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FEDERAL INCOME TAXATION

I.

INTRODUCTION
a. Tax Liability = Tax Base x Tax Rate
i. The tax base is usually featured in the name of the tax
1. In the case of the federal income tax, the base is taxable income, as defined in
63
a. The Code uses a three-step process in arriving at taxable income. 61
begins by defining gross income, 62 defined adjusted gross income
(AGI), and finally 63 defines taxable income
b. PROBLEM: p. 3
c. 61(a) states that gross income includes all income from whatever source derived, except
as otherwise provided in this subtitle
i. Many in-kind benefits are included in gross income, though some (e.g. employerprovided parking - 132) are not
d. Hundreds of Code sections are structured so that they provide general rule or definitions, which
depend on several terms themselves in need of definition
i. Thus, the first rule of reading the Code is to keep reading until you have found all the
definitions you need to make sense of the general rule
1. The search for the necessary definitions may extend through several layers of
provisions
ii. Sometimes reading the Code simply isnt enough. The Code comes encrusted with
judicial and administrative interpretations, some of which one might not imagine simply
from examining the statutory language
e. The concept of basis is simply a way of keeping track of amounts that have already been taxed
in order to prevent double taxation
i. The Code does not permit basis adjustments on account of inflation
f. Taken together, the standard deduction and personal exemptions ensure that taxpayers are not
taxed on an amount of income roughly equal to the official poverty level, as adjusted for family
size
g. In a progressive marginal tax rate schedule, the higher rates apply only to the portion of the
taxpayers income that falls within the higher brackets
i. Average tax rate: taxpayers tax liability as a percentage of their taxable income
ii. Marginal Tax Rate: the tax rate applied to their last dollars of income
h. A tax allowance takes the form of an exclusion if qualification for the allowance depends on the
source of an economic benefit (as with damages from a tortfeasor), and an allowance takes the
form of a deduction if it depends solely on the use of funds by the taxpayer
i. The Code tends to be more generous with exclusions than deductions
1. Taxpayers are forced to choose between itemized deductions and the standard
deduction, but they may claim both exclusions and the standard deduction
i. A credit directly reduces tax liability, while a deduction or exclusion reduces tax liability only
indirectly by reducing taxable income
i. Unlike the tax saving from an exclusion or deduction, which equals the amount of the
exclusion or deduction multiplied by the taxpayers marginal tax rate, the saving from a
credit is simply the amount of the credit
ii. Credits are allowed regardless of whether one itemizes deductions or claims the
standard deduction
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j.

All issues concerning the definition of the tax base fall into one of two categories: (1) whether
an amount should ever be included in income or deducted, or (2) in what year an item should be
included or deducted
i. One way of thinking about tax deferral is that it resembles an interest-free loan from
the government
1. The value of a deferral is a function of two things: (1) the length of the deferral
period, and (2) the rate of return the taxpayer can earn on investments during
the deferral period
k. The standard justification for using income as the tax base is that (1) taxes should be imposed
on individuals in accordance with their relative abilities to pay, and (2) a persons income is the
best practical measure of her ability to pay tax
i. If ability to pay rises proportionately with income, then tax liabilities should rise
proportionately with income (e.g. flat rate)
1. If ability to pay rises more than proportionately with income, then average tax
rates should be progressive
a. The current income tax uses progressive marginal rates to produce
progressive average rates
l. Tax Expenditures: revenue losses attributable to provisions of the Federal tax laws which
allow a special exclusion, exemption, or deduction from gross income or which provide a
special credit, a preferential rate of tax, or a deferral of tax liability
i. Tax provisions that provide treatment less favorable than normal income tax law and are
not directly related to progressivity are called negative tax expenditures
ii. The basic idea behind the tax expenditure concept is that it is possible to define a
normative (normal) income tax base, and that any narrowing of taxable income
relative to the normative tax base should be analyzed as a federal subsidy administered
through the tax system
1. Nothing in the basic tax rate structure is considered a tax expenditure
m. Like all taxes, the income tax is imposed by statute
i. Regulations promulgated by the Treasury Department under the Code have the force of
law unless they are inconsistent with the statute
1. Judicial invalidation of regulations is not common; if a court believes that a
Code provision could reasonably be interpreted in more than one way, it will
uphold any reasonable regulatory interpretation
ii. A revenue ruling sets forth the IRSs view as to how the Code applies to a hypothetical
set of facts
1. Unlike a regulation, a ruling does not have a presumption of validity or
correctness
2. Revenue procedures have the same legal status as revenue rulings, but they
resemble regulations in format, in contrast with the use of hypothetical facts
typical of rulings
iii. A taxpayer contemplating a major transaction of uncertain tax consequences may, for a
fee, request a private letter ruling from the IRS
1. The major difference between a letter ruling and a revenue ruling is that a
taxpayers reliance on a letter ruling issued to another taxpayer is not protected
iv. The taxpayer can gain entry to a district court or the Court of Federal Claims only by
paying the disputed tax and suing for a refund. The Tax Court, by contrast, allows the
taxpayer to litigate without having first paid the tax
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II.

v. Cliff Effect: a tax rule under which a very small change in the taxpayers income (or in
some other aspect of the taxpayers pre-tax situation) results in a huge change in tax
liability
1. Mostly avoided in the Code
vi. PROBLEMS p. 38
vii. Vertical Equity: fairness between taxpayers at different income levels
1. Horizontal Equity: fairness between taxpayers at the same income level
viii. Phasedown: reduces a tax benefit as income increases, but stops before the benefit is
eliminated
1. Phaseout sees the complete elimination of the benefit
a. Part of what makes the phaseout bad tax policy its hidden nature is
precisely what makes it attractive to Congress. Congress likes the tax
revenue that comes from marginal tax rates, but it does not like the
political heat associated with those rates when the public understands
them. What could be better, then, than a marginal tax rate increase
imposed in such a convoluted manner that few taxpayers understand
what is being done to them?
GROSS INCOME: DOES SOURCE MATTER?
a. Generally, no
b. Commissioner v. Glenshaw Glass: got punitive damages from prior suit. Didnt report on
return. Held: must report punitive too. 61 says gross income includes any gains, profits and
income derived from any source whatever. Source doesnt matter unless Code specifically says
so. Even if pure windfall. Not limited to gain from capital, labor, or combination like Eisner
said.
i. The language of 61 could not be any clearer on the irrelevance of source
1. Source is always irrelevant under the definition of gross income
a. Source is irrelevant under 61 itself, but source may become relevant
because some other Code section excludes receipts from a particular
source of gross income. (61: Except as otherwise provided in this
subtitle.)
c. From an efficiency standpoint, the best tax is one that does not depend on any choices made by
the taxpayer; since such a tax is not based on taxpayer behavior, it cannot inefficiently
discourage any behavior. By definition, a windfall arrives without any effort on the taxpayers
part, so a tax on windfalls is especially attractive from an efficiency perspective
d. Cesarini v. US: bought piano. 7 years later found $4.5k in it. Held: taxable under 61 b/c not
listed as specifically excluded and an old ruling lists treasure trove as taxable. Reg. 1.61-14 lists
several other sources of GI. Taxable b/c $ separate asset; if wouldve discovered that piano
was more valuable than previously thought (e.g. if it was found to be a Steinway), that wouldnt
be taxable (not covered by treasure trove regulation).
e. Most income is subject to information reporting, which means the payor must notify the
IRS that it has made taxable payments to the payee
f. 61(a)(3) states that gross income includes Gains derived from dealings in property.
i. 1001(a) defines the gain on the sale of property as the excess of the amount
realized on the sale over the adjusted basis of the property
1. 1001(b) defines a taxpayers amount realized on a sale as the cash received
by the taxpayer plus the fair market value of any non-cash property received
ii. 1012 defines a taxpayers basis in an asset as the cost of such property
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III.

g. The concepts of basis and adjusted basis are tax accounting devices for keeping track of
amounts on which the taxpayer has already been taxed, in order to prevent double taxation
i. The idea that taxpayers should not have to pay tax on previously taxed amounts is
sometimes referred to as the principle of tax-free recovery of capital
h. Garber v. US: sold blood plasma to health orgs for 60k. Held: Not guilty for trying to evade
her taxes b/c law is unclear in this area, so mistake does NOT = willfulness. Ct thought blood
exchange either service or product sale. Dissent: majority mistaking value and basis. Basis is
cost of property and value is set by market. Gain is value realized minus cost basis of property.
Plasma basis is 0, and 80k is amount realized. Tax all.
i. Government had to prove a tax deficiency, an affirmative act constituting evasion or
attempted evasion of the tax due, and willfulness
ii. Gain is the excess of amount realized over adjusted basis; there is no need to know
the value of the property in order to compute the taxpayers gain. The majority
appears to have labored under the mistaken impression that the Code defines gain as the
excess of amount realized over the value of the property, so that a taxpayer would
realize gain only in the unusual situation of selling property for more than its fair
market value
1. Absent an heroic effort to find a trivial basis in an allocated portion of her diet,
Garbers basis in her plasma is simply zero. And, contrary to the courts
impression, a master artist who sells one of her paintings does indeed realize
a taxable gain to the extent the amount realized exceeds the cost of the canvas
and paints
i. The traditional understanding is that the primary purpose of tax prosecutions is general
deterrence (that is, putting the fear of the IRS into taxpayers generally)
GIFTS AND BEQUESTS
a. Commissioner v. Duberstein: 2 cases. D bizman who helped another bizman, who was so
happy about references, that he bought D a Cadillac as thanks (and probably for future help). S
worked for church and resigned. Church corp gave him 20k for all his years of help. Held: must
make case by case determination; D was not gift b/c in return for services and future help, S
exempt b/c gift for helping church. Use 102(a) to consider gift in colloquial sense. Gift given
from detached and disinterest generosity. Look most at transferors intent, but still make
objective inquiry too. Key: what was the Dominant Reason to explain the transfer?
i. 102(a) excludes from gross income the value of property acquired by gift
ii. If the payment proceeds primarily from the constraining force of any moral or legal
duty, or from the incentive of anticipated benefit of an economic nature, it is not a
gift
1. Where the payment is in return for services rendered, it is irrelevant that the
donor derives no economic benefit from it
iii. The mere absence of a legal or moral obligation to make such a payment does not
establish it is a gift
iv. A gift proceeds from a detached and disinterested generosity, out of affection, respect,
admiration, charity, or like impulses
b. 274(b) denies the transferor a business expense deduction for any business gift, to the extent
the total value of gifts made by the taxpayer to the recipient during the year exceeds $25.
c. 102(c) declares that 102(a) cannot apply to any amount transferred by or for an employer to,
or for the benefit of, an employee
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IV.

V.

d. 102(a) applies to amounts received by bequest, devise, or inheritance, as well as to gifts


i. Thus, the provision excludes from gross income gratuitous transfers made by both the
quick and the dead
PERSONAL INJURY DAMAGES
a. 104(a)(2) excludes from gross income any damages (other than punitive damages) received
(whether by suit or agreement and whether as lump sums or as periodic payments) on account
of personal physical injuries or physical sickness.
i. Applies to all three major types of compensatory damages: nonpecuniary damages
for pain and suffering or loss of enjoyment, damages for medical expenses (past and
future), and damages for lost wages (past and future)
ii. The word physical was added to 104(a)(2) in 1996; before then the exclusion
applied to damages on account of personal injuries, whether physical or not
b. Amos v. Commissioner: cameraman who Rodman kicked in basketball game. Settled for
200k to release from any claims, non-disclosure, and no later prosecution. Didnt say what $
was for what. Held: 120k excluded under 104a2 for injury. 80k taxable b/c ct thinks for hush
provisions. Determine exclusion by nature and character of claim, not its validity (could be
bogus, dont care).
i. Two requirements that a taxpayer must meet before a recovery may be excluded under
104(a)(2). First, the taxpayer must demonstrate that the underlying cause of action
giving rise to the recovery is based upon tort or tort type rights; and second, the
taxpayer must show that the damages were received on account of personal injuries
or sickness.
ii. Where damages are received pursuant to a settlement agreement, the nature of the claim
that was the actual basis for settlement controls whether such damages are excludable
under 104(a)(2)
1. If the settlement agreement lacks express language stating what the amount
paid pursuant to that agreement was to settle, the intent of the payor is critical
to that determination
a. The character of the settlement payment hinges ultimately on the
dominant reason of the payor in making the payment. Whether the
settlement payment is excludable from gross income depends on
the nature and character of the claim asserted, and not upon the
validity of that claim
c. PROBLEMS (1-4), p. 102
NONCASH BENEFITS
a. Noncash benefits are generally taxable under 61
b. Rooney v. Commissioner: Accounting partners did cross-accounting where swapped their
services for the goods of clients who couldnt pay. Started to discount retail prices and reducing
gross receipts b/c didnt think public price proper. Held: Cant adjust retail P of goods just b/c
personally think overpriced. Fair market value is proper measure (retail P b/c thats P used in
arms length exchange).
i. 61 requires an objective measure of fair market value. Under such standard, the
petitioners may not adjust the acknowledged retail price of the goods and services
merely because they decide among themselves that such goods and services were
overpriced

c. The main purpose of including non-cash receipts in the tax base is not to raise revenue from the
taxation of non-cash receipts, but to protect the cash tax base by denying any tax advantage to
non-cash receipts. In the absence of an in-kind tax advantage, taxpayers will
overwhelmingly opt for the non-tax advantages of cash over barter
d. A workable tax system cannot be based on subjective valuations
i. The amount included in gross income is based on fair market value, and an
employees subjective perception of the value of a fringe benefit is not relevant to the
determination of the fringe benefits fair market value
e. Rev. Rul. 57-374: Where an individual refuses to accept an all-expense paid vacation trip he
won as a prize in a contest, the fair market value of the trip is not includible in his gross income
for Federal income tax purposes
i. This ruling is in conflict with the doctrine of constructive receipt. Under that doctrine,
a taxpayer who has the right to receive a taxable item cannot avoid the tax by
deliberately turning his back upon income.
f. 119 provides an exclusion from gross income for the value of meals and lodging furnished by
an employer to an employee, if the meals and lodging are furnished on the employers business
premises for the convenience of the employer.
g. If services are paid for in exchange for other services, the fair market value of such other
services taken in payment must be included in income as compensation
h. Although non-cash benefits received in an exchange are taxable, non-cash benefits you create
for yourself that is, in the absence of an exchange are not. These benefits are referred to as
imputed income from services, and they are not within the scope of 61
i. If you are able and willing to do everything yourself, you can legitimately avoid paying
any income tax
ii. There is one important group of taxpayers who have significantly more imputed income
from services than do other taxpayers: married couples in which one spouse is a fulltime homemaker
1. Valuation and privacy concerns are thought by most to rule out imposing a tax
on the imputed income of full-time homemakers
i. PROBLEMS (6-9), p. 119, 122
j. If your employer allows you to live, rent-free, in a house owned by the employer, you must
include the rental value of the house in your gross income (unless either of two narrow
exceptions applies)
i. When you live rent-free in a home that you own, you are benefitting from imputed
rental income. However, you are not taxed on the value of the use you make of your
own property
1. The home mortgage deduction preserves the benefit of the imputed income
exclusion for homeowners with mortgages. The underlying tax break, however,
is the exclusion, not the deduction
k. It is a rule of thumb for tax breaks that the early bird gets the free worm. Later birds must pay
for their worms
i. The value of a tax break for a particular type of property is largely capitalized
into the prices of the tax-favored assets. You would have enjoyed a windfall gain if
you had owned a house when the tax breaks for housing were introduced, but if you buy
a house today you have largely paid for your tax breaks. This is one reason why it is so
politically difficult to repeal tax breaks
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l.

VI.

Unrealized appreciation is the second of the two great implicit exclusions from gross income.
It resembles the other implicit exclusion of imputed income in that it is available only in the
absence of an exchange.
i. Considering the imputed income and unrealized appreciation exclusions together, the
base of the income tax generally does not include any economic benefits not related to
transactions or exchanges
ii. Upon sale, however, the 1001 formula for gain realized (amount realized minus
adjusted basis) will cause you to be taxed on what had been unrealized appreciation
until the sale
1. Because a sale triggers taxation of previously accrued appreciation, the
exclusion of unrealized appreciation usually results only in deferral of taxation
(until sale), rather than permanent exclusion of appreciation
a. However, the exclusion of unrealized appreciation will be permanent if
the taxpayer holds the property until death and the propertys basis is
then stepped-up to fair market value by 1014
iii. The usual policy explanation for the exclusion is that taxation of unrealized
appreciation would involve tremendous problems of valuation and liquidity
SOME STATUTORY EXCLUSIONS
a. 106(a) excludes from gross income of an employee the value of employer-provided health
insurance coverage. A companion provision, 105(b), excludes from gross income the value of
benefits received under employer-provided health insurance, to the extent the benefits constitute
reimbursement of medical expenses. Taken together, the two provisions remove employerprovided health insurance both premiums and benefits from the base of the income tax
i. The 106 exclusion applies not only to employer-provided basic health insurance
coverage, but also to so-called Cadillac employer-provided health insurance with small
or non-existent deductibles and co-pays, no or very high dollar ceilings on benefits, and
broad definitions of covered conditions and treatment
ii. The 106(a) exclusion applies only to health insurance for the employee, his
spouse, or his dependents, as defined in 152
1. If an employer provides health insurance coverage for unmarried partners of its
employees, the value of the partner coverage cannot be excluded under the
regulatory interpretation
a. So same-sex couples are out of luck if they cannot satisfy the
dependency test of 152(a)(9). Even if a same-sex couple is married for
purposes of state law, the marriage will not be recognized for federal
income tax purposes, by reason of DOMA
b. 125 provides that health insurance coverage may be offered under a cafeteria plan
i. A taxpayer who is offered a choice between cash and health insurance coverage,
and who chooses insurance, will not be taxed under the doctrine of constructive
receipt
c. For taxpayer without employer-provided health insurance, 213 allows them to claim their
medical expenses including health insurance premiums not excluded under 106 as itemized
deductions.
i. However, under 213(a), medical expenses are deductible only to the extent they
exceed 7.5% of AGI

d. Under 162(l), a self-employed person can claim an above-the-line deduction for the cost of
health insurance for herself, her spouse, and her dependents
e. A major purpose of the 2010 health care legislation was to subsidize health insurance for low
wage workers. In furtherance of that goal, the legislation created new 36B, which provides a
refundable premium assistance credit for low and moderate-income taxpayers purchasing
health insurance through a state-based health insurance exchange
i. Otherwise, low-wage workers may have income too high for Medicaid, but whose
employers do not provide health insurance
f. For taxpayer with employer-provided health insurance, the 106 exclusion is the
equivalent of an above-the-line deduction for the cost of insurance, not subject to any
percentage-of-AGI floor
g. Today, nondiscrimination rules apply to employers who self-insure for their employees
medical expenses instead of purchasing coverage from an insurance company (105(h)), and to
cafeteria plans providing health benefits (125(g)(2)). Except in those two situations, an
employer can provide unlimited amounts of tax-favored insurance to its executives, without
having to provide any insurance to its rank-and-file employees
h. 79 allows employees to exclude the value of group-term life insurance provided by their
employers, for up to $50,000 of insurance. The $50,000, sometimes called the face amount of
the policy, is essentially its death benefit
i. In a way, by simply failing to act to correct for the effects of inflation, Congress has
been gradually phasing out the value of this benefit over the subsequent decades
i. 117(a) excludes from gross income any amount received as a qualified scholarship by an
individual who is a candidate for a degree at a college or university. The exclusion applies both
to cash scholarships and to scholarships received in-kind (in the form of free or reduced tuition).
The exclusion is limited to the amount of the students tuition and fees, and the cost of
course-related books, supplies, and equipment.
i. However, 117(c) provides that the exclusion does not apply to any amount received
which represents payment for teaching, research, or other services by the student
required as a condition for receiving the qualified scholarship
j. When educational grants are made available by an employer to its employees on a preferential
basis, the employer-employee relationship is immediately suggestive that the grant is
compensatory
i. The Service will treat grant as scholarships if (1) the availability of the grants falls
outside the pattern of employment, and (2) the grants do not otherwise represent
compensation for past, present, or future services rendered or to be rendered the
foundation or employer by the employees or their children, and (3) the grants are not for
studies or research undertaken primarily for the benefit of the foundation or the
employer or for some other purposes not sanctioned by 117
k. 117(c) merely says that the scholarship exclusion is not available for amounts that represent
payment for services performed by the student; it does not deny the exclusion for amounts that
represent payment for services performed by the students parent. The rule that a scholarship
must not represent payment for services performed by anyone student or parent is
expressly stated only in the regulations
l. 127 provides an exclusion for an employee whose tuition is paid by his employer under an
educational assistance program

m. Under 117(d), a college or university can provide its employees with tax-free qualified tuition
reductions. Although the exclusion is a part of 117, it resembles the various fringe benefits
excluded under 132 more than it resembles scholarships excluded under 117(a)
n. The Hope Scholarship Credit (25A(b)) may be as much as $1,500 for each of a students first
two years of college
i. For expenses not eligible for the Hope Scholarship Credit, the Lifetime Learning
Credit (25A(c)) may be as much as $2,000 per taxpayer (not per student) per year
o. PROBLEMS: 10, 12, 13, 14 (p. 138-39)
p. 132 provides exclusions for a miscellany of fringe benefits. If a fringe benefit received as
compensation for services does not qualify for exclusion under 132 or some other provision,
61(a)(1) specifically provides for its inclusion in gross income
q. PROBLEMS, p. 208-10
r. Under the doctrine of constructive receipt, a taxpayer who has the right to receive a taxable
payment, but turns his back on the payment, is taxed just as if he had actually received the
payment
i. 132(f)(4) renders the doctrine of constructive receipt inapplicable to qualified
transportation fringes
ii. The constructive receipt doctrine is also overridden, and on a larger scale, by the
cafeteria plan rules of 125. This provision permits employees to choose between
taxable cash and a smorgasbord of tax-free benefits, without having to worry about
constructive receipt. Tax-free benefits that may be offered in a cafeteria plan include
group term life insurance (79), health benefits (105 and 106), dependent care
assistance (129), and retirement savings (401(k)).
1. Unlike 132(f)(4), 125 is subject to a nondiscrimination rule
s. 132(j)(1) imposes nondiscrimination requirements on the exclusions for no-additional-cost
services and qualified employee discounts. Similarly, 117(d)(3) imposes a nondiscrimination
requirement on the exclusion for qualified tuition reductions
i. E.g. An airline executive cannot exclude the value of a free standby flight unless
ticket agents are also entitled to free standby flights
ii. Discrimination in the provision of working condition fringes is justified by different
work-related needs of employees with different jobs. As for de minimis fringes, if the
fringe itself is de minimis then any discrimination in its provision must also be de
minimis and by definition not worth worrying about
t. By reason of 62(a)(1), unreimbursed employee business expenses are not deductible abovethe-line in arriving at AGI; instead they are deductible only if the taxpayer itemizes deductions
rather than claiming the standard deduction
i. Even among itemized deductions, unreimbursed employee business expenses are
disfavored, by being classified as miscellaneous itemized deductions under 67.
Miscellaneous itemized deductions are deductible only to the extent they exceed 2% of
the taxpayers AGI, and they are not deductible at all for purposes of the alternative
minimum tax
ii. For a reimbursement arrangement to qualify under 62(a)(2)(A), it must not allow
the employee to retain any amount in excess of the substantiated expenses
u. Consistent with prior practice, the IRS will not assert that any taxpayer has understated his
federal tax liability by reason of the receipt or personal use of frequent flyer miles or other inkind promotional benefits attributable to the taxpayers business or official travel.
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VII.

