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Tax Outline

Analysis:
1. When trying to define a term in the Code: (ex: gift)
a. Look elsewhere in Code (nothing here)
b. Look in Regulations (nothing here)
c. Look in legislative history (nothing)
d. Try to figure out logic/structure of provision (would have been better
here)
i. Based on chart, shouldnt tax if tax already paid by transferor,
which would make both gifts taxable here
2. Two main questions:
a. What is the rule?
b. How will the IRS enforce it?
3. If get lost, follow cash:
a. What did TP get (including debt forgiveness, in-kind)?
b. What did TP pay?
c. What did TP make in the end?
Chapter 1: Income Tax Basics p. 1
1. Background
a. Individual IT brings in about as much as payroll taxes (but much more
complex)
b. Why such a complicated tax system?
i. Fine-tuned to individual circumstances
ii. Subsidy delivery mechanism (electric cars, home interest)
iii. Draws attention to itself
c. Know: basis, realization, selected Code provisions, reading and applying
Code
2. Calculating tax liability
a. Basic formula: Tax liability = tax base (taxable income) x tax rate
b. Calculating taxable income
i. Calculate GI (61; see also 71-140) exclusions
1. What money even goes into pot?
ii. Calculate AGI (62) above-the-line deductions
1. Subtract any deductions referenced in 62
2. Dont compete with standard or other itemized deductions
iii. Calculate taxable income (63) below-the-line deductions
1. Include personal/dependency exemptions + itemized OR
standard deduction(s) cant have both
iv. Use taxable income to calculate tax liability (1 rates)
3. Adjustments (taxpayer-favorable):
a. Two questions:
i. Now or never? (permanently excluded?)
ii. Timing? (taxable, but when?)
b. Exclusions never included in GI
i. Value of exclusion = Amount of exclusion x MTR
ii. Dependent on source of funds (usually more generous)
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1. E.g. damages from a personal injury suit (104(a)(2))


iii. Dont compete with standard deduction and less frequently phased
out
c. Deductions subtracted from GI
i. Value of exclusion = Amount of exclusion x MTR (same as
exclusions)
ii. Dependent on use of funds (actual expenditures)
1. E.g. used to pay home mortgage
2. Except personal/dependency exemptions (adjusted yearly)
not based on expenditures
d. Credits directly reduces tax liability (not income)
i. Tax savings from credit = amount of credit (better)
ii. Usually % of some expense/activity
1. E.g. $600 paid, 10% allowed for credit = $600 credit
iii. Being used more frequently by Congress (value doesnt change
with MTR, so doesnt favor high-income earners)
1. Not dependent on itemizing
iv. Refundable v. non-refundable credits
1. Non-refundable stops at $0 tax liability
2. Refundable get check from govt if drops below 0
a. EITC (entirely)
b. 24 child tax credit (partially)
v. Ex: Married couple with 2 young kids; AGI = $100,000; spent
$9000 on childcare while parents working
1. 21 child care credit? ($6000 limit, phased-down to 20% at
$43,001
a. Qualified individual? Yes under 21(b)(1)
b. Employment-related expenses? Yes
c. Past phase-down AGI, so get 20%
i. $6000 (limit) x 20% = $1200 credit
4. Deferral (when will something be taxed?)
a. Deferral always better for TP (like interest-free loan)
i. Value of deferral = amount earned from tax savings tax savings
ii. Better if higher return for longer time
b. Ex: Bought stock in 2006, sold at 130,000 in 2010
i. If appreciated $5000 in 2006 & MTR is 20%, tax savings would be
$1000
ii. Instead, put $1000 in savings, earning 5% ($50/yr, compounding)
1. In 4 years grows to $1215 (amount earned from tax savings)
iii. So when sell in 2010, left with $215 (value of deferral)
c. Can calculate future value to see how much could spend now (p. 20)
i. Ex, cont.: 2006 perspective invest at 5% for 4 years, only need
$823 now to have $1000 to pay tax then (can spend $177 now)
1. Of course, $177 saved in 2006 = $215 saved in 2010
5. Tax Rates p. 34
a. Average tax rates (ATR) = total tax liability / [something]
i. Could be TI, GI, AGI (just changes concept measuring)
ii. More useful in civics, policy
2

b. Marginal tax rates (MTR) = rate that applies to last dollar of income
i. Includes hidden 0% tax rate up to personal exemption +
standard deduction
ii. More useful for tax planning
iii. Increases for additional income, but can decrease for deductions
1. Could be blended if spans 2 rates
c. Ex: Assume tax rate schedule: 0-30,000 = 10%, 30,000+=30%
i. X has wages of 30,000, so tax = 3000 (at 10% rate); should X earn
1000 more?
1. Last 1000 taxed at 30%, so $300 and 3300 total tax
6. Phaseouts useful for helping Congress avoid political heat
a. Personal exemption reduction for affluent taxpayers (151(d)(3))
i. Hard to understand/plan for (hidden MTR hike)
ii. Lose 2% of exemption for every $2500 by which AGI exceeds p/o
threshold
1. Completely phased out at $125,000 over threshold
a. MTR drops back down to 35% (but had to pass through
p/o paying higher rate to get there, so ATR still higher)
b. Ex: $200,000 AGI, MTR = 35%; 5 people x $3000 personal exemption =
$15,000 exemptions before p/o (at $200,000); should TP make another
10%?
i. 151(d)(3)
1. $210,000 AGI 200,000 p/o threshold = 10,000
2. 10,000/2500 = 4 x 2% = 8% reduction in exemption
3. 15,000 x 8% = 1200 increase in TI (lost exemption)
4. 10,000 additional income + 1200 lost exemptions = 11,200
5. 11,200 x 35% (MTR) = 3920 tax on last 10,000
a. Combo of additional income + lost exemptions
7. Tax principles:
a. Tax base: based on income and ability to pay
i. Income tax with consumption tax features (dont tax unrealized
appreciation or retirement savings)
b. Tax expenditures: special income tax provisions (have to be classified as
such) that favor the TP (exclusion, deduction, credit, deferral, preferential
rate)
i. Negative tax expenditures: less favorable treatment to TP
(executives, lobbyists)
c. Sources of law
i. Constitution Statutes (Code) Regulations (legislative or
interpretive) Revenue rulings and procedures Committee
reports (bluebooks)
d. Tax litigation
i. Choice of forum
ii.

Juris.

Tax Ct
Dist
Ct
Fedl
Cl.

Jury
?

Appeal to?

Likely
precedent?

Deficienc
y

Taxpayers
circuit

Most likely

Refunds

Taxpayers
circuit

Least likely

Refunds

Federal Circuit

In between

Notes
Travels, bench
trials, can invoke J
w/i 90 days if
dont pay; 90%
sue here
Pay and sue for
refund
Pay and sue for
refund

e. Policy
i. Progressive v. flat tax
1. Progressive tries to raise most money with least loss of
utility to TPs
2. Balance between:
a. Declining marginal utility of money ($$ worth less after
have a lot of it) and
b. Disincentive effects of high tax rates (people stop
earning)
3. Try to avoid cliff effects
a. Cliff effect = small change has major consequences
b. Instead progressive higher tax rates affect income
only after max out previous rate
ii. Distributive justice
1. Is tax redistributing income? How? In which direction? Is that
good?
2. Think about how government is spending the money
3. Make sure there is consistency in metrics (rate v. money)
4. Still look at overall effect (is it progressive enough??
5. Ex: Tax schedule 0-20,000 = 40%, 20,000+=10% (so
regressive MTR)
a. 2 types of people: Rich ($100,000) and Poor ($20,000)
i. Poor = $8000 tax (20,000 x 40%)
ii. Rich = $16,000 tax ((20,000 x 40%) + (80,000 x
10%))
b. Govt collects $24,000 in taxes, and spends:
i. $10,000 to Poor (gains $2000)
ii. $14,000 to Rich (loses $2000)
iii. SO Poor gains $2000 from Rich (progressive
redistribution)
1. Result of mixed metrics (regressive rate but
progressive redistribution of money)

Chapter 2: The Scope of Gross Income p. 71


1. Overview (calculations and definitions)
a. 61: Definition of GI (all income from whatever source derived)
b. 1001(a): Gain/loss = amount realized (ar) adjusted basis (ab)
i. 1001(b): Amount realized = cash + fmv (what you get)
ii. 1011, 1012: BASIS = COST
1. 1016 adjustments to basis (like depreciation,
improvements)
c. Policy why subtract basis from amount realized?
i. Already paid tax on money used to buy investment OR if untaxed,
probably intentional policy choice
ii. Could say no gain (trade X dollars for X value property)
1. Need a transaction dont tax unrealized gain/loss
d. Voluntary compliance system (with audits, some reporting and
withholding)
i. IRS might notice/read news lifestyle audit
ii. But generally, voluntary compliance drops when no checks
1. Both withholding and info reporting required (like wages) =
99%
2. Info reporting only required (interests/dividends) = 90-95%
3. No withholding or info reporting required (cash economy) = <
50%
e. Effect of inflation adjustments
i. Tax liability = Tax base (TI) x Rate
1. Base NOT usually adjusted for inflation (even though salaries
generally rise with inflation)
a. Bracket creep (great for Congress bc dont have to
raise rates)
b. WHY no adjustment?
i. Would be very complicated
2. Ex: Y1 rates: 0-50,000 = 10%, 50,000+ = 25%
a. Y1 = 60,000 TI = $7500 tax (5000 + 2500)
i. ATR = 7500/60,000 = 12.5%
b. Y2 = 66,000 TI (same as Y1 but with 10% inflation)
i. Tax = 9000 (5000 + 4000)
ii. ATR = 9000/66,000 = 13.6%
c. BUT if adjust brackets Y2: 0-55,000 = 10%, 55,000+ =
25%
i. Tax = 8250 (5500 + 2750)
ii. ATR = 8250/66,000 = 12.5%
f. Why no cost of living adjustment (geographically)?
i. Reflects amenities (NY is better)?
ii. Not all money spent locally
iii. Tax Uniformity Clause
iv. Composition of Senate
2. Source of Cash Receipts p. 71
a. Generally source of cash doesnt matter
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i. See Commissioner v. Glenshaw Glass where Court liberally


interpreted income in 61 to include windfalls, rejecting dicta in
Eisner v. Macomber that defined more narrowly
1. SOURCE DOESNT MATTER (cant argue different
characterization of income to avoid tax)
a. UNLESS specifically excluded elsewhere (like gifts)
ii. Economic efficiency of taxing windfalls (no deadweight loss)
1. To evaluate inefficiencies, ask:
a. In a utopia with no tax, would adding a tax change
behavior?
b. If yes, then its inefficient
2. With windfalls, taxing will not discourage behavior (not
inefficient)
a. Ex: Normally, inefficiency in taxing labor income
i. 10,000 taxable wages full amount of value to
society
ii. 3000 tax (30% MTR) loss in value to society
iii. 7000 after-tax income value to EE
iv. BUT if subjective value of leisure = 8000, then TP
wont work and keep his 8000 worth of leisure
1. 8000 value 0 tax = 8000 value to society
(no loss)
3. Treasure trove regulation: Reg. 1.61-14
a. Treasure trove included in GI in year it is reduced to
undisputed possession
b. See Cesarini v. US where couple found $$ in their piano
and claimed they had actually received it 7 years
earlier when bought piano and so SoL had run but court
found against them based on treasure trove reg
(above) and application of state property law (here,
yours when actually find it)
i. Could involve liquidity/valuation concerns if noncash
ii. BUT no other case decided on this basis
1. Nothing asserted by IRS with non-cash finds
until realize gain
2. But if wait until SoL runs and then claim
should have been taxed earlier?
iii. State law and federal IT problem here?
1. State law is factual, not base legal issue
2. Congress decides when state law matters
iii. So what is included?
1. Cash receipts almost always taxable under 61
2. In-kind receipts (non-cash) also generally taxable
b. Exception: tax-free recovery of capital is allowed
i. Dont have to pay tax on previously taxed amounts (just gains)
61(a)(3)
1. Just gain included (amount realized adjusted basis)
2. Can be confusing to figure out if taxed previously
3. For example, with state IT refund:
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a. If itemized, havent paid tax yet, so included in GI


b. If took standard deduction, then already taxed and
excluded from GI
c. Ex: Y1: take either $12,000 standard deduction OR
12,300 itemized deduction (8300 other itemized
deductions + 4000 state IT withholding); choose
12,300
i. In Y2: $500 state IT refund $300 taxable
because wasnt taxed before (12,300 12,000;
excess of state refund over standard deduction)
ii. Limits of tax-free recovery of capital p. 182
1. See Garber v. US where majority incorrectly defines gain as
ar value (in this case, of rare blood antibody) but dissent
correctly defines as value (set by market, basically ar) basis
(cost of property), which is this case was $0 (no basis in body
parts)
a. Note: Only criminal case in book; court found law was
too ambiguous to be willfully evaded
2. Dont be confused by capital in definition just stick to
formula
a. Gain = amount realized (value determined by market)
adjusted basis
c. Gifts and bequests: 102 Congressional exception (source
matters)
i. Gifts excluded from GI (both inter vivos and testamentary)
1. Donor cant take deduction from GI
2. Donee excludes from GI
ii. Policy? Donor probably has more money and in higher MTR
iii. What is a gift?
1. 102(c) ERs cant give gifts to EEs (1986)
2. 274(b) transferor of business gift cant claim deduction
above $25 (one or other has to pay it)
3. See Commissioner v. Duberstein where Court gave some
guidance in how to determine if gift; consolidated case where
businessman received car from acquaintance businessman
and another where EE received large gift after left (found CA
shouldnt have reversed on standard in 1 and remanded for
more factfinding in 2)
4. No clear test look to context and understanding of
intentions and human nature (very vague and unhelpful)
a. Make objective inquiry into transferors intent
i. Transferor can establish label of whether
something is a gift (unusual)
1. IRS doesnt care who pays if same tax
b. Term used in colloquial sense
c. Some guidance:
i. Not a gift if:
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1. Payment is return for services rendered,


even if donor derives no economic benefit
from it
2. Payment proceeds directly from moral or
legal duty or incentive of anticipated
benefit
ii. Yes a gift if:
1. Proceeds from detached and disinterested
generosity and out of affection, respect,
admiration, charity, or like impulses
iii. Possibly (but not necessarily) a gift if:
1. Voluntarily executed transfer of property
without consideration or compensation
2. Mere absence of legal or moral obligation
to make payment (insufficient)
5. Fact-finder makes ultimate decision based on facts and
experience with the mainsprings of human conduct
a. Only overturned if clearly erroneous (no more cases)
d. Personal physical injury damages: 104(a)(2) another source
exception
i. Excludes from GI 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
ii. Exclusion applies to all 3 types of compensatory damages:
1. Nonpecuniary damages for pain & suffering and loss of
enjoyment
a. Includes loss of consortium, but not emotional distress
b. Policy: dont tax Vs of forced sales (so doesnt apply if
voluntary more like a K then)
2. Damages for medical expenses (past and future)
a. Policy: Easier than including and then deducting
b. Cant get if itemized under 213 medical expense
deduction (213 not preferable because has more
conditions)
3. Damages for lost wages (past and future)
a. Policy: Hard to separate out in lump sum award
b. Also, like govt tax subsidy (indication of subsidy?)
i. Winner depends on amount of award
(nominal/legal v. actual/economic effect):
1. Ex: $100,000 lost wages, with $30,000 tax
a. Nominal = P wins (income excluded)
b. Actual = depends on how close to
actual wages compensation is
i. If $100,000 then P gets entire
$30,000 subsidy (no tax)
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ii. If $80,000 then P gets $10,000


of subsidy, but D gets other
$20,000
iii. Requires physical injury in tort or tort-like action
1. See Amos v. Commissioner where D was kicked by Rodman in
game and settled for 200,000, but went to physical injuries
but also included hush money and court found dominant
purpose of K was physical injuries but had to split settlement
for non-physical aspects (which would be taxable)
iv. To analyze:
1. Is this a tort or tort-like action?
a. Emotional distress not treated as physical injury
(underlying tort must be physical)
i. Ex: $100,000 award for IIED with $10,000 spent
on medical care: 10,000 excludable, 90,000
taxable
2. Is dominant reason/nature of settlement for physical injuries?
a. If not, entire award taxable
b. If so, what proportion of K does not go to physical
injuries and is therefore taxable?
v. How to settle with minimal tax liability?
1. Dont use terms that make it look like hush money
2. Insist on bigger settlement to compensate for tax
3. Indicate in K what allocation is (and make it mostly for injury)
a. More credible if liquidated damages for breach of that
term is equal to allocation (not self-serving)
vi. Damages
1. Can be in-kind, and value at time of transfer becomes basis
(excluded on policy, so dont want to tax later when sell it
either)
2. Can be lump sum or periodic
a. Periodic not possible in judgment (just settlement)
inducement to settle
b. Periodic payments also excluded (so better than taking
lump sum and making equivalent investment)
e. Enforcement difficulties Tips: 102
i. Clearly taxable, but cash nature makes difficult to enforce (16%)
ii. Solution? 6053 (compliance/enforcement provision)
1. If have restaurant where tips customary, must keep track of
tip-able sales, calculate 8%, and compare tips reported by
EEs + credit card tips
2. If reported tips less than 8% of tip-able sales, allocate among
tipped EEs (discretion)
3. Compliance jumped to 50% - enforce 1/2 of tipping
3. Non-Cash Income p. 111
a. Non-cash income is generally taxable (61 doesnt limit to cash)
i. Must value at fair market value = price at which the property
would change hands between a willing buyer and a willing seller,
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neither being under any compulsion and both having reasonable


