Federal Income Tax

Prof. Mildred Robinson, Spring 2015

Mechanics of Determining Individual Tax Liability:

o
1. Gross income minus Section 62 (above the line) deductions equals adjusted gross
income
o
2. Adjusted gross income minus section 63 deductions to reach taxable income.
o
3. Taxable income times applicable marginal rate equals tentative tax liability
o
4. tentative tax liability minus credits equals tax liability
o
OR Alternative Minimum Tax
Income:
o
Definition:

Eisner v. Macomber (p. 46) (1920)

Rule: The gain derived from capital, from labor, or from both combined

Later expanded by Glenshaw Glass

Commissioner v. Glenshaw Glass (p. 78) (1955) Current Law

Rule: Gains or profits and income derived from any source whatever.

Expands Eisner v. Macomber to include gains acquired from sources

other than capital or labor.

Money found in street

Prize winnings

Gambling winnings

Gratuitous transfers

Punitive Damages

Congress has general taxation power; courts will not impose restrictions
on Congress unless Congress has passed a statute restricting itself.

Compensatory damages: income because replaces income would have

received (later overruled by 104, excluding damages for personal physical
injury).

Punitive damages: is this from capital, labor? Should it be taxed? Court:

yes

Reasoning: if it affects your ability to pay, its income

Old Colony Trust Co. v. Commissioner (p. 50) (1929)

Rule: the discharge by a third person of an obligation to him is

equivalent to receipt by the person taxed

Haig-Simons definition (p. 46) (1938)

Personal income may be defined as the algebraic sum of (1) the market
value of rights exercised in consumption and (2) the change in the value of
the store of property rights between the beginning and the end of the period
in question.

Impractical - would need receipts of everything you do

For gifts as income see below

o
Inclusions (61)

Fringe benefits included except as enumerated in 132 (excluded)

Includes but not limited to the following: (may be excepted in other statutes)

(1) Compensation for services, including fees, commissions, fringe

benefits, and similar items;

(2) Gross income derived from business;

(3) Gains derived from dealings in property;

(4) Interest;

(5) Rents;

(6) Royalties;

(7) Dividends;

(8) Alimony and separate maintenance payments;

(9) Annuities;

(10) Income from life insurance and endowment contracts;

(11) Pensions;

(12) Income from discharge of indebtedness;

(13) Distributive share of partnership gross income;

(14) Income in respect of a decedent; and

(15) Income from an interest in an estate or trust.

Constructive Receipt: when a benefit (either at that time or for the future) is
treated as a taxable receipt at a certain time see later on
Mutual Exchange of Services

In a commercial context: usually taxable

In a social context: usually not taxable

See also 83 (property transferred in connection with performance or

services)

Rev. Ruling 79-24 (p. 76) (1979)

General Rule: if services are paid for other than in money, the
FMV of the property or service taken in payment must be included as
income. Assume stipulated price for services is FMV.

Facts 1: lawyer and house painter

Rule 1: FMV of value of services received by lawyer and the

house painter are includible in their gross incomes

Facts 2: renter of apartment gave work of art instead of cash

Rule 2: FMV of the work of art and the six months fair rental
value of the apartment are includible in gross income of the
apartment-owner and the artist respectively
Damages 104 - (lawsuits)

Business:

Recovery for lost profits: income (Glenshaw Glass)

Recovery for damage to property: include amount recovered

over the basis (Inaja Land Co., see below)

Punitive damages: include as income (Glenshaw Glass)

Even though this is a deterrent, its still taxable

Personal

104(a)(2): the amount of ALL damages received, other than

punitive damages, on account of personal (physical) injuries or
sickness is excluded (note that this includes all damages other than
punitive damages), see also the following for other exclusions:

(a)(1): workers compensation for injuries or sickness

(a)(2): all damages from personal physical injury or

sickness other than punitive. Includes both lump sum and
periodic payments, even if payments will over time exceed
the amount of physical damage done.

Medical expenses (but check 213)

Pain and suffering

Lost wages

Other non-punitive damages

(a)(3): accident health insurance

(a)(5): disability income as a result of terrorist or military

action

Note: there must be physical injury, emotional distress

doesnt count

Exclusion provisions of 104(a)(2) apply whether suit or

settlement, and whether lump sum or periodic payments, and lump
sum sale (JG Wentworth) follow same rules, but income therefrom
taxable for JG Wentworth because not from personal injury

Once tortfeasor has paid the money, they may deduct it

Can deduct upfront if structured settlement, but

need to wait for annuity payouts

Settlements are judged to see if

unreasonable/excessive (Dennis Rodman photographer was
seen as purchase of confidentiality, not settlement of purely
things related to injury)

Interest accrued for structured settlements/periodic

payments is also excludable

Note: Exclusions offset by previous deductions arising from the

same issue. E.g. medical expenses deduction taken in year of
accident:

2015: $100k Salary, $18k Med Expenses

Deduct in excess of 10% of salary - $8k

2016: $18k judgement (normally deductible)

Exclude $10k because you have already

deducted $8k/$18k

Exclude to the extent that you havent deducted

See also: tax benefit rule

Compensatory damages other than relate to personal physical

injury: treated as income (Glenshaw Glass)

Emotional distress

Dignitary torts (age discrimination, gender discrimination,

etc.)

Punitive damages: treated as income (Glenshaw Glass)

If (d) is a business entity, would usually get deduction for

payments to the person (P) 162 business expense.

Example: if judgment of $10k paid up front, interest (from

voluntary investment by the recipient) therefrom taxable. If instead
agree to $30k payments over ten years, then not taxable
Structured Settlements:

Problem:

Tortfeasor cannot deduct setting the money aside

Plaintiff is at risk for Tortfeasor becoming insolvent

Option: Tortfeasor pays lump sum upfront and takes deduction.

Tortfeasor loses out on ability to invest the money.

Best for plaintiff (assuming entire settlement is

deductible): can invest money immediately.

If settlement is taxable plaintiff gets no tax

deferral benefits.

Option: Tortfeasor purchases annuity with payout in amount of

settlement. Tortfeasor deducts each time annuity makes a payout.

Worst for tortfeasor: loses control of money and cant

deduct up front

Tortfeasor can give full sum to a structured settlement company:

Tortfeasor gets deduction right away, removes long term

obligation from the books but cant invest

Plaintiff reduces risk of non-payment while also getting

tax deferral.

Illegal Income:
Illegal income does not avoid tax liability! But what about embezzlement
where there is intention to pay back?

IRS will get its share of tax on illegal income before the
embezzler is allowed to repay the victim. (first in time first in right)

Victim may deduct as casualty loss (theft)

Embezzler may deduct what he repays to victim.

Rationale: criminal law, not tax law, is concerned with

punishing the embezzlement.

Can claim net operating loss if the embezzler can show that he is
in the trade/business of crime: must show pattern

Gilbert v. Commissioner (p. 181, 1977) - exception if its like a loan

Facts: Corporate exec embezzles company money to make a

stock transaction he believes is in the companys best interests. He
knows the taking is illegal but acts with every intention to repay.

Rule: Loan, not income. Clear expectation of full repayment

overrides illegality of taking.

Policy: some courts look to the circumstances of receipt to

determine whether borrower, or swindler (see note p. 185)
Gifts (see 102, generally not included)
Dividends (1(h))

Non-qualified dividends: ordinary income

Qualified dividends: capital gains

Preferable tax treatment (allow ordinary income investment to be

treated as taxable gain); incentivizes investment in stocks.

Strategy: purchase bonds (whose interest is always ordinary

income) out of pension trust (whose interest is not taxed annually)
and stocks (whose dividends are capital gains if qualified) out of
ordinary savings. Summary: pay capital gains now from stocks,
ordinary income later from pension trust
Possible Exclusions
Meals and Lodging (119) - narrowly tailored
exclusion for meals and benefits offered by employer. Extends to employees spouse
and dependants.

Current Law: 119

Lodging: income unless for convenience of employer and

required to accept as a condition of employment

E.g. oil rigs, military bases

Grey area: Benaglia, live-in maids and butlers

Not covered: people who live at work purely because its

convenient

Policy: levels playing ground for those with little

bargaining power

Meals: if (1) for the convenience of employer and on the (2)

premises then excludable

See possible meal deduction if not excludable as 162

business expense

Self-Employed Loophole

Incorporate, hire yourself as an employee of your

corporation, and make a contract requiring that you live on
the premises as a condition of employment

Cite staffing shortages and need to be on call

Hire spouse as a chef, then deduct the cost of meals

Note: Employer can write write them all of either as salary or as a

business expense (see Business Outlays)

Old Rule - Benaglia v. Commissioner (p. 52, 1937)

Facts: Hotel manager and his wife lived at the hotel for free and
got free meals because he was required to be on call at all times.
(although often traveling, and managing multiple hotels)

Rule: anything for the convenience or benefit of the employer is

not income

Result: broad exclusion for employee benefits

Fringe Benefits (132) - broader attempt than
just 119

Generally: All fringe benefits included by 61 except those exempted by

132.

Spouses, Dependent Children, Retired/Disabled Employees, Surviving

Spouses - 132(h)

Only applies to (a)(1) no additional cost services and (a)(2)

qualified employee discount

See details for definitions of the categories

(h)(3) airplane use by parent of employees treated as use by

employee

Employee Discount 132(a)(2) (details 132(c)): qualified exclusion,

must not:

Exceed profit margin for products, and/or

Exceed 20% for services

132(j)(1): bars highly compensated employees from using

discount unless it is offered to all other employees.

No Cost Additional Services 132(a)(1) (details 132(b))

Services ordinarily offered to the employee and at no cost to

employer (including forgone revenue)

E.g. airline employees flying in empty seats

Working Condition Fringe 132(a)(3) (defined by 132(d))

Use of employer property or services

E.g. trips on the company jet

De Minimis Fringes 132(a)(4) (details 132(e))

(1) Small value compared to other fringes so that

unreasonable/impractical to account

(2) Can include eating facility if (A) near business and (B)
revenue equals or exceeds operating costs of the eatery

Parking 132(f)(C)

Not available to self-employed workers or partners

Fringes in other s:

Life Insurance (up to $50k) 79

Deferred Compensation (409A)

Transportation (132, but travel deductions in 162)

Educational Assistance (127)

Child Care up to $5k 129

Cafeteria Plans (125)

Taxpayers can choose either the benefit or cash (which results in liability
for value of fringe)

No tax on otherwise excluded fringes simply because there was an

option to take cash instead (safe harbor). Limited to:

Everything in 132 plus whats below

Group term life insurance (up to $50k)

Dependent care assistance

Adoption assistance
Health saving accounts
Certain deferred compensation plans (generally excluded)
Everything else: considered constructive receipt (even if
otherwise considered a fringe)

Good deal for the taxpayer if he values the limited excluded fringes (132
and others) as much as he would the cash.