i. Frequent flier miles are taxable, but we have no intention of enforcing the law
ANNUAL ACCOUNTING, LOANS, AND DEBT CANCELLATION
a. For the government to function, income tax liability must be determined based on income
received within some relatively short and standardized period of time. For individuals, that time
period is the calendar year
b. The annual accounting system serves the governments need for closure with respect to tax
liabilities
i. Thus, an individual must pay tax if he has positive net income within the calendar year,
regardless of the losses he may foresee in future years
ii. The income tax cannot leave tax consequences open pending later developments, but
the closure requirement is not violated by tax rules that look back to earlier years to
determine the tax consequences of this years receipts. The most fundamental
backward-looking rule is contained in 1001, which calculates the gain or loss realized
on a sale in the current year by subtracting adjusted basis a product of past years
events from the amount realized on this years sale
c. Despite the need for an income tax based on regular accounting periods, the periodicity of the
tax can produce disturbing results for a taxpayer whose income (positive or negative) varies
greatly from year to year.
i. This is ameliorated by the loss carryover provision of 172, which permits a taxpayer
with a net operating loss (NOL) in one tax year to use NOL to offset positive income
in other years. In general, an NOL may be used to offset net income in the two years
preceding the loss year, and in the 20 years following the loss year. An NOL is carried
first to the earliest permissible year; to the extent it exceeds the income in the earliest
year, the excess is carried to the following year, and so on until the NOL is fully used or
the loss carryover period expires
1. In addition to the rather severe restriction on carryback years, the other major
limitation of 172 is that 172(d) permits carryovers only of business losses
a. 172(d) disallows personal exemptions in calculating NOLs, and it
allows other non-business deductions (such as the standard
deduction) only to the extent of the taxpayers non-business income
ii. Even when the annual accounting system does not result in mismeasurement of taxable
income (compared with some longer accounting period), it can impose unfairly high
marginal tax rates on a taxpayer whose income is bunched into one or a few years,
rather than being spread evenly over many years
d. United States v. Kirby Lumber Co.: issued bonds and later that year bought on mkt for less
than face value. Held: If corp buys and retires bonds for P less than face value, difference b/w
value and what paid is gain for the tax year.
i. The result in Kirby is succinctly codified in 61(a)(12), which provides that gross
income includes income from discharge of indebtedness
e. Borrowed money is not included in the borrowers gross income because her receipt of
funds is offset by her obligation to repay. In other words, borrowed money is excluded from
gross income based on the assumption that the taxpayer will eventually repay the loan. The
taxpayer is entitled to no deduction when she makes principal payments on the loan; those
payments merely serve to justify the original exclusion of the loan proceeds from income
i. If the return for the borrowing year was correct when originally filed, based on all the
facts known or knowable as of the end of that year, then the tax systems response to
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later inconsistent events is not to amend the original return. Instead, the gross income
inclusion is in the year in which it becomes apparent that the loan will not be fully
repaid
ii. If the original return was wrong from the beginning, based on information known or
knowable as of the end of the earlier year, then the mistake must be corrected in the
earlier year or not corrected at all, if the statute of limitations on the earlier year has
expired
f. One reason that taxpayers are sometimes able to obtain debt discharge on favorable terms is that
their creditworthiness has declined, and their creditors are accordingly worried about whether
they will be able to collect the full amount of the debt
i. 108(a) reflects Congresss judgment that debtors who are insolvent should indeed
not be taxed on income from favorable discharge of debt at least not immediately
and accordingly provides an exclusion for such income in such circumstances
1. 108(b) in effect converts the exclusion into a deferral, by requiring that a
debtor who benefits from the exclusion in (a) must reduce his tax attributes
by a corresponding amount
g. Under 108(a)(1)(E), no gross income inclusion results from the cancellation of qualified
principal residence indebtedness (QPRI) (before the end of 2012) if the cancellation is in
response to either (1) a decline in the value of the residence securing the debt, or (2) the
precarious financial condition of the taxpayer. QPRI is defined by 108(h)(2). The exclusion
does not apply to the cancellation of non-acquisition indebtedness (i.e. a home equity loan), and
it does not apply to the cancellation of any indebtedness secured by a secondary residence (such
as a vacation home). 108(h)(1) reduces the taxpayers basis in the home by the amount of
QPRI excluded from gross income
i. Enacted in response to the recent home mortgage crisis
h. Collins v. Commissioner: worked at betting salon. Punched tix for himself (stole) worth
$80k. Won $42k, but still behind by $38k. Turned himself in and gave up $42k winnings. Didnt
record $80k on return. Held: $80k is proper value of tix b/c thats fmv any purchaser would get
from buying. Gambling losses arent relevant in calculating gain from opportunity to gamble.
Should be taxed on $38k not repaid. Embezzling like self-help loan. Normally assume loan
repayment, but not w/ embezzlers, so not tax free now. Instead, taxed on all now, but any
amount repaid they can claim deductions on. Here, taxed on $38k. If he repaid $42k in next
year, then pay tax on $80k, then get deductions for tax on $42k.
i. Even treatment: taxed on $38k even tho left w/ 0 b/c if normal person gambled w/
income & lost gambling, under 165(d) cant deduct gambling losses (though can
deduct gambling losses from gamble gains and pay remainder of what you gained).
i. Disputed Liability Doctrine: applies when a taxpayer incurs a debt in order to acquire property
(not cash) a dispute arises concerning the value of the property, and the dispute is settled by
reducing the amount of the acquisition indebtedness
i. Should be limited to situations in which there is a dispute about the value of the
property the taxpayer received when he incurred the debt; it should not apply when the
dispute merely concerns whether the debt is legally enforceable
j. If most true (consensual) loans are repaid, but most embezzlements are not repaid, then it
makes sense for the tax system to assume repayment for true loans (thereby excluding loans
from gross income), but not to assume that embezzled funds will be repaid (thereby including
embezzlement proceeds in gross income). In the case of a true loan, the tax system relies on the
11

VIII.

lenders determination of the borrowers creditworthiness; if the lender is willing to bet that the
borrower will repay, so is the tax system. In the case of embezzlement, however, the involuntary
lender (the victim) has made no creditworthiness determination on which the tax system can
rely
k. If illegal income is taxable even when the criminal is under an obligation to repay the victim, a
fortiori illegal income is taxable when there is no victim entitled to repayment as with income
from drug dealing, prostitution, and illegal gambling, for example
i. The major practical significance of the taxation of illegal income is that sometime it is
easier for the government to convict a criminal a drug kingpin, say of a tax crime
than of the underlying non-tax crime
1. Al Capone was convicted only of tax crime
THE GREAT CASE OF TUFTS
a. Personal liability means that the bank is not limited to foreclosing on the mortgage if you
default on the loan; the bank may proceed against any of your assets in order to collect the
amount due. (A loan on which the debtor is personally liable is called a recourse loan.)
i. Nonrecourse mortgage: you are not personally liable on the loan; if you default the
sellers only remedy is to foreclose on the mortgage
1. The entire point of nonrecourse financing is that the risk of the decline in value
of the property below the principal amount of the nonrecourse mortgage is
borne by the creditor, rather than by the debtor
a. However, it is probable that the value of the building will not fall below
the principal amount of the loan
i. Based on that probability, nonrecourse acquisition debt is
normally included in basis in exactly the same way that
recourse debt is included in basis
b. In the unusual situation that repayment is unlikely judged from the time that you
purchase the property the debt should not be included in your basis. In fact, the best
analysis is that you really have not purchased the property at all. All you have is the equivalent
of an option which you may exercise, but probably will not to buy the building for the loan
amount. Since you do not really own the property, you have no basis in the property
c. Because the annual appraisals required by the theoretically correct approach are impractical,
168 provides cost recovery (depreciation) schedules for various categories of depreciable
assets. The applicable schedule will specify the percentage of the cost of the machine that you
may deduct in each year. 168 can be viewed as an exception to the general rule that unrealized
losses are not taken into account for tax purposes
i. Because the depreciation allowances represent a partial recovery of your basis in the
asset, you must decrease the assets adjusted basis by the amount of depreciation
claimed (1016)
ii. If the property declined in value more rapidly than the tax depreciation schedule
assumed, then you will be able to take the additional decline in value into account upon
sale (e.g. $2500 amount realized minus $3000 adjusted basis equals $500 loss realized).
But if the tax depreciation schedule has overstated the actual decline in value if, for
example, you sell the asset for $3500 then your gain realized on the sale will reflect
the amount by which the depreciation deductions were excessive: $3500 amount
realized minus $3000 adjusted basis equals $500 gain realized. (This gain is entirely an
artifact of the tax system.)
12

d. Commissioner v. Tufts: Partnership bought apts for 1.8M w/ nonrecourse loan. After
construction contributions of 44k and deductions of 439k, about 1.4M adjusted basis. Couldnt
pay, so sold and 3rd party took loan, but fmv not over 1.4M so partners said loss of 55k. Comm
says capital gain of 400k b/c realized full amount of nonrecourse obligations. Held: when tp
sells/disposes of property under nonrecourse loan, must include outstanding amount of
obligation in amount realized. FMV is irrelevant.
i. OConnor Concurrence: separate into 2 parts. Suppose tp pays off loan w/ 1.4M cash
and other 400k is cancelled (b/c easier for bank to walk away w/ some), then analyze
under 400k as Kirby income. 1.8-1.4 = .4M of income pay tax on. Step 2: property sold
at 1.4M 1.4M basis. 0 gain on property transaction and 400k Kirby income.
1. Differences: majority view prob taxed as capital gain w/ lower rate. Dissent
Kirby view would be taxed at higher rate unless there were an exemption to
avoid. So either less $ or possible exemption tradeoff. Prof prefers dissent.
ii. Owning property worth $1.4 million and subject to a nonrecourse debt of $1.8 million
does not decrease your net worth by $400k; rather, it has no effect positive or negative
on your net worth
1. If a person owns property subject to a nonrecourse mortgage in excess of the
value of the property, the persons economic benefit from relief from the
nonrecourse obligation cannot exceed the value of the property. If the 1001(b)
definition of amount realized is limited to economic benefit, then the amount
realized in Tufts must be limited to the value of the property (about $1.4
million). The amount by which the mortgage exceeds the value of the property
($400k) should not be included in amount realized
a. HOWEVER, the definition of amount realized is NOT limited to
economic benefit. The full amount of the loan - $1.8 million must be
included in amount realized not because the debt relief is worth $1.8
million to the taxpayer, but in order to correct a mistaken assumption.
The taxpayer was allowed to include the full $1.8 million loan in basis
(and to exclude it from income) on the assumption that the taxpayer
would eventually repay the loan.
i. The analysis is fundamentally the same as the Kirby analysis
1. In each case, the taxpayer received favorable tax
treatment based on the assumption the taxpayer
would repay a loan, and in each case a correcting
tax adjustment is needed when it becomes clear the
assumption was mistaken. The only difference is that
in Kirby the favorable tax treatment was the exclusion
of borrowed funds from income and the correction is to
include debt cancellation in gross income, whereas in
Tufts the favorable tax treatment was the inclusion of
debt in basis and the correction is to include debt relief
in amount realized
e. It is a basic principle of income taxation that in the end when the dust has settled the tax
treatment of a transaction should be consistent with the economics of the transaction
(apart from possible differences in timing)
13

f.

IX.

Tax benefit rule: if a taxpayer claims a deduction in one year, and in a later year an event
occurs that is fundamentally inconsistent with an assumption on which the deduction was based,
then the taxpayer must include the amount of the mistaken deduction (mistaken, that is, with the
benefit of hindsight) in income in the later year
g. Rev. Rul. 90-16: To the extent the amount of debt, 12,000x dollars, exceeds the fair market
value of the subdivision, 10,000x dollars, X realizes income from the discharge of indebtedness.
However, under 108(a)(1)(B), the full amount of Xs discharge of indebtedness income is
excluded from gross income because that amount does not exceed the amount by which X was
insolvent
i. 108(a)(1)(B) provides that gross income does not include any amount that would
otherwise be includible in gross income by reason of discharge (in whole or in part) of
indebtedness of the taxpayer if the discharge occurs when the taxpayer is insolvent
ii. 108(a)(3) provides that, in the case of a discharge to which 108(a)(1)(B) applies, the
amount excluded shall not exceed the amount by which the taxpayer is insolvent (as
defined in 108(d)(3))
iii. The analysis in Rev. Rul. 90-16 is the same bifurcation analysis favored by Justice
OConnor in her concurrence in Tufts.
1. Under this analysis, the taxpayer would be treated as having (1) persuaded the
lender to accept $1.4 million cash in cancellation of the $1.8 million loan, and
(2) sold the property no longer subject to the mortgage for its $1.4 million
fair market value. The tax treatment of step (1) would be $400k of Kirby
income, and the tax treatment of step (2) would be zero gain or loss on the sale
of the property
a. Under bifurcation, the fair market value is crucial in determining both
the amount of Kirby income and the amount of gain or loss under the
property transaction. However, the net amount of income under
bifurcation steps (1) and (2) will remain unchanged regardless of the
propertys value
2. An argument in favor of bifurcation is that it avoids the legal fiction inherent in
Justice Blackmuns analysis that the taxpayer is magically able to sell the
property for much more than its fair market value. On the other hand, tax
results under bifurcation depend on the fair market value of the property at the
time of the disposition, despite the fact that once the taxpayer decides to
dispose of the property, it makes no non-tax difference to him whether it is
worth $1.3 million, $1.4 million, or $1.5 million
THE INCLUSIONARY TAX BENEFIT RULE
a. Hillsboro National Bank v. Commissioner: Held: The tax benefit rule ordinarily applies to
require the inclusion of income when events occur that are fundamentally inconsistent with an
earlier deduction. The rule is addressed to events that occur after the close of the taxable year;
the purpose of the rule is to approximate the results produced by a tax system based on
transactional rather than annual accounting. The basic purpose of the rule is to achieve rough
transactional parity in tax, and to protect the Government and the taxpayer from the adverse
effects of reporting a transaction on the basis of assumptions that an event in a subsequent year
proves to have been erroneous. The rule will cancel out an earlier deduction when an

14

X.

event occurs that, if it had occurred within the same taxable year as the deduction, would
have foreclosed the deduction.
b. By far the most common application of the tax benefit rule is to state income tax refunds (to
taxpayers who itemized deductions, rather than claiming the standard deduction)
c. Cancellation of indebtedness income could be described as simply a special case of the
inclusionary tax benefit rule
d. There is a crucial distinction between (1) a deduction that was incorrect based on the facts
available (known or knowable) as of the end of the year for which the deduction was
claimed, and (2) a deduction that was correct based on the facts available as of the end of
the deduction year, but that is undermined by subsequent development. The only proper
response to the first type of mistaken deduction is to amend the return for the original year; if
the original is closed by the statute of limitations, then there is nothing to be done. The proper
response to the second type of mistaken deduction mistaken only with the benefit of
hindsight is to require a tax benefit rule inclusion in a later year
e. The claim-of-right doctrine addresses the mirror image of the tax benefit rule problem
i. Amounts received under a claim of right are taxable in the year of receipt, even if
events of later years result in the taxpayers being required to repay those amounts. The
mistaken assumption (that the taxpayer would be allowed to keep the money he
received under a claim of right) is corrected not by amending the return for the original
year of inclusion, but by allowing the taxpayer a deduction in the repayment year
1. 1341, however, gives the taxpayer special favorable treatment if the amount of
the deduction on account of the repayment exceeds $3000
f. Rosen v. Commissioner: The tax benefit rule provides that if a taxpayer receives a deduction
for a charitable contribution in one taxable year and recoups that donation in a later year, the
value of the contribution, on recoupment, is treated as income in the year in which it was
recouped. The application of the rule does not depend on whether the taxpayer retained a right
of reversion. The principle is well engrained in our tax law that the return or recovery of
property that was once the subject of an income tax deduction must be treated as income in the
year of its recovery
i. The rule should be applied flexibly in order to counteract the inflexibility of the annual
accounting concept which is necessary for administration of the tax laws. The rule
should apply whenever there is an actual recovery of a previously deducted amount or
when there is some other event inconsistent with that prior deduction.
THE GREAT CASE OF EISNER V. MACOMBER
a. Eisner v. Macomber: directors issued stock dividend of 50%, M had 2,200 old stock, got 1,100
of the new. Held: Unless the 16th amendment applies, a tax on stock dividends is
unconstitutional as an unapportioned direct tax on personal property. A tax is relieved of the
apportionment requirement by the Amendment only if it is a tax on income. Unrealized
appreciation is not income within the meaning of the Amendment. Stock dividends are a form
of unrealized appreciation. Therefore, the attempt to tax stock dividends without apportionment
was constitutionally invalid, even after the adoption of the Amendment.
i. If you taxed SHs share of undivided profits in corp, thatd be tax on property which
isnt allowed under Const. w/o apportioning among states by population.
ii. Would be different if cash dividend w/ real option for Sh to keep money or reinvest in
new shares. This is true stock dividend b/c nothing taken from corp and transferred to

15

XI.