K of the relevant facts
1. See Rooney v. Commissioner where TPs accepted payment in
services, but discounted value on taxes because didnt think
it was worth that much and court rejected subjective
standard always objective fmv
2. Policy prevent flight from cash to avoid taxes
ii. Therefore, dont collect in-kind payment if subjective value is less
than tax
1. Ex: $600 fmv; $100 subjective value; MTR = 30%
a. = $180 (600x30%) not worth it!!
iii. Exceptions:
1. Prize contest winnings: Rev. Rul. 57-374
a. If win in prize contest, can choose not to accept it and
dont have to include in GI (suspends doctrine of
constructive receipt)
2. Value of ER-provided housing required as condition of
employment excludable from GI: 119(a)
b. Non-statutory exclusions of non-cash economic benefits
i. Imputed income value of service do for yourself excluded from GI
as outside scope of 61 (not part of transfer/exchange)
1. Also excluded if barter income with good friends or family
(not keeping score; would probably even do it for free)
a. If could get a credit, may be beneficial to write checks
and report it in both directions anyway
2. Generally permanent exclusion, but if making home
improvements would serve as deferral until sell house (and
then more gain on higher fmv)
3. Policy?
a. Privacy implications
b. Doesnt erode tax base like with transfers
c. Valuation problems
d. Evens out (especially if include value of leisure)
i. EXCEPT fairness issue for couples with 2 incomes
v. couples where one spouse stays home (and
imputed income not taxed)
1. Not financially smart for homemaker to
enter workforce at lower salaries bc first
income pushes into higher MTR (stacking
effect), and would also incur additional
expenses (child care credit much less
helpful than a deduction)
2. Ex: H = $100,000; W deciding if stay home
or take job for $40,000 (+ incur $25,000
child care costs)
a. If MTR = 25% + SS @ 7.65% + state
IT @ 7.35% = 40% tax rate =
$24,000 tax
b. After tax pay is $24,000, so lose 1000
with child care
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c. Even with $600 child care credit, still


lose $400 (assuming 1 kid)
ii. To fix
1.
2.
3.

it:
Tax imputed income (unlikely)
Allow deduction for imputed income
Have system where marriage irrelevant
(avoids stacking effect)
4. Imputed income from property also not taxed on imputed
income from owner-occupied property (implicitly within 61;
no exchange)
a. Big tax break is in imputed income exclusion, not home
mortgage interest deduction
b. Ex: $500,000 fmv (unmortgaged)
i. With $25,000 net imputed rental value untaxed
economic benefit (understatement of income)
c. Ex: $500,000 fmv (fully mortgaged)
i. $25,000 interest deduction (gain)
ii. 25,000 net imputed income (gain) 25,000
interest (loss) = $0 net economic benefit (NO
ECONOMIC GAIN)
iii. 0 tax 25,000 interest = (25,000) loss
1. Just transfers tax break to salary (much
more visible)
d. Ex: Swapping houses for jobs would be a barter and
rent value is taxable income
i. Maybe not enforced, but if report income, could
also get rental deductions (maintenance, 168
depreciation)
ii. Unrealized appreciation
1. Implicitly excluded from GI
2. Not permanent exclusion just a deferral
a. Unless hold to death and stepped up under 1014
3. Policy: valuation and liquidity problems
a. Not always true (stocks excluded but easily valued, but
in-kind exchanges included and not easily
valued/liquidated)
c. Statutory exclusions based on non-cash nature of
benefit/required use of cash
i. ER-provided health insurance
1. Most significant tax subsidy in entire Code: 106, 105
2. Both ER-provided health insurance benefits and premiums
excluded
a. 106(a) excludes value of ER-provided health
insurance coverage/premiums from GI of EE
i. Plus for spouse and dependents (regs)
ii. Including Cadillac coverage (far from basic)
iii. Doesnt deal with unmarried partners (so cant be
excluded)
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b. 105(b) excludes value of benefits received under


ER-provided health insurance, to extent benefits
constitute reimbursements of medical expenses
c. 125: health insurance coverage can be offered under
a cafeteria plan (can choose among several) if EE
offered choice between cash and health insurance and
chooses insurance, not taxed under doctrine of
constructive receipt
3. If NOT insured through ER:
a. 213 can claim medical expenses (including health
premiums not excluded under 106) that exceed 7.5%
of AGI (high bar) as itemized deduction
i. EE pays all or part of cost through salary
deduction (usually working poor lose)
ii. See pg. 36 for more detail
b. 36B (Obamacare) tried to fill gap
i. Health insurance premium tax credit for people
who cant qualify for Medicaid but dont get
through ER (starting 2014)
1. Refundable
2. Must be 100-400% of poverty level
3. Amount based on complicated schedule
a. Assume health care shouldnt exceed
certain % of income
b. Have to purchase qualifying
insurance
4. Ex: 50,000 income = 250% fedl povery
level (FPL)
a. At 250% FPL, 15% ceiling on health
care expenses
b. 50,000 x 15% = 7500 max to pay
c. If insurance costs 12,000, get 4500
credit
5. Problem: must be payable during year as
expenses arise, but eligibility based on
income for that year (not determined until
following spring)
a. So base on most recent income
available (2012 filing would use 2010
income)
b. Then have tax return reconciliation
when know actual income (messy)
ii. Other provision makes cost-sharing deductible by
same population (not in Code)
1. Based on actual expenses and 2-year-old
income (no reconciliation required)
2. So in 2012, IRS not involved because
dealing with 2010 income (direct subsidy
not through taxes)
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3. Under 36B, people with federal IT liability


might drop below 50% (political
ramifications), with no good reasons for
difference in treatment of 2 provisions
c. Self-employed: 162(l) can claim above-the-line
deduction for cost of healthcare (counts as business
rather than medical expense)
ii. Scholarships and other tax benefits for higher ed expenses: 117
1. Amt received for scholarship at college or university excluded
from GI
a. Includes tuition, books, fees (not room and board):
117(b)
b. Does not apply to money (or other compensation for
services) received for teaching/research: 117(c)
i. Opposite of most exclusions, where income
usually MUST be related to employment
ii. ER could help with tuition and EE exclude it under
127
1. Not a scholarship
2. Capped at $5250
3. Subject to non-discrimination rule (high
earners)
c. Can be from charity or institution itself
i. Does not apply if its a family gift (like from
grandma)
d. Policy: Scholarships more like bargain price than
income
2. Scholarship to children of EEs must meet certain
requirements to show not based on compensation incentive
or expectation: Rev. Proc. 76-47
a. Must be based on merit
b. No more than 25% of eligible children get scholarship
in any given year
3. Education credits: 25A
a. Set to expire end of 2012
b. Cant claim both credits for any one student: 25A(c)(2)
(A)
i. But if have more than one student, could claim
one for each (and could mix)
c. Hope Scholarship Credit: 25A(b)
i. Permanent rule
1. Per student cap of 100% of first $1000 +
50% of second $1000 = $1500 total cap
2. Tuition and fees for 1st 2 years of college
ii. Temporary rule
1. 100% of first 2000 + 25% of next 2000 =
2500
2. Available for first 4 years of college
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3. Higher p/o range (160,000-180,000)


4. 30% refundable
iii. Claimed by whoever pays
iv. Phaseout: cant be too rich (p/o) or too poor (nonref.)
1. Full credit if AGI < 100,000; gradually
phased out from 100,000-120,000
v. Non-refundable
vi. If parents allowed dependency deduction, S cant
claim it: 25A(g)(3)
1. Ex: 3800 dependency deduction x 35%
MTR = 1330 tax savings
a. If AGI>120,000, nobody gets credit if
parents claim dependency deduction
b. Parents can waive 1330 dependency
deduction tax savings and S can
claim HSC, but would need 1500 tax
liability and must pay tuition
d. Lifetime Learning Credit: 25A(c)
i. No limit to how many years can use it
ii. 20% of qualified tuition/fees for first 10,000 (max
2000 per TP)
1. Per TP means if 2 married filing jointly get
2? IRS would say no
2. Not per child (so just get one)
iii. Same p/o as HLC and non-refundable
iii. 132 Fringe Benefits p. 204
1. Clarified that any fringe not included here is included in GI
under 61
2. Fringe has to be ER-provided (not third-party discount)
3. Spouses and dependent children also qualify
a. Or airfare for parents
b. If taxable, taxable to earner (even if flight goes to
sister)
4. Reciprocal agreements work if in same line of business (but
doesnt work with EE discounts)
5. No discrimination for highly compensated EEs: (j)(1)
6. No-additional-cost service: 132(b)
a. Discount that is offered to customers in ordinary line of
business in which EE is providing services, AND
b. ER incurs no substantial additional cost (including
forgone revenue)
i. If reserved (like seat on plane), assume forgoing
rev.
7. Qualified EE discount: 132(c)
a. EE discount on qualified property excluded if doesnt
exceed:
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i. Gross profit % of price being offered to customers


OR
ii. If service, 20% of price offered to customers
b. Qualified property/svcs = any property/services offered
for sale to customers in ordinary course of line of
business of EE
8. Transportation fringes: 132(f)
a. Commuting like non-deductible cost of living exp (not
business)
b. But excludable, subject to a ceiling, if:
i. ER-provided parking
ii. Transportation passes
iii. Bike provision
c. If EE pays for it, no deduction (ER has to provide it)
i. ER can reduce salaries and give free parking
ii. Or give choice of salary reduction + free parking
or neither (for non-drivers)
iii. Constructive receipt suspended if choose
transportation fringe instead of compensation:
132(f)(4)
9. Working condition fringe: (d)
a. Exclude something ER pays for EE that would otherwise
be deductible as business expense under 67
10.
De minimus fringe: (e)(1)
a. See list of qualifying examples in Reg. 1.132-6(e)
b. Administrability impracticality
i. Never includes cash
ii. Gift certificate MAYBE if to specific store and cant
buy anything else (not like cash)
iii. Enforcement decision mostly made by ER
11.
Frequent flier miles (FFM)
a. Not in 132 because not on radar at time
b. FFM really just discount/good deal
i. But if ER pays for trips and EE keeps miles?
ii. Taxing EE raises valuation/enforcement problems
c. Tech Advice Memo (TAM) says technically included
under 61
i. Created major tax liability issues for EEs and ERs
ii. IRS gave in and said wouldnt tax FFM too hard
(Announcement 2002-18)
d. Now: Citibank offering FFM for opening new bank
account
i. But not buying anything and not generated by
airfare
ii. So to be safe sent 1099s to everyone who got
FFMs
iii. IRS said yes, should be taxable, but wouldnt
have gone after it (too unpopular)
4. Income Inclusions as Mistake-Correcting Devices p. 139
15

a. Annual tax accounting period sacred (dont like to go back and amend
returns)
i. Need some period of tax finality; chose yearly
1. Nothing that happens after close of tax year affects what
happened in that tax year
a. If seemed right then, dont amend it
i. So if just made mistake (mistake from get-go and
should have known), amend return if SoL hasnt
run
ii. But if becomes a mistake with benefit of
hindsight and later events, dont amend
b. Instead, offsetting income inclusion in later year
i. So can look back (like for basis)
ii. But cant leave a year open pending
developments
c. Congress can override, of course
i. 219(f)(3) IRA contribution deductions
ii. 1033 involuntary conversion of property
ii. Most fundamental backward-looking rule: 1001 realization rule
(look back for basis)
iii. How know which year to take income/loss/deductions into account?
1. Individuals cash method
a. Follow cash flows (simpler)
b. Subject to cash/barter non-distinction
c. Subject to constructive receipt
2. Businesses accrual method (more accurate)
a. Follow obligation/right to pay or receive
b. Instances of annual accounting
i. Loss carryover provision: 172
1. TP with net operating loss (NOL) in business activities can
use NOL to offset positive income in 2 preceding years or 20
years following
2. Evens out unstable income a bit, but
a. Still limitation on # of years can move losses, and
b. 172 applies only to business losses
3. Ex: Income bunching can inflate MTR C and D each get
10,000 standard ded/person exemption (assume businesses)
a. C makes 15,000 in Y1 and 15,000 in Y2:
i. Y1 & Y2: 15,000 10,000 = 5000x2 = 10,000 TI
b. D makes 0 in Y1 and 30,000 in Y2:
i. Y1 = 0; Y2 = 30,000-10,000 = 20,000 TI
ii. EITC: 32 (most important instance) see pg. 57 also
1. Fully refundable
2. Favors regular income (not bunched), esp. as interacts with
child care credit because can take more of credits each year
a. Progressive MTR
b. Personal exemption and standard deduction dont
create NOL
c. Refundability of child care credit
d. EITCs sweet spot plateau is much more generous
16

3. Ex: A & B both single parents with one child; As income =


20,000 in Y1 and Y2; Bs income = 40,000 in Y1 and 0 in Y2
a. As liability = (6668) refund
i. GI = 20,000 8700 (standard ded) 7600
(pers/dep exemp.) = 3700 TI x 10% rate = 370
pre-credit tax
1. Less 24(d) child care credit (partly
refundable)
a. Refundable: 15% of excess over 3000
i. 20,000 3000 = 17,000 x 15%
= 2550 (refundable ceiling)
ii. So get entire $1000 max
b. 370 tax 370 nonrefundable = 0
630 = (630) refund
2. Less EITC (refundable):
a. 20,000 17,090 threshold where rate
100% = 2910 x 15.98% max rate =
465
b. 3169 (max for one child) 465
(phased out part) = 2704 credit
3. (630) + (2704) = (3334) refund x 2 =
(6668) refund for two years
b. Bs liability = 1935 owed
i. Y1 GI = 40,000 8700 (stand ded) 7600
(pers/dep exemp) = 23,700 (12,400x10% +
11,300x15%) tax liability = 2935 pre-credit tax
ii. 2935 1000 child care credit = 1935 tax liability
iii. No EITC because TI > 36, 920
iv. No Y2 tax consequences
c. Uses of hindsight
i. Later year mistake corrections:
1. Kirby/cancellation of debt income
2. Excessive depreciation
3. Tufts even if economic benefit limited to value of property,
in fact basis includes full amount of note
4. Tax benefit rule
5. Claim of right doctrine
ii. Loans and cancellation of indebtedness income: Kirby income
1. See US v. Kirby Lumber where Court found that loan
forgiveness qualifies as taxable income
2. GI includes [i]ncome from discharge of indebtedness 61(a)
(12)
a. Borrowed money excluded when receive it, but if when
discharge debt dont have to pay it all back, the debt
forgiveness included in income
i. Feels like double hit pay back loan AND owe
taxes
ii. Has to be real debt (not a gift)
17

iii. If ER advances money with expectation will work


OT in exchange, taxable (like compensation for
services)
iv. Doesnt include adjustments in purchase price
where never had full value (buy car with 10,000
loan but then switch to 7,000 when realize lower
value): 108(e)(5)
b. Included in year that it becomes apparent loan will not
be fully repaid (hindsight)
3. To determine if Kirby income: (2 options for rationales
unsettled)
a. Balance sheet theory debt forgiveness income
taxable because looking only at year of cancellation
(requires fewer assets to cancel all liabilities)
b. Mistake correction/overall transaction theory look at
current year and earlier year, where previously
received economic benefit tax-free on understanding
would repay, so now need correcting entry (preferred)
c. Usually doesnt matter, unless no tax-free economic
benefit from mistake correction (negotiated settlement
payment)
4. Insolvency exception if debt cancellation occurs while
insolvent and doesnt create any positive net worth, then can
exclude from GI
a. BUT as condition of exclusion, have to reduce tax
attributes proportionately (in order) 108(b)
i. NOL carryovers under 172
1. Anytime NOL >= insolvency debt
cancellation, 108 doesnt change anything
ii. Basis (and so on )
b. Ex: 100,000 insolvency debt cancellation; 125,000 NOL
carryovers
i. Can deduct debt cancellation (100,000) from TI,
but reduce NOL to 25,000
ii. If NOL carryovers are 0, but have 125,000 basis,
reduce basis to 25,000 (increases later gain)
iii. If no tax attributes, then 108 is permanent
exclusion
5. Qualified personal residence debt cancellation: 108(a)(1)(E)
and (h)
a. Requires three conditions: (instituted 2007)
i. Type of debt has to be acquisition indebtedness
for primary residence
1. Capped ($2M filing jointly)
ii. Qualified reason:
1. Decline in value of house
2. Diminished financial circumstances (like job
loss)
iii. Lender is willing to forgive debt
18

b. Get exclusion, but have to reduce basis in home by


amount cancelled
i. Usually a permanent deduction
1. If stay in home, no current tax
consequences
2. If sell at loss, loss reduced (basis reduced)
a. 165(c) losses only deductible if
incurred by profit activity (home are
personal), so no deduction anyway
3. If sell for gain, gain higher, but 121 says
usually dont have to pay tax on that gain
6. S loan debt forgiveness: 108(f)
a. Permanent forgiveness of S loan debt forgiveness for
working in certain field (public interest type job)
excluded from GI
i. Like 2-part scholarship, where loan becomes
scholarship if go into public interest work
iii. Illegal income and embezzlement
1. All unlawful gains are taxable (Collins citing James)
a. Need both legal obligation to repay AND likelihood of
repayment (assessed by lender, which is impossible
with theft where lending is not voluntary)
2. See Collins where EE stole 80,000 in horse racing tickets and
won back 42,000 which repaid but 38,000 net loss and court
said to treat like an 80,000 gain but with 42,000 deduction
(so 38,000 net gain)
a. Provides a way for government to prosecute criminals
i. Drug traffickers cant claim business expense
deductions under 280E help prosecutions
b. Gambling losses in excess of winnings not deductible:
165(d) so cant deduct 38,000 gambling income to
offset losses (basket approach)
3. Honest thieves who are just stealing temporarily and
expect to repay under same rule because generally cant
make distinction and probably couldnt get loan because of
low likelihood of repayment
a. But if do repay, get deduction then
iv. Debt relief associated with disposition of property
1. Acquisition indebtedness and basis:
a. Can usually include debt in basis because likely to
repay it
b. BUT if repayment unlikely, then acquisition
indebtedness not included in basis
i. Generally a nonrecourse loan with nothing down
(liability limited to mortgage on building)
c. Ex: Buy building with $1M fmv; COULD:
i. Pay cash $1M basis (cost)
19

