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Tax Outline

(Fall 2013 / Textbook: Bankman, Federal Income Taxation, 16th ed. 2012)
Introduction: Setting the Table
Tax Policy
Civilized society laws government(s) taxes (through either government spending or tax
breaks)
Size and structure of government is center of policy debate
Who gets taxed (people, corporations)
7/8 of tax revenue comes from individuals
1/8 of tax revenue comes from corporations
How much we tax
Consult table on p. 3 to see where federal revenue comes from
Tax base: thing that is taxed (income, property, sales, estates, consumption, wealth)
Tax Fraud
Tax gap = difference between the amount of taxes we would collect if people complied
perfectly with tax law and the amount of tax revenue generated in reality
Who is cheating on their taxes? Overall, US has high level of tax compliance.
Average person doesnt cheat. Employers have an incentive to accurately report how
much money you are getting paid because thats a deductible expense to them. That
means there is no much opportunity for individual to cheat.
Roughly half of the tax cheating comes from small businesses and self-employed people.
Particularly among cash businesses. Its a problem that arises from norm and opportunity,
not complexity of the tax code.
Large business dont cheat that much. Large businesses, by definition, have lots of people.
When you have lots of people in a business you have to keep track of cheating among
your employees. Largest businesses are under permanent audit. So it turns out tax gap is
not due to larger businesses.
Tax Incidence
Incidence of tax = who is really bearing the burden of the tax; who ends up with less money
in the bank as a result of it
Corporate income tax is collected from corporations, but the incidence of the tax is on
employees, shareholders, and suppliers
Tax expenditures vs. tax cuts
The same goal can be accomplished whether through tax expenditures or tax cuts
But politicians of course prefer to call something a tax cut than expenditure increase
Table 1-2: Housing ownership subsidies, pension subsidies & healthcare subsidies are the
largest tax expenditures
Tax Law -- Sources
Internal Revenue Code of 1986 (Title 26 of the US Code)
Note that whenever the Code says to the extent, that can be read as by the amount
Civil law
Goal is to try to make taxpayer and the Treasury whole
So tax evader will have to make up for underpayment as well as interest
Penalties may also be imposed, but that depends on how severe the evasion was
Criminal law
Criminal penalties rarely applied
Only apply where heightened mens rea is found (purposefulness w/o a reasonable belief that
what you are doing might be legal)
Treasury Regulations
Interpretive guidance
Fill in gaps in the Code
Not updated reliably
Revenue Rulings
Look and read like opinions, without the names of the taxpayers
Treasury can issue advisory opinions (unlike courts)
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Deference to these as well


Private Letter Rulings
Not binding
Essentially telling a taxpayer what to do in a certain situation, in response to taxpayer inquiry
Revenue Procedure
Where IRS has done the requisite calculations for you where they come up in the Code
Congressional intent very important (found in Committee reports)
Common law
Comes from administrative agencies primarily but also from courts
Most of the issues that arise are statutory interpretation issues
Substance dominates form = most important canon of interpretation
The rationale behind this canon is that it encourages taxpayer morale, which currently
favors paying taxes
Tax Law and Tax Policy Combined
Who loses when people dont pay their taxes or when a tax break is granted?
If you still want to collect as much money as the tax law should have collected, then the
losers are the people whose taxes go up.
If you instead reduce the governments activities (i.e. decide not to go after tax evaders and
simply accept a lower budget), then the beneficiaries of those activities are the losers.
If you do neither (neither collect taxes from other people nor reduce spending elsewhere in
the government), then the deficit rises.
Who loses then?
Future taxpayers if what this does is put higher tax liabilities on them.
People who had a good argument to increase the deficit lose. People who have an
argument as to what level of deficit is desirable lose in the sense that their proposed
deficit level is increased by whatever amount is lost through tax evasion.
Complexity, Congress, and the Code
Why is tax law so complicated?
Life is complicated. For example, we want to have this notion that it would be simpler if
everyone paid the same amount. Then you say well, theyre not all adults. So you leave out
the kids. Then you say not everyone has a job. So then you take out elderly and
unemployed. The list goes on. Congress looks at reality and reality is complicated.
People are highly motivated to reduce their tax burden. When you have several hundred
million people every year trying to figure out clever ways to reduce their tax burden, they
discover loopholes. Congress is always trying to play catch up to plug in those loopholes.
Congress is trying to seek political favor. Every single person has a special pleading.
Tax expenditures. Tax expenditures are ways to accomplish something such that we can label
them tax cuts. One of the reasons that tax expenditures became so popular is that, in
addition to the fact that they look like tax cuts, is that the Congressional committee system
encourages it. Passing a tax expenditure is easier than getting tax spending approved.
The IRS
A lot of public distrust of the IRS
RRA-98: Internal Revenue Restructuring and Reform Act of 1998
Congress wanted to rein in the purportedly out of control agency
Shifted burden of proof to IRS but kept burden of production on the tax payer
This was not such a big victory for anti-IRS people; burden of proof only matters where theres
an exact tie, and that pretty much never happens
Tax liability is based on preponderance of the evidence standard (50% + 1)
Two benefits from RRA-98:
Created Office of the Taxpayer Advocate. Responds to taxpayer complaints of IRS agent
abuse. Also conducts studies on general administration of the IRS, e.g. study during
George W. Bushs administration examining cost-benefit of outsourcing of tax collectors.
Created Treasury Inspector General for Tax Administration (TIGTA). Investigates potentially
over-the-line behavior of IRS employees.
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Tax Litigation
Very few tax controversies get litigated
Why? There are many opportunities to resolve the dispute before trial: letters, internal hearings,
offer-and-compromise process (where taxpayer gets to make an offer and IRS will consider and
maybe accept it)
Litigation forums:
COFC

Federal Circuit
SCOTUS

Federal
district court

Circuit court of
appeals

Taxcourt

When it comes to litigation, IRS may choose to acquiesce


Means IRS is not going to appeal a particular ruling but reserves the right to re-litigate the
issue when it comes up again
Legal Ethics and Tax Ethics
Evasion vs. Avoidance
If you decide its illegal, its called evasion
If you decide its legal, its called avoidance (its expected people will avoid paying taxes to
the extent that is legal)
Lawyers often try to sell strategies to clients that they claim will help clients minimize tax
liability
This can often subject lawyer to discipline for professional responsibility violations or to more
serious consequences
What can get lawyer disbarred: willful, reckless, or gross incompetence
In 1985 ABA opinion, the ABA says that a lawyer may assert a position in litigation if there
is some realistic possibility of success if the matter is litigated
Tax Protestors
Tax protestors argue that taxes are illegal for some reason or another and that they should not
have to pay them
Tax protests are completely baseless. They always lose.
On the other hand, liability only attaches to tax violations where heightened mens rea
requirement is met. If tax evader had sincere belief that the people who told you that you had no
income to report were telling the truth, then you are off the hook.
Frivolous Tax Arguments
861 position if you read sections 861 and 911 together, taxable income is only income earned
abroad
Response: taxable income includes income earned abroad, but not only income earned
abroad
Thirteenth Amendment argument income taxation is a form of slavery, which is forbidden by
the Thirteenth Amendment.
Sixteenth Amendment argument Sixteenth Amendment was never ratified
IRS is not actually a federal agency. Its a private collection agency for the twelve richest families
in the world.
Taxes are voluntary.
Response: Because we have high taxpayer morale we have high level of voluntary
compliance. It doesnt mean compliance is voluntary.
Average and Marginal Tax Rates
Average (effective) tax rate = tax paid / total income
Total income can be:
Gross income
Adjusted gross income
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Taxable income
Marginal tax rate = tax percentage paid on the next/last dollar of income
Next/last not the same thing, but often turns out to be the same thing
Zero bracket (ZB) = amount of income on which a taxpayer pays no income tax
It is possible to have a positive income and yet pay no income tax at the federal level b/c of
this zero bracket
Progressive rate
Rate rises as income rises
Federal tax system is designed to be progressive on its marginal rate and average tax rate
Regressive rate
Rate falls as income rises
Proportional rate
Rate is constant as income rises
Example: social security tax is proportional up to a certain threshold
Code 1 contains list of tax imposed depending on income
How to determine taxable income:
Taxable income = gross income zero bracket
Zero bracket = standard deduction + personal exemptions
Standard deduction = amount everyone is allowed to deduct (p 646 in textbook)
Personal exemptions = $3800
In a graduated bracket system (progressive marginal rates), you get an average rate that is
always lower than your marginal rate (unless its zero)
Example of calculating income tax:
Family of four. $420k in income.
Taxable income = $420k - $27,100 = $392,900
Tax owed = $105,062 + 0.35($392,900 $388,350) = $106,654.50
Average tax rate = $106,654.50 / $420,000 = 25.4%
Marginal tax rate = 35%

What is Income?
Some Characteristics of Income
Income is a flow variable
Flow variable can only be defined relative to the passage of time (e.g. $/year)
Wealth is a stock variable
Stock variable defined at a moment in time
Haig-Simons Definition
Y = fmvC + NW = consumption + savings
fmvC = fair market value of consumption
NW = change in net worth = change in persons property rights
Note that savings can be negative
The Code starts with the Haig-Simons definition of income, and then Congress whittles it down
Problems with applying Haig-Simons definition in real life:
Realization vs. accrual
An asset can grow in value, which increases individuals net wealth, but you dont
necessarily realize that growth in value (by turning it into cash), so taxpayer doesnt
necessarily have a greater ability to pay the tax.
In the real world, we use realization system. Taxpayer only gets taxed when he turns asset
into cash. Taxpayer can grow really wealthy but not have to pay tax on any of it (e.g. if he
holds stocks that grow tremendously in value).
Imputed income
Income through non-market transactions, e.g. enjoyment, growing your own vegetables,
cleaning your own home, stuff you do by yourself or stuff that has only a value to you
Example: You own your house fee simple. When you dont have to rent, that means you
dont have to pay rent money. So its rent-free living. Haig-Simons would say fair market
value of consumption how much would it have cost to rent your house in a fair market
transaction? So the proper definition of income would include imputed income from
owning a house.
Below market sales
People dont pay fair market value for everything. So income would be overstated when
taking into consideration those goods/services for which people paid below market prices
(e.g. in-state tuition).
Taxing leisure
Leisure time could be counted as income, and would be valued at its opportunity cost.
Valuation problems.
It can be hard to determine fair market value (what someone would pay in arms length
transaction) sometimes
Treasury Reg. 1.61-1: tells you what Code 1.61 says
Treasury Reg. 1.61-2(d): tells you how to value something in $ that was paid for not in $
If services were paid for with property use FMV of property
If services were paid for by some other means tax payer is allowed to estimate the
value of the services, and is given the benefit of the doubt with regard to that
estimation
Three sub silentio exceptions to income included under Haig-Simons/Code 61 (other exclusions
are explicitly written into the Code):
Imputed income doesnt get taxed
Some below market sales dont get taxed (e.g. in-state tuition)
Leisure
Policy goals in defining income:
Horizontal equity: Treat likes alike. If you have two people who are in other ways similar but
they receive their income in different forms, then we want to treat them the same.
Vertical equity: Those who have greater ability to pay should be taxed more than those who
have lesser ability to pay.
Old Colony Trust Co. v. Commissioner (US 1929)
Things that dont necessarily look like income are counted as income
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Income tax paid by employer directly to the IRS constitutes employees taxable
income
Facts: Employer paid the employees income taxes for the employee. IRS says that paying
of the income tax is itself income.
Held: This is equivalent to the taxpayer having received the money directly from the
employer and then using that money to pay the taxes. Simply because it came in a
different form doesnt change the substance.

