congress to use its taxing power broadly under the Sixteenth Amendment.
Prof. Q:
Where does it take place? (district court = paid first in tax court you do not have to pay)
Use section language
What is taxpayers argument through analogy? That its a gift like a surprise (dont work for either)
In Glenshaw they were hurt this is even more remote (dont earn it, work for it, etc.)
Deductions are a matter of legislative grace
What is the difference between a regulation (think of it as a higher source of law: SCOTUS case,
statutes, etc.) & a revenue ruling (applies to everyone)?
Letter ruling = applies to only you
SOL starts to run when they find the money (prof. not always persuaded by this state law does not
often work with federal outcome)
Facts: Plaintiffs purchased a used piano and found $4,467 in cash inside. Plaintiffs originally reported this
as income but filed an amended return and sought a refund of the taxes paid on that income.

Synopsis of Rule of Law. Gross income means all income from whatever source derived.

Holding: The rule requiring all income to be included as gross income is intentionally broad to allow
Congress to use its taxing power broadly under the Sixteenth Amendment. Plaintiffs could not show a
specific exception for found money.
Old Colony Trust Company v. Commissioner
The discharge of a taxpayers obligation by a third party is equivalent to direct receipt by the
taxpayer [receive a benefit] = taxes paid by company = additional income of person.

Prof. Q:
Whats the legal question?
What is the phrasing? tax indemnification trying to give him tax exempt income.
Pay the difference between the total amount, including income, from all sources minus the
amount of tax he would pay if we excluded compensation (if he didnt work for us, what
would he have to pay?) = like you were only ever taxed for what you made without
compensation. = designed to capture the marginal tax cost of his income (could have just
given him the money but then he would have to pay more taxes on that amount).
Is this double taxing? Not against the same person
compensation basically salary.
Argues that it is a gift.
Benefit in exchange for services = no gifts are possible with boss/employee relationship (this
rule is modified if family relationship as well)

Facts. William Wood was president of the American Woolen Company for the years 1918 through 1920.
The company instated a policy for 1919 and 1920 wherein the company would pay the taxes of the
president and other company officers. The company paid $681,169.88 for 1918 and $351,179.27 for 1919
on behalf of Wood. The Board of Tax Appeals held that these amounts paid were income of Wood.

Issue. Were the taxes paid by the company additional income of Wood? YES.
23

Synopsis of Rule of Law. The discharge of a taxpayers obligation by a third party is equivalent to direct
receipt by the taxpayer.

Holding: The Supreme Court notes that Wood and other employees received a direct benefit when their tax
obligation was discharged by the company. Wood received a benefit in exchange for his services to the
company. This was clearly a taxable gain.
REVENUE RULING 79-24
Lawyer did legal services for painter in exchange for him to paint his house = services for services
= gross income
Art in exchange for rental property = Property for property = gross income
o Value of artwork for homeowner, value of rent for artist
McCann v. US
when a company pays travel expenses, a taxpayer must include such compensation in gross
income when the excursion is viewed as a reward for outstanding employee success within the
company.

Prof. Q:
How did the IRS know? Company deducted as business expense [162]
What was the judges attitude? Salary = taxable
Buy it? Could be mandatory for the employee. Are they really getting a benefit?
Generally this doesnt result in income (real world hard for irs to target, etc)
The court had to decide whether travel expenses paid by an employer to enable an employee to attend a
company conference were part of the employees gross income. The company provided the travel award to
the employee for good work in increasing net sales during 1972. The court held that the travel expenses
were compensation to the employee for services rendered to the company during 1972 and should be
included in gross income. Therefore, when a company pays travel expenses, a taxpayer must include such
compensation in gross income when the excursion is viewed as a reward for outstanding employee success
within the company.
Pellar v. Commissioner
bargain purchases generally do not constitute gross income
cost > FMV > Price
court only cares about latter two
Roco v. Commissioner


Class Notes: 08-20 [Mon.]

o Finish up ch. 1 problem
o Handouts for chapter one
o Should know the court one for the exam

Class Notes: 08-23 [Wed.]
a) Ch. 3 where taxpayer has income that has to be returned for some reason
a. Loans (classic example) each of the other following three can be expressed as a loan
b. Illegal income never was really his (like a loan)
c. Deposit when are they prepayment for services, & when are they real deposits (will be
given back, like a loan)
24
d. Contingent receipts [claim of right doctrine] taxpayer gets something that looks like it
is his for the time being, but there is some type of uncertainty (Ex: wins at district court,
appeals expected).
i. Dependent on something outside your control
ii. As soon as the income is in taxpayers hands, determination can be made (if it
turns out to be wrong, will be given back later)
iii. Administrable policy rule arent perfect, but better when they are
administrable.
iv. 1341 protects the taxpayer


Chapter 3: The Effect of An Obligation to Repay [1341 over
$3k, BTL Deduction]

I. Problems
1. Kevin is paid monthly, incuding his regular salary & 3% commission (of gross sales in excess of
$250). His commissions average $1500/month. In December, he received a commission of $3k
(based on Nov. Sales). In Jan, he was advised that a mistake had been made, giving him $1k too
much in Dec.

a. How should he report the $3k commission in one year, and the repayment of $1000 the
next year?
i. still should report the $3k commission as gross income
ii. claim of right? Yes he had no knowledge that it was not owed to him
iii. 1341 he only gets a deduction if it is a $3k difference = here it is $1k, so he
does not get the deduction.
b. Assume that he received a Dec. check of $7k, & he immediately recognized that a
mistake had been made. He decided that he needed the money, and decided that it was
like an interest free loan, knowing that they would recognize & have him pay it back.
They required him to pay back $5k. Does he still have to report $7k?
i. Yes he still has to report the $7k
1. If claim of right under North American Oil, he is required to report it
as income
a. He can receive a deduction under 1341 because the difference
amounts to more than $3k ($5k). gets either credit or
deduction
2. If illegal income (claim of wrong) under James, he is required to
report it as income
a. The consensual recognition of indebtedness within the same
tax year doe not transform illegal funds into a loan. (Buff v.
Commissioner)
b. He cannot receive a deduction under 1341 because bad faith
(he can find a deduction if he can find a different
provision/authority)
c. Under the line deduction
i. He has to itemize or
3. Under the line deduction (not provided under 62)
2. Mark owns a private garbage collection service. He sends bills to his customers the first of every
month. If he doesnt receive payment within 20 days of mailing a bill, he sends second billing
statement to the customer. By the time some of the customers have mailed the first billing, they
25
receive the second, sometimes resulting in double payment. Maker then shows a credit balance on
their account, & applies it to the bill the following month. If a customer requests a refund instead,
he always issues the refund. At the end of Dec., he has $5k in overpayments that he has credited to
customer accounts. Should he report the payment this year or the next year, when he anticipates
actually earning the overpayments?
a. Under the complete dominion test in Indianapolis power & light company, the customers
had complete control of the funds, and therefore they are not considered income.
i. He never treated the money as his own, and recorded it as a credit to the
customers accounts
ii. at the moment the money is received, he credited it to the customers, & gave
them the option of refund.
b. Prof. says its likely income.
3. Kevin owns several homes that he rents to college students. He requires them to pay a security
deposit in the amount of one months rent. The agreement states that the security deposits will be
applied (a) to compensate Kevin for any property damage or (b) to cover any unpaid rent. If the
tenants comply, he must return the rent. When a tentant damages the property, he deducts the cost
from the deposit. Typically, the tenants request that the deposit be applied to last months rent, or
just fail to pay the last months rent. He rarely returns a security deposit to tenant. How should he
treat the security deposits for tax purposes?
a. He should treat the security deposit as income because he did have control over it, not
the payor. Kevin ultimately decides whether to keep the money.
b. Indianapolis Power & Light
c. If the recipient of payment controls the conditions under which the payment will be
refunded, the recipient has some guaranty that it will be allowed to keep the money, &
has complete dominion. Herbel v. Commissioner no applicable here, because he doesnt
REALLY control conditions (that would be with some type of
d. If he does end up returning the money, he can get a 1341 deduction if the difference
amounts to more than $3k.
4. Karen is a fitness consultant & personal trainer. She charges her clients $2k, payable in advance,
for a month-long diet & exercise regimen designed to lose a pre-determined amount of weight.
Karen promises to refund the $2k fee to anyone who follows the diet & exercise regimen but fails
to lose the specified amount of weight. She ends up refunding around 5% of fees. At the end of
Dec., she has $20k in fees for clients whos regimen ends in January. When must she report?
a. If the recipient of payment controls the conditions under which the payment will be
refunded, the recipient has some guaranty that it will be allowed to keep the money, &
has complete dominion. Herbel v. Commissioner
b. Refundability is not sufficient to determine as nontaxable deposit Indianapolis Power &
Light
c. Advance payment = income
d. If he does end up returning the money, he can get a 1341 deduction if the difference
amounts to more than $3k.
e. She would receive less harm than an employee would the fact that she ends up
refunding some is not despositive

II. Vocabulary
Claim of right doctrine
III. Objectives
1. To explain the rationale for excluding borrowed money from income
a. Its always a liability
2. To explain the rationale for including illegal payments as income
a. Dont want to give wrongdoers an exception of a rule required by goodstanding citizen.
3. To apply the claim of right doctrine to a given set of facts
4. To distinguish a security deposit from an advance payment
26
a. Advance payment = income
b. Security deposit = income if under the complete dominion of recipient of money
5. To distinguish among funds received under a claim of right, illegal payments, & loans or deposits.
6. To recall that advance payments are includible as gross income upon receipt as are payments
received under a claim of right
Every new dollar of income has to be taxed it can only be taxed once (but has to be taxed once) =
here there is an injustice, because you are putting yourself in a larger tax bracket, then getting
deduction later for smaller amount?
1341 always gives the benefit of highest tax bracket
IV. Overview
A. Loans - Loan proceeds do NOT constitute gross income.
i. No provision for this.
ii. No accession to wealth because the loan proceeds are also a liability = there is an
obligation to repay
b. Repayment of loan does NOT reduce gross income.
c. Failure to pay does not generate taxes, BUT forgiveness of a loan may constitute income.
i. Payment by 3
rd
party does not constitute income to them
d. It is not always clear whether a disbursement constitutes a loan or a taxable payment
i. Ex: a corp. makes substantial cash disbursements to a shareholder, permits the
shareholder to use the corps credit card for personal purposes, and pays federal & state
tax liabilities owed by shareholder court concluded that these payments &
disbursements were loans
B. Claim of Right if there is a contingent repayment obligation, have to treat it
as income as soon as you get it, then 1341
a. A contingent repayment obligation does not allow the receipt of money to be treated as a loan (you
do not wait to see if you have to pay it back/return it treat it as income as soon as you get it)
i. Ex: find $100, cannot find owner. Local law says that they have 2 years to claim it. Do
you treat it as income before those 2 years? Yes.
b. Claim of right doctrine:
i. If a taxpayer receives earnings under a claim of right & w/out restriction as to its
disposition, he has received income which he is required to return [that is, to report on his
tax return], even though it may still be claimed that he is not entitled to retain the money,
and even though he may still be adjudged liable to restore its equivalent.
ii. Two elements
Claim of right
Without restriction as to its disposition (like complete dominion)
c. 1341 = remedy a taxpayer who properly reports income under the claim of right doctrine is
entitled to a deduction (or reduction in taxes) if subsequently required to refund the money.
i. Protects the taxpayer from tax bracket
ii. Only applies when amount in question is over $3k
iii. Below the line or above the line?
Below-the-line deductions - deductions a taxpayer may take into account only
after the adjusted gross income has been determined
But then has to find authority for that deduction
d. What degree of restriction?
i. When taxpayer under court order to deposit excess commissions with clerk of court not
income
ii. When attorney, as require by rules of PR, sets advance money from client into special
account = not income
iii. Merely a conduit of funds = not income
iv. Nonprofit funds for used solely for not profit purposes, when received in Trust for
particular purposes, w. no gain accruing = not income.
C. Illegal Income
a. Illegal income = taxable income
27
i. Gains from illegal business
ii. Embezzled money [see James v. US]
iii. Extorded funds
b. Repayment of illegal funds entitles taxpayer to a deduction
c. The consensual recognition of indebtedness within the same tax year doe not transform illegal
funds into a loan.
D. Deposits
a. Advance payment = income
b. Deposits = it depends = control standard [complete dominion standard]
i. Determining factor = control over conditions of refund
ii. Payor controls = no income to recipient
iii. Recipient controls = income to recipient (complete dominion over payment, because
decides whether to keep it).
iv. Indianapolis Power & Light
v. Mere fact of refundability is not determinative
c. Ex:
i. Entry fee at condo complex
ii. Entry fee was considered earned out on a pro rata basis over 5 years at end of years =
non refundable (but prior to that = tenant who terminated occupancy = refundable)
iii. Court = refundable portions were not advance payments (not income)
North American Oil Consolidated v. Burnet (1932)
if a taxpayer receives earnings under a claim of right and without restriction as to its
disposition, he has received reportable income, even if he may later be required to repay. If
he does have to repay, it will be a deduction in that year.
Brief Fact Summary. Petitioner operated oil drilling on a parcel of land that belonged to the United States.
The U.S. filed suit to oust Petitioner and the oil operation went into receivership. There was income earned
for a year it was in receivership and the income was

Facts. Petitioner operated a section of oil land that belonged to the United States. The U.S. filed suit to
remove possession from Petitioner. A receiver was appointed to operate the property and hold the net
income. Income was earned and held by the receiver for the 1916 tax year. The receiver paid that income to
Petitioner in 1917 after the receivership was dissolve. Petitioner included this amount as income for 1916.
The Circuit Court of Appeals held that the income was taxable to Petitioner for the year 1917.

Synopsis of Rule of Law. Income is taxable during the year a taxpayer is entitled to the income and
receives it.

Issue. Is the amount received by Petitioner taxable as income during the year received?

Discussion. The Supreme Court notes that what is relevant is when Petitioner had the right to receive the
income and when it was actually received. Here, the amount became income of the company the year it was
entitled to receive the income. It could not have been income during 1916 when Petitioner had not yet
received the income and it was uncertain whether they ever would receive the income.

Title Suit Tax Suit NA OIL
(1916) hasnt received money yet (1917) 1916 accrual method (received
money on the books)
1917 DC dismissed the bill
- receives the cash (kind of like
voidable title)
? books were audited 1917 turned over
1920 - affirmed ? books were audited, somewhere in
here (between 1918 & 1927) =
should have been in 1917.
1918 amended return to 1916
(rather than 1917)
1922 SC dismissed 1927
28
?
1932 case decided > culmination of
tax suit & title suit.


the board = the board of tax appeals (before there was tax court)
Holding is in third paragrap
James v. US
receipt of illegal funds constitutes income taxable to the wrongdoer [if the taxpayer receives
income, lawfully or unlawfully, without consensual recognition of obligation to repay, that
income is taxable.

Facts: The defendant, Eugene James, was an official in a labor union who had embezzled more than
$738,000 in union funds, and did not report these amounts on his tax return. He was tried for tax evasion,
and claimed in his defense that embezzled funds did not constitute taxable income. His argument was that
just as the receipt of loan proceeds is not taxable to the borrower (because of the borrower's corresponding
obligation to repay the loan), the person who embezzles money should not be treated as having received
income, since that person is legally obligated to return those funds to their rightful owner. Indeed, Eugene
James pointed out, the Supreme Court had previously made such a determination in Commissioner v.
Wilcox, 327 U.S. 404 (1946). However, this defense was unavailing in the trial court, where Eugene James
was convicted and sentenced to three years in prison.
Issue: whether the receipt of embezzled funds constitutes income taxable to the wrongdoer, even though an
obligation to repay exists.
Holding: Ill-gotten gains constitute taxable income, even if they must be repaid.
Rationale: The Court was divided between several different rationales. The majority opinion was written
by Chief Justice Earl Warren, joined by Justices Brennan and Stewart. That opinion held that if a taxpayer
receives income legally or illegally without consensual recognition of obligation to repay, that income
is taxable. The Court noted that the scope of the Sixteenth Amendment was not limited to "lawful" income,
a distinction which had been found in the Revenue Act of 1913. The absence of the "lawful" modifier
indicated that the framers of the Sixteenth Amendment had intended no safe harbor for illegal income. The
Court expressly overruled Commissioner v. Wilcox and ruled that James was therefore liable for the federal
income tax due on his embezzled funds. The Court also ruled, however, that Eugene James could not be
held liable for the willful tax evasion because it is not possible to willfully violate laws that were not
established at the time of the violation.

Effect of the decision: Although Eugene James avoided criminal liability, the opinion of the Court left
James in a situation where he would be required not only to repay the embezzled $738,000 to the union, but
would also be required to pay federal income taxes on the receipt of those funds, just as though he had been
able to keep them.

Difference between extortion & embezzlement
o Extortion = exchange
o Embezzlement
the part that stated lawful business was removed and this indicated that unlawful money is
included.
Public policy argument for fairness if legal income is taxed, unlawful should as well
Dissent public policy concern social harm = less likely that rightful owner will get money
back.
If thief then has right to deduction he then has to find authority for that deduction
o Will be a below the line deduction
29
Commissioner v. Indianapolis Power & Light Company
control standard [complete dominion standard] - Determining factor = control over
conditions of refund Q = who has the dominion in the end?
Facts: Indianapolis Power & Light Company (IPL) required customers with suspect credit to make deposits
with it to assure payment of future bills for electric service. IPL paid interest on deposits held for a certain
period of time. A customer could obtain a refund prior to termination of service by making on time
payments or by demonstrating acceptable credit. The refunds were normally made in cash or by check but a
customer could also choose to have the deposit amount applied against future bills. Any deposit unclaimed
after seven years would escheat to the State. At the time of receipt, IPL did not treat the deposits as income
for tax purposes. The Internal Revenue Service (IRS) audited the utility and assessed a tax deficiency. IPL
appealed this assessment to the United States Tax Court, which sided with IPL. This decision was then
appealed, eventually reaching the Supreme Court.
Holding: Because customers were entitled to a refund of their deposit, the utility lacked complete dominion
over the funds, so the deposits did not constitute taxable income to the utility.
Importance: This case highlights an ambiguous area in the U.S. tax codes treatment of deposits. The code
treats advance payments and loans differently. Generally, the full amount of an advance payment for
services is taxable income to the recipient in the year received. This is true even if the services extend
beyond the taxable year. However, a loan is not gross income to the recipient. As the Court noted in this
case, the rights of the contracting parties at the time of the payment determine if a deposit is an advance
payment or a loan.
SC took this case because the 11
th
& 7
th
circuits were in conflict
Look at Goldsen case in handout this case helps you understand the that case
On their balance sheet = written as a liability (showing that it had to be paid back like a loan)
Highly regulated business makes a difference because they dont have the same amount of
freedom with the money
IRS argument its income because the money wasnt segregated into another account, &
they could use the money to make income (interest, investing, etc.)
o Court says = same thing with a loan no bid deal. Not good argument.
When do you have to make a decision about whether this arrangement is income or not = at the
moment the money is received (immediately).
What policy interest? = administrability

Notes
Title Suit Tax Suit NA OIL
(1916) (1917) 1916
1917 ? 1917
1920 ? 1918
1922 1927
?
1932

Chapter 5: Gifts, Bequests & Inheritance
1. Gross income does not include a gift, bequest, or inheritance
2. Federal law determines what is a gift, etc. (esp. title 26)
3. 102(b) -
a. 102(b)(1) - The income from property excluded as a gift, bequest, devise, and inheritance is
not excluded.
i. If X gives Y a share of stock, the value of the stock is excluded from Ys income, but
the dividends are not.
ii. Ex: gift of apartment, produces rent. The rent is income.
30
iii. Would narrow tax base
iv. Income from gift = income
b. 102(b)(2) denies exclusion to gifts of income from property
i. Gifts of income = income
1. Ex: I have property that creates income, & before I report it on my taxes, I
gift the income to another = one of them have to pay taxes on that property
2. Ex: stocks put in trust income from stocks/bonds distributed to son
annually.
3. Ex: I give you all the rent out of my apartment = someone has to report the
income (could be the donor, or donee)