ii. Pay 200,000 cash + 800,000 recourse loan


secured by mortgage on building $1M basis
(personally liable for recourse loan)
iii. Pay 200,000 cash + 800,000 recourse secured
seller financing $1M basis
iv. (ii) or (Iii) above but with n-r loan, but lender
thinks will repay $1M basis
1. Law treats rec/n-r same (doesnt track
riskiness of loan)
2. In n-r, repayment depends on fmv of
property (if maintains value, then yes;
otherwise, no)
v. (iii) above but building worth at most 400,000
200,000 basis?
1. Dont get basis for n-r debt if grossly higher
than fmv at time of purchase
a. NOT likely to repay
2. Previously done to inflate depreciation ded.
3. ASK: At time of purchase, was it reasonable
to assume would repay loan?
d. Depreciation/cost of recovery:
i. Not practical to value every year, so schedule:
ii. ACRS: cost recovery (depreciation) schedules for
various categories of depreciable assets: 168
1. Gradual basis recovery
2. Buildings depreciable, but not land
iii. Must decrease basis by amount of depreciation:
1016
1. Ex: 168 says to depreciate $5000 machine
by 20% each year (20%x5000 =
1000/year); in Y3 sell for:
a. $3000, then right on track (no
loss/gain)
b. $2500, get $500 loss (2500 ar 3000
b)
c. $3500, get $500 gain (3500 ar 3000
b)
iv. Deduction even though no negative cash flow
v. Basis recovery
vi. Example of mistake correction in later year
2. See Commissioner v. Tufts where TPs bought building with
1.8M n-r loan, took 0.4M in depreciation deductions, and then
handed over building just for loan; building was worth less
than loan and so claimed 0.4M loss (1.4M ar 1.8M ab) but
Court disagreed (treat n-r loan as true loan):
a. Calculation: (with n-r loan and fmv > basis)
i. Basis is value of property undiminished by
mortgage (part of cost) here, basis just
diminished by depreciation
20

3.
4.

5.

6.

7.

ii. Amount realized also includes full value of


outstanding loan (economic benefit of handing off
obligation) not just fmv of property (if lower)
b. Here, 1.8M ar 1.4M ab = 0.4M gain (should go to
bank)
i. Gain is capital gain
c. OConnor con: Works, but better to take in 2 steps:
i. Property transaction: sell unencumbered property
for 1.4M fmv
1. So 1.4M ar 0 ab = 1.4M gain
ii. Loan transaction: Use money from property
transaction to pay loan
1. 1.4M repayment 1.8M loan obligation =
(0.4M) owed
2. Loan forgiveness (Kirby income when
lender forgave loan), so taxable at ordinary
rates
Should match economic realities (got 0.4M ACRS deduction)
Ex: Instead of building, buys land (not depreciable)
a. 1.8M original b 0 depr = 1.8M ab
b. Give back to bank in a few years and economic result is
0
c. Tax result?
i. 1.8M ar 1.8M ab = 0
Rev. Rul. 90-16 uses OConnors bifurcation approach where
debt is recourse loan, so lender only accepts less than full
value of loan if TP is insolvent (fmv > basis)
a. Amount realized = fmv (normal IRS procedure)
b. Tufts odd for treating n-r loans different in this instance
Phantom gain/burned-out tax shelters
a. Cant have negative basis
b. Ex: 1.8M n-r loan, 0 down, no principal payments
i. 1.8M orig. b 1.8M ACRS over many years = 0 ab
ii. Fmv is still 1.8M
iii. ACRS effectively shelters income until basis gone
iv. If walk away when fully depreciated:
1. 1.8M ar 0 ab = 1.8M gain (legal fiction
that feels like negative basis)
2. Under Tufts includes debt relief, even if
over fmv
3. But still get:
a. Deferral
b. Conversion to capital gains
v. Way out? Die and 1014 steps up basis
N-r borrowing against unrealized appreciation
a. Lock in gain if borrow (eventual gain) against loan
b. Ex: Buy land for 100 (b = 100)
i. When appreciates to 400, borrow 250 from bank
(locking in at least 150 of gain by borrowing on
21

unrealized appreciation because 250 debt


forgiveness will be included in ar 100 b)
ii. Still later, sell for 450
1. 250 debt relief, 200 cash
2. 450 ar 100 ab (same as original) = 350
gain
v. Tax benefit rule requires inclusion of income when events occur
that are fundamentally inconsistent with earlier deduction
(inclusionary)
1. Dont amend fix mistake in later year
2. Can be exclusionary or inclusionary
3. Purpose: protect against incorrect assumptions
4. E.g. state income tax, 165(c)(3)recovered theft loss, 166
bad debts that actually get repaid
5. Must discern between:
a. Events consistent with purpose or function of deduction
b. Merely unexpected events
6. See Hillsboro National Bank v. Commission where Court laid
out tax benefit rule and that must be evaluated case-by-case
a. Reiterates sanctity of accounting period not simpler
to go back and change it
7. If TP recoups a previous deduction in a later year, amount
recouped treated as income in year recouped, up to amount
of previous deduction
a. Track what would have happened if had continued to
own property
i. Inclusion not limited to value of property on
return if declined in value
b. See Rosen v. Commissioner where TP donated property
to A (and took charitable deduction), who returned it
and then donated to B (another deduction), who also
returned it and court found that TP had to include
recouped charitable donations in year(s) of recoupment
8. Tax benefit rule and Kirby
a. Very similar, but TBR usually defined as deductions,
and Kirby as exclusions
vi. Claim of right doctrine: mirror image of tax benefit rule
(exclusionary)
1. If receive payment that reasonably seems to be includable,
but later becomes clear shouldnt have included it, can
deduct it later
a. 1341 if have claim of right amount > $3000, can:
i. Take deduction in later year OR
ii. Take credit against current year tax equal to prior
year mistake amount
iii. If MTR goes down, take credit; if goes up, take
deduction
iv. No equivalent for tax benefit rule
22

b. Ex: 10,000 claim of right inclusion for 2011; MTR =


25%
i. 10,000x25% = 2500 tax should have paid
ii. Deduction option: 10,000 claim of right deduction
in 2012 if MTR = 1500, get just 1500 back
iii. Would take credit here

23

Chapter 3: Property Transactions p. 249


1. Realization Doctrine p. 249
a. Tax system defers tax on appreciation until its realized
i. 1001 amount realized = cash + fmv of anything received at
sale or disposition of property
ii. Realization event serves as trigger for tax purposes
b. Policy avoid valuation and liquidity problems
c. Eisner v. Macomber (US)
i. TP protests tax on stock dividend (no cash)
ii. Court finds Revenue Act unconstitutional bc cant levy
unapportioned direct tax under 16th A unless income turns on
definition of income
1. Stock dividend tax is direct/unrealized (not income)
a. Will be taxed at sale
b. May not have cash to pay tax (not income)
c. Appreciation alone isnt income
2. Paid dividend tax is on income/realized (yes income)
iii. Focus on whether there was a realization/taxable event
1. Issue not gain; its occurrence of a taxable event
d. Constitutional issue
i. More relaxed since Eisner v. Macomber (more policy-based)
ii. But Eisner set policy for realization-based income tax (which
continues)
1. But Congress can say what qualifies as realization event
a. Generally 1001, but some cases end of year
2. Manipulation of the realization rules p. 260
a. Substance of a sale without realization of gain
i. Short sale against the box hold two precisely offsetting
positions (by borrowing identical assets and selling them, so have
both asset and liability), TP insulated from fluctuations, then dies
1. Ex: 100M fmv, 0 b
a. Borrow 100M identical shares (have to repay with 100M
in identical shares eventually)
i. 100M of long position (you own it)
ii. 100M of short position (you owe it to lender)
b. Sell 100M of shares (identified as borrowed shares, and
open transaction so no tax consequences until repay
lender)
i. Have 100M shares (long) and 100M shares (short)
1. Offset each other no risk and no gain
2. Also have 100M cash for shares sold
c. Left in position would be in if had sold shares for cash,
but without having to realize gain
d. Eventually will have gain if sell long shares, but if do it
when youre old and die, no consequences (return
100M stocks to lender; keep 100M original with
stepped-up basis)
2. Shut down by 1259 (sets up recognition event)
24

a. Gain recognized on constructive (inc. short) sale at fmv


on date of constructive sale
i. Appropriate adjustment made in amt of gain
realized
ii. New holding period begins on that date
b. Also applies to any transactions with substantially
same effect under 1259(c)(1)(E) but IRS hasnt done
anything
i. Meaning, substantially eliminates all risk for loss
and opportunity for gain
c. Ex: Collars still seem to work; assume same setup as
above
i. Buy put option at 95M (can force someone to
buy)
1. Pay for this (getting rid of risk below 95M)
2. Like n-r loan; eliminate downside risk, but
dont have cash yet (depends on their
credit)
ii. Sell call option at 110M (they can buy whenever)
1. Get paid for this (getting rid of gain above
110 balances out put option)
iii. So like short sale, but no cash here (but could get
loan off it if needed cash)
b. Substance of continued ownership without realization of loss
i. Exchange of assets qualifies as realization event if exchanged
assets are materially different (reg. 1.1001-1(a) and caselaw)
1. Just cant be identical (hairtrigger standard for realization
event)
2. See Cottage Savings (US) where S&Ls exchanged
substantially similar properties to avoid losses on the books
but claim tax losses; Court found that exchanged properties
were materially different (and therefore constituting
realization for tax purposes) if they embody legally distinct
entitlements
ii. Wash sale rules: 1091
1. If TP realizes loss on sale of stock, no loss deduction allowed
if TP purchases substantially identical stock within 30 days
before or after disposition
a. Disallowed loss preserved in new stock under special
basis rules of 1091(d) difference between
reacquisition price and price sold for
b. Ex: 1000 b, sells for 800 on 3/1; buys identical for 825
on 3/21
i. Cant recognize 200 loss (800 1000)
ii. But basis in new shares equals total cash
invested in property (1000 original + 25 on
reacquisition = 1025 ab)
1. 800 1025 = (225) unrecognized loss
25

c. Ex: 700 fmv and 1200 b; buys identical for 700 on


4/20; sells orig. for 740 on 5/1
i. Cant recognize loss under 1091
ii. Basis? Made $40 exchange on reaquisition
(recovery of original investment, so 1200 40
recovery = 1160 ab)
1. 700 1160 = (460) unrecognized loss
2. Cant recognize loss on sale/exchange if sell to related party:
267(a)
a. Like parent/child: (b)(1) + (c)(4)
b. No special basis rule, so buyer gets cost basis
c. If later sells for gain, gain realized is reduced by
unrecognized 274(d) loss (this is good)
i. Ex: F sells stock with 150,000 fmv to D for
100,000 and later D sells outside family for:
1. 160,000: D recognizes 10,000 gain (even
though realized 60,000 gain)
a. 160,000 ar 100,000 b = 60,000
greal
b. 60,000 greal 50,000 (267(d) loss)
= 10,000 grec
2. 140,000: D realizes no gain (gain not in
excess of allowable loss)
a. 140,000 ar 100,000 b = 40,000
greal
b. 40,000 greal 40,000 267 loss = 0
grec
3. 90,000: D realizes loss of 10,000
a. 90,000 ar 100,000 b = (10,000) loss
4. Fs losses permanently disallowed for 2 and
3
3. Deferral provision (get it when really sell it)
a. Ex: 150 b, 100 fmv; sell for 100 and buy again for 100
i. Still realization event because not exchange and
its cash sale
4. To avoid it: Wait 31+ days
a. Problematic if volatile market
iii. If MTR is higher later, may want gain now (if > time value of
money)
1. No mirror image provision for trying to recognize gain early
3. Nonrecognition p. 275
a. Nonrecognition generally
i. Gains and losses only taken into account if recognized (so realized,
but not taken into account for tax purposes)
1. 1001(c): Default recognized unless otherwise provided
2. If nonrecognition rule applies, gain/loss is deferred by
preserving basis across exchanges or transfers
26

3. Goal: Build into basis whatever gain/loss went unrecognized


on nonrecognition transaction, preserving it for future
recognition
b. Like-kind exchanges 1031 (TP-favorable)
i. Rule nonrecognition of gain/loss realized on exchange of trade or
business investment property for like-kind property that will also be
used in TPs trade or business or held for investment (not elective)
1. What qualifies?
a. Almost always involve exchanges of real property
i. May include IP, but generally tangible
ii. Admin ruling and regs treat all real property as
like-kind (so easy to qualify)
b. If not real estate, has to be within smaller class (light
trucks v. buses)
c. Excludes inventory, stocks, bonds, notes, other
securities
d. Excludes anything for personal consumption
i. Strict (gold coin more investment-like, silver coins
more industrial; not like-kind)
ii. Policy includes all 3 considerations of nonrecognition:
1. Difficulty of valuation
2. Lack of liquidity
3. Continuation of basic nature of investment
iii. Mechanics
1. Defers gain by assigning new property a basis equal to basis
of old property (not permanent)
2. If TP realizes a loss, not recognized (so avoid this provision if
loss)
3. Basis: exchanged so historic b becomes b in acquired
property
a. Adjustments:
i. Inc by amt of gain recognized by TP on
transaction
1. Because had to pay tax on this already
ii. Dec by amount of any $$ received by TP in
transaction
1. Because new $$ and need to pay tax on it
iii. Dec by amt of loss recognized by TP on
transaction
1. Would have to be on nonqualified property
iv. Inc by amt of $$ paid by TP in exchange (Reg.
1.1031(d)-1(a)
b. To check adjustment: fmv of replacement property
replacement basis (under 1031(d)) = gain realized
gain recognized (under 1031(b))
c. If TP received both qualified and nonqualified property,
basis applies:
i. First to nonqualified property (like with cash) up
to fmv
27

ii. Then to anything left to qualified property


iii. Think of as separate transactions
d. If property encumbered by mortgage, net liability
release that is in excess of any new cash invested by
transferor is treated as cash (to offset gain) like used
cash to pay down liability
4. If boot is exchanged (cash or nonpermitted property),
realized gain is recognized up to the value of the boot
received
a. Triggers some realization
b. If gr < boot, then recognize gain, not boot
5. Ex w/ gain: M transfers B ($500 fmv, $200 b) to F for W
($480 fmv, $450 b) + $20
a. Ms analysis:
i. Gain realized = (480 + 20 cash) ar 200 b = 300
gain realized
ii. Gain recognized? 20 (because less than gain
realized)
iii. New basis? 200 old basis + 20 gain recognized
20 cash received = 200
iv. What if F gives tractor (20 fmv, 35 b) instead of
cash?
1. Nothing changes (dont care about Fs basis
in tractor and still gets $20 boot
b. Fs analysis:
i. Gain realized = 480 (500 20) ar 450 b = 30 gr
(for land)
1. 20 20 = 0 (for cash)
ii. Gain recognized = 0 (no boot)
iii. New basis = 450 + 20 paid = 470 basis
6. Ex w/ loss: C transfers G (200 fmv, 230 b) to F for B (150
fmv) + 50 cash
a. Cs analysis:
i. Gain/loss realized = (150 + 50) 230 b = (30)
loss
ii. Gain/loss recognized = 0 (loss never recognized)
iii. New b? 230 old b 50 cash = 180 b
7. Ex w/ boot > gain realized: S transfers R (400 fmv, 380 b)
to M for B (370 fmv) + 30 cash
a. Ss analysis:
i. Gain/loss realized = (370 + 30) 380 b = 20 gain
realized
ii. Gain/loss recognized = lesser of boot (30) or gain
realized (20) = 20
iii. Taxed on entire gain, so lose benefit of 1031
iv. New b? 380 30 boot + 20 gain = 370 b
iv. Triangular exchanges works if structured right
1. In general
a. Almost always the case (more likely) gives practical
significance
28

b. Get buyer for your or s.o. elses land and then


exchange
i. But can be complicated
c. IRS keeps losing substance-over-form argument (so
dont pursue)
2. Difference between like-kind exchange and
sale/reinvestment?
a. Ex: F has farm (1000K b) which is worth 500k as farm
but 1.5M as shopping center, but doesnt want to pay
tax on gain
i. D developer wants Fs land
ii. McD has farm F wants
iii. Steps:
1. D transfers 1.5M to McD in exchange for
farm
2. D transfers McD farm to F in exchange for
Fs farm
a. Theoretically taxable event for D (not
holding McDs farm for business
purpose), but has no gain (1.5M b
1.5M purchase)
b. BUT D may resist owning McD farm,
even for a few minutes (transfer fees,
chain of title)
c. So skip and qualify as like-kind
exchange
3. Deferred exchanges (nonsimultaneous) can be hard to work
out timing
a. Under 1031(a)(3), TP has 45 days from transfer of his
property to identify exchange property, and actual
transfer has to occur within 180 days of initial transfer
or due date for TPs income tax return for the year of
the like-kind exchange (whichever is first)
c. Involuntary conversions: 1033 (only applies to gain good for TP)
i. Allows for nonrecognition of a cash sale followed by a
reinvestment, if cash sale qualifies as involuntary conversion
1. Involuntary conversion = condemnation, flood, fire, disaster
2. Must reinvest within 2 years of the end of the year in which
realized gain
3. If replacement property costs less than award, difference is
boot equivalent and triggers gain recognition
ii. Cost basis in replacement property must be reduced by amount of
gain realized but not recognized 1033(b)(2)
1. Only have to recognize gain that is realized above the cost of
the replacement property
2. Doesnt matter if purchase with loan or cash
iii. Two properties must be similar or related in service or use
29

iv.
v.
vi.

vii.

viii.