Grossing up
Employer can pay employee more to compensate the employee for the income taxes that he
will ultimately have to pay
To determine how much gross income an employer will have to give an employee to make
sure that employee receives the agreed upon amount, use the following calculation:
G = N/(1-t)
Gross income = income before taxes
N = net pay = desired amount negotiated between employer/employee
t = tax rate
Example
Employee/employer agree that employee should ultimately get $80k/year. Tax rate is 20%.
How much should employer pay employee?
G = N/(1-t) = 80k/(1-0.2) = 80k/0.8 = $100k
Grossing up in the instance where grossing up would put employee in a new tax bracket
Example:
Lets say the boundary b/w the 20% and 25% tax bracket is $50,000.
Employee wants his net pay to be $48,000. G = 48k/(1-0.2) = $60k.
But once you gross up to $60k you are in the 25% bracket.
So then you do G = 48k/(1-0.25) = $64k.
Gross income should be somewhere in the range b/w $60k and $64k. You would need
Excel to get the precise answer.
Noncash Benefits
Code 161 specifically mentions fringe benefits that are to be included in income
Why do we tax noncash benefits?
Noncash benefits are included in income to promote horizontal equity. If employer pays one
employee $100k in cash and another employee in benefits worth $100k, then employees
should be treated the same.
Employers would be incentivized to pay their employees through noncash means
When noncash benefits are NOT included as income
Common law
When lodging and meals are provided for the convenience of the employer, they are not
considered income. The convenience of the employer test is not just for camps provided
by employers. Benaglia.
Burden of proof is on the taxpayer to prove that the meals/lodging were for the
convenience of the employer
Court in Benaglia turns positive, statutory law in a Reg into common law
Benaglia v. Commissioner (BTA 1937)
Facts: Husband and wife filed joint tax returns in 1933 and 1934. The husband works
as manager of two hotels and a golf club in Hawaii. Husband and wife are provided
lodging and meals at one of the hotels at which the husband is the manager. Husband
reported salary he received on his tax return but did not include the value of the
lodging and the meals. The Tax Commissioner served deficiency notice.
Held: Because the lodging and meals were provided for the convenience of the
employer, they need not be included as taxable income. Its convenient for his
employer to have Benaglia live and eat at the hotel because Benaglia needs to be
constantly available to respond to client requests.
Dissent:
Dissent argues that convenience of the employer test is faulty. It creates
horizontal inequity, by not treating likes alike.
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Even if we do apply the convenience of the employer test, meals/lodging here were
not provided for the convenience of the employer. Benaglia didnt live at all the
hotels he was managing and he took extended vacations away from the hotels/golf
club.
Valuation under Benaglia
If Benaglias had lost and were required to report the lodging/meals as income, how
should they value the lodging/meals?
It should be the fair market value of what they received (would require further
factual findings)
To calculate fmv, you would ask: how much would a horizontally equivalent person
have to pay in the same situation? The difficult thing is that there might not be any
such people.
Code 119 (p 119)
Meals and lodging can be excluded from gross income but only if . . .
In the case of meals, meals are furnished on the business premises
In the case of lodging, the employee is required to accept such lodging as a condition
of his employment
To determine if employee was required to accept lodging, court can look to
employment contract but doesnt necessarily have to believe what it says
119(b)(4) non-discrimination requirement
If you have a group of employees, and they get free meals on the business premises of
the employer, and you have determined that half of them or more are getting them for
the convenience of the employer, then the others get a free ride
119(d) exception (meaning value of the lodging DOES have to be included as income) for
those cases where lodging is furnished by an educational institution and the rent is
inadequate
Numerical example.
Appraised value of lodging = $300,000
Rent paid by the employee = $250/month = $3000/year
Rent paid by non-employees = $1000/month = $12,000/year
Section 119(d)(2): exclusion does not apply . . .
119(d)(2)(A): to the lesser of . . .
119(d)(2)(A)(i): 0.05*300000 = $15,000
119(d)(2)(A)(ii): $12,000
OVER
119(d)(2)(B): $3000
So you do have to include as income $12,000 - $3,000 = $9,000
Code 132 -- Fringe benefits that should not be included in gross income (even though they
technically fit under the Haig-Simons income definition)
Rules of general applicability to fringe benefits:
132(h) retired and disabled employees and surviving spouse of employee who died
while employed by employer is treated as employee
Non-discrimination rule ( 132(j)) Company can provide non-taxable fringe benefits
but only so long as it does so for pretty much every employee in the company and
doesnt just aim it at highly compensated executives
(1) No additional cost service
Situation where the employer is providing a service and providing it to the employees
doesnt cost the employer anything
Line of business requirement if employee doesnt work in the line of business from
which he is getting the benefit, then value of that benefit must be counted as income
Examples:
Usher at movie theater watches a movie that is already being shown for customers
Airline employees given empty seats on a flight
(2) Qualified employee discount, 132(c)
Employer can sell the employees goods at cost, but not for an actual loss
Line of business requirement if employee doesnt work in the line of business from
which he is getting the benefit, then value of that benefit must be counted as income
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Example: employee works for Proctor and Gamble. If P&G charges customers $5/quart
for Tide, but makes a $1 on each sale, then employee needs to only pay $4 and
doesnt have to include that extra $1 as income. However, if P&G only made 25 cents
for each $5 quart sold, and sold it to employee for $4, then employee would have to
include 75 cents as taxable income.
(3) Working condition fringe
Anything the employer could deduct from their taxes, the employee could deduct also
by not paying tax on that
Example:
Employer buys book that is relevant to the companys line of work. If employee
bought the book, that should not be included as income.
Employer gives employee money to buy something that, if the employer had
bought it himself, would have been able to be deducted from taxable income
(4) De minimis fringe, 132(e)
Something really small in value
No line of business requirement
Example:
If employee is provided with coffee and donuts at a work meeting, he need not
count it as income
If employer puts out a bowl of candy for employees to share, employee need not
count a piece of candy as income
NOT meals provided to airline employees on flights (though those qualify under
convenience of the employer exclusion)
(5) Qualified transportation fringe, 132(f)
Transportation stuff
There is a limit however to the amount of service that can be excluded
Example:
IRS Commissioner gets driven around in limousine. Does he have to include the
value? Yes. Limousine is not a commuter highway vehicle. Those are really only
shuttle vans running between remote employee parking lot and office building.
How much should the Commissioner include? Reg. 1.61-21 says to include the fair
market value. Reg. provides a safe harbor provision; fair market value can be
estimated as the amount paid by the employer to the employee. Even if thats
wrong, you wont get in trouble.
(6) Qualified moving expense reimbursement
If employer gives you money to help you move for job purposes, then it doesnt count
as income
Section 217 defines moving expenses
(7) Qualified retirement planning services
If employer plans 401(k) planning service fees to manage retirement fund, then you
dont have to count what employer has paid as employees income
Example:
If employer hosts a JP Morgan representative to talk about retirement planning
services, employee doesnt have to count that as income
Cafeteria Plans (Code 125)
Benefits that employer can make available to employees that are deductible from taxable
income
But if other employees dont want those benefits, they can take cash instead (which is
taxable)
Cafeteria plan benefits include things like group term life insurance, adoption assistance,
excludable accident insurance

So if the IRS determines that something is taxable, how should it be valued??


Do not determination valuation on subjective basis!!
Subjective valuation like this creates two problems:
Tax outcomes will differ on the basis of whim
People will create self-serving testimony as to what something is worth to them
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Turner v. Commissioner (TCM 1954)


Facts: Turners won on a radio show two round trip first class cruise tickets between NYC
and Buenos Aires. They paid $12.50 and traded the tickets in for four round trip tourist
class cruise tickets to Brazil. Turners reported $520 on their tax return as the value
they got from the tickets. IRS says they should have reported $2,220 because thats
the retail value of the tickets to Buenos Aires.
Held: Turners should have reported $1400. Court probably averaged Turners
estimation and IRS estimation of the value. Tickets werent worth full retail value
because this is not something Turners would have bought in the first place and tickets
were not salable.
McCoy v. Commissioner (1962)
Facts: taxpayer won a new Lincoln car in a sales contest. The cars cost to the
employer was more than half of the taxpayers income for the year, and he did not
own another car. He droves the Lincoln for ten days and then traded it in for a Ford
station wagon plus $1000 cash.
Held: the amount includible in income was $3900 (dealers price of station wagon
$2600 + $1000 cash taxpayer received + $300).
Better approach is objective!!
Rooney v. Commissioner (1988)
Facts: court required members of an accounting firm who had accepted payment in the
form of goods and services in payment of fees to include these items at their market
prices

Regulations and safe harbor provision relevant to chauffeur services, Reg. 1.61-21(b)(5)
The FMV of chauffeur services provided to the employee by the employer is the amount that an
individual would have to pay in an arms-length transaction to obtain comparable chauffeur
services
Safe harbor = FMV of the chauffeur services may be determined by reference to the
compensation received by the chauffeur from the employer

Unusual forms of income


Imputed income doing things for yourself, this stuff is not taxed
Property other than cash
Services
Psychic income and leisure
Other unusual forms of income where you get something from someone else this is taxed
Realization rule = dont have to worry about being taxed on imputed income until you sell it for
cash.
If you win prizes or have found items, must pay tax on them
Examples:
Professors get free books. Under Haig Simons, that would be income. But its not treated
as income unless its sold for cash.
Barry Bonds hit career home run. Mets fan catches it. Ends up being worth lots of money.
He sells it for hundreds of thousands. Must pay tax because value was realized.
When Oprah gave her audience guests a new car, she grossed up. She gave audience
members a car, cash to pay taxes on the car, and cash to pay taxes on the cash.
Revenue Ruling 79-24: bartered services are taxable as income. What should be counted as income
is fmv of the service.
Situation 1: painter paints lawyers house in exchange for legal services. Both must include the
value of the service received as income.
Situation 2: artist pays rent in the form of a painting. Artist must include value of rent in income
and landlord must include value of painting.
Presumption is that services being exchanged are of equal value
Commissioner v. Glenshaw Glass (US 1955) Income = undeniable accessions to wealth and
over which the taxpayers have complete dominion (must have full right). Income becomes
taxable when the accession to wealth is clearly realized.
Facts:
Glenshaw Glass.
What is the money at stake in the Glenshaw Glass case? Punitive damages for fraud and
antitrust. $325k for punitive damages and $475k was compensatory.
What does GG do on their taxes? They reported the compensatory but not the punitive.
IRS says GG should have reported whole $800k.
William Goldman.
WG got $125k in compensatory damages and $250k in punitive damages as the result of
an antitrust suit.
They reported the compensatory damages but not the punitive.
Held: Punitive damages must be included as income to awardee. Definition of income is very
broad. Punitive damages are included in that broad definition.
Gifts
Section 102(a): gross income does not include the value of property acquired by gift, bequest,
devise, or inheritance
So recipient doesnt have to pay tax on the gift, but giver cant deduct from income
Section 102(b): there are some things that might look like they would be excluded under 102(a)
but theyre not . . .
(1) Income from any property referred to in subsection (a)
Lets say that you receive as a gift 1000 shares of stock in Apple. 102(a) says that you
dont have to include the value of the 1000 shares as income. 102(b) says that when you
start receiving dividends on those shares, the dividends are taxable.
Note that where the donor gives the donee a gift of more than $14,000/year, the donor must pay
a gift tax
Section 102(c) per se rule employer to employee cant be a gift
Section 274(b) -- doesnt say that theres no business gift, but deduction of business gift is limited
to $25. So Berman can deduct the first $25 but has to pay tax on the rest of the gift. Note that
Berman would also have a $14000 gift tax liability.
Business gifts are something like gifts between partners at a law firm
10