SH. Dissent argues that if getting cash to buy more shares is taxable, then this should be
too.
iii. Ex) A has 2 shares worth $50 each. Stock rises to 150, gets another stock dividend so 3
shares worth $50 instead of 2 worth $75. Not any richer. Dont tax b/c no realization
event by disposing of stock. Liquidity and valuation concerns b/c if you tax w/o selling,
then dont have cash and value can change over time. Stock dividends more like
nothing b/c same liquidity and valuation concerns.
iv. The Courts bottom line is clear enough: unless gain is clearly separated from the
taxpayers original invested capital as it is in the case of a cash dividend, but not in
the case of a stock dividend the gain is not income and it cannot be taxed by Congress
without apportionment
b. Just as you cant make a pizza bigger by cutting it into more slices, you cant make yourself
richer by dividing your ownership of a corporation into a larger number of shares
c. The income tax generally does not tax an increase in the value of a taxpayers asset, as long as
the taxpayer merely continues to hold the asset
i. Instead, there is no tax on the gain until the occurrence of a realization event, such as
a cash dividend. Although the cash dividend does not make you any richer, it serves as
the trigger for taxing the enrichment that the tax system had previously ignored. The
same analysis explains why a taxpayer can be taxed on a gain when he merely sells an
asset for what it is worth
1. In the absence of a realization event, it may be unclear how much (if at all) an
asset has increased in value, and in any event a mere increase in value gives the
taxpayer no cash with which to pay a tax. Taxing a cash dividend, by contrast,
presents no problems of either valuation or liquidity
d. Two provisions of the original Constitution provide that Congress may impose a direct tax
only if the tax is apportioned among the states according to their populations
i. 16th amendment allows Congress to lay and collect taxes on incomes without
apportionment
e. In later cases, the Supreme Court has backed away from Macomber as constitutional law.
Today, the Court describes the realization requirement as being founded on administrative
convenience a considerable demotion from being a constitutional requirement. Although the
Court has never officially overruled Macomber, almost all tax lawyers believe the Court no
longer takes the case seriously as a matter of constitutional law. In fact, the current Code
contains a number of provisions that would seem to be invalid under Macomber, but whose
constitutionality is not seriously questioned today
i. But Macomber remains important for what it says about the basic structure of the
income tax
1. The income tax remains realization-based, rather than accretion-based. Gains
are not taxed (and losses are not deducted) unless there has been a realization
event
a. Congress is probably free to define realization events in any way it
chooses, without regard to whether an event severs gain from capital
FUN AND GAMES WITH THE REALIZATION DOCTRINE
a. The most fundamental realization provision is 1001(a), which states that a taxpayer realizes
gain or loss on the sale or other disposition of property. This rule invites taxpayer
manipulation in two directions. If a taxpayer wants to dispose of appreciated property, the game
16

b.

c.

d.

e.

f.
g.
h.

is to find a way to accomplish the economic equivalent of a sale (or a close approximation)
without triggering 1001(a). On the other hand, if a taxpayer owns depreciated property that he
wants to retain, the game is to find a way technically to sell the property, while retaining the
economic equivalent of ownership.
Short sale against the box: a taxpayer borrows and sells shares identical to the shares the
taxpayer holds. By holding two precisely offsetting positions, the taxpayer is insulated from
economic fluctuations in the value of the stock
i. Ex) N has 100 stocks worth 100M but basis only 10M. Want to sell but not recognize
gain. Used to short sale against the box by borrowing identical stock from broker, sell
for cash, and until you return lended stocks, you have cash at hand plus already have
stock to transfer back. Only wealthy could do it, then Cong banned it w/ 1259
1. 1259 requires a taxpayer to recognize gain (but not loss) upon entering
into a constructive sale of any appreciated position in stock, a partnership
interest or certain debt instruments as if such position were sold, assigned or
otherwise terminated at its fair market value on the date of the constructive sale
a. A taxpayer is treated as making a constructive sale of an
appreciated position when the taxpayer does one of the following:
(1) enters into a short sale of the same property, (2) enters into an
offsetting notional principal contract with respect to the same property,
or (3) enters into a futures or forward contract to deliver the same
property
b. An appreciated financial position is defined as any position with
respect to any stock, debt instrument, or partnership interest, if there
would be gain upon a taxable disposition of the position for its fair
market value
Collar: In a collar, a taxpayer commits to an option requiring him to sell a financial position at a
fixed price (the call strike price) and has the right to have his position purchased at a lower
fixed price (the put strike price)
i. Can be a single contract or can be effected by using a combination of put and call
options
In the absence of regulations, it is not clear how close a taxpayer can come to cashing out an
appreciated financial position without triggering a constructive sale under 1259
i. In the absence of regulations, it appears that no collar, no matter how tight, can
trigger a constructive sale. This is because collars are not included in the statutory list
of types of constructive sales in 1259(c)(1)(A)-(D)
Most of the provisions of the Code are self-executing. That is, they have the force of law even
if the Treasury never gets around to issuing regulations interpreting them
i. 1259(c)(1)(E), by contrast, is not self-executing
It appears that the taking out of a nonrecourse loan against unrealized appreciation is not a sale
or other disposition within the meaning of 1001(a)
According to Reg. 1.1001-1(a), an exchange of your asset for another asset will qualify as a
realization event so long as the exchanged assets differ materially either in kind or in extent
Cottage Savings Association v. Commissioner: is savings/loan assn w/ long-term, low
interest morts that declined in value when interest rates surged. Agreement to sell 90% of
participation interest in morts for another assns 90% participation interests. Claimed deduction
for difference b/w face value of their interests and fmv of those it got (which was lower). Held:
17

XII.

Financial inst can realize deductible losses when exchanging loan interests for other loan
interests under 1001a so long as materially different such that they embody legally distinct
entitlements and pass test b/c made to different people and secured by different properties.
i. Under our interpretation of 1001(a), an exchange of property gives rise to a realization
event so long as the exchanged properties are materially different that is, so long as
they embody legally distinct entitlements. Cottage Savings transactions at issue here
easily satisfy this test. Because the participation interests exchanged by Cottage Savings
and the other S & Ls derived from loans that were made to different obligors and
secured by different homes, the exchanged interests did embody legally distinct
entitlements. Consequently, we conclude that Cottage Savings realized its losses at the
point of the exchange
ii. Dissent: looking at superficial distinctions. In substance about the same.
i. It should always be kept in mind that the realization requirement cuts both ways: Taxpayers
typically want to have realization events when they have losses that they may deduct, but want
to avoid realization events when they have gains that would be taxable. The gain/loss landscape
is not symmetrical, however, in at least three ways: (1) in an economy that is growing, and
experiencing inflation (both generally true of the US over the last 40+ years), there will always
be more gains than losses overall; (2) severe restrictions on the deduction of net capital losses
under 1211 truncate the tax advantages associated with losses for most taxpayers; and (3) the
taxpayer controls the facts of the transaction, and frequently can shape it to fall on whichever
side of a line is more advantageous
j. When a transaction has been elaborately designed to leave a taxpayer in as nearly identical
position after the transaction as he was before, it is something of a legal fiction to declare that
he has realized his losses
k. PROBLEMS (1-3), p. 273
l. Stocks are capital assets (as defined in 1221), and under 1211(b) an individual may deduct
capital losses only against capital gains and a piddling $3000 of non-capital gain income
i. 1211(b) is another provision like 1091 and 267 aimed at the manipulation of the
realization doctrine with respect to losses
1. The concern is that taxpayers might engage in cherry picking selectively
realizing losses in their investment portfolios while making a point of not
realizing gains. Although a taxpayer caught by 1211(b) may have genuinely
cashed out a particular losing investment, the suspicion is that the realized loss
is offset or more than offset by unrealized gains in the taxpayers remaining
investments. The target of 1211(b) is the fortunate investor whose realized
losses are offset by unrealized gains, but the provision is a blunt instrument; it
also limits the capital loss deduction of the unlucky investor who does not have
unrealized gains in other assets
NONRECOGNITION PROVISIONS
a. In some situations, Congress has decided that immediate tax recognition of particular realization
events would be unwise. Accordingly, the Code specifies several types of nonrecognition
transactions transactions in which gain or loss is realized by the taxpayer engaging in the
transaction, but will not be recognized for tax purposes (at least not at that time)
b. The rationale for allowing deferral of the reckoning of gains and losses is that the taxpayer
has maintained a substantially continuous investment, only slightly altered in form
18

c. 1031 allows taxpayers to defer taxation of gains on property that is exchanged for other
property that is of like kind with the transferred property, and 1033 allows taxpayers to
defer taxation of gains on property that has been involuntarily converted, as by
condemnation or physical destruction, if the proceeds of the involuntary conversion have been
reinvested in other similar property
d. Most taxpayers, most of the time, would like to defer recognition of gains, but not losses.
This is consistent with the general tax planning maxim that it is beneficial to defer income, but
to accelerate losses
i. Typically, however, nonrecognition provisions apply to both gain and loss situations.
Where that is true, it is also usually true that taxpayers can, with sound planning,
arrange their transactions so as to avoid applicability of nonrecognition provisions when
those provisions would work to their disadvantage
e. Nonrecognition provisions are designed to defer recognition of gain, but not to forgive taxation
of the gain forever. Preservation of gain or loss for future taxability is one of the functions
of the basic account maintained for each asset
i. So that any differences between that basis and the fair market value of that asset will
preserve the opportunity to recognize gain or loss when the asset is sold or otherwise
disposed of
f. In some cases, there is no property (in the usual) sense acquired by one of the parties to a
nonrecognition provision
i. E.g. Divorce, where marital rights (e.g. support) are transferred
1. Once surrendered by the spouse who held those rights, the rights cease to exist;
they can never be in any meaningful sense transferred again by anyone. Thus,
any gain (or loss) on the property transferred in exchange for the surrender of
marital rights cannot be preserved by assigning a historical basis to the marital
rights. Rather, the gain or loss must be preserved by transferring the historical
basis with the property. Thus, the transferee spouse must take a basis in the
property that is equal to the transferors adjusted basis at the time of the transfer
g. The basis determinations are critical in ensuring that gain or loss is merely deferred, rather than
extinguished forever
h. 1031 provides nonrecognition of gains and losses incurred on the transfer of property in
exchange for other property of like-kind
i. The provision is primarily useful in real estate transactions
1. The striking liberality of the IRS with respect to real estate transactions has led
to heavy use of 1031 in that industry
ii. 1031(a)(1): No gain or loss shall be recognized on the exchange of property held for
productive use in a trade or business or for investment if such property is exchanged
solely for property of like kind which is to be held either for productive use in a trade or
business or for investment
1. The provision is limited to property that is used in a business or held for
investment. This leaves out property held for personal use
iii. A further limitation on scope is provided by 1031(a)(2), which precludes applicability
of this nonrecognition rule to several categories of property, among which are stocks,
bonds, and notes; partnership interests; and inventory property
iv. Essentially, the scope of the section is limited to tangible property (including real
estate) held for use in a business or for investment
19

v. Perhaps Congress decided that nonrecognition was justified only when all three
considerations in favor of nonrecognition difficulty of valuation, lack of liquidity, and
continuation of the basic nature of the taxpayers investment are present, and that only
like-kind exchanges involve all three
vi. Like-kind refers to the nature and character of the property, and not to its
grade or quality.
1. Taxpayers may have like-kind exchanges if they exchange city real estate for a
ranch or a farm, improved real estate for unimproved real estate, and even fee
interests in real estate for long-term leaseholds of at least 30 years duration
2. As to tangible personal property, the regulations indicate that two properties
will be of like kind, as long as they are in the same asset class, as set forth in
the regulations
a. Thus, cars can be traded for other cars, light trucks for light trucks, and
so on. But, conversely, a light truck could not be traded for a bus, nor
for any other vehicle outside of the light truck class
vii. The IRS acknowledges that a properly structured three-party transaction can qualify
for nonrecognition under 1031. If the law did not permit such three-party exchanges,
the practical significance of 1031 would be very limited, as few taxpayers are
interested in straight two-party exchanges
i. Congress has generally chosen to structure nonrecognition rules by stating the rule first to
provide complete relief, but only to the purest form of the transaction involved. Typically, the
pure rule is followed by provisions that provide partial nonrecognition treatment to transactions
that involve some receipt of consideration in forms other than the qualified property
i. 1031(b) says that if the taxpayer has gain on the property she transfers, and receives
consideration both in the form of qualified (like-kind) property and nonqualified
property or cash (generally referred to as boot in either case), then the gain realized
on the transferred property will be recognized, but only up to the amount of the boot
the amount of cash or the fair market value of the nonqualified property
1. In other words, the taxpayers gain recognized is the lesser of gain realized
or boot received
j. 1031(c) adds that if the taxpayer has experienced a loss on the transferred property of like
kind, then none of the loss is to be recognized if the consideration received is a mix of qualified
and nonqualified property or cash
i. 1031(a) and (c) together proscribe loss deductions in like-kind transactions
whether or not there is any boot in the mix
1. For this reason, most taxpayers with losses on assets that they are disposing of
will prefer not to qualify under 1031, and will take care to avoid creating a
transaction structure that could be considered an exchange. Ordinarily, the
simplest method of doing this will be to sell the loss asset to one buyer and, in a
separately negotiated transaction, to buy the target asset (which might be of like
kind with the asset sold) from another party
k. 1031(d) provides generally that the basis of the acquired property will be an exchanged
basis, meaning that the historic adjusted basis in the transferred property will become the basis
in the acquired property
i. The basis of the acquired property must be adjusted by the following:

20

l.
m.

n.

o.

p.

1. Decreased by the amount of any money received by the taxpayer in the


transaction
2. Increased by the amount of any gain recognized by the taxpayer on the
transaction, and
3. Decreased by the amount of any loss recognized by the taxpayer on the
transaction
ii. The basis of the acquired property must also be increased by any money paid by the
taxpayer as part of the like-kind property
1. This is not specified in 1031(d)
a. Provided for in the regulations, which state that when additional
consideration is given in a 1031 transaction, the basis of the acquired
property is the basis of the transferred property, increased by the
amount of the additional consideration
PROBLEMS (4-7), p. 282
The like-kind standard is interpreted much more narrowly for exchanges of personal
property than for exchanges of real estate
i. 1031(e): The exchange of livestock of one sex for livestock of the other sex is not an
exchange of property of like kind
ii. Bullion-type coins and numismatic-type coins are not property of like kind
1. The IRS will insist on examining the investment climate affecting the coins in
question. Bullion-type coins will move with the market for the metal from
which they are minted; numismatic-type coins will move with whatever crazy
things influence the highly unstable collector markets
iii. Silver bullion and gold bullion are not property of like kind
1. Although the metal have some similar qualities and uses, silver and gold are
intrinsically different metals and primarily are used in different ways. An
investment in one of the metals is fundamentally different from an investment
in the other metal
2. The rule that seems to emerge is that you can have an exchange of metals that
will be tax-free under 1031, as long as the exchange would be pointless
The difference between the fair market value of the new like-kind property and its basis
(as determined under 1031(d)) should always equal the difference between the amount of
gain the taxpayer realized on the exchange and the amount of gain the taxpayer was
required to recognize on the exchange (under 1031(b))
An ancillary rule in 1031(d) provides that, if a taxpayer receives both qualified and
nonqualified property, then the basis carried over from the property he transferred, as
adjusted, is to be allocated between or among the qualified and nonqualified assets
acquired in the exchange. In making this allocation basis is to be allocated first to the
nonqualified property in the amount of its fair market value, with the residual basis (i.e. the part
of the total basis that is not allocated to the nonqualified property) being allocated to the
qualified property
i. Any consideration received other than like-kind property whether cash or non-likekind property is given a basis equal to its fair market value, while any deferred gain is
reflected in the basis of the like-kind property received
The final basis rule of 1031(d) is really more than just a basis rule, because it may affect as
well the amount of gain recognized in a like-kind exchange. It says that if a liability of the
21

taxpayer is assumed by another as part of the consideration for the transaction, the
amount of the liability is to be treated as though that amount of cash had been received by
the taxpayer
i. Regulations provide that only net liabilities released must be treated as the equivalent of
cash received
ii. Also provides that if a taxpayer invests additional cash in a like-kind exchange, and
also has a net liability release that would, but for this exception, be treated as cash
received, then he will be allowed to offset the new cash invested against the net liability
release, so that only the net liability release in excess of the new cash investment will be
treated as cash received
q. If 1031 applied only to simple two party exchanges Smiths farm for Gonzaless farm the
provision would be little more than a curiosity, because it would be rare that Smith and
Gonzales would each decide, simultaneously, that the others grass was greener
i. 1031 does not apply to cash sales followed by reinvestments
ii. It turns out, however, that Smith will be able to take advantage of 1031 by artificially
structuring his transaction as a three-party exchange rather than as a sale-plusreinvestment. In fact, virtually all 1031 real estate transactions involve three or
more parties
1. Typically, Smith will put Blackacre on the market. Real estate developer Chang
will appear on the scene, offering cash to Smith in exchange for Blackacre.
Smith will suggest instead that Chang buy Whiteacre from Gonzales, who has
also listed his property for sale. If all goes well, Chang will agree to buy
Whiteacre first for cash, then engage in a swap with Smith to obtain Blackacre,
giving Smith, finally, possession of Whiteacre
iii. As the law of triangular exchanges has developed, a well-advised taxpayer can
achieve nonrecognition for the functional equivalent of a cash-sale-plus-reinvestment so
long as he jumps through the appropriate exchange hoops
iv. 1031(a)(3): gives the taxpayer 45 days after the transfer of his property to identify the
property to be acquired in exchange, so long as the actual transfer of the property occurs
within the lesser of 180 days of the initial transfer or the due date for the taxpayers
income tax return for the year in which the purported like-kind exchange took place
1. Solves timing problems in triangular exchanges
r. 1033 provides for nonrecognition for a cash sale followed by a reinvestment, if the cash sale
qualifies as an involuntary conversion
i. 1033 applies to gains realized as a result of involuntary conversions generally, not just
condemnations. Thus, a taxpayer can take advantage of the provision if her property is
destroyed by a fire, flood, or other disaster, and she receives insurance proceeds or tort
damages in excess of her adjusted basis in the property
s. Under 1033(b), the taxpayers cost basis in the replacement property must be reduced by
the amount of gain realized but not recognized on the involuntary conversion. As with the
basis rules of 1031, the effect is to defer taxation of gain, rather than to permanently exempt
the gain from tax
t. 1033(a)(2)(A) requires recognition of realized gain to the extent the taxpayer has retained the
equivalent of a boot
u. PROBLEMS (8-9), p. 284

22

XIII.

v. 1031 and 1033 do not use the same similarity standard for the old and new properties. Under
1031 the two properties must be of like kind, whereas under 1033 the two properties must
be similar or related in service or use. The 1033 standard is the more demanding of the
two
i. The 1033 test looks not only to the inherent nature of the properties, but also to
the nature of the taxpayers relationship to each property
w. 121 allows a taxpayer to exclude up to $250k ($500k if married filing a joint return) of gain
realized on the sale or exchange of a principal residence. The exclusion is allowed each time a
taxpayer selling or exchanging a principal residence meets the eligibility requirements, but
generally no more frequently than once every two years
i. To be eligible for the exclusion, a taxpayer must have owned the residence and
occupied it as a principal residence for at least two of the five years prior to the
sale or exchange
ii. In the case of joint filers not share a principal residence, an exclusion of $250k is
available on a qualifying sale or exchange of the principal residence of one of the
spouses
x. The 163(h)(3) deduction is available for interest on mortgages on both the taxpayers principal
residence and one other residence (typically a vacation home). There is no provision permitting
the exclusion of gain on the sale of a vacation home
y. 121(d)(10) denies the benefits of 121 if the property in question had been acquired in a likekind exchange within the 5 years preceding its sale
z. The regulations flatly disallow any loss from the sale of residential property purchased or
constructed by the taxpayer for use as his personal residence and so used by him up to the time
of the sale
i. The same rule applies to losses on other consumer durables, such as a personal-use
automobile, apparently on the theory that the lost value over time was a nondeductible
consumption expense
INSTALLMENT SALES AND ANNUITIES
a. Under 453(a), gain from an installment sale is ordinarily reported on the installment
method, which is defined by 453(c) as a method under which the income recognized for any
taxable year from a disposition is that proportion of the payments received in that year which
the gross profit . . . bears to the total contract price
b. 453(c) requires the comparison of two ratios, or fractions
i. x/P = GP/CP
1. x = income recognized; P = payments received in the year; GP = gross profit;
CP = contract price
2. x = P(GP/CP)
c. The idea behind the installment method is to treat every principal payment as a
microcosm of the entire transaction. If, looking at the transaction as a whole, of the amount
realized is gain and is return of basis, then of each payment is taxed as gain, and of each
payment is treated as return of basis
d. Because 453 deals only with the gain from the disposition of property, its rules govern only the
tax treatment of the principal payments on an installment note. The tax consequences of the
interest payments are governed by other Code provisions
e. PROBLEMS (10-12), p. 292, 295-96

23

f.