102 is not a deduction its just never factored into gross income.
I. Problems
1. Carol is a legal assistant employed by Lucille, a lawyer, & works with an associate lawyer as well
(remains unnamed in this problem). This year for Christmas, Carol received a $250 gift certificate
to a department store from Lucille, a sweater from an associate lawyer, & a box of expensive
candy from one of Lucilles clients. Are these gifts includable in Carols gross income?
a. Under the general provision of 102, all of these items would be excluded from income
(detached & disinterested). However, 102(c)(1) does not include gifts from employers to
employees.
b. The gift from Lucille to Carol is considered an accession to wealth that is not excluded
from gross income under 102
c. 274(b) If the sweater from associate lawyer & expensive candy do not exceed $25, they
can be excluded as gross income under 102
i. also, there may be an interest from the colleague
2. Maria moved out of her apartment to care for her elderly father (at his request), & he offered to
devise his home to her, but she told him it wasnt necessary, she didnt need it, blah blah. She then
lived w. him & cared for him for three years of his life. Following his death, his will devised his
home to Maria, noting that it was made in gratitude for her care - & devised the rest of the estate to
her siblings. What tax consequences to Maria as a result of the devise of the home?
a. Look at the transferors intent when determining whether it was purely altruistic, with no
invested interest. [Commissioner v. Duberstein] here, although it was not the
transferees intention, the father gave the gift in return for the daughter performing on her
promise to live with him & take care of him. Therefore, she would have to pay taxes on
the property. = not excludable under 102.
b. If considered gift goodness of his heart Since there is no evidence that the property
generated any income, & unless she creates income off of the property (rents it out),
Maria does not owe any taxes on the gift.
3. Years ago, Dan purchased for investment purposes a tract of undeveloped land for $100,000. This
year, Dan deeded the land to his son, Will, as a gift. The land had a $250k fair market value at the
time of the gift & an adjusted basis to Dan of $100k.
a. Will either Dan or Will recognize income on the Transfer. What basis does will take in
the land?
i. 102(b)(2) if the property is producing, or has produced, any income - One or
the other will have to pay taxes on it. Otherwise, no one will recognize income
ii. 1015 = substitute basis or transferred basis - $100k transfers from Dan to
Will
b. How, if at all, would your answers to (a) change if Dan is also Wills employer.
i. It could be considered a business exchange, and would not be considered a gift
under 102. In that case, he would have to pay taxes on the accession of wealth
ii.
c. How, if at all, would your answers to (a) change if, instead of giving the land to Will,
Dan sold it to Will for $50k? For $200,000?
i. The property would no longer be a gift, and Will would have to pay taxes on
either the $50k or the $200k.
31
ii. If Will had a loan, interest payments = qualified residence interest =
deductible
1. 168(a) (interest accrued in indebtedness = deductible) qualified by
163(h), not including personal interest however it is qualified
residence interest (exception to rule)
2. above the line if incurred in business = below the line here.
iii. If he purchased for $50k, & it is worth $250k
1. Pellar v. Commissioner
2. bargain purchases generally do not constitute gross income
3. Dans Gain:
a. Part Gift, Part Sale Dan has gain to the extent that his AR
exceeds his AB = does not here, so no gain.
b. If $200,000 = he has a $100k gain
4. Wills Basis:
a. If bought for $50k = $100k (greater of the amount paid or AB)
b. If bought for $200k = $200k basis
d. How would your answer to (a) change if Dans land were encumbered by a mortgage in
the amount of $125, & Will agreed to assume the mortgage.
i. It would no longer be a gift if Dan is giving him the property in exchange for
Will assuming the mortgage (therefore not excluded from gross income under
102)
ii. He would be able to deduct interest payments = under the line deduction
because not business.
iii. interest payments = qualified residence interest = deductible
1. 168(a) (interest accrued in indebtedness = deductible) qualified by
163(h), not including personal interest however it is qualified
residence interest (exception to rule)
2. above the line if incurred in business = below the line here.
iv. Basis:
1. Liability is treated as amount paid = $125
a. Dans reportable income would be $25 (AR that exceeds
basis)
b. Wills basis = $125
e. Assume Dans land were worth only $90k when he made the gift of the land to Will.
What tax consequences to Will when he subsequently sells the land for $90k? 80k? 95k?
110k?
i. $90k? no tax consequences. No accession to wealth
ii. $80k? deduct the loss?
iii. $95k? pay taxes on $5k.
iv. $110k? pay taxes on $15k.
1. income = (1) any undeniable accession to wealth (improved situation),
(2) which is clearly realized (change in value) by the taxpayer, (3) over
which the taxpayer has complete dominion (can use it).
f. Assume Dan devised land to Will & the land had a fair market value of $250k at the time
of Dans death. What tax consequences to Will? What basis does Will take in the land?
i. Gift under 201, so excludable from gross income.
ii. 1014 allows to step up basis acquired from a decedent to FMV of property
at time of decedents death = only the appreciation after the death will be subject
to tax = $250k
iii.
g. How would your answer to (f) change if the land had a fair market value of $75k at the
time of Dans death?
i. It wouldnt change?
ii. 1014(a) if property decreased in value during the lifetime of the decedent so
the decedents basis exceeded the value of the property, 1014(a) will negate the
loss inherent in the property = $250k.
32
iii.
h. Assume Dan gives the land to his father, George, when the land has a fair market value of
$250k? George dies two months later & devises the land, still worth $250k, to Dans son,
Will. What basis does Will take in the land?
i. 1014(e) cannot step up basis acquired from a decedent to FMV of property
at time of decedents death because within a year of gift = basis is $100k


a) If sold it for 50k then Will takes a basis of 100k since the adjusted basis is greater than cost paid.
and dan does not recognize any gain since the gain would be amt realized adjusted basis. If he
sold it for 200k then wills basis would be 200k and dan would recognize gain of 100k.
b) Wills basis would be 225k and dan would realize
c) Dfs
d) Wills basis would be 250k
e) Depends on when dan died. If he died within 1 year of the gift, then will would have basis of
100k, if not he would have basis of 250k
f) Under 1014(e) , will would take a basis of 100k

II. Vocabulary
Gift -
Inter vivo = gift in life
= excluded from income
= accessions to wealth (Glenshaw Glass) = BUT = not income
most gifts occur in the family unit the further the gift departs from family unit, the
more the court will question as to whether it rises to the level of gift
includes friends, work, etc.
gifts given in life, or in death (will, etc)
transferors intention must be detached & disinterested generosity
Bequest testamentary transfer (personal property by will)
Devise testamentary transfer (real property by will)
Inheritance intestate succession
Part-gift, part-sale
Exclusion
Stepped-up basis
Stepped down basis
Carryover basis
Basis for purposes of computing loss
III. Objectives
1. To distinguish gifts & bequests from compensation and other taxable receipts
2. To recall the Duberstein definition of the term gift as used in 102
3. To explain in your own wods the statutory limitations on the exlusion of gifts, bequests, etc.
4. To recall that 102 excludes gifts, bequests, devises & inheritances
5. To recall that the disposition of appreciated property by gift generally does not constitute a
realization event for the donor.
6. To apply the basis rules of 1015 to situations in which gifts are made of appreciated and
depreciated property.
7. To compute the tax consequences to a donor who makes a transfer that is in part a gift and in part
a sale
8. To apply the 1014 basis rule and to contrast it to the basis rule in 1015
9. To explain the tax consequences to a donor who gives property encumbered by liabilities for
which the done assumes responsibility
33
IV. Overview

A. What is Excluded by 102?
1. The Nature of a Gift
a. Bequest, devise, or inheritance. gifts in life or in death
b. Question: whether what is received can be characterized as a gift, bequest, devise or inheritance?
c. Commissioner v. Duberstein:
i. a gift in the statutory sense .. proceeds from a detached and disinterested generosity
out of affection, respect, admiration, charity or like impulses.
ii. Looking at transferors intent
d. Provisions limiting scope of gifts:
i. 102(c)(1) any amount transferred by or for an employer, or for the benefit of, and
employee = not a gift.
ii. 274(b) in business - disallows a deduction for gifts to individuals in excess of $25
applies only to items excludable as gifts under 102
2. The Nature of a Bequest or Inheritance
a. Lyeth v. Hoey = when will is disputed, are the distributions still considered excludable from
income under 102? YES.
i. Federal law can determine the scope of these words
3. Statutory Limitations on the Exclusion -- 102(b)
a. Two limitations:
i. 102(b)(1) - The income from property excluded as a gift, bequest, devise, and
inheritance is not excluded.
If X gives Y a share of stock, the value of the stock is excluded from
Ys income, but the dividends are not.
Would narrow tax base
Income from gift = income
ii. 102(b)(2) denies exclusion to gifts of income from property
Gifts of income = income
a. Ex: I have property that creates income, & before I report it on
my taxes, I gift it to another = one of them have to pay taxes
on that property
b. Ex: stocks put in trust income from stocks/bonds distributed
to son annually.
b. Whats the property in question
c. What is the income
d. Exception to exclusion = income
B. Basis of Property Received by Gift, Bequest or Inheritance
1. Gifts of Appreciated Property LIFE 1015
a. 1015 = substitute basis or transferred basis
i. (a) what is the donees basis in the property situations contemplated
FMV > donors basis = donors basis
a. Rule = donors basis = donees basis
FMV < donors basis = FMV at time of gift (built in loss)
a. Gift ------- retransfer by the donee what is their basis? Only know
when they sell.
b. You will only know at moment of retransfer
c. for the purpose of determining loss
d. loss that accrued on the donees watch
there can be a situation where there is no gain or loss
a. ex: 100k (250k) --- 150 (?)
b. AB 100 AR 150 = no loss
c. AR 150 AB 250 = no gain
ii. The basis of the one giving the gift is transferred to the one receiving the gift
34
Ensuring that the gain remains subject to taxation
iii. Ex: Claude purchases a share of stock for $200 & gives the stock to Mary when the stock
is worth $500 per share.
Marys basis will be Claudes basis = $300 tax liability shifts
Claude will not realize the gain does not have the tax liability
iv. Taft v. Bowers SCOTUS said tax shift is constitutional
2. Gifts of Property Basis in Excess of FMV
a. Congress prohibits the shift of losses
3. Basis of Property Received by Bequest or Inheritance DEATH 1014
a. 1014 allows to step up basis acquired from a decedent to FMV of property at time of
decedents death = only the appreciation after the death will be subject to tax
b. 1014(a) if property decreased in value during the lifetime of the decedent so the decedents basis
exceeded the value of the property, 1014(a) will negate the loss inherent in the property
c. includes other types of property
i. joint tenancy
ii. community property
d. Ex:
i. 500k fmv (100k basis) $500k
ii. 50k fmv (100 basis) 50k basis for devisee
should advise to liquidate
iii.
hold on to capital gain property with built in gain
liquidate property that has a built in loss = so your estate ahs the benefit of the
loss, otherwise, your esteate loses its loss at time of death
e. Allows the estate the option to value the property 6 mos from the date of death
f. 1014(e) appreciated property acquired by decedent by gift within 1 year of death
i. if donor dies within a year of receiving gift = basis of donor transfers (rather than
stepping up basis)
ii. if property gifted to decedent within a year of death does not have a step up
iii. to prevent abuse
iv. 1014(e) applies only to children/spouses
friend could try but then the donee is free to devise or transfer, so risky
could have a k, where consideration, but then wouldnt be a gift
C. Part-Gift, Part-Sale - HYBRID
Seller-donor has gain to the extent that the amount realized exceeds the adjusted basis of the
property
o Ex: donor has $75k basis in property, and sells for $90 = $15k is realized
No loss is recognized with Part-Gift, Part-Sale
Donees basis will be the greater of the amount the donee paid for the property or the adjusted
basis of the donor.


Commissioner v. Duberstein
Look at the transferors intent when determining whether it was purely altruistic, with no
invested interest.

Common law gift = one gives another something without consideration or compensation
Government test = Gifts should be defined as transfers of property made for personal, not
business, reasons. court rejects
o More maxims than principles common sense sound
o Why does the court reject better to have the trier of fact determine under
totality of circumstances

35
Statutory gift = looks at transferors intention must be detached & disinterested generosity

Look at all the factors:
Whether the transfer amounts as a gift is a conclusion that must be reached on consideration of all the
factors
The taxing statute does not make nondeductibitliy by the transferor a condition on the gift exclusion
Each case will differ, fact finder can determine based on totality of the circumstances
If this creates too much litigation = congress can define more precisely
Fact: Taxpayer Duberstein received a Cadillac from a long-time business acquaintance. At issue was
whether the Cadillac was truly a gift or a payment in exchange for business information.

Issue. Was the Cadillac a gift excludable from gross income?

Held: in Duberstein it was not error to consider the Cadillac as income and not a gift.
It was at leat a recompense for past services, or an inducement for him to be of further service in
the future
Notes:
102 has always been there why? Policy reasons.
Theres another tax state income tax, state gift tax
Policy question: makes it easier for familys to pass on wealth.
Better to let a jury (trier of fact) determine what a gift is
We look to federal law to determine what a gift is (can look to state law to be informed, but
ultimately the decision is w. federal law)

Wolder v. Commissioner
Facts: Petitioner was an attorney and rendered legal services to a client. The parties agreed that he would
provide the services free of charge until the clients death and she would leave him a set amount of stock
and/or cash. The will did indeed provide for the payment to Petitioner as agreed.
Issue: were the amounts received by an attorney under the terms of the clients will compensation or a
bequest? Compensation.
This is also a PR question attorneys cannot receive gifts from clients. [Rule 1.8(c)]
(c.) A lawyer shall not solicit any substantial gift from a client, including a testamentary gift, or
prepare on behalf of a client an instrument giving the lawyer or a person related to the lawyer any
substantial gift unless the lawyer or other recipient of the gift is related to the client. For purposes
of this paragraph, related persons include a spouse, child, grandchild, parent, grandparent, or other
relative or individual with whom the lawyer or the client maintains a close, familial relationship.

Olk v. US
payments made by persons of whom the taxpayer provides services = compensation
Issue: whether tokens/chips to a casino dealer are considered income or gifts? Income.
Tokes gathered at end of the night & split between dealers.
Not detached or disinterested generosity (legal conclusion)
o People leave the tokes as a tip for the dealers services, or for good fortune.
Holding. P. 105
Transferors intent is prob. less important when there is an institutional arrangement

Goodwin v. US
Its not always the transferors intent. Adds to the Duberstein test. Looks to the mechanics of
how the gift is structured.
Issue: whether special occasion gifts to pastor constitute income or gifts? Income.
Made by a congregation as a whole
36
Cash payments were substantial gathered by congregation leaders in a routinized, highly
structured program
Look at transferors intent range of motives here .. but - includes interested motive (to keep
minister in church)
If denial of refund claim means it did not start in tax court (because it would be redetermination
of deficiency)

CHAPTER 12: BUSINESS & PROFIT SEEKING EXPENSES

Deductions start with 161
1. Ordinary & necessary = standard
2. Reasonableness = determines whether salary deduction is recognized or not
3. The taxpayer has to have a trade or business
4. Have to be carrying on in the current year (all of the startup expenses of the business are
disallowed until you are up & running) 195
5. Being an employee is a trade/business, & you get to deduct those cost = BUT = Below the
line (misc. itemized deductions) 162 62 63 67/63
a. Cost of looking for job are ordinary/necessary (except for your first job, because you
arent carrying on a trade or business yet)
6. If something doesnt qualify as 162 = the fallback is try to qualify it as a 212 expense for the
production of income (most of 212 is below the line, only ATL 212 are expenses in created
rents)
I. PROBLEMS
1.
a. Can Casey deduct the salary & bonus he paid to Brennan?
i. Reasonable = yes
1. She is more qualified
ii. Unreasonable = no
1. Closely related corp
a. Shes not a shareholder
b. Is he shifting income for tax purposes
iii. Considerations:
1. Closely related corp
a. Shes not a shareholder (no dividends)
b. I he shifting income for tax purposes?
2. What others in a similar industry are paid
3. Elliotts v. commissioner independent investor test should evaluate
reasonableness from the perspective of a hypothetical independent
investor investor wouldnt care because it is salary, not dividends
4. Other factors:
a. Employees role in corp (hours, duties)
b. The size & complexity of the company & general economic
conditions
c. Relationship between company & employee
b. If deemed excessive, how would the bonus be treated for tax purposes? = non deductible.
c. How would your answer in (b) change if Caseys business were incorporated? Assume
Casey is the sole shareholder.
i. I dont see how it would change the answer???
ii. If Brenna is an officer (top 4), cannot deduct moer than 1m for her.
2.
a.
i. ordinary?
37
1. Jenkins v. Commissioner for 162, must = determine the purpose or
motive of the taxpayer in making the payments = his purpose & motive
was to keep the client, incentive = deductible under 162
a. sufficient connection between the expenditures and the
taxpayers trade or business = yes.
b. This is an equity investment = assume high risk.
2. Common practice?
ii. Necessary?
1. Necessary to keep client?
b.
i. seems as though he may have more of a personal interest in the chauffeur
service [yacht case]
if he can show that it is ordinary & necessary to his business = keeps
clients & is important for his reputation & to succeed [equestrian case
(Relied on exposure & reputation for work (having clients, etc))
prof says more like the equestrian case relied on exposure &
reputation for work.
a. Or personal jet case
ii. over the line deduction 62(a) 162
3. ..
a. Trade or business of being an employee
i. Finding work in the same trade/business = deductible under 162
1. = below the line, subject to the 2% floor (67)
ii. employee agency expense = deductible if same trade/business
iii. payment of employment counseling fees = deductible
iv. travel expenses for students for interview? No?
v. how long a taxpayer must be employed & still be considered in the
trade/business? = taxpayer must establish that during the hiatus he/she intended
to resume the same trade/business
4.
a. objective would the reasonable taxpayer wear this
b. subjective -
II. VOCABULARY
Deduction
Ordinary
Necessary
Trade or business
Capital expenditure
Amortization
Start-up expense
III. OBJECTIVES
IV. OVERVIEW
162 & 212 reflect the principle that net income is subject to tax (not gross income)
o the expenses necessary to make money should be deductible
1. personal expenses = not deductible in determining net income subject to tax (they are bottom
of the line deductions 262(a))
1. capital expenditures = made to obtain an asset lasting for substantial or indefinite period of
time
A. Business Deductions 162
Deductions = legislative grace
gross income derived from business = the total sales, less the cost of goods sold.
162(a) requirements for deduction of business costs:
38
1) must be an expense (ch. 13)
2) must be ordinary
3) must be necessary
4) must be paid or incurred during the taxable year (ch. 28/29)
5) must be paid or incurred in "carrying on a trade or business