(c) cannot discriminate in favor of highly compensated employees, see

(e)

(d) definition: employees choose between cash or qualified benefit

See list of excluded benefits

(f) qualified benefits defined

Health and Accident Insurance (104, 106)

Deductible to employer and excludable to employee

Government subsidizes health care through tax code to encourage

employers to insure their employees.

Do concurrently with 213 describing deduction of medical expenses not

compensated by insurance
U.S. Treasury Bonds: 135 exempts interest
from U.S. Treasury bonds that is used to pay for higher education to the extent that it
does not exceed education expenses
State and Local Bond Interest (103)

Interest collected on state and local bonds generally excluded

Policy: Indirect method of support from federal government to

state and local governments (subsidy)

Incentivizes investment in state/local bonds over federal bonds

Putative tax: allows state and local governments to pay less

interest, knowing investors will pay less tax (putative tax is the
difference in interest from state and local bonds and that of other
investments)

Exception: Arbitrage, Private Activity Bonds, and Unregistered Bonds

Arbitrage Bonds: when the state or local government takes

advantage of higher rate of return in the private market to turn a
profit for paying back interest to bondholders as well as for
themselves

Also not allowed for taxpayers who take advantage of

different tax treatments of bonds and deduction for loan
interests to pay for the bonds in order to change other
ordinary income into capital gains

Private Activity Bonds - see 141

Public: has a salutary effect on the general welfare

Ex: Schools, roads, govt buildings

Private: serves the monetary interest of a private party

Ex: Industrial development bonds

Exception to the Exception: Qualified Private

Activity Bonds

E.g. airports, mortgage subsidy, and

student loan bonds

Unregistered Bonds: more like a promissory note than a formal

government debt. Not binding in a court of law without the physical
document.
Valuation

Turner v. Commissioner (p. 67) (1954)

Facts: Taxpayer won 2 tickets to Buenos
Aires on a radio show (could not afford them himself). He reported them as
income at 25% of FMV.
o
Issue: how do we value it as income?

Value to Taxpayer (Subjective Approach)

Pro-taxpayer, pro-liquidity, administrative nightmare

Limited to occasional receipts, not routine ones

Market Value (Objective Approach)

Pro-market, pro-efficiency, harsh marginal effects

Cost by Employer/Provider of the Benefit

o
Ruling: Split the baby--halfway between
subjective value and FMV.
See also homerun baseball case: treats as
income at time of sale of the ball, not when you caught it
Imputed Income: non-taxable
o
Benefits or satisfaction to taxpayer from
(1) using and enjoying property owned, (2) producing and consuming goods,
(3) performing services for self
o
All excluded: consuming food you grew
yourself, stay-at-home parents saving cost of child care, paying in-state
tuition.,
o
Policy: valuation, line drawing, and
oversight problems
o
Mutual Exchange of Services: Taxable
Income if not between family unit

See Revenue Ruling 79-24 (p. 76): lawyer exchanging services

for painting personal residence
o
Psychic income: subjective reward you
get from various activities/employment/leisure (obviously not taxed in part
due to valuation problems)

Cant tax people for choosing not to work full time based on
enjoyment of leisure
See Inaja Land: recovery of capital
Gifts (102(a))
Definition/Exclusion: gross income does not
include the value of property acquired by gift, bequest, devise, or inheritance (does
not need to be reported to IRS)
o
Generally does not exclude gifts from
employers from income (see Duberstein)
Carveout for 61 that would otherwise include it
as income
Strategic Transfer:
o
Since gift is not defined well, taxpayers
can aggressively seek gift label
o
Label as a gift makes it non-deductible
for the giftor
o
Options:

Donor deducts, done includes

Donor has no deduction, Donee has income

Donor has no deduction; Donee has no income Law

Reasoning: gift is out of donors post-tax income.

o

Business Gifts: Commissioner v. Duberstein (p.

83) (1960)
o
Facts: D received Cadillac as a
business gift from an associate he gave valuable advice to.
o
Rule: Intent of the donor controls,
although courts/IRS may make an inquiry into whether something the donor
classifies as a gift is actually a gift and not compensation. (detached and
disinterested generosity/out of affection, respect, admiration, charity)
o
Policy: jury generally controls outcome
in case by case basis, leading to uncertainty
Current Rule for Employers/Employees 102(c):
No transfer from an employer to employee is a gift.
o
74(c) Lone Exception: employee
achievement awards are considered gifts
274(b): Employers may deduct gifts as
business expenses, but only $25 per donee per year.
Stanton v. United States (p. 84) (1960) overruled by 102(c)
o
Facts: As Mr. Stanton leaves
employment for managing Trinity Churchs holdings, the church offers $20k
gift for his fabulous services. Released from all claims to benefits not already
accrued: was this bargaining?
o
Ruling: because it was the employers
desire to become a benefactor (not to compensate) it should be treated as a
gift
o
Overruled by 102(c) because no
transfer from employer to employee is a gift
Possibly Illegal Gifts: United States v. Harris
(p. 91) (7th Cir. 1991)
o
Facts: mistresses/prostitute, benefactor
now diseased. Letters regarding decedent's intent. Tax evasion case.
o
Rule: Prostitution income taxable, but
general gifts not quid pro quo for sex is not.
o
Policy: even income from illegal jobs is
taxable (wages of sin)
Gifts of Appreciated Assets: Taft v. Bowers (p.
104) (1929) - see 1015
o
Facts: Grandfather transferred
appreciated stock to granddaughter. It further appreciated, and then she sold
it.
o
Rule: Donors basis is recipients basis.
Recipient is taxed on everything above the donors basis at the time she sells
the asset. No tax consequences at the time of the gift.
Gift tax: separate from income tax, paid by
donor with secondary liability on the donee if the donor does not pay (p. 107 fn. 14)
Basis for Gifts: 1015
o
Donee assumed donors basis unless
the donors basis is greater than FMV at the time of gift, in which case the
basis changes to the FMV.

Cannot gift a loss. o.k. boss.

o
If no evidence to determine donors
basis then use FMV at time of gift.
o
Exception: Upon death you always
assume FMV as basis (see 1014)

Strategy:
Hold appreciating assets, and leave in
will (take advantage of 1014)
o
Sell depreciating assets to take the
capital loss (avoid 1015 problem)
Transfers At Death
1014: Basis step-up
o
Basis for bequeathed appreciating asset
is FMV on the date of death

Incentivizes people to hold onto appreciating assets and will

them instead of gifting them while alive.

Incentivizes people to sell depreciating assets while alive--take

deduction.
o
No income tax liability to recipient at
time of death
Recovery of Capital
1001 - Determining Gain or Loss
o
Gain = amount realized (AM) adjusted
basis (AB)
Inaja Land Co. v. Commissioner (p. 111) (1947) Basis First
o
Facts: bought land for $61k and fished
on it, city started dumping in water, settled for an easement of $50k less $1k
attorneys fees
o
Rule: Property devaluation damages
reduce basis. 49K in damages subtracted from 61K basis to produce 12K
adjusted basis. If damages exceed basis, basis goes to 0 and taxpayer pays
taxes immediately on excess damages.
o
Policy: valuation problems, and tax
deferral because property (timing)
Life insurance payouts (101)
o
Payout received at death of insured is
not income
o
Taxpayer looking for mortality gain
(recovery of investment), insurance looking for mortality loss
o
Mortality loss non-deductible
o
Definitions:

Mortality Gain: amount of interest gained upon payout above

the total sum of premiums. When you die earlier than expected. Gain
is excluded by 101.

Mortality Loss: the gap between what was paid out and the total
sum of the premiums (only when it is negative, you live longer than
expected) - no loss deducted per 101
o
Exclusionary treatment to insured may
extend to inside buildup

Endowment policy: insured makes payment(s) so that there is

payout to the insured at a specified time. Payouts receive
exclusionary treatment to the extent of the basis (premium(s) paid),
the gain is treated as ordinary income. Gain = AR Basis.

Viatical settlement: exclusion for terminally ill person who sells

life insurance policy to third party. You get an exclusion for the
payment received from third party.
Annuities (72)
o

Annuities given as compensation:

Income at time it is given (i.e. when they put it in the annuity, not delayed
until you actually get the $).

Basis is what you paid tax on for final payout rules below.
o
All annuities: Income at payout is
treated as follows

Inside buildup (interest) excluded until payout

Gain above basis is taxed; no tax on recovery of basis

Payout over multiple years: Exclusion Ratio (pro rata)

Each payout is taxable at the ratio of basis to interest

E.g. Basis of 100, payout of 120: 20% of the payout is

interest so 20% of each payment is taxable income (the rest
is recovery of basis).

Old rule: basis first. No taxation until amount paid out exceeds
basis.
o
72(b): If you die before the annuity is
paid out, you may deduct unrecovered basis.
Gambling (165)
Rule: annual basketing years total gambling
activity is grouped whereby losses are deductible only to the extent of that years
gains (i.e. no deduction for net loss, and net gains taxable)
Professional gamblers can deduct expenses
(travel, meals, lodging, etc.) if they are considered business expenses under 162.
Gains and losses still basketed above the line.
Recovery of Loss
Clark v. Commissioner (p. 122) (1939)
o
Facts: attorney filed erroneous 1932
return (improperly deducted from income the total amount of losses from sale
of capital assets for period of more than two years instead of applying
limitation in 101(b)) and gave amount of overpayment to client to retain
business
o
Rule: not income if not derived from
capital, labor, or both

Would be income under Glenshaw but not Eisner

o
Policy: gave up wealth, then trying to get
it back
Less relevant now because there is a 2 year
window to amend
Loans and Debt
In general:
o
Not treated as income to the debtor
because there is an expectation that it will be paid back
o
Lender may not deduct at time of loan
because the note he holds is worth what he paid out.
o
Lender must bifurcate repayments
between interest and recovery of basis

Recovery not taxable to the lender because it is just offsetting

the original outlay

Interest is ordinary income

Discharge of Indebtedness
o
General Rule: difference between the
original obligation and the repayment value is considered income

Test: was the lender made whole?

o

United States v. Kirby Lumber Co. (p.