A prototypical annuity provides, in exchange for one or more payments by or on behalf of the
beneficiary (annuitant), a stream of equal periodic payments for the life of the annuitant, thus
protecting the annuitant against the risk of depleting her savings by outliving her life expectancy
i. While life insurance provides financial protection against the risk of an early demise, a
life annuity protects against the danger of an unexpectedly long life. Life insurance and
annuities thus represent opposite bets with an insurance company
g. Instead of a basis-first rule, Congress has provided for gradual recovery of an annuitants basis,
according to the exclusion ratio of 72(b)(1).
i. Nontaxable amount/annuity payment = investment in the contract/expected return
1. Nontaxable amount = annuity payment (investment in the contract/expected
return)
ii. 72(c)(1): the investment in the contract equals the premium(s) paid by the taxpayer,
reduced by any amounts received by the taxpayer before the annuity starting date and
excluded from income
iii. 72(c)(3): if the expected return on an annuity depends on the annuitants life
expectancy, the expected return shall be based on actuarial tables prescribed by the
Treasury
iv. There is a simpler way of calculating the amount of each payment excluded from
income, whenever an annuity provided for equal annual payments. In that case, the
effect of the formula is to allocate the basis recovery evenly over the annuitants life
expectancy
1. However, if the payments are not level over time (or if the payments are level
over time but begin or end midyear), the slightly more complicated statutory
formula must be used
h. The pre-starting date deferral is probably the most significant tax advantage afforded to
annuitants
i. 72 offers two significant tax advantages to owners of annuities: the deferral of tax on the
increase in the value of the annuity during the period before payments begin, and the
understatement of the income portion of payments in the early years. Aware that these rules are
quite generous, Congress has sought to limit their applicability to investments serving the basic
non-tax purpose of annuities: providing annuitants with income security. For example, 72(e)(4)
provides that most loans under annuity contracts are treated as taxable distributions
i. In addition, 72(q)(1) imposes a 10% penalty tax (on top of the regular income tax) on
annuity distributions unless one of the 72(q)(2) exceptions applies. Two of the most
significant exceptions are (1) for any distribution to an annuitant at least 59-1/2 years
old, and (2) for a distribution which is part of a series of substantially equal period
payments . . . made for the life (or life expectancy) of the taxpayer or the joint lives (or
joint life expectancies) of such taxpayer and his designated beneficiary
j. The Treasury has issued taxpayer-favorable regulations that generally avoid treating debt
relief as payment triggering gain
i. Under Reg. 15a.453-1(b)(3)(i), payment generally does not include the amount of
qualifying indebtedness . . . assumed or taken subject to by the person acquiring the
property. Qualifying indebtedness is defined to include a mortgage or other
indebtedness encumbering the property
ii. Reg. 15a.453-1(b)(2)(iii) provides that the contract price must be reduced by the
amount of the qualifying indebtedness
24

k. The special treatment of debt relief in the regulations leaves unchanged the total amount of gain
eventually recognized, but it changes the timing of gain recognition, in a taxpayer-favorable
direction. The regulations treat the entire amount of the debt relief as a recovery of basis, but
this means there is less basis left to be recovered against the amounts that are treated as
payments. As a result, a smaller percentage of each cash payment must be treated as basis
recovery and a larger percentage treated as gain. This is accomplished by the upward adjustment
in the profit ratio caused by the reduction in the contract price by the amount of the debt relief
l. Reg. 15.453-1(b)(3)(i) provides that relief from qualifying indebtedness is treated as a
payment to the extent the indebtedness exceeds the taxpayers basis
i. Reg. 15a.453-1(b)(2)(iii) provides that the contract price is not reduced by the portion
of the qualifying indebtedness that exceeds basis
m. Thus, whenever any part of the debt relief is treated as payment, all available basis has been
used to offset the remainder of the debt relief. That means there is no basis left to recover
against any payments, which in turn means that the profit ratio will always be 100% when debt
relief exceeds basis
n. There is a taxpayer-favorable inconsistency between the tax consequences of installment notes
for sellers, on the one hand, and for buyers, on the other. Although the seller is able to avoid
recognition of gain until she receives principal payments on the note, the buyer is permitted to
treat the installment note like any other acquisition debt which means the buyer is
immediately allowed to include the amount of the note in his basis in the property. This
inconsistency becomes important in two situations where the buyer can quickly put his basis to
use: if the buyer sells the property, or if the buyer is able to claim depreciation (ACRS)
deductions on the property. Congress has responded to both possibilities in 453
o. 453(e) is triggered when there is an installment sale between related persons, and the
related buyer turns around and sells the property within two years of the date of the first sale. In
that case, the original seller is treated as having received a payment on the note at the time of
the second sale, with the amount of the payment generally being equal to the amount realized by
the original buyer on the second sale
i. 453(f)(1) provides the definition of related person
p. 453(g) provides that the installment method does not apply to sales of depreciable property
between related persons
i. To make matters worse, 1239 provides that all of the gain recognized on the sale of
depreciable property between related persons will be taxed as ordinary income, rather
than as capital gain
q. The same term (related persons) is given very different definitions for purposes of two
different subsections (453(e) and (g)) of the same Code provision. This is a good example
of how carefully one must read the Code; never assume you know what a term means simply
because you know how the term is defined for purposes of some other Code provision
i. Two human beings are never related persons for purposes of 453(g), so it is always
possible for an installment sale of depreciable property between close relatives to
generate depreciation deductions for the buyer before the seller has had to recognize
gain
r. Gain on some sales cannot be reported on the installment method. For example, 453(k)(2)
excludes from installment method reporting any gain on the sale of stocks and securities
regularly traded on an established market
25

XIV.

i. Perhaps the most important exclusions from the installment method are those for sales
of inventory items and for sales by dealers in personal or real property. Basically, a
person who is in the business of selling property on a regular basis cannot use the
installment method to defer gain on ordinary business sales. To put the point the other
way around, the installment method is available only for casual (non-dealer)
installment sales
s. Another important limitation is imposed by 453(i), which requires recognition of all recapture
gain in the year of sale
i. Under 1245, gain is recapture gain to the extent of depreciation deductions previously
taken
t. Congress amended 453 to prohibit the use of the installment method by taxpayers using an
accrual method of accounting for tax purposes. Since most businesses are required to use the
accrual method, this was a huge restriction on the availability of 453
u. 453(f)(6) specifically permits 1031 and 453 to be used together
v. 453A: the general idea is that a taxpayer who receives installment notes in excess of $5 million
from sales in a single year must pay interest annually on the tax liability deferred under 453
until the notes are paid and the gain is recognized
w. 453(d) allows a taxpayer to elect out of the installment method
i. In the vast majority of cases, the regulations require closed transaction treatment.
Under this approach, a cash method taxpayer must include the fair market value of the
installment obligation in her amount realized in the year of sale, and recognize gain in
that year to the extent the total amount realized exceeds the taxpayers basis. Similarly,
an accrual method taxpayer ordinarily must include in amount realized in the year of
sale the total amount payable under the installment obligation (not including interest or
original issue discount)
ii. Electing out of 453 will improve ones tax situation only if: (1) opting out results in
open transaction treatment; or (2) the taxpayer has reason to believe that his marginal
tax rate will be higher in the year(s) of payment than in the year of sale (to a degree
sufficient to offset the financial advantage of deferral)
1. Open transaction treatment: all payments are treated as tax-free returns of basis
until basis is exhausted
iii. 453(d) elections are rare
BASIC RULES FOR GRATUITOUS TRANSFERS
a. The implicit rule is that a gift of appreciated property does not constitute a realization
event despite the statement in 1001(a) that gain or loss is realized on the sale or other
disposition of property, and the fact that a gift certainly seems like a disposition
b. The tax treatment of appreciation in gifted property resembles the treatment of like-kind
exchanges in that (1) gain is not taxed even though a taxpayer has transferred appreciated
property, and (2) the tax on the appreciation is deferred rather than being permanently excused
by a special basis rule
i. A significant difference is that 1031 preserves the potential for tax by making the
original taxpayer take a below-value basis in a new asset (the property received in the
like-kind exchange), while 1015 makes a new taxpayer (the donee) take a below-value
basis in the original asset

26

XV.

1. Both rules are examples of substituted basis, but the like-kind rule is an
instance of exchanged basis, while the gift rule is an instance of transferred
basis
c. Generally, the donee succeeds to the donors basis in gifted property
i. However, if the donors basis is greater than the fair market value of the property at the
time of the gift in other words, if the gift is of property with an unrealized loss then
for the purpose of determining loss the basis shall be such fair market value [at the
time of the gift]
d. PROBLEMS (13-18), p. 298, 300
e. A transfer at death is not treated as a realization event, and 1014 gives the transferee a basis
equal to the propertys value as of the decedents death. As a result of this tax-free step-up in
basis at death, no one neither the decedent nor the transferee is ever taxed on the
appreciation that accrued while the decedent owned the property
i. Technically, 1014 is a two-way street. If a taxpayer dies owning property with an
unrealized loss, he is not allowed to deduct the loss and the transferee takes the property
with a basis stepped down to the date-of-death value
ii. There is no obvious policy justification for the permanent exemption from the income
tax of appreciation transferred at death
f. With the estate tax reinstated for 2011 and later years, 1014 determines the basis of property
acquired from a decedent after 2010
g. 1014(c) contains an important exception to the general rule permitting tax-free increases in
basis at death. No basis increase is allowed for property which constitutes a right to receive an
item of income in respect of a decedent [IRD] under 691
i. IRD consists of amounts that would have been taxed to the decedent during his lifetime
if he had been on the accrual method instead of the cash method. The classic example is
compensation paid after death for services performed by the decedent. By far the most
important examples of IRD, however, are distributions from tax-deferred retirement
savings vehicles
BASIS ALLOCATION
a. Gamble v. Commissioner: bought pregnant mare for 60k. Got foal insurance from in utero to
30 days post birth for 3.6k, that paid 20k. Full life insurance (for the mare) for 30k. Sold colt for
125k. Held: Defendant paid $60k to acquire pregnant mare. To the extent that a portion of this
purchase price was in fact paid to acquire the unborn foal, that amount became petitioners cost
basis in the foal. It is our best judgment that $20k of the purchase price was attributable to the
unborn foal. The insurance policy which D obtained to cover the unborn foal indicated that its
purchase price had been $20k.
i. Gamble is an example of the common tax problem of basis allocation. As in Gamble,
the problem can arise when a taxpayer pays a single unallocated price for two (or more)
assets, and later sells one asset while retaining the other. Basis allocation problems also
arise when a taxpayer buys what seems to be a single asset such as a tract of
undeveloped land and later sells only a portion of the asset
b. Reg. 1.61-6(a) provides, When a part of a larger property is sold, the cost or other basis
of the entire property shall be equitably apportioned among the several parts, and the gain
realized or loss sustained on the part of the entire property sold is the difference between the
selling price and the cost or other basis allocated to such part. This regulation keeps numerous
appraisers busy as expert witnesses in tax controversies
27

XVI.

c. But the fight over basis allocation is not really much about nothing. What is at stake is the
timing of the tax on $20k of Mr. Gambles gain
i. Gamble provides another context for examining the importance of timing in taxation,
and the economic benefit of being able to defer tax liability to a later year
d. Note on future value/present value calculation: p. 305
e. Perhaps the most difficult basis allocation problems arise in connection with the purchase of an
ongoing business, in which a taxpayer pays a lump sum for a collection of hundreds or
thousands of different assets
f. A taxpayer who receives an installment note in exchange for property has a basis in the
note equal to her basis in the property (reduced by any basis recovered against the down
payment, if there is a down payment). The question is how the taxpayer should be allowed to
recover that basis as she in effect gradually disposes of the note by receiving principal payments
on it. 453 answers that question. Similarly, 72 allows a taxpayer who buys an annuity
gradually to recover her basis as she gradually disposes of the annuity (in effect) by receiving
periodic annuity payments
i. Both sets of rules can thus be understood as special instances of the general basis
allocation principle embodied in Reg. 1.61-6(a)
CHARITABLE CONTRIBUTIONS
a. Personal deduction: term simply refers to those deductions that are available only to individual
taxpayers
b. Form 1040 is the basic individual tax return
i. After income items have been listed and totaled, the taxpayer is allowed to subtract
several specific items (above-the-line deductions) from income to reach AGI
c. All items that are allowed as deductions in computing AGI are listed in 62 of the Code
d. The most important categories of personal deductions are referred to collectively as itemized
deductions. This phrase is a term of art, defined by exclusion in 63(d) as allowable
deductions other than (1) those allowable in calculating AGI, and (2) those reflecting personal
exemptions for the taxpayer(s) and dependents
i. Three categories of expenses are claimed by almost all itemizing taxpayers: state and
local taxes, interest, and charitable contributions
e. The Code offers an alternative to claiming itemized deductions: The taxpayer may instead
elect to take a standard deduction, of varying amounts, depending on the type of return
(single, joint, etc.), whether the taxpayer qualifies as blind or aged, and what tax year is
involved. The various standard deduction amounts are indexed for inflation, and so are adjusted
every year
i. Most taxpayers choose to claim the standard deduction rather than to itemize their
deductions, presumably because the total amount of their itemized deductions is less
than the applicable standard deduction
f. The tendency to itemize is strongly correlated with income, which in turn is of course strongly
correlated with the size of the tax liabilities
i. Taxpayers in relatively high income groups are more likely to be homeowners, pay
higher state and local taxes, and have more resources from which to make charitable
contributions
g. Deductions are sometimes allowed, at least in part, because a conscious decision on the part of
Congress that an activity or behavior pattern should be encouraged. In other cases, a deduction
may be allowed because it could be called income-defining (e.g. costs of producing income).
28

h.

i.

j.

k.

l.

m.
n.

o.

In some cases, Congress may allow a deduction simply to refine its differential assessment of
tax burdens on the basis of the taxpayers ability to pay
170: Charitable contributions
i. Treas. Reg. 1.170A-1(g) states flatly that no deduction is allowed under 170 for a
contribution of service
1. The rule thus reflects the commonsense notion that one should not be treated as
giving away what one was never treated as possessing
In most cases, the unrealized gain in donated property is deductible only if:
i. The gain would have been long-term capital gain had the taxpayer sold the property
ii. In the case of a contribution of tangible personal property, the use of the property by the
charity is related to the charitys tax-exempt purpose, and
iii. The property is not given to a private foundation, a category of charities that has been
singled out for special treatment in a number of respects
In addition to violating tax logic, the deduction for unrealized appreciation encourages
taxpayers to put unrealistically high values on donated property, and leads to frequent tax
litigation over the value of contributed property
i. 170(f)(11)(C) requires a taxpayer to obtain an appraisal for donated property with a
claimed value of more than $5000
ii. (Violates tax logic because tax law normally does not allow a deduction for the loss of
an amount that was never taken into income)
Lary v. United States: tp wants to deduct for donating blood. Held: If the donation of blood
were the performance of a service, then the taxpayers are not entitled to a charitable deduction
because the regulations expressly prohibit charitable deductions for the performance of services.
170(e)(1)(a) provides that if property donated to charity would have resulted in ordinary
income or short-term capital gain to the donor had the property instead been sold, the donors
charitable deduction would not include any amounts attributable to such gain, but rather would
be limited to his adjusted basis in property
i. Here, 170(e)(1)(A) precludes any charitable deduction for the value of the donated
blood. Taxpayers have proffered no evidence as to any basis in the donated blood or that
the holding period for blood is more than 6 [now 12] months, which is the required
holding period for a capital asset to qualify for long-term capital gain treatment
As the court notes, if blood is property the taxpayer would be entitled to a deduction for his
basis in the blood, even if he had not owned the blood long enough to satisfy the long-term
capital gains holding period
Ordinarily, a charitable contributions deduction is available only for the net value that flows to
the charitable target
Rolfs v. Commissioner: donated house to fire dept to burn down in training, then clean up.
Never gave up land b/c wanted to rebuild there. Held: Doesnt qualify as CC under 170(a);
failed to show house had fmv over 10k (cost of demolition service) b/c so many restrictions on
prop donated that fmv was de minimus. CC cant be given w/ expectation of return benefit. Ct
looks at structure of transaction (not tp motivation). 2 prong test if CC has benefit: 1) only
deductible if and to extent it exceeds mkt value of benefit received, 2) excess payment must be
made w/ intention of giving gift. anticipated benefit of demolition, so see if fmv as donated
exceeds value of demolition services received. Property below that. No deduction.
Congress: The exemption from taxation of money or property devoted to charitable and other
purposes is based upon the theory that the government is compensated for the loss of revenue by
29

p.

q.

r.

s.

t.
u.

v.

w.

its relief from financial burden which would otherwise have to be met by appropriations from
public funds
To be deductible, a contribution must be made to an organization that is either a governmental
unit, or a corporation, trust, or similar organization that is organized and operated for one of
several charitable purposes, prominently including religious, charitable, and educational
purposes. See 170(c)
170(b) imposes some limits on charitable contribution deductions based on the taxpayers
income. In general, an individual taxpayers deduction for any given tax year is limited to 50%
of the taxpayers contribution base, which in most cases is simply his AGI.
i. Other limitations apply in special cases (e.g. gifts made to private foundations are
deductible only to the extent of 30% of the contribution base). These limits are applied
sequentially; that is, the total of all gifts is first compared with the overall 50% limit. If
it exceeds that limit, the deductions disallowed are considered to come from the leastfavored category first
Any amounts that are disallowed by these rules may be carried over by the taxpayer and
deducted in up to 5 subsequent years, pursuant to the rules of 170(d). The charitable gifts
retain their character in the carryover year
Corporate taxpayers are subject to a different limitation: They may deduct up to 10% of their
taxable income, computed without regard to their charitable gifts, their dividends-received
deduction, and any carrybacks for capital or operating losses (170(b)(2))
i. Overall corporate giving amounts to only about 1% of net corporate income in most
years
PROBLEM 4, p. 381
Deductible contributions are similar to cash grants of the amount of a portion of the
individuals contributions
i. But many organizations that would never receive direct grants from Congress are able
to qualify under 170(c)
1. Are all of these organizations deserving of public support?
ii. The second problem with the matching grant analysis is the difference in the way the
contributions of different taxpayers are matched
1. Upside-down subsidies, in which the highest bracket and therefore highest
income taxpayers receive the most generous subsidies for each dollar of
deduction
iii. The final difficulty with the matching grant justification is that it seems to reflect an
assumption that taxpayers respond to the existence of the deduction by increasing the
amounts of their contributions
1. Not surprisingly, the evidence is that different taxpayers respond differently to
the existence of the deduction
As a general rule, if a payment to a charitable organization results in the receipt of a substantial
benefit the presumption arises that no gift has been made for charitable contribution purposes
i. In showing that a gift has been made, an essential element is proof that whatever
portion of the payment that is claimed as a gift represents the excess of the total amount
paid over the value of the monetary benefits received in return
ii. If the value received is less than the amount given to the charity, then only the
difference is deductible
170(f)(8) disallows a deduction for any contribution of $250 or more unless the taxpayer
receives a written acknowledgement of the contribution from the charity, including a
30

description and good faith estimate of the value of any goods or services received by the
donor in exchange for the contribution
i. Provides an exception to the valuation requirement for any intangible religious
benefit
1. Defines intangible religious benefit as any intangible religious benefit which is
provided by an organization organized exclusively for religious purposes and
which generally is not sold in a commercial transaction outside the donative
context
x. Rifle shot tax provision: confers special benefits on a very narrow class of taxpayers
y. Private school tuition is ordinarily not deductible, because the parents of a student receive an
educational quid pro quo equal in value to the tuition paid
z. Pew rents, building fund assessments, and periodic dues paid to a church (defined in 170(c))
are deductible as charitable contributions
aa. Hernandez v. Commissioner: fixed donation for Scientology auditing sessions. Held:
payments not deductible under quid pro quo analysis. didnt want to use b/c religious benefit
only. Ct says may make entanglement issues. Different treatment from other religion
i. IRS later repudiated this victory
ab. Sklar v. Commissioner: deducted 55% of tuition to private religious school, on the basis that
this represented the proportion of the school day allocated to religious education. Held: religious
portion not separated from secular in way ct will allow dual payment and rel part deductible.
didnt show religious part exceeds fmv of similar educations.
i. The courts actual holding assumes for the sake of argument that intangible religious
benefits dont count for purposes of quid pro quo analysis. The court concludes that
the Sklars lose anyway because they failed to prove that their childrens school was
more expensive than secular private schools
ii. A different rationale: During the 55% of the school day devoted to religious instruction,
the school necessarily provided the secular benefit of child care along with religious
instruction
XVII. INTEREST EXPENSE
a. 163(a) says simply that taxpayers may deduct all interest paid or accrued within the taxable
year on indebtedness
i. 163(h), a rule that disallows deductions for personal interest, was added in 1986
1. It is fair to say that the disallowance rule of 163(h) effectively reverses, for
individual taxpayers, the presumption of 163(a) in favor of deductibility
2. The exceptions to 163(h), while few in number and narrow in scope, are for
most taxpayers items with relatively large dollar amounts at stake
b. The rule of 163(h) generally disallows interest deductions for personal interest
i. All interest is personal interest unless it falls within a specific statutory exception
1. Major exceptions include business interest, certain amounts of home mortgage
interest, investment interest, passive activity interest, and educational loan
interest
ii. In general, interest is assigned to a particular category based on the taxpayers use
of the borrowed funds on which the interest is paid. Because the taxpayer often has a
good deal of latitude to determine how particular borrowed funds are used, the rules in
this area invite manipulation by taxpayers
c. Taxpayers continue to be allowed to deduct most interest on mortgages that are secured by their
personal residence
31

i. The number of personal residences whose mortgages can generate deductible interest is
limited to two, with married couples who file separately being allowed only one
residence each
ii. The taxpayers principal residence is automatically qualified; a second home will
qualify only if it is designated for this purpose by the taxpayer, and is used as a
residence by the taxpayer for at least 15 days during the tax year
iii. The home in question must secure the mortgage loan the interest on which the taxpayer
seeks to deduct
iv. The mortgage loan must be either acquisition indebtedness or home equity
indebtedness.
1. Acquisition indebtedness is essentially a purchase-money mortgage, used either
to buy or to build the residence. It can also include amounts borrowed to
improve the residence or to refinance existing acquisition indebtedness
2. Home equity indebtedness is any debt secured by a residence that is not
acquisition indebtedness
a. By implication, home equity indebtedness need not be invested in
improving the property. Home equity indebtedness is thus an exception
to the general rule that interest is categorized according to the use of
the loan proceeds
3. The loan amounts generating deductible interest (but not directly the interest
itself) are limited by dollar-level maximums: Interest with respect to up to $1
million of acquisition indebtedness can be deducted, as can interest with respect
to up to $100k of home equity debt
a. These numbers are not indexed for inflation
d. PROBLEMS (5-9), p. 384-85
e. Pau v. Commissioner: bought home for 1.78M, mort principal 1.33M. Claim deduction in
1.1M indebtedness. Held: 163(h)(3) limits deduction for interest paid on acq debt of 1M. Can
get home eq indebt up to 100k only if show other indebtedness besides acq indebt.
i. Basically, debt that qualifies for acquisition indebtedness cannot also qualify as home
equity indebtedness
f. Rev. Rul. 2010-25: The holding in Pau was based on the incorrect assertion that taxpayers must
demonstrate that debt treated as home equity indebtedness was not incurred in acquiring,
constructing or substantially improving their residence. The definition of home equity
indebtedness in 163(h)(3)(C) contains no such restrictions, and accordingly the Service will
determine home equity indebtedness consistent with the provisions of this revenue ruling,
notwithstanding Pau
i. Indebtedness incurred by a taxpayer to acquire, construct, or substantially
improve a qualified residence can constitute home equity indebtedness to the
extent it exceeds $1 million (subject to the applicable dollar and fair market value
limitations imposed on home equity indebtedness by 163(h)(3)(C)
g. As a practical matter, Rev. Rul. 2010-25 finally resolves the ambiguity (in the definition of
home equity indebtedness), for the simple reason that no taxpayer will have any reason to argue
against the IRSs adoption of the pro-taxpayer interpretation
XVIII. STATE AND LOCAL TAXES
a. 221: deduction for educational loan interest
i. Phased in a limited deduction for up to $2500 of such interest
32