1. The Expense Must be Ordinary & Necessary - 162
b. Is the Expense Ordinary?
i. Welch v. Helvering = ordinary requires that the cost be customary or expected
in the life of a business (life in all its fullness must supply the answer)
Ordinary expenses are to be distinguished from capital expenditures
such as reputation (goodwill) & learning.
voluntary repayment of a debt = not deductible in Welch [Twit
ii. Depends on the situation/circumstances of each case
what is ordinary .. is nonetheless a variable affected by time & place
& circumstance
iii. Jenkins v. Commissioner for 162, must:
Ascertain the purpose or motive of the taxpayer in making the
payments
Determine whether this is a sufficient connection between the
expenditures and the taxpayers trade or business
a. Doesnt have to be the same business, only that it is related
iv. Deputy v. Dupont the transaction which gives rise to it [expense] must be of
common or frequent occurrence in the type of business involved
v. Commissioner v. Tellier legal expenses were not capital expenditures (not
deductible as business expense
vi. Goedel v. Commissioner insurance policies = not deductible under 162
vii. Gilliam v. Commissioner acting out on a plane is not an ordinary expense
c. 162(m)
i. 100mil cap but creates perverse effect of increasing prices on shares (increase
taxes)
ex: pay ceo 10m, can only deduct 1mil shareholders pay rest of tax
ii. closely held corp person wears two hats (sole shareholder & employee)
transfers profit to employees through dividends (dividend is not
deductible for corp)
best thing for him is to never get a dividend & make all salary (gets that
deduction)
understand = salary vs. dividend
a. since they are going to use salary what is IRS going to want
to do? 162(a) reasonable.
i. Compare how salary in one corp. matches up to the
other.
ii. Independent investment test if Im an invester &
get double what my investment is, do I care if the
CEO gets more money? NO. If my only goal is
maximum return, dont care about management fees.
iii. (just compare the numbers) whats the problem? Make
sure you have comparable companies
iv. shifts what reasonableness means into a business
context

d. Is the Expense Necessary?
i. Welch v. Helvering = necessary = appropriate & helpful courts are slow to
override the judgment of a business person regarding the necessity of any
costs incurred
ii. Few cases have focused on whether something is necessary
39
iii. Court tends to defer to taxpayer to determine what is necessary
iv. What is necessary is a factual determination
v. Palo v. commissioner: private plane on standby was ordinary & necessary for
business because it saved them money & was the normal response expected in
the circumstances.
vi. Henry found that yacht to promote business by proving contacts in the
yachting business was not necessary = furthered primary personal ends
(wasnt solely for the purpose of promoting business)
vii. Dobb v commissioner court rejected the corps. Attempt to deduct landscaping
around the personal residence of its sole shareholders. = main benefit was for the
shareholders, not the business
viii. Topping v commissioner expenses for designing barns for equestrian activities
Relied on exposure & reputation for work (having clients, etc)
Found necessary to her success as interior designer
Had PROOF that her efforts generated clients.
ix. Reasonable salaries:
Unreasonable salaries are not ordinary & necessary
Closely held corps = where all employees are likely to be shareholders
a. More possibility of income shifting
b. Income generated by corp is taxed to corp
c. Dividends paid out to shareholders are taxed to shareholders
d. Double taxing eliminated
e. The reasonableness standard is the biggest obstacle to this
Elliotts v. commissioner independent investor test should evaluate
reasonableness from the perspective of a hypothetical independent
investor
Other factors:
a. Employees role in corp (hours, duties)
b. Salaries of similar companies with similar services
c. The size & complexity of the company & general economic
conditions
d. Relationship between company & employee
e. Whether compensation stems from a compensation program
that itself is reasonable, longstanding, and consistently applied
x. Clothing
Not deductible when the clothing can be worn for general or personal
wear
Three part test tax court applies:
a. The clothing is not suitable for general or personal wear by the
taxpayer (subjective test)
b. The clothing is required or essential in the taxpayers
employment
c. The clothing is not, in fact, used for taxpayers general or
personal wear
IRS standard:
a. Does not use the subjective test = objective standard
Bernardo v. commissioner work required her to wear black clothing
her new wardrobe was not deductible because it was suitable for every
day wear
a. Couldnt prove that she didnt wear the clothes away from
work
Uniforms like police, fireman, etc. = deductible
xi. Public Policy Considerations

2. Carrying On a Trade or Business - 162
a. What Constitutes a Trade or Business
40
i. Groetzinger
Depends on facts of each case
Continuity & regularity of activity
Primary purpose for engaging in activity must be for profit/income
Holding ones self out to others as engaged in selling goods/services
Not include hobbies
ii. Traders vs Investors
Traders = business activities directed toward short-term trading with
income being deprived principally from the sale of securities rather
than from the dividends & interest which investors typically seek
Investors = not business
Look to taxpayers:
a. Intent
b. Nature of income to be derived from the activity
c. The extent & regularity of securities transactions
b. The Carrying On Requirement
i. Start up expenses (investigatory stage) = not deductible under 162, because not
yet carrying on.a
ii. Pre opening costs = not deductible under 162
Provide benefits beyond the tax year
c. 195 & The Amortization of Certain Pre-Operational or Start-Up Costs
i. must satisfy 2 requirements:
1. be paid/incurred in connection with creating, or investigating the creation or
acquisition of, a trade or business entered into by the taxpayer
2. expenditure must be one which would be allowable for deduction for the
taxable year in which it is paid/incurred if it were paid/incurred in
connection with the expansion of an existing trade or business
a. would have had to be deductible if you had an (active) trade or
business
3. requires business to actually be open
ii. include:
investigatory costs
a. marketing surveys, products, labor supply, etc.
startup costs (made after decision to establish business, & before bus.
Begins)
iii. limitations:
can amortize over a period no less than 60 months
up to $5000 deductible (in that year the business begins)
a. reduced by the amount of start up costs that exceed $50k
b. ex: if $55k, no deductible
c. ex: If $52k = $3k deductible = remaining $48 amortized over
180 mo.s
d. must actually engage in trade or business
d. Application of the Carrying On Requirement to Employees
i. Trade or business of being an employee
Finding work in the same trade/business = deductible under 162
a. = below the line, subject to the 2% floor (67)
employee agency expense = deductible if same trade/business
payment of employment counseling fees = deductible if employment is
actually secured
travel expenses for students for interview? No?
how long a taxpayer must be employed & still be considered in the
trade/business? = taxpayer must establish that during the hiatus he/she
intended to resume the same trade/business
B. 212 Deductions
41
1. for expenses incurred in producing or incurring income, and the management, conservation, or
maintenance of property held for the productin of income
2. not expenses incurred in attempts to create income
Welch v. Helvering
What does ordinary mean? = requires that the cost be customary or expected in the life of a
business (life in all its fullness must supply the answer have to look at the
facts/circumstances)
o Ordinary expenses are to be distinguished from capital expenditures such as reputation
(goodwill) & learning.
Would have to be amortized (investing in name = goodwill) profitable for
many years.
o Here, it is not normal to pay debt of old company (not ordinary)
o It can happen only once in the co. life but as long as it is ordinary (in that any co. in the
industry could encounter it)
Downfall this is tough for innovative industries (new domain of activity)
necessary = appropriate & helpful courts are slow to override the judgment of a business
person regarding the necessity of any costs incurred
Facts. Petitioner was the secretary of the E.L. Welch Company which was involved in the grain business.
The went bankrupt and was discharged from its debts. Petitioner entered into a contract with the Kellogg
Company to purchase grain for it on commission (he was a broker). Petitioner decided to pay the debts of
the Welch Company in order to repair his credit and standing from the bankruptcy of the Welch Company.
The Commissioner ruled that these payments of the debts were not deductible from income as ordinary and
necessary business expenses. The Board of Tax Appeals sustained and the Court of Appeals affirmed.

Issue. Are the expenses deductible as ordinary and necessary business expenses? No.
Synopsis of Rule of Law. In computing net income one may deduct ordinary and necessary expenses
incurring in carrying on any trade or business.
Higgins v. Commissioner
Facts. Taxpayer, Petitioner, had extensive investments in real estate and securities. He devoted time to
overseeing these interests and hired others to assist him. He claimed the salaries and expenses for looking
after these investments as deductible business expenses. The Board of Tax Appeals found that the activities
did not count as a carrying on a business because the activities were for personal business regardless of the
amount of time involved. The Court of Appeals affirmed.

Synopsis of Rule of Law. All ordinary and necessary expenses paid or incurred during a tax year in
carrying on a trade or business are deductible.
Issue. May the expenses be deducted as business expenses? What does carrying on a business
mean
Held. expenses are not deductible because was he was not carrying on a business.
Rather, he was managing his personal portfolio. Size of a personal portfolio or the amount of time
spent doing something does not factor into considering whether or not something is a business.
Board of appeals reexamines facts and then next appeal reviews law. Investor is in the trade or
business of capital the good he is providing is capital ; Despite the fact that Higgins said no
under 162, you could probably deduct under 212
Fact by fact analysis

Commissioner v. Groetzinger
Full time gambler gross loss = $72k, & winnings of $70. = Net of $2k.

Alternative Minimum Tax = not relevant to this case. Tax that runs at the same time as the section 1 tax -
55 =

42
Legal question raised by this case = what is a trade or business?

Rule: if gambling activity is pursued in full time, in good faith, and with regulatrity, to produciton
of income for a livelihood, and not a mere hobby, it is a trade or business within meaning of
statutes. (1)Continuity and regulatory; and (2) for profit [See sec. 1.183-2 for 9 factors to
determine if activity performed for profit or pleasure.]
Deduction by 62(a)(1), under 162

Revenue Ruling 75-120
Are amounts paid by an employee in seeking new employment deductible under 162 or 212?
If seeking new employment in the employees current trade or business they are deductible under
162 if directly connected with such trade or business as determined by all the objective facts and
circumstances.
Expenses not deductible if seeking employment in new trade or business, even if employment is
secured.
If unemployed, trade or business is whatever his last job was as long as there was not a substantial
lack of continuity between the jobs[1 year or more.]
Under 212, stuff that isnt deductible under 162 is deductible as long as expenss incurred with
respecr to existing business.
Important Q. is- Is whatever your looking for in the same trade or business.
o Edu. Deductions - does the education permit you to do new things? Not the same
trade/business- No deduction(applies to different Bar test expenses.)
o Permits you to do the same things? Deductible.
Pevsner
Facts: Taxpayer employed in clothing store that sells only womens clothes and accessories
designed by Yves st laurent. As a manager of store, taxpayer is expected to wear the YSL clothes
while at work (clothes is very expensive). She said she never wore the clothes outside of work
because they were too much for her simple lifestyle but admitted that she could have worn them
off the job. In 1975 tax return she claimed a deduction for the clothes.
Issue: Can the taxpayer deduct the cost of purchasing and maintaining YSL clothes worn by
taxpayer in her employment as manager as an ordinary and necessary business expense?
Rule: clothing expense is deductible as business expense only if : (1) the clothing is of a type
specifically required as a condition of employment, (2) it is not adaptable to general usage as
ordinary clothing, and (3) it is not so worn. The general use prong should be an objective test
no reference is made to individual taxpayers lifestyle or personal taste. Adaptability depends on
what is generally accepted for ordinary street wear.
Holding: The clothing was not deductible when viewed objectively. An objective test is needed
for administrative purposes. It is practical. that deduction should be denied because the cltohes
could have been used for general purposes This is unlike commuting expenses because she had
to wear the clothing for work. Commuting expenses are not deductible because a person has a
choice of how far they want to live from work
Policy reason for this case is 262 (deductibility of personal expenses)
TEST- Can anyone wear the clothing outside of work. Not would that specific person.
43



Ch. 32
Lucas income is taxed to whoever earns it
2
nd
income from property is taxed to the owner of the
property, not recipient of income
































Deducted Not deducted
Voluntary repayment Twitty Welch
Criminal defense Tellier Gilliam
Luxury Goods Equestrian (substantiate claim) Yacht
Landscaping case (Dobb v.
Commissioner)

Not deductible
Deductible
262 disallows an entire class of
expense from deductability
(personal, living, family expenses)
Public Policy
Tax-exempt
Unreasonable (ex: unreasonable
salaries - 195)
o Closely related co.
(Small co.)
o 1mil cap
A-T-L
Now
B-L-T
162 gives rise to current
year expense, & expenses
that have to be expensed
over time (above the line
deduction)
212- expenses for
production of income (ex:
(3) allows you to deduct
turbo tax)
Later
Now
Later
Take it below the line
when 162 & 212 are
below the line
44
Chapter 34: Assignment of Income
I. Problems
II. Vocabulary
III. Objectives
IV. Overview
Q: who is the proper taxpayer to be charged with the income or expenditure at issue?
A. The Progressive Rate Structure
who is important because of the codes progressive tax rate structure [1] = the tax cost of
the dollar depends on the rate that it is taxed (higher bracket or lower bracket)
o if they can shift the income to another person in family, they can be taxed at a lower
bracket
our tax system taxes individuals on their net income
B. Development of Rules Limiting Income-Shifting
Annual accounting principle = if the same income will be taxed at a higher rate the next year
than this year, the taxpayer will try to accelerate future income into the current year (when the
taxpayer has realized the income)
Capital gain income is subject to tax rate much lower than ordinary income taxpayers will
try to convert ordinary income into capital gain (profit from stock, bond, real estate etc.)
o 1211 the amount of capital losses that are currently deductible depends in part on
the amount of capital gains currently reportable
in answering who question, 2 rules:
1. income is taxed to the taxpayer who controls the earning of the income
2. income from property is taxed to the one who owns the property & thus controls the
income generated from the property
community property laws:
o Poe v. Seaborn (1930) SCOTUS allowed couples to split their earnings, & each
would be responsible for their half of earnings (under community property laws) =
mechanism is state law (with lucas, the mechanism was a contract)
o Authorized by Congress in 1948 for all married couples to file joint returns
o Applies to partners in California
o Eatinger v. Commissioner employee spouse & nonemployee spouse will each be
taxable on the pension benfits
o Commissioner v. Duncan splitting of income does not apply to court ordered
payments to ex-wife.
o
C. Application of the Assignment of Income Rules
Kochansky v. Commissioner man gave portions of his attorney fees to ex-wife (as agreed in
divorce settlement), and was still taxed on all of it. Earl v Lucas = assignment of personal
income does not shift the tax liability [mechanism = settlement have the ability to negotiate,
thats how diff from state requirement]
Commissioner v. Giannini president of corp. refused to let the corp. give him income for the
rest of the year, & suggested that they use it for some worthwhile cause = they donated it to
university. The court found that he had renounced his interest in the money, and had not
directed its assignment = finding in favor of the taxpayer. [mechanism = disclaimer]
Taxation can turn on the law of agency = if agents gather money & submit it to the principal =
not taxable
o Unless amounts are received in individual capacity, and not as an agent
o Law school faculty = working solely as agents of the law school = just the agents
Conglomerates
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o Holding company, that owns two other companies has full control over them
(usually have affiliates in diff. countries that have diff tax codes = thinks about its
consolidated tax position as an enterprise, taking into account all the subsidiaries =
what can we due to reduce our tax burden?
Lets assume one of the two companies has a higher rate thant he other, &
sell to eachother = Transfer pricing = change price between two entities
to shift income
482 allocation of income & deductions among taxpayers

Income from Property interest:
o Author of book vs. individual with copywrite interests (son) = copywrite treated as
property, son taxed, not author
o The fact that its viewed as property suggests that you can treat it differently
o If the owner gives away the asset = transfers the tax liability
o If the owner gives away earnings from an asset = does not transfer tax liability
D. Income-Shifting Within Families & Between Related Parties
kiddie tax [1(g)] = taxes the unearned income of certain children at the top marginal rate of
their parents
shifting in corporations to get lower tax bracket

Notes:
ways to pool income
o joint returns
o partnership tax
progressivity (from 0% - 35% last year)
o form highest marginal income tax rates
want to shift the tax liability around so that can pay smaller tax bracket rates
o alternative minimum tax is almost like a flat tax
your trigger for is there an assignment of income is when there are two taxpayers in the problem
o when just one taxpayer = playing the game of different tax years
there is also income characterization
two situations that are difficult
o dividends
when shares sold, & there is a dividend, who gets that diviend
four days
declaration date date that the ceo announces the date
ex-dividend day first day that a purchaser of that share of stock has
no right to the dividend because he is buying to late for his ownership
to be registered in time (as time goes on, there will prob be less time
between the ex-dividend day & the record date)
record date = if you own our stock on the record date, you get a
dividend on payment date (open the books to see who has ownership)
payment date = t
on the books, an agent writes in who the new owners are when there is a sale of
a share
o personal service corporation - a lot of this with athletes:
athlete doesnt want to enter k directly with the team, so he doesnt recognize
the income that will accrue to him directly so he sets up the personal service
corporation, and then his corporation hires him enters a k with the corporation
as employee , and determine when to be paid, & when the flow is (to account for
the different marginal rates that he will be in years down the road).
Control test for this = does the team establish what he does, when he does it, &
uses the corp as a way to implement what has already agreed on, then allowed.
If player has control = he is liable for those taxes.
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Lucas v. Earl (1930)
The respondent, Earl, & his wife entered a k where all their earnings & belongings, regardless of their
source or nature, would be considered as owned by both as joint tenants (both have equal interest in
property tenancy in common have undivided interest in the property & can hold unequal interest) (w.
right of survivorship). trying to shift the income between the two = lower tax bracket

Argument: the statute seeks only to tax income beneficially received (the amount of interest you have in
it 100% interest, or you have 1/2 interest) - & at the moment Earl receives income, it becomes joint
property of Earl & his Wife basically saying that he only benefits from 1/2h is income
beneficially received goes to trust component (Trustee initially has 100%, but not full
interest in it.
Court = Earl was the only party to the contracts by which his income is received, and he is the
only one that can perform on the ks.
Not to be decided on attenuated subtleties, (trifling/small distinctions)
It turns on the import and reasonable construction of the taxing Act (it turns on the
interpretation of the statute
o the statute doesnt recognize the slight distinctions
no distinction can be taken according to the motives leading to the arrangement by which the
fruits are attributed to a different tree from that on which they grew (it doesnt matter how you
define your income assigning it to someone else wont shift the tax liability = its still taxable)
o the taxpayer is transferring only the fruit its still the same tree (the person who earns
the income, pays taxes on it)
o the tree is taxed on the income, regardless of who the fruit is transferred to.

Issue: whether Earl should be taxed for his whole salary, or just half of it as a result of the k with his wife
to own everything as joint tenants w. right of survivorship.

Holding: Income is taxed to whoever earned it.

Board of Tax Appeals (before there was a tax court) held that his whole salary should be taxed
Circuit court of appeals REVERSED.
SCOTUS = REVERSED (upheld tax courts original finding)

K not at issue presumed to be valid.

This case doesnt matter now because they would be able to file joint returns today = but the metaphor
lives on.

Poe (1930) Community property = earnings during marriage are deemed property of the husband-wife
community &not the property of the spouse performing the services generating the earnings.

1. income is taxed to the taxpayer who controls the earning of the income
2. income from property is taxed to the one who owns the property & thus controls the income generated
from the property

Revenue raising
Taxation
Borrowing
Administrable
Can we enforce it?
Withholding

Helvering v. Horst
Facts: In 1934 and 1935, father detached from negotiable bonds the interest coupons and delivered them to
son shortly before their due date.
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Issue: Did the father recognize income, even though he gave the interest bearing coupons to his son before
they matured?
Rule: even if the taxpayer does not receive payment of income in money or property , realization may
occur when the last step is taken by which he obtains the fruition of the economic gain which has already
accrued to him. Income is realized by the assignor because he, who owns or controls the source of the
income, also controls the disposition of that which he could have received himself and diversts the payment
from himself to others as the means of procuring the satisfication of his wants.
Holding: The father enjoyed the economic benefit that accrued to him by giving a gift to his son. Even
though he never received the money, he derived moneys worth from the disposition of the coupons.
Common understanding and experience are the touchstones for the interpretation of revenue laws
Power to dispose of income is the equivalent of ownership of it and the exercise of that power to
procure the payment of income to another is the enjoyment, and hence the realization. fruit
is not to be attributed to a different tree from that which it grew on
Bond is the tree and the coupon is the fruity if he had given the entire bond and not just coupon
what would have happened
Bond has face of 100k and pays 5k in interest each year
5k in income when he receives it (income from property)
The gift of 100k bond, even when It is retired, is not recognized as income the principal was
already taxed because assume it was originally bought with aftertax dollars
Lucas - the assignment came before the service (instanteous vesting)
Helvering the service came before the assignment (not vested)

Next Chapter: Basis
Amount realized $200,000 (minus) adjusted basis $100,000 (appreciation) = gain $100k 61(a)(3)
Why? We only tax net income.
o Plus, you have a right to recover what you have already paid tax on.
adjusted basis because it can change (pro rate it)

Chapter 4: Gains Derived from Dealings in Property
I. Problems
Two questions to ask: (1) what is their gain, & (2) what is the new basis

1. Reports $200k of income. If he sells each parcel for 75k he recognizes $275k of income (if fmv
does not change)
2. A. Her basis is 500k because liabilities are included in basis. My answer would not change if she
financed it
b. it will not affect her basis because when she included the lloan it was like an advancement, thus
she doesnt receive more basis when paying it down
c. still has original basis of 500k + 75k to remodel =575k basis. She has a basis of 125 in the
land she is holding for investment
d. 700k 575k = 125k gain. Purchaser takes a basis of 700 k
- we care about the 700k basis, because he will want to know because it may depreciate
taxpayer can control basis, and liability but not the fmv
3. like regocnizes 6k of income when she recived the painting and a 6k (1012) basis in the paining. Thus
when she sells it she recognizes a gain of 4k.. same consequences
4.
a. they each take a 750 k basis in the property that they received. Kate recognizes 300k of gain and Patrick
recognizes 6500k of gain.
- Katie = AR 750 AB 450 = 300 (new tax basis is 750 = AB + Gain (bought 300k worth of
basis))
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- Patrick = 750 (Arizona land) 100k = 650 Gain (new tax basis is $750 = AB 100 + 650 gain)
b. Katie: amt realized =[750 + 50] 450 adjusted basis = 350 gain; new basis of 750k (the cash is separate,
& she could turn around & invest the $50k in the property = turn the cash into basis)
1. cash included in AR
2. cash is not absorbed in basis (act as if the cash is its own basis)
Patrick : amt realized = 800 [100k + $50k adj basis] = 650k ; basis of 800k
1. Patrick gets credit for the cash he paid

c.