147) (1931)

Company issued $1M in bonds and then bought them back from
the bondholders for $862K.

Rule: True discharge of indebtedness. Company has taxable

income of $138K for eliminating its loan obligations.
108: acts the same as Kirby with
qualified exceptions that are tax exempt listed in (a)(1)

Key criterion: is the lender made whole?

E.g. if a law firm pays off student debt, it is income because its
not discharge, but if the lender forgives based on loan forgiveness
then it would be discharge from indebtedness but exempt pursuant
to 108(f)(1) yay law school!
Zarin v. Commissioner (p. 150) (1990)

Facts: (d) gambles on credit up to ~$3.5m, against NJ law and

orders; casino accepted $500k to satisfy

Rule: no discharge of indebtedness because casino never had

legal latitude to construct $3.5m in debt

61(a)(12) defining income sends you to 108(d)(1)

Diedrich v. Commissioner (p. 159)
(1982)

Facts: Parents made gift of stock to children on condition that the

children pay the gift tax the parents incurred.

Ruling: Not discharge of indebtedness because the IRS was

made whole by the kids paying the tax. Payment of taxes is income
to the parents because they were put in a better position by not
having to pay tax.

Notes:

Childrens basis is, per Tax Reg 1015-4: the higher of the
amount paid or the transferors adjusted basis

Parents have income in the amount the kids paid for

them
Transactions Involving Real Estate and

Loans:
o

Calculations in general:
Amount realized:

Foreclosure or others assuming the mortgage:

Recourse: the FMV of the house (note, if this is

less than the loan value they are still subject to the
difference as personal liability)

Non-recourse: full amount of the outstanding

loan

Sale:

Recourse: FMV of the house (loan + cash)

Non-Recourse: same
Basis:

Foreclosure or others assuming the mortgage:

Recourse/Non Recourse: original basis

(payment + loan value) depreciation
Can result in long term capital gains, but not necessarily losses
for individuals (see 465 and 469)

See also 1245: recapture for depreciated personal property up

to the original basis is ordinary income, but still capital gains for real
property

1250: effect is that all gain from depreciated real

property is capital gain (exception is when recourse loan is
higher than FMV, upon disposition, if the rest of the loan
above the FMV is forgiven then that is income from
discharge of indebtedness)

See Quasi Capital Assets under 1231 for if in trade or business

Note: bifurcation for recourse if you are under water

Note: if a home has been lived in for prior years then see
121 for exclusion of proceeds up to 250k/500k
Crane v. Commissioner (p. 165) (1947) see depreciation below

Facts: TP inherited property fully mortgaged (debt = FMV),

nonrecourse, took depreciations, then sold for assumption of
mortgage and $2500 boot

Issue: (1) what was original basis? (2) does depreciation count
against that original basis? (3) is the mortgage included in the
amount realized?

Rule: (1) upon inheritance the basis of the property is the FMV,
(2) it gets adjusted for depreciations, (3) loan value must be included
in AR as discharge of indebtedness

No reason to use equity in basis calculation

Policy: sheltered income by taking deductions early, and then

paying back only when the property is disposed of

Policy: if property used for trade or business/production of

income, then you can get a tax shelter by depreciating where the
depreciations go against your ordinary income, and then selling, with
capital gains on the amount equal to FMV at sale minus the
depreciated basis (thus converting ordinary income into capital
gains)

Leverage

Deferral

Conversion

Congressional Response: 465 (personal property limiting

depreciation deductions to amount repaid loan or at risk) and 469
(passive activity: basket activity, if there loss there can be no
deduction, but you can carry that loss forward to basket in a later
year)

Can still do tax shelter with real property used for trade
or business in which you are activity involved, as above
Commissioner v. Tufts (p. 173) (1983)

Facts: general partners purchased with $45k and $1.85m

nonrecourse loan (basis $1.895m); took depreciation deductions of
$440k (AB = $1.455m); disposed in exchange for buyer assuming
the mortgage (still $1.85M) when FMV was $1.4m but no cash
changed hands; reported loss of $55k by gain = AB - FMV

Issue: can they deduct the $55K loss despite it being subject to a
nonrecourse loan?

Rule: gain = AR ($1.85m) - AB (1.455M) = $395k; where AR is

the discharge from indebtedness, i.e. the loan value

OConnor dissent: Treat $395K as ordinary income. This would

have been the case IF the mortgage had been recourse.

o
and Tufts

Congressional Response: 465 and 469

469: Requires taxpayer to be materially involved in the

trade or business the property is used in in order to take the
deduction. If he is not, the basis still depreciates, but the
deduction is not allowable until he becomes materially
involved or disposes of the property.

465

Targets personal (not real) property subject to

nonrecourse debt

Limits taking the depreciation deduction to the

amount that you have repaid the loan

Personal property financed by recourse loans

may be leveraged as tax shelters just as in Crane
and Tufts
Third party purchaser basis after Crane

Crane: FMV > mortgage assumed

Basis = mortgage (Z: ???)

From Estate of Franklin

Tufts: FMV < mortgage

Completely exclude debt from basis, so basis for third

party is $0?

Better response is Pleasant Summit (p. 172) (1988):

basis is debt up to FMV: $1.4m

Bank cannot collect full mortgage value of

$1.85m

Policy questions:

Should we distinguish loans based on collateral?

Should we distinguish based on recourse vs.

nonrecourse?

Should we treat a credit advance as income?

Estate of Franklin (p. 172) (9th Cir. 1976)

Facts: purchased hotel for way more than FMV,

nonrecourse loan, immediately leased back to seller

Rule: this shit is a sham - cannot game the system to get

artificially high basis (i.e. that value of the loan was not his
basis)
Example: buys home for $100k and
$900k mortgage, five years later loan still $900k and FMV $850k

(1) loan was nonrecourse, and took $170k depreciation

deductions, foreclosed

Basis = $1m; AB = $830k; AR = $900k

Income of $70k

If was recourse, then AR = $850k, and thus income of

$20k

(2) Nonrecourse loan

Basis $1m; AB $1m; AR $900k;

Loss of $100k, not deductible because foreclosure sale

(i.e. not transaction entered into for profit

(3) recourse loan foreclosed

Basis $1m; AB $1m; AR $850k

Loss of $150k, with potential $50k income from

discharge of indebtedness

(4) no foreclosure, nonrecourse loan, but discharged of $50k of

loan

AB = $950k

Income from discharge from indebtedness of $50k

(5) same as (4), but recourse loan

AB = $50k

Income from discharge from indebtedness of $50k

(samesies!)

Home Sales

121: Gross income shall not include gain from the sale or exchange of property
if, during the 5-year period ending on the date of the sale or exchange, such property
has been owned and used by the taxpayer as the taxpayers principal residence for
periods aggregating 2 years or more

Exclusion cannot exceed $250k ($500k for married couple)

Can only be used once every 2 years

Timing
Policy

Tax in year realization event occurs (claim of right)

Convenience to IRS

Taxing before realization creates valuation problems

Equity to taxpayer

Taxing before realization creates liquidity problems (ability to

pay)

Time value of money: taxpayer wants to defer, IRS wants it now

Variable tax rates by year

SOL: if you wait long enough, the IRS wont be able to claim a deficiency
Realization (1001)

General rule: sale or disposition is a realization event, but unrealized

appreciation of value is not

Taxpayer is in control of realization events for investments

Windfalls: taxable in year of discovery/winning

Stocks

Appreciation in value is not taxable, but cash dividends paid out are

Amount tax = AR basis

If you buy painting at yardsale for squat and:

Find out later that its a Van Gogh, then taxed only upon disposition

Find $75k in hidden in the frame, then taxed on $75k in the year found
because unrelated property

Both: bifurcate and treat separately

Eisner v. Macomber (p. 197, 1920):

Facts: received dividend in the form of common stock

Issue: is this more like a cash dividend or unrealized appreciation?

Ruling: there was nothing derived and thus its not taxable income

Helvering v. Bruun (p. 208) (1940) Overruled by 109 & 1019

Facts: leased property for 99 years, tore down building, then built new
more valuable building, defaulted on lease, landlord repossessed

Rule: gain need not be in cash derived from sale, it may result from the
completion of a transaction

Policy: explicitly overruled by 109 and 1019

109: Improvements made by tenant are not income to property

owner

1019: Landlord may not add improvements made by tenant to

his basis. He is liable for the improvements at the time of disposition:
the improvements inflate the sale value without inflating basis.

Extreme Home Makeover example: Owners lease home to TV

show so they are not tax liable for improvements until they sell.
Example: buys home for $100k, increases in value to $250k, takes loan for
$195k

Disposition with FMV of $190k if recourse results in $5k income from

discharge of indebtedness, $90k capital gains, $100k recovery of basis (not
taxed)

Disposition with FMV of $190k if nonrecourse results in $95k capital

gains, $100k recovery of basis (not taxed)

Note: this is different for businesses dealing with property, e.g. flipping
homes - all of it is ordinary income

Home equity loan

Woodsam Associates, Inc. v. CIR (p. 213) (1952)

Facts: property purchased in 1922; took out mortgage after purchase;

loan renegotiated from recourse to nonrecourse in 1931; title transfers to
corporation 1934; foreclosure sale 1943

Rule: no taxable event until disposition

Policy: differentiate from Tufts loans (recourse or nonrecourse) only

become part of basis when they are for investment in the property (cost of
acquisition, improvement)

Note: if the loan is used to improve the property then it goes into
the basis
1031: Like-kind exchanges (NOT realization events exception to 1001
(recognition event defined))

Limited to property held for use in trade or business or for investment

when such property is exchanged solely for property of like kind which will be
put to the same productive trade or business or investment use

(2) Exception: This subsection shall not apply to any exchange of

(A) stock in trade or other property held primarily for sale,

(B) stocks, bonds, or notes,

(C) other securities or evidences of indebtedness or interest,

(D) interests in a partnership,

(E) certificates of trust or beneficial interests, or

(F) choses in action.

(d): voluntary basis transfers

Formula for Cash Boot: New Basis = Original basis (of all
property exchanged) - cash received + gain recognized - loss
recognized

(b) Gain recognized: the gain realized to the lesser of

Value of the boot (either cash, or FMV of noncash property received) OR

gain realized

Gain/Loss realized

Only for when you give a boot, and the boot has
appreciated or depreciated from its original basis

This is the gain or loss that you must recognize

in relation to the boot FMV - Original boot basis

Reason: like kind exchanges are for avoiding

recognition events for the like kind property, not for
property in the boot

Formula for Non-Cash Boot: New Total Basis = Original basis ($0 cash) + gain recognized - loss recognized

Apportion new basis first by assigning FMV, then leftover

basis goes to like-kind property receive

Basis in new property: first assign FMV to boot, then what is

leftover is basis in like-kind property received.