XIX.

ii. Is an above-the-line deduction; thus, taxpayers may also claim the benefits of the
standard deduction
iii. Only available with respect to interest paid on a qualified education loan that was
incurred to pay for qualified education expenses (defined in 221(d))
1. The latter term refers primarily to tuition, fees, room and board, and related
expenses, reduced by the amounts of scholarships or similar payments from
sources other than the taxpayer
2. The qualified education loan definition primarily requires a reasonable nexus
between the time the loan is taken out and the time the expense is incurred. It
includes loans that are used to refinance other loans that were themselves
qualified educational loans
iv. If modified adjusted gross income (as defined in 221(b)(2)(B)) exceeds $60k for a
single taxpayer, or $120k for taxpayer filing jointly, deductibility begins to be phased
out; by the time modified AGI reaches $75k ($150k for a joint return), all
deductions for education interest are denied
b. Deductibility of state and local taxes is probably best justified as something of a concession to
federalism: The federal government (1) recognizes by this deduction that state and local
governments have their own revenue needs, and (2) consents to assess federal taxes only against
the income that remains after state and local governments have exacted their assessments
i. Congress has since repealed the deductibility of state and local gasoline taxes and state
sales taxes
c. Generally, 164 provides that state and local income taxes, real property taxes, and personal
property taxes are deductible, as are a few less general types of tax
i. Somewhat surprisingly, 164 also allows deduction of foreign income and real property
taxes
ii. 164(b)(1) makes it clear that personal property taxes must be of the ad valorem type
assessed based on value of the property, rather than, for example, the weight of the
vehicle
d. Loria v. Commissioner: didnt have credit to buy prop, so bro bought and was legal owner
w/ mort on prop. Interest payments paid by though. Held: cant deduct mort loan interest or
real prop taxes b/c not legal owner and interest paid on indebtedness of bro, not his. Tax regs
say taxes generally deductible only by person on whom imposed, and couldnt show tax
imposed on him.
MEDICAL EXPENSES
a. The current form of the medical expense deduction allows taxpayers who itemize their
deductions to claim a fairly broad range of expenses in this area, incurred on their own behalf or
on behalf of their dependents, but only to the extent that the expenses exceed 7.5% of the
taxpayers AGI in the tax year in which the expenses are paid, and only to the extent that the
expenses exceed amounts covered by insurance or other third-party payers (such as a tortfeasor)
b. The statutory definition of medical care is found in 213(d)(1)(A), which says that medical
care means amounts paid for the diagnosis, cure, mitigation, or prevention of disease, or for the
purpose of affecting any structure or function of the body. Subparagraphs (B) through (D) of
this paragraph add transportation costs to access medical care, certain long-term care services,
and medical insurance costs, respectively, to the definition of medical care
c. Commissioner v. Bilder: told to go to warmer climate for health. Tried to deduct for rent
when he and his wife and kid went south for winter months. Held: Cant deduct as medical
33

d.

e.

f.

g.

h.

i.

j.

expense under 213 rent paid just b/c doc said go warmer. Committee reports specifically say
no deductions for meals and lodging while away from home receiving med treatment.
i. IRS looks out for med expense deductions for consumption patterns that many tps
follow for non-med reasons. above got to deduct for travel expense to FL, but
normally tp doesnt win.
In 1984, Congress tightened the rules on deduction of travel costs as medical expenses. In
213(d)(2), it has allowed travel expenses to be deducted as medical expenses only if the care
for which the travel is incurred is provided by a physician, in a licensed hospital [or
equivalent] and only if the travel involves no significant element of personal pleasure. There
is a limit on the deduction of $50 per day for each eligible individual
i. No deduction is allowed as a medically necessary travel expense for the cost of food
consumed during the trip
Since 1990, no deductions have been allowed for cosmetic surgery unless it is necessary to
ameliorate a deformity arising from, or directly related to, a congenital abnormality, a personal
injury resulting from an accident or trauma, or disfiguring disease. (See 213(d)(9))
ODonnabhain v. Commissioner: had gender identity disorder. 21k uninsured expense for
therapy, surgery and 4.5 for breast implants. Held: surgery deductible as med expense b/c
disease treatment but boob job not b/c not essential element of treatment and served personal
purpose so cosmetic. GID is disease b/c recognized by health professionals. Dont need 100%
proof treatment will work, so long as can justify reasonable belief itll be effective.
i. 213 allow deduction only if 1) existence or imminent probability of disease, mental or
physical and 2) payment for good/service directly or proximately related to diagnosis,
cure, etc. If not wholly medical but can serve personal purpose, too, must pass but
for test that 1) expenditure essential element of treatment, and 2) wouldnt have
otherwise been incurred for nonmed reason.
1. Cosmetic surgery not deductible under 213(d)(1)(A). Essentially any
procedure to improve appearance, and doesnt meaningfully promote proper
body function or prevent/treat illness.
The deduction is allowed for expenses paid during a taxable year, and the regulations make
clear that this refers to the actual year of payment, regardless of when the medical services were
performed, and regardless of the taxpayers usual method of accounting
i. In light of the AGI floor, it makes sense for taxpayers who can reasonably do so to
bunch their medical expenses, by delaying payment in some years, and paying
promptly in others
ii. The operation of this rule may also provide a rare instance in which it may be to the
advantage of married taxpayers to file separate returns: If only one spouse has
significant medical expenses, separate filing will lower the threshold of deductibility by
comparing the medical expenses with 7.5% of only that persons AGI
Another favorable timing rule is that the IRS generally permits deductions as medical expenses
of the cost of capital improvements necessitated by medical necessities such as the cost of
installing an elevator in the home of a paraplegic taxpayer
Rationale for AGI floor is that ordinary medical expenses are part of personal living expenses,
and unworthy of any special note in the income tax; only extraordinary medical expenses should
be considered in assessing a taxpayers ability to pay
223 allows an eligible taxpayer to claim an above-the-line deduction for cash contributions to
the taxpayers health savings account (HSA)
34

XX.

XXI.

i. To be eligible, a taxpayer must be covered under a high deductible health plan


(HDHP), defined as health insurance with an annual deductible of at least $1200 in the
case of self-only coverage, or $2400 in the case of family coverage. The maximum
annual HSA deduction is $3050 in the case of a taxpayer with self-only health insurance
coverage, or $6150 in the case of taxpayer with family coverage
ii. Amounts in the taxpayers HSA may be used to pay medical expenses not covered by
the taxpayers health insurance (either because of the high deductible, or because of
other policy limitations). Amounts in the HSA ordinarily may not be used, however,
to pay health insurance premiums
SPECIAL LIMITATIONS ON ITEMIZED DEDUCTIONS
a. As a practical matter, miscellaneous itemized deductions consist primarily of (1) expenses
associated with investment activities, such as investment advice, safe-deposit boxes, and the
like; (2) expenses associated with preparing tax returns and defending them, if necessary, in
administrative or judicial proceedings; and (3) unreimbursed employee business expenses, such
as subscriptions to journals, professional society membership fees, and so on
b. When the Tax Reform Act of 1986 created the miscellaneous itemized deductions category, it
also imposed a floor on these deductions equal to 2% of the taxpayers AGI. Since most of
the items that fall within this category tend to be small, the effect is to disallow these expenses
for most taxpayers
c. 68 provided that deductions must be reduced for taxpayers whose AGI exceeded $100k ($50k
in the case of married taxpayer who file separately). This threshold has been indexed for
inflation since 1991
i. In response to criticism, Congress added 68(f), which temporarily phased out the
phaseout
d. Because the effective limitation of 68 is almost always based on AGI, rather than on itemized
deductions, it is best viewed as simply an increase in the marginal tax rate
e. In recent years, Congress has tended to favor credits over deductions as vehicles for newly
enacted tax subsidies
i. The tax savings from a credit, unlike the tax savings from a deduction, do not depend
on the taxpayers marginal tax rate. In addition, the availability of a credit unlike the
availability of most personal deductions does not depend on the taxpayers not
claiming the standard deduction. Many credits are reduced or eliminated (i.e. phased
down or phased out) for taxpayers with AGIs above specified levels. This results in
right-side-up subsidies, in sharp contract with the subsidy pattern for deductions
ORDINARY AND NECESSARY BUSINESS EXPENSES
a. With few exceptions, Congress is not trying to encourage any particular behavior in allowing
business expenses. The tax rules are simply an attempt to define income properly
b. For most businesses, in most years, expenses will substantially offset receipts, so that net
income the base of the income tax is only a small fraction of total receipts
c. 162 says that deductions shall be allowed for all the ordinary and necessary expenses paid or
incurred during the taxable year in carrying on any trade or business
d. The Supreme Court described the word necessary in 162(a) as requiring only that expenses
be appropriate and helpful in the development of the taxpayers business
i. A requirement that a business show the absolute necessity of its expenses would put the
IRS in the position of reviewing every business decision to ensure that no money was
spent (and deducted) unnecessarily
35

e. Palo Alto Town & Country Village, Inc. v. Commissioner: had plane it kept on standby
basis to fly them and clients. Saved lots of money sometimes. Can deduct b/c ordinary b/c
expected expense in tps position and necessary b/c helpful and appropriate for biz.
f. Ordinary tends to mean something that does not provide continuing value, but is rather used
up in the production of income in the current tax year
i. The principal function of the term ordinary in 162(a) is to clarify the
distinction, often difficult, between those expenses that are currently deductible
and those that are in the nature of capital expenditures, which, if deductible at all,
must be amortized over the useful life of the asset
g. Commissioner v. Heininger: paid legal fees to fight prohibition of using mail to promote biz
b/c fraud. Held: deductible b/c would expect someone to protect their biz, so normal. Using
common meaning of ordinary. Response youd expect n the situation. Dont consider that
underlying fraud behavior (not ordinary) led him to get legal fees; like malpractice case: can get
lawyer & deduct whether or not bad practice underlying.
XXII. PUBLIC POLICY LIMITATIONS AND LOBBYING
a. Courts have routinely treated allowance of a deduction in computing taxable income as an
extension of legislative grace
i. Under this conception of deductions, allowance of a deduction constitutes something a
congressional blessing, an indication that Congress regards the expenditure in question
as worthy and appropriate
b. Tank Truck Rentals, Inc. v. Commissioner: PA limited truck weight below surrounding states.
Trucks took risk of going thru heavy and paying fines if caught. Mostly intended, some
accidentally too heavy. Held: wont allow fines as deductible ordinary and necessary biz
expenses b/c encourages noncompliance w/ state law. Cannot find fines as necessary if allowing
deduction sharply frustrates natl or state policy proscribing said conduct. Dont allow innocent
ones either b/c makes no exception.
i. Note that the fines are not predicated on any moral opprobrium that is attached to
driving an overweight truck. Rather, it is that overweight trucks cause measurable
physical damages, primarily in the form of greater road repair and maintenance costs
c. 162(c)(1) now prohibits deduction of illegal bribes or kickbacks to officials or employees of
any governmental unit, agency, or instrumentality; if the payment is to an employee or official
of a foreign government, it is nondeductible if it violates the Foreign Corrupt Practices Act of
1977
i. 162(c)(2) bars deduction of payments to any other persons if the payment constitutes
an illegal bribe or kickback; but if the payment violates only state law, it will be
nondeductible only if that law is generally enforced
ii. 162(c)(3) denies deductions for kickbacks, rebates, and bribes in connection with the
Medicare and Medicaid programs, whether or not the payments are illegal
iii. 162(f) denies deduction of fines or similar penalties paid to a government for a
violation of law
iv. 162(g) disallows deductions for two-thirds of any judgments or settlements of private
antitrust suits that follow criminal convictions of violations of antitrust laws
d. Californians Helping to Alleviate Medical Problems, Inc. v. Commissioner: Co like a
charity to give members help w/ diseases and counseling. Also give medical weed under st. law.
Comm denied deductions under 280E for trafficking controlled substances. Held: 280E

36

doesnt preclude all biz expenses just b/c tp involved in trafficking. Can separate the
caregiving biz side from the weed side and allow all caregiving biz expense deductions.
e. Although it seems as if costs of goods sold (i.e. inventory costs) should be deductible as
business expenses under 162, the regulations under 61 take the position that such costs are
deductible from gross receipts in arriving at gross income (rather than deductible from gross
income in arriving at taxable income): In a manufacturing, merchandising, or mining business,
gross income means the total sales, less the costs of goods sold
f. Congress indicated in the legislative history of 280E that the provision does not disallow
deductions for drug traffickers costs of goods sold (COGS), and both the IRS and the Tax
Court have interpreted 280E in accordance with the legislative history
g. The main consequence of 280E is to make is easier for the government to prosecute drug
dealers for tax evasion, by making it harder for dealers to claim that they had no taxable income
after taking their expenses into account. 280E would be considerably more effective in this
respect, however, if it applied to inventory costs as well as to deductions under 162
h. 162(e) effectively prohibits the deduction of lobbying expenses in virtually all cases
i. Geary v. Commissioner: officer used dummy on routes. Dept forbade him, so started
campaign to get it on ballot to have voters decide if he could keep dummy. Spent 11.5k to
petition and promote. Held: 162(e)(2)(B) denies any amount spent in connection w/ attempts to
influence the public. He tried to sway general public. Reject argument that just trying to inform
voters of issue b/c telling them how he wanted them to vote.
j. The Supreme Court has emphasized that (1) 162(e) does not deny rights to speak, but merely
opportunities to claim deductions, which are not constitutionally protected; (2) the disallowance
is necessary to make sure that the Treasury doesnt finance business lobbying with tax dollars;
and (3) the disallowance is necessary to put all taxpayers on the same footing with respect to
lobbying (the theory being that nonbusiness taxpayers would ordinarily have no grounds on
which to deduct any expenses they might incur in lobbying)
XXIII. TRAVEL AND ENTERTAINMENT
a. 162(a)(2) allows deduction of traveling expenses (including amounts expended for meals
and lodging) while away from home in pursuit of a trade or business
b. The taxpayer must be away from his tax home in order to qualify for these deductions, by
which the IRS means away from the general vicinity of his work place; and the taxpayer must
satisfy the overnight rule, meaning that any trip that doesnt involve a substantial rest period,
approximating the usual eight hours in bed, doesnt put the taxpayer in travel status for purposes
of this provision
c. Perhaps the best view is that these expenses are jointly caused by the decision to accept a
particular job (a business decision) and the decision not to live at the job location (a personal
decision)
d. While meal costs that are to be deducted as travel expenses under 162(a)(2) must meet the
overnight and tax home condition, certain other lunch costs can be deducted under the more
general language of 162(a)
e. Hantzis v. Commissioner: lives in Boston (Harvard Law), summer job in NYC. Deducted cost
to go to B and live/eat in NYC under 162a2. Held: costs in pursuit of biz, but not while away
from home. Expense must be 1) reasonable and necessary, 2) incurred away from home, 3)
necessitated by biz. Decide if tp maintaining 2 homes is personal, deny. If for biz reasons, will
consider home as home and allow.

37

i. To get biz expense deduction, need biz connection to place youre leaving behind. Have
biz reason for having duplicative expenses.
ii. Hypo: travelling salesman. Has no home. 162(a)(2) lang is while away from home,
but he has none. Could read as just not at home? which he would make. Unclear.
iii. The Court rules against Mrs. Hantsiz because it found that she had no trade or business
connection to Boston
1. The duplication of living expenses for a business reason seems central to
the policy goals of the away from home deductions
2. Because Mrs. Hantzis had no permanent business connection to Boston, the
court did not consider the duplication of living expenses while she was in New
York to be attributable to the exigencies of business
iv. The Peurifoy rule discussed in the Hantzis opinion distinguishes between jobs that are
temporary, for which travel expenses are generally deductible, and ones that are
indefinite, for which travel costs are generally not deductible
1. This approach was endorsed by Congress in 1992, when it added a sentence to
the flush language of 162(a) to the effect that temporary jobs must have a
duration no greater than one year
f. The argument is essentially that a taxpayer cannot deduct trade or business expenses until
she is actually engaged in that trade or business
i. So law school doesnt count
g. Pure commuting costs the costs of travel to and from work are not deductible. But
transportation costs incurred over the course of a workday for taxpayers who must travel locally
as part of their jobs generally are deductible
h. In general, daily transportation expenses incurred in going between a taxpayers residence
and a work location are nondeductible commuting expenses
i. A taxpayer may deduct daily transportation expenses incurred in going between the
taxpayers residence and a temporary work location outside the metropolitan area where
the taxpayer lives and normally works
ii. If a taxpayer has one or more regular work locations away from the taxpayers
residence, the taxpayer may deduct daily transportation expenses incurred in going
between the taxpayers residence and a temporary work location in the same trade or
business, regardless of the distance
iii. If a taxpayers residence is in the taxpayers principal place of business within the
meaning of 280A(c)(1)(A), the taxpayer may deduct daily transportation expense
incurred in going between the residence and another work location in the same trade or
business, regardless of whether the other work location is regular or temporary and
regardless of the distance
iv. If employment at a work location is realistically expected to last (and does in fact last)
for 1 year or less, the employment is temporary in the absence of facts and
circumstances indicating otherwise
1. If employment at a work location initially is realistically expected to last for 1
year or less, but at some later date the employment is realistically expected to
exceed 1 year, that employment will be treated as temporary (in the absence of
facts and circumstances indicating otherwise) until the date that the
taxpayers realistic expectation changes, and will be treated as not temporary
after that date
38

i.

274 operates as a limitation on 162(a) and, to a lesser degree, 212; 274 authorizes no
deductions, but limits, conditions, or prohibits certain deductions that 162 or 212 would
otherwise permit
i. 274(d) imposes an obligation on taxpayers to document their travel and
entertainment expenses
1. Requires that the taxpayer document, by adequate records or by sufficient
evidence corroborating the taxpayers own statement, (a) the amount of the
expense; (b) the time and place that the expense was incurred; (c) the business
purpose for which the expense was incurred; and (d) the business relationship
to the taxpayer of the party whose entertainment, etc. was in issue
ii. If an activity is of a type generally considered to constitute entertainment,
amusement, or recreation, its expense may be deducted only if (1) the activity is
directly related to the taxpayers business, or (2) the activity is associated with
the conduct of the taxpayers business and it immediately proceeds or follows a
substantial business discussion
1. In general, entertainment can qualify as directly related only if the
entertainment is of a sort conducive to a business discussion
a. If the nature of the entertainment is not conducive to a business
discussion because it is too loud, or because talking during the
entertainment is frowned on then it is relegated to the associated
with category
iii. Deductions for facilities used in connection with entertainment (such as yachts, clubs,
and the like) are denied, unless the facility is used primarily for the furtherance of the
taxpayers business, and was directly related to the active conduct of such trade or
business
iv. 274(a)(3) flatly prohibits deduction of club dues
v. 274(b) severely limits the deduction for business gifts to individuals, whether they
are customers, clients, or even employees. The limitation is set at $25 per recipient, per
year
vi. 274(c) requires allocation between business-related (and deductible) expenses and
nonbusiness-related expenses in the case of certain foreign travel basically, travel for
longer than one week, during which at least 25% of the trip is not related to business
vii. 274(n) limits deductions for both types of deductible business meal expenses travel
and non-travel to 50% of the amount actually spent
1. 274(n) also applies to entertainment expenses, such as tickets for concerts and
sporting events. It does not, however, apply to lodging expenses incurred on a
business trip
2. 274(n) also denies the taxpayer a deduction for half the cost of his guests
meal or entertainment
a. This is probably an instance of surrogate taxation
i. From the governments point of view, the overtaxation of the
host and the undertaxation of the guest cancel out (assuming
host and guest have the same marginal tax rate), and the
government collects the appropriate amount of tax
viii. 274(e) provides a number of exceptions to the other rules of 274

39

j.