Katie: $750 (fmv of patricks land) + $50 liability relief = $800 - $450 = $350 Gain new basis of $750

Patrick: AR = AR = 800k [100k + 50k] = 650k, new basis of 800k
Patrick gets the $50k basis credit for the amount he assumed
pays $10k back (doesnt effect his basis) [$40k left]
sold for 890k 850k in cash & rest of $40k is assumed (relief of liability)
o purchaser takes $890 basis
o

61(a)(3) gains derived from real property


II. Vocabulary
Amount realized
Basis
Adjusted basis
Cost basis
Tax cost basis
Gain
Recovery of capital
Nonrecourse debt
Recourse debt
Taxable exchange
III. Objectives
IV. Overview
Bases = tax paid investment; unrecovered cost
Professor points:
1. Basis always deals with property amount of investment the taxpayer has in the property for
which he has already paid tax
2. Area of controversy corporations being double taxed now have ways to get by this (LLM,
LLP, etc.)
3. Only pay tax on net income (only once)
4. CASH (buy property, turns into basis) = BASIS = (with basis can claim deduction,) DEDUCTION
(deduction is recovering cash you never had to pay taxes on it)


FMV (BASIS) ^liability (these factors change)
FMV = market
BASIS = homeowner upkeeps, puts money into, etc. (goes up) (depreciation goes down)
Liability = whether the homeowner pays down the principal, or pays more
these three numbers move independently
ex: 350(300k) = gain
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121 excludes gain on residence if taxpayer has occupied it for 2 of the last 5years (to keep
taxpayer from recognizing gain)


1001a defines gain and loss
Gain = (excess of) AR (cash, property, value of services, relief of liabilities) AB
o For relief of liabilities as if they gave you cash for the liability
o Amt realized = money received + fmv of other property received
o Adjusted basis: (adjusted up) Look to 1011 for definition of adjusted basis says basis
as determined under 1012 adjusted by 1016 (recovery in investment or additional
investment made in property)
1012- basis= cost , except as otherwise provided
If you assume liabilities as part of transactin, it gets added to basis (treat as
outflow of cash)
Loss = AB- AR
cost = unrecovered costs
Policy to avoid double taxing (tax-paid investment only taxed on new gain)
Under 1001( c) you recognize all realized g/l unless exception applies (1031 like kind exchange)
o Recognize just means that you report it on tax return you come clean, dont necessarily have to
pay tax on it
Reg 1.61-6(a) gain=excess of amt realized over unrecovered cost or other basis for the property sold or
exchanged look to 1001 to compupte gain or loss
Taxpayer may recover tax free her investment in property before being charged with income from
a disposition of the property
Repayment of loan principal also equals recovery of capital and is not taxable there is no
accession to wealth as discussed in Glenshaw Glass
4 types of basis:
1. Cash cost
a. 1012
b. analogy = we tax every dollar of new income
c. mill = recognition = coming clean & declaring
2. Tax cost
a. Already paid tax on item
b. Lexis example (was given a lexus for $50k, for fees paid income tax on it sells it
next year for $55k = $55k AR, & $50k AB) = that $50k is tax cost basis
3. Cost based on liabilities
a. Rules of liability: (table)
200k ( ) Sellers AR = 200k Buyers AB
Cash 200k 200k
Lender 200k (loan) ($200k)
Seller-financed 200k (in taking that money,
I created a new asset)
(loan) basis = 200k; AR
200k + interest
($200k)
Non-Recourse Liability
(does not look to you for
payment when foreclosed)
$200k ($200k)
50
= we are going to treat
recourse & nonrecourse the
same in this course
b. When the seller is relieved of a liability, that relief goes into AR, & the buyer gets a basis
credit
4. Taxable exchange of property
a. Likekind exchange = non-recognition taxation
b. Most similar to tax cost basis - fmv
Two rules of philidelphia park
1) Basis of property received is the fmv of the property when it is received (because that is what
the taxpayer had to include in income)
2) AR in the exchange is the FMV of property received
a. That is going to be the amount of your basis too see below
Property for property exchange trade wine for desk
Henry (wine) : 10(5)
Dianne (desk): 10(12.5)
Henry on this exchange only:
Calculation of gain
AR: 10 (from desk)
AB 5 (his basis)
Gain: 5 (makes sense cause already had paid 5k on wine)
New basis in desk: 10 (new basis will always = old basis + gain/- loss on transaction)
The reason that you have the new basis is because you have already recognized it

Dianne on this exchange:
AR: 10 (from wine FMV of property received)
AB: 12.5 (her basis)
No gain (no excess)

AB: 12.5 (basis of her desk)
AR: 10 (fmv of wine)
Loss: 2.5 (the basis gets transformed into cash through loss)
New Basis in wine: 10 (she didnt lose basis because she bought loss which is like getting cash)
c. For when she sells it, her basis
Wrong rule:
If Denise = 9 (12.5)
AB = 12.5
AR = 10
basis going forward = $9k (FMV of what she gave) = then she is losing an extra $1k in basis
V.
A. Tax Cost Basis
Philadelphia Park
Ex: land in lieu of cash for compensation fmv of $50k = $50k of income sells for $60k
o Amount realized [AR] = $60
o Basis = $50k
o Gain = $10k
Ex: land in lieu of cash for compensation fmv of $60k & attorney paid client $10k for it. =
$50k income
o Treasury Reg 1.61-2(d)(2)(i)
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o Basis = $60 (the amount paid plus the gain)
o So.. if sells for $65k, will only have to report $5k gain

If it is an arms length transaction, & you are just getting the benefit of the bargain, you do
not have to report gain.
B. Impact of Liabilities
1. Impact on Basis

2. Impact on Amount Realized
3. Basis of Property Acquired in Taxable Exchange
C. Basis of Property Acquired in Taxable Exchange

Philadelphia Park Amusement Co. v. United States (1954)

Facts: Taxpayer owned 50 year franchise from philly to operate a railroad to serve amusement
park. Taxpayer constructed Strawbrerry Bridge across a river. Then exchanged bridge for 10 year
extension of railroad franchise. Taxpayer than abandoned franchise and arranged for a bus
company to give passenger service to park. Taxpayer claimed a deduction for unrecovered cost of
franchise and said that unrecovered cost = undepreciated cost of bridge is the basis in the extended
franchise.
Issue: What is the cost basis of the 10 year extension of the franchise? (thats the only thing that
can be recovered here) What is the basis of property acquired in a recognition event?
Rule: Basis of property acquired in a recognition exchange, his basis of the property received is
measured by the FMV of the property received in the exchange
Adjusted basis you use in 1001 exchange is the adjusted basis of the property give and
the amount realized is the fmv of the property received
When property is exchanged for property in a taxable exchange, taxpayer is taxed on
difference between the adjusted basis of p[roperty given in exchange and the fmv of the
property received. Fmv of property received is treated as cash
Basis of property received = adj basis of property given + gain recognized or loss
recognized
Holding: fmv of the franchise is the cost basis of the 10 year extension. Bridge was given in
exchange for the franchise and is therefore a taxable exchange. Doesnt matter if you use fmv of
property recived or given in this case because it is an armed lengths transaction and the value is
presumed equal. Since the value of 10 year extension on lease is hard to determine, you could use
the value of the bridge since it is easier to determine (if all else fails, can use the fmv of the bridge)
Notes:
o Ps AB = 10 yr franchise
o Tried to claim that it was a non-recongizable exchange = because they want the basis in
the bridge (probably basis was higher than FMV in the bridge) (1031 like kind non
recognition exchanges would allow them to get basis in bridge)
Want to depreciate it (because they have unrecovered cost in the bridge)
o Because 1001(b) says amount realized includes amount received, the only way to further
policy objectives is to make sure that going forward the tax payer gets full credit for the
property realized
Two rules of philidelphia park
Basis of property received is the fmv of the property when it is received (because that is what
the taxpayer had to include in income)
AR in the exchange is the FMV of property received
o Because moving forward it is only fair to move forward with that basis of the fmv
received
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Each party in the transaction are both transferee/or =
Each

Chapter 13 Capital Expenditures
I. Problems
1. Dorothy made following expenditures: deductible or capitalization?
a. Roof = generally considered as a capital asset (separate & distinct asset) = has its own
useful life
b. Repaint = generally seen as current year expense
i. Not structural fix
ii. Have you triggered the rehabilitation doctrine? Probably more like situation 2 in
revenue ruling, where there are some maintenance expenses, as well as
structural changes.
1. Maybe if she was doing radical improvement, like walls, rewiring
electrical blah blah, would likely be more like situation 3 in revenue
ruling
c. Remodel interior of store = probably capitalized
i. Structural changes
ii. Improves value
iii. 3
rd
situation in revenue ruling
1. cost of paint absorbed by overall expenditure
d. furtniture
i. separate & distinct asset = capitalized
ii. what if leased the furniture =
1. would try to get current year deduction
2. BUT looks more like a disguised sale
a. Substance over form (disregard the lagal form & ask, whats
really going on here?) = seems more like a purchase
e. Office supplies =
i. Ordinary/necessary = deductible
ii. What if she had bought a huge amount at a time, way more than necessary? =
probably would deduct amount of supplies that can be used in current year, and
rest would be capitalized.
f.
i. Website for independent contractor
ii. Advertising consultant 2 year advertising campaign = deductible (general rule =
unless some physical asset)
1. Software = capital, so maybe the website will be viewed as software
g. Liability insurance (12 month premium) 11 months of this year, plus 1 month of year 2
= deductible under the 12 month rule (freight ways case)
i. What if she paid in advance the dec 31 of last year = will be capitalized because
no longer within 12 month rule (very nit picky exception)
h. Legal fees =
i. Capital asset = cost of defending title/legal fees
ii. What if the cloud has been on title since she purchased the property?
Foreseeable? = capitalized
iii. What if fraudulent lien? Something that came up during the current year, you
arent really protecting title, you are protecting income stream
i. Rule of Idaho power applies here.
i. bonuses can be expensed (not being held responsible for that)
53
II. Vocabulary
III. Objectives
IV. Overview
Main rules to take out of this chapter: Cheat Sheet On Rules to Know
Separate & distinct asset test = that asset now is given a basis, and the cost is
recovered over the life of the asset
INDOPC Test = if a business expense gives rise to something that creates benefits
beyond the current year, that expense has to be taken into bases and recovered over
the life of the asset
o 12 month rule taxpayer can deduct full (truck company, recurring 1 year
license)
o freight ways rule
Capital assets:
o Cost of acquiring
o Cost of defending
o Cost of disposing
If just a repair = deductible in current year
o But if increases useful life of the property, or expands functional use of
asset = capitalize (general plan of rehabilitation doctrine = but if part of an
overall renovation, have to take it into basis & recover it when you dispose
of the asset or as you depreciate it)
Stegar Case
Trade or business acquiring = has to be capitalized
o Cost of entering a new trade or business has to be capitalized
Cost of changing the capital structure
Advertising = deductible in current year
o Exception = if it produces a physical asset (billboard)
Employee training (generally, deductible in current year)
Regulations on Intangible Assets
o Not going to be held to know this
o Apply general rules
A. Deductible Expense or Capital Expenditure
162 business expense deductions
o 161 warns of exceptions
263 denies a deduction for the cost of new buildings or for permanent improvements or
betterments increasing the value of the property, & for restoration costs for which an
allowance is made.
o except as provided in Ch. 1 of the internal revenue code
o Timing question when is it recoverable?
o Although ordinary & necessary, shouldnt be deducted in the current year
o If the expense is disallowed in the current year = it is taken into the basis, &
recovered over the life of the asset (depreciation).
If it cant be recovered over the life of the asset, there will come a point at
the end of the assets life/businesses life = where it is sold off & recovered.
Tax payer always wants to accelerate the deduction, rather than capitalize
Rules in capitalization make basis go up
B. Defining Capital Expenditure INDOPCO
Capital expenditures vs currently deductible expenses
o INDOPC v. Commissioner the distinction is of degree & not of kind
o Deductions are exceptions to the norm of capitalization
o Deductions are strictly construed & allowed only as there is a clear provision
therefor.
54
Affirmed National Starch & Chemical Corporation v. Commissioner
consulting/legal fees incurred by a company in determining whether to
accept a takeover = long term benefit = had to be capitalized
o Lincoln savings an expenditure that creates or enhances a separate & distinct asset
should be capitalized under 263 NOT that only expenditures that enhance/create a
separate/distinct asset are to be capitalized
Duration/extent of the benefits realized in determining capitalization
Is it ordinary & necessary in the meaning of 162(a)?
Expenses incurred for the purpose of changing the corporate
structure for the benefit of future operations are not ordinary &
necessary expenses.
Q: does it generate future benefits?
US Freightways v. Commissioner if an expenditure is made in one tax year, and its useful
life extends substantially beyond the close of that year, then it must be capitalized. = works
in simple cases most cases fall in between this spectrum
One year items where the benefit will never extend beyond the year, that are ordinary,
necessary, recurring expenses = deductible expenses
C. Selected Categories of Capital Expenditures

1. Cost of Acquisition & Costs Incurred in Perfecting & Defending Title
o Acquisition costs = capital expenditures
Purchase price
Transaction costs
Cost for work performed prior to the date the unit of property is paced in
service by the taxpayer[p. 282]
o Property creates a continuing, long-term benefit, & its cost must be capitalized
o Bases = equal to the cost
o Ex: purchase building for $500k
$500k = capitalized
$500k = basis
brokerage fees = capitalized
$300k to expand building = capitalized (increase basis under 1016(a)(1))
o Legal fees = capital expenditures (not all legal fees)
Georator Corp. v. US legal fees incurred in infringement action
Medco Products v. Commissioner
Fees in perfecting title
Including fees in action to recover royalty payments
o Disposition costs = capital expenditures
However, if the asset is merely retired & discarded, the cost is ordinarily
deductible
Attorney retired, & purchased a nonpractice malpractice insurance policy =
deductible
o Commissioner v. Idaho Power - Q: how should a taxpayer treat the costs of
constructing an asset having a useful life extending substantially beyond the
taxable year
263(a) incorporates princples of Idaho Power, requiring capitalization of
direct/indirect costs incurred by taxpayers that acquire/hold inventory
property for resale.
o Encyclopedia Britannica v. US - court found that payments to another publishing
company were for the acquisition of an asset, a book which would yield income to
them over a period of years.
o Stegar v. Commissioner
2. Repair & Improvement
a. Historic Rules
i. US . Wehrli = the one year rule is not an absolute rule = a guidepost
55
b. Temporary Regulations: I mprovements & Repairs
i. Temporary regulations took effect in 2012
ii. Determine the appropriate units of property to which the improvement
regulations apply
1. Ex: whether a cost associated with property is to be treated as a
deductible repair cost or a capitalizable improvement
2. FedEx Corporation v. U.S = before the court could determine
whether the jet maintenance was deductible, had to decide whether
the aircrafts themselves, rather than the engines, were the
appropriate unit of property [aircrafts themselves did not prolong
the life of the aircraft]
3. functional interdependence standard = all components that are
functionally interdependent comprise a single unit of property
a. if the placing in service of one component by the taxpayer
is dependent on the placing in service of the other
component by the taxpayer
b. ex: laptop computer & a printer used in providing legal
services constitute separate units of property because they
are not components that are functionally interdependent
(placing in service of the computer is not dependent on
the placing in service of the printer)
c. building & structural components are generally treated as
a single unit of property
iii. betterment p. 286-287
iv. restore unit of property
v. Safe harbor rule for routine maintenance
vi. Expenditures for employee training = generally have been deemed
deductible expenses
1. Where the training provides benefits significantly beyond those
traditionally associated with training in the ordinary course of
business
3. Intangible Assets
Capitalization = "future benefit? Yes. no certainty with this standard
Future benefit standard not used for intangible assets
Standard = capitalization of amounts paid to acquire or create intangible = to facilitate the
acquisition or creation of an intangible, or to create or enhance a separate & distinct asset.
o Acquired tangibles = ownership interest, debt instruments; options to provide or
acquire property, leases, patents/copyrights, franchises/trademarks, etc.
o Created intangibles financial interests (that turn on ownership interests), prepaid
expenses, membership fees, contracts for property/services, amounts paid to defend title
i.
4. Expansion Costs
5. Advertising Expenses
D. Purchase or Lease
Commissioner v. Idaho Power Co.
Horizontal equity Equity between the make or buy decision = this decision creates tax
equity/fairness. Treats the person who makes the building the same as the person who buys the
building

Facts: Taxpayer, Idaho Power Co., used its own equipment and employees to improve and add to its
capital facilities (for upkeep, & also for improvements) On its books, Idaho Power capitalized the
construction-related depreciation on this equipment used for construction of the capital asset. But for
income tax purposes, the taxpayer deducted the entire amount of depreciation on equipment used in
56
construction of the capital asset under 167(a) including the amount capitalized as construction costs. They
were using the same trucks for two purposes. One was ordinary use and one was for building the new
facility. [its okay to put something diff. on books than on tax forms]
o using truck that is depreciated over 10 years, to make improvements on building that
depreciates on 30 year schedule
o they took the trucks as stand alone assets, and recovered the cost of the basis
o Issue: were they depreciable on a 10 year schedule or a 30 year principle
Matching principle = assets were being converted into an asset that would be
depreciated over 30 years.
o Example:
100,000 in truck expenses
50% went to ordinary wear/tare
50% went into building
= $50k of that can be recovered over 10 years
= $50k of that has to be recovered over 30 years
Issue: Whether, for federal income tax purposes, a taxpayer is entitled to a deduction from gross income
under 167(a) of the Code for depreciation on equipment the taxpayer owns and uses in the construction of
its own capital facilities, or whether the capitalization provision of 263(a)(1) of the Code bars the
deduction? Do you recover over the cost of the asset or over the cost of the thing that the asset is being
used?
Rule: Construction-related expense items, such as tools, materials, and wages to construction workers are
treated as part of the cost of acquisition of a capital asset. Reasonable wages paid in carrying on of a
trade or business qualify as a deduction from gross income, but when wages are paid in connection with
construction or acquisition of a capital asset they must be capitalized and are then entitled to be amortized
over the life of the capital asset so acquired. 263(a)(1) of the Internal Revenue Code denies a deduction
for any amount paid out for construction or permanent improvement of facilities. This extends to the cost of
acquisition, construction, or erection of buildings.
Reasoning: The cost of the transportation equipment used for construction activities was paid out in the
same manner as the cost of supplies, materials, and the wages of construction workers. 161 and 261 of
the Internal Revenue Code require that the capitalization provision of 263(a) take precedence over 167(a)
Wages must be capitalized into the ultimate asset that is being created even though they have to recognize
it as income that year. If you take an asset with one useful life and use it to create an asset with a longer
useful life, you use the longer useful life to recover the cost
Holding:The equipment depreciation allocable to taxpayers construction of capital facilities is to be
capitalized. Horizontal equity when you buy a finished building , the price you pay is your 1012
basis and in that cost includes someones physical labor, lawyer fees, licenses, trucks etc that the
previous person put into the asset. This outcome produces fairness between the investors who make
an asset and those who buy an asset
o Equity between the make or buy decision = this decision creates tax equity/fairness.
Treats the person who makes the building the same as the person who buys the building