1. Looks to nature of TPs relationship to property (stricter than


1031)
2. For ex, if original is supermarket operated burns, cant be
replaced with supermarket leases to chain (different
relationship to property)
a. BUT 1033(g)(1) exception that if property held for
productive use or investment and condemned (not fire,
disaster), then broader analysis of similar property (like
1031)
b. Ex above would qualify because still an investment
(1031 anal)
Defers taxation of gain on property that is involuntarily converted
Policy: treat new policy like continuation of old (because
involuntary)
Analysis:
1. Gain realized = ar (award) b
2. [if replacement < award] Gain real replacement cost = boot
equivalent (recognized gain)
3. New basis = replacement cost gain realized/not recognized
a. Gain realized/not recog = gain real gain recog
Ex: land (100 b, 300 condemnation award) straight-up
replacement
1. Buys replacement w/i 2 years for 300
a. 300 ar 100 b = 200 greal
b. 200 greal, 0 grec 1033(a)(2)
c. Basis = 300 new b 200 unrecognized gain = 100 b
new
2. Instead, buy replacement property w/i 2 years for 280
a. 300 ar (award) 280 replacement cost = 20 boot
equivalent under 1033(a)(2)
b. Basis = 280 replacement cost 180 unrecognized gain
= 100 new basis
i. 200 greal 20 grec = 180 unrecognized gain
Ex (w/mortgage): unencumbered land (250,000 b; 600,000
award); purchased similar property w/i 2 years for 560,000
(400,000 cash + 160,000 loan)
1. Gain real = 600,000 250,000 = 350,000
2. Boot equivalent = 600,000 560,000 = 40,000 (gain recog)
a. Notes say 350,000 310,000 = 40,000
3. New basis = 560,000 310,000 = 250,000

d. Permanent exclusion of gain on sale of a principal residence: 121


i. Old law replaced in 1997 1034, that deferred gains (but
unlimited gains) because could roll over every time, but always had
to cost more (forcing people to buy unnecessarily large homes)
ii. 121 new rule
1. Permanently avoid taxation of up to 250,000 (500,000
married) of gain on sale of personal residence
a. Applies every time sell personal residence (but
generally limited to once every 2 years)
30

i. Exception possible if get new job, maybe health:


121(c)
1. Ceiling can be prorated if less than 2 years
and qualify for exception
2. Ceiling excludable = Ceiling(mos. lived
in/24 mos.)
ii. Ex: buy house on 1/1 for 300,000; sell for
350,000 on 7/1
1. CE = 250,000(6/24) = 62,500 ceiling
excludable
2. So all 50,000 gain excludable (less than
ceiling)
b. New basis = what you pay for house (normal)
c. Must live in residence 2 out of 5 years prior to
sale/exchange
d. Loss: if realized (even recognized), only deductible if
incurred in trade or business, transaction for profit, or
in connection with casualty/theft: 165(c)
e. No rules on what do with gain (dont have to reinvest in
home)
f. Ex: Sell personal residence (400,000 b) for 1.2M and
buy new home for 1.4M
i. Still limited to 500,000 gain exclusion (joint)
ii. Doesnt matter what you buy next
2. Doesnt tax labor/improvements for fixing up (all equally
excludable)
a. Ex: Bought for 200,000; worth 450,000 in 2 years
(combo of market, improvements, labor)
i. Gain = 450,000 ar 200,000 b = 250,000 (all
excludable)
ii. Also avoids payroll and fed/state taxes
3. Makes home turning more profitable
a. Ex: buy home (600,000 b; 1.2M fmv);
i. Want to sell before price goes up more (gain is
taxable above 500,000)
ii. If sell, 500,000 gain excluded and base resets
(last 100,000 of gain taxable)
1. AND get home mortgage deduction rules
benefit (more generous than home equity
interest deduction rules)
b. But mitigated by transaction costs
4. Installment Sales p. 290
a. 453 installment method rules for seller-financed dispositions where
seller realizes gain in installments
i. Gain recognized on principal each year is microcosm of entire
transaction (proportional): 453(c)
1. Solves liquidity problem but doesnt wait until sellers basis
recovered to pay any tax
31

2. Doesnt apply to interest payments (includable as ordinary


income to S)
ii. Formula: x = P(GP/CP)
1. x = income recognized that year
2. P = principal payments received that year
3. GP = gross profits (gain realized)
4. CP = contract price (amount realized)
5. NOTE: (GP/CP) = percentage of payment recognized
(consistent)
iii. Ex: land (90 b; sold for 30 cash + 120 note from buyer)
1. Gain realized/recognized = (120+30) 90 = 60
2. Apply formula to calculate income recognized:
a. x = 30(60/150) = $12 income recognized that year
i. (60/150) = 40%, which is rate that will apply
every year
3. If later the 120 note paid in balloon payment in one year:
a. 120(40%) = $48
b. 12 + 48 = 60 total income recognized = gain realized
= taxed
b. Installment method and debt relief
i. Debt relief not included in payment and thus doesnt trigger gain
1. Adjustment made to equation: CP reduced by amount of
qualifying indebtedness
a. Qualifying indebtedness doesnt include any loans
taken out to dispose of property Reg. 15a.453-1(b)(2)
(iv)
i. So cant take out loan and then have buyer pay it
for you instead of cash to defer gain recognition
b. Ex: land (50,000 b, 200,000 fmv w/ 40,000 mort.) sold
for 30,000 cash, 130,000 note, and 40,000 debt relief
(took over mortgage)
i. P = 30,000 cash + 40,000 mort relief = 70,000
1. BUT excludes 40,000 debt relief = 30,000
2. Would normally be 30,000 + 40,000
ii. CP = 30,000 + 40,000 + 130,000 = 200,000 ar
1. BUT CP reduced by 40,000 = 160,000
iii. GP = 200,000 ar 50,000 b = 150,000
iv. SO: x = 30,000(150,000/160,000)
2. BUT if debt relief exceeds basis:
a. Indebtedness IS treated as payment (P) to the extent it
exceeds basis (P = debt relief basis)
b. CP is not reduced by amount debt relief exceeds basis
(basically, just reduced by the basis)
i. GP/CP becomes 100%, and entire payment is
taxable
ii. Treats excess of mortgage over basis as payment
c. Ex: land (50,000 b; 200,000 fmv w/ 70,000 mort) sold
for 70,000 mort rel + 130,000 note
i. P = 70,000 mortgage relief
1. BUT debt relief excluded = 0
32

2. BUT because debt relief > basis, P =


70,000 50,000 = 20,000
ii. CP = 70,000 + 130,000 = 200,000 ar
1. BUT reduced by basis = 200,000 50,000
= 150,000
iii. GP = 200,000 ar 50,000 b = 150,000
iv. SO, x = 20,000(150,000/150,000) = 20,000
c. If A sells to a related person B under 453(f)(1), and B resells within 2
years, triggers 453(e)
i. A treated as having received payment at time of second sale (and
has to recognize gain)
1. Amount of deemed payment to A limited to:
a. (Lesser of: ar in 2nd disposition OR total CP of 1st
disposition) (payments received for 1st disposition for
this year + payments from prior years)
i. Payment from prior years usually when B sold
property piecemeal and so had to deem partial
payment earlier
2. When A receives actual payment 10 years later, not taxable
ii. Ex: Mother (M) sells land (400,000 fmv; 100,000 b) to daughter (D)
for 400,000 balloon payment on 10-yr loan; D then sells to B for
425,000 cash w/i 2 years
1. Amount of deemed payment to M?
a. Ar is 2nd disposition = 425,000 ar
b. CP of 1st disposition = 400,000 (lower)
c. Payments? 0
d. 400,000 0 = 400,000 deemed payment
i. 400,000 ar 100,000 b = 300,000 gr
5. Annuities: 72 p. 295
a. Protect against unexpectedly long life and get more than investment
back because insurance company can invest it
b. Basis recovery proportional calculation: 72(b)(1) (just like installment
sales)
i. Nontaxable amount = annuity payment(investment in K/expected
return)
1. Annuity payment = payment for that year
2. Investment in K = premiums paid any amts received before
annuity starting date and excluded from income (basis)
3. Expected return = premium x expected years (see Treasury
table)
ii. Ex: TP, age 60, w/ actuarial life expectancy of 25 years, buys
annuity for 75,000; 5000/yr payment for life
1. Expected return = 5000x25 = 125,000
2. Nontaxable amt = 5000(75,000/125,000) = 3000 (so 2000 TI
each yr)
a. NOTE: (Invest in K/exp return) rate holds (here 60%)
c. If live past expected life: Exclusion limited to unrecovered investment (so
taxed on full payment 72(b)(2)
33

d. If dont make it to expected life: under 72(b)(3)(A), unrecovered


investment due at death of annuitant can be excluded for annuitants last
taxable year
i. If cant use entire deduction, can treat as 172 NOL and carry back
2 years
e. Benefits of 72:
i. Deferral of increase in value of annuity if invest early (nothing until
payments begin) but lower exclusions each year
1. Ex: Same as above but buys at 50 to start receiving
payments at 60 (and investment just 50,000) same result
a. x = 5000(50,000/125,000) = 2000 (so 3000 TI each
year)
ii. Understatement of income portion of payments in earlier years
(unlike mortgages with heavy interest at first)
iii. BUT hits elderly people on fixed income with suddenly higher TI
6. Basis Rules for Property Transferred by Gift or Bequest p. 296
a. Transfer by inter vivos gift: 1015
i. Defer tax on appreciation until donee sells gift by:
1. Not treating gift as realization event for donor (timing) AND
2. Requiring donee to take gift with donors basis (TP ID)
a. Ex: M has stock (1000 b, 3000 fmv) and gifts to S, who
later sells for 3500
i. Ss gr = 3500 ar 1000 b = 2500
ii. Special loss rule if donors basis is greater than fmv at time of
gift (aka with unrealized loss), then donee has bifurcated basis:
1. For determining loss (fmv at gift)
2. For determining gain (donors basis)
3. If sells in between fmv and donors basis, no gain or loss
4. Ex: M gifts stock (4000 b, 3000 fmv) to S, who later sells for
2800 (loss)
a. Special loss rule applies because S sells for less than
fmv basis acquired at time of gift (loss)
i. SO 2800 ar 3000 b = (200) loss
b. BUT if S sells for 4800, then use Ms original basis (not
a loss)
i. SO 4800 ar 4000 b = 800 gain
c. BUT if S sells for 3500, no gain or loss
5. Similar to 267 (sale to a related party) see notes p. 22
(sellers loss disallowed)
b. Transfer at death: 1014
i. Not treated as realization event
ii. Transferee gets basis equal to propertys value at transferors
death (stepped up basis)
1. Permanent exclusion
2. Could step down but less common
iii. Exception: 1014(c)
1. No basis increase allowed for property that is IRD
34

iv.

v.
vi.
vii.

2. IRD = amts that would have been taxed to decedent during


his lifetime if he had been on accrual method instead of cash
method
a. Usually tax-deferred retirement savings vehicles
Any gift of appreciated property acquired by decedent within 1 year
of death excluded from stepped-up basis (just get donors basis per
1015): 1014(e)
1. Sham doctrine would apply to any secret agreement
2. A bit risky/uncertain/weird (to bet on death of family
members)
Decedents income taxed normally on payments received (like from
retirement account)
No estate tax to anyone who died in 2010
Policy: unclear
1. Avoids double taxing with estate and income taxes, but
estate tax often avoided and sometimes TPs pay twice on
stuff

c. Part gift-part sale transactions


i. Transferors gain? Reg. 1.1001-1(e)
1. Gain to extent amount realized by him exceeds his adj b in
property
a. No loss sustained if ar < adj b
2. Ex: F owns land (60,000 b; 400,000 fmv) and sells to D for
100,000 (intending 300,000 gift)
a. Fs gain = 100,000 ar 60,000 adj b = 40,000
ii. Transferees basis? Reg. 1.1015-4(a)
1. Basis is sum of:
a. Whichever is greater of:
i. Amt paid by transferee for property
ii. Transferors adj b at time of transfer
b. Amt of increase (if any) in basis authorized by 1015(a)
for gift tax paid
2. Ex: same facts as above
a. Basis = 100,000 (amt paid by D > Fs adj b)
iii. Bargain sale to charitable organization: 1011(b)
1. x (basis allowed to recover) = ab(ar/fmv)
a. Lower b because governments last chance to tax the
money
2. Ex: same facts as above
a. x = 60,000(100,000/400,000) = 15,000 recoverable b
b. Gain realized = 100,000 ar 15,000 rec b = 85,000 gr
7. Basis Allocation: Piecemeal Asset Dispositions and Other Contexts p.
301
a. When property sold piecemeal, basis of entire property is equitably
apportioned among the several parts Reg. 1.61-6(a)
i. Gain/loss on entire property = selling price b of that part
ii. By the time everything sold, entire basis recovered
35

iii. Courts often split the different between parties claims (which
incentivizes unreasonable positions)
iv. Frequently at issue
1. Even if dont sell, may need to for depreciation, home office
deduction, purchase of small business, or different tax
treatment may apply for different parts even if maintain
ownership
b. Gamble v. Commissioner (TC 1977)
i. P bought horse in foal at bargain price of 60,000 and after foal
born, sold foal for 125,000; claimed 30,000 as b of foal (big stud
fee); G said no basis
ii. Court found basis of foal is 20,000 (what P claimed on insurance)

36

Chapter 4: Personal Deductions p. 363


1. Overview:
a. Remember: I = Consumption + Savings
i. Tax on net I (after expense), not gross receipt (not I if really have to
use to run a business)
ii. Congress uses deductions to subsidize different areas (housing,
charities, etc.)
1. Biggest winners? (itemizers mostly homeowners)
2. If take standard deduction dont benefit (but often lower
rates)
b. Lost revenue estimates:
i. 170 charitable contributions = $47.6B
ii. 163(h)(3) HMID = $94.1B
iii. 164 state/local tax = $77.1B
c. Two types of deductions
i. Above-the-line deducted from GI to calculate AGI
ii. Below-the-line deducted from AGI to calculate TI
1. Itemized v. standard
2. Charitable Contributions Under 170 p. 366
a. Rationale
i. Lowers TPs consumption opportunities
ii. Encourage TPs to support charities (which ease govt
responsibilities) like matching grant program for eligible charities
1. Ex: If at 25% MTR and give $100 to eligible charity (and
itemize):
a. $75 from TP, $25 from govt in uncollected taxes (like
3:1 match)
2. BUT
a. WHY does charity deserve govt subsidy?
i. May not need it (but positive externality problem,
so possibly does)
ii. May go to orgs Congress cant or wont support
or that are opposed to each other
b. Greater incentive for higher bracket TPs (depends on
MTR and itemizing) could make it flat-rate credit?
c. Dependent on underlying assumption that TPs take
matching grant into account in deciding amount of
deduction
i. But breaks down with religious donations
b. Contributed services no deduction allowed for value of services you
contribute (limited to tangible property) Reg. 1.170A-1(g)
i. Illogical to allow deduction when never taken into income
1. Ex: Donate 10 hrs x $200/hr = $2000 value of time (no
deduction), no income left
a. OR donate $2000 cash (61 income) 2000 170
deduction = 0 (no income left)
b. They match (good)
c. Amount of the deduction
i. Appreciated property (Zelenak thinks this is stupid)
37