In the case of business travel expenses, 162(a)(2) specifically disallows deductions for food
and lodging expenses that are lavish or extravagant under the circumstances. The IRS,
however, seldom disallows either travel or entertainment expenses on grounds of extravagance,
and the courts do not always support it when it does
k. The regulations state that airline clubs are indeed clubs for purposes of the 274(a)(3) denial of
deductions for club dues
XXIV. CAPITALIZATION AND DEPRECIATION: THE BASICS
a. 168 provides various cost recovery formulas from which cost recovery schedules can be
derived for different kinds of tangible assets used in business. Under the accelerated cost
recovery system (ACRS) of 168, the cost recovery schedule for a particular asset depends on
three things the total amount of cost to be recovered, the number of years over which the cost
is to be recovered, and the rate at which the cost is to be recovered over those years
b. In theory, the total amount of cost to be recovered is the total expected decline in value while
the asset is used in the taxpayers business
c. 168(b)(4) provides that salvage value is always treated as zero
d. 168 provides recovery periods for many different types of assets. (For cars and light trucks,
the recovery period is 5 years.)
e. Although 168 requires straight line depreciation for buildings and a few other types of assets,
most assets are eligible for an accelerated schedule, under which larger deductions are
allowed in the earlier years. According to 168(b)(1), the depreciation method for cars (and
many other assets) is the 200% declining balance method, with a switch to straight line when
straight line recovery of the remaining basis produces a larger deduction than continued use of
200% declining balance
f. Half-year convention: If an asset is not placed in service at the very beginning of Year 1, the
deduction for that year should be based on less than an entire years use of the asset
i. 168(d)(1) treats most assets as being placed in service in the middle of the year,
with the result that only a half-years worth of depreciation is allowed in the first year
g. Rev. Proc. 87-57, 1987-2 C.B. 687 contains a number of tables indicating the percentage of
adjusted basis that is deductible each year for various types of ACRS property
i. Although the double declining balance method applies the assets adjusted basis by a
fixed percentage each year, the table translates this into multiplication of the assets
unadjusted basis by percentages that change from year to year
h. Congress has intentionally permitted cost recovery allowances that will usually be
significantly faster than the actual declines in value of business assets
i. As long as a taxpayer continues to hold a 168 asset, the tax system assumes the asset
declines in value in accordance with the applicable ACRS schedule. When the taxpayer
disposes of the asset, however, the system can measure the extent to which that
assumption was mistaken, and require an appropriate correction
i. Since ACRS is a method of recovering a taxpayers cost, 1016(a)(2) provides that the
taxpayers adjusted basis in an ACRS asset must be reduced by the amount of the deductions
allowed under 168
j. 1245 provides that any gain that represents the recapture of overly generous ACRS
deductions on tangible personal property will be treated as ordinary income. The amount
of gain treated as ordinary under 1245 is the lesser of (1) the total gain realized on the
disposition of the asset or (2) the ACRS deduction s previously taken with respect to the asset

40

k.

l.

m.

n.

o.
p.

q.

r.

s.

i. To the extent the gain results from artificial depreciation deductions, 1245 applies; to
the extent the gain results because the taxpayer sells the property for more than he paid
for it, 1245 does not apply
In most cases, 1250 does not require depreciation recapture for buildings. 1250 applies
recapture principles to gain on the sale of a building only if there is additional depreciation,
defined as depreciation allowances in excess of straight line depreciation
168(k) allows a taxpayer to deduct 50% of the cost of most 168 assets (other than real estate)
in the year the assets were placed in service, but only for assets placed in service in 2008, 2009,
2010, or 2012
179 allows a taxpayer an immediate deduction for the cost of 179 property placed in
service during the year, up to a maximum annual amount of $500k in 2010 and 2011, and $125k
in 2012. In general, 179 property is property eligible for ACRS under 168, with the exception
of buildings
280F imposes special limitations on the deductions that may be claimed under 168 and 179
with respect to an expensive automobile used by a taxpayer in her business
i. Congress originally provided that the limitations of 280F did not apply to vehicles
weighing more than 3 tons, but the country soon became crazy for SUVs
1. In response, Congress enacted 179(b)(6), which provides that the cost of an
SUV that may be written off under 179 is limited to $25k. This is still a much
better deal than is available for purchasers of luxury sedans
PROBLEMS (1-5), p. 620-21
When a taxpayer is denied a current business expense deduction for a long-lived business
asset, the usual consolation prize is permission to deduct the cost of the asset over a
number of years. Not every long-lived business asset is depreciable, however, because not
every business asset can be expected to decline in value due to wear and tear, to decay or
decline from natural causes, to exhaustion, or to obsolescence
i. Land is by far the most important example of nondepreciable tangible property
1. Art or antiques used in a business are also generally nondepreciable
An intangible business asset is also eligible for depreciation (usually called amortization, in
the case of intangible assets) if it will be used in the business for only a limited period, the
length of which can be estimated with reasonable accuracy
i. What about an intangible business asset that does not have an ascertainable useful life?
Under Treas. Reg. 1.167(a)-3(b), such assets may generally be amortized over 15
years, using the straight line method. This regulation does not apply to assets the
amortization of which is specifically prohibited by any Code section (such as 197)
Under 197, taxpayers are allowed to recover the cost of a wide range of purchased intangibles,
including goodwill and other customer-based intangibles, on a straight line basis over 15
years, without regard to the actual useful life of the asset. With a few exceptions, 197 does
not apply to intangibles created by the taxpayer itself, such as goodwill created by the
taxpayers own advertising. This exclusion is of little practical significance, however, because
taxpayers are allowed to deduct the vast majority of the costs of creating goodwill as current
business expenses under 162; thus, taxpayers will usually have no basis in self-created
goodwill. 197 does apply, however, when a taxpayer purchases an ongoing business and part
of the purchase cost if allocated to goodwill and other 197 intangibles
The Code permits gradual cost recovery in the case of exhaustible natural resources, such as
mines, wells, and other natural deposits. The deductions are called depletion allowances
41

i. Taxpayers are generally able to choose between two different cost recovery methods:
cost depletion under 612, and percentage depletion under 613. A taxpayer may go
back and forth between the two depletion methods with respect to the same mine
in different years, using whichever method produces the larger deduction in a
particular year
ii. Under cost depletion, a taxpayer operating a mine divides the mines basis by the
estimated number of recoverable units of mineral to arrive at a per-unit depletion
allowance. The allowance for a particular year is the number of units mined during the
year multiplied by the per-unit allowance. Cost depletion ceases when the taxpayers
adjusted basis has been reduced to zero
iii. The percentage depletion alternative does not require an estimate of the number of
recoverable units in the mine. Rather, the taxpayer claims a cost recovery allowance
equal to a statutorily fixed percentage of the taxpayers gross income from mining
1. Nothing in 613 limits percentage depletion to basis, and it continues merrily
along even after the taxpayers basis has been reduced to zero. Moreover,
percentage depletion in excess of basis does not result in negative basis
2. Because it is not limited to basis, percentage depletion is better understood as
a reduction in the effective tax rates applicable to extractive industries than as a
true cost recovery allowance. 613A restricts the available of percentage
depletion for oil and gas wells to certain small producers; large oil and gas
producers must be content with cost depletion limited to basis
XXV. SELF-PRODUCED PROPERTY AND INDOPCO
a. Commissioner v. Idaho Power Co.: equipment used for normal operation and also
constructing capital facilities for itself w/ longer life than 1 year. Held: equipment depreciation
thats allocated to constructing capital facilities is capitalized under 263(a)(1) and not deducted
under 167(a).
i. Would be unfair to allow firm that can construct for itself to get current deduction while
those who contract out must capitalize. 161 prioritizes capitalization of 263 over
167.
b. In 1986, Congress enacted the uniform capitalization (unicap) rules of 263A, which apply
the principle of Idaho Power with a vengeance. In general, 263A denies a taxpayer an
immediate deduction for the costs of producing property that the taxpayer will either use in its
business or sell as inventory
i. Costs that must be capitalized (or added to the cost of inventory) include depreciation
on equipment used in producing the property, employees wages allocable to production
of the property, and an appropriate share of the rent and utilities expenses of the facility
where the property is produced
ii. When a taxpayer produces a depreciable asset that it will use in its business, the
operation of the unicap rules basically follows the Idaho Power approach
c. 263A(h): qualified creative expense exemption to unicap rules. To qualify, the taxpayer
must be an individual in the business of being a writer, protographer, or artist
i. 263A(h)(3)(C)(i) defines an artist as a person who creates a picture, painting,
sculpture, statue, etching, cartoon, graphic design, or original print edition. The statute
also provides that the determination of whether a person is an artist should take into
account the originality and uniqueness of the item created and the predominance of
aesthetic value over utilitarian value of the item
42

d. INDOPCO, Inc. v. Commissioner: Corporation incurred professional expenses (law


firm/investment firm) in the course of a friendly takeover. Held: Although the mere presence of
an incidental future benefit may not warrant capitalization, a taxpayers realization of benefits
beyond the year in which the expenditure is incurred is undeniably important in determining
whether the appropriate tax treatment is immediate deduction or capitalization. Indeed, the text
of the Codes capitalization provision, 263(a)(1), which refers to permanent improvements or
betterments, itself envisions inquiry into the duration and extent of the benefits realized by the
taxpayer.
i. This transaction produced significant future benefits to the corporation, and is therefore
not an ordinary and necessary 162(a) business expense; the expenses should be
capitalized
1. The fact that the expenditures do not create or enhance a separate and distinct
additional asset is not controlling
ii. The creation of a separate and distinct asset well may be sufficient, but not a necessary,
condition to classification as a capital expenditure
iii. Deductions are exceptions to norm of capitalization and strictly construed. Dont need
creation or enhancement of asset to get capitalization. Just need future aspect.
e. Rev. Rul. 92-80: The Indopco decision does not affect the treatment of advertising costs under
162(a). These costs are generally deductible under that section even though advertising may
have some future effect on business activities, as in the case of institutional or goodwill
advertising
i. Only in the unusual circumstance where advertising is directed towards obtaining future
benefits significantly beyond those traditionally associated with ordinary product
advertising or with institutional or goodwill advertising, must the costs of that
advertising be capitalized
f. INDOPCO could be a powerful tool in the hands of the IRS, but the Service has been sparing in
its use
g. For the most part the new regulations abandon the future benefits test of INDOPCO in
favor of the separate-and-distinct asset test that the Supreme Court rejected in INDOPCO
i. Separate and Distinct Intangible Asset: Courts have considered (1) whether the
expenditure creates a distinct and recognized property interest subject to protection
under state or federal law; (2) whether the expenditure creates anything transferrable or
salable; and (3) whether the expenditure creates anything with any ascertainable and
measurable value in moneys worth
ii. Regulations provide a simplifying assumption that employee compensation and
overhead costs do not facilitate the acquisition, creation or enhancement of an
intangible asset
iii. The new regulations address only the capitalization costs related to intangible assets.
As a result of the new regulations, there are now much more rigorous
capitalization requirements for tangible assets than for intangible assets. The new
regulations are particularly generous with respect to employee compensation costs
iv. Intangible Asset: (1) any intangible that is acquired from another person in a purchase
or similar transaction; (2) certain rights, privileges, or benefits that are created or
originated by the taxpayer; (3) a separate and distinct intangible asset; or (4) a future
benefit that the IRS and Treasury Department identify in subsequent published guidance
as an intangible asset for which capitalization is required
43

XXVI. REPAIRS, THE GREAT CASE OF WELCH V. HELVERING, AND JOB HUNTING
EXPENSES
a. Repairs are an important area where the IRS continues to allow current deductions under 162
for expenditures with obvious future benefits
i. Rev. Rul. 2001-4: Reg. 1.162-4 allows a deduction for the cost of incidental repairs
that neither materially add to the value of the property nor appreciably prolong its
useful life, but keep it in an ordinary efficient operating condition. However,
1.162-4 also provides that the cost of repairs in the nature of replacements that arrest
deterioration and appreciably prolong the life of the property must be capitalized and
depreciated in accordance with 167
1. Repair and maintenance expenses are incurred for the purpose of keeping the
property in an ordinarily efficient operating condition over its probable useful
life for the uses for which the property was acquired. Capital expenditures, in
contrast, are for replacements, alterations, improvements, or additions that
appreciably prolong the life of the property, materially increase its value, or
make it adaptable to a different use
2. Where an expenditure is made as part of a general plan of rehabilitation,
modernization, and improvement of the property, the expenditure must be
capitalized, even though, standing alone, the item may be classified as one of
repair or maintenance
b. In some cases, repairs are a response to casualty damage, and a deduction for the repairs can be
justified as a substitute for a casualty loss deduction even if the repair is not trivial and clearly
produces benefits beyond the current year
c. There is no apparent justification for an immediate repair deduction in Rev. Rul. 2001-4
d. If a taxpayer can plausibly describe an expenditure as a repair, there is a good chance of a
current deduction, even if the cost is large and there is no related casualty
e. PROBLEM: 8, p. 643
f. Welch v. Helvering: Welchs company went bankrupt. He attempted to pay off the debts of the
corporation with his own money in an endeavor to strengthen his own standing and credit. Held:
Cant deduct as ordinary biz expense. May be necessary b/c appropriate and helpful, but that
doesnt make them current. Not ordinary b/c not normal industry practice and capital
expenditures to develop reputation and good will.
i. In some parts of the opinion, Justice Cardozo focuses on the distinction between current
and capital expenditures, as when he remarks that many necessary payments are
charges upon capital
1. Most later cases have read Welch as being based on the current-versus-capital
distinction, and have paid little attention to Justice Cardozos distrust of bizarre
expenses
ii. The payments were made to generate goodwill, and goodwill does not have the
ascertainable useful life necessary to support depreciation deductions. 197 would not
help, because although he spent money to generate goodwill, he did not purchase
goodwill. The end result is that Mr. Welch has spent money for a business purpose, but
he may never be allowed any tax recognition for that expenditure not now (because it
is capital), not through depreciation (because there is no ascertainable useful life), and
perhaps not even as an offset to amount realized on a sale of the business (because the
goodwill may be too personal to Mr. Welch to be transferrable)
44

g. Jenkins v. Commissioner: Twitty helped set up Twitty Burger. Went under and he paid off
investors even tho no personal liability. Held: Can still be ordinary/necessary biz expense even
though voluntary. Deductible under 162 in this case b/c protecting country reputation. Ok b/c
1) Prompted by biz motive more than personal/moral motive and 2) sufficient connection
to his other biz b/c reputation means a lot and investors related to music industry.
h. Necessary expenses dont have to be in the same line of taxpayers business
i. It is possible to distinguish the two cases by considering whether the expenditures in each case
are analogous to deductible repair expenses for physical assets. Mr. Welch lost his case because
his business reputation was more or less destroyed, and he was spending money to rebuild it
from scratch. Conway Twitty, by contrast, never lost his good reputation among country music
fans; it was just slightly damaged, and he spent money to repair it. Mr. Welch was trying to
establish himself in a new business; Twitty was just protecting the reputation he had already
established in the music business
i. In short, there is a strong argument that Twittys expenses are analogous to deductible
repair expenses for physical assets, while Mr. Welchs expenses were not
j. Job hunting expenses are deductible if the taxpayer is seeking new employment in the same
trade or business in which he is currently employed. In other cases where the taxpayer is
seeking his first job, or employment in a new trade or business no current deduction is
allowed. As with Mr. Welchs payments to generate goodwill, there is no authority permitting
these nondeductible expenditures to be amortized over the life of the job
k. A change of duties does not constitute a new trade or business if the new duties involve the
same general type of work as is involved in the taxpayers present employment
l. Bona fide expenses, incurred in seeking new employment in the same trade or business in which
a taxpayer is presently engaged, are deductible under 162 if directly connected with such trade
or business as determined by all the objective facts and circumstances
m. Criteria used in determining the existence or nonexistence of a trade or business include
continuity and regularity of business activities by a taxpayer
n. Because of the intervening enactment of 67, the deductibility of job hunting expenses is not as
significant today as it was in 1978. Job hunting expenses are unreimbursed employee business
expenses, and thus are among the miscellaneous itemized deductions subject to the 2% of
AGI floor of 67
o. PROBLEM: 9, p. 653
XXVII.TAX SHELTER BASICS
a. Tax Preference: Any exclusion or deduction that results in taxable income understating a
taxpayers true economic income
b. Tax Shelter: An investment that produces artificial tax losses that is, tax losses in excess of
actual economic losses (if any), which can be used to eliminate the tax on income from sources
unrelated to the tax shelter investment.
i. Most tax shelter investments are debt-financed; the artificial loss is created by the
combination of a tax preference (for example, ACRS deductions under 168) and an
interest expense deduction
c. 103(a) provides that gross income does not include the interest on a bond issued by a state or
local government (so-called municipal bonds). A taxpayer who wants to buy bonds has a choice.
He can invest in corporate bonds (or debt of the federal government) and receive taxable
interest, or he can invest in municipal bonds and receive tax-exempt interest

45

d. When a top-bracket (30%) taxpayer invests $100 in a municipal bond paying 7% instead of in a
taxable bond paying 10%, the federal government loses $4 of tax revenue, the borrowing
government enjoys a $3 reduction in borrowing costs, and the taxpayer reaps no windfall
i. The taxpayer accepts a lower interest rate on the municipal bond because of the tax
advantages
1. The reduced pre-tax rate of return the taxpayer must accept in order to obtain
the tax preference is sometimes referred to as an implicit tax, or a putative tax
a. Here, the taxpayer has replaced a 30% explicit tax with a 30% implicit
tax. The reason the taxpayer enjoys no windfall is that the implicit tax
rate is as high as the explicit tax rate
ii. The borrowing government enjoys the reduction in borrowing costs because it can
borrow at 7% interest instead of 10% interest
iii. The sort of efficiency described above might be labeled delivery efficiency. Delivery
efficiency simply means that the federal governments revenue loss from a subsidy ends
up in the pockets of the intended beneficiary of the subsidy (in this case, the borrowing
state or local government), rather than in the pockets of some lucky third party
e. 103(b)(1) denies the exemption for interest on any private activity bond which is not a
qualified bond. This limits the extent to which a state or local government can share its ability
to borrow on a tax-favored basis with private businesses within its jurisdiction
f. 103(b)(2) denies the exemption for interest on any arbitrage bond. This prevents a state or
local government from borrowing at 7%, and then turning around and investing the borrowed
funds in corporate bonds paying 10%
g. There is no way to price-discriminate among different buyers of municipal bonds. If state and
local governments must pay 8% interest to attract investors in the 20% bracket, then they must
also pay 8% interest to investors in the 30% bracket. But in that case, the 30% bracket taxpayer
is faced with a choice between corporate bonds paying interest subject to a 30% explicit tax
rate, and municipal bonds paying interest subject to an implicit tax of only 20%. Now 103 does
not feature delivery efficiency
h. 103(a) provides for the exclusion only in the case of interest on a government bond, but
103(c)(1) defines bond as simply an obligation of a state or local government
i. United States Trust Co. of New York v. Anderson
i. Where the crucial statutory language (obligations) is ambiguous, the interpretation
should be guided by the policy behind the statute. The court identifies that policy as
reducing the borrowing costs of state and local governments, and reasons that 103 will
have the desired effect only when the borrowing government must compete with other
borrowers for a limited supply of lenders funds. When a state is faced with an
involuntary lender such as the owner of condemned property, or someone who has
overpaid his taxes the state does not have to offer a competitive interest rate. Instead,
the state can present the involuntary lender with whatever interest rate it chooses, on a
take-it-or-leave-it basis. In that situation, making the interest rate tax exempt would not
inure to the benefit of the state, and Judge Hand reasonably concludes that such interest
is outside the scope of the 103 exclusion
ii. It does not follow from United States Trust, however, that 103 applies only to interest
on what one would normally think of as bonds
1. Look for situations where the parties bargain

46

j.

k.

l.

m.
n.

o.

p.

When tax professionals refer to a tax shelter, they generally mean an investment or transaction
that produces artificial tax losses, which can be used to avoid tax on income from other
unrelated sources
i. The first critical point is that the losses must be artificial
ii. The second critical point is that the income being sheltered is unrelated to the shelter
investment or transaction
Allowing taxpayers to use municipal bonds in shelters would significantly improve the delivery
efficiency of 103
i. Why, then, does Congress not permit taxpayers to deduct the interest expense on
amounts borrowed to finance purchases of municipal bonds? The main reason is the
great revenue cost that would be associated with municipal bond tax shelters. An
implicit tax may be just as burdensome to the taxpayer as an explicit tax, but it does not
remotely resemble an explicit tax from the point of view of the federal government
ii. Permitting the use of municipal bonds in shelters would make 103 a more deliveryefficient subsidy, but the resulting increased demand among high bracket taxpayers
would also make it a much larger subsidy
iii. 265(a)(2) provides that no deduction shall be allowed for interest on indebtedness
incurred or continued to purchase or carry obligations the interest on which is wholly
exempt from the taxes imposed by this subtitle
1. This obviously disallows the interest expense deduction when a taxpayer uses
borrowed money to buy municipal bonds
2. It also applies when a taxpayer who already owns municipal bonds takes out a
loan secured by the bonds, and uses the money to pay some unrelated expense
or to make some unrelated purchase. In that case, the loan is viewed as enabling
the taxpayer to continue to carry the municipal bonds
3. It does not apply merely because a taxpayer happens to have outstanding debts
at the same time he owns municipal bonds. The statute requires some nexus
between the bonds and the debt before the disallowance kicks in
Whenever the Code provides a tax break for a particular type of investment income, that break
can be converted to a tax shelter that is, an artificial loss to shelter unrelated income from tax
if taxpayers are allowed to buy the tax-favored asset with borrowed money and deduct the
interest expense
One important tax preference for investment income is the deferral of taxation on unrealized
appreciation
163(d) provides that investment interest generally, interest on debt incurred to buy
investment assets is deductible only to the extent of investment income
i. Based on the presumption that any excess of investment interest expense over
investment income is an artificial loss, because it is offset (or more than offset) by
unrealized appreciation in investment assets. The rule operates as a conclusive
presumption.
Another important tax preference is the ACRS of 168. To the extent ACRS allows cost
recovery faster than the actual decline in value of business assets, it results in the
understatement of economic income for tax purposes
469 passive loss rules: prohibit the deduction of passive losses defined as losses from
businesses in which the taxpayer does not materially participate against either income
from personal services or portfolio income (such as dividends, royalties, and interest income).
47

q.

XXVIII.
a.

b.

c.

d.

e.

f.
g.