Commissioner v. Duberstein (US 1960)


For a transfer to constitute a gift, it must proceed from a detached and disinterested
generosity and out of affection, respect, admiration, charity or like impulses. Its an
objective, totality of the circumstances test.
This was the only case thats ever dealt with the definition of a gift
Facts:
Commissioner v. Duberstein
Facts: Duberstein is president of Duberstein Iron & Metal Company located in Dayton,
Ohio. The company buys metals and forms them into products for sale. Duberstein
does business with Mohawk. Berman is president of Mohawk, located in New York. They
do regular business with each other. Duberstein refers Berman to some people who
might buy his products. Turns out to be lucrative. Berman gives Duberstein a Cadillac.
Duberstein says its a gift.
Held: Cadillac wasnt a gift; it was compensation for the referral. Berman deducted the
car as a business expense and claims it to be past consideration for the help
Duberstein gave him.
Stanton
Facts: Stanton was Comptroller of Trinity Church and was president of their subsidiary
corporation a real estate corporation. He worked at Trinity for 10 years but he
resigns. He resigns because the Board got rid of the Treasurer and Stanton disagreed
with that. So Board gave him $22,000 upon the resignation. They call it a gratuity
but they also call it for services rendered. So its kind of unclear whether its out of
gratitude or whether its delayed compensation. Stanton says its a gift.
Held: remanded because trial court didnt sufficiently explain why it reached the
conclusion that the $22k was a gift. On remand, court concludes again it was a gift.
Key points
SCOTUS rejects per se rule that no business related transfers could be a gift.
They reject Frankfurters rebuttable presumption that business related transfers are not
gifts
They reject common law definition of gift
Instead they give donors intent drives the result test
Standard on review of appeal of determination of whether something is a gift
Going to be slightly different depending on whether its jury trial or bench trial
Bench trial clearly erroneous
Jury trial reasonable men could not reach differing conclusions on the issue
Court is basically making sure nothing gets to the appellate level
Plus, intent is really subjective, its the type of call thats better for a trial court to make
United States v. Harris (7th Cir. 1991)
Facts: Conley and Harris are Kritziks companions. He gives them each over half a million dollars
over the course of several years. Theyre both charged and convicted of tax evasion.
Elements of criminal tax evasion: (1) the money was income, (2) D knew she had the duty to
pay taxes, and (3) she willfully failed to file.
Held: criminal convictions are reversed. Government failed to prove mens rea element of the
crime.
Dicta about gifts: its income only if each act of sex is paid for on an a la carte basis
If this had been a civil case . . .
And the government had lost, Conley and Harris wouldnt have had to report income but no
deduction for Kritzik because no deduction for personal services
And the government had won, Conley and Harris would have had to report income & Kritzik
would have gotten a deduction
If Kritzik was a business . . .
And the government had lost, Conley and Harris wouldnt have had to pay income tax and
Kritzik would have been able to deduct from his income $25 but any more than that would
have been taxable against Kritzik
And the government had won, Conley and Harris would have had to report payments as
taxable income but Kritzik could have deducted the full amount
11

Tips and Unusual Gifts


Tips
Reg. 1.61-2: Tips are income
The problem is enforcement. Its often done in cash.
Employer reports gross receipts to IRS. Then in addition they report the tips that were paid for
with credit cards. Employees are told to report at least 12% of gross receipts as income.
Unusual payments
United States v. McCormick: contributions received by a city clerk after marriage ceremonies
from bridegrooms who were fearful of being accused of stinginess were taxable
Olk v. United States: money given to craps dealer out of superstition in a casino by gamblers
is income. People are buying luck, not giving gift.
Welfare payments. Ruling says its not income at all. Thats not true, but it resolves the
question.
Social security treatment of social security benefits depends on taxpayers adjusted gross
income. As income rises, exclusion phases out.
Alimony vs. gift Alimony payments are deductible by the payor and taxable to the recipient.
Child support and property settlement payments are not deductible by the payor and are not
income to the payee.
Taft v. Bowers (US 1929) Recipient of non-cash gift should be taxed on realization of
increase in value even though part of that increase in value accrued before recipient
received the gift
Introduces idea of basis = price it was bought at only applies to property of some sort
Gift not in the form of cash
Facts: Ts father bought 100 shares of stock for $1,000 in 1916. In 1923, he transfers the shares
to Taft when FMV is $2,000. Later in 1923, she sells the shares for $5,000. Taft reported income of
$3,000, which is the amount that her net worth has gone up. IRS says Taft should have reported
$4,000 in income.
Issue: does she have to pay tax on $4000 or $3000?
Answer: she has to pay the tax on $4000.
Reasoning:
If you look at Sixteenth Amendment, theres no restriction as to whom the IRS can tax
Plus, this isnt such a horrible outcome for Taft.
She could have just turned down the gift.
She didnt have to pay tax on the $2000 gift when she received it in the first place, so be
happy.
Introduction to surrogate taxation
Carryover Basis / Substituted Basis (Code 1015)
Congressional response to the Taft case
Deals with the question of: what do you count as income when you get a non-cash gift and then
sell it? ONLY APPLIES TO GIFTS!!
To calculate how much you should tax, do the calculation: gain = proceeds adjusted basis
Proceeds FMV at transfer = gain
If this number is positive, then use the original purchase price instead of FMV at transfer.
If this number is negative, then count it as your loss.
If selling price is in between fmv at time of transfer and original purchase price, taxpayer
reports $0.
Examples
FMV at transfer = $1000. Original owner paid $1500. No other adjustments to basis.
Example 1. Recipient later sells for $800.
Gain = $800 -- $1000 = - $200
This loss is deducted from taxable income of the recipient
Example 2. Recipient later sells for $1600.
Gain = $1600 - $1000 = $600 because this number is positive, we must use original
purchase price
Gain = $1600 - $1500 = $100 gain
Example 3. Recipient sells for $1200.
12

Gain = $1200 -- $1000 = $200 because this number is positive, we must use original
purchase price
Gain = $1200 - $1500 = - $300 this is not right either because we end up with a loss.
So in this scenario, taxpayer declares no gain or loss. Taxpayer just reports $0.

Transfers at Death
Section 1014(a) taxing sale of property by heir that was passed to him/her by will or intestacy
When property is transferred at death, and then relative turns around and sells the property,
the basis is the value of the property on the date of death
Creates a lock in effect -- The older you are, and the more the property has appreciated, the
less likely it is that you will want to sell the property. You have a very good incentive to take
advantage of 1014(a)(1) for your heirs.
What an old person would prefer to do instead is to borrow against the shares loans are not
countable as income
Estate tax
You can give a total of $5.25m throughout life and at death without getting taxed
Only when the transfers amount to more than $5.25m does the estate have to pay a tax

13

Loans
Income to borrower
Loans do not count as income
Discharge of indebtedness does count as income
Borrower cannot deduct interest payments when
borrower is a corporation
Borrow can deduct interest payments when borrower
is an individual (only applies to specific types of
loans)

Income to lender
Repayment of principal does not count as income to
lender
Interest payments do count as income

Debt-equity distinction
Equity: ownership interest, where Party A gives money to be invested in a business enterprise,
in return for some of the profits; owning stock is a form of equity
Debt: loan from Party B to Party C where Party C agrees to pay specific amounts at specific
times
Company has to pay back loans before it pays shareholders
Bond is a type of loan, buyer of bond is lender and seller of bond is borrower
Structuring loans to make them less risky to lender:
Secured v. unsecured loans
Recourse v. non-recourse loans
Recourse loan: borrower is personally on the hook for what borrower said he would pay
Kirby Lumber plain vanilla DOI case
Discharge of indebtedness income is counted as taxable income.
Facts: Kirby Lumber decides that they need to raise money. They issue their own bonds worth
$12m in July 1923. Then Kirby Lumber re-purchases $1m in bonds for $862,000. So they
increased their net worth by $138,000.
Held: the $138,000 is taxable. There was a clearly realized accession to wealth. Accession was
realized in the year the debt was discharged.
Kerbaugh-Empire reference Court uses KE case to distinguish. But the problem is that KE isnt a
DOI income case at all. They borrowed 1 million reichsmarks and paid back 1 million reichsmarks.
Application of Kirby Lumber
When custodial parent gives up on trying to recover child support payments from noncustodial parent who refuses to pay, the deadbeat parent has DOI income.
The rationale is that wed at least rather have tax on DOI income than no child support
payments at all.
Code s 108
Exceptions categories of people who dont have to recognize DOI income as taxable income:
108(a)(1)A). When a taxpayer is declared bankrupt, any DOI income he has is not taxable.
108(a)(1)(B). When a taxpayer is insolvent, any DOI income he has is not taxable.
Definition of insolvent. 108(d).
When liabilities > assets. When net worth is negative.
Rationale = dont hit a person when hes down
108(a)(1)(C). Discharge occurs when indebtedness is qualified farm indebtedness.
Qualified farm indebtedness is defined in 108(g).
Qualified farm indebtedness = debt incurred in the operation of a farm by a person
who, during the three preceding taxable years, derived more than 50% of his or her
annual gross receipts from farming
Farmers dont have to be insolvent to get the exception. Congress loves farmers.
108(a)(1)(E). Discharge occurs when qualified principal residence indebtedness is discharged
before January 1, 2013.
So basically this helps people who were kicked out of their home during the recession.
Its not that helpful because people whos principal residence indebtedness is discharged
are also highly likely to be insolvent, so they wouldnt have to count DOI income under
108(a)(1)(B).
108(h) defines principal residence indebtedness.
14

108(e)(5). Purchase-money debt treated as price reduction.


Describes situation in which a person buys something from a company and the company
itself loans buyer money to buy the piece of property.
If that company later says you can stop paying us back now, for any reason, then rather
than treating that as DOI, well treat that as a purchase price adjustment. Both parties can
just treat it as if the purchase price adjustment was the original price the seller sold the
good for.
Example: Seller sells buyer couch for $1000 and gives buyer loan to buy the couch. Later,
seller agrees to accept only $732. We wont treat the balance as DOI income.
108(f). Student loans.
Excludes from income any cancellation or repayment of a student loan, provided the
cancellation or repayment is contingent upon work for a charitable or educational
institution

Zarin v. Commissioner (3d Cir. 1990)