Examples: see Robinsons handout, dont use examples or logic

below

Other examples: (remember, you dont recognize any gain or

loss on like-kind exchange for the like-kind part! thus you cant avoid
recognition just because its in the boot)

X buy tractor for $90k, it depreciates to FMV $50k

Y buys tractor for $60k, it depreciates to FMV $45k

X gives tractor to Y in exchange for Ys tractor and $5k

cash

X: new basis = $90k $5k + $0 $0 = $85k (all

in the tractor because cash obviously has $5k basis
of its own)

Y: new basis = $65k $0 + $0 $0 = $65k (all in

the tractor); note original basis is $5k in cash and
$60k in tractor

X gives tractor to Y in exchange for Ys tractor and $5k in

stock, in which Ys basis was $10k

X: new basis = $90k $0 + $0 $0 = $90k ($5k

basis in stock, $85k basis in tractor)

Y: new basis = $70k ($60k in tractor, $10k in

stock) $0 + $0 $5k (from stock) = $65k (all in
tractor)

Y recognizes $5K loss in stock at time of

transfer (disposition, so recognition event)

Note: this example unlikely to happen since taxpayers

are deferring recognition of loss against their best interests.
Cannot be a pure cash exchange
Standard: material difference (in
Cottage Savings different houses in the same area are treated as different
because there is different legal status)

Nature and character not value and quality

Real property and personal property are
never a like-kind exchange
Cottage Savings Association v.
Commissioner (p. 216) (1991)

Facts: Savings and loan swapped bad mortgages with other

savings and loans in order to recognize a tax loss without putting a
loss on its books (tried to make as similar as possible)

Rule: Realization event, may deduct for capital losses below

basis.. loss or gain recognized for swap of legal entitlements if not a
like-kind exchange (as defined in 1031)

Policy: this was just different enough to be not like-kind

exchange, but TP made out like bandit because could recognize tax
loss without having to report business loss on books (for some
reason we dont need to know)
PLR 200203033 (p. 229) (2002)

Facts: taxpayers conveying perpetual conservation easement

(PCE) on Old Ranch in exchange for New Ranch which will also

o
o

o
o

be burdened with PCE, PCEs were considered real property rights in

the state
Rule: exchange for PCE in real property for interest in other real
estate subject to PCE is a like kind exchange of like-kind property
when held for productive use in trade or business or for investment
Like-kind is concerned with nature or character of property, not
grade or quality
1033: involuntary conversion w/ like kind

replacement
o
If you receive cash in response to an
involuntary conversion (e.g. insurance payout after theft/damage) you can
avoid tax liability on gain by purchasing like-kind property within two years
(optional, you can pay up front)
o
If you replace the property then you get
to defer indefinitely until disposition of the new property
o
1231 for property involved

Nonrecognition Rules for Corporate

Transactions: Converting Sole Proprietorship to a Corporation
o
351 - Nonrecognition

If you exchange property for stock in a corporation you do not

recognize gain or loss based on FMV at time of transfer IF you or
those joining you become in control of the corporation

Essentially this limits it to forming new corporations

o
358 - Basis

Individuals basis in property contributed to corporation becomes

that individuals basis in the corporate shares they receive.

Corporation assumes the individuals basis in the contributed

assets

Problem: when the corporation sells the property it gets taxed on

gain, when the individual sells the stock, they get taxed on gain, thus
the gain over the basis is taxed twice
Annual Accounting (when payment received) and Accrual
Accounting (when transaction occurs)

Net Operating Loss

o
172: deduction for net operating
business losses (not personal)

Can go back 2 years back or 20 years forward

Best to go back first, except when rates have changed

If you have multiple businesses, you can only offset losses from
one against the other if you are actually engaged in both.
o
Burnet v. Sanford & Brooks Co. (p. 127,
1931) Overruled by 172

Facts: worked on a project for 4 years, had losses in 3 of them,

wasnt compensated until several years later. Taxpayer wanted the
compensation to be applied to the earlier years because tax rates
had risen.

Ruling: Liable in full in years of payment. Did not take a

transactional approach, also couldnt treat operational expenses as a
capital expenditure

Claim of Right Doctrine

o
North American Oil Consolidated v.
Burnet (p. 132) (1932) claim of right doctrine

Facts: dispute over rights to drill land, profits held by receiver in

1916, in 1917 lawsuit resulted in payment to taxpayer

Ruling: does not matter when you had a claim to a sum, or if it is

still in litigation, it matters when you have your first legal right to the
money (undeniable accession to wealth)
o
Loss of claim of right: Congress
responded to Lewis (below) with 1341:

For all amounts at stake greater than $3k where claim of right is
lost: Places in position would have originally occupied

If tax rates of present year are more favorable, deduct as

normal

If tax rates of previous year were more favorable,

calculate that deduction, then apply it as a credit to your
present-year return.
o
United States v. Lewis (p. 136) (1951)
Overruled by 1341

Facts: guy gets bonus in 1944, pays all taxes, then court rules in
1946r that it was a mistake, pays half back

Issue: in which year is the deduction for the payback taken?

Ruling: taxed in the year you had the right, even if it was
mistaken:

Had right in 1944, rightly paid tax then

Lost right in court in 1946, thus takes deduction for what

he paid back in 1946.
Tax Benefit Rule: when taxpayer deducts in one
year and recovers in a subsequent tax year (see medical expenses, squaring up)
o
Exclusionary aspect (111): taxpayer
need not include anything in income if no tax benefit in year of deduction (i.e.
the taxpayer didnt make a deduction prior to the recovery)
o
Inclusionary aspect (111): taxpayer
must include income equal to the amount previously deducted (i.e. the
taxpayer had taken a deduction prior to the recovery)
Deemed Realization
Constructive Sale
o
Short against the box (now prevented
by 1259)

Behavior: you own 100 shares in XYZ company, short them

(borrow from someone else, and instantly sell at FMV), then repay
loan with your shares if value is higher than short price when the
stocks must be returned or purchase new if FMV lower than short
price at time stocks must be returned

Effect: insulate yourself against decreases in price

Rule: initial sale is treated as realization point by 1259

Treat sale of borrowed stock as if it were sale of your

own stock
o
Zero cost collar

Behavior: buy put option below FMV (option to sell at a price

below FMV; insures owner against massive depreciation) and sell
call options above FMV (giving someone else option to purchase at a
price above FMV at a future date, gives buyer the power to call in a
good deal).

Effect: eliminates owners exposure to changes in value

outside the window set by the put and call options

Rule: Not a constructive sale, although Treasury retains right to

write regulations deeming it one.
Original Issue Discount (OID) 1272-1275

Occurs when a present asset is transferred for a

future payment. Total redemption price must be split into (1) untaxed recovery of
basis, (2) capital gains above basis, and (3) interest taxed as ordinary income.
o
Annual taxpayers must account for
interest and capital gains each year despite final payout not occurring until
years in the future.
Also plays a role if you receive property and pay
later - must use OID to figure out reduced price of property at the time of the sale and
interest on that value to reach final agreed upon future payment
Exceptions
o
Principal residences
o
Farms of FMV under $1m
o
Payments of under $250k
Policy:
o
Hurts cash-basis taxpayer
o
Reigns in problems between lenders
using accrual method and borrowers using cash method
o
Prevents tax deferral
Burnet v. Logan (p. 249) (1931) - Open
Transaction Approach Basis First (instalment method prefered now)
o
Facts: Taxpayer sells stock with basis of
$180k for $120k cash and undetermined future payments based on what the
company produces over the next 25 years, tentatively valued at $100k.
o
IRS contention: tax immediately on
$220k amount realized ($40k recognized over basis).
o
Rule: Open transaction. Transaction will
not be closed until taxpayer knows total gain or loss in 25 years. As
payments come in, taxpayer has no liability until payments exceed her basis,
then all payments above that are taxed as capital gain.
Note: if there are sales with contingent
payments
o
If it is possible to determine a maximum
amount that may be paid, basis is allocated by treating that maximum as a
selling price.
o
Where a maximum selling price cannot
be determined, but it is possible to determine a maximum period of time over
which payments will be made, basis is allocated in equal annual amounts
over that time period.
o
If it is not possible to determine either a
maximum price or a maximum time period, basis is recovered in equal
annual amounts over a period of fifteen years.
Ways to deal open transactions
o
If open transaction, then basis first
approach

IRS will always argue that its not an open transaction

o
If not open transaction, can elect
between:

Present value approach: determine present value of the

payments and treat as if it were sum of cash received on date of
sale, gain or loss is then determined in comparison to basis

Can be elected over the Installment Method, but theres

no reason to pay taxes up front

Instalment method (current law 453): allocate some portion

of basis to each expected payment received so that some portion of
the gain or loss is recognized as each payment is received (lump
sum/lumpsum issues?)

Non-basis element of each payment received may be

interest (ordinary income) or capital gains, or both,
depending on nature of transaction.

Policy: helps people who do not have the cash to pay

taxes when havent received tax: can choose present value
approach, but everyone chooses to defer taxation

453e: cannot take advantage of installment method if

buyer is related

In response to relative 1 selling to relative 2 in

exchange for annual payments, then relative 2 sells
immediately to third party for no tax consequences
because sale price should be the same as the FMV,
then relative 1 gets to defer taxes (straw man)

Loophole: same-sex partners were not related

people (now they are because of DOMA)
Constructive Receipt - 26 CFR 1.451-2
Constructive Receipt: (a) Income although not
actually reduced to a taxpayer's possession is constructively received by him in the
taxable year during which it is credited to his account, set apart for him, or otherwise
made available so that he may draw upon it at any time, or so that he could have
drawn upon it during the taxable year if notice of intention to withdraw had been
given.
o
See North American Lumber:
undeniable accession to wealth
No Constructive Receipt: (a) income is not
constructively received if the taxpayer's control of its receipt is subject to substantial
limitations or restrictions
Amend v. Commissioner (p. 257, 1950):
o
Facts: Farmer sold wheat in 1944 and
agreed to collect payment from buyer in 1945. IRS tried to tax farmer in 1944
for sale.
o
Ruling: Not taxable until 1945; no
constructive receipt. An unfunded promise to pay is not income until the
money is available to the taxpayer.
Self Imposed Limitations: do not change
classification as constructive receipt
o
E.g. person refusing to dip into savings
account doesnt change the fact that they have the right to use it.
Economic Benefit
Economic Benefit: when you acquire an
irrevocable right to funds that have been set aside for you the sum is treated as
income
o
Fund is beyond reach of the payers
creditors
o
Most constructive receipts would be
economic benefit
Pulsifer v. Commissioner (p. 262) (1975)
o
Facts: Father gambles on horse race in
his childrens name. He wins, but the children cant collect their winnings until
theyre 21.