Next 2 cases difficulty in determining if expense KEEPs in working order, or PUTs in new working
order
Midland Empire Packing Company v. Commissioner
Facts: For 25 years, P used basement rooms of its plant as a place for curing hams and bacon and
for the storage of meat and hides. In taxable year, it was found that not only water had seeped into
room, but oil was coming through walls of the basement, remained on floor and gave off odor and
created a fire hazard. Inspectors told petitioner he must discontinue use of water from the wells
57
and oil proof basement, or else the plant would be shut down. Petitioner fixed situation by adding
concrete lining to walls and concrete to floor of basement. Petitioner wants to deduct the cost of
this work as a repair.
o Keep? = yes, fixing couldnt operate one more day without fixing
o Put? = technically yes improvement to property
o If he couldnt have deducted it for the current year he would have added it to basis, and
recovered it over the life of the asset in question
Issue: was fixing the basement an ordinary expense in the petitioners particular business? YES.
(repair, not improvement)
Holding: expense was ordinary and was 162 deductible. After the expenditures, the plant did not
operate on a changed or different scale and was not suitable for another business. It only allowed
him to continue using the basement for its normal operations. Expenses incurred did not add value
or prolong expected life expectancy of property beyond what it would have been before the
expenses. Expenses didnt occur until business was started and P didnt know about the problem
before- hand. Did not matter that petitioner had not made similar expenditure to prevent damage
and disaster to its property does not mean that it is not ordinary.
Keep something in working order (current year deduction)
Fix
Repair
Maintain
Put something in working order that wasnt in order before (Capitalize)
Rehabilitate
Acquire
Extend
Modify to new use

Mt. Morris Drive-In Theatre Co. v. Commissioner
(unforeseeable= deduct/ foreseeable=cap.)
Facts: purchased land to construct theater with the knowledge before he purchased that slope of land
flowed onto neighbors property. did not change slope and after construction water flowed to neighbors
prop. causing damage. Neighbor sued & reached settlement with where would build a drainage system
to across neighbor property and to public drain. tried deducting expense.
Issue: Was the expense ordinary and necessary or a non-depreciable capital expenditure?
Rule: test to determine if ordinary and necessary look at character of transaction which gives rise to the
payment. Foreseeability of the expense is a factor (unforeseeable= deduct/ foreseeable=cap.)
o Whatever price he paid, is less than whatever he should have paid
Holding: the drainage system was a capital expenditure it was obvious at time of purchase that drainage
system would be required to properly dispose of normal rain to be expected and until it was build, the
capital investment was incomplete. It is irrelevant to the analysis that the drainage system was built after
threat of being sued. This is the kind of expense that would have been built into basis in the beginning
since it was foreseeable and therefore should have been capitalized in the first place
Dissent mentions basement case - & says its business expense = deduction
58

Revenue Ruling 2001-4
I ts not about the nature of the expense, its how that expense relates to everything else that
is being done
This revenue ruling deals with whether work performed on aircraft airframe, including heavy maintenance
visit are ordinary and necessary or is a capital expenditure (3 situations look in case)
Work in airframe as part of heavy maintenance visit are generally deductible as ordinary and
necessary (no significant structural change but replacing a few parts)
However, if costs materially add to value of, substantially prolong useful life, or adapt airframe to
new or different use, they would be capitalized. PUTS airplane into new working condition
(improves plane, increases value, etc.)
Structural changes and replacing parts = general plan of rehabilitation = capitalize all
o If part of rehabilitation program = everything has to be capitalized
Repair and maintenance expenses are incurred for purpose of keeping property in an ordinarily efficient
operating condition over probable useful life for uses for which property was acquired
Capital expenditures are for replacements, alterations, improvements, or additions that appreciably prolong
the life of the property, materially increses its value, or makes it adaptable to a different use
Even if expenditures include replacement of numerous parts of an asset, if they are merely a minor portion
of the physical structure of the asset or any of its major parts, such that the asset as a whole has not gained
materially in value or useful life, the costs incurred can be deductible as ordinary repairs or maintenance
expense
However, if the asset as a whole has increased in value, life expectancy, or use then
costs of replacement should be capitalized.
If expenditure made as part of general plan of rehabilitation, modernization, and improvement of property,
the expenditure must be readily capitalized, even though standing alone it would be one of repair and
maintenance (total rehabilitation of the entire asset)
Chapter 14 Depreciation
I. Problems
II. Vocabulary
III. Objectives
Capitalization from ch. 13 now = When can you recover that basis?
Rules for cost recovery of capitalized expenditures
IV. Overview
A. Depreciation
Policy is the same set of policy from ch. 13
Matching theory = matcing of expense & income
Notion of cost recovery
Depreciation = derive tax benefit from waste in the asset

1. Depreciable Property
2 requirements:
1. has to be an asset that is capable of waste losing value over time (not
intangible)
59
2. has to be property that the taxpayer holds for a business or investment
purpose
a. not 262 = not your personal home, etc.
b. has to be invested in for 162 business reason for the purpose of
creating profit
c. can be owned for both purposes = allocate the share of personal
use over business use
i. ex: aircraft worth 50k,
ii. 4/5 of the time I use for pleasure
iii. 1/5
th
of the time I use as ordinary/necessary asset in
business
iv. = 10k is recoverable under 162
3.
Relationship to basis = basis is unrecoverable cost = depreciation is recovering cost
(by offsetting income) = you would be getting double tax credit if you didnt reduce
the basis amount with depreciation amount
Ex: buy car for 100k, and congress allows you to depreciate at 5 years instead of
10 years (so receive 20k per year for five years, rather than 10k per year for 10
years) = technically at end of the 5 years, still have 5 years left on it = $50k
AR = $50k
AB = = $0
= $50k Gain (already recovered basis)
look at purchaser now:
o his period is 5 years to recover = 10k/yr (rather than 10 years)
= 25k gain
o total depreciation = $150 (but was worth $100) how is that
fair? Tax was paid on the $50k gain. = new gain every time
there is a resale =
Depletion Allowance = oil, coal, etc. industries = therefore, our supply is
wasting we should be allowed a deduction for it tax code allows them a
deduction, but its for money they never spent. = NOT depreciation, because it
does not involve unrecovered costs
Incentive policy reason = to have people invest in property
167 depreciation deduction = a reasonable allowance for the exhaustion, wear &
tear of:
(1) property used in trade or business or
(2) property held for the production of income
o exhaustion, wear & tear
does not include stock, land, etc..

2. Recovery Period The Useful Life Concept
Asset Depreciation Range [ADR] provides an industry-wide set of useful lives for
classes of assets standardize class lives
Accelerated Cost Recovery System [ACRS] = assigns all tangible property to one of
five recovery periods based on the assets class life as defined in 168(i)(1)
This was used to increase property investments
De-emphasized the useful life concept
Real property = 15 yrs
Tangible personal property = 3-5 years
No assigned class life (ex: violin) = 5 years
Modified Accelerated Cost Recovery System [MACRS] applicaple to tangible
depreciable property placed in service after Dec. 31 1986
Lengthens the recovery period of real property
Nonresidential real property = 39 years
Residential rental property = 27.5 years
60
Other property = one of six categories
3
5
7
10
15
20
class life of asset = the midpoint life in the Asset Depreciation Range [ADR]
o Selig v. Commissioner taxpayer was allowed depreciation deductions on exotic
automobiles
o
3. Depreciation Methods
Two categories
1. Straight line depreciation divide the cost of the asset by the number of years in the
recover period to determine the depreciation allowance for the given year
o ex. Rental property for $275k, 27.5 years
100%/27.5 = 3.6% of $275 per year (275k x .036) = $9,900
3.6 % = straight line rate
Salvage value = the remaining value at the end of the 27.5 year period
($0)

o simplest form
2. Accelerated depreciation
o declining balance method = cost less the depreciation deductions claimed for
prior 200% (double) balance method
EX: $30k, 5 yrs

100 % / X yrs = .X%
.X % * ($B)= Y (1
st
year depreciation)
(B) y * .20 = (z) * 2 = y(2
nd
year)
($AB) y x .20 = (z) *2 = y(3
rd
year)
($AB) y x .20 = (z) * 2 = y(3
rd
year)

.20% * $30k = $6000
$6000 * 2 = $12000 [1
st
year]

($30,000) - $12000 = ($18000) x .20 = $3600 * 2 = $7200(y/2
nd
year)
(18000) - $7200 = ($10800) x .20 = $2160 * 2 = $4320(y/ 3
rd
year)
($10800) - $4320 = ($6480) x .20 = $1296 * 2 = $2592(y/4
th
year)


100%/5 = 20% 30k x .20 = 6k x 2 = 12k first year
30k 12k = 18k x .20 = $3600 x 2 = $7200 2
nd
year
18k 7200 = 10,800 x .20 = 2160 x 2 = 4320
o use the accelerated depreciation until the year where the straight line method
would produce the larger deduction
should be able to do this in exam (table below)
100k
5 year = 20% $20
mid year convention
year Original basis % Deductive Amt AB
1 100 10% 10k 90k
2 100 20% 20k 70k
3 100 20% 20k 50k
61
4 100 20% 20k 30k
5 100 20% 20k 10k
6 100 10% 10k 0k

4. Conventions
Period begins when the property is placed into service placed in a condition or state of
readiness & availability for the specifically assigned function
Residential rental property & nonresidential real property = prorated by month
o Ex: placed into service in mid Jan. = 11.5/12 of the annual depreciation amount
mid month whatever month you bought it in = count it as mid month
Other classes of real property = half year convention (mid-year convention
responsible for this)
o Never mind when you really placed it in purpose = assume that you put it into
service at the end of 6 months of a year
o how could you exploit this? Purchase in December & get 6 months of credit.
o If your period is 10 years = for mid year, how many years? After 10 years, you
will only have recovered 95% (5% at first mid year, then 10% the rest 9 years,
so have to pay the other 5% the next year = 11 years)
The effect of the mid year convention is to add one year to the
recovery period remember this in depreciation problem with mid
year convention

Mid-quarter convention = prevents the exploitation of mid year

B. Computing the Depreciation Deduction
168(a) determine depreciation deduction by using:
1. the applicable depreciation method (rate)
2. the applicable recovery period
3. the applicable convention
First determine the adjusted basis of the property
Ex: basis = 100k
o Depreciation method = 200% accelerated method
o Recovery period = 5 yrs
o Convention = year
o = 100%/5 = 20% 100k x .20 = 20k 1
st
year
o yr 2 =32% = 100k x .32 = 32000k 2
nd
year
o Revenue Procedure 87-57 (makes it simpler, with different rates same result)
168(k) bonus depreciation = for property acquired after Dec. 31 2007 & placed in service
before Jan. 1 2013. = allows an additional 1
st
year depreciation deduction in the amount of
50% of the cost of qualified property
C. Amortization of Intangibles - 197
197- allows taxpayers to amortize certain intangibles ratably over a 15 yr period
allows for the amortization of goodwill and going concern value

D. Relationship Between Basis & Depreciation
It is the basis that the taxpayer recovers through depreciation deductions
1016(a)(2)
reduce basis by depreciable amount
a taxpayer must reduce her basis in a depreciable asset by the depr claimed but not less than
the amt allowable (still have to reduce basis by full amt of depr deduction even if fail to claim
full deduction)

E. 179 Expensing Tangible Personal Property
62
allows taxpayers to expense (to deduct currently) the cost of acquisition of certain depreciable
business assets = only 179 property
generally limited to $500k
F. The Relationship of Debt to Depreciation
G. Conclusion
Revenue Ruling 68-232
Simon v. Commissioner
Liddle v. Commissioner
Revenue Procedure 87-56


13-28
Look at tax topic map =helpful organize outline according to this scheme
Chapter 39 like kind exchanges
Section 4, A-G, I
Revenue ruling p. 942

Chapter 39 Like Kind Exchanges
I. Problems
II. Vocabulary
III. Objectives
Why is there no recognition? Policy reasons:
1. Main reasoning is = Continuity of investment- as long as purpose of holding property is for
trade/business/investment
2. Illiquitidy potential concern = wouldnt be fair to make the taxpayer recognize the gain when the
taxpayer hasnt gotten the cash to pay tax with
a. One rationale for 1031 nonrecogntion - If two taxpyaers exchange property and no cash is
exchanged, than the transaction has produced income but no cash liquidty to pay income tax
3. Value of economic exchange free market economy want to foster exchanges
Want to remove tax disincentives to promote the free flow of property
Property is in the hands of people that want it the most
People would hold on to property that they dont really want, to avoid taxes
Administratively hard to value the properties
The direction of 1031 is broadening the scope (hard for IRS to take back a right)
1. Boot nonlike kind
2. Simultaneous three way
3. Deferred exchanges

1) Why non-recognition? Taxpayer is changing form of investment and letting it ride as opposed to liquidating (continuity of
investment)
o Continuity of investment = analogy = Think of it as going from table to table in the casino and not cashing out
until the night is over
2) Requirements for eligibility
1. 2 properties must be like-kind
2. Property being given must have been held for trade/investment purposes
3. Property received must be held for trade/investment purposes
3) 1031(d) basis adjustments what is taxpayers basis in the property received in the exchange
63
1031(a) Nonrecognition of gain or loss from exchanges solely in kind
(1) In general
No gain or loss shall be recognized on the exchange of property held for productive use in a trade or
business (162) or for investment (212) if such property is exchanged solely (no boot) for property of like
kind (real property & personal property) which is to be held either for productive use in a trade or business
or for investment.
Requirements for eligibility of 1031
1. 2 properties must be like-kind
2. Property being given must have been held for trade/investment purposes (in the past)
3. Property received must be held for trade/investment purposes (look forward to = when the
taxpayer gets this property, what is she going to do with it?)
Have to have a purpose, which has to be T/B/I (trade business or investment)
o Does not include financial assets like stock (rational may be because it would be too easy
to avoid potential gain by exchanging stocks)

1031(b)- when is boot recognized
Gain from exchanges not solely in kind
If an exchange would be within the provisions of subsection (a), of section 1035(a), of section 1036(a), or
of section 1037(a), if it were not for the fact that the property received in exchange consists not only of
property permitted by such provisions to be received without the recognition of gain, but also of other
property or money, then the gain, if any, to the recipient shall be recognized, but in an amount not in
excess of the sum of such money and the fair market value of such other property.
When to recognize boot
How much can you recognize?
o You are not going to recognize more gain than you have realized
o The ceiling is boot up to gain or gain up to boot = the lower of the 2 numbers
o Ex:
A (wants 1031) B
BA 800k(500) WA $600k [will have to give $200k boot or
another piece of like-kind property] gives
$200 cash
1001 analysis
AR = 800
AB = 500
Realized gain = $300


Apply 1031(b) = boot cap = 200k she
cashed out (& has to recognized as gain) =
the other 100k, she lets it ride)


How does this make sense with liquidity?
- illiquidity = didnt receive the 100k
- if WA was 200k fmv with $600 cash) =
she has $600 in boot = recognize $300
because you cant recognize more gain than
you have realized (she only realized 300k)



1031(c) - no losses recognized on like kind property but if there is a loss in the boot property, that
loss can be recognized

1031d basis for property received in a like kind exchange (see pg. 914 of book)
+ old basis (that of property exchanged)
+ recognized gain (increased in amount of gain recognized on non-like kind) = tax cost basis
- cash received (decreased in amount of money received) pg. 74 k& p problem
- recognized loss (decreased in amount of loss recognized of non-like kind) like depreciation
- liabilities relieved old colony case
64
+ cash paid not in actual 1031 d rule basis = cost and cash is deemed buying basis
+ liabilities assumed not in actual 1031 d rule liab assumed are like cash paid
+ basis in boot property given not in 1031 d rule

IV. Overview
Under 1031, no gain or loss is recognized (even though it is realized) when property held for
productive use in a trade or business or for investment is exchanged solely for property of like
kind to be held for productive use in a trade or business
1031(a)(2) = 6 like kind exchange exceptions:
A. Continuity of Interest
1031 assumes that the property received in an exchange is simply a continuation of your original
investment (in a modified form) = has not effectively realized gain or loss
One justification for 1031 is that it is administratively hard to value property received in like
kind exchanges.
Calculation of profit or loss is deferred until it is realized in cash or other property not of the
same kind having a fair market value

B. The Like Kind Requirement
like kind = refers to the nature/character of property, or its class or kind not its grade or quality
Very broad definition of like kind in real estate transactions there is no difference between
improved and unimproved property.
Wichens v. US exchange of 50 year water rights limitd in priority and quantity for a fee simple
interest in farmland did not qualify as like kind
Revenue Ruling 55-749 30 yr leasehold = fee interest
Peabody natural resources company v. commissioner court held that supply contracts in
exchange of gold mine for coal mine was like kind
Personal property like kind requirement is satisfied if depreciable tangible personal property is
exchanged for property that is either of a like kind or a like class
o Depreciable tangible personal property is of like class to other depreciable tangible
personal property if both properties are within the same general asset class
o Also of like class if within the same product class
Intangible personal property or non depreciable personal property qualify for like kind treatment if
they are like kind to one another
o Ex: exchange of copyrights on two novels is a like kind exchange but an exchange of
copyright on a novel and copyright on a song are not like kind.
o Also goodwill of one business is not like kind to goodwill of another business
Transfer of assets of similar business cannot be treated as the transfer of a single property for
another single property must be analyzed in terms of the undelrying assets

C. The Holding Requirements
The property exchanged must be property held for productive use in a trade or business or for
investment and the property acquired must be property to be held either for productive use in a
trade or business or for investment. (thus exchange of residential property wont qualify)
= excludes personal use property
2 year holding period
1031(f) prevents swapping of basis between related parties
o 1031(f)(4) prevent related parties from using third party to avoid (f)
Applicability of 1031 to one party does not depend on if it is applicable to another party
Exchange may not qualify for non-recognition where the intent at the time of the exchange is to
make a charitable contribution of the property received

D. Solely for Like Kind Property: The Presence of Boot (Broadening)
65
1031(c)
boot cash or non-like kind property (to even up the exchange, because often, one is more
valuable than other) deal with these in most 1031s
1. cash
2. relieved of liability
3. non-like kind property
The party giving cash or other non-qualifying property is still covered by 1031 since he is only
receiving like kind property for what he gave up the cash paid is reflected in the basis in
property acquired
Party receiving cash requires recognition of gain on like kind property to extent of the boot
received (never recognition of loass) gain will never exceed gain realized on sale

E. Treatment of Liabilities
1031(d)
Relief of liability = boot
If both parties exchange liabilities, only the net relief constitutes money received
Net relief cash paid = money received