Buchanan thinks the court came out wrong on this one. Professor thinks this is a DOI case, and
Zarin should be taxed. This case is mostly not good law anymore.
Facts: Zarin is a huge gambler. Resorts casino was extending him credit in violation of New Jersey
regulations. Eventually Zarin racks up $3.435m in debt. He promises to pay Resorts back. He
doesnt, so Resorts sues. They settle for $500k. Tax Commissioner goes after Zarin seeking tax on
the $2.935m balance as DOI income.
Held: Zarin doesnt have to pay tax.
This isnt DOI income because Zarin wasnt indebted to Resorts.
Definition of indebtedness requires that (1) the debt be enforceable against Zarin, or
that (2) Zarin hold property subject to the loan. Buchanan thinks using this definition of
indebtedness is wrong because indebtedness was only meant to apply to the section in
which it was defined, not to 61.
First of all, the debt against Zarin isnt enforceable because he was extended the credit
in violation of the state regulations.
Second of all, Zarin did not hold property subject to the indebtedness because the
chips arent property. They are owned by the casino and arent worth anything. Even if
this definition were right for the purposes of defining income, the chips should be
considered property.
DOI income is the wrong way to conceptualize this issue. This is CONTESTED LIABILITY or
DISPUTED DEBT.
Under the doctrine of contested liability, if a taxpayer, in good faith, disputed the
amount of a debt, a subsequent settlement of the dispute would be treated as the
amount of debt cognizable for tax purposes.
So the amount of debt that Zarin owed Resorts was $500k and he paid that all back.
This is wrong because contested liability doctrine applied only where there is an
unliquidated debt a debt for which the amount cannot be determined. Here, we know
exactly how much Zarin borrowed and how much he promised to pay back.
CONTESTED LIABILITY only comes up where there is a dispute over how much is
owed or if the lender doesnt have a clear right to getting the property back or if
there is a dispute about liability.
Code s 165(d) Gambling
1.165-10: You pay taxes on net winnings (H-S income), but you cannot deduct net losses
You can only use losses to offset winnings (if total gains exceed total losses, deduct losses to
offset gain, report rest as TI), however you cannot make deductions for additional losses (zero
sum gain)
The IRS has ruled on comps and the Tax Court has said the taxpayer can offset
the comps as if they are winnings from gambling.
Comps are considered gambling income.
Gambling income can be offset by gambling losses.
AND, winnings before New Years Eve cannot be offset by losses after New Years Eve
losses can be offset, but only in the taxable year
Gain on Home Sales
15

If you have loss on sale of home, you are not allowed to deduct that loss.
121 excludes gain on sale of home from taxable income
A single taxpayer gets to exclude $250k or less
A married couple gets to exclude $500k or less
Any amount of gain over and above the exclusion limit is taxed at a capital gains rate

Qualifications for single taxpayer


Single taxpayer gets $250k exclusion if, for at least
two out of the past five years, taxpayer:
Owned the home
Used the home as taxpayers principal residence
Not gotten the exclusion during the two year
period prior to the sale of the home

Qualifications for married taxpayer


Married couple gets $500k exclusion if, for at least
two of past five years,:
Either spouse has owned the home for at least
two of the past five years
Both spouses have used the home as their
principal residence for two of the past five years
Neither spouse must have gotten the exclusion
within the past two years

If a taxpayer doesnt qualify for the exclusion because of the use, ownership, or timing
requirements, the taxpayer can still exclude some of the gain if the reason he or she is selling the
house is because of:
Change in place of employment
Health
Unforeseen circumstances
Examples:
Blended family moves to childrens school district
Adult child moves in with parents
Taxpayer adopted kids and wants to get bigger house
Disabled parent moves in with taxpayer and taxpayer must buy different house as a
result
Aircraft noise
Child assault on school bus, so family moves to new school district
DEA (narcotics) agent threatened by drug lord and has to move
How much can taxpayer exclude if he doesnt qualify for the full exclusion but falls into one of the
special categories (health, change in place of employment, unforeseen circumstances)?
(no. of months since TP used exclusion/24 months)*(total amount of exclusion for which TP
would normally be eligible) = $ amount
Example:
Wife lived in House A from 2009 to 2010. Husband lived in House B from 2009 to 2012. Wife
lived in House B from 2010 to 2012. Wife sells House A on July 1, 2011 for $450k gain and
uses the exclusion to exclude $250k from taxable income. Husband gets sick and Husband
and Wife sell House B on January 1, 2013 for $500k gain. How much can they exclude?
Answer:
Husband gets $250k exclusion because he has not used the exclusion in the past two years,
and he owned and lived in the home for the past three years.
Wife used the exclusion 18 months ago when she sold House A, so she gets to exclude
(250,000)*(18/24) = $187,500.
Together they can exclude $250,000 + $187,500 = $437,500. The remainder of the gain
($62,500) is taxed at capital gains rate.

16

When Is Income Taxable?


Depreciation
Tangible/real property assets bought by a business depreciate over time and that depreciation
can be deducted from taxable income
Two ways to calculate depreciation:
Straight-line method
(Initial cost salvage value) / useful life = annual deduction
or cost recovery
Example: Original purchase price was $10,000. Useful life is
10 years.
(10,000 0) / 10 = $1000 every year for 10 years the
business can reduce profits by $1000

Double declining balance method


A lot of depreciation in the beginning of the assets usefu
life and then a switch to straight-line method when the
point is reached where the straight-line amount exceeds
the declining balance amount
Example: Original purchase price was $10,000. Useful life
10 years. Declining balance factor is 200%.
First year deduction = $2000 (straight-line method
deduction x 2)
That means asset is now valued at $8000.
Second year deduction = $1600 (20% of $8000)
That means asset is not valued at $6400.
Third year deduction = $1280 (20% of $6400)
That means asset is now valued at $5120
Fourth year deduction = $1024 (20% of $5120)
That means asset is now valued at $4096
Fifth year deduction = $819.20
That means asset is not valued at $3276.80

Etc. But revert to using straightline method when


straightline depreciation amount exceeds declining balan
amount.

Salvage value default = $0


Useful life of an asset found in Code 168(e), p 193 of supplement
Three year property
Five year property
Seven year property
Ten year property
Fifteen year property
Twenty year property
When you sell a piece of property that youve been depreciating, count as income the sale price
depreciated value (not the entire sales price!!)

Summary of Annual Accounting Issues (material below)


Big picture:
We have annual accounting system
No negative tax refundability
Because of these things, Congress goes around trying to fix inequities that result
Under the claim of right doctrine (date rule), we have two prong test:
You pay taxes in the year in which the second of the two prongs: (1) taxpayer becomes
entitled to the money and (2) taxpayer actually receives the money.
Inequities that flow from the claim of right doctrine
Three possible situations:
Loss in earlier year, income in later year (Sanford & Brooks situation)
Congressional response = Section 172 net operating losses
Income in earlier year, loss in later year (Lewis)
Congressional response = Section 1341, gives taxpayer a windfall
Deduction in earlier year, restoration in later year
17

Section 111 (the tax benefit rule), which is limited to situation where TP got literally no
tax benefit in the earlier year

18

NAO v. Burnet (US 1932)


Money should be counted as income in the year in which the taxpayer has a CLAIM OF
RIGHT to the money.
Taxpayer has claim of right when (1) you have legal entitlement to money and (2) you
actually receive the money. Both prongs have to be met.
In this case, that was the year district court issued final decree.
If a taxpayer receives earnings under a claim of right and without restriction as to its
disposition, he has received income which he is required to 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
Background: 1916 corporate income tax rate 2%, 1917 corporate income tax rate 6% plus an
excess profits tax from 20 60%, 1922 corporate income tax rate 12.5%
Facts:
NAO leases government property. Government sues for ouster. While that case is being
settled, court sets up receiver to manage the property. Receiver gets paid $172k in 1917 for
the work done by NAO in 1916. In 1922, ouster case gets dismissed. NAO wants to count
money as income either in 1916 or in 1922 and IRS wants to count the money as income in
1917 because thats when it was paid.
Held: Money should be counted as 1917 income. That is when the district court issued its final
decree.
Repercussions from annual accounting system:

Loss in Earlier Year, Income in Later Year


Congressional response
Sanford & Brooks
Net operating losses (NOLs), 172
We use an annual accounting system, not a Congressional response to S&B now you can us
transactional accounting system. So when
some of the net operating losses incurred in one
TP has loss in earlier year and income in
year to reduce net income in another year
later year, all stemming from the same
NOLS = negative profits = when expenses >
transaction, TP still has to pay tax on the
revenue
later income.
Only applies to NOLs, not:
Facts: S&B was subcontractor for a dredging
Capital losses (e.g. depreciation, loss
project. In years 1913, 1915, 1916 they declared
incurred from selling an asset for less than
net loss. In 1914 they declared net income. In
you bought it for)
1915, S&B abandoned work on the project and
Personal exemptions. 172(d)(3).
sued for compensatory damages. In 1920, S&B
Nonbusiness deductions. 172(d)(4).
gets damages for doing the work they werent
Under 172(b)(2), you have a choice about how t
paid for. S&B says they shouldnt be taxed on
transfer your net operating losses to another yea
the compensatory damages because overall the
Apply them to income return from two years
project was not profitable. IRS says they
ago and then, if you still have NOLS, apply
recognized income in the year 1920.
them to return from last year, and then, if you
Held: S&B must recognize the damages as
still have NOLS, apply them forward for the
income in the year 1920. So there were some
subsequent twenty years, OR
years that S&B didnt have to pay income tax
Forget about the past and just go forward
(the years with net loss) and in 1920 S&B does
Example.
have to pay income tax, even though if we used
In 2012, Bob earns salary of $60k. He had
a transactional accounting system, they wouldnt
deduction for personal exemptions of $4000
have had to pay tax.
and itemized nonbusiness deductions of
$16000, so taxable income was $40k.
In 2013, Bob earns salary of $60k. Suffers
ordinary loss of $80k from wholly owned
business. His deduction for personal
exemptions was $6000 and nonbusiness
deductions were $15k.
How come loss can Bob carry back to 2012?
Bob cant carry over personal exemptions
and nonbusiness deductions.
So the only thing he can carry over is $60
Case law

19

20

-- $80k = $20k.
So 2012 income can be reduced by $20k.

Income in Earlier Year, Loss in Later Year


Congressional Response
Claim of right/Lewis
Congressional response to Lewis:
Facts: Mr. Lewis receives $22,000 bonus in 1944.
1341(a) income in earlier year, loss in later
He uses it as his own, in good faith though
year
mistaken belief, that that was a bonus that he
Taxpayer gets to deduct the amount of tax
had earned. Then two years later his employer
they paid in the prior year
says that they meant to only have given him a
However, if this years tax rate is higher than
$11,000 bonus. So they want $11,000 back. So
the previous year, then you get to use this
then he wants to deduct the money by amending
years tax rate when calculating how much to
1944. IRS says he should deduct the $11,000
deduct from this years income.
from his 1946 return.
Example.
Held: Lewis should deduct from his 1946 return.
Two years ago I earned $5000 of income
Lewis had a claim of right to that money in 1944
and today I lost that because it wasnt
so it was properly counted as income in that
owed to me. Two years ago, the tax rate
year.
was 10%, so I owed $500 worth of tax.
Today the tax rate is 15%. Because the ta
rate today is higher than it was at the tim
I counted the money as income, I can
deduct 15% of the original amount ($750
rather than $500.
Case Law

1341(b)
If you embezzle money, you have to pay taxe
on that income.
However, if its found out that you embezzled
and have to pay the money back, you cant
take advantage of 1341 or 172 (NOLs)

Deduction in Earlier Year, Restoration in Later Year


Case Law
Congressional Response
N/A we didnt read a case for this
Tax benefit rule, 111
Deduction in later year, restoration in earlier year
Must include the value of the restoration in your
current income
Exclusionary aspect
If, in the year you took the deduction, you
were already in the zero bracket or it put
you in the zero bracket, then you dont hav
to include it as income in the year it is
restored
If the deduction created a NOL, then you
have to include the restoration in the later
year
Inclusionary aspect
If its unclear, upon restoration, what the
value of the restored income is, then you
can just include the same value you used
when you took the deduction earlier
Alice Phelan Sullivan Corp. v. United States
Taxpayer made a charitable gift of
property and calimed a charitable
deduction. Nearly twenty years later, th
charity decided not to use the property
and return it to the taxpayer. The
recovery was held to generate taxable
income in the amount of the earlier
21

deduction as opposed to the value of th


property in the year in which it was
returned.