Rule: Income, taxable in year father

won, under economic benefit rule because children have irrevocable right to
funds set aside for them. Not constructive receipt because children did not
have right/power to collect funds in the tax year.
Nonqualified Deferred Compensation: essentially no limit on
the amount of current compensation that can be deferred to, and become taxable in, future
years. Generally for senior corporate executives and other high-income plans

Revenue Ruling 60-31: cash basis taxpayers

no current liability for compensation (mere promise to pay, unfunded promise)

Minor v. United States (p. 264, 1985)

o
Facts: employer withheld percentage of
doctors pay, placed into a trust with employer as settlor and beneficiary and
doctor as trustee, to eventually be paid to doctor in future
o
Ruling: neither constructive receipt nor
economic benefit because funds are not available to doctor now (CR) or
irrevocably held for doctor (EB) (held for benefit of employer).
o
Result: only a promise to pay, benefit is
to the employer not the employee, but the employer doesnt get a deduction

If employer becomes insolvent then employee does not get $

Employee Deferred Compensation

Qualified deferred compensation 401(k) and

409(a): deferred compensation plans typically given to all employees, where there
would be constructive receipt (unlike Minor), but based on meeting criteria: Employer
deducts, Employee defers until payout
o
Defined Benefits Plans: Retirement
benefits fixed (specific amount) on the basis of employee time of service
o
Defined Contributions Plans: Employer,
employee, or both annually contributes fixed amt to retirement plan;
retirement driven by investment strategy
o
Beneficial Features:

Deferral effect for employees initial contribution and return on

investment

Deduction for employers for amount contributed immediately

Deferral enhanced compounding increases returns

o
Anti-discrimination rules: cannot offer
these only to highly-compensated

Problem: Plans attractive to rank-and-file (who need more cash

up front) are less tax favorable to the highly compensated, but the
employer cant offer a different plan structure only for the highly
compensated.
o
Penalty for early withdrawal (see p. 275)

Other Plans:
o
Employees are immediately liable for
the amount in their contracts even if parts are deferred (through mutual
agreement) and set aside IF employee retains option to accelerate the
benefit

Economic benefit rule: money set aside that employee has

irrevocable right to.

Constructive receipt: employee has the right to take the

cash/benefit at any time; that he chooses not to accelerate the
benefits is no different than people who choose not to withdraw from
their savings
o

Result: employee incurs immediate

liability for offshore trusts and rabbi trusts (whereby trust protected against
employers creditors) if they are the beneficiary
Stock Options for Employees:
Ordinary treatment - investment behavior, thus
not income
o
Problem: if employee gets investment
treatment, then employer cannot deduct upon grant
Three possible treatments:
o
(1) income when option received
o
(2) income when restrictions expire
o
(3) gain recognized only when stock
sold (422)
422 - Incentive Stock Options (part of
Qualified Employee Benefit Plans)
o
Taxed as capital gain upon sale of stock
o
Only applies when stock meets statutory
requirements:

Employee must retain stock for 2 years after grant of the option
and 1 year after receipt of stock

Option price must not be lower than FMV at time of grant (thus
incentivizes employee to increase value of the company)

Corporations shareholder must approve of plan before granting

$100K ceiling on stock value (at time of granting) of unexercised

options

Any stock in excess is not an ISO, and falls under 83

E.g. employee gets $125k in stock options, first $100k

governed by 422 and other $25k by 83
83 - Non-Statutory Stock Options
o
Does stock option have a readily
ascertainable FMV at time of granting?

If yes (rare): ordinary income to employee at time of grant

Exception: If option is nontransferable AND subject to

substantial risk of forfeiture, no income until one of these two
conditions lapses.

If no (usual): difference between the FMV and the option price is

treated as ordinary income at the time the option is exercised (the
stock is purchased)

Does not matter if FMV of option becomes readily

ascertainable between granting and exercise--if not
ascertainable at granting, no income until exercise.
o
There will be capital gains tax on the
remaining gain when the stock is actually sold

Basis after purchase of the stock is treated as the amount

included as ordinary income plus the option price (essentially FMV at
time that 83 applies)
o
Employer deducts the value considered
income to the employee in the same year that income taxed on employee
o
Exception: if options are sold before
they can be exercised

Cramer v. Commissioner (p. 283) (1995)

Facts: received option subject to substantial restrictions

and declared FMV of $0 to avoid income tax liability (and
o

events
o

o
o

have all capital gains liability); later on sold the options for
megabucks and claimed he was under second prong of 83
whereby basis was FMV at time of sale

Rule: controlled by 83, TP was wrong in declaring FMV

of $0 because there was no readily ascertainable FMV at the
grant of the option. The FMV of the option was imputed to be
the ultimate sale price, which is thus a deficiency from the
original claim that it was $0. TP received taxable income in
that value.

Takeaway: you cant get it for free, you cant get it for all
capital gains (The option itself is not a capital asset)
Marital and Divorce Transfers
Property Settlements - Timing Issue
1041:

No gain or loss is recognized on transfer of property at divorce or

during marriage

Exception: Alimony (see 71 - basically salary:

deductible for payor and taxable for payee)

Basis is transferred, thereby preventing tax liability easing the

mediation process (nonrecognition event)

Essentially the same rules as gifts (since we dont care about the
gift tax)

Limitation on accrued interest for U.S. Savings bonds: if you

have to reissue the bond with a new name on it then there may be
tax liability for the original owner
United States v. Davis (p. 291) (1962) overruled by 1041

Facts: Husband transferred stock to wife as part of divorce

settlement

Rule: Recognition event because wife was not previously the

owner of the stock.

Result: Normally this was a recognition event

Transferor accounts for gains over original basis

Transferee takes basis at FMV at time of transfer

Antenuptial Property Transfers: taxable
Farid-es-Sultaneh v. Commissioner
(p.296) (1947)

Facts: Husband transferred large amount of stock to wife before

marriage.

Rule: Pre-marital transfers are recognition events akin to a sale

because a womans hand in marriage is valuable consideration

Transferor recognizes gain or loss on assets transferred

Transferees basis is FMV at time of agreement.

Alimony
71(a): payments received taxable
215: payments paid deductible above
the line

In order to take deduction, transferor must provide SSN of

transferee so the IRS can tax that person.
Restrictions: in 71

Cannot have a contingency about a child--automatically

becomes child support, even if its in excess of what court ordered

Must be paid in cash (not stock, etc.)

Stock transfers automatically considered property

settlements

Payment must be received through an instrument of divorce

The parties must not have agreed that payments will be

nontaxable to the payee and nondeductible by the payor

Parties may not be members of same household

Payments cannot continue after death of payee-spouse

Only payments that are substantially equal throughout the first

three years will be considered alimony

Front-Loading Recapture Rule ((71(f)): if payments in

first year exceeds average of second and third year by $15k
or more, alimony is recaptured and payor must include
excess in income retroactively (payee may deduct excess).

*If any restrictions met (such as if it continues after death), then it

is not alimony, and it is a payment incident to divorce, which
NEITHER taxable to recipient, NOR deductible to the payor
Child Support
o
Not deductible to person paying, not
taxable to person receiving
o
Policy: when married, a couples
obligation to support their children is after-tax and not deductible
o
Diez-Argulles v. Commissioner (p. 304)
(1984)

Facts: Wife tries to write off non-payment from deadbeat as bad

debt under 166(d)

Rule: no bad debt deduction for child support payments that

were not paid as they were supposed to be
Deductions Policy
Transformations
Personal Itemized Deductions
165(c) Note on Personal Losses: Only deductible if:
Connected with trade or business or
Connected to a transaction for profit (home sale,
stock sale, but not foreclosure)
Casualty Loss
Casualty Losses 165(c)
Fire, storm, shipwreck, other casualty or theft
Calculation
o
Subtract amount realized (value after
casualty, subtract 0 if it is a total loss) from basis to find loss amount (so for
total loss this is just the basis)
o
Subtract any insurance compensation
from this loss amount
o
Determine whether damage is from
casualty
o
Determine whether aggregated casualty
losses for the year exceeds 10% of AGI (if yes then deduct in amount over
10%)

Each individual loss is only deductible in excess of $100 (copay)

This is only for uncompensated losses:
taxpayer cannot forgo insurance to take loss

o
o

Special Rule 165(i): for major natural disaster,s

move the deductibility around time wise (preceding year or year it occurs)
o
Policy: you may not make a lot of $$
when there was a natural disaster

Special Rule 165(k): if ordered to demolish or

relocate residence because of natural disaster

Dyer v. Commissioner (p. 336) (1961)

o
Facts: normally tame cat knocked over
1/pair of vases in a fit, fixed, then pair worth less
o
Rule: casualty losses denied when
behavior not sufficiently sudden (fire, storm, shipwreck)

unexpected, accidental, or unusual

Chamales v. Commissioner (p. 338) (2000) value must not be able to return
o
Facts: owned house next to OJ
Simpson, tried to sell but couldnt, nothing physically happened to the
property, TP kept improving property
o
Rule: not a casualty loss if the value will
come back
o
Remedy: TP not liable for penalty
because reasonable cause/good faith for the deduction

Blackman v. Commissioner (p. 345) (1987) - no

gross negligence
o
Facts: TP found wife cheating on him in
home he owned, TP took her clothes and lit on fire on stove, said put out,
significant fire damage
o
Rule: Taxpayers own gross negligence,
unlike simple negligence, cannot be the cause of the casualty
o
TP charged with arson and destruction
of property

Policy:
o
Only available to taxpayers with income:
no relief for poor people who lose property.
o
Incentivizes people to live in disaster
prone regions (so long as they have income)
Extraordinary Medical Expenses: 213 (but work through
concurrently w/ 104)

Major uncompensated medical expenses

o
Nothing covered by insurance is
deductible, and no indirect expenditures (like health clubs)
o
But may include: elevators for aging
people, lap pools, etc.