1. Amount of deduction for gifts of property is fmv: Reg. 1.170A1(c)(1)


a. Illogical should be basis
b. Valuation problem with fmv
2. Requirements: (if dont meet, just get deduction of b)
a. For tangible property, only get deduction for fmv if
charitable organization uses it in connection with
purpose (or limited to b)
b. Gain must have qualified as long-term capital gain if
sold (if ordinary or short-term capital gain, excluded) to
get fmv ded.
i. See Lary where court found that TPs donation of
valuable blood did not qualify as charitable
donation because:
1. If service, always disallowed
2. If product, not long-term capital gain
because cant hold for long enough to
qualify, so limited to adj b in property,
which is 0
ii. Ex: Donate property (1M fmv, 400,000 b) to char.
org.
1. If sold, would have 600,000 gain (at 15%
capital gains rate),
2. But if donate instead, get 600,000
deduction at ordinary rate (35%)
ii. Quid pro quo issues (Rolfs)
1. Rule: If TP receives substantial benefit in return for
contribution, then contribution/deduction reduced by amt of
the benefit received
a. Only deductible to extent payment/property exceeds
fmv of benefit received
i. Look at conditions imposed when assessing value
of benefit
b. Excess payment must be made with intention of
making gift
i. If conditions reduce market value of donation to
0, then fails here
2. See Rolfs v. Commissioner where R wanted to tear down
lakehouse and rebuild, so donated to fire dept on condition of
demolition (and didnt include land), and deducted cost of
house
a. Court denied deduction under quid pro quo rule
b. TP saved at least 10,000 in demo costs:
i. 10,000 ar 6000 b = 4000 gr
c. Conditions imposed lowered value to nothing (severed
from land, non-residential, limited use)
i. So market value of property did not exceed
benefit
3. College football exception: 170(l) p. 442
38

a. Can claim 80% contribution to an educational


organization even if get some perks (like football
tickets) as charitable deduction
4. Intangible Religious Benefits
a. Dont have to reduce deduction for purely religious
benefits (pew rents) Rev. Rul. 70-147
i. But later obsoleted in Rev. Rul. 93-73 (after
Hernandez gave up win)
ii. No one with standing who would challenge
change of position
b. But disallowed deductions to members of Church of
Scientology if set up like transactions (limited to extent
exceed fmv of any consideration received) Rev. Rul. 78189
i. Position upheld in Hernandez v. Commissioner
where Court engaged in very textual reading of
170 where transactions are inherently
reciprocal
1. Diss: Cant value religious intangibles bc no
market for them, so analysis doesnt work;
disregard completely or tax them all; not
consistent
c. Charitable donation substantiation requirement: 170(f)
i. Provides exception to valuation requirement for
any intangible religious benefit, defined as:
1. Provided by organization organized
exclusively for religious purposes
2. Generally not sold in commercial
transaction outside donative context
d. Limitations on deductions and carryovers: 170(b)
i. Limited to 50% of TPs contribution base (CB) usually GI
1. 30% of CB for private foundations
2. 30% of CB for gifts of appreciated property (less favored)
a. Ex: TP with 1M AGI wants to give barely appreciated
stock (500,000 fmv; 490,000 b) to Duke
i. 500,000 deduction would be allowed but limited
to 300,000 under 30% limit for appreciated
property
1. Could carry 200,000 forward
ii. BUT if fmv = 490,000 then not appreciated, so
can claim 50% of AGI and deduct entire 490,000
now
1. Can choose under 170(b)(1)(C)(iii)
2. Depends on a lot of factors, but often
preferable
3. 20% of CB for gifts of appreciated property to private
foundations
ii. Any amts disallowed may be carried over by TP and deducted in up
to 5 subsequent years: 170(d)
39

3. Interest Expense p. 381


a. Overview
i. Default: all interest is deductible (exceptions then laid out) 163(a)
ii. Depends on what do with income and which basket money is in
1. Tracing rule trace what do with loan money paying interest
on to see which rule applies or if deductible
b. Important provisions of 163
i. Active business interest deductible under 163(a)
ii. Investment interest expense partly deductible under 163(d)
1. Basket analysis: only deductible against any investment
income
a. But can carry it forward (but never deduct against
ordinary income)
2. Ex: TP borrows 100,000 at 5%, so 5000 interest expense/year
a. Apply tracing rule: if used to buy investments, then
deductible
b. Apply basket rule: deduct against investment income or
carry forward
iii. Personal interest deductions disallowed unless specifically allowed:
163(h)(2)
1. Tracing rule: if use money for personal consumption, nondeductible
2. Exceptions where personal interest deduction allowed:
a. Includes business interest, investment interest, passive
activity interest, educational loan interest
b. Easy for TP to manipulate to get funds into these
exceptions
iv. Qualified residence interest: 163(h)(3)
1. Deduction allowed for mortgages secured by their personal
residence
a. Home must secure mortgage interest seeking to deduct
b. Biggest personal interest deduction allowance
c. Limited to 2 residences - 163(h)(4)(A)
i. One personal residence
ii. One used as residence at least 15 days during
tax year
1. Includes mobile home, trailer, boat (eat,
sleep, bathroom)
2. Two types of indebtedness:
a. Acquisition indebtedness
i. Purchase-money mortgage used in acquiring,
constructing, or substantially improving any
qualified residence
1. Tracing rule applies
ii. $1M cap on loan
b. Home equity indebtedness
40

i. Any other indebtedness secured by a residence


(just need enough equity but can use for any
purpose)
1. Tracing rules doesnt apply
2. Calculate amount of equity in house (fmv
mortgage) basis doesnt matter
a. Can argue fmv its soft
3. If take out loan for more than equity, only
amt up to equity is deductible
ii. $100,000 cap on home equity debt
c. Using both types of indebtedness, TP can borrow up to
$1.1M if for purposes that qualify for acquisition
indebtedness under 163(h)(3)(C)(i)
i. First $1M is acquisition indebtedness
ii. Next 100,000 cant be that, so must be home
equity indebt.
1. See Rev. Rul. 2010-25
a. Overruled Pau v. Commissioner,
which said cant be home equity debt
if for same purpose of acquisition
debt
d. Ex: A lives in and owns house (400,000 fmv; 250,000
acq. indebt.)
i. Wants to purchase 80,000 vehicle
1. Must be home equity bc its a car
a. Falls under 100,000 cap
b. Sufficient equity? YES
i. 400,000 fmv 250,000
mortgage = 150,000 equity
ii. What if value of home is just 300,000?
1. Insufficient equity
a. 300,000 fmv 250,000 mort =
50,000
b. Only interest on first 50,000
deductible
2. OR if vehicle is mobile home/trailer/boat
4. State and local taxes p. 394
a. History and rationale
i. Like federal recognition of need for local taxes, and willingness to
lower NI to post-local tax amts (local govt can tax with fewer
complaints)
1. But incentivizes higher local taxes
ii. Underlying assumption that local governments use tax money for
non-public goods (not getting benefits), so deduction is merited
1. But in theory provides citizens with consumption benefits
a. If use for public goods, shouldnt get deduction (getting
something back)
iii. Below-the-line, so have to itemize to get it
b. What taxes are deductible
41

i. State and local income taxes


1. BUT NOT state/local sales tax (removed 1986) and federal
income tax
a. Option to deduct sales tax instead of income tax
(based on table)
i. Temporary measure allows deduction, but its in
and out (currently OUT) - 164(b)(5)
b. Permanent rule = IT deduction but not sales tax
c. Temporary rule = choose IT or sales deduction
i. Weird incentives, depending on how states tax
(income v. sales v. both)
A (NC)
B (OR)
C
(TX)
Income tax 5000
10,000
0
Sales tax 5000
0
10,000
Rankings on tax treatment:
Perm. rule #2
#1
#3
Temp rule #3
#1
#1
ii. Real property taxes (valuation problems sometimes)
iii. Personal property taxes (ad valorum based on value of
property)
iv. 1/2 of self-employment taxes
v. Foreign income (sometimes categorized strangely)
vi. Foreign real property taxes
c. Who can claim the deduction
i. Usually based on legal incidence (who actually bears tax burden),
which is sometimes unfair
1. See Loria v. Commissioner where IRS disallowed property
tax deductions for N, who made all the payments but whose
brother L had actually taken out loan (legal owner) because
legally, taxes had been imposed on L regardless of who paid
them
5. Medical Expenses p. 412
a. TPs who itemize can claim medical deductions for themselves and their
dependents that exceed 7.5% of AGI (going back up to 10% in 2013)
213
i. Usually only applies to something expensive that isnt covered by
insurance
ii. Taxed in year when actually make unreimbursed payment
1. Encourages bunching into single year if possible
iii. Ex: 100,000 AGI, 7000 uninsured medical expenses
1. Not deductible (only 7% of AGI)
2. But if 11,000 in medical expenses, can deduct last 3500
(11,000 7500)
b. Definition of medical care under 213(d)(1)(A)
i. Amounts paid for the diagnosis, cure, mitigation, or prevention of
disease, or for the purpose of affecting any structure or function of
the body
1. Pretty broad, but sometimes IRS pushes bak
42

2. Includes premiums for private health insurance


a. But if self-employed, 162(l) says can treat health
insurance premiums as business expense (so abovethe-line and no floor)
3. Includes copays or other expenses in excess of what
insurance pays
a. Tax bias in favor of Cadillac plans with no or small
copays because in other plans if not covered, cant
usually clear floor, and has to come out of pocket
i. Moral hazard of encouraging too much medical
stuff?
b. BUT FSAs are excludable under 125, and no
constructive receipt
i. So avoids AGI floor of 213
ii. But use it or lose it rule
iii. Similar with HSAs with high deductibles
4. Deductions for travel costs only allowed if: 213(d)(2)
a. Care for which travel is incurred is provided by a
licensed doctor/hospital
i. Does not include living expenses or travel for
family
1. See Commissioner v. Bilder where Court
found that TP could deduct travel to FL for
health reasons for himself, but not living
expenses or travel for wife and child
b. AND travel involves no significant element of personal
pleasure
c. Subject to limit of $50/day (for each eligible individual)
5. Excludes cosmetic surgery: 213(d)(9)
a. Unless medically necessary for treatment of a disease
b. ODonnabhain v. Commissioner (TC 2010) p.
417
i. TP had gender ID disorder (GID), so underwent
hormone therapy, sex reassignment surgery, and
breast augmentation and IRS denied deductions
as med. exp.
ii. Test TP must show fits under definition of 213
1. Disease? Yes
a. Doesnt have to be organic in origin
physiological counts if recognized in
medical literature, by courts,
impairment
b. If qualifies under (d)(1)(A) then not
cosmetic surgery under (d)(9)(B)
2. Treatment? Yes
a. Procedures were an essential
element of the treatment and
wouldnt otherwise be incurred
b. Cant deny based on social policy
43

c. BUT breast augmentation doesnt


qualify because not necessary for
treatment here
c. Mechanics of the deduction
i. Deducted in year actually paid, so room for some manipulation
(bunching) Reg. 1.213-1(a)(1)
ii. May be to advantage of married TPs to file separate returns
iii. Permits deductions of cost of capital improvements necessitated by
medical necessities (like installing elevator), but have to deduct
value added to property Reg. 1.213-1(e)(1)(iii)
iv. Most people cant take this deduction
d. HSAs and health FSAs
i. HSA: 223
1. Can claim above-the-line deduction for cash contributions to
HSA (under qualified plan)
ii. FSA: 125
1. TP can agree to a salary reduction and ER contributes
amount deduction to health FSA, which EE can use to pay
medical costs and exclude from GI
a. But if dont use it all, its gone
2. Renders constructive receipt doctrine null
6. Special Limitations on Itemized Deductions p. 429
a. Miscellaneous itemized deductions: 67
i. Mostly includes investment expenses, tax return expenses, and
unreimbursed EE business expenses (biggest one)
1. Lists whats NOT included (so otherwise included)
ii. Must itemize and exceed 2% of AGI floor, which disallows for most
TPs
b. Reduction of itemized deductions for high income TP: 68
i. Not currently in force, but scheduled back in 2013
ii. If TPs income exceeds inflation-adjusted level ($166,800 in 2009)
then itemized deduction total reduced by lesser of:
1. 3% of excess of AGI over threshold amount OR
2. 80% of itemized deductions otherwise allowable
iii. Reduces benefit of higher AGI, but not higher itemized deduction
iv. Analysis:
1. Does it apply (AGI exceeds threshold level)?
2. If so, how does it apply?
a. Practically speaking, its always the first (itemized
deductions tend to increase with income)
i. SO, at the margin, 68 doesnt do much
ii. Mostly an increase in MTR (equal to TPs nominal
MTR x 3%)
v. Ex: 160,000 AGI threshold; 220,000 AGI; 20,000 itemized
deductions; 30% 1 MTR
1. Option 1: 220,000 160,000 = 60,000 excess of AGI over
threshold
a. 60,000 x 3% = 1800 (lesser)
2. Option 2: 20,000 x 80% = 16,000
44

3. Same facts, but want to give 10,000 to charity; at 30%, tax


savings = 3000
a. Itemized deduction option 2 = 30,000 x 80% = 24,000
i. Still higher than 1800 (3% of excess), so get
entire 10,000 deduction and same tax savings
(no marginal impact)
4. Same facts, but instead earn 10,000 more at work (so keep
7000)
a. Option 1: AGI = 230,000 160,000 = 70,000 excess x
3% = 2100 disallowed (still lower)
b. So taxable income goes up by 10,000 + 300 (higher
disallowed itemized deduction) = 10,300 additional tax
income
i. 10,300 x 30% = 3090 additional tax liability
ii. 3090/10,000 = 30.9% MTR on last 10,000
iii. SO, way of imposing higher MTR without being
aware of it (taxation without comprehension)
c. Personal credits as legislative alternative to personal deductions
i. Congress tending to favor using credits in new enactments because
1. Dont depend on TPs MTR (because above-the-line)
2. Availability doesnt depend on itemizing (because above-theline)
3. Right-side-up subsidies because can reduce or eliminate
them above certain AGIs

45

Chapter 5: Business Expense Deductions p. 519


1. Overview
a. Business expense deductions are necessary to establish business NI (as a
definitional matter)
i. I = C + S (gross income not available to C or S, so have to define as
NI)
b. Why wouldnt you get an otherwise seemingly valid business expense
deduction?
i. Public policy concerns
ii. Personal (262)/business borderline
iii. Capital, not current
2. Ordinary and Necessary Business Expenses p. 521
a. Deductions allowed for all the ordinary and necessary expenses paid or
incurred during the taxable year in carrying on any trade or business
162(a)
i. Definitions not clarified by Congress, so regs/cases
b. Necessary?
i. Appropriate and helpful (Welch)
1. Literal interpretation would have been impractical
2. See Palo Alto Town & Country Village where company
deducted expense of standby plane; court finds that it meets
the definition
ii. In practice, deductions rarely denied because not necessary
c. Ordinary?
i. Two possible definitions
1. Not providing continuing value, but used up in production of
income in current tax year (closer to use in actual cases)
a. Clarifies distinction between current expenses
(deductible now) and capital expenses that have to be
amortized
2. Not extraordinary
a. Normal, usual, or customary in trade or business
3. Public Policy Limitations p. 533
a. Cannot deduct fines for breaking the law (against public policy)
i. Tank Truck Rentals v. Commissioner (US 1958) p. 534
1. Company intentionally violated weight limits due to economic
necessity, and fines went to road repair; deduction denied
2. If would frustrate public policy (lessens bite of fine), then
not allowed
3. Not absolute bar context-specific
a. Test: severity and immediacy of the frustration
4. Trying to accommodate intent of defining business NI and
presumption against encouraging violation of public policy
ii. BUT Tank Truck policy wrong because the violation was an
economic, not moral, wrong, and fee paid for damage to roads
1. Ex: Co. has 1000 trucks and 2 choices (fines 500; 7000 to
comply):
a. Violate law and pay fines
46

i. Expect 10 caught = 5000


ii. If damage to roads = 5/truck x 1000 = 5000
iii. So need to catch 1/100 and assess 500 fine to
recover costs of road repair
1. State gets damage paid for (so indifferent),
and saves 2000 overall (see below)
b. Comply with law = 7000 total (2000 net loss)
c. Effect with income tax of 40%
i. If deductible either way:
1. 3000 to violate (5000 2000 tax)
2. 4200 to comply (7000 2800 tax)
ii. But if not deductible if violate (like Tank Truck)
1. 5000 cost to violate > 4200 after-tax
compliance cost, so change behavior and
comply
2. Less efficient economically
a. TP paying 7000 to avoid 5000 of
damage (2000 loss)
i. TP loses 1200 (4200 3000)
ii. Feds lose 800 in tax revenue
(because deductible if comply)
b. Other provisions that limit deductions based on policy (and tax people on
MORE than economic net income to penalize economic activity reverse
tax expenditure):
i. For illegal bribes/kickbacks to govt officials/EEs 162(c)(1)
1. Unclear if legal bribes are deductible (IRS challenges
sometimes)
ii. For illegal bribes/kickbacks to non-govt actors 162(c)(2)
1. BUT if violates only state law that is not enforced, deductible
iii. For kickbacks, rebates, and bribes with Medicare and Medicaid
programs, whether legal or illegal 1(62(c)(3)
iv. For fines/penalties paid to govt for violation of law 162(f)
v. For 2/3 judgments/settlements of private antitrust suits following
criminal convictions of anti-trust laws 162(g)
vi. Trafficking in illegal substances NO business deductions under
162 280E
1. Allows criminal prosecutions for tax evasion
2. Can still get around it through CGS (just part of definition of
GI, not 162)
a. Gross receipts CGS (like b but for inventory) = GI
business expenses (162) = TI
b. CGS would include anything for
manufacturing/production (like for growing pot)
i. Disallowance of CGS deduction might have
constitutional implications because direct tax (not
income)
vii. If business has 2 separate purposes, and only one is legal, can still
deduct expenses for legal part under 280E
1. Californians Helping to Alleviate Medical Problems (TC
2007)
47