Eisner v. Macomber (US 1920) for income to be taxable, the income must be realized.
Stock dividends are not realized gain to taxpayer.
Buchanan says that the governments arguments are right given the law at the time. The
Supreme Court gets it wrong here.
Facts: Macomber is a stockholder. She owns 2200 shares of stock in Standard Oil. In 1916,
company issues stock dividends. So Macomber receives an additional 1100 shares. She now has
a total of 3300 shares. Because par value of the stock is $100/share, it looks like she has received
income of $110,000, but the market value of the total number of stocks she owns has remained
the same. IRS argues the stock dividend was income and the issuance constitutes a realization
event.
Held: the issuance of the stock dividend was not a realization event.
Governments arguments:
(1) stock dividend is income. The law at the time explicitly said that a stock dividend is
income. Court says the statute is unconstitutional and that a stock dividend is not income.
While its true that a stock dividend is not income, the way the court got to that conclusion
made a big mess.
(2) issuance of stock dividends is a realization event. Buchanan thinks Brandeis dissent
got it right: substance dominates form. Giving Macomber the stock dividend would be the
same as her selling her shares back to Standard Oil, the company giving her money, and
then she buys the shares herself. In that scenario, the purchase of the stocks would be
counted as income, so the equivalent should be counted as income.
(3) the time at which the stock dividends are issued is no worse a time than any other
time to tax the income. Macomber had been getting a free ride for years, so that should
come to an end.
Aftermath of Macomber
Congress put realization requirement into section 1001 of the Tax Code
Exactly as Macomber is saying, when you have a disposition of property, any excess that is
realized will be counted as realized and any loss that is realized will be counted as a loss
Bruun v. Helvering (US 1940)
Realization events are not limited to cash exchanges.
Gain may occur as a result of (1) exchange of property, (2) payment of the taxpayers
indebtedness, (3) relief from a liability, or (4) other profit realized from the completion of
a transaction
Court limits Macomber severability and detachable language so that it only applies
to stock dividends. Bruun narrows Macomber.
Facts: Bruun leases building in 1959 with a 99 year lease. In 1929 lessor builds a new structure on
the property that increases the value of the property $50k. In 1933, lessor defaults on the lease
payments and the property gets return to Bruun. IRS says Bruun has realized income in the year
1933 in the amount of $50k because of the improvements on his property.
Held: this was a realization event, so Bruun recognized income in 1933.
Court limits the Macomber opinion to its facts. In Macomber the court seemed to say that for
realization event to occur, the income must be severable or detachable. The court says
that requirement only applies to stock dividends.
Bruun Aftermath
Section 109 = future Bruuns do not have realization events. Where a lessee makes improvements
(some kind of structure or something attached to the land) upon a property and then defaults on
the payments with the result that the more-valuable property goes back to the lessor, the lessor
does NOT have to recognize income.
Stock dividends are still not income.

22

Section 1019 = if/when lessor sells the improved property, the basis is the value of the old
land/building, not the value of the land/building with improvements. The IRS wants to tax every
dollar of gain that the lessor got.
Whether you apply Bruun framework of 109/1019 framework, the ultimate amount subject to
income tax is the same:
In 1933, lessor gets property back with $50k in improvements. Hes able to rent the property out at
$7k per year.
Bruun
$50k realization event in 1933
$7k income per year for 10 years but with
depreciation deduction each year of $5k (so $20k in
income over the course of ten years)
Total income of $70k

109/1019
No realization event in 1933
$7k income per year for 10 years ($70k total in rent
income)
Total income of $70k

Note 3, p 211
Reg. 1.61-8(c) says that if building is basically a substitute for rent (determined by the facts and
circumstances), then the building will be counted as income
If IRS thinks this is happening, then IRS would determine what the rental rate would be for a
property like this, and then charge it as income to the taxpayer.
Woodsam
There are some transactions that are not realization events. Change from recourse to
nonrecourse mortgage is one of them.
For a sale or disposition of property to count as a realization event, someone has to give
up ownership of something; there must be a relinquishment
The borrowings did not change the basis of the property for the computation of gain or
loss
Facts:
In 1922, Mrs. Wood bought a piece of property for $296,400
Mrs. Wood was personally liable for the mortgage she owed on that property (recourse
mortgage liability)
In 1931, she re-mortgaged and consolidated the mortgages into a $400k nonrecourse
mortgage meaning she was not personally liable for the mortgage
In 1933, she defaults on the loan. The mortgage lender takes possession of the property and
cancels the mortgage. The mortgage balance by that point was $381,000.
IRS argues that Wood should have to recognize DOI income in the amount of the loan
cancelled.
Wood argues that she should have been taxed when the loan was converted from a recourse
to a nonrecourse mortgage because that was tantamount to a disposition of the property
since legal entitlement to the property was transferred to the bank should she default. So in
1931, she should have been taxed on more than $100k gain, but SOL has run to tax that
income. Because IRS didnt tax at that point, basis became $400k and her corporation
suffered $19,000 loss when the property was sold for $381,000.
Held: Change in the type of loan from recourse to nonrecourse is not a realization event. There
was no relinquishment of the property after the 1931 refinancing event.
Savings and Loans Crisis
S&L companies were depository institutions for the personal side of banking
Individuals would deposit their money into S&Ls and take mortgages out of S&Ls
The way the S&Ls would make money would be to charge a higher percentage rate on the
mortgages they loaned out than the percentage rate that the S&L paid out on deposits
The S&L balance sheet looked like this:
Assets
Cash
Mortgages issued (issued at 7% interest
rate)

Liabilities
Deposits (generating 5% interest/yr)

23

Net worth = assets liabilities


In the 1970s, there was huge inflation; inflation was higher than the amount an individual could
get from depositing money in an S&L
Regulators did not allow the S&L companies to raise the deposit interest rates, so depositers
started to take their deposits out either b/c they wanted to spend it before inflation devalued
their money even more or b/c they wanted to invest abroad and getting higher interest rates.
Another effect of the inflation was that the mortgage portfolios held by the S&Ls went down in
value
The mortgages are set at a fixed interest rate
But when interest rates in the rest of the economy go up, the mortgage portfolios are less
valuable; their net worth in fact was negative
Regulators had to decide what to do to avoid shutting down all these insolvent S&Ls that were too
big to fail
So they allowed the S&Ls to invest in junk bonds (investments that were very risky but
potentially high pay-offs)
The junk bonds didnt get the return the S&Ls hoped, so eventually the government had to do a
bail out of the S&L industry
Cottage Savings case comes at the end of the S&L crisis
Cottage Savings, p 216
If there are distinct legal entitlements in the two pieces of property being exchanged,
then the property is materially different and a realization event has occurred.
Distinct legal entitlements exist where the property is different in either kind or
extent
Mortgage portfolios exchanged were materially different so S&Ls can deduct losses from
income.
Dissent: material difference exists where it influences a decision.
Buchanan thinks the majority got it wrong here and that the dissent (Blackmun and White) got it
right. Majority essentially approves form dominating substance
Facts:
Federal Home Loan Bank Board is an agency that promulgates savings & loans regulations. In
addition, it goes to every S&L, asks for its balance sheet, and looks to see whether net worth
is positive. If its not, it shuts the S&L down.
Because every S&L is insolvent due to the S&L crisis, the Board comes up with a solution
Memorandum R-49.
Memorandum R-49 says that S&Ls do not have to report losses on their book for
mortgages that are exchanged for substantially identical mortgages held by other
lenders. But it does allow the S&Ls to report the difference b/w the market value and face
value of the exchanged mortgages as a loss for income tax purposes.
Mortgages are substantially identical where they meet 10 criteria (FN 3, p 217). The
point is to make sure that no investor would notice the difference b/w one mortgage
portfolio and another.
To take advantage of Memorandum R-49, Cottage Savings sold 252 mortgages and then
simultaneously bought 305 mortgages. The mortgages are for houses in the Cincinnati area.
Issue: does a realization event occur when Cottage Savings exchanges its mortgage portfolio for
one that is substantially identical and therefore allow Cottage Savings to recognize taxdeductible losses?
Answer: yes.
To determine whether non-cash sale is a realization event, court asks two questions:
(1) does the realization principle under s 1001(a) require that property disposed of be
materially different?
(2) are the mortgage portfolios exchanged b/w the S&L companies materially different?
Under first prong, Treas. Reg. 1.1001-1 clearly says that for a realization event to occur, the
property exchanged must be materially different, the answer is clear. Its been around so
long that Congress has passively approved it.
Under the second prong, court says there is a material difference in these mortgage
portfolios. Buchanan thinks theres no difference.
24

IRS test for material difference: look to the attitudes of the parties, how the market treats
the property, the views of the relevant regulatory agency. Court thinks this test is too
subjective and un-workable. Buchanan thinks the test is workable in these circumstsances.
Courts test is whether the respective possessors enjoy legal entitlements that are
different in kind or extent by virtue of the exchange.
Court says that if you adopted IRS position that there can only be a meaningful
difference if theyre different in a way that an investor would care about then that would
render the like-kind doctrine unnecessary.
o Buchanans two responses:
Thats wrong. If you think about what LKE doctrine encompasses, LKE would
clearly expand what the IRS is trying to get at here.
It is an example of where the court is reading into the Tax Code a
requirement that there not be surplusage. We know thats not true in the
Tax Code; the Tax Code is very repetitive.
o The court gives no reason as to why the word material doesnt mean anything in
the phrase material difference

Applying Cottage Savings


Problem 1, page 226.
Jim and Barbara are cotton dealers. They have each deposited 1000 bales of cotton into
warehouse. Basis = $100k. Current fmv = $60k. So they each have unrealized loss of $40k. They
want to exchange cotton to realize their losses.
If cotton is just dumped into the warehouse without
segregation . . .
Exchanging pieces of paper indicating ownership of
cotton does nothing. No realization event. Jim and
Barbara cant recognize losses.

If cotton is kept segregated in warehouse according


to who owns it . . .
Exchanging pieces of paper indicating ownership is
realization event. Jim and Barbara can recognize
losses.

Cottage Savings makes the second scenario look different, and because of that we waste
economic resources (someone has to segregate the cotton).
Problem 2, page 226.
Machorari cars. Get sent to dealers. Dealers customize the cars for their ultimate clients. Susan is
in New York City and she owns Streaker #13. Josh is in Miami and he owns Streaker #14. Upon
delivery, Susan gets #14 and Josh gets #13 by accident.
Each have a basis of $500k because thats who much they paid upon delivery. The FMV of the
cars is $750k.
If they ship each other the cars
No realization event

If they exchange ownership papers


Realization event! They have exchanged property
with distinct legal entitlements. Susan and Josh hav
to recognize gains.

To avoid recognizing gains, Josh and Susan will have to do the more expensive thing!
Non-recognition and like-kind exchanges
Non-recognition rules are those where you have realized gains but Congress says you dont have
to recognize them until later
Theyre transfers of property that should be income and should be realized, but Congress says
theyre not
Rationale behind non-recognition rules:
Gain should not be recognized if the transaction does not generate cash with which to pay the
tax
Gain or loss should not be recognized if the transaction is one in which the gain or loss is or
might be difficult to measure valuable problems

25

Gain or loss should not be recognized if the nature of the taxpayers investment does not
significantly change (as long as TP is doing the same type of business as he was before the
exchange, gain or loss shouldnt be recognized)
Gain should not be recognized in order to avoid discouraging mobility of capital
Like-kind exchanges are the most prominent kind of non-recognition events
Like-kind exchanges
Original purpose = allow farmers to trade farm lands
Section 1013: if you have two businesses that have similar types of property (held for
productive use in a trade or business or for investment) and they want to exchange them,
thats a realization event but it doesnt have to be recognized for tax purposes in the year of
the exchange
Exceptions!! (times when similar property is exchanged and the gain/loss DOES have to be
recognized; excepting out property thats not real property):
Exchange of:
Stock in trade or other property held primarily for sale (inventory)
Stocks, bonds, or notes
Other securities or evidences of indebtedness or interest
Interests in a partnership
Examples are these exchanges taxable? Page 229
Stock for stock falls within exception, so exchange is taxable.
Farm held for investment for another farm not taxable, so long as the second farm was
also held for productive use or for investment.
TP sells farm, gets cash, uses cash to buy another farm taxable, this is a normal
purchase not a like kind exchange.
Farm for fleet of tractors taxable, not a like-kind exchange.