Only allowed in excess of 10% of AGI

If you deduct in a previous year, then you must

square up and pay when you receive compensation in a later year (see 104, does
not exclude from income compensation for prior medical expenses if it is to
compensate an expense deducted in a previous year under 213)

Can move to 162 if its connected to trade or

business
o
Ex: Cosmetic dentistry for salesmen
o
Cosmetic surgery: used to be
deductible, now only for performers

Can include expenses of dependents as

defined by 152
Charity 170

Caps the deduction at 50% of AGI for nonprofits,

30% for private foundations
o
regardless of which one

Tax benefit: donate appreciated asset

Donor may deduct FMV without
accounting for gains on basis
o
Charity may sell at FMV
Exception: can only deduct 80% of contribution
to (1) educational institutions that result in (2) tickets (3) at a stadium of (4) that
institution
o
Search the statute for other oddities
Problem: Incentive for givers and charity to
overvalue gifts; IRS is on its own to figure out true value in these cases
Part Gift Part Sale: (1011(b)) If sold to charity
at below FMV, allocated basis between gift and sale element
o
Example: T sells goods (basis 20, FMV
100) to charity for $20. 20% of transaction is sale and 80% is gift, so
apportion basis likewise: 20% of basis, or $4, was sold for $20, so he has
$16 in gain and an $80 charity deduction.
Ottawa Silica: if the benefit to the donor exceeds
the aggregate benefit to the donee and the general public then the gift does not
qualify under 170
Interest 163
Cannot generally deduct interest paid on
indebtedness, subject to exceptions (mortgage, student debt up to a limit, investment
debt, see below)
163(d): Investments (netting)
o
Applies when taxpayer borrows money
(and pays interest on that) to invest in something
o
Net investment gains each year against
interest paid that year
163(h)(3): Qualified residence indebtedness
o
Acquisition indebtedness: deductible up
to $1M
o
Home equity indebtedness: deductible
up to lesser of $100K or equity taxpayer has in the home

Tax benefit: Take out home equity line to pay off other nondeductible debt; this interest will be deductible.
o
Encourages homeownership
o
Applies to second homes, too
o
Problems

Incentivizing borrowing creates more demand for credit and

higher rates

Incentivizing people to borrow for home beyond what they can

afford led to the 2008 crisis
Non-deductible interest: Most student loans (but
see 221), credit card debt
But see 264: relating to debt for insurance
policies (generally not deductible)
o

Corporate donors may only deduct 10%

calculated
o
o

o
o

Most credits phased (in and then) out as income goes up

Earned Income Tax Credit 32
Policy: type of welfare that requires work to

But see 265: cant deduct debt incurred to

obtain exempt income
Student Loan Interest 221
Only deductible up to $2,500
Phased out starting at $50,000 of AGI
May not be taken by someone who is a
dependant
State and local taxes 164
Includes income, real property, and personal
property taxes
If state does not have an income tax (e.g.
Florida) may deduct state sales tax
Tax Credits: dollar for dollar reductions of tax liability. Last thing that gets

qualify
Entitled to credit equal to specific percentage of
earned income up to a certain level
More kids, up to 3, means more EITC
o
152 defines dependant
Phased in as a wage subsidy and then phased
out as need declines
o
Possible incentive to work less
Child Tax Credit 24
$1,000 for each dependent child under 17
o
152 defines dependant
Phased out
Refundable (if this exceeds your income,
government will pay you)
Subject to AMT
Exemptions 151
Personal
Dependant
62: AGI
63: Taxable income defined
Business Outlays/Deductions
Mixed Business and Personal Expenses
(IRS wants you to the right, taxpayer wants toward the left)

Type:

162 - Trade or
Business

212 - For
Profit

Basketing

262 - Personal

Treatment

Above the line

Itemized below
the line, 2%
haircut (67)

Basketed, some get 2%

haircut (see for what gets
haircut)

No deduction

Benefit:

- No 2% haircut
- No need to
itemize

- Full deduction
allowed even if
losses exceed

- Gains may be offset by

losses to reduce tax liability

-None. You can

keep the crap you
bought!

Included
Activities

- Standard
deduction still
available
- Reduces AGI
(for purposes of
other statutes
with phase-out
provisions)

gains for the

year

Purely business
use property

Profit oriented
activities

-Problem: if you
generate any
income, it cannot
be offset by other
expenses in that
category
183 - Hobbies (also subject
to 2% haircut): primary
purpose is not profit

Living expenses,
personal, or family
expenses

163(d): Investment interest

(no 2% haircut)

purely personal

164: state and local taxes

(no 2% haircut)

Child care/child
support payments

165: Gambling, casualty

losses, personal losses, etc.
(no 2% haircut for gambling
and casualty; yes for other
personal)
469 - Passive Activity
exception to 162 or 212 (not
materially participating in a
continuous or substantial
way): prevents taking a loss,
but makes a credit for other
years
Cases:

Nickerson:
continuous
activity and
reasonable
expectation of
profit.
o

Bad Debts

166 allows for deduction of bad debt created or acquired in connection with a
trade or business (if wholly or partially worthless)

Exception: if the debt is a security defined in 165(g)(2)(C)

Still may be able to call it a capital loss, etc.

Depreciation and wasting assets

Certain expenditures are not allowed as deductions under 162, and are instead
treated as capital expenditures under 263, which depreciate and are treated under
167

263 says you must use (the property in trade or business), you cant
just capitalize (buy and mothball) it and then take the deduction. No passive
activity!

167: is it eligible property?

Must be used for trade or business, or production of income


Same standards as 162/212 deductions
Includes machines, buildings, patents, etc. that will deteriorate but does
not include capital assets or land which are nonwasting

Also Includes methods for determining useful life

465

Targets personal (not real) property subject to nonrecourse debt

Limits taking the depreciation deduction to the amount that you have
repaid the loan

Personal property financed by recourse loans may be leveraged as tax

shelters just as in Crane and Tufts
469: Requires taxpayer to be materially involved in the trade or business the
property is used in, in order to take the deduction. If she is not, the basis still
depreciates, but the deduction is not allowable until he becomes materially involved
or disposes of the property.
168: specifies the recovery period for tangible assets
1221: depreciable assets are not capital assets and vice versa

BUT they may be quasi-capital assets if used for trade or business

(1231)

Land is not a depreciable asset

1231: Quasi Capital Asset

(b)The term property used in the trade or business means property

used in the trade or business, of a character which is subject to the
allowance for depreciation provided in section 167, held for more than 1 year,
and real property used in the trade or business, held for more than 1 year,
and not subject to exceptions listed

(b)(1)(b) primarily for sale (just for inventory)

1245 Recapture of Depreciation for Personal Property

Treat as ordinary income (not as capital gains) the amount at sale

constituting the adjusted basis subtracted from the lesser of

The reconstructed basis (adjusted basis + all deductions)

Includes depreciation but negates the effects of

easements, putting work into it, etc. used to reduce the basis

The sale price/FMV

Property includes that which is subject to 167 depreciation and fits in

one of the categories in 1245(a)(3)

SUM UP: buy personal property for $100, depreciates at $10/yr for 8
years. AB = $20. You have taken $80 in deductions. Reconstructed Basis
(RB) = $100.

If sells for $80, then this is less than RB so you pay no taxes on
$20, income tax on $60 (sale price - AB = $60), and no capital gains

This makes sense, you have not recouped all the $80 in
deductions in the sale, so you treat those as still being a
losses, and only compensate for the deductions that you
have recouped

If you sell for $120, then this is more than RB so you pay no
taxes on $20, income tax on $80 (RB - AB = $80), and capital gains
on the remainder ($20)

This makes sense, you have recouped all of the $80 in

deductions, so you must pay all of it back.

This is bifurcation in action!

Note: reconstructed basis is not original basis, as it does not put

back in things like easements, etc.
1250 Depreciated Real Property

All gain above adjusted basis is capital gain, dont need to do the
bifurcation 1245 requires for personal property
Mixed Business and Personal Outlays
Nickerson v .Commissioner (p. 393) (1983)
Facts: H&W non-farmers bought farm intending to dairy farm, w/no expectation of
profit for 10 years. Work on weekends (renovate & learn). Tried deduct 162
business expense, disallowed under 183 b/c not for profit. Appealed.
Rule: Second trade or business gets 162 treatment. Will be for profit if there is
reasonable expectation would eventually profit.
Mixed/Hobbies 183
Definition: Primary purpose of activity is not to make a profit
Basketing: losses only deductible against gains, and subject to 2% haircut from
67
Vacation Homes 280A: spectrum of business and personal

o
use

Standards:

Purely Rental Use

Sections 162, 167 and 62 (possibly under 212)

Incidental Personal Use Less than 14 days or 10% of days rented

Business deductions pro-rata from rental income

Itemized deductions remain available as appropriate

Excessive Personal Use More than 14 days or 10% of days rented

All deductions pro rata from rental income

Itemized deductions remain available as appropriate

Incidental rental use (Essentially Purely Personal) Rental use < 15

days

Itemized deductions only

Rental income for < 15 days ignored

Some rules:

Mortgage interest: three regions

(1) no personal use to 14 days/10% of total rental days used for

personal use, rest business use: not deductible as personal,
deductible pro rata according to business use (100% to 90%)

(2) middle between (1) and (3): deductible pro rata for both
personal (163, below the line) and business (162 or 212)

(3) less than 15 days business use, rest personal use: de

minimus business use so not deductible, but deductible entirely
under personal use (100%)

Property taxes: always deductible in its entirety, sometimes bifurcated

between personal below the line and business above or below the line
deduction
Purely Rental Use: All expenses deductible per 162 or 212; check for passive
activity per 469
Incidental Personal Use: Rental use > 15 days, personal use < 14 days and
10% of rental days

Non-business deduction taken in full (taxes)

Business deductions taken pro rata against percentage of time property

was rented AND basketed against business gains - Cant generate a loss

Property taxes and other itemized deductions available

Excessive Personal Use: Rental use > 15 days, personal use > either 14 days
or 10% of rental days

All deductions (business deductions and non-business deductions) taken

pro rata against percentage of time property was rented AND basketed
against business gains. - Cant generate a loss

Property taxes may be itemized in full

Purely Personal/Incidental rental use: Rental use < 15 days

All rental income is excluded

162 and 212 business/profit deductions unavailable

Property taxes and other deductions may be available

Home Office 280A
Broad language denying deduction only deductible as a trade or business
expense (162), not as a profit-oriented activity (212)
Room/space/structure must be used exclusively for business activity
Must be used as one of these:

Principal place of business (balancing test from Popov)

Importance of activity spent in home office compared to

elsewhere

Time spent in home office compared to elsewhere

Place where administrative tasks are done if there is no other place for
this

Place where the taxpayer meets clients or customers

Separate structure used for convenience of taxpayers employer

Popov v. Commissioner (p. 402) (9th Cir. 2001)

Facts: violinist practiced in apartment in dedicated space

Rule: deduction allowed for principal place of business (balancing test,

see above)
Moller v. United States (p. 407) (Fed. Cir. 1983)

Facts: Ms works 40+ hrs/week on investment from two home offices

Rule: investor trader (investing is long-term investments focused on

interest and dividends, trading is short-term daily trades to catch swings of
the market), and only trader = trade or business

Does not hold his services out to anyone (only managed own
money)

Policy: 212 (unlike section 162) does not have trade or business
language, so many expenses may be deductible under here even if home
office not deductible under 280A
Henderson v. Commissioner (p. 413) (1983)

Facts: state employee tries to write off office furnishings as 162

expense

Rule: Not in pursuit of trade or business; she works for the state so she
doesnt need a fancy office to impress customers or clients.