a. TP was caregiving organization that included


distribution of marijuana (not recognized as non-profit
under federal law)
b. Court that can deduct:
i. Expenses for caregiving portion of organization
(here, allowed almost all of it)
ii. CGS for marijuana production (big part)
4. Lobbying Expenses p. 547 (Geary)
a. Deductions for lobbying expenses effectively prohibited under 162(e) if
in connection with
i. Influencing legislation
ii. Influencing a political campaign
iii. Including grassroots lobbying (influencing general public)
1. See Geary v. Commissioner where TP police officer
deducted advertising costs to get his dummy partner on the
ballot; court said not allowed because was used in
connection with any attempt to influence the public
b. Rationale level playing field for lobbying between businesses and
individuals (who would never qualify for business deduction)
i. Could get deduction if funnel through 170, but 501(h) says
charitable organization cant be eligible if substantial part of
activities consist of lobbying
5. Travel: 162(a)(2) p. 558
a. Travel deduction allowed for traveling expenses (including amounts
expended for meals and lodging ) while away from home in pursuit of a
trade or business
i. IRS-added requirements for business travel deduction:
1. Overnight rule (involves substantial rest period like night)
2. Must be away from tax home
a. What is traveling salesman with no home? Language
implies that you have a home (2d Cir) or just means
not at home?
3. Subject to 67 2% of AGI floor
ii. Rationales
1. Excess expense rationale of 274(n) if expense is
duplicative, then excess cost and should be deductible
a. Meals possibly 50% deductible under 274(n)
i. 274(e)(3) says if ER pays for it or reimburses EE,
EE doesnt have to claim any income and ER gets
50% ded.
b. Lodging duplicative expense (still have to pay
rent/mortgage), so get deduction
iii. Longer-term travel (like visiting professor)
1. Not considered temporary if trip is more than a year
a. But if less than a year, can deduct:
i. Half of food for entire time (including using food
estimate table which is high)
48

ii. Lodging usually trade housing so not really


duplicative, but get lodging deduction anyway
b. But miscellaneous deductions, so subject to 2% AGI
floor of 67
i. Best if can bunch into one calendar year
ii. Unless incur expenses and EE reimburses them,
then can exclude reimbursement and not subject
to 67
iv. Requires business necessity for incurring living expenses in both
locations
1. Must already (currently) be in business to have a business
connection
a. Oriented toward current (not future) profit
i. So being a full-time S doesnt work
b. Unclear how substantial employment relationship
would have to be (part-time work during school year?)
2. Hantzis v. Commissioner (1st Cir. 1981) p. 561
a. TP married law student got internship for summer in NY
(school and husbands job in Boston); IRS disallowed all
business expenses
b. Court agreed no business necessity for maintaining
home in Boston (no job, just S, H doesnt count)
v. Commuting
1. But for causation problem that works both ways with
home/work
2. Limited deductions available through 132 fringe rule
a. Unfair? Should be more deduction (affects C/S)?
b. Commuting expenses vary substantially
i. Retired people with no commuting expense
ii. 2-earner v. 1-earner couples
vi. Extravagant spending not explicitly prohibited anywhere
1. 162(a)(2) disallows lavish or extravagant expenditures
under the circumstances
2. But IRS rarely/never enforces it
3. Congress could set caps on deductible spending, but they
dont
6. Entertainment: 274
a. 274(a): Requirements for deduction (even for substantiated expenses):
i. Directly related to TPs trade or business OR
1. Regs: qualifies only if could have meaningful business
conversation during entertainment
ii. Associated with business
1. Regs: not directly related because circumstances such that
couldnt have meaningful business conversation during
entertainment
a. Deductible only if directly preceded or followed by
substantial business discussion (enforceable?)
b. Specific records requirement if claiming deduction for business travel or
entertainment 274(d)
49

i. Overrules Cohan v. Commissioner, where TP didnt keep records,


paid lavishly for clients in cash, and court estimated (low)
c. Meals: 274(n)
i. Can sometimes deduct 50% of own and clients meals even if local
if qualifies as business entertainment
1. Also applies to other events (facilitates business?)
ii. Policy for allowing 50% deduction for clients meal?
1. Surrogate taxation would expect to tax 1/2 of clients
personal consumption value, but impractical, so to still collect
tax, overtax host while undertaxing guest
d. Never get business entertainment deduction for club dues: 274(a)(3)
i. Personal consumption so high that shouldnt get deduction
ii. Airline clubs?
1. Not really clubs (more like marketing device)
2. BUT treasury said included as club so no deduction
3. Unless included in price of first class ticket (which is
deductible)

50

Chapter 6: Capitalization and Cost Recovery p. 613


1. Overview
a. Last reason why something is excluded that would otherwise be
deductible
b. With long-term assets, only loss is difference between purchase price and
value at end of year (depreciation), but annual valuation is impractical
i. So need formula-based allowance that is adjusted when dispose of
asset
1. Formulas provided by 168 ACRS
2. What Is Depreciable? p. 620
a. Tangible, physical assets that are used in business, of type that is
expected to gradually decline in value as used
i. NOT land, non-inventory art and antiques (dont decline in value
over time)
1. Might depend on what do with it
2. For example, antique carpet on floor (at least in 2d/3d Cir.),
would get ACRS because wear and tear, but on wall, no
deduction
ii. Test: Is asset subject to substantial wear and tear as used in
business?
1. Not very factually dependent (allowed depreciation on
valuable musical instruments used in symphonies)
b. Intangible assets are depreciable (amortization) if have reasonably
ascertainable useful lives 167
i. Straight-line depreciation
ii. Goodwill? Depends on if can creatively ascertain useful life with
expert testimony by categorizing as other than goodwill (SCOTUSapproved)
iii. If purchase ongoing business and part of purchase includes
customer-based intangibles (goodwill, customer lists), amortizable
S-L over 15 years: 197
1. Ex: NML purchases business where 1.5M allocated to
subscriber list; spends 100,000/yr for 15 years to get new
subscribers, which just replaces them all in 15 years
(complete turnover)
a. Can amortize (1.5M, AND get advertising costs
deduction (1.5M), so deduct 3M, even though basis still
equals 1.5M
3. Calculating 168 ACRS depreciation
a. Three (four questions) necessary for formula:
i. Depreciable amount = purchase price salvage value
1. But 168 assumes salval is always 0, so depreciate entire
purchase price
ii. Depreciation (recovery) period = # of years over which will claim
depreciation deductions
1. Usually short (generous) compared to actual economic life
2. Look up in statute (by category)
iii. Depreciation rate = depends on asset (either S-L or accelerated)
51

1.
2.
3.
4.

TPs prefer accelerated because defers income recognition


Buildings S-L
Tangible personal property accelerated (schedule)
Calculating accelerated depreciation
a. Calculate S-L depreciation
b. Double it (yearly deduction of remaining basis)
c. When S-L rate is greater than doubled rate, switch to SL
5. Ex: 10,000 car; 5-yr period
a. Calculate S-L: 20%
b. Double it: 40% (yearly deduction of remaining basis)
i. Y1: 10,000x40% = 4000 ded (6000 ab)
ii. Y2: 6000x 40% = 2400 ded (3600 ab)
iii. Y3: 3600x40% = 1440 ded (2160 ab)
c. Here, S-L rate (50% because just 2 years left) is greater
than ACRS (40%), so switch
i. Y4: 2160x50% = 1080 ded (1080 ab)
ii. Y5: 1080 1080 = 0 ab
iv. Half-year convention: 168(k)
1. In first year, assume put asset into service for half the year
(whether Jan or Dec) unless literally on 1/1
a. Except for buildings, which have half-month convention
2. Can just use table in back (its included)
4. Analysis for calculating depreciation and new basis:
a. (1) Determine depreciable amount (purchase price salvage value;
usually salval = 0)
b. (2) Determine years of depreciation (see statute)
c. (3) Consult table in back to determine rate (includes half-year
convention)
d. (4) Multiply rate by depreciable amount = deduction
i. Even if not Y1, use original depreciable amount
e. (5) Adjusted basis = old basis deduction
f. (6) Repeat steps 3-5 for each year
5. Analysis for calculating gain/loss on disposition:
a. Find adjusted basis
b. Calculate gain/loss based on adj b and ar
c. Amount that gain exceeds ACRS deductions is capital gains income
(otherwise taxed as ordinary income)
i. Ex: Sell machine with 70,000 ACRS deductions for 100,000:
1. Realizes 45,000 on sale
a. Gain = 45,000 ar 30,000 ab = 15,000
b. Gain (15,000) < ACRS deductions (70,000), so ordinary
income
2. Realizes 25,000 on sale (depr slower than economic reality
unusual)
a. Loss = 25,000 ar 30,000 ab = (5000)
b. Taken against ordinary income (like ACRS would be)
3. Realizes 105,000 (didnt actually depreciate at all)
a. Gain = 105,000 ar 30,000 ab = 75,000
b. Taxed at two rates:
52

i. 70,000 (amount of ACRS) taxed as ordinary


income
ii. 5000 (in excess of ACRS) taxed as 1231 capital
gains
6. Additional generous writeoffs:
a. Even more quickly accelerated depreciations in addition to ACRS: 168(k)
temporary
i. 50% first-year deductions
ii. Applies 1/1/08 12/31/12
iii. Ex: 1M asset, 5-year
1. Y1: 1,000,000 500,000 168(k) ded = 500,000 ab
a. Also get normal ACRS: 500,000 500,000x20%
(100,000) = 400,000 ab
b. Immediate deduction rather than gradual ACRS: 179
i. Permanent tax break aimed at small businesses
ii. 2012: allowed immediate deduction up to 125,000 with 500,000
ceiling on purchase price of assets (see 179(b) for other years; not
before 2007)
1. Reduced for every dollar for which total purchase price of all
assets put into service in year exceeds ceiling
2. Ex: purchase price of 550,000
a. Claim 75,000 deduction (550 500 = 50; 125-50 = 75)
iii. 2013: reduced to 25,000 max deduction with 200,000 ceiling
c. Interaction of 168(k) and 179
i. 179 applies first, then 168(k)
ii. Ex: 325,000 asset in 2012
1. Immediate 125,000 ded (325,000 below 500,000 cap)
a. 325,000 125,000 = 200,000 ab under 179
2. Apply 168(k)
a. 200,000x50% = 100,000 ded; 200,000 100,000 =
100,000 ab
3. Apply regular ACRS
a. 100,000x20% = 20,000 ded; 100,000 20,000 =
80,000 ab
d. ACRS deduction taxed as ordinary income: 1245
i. Deduction was on ordinary income, and gain on disposition is on
ordinary income (to extent of depreciation deduction previously
taken)
e. For real estate/buildings, depreciation subject to recapture is limited to
depreciation allowed in excess of S-L method: 1250
i. So can pay tax on gain at capital gains rate instead of ordinary
income
ii. Only applies if acquired pre-1986 (could have depreciated faster
than S-L)
f. Loss treated as ordinary income as long as TPs total 1231 gains dont
exceed 1231 losses
i. If net losses, everything ordinary
ii. If net gains, taxed at capital gains rate
g. Special limitation on slower depreciation of expensive vehicles: 280F
i. Slowed down depreciation deduction for luxury vehicles
53

ii. Exempted vehicles over 3 tons (most SUVs) probably intended for
trucks for business reasons (1984), but then everybody started
buying SUVs (bad policy)
iii. Congress reduced ceiling to 25,000 to SUVs under 179(b)(6), but
still there
iv. Ex: 2013 and want either luxury sedan or heavy SUV for 60,000
1. Sedan: limited to 280F; Y1 deduction only about 3000
2. SUV: 25,000 179 + 35,000x20% ACRS (=7000) = 32,000
deduction
7. What Costs Must Be Capitalized? p. 623
a. Capitalization = spread out cost of long-term asset through depreciation
(usually prefer deductions as early as possible)
i. Tangible, physical property capitalize almost everything
ii. Intangibles separate and distinct test allows avoidance of
capitalization
b. Self-produced property: 263A (1986)
i. Anytime TP self-produces property, have to capitalize (not currently
deduct) not only obvious direct costs (EQ, wages), but also indirect
ones (depr on all facilities used to construct, all wages allocated to
it, rent and utility expense)
1. Codifies and expands Commissioner v. Idaho Power Co. (US
1974) where Court said that TP business who used own
resource (crane) to do maintenance and also create new
capital asset had to capitalize the value into basis of new
asset (more like an investment than an expense); if also use
for other repairs then apportion value accordingly
a. Ex: Crane (100,000 orig b; 168 S-L depr over 10
years); powerlines (40-year S-L ACRS recovery)
i. So 10,000/yr S-L, which is added to basis of
powerlines
ii. So 250 over 40 years (instead of 10,000 over 10
years)
2. If self-producing inventory, recover inventory costs (which
include overhead, like rent) when sell inventory
a. If sales come sporadically or are uncertain, cant
always claim deductions currently
b. Ex: M produces 1 piece of jewelry/month, has expenses
1200/mo in rent + utilities; sells 8 out of 12 last year
i. Under 263A, gets CGS deduction for 9600
(8x1200)
ii. But nothing for 4 (4800) still in inventory
(4x1200)
ii. BUT writers, artists, photographers not subject to rules and can
deduct inventory costs currently even if not sold: 263A(h)
1. Artist = general definition, then look at uniqueness and
aesthetic value over utilitarian value
2. LH says in general, people who make jewelry, furniture, or
pottery are not artists under this provision
54

3. If EEs help in prod., turns on whether could/are doing the


work yourself (disabled artist minutely supervising v. mass
producing manager)
c. INDOPCO: Taking capitalization seriously?
i. Separate and distinct intangible asset test (Lincoln Savings) if
expenditure serves to acquire, create, or enhance a separate and
distinct intangible asset, then should be capitalized (more narrow
than INDOPCO)
1. But even if so, still dont have to capitalize EE compensation
and OH costs (bc dont meet rule)
2. Overruled INDOPCO, where Court applied strict construction
for deductions using significant future benefits test (if asset
will result in future benefits, then should be capitalized) with
really broad pro-capitalization language
ii. Advertising costs generally deductible even though provide future
benefits (unless really significant future benefit): Rev. Rul. 92-80
1. IRS issued other similar rulings (EE training, repairs )
d. Repairs
i. Cost of repairs can be deducted currently, especially if only
intended to keep it working for its intended useful life and doesnt:
1. Appreciably prolong life of property,
2. Materially increase its value, OR
3. Make it adaptable to a different use
ii. Applies if can plausibly describe expenditure as a repair, even if
cost is large and there is no related casualty
1. See Rev. Rul. 2001-4 where IRS allows $2M heavy
maintenance on plane worth $15M that does not increase
value or prolong useful life
iii. Can choose to deduct casualty and capitalize or just deduct repair
1. Do lesser of basis (casualty loss) and amount of damage
(repair)
2. If take repair deduction, just deduct repairs, and same basis
3. If take casualty loss, deduct basis, capitalize repair costs, and
get new basis = cost of repairs
iv. Ex: 2M fmv and 100,000 ab; flood 500,000 repairs
1. If deduct repair, deduct 500,000 (and keep 100,000 b)
2. If take casualty loss/capitalize, get 100,000 loss (to extent of
basis), and get 500,000 capitalization of repair costs and
500,000 new b
v. No apparent justification (fails de minimus and substitute for
casualty loss)
1. Casualty losses only deductible for certain personal nonbusiness losses
e. Expenses to create or maintain a business reputation
i. If business (not personal) is primary motivation for expenses, then
deductible, even if moral considerations are secondary
1. Looks at meaning of ordinary (not weird would other
people do that?) and necessary (reputation IS business?)
55

2. If looks more like repair to already existing part of business,


more likely to get deduction (rather than starting from
scratch)
ii. See Welch v. Helvering where TP paid off old ERs debts to keep
customers as started new business even though not liable and
Court found that they were capital (and non-deductible) because
its like a long-term investment in goodwill and people dont usually
do that
1. Possibly overruled by anti-INDOPCO regulations (if not, cant
even get business deduction later)
iii. But see Jenkins v. Commissioner where Conway Twiddys restaurant
idea failed and paid back investors even though not personally
liable to protect reputation which was essential to business; court
found that deductible because business was primary motivation
(moral secondary) and necessary to avoid adverse publicity given
his industry (singer)
f. Job hunting expenses
i. Deductible if TP seeking new employment in same trade or
business (treated as current expense)
1. But unreimbursed business expense so goes to 67 with 2%
of AGI floor
2. If new trade or business, no deduction
3. Can have multiple trades or businesses
a. See Rev. Rul. 78-93 where IRS said adjunct law
professor-atty could deduct job hunting expenses to get
full-time law faculty position because found not
substantially different
i. Arbitrary (they are pretty different)?
ii. Can deduct education as business expense when: (Reg. 1.162-5)
1. Its in the nature of repair/maintenance (like CLE)
2. Already in business, making money
3. BUT if educational expenses are for degree/certificate to
qualify to enter different trade/business, have to capitalize it
(absolute rule)