F. Basis Calculations
(d) Basis
If property was acquired on an exchange described in this section then the basis shall be the same as that
of the property exchanged, decreased in the amount of any money received by the taxpayer and increased
in the amount of gain or decreased in the amount of loss to the taxpayer that was recognized on such
exchange. If the property so acquired consisted in part of the type of property permitted by this section,
section 1035 (a), section 1036(a), or section 1037 (a), to be received without the recognition of gain or loss,
and in part of other property, the basis provided in this subsection shall be allocated between the properties
(other than money) received, and for the purpose of the allocation there shall be assigned to such other
property an amount equivalent to its fair market value at the date of the exchange. For purposes of this
section, section 1035 (a), andsection 1036 (a), where as part of the consideration to the taxpayer another
party to the exchange assumed (as determined under section 357 (d)) a liability of the taxpayer, such
assumption shall be considered as money received by the taxpayer on the exchange.
1031(d) =
the taxpayer who receives the boot is treated as having purchased the non-like kind property
Unrecognized gain or loss is preserved through basis (taxpayer is treated as having purchased the
non-like kind property
Starting point for basis total bases of all properties given up
Substituted basis is then adjusted up and down for gain or loss recognized on the transaction (and
reduced by money received )
Liability relief is treated as money received, liabilities taken on are treated as money paid which
increases basis
Unlike calculation of gain recognized, total liability relief is what is considered money received
Non-like kind property received has a fmv basis and the like kind property has a basis that
preserves the unrecognized gain or loss in the property given up

Total basis is then allocated first to non-like kind property up to fmv and remaining basis
is the basis in the like kind property

Calculation: (whats the basis of the property the taxpayer got)
+ old basis (that of property exchanged) basis of property given
+ recognized gain (increased in amount of gain recognized on non-like kind) = tax cost basis
+ cash paid/given not in actual 1031 (d) rule basis = cost and cash is deemed buying basis
+ liabilities assumed not in actual 1031 d rule liab assumed are like cash paid (you are building cost)
66
+ basis in boot property given not in 1031 d rule
These four + work because you are adding to your unrecovered cost
- cash received/ (decreased in amount of money received) pg. 74 k& p problem (you recovered some
of your unrecovered cost)
- recognized loss (decreased in amount of loss recognized of non-like kind) like depreciation (lets you
recover some of your basis)
- liabilities relieved old colony case (you recovered some of your unrecovered cost)
These three - make sense because you are letting it ride (you recognized a loss that you are now
recovering cost)



G. The Relationship Between Sections 276(a)(1) & 1031

H. ..
I. Three-Way Exchanges & Deferred Exchanges (these 2 Broadened)
3-way exchanges can qualify under 1031 if like-kind exchange- not necessary to receive like kind
property from the same person to whom one has transferred the property
Receipt of cash in return for property, even if proceeds are immediately invested in like kind
property, will destroy 1031 treatment thus the regs authorize use of qualified intermediary in a
simultaneous exchange
Need B to be willing to purchase Cs farm- can hire qualified intermediary if B does not agree to
this
1031(a)(3): (overruled Starker) You can use qualified intermediary but taxpayer must identify
replacement property within 45 days of transfer of property given up and must receive the
replacement property no later than 180 days after transfer or due date of taxpayers tax return for
the year of the transfer
3-property rule:
Since replacement property has issues, taxpayer may identify 3 replacement properties of any
value, or any number of replacement properties that in aggregate dont exceed twice value of what
is given (200% rule)
Problems: zoning, title, environmental problems
General rule: if the taxpayer identifies too much property, the taxpayer will be treated as having
identified no property and not entitled to the 1031 benefit
If both of those fail (200% rule or 3-property rule), still can get 1031 if taxpayer actually receives
identified replacement property with FMV that is 95% of aggregate FMV of all identified
replacement property (95% rule)
Incidental property ex. furniture transferred w an apt building, will not cause the taxpayer to fail
the 3 property rule
Exchange period: 180 day period- if the replacement property rec. is substantially the same
property
Safe harbors: permit taxpayers to use security or guarantee arrangements, escrow accts or
qualified intermediary as part of deferred exchanges
A taxpayer who uses a safe harbor acct will not be in actual or constructive receipt of the money in
the acct
Qualified intermediary: is not considered an agent of the taxpayer for purposes of 1031
Permit direct deeding- enabling intermediary to remain outside of the chain of title

Revenue Ruling 72-151
Example of simultaneous exchange
A wants a 1031 exchange for Ranch 1 B says he will find a like kind property that A wants,
buy that property, and do a likekind exchange
A wants ranch C
67
B buys Cs ranch
A & B swap
A takes Cs liabilities
B takes As liabilities
only A has qualified for 1031
A = ranch 2
B = ranch 1
C = cash payment
works for everyone
A sells to B for $1000 a ranch used by A in bus.
B placed $100 into escrow and agreed to pay at closing an addl $200 cash and assume $160
liability of A and to execute a note for $540
A located another ranch owned by C and B entered into a k with C to purchase the 2nd ranch for
$2000
B placed $40 into an escrow acct, agreed to pay $800 at closing, assume $400 liability of C, and
execute a note for $760
After B purchased the 2nd ranch then B exchanged the 2nd ranch w A for the first ranch (A
assumed Cs $400 liability and Bs note for $760)
Escrow agent returned Bs $100
A and B entered into a sales agreement w an exchange option if suitable property were found
o Treat as like-kind exchange even though the original agreement called for a sale of
the property
o As $160 liability assumed by B was offset by Bs liabilities assumed by A
o A- the exchange of ranches qualified for nonrecog. Of g or l under 1031
o B- the exchange of ranches does not qualify for nonrecog. Under 1031 bc B did not
hold the second ranch for productive use in a trade or bus. or for investment
Acquired the property solely for the purpose of exchanging it for like kind-
property
o However- in this case B did not recog a g or l as a result of the exchange since the
total consideration received by B is equal to Bs basis in the property given up

Worksheet on twen

Ch. 31 = Capital Gains:
Overview A, B1, D-G
Problem IA1
Arkensas Bet Case
Horst Case

Ch. 29 schlude case
68


Chapter 31 Capital Gains & Losses
I. Problems:
A. Definition of Capital Asset:
1.
a. 1221(a)(1) = [first exception] not a capital asset = primarily for sale in the ordinary
course of trade or business
i. what if he was not going ot sell the car, but wants to use it the same way he
uses futniture, etc. = would go under (a)(2) [2
nd
exception]
b. Van used to transport customers = 2
nd
exception (a)(2)
c. Car used for family = falls in flush language of 1221(a)
d. 1221(a)(2) for land; (a)(2)
e. vacant land for investment = capital asset = no exception for it.
i. Investments assets treated as capital
f. Promissory note received in sale of new car = accounts receivable
g. Capital asset
h. Received gift of painting before mother died (takes mothers basis cost of creating
it); painting received after mothers death (you dont care about the mothers basis =
1014 fare market value)
i. (a)(2)(C) = because of the gift basis rule = the first one is ordinary
ii. (a)(2)(C) = second one is capital, because you dont care about mothers
basis
i. wedding ring = capital asset
j. stock in car dealership that they own = capital asset
i. business will own things for business assets, but Terry & Marg own the
stock as investors (if the dealership was the taxpayer, would be a ordinary
asset)
k. compter owned by friendly in dealership = ordinary (a)(2) then owned by Terry &
Marg who own it to manage their investments = capital asset
i. same asset, but changes hands = & now is no longer ordinary decide if it
has changed in the life of the asset.
ii. Whether something is ordinary or capital, isnt about the asset = its about
who owns the asset & what they do with it.
A. Historical Overview
Test question = know the life of the asset (one type of asset for someone one year, another
type of asset for someone else the next year, etc)
1. Preferential Treatment for Long Term Capital Gain
Profit from sale of stock = income
Revenue Act of 1921 = preferential tax treatment for the gains (capital gains)
from the sale or exchange of capital assets
o Capital asset = property acquired & held by the taxpayer for profit or investment
for more than 2 years, but does not include stock or other property of a kind
which would properly be included in the inventory of the taxpayer if on hand at
the close of the taxable year
o Limited to assets that had been held for a minimum of 2 years
Long term capital gains (over 2 years) = tax-preferred
Short term capital gains (under 2 years) = not tax-preferred
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o Rationale = Bunching problem - realization = the appreciation will generally
not be taxed as income until the asset is sold/exchanged
* bunching several years worth of unrealized gain in a single taxable
period to be taxed at the taxpayers marginal rate deprives the taxpayer
of the benefit of the lower marginal rates which would have resulted in
less tax had the gain be recognized in each year. This is a horizontal
equity argument.
Example: Assume a taxpayer who owns a capital asset and has no
other sources of income. Between Years 1 and 4, his asset appreciates
20K each year. He disposes of the asset in Year 4 and recognizes 80K
in gain. Without a capital gains preference (disregarding deductions for
the moment), each years gain would be stacked on the prior gain and
he would be taxed as follows: the first 20K would be taxed at 15%, the
next 30.5K would be taxed at 28%, and roughly the last 50K would be
taxed at 31%. See 1(c). Alternatively, if gain had been taxed each
year, he would never have paid more than 15% on any years gain.
o The capital mobility argument: Proponents of a capital gain preference also
make an efficiency argument that a high marginal rate on capital gain creates a
tax disincentive for taxpayers to dispose of appreciated assets. In the extreme
case, some of these taxpayers may prefer to hold on to property until death, at
which point the asset receives a market value basis. This argument assumes that
the economy benefits from the recirculation of capital assets. This argument
must be open to empirical analysis demonstrating a link between the capital
gains rate and asset turnover.
o The inflation argument: Proponents make another fairness argument that to the
extent that capital gain reflects inflation over the holding period, a taxpayer is
unfairly taxed on phantom gain. What makes it phantom is that it is
consumed, in part, by inflation. Moreover, the fact that basis is not inflation-
adjusted means that inflation also eats into the taxpayers ability to meaningfully
recover his basis.
Arguments AGAINST Capital Gains Preference
o The regressivity argument: In many cases, capital gain occurs in assets held
by wealthy taxpayers with significant disposable income. Taxing investment
gains of the wealthy at a lower rate than wage income (which contributes more
directly to the standard living of taxpayers in lower tax brackets) shifts the tax
burden away from the wealthy and towards less affluent taxpayers. This is an
argument based on vertical equity concerns.
o The deferral value of bunching through the realization requirement:
Proponents of the capital gains preference ignore the benefit that holders of
appreciated assets enjoy from deferral of tax liability on unrealized appreciation.
When a taxpayer finally recognizes capital gain, due to inflation and the time
value of money he discharges with current dollars a present tax liability with
respect to a gain which has been compounding tax-free during the assets
holding period. If investors feel entitled to lower marginal rates applicable to
appreciation that occurred in previous tax years, ought they also to be liable for
the compounded value of the tax (which would have been paid in the year of
appreciation) which they have postponed?
o Availability of less complex alternatives: Opponents of the capital gains
preference also argue that the concerns raised by its proponents would be better
handled through other mechanisms. For example, the basis of a capital asset
could be adjusted upwards for inflation. Or to avoid the bunching problem,
gross gain on a capital asset could be averaged over the holding period of the
asset.
What is at stake in determining if Capital Asset?
a determination of which assets will produce
70

1) capital gain taxed more favorably than ordinary gain and
2) capital loss deductible more restrictively than ordinary losses.

In this sense, a determination that an asset is capital is a two-edged sword favorable if the asset
appreciates during the holding period, but adverse if the asset loses value during the holding period.

Capital asset status is the default characterization
The flush language of 1221(a) defines a capital asset broadly as any property held by the
taxpayer (whether or not connected with his [sic] trade or business)
Several paragraphs of the subsection go to exclude some major classes of assets from the
definition, some of which we will consider today.
The common theme running through all of these exceptions is that, in one way or another, each
exception targets an asset which under other tax rules should produce ordinary income.
Crucial point: an asset is never intrinsically capital or ordinary. Figuring out its character
is a contextual determination based on what the taxpayer does with it. For example, consider the
difference between a share of IBM which I own (it is CAPITAL) in my hands and another share of
IBM held by a securities dealer. If the security is part of the security dealers inventory, then it
falls into one of the exceptions which we are about to consider.


1222 classifies all the capital gain/loss as
1. Short term capital gain
2. Short term capital loss
3. Long term capital gain
4. Long term capital loss
Ex:
1. Short term capital gain - $50k
2. Short term capital loss - $30k
3. Long term capital gain
4. Long term capital loss
= has net short term capital gain of $20k = not net capital gain, so doesnt get 1(h) rate [still better
though than having $20k in ordinary income because allows the taxpayer to use any other
capital losses [1211] unexpired, unused capital loss = capital gain allows you to offset your
capital loss
Ex:
1. Short term capital gain - $30k
2. Short term capital loss - $50k
3. Long term capital gain -
4. Long term capital loss
= net loss of $20k
Ex:
1. Short term capital gain -
2. Short term capital loss -
3. Long term capital gain - $30k
4. Long term capital loss - $50k
Net long term capital loss of $20k = no gain with preferential rate, because you are in loss world
(losses wont expire, but if you are a corporation, the clock has begun to run)
Ex:
1. Short term capital gain - $30k
2. Short term capital loss - $50k
3. Long term capital gain - $100
4. Long term capital loss - $50
NLTCG - $50k = may be subject to preferential rate in 1(h) (you dont know yet, because you
have to subtract the net short term capital loss [1222(11)], say its $20k = $20k subject to 1(h)
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He got to use:
o STCL = $30k [offset the $30k of STCG]
o NSTCL = $20k
o LTCL = $50k
Net by term:
1. Net the short term
2. Net the long term
3. Use the 1222(11) formula



2. Limitation on the Deduction of Capital Losses
3. Justification for Preferential Capital Gain Treatment
B. Current Law: Section 1(h)
1. Maximum Rates on Long-Term Capital Gain under the Current Law
C.
D. Definition of Capital Asset [exclusions]
1221 first thing you ask = does it fit into any of the exclusions = yes = ordinary asset = all the
gain is taxed at the ordinary taxing rate

1. Section 1221(a)(1): Inventory, Stock in Trade, & Property Held Primarily for
Sale to Customers in the Ordinary Course of the Taxpayers Trade or Business
- The first exception from capital asset status in 1221, 1221(a)(1), excludes any inventory or
item held by the taxpayer primarily for sale as part of the taxpayers trade or business. Gain or
loss on inventory or such items is ordinary business income and, according to Congress, should
receive ordinary tax treatment. Clearly, none of the rationales advanced by proponents of the
capital gains preference apply to gain on inventory or other forms of ordinary business income.

2. Section 1221(a)(2): Property Used in the Taxpayers Trade or Business
- The second exception from capital asset status in 1221 excludes any depreciable property or real
property held by the taxpayer used in his trade or business. This exclusion applies to a taxpayers
physical plant, machinery, other tangible business assets, and also to intangible assets amortized
under 197.
- Most of the business assets excluded by this exception do qualify for quasi-capital asset status
under 1231, which in most circumstances allows the taxpayer to treat gain as capital and loss as
ordinary.

3. Section 1221(a)(3): Copyrights, Literary, Musical, or Artistic Compositions
- Because they are -- in essence -- a substitute for ordinary income, 1221(a)(3) also excludes
copywrights from capital asset status.

4. Section 1221(a)(4): Accounts Receivable for Services Rendered or Inventory-
Type Assets Sold
- An exception related to the inventory exception of 1221(a)(1), 1221(a)(4), excludes from
capital asset status any accounts receivables for services rendered or inventory sold. (You can
view the accounts receivable as a substitute for inventory.) This section is directed at taxpayers
who sell their accounts receivable in the receivables market. Ordinarily, a cash-basis taxpayer will
not sell a receivable at a loss because she has not yet recognized the income on the transaction
giving rise to the receivable. As a result, she has no tax cost basis in the receivable. An accrual-
method taxpayer, in contrast, will already have recognized in income the receivable upon
satisfying the all-events test. Because she has a basis in the asset, she may recognize a loss upon
disposition for less than the basis. This exception helps the accrual-method taxpayer by ensuring
that the loss on the receivables transaction will be ordinary, rather than capital.
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5. Section 1221(a)(5): Certain Publications of the U.S. Government
6. Section 1221(a)(7)
- Still another exception closely related to the inventory exception of 1221(a)(1), 1221(a)(7),
excludes from capital asset status any hedging contract in connection with the taxpayers trade or
business. Hedging contracts are related to inventory because many businesses manage the price
risk, i.e. rising prices, from commodities used in their business with such contracts. Taxpayers also
manage the price risk of their own products, i.e. falling prices for the taxpayers finished products
or services, by entering into contracts that make the taxpayer whole in the event of an adverse
price move in its finished products. (You can view this type of hedging contract as a substitute for
sales income.) Obviously, both inventory and sales income are ordinary and, applying the
doctrine of substance over form, gain or loss on contracts that replicate those assets synthetically
should receive ordinary income treatment.
- Arkansas Best Corp

7. Section 1221(a)(8): Supplies Used or Consumed in the Taxpayers Trade or
Business
- Another exception closely related to the inventory exception of 1221(a)(1), 1221(a)(8),
excludes from capital asset status any supplies or products consumed in the taxpayers trade or
business. Like inventory, items falling under this section are factor inputs used by the taxpayer in
his trade or business. Just as with inventory, none of the policy objectives for extending capital
asset status apply to these items

8. Judicially Established Limits on Capital Asset Characterization
- Example: A manufacturer of products made with corn bought corn futures to ensure the
availability of corn and to reduce the risk that corn prices would rise. The manufacturer sold some
futures contracts at a gain and treated the gain as capital. The Supreme Court disagreed,
concluding that the futures contracts were an integral part of the manufacturers ordinary business
operations. Corn Products. (This precedent is reviewed in the Arkansas Best.)
The Corn Products case was decided before the adoption of 1221(a)(7), although this subsection
would apply on similar facts that arose today. (The case might also serve as an example of the
inventory exception. That is the Supreme Courts view in Arkansas Best.) The case stands for the
principle that although an item may not fit squarely into one of the statutory exclusions from
capital asset status, courts may construe the definition narrowly to avoid favorable treatment for
gains. (Of course, such a policy results in ordinary, i.e. taxpayer-friendly, treatment for losses on
such assets.)


E. The Sale or Exchange Requirement
1222 provides that only a sale or exchange of a capital asset qualifies for capital
treatment.
Courts have interpreted this phrase widely to include the taxpayers abandonment of property, an
involuntary foreclosure of the taxpayers property, and a property transfer through quitclaim deed.
In most of these cases, the taxpayer would have realized a loss on the transfer. Therefore, these
decisions serve to limit the taxpayers deductibility of these losses as capital losses.


F. The Arrowsmith Rule: Characterization of Certain Gains or Losses
Dependent on Prior Tax Treatment of Related Gains or Losses
Looks at substance over form disregards particular transactions that are spread out over many
years.
- Treat the loss & gain as if it all happened in the same nucleus
- Aka step transaction doctrine court concludes that all steps were interdependent, so we are
going to recombine what you did
73

The Arrowsmith rule allows a court, when evaluating whether gain or loss is capital, to put a
current year transaction in the context of transactions and tax events which have occurred in prior
tax years. You can see this rule as an example of a transactional accounting approach that cuts
across the annual accounting concept.
The rule emerged in a case in which the Commissioner successfully challenged a taxpayers
characterization of a loss as ordinary, but the rule has wider implications beyond the
characterization issue.
Example: In Year 1 the taxpayer received a liquidating distribution from a corporation in which
he held stock. Since the taxpayer received the liquidation in exchange for a capital asset, i.e. his
shares in the liquidating corporation, the gain on the transaction was properly characterized as
gain. In Year 5, the taxpayer paid an outstanding liability of the corporation and characterized the
payment as an ordinary expense. The Commissioner and the court disagreed by putting the
subsequent liability in the context of the previous liquidation, which had been treated as a capital
transaction. The court noted that had the liability been assumed in the year of the liquidation, the
amount of the liability would have offset the gain on the transaction. The court reasoned that the
intervening time period was to be disregarded when evaluating the character of the payment
inYear 5.