Reasonable office furnishing expenses deductible in private

sector (impressive looking office attracts clients)
Travel & Entertainment 274
LOOK TO WHETHER BENEFIT TO EMPLOYEE OR TO CLIENT
Always ask first: is there a business purpose?

Elements of personal enjoyment do not defeat a business purpose

For domestic travel: no proration (pro rata) of business vs. personal

elements of trip--one or the other, take it all as business if its business
purpose

Foreign travel: must prorate business and personal elements

(see 274(c) for details)

Exception: if less than one week, or personal component

is less than 25%

Treat taxpayers trip first, then ask about spouse/dependants

No spousal deduction for attending business trip unless (1)

spouse is an employee of person claiming deduction, (2) spouse had
bona fide business purpose for going, and (3) the additional expense
would otherwise be deductible

If these are not met, this is a personal expense to the

spouse/dependant

274(h) cruises and foreign conventions

Standard for Business Purpose

Will employees be conducting themselves as they would at

work?

If the setting is not one we associate with business (e.g.

a resort), employees must be behaving in a work-like
manner (e.g. going to meetings, etc.) for this to qualify as
business.

Is work being done?

If clients/customers present:

Events to drum up business or retains goodwill are

business deductible

Events for mere entertainment (see Churchill Downs)

are not

What is the setting?

Is it necessary?

See Rudolph (reward trip?)

Second ask: did employer reimburse all/part of costs?

Yes: deductible either way to employer

If there is a business purpose, no effect on taxpayer (274)

If there is not a business purpose, treat as compensation;

taxpayer has income in FMV of what employer paid for

But see: 274(n), employer may only deduct 50% meals and
entertainment

See 274(n)(2) for exceptions

No effect on employees though (if they are required to

be there for business)

No: see 67; taxpayer may deduct all unreimbursed expenses for
business trips

Limited to business expenses like travel, meals, lodging

Cannot be lavish/extravagant under the circumstances

Business Lunches (not with clients)

Moss v. Commissioner (p. 423) (1985)

Facts: Lawyers met everyday at restaurant for lunch for

convenience; tried to deduct cost of meals as a business expense

Rule: Restaurant was not a required locale (could have met

elsewhere), the lawyers needed to eat lunch anyway, and the setting
was not needed to grease the wheels of social interaction

General rule: If the lunch setting adds to the business nature of the
meeting, its deductible (e.g. retaining goodwill, seeing people outside of an
office setting, etc.). If the lunch is just gratuitous, no.
Rudolph v. United States (p. 417) (1962)

Facts: salesman sold enough to qualify for employer-funded trip to NYC

convention

Rule: employer/employee motive/purpose determines whether deductible

for employee

Is it a reward? Treat as income to employee

Is it to do work? Treat it under 274
Here it was primarily personal (pleasure trip and a bonus and
reward for job well done)

Policy: retreats now common

Churchill Downs, Inc. v. Commissioner (p. 427) (6th Cir. 2002)

Facts: racetrack throws gala

Rule: this was only entertainment, unrelated to the business of racing

horses or goodwill, and thus not deductible

Note: this is different if you are in the business of entertainment

Commuting and other Travel Expenses 162(a)(2)
Standard:(1) reasonable (2) away from home and (3) in pursuit of business

Normal costs of commuting, parking, meals, etc. not deductible

When away from home, reasonable and necessary costs of business

travel deductible--gas, parking, travel tickets, lodging, and meals (but no
luxury expenditures)

Note: once you are at the office you can deduct costs of moving around
to deal with clients, etc.
Commissioner v. Flowers (p. 437) (1945)

Facts: works in one city officially, entered into agreement with RR

employer to chose allocation of time between home city (working at old firm)
and office in new city

Rule: maintaining an out of city personal residence is personal reasons,

thus travel expenses not deductible. Does not satisfy in pursuit of business

Effect: even though home in Jackson, his home for business

purposes is in Mobile. Theres no business reason for him to ever be
in Jackson so travel there is not deductible.

Policy: likely could have deducted if he picked up some business from

his old firm
Hantzis (p. 443) (1st Cir. 1981)

Facts: Law student lives in Boston and takes summer job in NYC, tries to
deduct NYC expenses

Rule: Since NYC is her only job, it is her business home so she is not
away from home while there, and she is never in Boston for business. No
deductions.

Rule: Being a student is not a trade or business.

Transitory vs. Intermediate Commuting/Travel Expenses (for purposes of where
is your home)

Look to taxpayers reasonable expectations

Default line is a year: if you are working there for more than a year its
your business home and no longer under travel expenses
Moving Expenses 217: ABOVE THE LINE
Uncompensated moving expenses deductible if:

New job is more than 50 miles from old house than old job was

Will work 39 or more weeks at new job in upcoming year

217 is for permanent or indefinite moves

Permanent or indefinite: standard is one year

Use 162(a)(2) (travel expenses) if you temporarily move for work (see
above standard)
Legal Expenses: may fit into 162 and 212
General Rule: Deductible only if ex ante cause of legal action was related to
business/profit activity. Does not matter if these are affected ex post as a
consequence if the legal action was for personal reasons.

United States v. Gilmore (1963) (p. 455)

Facts: Taxpayer not allowed legal expenses (attorneys fees) for a

divorce because divorce is personal, even though he was trying to keep a
profit-producing property

Rule: Proceedings were not initiated to protect profit/business

Accardo v. Commissioner (1991) (p. 460)

Rule: Criminal defendants may deduct if they are found guilty of being in
a criminal business, but if they are not convicted, they are by definition not in
the business of crime so they cant deduct

Civil Plaintiff Suits (for money damages) are always profit motivated and thus
fall under 212 (business suits could fall under 162)

Doesnt matter if it was related to previous profit seeking activity: it is

profit seeking activity in and of itself
o
Personal items

Clothing generally not deductible, unless so unusual that cant be used on

regular basis

(wasnt assigned - p. 45255)

o
Education (p. 461): deducitble when it is an ordinary and
necessary business expense

Carroll v. Commissioner (7th Cir 1969) (461)

Facts: detective tried to deduct cost of enrollment in DePaul for major in

Philosophy for improving job skills and maintaining position as detective

Rule: taking courses based on profession not deductible

Policy: sometimes deduction available pursuant to 62 (points to 221,

and 222 which got repealed) or 63(d)

Education: 1.162-5 adopts set of objective test to distinguish between capital

expenditures and current expenses for education relating more directly to production
of income (this is a 162 expense, because 222 was repealed)

Allowed for (1) maintaining or improving skills required in employment or

trade or business, or (2) education meeting express requirements of the
employer or requirements of applicable law/regulation for retention or
status/rate of compensation

Rule often applies to schoolteachers completing or continuing their

education or CLE for lawyers

Bar prep courses do not matter, but you may be able to take a sabbatical
for education

No deduction allowed for expense of meeting minimum education

requirements for qualification in employment or other trade or business, or for
programs to qualify for a new trade or business (e.g. classes needed to get
CPA)

Education as a capital expenditure: possible to deduct at the end of your

career?
Capital Expenditures (deductions for the cost of earning income) vs.
Ordinary + Necessary Expenditure
o
First question is personal or business, second question is current
or capital!
o
162: ordinary and necessary--current expenditures (see also
212)

Contribute to business immediately

Subject to immediate deduction

Will be used up before they can be depreciated through deductions

General cutoff: one year

o
o

263: If the asset will last a long time, it must be capitalized and
deduction delayed until sale or other disposition

Wasting assets: pro-rata deduction under 263/263A and 167/168 (tangible

wasting assets) or 197

Non-wasting assets (like land): no deduction until sale or disposition (cannot be

depreciated)
Trend: Away from old presumption of capitalization; more
regulations now allow taxpayers to currently deduct more types of assets.
Encyclopedia Britannica v. Commissioner (p. 466) (7th Cir. 1982)
- Capital Expenditure

Facts: Encyc. Brit. produced dictionary of natural sciences and hired third party
to write the book and gave them advances (normally would do this in house), would
give them royalties, and then Encyc. would market it, treated advances to 3rd party
as business expenses even though hadnt received profits yet

Rule: nonnormal and nonrecurrent transaction should be capitalized (could have

been deducted as business expense if in house, before congress amended in
response*)

Relevant Facts:

Low amount of oversight with only periodic feedback

Contractual rather than ongoing

Expectation of a product in the future

Self-contained project with non-employee

New product not currently producing income

*Policy: congress amended 263 - UniCap rules (uniform capitalization rules)

which also apply to self-produced assets

New Rule: Neither in-house nor outside efforts are immediately

deductible, must be capitalized if they meet the abovementioned relative
facts
INDOPCO (p. 474) (1992):

Facts: trying to do merger, so question of what fees need to be capitalized

Rule: any expenses incurred in creating or acquiring various intangibles, such as

goodwill, customer lists, covenants not to compete, an assembled workforce, an
ownership interest in a corporation or partnership, or a license to practice law, must
be capitalized

Lead to INDOPCO regulations (p. 47475) speaking to specific situations as to

whether to deduct or capitalize

The general important principle of the INDOPCO regulations is that

expenses must be capitalized if they create, or facilitate the creation of, a
separate and distinct intangible
Repair and Maintenance Expenses vs. Replacement and
Improvement