Defining like-kind exchanges


What makes something like kind is the nature or character of the property and not its grade or
quality. Reg. 1.1031(a)-1(b).
Examples: super high-end wool is the same as low-end wool to be used as pillow filler. Land
exchanged with skyscraper is same as land with nothing on it.
Reg. 1.1031(a)-1(c) examples of like kind exchanges:
Truck for a new truck
Passenger automobile for a new passenger automobile to be used for a like purpose
Taxpayer who is not a dealer in real estate exchanges city real estate for a ranch or farm
Taxpayer who is not a dealer in real estate changes a leasehold of a fee with 30 years or more
to run for real estate
Taxpayer who is not a dealer in real estate exchanges improved real estate for unimproved
real estate
Taxpayer exchanges investment property and cash for investment property of a like kind
In general, assets are of like kind if they are in the same asset class. Reg. 1.1031(a)-2.
Asset classes, supplement p 630:
Office furniture, fixtures, and equipment
Information systems (computers and peripheral equipment)
Data handling equipment, except computers
Airplanes, except those used in commercial or contracting carrying of passengers or
freight, and all helicopters
Automobiles, taxis
Buses
Light general purposes trucks
Heavy general purpose trucks
Railroad cars and locomotives, except those owned by railroad transportation companies
Tractor units for use over the road
Trailers and trailer mounted containers
Vessels, barges, tugs, and similar water-transportation equipment, except those used in
marine construction
Industrial steam en electric generation and/or distribution systems
26

Boot
Boot = cash and non-like-kind property
Recognizing gain/loss in the year of the transaction
NO BOOT
You dont have to recognize a gain or loss in the year of the transaction, except under certain
circumstances:
Stock in trade or other property held primarily for sale (inventory)
Stocks, bonds, or notes
Other securities or evidences of indebtedness or interest
Interests in a partnership
THERE IS BOOT
TP gains from the exchange (fmv of what TP got > basis in property TP gave away), then the
amount of gain TP must recognize is lesser of the amount of gain realized or the amount of
the boot. 1031(b).
TP loses from the exchange (fmv of what TP got < basis in property TP gave away), then TP
reports $0.
Since most of the time you want to recognize losses, youd be better off selling the
property for a loss than exchanging the property for a loss.
Example 1. Example of 1031(b) where gain > boot.
TP gives up property with basis of $10k. In exchange, she gets property with fmv of $100k,
cash of $15k, and tractor worth $8k.
Boot = $15k + $8k = $23k.
Proceeds from sale are $123k.
Her gain is $123k - $10k = $113k.
She only has to recognize the lesser of the amount of the gain ($113k) or the amount of the
boot ($23k). So her recognized gain is going to be $23k.
Example 2. Example of 1031(b) where gain < boot.
TP gives up property with basis of $110k. In exchange, she gets property with fmv of $100k,
cash of $15k, and tractor worth $8k.
Boot = $23k.
Proceeds from sale = $123k.
Gain = $123k - $110k = $13k.
She has to recognize gain of $13k.
Example 3. Example of 1031(c).
TP gives up property with basis of $130k. In exchange, she gets property with fmv of $100k,
cash of $15k, and tractor worth $8k.
Boot = $23k.
Proceeds from sale = 100k + 15k +8k = $123k.
Loss from sale = $7k.
So she has $0 in gain/loss to report.

27

Basis
So when you ultimately go to sell the property you just got in the exchange what should you use
as your basis?
When theres no boot at all the basis for the property received will be the same as the basis of
the property relinquished
When there is boot
(A + B) D = E = substituted basis of the like-kind property received
A = original basis of the property you just traded away
B = amount of gain recognized = tax consequence today
Gain realized = proceeds basis in property traded away
If positive use that number for gain recognized
If negative use 0 for gain recognized
D = fair market value of the boot (this is positive if you got boot or negative if you gave it
away)
Example 1 (gain to TP from transaction):
TP has basis in farm X of $10,000. She trades for farm Y, which has fmv of $100k, and boot of
$15k. Original owner of Y farm has basis of $50k.
So that means farm X must have fmv of $115k.
How much should TP getting farm Y recognize in gain
in the year of the transaction?

How much should TP getting farm X recognize in ga


in the year of the transaction?

Gain recognized is the lesser of the amount of gain


realized or the amount of the boot you got. 1031(b).

$0. See 1031(a) (for the payor of the boot who


receives no boot, it is a pure like kind exchange).

Amount realized = proceeds basis = ($100k +


$15k) -- $10k = $105k gain
Amount of boot = $15k
So TP must recognize a gain of $15k in the year of
the transaction.
Basis for recipient of the boot
(A + B) D = E
($10k + $15k) -- $15k = $10k

Basis for giver of the boot


(A+B) D = E
(50k + 0) (-15k) = 50k + 15k = $65k

So if TP later sells farm Y for $100k, her gain realized


and recognized = proceeds basis = $100k -- $10k =
$90k

So if TP later sells farm, his basis will be $65k.

Example 2 (loss to TP from transaction):


TP gives up property with basis of $130k. In exchange, she gets property with fmv of $100k, cash of
$15k, and tractor worth $8k.
What is TPs immediate tax consequence?
Gain = proceeds basis = 123k 130k = - $7k
Immediate tax consequence TP recognizes gain/loss of $0
What is TPs basis for the future?
(A + B) D = E
(130k + 0) 23k = $107k
So if TP sells the property for $100k, what is the tax consequence?
Gain/loss = proceeds basis = $100k -- $107k = -$7k
28

So TP gets to recognize $7k loss.

29

Transfers Incident to Marriage and Divorce


United States v. Davis
Exchange of property as part of divorce settlement is not a gift; its a bargained-for
exchange. Husband has realization event when he turns over stock, and wife will use fmv
at time of transfer as her basis.
Facts: In divorce settlement, Mr. Davis agreed to pay Mrs. Davis 1000 shares of stock in
exchange for her inchoate marital rights (her dower and intestacy rights). The title to the
property is in his name because this is a separate property state.
Held: This was a bargained-for exchange. That means Mr. Davis has a realization event in the
year of the exchange and has to pay tax on the difference of the fmv of the stock and his
basis in the stock. Mrs. Davis adopts the fmv of the stock at the time of transfer as her basis
for the future.
Congress didnt like this outcome, see 1041 (transfers of property b/w spouses or incident to
divorce)
Transferor doesnt have to recognize income pursuant to a divorce settlement where he turns
over property
Transferee will get transferors basis. Transferred basis (like a gift).
Post-Davis problems
Ask: what is person in dollar amounts? What is the person giving up (e.g. legal right in
property)? What is the basis that is going to apply to this new property?
In other words, how does basis compare to amount of value transferred?
If the person that is receiving the property had a basis in the property ($50k in example) that
is different than just the cash value of it at the time of transfer ($200k in example) there is
going to be some tax that the recipient owes.
If the person that is receiving the property had a basis in the property that is the same as the
cash value of it at the time of transfer, then there will be no gain for recipient or receiver
under 1041 and Davis.
H and W are living in a house where they have basis of $100k. The house has fmv of $400k. They
divorce. W moves out and H buys her half of the house. So he gives her a promissory note of $200k
for her half of the house.
What amount of gain does W
recognize?

Result under 1041


Realized gain = proceeds basis
Realized gain = $200k -- $50k =
$150k

Result under Davis


Ws realized gain = $200k - $50k
= $150k
Her recognized gain is also $150

But under 1041(a)(2), she has no


recognized gain.
What is Ws basis in the note?

$200k. The reason it is $200k is


because we are treating it like
cash. Later, she will receive $200k
in cash and she will give up the
note.

Result for W?

She gets $200k and has a basis of


$50k, so she ends up with $150k
gain.

Lets assume tax rate is 20%. So


she has to pay taxes of 20%
($150k) = $30k

This is NOT taxable b/c it was


transfer of property during divorce.
The promissory note is to be
treated like a gift, so when she
realizes the promissory note for
$200k, she has $0 gain and no tax
consequence.

So she winds up with cash of


$170k
Because her basis was $50k, she
really only netted $120k

30

What is Hs basis in the house?

His basis is now $100k. 1041(b)(2).

$250k

Result for H?

Lets say he sells house for $400k.


Proceeds = 400k 100k = 300k

So if he does sell for $400k, then


his realized gain is $400k $250
= $150k.

If tax rate is 20%, he has to pay


20%(300k) = $60k in taxes.
So he has $340k in cash left, but
he has to pay off the note of
$200k, so ultimately he has $140k.

Punch line.

Person who moved out is better off


than person who stayed in the
house.

Again assuming a 20% tax rate,


his tax bill would be 20%*$150k
$30k.
So he nets $170k in cash.

But because his basis is $50k, he


really only makes $120k.
W and H end up the same.

What result if we consider 121 (gain from sale of home is excluded)?


Usually there is a two out of the last five years use requirement.
But if one spouse moved out, and pursuant to the divorce agreement, one spouse stays living in
the house until the children reach 18, at which point the house is to be sold, then the two out of
the last five years use requirement is waived. 121(d)(3)(B).
Farid-es-Sultaneh (Mercer)
Taxpayer can transfer inchoate marital rights in anticipation of marriage as
consideration in a prenup. 1041 is not applicable because transfer was made before
marriage.
Transfer of stock was contractual agreement; not a gift.
Facts: Kresge and Mercer sign a pre-nup. He gives her $800k worth of stock and in return she
promises to marry him and not claim her inchoate marital rights. Kresge and Mercer marry
and divorce. She ultimately sells the stocks. IRS says she should have to pay tax using
Kresges basis as her basis. She said it was a bargained-for exchange, and that her basis is
the fmv at time of transfer.
Held: This was a contractual agreement. Kresge had a realization event when stocks were
transferred. Mercers basis is the fmv of the stock at the time of transfer.
Marvin v. Marvin
Payment for personal services is not deductible but is income to the recipient.
Common law marriage in a state that didnt recognize common law marriages. She cooks,
cleans, etc. for him and he takes care of her financially. Upon the dissolution of their not legal
marriage, does Michelle Marvin get any fraction of his legally owned property as if she were a
wife?
Court says P stated a cause of action.
Whats the tax treatment of whatever P ultimately receives?
Income to her.
No deductions for him (personal services are not deductible).
1041 is irrelevant because theyre not actually married.
Basis in Davis and Mercer
Buchanan: As wrong as it seems, treating the transactions as gifts is better tax doctrine than
treating them the way the courts in Davis and Mercer treated them.
In Davis and Mercer, there are realization events with respect to the husband/fianc selling
stocks to wife/fiance. Wife/fiance is giving up her marital rights. This should be a realization
event to the wife/fiance, but the courts are just ignoring that.
Court disposes of the problem briefly page 294, footnote 20 the release of marital rights
in exchange for property or other consideration is not considered a taxable event as to the
wife
31