G. Holding Period
Determining Net Capital Gain
The next step in estimating capital gains tax liability is determining under 1222 whether a
taxpayer has a net long-term capital gain. 1222(11) defines net capital gain as the excess of net
long-term capital gain over net-short term capital losses.
Although whether a loss is short or long-term is irrelevant for determining its deductibility (i.e. all
capital loss is deductible against all capital gain), the taxpayers holding period (defined in 1223)
is very important for determining net capital gain.
This process distinguishes between a capital asset held for one year or less (such an asset produces
short-term gain or loss) and a capital asset held for more than one year (such an asset produces
long-term gain or loss). Only net long-term capital gain qualifies for preferential rates. Since
1986, corporations have enjoyed no rate preference on net capital gain. The preferential rates in
1(h) apply only to individuals, trusts, and estates.
Netting steps in 1222

The formula in 1222 provides for
1) netting short-term gains against short-term losses
(this step yields net short-term gain or loss)
2) netting long-term gains against long-term losses
(this step yields net long-term gain or loss) and, finally,
3) netting any net short-term losses against net long-term capital gains
(you will notice that although long-term capital losses are offset against short-term capital gain for
purposes of determining whether a loss is deductible under 1211, net short-term gains are not netted
against any net-long term loss for purposes of determining net capital gain under 1222 remember to
keep the Sec. 1211 and the Sec. 1222 processes separate).
The result of these three steps is net capital gain, which is the only type of capital gain subject to
the rate structure in 1(h) for noncorporate taxpayers.

Lets return to some of the examples from above to see how 1222 works.
Example: Taxpayer has a 100K short-term capital gain, a 100K long-term capital gain, and a
100K short-term capital loss. As we concluded above, he has capital gain net income of 100K. Is this
income short-term or long-term capital gain? 1222 requires the 100K short-term capital loss to absorb the
100K short-term capital loss, leaving a 100K long-term capital gain. By operation of 1222(11) this long-
term capital gain is net capital gain, subject to preferential rates under 1(h).
74
Example: Taxpayer has a 100K long-term capital gain, 100K in ordinary income, and a 100K
short-term capital loss. The capital gain and loss are netted. As we concluded above, the taxpayer has
ordinary income of 100K. There is no need to turn to 1222.

REVI EW:
So far, you should be able to see why the following statements are true:
All capital losses (whether short- or long-term) may be deducted against all capital gain (whether
short- or long-term). Individuals may also deduct 3K annually against ordinary income.
Under 1222(11) and 1(h), only net long-term capital gain qualifies as net capital gain and,
hence, receives preferential rates. All else being equal, a taxpayer prefers to have long-term
capital gain to short-term capital gain.
Short-term capital gain is taxed at ordinary rates, but is still preferable to ordinary income.
As the third netting step in 1222 shows, a net short-term capital loss may offset a net long-term
capital gain. The first netting, however, requires that any short-term loss first be absorbed by any
short-term gain before being used against long-term capital gain.

Arkensas Best Corp. v. Commissioner
Facts: Arkansas Best is a holding company that bought 65% of stock of National Bank in 1969. Over
time they bought more shares of bank and when bank started failing in 1972, they bought even more
shares to keep bank afloat. The Bank had a lot of problems and in 1975 sold stock in Bank, leaving
only 14.7%. Arkansas best argued that intention matters in purchase. In 1975 reported ordinary loss of
$9,995,688 from sale of stock and IRS said that loss was capital and subject to capital loss limitations.
Issue: Is Capital stock a capital asset, regardless of whether the stock was purchased and held for a
business purpose or an investment purpose? Does the intention of a company matter in the purchase?
Rule: Taxpayers motivation in purchasing an asset is irrelevant to question of whether asset is capital
or not. A business connection is only relevant in determining if one of the statutory exceptions apply.
Holding: the loss on the sale of stock was a capital loss court rejected motive test saying that
broad definition of capital asset explicitly makes irrelevant any consideration of properties connection
with taxpayers business. court also held 5 classes of property listed as exceptions are exclusive.
Stuff held from 1969 1972 were held for investment purposes and investment does not fall
within the inventory exception and so from 1969-1972, it is a capital asset. The acuisitions from
1972-1974, the shares it bought then were bought (purely for business purposes of Arkansas best)
because the bank was tanking which would reflect poorly on Arkansas best it helped their own
business reputation and probably fall under the first exception (property held in the ordinary
course of business) = tax court accepted [reversed on appeal.. all assets are determined to be
capital = arkensas best can deduct those capital losses, only if they have capital gains]
In further addressing the corn products holding again the court addressed the hedingg that was
done in that case. Hedging transactions have consistently been considered to give rise to ordinary
gains and losses they only exercised the futures contract or sold the remainder as the need for
corn arose and they were in the business of using corn. when futures are utilized soley for
purpose of stabilizing inventory cost, they cannot reasonably be separated from inventory items.
Corn products now stands for fact that stock held for inventory will be treated the same was as the
underlying commodity. The hedging exception in corn products was codified in 1221
o In locking in a price today, have peace of mind = have effectively hedged = made money
on the contracts (didnt have to use all of them, so they sold them & made one them) =
corn futures were surrogate for inventory, so were inventory items.
o These are securities, but because the taxpayer got tem in ordinary business = ordinary
gain
o Arkensas is going to say I bought these shares, not as a capital asset, but to hold
inventory in the course of ordinary business
75
Prof: as a holding company, seems reasonable that the purchase of stock could
be considered inventory in the ordinary course of business. But with that
reasoning, why wouldnt it ALL considered inventory?
This case does not overrule corn products
Should read corn products case as ONLY dealing with inventory exclusion

Hort v. Commissioner
Facts. Petitioner acquired a lot and ten story office building from his father after he died in 1928. When he
became owner, the building was leased to a firm which sublet the main floor to the Irving Trust Co.
Petitioners father and Irving Trust Co. entered into an agreement wherein Petitioners father agreed to
lease the main floor and basement to Irving Trust Co. for a fifteen year term. Petitioner and Irving Trust
Co. agreed to terminate the lease in consideration for a payment of $140,000 to Petitioner. He did not
include this in his gross income but reported a loss of $21,494.75. His theory was that the amount he
received for canceling the lease was less than the present value of the unmatured rental payments and the
fair rental value of the main floor and basement for the unexpired term of the lease. The Commissioner
included the entire amount in Petitioners gross income. The Board of Tax Appeals and the Circuit Court of
Appeals affirmed.

Issue. May a taxpayer offset the value of the lease canceled against the consideration received for the
cancellation in computing net gain or loss for income tax purposes?

Synopsis of Rule of Law. Gross income includes gains, profits, and income derived from rent, or from any
source whatsoever.
Wants to say that it was a loss = BUT it was a gain of $140k = gross income
Its not fair to lose something that you have not recognized yet (hasnt gone through the mill yet) =
he is acting like he had a basis of $160k, but in fact he only got $140k, so he wants to recover the
cost = but this is a bogus loss.

















Chapter 28 Cash Method Accounting
I. Problems
Yr 1 Dec. 30
th
= mailed = developer records in year 1
Yr 2 Jan. 2
nd
= received check = recognize income
Yr 3
1. (Above)
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a. would it make a difference if Developers office were less than a Block from Mikes
office? No. [asking about constructive receipt doctrine = could have walked over to get it,
but didnt have to]
2.
Yr 1 = arrived at his office = Mike recognize income; Developer
recognizes income
Yr 2 = was out of town, got it Jan 15th
Yr 3
a. would it make a difference if placed in Mikes post office box on Dec. 31
st
= No. Where
business is
3.
Yr 1 dec. 31 = supposed to receive = constructive receipt = yr 1 = mike recognizes
income
Yr 2 jan = requested to pay (postponed);
received check jan. 2
nd

= Developer recognizes (no constructive receipt
for his side)
Yr 3
4. ..
Yr 1 = developer tells mike that he is having $
problems, and gives promissory note to pay in
march, yr 2 = received note dec. 30

Yr 2 = received note = cash equivalency (insolvent) = likely
recognizable
= for developer = realized (wait until he makes
payment)

Yr 3
a.
II. Vocabulary
III. Objectives
The taxpayer is free to use any such method under 446
But see: 448 limiting the use of the cash-method by certain nonhuman taxpayers.
A taxpayer may also combine accounting methods, so long as the combination of methods
accurately measures income.
Once the taxpayer chooses a method of accounting, she may change it only with the permission of
the IRS.
If the IRS determines that the method of accounting used by a taxpayer (including an accrual
taxpayer) does not clearly reflect income, the IRS may direct the taxpayer to use another, more
accurate method to calculate the taxpayers income.
The cash method is a cash flow approach; it matches cash flows, i.e. the timing of income and
deductions follows the timing of corresponding cash inflows and outflows.
The evil/tax planning opportunity which the IRS is concerned about with respect to the use of
the cash method is that the taxpayer will manage the recognition of income or loss by
manipulating the timing of this recognition when she has effective control, whether or not that
control is formalized.
To mitigate this evil, on the income side, three doctrines apply to the recognition of income
which has not been reduced to possession constructive receipt, the cash equivalency doctrine,
and the economic benefit doctrine.
o Economic benefit = like the H Simon concept of income
Ames case
When someone has made an irrevocable transfer
o Courts tend to confuse the three doctrines
o These doctrines broaden
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IV. Overview

Annual tax accounting system
Question: in what tax year is something income?
A. Income Under the Cash Method
1. In General
Requires taxpayer to report cash as received and to deduct expense as they are paid
Critical events = receipt & disbursement/payment
Three Doctrines:
o Constructive receipt
o Cash equivalency
o Economic benefit
2. Constructive Receipt
Regulation 1.446-1(c)(1)(i) provides that any item constitutes gross income is to be included in
the taxable year in which it is actually or constructively received.
When approaching a potential constructive receipt problem, ask two factual questions:
1. Does the taxpayer have physical and legal access to the income? The following are four
examples in which the taxpayer does have access to the income. (The analysis does not end with
this question, however.)

2. Is there a fact mitigating the taxpayers access to the income? Even if the taxpayer has
physical and legal access to the income, is there any fact which argues against the conclusion that the
taxpayer is in constructive receipt of the income?

Income is taxable in the year where the taxpayer has control of its receipt
Income is not constructively received if the taxpayers control of its receipt is subject to
substantial limitations or restrictions
a) Specific Factors Affecting Application of Constructive Receipt Doctrine
2 requirements:
o (1) the amount must be available to the taxpayer
o (2) the taxpayers control over receipt must not be subject to substantial restrictions
or limitations
unfettered control over the date of actual receipt

Factors that mitigate access/control = courts look at:
1. Distance
a. Geographical proximity to the location where an item of income is being
made available to the taxpayer
b. The date a check is received & NOT the date it is mailed determines the
year of taxation
c. must the taxpayer travel a significant distance to get control over the
income? If yes, the doctrine does not apply.
d.
2. Knowledge:
a. Did the taxpayer KNOW the check (etc) was available to them?
3. Contractual arrangements:
a. Ex: if the rent isnt due until Jan 1, the landlord should not be required to
accept it before that time = not constructive receipt
b. Does the taxpayer have a legal instrument that stipulates the timing of the
income? If so, actual access to the income may be irrelevant. In Example 2
above, the landlord has a rental agreement that provides for monthly
payments, not prepayments. In contrast, if the landlord has demanded and
78
accepted prepayment for the lease term, the prepayment is includable as
income. In Example 4 above, the corporation may have a validly-enacted
resolution providing a deferred compensation for the shareholder. The
doctrine of constructive receipt will not override the legal instrument in
either Example 2 or Example 4.
c.
4. Forfeitures or other penalties
a. No constructive receipt when penalty (worth 3 months interest) for early
withdrawal
b. No constructive receipt when early withdrawal would result in forfeiture of
the right to benefit from further appreciation of stock
c. Financial penalty: Many time deposits impose a penalty if the taxpayer
withdraws the deposit before maturity. This might apply to Example 3
above. By regulation, on instruments of one year or less, a prepayment
penalty of 3 or more months of interest mitigates the risk of constructive
receipt.
d.
5. Relationships of the taxpayer to the payor
a. Closely held corporations? Postpones payment to future year.
b. The sole shareholder of a corporation may direct the structure of
the corporations deferred compensation arrangement with her.
She has physical access to the income.
i. Receives according to the terms the shareholder has set up =
generally this is allowable
1. We respect legal forms
c. A corporation is a separate legal entity from its shareholders. Respect for
this legal form also bars the application of constructive receipt in Example 4
above.
6. Disclaimer of a prize: If a taxpayer disclaims (not defers) a prize to which he has
unrestricted physical and legal access, the doctrine of constructive receipt does not
apply.
a.
b) Specific Exceptions to Construct Receipt Rules
a. Exceptions to unfettered control
i. Refuse prize (not just defer), not required to report it as income
ii. 125 cafeteria plans = when work allows you to chose between receipt of
cash or excludable fringe benefits
iii.
3. Cash Equivalency Doctrine
Generally, this doctrine results in recognition to the taxpayer of income when she has received an
obligation, e.g., a note or other form of debt instrument, with a ready market value.
Court decisions have established the standards to determine whether an obligation has market
value.
o Indicia of market value include the following:
A solvent obligor
An unconditional obligation
Assignability of the obligation
A secondary market for an obligation of this type
Easy to liquefy = if can turn into cash right away
o
Ex: Promissory note
Notion that certain intangibles have so clear a value and are so readily marketable that a cash
method taxpayer receiving them should not be entitled to defer reporting income
Cowden case readily marketable & immediately convertible into cash
RR = freely transferable & readily saleable (value of an installment bonus k)
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Williams case = a promissory note is not a cash equivalent if it is merely intended as evidence
of indebtedness and not the bargained for consideration
o Example: A promises to pay 10K in cash to B, a cash-basis taxpayer, upon
completion of Bs work on As home. When payment is due, A is experiencing financial
difficulties, so, instead, he gives B a promissory note for the 10K to be paid in the
following year. Is B in receipt of income?
Likely = not cash equivalent
Check = received dec. 31 in evening = cant cash until Jan 2? Does matter = court says that it is
still paid in that previous year.
o Post-dated check? Like considered cash equivalency
Considered gross income:
o Stock = yes
o Bond = yes
o Letter of acknowledgement of owing money = only upon receipt
o An oral promise of money = only upon receipt

Promise to pay will be considered cash equivalent if: (see Cowden)
1. Made by solvent obligor
2. is unconditional and assignable
3. Not subject to set-offs
4. Is a kind frequently transferred to lenders or investors at a discount not substantially greater
than the generally prevailing premium for money (cowden was one of few cases to make the
amount of the discount a factor
Williams v. commissioner court held that promissory note was not cash equivalent because it
was a mere change in form from an account payble to a note payable, bore no interest, and was not
marketable
After Williams and cowden promissory note is not cash equivalent if it is merely intended as
evidence of indebtedness and not bargained for consideration.

4. The Economic Benefit Doctrine (comes out of the HS test for income)
Deferred or pre-funded compensation arrangements may not fit under either the constructive
receipt (no possibility of possession) or the cash equivalency doctrine (no transferable interest
created). For this situation, courts have sometimes required cash method taxpayers to recognize
income because a compensation or other arrangement confers an economic benefit.
This argument draws on Haig-Simon ideas about economic income, as suggested by its name.
Under this doctrine, the taxpayer recognizes as income in respect of a future promise to pay when
the right to payment is unconditional and when the promised amount is funded (somewhere, there
is a pot of money, with his name on it = its real = liquidity set aside to make good on that
promise). Generally the situation arises when an employer irrevocably earmarks liquidity for
future payment to the taxpayer or in the context of prizes and awards. As one case put it, the
doctrine applies if the employers executory (a promise that hasnt been performed on, until the
actual payment has been made) promise [to pay] is capable of valuation. Minor.

Gross income includes any economic benefit conferred upon a taxpayer to the extent the benefit
has an ascertainable FMV
Economic benefit to person:
o Irrevocable trust = constituted income to the employee in that year (even though not
payable until years later)
o When bonus placed in escrow for football player (to be payed out in installment of 5
years)
Applicable only if the employers promise is capable of valuation
o NOT Contest case = received 12k in contest, payable out in 2 year period from escrow
account = but, taxpayer didnt get interest = so as the payments were received, the
balance would be includible in income
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B. Deductions Under the Cash Method
1. In General
Expenses are deductible when paid (if paid in 2012, deductible in 2012)
o There is no constructive receipt doctrine for deductions
What constitutes payment of an expense?
o Not when the taxpayer transfers funds to his own agent
o Not when mere deposit of funds with a government agent as offer (only deductible when
offer is received)
o Not when issuance of ones own promissory note (not payment)
o Payment can be made in property other than money:
Business expenses paid with property = yes
Also, may generate taxable gain, depending on the taxpayers AB in the
relinquished property
Payment with borrowed funds = payment for tax purposes
o Check = payment takes place when check is delivered
o Cards = payment takes place when charge is made (not accepted)
2. Cash Method Prepayments
Rational incentive of cash-method taxpayers to pre-pay costs: Prepayments by a cash basis
taxpayer are subject to the 12 month rule on capitalization of costs. In other words, if the
prepayment produces an asset expected to produce income for more than one year, the taxpayer
may only deduct one years worth of expenses for the taxable year. See Freightways.

Deductibility of prepayments has limitations
o Ex: purchase a building 263 capitalization (not deductible in that year)
o Theory: you havent consumed the resource yet
263 exception = 12 month rule (1 year rule) = exception to the general rule requiring
capitalization of prepaid expenses.
o Ex: 12 month prepaid lease that extened 11 months into next year = deductible in prior
year [Zaninovich case]
o Ex: 10k insurance premium = paid on dec. 1, and term begins in Feb. = NOT deductible,
because the payment extends beyond the end of the taxable year following the taxable
year in which the payment is made
If term had begun on dec. 1
st
= would have been deductible
461(g) = cash method taxpayers must treat prepaid interests as having been paid in the period to
which it is property allocable (in effect, taxpayer is put on the accrual method with respect to
prepaid interest, with an exception allowed for points paid in connection nwith a principal
residence)
448 use of cash method is prohibited for certain categories of taxpayers
o tax shetlers
o certain corps & partnerships

Although cash method is very simple, it results in a mismatching of income and expenses. Ways to
help minimize the mismatching include:
1. Limiting deductibility of certain prepaid expenses
2. Forbid use of cash method in some instances (448 tax shelters, corporations, and partnerships)
3. Taxpayer must use accrual for purchases and sales where use of inventory is necessary.

Ames v. Commissioner
Facts: Taxpayer is on the cash method. Taxpayer worked for the CIA and in 1985 he entered into
a relationship w Soviet officials under which he betrayed his country and sold classified CIA info
to the Soviet Union. In 1985, the taxpayer was informed by the Soviet Union that an amt of $2 mil
was set aside for him in an acct that he would be able to draw upon. During the yrs 1989 to 1992
taxpayer made deposits of cash received in connection w taxpayers unlawful espionage activities.
(taxpayer did not report these amts on his tax returns). IRS argues: that the income was reportable
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in 1989 to 1992- the yrs the petitioner actually received and deposited cash in his bank accts.
Taxpayer was the one trying to invoke constructive receipt doctrine cause he constructively
received money in 1985 and recognized then.(odd because normally the irs is the one invoking the
doctrine)
Issue: When should petitioner have reported the income from his illegal espionage activities?
When he had unfettered control = when he receive the income.
Rule: Constructive Receipt: income although not actually reduced to a taxpayers possession is
constructively received by him in the taxable yr during which it is credited to his acct, set apart for
him, or otherwise made available so that he may draw upon it at any time, or so that he could have
drawn upon it during the taxable yr if notice of intention to withdraw had been given
o Economic benefit = would have need an irrevocable transfer
Holding: no constructive receipt in 1985 because taxpayer did not possess unfettered control
over the money in 1985. Even if you assume that some type of acct was created and funds were
segregated for taxpayer, he did not have ready access to it, and certain conditions had to be met or
had to occur before he could gain physical access to any funds. In order to get money, many
things had to occur and there was no certainty that the necessary conditions would occur. Soviets
retained ability to withhold or control funds.