56

Chapter 8: Tax Preferences, Tax Shelters, and the Alternative Minimum Tax
p. 697
1. Tax Preferences and Implicit Taxes: The Case of Municipal Bonds p. 698
a. Tax preference = any deduction or exclusion that results in TI
understating TPs true economic income (usually ACRS)
i. Usually attribute of asset (planes ACRS), but with Roth IRA, its all
tax-free because of TP attribute (earned $, age)
1. So can buy investments with no implicit tax and put into Roth
IRA and avoid all tax on interest
b. Economics of the exclusion
i. 103 says interest on municipal bonds (MB) excluded from GI
1. So if same rate as corporate bond, will buy MB (full after-tax
return)
2. So MB rate will drop (can offer cheaper), and federal
government essentially subsidizes through exclusion
a. Implicit tax = reduced pre-tax rate of return in
exchange for tax preference
3. But cant discriminate on price, so cant drop bond rate all
the way to highest bracket limit because lower brackets
wouldnt buy and may not have enough buyers in top bracket
a. Which leads to delivery efficiency
i. Federal government still gives full tax break as if
were in top bracket, but not all of the benefit
goes to state/local government (some goes to TP)
ii. Ex: Tax system with 3 brackets (30%, 20%, 10%) and $100 MB and
$100 corporate bond (CB) at 10% interest
1. If price MB at 7%, can match CB; like $3 federal subsidy
(delivery efficiency)
a. MB = 100 x 7% 0 tax = $7 after-tax return
b. CB = 100 x 10% $3 tax = $7 after-tax return
2. But if not enough TPs in top (30%) bracket, then have to raise
rate to 8% so TPs in 20% bracket will buy too (cant
discriminate), then inefficient delivery:
a. Feds still out $3 (would get $3 if bought CB and paid
tax), but only $2 goes to state/local govt and $1 goes
to TP
c. Bond = obligation of state or local government
i. Exclusion intended to benefit state, not just give windfall to TP
ii. See US Trust Co. of NY v. Anderson where court held that interest
payments from state on condemnation award are not excludable
because LH indicates wouldnt apply where there was no
bargaining or implicit tax (just windfall for TP)
d. Delivery efficiency = when federal governments revenue loss from a
subsidy ends up in the pockets of the intended beneficiary (here,
state/local government)
2. Tax Shelters
a. Tax shelter = investment that produces artificial tax losses that can be
used to eliminate tax on income from unrelated sources
i. Artificial loss money not really gone
57

ii. Unrelated source for example, use MB to shelter investments in


CB
1. Whenever Code provides tax break for particular type of
investment income (tax preference), that break can be
converted into a tax shelter IF TPs are allowed to buy taxfavored asset with borrowed money and deduct interest
expense (combine tax preference with deductibility of
interest)
iii. Congress hates because:
1. Feds dont benefit from implicit tax
2. Cant guarantee any tax because could shelter it
iv. But maybe not bad?
1. Tax shelter doesnt change size of tax preference; just shifts
to unrelated income
2. Encourages investments in tax-favored assets
3. Increased efficiency by increasing demand among topbracket TPs
b. Hypo: debt-financed shelter using municipal bonds
i. Need to buy MB with borrowed money
ii. Borrow 100 at 10% to buy MB for 100 paying 10%
1. Economic effect = 10 int. on MB 10 int exp (163) = 0 econ
gain
2. Tax results = 0 TI (103) 10 int exp = (10) artificial tax loss
3. Use (10) tax loss to offset other income
iii. BUT Congress shut down this tax shelter: 265(a)(2)
1. If borrowing money to purchase something offering taxexempt income, not deductible (need sufficient nexus)
iv. Different result with smaller TP benefit
1. Borrow 100 at 10% to buy MB for 100 paying $8
a. Econ effect: 8 int inc 10 int exp (163) = (2) pre-tax
loss
b. Tax results = 0 TI (103) 10 int exp = (10) tax loss
c. After-tax benefit to TP = $1
i. $3 total tax savings from not buying CB, but $2
economic loss goes to state/local
2. As long as tax savings is greater than economic loss, still
valuable
v. Analysis:
1. Without tax preference, what happens?
a. Tax savings?
2. Economic effect?
3. Tax effect?
c. Owner-occupied housing last great tax shelter
i. If value increases, have tax-deferred unrealized appreciation
1. Even if sell 121 excludes gain from income
2. While live in it, get tax-free imputed rental income
a. If then deduct mortgage interest, have tax shelter
(artificial loss)
ii. BUT cant take home equity loan and use to purchase MBs (265(a)
(2)) prevails
58

d. Passive loss rules of 469


i. Prohibits deducting losses from passive business activities
against either salary income (active business) or portfolio income
(not subject to 469 because not business)
1. Most important restriction on tax shelters because prohibits
168 ACRS + interest deduction combo to shelter income)
2. Very complex provision, but now people mostly avoid shelters
so actually simplified overall
a. Still a few Congress allows to continue/encourage
ii. What makes an activity active?
1. Material participation standard TPs involvement must be
regular, continuous, and substantial 469(h)(1)
a. Regs interpreted to 500 hours/year
b. If limited partner, then per se passive
c. Functions as de facto limitation on deductibility of
interest associated with passive activities
iii. Basketing approach
1. All passive activity losses that exceed passive activity gains
not further deductible against non-passive income (all
passive activities in same basket)
a. Use tracing approach with interest what did TP use
loan $ for?
b. Non-passive income includes stocks/bonds
c. Other baskets (cant cross over):
i. Portfolio investment basket of 163(d)
ii. Capital gains/losses of 1211
iii. Gambling losses of 165(d)
2. Can carry forward and use loss against future positive income
469(g)
3. Final accounting made when asset disposed of, so if losses
still there when sell, allowed then
a. But still cant use passive basket net losses to offset
any income outside the basket
b. Doesnt distinguish between real and artificial losses
until disposition
4. If TP has 2 related undertakings but only materially
participates in one, can choose whether to classify together
(as non-passive income) or separate
a. But then stuck with classification (even if bad for TP in
future)
5. Ex1: On 1/1/X1 M purchases bldg. for $2.5M; pays $500,000
cash + $2M non-recourse loan (qualified under 465(b)(6)).
Interest expense is $100,000; ACRS is $50,000; rental income
is $100,000
a. Total deductions = 100,000 int exp + 50,000 ACRS =
150,000
b. Total income = 100,000 rental inc
59

i. SO 469 limits deductions to 100,000 against


passive income
1. But can carry other 50,000 forward
(suspended)
c. New basis: 2.5M 0.05M = 2.45M ab
6. Ex2: Same facts as above, but on 1/1/X2 M sells land for
600,000 cash + 2M debt relief
a. Gain = 2.6M ar 2.45 ab = 150,000 50,000
suspended 469 loss = 100,000 gain
i. Can take suspended loss because completely
disposing of interest
iv. Now to shelter income have to find a PIG (passive-income
generator); must:
1. Qualify as a trade or business
2. Be passive
3. Be a reliable source of TI rather than tax losses
v. How it worked (pre-1986)
1. TP buys limited partnership (office bldg.); 0 down; 2M TP
share of building financed entirely by 2M n-r loan at 5%
a. Y1: 100,000 net rental income; 100,000 int exp (2M x
5%); 60,000 ACRS
i. 60,000 tax loss (artificial unless ACRS actually
accurate)
ii. No negative cash flow (rental income and interest
payments offset)
iii. So use 60,000 to offset unrelated income (like
salary)
vi. Reasons for change:
1. Loss of confidence in tax system (rich people can hide gains)
2. Average TPs bearing disproportionate burden
3. Lost federal income (or super high MTRs)
e. Judicial anti-abuse doctrines
i. CL doctrines to restrain use of aggressive tax shelter strategies
1. Congress cant keep up with all the new tax shelters, so
necessary to keep up (can work retroactively and more
profitable)
a. But rule of law concern
ii. Sham transaction doctrine never would have done it absent tax
consequences
1. Test: (Rices Toyota World)
a. Economic substance (objective)?
i. Is there a possibility of meaningful potential for
nontax economic profit on entire transaction?
1. If never benefitted economically (just tax),
then problematic
b. Business purpose (subjective)?
i. Did TP have intent to make nontax profit?
1. Inflated price? N-r loan? No residual value?
60

2. If found to be a sham, can be taxed on substance, ignoring


parties labels
3. Need both prongs, but always go together (77.01.0 2010)
iii. See Rices Toyota World where D purchased computer through F
and elaborate seller-financed n-r loan and inflated value and court
found prohibited under sham doctrine
iv. See Knetsch v. US where Court introduced sham and economic
substance doctrines where TP bought annuity payable starting in
30 years and then borrowed against inside buildup (so never really
worth anything) but deducted interest paid anyway (just deferral);
would be prevented by 3 anti-shelter provisions today
f. Post-1986 tax shelters
i. Overview
1. Generally for large corporations or extremely wealthy
individuals
2. TP argument: apply code literally, regardless of
consequences (find something that mismeasures economic
income)
3. IRS argument: apply sham transaction test and ignore literal
language if would produce unreasonable results not
contemplated by Congress
ii. Typical post-1986 shelter
1. Not shut down by 469 because not like debt-financed
shelters 469 addressed, and not really business activities so
cant be passive, so have to win under sham transaction
doctrine
iii. Sometimes IRS wins:
1. ACM Partnership (3d Cir. 1998)
a. C, ML, and ABN for team that buys 180M in Ds debt
securities and immediately sells for 140M in cash and
40M in notes, resulting in 110 artificial gain (which ABN
takes because is foreign and can avoid it) in Y1 and
then 110 loss in later years, but changes partnership so
D is majority partner and gets losses to offset capital
gains
b. Court found prohibited under sham doctrine
iv. Sometimes IRS loses:
1. See IES Industries v. US where TP engaged in complicated
foreign tax credit transaction used as tax shelter and 8th Cir.
applied economic substance and business purpose test and
said just good business sense and technically works
v. Tax shelters mostly gone now why?
1. Justice department started prosecuting some tax shelter
promoters
2. IRS started winning almost every time by 2005, so TPs would
settle with IRS and then sue law and accounting firms
promoting shelters
3. Reporting rules of 2003
3. Alternative Minimum Tax p. 743
61

a. Shadow tax system of regular tax


i. Large exemption amount
1. AMTI = base (broader than regular tax)
2. Disallows many exclusions and deductions (like MBs, ACRS,
personal exemptions)
ii. Moderate rate, semi-flat tax
1. Exemption amount, then rate rises to 26%, then to 28%
2. Patch: raises exemption amount from 45,000 to
74,450/48,450 until end of year
iii. TP pays tax on larger of AMTI or regular TI under respective rates
1. Ex: TP with 200,000 regular TI at flat rate of 35% = 70,000
tax
a. But if has 100,000 AMTI-only items, then has 300,000
AMTI at 25% = 75,000 tentative minimum tax
b. AMTI is larger, so have to pay that
i. Technically, pay 70,000 regular tax + 5000 AMT
excess over regular tax, but same result as just
paying entire AMT
b. Usually paid by TPs with large amounts of tax preferences, but over time
has shifted to upper middle income rather than truly rich
i. Not adjusted for inflation (so upper middle income arriving), but
super-rich have money in capital gains, investments, charitable
giving (not AMT preferences)
ii. Why?
1. 1986 Act broadened regular tax base (more people in it)
2. Some common deductions now AMTI preference items
a. Children (no family size adjustments)
i. Upheld by 10th Cir. in Klaassen where court said
AMT applied to family with 10 kids under plain
language of statute and only Congress can
change it; doesnt violate FEC (anti-conception)
because furthers compelling government interest
and no DP/EP violation because passes rational
basis
b. State/local taxes (so worse in high-tax states)
c. Interest on home equity indebtedness (acquisition debt
still ded.)
d. Miscellaneous itemized deductions under 67
3. Bush tax cuts lowered regular tax base, but AMT stayed
flat/rose slightly
a. Eventually cross over and have to pay up to AMT
amount
iii. Ex: Married couple with 200,000 AGI; itemized deductions: 25,000
state/local taxes and 5000 2nd mortgage; 3 kids
1. Regular tax liability:
a. 200,000 AGI 19,000 personal exemptions (3800 x 5
people) 30,000 itemized ded = 151,000 TI
b. Total tax liability = 30,059 if MTR = 28% (just barely
over limit)
2. AMT tax liability (no itemized ded or personal exemptions)
62

a. With patch:
i. 200,000 78,750 = 121,250 x 26% = 31,525
1. Technically, 30,059 regular tax + 1466 AMT
2. Base smaller than regular base, but AMT
rate is higher than regular blended rate
b. Without patch:
i. 200,000 45,000 = 155,000 x 26% = 40,300
1. Pay 30,059 regular tax + 10,241 AMT
c. AMT and its discontents
i. Amt was intended to make sure rich people paid their share of
taxes
ii. But because not indexed for inflation (and Bush tax cuts) means
more and more people being affected
1. Especially if Bush tax cuts extended

63

Chapter 9: Taxation of the Family p. 757


1. Tax Allowances for Child Care p. 757
a. Allowances for child care expenses based on expenditures
i. 21 child care credit
1. Credit for limited amount of child care expenditures
2. Credit = % of TPs child care expenses incurred to enable TP
to be gainfully employed
a. Works if TP is full-time S, too
b. Credit does not apply to tuition expenses after child
enters K (primarily for education, not child care) but
after school care could apply
3. Capped at 3000 (1 qualifying individual) or 6000 (2 QIs)
a. Qualifying individual usually child under 13
4. If AGI = 15,000 or less, credit is 35% of credit-eligible
expenses
a. Rate reduced by 1% for each 2000 by which AGI
exceeds 15,000
i. But never below 20% (which hits at 43,001 AGI)
b. Calculations: (only if AGI < 43,001)
i. AGI 15,000 = amount exceeding 15,000
ii. Divide that by 2000 = % to reduce credit by
iii. 35 that (%) = credit % (cant go under 20%)
5. Ex: 20,000 in child care expenses, 1 child, AGI over 43,001
a. 3000 x 20% = 600 credit
b. Much less than expenses deduction because of cap
(3000) and limited credit rate (usually 20%)
6. Rationale: acts as subsidy for working parents
ii. 129 dependent care assistance exclusion
1. Exclusion of benefits received from ER pursuant to a
dependent care assistance program (DCAP)
a. Usually for cash reimbursements (or on-site ER
program)
b. Capped at 5000
c. ER reduces EEs salary by amount requested, then pull
out of fund throughout year to reimburse (lots of
hoops)
i. If excluded from income under 129, also
excluded from payroll tax
d. If use exclusion of income under 129, cant use for 21
for same dollars 129(e)(7)
i. Cant take 129 5000 exclusion and then 21
3000 credit
1. 21 reduced dollar for dollar by any 129
exclusion 21(c)
ii. But can combine with 2 kids (bc 21 credit =
6000)
1. Ex1: TP with 15,000 of work-related child
care expenses; AGI = 60,000; MTR = 25%
a. 21: 6000 x 20% = 1200 tax savings
64

b. 129: 5000 (excl) x 25% MTR = 1250


tax sav
i. Take last 1000 of 21:
1000x20% = 200 tax savings
ii. Payroll taxes also excluded:
5000x7.65% = 382.50 tax
savings
iii. Total tax savings = 1832.50
2. Ex2: Same as above but 1 kid and 9000
expenses
a. 21: 3000x20% = 600 tax savings
b. 129: 5000x25% = 1250 tax savings
e. Exclusion, so operates at MTR (which is usually higher
than 21 credit rate)
2. Policy? Weird to have 2 options, with 1 only through ERs
(expensive to administer)
b. Child tax benefits not based on expenditures (just that TP has dependent
children)
i. Dependency exemption: 151
1. Helps adjust tax liabilities for families of different sizes
2. Adjusted for inflation; functions like a deduction
3. Tax savings = exemption x MTR
4. Phased out for upper income TPs beginning at AGI of 150,000
joint until 272, 501 totally gone (scheduled to come back
2013) 151(d)(3)
ii. Child credit: 24
1. Value is independent of TPs MTR
2. Multiply 1000 by # of TPs qualifying children (under 17)
3. Refundable to 15% of amount by which EI exceeds 10,000
(adjusted for inflation)
a. Calculation:
i. AGI 10,000 = excess over threshold
ii. Excess x 15% = refundable portion
iii. But only refundable up to total credit allowed
(after add in non-refundable part)
b. Ex: TP with 18,000 AGI; 2 kids; pre-credit IT liability =
600
i. 1000 x 2 = 2000 available credit
ii. Limited by 600 tax liability, but partly refundable
1. 18,000 10,000 = 8000 AGI above
threshold
2. 8000 x 15% = 1200 refundable portion
iii. So get 600 non-refundable and 1200 refundable
1. Only lose last 200 of available credit
4. Very middle-income focused
a. Phased out for higher-income TPs (not adjusted for
inflation)
i. P/o begins at 110,000 joint and 75,000 unmarried
1. All phaseouts are hidden increases in MTR
65

ii. For every 1000 that AGI exceeds threshold, lose


50: 24(g)
1. Calculation:
a. 1000 x # of qualifying children
b. Excess of AGI over threshold/1000 =
p/o units
c. P/o units x 50 = $ reduction in credit
i. Total reduction (not per child
reduction)
d. Credit from (1) - $ reduction = credit
2. Ex: 118,000 AGI with 2 kids
a. 2000 credit, but 8000 over threshold
b. 8000/1000 = 8 p/o units
c. 8 units x 50 = 400 reduction in credit
d. 2000 400 = 1600 credit
b. Low-income TPs dont have enough income to get
much of it (mostly non-refundable) see example
above
iii. Head-of-household status benefits
1. HoH = single parent with one or more dependent children
a. Substantially larger standard deduction
b. 1 rate schedule with wider bracket
iv. EITC (Earned Income Tax Credit): 32 p. 791
1. Goal: increase after-tax incomes of low wage workers with
family responsibilities
2. Fully refundable
3. Need to know:
a. Number of qualifying children (QC)
b. Age have to be between 25 and 64
c. Income (for single parents different for married
couples)
i. 1 QC
1. Serves as family-responsibility adjustment
to minimum wage; no wage requirement
2. Phase-in stops at 9820 (so 34% increase for
max EITC = 3169)
a. Negative tax (government pays you)
3. Plateaus until phase-out starts at 17,090
a. Take excess over this threshold x
15.98% to get reduction in max
credit
4. P/o ends at 36,920 (15.98% credit
reduction/$ earned)
a. Positive tax (in effect increase in
MTR)
ii. 2 QC
1. Special rule expiring this month extending
to 3+ kids at 45%
2. Phase-in stops at 13,090 (40% credit
increase for max EITC = 5236)
66

a. Negative tax
3. Plateaus until p/o starts at 17,090
a. Take excess over this threshold x
21.06% to get reduction in max
credit
4. P/o ends at 41,952 for 2+ kids (21.06%
reduction/dollar earned)
a. Positive tax (in effect increase in
MTR)
iii. No-child TPs: small credit
1. Functions as rebate of payroll tax on first
6070 of earned income
2. Phased out at AGI of 13,660
v. Ex all credits: single parent with 2 kids with EI of 25,000
1. Tax liability:
a. Pre-credit tax = 25,000 8700 HoH standard ded
11,400 (3 personal exemptions) = 4900 TI x 10% 1(b)
rate = $490
2. 24 child tax credit
a. 1000 x 2 = 2000 available tax
b. 490 non-refundable part takes tax liability to 0
c. Refundable part?
i. 25,000 3000 threshold (earlier number?) =
22,000x15% = 3300 ceiling on refundability
1. 2000 max credit 490 already got = 1510
refundable remainder of 24
2. < 3300 ceiling so get entire 1510
refundable
3. EITC:
a. 25,000 17,090 p/o threshold = 7910 excess of
threshold
i. 7920 x 21.06% reduction = 1666 reduction
ii. 5236 max credit 1666 reduction = 3570 EITC
credit
4. 1510 24 refundable credit + 3570 refundable EITC = 5080
refundable credits (check from government)
2. Income Tax Treatment of Marriage p. 767
a. Current law
i. In two lowest brackets, marriage bracket is double single bracket
(pro-marriage; like single penalty)
ii. In middle brackets, single bracket more than half marriage bracket
1. Could produce Boyter marriage penalty (1969 system)
2. Could also produce marriage bonuses
iii. In top brackets, single and marriage brackets are the same (big
marriage penalty)
b. Historical development
i. Pre-1949 marriage didnt matter; tax assessed individually
1. Earned income must be taxed to the earner
67

ii.