Note: 1041 applies only to couples that are married as recognized by federal law (so same-sex
couples dont get 1041 treatment).
Alimony
Alimony
Alimony counts as income to the recipient. 71.
Payor gets deduction for the amount of the alimony payment. 215.
To be properly considered alimony, the payments must meet certain conditions:
(1) Payment must be in cash. 71(b)(1).
(2) Payment must be received under an instrument of divorce or separate maintenance.
Oral agreements will not do.
(3) The payments have to be taxable to the payee and deductible to the payor.
Parties can opt out. Can elect not to include in income and not to deduct.
(4) The parties must not be members of the same household.
(5) The payments cannot continue after the death of the payee spouse.
If payment made is less than the full alimony + child support payment the payor was supposed to
make, then the payment should be treated as child support first and then the balance is to be
treated as alimony. 71(c)(3).
Example: Payment is supposed to be $2000. Thats $1200 in child support and $800 in
alimony. Payor only pays $1500. So $1200 is treated as child support and $300 is treated as
alimony.
Child Support
Child support does not count as income to the recipient
Child support payments are not deductible to the payor spouse. Its just a personal expense,
which is not deductible. 262.
Excess Front-Loading
Scenario: Payor is paying a lot of money to payee incident to divorce. Its being called alimony,
but it should be property settlement.
Section 71 (p 73 supplement)
Section 71(f)(4): Excess payments for second post-separation year
71(f)(4) = A B
71(f)(4)(A) = alimony payments made in second year
71(f)(4)(B) = alimony payments made in third year + $15,000

Section 71(f)(3): Excess payments for first post-separation year


71(f)(3) = A B
71(f)(3)(A) = alimony payments made in first year
71(f)(3)(B) = sum of . . .
(i) average of (the second year alimony payments less what you got above) and
third year alimony payments, and
(ii) $15,000

Section 71(f)(2): Excess alimony payments


71(f)(2) = Add the main numbers you got above

Section 71(f)(1)
The payor spouse includes the excess payments in his gross income in the third postseparation year
The payee spouse deducts the excess payments from her income in the third postseparation year
Example: $50k in year 1; $0k in year 2; $0k in year 3
Excess payments for second post-separation year
71(f)(4) = $0, there is no excess.
32

71(f)(4)(B) = $0 + $15k = $15k


o (i) $0
o (ii) $15k
71(f)(4)(A) = $0

Excess payments for first post-separation year


71(f)(3) = $35k
71(f)(3)(B) = $0 + $15k = $15k
o 71(f)(3)(B)(i) = 0
o 71(f)(3)(B)(ii) = $15k
71(f)(3)(A) = $50k
Excess alimony payments
71(f)(2) = $35k
71(f)(2)(A) = $35k
71(f)(2)(A) = $0

33

Diez-Arguelles v. Commissioner (Tax Court 1984) Wife cannot deduct non-paid child
support payments. Lack of child support payments does not fall under section 166. In
order to write off the money that you are owed, you have to have some kind of basis/cost
that you paid to get that in the first place (example = you incur costs in producing
iPhone. Customer never pays. You can deduct that as nonbusiness bad debt.)
Facts: Deadbeat dad. Kevin doesnt pay child support. Christina tries to deduct what she should
have gotten as a nonbusiness bad debt under section 166. IRS disallows this.
Held: Christina cant deduct what she didnt get as a nonbusiness bad debt. Buchanan thinks Tax
Court got it wrong.
(1) Court looks to sections 166(a) (b) to require that Christina have some basis in the debt
for the debt to qualify for deduction as a nonbusiness debt.
Christina is relying on provision 166(d), which specifically says that 166(a) does not apply.
Therefore the requirement under 166(b) of basis does not apply either.
(2) Court relies on Long v. Commissioner to argue that Christina has no basis in the debt
because she is not out of pocket anything as a result of Kevins failure to pay.
Christina does have a basis in the debt. The amount she paid for her children are her out
of pocket expenses and thus her basis.
How should a future Christina avoid the same result in the future?
(1) Re-argue in the Tax Court for new law. Point out that payments to support children,
mentioned in s 71(c), are not supposed to have tax consequences and whats happening
is that she is making payments out of pocket that someone else was supposed to pay.
o A good faith argument that the law is wrong is not a frivolous argument. So dont
fear individual sanction.
(2) Go forum shopping. This is in Tax Court. You can still go to COFC or district court.
(3) Appeal to scholarly commentary. Commentary on good ways to develop the law.
Perry v. Commissioner (note case)
Facts: Same scenario as Diez-Arguelles case. Tax Court didnt budge and got nasty about it.
Courts points: (1) Courts dont legislate. TP can go to Congress if they want a change. (2)
Because TP doesnt get max benefit (she isnt in highest tax bracket), she shouldnt get any
benefit.
McClendon v. Commissioner
Legal fees for litigating these types of deadbeat dad cases are non-deductible also

34

Personal Deductions, Exemptions, and Credits


Gross income ( 61)
Minus
Above the Line Deductions ( 62(a)(1) (20))
Equals
------------ Adjusted Gross income ( 62) ------------

Examples: alimony,
educators
expenses,
retirement savings,
higher education
expenses

Minus
Below the Line Deductions
(Either: the standard deduction, 63(c) & supp. p. 646, or itemized deductions, 63(d))
And

Zero
bracket

Deduction for personal exemptions ( 151 & supp. p. 647)


Equals
Taxable income ( 63)
Introduction
A taxpayers zero bracket is at least as big as their standard deduction + personal exemption, but
may be larger if their itemized deduction > standard deduction
Tax benefit from using itemized deduction rather than standard deduction = TPs marginal tax
rate * (itemized deduction standard deduction)
Its NOT the marginal tax rate * itemized deduction!
The personal exemption and itemized deduction have been subject to phase out amount of
deduction gets smaller as adjusted gross income rises
Health Insurance
Employers are allowed to deduct the cost of medical insurance that they buy for their employees
as a business expense under 162.
At the same time, benefits received by employees are excluded from their gross income under
106(a).
Self-employed people can deduct premiums from their income.
So its a total lost taxable opportunity for IRS.
Medical Expenses, 213
Medical expenses are deductible to the extent that they exceed 7.5% of gross income.
Example: TP makes $100k. TP can deduct any medical expenses in excess of $7500.
Amounts paid for medicine shall be counted as deductible medical expense ONLY IF the medicine
is a prescribed drug or insulin.
Defining medical care. 213(d).
Amounts paid for the diagnosis, cure, mitigation, treatment, or prevention of disease, or for
the purpose of affecting any structure of function of the body.
Medical care does include . . .
Breast pumps and supplies that assist lactation
Amount paid for lodging, but its limited to $50 per
night for each individual

35

Medical care does not include . . .


A cosmetic surgery unless the surgery or procedure
necessary to ameliorate a deformity arising from a
congenital abnormality, a personal injury, or
disfiguring disease
Health care provided by spouse or relative is not
deductible

Depreciation on property does not count


Taylor v. Commissioner (1987) Paying someone to mow your lawn b/c you have allergies is
not a medical expense.
Facts: TP has severe allergies so doctor recommends he avoid mowing the lawn. TP pays
someone else to do it for $178 and then tries to deduct the money as medical expense.
Held: the money was not spent as a medical expense.
(1) TP has burden of proof. TP didnt cite any legal authority that this is medical expense.
(2) Altman case. Golf expenses are not medical expenses, even if golf helps TPs emphysema.
So if mitigation of emphysema isnt going to get a deduction, mitigation of allergies is not
going to get a deduction.
Ochs v. Commissioner Boarding school expenses not deductible.
Facts: TPs wife gets cancer. Doctor recommends that wife avoid anything that could irritate her
or create nervousness. TP sends two children (4 and 6) to boarding school for two years until they
are certain wife is cured. Then they bring the kids home and send them to public school. TP wants
to deduct boarding school expenses as medical expenses.
Held: boarding school expenses not deductible.
The personal expenses benefited the whole family, not just the sick person.
This is more like a personal expense b/c its the equivalent of hiring a nanny, which wouldnt
have been deductible.
Dissent: Buchanan sides with the dissent. Dissents rule is the one that has become reality.
If mother had been sent to sanitarium, that would have been deductible expense. We should
treat it the same.
The doctor didnt prescribe less housework, he specifically prescribed peace and quiet,
and mothering is incompatible with peace and quiet.
This isnt going to open the floodgates. Here are some factors to consider:
Would the TP, considering his income and living standard, normally spend money in this
way regardless of illness? (no deductible).
Has he enjoyed such luxuries or services in the past? (no deductible).
Did a competent physician prescribe this specific expense as an indispensable part of the
treatment? (yes deductible).
Has the TP followed the physicians advice in the most economical way possible? (yes
deductible).
Are the so-called medical expenses over and above what the patient would have to pay
anyway for his living expenses, that is, room, board, etc.? (yes deductible)
Is the treatment closely geared to a particular condition and not just to the patients
general good health or well being? (yes deductible).
Ochs is still the law, but IRS has loosened up over time and allowed more medical expense
deductions
Taxpayers can deduct the excess cost of Braille books for blind child over the cost of regular
editions
Taxpayers can deduct cost of hiring a person to accompany TPs blind child for the purpose of
guiding the child in walking
Charitable Contributions
Cash Donations
Effect on Donor
Taxpayer can deduct donations he gives to charity. 170.
Anti-abuse mechanisms:
The max deduction you can take is 50% of your AGI. 170(b). Example: if you have
$100k in AGI and donate $100k, you can only deduct $50k.
But, five year carryover allowed.
Donating used motor vehicles, boats, airplanes
Charities typically sell these things for cash, so TP can deduct what the charity is able
to sell the car for.
170(f)(12).
36

Effect on Recipient
Charities dont have to pay income tax. 501.
For our purposes, charities under 501 are the same as charities under 170.
Property Donations
Property held by donor for short-term (one year or less)
Donor can only deduct the basis
Property held by donor for long-term
Donor can deduct FMV
Donor does not have to pay tax on gain
Whats a charity? 170(c), 501(c)(3).
Government, but only if contribution is made for exclusively public purposes
Organization operated for religious, charitable, scientific, literary, or education purposes, or to
foster national or international amateur sports competition, or for the prevention of cruelty to
children or animals
Fraternity of some sort
Organization for war veterans
The earnings of the corporation cant inure to the benefit of any private individual or
shareholder
When Private Business/Person Benefits in Exchange for Charitable Contributions

For businesses:
Rule

Case

COFC/Federal Circuit
If donor RECEIVES or EXPECTS TO
RECEIVE substantial benefit (benefit
that doesnt inure to the public at
large), then donor gets no deduction

Tax Court
If primary or dominant INTENT o
the donor is to get a personal
benefit from the donation, then
no deduction

Ottawa Silica
Facts: Ottawa Silica is involved in
mining operation in southern
California. Donates 70 acres to school
district with knowledge that county
will have to build access roads to
access the donated property. Claims a
deduction for fmv of property. Access
roads will improve access to Ottawa
Silicas mining operations and
increase the value of the land for
when OS sells the property for
residential development.
Held: Because OS received a
substantial private benefit (did not
inure to the general public), it cant
claim a charitable deduction.

DuVal v. Commissioner
Facts: Developer contributed lan
as site for a library. Developer
needed rezoning for a parcel of
property he intended to develop
Held: DuVal can claim a
charitable deduction. DuVal
wanted to give something back
to the community.