Although 469 does not explicitly focus on interest expense deductions, in practice most
disallowed passive losses will be produced by the combination of ACRS (or some other assetbased tax preference) and an interest expense deduction
i. Brought the tax shelter industry to its knees
163(h)(3) allows a deduction for qualified residence interest, which covers the interest on
most home mortgages
i. Thus, 163(h)(3) sanctions a classic interest deduction-based tax shelter
ii. Owner-occupied housing is the last great interest-based tax shelter
THE PASSIVE LOSS RULES
The most important restriction on the ability of taxpayers to create tax shelters by borrowing
money to invest in tax-favored assets is imposed by the passive loss rules of 469. These rules
generally prohibit taxpayers from deducting losses from passive activities against either
salary income or portfolio income (such as interest and dividends)
The Act provides that deductions from passive trade or business activities, to the extent they
exceed income from all such passive activities (exclusive of portfolio income), generally may
not be deducted against other income. Suspended losses and credits are carried forward and
treated as deductions and credits from passive activities in the next year. Suspended losses
from an activity are allowed in full when the taxpayer disposes of his entire interest in the
activity
Salary and portfolio income are separated from passive activity losses and credits because the
former generally are positive income sources that do not bear deductible expenses to the same
extent as passive investments
469 does not prohibit the deduction of a loss from a passive activity against any unrelated
income; a loss from one passive activity can be used to shelter income from another passive
activity
i. As a result, a taxpayer with a loss-producing passive activity would do well do purchase
an interest in a PIG a passive income-generator
The passive loss rules dont bother to investigate whether a particular disallowed loss really is
artificial
i. Congress decided it was too difficult to distinguish between real and artificial losses, so
it decided to treat all passive losses as artificial
469(g) says that all suspended losses are deductible upon disposition of a taxpayers entire
interest in a passive activity
Passive activities occupy a middle ground on a continuum between active businesses and
nonbusiness portfolio investments. In a nutshell, a passive activity is a business in which the
taxpayer does not materially participate
i. The general rule of 469(h)(1) tells us only that material participation must be regular,
continuous, and substantial. In addition, 469(h)(2) provides that a limited partner
cannot materially participate in a limited partnership
ii. In most cases, a taxpayer will not satisfy the material participation standard unless he
participates in the activity for more than 500 hours during the year
iii. 469(c)(2) provides that any rental activity is passive, but two special rules provide
limited relief for some real estate investors. Under 469(i), moderate-income taxpayers
who actively participate (a less demanding standard than material participation) in
rental real estate activities can deduct up to $25k of their losses. In addition, real estate
professionals (such as developers and brokers) who devote more than 750 hours per
48

year to real estate businesses are not subject to the rule that rental activities are
automatically passive
h. The regulations governing the treatment of undertakings as one or several activities give
taxpayers a great deal of freedom in deciding whether to aggregate or separate their related
undertakings. Treas. Reg. 1.469-4(c)(2) permits a taxpayer to use any reasonable method of
applying the relevant facts and circumstances in grouping activities. The only catch is that
once a taxpayer has selected a particular grouping, he is stuck with it
i. May be useful if you materially participate in one activity and do not materially
participate in a related activity
i. The basic idea behind Treas. Reg. 1.163-8T is to allocate debt and hence the interest on the
debt among baskets according to the use of loan proceeds
i. This tracing approach gives sophisticated taxpayers considerable flexibility in planning
their affairs so as to put their interest expense in the best possible tax basket
j. 465 limits deductions from an activity to the amount the taxpayer has at risk in the activity.
In general, a taxpayer is at risk with respect to investments made with his own money, and with
respect to debt on which he is personally liable
i. A taxpayer involved in a real estate activity is considered at risk with respect to
qualified nonrecourse financing, as defined in 465(b)(6)(B)
k. Think of 469 as a fence with a sign: Anti-Tax Shelter Rules: Keep Out. The rules inside the
fence may be complex, but to the extent that the sign serves its purpose and taxpayers keep out,
nobody has to deal with the complexity
l. Both 163(d) and 469 allow interest expense deductions only to the extent of the income
generated by the investments (163(d)) or passive activities (469). No net loss deductions (as
in a case where interest expense exceeds income) are allowed
m. PROBLEMS (2, 3, 5, 6), p. 718
XXIX. ANTI-ABUSE DOCTRINES
a. Even in the absence of specific anti-tax shelter legislation, the courts have used a number of
common law doctrines to restrain the use of particularly aggressive tax shelter strategies
b. Knetsch v. United States: bought 4M annuity savings bond w/ nonrecourse loan. 3.5% interest
on loan, annuities return at 2.5%. Losing more to pay interest, but save on taxes. Pulled out
notes from indebtedness leaving almost no cash in annuity. Held: Sham transaction b/c look at
facts and see he was using for only the tax benefits since no money for annuity to make interest
on. Reject arg that 264(a)(2) denying deductions for amounts on indebtedness to get annuity
Ks only for those after certain date so Cong allowing til then.
i. Dissent: Doesnt matter if just for tax break. Same if tp borrows at 5% to get security
paying 3%. As long as transaction not fake, should allow.
c. Some tax shelters are based on permanent tax preferences, and some are based on deferral tax
preferences
d. The enactment of 264(a)(2) clearly shut down Knetsch-type deals for contracts purchased after
March 1, 1954
e. The scope of the sham transaction doctrine (and of related anti-abuse doctrines) remains
uncertain
f. Rices Toyota World, Inc. v. Commissioner: bought used computer for 1.4M w/ 250k recourse
note and two 1.2m nonrecourse seller financed notes. Lease computer back to seller and get
rental payments but only slight chance of selling later to turn profit. Held: Sham transaction
under 2 prong test. Test: 1) not motivated by biz purpose other than getting tax benefit and 2) no
49

g.
h.

i.

j.

k.
l.
m.

n.

economic substance b/c no reasonable possibility of profits existed. Denied depreciation


deductions for amounts of notes in basis and interest deduction for nonrecourse. (Did deduct
interest payments for recourse note).
i. The business purpose prong of the test inquires into the subjective motivation of the
taxpayer, while the economic substance prong considers the objective profit potential of
the transaction. Applying the two-pronged test requires a close examination of the
taxpayers behavior and of the economics of the transaction
The business purpose and economic substance tests do not apply to disallow tax benefits
contemplated by Congress
Tax shelters with intentionally inflated purchase prices made sense only in the context of
nonrecourse financing provided by the seller (as in Rices Toyota World). The buyer was willing
to agree to the inflated price because he knew he would never have to make the payments on the
under-secured nonrecourse note. The seller did not care that the buyer would never pay off the
note, because the deal was structured for the seller to make a nice profit even with the buyer
defaulting on the note. Finally, the seller could use the installment method of 453 to avoid
paying tax on the gain generated by the inflated purchase price
The enactment of the passive loss rules in 1986 virtually eliminated the traditional type of tax
shelter. Beginning in the 1990s, however, the IRS struggled with a new generation of tax
shelters. These were commonly referred to as corporate shelters, because tax shelter
promoters originally marketed them only to large corporations. These sophisticated shelters
often used literal interpretations of highly technical statutory and regulatory provisions to
produce results that Congress never intended or even imagined
ACM Partnership v. Commissioner: move around notes so foreign shelter recognizes the
gains that dont matter for tax purposes, and then partnership transferred to Colgate who can sell
notes and under 453B, b/c installment method and already deducted some, recognized tons of
artificial loss to offset other, legit capital gains. Held: apply more smell test, but econ and biz
purpose not really satisfied such that sufficient economic substance. Form satisfies
requirements, but substance doesnt show anything but tax benefit. To deduct, must be true loss,
not that from applying tax rules to bifurcate loss component of transaction from offsetting gain
component and create artificial loss.
i. Dissent: should allow if follow letter of law.
The mere fact that a tax shelter plan complies with the literal requirements of the Code or
regulations is no guarantee that the plan will survive an IRS challenge
The IRS cannot lose discovered loopholes as fast as tax planners can discover new ones
In the wake of recent statutory and regulatory developments, however, taxpayers should
assume that the odds are very high that the IRS will detect their shelters. Treas. Reg.
1.6011-4(a) requires any taxpayer who has participated in a reportable transaction to file a
reportable transaction disclosure statement with the IRS as a tax return attachment.
Reportable transactions are defined broadly enough to include most tax shelters
i. 6111 requires a material advisor with respect to any reportable transaction to
disclose the details of the transaction to the IRS, and 6112 requires the advisor to
maintain and make available to the IRS for inspection a list of the taxpayers investing in
the shelter
IES Industries, Inc. v. United States: Illustrates a judicial attitude to corporate tax shelters
very different from the attitude illustrated in ACM. You found it; you should get to keep it.
50

o. 7701(o) provides that in the case of any transaction to which the economic substance
doctrine is relevant, such transaction is treated as having economic substance only if (1) the
transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayers
economic position, and (2) the taxpayer has a substantial purpose (apart from Federal income
tax effects) for entering into such transaction
i. The economic substance doctrine involves a conjunctive analysis there must be an
inquiry regarding the objective effects of the transaction on the taxpayers position as
well as an inquiry regarding the taxpayers subjective motives for engaging in the
transaction
ii. Under the provision, a taxpayers non-Federal-income-tax purposes for entering into a
transaction (the second prong in the analysis) must be substantial
iii. A taxpayer may rely on factors other than profit potential to demonstrate that a
transaction results in a meaningful change in the taxpayers economic position or that
the taxpayer has a substantial non-Federal-income-tax purpose for entering into such
transaction. The provision does not require or establish a minimum return that will
satisfy the profit potential test. However, if a taxpayer relies on profit potential, the
present value of the reasonably expected pre-tax profit must be substantial in relation to
the present value of the expected net tax benefits that would be allowed if the
transaction were respected
p. A court is still free to decide a tax shelter case in the taxpayers favor by determining that the
economic substance doctrine is not relevant to the taxpayers transaction
XXX. THE ALTERNATIVE MINIMUM TAX
a. The AMT, which is codified in IRC 55 through 59, amounts to a shadow tax system running
alongside the regular tax. The base of the AMT is alternative minimum taxable income
(AMTI), which is defined so as to disallow many exclusions and deductions that are allowed
under the regular tax. After the allowance of a large exemption amount in effect, a zero rate
tax bracket the AMTI is subject to a moderate rate, semi-flat tax
i. The tax rate is 26% for the first $175k of income above the exemption amount, and
28% for all other income
ii. Applying these tax rates to AMTI produces what the statute calls tentative minimum
tax
b. The AMT features a broader base than the regular tax, combined with tax rates that are
sometimes lower and sometimes higher than the applicable rates under the regular tax. A
taxpayer who has reason to suspect her AMT liability will be higher than her regular tax liability
must calculate her AMT liability as well as her regular tax; she must then pay whichever tax
liability is greater
c. Klaassen v. Commissioner: dont buy arg that only apply AMT to tp w/ 57 tax preferences or
those making over a certain amount. Dont care if not intended target, congress never said
otherwise.
i. Concur: cant do anything b/c , but not intended. Cong or IRS needs to fix. Possible
fixes are:
1. Eliminate itemized deductions and personal exemptions as adjustments to reg
taxable income to arrive at AMTI
2. Exempt low and moderate income tp from AMT
3. Raise and index AMT exemption amount

51

d. Congress originally enacted a minimum tax in 1969 to guarantee that high-income individuals
paid at least a minimal amount of tax each year
i. For a variety of reasons, the number of moderate income taxpayers subject to the
AMT has been steadily increasing
ii. One reason for the expansion of the AMT is that unlike the regular income tax system
the AMT brackets and exemption are not indexed for inflation
iii. The Bush tax cuts exacerbate the AMT problem because they reduce income taxes
without a corresponding permanent reduction in the AMT
iv. Exemptions in the AMT are neither indexed for inflation nor adjusted for family size
e. The share of taxpayers affected by the AMT varies widely depending on number of children,
state tax level, and filing status. Because the AMT disallows dependent exemptions, it affects
filers with many children more than those without children
f. The state and local tax deduction accounts for about two-thirds of all exemption preferences,
making it the largest AMT preference item
i. Residents of high tax states are more likely to pay AMT than residents of low tax states
g. Because the AMT exemption for married couples is less than double that for singles and
because the AMT brackets are the same regardless of filing status, married couples are much
more likely to pay the AMT than single or head of household filers
h. To avoid the AMT explosion, Congress has enacted temporary AMT patches on an annual
basis that raise the AMT exemption and allow certain credits against the AMT
i. Among the many targets of the AMT are 67 miscellaneous itemized deductions most
significantly, unreimbursed employee business expenses and 212 expenses for the production
or collection of income
XXXI. TAX ALLOWANCES FOR FAMILY RESPONSIBILITIES
a. The income tax provides two types of benefits for parents with dependent children.
i. Benefits of the first type are based on actual dollars paid for child care while parents are
at work. 21 provides a credit for a limited amount of child care expenditures, and 129
allows an exclusion for benefits (including cash) received from an employer pursuant to
a dependent care assistance program
ii. The second type of benefit is based simply on the fact that the taxpayer is a parent of
dependent children. The two best examples are the 151 dependency exemption and the
24 child credit
b. Neither child care costs nor commuting costs are treated as business expenses. The underlying
principle seems to be: If we can imagine another taxpayer with the same job, but with a
different personal life (no child in one case, a home across the street from work in the other),
who would not incur the expense, then the expense is not treated as a business expense
c. 21 provides a credit equal to a percentage of a taxpayers child care expenses, if the expenses
are incurred to enable the taxpayer to be gainfully employed. Expenses eligible for the
credit are capped at $3k for a taxpayer with one qualifying individual (generally, a child
under the age of 13, or another individual unable to care for himself), and at $6k for a taxpayer
with two or more qualifying individuals
i. For a taxpayer with AGI of $15k or less, the credit is 35% of the credit-eligible
expenses. The rate of credit is reduced by one percentage point for each $2k (or fraction
thereof) by which AGI exceeds $15k, but the credit is never reduced below 20%. The
credit rate hits the 20% floor at AGI of $43,001. Thus, for most taxpayers of middling
incomes or above, the credit rate is simply 20%
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d. From a subsidy point of view, both the use of a credit rather than a deduction and the low
ceiling on eligible expenditures can be explained as attempts to ensure that the largest subsidies
do not go to higher income taxpayers
e. 129 provides an exclusion for dependent care assistance received by an employee from his
employer, if the employer has a qualifying dependent care assistance program (DCAP). The
exclusion is subject to a ceiling of $5k, regardless of how many children the taxpayer has
i. It does cover child care services provided in-kind, but its more frequent application is to
cash reimbursements of employees child care expenses
ii. The exclusion is the equivalent of a child care deduction, but only for taxpayers whose
employers are willing to go to the trouble and expense of setting up and administering a
DCAP, and who are themselves willing to deal with all the DCAP red tape
iii. A taxpayer cannot use the same dollars of child care expenses to generate both an
exclusion under 129 and a credit under 21; 129(e)(7) provides that any expenditure
used to support an exclusion under 129 cannot be the basis of a credit under 21.
However, a taxpayer whose employer offers DCAP benefits can choose between the
benefits of 129 and the benefits of 21
f. PROBLEMS (9-12), p. 761, 765
g. 151 allows a taxpayer to claim one personal exemption for himself (two exemptions for a
married couple filing a joint return) and an additional exemption for each dependent. The
amount of the exemption is indexed for inflation; the exemption amount for 2011 is $3700. As
used in this context, exemption is just another word for deduction. A taxpayer would
generally be entitled to a 151 deduction equal to the inflation-adjusted exemption amount
multiplied by the number of people in his household
h. The personal and dependency exemptions combine with the standard deduction to prevent
the imposition of income tax liability on persons living at or below the poverty level
i. Exemptions also adjust tax liabilities for differences in family size, across a wide range
of income levels
1. Exemptions are about horizontal equity (fairness between taxpayers at the
same income level, but with different family sizes)
i. As with any deduction, the tax savings from an exemption is the amount of the exemption
multiplied by the taxpayers marginal tax rate
j. 151(d)(3) phases out exemptions for upper income taxpayers. The statute indicates that the
phaseout begins at AGI of $150,000 (for joint returns) and ends at $272,501. The phaseout
range is adjusted for post-1991 inflation
k. In the case of a child of divorced parents, 152(e) generally allocates the dependency
exemption to the parent who has custody of the child for most of the year, but the custodial
parent can waive the right to the exemption in favor of the noncustodial parent
l. The 24 child credit is in addition to, rather than a replacement for, the 151 dependency
exemption. In contrast to the exemption, the value of the credit is independent of the taxpayers
marginal tax rate
i. For most taxpayers, just multiply $1k by the number of the taxpayers qualifying
children
ii. The child credit phaseout begins at $110k for married couples filing joint returns and at
$75k for unmarried taxpayers. (These phaseout thresholds are not adjusted for inflation)

53

m. Most tax credits, with the very important exception of the earned income credit, are
nonrefundable. That means they are of value to a particular taxpayer only to the extent that the
taxpayer has a before-credit income tax liability
i. 24(d): partial refundability
1. The credit is refundable to the extent of 15% of the amount by which earned
income exceeds $10k. The $10k amount is adjusted for post-2000 inflation, and
a special rule reduces the threshold amount to $3k for 2009 through 2012
2. The partial refundability is determined on a per-taxpayer basis rather than a perchild basis
3. The partial refundability rule acts as a negative 15% marginal tax rate,
beginning at $10k earned income
n. Most of the time, if a child qualifies as a taxpayers dependent for exemption purposes, the child
will also be a qualifying child for purposes of the child credit. There is, however, one
important difference: The credit is allowed only with respect to a child who is 16 or younger at
the end of the taxable year. Thus, parents will often be unable to claim the credit with respect to
children attending high school
o. A single parent who lives with one or more dependent children will usually qualify as a head of
household for purposes of the income tax
i. A head of household is entitled to a substantially larger standard deduction than that
available to other unmarried taxpayers
ii. A head of household pays tax under a 1 rate schedule with wider brackets than the 1
rate schedule for other unmarried taxpayers
iii. These rules makes the first dependent child of an unmarried taxpayer uniquely valuable
for tax purposes
p. Lucas v. Earl: H and W had K that everything they made was jointly owned. Wanted to split
income b/w them. No joint returns til 1948. Held: Wont K around salary being attributed to
person who made it. H taxed on all his income. Fruit must be attributed to tree where it grew
i. Here, the only disagreement is over the identity of the proper taxpayer. The identity of
the correct taxpayer can be crucial in a tax system with progressive marginal rates
ii. Earl remains good law with respect to earned income, but a taxpayer can shift the tax
liability on income from property by making a gift of the income-producing property
q. Poe v. Seaborn: Live in community prop state; H/W filed separately each claiming half income
and half deductions. Held: Can divide up income, even tho just H making it b/c state law gives
W vested right in community property. Doesnt matter that H exercises control.
r. After Earl and Seaborn, if two husbands had equal salaries and had wives with no income of
their own, and one couple lived in a common-law property state and one lived in a community
property state, the salary of the common-law property husband would be more heavily taxed
i. In 1948 Congress provided for automatic income-splitting between spouses as a
matter of federal law. Under this new system, any married couple regardless of state
marital property law had a tax liability equal to the tax liabilities of two single
persons, each with half of the couples income. This was accomplished by allowing a
married couple to file a joint return, combining the incomes (and deductions) of the
spouses, and then taxing that income under a rate schedule with brackets twice as wide
as the brackets applicable to unmarried taxpayers

54

1. The 1948 approach extended to couples in common-law property states the


income-splitting benefit already enjoyed by couples in community property
states
s. The new tax victims were single people
i. Single taxpayers complained that their married coworkers were allowed to use their
homemaking spouses as a sort of human tax shelter. In 1969 Congress responded to
complaints about singles penalties by widening the brackets for unmarried taxpayers,
while leaving the joint return brackets unchanged
1. Now there were marriage penalties. It was now possible for a two-earner
couple to have a higher tax bill because they were married, than they would
have as unmarried cohabitants
t. Boyter v. Commissioner: tps married during year, at end get a divorce to file as unmarried and
get lower taxes. Divorced abroad. Some question whether st recognizes those divorces or not.
SCt ignores st question and remands to see if fits sham doctrine. Thinks Rev Rul 76-255 applies
sham doctrine to divorce tps who promptly remarry. Never decided, but IRS treats as good law.
u. Sham Transaction Doctrine: Roughly speaking, it means that if the judge is convinced the
taxpayer is trying to get away with something, and the judge doesnt admire that sort of thing
(some judges do), the taxpayer will lose and the official explanation will be sham transaction
v. Equal protection challenges to the marriage penalty have been consistently rejected by the
courts
XXXII.THE INCOME TAX TREATMENT OF DIVORCE
a. When one former spouse makes cash payments to the other, those payments will usually qualify
as alimony under the definition of 71(b). Payments meeting the definition of alimony are
taxable to the payee (71(a)) and are deductible by the payor (215(a)). By reason of 62(a)
(10), the deduction is allowed in arriving at AGI, so it is available even to a payor claiming the
standard deduction
b. The net effect of the alimony tax rules is to shift an amount of income equal to the alimony
payment from one taxpayer to the other
c. 71(b)(1)(B) is, in most cases, a trap for the unwary. It permits the spouses to opt out of
alimony tax treatment, by providing in the divorce or separation instrument that payments
otherwise qualifying as alimony are not to be treated as alimony for tax purposes
d. The default rule (expressed in 152(c)(4)(B)) is that the parent with whom the child resides for
the larger portion of the year is entitled to the dependency exemption. However, 152(e)(2)
permits the custodial parent (i.e. the winner under the default rule) to waive the exemption in
favor of the noncustodial parent
i. Unfortunately, the analysis of whether the noncustodial parent should waive the
exemption has become more complex in recent years. Although a $3k exemption is, of
course, more valuable to the higher bracket parent, that parent may not be entitled to the
same dependency exemption amount as the lower bracket parent, because of the
151(d)(3) phaseout of personal exemptions
e. 24(c)(1) provides that the child tax credit goes to the parent who is entitled to the dependency
exemption. Thus, a 152(e)(2) waiver of the exemption also waives the credit. The value of the
credit is independent of ones tax bracket, but the credit is (like the exemption) phased out for
higher income taxpayers
f. PROBLEMS (14-22), p. 781-84