Chapter 29 Accrual Accounting Method
I. Problems
Problem 1:
Yr 1 Completed 3 month project on
Dec. 15 sent developer check
of $50k for services rendered

Yr 2 Developer Mailed check to mike
on Jan. 2
Mike received check on Jan. 4



Both taxpayers are on the accrual method.
a. Triggering event is the same for Mike to recognize income and developer having duty to pay.
December 15
th
yr 1 under the all events test. = both recognize in year one
b. Dceember 15
th
, doesnt matter if willing to pay or not = wouldnt change anything = still when
services completed
c. This question is trying to confuse you with cash equivalency doctrine. That doctrine doesnt
apply under accrual accounting. Mike could make an argument not to include because there needs
to be certainty of collection to include. Dont reach a conclusion on this problem because we
dont know if he will collect. = wouldnt change anything =
d. In year 1, the income is contested and because it is contested, most likely nothing will be included
or deducted in year 1. In year 2, there is certainty, collectibiliy, all events have occurred. Year 2
would be 45,000 of income. when they have reached an agreement = thats when the legal duty
to pay has been recognized, legal right to receive
Problem 2.
Yr 1 March:
P = debtor = purchases 15k of paintings on act
C = seller = goods
- lender = financing sale = monthly interest
Dec
C realizes that it is unlikely that he is not likely to
receive money owed by P
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Yr 2 Feb
P declares bankruptcy
C never gets money
* we will see, that in accrual, yr 2 doesnt really matter
a. Clint does have to report sale of goods of $15k (rendered)
a. For interests = he didnt have uncertainty of collectibiilty until Dec (March to Nov, must
report accrued interest)
b. Since he accrued the income, he has a basis of $15k
c. Yes P he can deduct it for the 9 months (March Dec) = he has gotten a windfall (which is
recaptured in the future years, will have to come clean with it the next year)
d. Will have to take a loss for it

II. Vocabulary
III. Objectives
Policy goal = To promote the accurate reflection of income
IV. Overview
In general, accrual methods disregard cash flows (which are the focus of the cash method) and
look to the underlying legal status of potential items of income and deduction. In an economic
sense, accrual methods are the only accurate way to track income and deductions.
Any business that uses inventories must use the accrual method. As a result most
manufacturers and merchants use the accrual method. A service business, e.g. a law or medical
practice, could use either the cash or an accrual method.

Report income when you EARN it, not when you receive it
Report deduction upon the fixing of the obligation to pay not payment itself
A. The All Events Test = performance
This test provides for recognition of income and deductions only after all the legal and economic
events have occurred which are necessary to establish the item of income or deduction.
Income should be included when the right to income has been fixed:
Fixed when: (broader now)
The payment has been earned through performance
Payment is due, or
Payment is received
With respect to a contract for services by a taxpayer, usually the taxpayer fixes his right to income
(and, hence, incurs a duty to recognize it) by performance of the services.
Ex: attorney prepares estate plan for someone when you send them (event) the estate
plan, you have fixed your right to income = year in which you finish the work, is year in
which you recognize the income
With respect to contracts for goods, the taxpayer fixes his right (recognition) to income by making
the goods available to the buyer.
Ex: delivery of goods to buyer
When you tender those goods
With respect to (gain on) property, generally the taxpayer fixes his right to income (recognition)
by transferring legal or equitable title.
Closing = transfer legal title. But moment of k, equitable title = recognize gain/loss
upon equitable title
With respect to capital, the taxpayer typically fixes his right to income (recognition) with the
actual transfer of the financial capital or with a binding legal contract proving for such transfer.
Bank loan (interest) = to bank, interest is income (they accrue income, one day at a time
= you are accruing obligation per day)
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Fees = those are required to be recognized as soon as the loan is executed (the instant
that the loan capital is transferred = typically the day of closing)

Example: Execution of a purchase and sale contract for property transfers equitable title to the
buyer. Hence, the seller of the property must recognize any gain on the transaction in the year of
the execution of the contract, not in the year of the closing.
Example: A bank on an accrual method recognizes any non-interest income on a loan on the
earlier of the disbursement of the loan funds or the execution of binding loan documents. ???
(Interest and the lenders corresponding duty to recognize income -- accrues ratably over the life
of a loan.)

B. Accrual of income
1. General Rules
The all events test for income also requires that the amount of income be estimated with
reasonable accuracy.
o If a taxpayer accrues an estimate of income that underestimates the actual income
received, the taxpayer includes the difference between the estimate and the actual receipt
in the year of actual receipt.
o If a taxpayer accrues an estimate of income that overestimates the actual income
received, the taxpayer may take a bad debt deduction in a subsequent tax year.
o These adjustments for under- and over-estimating income should remind you of the
interests which basis tries to serve in the tax code: making sure that each new dollar of
income is taxed once, but only once.
o This should remind you of basis = recognizing something you havent received =
(unrecovered costs) = its like tax cost basis in whatever you recognized, because later
when you recognize, you dont have to report or, if they dont pay, you have this basis
that youve paid tax on, you are going to be able to deduct it (through bad debt deduction)
Basis is a helpful way to
o If an accrual-based taxpayer has a reasonable doubt about the collectibility of an
otherwise accrued obligation, the taxpayer does not include that item as income until its
collectibility is established.
o
2. Income Prior to Receipt: Accrual Issues
If an accrual-based taxpayer has a reasonable doubt about the collectibility of an otherwise
accrued obligation, the taxpayer does not include that item as income until its collectibility is
established.

When an obligor (would-be payor) contests the duty to pay the taxpayer (would-be payee),
the taxpayer postpones recognition of the income until either the taxpayer actually receives
the income (as happens under the claim of right doctrine) or the dispute is resolved.
Example: A hires B, an accrual-based taxpayer, as a general contractor to build As home. When
the home is completed, A, not satisfied, refuses to pay B. A and B enter into negotiations. B has
not accrued income until the conflict is resolved.
Example: A hires B, an accrual-based taxpayer, as a general contractor to build As home. When
the home is completed, A is not satisfied with Bs work. A pays Bs bill and sues him in court for
restitution and consequential damages. B receives As payment under a claim of right (has a shred
of title = claim of right) so he must include the income that year. If A prevails against B in the
law suit and B returns some of the money, B may have a remedy under 1341.

3. Income Prior to Earning: Prepayments & the Earliest of Test
Often, even an accrual-based taxpayer must report a prepayment of income received before
the taxpayer has performed on the contract providing for payment.
This exception to a strict application of the accrual concept puts an accrual-method taxpayer on
the cash-method with respect to prepayments.
84
o Example: A corporation retains an accrual-basis management consultant to advise the
corporation on long-term corporate strategy. The contract requires the consultant to
produce a final report summarizing strategy analysis and making recommendations. The
corporation fully pays the consultant before she writes the report. The consultant must
report the income in the year of receipt, unless Revenue Procedure 71-21 (discussed
below) applies.
Regulatory Exception: Revenue Procedure 71-21 allows an accrual-basis taxpayer to defer a
prepayment for services income for one year, so long as the service contract provides that all
services must be provided for by the end of the second year.
o Example: Assume the facts of the example above. The corporation pays consultant in
full in Year 1. The service contract between the corporation and the consultant provides
that the consultant must finish the report by the end of Year 2. Revenue Procedure 71-21
applies, and the consultant may defer complete recognition of the payment until Year 2.
However, the consultant must include in income in Year 1 the amount of income
allocable to any services provided in Year 1.
Why doesnt the claim of right require income recognition here as it did in the previous example?
Judicial Exception - When the taxpayer can allocate prepaid income to services to be performed
at a specific time and place, the taxpayer may defer recognition of prepaid income until so
allocated.
o Example: Owner of baseball team did not have to include receipts from advanced ticket
sales until the games corresponding to the ticket sales had been played.
Both dividend income and contractually-required prepayments of rental income are included in the
year of receipt. (recognized in year of receipt)

Schlude v. comm. - Include advance payments as income as well as payments that had not yet
been received or earned but nonetheless w ere due.
o Schlude gave rise to earlier of test which provides that all the events that fix right to
recive income occur when:
o 1) payment earned through performance (fixed standards above),
o 2) payment is due the taxpayer, or
o 3) payment is received by the taxpayer (prepaid) whichever happens earliest
Artnell co v. commissioner (ticket sales case) where time and extent of performance are certain
and where income can be properly allocated to performance, deferral of income until year of
performance will be found to reflect income clearly. Fixed schedule = (they know that they will
be redeemd within that year)
Rev Proc. 2004-34 gives an option to taxpayer receiving a covered advance payment to:
1. Full inclusion method = Include the full amount of the advance payment in income in year
of receipt (full inclusion method)
2. deferall method = Include advance payment in income in year of receipt to extent
recognized in revenues in applicable finaincial statemetns
3. If no financial statement, recognize to the extent earned that year (deferral method)
o Under any method the portion of the advance payment not included in income in
the year of rceipt must be included in income in the next tax year
o Prepayments for rent or interest and certain other prepayments are not allowed to
be treated this way.
Deposits are not income
Advance rentals are income on receipt regardless of taxpayers accounting method

C. Deductions Under the Accrual Method
1. General Rules
Taxpayer wants to deduct as soon as possible incentive is different! Think of all the examples,
but from the other perspective.
Question = When CAN a taxpayer take a deduction IN the current year?
Have to look at the legal status
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Just as with accrual of income, the all events test for accruing a deduction requires that all events
which establish the fact of liability have occurred and that the amount of the deduction be
estimated with reasonable accuracy.
Example: An accrual-method taxpayer retains an attorney to assist in a corporate acquisition. The
taxpayer knows the attorneys hourly rate. Upon receiving an estimate of the hours worked by the
attorney on the acquisition, the corporation accrues a deduction for legal fees, even before being
billed by the attorney or paying for the legal services.
Ex: attorney example from before = if client is on accrual method = client can deduct cost when
you perform services



Expense is deductible for the tax year in which all the events have occurred which determine the fact of
liability, the amount of the liability can be determined with reasonable accuracy, and economic
performance has occurred with respect to the liability.
Match income with the expenses incurred in producing that income

What events establish a liability?
Most often accrues when taxpayer receives performances from another
Earlier of 1) the event fixing the liability (required performance or other event) or 2) payment is
due
Financial condition of taxpayer at time of accrual does not bar a deduction because the liability
turns on the fixing and not the payment
Doubt of payment is different from a contingency doubt of payment still entitles to deduction

Premature Accruals
If the related expenditure is so far away from the time the money is received then a deduction will
not be allowed. the longer the time, the less probable that the liability will ever in fact be paid.

2. The Economic Performance Test Section 461(h) [This test is formally applied
to deduction side but is helpful way to think of all events test on income side
too]
These rules reaffirm what the events rule is all about
o Economic performance of services: The taxpayer may accrue a deduction for services
only when the counterparty has provided services.
o Economic performance for transfers of property: The taxpayer may accrue a deduction
for property, e.g., goods or real estate, only when the counterparty has tendered the
goods.
o Economic performance for use (versus acquisition) of real property: The taxpayer may
accrue a deduction for the use of property only ratably during the use of the property.
Ex: rent property = accrue ratably (as you occupy/use property)
o Example about financial capital: As mentioned earlier, interest on financial capital
accrues ratably over the life of the loan. This is an example of the third rule from above,
i.e. the money is the property in question.
86
o
for there to be a current deduction, the liability must be fixed, the amount of the liability can be
determined with reasonable accuracy, and ECONOMIC PERFORMANCE MUST OCCUR
(current liability)
461(h)(2) establishes rules for determining when economic performance occurs
o Services economic performance occurs as services are provided
o Use of property economic performance occurs ratably over period the time the
taxpayer can use the property
o Recurring items deduction is avaliabl even though economic performance has yet to
occur but there are 4 statuory requiremetns that must be met (461(h)(3)
Capitalization
Contested Liabilites
o The taxpayer may not accrue a deduction with respect to any liability which she is
contesting.
If she pays the liability and goes on to contest the payment, she may accrue a
deduction.
This is the mirror-image rule of the rule discussed previously on the accrual of
income from a contested item.
Example: An accrual-based taxpayer, A, hires B as the general contractor on
the construction of an office building. When the building is completed, A is not
satisfied with Bs work and refuses to pay. A and B enter into negotiations. A
has not accrued a deduction until resolution of the conflict.
Example: An accrual-based taxpayer, A, hires B as the general contractor on
the construction of an office building. When the building is completed, A is not
satisfied with Bs work. Nevertheless, A pays Bs bill and sues him in court for
restitution and consequential damages. A has accrued a deduction for the
payment to B.

Contested liability rednders the liability contingent which prevents it from being fixed or established no
current year deduction

Contested liabilities accure at the earlier of payment of the liability or when the dispute is resolved.
o Accrual during a contest rquires that taxpayer transfer money or property in satisfaction of the
liability to someone or someplace that is beyond his control

D. Choice of Accounting Methods
446c taxpayer has a choice of accounting method and can select one method for one business and another
method for the other business. You could also use combo of methods within one business but there are
certain limitations.
1. Method of accounting chose must be one taxpayer uses to compute income in keeping book (if no
books or recrods are deemed on cash method)
2. Method must clearly reflect taxpayers income
3. Method must provide consistent treatment of income and deduction items from year to year and
once a method is chosen it cant be changed without commissioners consent
4. If inventory is involved, accrual is required for purchases and sales
5. C corps must use accrual.

To reiterate, whenever the IRS determines that the method of accounting used by a taxpayer
(including an accrual taxpayer) does not clearly reflect income, the IRS may direct the taxpayer to
use another, more accurate method to calculate the taxpayers income. (nothing individuals have to
worry about)
Schlude v. Commissioner (Supreme court 1963)

87
Facts: IRS included in gross income for 3 years amounts received or receivable under contracts executed
during those years even though under the contract performance would not be rendered until subsequent
periods. H&W formed Pshp to operate ballroom dancing studios pursuant to Arthur Murry Inc. franchise
agreements. Lessons could be paid under cash plan which required student to pay entire down payment in
cash at time of execution with balance due in installments or deferred payment contract which required
only a portion of payment to be paid in cvash.
o Under either contract: 1) student was required to pay tuition for lessons in certain amounts; 2)
student would not be relieved of obligation to pay tuition; 3) no refunds would be made; 4)
contract was not cancelable. Contract prescribed a specific number of lesson hours but did not
contain specific dates because they were arranged from time to time as lessons were given.
o They could pay in cash or finance
o A lot of different types of ks (5 classes 1200) = lifelong period
o Open ended schedule = students decided
o Would credit all of the k price to the deferred income account = then reduce it per year
for hours taught (also hours that expired) = this is legit in terms of accounting
o Studio has always been accrual method taxpayer If lessons werent used, they would write of part
of contract and treat it as income. comanySet up a deferred income account of 100k, which was
face value of contract. In companys mind only had income when they received cash or as time
passed, the recorded it as income when amoutns become day. For accounting purposes, it was fine
to keep the books this way but it was not ok for tax purposes (tax and gaap are different in their
notions of accrual method)
o we havent earned it yet = we have to have the performance before we report
o 4 ways of getting money
1. Cash
2. Negotiable note
3. Due & payable
4. Contractual obligation
Court said = dont have to include the balance (k to income is different from cash, loan, or earning)
AAA case = didnt know when cars would break down, etc.. = so you report when received
Could have made a fixed schedule to deduct when earned (like baseball team)
Issue: Did commissioner have discretion to reject studios accounting system and include in income
advance payments?
Rule: it is the right to receive and not the actual receipt that determins the inclusion of the amount in gross
income.
Holding: Affirm the inclusion in income of amounts representing cash receipts, notes received and contract
installments due and payable. Reverse the part of judgment that included amounts for services not
performed and that were not yet due or payable. There was no way of knowing about collectability of the
contract. Might have been different if there was a surety bond or collateral or something have that sort to
help assure collection.
o Studio sought to defer its cash receipts on basis of contracts that did not provide for lessons on
fixed dates after taxable year but left such dates to be arranged by the instructor and the student
regardless if the lessons ever occurred, the studio was still able to demand payments.
Furthermore, the studio could schedule classes at tax favorable times. Taxpayer couldnt predict
when the classes wwould occur so they couldnt wait to recognize like a baseball team.

88

Send questions by sunday
Review on Midterm Exam
Haig-Simon Definition of Income
o Generally permits fewer exclusions of economic income thn does title 26
o The def. generally captures a wider range of economic loass than title 26 allows to be
recognized when calculating 63 taxable income
o Adoption of haig simon would likely make title 26 more difficult
The borrower does not need to include the proceeds of a loan as statutory gross income only so
long as the borrower continues to pay interst on the loan = false (the premise is that you are going
to repay that money back with after tax proceeds)
If the borrower fails to repay a loan, then the borrower may have to recognize income & the lender
may be able to take a deduction (bad debt deductions) = true
Jane buys Greenacre for 100k. when property worth $50, she makes a 102 gift to Mark
Mark sells for 75k
o Loss: AB-AR [50-75 = no loss]
o Gain AR-AB [75-100 = no gain]
o You need to calculate a gain & a loss calculation
o = Twilight zone
The only situation where the IRS will raise objections based on assignment of income is when
there are two or more separate taxpayers. = false (one tax payers in between years)
Amy purchased depreciable property in 1998 for 300k, using 250k acquired in a loan secured by
the property & 50k in cash from her savings. In 1999, she invested 10k to renovate the property. In
2002, Amy took 20k in depreciation deductsion. As a result of the sale, amy will recognize a gain
equal to: [40k]
o 300k 310 ^250
o AR = 330
o Between 1998 & 2002, Amy took 20k in depreciation deductions = reduces basis by 20k
(290)^240
330-290=40k
Sam purchased an investment property with a loan of 200k secured by a mortgage on the property.
The property is also encumbered with a 20k second mortgage that sam took out a month ago to
pay off his student loans. Brad offers to buy the property from Sam by paying 30k cash &
assuming the two mortgages. At the time of the offer, Sam has taken 20k in depreciation
deductions, but he has not reduced the principal balance of the mortgages. The property is
appraised for 255k. If Sam accepts Brads offer, Sams gain or loss, if any, will be:
o (200k) = AB
o 30 = does NOT increase basis in property
o basis = 180 after 20k depreciation
o AR = 260
B purchased a boat worth 10k from sam. Sam allowed B to cover the cost by making annual
payments of 1k .. forgave his debt assume a gift has not been given:
o = statutory gross income because sam forgave a lawful debt
In future years, the taxpayer may be able to recover some trade or business exenses that are not
deductible in the current year? = true
Claim of right = have to have some time of legal title to it. (control, upon receipt)
In yr 1, M borrows 200k from the bank. Yr 2, she used some borrowed moneyt o buy a parcel of
land for 150k. between yr 1-4, the land rises in value. In year 5 m transfers the land to the bank to
completely satisfy the original loan. M is most likely to recognize the income when: [when is it
realized?]
o She obtained the loan from the bank = no
o She purchased the parcel of land = no
o As the land rose in value = no
89
o She transferred the land to the bank = yes
If paul makes a transfer of blackacre to carol that qualifies as a gift under 102(a). she includes the
gift in her 61 gross income and then deducts it when calculating her 63 income = false, never a
deduction = not factored in
In yr 1, june bought a vaca home for 300k, paying 50k in cash & 250k in loan. By the end of yr 5,
repaid 10k on loan, leaving the outstanding balance at 240k. over the same 5 yr period of time, the
property had increased in value by 30k even though june had made no improvements to it. What is
the basis in property at yr 6? = 300k
o (50)250 (50)240
a taxpayers effective rate of tax (dollar weighted average) will never exeed her highest marginal
rate? TRUE.
The following all happens the same tax year. Carlos buys 100 shares of acme stock for 100k. he
borrows 20k by pledging 10 shares as collateral. When the market value of the shares has risen to
200k, he sells 10 of 100 shares for 20k. what is his neg gain/loss on sale? = 10k in gain
The policy against the deductibility of personal expenses explains why a taxpayers expenses in
commuting to and from work may not be deducted. = false
Title 26 does not allow any personal expenses to be deducted for gross income = true