For individuals:
Amount of deduction is limited to the excess of the payment to the charity over the value of any
benefit received by the donor
Value of benefit = fmv of whatever is received by the donor
Example:
You bid $2000 for dinner with Buchanan at EJF auction. Normally the dinner would cost you
$200. So you get a charitable deduction of $2000 - $200 = $1800.
Bob Jones University
To get 501(c)(3) tax exemption, the organization has to (1) fall within one of the
specific categories of 501(c)(3) and (2) has to be harmonious with public policy.
If tax exempt organization is racially discriminatory, it will lose tax exempt status.
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Facts: Bob Jones University is Christian school that forbids interracial relationships. In 1970, IRS
denied it tax exempt status on the basis that it is racially discriminatory and therefore not
consistent with public policy. Bob Jones University sued because it wants to retain tax exempt
status.
Held: Tax exempt status denied.
Majority:
Public policy requirement stems from common law and policy (if everyone has to pay more
tax to make up for the tax exemption, the recipient of the tax exemption should be
something helping everyone).
Congress has acquiesced in the IRS rulings b/c it hasnt done anything to disallow them
even though they are more than a decade old.
Indeed, Congress has enacted 501(i) denying tax exemption for organizations with written
policy of discrimination on the basis of race, color, or religion.
No First Amendment violation because combating racism is more important.
Powell concurrence:
Wants to limit the holding of the majority.
You should lose 501(c)(3) status if you are an openly racist organization.
Tax Credits
Earned Income Tax Credit, 32
Several features:
Amount of credit depends on number of children
Its a refundable credit meaning it doesnt offset tax liability but rather results in
payment from the government
Credit rises as earned income rises and then at a certain point the credit decreases
Marriage penalty when two wage earners get married, their combined EITC is lower than
the sum of their EITCs had they stayed single
Phase in & phase out graph, p 385
Anti-abuse mechanism -- 32(k)
(1) if you fraudulently claim a deduction, you cant get a EITC credit for the next ten years
(2) if you improperly claimed a credit due to recklessness or intentional disregard of rules
and regulations (but not due to fraud), you cant get EITC credit for the next two years
Personal exemptions vs. standard deductions
Personal exemptions counts one per person on tax form
Standard deduction one per tax form
Mixed Business Deductions
Mixed business/personal consumption deduction
Scenario: operate business out of their home, operate a business on the side, buying
pens/paper for your job
Statutory scheme
162(a) allows a deduction for ordinary and necessary expenses paid or incurred in
carrying on any trade or business
The amount that you are trying to deduct has to be greater than 2% of AGI
Example: you make $50k. Expenses would have to be at least $1000 before you get
deduction.
183 business deduction is not allowed if activity is not engaged in for profit
183(d) presumption if TP made profit on the activity in 3 of past 5 years, theres a
presumption that the activity is engaged in for profit
212 covers expense of generating income from sources other than a trade or business
A person with investments in stocks and bonds would claim deductions for fees paid to
investment advisors, subscription to WSJ, and expenses incurred in attending investment
seminars
262 no deduction shall be allowed for personal, living, or family expenses
Nickerson v. Commissioner
Expenses for hobbies are non-deductible. If you are intending to make a profit from
your activity, then you get the deduction.
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Whether or not activity is engaged in for profit is a facts and circumstances test. Factors to
consider:
Manner in which TP carries on activity (is it businesslike with accurate recordkeeping?)
The expertise of the TP or his advisors
The time and effort expended by the TP in carrying on the activity
Expectation that assets used in activity may appreciate in value
The success of the TP in carrying on other similar or dissimilar activities
The TPs history of income or losses with respect to the activity
The amount of occasional profits, if any, which are earned
The financial status of the TP
Elements of personal pleasure or recreation
Facts: TP Nickerson buys a farm in Wisconsin. He wants to transition out of advertising career.
He goes there every weekend during growing season and twice per month during non-growing
season. He mostly works on the home while hes there. Nickerson has experienced losses on
the farm and wants to deduct them under 162.
Held: This is an activity engaged in for profit, so TP can get the deductions.
Appellate court is supposed to apply clearly erroneous standard. Appellate court actually
applies de novo.
Court says people dont do hard labor unless its for profit. What about Iron Man
competitions??
Buchanan thinks the farm is just a man cave so that TP can take a break from family/city
life.

Business use of a home, 280A


Generally, business use of a home is not deductible
Exceptions: When portion of the home is exclusively used on a regular basis
As the principal place of business for any trade or business of the taxpayer,
Solimon majority: what is the principal place of business? Consider:
Relative importance of the activities performed at each business location
The time spent at each place
Solimon concurrence (Thomas and Scalia):
To be a PPB, there has to be income earned in that location
We should rule out any place where theres no money earned at all
If there is, then you would move onto majority test
As a place of business which is used by patients, clients, or customers in meeting or dealing
with the taxpayer, or
In the case of a separate structure which is not attached to the dwelling unit, in connection
with the taxpayers trade or business.
Popov v. Commissioner
Musician may deduct expenses from the portion of their home used exclusively for
musical practice.
Facts: Popov is a professional violinist. She practices 4-5 hours at home per day in her living
room. Her employers do not provide her practice space.
Held: She can deduct 40% of her rent and 20% of her electricity bill b/c her home is her
principal place of business. Her living room space was used exclusively for her business.
While the place of delivery is important, the four to five hours of daily practice she did at
home lay at the very heart of her career as a professional violinist
She spent a lot of time in her practice space as compared to place of delivery
Henderson v. Commissioner
Facts: Henderson buys plant and print for her office and tries to deduct as a business expense.
Held: No deduction allowed.
For 162, there has to be sufficient nexus b/w the expense and the carrying on of the
business. If the expense is in essence personal, then no deduction is permitted.
These expenses werent necessary for her to perform her job.
262 trumps 162.
Cf. Judge (allowing deduction for pediatricians expenses spent on pictures specifically
appealing to children and displayed in patient rooms).
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Travel & Entertainment Expenses


Rudolph v. United States
T&E expense of traveling to NYC as reward for meeting sales goal is income and
not deductible as a business expense under 162
Facts: TP and wife went to NYC. He got to go on the trip because he met certain insurance
sales goal.
Held: This was income. No deduction allowed.
Prong one: was this income? Yes. It was for pleasure.
Test = dominant motive and purpose
Prong two: is this personal expense or deductible business expense?
Test = whether its related primarily to business or is primarily personal. Fact specific
inquiry.
This is personal. He wasnt forced to go.
Dissent:
Prong one: this isnt income.
No evidence this was a sham. But thats not the legal test.
This isnt compensation. No connection between the trip and services rendered. Thats
exactly what this is! A reward for selling insurance!
Expense as to wife is a business deduction
Wives contribute to productivity of the husbands
Section 274
Expenses of spouses, 274(m)(3)
When TP is on legit business trip, no deduction allowed for spouse who comes along
unless:
Spouse is employee of TP,
Primary purpose
Spouse had bona fide business purpose for going on the trip, and
depends on the
Additional expenses would otherwise be deductible
facts &
Reg. 1.162-2: traveling expenses
circumstances
in each case,
If trip is primarily related to TPs business, traveling expenses to and from
but amount of
destination are deductible
time spent on
If trip is primarily personal, traveling expenses to and from destination are not
personal/biz
activities is
deductible even though the TP engages in business activities while at the
important
destination
Expenses at the destination that are related to business are deductible
Clothing as a Business Expenses
The cost of clothing is deductible as a business expense only if:
The clothing is of a type specifically required as a condition of employment
It is not adaptable to general usage as ordinary clothing (objective test)
General adaptability cant have national meaning. See Nelson v. Commissioner (allowing a
business deduction for clothing expenses where clothing was heavy costumes worn on the
set of a TV show filmed in southern California).
It is not so worn
Pevsner
Facts: TP is manager at YSL boutique. She has to wear YSL clothes at work and at work
events. She does not wear them when shes off duty because she leads simply life. She
wants to deduct the expense of the clothes from income.
Held: She cant deduct. The clothing is adaptable to general usage as ordinary clothing.
Types of clothing that would qualify: astronaut suit, deep sea divers suit, something that would
look weird in public
Educational Expenses, Reg. 1.162-5(b)
Expenditures made by an individual for education are deductible as business expenses if the
education:
Maintains or improves skills required by the individual in his employment or other trade or
business
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Meets the express requirements of individuals employer or requirements of regulations (e.g.


CLEs)
The following are non-deductible education expenses:
Expenses required of TP in order to meet minimum educational requirements for qualification
in his job
Expenses for education which is part of a program of study being pursued by him which will
lead to qualifying him in a new trade or business (this could be considered a capital expense
rather than a current expense)
Even if the employee does not ultimately switch jobs, but the education still qualified him
for a new trade or business, the expenses are still not deductible
New trade or business new duties involving the same general type of work as is
involved in individuals present employment (e.g. elementary to secondary school
classroom teacher)
Limitations on amount TP can deduct for educational expenses, 222
If AGI < $65,000 maximum deduction is $4,000
If AGI is between $65,000 and $80,000 maximum deduction is $2,000
If AGI > $80,000 no deduction is permitted
When you are determining whether you are above the AGI threshold, ignore this particular
deduction. 222(b)(2)(C)(i).
To figure out if youre qualified for the deduction, take out all your other above-the-line
deductions and then use that as your AGI to determine for what level of deduction you
qualify.
Carroll v. Commissioner
Facts: TP was police officer. He took liberal arts courses at DePaul University and tried to
deduct them as a business expense.
Held: TP cant deduct the expense of the classes. The classes did not maintain or improve
skills required by him in his employment. The classes were not connected to his work.

Hierarchy of Tax Reduction Techniques


Tax Credits you get your money back
Expensing TP can take deduction in full in a single year
Depreciation TP can deduct in allotments over several years
Add to basis then when TP sells the property, he has to pay less tax on the gain
No deduction, e.g. personal expenditures

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Alternative Minimum Tax


If you are in a certain income range, you have to calculate your tax liability using both the 1040
method and AMT method
Whichever one is bigger is the one that you pay
AMT = (taxable income + disallowed itemized deductions alternative minimum standard
deduction) * tax
Disallowed itemized deductions:
Standard deduction
Deductions for personal exemptions
Deduction for state and local taxes
Deduction for interest on home equity loans
Certain job-related outlays
Deduction for medical expenses is limited to excess over 10% of AGI (as opposed to 7.5% for
the normal tax)
Alternative minimum standard deduction
$50,600 for singles
$78,750 for married couple filing jointly
Tax
26% tax rate for first $175k
28% of so much of the taxable excess as exceeds $175k
Klaassen v Commissioner
Facts: Klaassens had ten kids and want TMT to apply to them rather than AMT. AGI = $83,056.
Tentative Minimum Tax
AGI itemized deductions personal exemptions
= taxable income = $34,092
Itemized deductions = $4,767 for medical
expenses, $3,264 for state and local taxes,
$11,533 for charitable donations)
12 personal exemptions = $29,400
Tax * taxable income = TMT = $5,111

Alternative Minimum Tax


$34092 + 3264 + 29400 + 2076 = $68,832
$68,832 standard deduction at the time (which
was 45000) = $23,832

0.26*23,832 = $6,196

Held: they have to pay AMT.


Concurrence (Kelly):
Kelly is very sympathetic. You can look at congressional intent. He doesnt want majority
to say that congressional intent doesnt matter.
Suggested alternatives:
(1) Eliminating itemized deductions and personal exemptions as adjustment to regular
taxable income in arriving at AMT income
(2) Exempting low and moderate income taxpayers from the AMT
(3) Raise and index the AMT exemption amount (this one has actually come to be)
(4) Some other measure.

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