Midland Empire Packing v. Commissioner (p. 476) (1950)

Facts: storage space for meats, oil began seeping through walls, needed
fix or would be shut down

Rule: this is a current business expense because it is restoring

something wrong with building bringing it back to baseline

Note: size of the outlay is not dispositive

Takeaway language:

Repair (deductible): Restore to a sound state or to an efficient

operating condition/status quo

No addition to basis

Deductible immediately under 162

Usually respond to a problem that onsets gradually

(natural wear and tear)

No change to expected use or profitability of property

Protects prior and continuing use

Have a routine and common nature

Small nature of outlay

Replace (capitalized): betterment, substitute, replace, alter,

improve or add to property prolonging its life

Addition to basis

Then capitalize under 263

Generally change in ordinary use or enhancement of

expected returns

Generally a response to a sudden change

May be a response to something mandated by the state

(not all responses to regulation are deductible)

Storm example: improving property in preparation for a

storm is a capital outlay because the improvements will still
be available for future storms.
Hotel Case: hotel in CA earthquake threat
when you make code compelled expenditures, you bring it up to what market value
would be, but it is still a better building so still capital expenditure
Rev. Rul. 2004-18 (2004) (p. 480) 263A: no
current deduction for environmental remediation costs for land contaminated by the
taxpayer.
Current expenditures under 162: ordinary and necessary
Welch v. Helvering (p. 489) (1933) - purchasing
goodwill

Facts: TP worked for Welch, going out of business, then worked for
Kellogg Company, but paid of Welchs debt to secure customer base he got
while working for Welch. Tried to deduct expense as current business
expenditure

Rule: Not an ordinary + necessary expenditure because this situation is

not common in the business world and is an intangible and wasting asset
(not deductible or capital expenditure)

Reputation here is a capital expenditure (like goodwill), not an

ordinary business expenditure (changed with 197)
Today: goodwill acquired through purchase and
other intangibles can be amortized over 15 year period under 197 (see statute for
things included, e.g. patents, books of business, labor force, etc.)

For a business: purchase price assets = intangible/goodwill

Friedman v. Delaney (p. 500): Lawyer paid clients creditors, after he had
promised that the client would pay them, out of a moral obligation. Not
deductible.

Pepper v. Commissioner (p. 501): Lawyer paid when a client committed

fraud so that the firm would not lose business imperative to save the law
practice, Deductible as a necessary business expense.
Advertising has special treatment in Regs.
1.263A-1(e)(3), it is a current deduction
Education: (see above) 1.162-5 adopts set of
objective test to distinguish between capital expenditures and current expenses for
education relating more directly to production of income

Allowed for (1) maintaining or improving skills required in employment or

trade or business, or (2) education meeting express requirements of the

employer or requirements of applicable law/regulation for retention or

status/rate of compensation

Rule often applies to schoolteachers completing or continuing their

education

Bar prep courses do not matter, but you may be able to take a sabbatical
for education

No deduction allowed for expense of meeting minimum education

requirements for qualification in employment or other trade or business, or for
programs to qualify for a new trade or business

Education as a capital expenditure: possible to deduct at the end of your

career?
Section 195: start-up expenditures not
deductible

Some leeway for taxpayer who ends up in acquisition of specific

business (can be capitalized over five years)

Costs of acquiring a specific business are deductible

Cost of seeking new job isnt deductible: by
definition you are not in the trade or business yet
Cost of moving Jobs is deductible because
youre already in the trade or business of being an employee in the field
Gilliam v. Commissioner (p. 495) (1986)

Facts: visual artist and lecturer on medication to control occasional

outbursts; been invited to lecture at place away from home town so needs to
travel by airplane; before leaving changes medication, and has an outburst
on the plane; deducted resulting criminal defense expenses as business
expenses

Rule: extraordinary behavior, or medical behavior like this, is a

personal expense, not business could just have easily had them at home

Policy: line-drawing? How is this different from hearing aids, glasses,

diabetes insulin, etc. which all may be necessary to do business
Trebilcock v. Commissioner (p. 501): Cost of an
ordained minister not deductible because it is not necessary. Personal in nature.
Salary

Must be reasonable to be deducted

Unreasonable salaries are only deductible to the extent of the

reasonable amount

Performance based pay is more likely to be presumed

reasonable

Big salary shifts are suspicious

CEO/Executives (162(m)): Publicly held corporations may only deduct

$1M each for CEO and other 4 highest-paid employees.

Tax strategy: Hire your child as an intern and pay them FMV to shift tax
obligation from higher bracket payer to lower bracket payer.
Illegal Activities:
Illegal income is taxable, and thus, under 162
expenses are deductible

162(c),(f),(g): exception for fines, etc.

No deduction for bribes, kickbacks, or other illegal payments to

government officials, or for bribes to private parties that result in criminal
enforcement

280E: no deductions in trade or business involving from sale of illegal

drugs, but income is still taxable

Loophole: May still take 212 deduction if drugs are merely a

profit oriented activity

Note: outcome of criminal cases have effects on whether you are or are
not in an illegal trade or business

Lincoln v. Commissioner (p. 504) (1985)

Facts: TP put up $140k in scheme thinking buying $600k of stolen

money, but the scheme ran in reverse and they took his $

Rule: deduction denied because TP not protected from his own

stupidity/gullibility (public policy)

Robinson: otherwise, should be a 165(c)(2) loss

Policy: if he could show he was in trade or business of buying stolen

money, then could deduct now, as a business loss under 162
Alternative Minimum Tax: 55-59
Tax liability is calculated the regular way and by AMT; you pay
whichever is higher
Calculating AMT

Start with taxable income that the regular

method ends up with

Most deductions are added back (exception:

mortgage interest, and some other ones we didnt really learn)

Interest on private activity bonds

All itemized deductions subject to 67 2% threshold

State and local taxes (thus hits big tax state citizens more)

Medical expenses

Home equity loan interest

Standard deduction

Personal exemption (including dependent exemptions)

Stock option spread

Then a single big exemption is taken (eliminates

most low/middle income TPs)

The multiply by either 26% or 28% (only two

AMT brackets)
Klaasen v. Commissioner (p. 547) (1999)

Facts: Middle class family has to pay AMT

because they took exemptions for 10 kids

Rule: Even middle class people have to pay the

AMT when it applies, not just the wealthy.
Capital Gains
Long-term gains given preferential treatment, but long-term
losses are comparatively unfavored
Only way to get preferential treatment is to net long term gains
against short term losses
Capital asset (1221): property held by the taxpayer whether or
not used in a trade or business, defined by what it is not

Only type of business property allowed is stock,

because we want to encourage investment
Process

(1) determine if capital asset under 1221

(2) Sale or exchange of long term (>1yr) or short

term (<1yr) capital asset?

(3) Net all short term capital asset transactions,

and net all long term capital asset transactions

o
o

o
o
o

(4) Subtract any net short term capital loss,

against any net long term capital gain. Preferential Tax Treatment for Capital
Gains

If, instead there are net short term gains, they are treated as regular
income.

If there are net long term losses OR net short term losses leftover after
youve netted them with long term gains, they are deductible against ordinary
income, but only $3K per year (can be carried forward).
165(c) Note on Personal Losses (see above, as well): Only
deductible if:

Connected with trade or business or

Connected to a transaction for profit (home sale,

stock sale, but not foreclosure)

Casualty Loss
Quasi-Capital Assets 1231: only for property in trade or
business (doesnt include just profit seeking activity)

Assets covered by 1221(a)(2) are quasi capital

assets. Gain on them is considered capital and loss is ordinary (basketed)

Example: Depreciated building held for more than 1 year sold for a profit;
gain above adjusted basis is capital gain. A loss on this transaction would be
an ordinary loss deductible under 162 (see 1231(b) regarding assets
depreciable under 167)

Exception: 1231(c). If you take an ordinary loss under 1231, you must
first offset that against any 1231 gains for the next 5 years. (prevents you
from taking a huge loss in one year, and a huge gain in another year)

I.e. basket not only in tax year, but also between that year and
next 5 years

Recapture by treating future 1231 gains as ordinary income to

offset benefit of previous loss

Check this before you include a gain (not a loss because an

ordinary loss) in the capital gains calculation

1221(b)->1231(->162 to treat an ordinary loss)

1221(a)(2) excludes trade or business property

subject to 167 depreciation from being capital assets. 1231 trumps 1221, and says
that things in 167 that are property used in trade or business get capital gains and
ordinary losses treatment

Best of both worlds for businesses

Policy: Capital Gains + Favorable Rate (p. 616-18)

Bunching: gains accrue over many years, if you

had to pay normal income tax on it then it would be a higher marginal rate than if
accrued and taxed over the years of accrual

Lock-in: leads to immobility of capital and

inefficient uses of capital because prevents people from reinvesting in other areas

Inflation: mitigates unfairness of taxing gains

attributable to inflation

General incentive: incentive to save and invest,

leading to economic growth

Incentive to new industries: new industries tend

to generate capital gain, so favorable treatment favors those industries

Failure to tax unrealized appreciation: reduces

disparity in treatment of realized and unrealized gains

o
o
o
o

o
o
o

o
o

Double-tax on corporate earnings: corporate

income is taxed once when earned, and again when distributed to shareholders, this
helps reduce that problem
Policy
Types of Taxes:
Head Tax - easy to apply
Flat Tax - fair
Ability to Pay (Progessive Tax/Marginal Rates) equitable
Alternative minimum tax:
No Cash Transactions
Valuation Problems
Timing Problems
Forum Shopping/Court Choice
Tax Court:

File petition for review without paying amount in dispute this is

reviewed by an expert

Reviewed by Court of Appeals for the district of taxpayers residence

File in District Court:

Establishes jurisdiction by paying amount in dispute and then suing for a

refund

Dont have to worry about interest

You get an option for a jury trial

Court of Federal Claims:

Pay amount in dispute to get jurisdiction

Generally for businesses

Reviewable by CAFC
Twin Aims of Tax Code
Revenue: raise money for Congress
Incentives: encourage certain spending and
saving patterns over others
Other goals:

Simple Administration

Clarity/Consistency

Constitutionality

Ability to Pay (Fairness)

Formula
61 Gross Income (doesnt include exclusions)
Deductions (above the line) 62 Adjusted Gross Income
Deductions (below the line) 63 (Taxable income)
Standard Deduction
Itemized Deductions
Personal/Dependant Exemptions
Apply tax (63)
Tax Credits
Alternative Minimum Tax