iii.
iv.

v.

c. Cant
i.

ii.

a. See Lucas v. Earl (US 1930) where Court said H couldnt


shift to W through contract when earned it himself
i. Fruit must be attributed to the tree on which it
grew
2. But if lived in community property state than W legally
owned half
a. See Poe v. Seaborn (US 1930) where Court looked to
WA state law to determine Ws ownership of property;
because it was community property state, could split
income between them
In 1949 Congress made income-splitting automatic under 1(a)
with joint returns (states had changed property laws to get under
Poe v. Seaborn)
1. H&W combined income on one return, subject to tax rate
schedule twice as wide as that applicable to unmarried TPs
Then singles got upset (married co-workers paying way less tax
with spouse acting as human tax shelter with non-taxable imputed
income)
So in 1969 Congress gave singles slightly wider brackets but not up
to married level; for example
Married 1(a)
Single 1(c)
Post-1969
Single
10% 0 80,000
0 40,000
0 50,000
30% > 80,000
> 40,000
> 50,000
Created incentive to not be married if income fell in between the
two (e.g. each made 50,000 so in 10% bracket but if married last
20,000 taxed at 30%)
1. See Boyter where H and W divorced overseas at end of each
of 2 years and remarried early following year to file separate
unmarried returns; divorces questionable under MD law
a. Court applied sham transaction doctrine (compared
personal to business behavior; Rev Rul 76-255) no
substance
b. Remanded for factual finding on if divorces/remarriages
were actually shams
please everyone:
Three policy objectives
1. Progressive MTR
a. BUT could have all 3 with progressive rate if had
system with flat tax on all income + demogrant where
govt gives you $ for existing
2. Couples neutrality (all couples with same combined income
should have same tax liability)
3. Marriage neutrality (marriage shouldnt change tax liability if
income stays constant)
But circular with interests of 3 groups
1. Single people, one-earner couples, two-earner married
couples
2. Start with 1948-style joint returns
a. Single TPs complain
68

b. 1969 reform broadening single bracket relative to 2earner married couples


c. 2-earner married couples complain (marriage penalty)

d. Congress says can choose to file separately or jointly


e. 1-earner married couples complain because filing
separately doesnt help (homemaker penalty)
f. Go back to 1948 system(start over)??
iii. Joint return system pushes stay-at-home spouse with nontaxable
imputed income out of job market because of stacking effect
d. California domestic partnerships get ideal situation under private letter
ruling
i. Same-sex couples get domestic partnership under state law but not
recognized federally under DOMA
1. If one partner earns 100,000 and the other 0:
a. Under Poe v. Seaborn, because community income, can
split 50/50, but can file separately under federal 1(c)
so all taxed at 10% (only time this works)
3. Income Tax Consequences of Divorce p. 778
a. Alimony = Cash payment from one former spouse to another
i. Must cease upon death of spouse
ii. Must be cash
iii. Must be for spouses use (not child support)
iv. Must not live in same household (even if divorced) 71(b)(1)(C)
b. Income-shifting:
i. Alimony taxable to payee under 71(a)
ii. Alimony deductible by payor under 215(a)
1. Above-the-line deduction (62(a)(10))
iii. If payee in lower tax bracket, income-shifting can be good for both
(bargain to split tax savings):
1. TPs can opt out (not call it alimony) under 71(b)(1)(B) good
idea?
2. But income-shifting is self-limiting when hit limits of brackets
and lose benefits (max benefit in low 5-figure range so
doesnt work for really rich people)
3. Ex: Agree to 7000 payment (cost to H and benefit to W)
a. BUT if H in 30% bracket and W in 20% bracket, there is
range of payments in between that costs H less than
7000 and benefits W more than 7000:
i. H: 9000 2700 deduction = 6300 after-tax cost
ii. W: 9000 1800 deduction = 7200 after-tax
benefit
iv. Departure from rule that income be taxed to the earner
1. Alimony transfer involuntary
2. Payee has unfettered discretion in how to spend it
c. Alimony v. child support
i. Only allowed for money that goes to SPOUSE (not support of kids or
settling claims of marital property rights) - 71(c)
69

1. Spouse child resides with most of year gets dependency


exemption 152(c)(4)(B)
a. Can waive it (if other parent would get bigger tax
savings) 152(e)(2)
b. But can be hard to calculate, with 151(d)(3) personal
exemption p/o see pg. 2-3
c. And 24(c)(1) child tax credit goes to parent who gets
exemption (and also phased out)
ii. Money designated as alimony generally deductible, and if
designated as child support not deductible
1. Unless alimony reduced on a contingency specifically
relating to the child (like her 19th birthday)
2. Or unless reduced within 6 mos. of 18 (or local age of
majority)
3. Or unless multiple kids and reduced when each kid reaches
same age
4. BUT if just name a date without naming child that doesnt fall
under above exceptions, works (like on this date, which
happens to be 19th birthday)
d. Alimony v. property settlement
i. Payments must be cash to qualify as alimony - 71(b)(1)
ii. But cant be alimony if payor spouse would be required to make
payments after death of payee spouse - 71(b)(1)(D)
1. If triggered (K doesnt end at death), changes payments
while alive too
a. So atty should make sure to include that clause
(sometimes assumed by state law)
e. Alimony recapture rules - 71(f)
i. Alimony expected to be long-term, so if dont last or too frontloaded, not alimony
ii. H gets deferral, but W has negative deferral with more income in
Y1/Y2, and maybe cant use later ded if not enough off-setting
income in Y3
1. Might be a good idea to opt out here and can opt out
partially
2. Maximum payments that wont trigger this rule (if x is
payment in Y1) = Y1 = x; Y2 = x 7500; Y3 = x 22,500
iii. 71(f) calculates how much excess alimony was paid in earlier
years (with benefit of hindsight), and then makes adjustment in Y3
1. Two steps: (sum = total excess alimony payments)
a. (f)(4): Y2 payment (Y3 payment + 15,000) = Y2
excess
b. (f)(3): Y1 payment (((Y2 Y2 excess) + Y3)/2) +
15,000) = Y1 excess
2. Ex: Y1 = 80,000; Y2 = 40,000; Y3 = 10,000
a. (f)(4): 40,000 (10,000 + 15,000) = 15,000 Y2 excess
b. (f)(3): 80,000 (((40,000 15,000) + 10,000)/2) +
15,000) = 47,500 Y1 excess
c. Total excess = 47,500 + 15,000 = 62,500
f. Transfers of property between spouses and former spouses: 1041
70

i. No gain or loss is recognized on transfer of property to ones


spouse or former spouse if transfer is incident to divorce
1. Transferee spouse gets basis = transferors adjusted basis
(and transferor recognizes no gain/loss) - 1041(b)(2)
2. Can be cash
3. So if want to transfer property in a prenup, include that
transfer wont happen until after the marriage (formalistic)
ii. Even if transfers loss property, retains Hs adjusted basis
1. Ex: H transfers stock (100,000 fmv; 150,000 ab); W later
sells for 120,000
a. No tax consequences for H
b. W get 30,000 loss (not bifurcated)
iii. So if H wants to transfer stock worth 1M (200,000 b) to W instead
of 1M in cash, W should ask for a little more
1. Will have to pay capital gains tax on 800,000(ish) gain when
sell (=120,000)
2. But gets deferred income and capital gains rate
iv.

71

Chapter 10: Identifying the Proper Taxpayer p. 839


1. Overview
a. Principle income taxed to person with strongest connection with, or
control over, the source of the income
i. With labor income, thats always the earner
ii. With property, can gift it and give someone else control
b. Progressive MTRs incentivize wanting to shift income to TP in lower
bracket
i. Usually closely-related parties concerned with amount of tax, not ID
of TP
2. Earned Income p. 840
a. Rule: Income is taxed to the earner (Lucas v. Earl)
i. But specifically dealing with related parties/family members, not
non-arms-length, family-type relationships excluded from rule
(progressive MTR not threatened)
1. I.e. associate doesnt have to pay tax on what firm earns
from input; just pays on salary
b. Exploring limits of the doctrine: Case of contingent attorneys fees
i. TP cant exclude income by assigning it to another party (like
contingent attorneys fees)
1. Anticipatory assignment doctrine: prevent TPs from avoiding
taxation through arrangements devised to prevent income
when paid from vesting even for a second in earner
2. Assignor retains dominion over income-generating asset
(controls source and can dispose of it to his satisfaction)
a. Doesnt matter if contingent and amount uncertain
b. Principal-agent relationship means client retains control
3. May be deductible, but not excludable (less TP-friendly)
4. Illogical place to apply Lucas v. Earl arms-length
transaction, not like assignment of income
a. Congress passed 62(a)(20) dont have to include
settlement for discrimination in GI (but not retroactive)
i. And still doesnt reach party whose damages are
not for physical injury (already excluded) or
unlawful discrimination
ii. See Banks/Banaitis where Court applied Lucas v. Earl to say
contingent attorneys fees not excludable (so both client and
attorney have to include them, and maybe can deduct)
1. 9M settlement, including 4M attys fee
a. Taxed on 9M and 4M is 67 itemized deduction
b. So 4M reduced by 2% x 9M = 0.18M; 4M 0.18M =
3.82M deduction
c. 9M AGI 3.82M deduction = 5.18M TI
2. Even worse with AMT, which doesnt allow the 67 deduction
a. 9M x 28% = 2.52M tax liability
b. Over 700,000 increase in tax liability
3. Income From Property p. 853
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a. Can shift tax liability to lower bracket through property transfers


(fundamentally different rule)
b. Unrealized appreciation in gifted property income shifting ok
i. Donor not taxed on appreciation at time of gift
ii. Donee takes property with transferred basis of donor, so when sells
entire appreciation taxed at donees rate (shifting income)
iii. See Taft v. Bowers where A transferred stock to B and Court said B
inherited As basis (not fmv)
c. Income streams from income-producing property
i. TP can shift tax liability on future investment stream by making gift
of income-producing property
1. Rule income taxed to owner of property
ii. If retain reversionary interest (just give limited property right),
original owner may still be owner just gifted a carve-out
1. See Helvering v. Horst where F gave S that years interest
coupon and S cashed it in, but F retained book and court said
F still owner so taxed to him
2. Grantor trust rules explain at what point have given away
enough that income shifts (trusts allow people to give away
money and retain some control)
a. Grantor who retains reversion in property (like retaining
principal of bond) transferred to a trust will be taxed on
income from that property during term of trust UNLESS
reversion worth no more than 5% of value of property
at time of transfer 673
i. See present value table p. 20 almost never
works
b. IRS applies by analogy to transfers outside of trust
iii. Self-produced property (created by own labor)
1. Gifts of TP-created income-producing property effecting in
transferring tax liability to donee
a. Only applies to items that are ordinarily considered
property for non-tax purposes (house, patent, copyright
work, but not K)
iv. Kiddie tax 1(g)
1. Investment income of child under 18 taxed to child at
parents MTR
a. If divorced, parent with highest MTR
2. Doesnt apply to labor income
3. Applies to adult child if childs earned income is less than half
of childs support AND either (basically, if parents can claim
dependency exemption):
a. (1) hasnt reached 19 by end of year OR
b. (2) is full-time student and hasnt reached 24
4. But could shift through grandparents if have higher MTR than
parents
v. Interest-free gift loans and 7872
1. Gift loan = loan bearing below-market rate of interest and
forgone interest is in the nature of a gift
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2. Creates deemed interest payment from borrower to lender


equal to difference between interest at applicable federal
rate (AFR) and actual interest charged (often 0)
3. Calculations to identify amount of forgone interest (amount
of gift)
a. Principal amount x AFR
4. Ex: Ps gift to D of 500,000 (0 interest), which D invests at 5%
a. If AFR is 5%, then 7872 creates deemed interest
payment of 25,000 (500,000 x 5%) from D to Ps
i. Taxable to Ps (just like paying investing
themselves)
ii. Deductible by D (so loses benefit of investment)
Chapter 12: Capital Gains and Losses p. 889
1. Makes realization doctrine even more favorable to TPs
a. TP controls timing
b. AND substantially lower capital gains rate (15%)
2. Long-term capital gain is gain on sale of a capital asset
a. Investment must have holding period of more than a year
b. Capital assets are any asset unless specifically excluded 1221
i. Includes investment-type assets (real estate, stocks/bonds,
collectibles/art/antiques)
ii. Cant be labor or inventory (and so on)
1. Ex: TP owns land (0 b, 1M fmv) and wants to sell:
a. If sells to developer for 1M:
i. 1M ar 0 b = 1M gain x 15% rate = 150,000 tax
ii. 1M 150,000 = 850,000 after-tax gain
b. If develops himself and sells lots for 1.2M net ar:
i. Changed character of asset, and no longer capital
ii. 1.2M ar 0 b = 1.2M gain x 35% = 420,000 tax
iii. 1.2M 420,000 = 780,000 after-tax gain
c. Lost 70,000 in income even though increased fmv by
200,000 by changing nature of asset
i. Extra 200,000 x 35% = 70,000 (addl tax)
ii. Original profit also converted to ordinary income
1. 1Mx(35%-15%) = 200,000 addl tax bad
iii. Major cliff effect
3. Mechanics of calculating capital gains
a. Figure out holding period of assets (long or short) 1223(1)
i. Long-term = more than a year
1. Includes prior owners holding period if transaction to acquire
it deferred recognition of gain or loss (can combine),
including:
a. Transfer: inter vivos gift/inheritance, marital property
settlement
b. Exchange: 1031 like-kind exchange, 1033 involuntary
conversion
b. Sort into 4 groups of long/short and gain/loss
i. LTCG & LTCL
ii. STCG & STCL
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c. Net four groups against each other 1222


i. Long-term gains (LTCG) netted against long-term losses (LTCL)
ii. Short-term gains (STCG) netted against short-term losses (STCL)
iii. Results:
1. If both losses OR both gains, then TP has that amount of each
type of net gain or loss
a. Short-term gains taxed at ordinary income
2. If one gain and one loss, net against each other and taxed
according to winner
a. So practically, to get favorable treatment, long-term
capital gains have to exceed both long-term capital
losses and net short-term capital losses
3. Big changes at margins (where tax planning should happen)
iv. Ex1: 9000 LTCG, 0 LTCL, 2000 STCG, 4000 STCL
1. 9000 LTCG; 0 LTCL = 9000 LTCG
2. 2000 STCG 4000 STCL = (2000) STCL
3. Different signs, so net again 7000 LTCG (taxed at 15%)
v. Ex2: Same as above, but change to 5000 STCG
1. 9000 LTCG; 0 LTCL = 9000 LTCG
2. 5000 STCG; (4000) STCL = 1000 STCG
3. Same sign, so 9000 LTCG taxed at 15% and 1000 STCG taxed
as ordinary income
a. So even though 3000 more STCG, 2000 of it taxed as
LTCG (because at margin)
4. Several capital gains rates
a. 15% usual rate
b. 28% rate for:
i. Collectibles gain (art/antiques)
c. 25% rate for:
i. Unrecaptured 1250 gains (gain on sale of depreciable real
estate bldgs)
d. Also depends on TPs MTR if below 25% (15% or 10% brackets)
i. Then rate is 0 (like being exempt)
e. Date of realization (if after 12/31/12)
5. Best policy rationale lock-in and Laffer curve
a. See curve p. 893
b. As tax rate increases from 0, revenue increases from 0, until peaks where
revenues are maximized, and then investment is disincentivized and falls
until revenue back to 0 when rate = 100%
i. X% is rate at which can maximize revenue
1. Still on rising side of it dont want to max it out
ii. X changes depending on what youre taxing
1. Labor income max is probably above 70% (because
alternative of not working isnt that attractive)
2. But investment income is much lower (because can just hold
asset and leave value unrealized to avoid tax)
a. If need cash, can borrow against unrealized
appreciation and not be taxed
b. 35% rate may be on the right (disincentivized) part of
the curve
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3. May want to be on right side of max if WANT to discourage


activity and revenue is a secondary concern

76