55

g. There are three basic reasons why one ex-spouse might make transfers to the other: (1) to
satisfy a continuing obligation of spousal support; (2) to support children of the marriage living
with the other parent; and (3) to settle claims relating to marital property rights. Congress has
decided that the income-shifting rules of 71 and 215 should apply only to transfers of the first
type
h. Alimony versus child support: see 71(c) and Reg. 1.71-1T(c)
i. Two mechanical aspects of the 71(b) definition of alimony are designed, in a rough sort of
way, to weed out property settlements masquerading as alimony. First, 71(b)(1) provides that
only payments in cash can qualify as alimony. No non-cash transfer between former
spouses ever generates an alimony deduction for the transferor or taxable alimony income for
the recipient. Second, 71(b)(1)(D) provides that payments cannot qualify as alimony if the
payor spouse would be required to continue to make payments even after the death of the
payee spouse
i. As to the second, the policy explanation is that payments that would continue beyond
the death of the payee spouse cannot really be for the support of the (possibly deceased)
spouse; they must be in the nature of a property settlement payable in installments
j. Nothing in the 71(b) definition of alimony would prevent a large one-time cash payment say,
$100k in the year of the divorce from qualifying as alimony, even though such a payment
obviously has a strong flavor of property settlement. Instead of policing payments of this sort
through the definition of alimony, the Code subjects such payments to the alimony recapture
rules of 71(f). In general terms, these rules provide that, if annual alimony payments
decrease sharply during the first three post-separation years, then tax benefit rule
principles will apply in the third year
i. In keeping with the tax benefit rule approach, a mistake is not corrected by amending
the returns for the (e.g.) first year. Instead, 71(f)(1)(A) requires the payor spouse to
correct the mistake in the third year, by including the excess income on his Year 3
return. 71(f)(1)(B) allows the payee spouse a corresponding above-the-line deduction
in Year 3
ii. The maximum permissible reductions in payments, which will not trigger alimony
recapture under 71(f), are $7500 from Year 1 to Year 2, and $15k from Year 2 to Year
3. If $X is the payment in Year 1, the smallest Year 2 and Year 3 payments which will
not trigger recapture are $X - $7500 in Year 2, and $X - $22500 in Year 3.
1. Taxpayers who want to avoid 71(f) while front-loading payments as much as
possible can design their alimony schedules accordingly. As noted earlier, they
can also use 71(b)(1)(B) to designate payments as non-alimony to the extent
necessary to avoid recapture
k. Under 1041(a), no gain or loss is recognized on any transfer of property to ones spouse, or to
ones former spouse if the transfer is incident to the divorce. The unrecognized gain or loss
does not disappear. Instead, 1041(b)(2) gives the transferee spouse a basis in the property equal
to the transferors adjusted basis
XXXIII. THE EARNED INCOME TAX CREDIT
a. 32: Earned Income Tax Credit
b. Can be understood as serving the goal of increasing the after-tax incomes of low wage
workers with family responsibilities
i. From the workers perspective, the credit serves the same function as a family-size
adjustment to the minimum wage. For several reasons, it is arguably superior to
56

c.
d.

e.
f.
g.

h.
XXXIV.
a.

b.

c.

d.

requiring employers to pay different minimum wages to workers in different family


circumstances. First, it may be easier for the government to determine a workers family
circumstances (through the tax system) than it would be for an employer. Second, any
minimum wage functions as a quasi-tax on the party required to pay the wage, and it
may be fairer to use a credit to impose much of that burden on society at large, rather
than using differential minimum wage laws to impose the entire burden on employers.
Finally, using a credit avoids the disincentive to hire workers with children, which
would be inevitable under a system requiring employers to pay those workers higher
wages
Is refundable, and in fact the credit is largely received as transfer payments rather than as
reductions in tax liability
The amount of the credit depends in part on the number of the taxpayers qualifying children
i. There is also a small credit for childless workers functions as a rebate of the payroll
tax
1. A special rule provides that the childless EITC is available only to taxpayers
who are at least 25 years old, but no older than 64, at the close of the taxable
year. The rule amounts to a conclusive presumption that very low incomes
earned by childless workers under 25 and over 64 are due to low hours worked
(by students or by retirees), rather than to low wage rates
A taxpayer with a qualifying child may claim the credit regardless of the taxpayers age
The credit is subject to a phaseout
The amount of the EITC is not increased on account of children beyond the first two (with the
exception of a temporary rule that expands it to three)
i. Congresss position, embodied in the design of the EITC, is that if low income workers
have more than two (or three) children, they must find some way to pay for the
additional children without help from the federal government
The earned income tax credit is, by far, the most significant federally administered anti-poverty
program
IDENTIFYING THE PROPER TAXPAYER: EARNED INCOME
In Lucas v. Earl, one of the most important cases in the history of the income tax, the Supreme
Court held that earned income must be taxed to the earner: The fruits may not be attributed
to a different tree from that on which they grew
Because of progressive marginal tax rates, the identification of the proper taxpayer may affect
the amount of tax owed on the income in question
i. A taxpayers goal in the income-shifting game is to transfer the tax liability on an item
of income to a related taxpayer in a lower bracket
Earned income must be taxed to the earner, even if the earner is not also the consumer. The
apple is attributed to the owner of the tree, not to the person who comes to own, or ultimately
eat, the apple
i. 132: A taxable fringe benefit is included in the income of the person performing the
services in connection with which the fringe benefit is furnished. Thus, a fringe benefit
may be taxable to a person even though that person did not actually receive the fringe
benefit
The Lucas v. Earl doctrine is designed to police the shifting of earned income to family
members and controlled entities; it is far from clear that it should have any application to
allocations of income pursuant to arms-length agreements between unrelated taxpayers
57

e. Commissioner v. Banks, Commissioner v. Banaitis: Banks fired from job and Banaitis sued
after discrimination. Both won awards, part of which went to contingent attorney fees. Held:
when litigants recovery is income, income includes contingent fee. Anticipatory assignment
doctrine doesnt allow Ks to prevent income from going to earner; look to who retained control
over source of income. s did b/c controlled action.
i. Quintessential principal-agent relationship; client retains ultimate dominion and control
over the underlying claim
ii. A taxpayer cannot exclude an economic gain from gross income by assigning the gain
in advance to another party
iii. Though the value of the plaintiffs claim may be speculative at the moment the fee
agreement is signed, the anticipatory assignment doctrine is not limited to instances
when the precise dollar value of the assigned income is known in advance
f. 62(a)(20) allows many taxpayers who obtain taxable tort recoveries (not excluded by 104(a)
(2)) to effectively deduct their attorneys fees for AMT purposes as well as for regular tax
purposes. But because the relief provision is limited to actions involving a claim of unlawful
discrimination it leaves some successful plaintiffs (in defamation cases, for example) still in
the box in which the taxpayers in Banks founds themselves
g. Reg. 1.61-2(c): the value of services is not includible in gross income when such services
rendered directly and gratuitously to a charitable organization
XXXV. IDENTIFYING THE PROPER TAXPAYER: INCOME FROM PROPERTY
a. Taft v. Bowers: cong has power to make donees of gifts take on donors basis.
i. The donor is not taxed on the appreciation when the gift is made, and the donee
generally takes the property with a transferred basis under 1015
1. This permits the shifting of a particular type of income to a lower bracket
taxpayer
a. A taxpayer can shift the tax liability on a future stream of investment
income by making a gift of the income-producing property
b. Income from property is taxed to the owner of the property
c. The grantor trust rules provide that income from a trust will be taxed to the grantor of the trust
(rather than to the trust itself or to the beneficiaries of the trust) if the grantor retains certain
powers over the trust or certain economic interests in the trust. The relevant provision here is
673, which provides that a grantor who retains a reversion in property transferred to a trust will
be taxed on the income from that property during the term of the trust, unless the reversion is
worth no more than 5% of the value of the property at the time of the transfer
i. This rather strict treatment applies only to gifts of carved-out income interests, in which
the high bracket taxpayer makes a gift of less than his entire temporal interest in
income-producing property. If the taxpayers own interest is temporally limited for
example, a life estate and the taxpayer makes a gift covering the entire period of his
interest, the taxpayer will succeed in transferring the tax liability on future income
d. PROBLEMS (2-6), p. 856-57, 859
e. 1286 applies a special rule when a taxpayer owning a debt instrument makes a gift of the
right to receive some or all of the interest payments on the instrument, while retaining the
instrument itself
i. What the taxpayer gives away and what he retains are treated as two separate assets,
and the taxpayers total basis is allocated between the two assets according to their
relative fair market values on the date the bond is stripped
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1. The interest income taxable to each will then be determined under original issue
discount (OID) principles
ii. Thus, 1286 does permit a limited amount of income-shifting for an interest-stripping
donor
f. The IRS has long taken the position that gifts of taxpayer-created income-producing property
are effective in transferring tax liability to the donee. In practice, this most often involves
intangible assets, such as patents and copyrights
i. The labor-embodied-in-property rule applies only to items that are ordinarily
considered property and are bought and sold as such for non-tax purposes. Houses,
patents, and copyrights all qualify, but drafted-to-order contracts do not
g. The Kiddie Tax: 1(g) provides that the investment income of a child under the age of 18 is
taxed to the child, but that it is taxed at the marginal tax rate of the childs parents. 1(g) also
applies to the investment income of an adult child, if the childs earned income does not exceed
half of the amount of the childs support, and the child either (1) has not reached age 19 before
the end of the year, or (2) is a full-time student and has not reached age 24 before the end of the
year. The effect of these rules is to tax the investment income of an adult child at the parents
marginal tax rate if the parents are able to claim a dependency exemption for the child
h. 7872: In the case of a gift loan defined as a loan bearing a below-market rate of interest
when the forgoing of interest is in the nature of a gift the statute creates a deemed interest
payment from the borrower to the lender. The amount of the deemed interest payment is the
difference between interest at the applicable federal rate (AFR) and the actual interest charged
i. The deemed interest income is taxable to the lender. The deemed interest payment is
deductible by the son, subject to the various limitations imposed on interest expense
deductions under 163
i. Ordinarily, the income of a trust is taxed either to the beneficiaries of the trust (if the income is
distributed to the beneficiaries) or the trust itself (if the income is accumulated by the trust).
Thus, a taxpayer who makes a gift of income-producing property to a trust can shift to the trust
or its beneficiaries the tax liability on future investment income
i. 1(e) provides a very compressed rate schedule for accumulated income taxed to the
trust
1. In many cases, a successful shifting of tax liability from a grantor to a trust
will be a pyrrhic victory, because the trusts marginal tax rate will be higher
than the grantors
j. Grantor Trust Rules
i. Under 673, the grantor will be treated as the owner of trust property if he retains a
reversionary interest in the trust, unless the present value of the reversion (at the time of
the transfer to the trust) is not greater than 5% of the value of the transferred property. If
the grantor retains any power to decide who will have beneficial enjoyment of trust
income or corpus, the grantor will generally be taxed as the owner of the trust under
674. It is no defense to the application of 674 that the grantor retained no power to
make trust distributions to himself. 674 does not apply, however, to a power
exercisable only with the consent of an adverse party
1. 675 treats the grantor as the owner of trust property with respect to which he
retains specified administrative powers, including the power to deal with trust
property for less than adequate and full consideration, and the power to borrow
from the trust without adequate interest or security. Some of the 675
59

k.

l.

m.

XXXVI.
a.

b.

administrative powers are the functional equivalent of the power to revoke the
trust. 676 tackles revocation head-on; the grantor is generally taxable on trust
income if he retains the power to revoke the trust. Under 677, the grantor is
generally taxable if the trust income may be distributed to the grantor or
grantees spouse, regardless of whether the trust income actually is so
distributed
ii. The grantor trust rules remain in the Code in all their grandeur, even if they have
outlived the circumstances that called them into existence. (That is, the kiddie tax and
the compressed rate schedule for trusts have made the grantor trust rules largely
unnecessary.)
A corporation is ordinarily a taxpayer in its own right
i. If a corporation earns income and does not distribute the income to its shareholders, the
income is taxed to the corporation and only to the corporation at rates set forth in
11. Under 11, the first $50k of corporate taxable income is taxed at the rate of 15%;
the next $25k is taxed at 25%; and additional income is taxed at 34% and 35% rates
Distributed corporate earnings are subject to a double tax. The corporation is taxed on its
earnings, regardless of whether it retains or distributes its income, but the nontaxation of
shareholders on corporate earnings lasts only as long as the earnings remain in the corporation.
Sooner or later, shareholders will want corporations to distribute the earnings to them, and the
distributions will then be taxable to the shareholders (without any offsetting deduction for the
corporation). Before 2003, dividends were taxable to shareholders as ordinary income.
Temporary legislation, however, provides that most dividends received in 2003 through 2012
are taxed at the rate applicable to long-term capital gains (15%, for most dividend-receiving
taxpayers)
i. In many cases, the second tax takes all the fun and then some out of the game of
shifting income to controlled corporations
If a closely held corporation meets certain eligibility requirements, its taxpayers may elect
taxation under the rules of subchapter S. S corporations ordinarily pay no tax, but their income
is taxed to their shareholders (at whatever tax rates apply to the shareholders under 1),
regardless of whether the income is retained or distributed. Since shareholders are taxed on their
shares of undistributed S corporation income, distributions from S corporations are ordinarily
tax-free for shareholders.
i. As is apparent from this description, a taxpayer cannot shift income away from himself
by transferring income-producing property to a 100%-owned S corporation
CAPITAL GAINSPOLICY AND MECHANICS
At the present time, for individual (and other noncorporate) taxpayers, the top rate for most
types of capital gain income is 15%, rather than the rates of up to 35% that might otherwise
apply
This favorable treatment doesnt apply to all assets, under all circumstances. The asset in
question must be a capital asset, and, generally, that asset must have been held for more
than one year
i. Most of the assets that are generally considered investments stocks, bonds, real estate,
interests in partnerships or other unincorporated businesses are usually capital assets.
In contrast, property that constitutes the inventory of a business is not a capital asset.
Real estate and depreciable equipment used in a business are technically not capital
assets, but such property ordinarily falls, after it has been owned by the taxpayer for a
60

c.

d.

e.

f.

g.

h.

year, into a category referred to as quasi-capital assets. Gains with respect to such
property are eligible for favorable treatment in much the same way that gains on the
disposition of capital assets are. Generally, then, the 15% rate will apply to most
investment assets, so long as an individual taxpayer has held those assets for at least
one year
Taxes on capital gains are easily avoided if the taxpayer eschews realization of those gains
i. In the case of capital gains, one can enjoy the benefit of the increased wealth in a
variety of ways without subjecting oneself to a realization event and the consequent tax;
little is ordinarily foregone by retaining the capital asset
ii. Faced with the negative and largely avoidable tax consequences of realizing gains,
many taxpayers are reluctant to part with assets in which they have accrued gains. This
reluctance is sometimes called the lock-in effect associated with a capital gains tax
that can be dodged simply by retention of the asset
1. Because of the lock-in effect, some economists believe that the government
actually raises more money taxing gains at 15% than would be raised by taxing
gains at regular rates above 30%
a. Laffer curve
High tax rates on labor income do not greatly deter people from working for money, because
alternative uses of their time are not good substitutes for cash wages. The top of the Laffer
curve for capital gains, however, is much lower. This is because the alternative to paying capital
gains tax simply holding onto unrealized appreciation is reasonably attractive
The rate preference for gains on the sale or exchange of certain capital assets in the current
Code is embodied in the basic rate provisions of 1(h). It provides favorable treatment for a
taxpayers net capital gain for the tax year
Holding Period: Only assets held for more than one year can qualify for favorable treatment
i. Generally, a taxpayers holding period includes the holding period of prior owner(s) of
the capital asset if the asset was acquired in a transaction in which recognition of the
prior owners gain or loss was deferred by operation of law
ii. Under a special holding-period rule applying to transfers at death, even property that
receives a new basis in the hands of an heir under 1014 is treated as though the heir
had held the property for more than one year from the moment she receives it
Gains and losses from property held for (or considered to have been held for) more than one
year are referred to as long-term capital gains or losses. Property held for one year or less
generates short-term capital gains or losses
Once a taxpayer has ascertained her holding periods with respect to all capital assets sold or
exchanged during a tax year, she can categorize them into four groups, according to whether the
dispositions produced gain or loss and whether the assets were held for more or less than one
year. The four groups are then netted against one another according to the following rules
(1222):
i. Long-term gains are netted against long-term losses
ii. Short-term gains are netted against short-term losses
iii. If the results of the first two netting procedures have the same sign (that is, both are
losses or both are gains), then the taxpayer has that amount of each type of net gain or
loss, and each is treated accordingly. But if the results of the first two netting
procedures have opposite signs (that is, if one is a net gain and the other a net loss),
those two outcomes are netted against each other in the championship game
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iv. The final result has the character of whatever type of gain or loss sticks out after the
netting procedures
i. Since capital gains are explicitly included in the list of income items recited in 61, the effect of
receiving no favoritism on the short-term gains is that they are taxed at the same rate that would
apply to ordinary income items
j. Marginal transactions must be evaluated at the margin; they must be viewed taking into
account all previous capital asset transactions in the same year, as well as any others that are
planned before the year ends. Without that full context, one cannot say definitively whether any
marginal realization event will or will not receive favorable tax treatment
k. There is now a panoply of capital gains rates that may apply in particular instances.
Characteristics of the assets, of the taxpayers, of the holding periods, and of the year the gain is
realized, all come into play in setting these various rates
i. Collectibles Gain: A gains rate of 28% applies. Collectibles include works of art,
rugs and antiques, stamps and coins, metals and jewels, alcoholic beverages, etc.
ii. 1201 Gains: A gains rate of 28% applies. This is a special category of small-business
corporate stock
iii. Unrecaptured 1250 Gains: A gains rate of 25% applies. 1250 applies to dispositions
of depreciable real property. This permits gain that is attributable to depreciation at the
straight-line rate to be taxed as capital gain, rather than being recaptured as ordinary
income
l. There are also special rates based on taxpayers income levels. If the capital gain income, when
stacked on top of the taxpayers ordinary income, would have been taxed at marginal tax rates
below 25%, then and to that extent such gains will be taxed at the following rates:

Normal Capital Gains Rate


Rate for Low Rate Taxpa
Residual capital gains
15%
0%
1202 gain
28%
Regular rate
1250 gain
25%
Regular rate
Collectibles gain
28%
Regular rate
i. Regular rate = taxpayer simply pays tax on these gains as if they were ordinary income
m. The date of the realization may also affect the rate applied to the gains. The background
capital gains rate of 15% and the low bracket capital gains rate of 0% are effective generally
with respect to gains realized on or before December 31, 2012. Gains realized after that date are
generally subject to a tax rate of 20% (or 10%, in the case of a low bracket taxpayer)
n. Netting the Special Rate Categories: The statutory scheme is quite pro-taxpayer on this point.
It mandates netting the loss first against the category of gain that would be more highly taxed
o. If there were no limitation on loss deductions against ordinary income, many wealthy people
would be able to use their control of their realization events to offset income with realized
losses, and thus to pay little or no tax
i. 1211 thus imposes some severe limits on the deductibility of capital losses. For
noncorporate taxpayers, the rule is that capital losses are allowed up to the amount of
capital gains in the same year, plus $3k. Thus, if a taxpayer had $10k of losses in a
particular tax year, and $5k of capital gains in the same year, he would be allowed to
deduct $8k of his capital losses
1. For corporate taxpayers, the limitation is even more severe: They can deduct
losses only to the extent of gains in the same year
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p. In certain circumstances, 1244 allows an important exception to the loss limitation rules for
losses realized with respect to investments in small businesses. Qualifying losses are allowed
up to $50k per year (or up to $100k for a couple filing a joint return) on the sale of stock of a
corporation that was capitalized with less than $1 million of capital contributions, so long as
several conditions specified in 1244 are met
q. The undeductible capital losses a taxpayer might have in any particular year do not simply
disappear, however. Under 1212, corporate taxpayers may carry back those capital losses for
up to the 3 preceding taxable years, to offset any net capital gains the corporation might have
enjoyed (and been taxed on) in those prior years. In such a case, an immediate refund of the
taxes paid with respect to those earlier net gains can be sought, to the extent that those gains are
now offset retrospectively by the new net losses. If the losses cannot be absorbed by prior gains,
then those losses may be carried over to any of the 5 taxable years following the year the loss
was sustained
i. For noncorporate taxpayers, there is no carryback provision. However, losses that are
nondeductible because of the 1211 limitations may be carried over to future years
indefinitely. In each of those years, the carried over losses are treated as if they arose in
that subsequent year. If the net loss was a short-term loss, it is treated as a short-term
loss in that subsequent year; if it was a long-term loss, it is so treated in the subsequent
year

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